UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2006

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 1-10777

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

Delaware	13-3621676
(State of incorporation)	(I.R.S. employer identification no.)
One State Street Plaza New York, New York	10004
(Address of principal executive offices)	(Zip code)

(212) 668-0340

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act: (Check one):

Large accelerated filer  x         Accelerated filer  ¨        Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):    Yes  ¨    No  x

As of May 5, 2006, 105,720,816 shares of Common Stock, par value $0.01 per share, (net of 3,472,280 treasury shares) of the Registrant were outstanding.

Ambac Financial Group, Inc. and Subsidiaries

INDEX

		PAGE
PART I FINANCIAL INFORMATION
Item 1.	Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
	Consolidated Balance Sheets – March 31, 2006 (unaudited) and December 31, 2005	3
	Consolidated Statements of Operations (unaudited) – three months ended March 31, 2006 and 2005	4
	Consolidated Statements of Stockholders’ Equity (unaudited) – three months ended March 31, 2006 and 2005	5
	Consolidated Statements of Cash Flows (unaudited) – three months ended March 31, 2006 and 2005	6
	Notes to Unaudited Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	47
Item 4.	Controls and Procedures	50
PART II OTHER INFORMATION
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	51
Item 6.	Exhibits	52
SIGNATURES		53
INDEX TO EXHIBITS		54

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

March 31, 2006 and December 31, 2005

(Dollars in Thousands)

	March 31, 2006			December 31, 2005
	(unaudited)
Assets
Investments:
Fixed income securities, at fair value (amortized cost of $15,612,105 in 2006 and $14,781,028 in 2005)	$	15,811,299		$	15,124,016
Fixed income securities pledged as collateral, at fair value (amortized cost of $421,915 in 2006 and $378,480 in 2005)		412,659			371,160
Short-term investments, at cost (approximates fair value)		203,891			472,034
Other (cost of $13,561 in 2006 and $13,537 in 2005)		14,442			14,173
Total investments		16,442,291			15,981,383
Cash		26,497			28,295
Securities purchased under agreements to resell		306,000			419,000
Receivable for securities sold		23,295			2,161
Investment income due and accrued		150,362			178,779
Reinsurance recoverable on paid and unpaid losses		5,327			3,730
Prepaid reinsurance		281,835			303,383
Deferred acquisition costs		215,436			202,195
Loans		1,321,016			1,344,140
Derivative assets		862,674			1,101,948
Other assets		101,649			160,126
Total assets	$	19,736,382		$	19,725,140
Liabilities and Stockholders’ Equity
Liabilities:
Unearned premiums	$	2,966,959		$	2,954,718
Loss and loss expense reserve		298,160			304,139
Ceded reinsurance balances payable		15,737			23,746
Obligations under investment and payment agreements		7,026,570			7,056,222
Obligations under investment repurchase agreements		173,800			196,568
Securities sold under agreement to repurchase		39,000			—
Deferred income taxes		206,659			257,987
Current income taxes		82,704			16,726
Long-term debt		2,282,187			2,233,582
Accrued interest payable		88,550			108,195
Derivative liabilities		699,974			935,440
Other liabilities		211,199			253,969
Payable for securities purchased		169,996			11,641
Total liabilities		14,261,495			14,352,933
Stockholders’ equity:
Preferred stock		—			—
Common stock		1,092			1,092
Additional paid-in capital		739,664			723,680
Accumulated other comprehensive income		117,205			202,312
Retained earnings		4,864,748			4,692,701
Common stock held in treasury at cost		(247,822	)		(247,578	)
Total stockholders’ equity		5,474,887			5,372,207
Total liabilities and stockholders’ equity	$	19,736,382		$	19,725,140

See accompanying Notes to Unaudited Consolidated Financial Statements

3

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

For the Three Months Ended March 31, 2006 and 2005

(Dollars in Thousands Except Share Data)

	Three Months Ended March 31,
	2006			2005
Revenues:
Financial Guarantee:
Gross premiums written	$	219,007		$	229,126
Ceded premiums written		8,757			26,627
Net premiums written	$	227,764		$	255,753
Net premiums earned	$	194,180		$	199,634
Other credit enhancement fees		14,188			12,067
Net premiums earned and other credit enhancement fees		208,368			211,701
Net investment income		113,955			102,008
Net realized investment (losses) gains		(379	)		2,021
Net mark-to-market gains on credit derivative contracts		1,953			5,266
Other income		29,454			2,385
Financial Services:
Interest from investment and payment agreements		81,935			57,681
Derivative products		4,686			8,065
Net realized investment gains (losses)		5,503			(155	)
Net mark-to-market gains on total return swap contracts		5,223			748
Net mark-to-market gains on non-trading derivatives		244			691
Corporate:
Net investment income		3,000			409
Net realized investment losses		—			—
Total revenues		453,942			390,820
Expenses:
Financial Guarantee:
Loss and loss expenses		127			23,472
Underwriting and operating expenses		37,896			33,403
Interest expense on variable interest entity notes		12,623			11,579
Financial Services:
Interest from investment and payment agreements		74,965			50,780
Other expenses		3,572			3,819
Interest		19,475			13,513
Corporate		3,643			2,282
Total expenses		152,301			138,848
Income before income taxes		301,641			251,972
Provision for income taxes		80,501			66,429
Net income	$	221,140		$	185,543
Net income per share	$	2.08		$	1.68
Net income per diluted share	$	2.06		$	1.66
Weighted average number of common shares outstanding:
Basic		106,438,758			110,191,422
Diluted		107,430,787			111,772,811

See accompanying Notes to Unaudited Consolidated Financial Statements

4

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

For The Periods Ended March 31, 2006 and 2005

(Dollars in Thousands)

	2006						2005
Retained Earnings:
Balance at January 1	$	4,692,701					$	4,032,089
Net income		221,140		$	221,140			185,543		$	185,543
Dividends declared - common stock		(15,867	)					(13,616	)
Exercise of stock options		(33,226	)					(157	)
Balance at March 31	$	4,864,748					$	4,203,859
Accumulated Other Comprehensive Income:
Balance at January 1	$	202,312					$	296,814
Unrealized losses on securities, ($141,225) and
($134,405), pre-tax in 2006 and 2005, respectively(1)					(88,263	)					(90,540	)
Gain on derivative hedges, $3,952 and $1,499 pre-tax in 2006 and 2005, respectively					2,208						1,083
Foreign currency translation gain (loss)					948						(1,145	)
Other comprehensive loss		(85,107	)		(85,107	)		(90,602	)		(90,602	)
Comprehensive income				$	136,033					$	94,941
Balance at March 31	$	117,205					$	206,212
Preferred Stock:
Balance at January 1 and March 31	$	—					$	—
Common Stock:
Balance at January 1	$	1,092					$	1,089
Issuance of stock		—						—
Balance at March 31	$	1,092					$	1,089
Additional Paid-in Capital:
Balance at January 1	$	723,680					$	694,465
Stock-based compensation		7,566						7,613
Excess tax benefit related to share-based compensation		8,418						600
Capital issuance costs		—						(1,177	)
Issuance of stock		—						908
Balance at March 31	$	739,664					$	702,409
Common Stock Held in Treasury at Cost:
Balance at January 1		($247,578	)				$	—
Cost of shares acquired		(42,823	)					(721	)
Shares issued under equity plans		42,579						380
Balance at March 31		($247,822	)					($341	)
Total Stockholders’ Equity at March 31	$	5,474,887					$	5,113,228
(1)      Disclosure of reclassification amount:
Unrealized holding losses arising during period		($88,598	)					($89,180	)
Less: reclassification adjustment for net (losses) gains included in net income		(335	)					1,360
Net unrealized losses on securities		($88,263	)					($90,540	)

See accompanying Notes to Unaudited Consolidated Financial Statements

5

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

For The Years Ended March 31, 2006 and 2005

(Dollars in Thousands)

	Three Months Ended March 31,
	2006			2005
Cash flows from operating activities:
Net income	$	221,140		$	185,543
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		675			648
Amortization of bond premium and discount		(53	)		46
Share-based compensation		8,405			7,613
Current income taxes		65,978			50,499
Deferred income taxes		165			14,654
Deferred acquisition costs		(12,292	)		(16,877	)
Unearned premiums, net		33,789			55,794
Loss and loss expenses		(7,576	)		(812	)
Ceded reinsurance balances payable		(8,009	)		(4,555	)
Investment income due and accrued		28,417			23,575
Accrued interest payable		(19,645	)		(15,669	)
Net realized investment gains		(5,124	)		(1,866	)
Other, net		364			(11,404	)
Net cash provided by operating activities		306,234			287,189
Cash flows from investing activities:
Proceeds from sales of bonds		104,725			171,086
Proceeds from matured bonds		365,385			290,844
Purchases of bonds		(1,206,581	)		(961,609	)
Change in short-term investments		268,143			93,017
Securities purchased under agreements to resell		113,000			256,000
Loans, net		30,033			39,873
Purchases of securitization collateral		—			(101,600	)
Other, net		9,436			3,753
Net cash used in investing activities		(315,859	)		(208,636	)
Cash flows from financing activities:
Dividends paid		(15,867	)		(13,616	)
Securities sold under agreements to repurchase		39,000			—
Proceeds from issuance of investment and payment agreements		277,937			221,295
Payments for investment and payment agreement draws		(309,548	)		(292,223	)
Proceeds from the issuance of long-term debt		50,000			50,000
Payments for redemption of long-term debt		(8,583	)		(27,336	)
Capital issuance costs		(894	)		(1,177	)
Net cash collateral received		703			5,810
Issuance of common stock		—			908
Purchases of treasury stock		(42,823	)		(721	)
Proceeds from sale of treasury stock		9,484			249
Excess tax benefit related to share-based compensation		8,418			—
Net cash provided by (used in) financing activities		7,827			(56,811	)
Net cash flow		(1,798	)		21,742
Cash at January 1		28,295			19,957
Cash at March 31	$	26,497		$	41,699
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Income taxes	$	5,885		$	1,235
Interest on long-term debt	$	36,967		$	18,146
Interest on investment agreements	$	79,986		$	48,788

See accompanying Notes to Unaudited Consolidated Financial Statements

6

Ambac Financial Group, Inc. and Subsidiaries

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(1) Background and Basis of Presentation

Ambac Financial Group, Inc. is a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world. Ambac’s principal operating subsidiary, Ambac Assurance Corporation, a leading guarantor of public finance and structured finance obligations, has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch Inc., and Ratings and Investment Information, Inc. These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement and any reduction in these ratings could have a material adverse affect on Ambac Assurance’s ability to compete in the financial guarantee business. Ambac Assurance provides financial guarantees for bond issues and other forms of debt financing. Financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer fails to meet its obligations. A bond guaranteed by Ambac receives triple-A ratings, typically resulting in lower financing costs for the issuer and Ambac Assurance’s guarantee generally makes the issue more marketable, both in the primary and secondary markets.

Ambac’s consolidated unaudited interim financial statements have been prepared on the basis of U.S. generally accepted accounting principles (“GAAP”) and, in the opinion of management, reflect all adjustments necessary for a fair presentation of Ambac’s financial condition, results of operations and cash flows for the periods presented. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The results of operations for the three months ended March 31, 2006 may not be indicative of the results that may be expected for the full year ending December 31, 2006. These consolidated financial statements and notes should be read in conjunction with the financial statements and notes included in Ambac’s Annual Report on Form 10-K for the year ended December 31, 2005, which was filed with the Securities and Exchange Commission on March 13, 2006.

The consolidated financial statements include the accounts of Ambac and all other entities in which Ambac has a controlling financial interest. The usual condition for a controlling financial interest is ownership of a majority of the voting interests of an entity. However, a controlling financial interest may also exist in entities, such as special purpose entities (“SPEs”), through arrangements that do not involve controlling voting interests. All significant intercompany balances have been eliminated.

Certain reclassifications have been made to prior period’s amounts to conform to the current period’s presentation.

(2) Loss and Loss Expenses

Ambac’s financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer of the insured obligation fails to meet its obligation. The loss reserve policy for financial guarantee insurance discussed in this footnote relates only to Ambac’s non-derivative insurance business. The policy for derivative contracts is discussed in Note 3

7

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

“Derivative Contracts”. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining the level of reserves is subject to certain estimates and judgments. In most instances, claim payments are forecasted in advance of issuer default as a result of active surveillance of the insured book of business and observance of deterioration in the obligor’s credit standing. Based upon Ambac’s experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The trustee, on behalf of the insured party, named beneficiary, or custodian has the right to make a claim under Ambac’s financial guarantee insurance policy at the first scheduled debt service date of the defaulted obligation. As discussed in the last paragraph of this note, the accounting for credit loss reserves is subject to change.

The liability for losses and loss expenses consists of active credit and case basis credit reserves. Active credit reserves are for probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported and are reflected on an undiscounted basis as of the reporting date. The establishment of reserves for exposures that have not yet defaulted is a common practice in the financial guarantee industry. However, Ambac is aware that there are differences in the specific methodologies applied by other financial guarantors in establishing such reserves. Ambac’s active credit reserve is based on management’s on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac’s Surveillance Group to track credit migration of insured obligations from period to period and prepare an adversely classified credit listing. The active credit reserve is established only for adversely classified credits. The criteria for an exposure to be included on the adversely classified credit listing includes the deterioration in an issuer’s financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), problems with the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of an insured securitization transaction is a consideration in assessing credit quality because the servicer’s performance can directly impact the performance of the related issuer. For example, a servicer of a mortgage-backed securitization that does not remain current in their collection efforts could cause an increase in the delinquency and potential default of the underlying obligation.

The active credit reserve is established through a process that begins with estimates of probable losses inherent in the adversely classified credit portfolio. Estimates are computed for each adversely classified credit. These estimates are based upon: (i) Ambac’s internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by Ambac’s Portfolio Risk Management Committee. The Portfolio Risk Management Committee is comprised of senior risk management professionals and other senior management of Ambac. For certain credit exposures that have deteriorated significantly, Ambac will undertake additional monitoring and loss remediation efforts. Additional remediation can include various actions by Ambac. The most common actions include obtaining detailed appraisal information on collateral, more frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. For these credits Ambac would use relevant information obtained from its remediation efforts to adjust the

8

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

estimate discussed above. Senior management meets at least quarterly with the Surveillance Group to review the status of their work to determine the adequacy of Ambac’s loss reserves and make any necessary adjustments. Active credit reserves were $171,697 and $197,607 at March 31, 2006 and December 31, 2005, respectively. The active credit reserves at March 31, 2006 and December 31, 2005 was comprised of 78 and 90 credits with net par outstanding of $5,755,585 and $6,319,724, respectively. Included in the calculation of active credit reserves at March 31, 2006 and December 31, 2005 was the consideration of $19,460 and $17,479, respectively, of reinsurance which would be due to Ambac from the reinsurers, upon default of the insured obligation.

