A type of insurance policy that a bond issuer purchases that guarantees the repayment of the principal and all associated interest payments to the bondholders in the event of default. Bond issuers buy insurance to enhance their credit rating to 'AAA' in order to reduce the amount of interest that it needs to pay.
As compensation for its insurance, the insurer is paid a premium (as a lump sum or in installments) by the issuer or owner of the security to be insured. Bond insurance is a form of "credit enhancement" that generally results in the rating of the insured security being the higher of (i) the claims-paying rating of the insurer and (ii) the rating the bond would have without insurance (also known as the “underlying” or “shadow” rating).
The premium requested for insurance on a bond is a measure of the perceived risk of failure of the issuer. It can also be a function of the interest savings realized by an issuer from employing bond insurance or the increased value of the security realized by an owner who purchased bond insurance.
A majority of insured securities are municipal bonds issued by states, local governments and other governmental bodies in the United States. Financial guarantees have also been applied to infrastructure bonds, such as those financing public-private partnerships, non-U.S. regulated utilities, and asset-backed securities (“ABS”) in the United States and elsewhere, as well as non-U.S. municipal bonds. Financial guaranty insurers withdrew from the residential mortgage-backed securities ("RMBS") market after the 2008 financial crisis.
Bond insurers generally insure only securities that have underlying or "shadow" ratings in the investment grade category, with unenhanced ratings ranging from “triple-B” to “triple-A.” Beginning in the 1970s, municipal government bonds were insured by bond insurers, also known as the “monolines.” Although the global financial crisis of 2008 caused most bond insurers to cease issuing insurance policies, bond insurance has continued to remain available from highly rated providers, including legacy insurers and new industry participants.
Municipal Bond Insurance and the Monolines
Municipal bond insurance was introduced in the U.S. in 1971 by American Municipal Bond Assurance Corp. (subsequently renamed AMBAC and later "Ambac"), the first of the financial guaranty corporations, being a separately capitalized insurance company formed for the purpose of insuring bonds. Ambac was joined in 1973 by Municipal Bond Insurance Association (subsequently renamed “MBIA”), Financial Guaranty Insurance Company (“FGIC”) in 1983, and Financial Security Assurance Inc. (“FSA,” now known as Assured Guaranty Municipal) in 1985. These became known as the “big four” bond insurers. Other participants in this sector included Capital Markets Assurance Corp. (“CapMac”) (1988) and Bond Investors Guaranty Insurance Company (“BIG”) (1985), both subsequently acquired by MBIA; Capital Guaranty Corp. (1986), subsequently acquired by FSA; and College Construction Loan Insurance Corporation (“Connie Lee”) (1987), subsequently acquired by Ambac. FSA, which was the first bond insurer organized to insure non-municipal bonds, established the business of insuring ABS. The 1980s also saw the birth of monoline financial guaranty reinsurance companies, including Enhance Reinsurance Company (“Enhance Re”) (1986) and Capital Reinsurance Company (1988). The 1990s then saw the combination of the municipal bond insurance business with the ABS insurance business, and also saw the expansion of bond insurance into Europe, Asia, Australia, and Latin America.
In the late 1990s and early 2000s a new group of bond insurers emerged. These included ACA Financial Guaranty Corp. (1997); XL Capital Assurance Inc. ("XLCA") (2000), initially a subsidiary of XL Capital Ltd. before being spun off in 2006 and subsequently renamed "Syncora Guarantee Inc."; and CIFG (2001). This era also saw the emergence of new reinsurers, such as Ram Reinsurance Company Ltd. ("Ram Re") and AXA Re Finance.
In 1999, ACE Ltd. acquired Capital Re, and renamed the company “ACE Capital Re.” ACE Capital Re was spun off from ACE Ltd. in 2004 and renamed Assured Guaranty Corp. (“AGC”). AGC's parent holding company, Assured Guaranty Ltd. (together with its subsidiaries, "Assured Guaranty"), engaged in both financial guaranty insurance through AGC and reinsurance through its subsidiary, Assured Guaranty Re Ltd. (AG Re).
In 2001, Radian Group Inc. acquired Enhance Reinsurance Company and its affiliate, Asset Guaranty Insurance Company, renaming the companies Radian Reinsurance Inc. and Radian Asset Assurance Inc. ("Radian Asset"), respectively. Both companies engaged in financial guaranty insurance and reinsurance. In June 2004, Radian Reinsurance and Radian Asset Assurance merged, with the surviving corporation being Radian Asset.
The financial crisis that began in late 2007 negatively impacted the bond insurers. Beginning in 2008, the financial guaranty insurers became subject to rating agency downgrades, largely as a result of their exposure to RMBS, either directly or through insurance of collateralized debt obligations of asset-based securities (so-called “CDOs of ABS”), which included CDOs backed by mezzanine RMBS. Insurers that guaranteed CDOs of ABS suffered the most extreme losses.
In 2009, Assured Guaranty acquired FSA and subsequently renamed it Assured Guaranty Municipal (“AGM”), thus combining under the same ownership the two most highly rated bond insurers at that time. As a result, Assured Guaranty was to become the only legacy bond insurer to write insurance continuously from the pre-crisis period to the present.
Business model
Bond insurance generally reduces the borrowing costs for an issuer since investors are prepared to accept a lower interest rate in exchange for the credit enhancement provided by the bond insurance. The interest savings from the use of bond insurance are generally shared between the issuer (as its incentive to use the insurance) and the insurer (as its premium for providing the insurance). Since an issuer generally has the option of selling its securities with or without insurance, the issuer will generally only use insurance when doing so results in overall cost savings acceptable to the issuer. Municipal bond insurance premiums are generally paid up-front as a lump sum; while non-municipal bond insurance premiums are generally paid in periodic installments over time.
In July 2008, the Association of Financial Guaranty Insurers (“AFGI”), the trade association of financial guaranty insurers and reinsurers, estimated that, since its inception in 1971, the bond insurance industry has saved municipal bond issuers $40 billion. In addition to credit enhancement, bond insurance provides other benefits to investors, including improved liquidity for the insured securities, surveillance of the underlying transactions, and remediation of the underlying transaction, should that prove necessary. Significantly, uninsured transactions are often not monitored by rating agencies following issuance of the initial ratings and, in the event of default, bond trustees often fail to take appropriate remedial actions absent direction and indemnity from the bondholders, which is typically not forthcoming.
See also
- Nuclear Implosions: The Rise and Fall of the Washington Public Power Supply System
- Credit rating agency
- Credit Derivatives Product Company
- Credit default swap
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