Bond insurance, also known as "financial guaranty insurance", is a type of insurance whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer of the bond or security. It 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 or (ii) the rating the bond would have without insurance (also known as the "underlying" or "shadow" rating).
The insurer is paid a premium by the issuer or owner of the security to be insured. The premium may be paid as a lump sum or in installments. The premium charged 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.
Bond insurers are "monoline" by statute, which means that companies that write bond insurance do not participate in other lines of insurance such as life, health, or property and casualty. The term monoline does not mean that insurers operate only in one securities market, such as municipal bonds, as the term has sometimes been misconstrued. Although bond insurers are not the only monoline insurers, they are sometimes colloquially called "the monolines". Bonds insured by these companies are sometimes said to be "wrapped" by the insurer.The term 'wrap' is used in the various FAQs and documents referenced in this article. Also see Structured Finance & Collateralized Debt Obligations, by Janet Tavakoli, 2008, Wiley
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".
Benefits Value to issuers The economic value of bond insurance to the governmental unit, agency, or other issuer of the insured bonds or other securities is the result of the savings on interest costs, which reflects the difference between yield payable on an insured bond and yield payable on the same bond if it was uninsured—which is generally higher.
Borrowing costs are generally reduced for issuers of insured bonds because investors are prepared to accept a lower interest rate in exchange for the credit enhancement provided by the insurance. The interest savings are generally shared between the issuer (as its incentive to use the insurance) and the insurer (as its insurance premium). Since an issuer has the option of selling its securities with or without insurance, it will generally only use insurance when doing so results in overall cost savings. 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 ("AGFI"), the trade association of financial guaranty insurers and reinsurers, estimated that, since its inception in 1971, the bond insurance industry had saved municipal bond issuers and their taxpayers $40 billion.
A majority of insured securities today are municipal bonds issued by states, local governments and other governmental bodies in the United States and in certain other countries. Bond insurance has also been applied to infrastructure project financing, such as those for public-private partnerships, bonds issued by non-U.S. regulated utilities, and U.S. and non-U.S. asset-backed securities ("ABS"). Financial guaranty insurers withdrew from the residential mortgage-backed securities ("RMBS") market after the 2008 financial crisis.
Value to investors Investors purchasing or holding insured securities benefit from the additional payment source provided by the insurer if the issuer fails to pay principal or interest when due (which reduces the probability of a missed payment to the probability that not only the issuer but also the insurer defaults).
The value proposition of bond insurance includes the insurers' credit selection, underwriting, and surveillance of the underlying transactions. Significantly, uninsured transactions are often not monitored by rating agencies following their initial rating issuance. In the event of default of such transactions, bond trustees often fail to take appropriate remedial actions absent direction and indemnity from the bondholders (which is typically not forthcoming). In contrast, bond insurers frequently have the ability to work directly with issuers either to avoid defaults in the first place or to restructure debts on a consensual basis, without the need to obtain agreement from hundreds of individual investors. Litigation to obtain recovery, should it be necessary, is the insurer's responsibility, not the investor's.
The insurance may also improve market liquidity for the insured securities. The uninsured bonds of an individual issuer may trade infrequently, while bonds trading in the insurer's name are more likely to be actively traded on a daily basis.
Investors in insured bonds are also protected from rating downgrades of issuers, so long as the insurer is more highly rated than the issuer.
Following the 2008 financial crisis, municipal market events have helped to refocus investors and issuers on the benefits that bond insurance provides. A number of well-publicized municipal defaults, bankruptcies and restructurings occurred, which proved that bond insurance remains valuable in the public finance market. For example, holders of insured bonds were kept whole by Assured Guaranty and National Public Finance Guarantee in situations involving Detroit, Michigan; Jefferson County, Alabama; Harrisburg, Pennsylvania; Stockton, California and Puerto Rico. In the secondary market, insured bonds have generally exhibited significant price stability relative to comparable uninsured bonds of distressed issuers. Additionally, investors were spared the burdens of negotiating or litigating to defend their rights.
Although the 2008 financial crisis caused most bond insurers to cease issuing insurance policies, the insurance has continued to remain available from highly rated providers, including legacy insurers and new industry participants.