Case basis credit reserves are for losses on insured obligations that have defaulted. We believe our definition of case basis credit reserves differs from other financial guarantee industry participants. Upon the occurrence of a payment default, the related active credit reserve is transferred to case basis credit reserve. Additional provision for losses upon further credit deterioration of a case basis exposure are initially recorded through the active credit reserve and subsequently transferred to case basis credit reserves. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider anticipated defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral and subrogation rights. The estimate does not consider future installment premium receipts, as the likelihood of such receipts is remote. Ambac discounts these estimated net payments using discount rates that approximate the average taxable equivalent yield on our investment portfolio.

Discount rates applied to case basis credit reserves were 4.75% at March 31, 2006 and December 31, 2005, respectively. Case basis credit reserves were $121,310 and $106,532 at March 31, 2006 and December 31, 2005, respectively. The case basis credit reserves at March 31, 2006 and December 31, 2005 were comprised of 10 credits, with net par outstanding of $740,551 and $838,975, respectively. Additionally, we have reinsurance recoverables on case basis credit reserves of $5,153 and $3,468 at March 31, 2006 and December 31, 2005, respectively.

Ambac provides information on the classification of its loss reserve between active credit reserve and case basis credit reserve for the purpose of disclosing the components of the total reserve that relate to exposures that have not yet defaulted and those that have defaulted. The total reserve (active credit and case basis) was $298,160 and $304,139 at March 31, 2006 and December 31, 2005, respectively. Due to the relatively small number and large size of certain insured obligations comprising the active and case basis credit reserves, improvements or further deterioration in any one credit may significantly impact our loss provision in a given period. The provision for losses and loss expenses in the accompanying Consolidated Statements of Operations represents the expense recorded to bring the total reserve to a level determined by management to be adequate for losses inherent in the non-derivative financial guarantee insurance portfolio.

Our liabilities for credit losses are based in part on the short-duration accounting guidance in SFAS No. 60, “Accounting and Reporting by Insurance Enterprises.” The trustee (on behalf of the insured party), named beneficiary or custodian has a right to a claim payment under the financial guarantee insurance policy at the date of the first scheduled debt service payment of a defaulted security in the amount equal to the payment shortfall. We believe a loss event occurs for financial guarantee insurance products at the time the issuers’ financial

9

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

condition deteriorates to an impaired credit status rather than at the time the insured party has a right to a claim payment. Because of this belief and the ambiguities discussed below in the application of SFAS No. 60 to the financial guarantee industry, Ambac does not believe that SFAS No. 60 alone provides sufficient guidance. As a result, Ambac supplements the guidance in SFAS No. 60 with the guidance in SFAS No. 5, “Accounting for Contingencies,” which calls for a loss to be accrued if it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Ambac also relies by analogy on EITF Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which states that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5.

In management’s view, the accounting guidance noted above does not comprehensively address the attributes of financial guarantee insurance contracts, primarily due to the fact that SFAS No. 60 was developed prior to the maturity of the financial guarantee industry. Financial guarantee contracts have elements of long-duration insurance contracts in that they are generally irrevocable and extend over a period of time that may be 30 years or more but are considered and reported for regulatory purposes as property and casualty insurance, normally considered short-duration contracts. The short-duration and long-duration classifications have different methods of accounting for premium revenue, deferred acquisition costs and contract liability recognition.

Ambac is aware that there are certain differences regarding the measurement of liabilities for credit losses among participants in the financial guarantee industry. Difficulties applying the existing insurance accounting literature such as the classification of the insurance contracts as either short-duration or long-duration to the attributes of financial guarantee insurance, different measurement models and assumptions utilized, regulatory guidance provided to certain entities, and the existence of accounting literature providing guidance with respect to liability recognition for loan guarantees are the reasons for differences among the industry participants.

In January and February of 2005, the Securities and Exchange Commission (“SEC”) staff discussed with the financial guarantee industry participants differences in loss reserve recognition practices among those participants. In June 2005, the Financial Accounting Standards Board (“FASB”) added a project to its agenda to consider the accounting by financial guarantee insurers for claims liability recognition, premium recognition and deferred acquisition costs. The proposed and final documents are expected to be issued in 2006. When the FASB or SEC reach a conclusion on this issue, Ambac and the rest of the financial guarantee industry may be required to change some aspects of their loss reserving policies and the potential changes could extend to premium and expense recognition. Ambac cannot predict how the FASB or SEC will resolve this issue and the resulting impact on our financial statements. Until the issue is resolved, Ambac intends to continue to apply its existing policy with respect to the establishment of both case and active credit reserves.

(3) Derivative Contracts

SFAS 133 “Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS 138 and SFAS 149”, establishes accounting and reporting standards for derivative instruments. All derivatives, whether designed for hedging relationships or not, are required to be recorded on the Consolidated Balance Sheets at fair value. When available, quotes are

10

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

obtained from independent market sources. However, when quotes are not available, Ambac uses internally developed valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads on underlying referenced obligations, yield curves and tax-exempt interest ratios. The valuation results from these models could differ materially from amounts that would actually be realized in the market. In accordance with the Emerging Issues Task Force (EITF) Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” (EITF 02-3), recognition of a trading profit at inception of a derivative transaction is prohibited unless fair value of that derivative is obtained from a quoted market price, supported by comparison to other observable market transactions, or based upon a valuation technique incorporating observable market data. Ambac defers trade date gains or losses on derivative transactions where the fair value is not determined based upon observable market transactions and market data. The deferral is recognized in income when the market data becomes observable or over the life of the transaction. The fair value includes an adjustment for counterparty credit risk and other adjustments, as appropriate, to reflect liquidity and ongoing servicing costs.

All derivative contracts are recorded on the Consolidated Balance Sheets on a gross basis; assets and liabilities are netted by customer only when a legal right of set-off exists. Gross asset and gross liability balances for all derivatives are recorded as Derivative Assets or Derivative Liabilities on the Consolidated Balance Sheets.

Derivative Contracts Classified as Held for Trading Purposes:

Financial Guarantee Credit Derivatives:

Ambac Assurance Corporation, through its subsidiary Ambac Credit Products, enters into structured credit derivative transactions with various financial institutions. Management views these structured credit derivative transactions as an extension of its financial guarantee business, under which Ambac intends to hold its position for the entire term of the related contract. These structured credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under SFAS 133, as amended. Changes in fair value are recorded in the Consolidated Statement of Operations. The fee component is reflected in “Other Credit Enhancement Fees”, and the mark-to-market gains or losses associated with fair value changes are reflected in “Net Mark-to-Market Gains on Credit Derivative Contracts”.

Financial Services – Derivative Products:

Ambac, through its subsidiary Ambac Financial Services, provides interest rate and currency swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. Ambac Capital Services enters into total return swaps with professional counterparties. Total return swaps are primarily referenced to fixed income obligations, which meet Ambac Assurance’s financial guarantee credit underwriting criteria. These contracts are recorded on trade date at fair value. Changes in fair value are recorded in the Consolidated Statements of Operations. The entire change in fair value of interest rate and currency swaps and the fee component of total returns swaps are reflected in “Derivative Product Revenues” and the mark-to-market gains or losses associated with the fair value changes on total return swaps are reflected in “Net Mark-to-Market Gains on Total Return Swap Contracts”.

11

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

Derivative Contracts used for Non-Trading and Hedging Purposes:

In order to qualify for hedge accounting, a derivative must be considered highly effective at reducing the risk associated with the exposure being hedged. Each derivative must be designated as a hedge, with documentation of the risk management objective and strategy, including identification of the hedging instrument, the hedged item, the risk exposure, and how effectiveness will be assessed prospectively and retrospectively. The extent to which a hedging instrument is effective at achieving offsetting changes in fair values or cash flows must be assessed at least quarterly. Any ineffectiveness must be reported in net income.

Interest rate and currency swaps are utilized to hedge exposure to changes in fair value of assets or liabilities resulting from changes in interest rates and foreign exchange rates, respectively. These interest rate and currency swap hedges are referred to as “fair value” hedges. Gains and losses on derivative hedges are recognized currently in net income. If the provisions of the derivative contract meet the technical requirements for hedge accounting under SFAS 133, the change in fair value (gain or loss) on the hedged asset or liability attributable to the hedged risk (interest rate or foreign exchange risk) adjusts the carrying amount of the hedged item and is recognized currently in net income. The net amount representing hedge ineffectiveness, recorded as a component of “Net mark-to-market gains on non-trading derivative contracts” in the accompanying Consolidated Statements of Operations, was $293 and $636 for the three months ended March 31, 2006 and 2005, respectively.

Interest rate swaps are also utilized to hedge the exposure to variable interest rates. These interest rate swap hedges are referred to as “cash flows” hedges. Gains and losses on interest rate swaps that meet the technical requirements for hedge accounting under SFAS 133 are reported in “Accumulated Other Comprehensive Income” in Stockholders’ Equity, until earnings are affected by the variability in cash flows of the designated hedged item. For the three months ended March 31, 2006 and 2005, hedge ineffectiveness reported in net income for cash flow hedges was $255 and $0, respectively.

Ambac enters into non-trading derivative contracts for the purpose of economically hedging exposures to fair value or cash flow changes caused by fluctuations in interest rates and foreign currency rates. If the hedging relationship does not meet the technical requirements for hedge accounting under SFAS 133, changes to the fair value of the derivative contract are recorded as a component of “Net mark-to-market gains on non-trading derivative contracts” in the accompanying Consolidated Statements of Operations. The change in fair value of such derivative contracts for the three months ended March 31, 2006 and 2005 was ($49) and $55, respectively.

Ambac discontinues hedge accounting prospectively when it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative expires, is sold or terminated. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value hedge, Ambac continues to carry the derivative on the balance sheet at its fair value, and no longer adjusts the hedged asset or liability for changes in fair value. The adjustment of the carrying amount of the hedged asset or liability is accounted for in the same manner as other components of the carrying amount of that asset or liability. The net derivative gain or loss related to a discontinued cash flow hedge (recognized during the period of hedge effectiveness) will continue to be reported in Accumulated Other Comprehensive Income and

12

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

amortized into net income as a yield adjustment to the previously designated asset or liability. If the previously designated asset or liability is sold or matures, the net derivative gain or loss related to a discontinued cash flow hedge reported in Accumulated Other Comprehensive Income will be reclassified into net income immediately. All subsequent changes in fair values of derivatives previously designated as cash flow hedges will be recognized in net income.

(4) Segment Information

Ambac has two reportable segments, as follows: (1) Financial Guarantee, which provides financial guarantees (including structured credit derivatives) for public finance, structured finance and other obligations; and (2) Financial Services, which provides investment agreements, funding conduits, interest rate, total return and currency swaps, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, investor-owned utilities and asset-backed issuers. Ambac’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.

Pursuant to insurance and indemnity agreements, Ambac Assurance guarantees the swap and investment agreement obligations of its Financial Services affiliates. Intersegment revenues include the premiums earned under those agreements and dividends received from its Financial Services subsidiaries. Such premiums are determined as if they were premiums paid by third parties, that is, at current market prices.

Information provided below for “Corporate and Other” relates to Ambac Financial Group, Inc. corporate activities, including interest expense on debentures. Corporate and other revenue from unaffiliated customers consists primarily of interest income. Intersegment revenues consist of dividends received.

The following table is a summary of financial information by reportable segment as of and for the three-month period ended March 31, 2006 and 2005:

(Dollars in thousands) Three months ended March 31,	Financial Guarantee		Financial Services			Corporate And Other			Intersegment Eliminations			Consolidated
2006:
Revenues:
Unaffiliated customers	$	353,351	$	97,591		$	3,000		$	—		$	453,942
Intersegment		12,109		(1,058	)		34,000			(45,051	)		—
Total revenues	$	365,460	$	96,533		$	37,000			($45,051	)	$	453,942
Income before income taxes:
Unaffiliated customers	$	302,705	$	19,054			($20,118	)	$	—		$	301,641
Intersegment		13,493		(1,947	)		33,005			(44,551	)		—
Total income before income taxes	$	316,198	$	17,107		$	12,887			($44,551	)	$	301,641
Total assets	$	11,081,456	$	8,390,146		$	264,780		$	—		$	19,736,382
2005:
Revenues:
Unaffiliated customers	$	323,381	$	67,030		$	409		$	—		$	390,820
Intersegment		198		(468	)		29,600			(29,330	)		—
Total revenues	$	323,579	$	66,562		$	30,009			($29,330	)	$	390,820
Income before income taxes:
Unaffiliated customers	$	254,927	$	12,431			($15,386	)	$	—		$	251,972
Intersegment		1,921		848			28,820			(31,589	)		—
Total income before income taxes	$	256,848	$	13,279		$	13,434			($31,589	)	$	251,972
Total assets	$	10,332,236	$	8,230,344		$	63,196		$	—		$	18,625,776

13

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

The following table summarize gross premiums written and net premiums earned and other credit enhancement fees included in the Financial Guarantee segment by location of risk for the three months ended March 31, 2006 and 2005:

(Dollars in thousands)	Three Months 2006				Three Months 2005
	Gross Premiums Written		Net Premiums Earned and Other Credit Enhancement Fees		Gross Premiums Written		Net Premiums Earned and Other Credit Enhancement Fees
United States	$	171,090	$	156,692	$	181,314	$	157,784
United Kingdom		16,146		15,204		18,184		15,941
Japan		6,660		6,115		7,072		7,209
Australia		682		3,034		691		2,180
Brazil		2,553		2,237		2,964		2,404
Italy		1,476		2,066		1,503		2,081
Mexico		1,210		1,095		3,497		1,611
Internationally diversified (1)		9,396		12,855		8,466		14,622
Other international		9,794		9,070		5,435		7,869
Total	$	219,007	$	208,368	$	229,126	$	211,701

1) Internationally diversified includes guarantees with multiple locations of risk and includes components of United States exposure.

