BOND INSURERS

 

Many municipal bond issuers choose to purchase insurance coverage as a way of enhancing the safety of the bonds and thus make them more appealing to investors. Bond insurers assume responsibility for timely payment of interest and principal if an issuer becomes unable to meet those obligations.

 

The presence of this protection—sometimes called “sleep well” insurance--allows an issuer to offer a somewhat lower rate of interest, and it improves the liquidity (i.e., the salability) of bonds in the secondary market. Insurance is considered a more solid form of credit enhancement than letters of credit provided by commercial banks. The conventional wisdom is that the cost of the insurance premium to the issuer (which averages about one-half of one percent of the bond’s total interest and principal but which can vary widely) more than pays for itself, thanks to the lower yield.

 

Private muni bond insurance was introduced in the early 1970s as a way of making tax-exempts more appealing to cautious investors. It was slow to catch on, but there has been a sharp growth in its use over the past quarter century. In 1980 only 2.5 percent of new long-term municipals carried insurance; by the late 1990s the insured portion of the market was up to 50 percent. The appeal of the insurance greatly increased in the wake of the Washington Public Power Supply System default. Holders of the small portion of WPPSS bonds that were insured got paid on time and in full, while most investors ended up with pennies on the dollar. The risks taken by insurers were also highlighted in 1998, when Pittsburgh-based Allegheny Health, Education and Research Foundation went bankrupt, leaving insurers to make good on more than $250 million in bonds.

 

“AN ALMOST PERFECT MONEY MACHINE”

Business Week once called municipal bond insurance “an almost perfect money machine.” Focusing on MBIA, then the leader in the field, the May 30, 1994 article said the company’s business “doesn’t seem very glamorous. But it has been producing an almost relentless flow of profits.” Indeed, business boomed for the insurers during the early 1990s as the volume of municipal issues increased to a record high in 1993. It climbed again after a plunge in 1994 brought on by high interest rates and the fallout of the bankruptcy filing by Orange County, California. The volume of new tax-exempt issues slumped in 1999 but then resumed its climb. In 2003 the total volume of new long-term issues reached a new record level of $379.1 billion.

When the volume of new issues rises, that translates into more business for the companies that insure a substantial portion of those bonds.  The most heavily insured categories of munis are transportation and public facilities. The portion of revenue bonds that are insured is especially high.

 

Muni bond insurance has always been dominated by a handful of companies that specialize in the field. For the past decade, the leaders have been the following four firms:

• MBIA Corporation (2003 revenues: $1.9 billion). Originally known as Municipal Bond Insurance Association, MBIA was founded in 1974 as an insurance pool by property-casualty companies. In 1989 it acquired Bond Investors Guaranty Insurance Co., a move that gave it a market share of about 51 percent. A portion of MBIA went public in 1987, and most of the rest was later spun off as well. MBIA acquired a smaller competitor called Capital Markets Assurance Corp. in 1998.
  
  
• Ambac Financial Group (AMBAC; 2003 revenues: $1.3 billion). Founded in 1971 by MGIC Investment Corp. as American Municipal Bond Assurance Corp., AMBAC was initially the dominant player in the muni bond insurance business. However, it was hit hard in the 1980s by the Washington Public Power Supply System default and by the Chapter 11 filing of AMBAC's parent company Baldwin-United (which had bought MGIC). AMBAC, relegated to the number two position, was acquired in 1985 by Citicorp, which sold off 50.3 percent of the company in a public offering in 1991 and spun off the rest a year later. AMBAC purchased a small insurer called Construction Loan Insurance Association (or Connie Lee, initially a federal government-sponsored enterprise) in 1997.
  
• Financial Guaranty Insurance Company (FGIC; 2003 revenues: $299 million). Founded as an independent firm in 1983, it was acquired by General Electric Capital Corp. in 1988. In August 2003 GE sold FGIC to an investment consortium led by mortgage insurer PMI Group Inc. and backed by the Blackstone Group.
  
  
• Financial Security Assurance Inc. (FSA; 2003 revenues: $632 million). Founded in 1985 by a group of banks and insurance companies, FSA originally focused on taxable corporate issues. It moved into the muni market in 1990 and acquired competitor Capital Guaranty Corporation in 1995. That move put FSA in a league with MBIA, AMBAC and FGIC. After being owned by U.S. West Inc. and and then by Tokio Marine & Fire Insurance Co., the company was acquired by the French-Belgian banking concern Groupe Dexia in 2000. FSA jumped to the number one spot in 2002.

 

The credit rating of each of these insurers is triple-A, so the bonds they insure normally have that top rating. In fact, some bond analysts argue that insured bonds are even more secure than bonds that achieve triple-A status without such a guarantee.

 

Most insured issues start out as A bonds, which is the most desirable type of issue for the insurers. Double-A bonds don’t pay as much in premiums, and anything less than A may represent too great a risk of default. However, in a bid to increase revenues, triple-A firms such as MBIA have increased their involvement in junk bond debt in recent years, a move that requires greater capital cushions.

 

Since 1997, high-risk issues, including those that are unrated or below investment-grade, have been the province of a new insurer called American Capital Access. ACA, which has insured a number of controversial prison bond issues, has experienced frequent financial instability and threats of ratings downgrades. The firm’s chairman, H. Russell Fraser, was forced out in 2001. American Capital Access announced plans for an initial public offering of stock in early 2004 amid continuing concerns about the firm’s capital adequacy.

 

In recent years the Big Four have faced increasing competition in the lower-risk sector from a handful of upstart companies. These include the following:

• XL Capital Assurance Inc., a subsidiary of Bermuda-based XL Capital Ltd., which started operations in late 2000;
  
  
• CDC IXIS Financial Guaranty (CIFG), which was launched by the French investment bank CDC IXIS (a subsidiary of Caisse des Depots) in 2001; and
  
  
• RaDain Asset Assurance, which started out as Asset Guaranty Insurance Co., a unit of Enhance Financial Services Group. In 2001 Enhance and Asset Guaranty were acquired by mortgage insurer RaDain Group Inc., which changed the name to RaDain Asset Assurance. RaDain, with a double-A rating, stands between the triple-A mainstream and the high-risk sector in which ACA specializes.

MARKET SHARES OF BOND INSURERS IN 2003
ranked by proceeds of municipal bond issues insured

                                                       Proceeds                  Market                      No. of

                                                      ($ million)                   share                         issues

1. FSA............................................. 68,838.5................ 33.5.......................... 1,953