History: 1970s–2008 Prior to the 2008 financial crisis, bond insurers suffered few material losses. Notable exceptions in the municipal sector include:
a 1984 Ambac loss on its exposure to the Washington Public Power Supply System (WPPSS), which helped establish the value of bond insurance; and a 1998 MBIA loss on its exposure to Allegheny Health, Education and Research Foundation (AHERF), which declared bankruptcy.
As publicbonds.org points out, a 1994 BusinessWeek article called MBIA "an almost perfect money machine". The BusinessWeek story noted that, as of that time, MBIA had seen only one loss., publicbonds.org, accessed 2010 4 15, Corporate Research Project / Good Jobs First. (editor Philip Mattera, writer Mafruza Khan, analyst Kevin Pranis)Ninety-Five Percent Of Our Profits Are Locked In, BusinessWeek: May 30, 1994, Tim Smart, Charlie Hoots
By the late 1990s and early 2000s, about 50% of U.S. municipal bonds were insured.Major Players, publicbonds.org, Corporate Research Project / Good Jobs First, accessed 2010 4 11
Although penetration of insurance in the municipal bond market is far lower today than when numerous triple-A insurers were active, the ability of Assured Guaranty to continue insuring municipal bonds that were issued during a prolonged period of low interest rates and narrow credit spreads is evidence that a market continues to exist for municipal bond insurance.
Timeline 1971 saw the introduction of municipal bond insurance in the U.S. by American Municipal Bond Assurance Corp. (subsequently renamed AMBAC and later "Ambac"). Ambac was the first separately capitalized insurance company formed for the purpose of insuring bonds. In 1973 Municipal Bond Insurance Association (subsequently renamed "MBIA") formed, followed by Financial Guaranty Insurance Company ("FGIC") in 1983. Financial Security Assurance Inc. ("FSA", now known as Assured Guaranty Municipal) formed in 1985. FSA was the first bond insurer organized to insure non-municipal bonds, and it established the business of insuring asset-backed securities (ABS). These became known as the "big four" bond insurers.
By 1980, about 2.5% of long-term municipal bonds were insured., publicbonds.org, Corporate Research Project / Good Jobs First, accessed 2010 4 11
In 1983, the Washington Public Power Supply System (WPPSS) defaulted on $2.25 billion of revenue bonds relating to troubled nuclear power projects. Most of the 30,000 bondholders lost 60-90 cents on the dollar. Ambac had insured a small portion of the bonds, and holders of the insured debt received full and timely payment from Ambac, which demonstrated the value of bond insurance to the market. This proved to be a watershed moment for the bond insurance industry, igniting steady growth in demand for many years.
During the 1980s, other participants emerged in the sector including Bond Investors Guaranty Insurance Company ("BIG") (1985) and Capital Markets Assurance Corp. ("CapMac") (1988), both of which were subsequently acquired by MBIA; Capital Guaranty Corp. (1986), which was subsequently acquired by FSA; and College Construction Loan Insurance Corporation ("Connie Lee") (1987), which was subsequently acquired by Ambac.
The 1980s also saw the birth of monoline financial guaranty reinsurance companies, including Enhance Reinsurance Company ("Enhance Re") (1986) and Capital Reinsurance Company (1988).
FSA insured the first collateralized debt obligation ("CDO") in 1988, and experienced only minor losses in the asset-backed securities (ABS) sector before the 2008 financial crisis.
In 1989, New York State enacted a new Article 69 of the New York State Insurance Law, which established "financial guaranty insurance" as a separate line of insurance. Article 69 excluded financial guaranty insurers from coverage under the property/casualty insurers security fund, which covered payments owed by insolvent insurers. It also established financial guaranty insurance as a monoline business, limiting industry members to writing bond insurance and closely related lines of insurance that include surety, credit, and residual-value insurance. The monoline restriction also prevented other types of insurance companies from offering financial guaranty insurance. A cited rationale for the monoline approach was to simplify regulation and help ensure capital adequacy.
The 1990s saw industry members insure both municipal bonds and asset-backed securities (ABS). At the same time, the industry expanded into overseas markets in 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), a subsidiary of XL Capital Ltd. that was 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. ("Assured Guaranty"), engaged through its subsidiaries in both financial guaranty insurance – through AGC—and reinsurance—through Assured Guaranty Re Ltd. ("AG Re").