(5) Employee Benefit Plans

Stock-based Compensation:

The Ambac 1997 Equity Plan (the “Equity Plan”) provides for the granting of stock options, stock appreciation rights, restricted stock units (“RSUs”), performance units and other awards that are valued or determined by reference to the Common Stock. Ambac also maintains the Ambac 1997 Non-employee Directors Equity Plan, which provides awards of stock options and restricted stock units to non-employee members of Ambac’s Board of Directors. Ambac generally expects to deliver shares to employees under this plan from its treasury stock. As of March 31, 2006, approximately 7,442,943 shares were available for future grant under the Equity Plan and the Directors Equity Plan. The number of options and their exercise price, and the number of restricted stock units awarded to each non-employee director under the Directors Equity Plan are determined by formula.

Since January 1, 2003, Ambac accounted for stock-based employee compensation in accordance with the fair-value method prescribed by SFAS No. 123 as amended by SFAS Statement 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” (“SFAS 148”), prospectively to all employee awards granted after January 1, 2003.

Effective January 1, 2006, Ambac adopted SFAS No. 123-R, “Share-Based Payment”, (“SFAS No. 123-R”) by using the modified prospective approach to all employee awards granted after the effective date. Beginning with the effective date, SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date and for all awards granted to employees prior to the effective date of SFAS No. 123-R that remain unvested on the effective date using the fair-value measurement method and

14

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

estimating forfeitures for all unvested awards. Key differences between SFAS No. 123-R and SFAS No. 123 are:

SFAS No. 123-R provides further clarification that the Black-Scholes-Merton model is not appropriate for stock options containing a market condition that affects vesting and the ability to exercise. The fair value of each market condition award was estimated on the date of grant using a Monte Carlo simulation model. Stock options granted prior to the adoption of SFAS 123-R were valued using the Black-Scholes-Merton model. Stock options granted in 2006 will vest on the earlier of Ambac’s Common Stock achieving certain price targets (market conditions) or meeting the requisite service requirement.

SFAS 123-R requires compensation expense be recognized for partially vested awards outstanding at its effective date. Expense will be recognized for the remainder of the requisite service period. Certain market condition stock option grants previously accounted for under APB No. 25 were partially vested as of January 1, 2006. For the quarter ended March 31, 2006 approximately $205 of compensation expense is recorded for these partially vested awards.

SFAS No.123-R requires the grant date expensing of share-based awards granted to retirement-eligible employees. This is consistent with how Ambac recognized such awards under SFAS 123. Based on interpretative guidance under SFAS No. 123-R, Ambac must elect to continue to expense awards to retirement eligible employees on the grant date or accrue in the year prior to the grant date. Ambac elected to accrue the estimated cost of the 2007 stock-compensation grants to retirement-eligible employees over the service period. Therefore, Ambac will accrue the estimated cost of such awards over the course of the fiscal year preceding the grant date ($1,787 recognized in the first quarter of 2006).

For the quarter ended March 31, 2006, basic and diluted earnings per share would have increased by $0.01 and $0.01 per share if Ambac had not adopted SFAS No. 123-R.

Stock Options:

As discussed above, with the adoption of SFAS 123-R, Ambac used a Monte Carlo simulation model. The model utilizes multiple input variables that determine the probability of satisfying each market condition stipulated in the option grant and calculates the fair market value for each option granted based on certain assumptions. The assumptions for the 2006 stock option grants are as follows:

Expected volatility	25.34	%
Suboptimal factor	175	%
Dividend Yield	0.8	%
Risk-free interest rates	4.27	%-4.41%
Expected term	5.23	years

The expected volatility is based on the average of implied volatility in Ambac’s traded options and historical volatility levels on Ambac’s common stock over the contractual term of the option. We have adjusted the contractual term of the option for the effect of retirement-eligible participants. Suboptimal factor represents the option holder’s expected exercise behavior, that is, the percentage multiplied by the option grant’s strike price results in the market price at which Ambac expects the holder to exercise their option. The determination of

15

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

the suboptimal factor is based on the exercise history of Ambac’s previous grants considering management’s future expectation of exercise behavior. The expected dividend yield is based on historical dividend payments. The risk-free interest rates reflect the yields on U.S. Treasuries over the contractual term of the award.

A summary of option activity for the three months ended March 31, 2006 is as follows:

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Aggregate Intrinsic Value		Weighted Average Remaining Contract Life
Outstanding at beginning of year	4,338,886		$	59.55
Granted	665,650		$	74.45
Exercised	(224,701	)	$	41.88
Forfeited	(60,250	)	$	72.67
Outstanding at end of quarter	4,719,585		$	62.33	$	81,149,617	4.1
Exercisable	2,621,696				$	65,185,972	2.9

The grant date fair value of stock options granted during the three months ended March 31, 2006 and 2005 were $22.25 and $21.23, respectively. The fair value of the 2006 option award is attributed over the derived vesting periods based on the output of the valuation model and represents the median time required to satisfy the market conditions of the award. The intrinsic value for stock options exercised during the quarter ended March 31, 2006 and 2005 was $8,309 and $1,460, respectively.

As of March 31, 2006, there were $18,552 of total unrecognized compensation costs related to unvested stock options granted. These costs are expected to be recognized over a weighted average period of 3.8 years. Gross stock option expense was $6,229 and $5,347 for the three months ended March 31, 2006 and 2005, respectively. The net income effect from stock options were $2,102 and $1,731 for the three months ended March 31, 2006 and 2005, respectively. Excess tax benefits are included in financing activities of the Consolidated Statements of Cash Flows.

Cash received from stock options exercises for the three months ended March 31, 2006 was $9,420. The income tax benefits from share-based arrangements totaled $8,418 for the three months ended March 31, 2006, with approximately $3,240 attributed to stock option exercises.

Restricted Stock Units (“RSU”):

Ambac has an annual incentive program (the “Program”) that makes available to all eligible employees awards that are based upon the performance of Ambac, the performance of the employee’s department and the performance of the employee. The Program awards consist of cash and RSU for all employees and, in lieu of a predetermined percentage of cash, RSU that may be granted to officers at the level of Managing Director and above. RSU granted in lieu of the first twenty-five percent of the cash award are granted at a twenty-five percent discount to the average of the high and low of Ambac common stock on the date of grant. An eligible employee can elect to defer more than twenty-five percent of their cash award in the form of RSU, however, the aforementioned discount does not apply. RSU granted in lieu of the

16

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

cash award vest equally over three years. The RSU representing the twenty-five percent discount vest on the fourth anniversary of the date of grant. Prior to vesting, the RSU cannot be sold or transferred by the participant and are subject to cancellation if the participant’s employment is terminated. All RSU agreements provide that vesting is accelerated in certain circumstances, such as retirement or death. Of the total RSU outstanding at March 31, 2006 of 1,343,616 (i) 592,847 units required future service as a condition to the delivery of the underlying shares of common stock and (ii) 750,769 units did not require future service.

Information with respect to the RSU awards is as follows for the three months ended March 31, 2006:

	Shares		Weighted Average Grant Date Fair Value
Outstanding at beginning of year	1,535,309		$	56.78
Granted	241,191		$	74.44
Delivered	(404,472	)	$	39.38
Forfeited	(28,412	)	$	74.45
Outstanding at end of quarter	1,343,616		$	64.80

As of March 31, 2006, there was $28,524 of total unrecognized compensation costs related to unvested RSUs granted. These costs are expected to be recognized over a weighted average period of 2.2 years. Gross RSU expense was $8,025 and $8,267 for the three months ended March 31, 2006 and 2005, respectively. The net income effect from RSUs were $3,162 and $3,094 for the three months ended March 31, 2006 and 2005, respectively.

The fair value for RSUs vested during the quarter ended March 31, 2006 and 2005 was $6,698 and $8,960, respectively.

Pensions:

Ambac has a defined benefit pension plan covering substantially all employees of Ambac. The benefits are based on years of service and the employee’s highest salary during five consecutive years of employment within the last ten years of employment. Ambac’s funding policy is to contribute annually the maximum amount that can be deducted for Federal income tax purposes. A contribution of $2,000 is estimated to be made in 2006. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future.

Net periodic pension costs for the three months ended March 31, 2006 and 2005 include the following components:

	March 31, 2006			March 31, 2005
Service cost	$	543		$	471
Interest cost		425			363
Expected return on plan assets		(651	)		(599	)
Amortization of prior service cost		(26	)		(36	)
Recognized net loss		66			36
Total pension expense	$	357		$	235

17

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

Postretirement and Other Benefits:

Ambac provides postretirement and postemployment benefits, including health and life benefits covering substantially all employees who meet certain age and service requirements. All plans are contributory. None of the plans are currently funded. Postretirement benefit expense was $171 and $121 for the three months ended March 31, 2006 and 2005, respectively. Post employment benefit expense was $70 and $79 for the three months ended March 31, 2006 and 2005, respectively.

(6) Stockholders’ Equity

Ambac is authorized to issue 350,000,000 shares of Common Stock, par value $0.01 per share, of which 109,193,096 were issued and 105,705,774 were outstanding as of March 31, 2006. Ambac is also authorized to issue 4,000,000 shares of Preferred Stock, $0.01 par value per share, none of which was issued and outstanding as of March 31, 2006.

(7) Special Purpose and Variable Interest Entities

Ambac has involvement with special purpose entities, including variable interest entities (“VIEs”) in the following ways. First, Ambac is a provider of financial guarantee insurance for various debt obligations. Second, Ambac has sponsored two special purpose entities that issue medium-term notes (“MTNs”) to fund the purchase of certain financial assets. As discussed in detail below, these Ambac sponsored special purpose entities are considered QSPEs. Lastly, Ambac is an investor in asset-backed securities issued by VIEs, and, in one transaction, has a beneficial interest in a VIE that purchases fixed rate municipal bonds with proceeds from the issuance of floating rate short term beneficial interests as discussed in detail below.

Financial Guarantees:

Ambac provides financial guarantees to debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance or credit derivative contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms; however, the most common are over-collateralization, first loss and excess spread. In the case of over-collateralization, (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac. In the case of first loss, the financial guarantee insurance policy only covers a senior layer of losses on debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt.

18

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

As of March 31, 2006, Ambac is the primary beneficiary under three transactions as a result of providing financial guarantees to these entities. Ambac consolidated these entities since the structural financial protections are outside the VIEs. These structural protections, had they existed inside the VIEs, would have absorbed a majority of the VIEs’ expected losses and consequently Ambac would not have consolidated these entities. All consolidated VIEs are bankruptcy remote special purpose financing entities created by the issuer of debt securities to facilitate the sale of notes guaranteed by Ambac Assurance. Ambac is not primarily liable for the debt obligations of these entities. Ambac would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of these VIEs.

Proceeds from the note issuance of the first VIE transaction, which closed in 2002, were used to purchase senior mortgage-backed floating rate notes of a South Korean mortgage-backed securities issuer. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and the issuance of subordinated debt. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the South Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes. Total long-term debt outstanding under this note issuance was $55,939 and $64,522 with a maturity date of December 3, 2022 and a variable rate of interest which was 4.94% and 4.26% at March 31, 2006 and December 31, 2005, respectively.

Proceeds from the note issuances of the other transactions, both of which closed in 2004, were used to purchase notes issued by special purpose reinsurance companies in connection with their reinsurance of defined blocks of life insurance contracts. Protections afforded Ambac Assurance were in the form of capital contributed to the reinsurance companies and the issuance of subordinated debt by the VIEs. Ambac Assurance will pay claims under its financial guarantees in these transactions if cash flows generated under the reinsurance agreements and the proceeds from the contributed capital and subordinated debt are insufficient to repay the noteholders. Total debt outstanding under these note issuances was $1,034,496 at March 31, 2006, with maturity dates ranging from April 15, 2016 to February 6, 2025. At March 31, 2006 the interest rate on these notes ranged from 4.65% to 4.91%. Under one of these transactions, Ambac is subject to potential consolidation of an additional $250,000 of assets and liabilities in connection with future utilization of the VIE by the reinsurer.

The following table provides supplemental information about the combined assets and liabilities associated with the VIEs discussed above. The assets and liabilities of these VIEs are consolidated into the respective Balance Sheet captions.

	At March 31, 2006		At December 31, 2005
Assets:
Cash	$	666	$	676
Loans		660,840		659,379
Investment in fixed income securities		431,335		390,423
Investment income due and accrued		7,474		7,448
Total assets	$	1,100,315	$	1,057,926
Liabilities:
Long-term debt	$	1,090,435	$	1,041,848
Other Liabilities		9,790		15,493
Total liabilities		1,100,225		1,057,341
Stockholders’ equity:
Accumulated other comprehensive income		90		585
Total liabilities and stockholders’ equity	$	1,100,315	$	1,057,926

19

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

Qualified Special Purpose Entities:

Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These entities meet the characteristics of QSPEs in accordance with SFAS 140. QSPEs are not subject to the requirements of FIN 46-R and accordingly are not consolidated in Ambac’s financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac, and Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of March 31, 2006, there have been 14 individual transactions processed through the QSPEs of which 9 are outstanding. In each case, Ambac sold fixed income debt obligations to the QSPEs. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase or redeem assets of the QSPE. Additionally, Ambac’s creditors do not have any rights with regards to the assets of the QSPEs. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and related administrative services. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued or both. As of March 31, 2006, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.

Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

There were no assets sold to the QSPEs during the three months ended March 31, 2006 and the year ended December 31, 2005, respectively. As of March 31, 2006, the estimated fair value of financial assets, MTN liabilities and derivative hedge assets of the QSPEs was $1,571,256, $1,610,929 and $4,094, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $1,737 and $1,462 for the three months ended March 31, 2006 and 2005, respectively. Ambac also received fees for providing other services amounting to $63 and $90 for the three months ended March 31, 2006 and 2005, respectively.

20

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands, except share amounts)

VIE Beneficial Interest:

Ambac owns a beneficial interest in a special purpose entity that meets the definition of a VIE. This entity has issued floating rate beneficial interests to investors and invested the proceeds in fixed income municipal investment securities. These beneficial interests are directly secured by the related municipal investment securities. Ambac is the primary beneficiary of this entity as a result of its beneficial interest. The fixed income municipal investment securities, which are reported as Investments in fixed income securities, at fair value on the Consolidated Balance Sheets, were $256,719 and $258,806 as of March 31, 2006 and December 31, 2005. The beneficial interests issued to third parties, are reported as Obligations under investment and payment agreements on the Consolidated Balance Sheets, were $248,750 and $248,760 as of March 31, 2006 and December 31, 2005. As of March 31, 2006 and December 31, 2005, the interest rates on these beneficial interests ranged from 2.95% to 3.26% and from 1.49% to 3.55%, respectively.

(8) Accounting Standards

On February 16, 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments”. SFAS 155 amends SFAS 133 and SFAS 140, and addresses issues raised in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” The primary objectives of SFAS 155 are: (i) with respect to SFAS 133, to address the accounting for beneficial interests in securitized financial assets and (ii) with respect to SFAS 140, eliminate a restriction on the passive derivative instruments that a QSPE may hold. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. Ambac will adopt SFAS 155 on January 1, 2007 and is currently evaluating the implications of SFAS 155 on its financial statements.

On April 13, 2006, the FASB issued Staff Position (“FSP”) No. FIN 46(R)-6 “Determining the Variability to be Considered in Applying FASB Interpretation No. 46(R)”. This FSP addresses the approach to determine the variability to consider when applying FIN 46 (R) and includes illustrative examples of how the variability should be considered. The variability that is considered may affect the determination as to whether the entity is a VIE, the determination of which interests are variable interests in the entity, if necessary, the calculation of expected losses and residual returns of the entity, and the determination of which party is the primary beneficiary of the VIE. The effective date for prospective application is the first day of the first reporting period beginning after June 15, 2006. Retrospective application, if elected, should be completed no later than the end of the annual reporting period after July 15, 2006, effectively December 31, 2006 for Ambac. Ambac is currently evaluating the implications of this FSP on its financial statements.

The FASB is currently working on a number of amendments to the existing accounting standards governing financial guarantees, asset transfers, securitization, consolidation, and fair value of financial instruments. Upon completion of these standards, Ambac will need to reevaluate its accounting and disclosures. In addition, the FASB is currently working on a project that will change the accounting and reporting for pension and postretirement plans. Management expects the new standard to require companies to record an asset or liability on the Consolidated Balance Sheet equal to the funded status of the plans. Any other plan assets or liabilities would be reflected net as an adjustment to stockholders’ equity.

21

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Ambac Financial Group, Inc. is a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world. Our diluted earnings per share were $2.06 for the first quarter of 2006, a 24% increase from $1.66 for the first quarter of 2005. The first quarter of 2006 benefited from improvements in our classified credit portfolio resulting in lower losses incurred and the sale of the remaining three aircraft from a previously reported defaulted enhanced equipment trust certificate. Return on average shareholders’ equity was 16.3%.

Ambac’s principal operating subsidiary, Ambac Assurance Corporation, a leading guarantor of public finance and structured finance obligations, has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch Inc., and Rating and Investment Information, Inc. Ambac Assurance provides financial guarantees for bond issues and other forms of debt financing. Financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer fails to meet its obligations. A bond guaranteed by Ambac Assurance receives triple-A ratings, typically resulting in lower financing costs for the issuer and Ambac Assurance’s guarantee generally makes the issue more marketable, both in the primary and secondary markets.

Ambac reports its financial guarantee business segment broken out by three principal markets: Public Finance, Structured Finance and International Finance. Public Finance includes all U.S. municipal issuance including general obligations, lease and tax-backed obligations, health care, public utilities, transportation and higher education, as well as certain infrastructure privatization transactions, such as stadium financings, military housing and student housing. Structured Finance covers U.S. structured finance transactions, including mortgage-backed securities and other consumer asset-backed securities, commercial asset-backed securities, pooled debt obligations, investor-owned utilities and asset-backed commercial paper conduits. International Finance covers infrastructure transactions, investor-owned utilities, certain sub-sovereign obligations and structured finance transactions including pooled debt obligations involving assets outside of the U.S.

Ambac’s Financial Services segment provides financial and investment products including investment agreements, interest rate swaps, currency swaps, total return swaps and funding conduits, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, investor-owned utilities and asset-backed and structured finance issuers. Ambac focuses on these businesses due to the complementary nature of the products to its financial guarantee product.

Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of 1995

Materials in this Quarterly Report may contain information that includes or is based upon forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts but instead represent management’s belief regarding future events, many of which, by their nature, are inherently uncertain and outside our control. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future plans or objectives and results.

22

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Any or all of management’s forward-looking statements here or in other publications may turn out to be wrong and are based on current expectations and the current economic environment. Ambac Financial Group’s actual results may vary materially, and there are no guarantees about the performance of Ambac Financial Group’s securities. Among factors that could cause actual results to differ materially are: (1) changes in the economic, credit, or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide debt markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) the policies and actions of the United States and other governments; (7) changes in capital requirements or other criteria of rating agencies; (8) changes in accounting principles or practices that may impact Ambac Financial Group’s reported financial results; (9) the amount of reserves established for losses and loss expenses; (10) default of one or more of Ambac Assurance’s reinsurers; (11) market spreads and pricing on insured pooled debt obligations and other derivative products insured or issued by Ambac Financial Group; (12) prepayment speeds on insured asset-backed securities and other factors that may influence the amount of installment premiums paid to Ambac Assurance; and (13) other risks and uncertainties that have not been identified at this time. Ambac Financial Group is not obligated to publicly correct or update any forward-looking statement if we later become aware that it is not likely to be achieved, except as required by law. You are advised, however, to consult any further disclosures we make on related subjects in Ambac Financial Group’s reports to the SEC.

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Critical accounting estimates are defined as those that require management to make significant judgments and could potentially result in materially different results under different assumptions and conditions. Management has identified the accounting for loss and loss expenses and the valuation of financial instruments as critical accounting estimates. This discussion should be read in conjunction with the consolidated financial statements and notes thereon included elsewhere in this report, and in the 2005 Form 10-K filed with the SEC on March 13, 2006. Management has discussed each of these critical accounting estimates with the Audit and Risk Assessment Committee of the Board of Directors.

Financial Guarantee Insurance Losses and Loss Expenses. The loss reserve for financial guarantee insurance discussed in this critical accounting estimates disclosure relates only to Ambac’s non-derivative insurance business. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative Financial Guarantee portfolio as of the reporting date. The evaluation process for determining the level of reserves is subject to certain estimates and judgments.

23

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The liability for losses and loss expenses consists of active credit and case basis credit reserves. Ambac establishes an active credit reserve to reflect probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported as of the reporting date. The active credit reserve is established through a process that begins with estimates of probable losses inherent in the adversely classified credit portfolio. Estimates are computed on each adversely classified credit. These estimates are based upon: (i) Ambac’s internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by Ambac’s Portfolio Risk Management Committee. The Portfolio Risk Management Committee is comprised of senior risk management professionals and other senior management of Ambac. For certain credit exposures that have deteriorated significantly, Ambac will undertake additional monitoring and loss remediation efforts. Additional remediation can include various actions by Ambac. The most common actions include obtaining detailed appraisal information on collateral, more frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. For these credits Ambac would use relevant information obtained from its remediation efforts to adjust the estimate discussed above.

Case basis credit reserves are established for losses on insured obligations that have already defaulted. We believe our definition of case basis credit reserves differs from other financial guarantee industry participants. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral and subrogation rights.

The primary estimates impacting the statistical loss calculation are probability of default and severity of loss. The probability of default increases as a credit exposure deteriorates in quality. Political, economic or other unforeseen events could have an adverse impact on default probabilities. However, despite such unforeseen events, our experience has shown, it is not reasonably likely that there would be a change in the probability of default estimates such that a material change in our loss reserve estimate would occur. Our experience has shown that credit deterioration and related changes in default probabilities are a gradual process that typically occurs over a long period of time. Historically, claim payments on financial guarantee contracts have been infrequent but subject to potential high severity. Severity represents the amount of loss that would be incurred on a defaulted obligation due to the difference in the amount of net par guaranteed and the value of the related collateral and other subrogation rights. Loss severity estimates are based upon available information such as rating agency recovery rates or surveillance data such as collateral appraisals. However, severity data used are estimates that are subject to change with political, economic and other market conditions or as new information becomes available. Severity of loss is a primary assumption used to estimate losses and an increase or decrease of the severity would provide a range of reasonably possible future outcomes that would differ from our current loss estimate, which could be material.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Ambac has exposure to various bond types. Our experience has shown that for the majority of bond types, the estimate of loss severity has remained consistent in that material changes to severity estimates have not occurred. However, for certain bond types, factors or events could have a material impact on the estimate of loss severity. Based upon our historical experience, certain types of exposures are more likely to experience changes in loss severity estimates. We believe, based on our experience, there are three bond types in particular where it is reasonably possible that a material change in loss severity estimates could occur. These three bond types are aircraft lease securitizations known as Enhanced Equipment Trust Certificates (“EETC”), health care institutions and mortgage-backed and home equity securitizations. The collateral for an EETC bond is commercial aircraft. Intense competition in the global airline industry continues. As a result, major airlines have been forced to reduce costs and scale back aircraft purchases. Additionally, high energy costs have negatively impacted operations and competition between the largest aircraft manufacturers has served to reduce overall aircraft pricing. These events have adversely impacted the value of certain aircraft and accordingly impacted the loss severity estimates associated with certain EETC exposures. We have observed that the health care industry is also particularly subject to changes in severity estimates. Typically, bonds insured by Ambac in the healthcare sector are secured by revenues generated by a hospital enterprise. The value of a hospital enterprise and its ability to generate revenues are primarily impacted by the essentiality of that hospital enterprise to a particular community. For example, hospitals that do not have significant competition in a community generally have more stable collateral values than facilities in communities with significant competition. It is also reasonably possible that severity estimates could materially change in the mortgage-backed and home equity securitization sector. Severity estimates in this sector are impacted by residential real estate values. Increases in mortgage interest rates, increased unemployment or personal bankruptcies could have an adverse impact on residential real estate values and mortgage-backed and home equity loss severity estimates. See Losses and Loss Expenses section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations below.

The table below outlines the estimated impact on the March 31, 2006 consolidated loss reserve estimate (both active credit and case basis reserve) of reasonably possible changes in the loss severity assumptions. These changes in the loss severity assumptions, while maintaining the current probability of default and adversely classified credit rating constant, represent management’s estimate of reasonably possible changes in severity, which are based upon our historical experience.

(Dollars in millions)Category	Current Severity Assumption		Reasonably Possible Severity Assumption		Increase in Reserve Estimate
EETC	20	%	26	%	$	3
Health care	62	%	79	%	$	15
Mortgage-backed and home equity	17	%	19	%	$	4

As a result of the widespread devastation caused by Hurricane Katrina, Ambac recorded loss and loss expenses of $91.5 million in 2005. Ambac’s exposure to losses as a result of the hurricane is derived primarily from its guarantees of municipal bonds in the greater New Orleans area and the Gulf-front regions that were most severely impacted by the storm. In determining our loss estimates, our analysis has considered the unprecedented nature of the disaster, including the displacement of the communities’ residents, and the unique aspects of

25

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

each insured bond, such as the nature of the revenue source, the level of debt service reserves, if any, and other transaction protections. The severity of loss on these credits will be impacted by the timing and extent of residents’ return to the affected areas. Throughout the history of Ambac, there have not been any significant losses resulting from natural disasters. As a result, management has adjusted our assumptions to reflect the unprecedented nature of the disaster. Future decreases, if any, to these severity assumptions will have a similar relative effect on our loss reserves and future increases, if any, to these assumptions, excluding those credits fully reserved, will also have a similar relative effect on our loss reserves.

Ambac’s management believes that the reserves for losses and loss expenses are adequate to cover the ultimate net cost of claims, but the reserves, including the probability of default and loss severity assumptions are based on estimates and there can be no assurance that the ultimate liability for losses will not exceed such estimates.

Valuation of Financial Instruments. The fair market values of financial instruments held are determined by using independent market quotes when available and valuation models when market quotes are not available. Ambac’s financial instruments categorized as assets are mainly comprised of investments in fixed income securities and derivative contracts.

Investments in fixed income securities are accounted for in accordance with Statement of Financial Accounting Standards (“SFAS”) 115, “Accounting for Certain Investments in Debt and Equity Securities”. SFAS 115 requires that all debt instruments and certain equity instruments be classified in Ambac’s balance sheet according to their purpose and, depending on that classification, be carried at either cost or fair market value. Ambac classifies investments in fixed income securities as available-for-sale.

The fair values of fixed income investments are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. For those fixed income investments where broker quotes were not available, fair values are based on internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and generic yield curves for industry and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Approximately 1% of the investment portfolio was valued using internal valuation models at March 31, 2006 and December 31, 2005.

Ambac’s exposure to derivative instruments is created through interest rate, currency, total return and credit default swaps. These contracts are accounted for at fair value under SFAS 133 “Accounting for Derivative Instruments and Certain Hedging Activities,” as amended (“SFAS 133”). Fair value is determined based upon market quotes from independent sources, when available. When independent quotes are not available, fair value is determined using valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads on underlying referenced obligations, yield curves and tax-exempt interest ratios. The net fair value of derivative contracts was $163 million and $167 million at March 31, 2006 and December 31, 2005, respectively. Ambac uses both vendor-developed and proprietary models, based on the complexity of transactions. The selection of a model to value a derivative depends on the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. For derivatives that trade in liquid markets, such as interest rate and currency swaps, we utilize vendor-developed models. For derivatives that trade in less liquid markets, such as credit derivatives on synthetic

26

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

collateralized debt obligations and total return swaps, a proprietary model is used because such instruments tend to be more complex and pricing information is less available in the market. These models and the related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in modeling techniques.

In accordance with the Emerging Issues Task Force (“EITF”) Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” (“EITF 02-3”), recognition of a trading profit or loss at inception of a derivative transaction is prohibited unless fair value of that derivative is obtained from a quoted market price, supported by comparison to other observable market transactions, or based upon a valuation technique incorporating observable market data. Ambac defers trade date gains or losses on derivative transactions where the fair value is not determined based upon observable market transactions and market data.

Results of Operations

The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for the three months ended March 31, 2006 and 2005, and its financial condition as of March 31, 2006 and December 31, 2005. These results are presented for Ambac’s two reportable segments: Financial Guarantee and Financial Services.

Consolidated Net Income

Ambac’s net income for the three months ended March 31, 2006 was $221.1 million or $2.06 per diluted share. This represents a 19% increase from the first quarter 2005 net income of $185.5 million, and a 24% increase in net income per diluted share from $1.66 in the first quarter of 2005. Ambac’s income before income taxes was $301.6 million for the three months ended March 31, 2006, an increase of 20% from income before income taxes of $252.0 million in the three months ended March 31, 2005. Of the $301.6 million of income before income taxes in the first quarter of 2006, $302.7 million was from Financial Guarantee, $19.0 million from Financial Services and $(20.1) million from Corporate, compared to $254.9 million, $12.5 million and $(15.4) million for Financial Guarantee, Financial Services and Corporate, respectively in the first quarter of 2005. Corporate consists primarily of Ambac’s interest expense on its long-term debentures outstanding, partially offset by interest income on investments held at the parent company.

Financial Guarantee net income for the three months ended March 31, 2006 increased primarily as a result of (i) higher other income resulting from the sale of three aircraft from a previously reported defaulted enhanced equipment trust certificate, (ii) higher investment income, and (iii) a lower provision for loss and loss expenses, partially offset by (i) lower total net premiums earned and other credit enhancement fees, and (ii) higher underwriting expenses. The Financial Services increase in the first quarter of 2006 is primarily attributable to (i) higher investment income in the investment agreement business (ii) higher net realized gains, and (iii) higher net mark-to-market gains on total return swap contracts, partially offset by (i) higher interest expense from investment and payment agreements and (ii) lower derivative product revenues.

Included in the three months ended March 31, 2006 net income in the Financial Guarantee segment, is the impact from cancellations of the remaining reinsurance contracts

27

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

with AXA Re Finance S.A. (“AXA Re”) and American Re-Insurance Company (“American Re”). The insured par that was recaptured as a result of the cancellation totaled approximately $3.9 billion. Included in ceded premiums written in Ambac’s Consolidated Statement of Operations is $37.0 million in returned premiums from the cancellation, of which $29.3 million was deferred. The difference, $7.7 million, included in net earned premiums, results from the difference between the negotiated amount of returned premiums and the associated unearned premium remaining on the previously ceded portion of the underlying guarantees. The net impact of this cancellation to the Consolidated Statement of Operations amounted to approximately $3.1 million, $2.0 million after-tax.

Included in the three months ended March 31, 2005 income before income taxes in the Financial Guarantee segment, is the impact of a cancellation of a reinsurance contract with Radian Asset Assurance Inc. (“Radian”). The insured par that was recaptured as a result of the cancellation totaled approximately $7.5 billion. Included in ceded premiums written in Ambac’s Consolidated Statement of Operations is $55.8 million in returned premiums from the cancellation, of which $51.3 million was deferred. The difference, $4.5 million, included in net earned premiums, results from the difference between the negotiated amount of returned premiums and the associated unearned premium remaining on the underlying guarantees. The net impact of this cancellation to the Consolidated Statement of Operations amounted to approximately $2.7 million, $1.8 million after-tax.

Financial Guarantee

Ambac provides financial guarantees for debt obligations through its principal operating subsidiary, Ambac Assurance Corporation, as well as credit protection in the form of structured credit derivatives through Ambac Credit Products LLC, a wholly owned subsidiary of Ambac Assurance. Ambac provides these services in three principal markets: public finance, structured finance and international finance.

Ambac Assurance guaranteed $28.5 billion of gross par value bonds during the three months ended March 31, 2006, an increase of 52% from $18.8 billion during the comparable prior year period.

The following table provides a breakdown of guaranteed net par outstanding by market sector at March 31, 2006 and December 31, 2005:

(Dollars in billions)	March 31, 2006		December 31, 2005
Public Finance	$	270.2	$	264.1
Structured Finance		153.5		144.3
International Finance		68.0		70.7
Total net par outstanding (1)	$	491.7	$	479.1

(1) $3.9 billion of the net par outstanding increase in 2006 was a result of the reinsurance cancellation noted above.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The following tables provide a rating distribution of guaranteed net par outstanding based upon internal Ambac Assurance credit ratings at March 31, 2006 and December 31, 2005 and a distribution by bond type of Ambac Assurance’s below investment grade exposures at March 31, 2006 and December 31, 2005. Below investment grade is defined as those exposures with a credit rating below BBB-:

	Percentage of Guaranteed Portfolio(1)
	March 31, 2006		December 31, 2005
AAA	8	%	8	%
AA	26		26
A	45		45
BBB	20		20
Below investment grade	1		1
Total	100	%	100	%

Summary of Below Investment Grade Exposure ⁽¹⁾

Bond Type (Dollars in millions)	March 31, 2006		December 31, 2005
U.S. Public Finance:
Transportation	$	653	$	653
Health care		589		584
General obligation		349		387
Tax-backed		135		135
University		70		70
Other		153		146
Total U.S. Public Finance		1,949		1,975
U.S. Structured Finance:
Mortgage-backed and home equity		1,099		507
Enhanced equipment trust certificates		989		927
Investor-owned utilities		575		575
Pooled debt obligations		332		384
Asset-backed		179		188
Total U.S. Structured Finance		3,174		2,581
International Finance:
Transportation revenue		224		219
Investor-owned utilities		54		52
Sovereign/sub-sovereign		38		38
Other		200		203
Total International Finance		516		512
Grand Total	$	5,639	$	5,068

(1) Internal Ambac Assurance credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac and may differ from ratings determined by the independent ratings agencies. The ratings are subject to revision at any time and do not constitute investment advice.

There were 75 credits with Ambac Assurance ratings below investment grade at both March 31, 2006 and December 31, 2005.

29

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Public Finance:

Public finance obligations are bonds issued by states, municipalities and other governmental or not-for-profit entities located in the United States (“Public Finance”). Bond proceeds are used to finance or refinance a broad spectrum of public purpose initiatives, including education, utility, transportation, health care and other general purpose projects. Public Finance bond obligations par value written was $10.0 billion for the three months ended March 31, 2006, which was 9% lower than $11.0 billion of par value written in the three months ended March 31, 2005. This decline was primarily due to volume decreases in the new issue municipal market as well as lower insured penetration, partially offset by a higher market share by Ambac.

Structured Finance:

Structured finance obligations include securitizations of a variety of asset types such as mortgages, home equity loans, student loans and credit card receivables; commercial asset-backed securities; leases; pooled debt obligations; investor-owned utilities and asset-backed commercial paper conduits originated in the United States (“Structured Finance”). Included within the commercial asset-backed sector are securitizations of operating assets, including aircraft, rental car fleets, and rail cars, as well as film and publishing royalties. Structured Finance obligations par value written was $17.2 billion for the three months ended March 31, 2006, which was 192% higher than $5.9 billion of par value written in the three months ended March 31, 2005. The increase in Structured Finance obligations guaranteed for the first quarter of 2006 resulted primarily from higher pooled debt obligations, asset-backed and conduits and mortgage-backed and home equity securitization obligations.

International Finance:

International finance obligations include public purpose infrastructure projects and asset-backed securities originated outside the United States (“International Finance”). International Finance asset-backed obligations may include significant components of domestic exposures. Ambac Assurance’s emphasis internationally has been on Western Europe and Australia. In the United Kingdom, Ambac Assurance has participated extensively in the Private Finance Initiative whereby the government has been privatizing certain infrastructure finance activities. Ambac Assurance expects demand for our financial guarantees on infrastructure privatization transactions to increase in certain other European countries. Ambac also participates in less developed markets through certain structures such as pooled debt obligations and future flow transactions. Future flow transactions essentially securitize U.S. dollar-based future revenue streams arising from exports or banking flows. International Finance bond obligations par value written was $1.3 billion for the three months ended March 31, 2006, which was 32% lower than $1.9 billion of par value written for the three months ended March 31, 2005. The decrease in International Finance obligations guaranteed during the first quarter of 2006 is primarily due to lower pooled debt obligations.

Gross Premiums Written. Ambac receives insurance premiums either upfront at policy issuance or on an installment basis over the life of the transaction. The collection method is determined at the time of policy issuance. Gross premiums written for the three months ended

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

March 31, 2006 were $219.0 million, a decrease of $10.1 million or 4% from 229.1 million in the three months ended March 31, 2005.

Up-front premiums written during the three months ended March 31, 2006 were $96.7 million, a decrease of $8.3 million or 8% from $105.0 million in the three months ended March 31, 2005. Up-front premiums written in the first quarter of 2006 saw a decrease in Public Finance, partially offset by increases in both Structured and International Finance.

Installment premiums written for the three months ended March 31, 2006 were $122.3 million, a decrease of $1.8 million or 1% from $124.1 million in the three months ended March 31, 2005. Installment premiums written in the first quarter of 2006 saw a decrease in International Finance, partially offset by increases in Public and Structured Finance.

Reinsurance. Ambac Assurance’s reinsurance program is principally comprised of a surplus share treaty and facultative reinsurance. The surplus share treaty requires Ambac Assurance to cede covered transactions while retaining flexibility to cede those transactions within a predefined range. Certain types of transactions are excluded from the surplus share treaty and management may use facultative reinsurance to cede such risks. Ceded premiums (returned) written for the three months ended March 31, 2006 and March 31, 2005 were ($8.8) million and ($26.6) million, respectively,

Included in ceded premiums written in the three months ended March 31, 2006 and 2005 is $37.0 million and $55.8 million, respectively, in return premiums from reinsurance contract cancellations. Excluding the return premiums from the three months ended March 31, 2006 and 2005, ceded premiums written were $28.2 million for the three months ended March 31, 2006 compared to $29.2 million in the three months ended March 31, 2005, a decrease of 3%. Ceded premiums (exclusive of the return premiums) as a percentage of gross premiums written were 12.9% and 12.7% for the three months ended March 31, 2006 and 2005, respectively.

The reinsurance of risk does not relieve Ambac Assurance of its original liability to its policyholders. In the event that any of Ambac Assurance’s reinsurers are unable to meet their obligations under reinsurance contracts, Ambac Assurance would nonetheless be liable to its policyholders in the full amount of its policy. To minimize exposure to significant losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) is entitled to receive collateral from its reinsurance counterparties in certain reinsurance contracts; and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. Ambac Assurance held letters of credit and collateral amounting to approximately $175.7 million from its reinsurers as of March 31, 2006. The rating agencies continually review reinsurers providing coverage to the financial guarantee industry. The following table provides ceded par outstanding by financial strength rating of Ambac Assurance’s reinsurers, on a Standard and Poor’s (“S&P”) basis:

(Dollars in billions)	March 31, 2006		December 31, 2005
AAA	$	19.7	$	19.2
AA		22.5		21.1
A		—		2.3
Not rated		—		1.6
Total	$	42.2	$	44.2

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Net Premiums Earned and Other Credit Enhancement Fees. Net premiums earned and other credit enhancement fees for the three months ended March 31, 2006 were $208.4 million, a decrease of $3.3 million or 2% from $211.7 million for the three months ended March 31, 2005. The decrease was primarily the result of lower refundings and calls of previously insured obligations and other accelerations, such as reinsurance cancellations, (collectively referred to as “accelerated earnings”), partially offset by the larger Financial Guarantee book of business.

When an issue insured by Ambac Assurance has been refunded or called, any remaining unearned premium (net of refunding credits, if any) is earned at that time. The level of refundings or calls vary, depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. The current relatively low long-term interest rate environment continues to prompt the high levels of refundings. As long-term interest rates rise in the future, refundings should decline. Earnings on refundings relate to transactions where the premium was paid up-front at the inception of the policy. Accelerated earnings also include the difference between negotiated return premiums and the associated unearned premium on reinsurance cancellations. Net premiums earned during the three months ended March 31, 2006 included $25.0 million from accelerated earnings as compared to $34.4 million for the three months ended March 31, 2005, respectively. Included in the three months ended March 31, 2006 and 2005 accelerated earnings amounts were approximately $7.7 million and $4.5 million, respectively, from the cancellation of a reinsurance contracts previously mentioned.

Excluding the effect of accelerated earnings, normal net premiums earned (which is defined as net premiums earned less accelerated earnings and reconciled to total net premiums earned in the table below) in the first quarter of 2006 were $169.2 million, an increase of $4.0 million or 2% from $165.2 million in the first quarter of 2005. Normal net premiums earned for the three months ended March 31, 2006 increased 1% and 7% for Public and Structured Finance, respectively, and decreased 2% for International Finance from the three months ended March 31, 2005.

Overall, the business environment has become more competitive. Increased competition from bank funding, the uninsured market, senior/subordinated securitizations and other triple-A-rated financial guarantors has increased. This increased competition has had an adverse impact on pricing. The growth in normal earned premiums in Structured Finance and International Finance that has been exhibited over the past several years has moderated as those lines of business have grown significantly, resulting in more difficult comparisons. Additionally, a significant portion of the recent premium writings in Public Finance and for certain bond types within Structured Finance and International are for longer-term transactions. While the earned premium impact from such writings is not as immediate as the mortgage-backed or pooled debt obligations, they increase the stability of earned premiums over time. Similarly, due to a tight credit spread environment in International Finance, our exposures relating to pooled debt obligations have decreased over the past few quarters, adversely impacting earned premiums and other credit enhancement fees. This, combined with the continued high level of run-off in the mortgage-backed securities book, adversely impacted overall earned premium growth.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Competitive and credit trends such as the ones we are currently experiencing in domestic mortgage-backed securities and international pooled debt obligations are a normal part of Ambac Assurance’s business.

Other credit enhancement fees, which is primarily comprised of fees received from the structured credit derivatives product were $14.2 million for the three months ended March 31, 2006, an increase of $2.1 million or 17% from $12.1 million in the three months ended March 31, 2005, primarily due to new domestic business growth.

The following table provides a breakdown of net premiums earned by market sector and other credit enhancement fees:

(Dollars in millions)	March 31, 2006		March 31, 2005
Public Finance	$	55.8	$	55.2
Structured Finance		69.3		64.8
International Finance		44.1		45.2
Total normal premiums earned		169.2		165.2
Refundings		25.0		34.4
Total net premiums earned		194.2		199.6
Other credit enhancement fees		14.2		12.1
Total net premiums earned and other credit enhancement fees	$	208.4	$	211.7

Net Investment Income. Net investment income for the three months ended March 31, 2006 was $114.0 million, an increase of $12.0 million or 12% from $102.0 million in the three months ended March 31, 2005. The increase was primarily attributable to (i) the growth of the investment portfolio resulting from the positive operating cash flows of the Financial Guarantee book of business, including cash received during the quarter related to the previously mentioned reinsurance cancellations, (ii) a capital contribution from Ambac Financial Group, Inc. of $200 million in the fourth quarter of 2005, and (iii) rising interest rates. Investments in tax-exempt securities amounted to 73% and 69% of the total fair value of the portfolio as of March 31, 2006 and March 31, 2005, respectively. The average pre-tax yield-to-maturity on the investment portfolio was 4.59% as of March 31, 2006 compared with 4.51% at March 31, 2005.

Net Realized Investment (Losses) Gains. Net realized investment losses in the three months ended March 31, 2006 were $0.4 million compared to net realized investment gains of $2.0 million for the three months ended March 31, 2005. The following table details amounts included in net realized investment (losses) gains:

(Dollars in millions)	March 31, 2006	March 31, 2005
Net (losses) gains on securities sold or called	($0.5)	$	2.2
Foreign exchange gains (losses) on investments	0.1		(0.2	)
Net realized investment (losses) gains	($0.4)	$	2.0

33

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Net Mark-to-Market Gains on Credit Derivative Contracts. Net mark-to-market gains on credit derivative contracts for the three months ended March 31, 2006 were $2.0 million compared to net mark-to-market gains of $5.3 million in the three months ended March 31, 2005. The change in estimated fair value of structured credit derivatives reflects net mark-to-market gains due to improvements in credit spreads on the underlying obligations. There were no realized net losses paid on structured credit derivatives for the three months ended March 31, 2006 and 2005.

Other Income. Other income for the three months ended March 31, 2006 was $29.5 million compared to other income of $2.4 million for the three months ended March 31, 2005. During the first quarter of 2006, Ambac Assurance sold the three remaining aircraft from a previously reported defaulted enhanced equipment trust certificate. The gain on the sale amounted to $25.0 million. Also included within other income are structuring fee revenues of $0.3 million for both the three months ended March 31, 2006 and 2005, respectively. Structuring fees are negotiated for certain domestic and international structured finance transactions, typically are collected at close of the transactions, and are earned ratably over the life of the transactions. Ambac has approximately $16.6 million and $16.4 million of deferred structuring and commitment fees included in “Other liabilities” on the Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005, respectively.

Loss and Loss Expenses. Losses and loss expenses are based upon estimates of the aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. Loss and loss expenses for the three months ended March 31, 2006 was $0.1 million compared to $23.5 million for the three months ended March 31, 2005.

The following table summarizes the changes in the total net loss reserves for the three months ended March 31, 2006 and the year-ended December 31, 2005:

(Dollars in millions)	March 31, 2006			December 31, 2005
Beginning balance of net loss reserves	$	300.6		$	237.5
Provision for losses and loss expenses		0.1			149.9
Losses paid		(10.8	)		(119.1	)
Recoveries of losses paid from reinsurers		1.1			22.9
Other recoveries, net of reinsurance		2.0			9.4
Ending balance of net loss reserves	$	293.0		$	300.6

The loss and loss expense provision for the quarter ended March 31, 2006 is a result of an increase in case reserves amounting to $26.0 million during the quarter, offset by net positive migration in the active credit reserve amounting to $25.9 million. Net loss reserves as of March 31, 2006 include $91.1 million for Hurricane Katrina credits, down slightly from $91.5 million at December 31, 2005. Approximately $1.1 billion of Katrina impacted credits remain in Ambac’s classified credit portfolio. Ambac did not pay any Katrina related claims during the quarter.

34

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The following tables provide details of losses paid, net of recoveries received for the three months ended March 31, 2006 and 2005 and gross case basis credit reserves at March 31, 2006 and December 31, 2005 by market sector:

(Dollars in millions)	March 31, 2006			March 31, 2005
Net losses paid (recovered):
Public Finance	$	5.5		$	4.6
Structured Finance		3.3			17.2
International Finance		(1.0	)		(1.4	)
Total	$	7.8		$	20.4

(Dollars in millions)	March 31, 2006		December 31, 2005
Gross case basis credit reserves:
Public Finance	$	120.3	$	97.0
Structured Finance		6.2		9.5
International Finance		—		—
Total	$	126.5	$	106.5

The following table summarizes Ambac Assurance’s loss reserves split between case basis credit loss reserves and active credit reserves at March 31, 2006 and December 31, 2005.

(Dollars in millions)	March 31, 2006		December 31, 2005
Gross loss and loss expense reserves:
Case basis credit reserves(1)(2)	$	126.5	$	106.5
Active credit reserves		171.7		197.6
Total	$	298.2	$	304.1

(1) Ambac Assurance discounts estimated net payments using discount rates that approximate the average taxable equivalent yield on our investment portfolio. Discount rates applied to case basis credit reserves were 4.75% at both March 31, 2006 and December 31, 2005, respectively.

(2) Reinsurance recoverables on case basis credit reserves were $5.2 million and $3.5 million at March 31, 2006 and December 31, 2005, respectively.

Active credit reserves were $171.7 million and $197.6 million at March 31, 2006 and December 31, 2005, respectively. Included in the calculation of active credit reserves at March 31, 2006 and December 31, 2005 was the consideration of $19.5 million and $17.5 million, respectively, of reinsurance which would be due to Ambac Assurance from the reinsurers, upon default of the insured obligations. The active credit reserve at March 31, 2006 and December 31, 2005 was comprised of 78 and 90 credits with net par outstanding of $5,756 million and $6,319 million, respectively. The decrease in net par outstanding of credits within the active credit reserve was driven primarily by credit improvements and exposure paydowns, and transfers to case basis credit reserves.

Case basis credit reserves at March 31, 2006 and December 31, 2005 were both comprised of 10 credits, respectively, with net par outstanding of $740.6 million and $839.0 million, respectively. Increase to the case basis credit reserves is primarily due additional case

35

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

reserves for a public finance infrastructure transaction and a home equity mortgage transaction, partially offset by payments out of case reserves during the quarter.

At March 31, 2006, expected future claim payments on credits that have already defaulted, net of estimated recoveries totaled $70.0 million. Related future payments are $62.6 million, $2.2 million, $0.5 million, $3.7 million and $4.9 million for the remainder of 2006, 2007, 2008, 2009 and 2010, respectively.

Please refer to the “Critical Accounting Policies and Estimates” section of this Management’s Discussion and Analysis and to Note 2 of the Consolidated Financial Statements for further background information on loss reserves, our policy and for further explanation of potential changes.

Underwriting and Operating Expenses. Underwriting and operating expenses for the three months ended March 31, 2006 were $37.9 million, an increase of $4.5 million or 13% from $33.4 million in the three months ended March 31, 2005. Underwriting and operating expenses consist of gross underwriting and operating expenses, less the deferral to future periods of expenses and reinsurance commissions related to the acquisition of new insurance contracts, plus the amortization of previously deferred expenses and net reinsurance commissions. The following table provides details of underwriting and operating expenses for the first quarters of 2006 and 2005:

(Dollars in Millions)	March 31, 2006			March 31, 2005			% Change
Gross underwriting and operating expenses	$	52.9		$	47.0		13	%
Net reinsurance commissions received (1)		3.4			9.4
Operating expenses and reinsurance commissions deferred		(22.3	)		(19.5	)
Amortization of previously deferred expenses (1)		3.9			(3.5	)
Underwriting and operating expenses	$	37.9		$	33.4		13	%

(1) The first quarter 2006 and 2005 cancellations of reinsurance contracts disclosed above impacted net reinsurance commissions received by ($10.3) million and ($17.4) million, respectively, and the amortization of previously deferred expenses by $8.1 million and $15.9 million, respectively.

The increase in gross underwriting and operating expenses for the three months ended March 31, 2006 is primarily attributable to higher compensation costs. Compensation expenses for the three months ended March 31, 2006 was $40.9 million, and increase of 15% from $35.7 million in the three months ended March 31, 2005. Ambac’s first quarter 2006 expenses include the impact of implementation of Statement of Financial Accounting Standards (“SFAS”) No. 123-R “Share-Based Payment” Under provisions of SFAS 123-R, Ambac will accrue the 2007 stock-based compensation for those employees that are retirement eligible throughout 2006. Previously, such awards were recognized on the date of grant. Stock-based compensation for the three months ended March 31, 2006 were $13.8 million compared to $13.0 million for the three months ended March 31, 2005.

36

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Financial Services

Through its Financial Services subsidiaries, Ambac provides financial and investment products including investment agreements, funding conduits, interest rate swaps, currency swaps and total return swaps, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, and asset-backed and structured finance issuers. The investment agreement business is managed with the goal of approximately matching the cash flows of the investment agreement liabilities with the cash flows of the related investment portfolio. To achieve this goal in the investment agreement business, derivative contracts are used for hedging purposes. The primary activities in the derivative products business are intermediation of interest rate and currency swap transactions and taking total return swap positions on certain fixed income obligations. Most of the swap intermediation is done on a fully hedged basis with the exception of certain municipal interest rate swaps that are not hedged for the basis difference between taxable and tax-exempt interest rates. As such, changes in the relationship between taxable and tax-exempt interest rates will result in mark-to-market gains or losses.

Revenues. Revenues for the three months ended March 31, 2006 were $97.6 million, an increase of $30.6 million or 46% from $67.0 million in the three months ended March 31, 2005. The increase for the three months ended March 31, 2006 are primarily due to (i) higher interest income from the investment agreement business driven by the increase in interest rates, (ii) higher net realized investment gains, and (iii) higher net mark-to-market gains on total return swap contracts, partially offset by lower derivative product revenues. Interest earned from investments made with proceeds from investment and payment agreements were $81.9 million in the first three months ended March 31, 2006, up $24.2 million or 42% from $57.7 million in the three months ended March 31, 2005. The increase was primarily driven by higher income from floating rate securities in the investment portfolio. Derivative product revenues were $4.7 million in the three months ended March 31, 2006, down $3.4 million or 42% from $8.1 million in the three months ended March 31, 2005. This decrease is primarily due to lower new business revenues on interest rate swap contracts. The net mark-to-market gain on total return swap contracts for the three months ended March 31, 2006 was primarily due to spread narrowing on certain credits within the total return swap portfolio.

During 2002 and 2003 realized losses included an impairment write-down of $139.7 million and $10.5 million, respectively, related to asset-backed notes issued by National Century Financial Enterprises, Inc (“NCFE”). These notes, which were backed by health care receivables and rated triple-A until October 25, 2002, have defaulted and NCFE filed for protection under Chapter 11 of the U.S. Bankruptcy Code in November 2002. The loss was specific to the NCFE notes and had no impact on other investments held. In the first quarter of 2006, full year 2005 and full year 2004, Ambac has received cash recoveries of $5.9 million, $10.8 million and $17.9 million, respectively, resulting from distributions under the NCFE Bankruptcy Plan, payments made by a Trust created under the Plan and litigation settlements. In April 2006, Ambac and a group of certain other note holders received a final court ruling in connection with litigation settlement agreements. In connection with such settlement agreements, Ambac expects to receive approximately $36 million of which $34 million was received in April 2006.

Expenses. Expenses for the three months ended March 31, 2006 were $78.5 million, up $23.9 million or 44% from $54.6 million in the three months ended March 31, 2005. Included in the above are expenses related to investment and payment agreements of $75.0 million and $50.8 million for the three months ended March 31, 2006 and 2005, respectively. The increase is primary related to higher interest rates in floating rate investment agreements.

37

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Corporate Items

Interest Expense. Interest expense was $19.5 million in the three months ended March 31, 2006, up $6.0 million or 44% from $13.5 million in the three months ended March 31, 2005. The increase is primarily attributable to Ambac’s issuance of $400 million, 5.95% debt, due December 5, 2035 in December 2005.

Corporate Expense. Corporate expenses include the operating expenses of Ambac Financial Group. Corporate expenses for the three months ended March 31, 2006 were $3.6 million, an increase of $1.3 million or 57% from $2.3 million in the three months ended March 31, 2005. The increase is primarily related to Ambac’s contingent capital facility. First quarter 2005 contingent capital facility fees of $1.2 million was recorded directly in shareholders’ equity in the Consolidated Balance Sheet rather in corporate operating expenses.

Provision for Income Taxes. Income taxes for the three months ended March 31, 2006 and 2005 were at an effective rate of 26.7% and 26.4%, respectively. The increase in the effective tax rate relates to an increase in taxable pre-tax profits.

Liquidity and Capital Resources

Ambac Financial Group, Inc. Liquidity. Ambac’s liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon: (i) Ambac Assurance’s ability to pay dividends or make other payments to Ambac; (ii) external financings and (iii) investment income from its investment portfolio. Pursuant to Wisconsin insurance laws, Ambac Assurance may pay dividends, provided that, after giving effect to the distribution, it would not violate certain statutory surplus, solvency and asset tests. Additionally, no quarterly dividend may exceed the dividend paid in the corresponding quarter of the preceding year by more than 15% without regulatory approval. Based upon these tests, without regulatory approval, the maximum amount that will be available during 2006 for payment of dividends by Ambac Assurance is $332.7 million. Ambac Assurance paid dividends of $34.0 million in the first quarter of 2006.

Ambac’s principal uses of liquidity are for the payment of its operating expenses, income taxes, interest on its debt, dividends on its shares of common stock, purchases of its common stock in the open market and capital investments in its subsidiaries

Based on the amount of dividends that it expects to receive from Ambac Assurance and other subsidiaries during 2006, and the income it expects to receive from its investment portfolio, management believes that Ambac will have sufficient liquidity to satisfy its needs over the next twelve months, including the ability to pay dividends on its common stock in accordance with its dividend policy. Beyond the next twelve months, Ambac Assurance’s ability to declare and pay dividends to Ambac may be influenced by a variety of factors including adverse market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although management believes that Ambac will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, no guarantee can be given that Ambac Assurance will be able to dividend amounts sufficient to pay all of Ambac’s operating expenses, debt service obligations and dividends on its common stock.

38

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

A subsidiary of Ambac Financial Group provides a $360 million liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility, which is guaranteed by Ambac Assurance, provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurance company is required to repay all amounts drawn under the liquidity facility. No amounts have been drawn under this facility at March 31, 2006.

Ambac Assurance Liquidity. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claim payments, reinsurance premiums, taxes, dividends to Ambac, and capital investments in its subsidiaries. Management believes that Ambac Assurance’s operating liquidity needs can be funded exclusively from its operating cash flow. The principal sources of Ambac Assurance’s liquidity are gross premiums written, scheduled investment maturities, net investment income and receipts from structured credit derivatives.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment and payment agreement obligations pursuant to defined terms, net obligations under interest rate, total return and currency swaps, operating expenses and income taxes. Management believes that its Financial Services liquidity needs can be funded from its operating cash flow, the maturity of its invested assets and from time to time, by short-term inter-company loans from Ambac Assurance. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities of securities from its investment portfolio (which are invested with the objective of closely matching the cash flows of its obligations under the investment agreements) and net receipts from interest rate, currency and total return swaps. The investment objectives with respect to investment agreements are to achieve the highest after-tax total return, subject to a minimum average quality rating of AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity risk. Financial Services subsidiaries maintain a portion of their assets in short-term investments in order to meet unexpected liquidity needs.

Investment agreements subject Ambac to liquidity risk associated with unscheduled withdrawals of principal allowed by the terms of the investment agreements. As of March 31, 2006, approximately $5.1 billion, or 80%, of the outstanding investment agreements (at amortized cost) relate to either scheduled or contingent draw, floating rate investment agreements, which expose Ambac to minimal liquidity risk. Contingent draw floating rate investment agreements are sourced in the structured finance markets and will only permit a draw in the event that well-defined, observable events have occurred. Ambac considers these contingent draw events to be remote. The remaining portfolio of investment agreements, approximating $1.3 billion at March 31, 2006, consists of fixed rate investment agreements, primarily relating to debt service reserve and construction funds in support of municipal bond transactions. Debt service reserve fund investment agreements may be drawn unexpectedly upon a payment default by the municipal issuer. Ambac also considers these draw events to be remote. Construction fund investment agreements may be drawn faster or slower than anticipated when construction of the underlying municipal project does not proceed as expected.

39

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Credit Ratings and Collateral. Downgrades in Ambac Assurance’s triple-A financial strength rating would adversely affect Ambac’s ability to compete for business. Credit ratings are very important to the ability of financial institutions to compete in the financial guarantee, derivative, investment agreement and structured transaction market. In the event that Ambac Assurance is downgraded, Ambac may be required to post incremental collateral to its investment agreement and derivative counterparties, introducing liquidity risk. In addition, most investment agreements provide certain remedies, including a termination of the investment agreement contract, for the investment agreement purchaser in the event of a downgrade of Ambac Assurance’s credit rating, typically to A1 by Moody’s or A+ by S&P. In most cases Ambac is permitted to post collateral or otherwise enhance its credit, prior to an actual draw on the investment agreement.

The financial services business executes a range of interest rate and cross-currency swaps to reduce the market risk on investment agreements with Ambac’s derivatives subsidiary, Ambac Financial Services, LLC. In addition, Ambac Financial Services provides interest rate and currency swap transactions for states, municipalities, asset-backed issuers and other entities in connection with their financings. Ambac Financial Services offsets most of the interest rate and currency risks in these instruments and incorporates these transactions under standardized derivative documents including collateral support agreements. Under these agreements, Ambac could be required to post collateral to a swap dealer in the event unrealized losses exceeds a predetermined threshold amount. Ambac has posted collateral of $13.9 million under these contracts at March 31, 2006. Conversely, Ambac could receive collateral from the counterparty in the event unrealized gains exceed a predetermined threshold. Ambac has received collateral of $173.1 million under these contracts at March 31, 2006. The thresholds afforded Ambac by the swap dealer would be reduced in the event of a downgrade of Ambac’s credit rating. The reduction in the threshold could result in Ambac posting additional amounts of collateral to the counterparty.

Ambac Capital Services enters into total return swaps and Ambac Credit Products enters into credit derivative contracts. All of our total return swaps and a portion of our credit derivatives have collateral support agreements. In addition, a downgrade of our financial strength rating below specified levels would allow credit derivative counterparties to terminate certain agreements, resulting in a possible payment of a settlement amount or we would have to pledge collateral for the benefit of the counterparty. At March 31, 2006, Ambac has not pledged collateral under any of its credit derivative or total return swap contracts.

Ambac manages this liquidity risk through the maintenance of liquid collateral and bank liquidity facilities. Additionally, Ambac generally has the right to re-hypothecate collateral that it receives under derivative contracts to counterparties.

Credit Facilities. On July 28, 2005, Ambac and Ambac Assurance, as borrowers, entered into a $400 million five year unsecured, committed revolving credit facility (the “Credit Facility”) with a group of highly rated banks (the “Banks”). The Credit Facility expires on July 28, 2010. The Credit Facility provides for borrowings by Ambac and Ambac Assurance on a revolving basis up to an aggregate of $400 million at any one time outstanding, which maximum amount may, at Ambac’s and Ambac Assurance’s request and subject to the terms and conditions of the facility, be increased up to $500 million.

40

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Ambac and/or Ambac Assurance may borrow under the Credit Facility for general corporate purposes, including the payment of claims. Subject to the terms and conditions thereof, Ambac and/or Ambac Assurance may borrow under the Credit Facility until the final maturity date, which will occur on July 28, 2010. Loans may be denominated in U. S. Dollars or certain other currencies at the option of Ambac and/or Ambac Assurance. Ambac and/or Ambac Assurance has the option of selecting either (i) a Base Rate, a fluctuating rate equal to the higher of Citibank’s Base Rate and the Federal Funds Rate plus 0.5%, plus the Applicable Margin (as defined in the Credit Facility) or (ii) a Eurocurrency Rate, a periodic fixed rate equal to LIBOR plus the Applicable Margin. There are no outstanding loans under the Credit Facility. Neither Ambac nor Ambac Assurance have previously incurred any borrowing under this or prior similar facilities.

The Credit Facility contains customary representations, warranties and covenants for this type of financing, including two financial covenants requiring Ambac to: (i) maintain as of the end of each fiscal quarter a debt-to-capital ratio, excluding debt consolidated under FIN 46, of not more than 30%, and (ii) maintain at all times total stockholders’ equity equal to or greater than $2.87 billion. The stockholders’ equity financial covenant will increase annually, in an amount equal to 15% of the prior fiscal year’s net income and 15% of the net proceeds of any future equity issuances. The Credit Facility also provides for certain events of default with corresponding grace periods, including failure to pay any principal or interest when due, failure to comply with covenants, any material representation or warranty made by Ambac or Ambac Assurance proving to be false in any material respect, certain bankruptcy, insolvency or receivership events affecting Ambac or Ambac Assurance, defaults relating to other indebtedness, imposition of certain judgments and a change in ownership of Ambac and/or Ambac Assurance.

Capital Support. Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to Ambac Assurance by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, Ambac Assurance would receive up to $800 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose, including the payment of claims. The preferred stock would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high-quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual securities. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s, respectively. During the first quarter of 2006 and 2005, Ambac Assurance paid contingent capital facility fees of $0.9 million and $1.2 million, respectively. Put option fees are included as Corporate expenses for 2006 and recorded in adjusted paid-in capital on the Consolidated Balance Sheets for the first quarter of 2005 and prior.

From time to time, Ambac accesses the capital markets to support the growth of its businesses. In February 2006, Ambac filed Form S-3 with the SEC utilizing a “shelf” registration process for well known seasoned issuers. Under this process, Ambac may issue through February 2009 an unlimited amount of the securities described in the prospectus filed

41

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

as part of the registration, namely, common stock, preferred stock, debt securities, and warrants of Ambac.

Balance Sheet. Total assets as of March 31, 2006 were $19.74 billion, up 1% compared to total assets of $19.73 billion at December 31, 2005. The increase was primarily due to cash generated from operations during the period, partially offset by a decrease in unrealized gains in the investment portfolio driven by higher long-term interest rates and stock repurchases during the period amounting to approximately $30.0 million. As of March 30, 2006, stockholders’ equity was $5.47 billion, a 2% increase from year-end 2005 stockholders’ equity of $5.37 billion. The increase stemmed primarily from net income during the period, partially offset by stock repurchases during the period and lower “Accumulated Other Comprehensive Income” driven by higher long-term interest rates.

Ambac Assurance’s investment objectives for the Financial Guarantee portfolio are to maintain an investment duration that closely approximates the expected duration of related financial guarantee liabilities and achieve the highest after-tax net investment income, while maintaining a credit risk profile within the established investment guidelines. The Financial Guarantee investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

The Financial Services investment portfolio consists primarily of assets funded with proceeds from the issuance of investment agreement liabilities. The investment objectives with respect to investment agreements are to achieve the highest after-tax total return, subject to a minimum average credit quality rating of Aa/AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity exposure. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

The amortized cost and estimated fair value of investments in fixed income securities and short-term investments at March 31, 2006 and December 31, 2005 were as follows:

	March 31, 2006				December 31, 2005
(Dollars in millions)	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Fixed income securities:
Municipal obligations	$	7,298.5	$	7,461.1	$	6,649.8	$	6,896.4
Corporate obligations		521.1		542.8		525.6		556.2
Foreign obligations		204.1		205.3		203.4		206.7
U.S. government obligations		177.1		171.7		184.5		184.5
U.S. agency obligations		828.0		845.8		902.2		946.4
Mortgage and asset-backed securities		6,583.3		6,584.6		6,315.6		6,333.8
Short-term		203.9		203.9		472.0		472.0
Other		13.6		14.4		13.5		14.2
		15,829.6		16,029.6		15,266.6		15,610.2
Fixed income securities pledged as collateral:
Mortgage and asset-backed securities		421.9		412.7		378.5		371.2
Total	$	16,251.5	$	16,442.3	$	15,645.1	$	15,981.4

42

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The following table represents the fair value of mortgage-backed securities guaranteed by either a U.S. government agency or U.S. government sponsored enterprise at March 31, 2006 and December 31, 2005 by segment:

(Dollars in millions)	Financial Guarantee		Financial Services		Corporate		Total
March 31, 2006:
Government National Mortgage Association	$	10.1	$	3.8	$	—	$	13.9
Federal National Mortgage Association		719.6		261.4		—		981.0
Federal Home Loan Mortgage Corporation		286.2		298.3		—		584.5
Vendee Mortgage Trust		—		0.1		—		0.1
Total	$	1,015.9	$	563.6	$	—	$	1,579.5
December 31, 2005:
Government National Mortgage Association	$	11.1	$	5.0	$	—	$	16.1
Federal National Mortgage Association		758.2		290.3		—		1,048.5
Federal Home Loan Mortgage Corporation		299.0		309.7		—		608.7
Vendee Mortgage Trust		—		2.0		—		2.0
Total	$	1,068.3	$	607.0	$	—	$	1,675.3

43

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The following table summarizes, for all securities in an unrealized loss position as of March 31, 2006 and December 31, 2005, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position:

	March 31, 2006				December 31, 2005
(Dollars in millions)	Estimated Fair Value		Gross Unrealized Losses		Estimated Fair Value		Gross Unrealized Losses
Municipal obligations in continuous unrealized loss for:
0 – 6 months	$	1,443.2	$	16.3	$	1,123.4	$	9.8
7 – 12 months		904.2		21.0		212.5		4.0
Greater than 12 months		420.6		14.2		278.7		7.7
		2,768.0		51.5		1,614.6		21.5
Corporate obligations in continuous unrealized loss for:
0 – 6 months		24.7		0.6		23.2		1.0
7 – 12 months		—		—		1.5		—
Greater than 12 months		52.6		0.7		51.1		0.7
		77.3		1.3		75.8		1.7
Foreign obligations in continuous unrealized loss for:
0 – 6 months		51.8		0.5		46.7		0.9
7 – 12 months		40.1		1.4		5.5		0.3
Greater than 12 months		14.3		1.6		14.2		1.6
		106.2		3.5		66.4		2.8
U.S. government obligations in continuous unrealized loss for:
0 – 6 months		83.2		3.3		131.8		0.9
7 – 12 months		68.9		2.0		7.4		0.1
Greater than 12 months		14.3		0.1		17.4		0.1
		166.4		5.4		156.6		1.1
U.S. agency obligations in continuous unrealized loss for:
0 – 6 months		342.2		6.2		296.5		4.5
7 – 12 months		166.7		5.9		16.6		0.3
Greater than 12 months		38.3		1.4		23.0		1.0
		547.2		13.5		336.1		5.8
Mortgage and asset-backed securities in continuous unrealized loss for:
0 – 6 months		830.9		5.4		1,091.1		9.6
7 – 12 months		659.0		12.2		411.6		3.4
Greater than 12 months		984.4		27.8		885.8		19.1
		2,474.3		45.4		2,388.5		32.1
Other in continuous unrealized loss for:
0 – 6 months		0.1		—		0.3		—
7 – 12 months		—		—		—		—
Greater than 12 months		0.4		0.1		0.5		0.1
		0.5		0.1		0.8		0.1
Total	$	6,139.9	$	120.7	$	4,638.8	$	65.1

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Management has determined that the unrealized losses in fixed income securities at March 31, 2006 are primarily attributable to the current interest rate environment and that these unrealized losses are temporary in nature based upon (i) no principal and interest payment defaults on these securities; (ii) analysis of the creditworthiness of the issuer; and (iii) Ambac’s ability and current intent to hold these securities until a recovery in fair value or maturity. Of the $6,139.9 million that were in a gross unrealized loss position at March 31, 2006, below investment grade securities and non-rated securities had a fair value of $15.9 million and an unrealized loss of $0.4 million, which represented 0.3% of the total fair value and total pre-tax unrealized losses shown in the above table. Of the $4,638.8 million that were in a gross unrealized loss position at December 31, 2005, below investment grade securities and non-rated securities had a fair value of $19.8 million and an unrealized loss of $1.0 million, which represented 0.4% of the total fair value and 1.5% of the total pre-tax unrealized losses shown in the above table.

There were no impairment write-downs during the three months ended March 31, 2006 and 2005. The net investment gains in the three months ended March 31, 2006 were primarily the result of the NCFE recoveries received in February 2006. The net realized investment gains in the three months ended March 31, 2005 were the result of security sales made in the usual course of business in order to achieve Ambac’s investment objectives for the Financial Guarantee and Financial Services investment portfolios.

The following table provides the ratings distribution of the Financial Guarantee investment portfolio, at fair values of $9.56 billion and $9.30 billion at March 31, 2006 and December 31, 2005, respectively, and the Financial Services investment portfolio, at fair values of $6.88 billion and $6.62 billion at March 31, 2006 and December 31, 2005, respectively:

Rating ⁽¹⁾ :

	Financial Guarantee		Financial Services		Combined
March 31, 2006:
AAA	84	%	90	%	87	%
AA	14		3		9
A	1		5		3
BBB	<1		1		1
Below investment grade	—		<1		<1
Not Rated	<1		—		<1
	100	%	100	%	100	%
December 31, 2005:
AAA	85	%	91	%	88	%
AA	14		3		9
A	1		4		2
BBB	<1		2		1
Below investment grade	—		<1		<1
Not Rated	<1		<1		<1
	100	%	100	%	100	%

(1) Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s rating is used.

Ambac’s fixed income portfolio includes securities covered by guarantees issued by Ambac Assurance (“insured securities”). The published ratings on these securities are triple-A

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

by the major rating agencies as a result of the Ambac Assurance insurance policy and are reflected in the above table as AAA. Rating agencies generally do not publish separate underlying ratings (those ratings excluding the Ambac Assurance insurance) because the insurance cannot be legally separated from the underlying security by the insurer. Ambac obtains underlying ratings through ongoing dialog with rating agencies. In the event these underlying ratings are not available from the rating agencies, Ambac will assign an internal rating. At March 31, 2006, securities with a total carrying value of $652.1 million representing 4% of the investment portfolio with a weighted-average underlying rating of BBB+ was insured by Ambac. In determining this BBB+ rating, approximately $98.4 million of the securities were assigned internal ratings by Ambac.

Special Purpose and Variable Interest Entities. Information regarding special purpose and variable interest entities can be found in the Notes to the Unaudited Consolidated Financial Statements of this Form 10-Q.

Cash Flows. Net cash provided by operating activities was $306.2 million and $287.2 million during the three months ended March 31, 2006 and 2005, respectively. These cash flows were primarily provided by Financial Guarantee operations.

Net cash provided by (used in) financing activities was $7.8 million and ($56.8) million during the three months ended March 31, 2006 and 2005, respectively. Financing activities for the three months ended March 31, 2006 included proceeds from the issuance of long-term debt associated with VIEs of $50.0 million and securities sold under agreements to repurchase of $39.0 million, partially offset by purchases of treasury shares of $42.8 million and $31.6 million in net investment and payment draws paid (net of investment and payment agreement issued). Financing activities for the three months ended March 31, 2005 included $70.9 million in net investment and payment agreement draws paid (net of investment and payment agreements issued).

Net cash used in investing activities was $315.8 million during the three months ended March 31, 2006, of which $1,206.6 million was used to purchase bonds, partially offset by the proceeds from sales and maturities of bonds of $470.1 million. For the three months ended March 31, 2005, $208.6 million was used in investing activities, of which $961.6 million was used to purchase bonds, partially offset by the proceeds and maturities of bonds of $461.9 million. Additionally, in connection with loss remediation efforts during the first quarter of 2005 for a securitization credit, Ambac purchased six aircraft for $101.6 million.

Net cash (used in) provided by operating, investing and financing activities was ($1.8) million and $21.7 million during the three months ended March 31, 2006 and 2005, respectively.

Material Commitments. The following table includes aggregated information about contractual obligations for Ambac, excluding those of entities consolidated under the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). For a further discussion of FIN 46, see Note 7 “Special Purpose Entities and Variable Interest Entities”. These contractual obligations impact Ambac’s and its subsidiaries short-and long-term liquidity and capital resource needs. The table includes information about payments due under specified contractual obligations, aggregated by type of contractual obligation, including claim payments, principal and interest

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

payments of Ambac’s consolidated long-term debt obligations, investment agreement obligations, payment agreement obligations and payments due under operating leases.

	Contractual Obligations by Year
(Dollars in millions)	2006		2007		2008		2009		2010		Thereafter
Long-term debt obligations (1)	$	63.2	$	79.0	$	79.0	$	79.0	$	79.0	$	4,486.6
Investment agreement obligations (1)		955.3		1,414.1		1,571.5		562.9		494.4		3,767.2
Payment agreement obligations (1)		12.9		71.2		78.0		66.8		65.5		1,189.6
Operating lease obligations		6.3		8.5		8.6		8.9		9.4		80.6
Purchase obligations (2)		5.1		3.2		1.9		—		—		—
Pension and post retirement benefits (3)		3.0		2.4		2.5		2.5		2.5		13.9
Other long-term liabilities (4)		64.7		2.2		0.5		3.7		4.9		169.5
Total.	$	1,110.5	$	1,580.6	$	1,742.0	$	723.8	$	655.7	$	9,707.4

(1) Includes principal of and interest on obligations using current rates for floating rate obligations.

(2) Purchase obligations includes various technology related maintenance agreements, rating agency fees and other outside services.

(3) Amount represents expected contributions to the funded defined benefit pension plan and benefit payments on unfunded pension and other postretirement benefit plans for the next 10 years. Contributions to the funded pension plan are equal to the maximum amount that can be deducted for Federal income tax purposes, under current law.

(4) Amount represents expected claim payments on financial guarantee insurance contracts that have already defaulted. Expected claim payments on financial guarantee insurance contracts that have not yet defaulted are not included.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

In the ordinary course of business, Ambac manages a variety of risks, principally credit, market, liquidity, operational and legal. These risks are identified, measured and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization.

Credit Risk. Ambac is exposed to credit risk in various capacities including as an issuer of financial guarantees, as counterparty to reinsurers and derivative and other financial contracts and as a holder of investment securities. Ambac’s Portfolio Risk Management Committee (“PRMC”) employs various procedures and controls to monitor and manage credit risk. The PRMC is comprised of senior risk professionals and senior management of Ambac. Its purview is enterprise-wide and its focus is on risk limits and measurement, concentration and correlation of risk, and the attribution of economic and regulatory capital in a portfolio context.

All financial guarantees and structured credit derivatives issued are subject to a formal underwriting process. Various factors affecting the creditworthiness of the underlying obligation are evaluated during the underwriting process. Senior credit personnel approve all transactions prior to issuing a financial guarantee. Subsequent to issuance of a financial guarantee, Ambac periodically performs reviews of exposures according to a schedule based on the risk profile of the guaranteed obligations. Proactive credit remediation can help secure rights and remedies which mitigate losses in the event of default.

Ambac manages credit risk associated with its investment portfolio through adherence to specific investment guidelines. These guidelines establish limits based upon single risk concentration and minimum credit rating standards. Additionally, senior credit personnel monitor the portfolio on a continuous basis. Credit risk relating to derivative positions (other than structured credit derivatives) primarily concern counterparty default. The majority of these counterparties are clients of the financial guarantee business which have been subject to our formal underwriting process upon the issuance of a financial guarantee. The counterparty

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Item 3. Quantitative and Qualitative Disclosures About Market Risk (Continued)

credit worthiness of new clients is separately evaluated by senior credit personnel upon entering these contracts. Counterparty default exposure is mitigated through the use of industry standard collateral posting agreements. For counterparties subject to such collateral posting agreements, collateral is posted when a derivative counterparty’s credit exposure exceeds contractual limits.

Market Risk. Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of Ambac’s financial instruments are interest rate risk, basis risk (e.g., taxable interest rates relative to tax-exempt interest rates, discussed below) and credit spread risk. Below we discuss each of these risks and the specific types of financial instruments impacted. Senior managers in Ambac’s Risk Analysis and Reporting group are responsible for monitoring risk limits and applying risk measurement methodologies. The results of this effort are reported to the PRMC. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. Ambac utilizes various systems, models and stress test scenarios to monitor and manage market risk. This process includes frequent analyses of both parallel and non-parallel shifts in the yield curve, “Value-at-Risk” (“VaR”) and changes in credit spreads. These models include estimates, made by management, which utilize current and historical market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market.

Financial instruments that may be adversely affected by changes in interest rates consist primarily of investment securities, loans, investment agreement liabilities, obligations under payment agreements, long-term debt, and derivative contracts used for hedging purposes.

Ambac, through its subsidiary Ambac Financial Services, is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. Ambac Financial Services manages its municipal interest rate swaps business with the goal of being market neutral to changes in overall interest rates, while seeking to profit from retaining some basis risk. Ambac’s municipal interest rate swap portfolio may be adversely affected by changes in basis. If actual or projected tax-exempt interest rates change in relation to taxable interest rates, Ambac will experience a mark-to-market gain or loss. A portion of the municipal interest rate swaps transacted by Ambac Financial Services contain provisions that are designed to protect Ambac against certain forms of tax reform, thus mitigating its basis risk. The estimation of potential losses arising from adverse changes in market relationships, known as VaR, is a key element in management’s monitoring of basis risk for the municipal interest rate swap portfolio. Ambac has developed a VaR methodology to estimate potential losses using a one day time horizon and a 99% confidence level. This means that Ambac would expect to incur losses greater than that predicted by VaR estimates only once in every 100 trading days, or about 2.5 times a year. Ambac’s methodology estimates VaR using a 300-day historical “look back” period. This means that changes in market values are simulated using market inputs from the past 300 days. Ambac supplements its VaR methodology, which is a good risk management tool in normal markets, by performing rigorous stress testing to measure the potential for losses in abnormally volatile markets. These stress tests include (i) parallel and non-parallel shifts in the yield curve and (ii) immediate changes in normal basis relationships, such as those between taxable and tax-exempt markets.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk (Continued)

Financial instruments that may be adversely affected by changes in credit spreads include Ambac’s outstanding structured credit derivative and total return contracts. Ambac, through its subsidiary Ambac Credit Products, enters into structured credit derivative contracts. These contracts require Ambac Credit Products to make payments upon the occurrence of certain defined credit events relating to an underlying obligation (generally a fixed income obligation). If credit spreads of the underlying obligations change, the market value of the related structured credit derivative changes. As such, Ambac Credit Products could experience mark-to-market gains or losses. Market liquidity could also impact valuations. Changes in credit spreads are generally caused by changes in the market’s perception of the credit quality of the underlying obligations. Ambac offers credit derivatives to provide credit protection enabling financial institutions to hedge portfolios of credit risk achieving either economic or regulatory relief. Ambac Credit Products structures its contracts with partial hedges from various financial institutions or with first loss protection. Such structuring mitigates Ambac Credit Products’ risk of loss and reduces the price volatility of these financial instruments. Management models the potential impact of credit spread changes on the value of its contracts.

Ambac, through its subsidiary Ambac Capital Services, enters into total return swap contracts. These contracts require Ambac Capital Services to pay a specified spread in excess of LIBOR in exchange for receiving the total return of an underlying fixed income obligation over a specified period of time. If credit spreads of the underlying obligations change, the market value of the related total return swaps changes and Ambac Capital Services could experience mark-to-market gains or losses.

The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. The increase in sensitivities to changes in credit spreads is primarily due to the average tenor of the portfolio.

Liquidity Risk. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in financial guarantee contracts, derivative contracts and investment agreements. Ambac Assurance manages its liquidity risk by maintaining a comprehensive daily analysis of projected cash flows. Additionally, Ambac Assurance maintains a minimum level of cash and short-term investments at all times. Ambac Credit Products manages the liquidity risk inherent in the structured credit derivative portfolio by holding cash and short-term investments. The investment agreement business manages liquidity risk by matching the maturity schedules of its invested assets, including hedges, with the maturity schedules of its investment agreement liabilities. Ambac Financial Services maintains cash and short-term investments and closely matches the dates swap payments are made and received. See additional discussion in “Liquidity and Capital Resources” section.

Operational Risk. Operational risk relates to the potential for loss caused by a breakdown in information, communication and settlement systems. Ambac mitigates operational risk by maintaining systems (and system backup) and procedures to monitor transactions and positions, documentation and confirmation of transactions, and compliance with regulations.

Legal Risk. Legal risks attendant to Ambac’s businesses include uncertainty with respect to the enforceability of the obligations insured by Ambac Assurance and the security therefore, as well as uncertainty with respect to the enforceability of the obligations of Ambac’s counterparties, including contractual provisions intended to reduce exposure by providing for the offsetting or netting of mutual obligations. Ambac seeks to remove or minimize such uncertainties through continuous consultation with internal and external legal advisers to analyze and understand the nature of legal risk, to improve documentation and to strengthen transaction structure.

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Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures. Ambac Financial Group’s management, with the participation of Ambac Financial Group’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of Ambac Financial Group’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this report. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, Ambac Financial Group’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Ambac Financial Group’s disclosure controls and procedures are effective at the reasonable assurance level in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Ambac Financial Group (including its consolidated subsidiaries) in the reports that it files or submits under the Exchange Act.

(b) Changes in Internal Controls Over Financial Reporting. There have not been any changes in Ambac Financial Group’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during Ambac Financial Group’s fiscal quarter ended March 31, 2006 that have materially affected, or are reasonably likely to materially affect, Ambac Financial Group’s internal control over financial reporting.

50

PART II - OTHER INFORMATION

Items 1, 3, 4 and 5 are omitted either because they are inapplicable or because the answer to such question is negative.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

The Board of Directors of Ambac has authorized the establishment of a stock repurchase program that permits the repurchase of up to 18,000,000 shares of Ambac Financial Group’s Common Stock. Ambac Financial Group will only repurchase shares of its Common Stock under the repurchase program where it feels that it is economically attractive to do so and is in conformity with regulatory and rating agency guidelines. The following table summarizes Ambac Financial Group’s repurchase program during the first quarter of 2006 and shares available at March 31, 2006:

	Total Shares Purchased (1)	Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan (1)	Maximum Number of Shares That May Yet Be Purchased Under the Plan
January 2006	—	$	—	—	4,547,802
February 2006	518,098	$	75.96	518,098	4,029,704
March 2006	45,978	$	75.40	45,978	3,983,726
First quarter 2006	564,076	$	75.92	564,076	3,983,726

(1) All shares repurchased were pursuant to a stock repurchase plan authorized by Ambac’s Board of Directors which included the repurchase of 168,476 shares during the first quarter of 2006 for settling awards under Ambac’s long-term incentive plans.

From April 1, 2006 through May 5, 2006, Ambac has not repurchased shares under its stock repurchase program.

51

PART II - OTHER INFORMATION (Continued)

Item 6 - Exhibits

The following are annexed as exhibits:

Exhibit Number	Description
31.1	Certification of CEO Pursuant to Exchange Act Rules 13a-14 and 15d-14.
31.2	Certification of CFO Pursuant to Exchange Act Rules 13a-14 and 15d-14.
32.1	Certification of CEO Pursuant to 18 U.S.C. Section 1350.
32.2	Certification of CFO Pursuant to 18 U.S.C. Section 1350.
99.03	Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of March 31, 2006 and December 31, 2005 and for the periods ended March 31, 2006 and 2005.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.

	Ambac Financial Group, Inc. (Registrant)
Dated: May 10, 2006	By:	/s/ Sean T. Leonard
		Sean T. Leonard
		Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer)

53

INDEX TO EXHIBITS

Exhibit Number	Description
31.1	Certification of CEO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of CFO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.03	Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of March 31, 2006 and December 31, 2005 and for the periods ended March 31, 2006 and 2005.

54