BOND INSURANCE
A bond issuer can purchase bond insurance to improve the credit rating on a bond issue and therefore get a lower interest rate when the bonds are sold. An insured bond carries the commitment of the insurer to pay the principal and interest on a bond if the issuer is unable to do so.
Advantages
The primary advantage for the issuer is an improved credit rating on the issue. Issues covered by bond insurance receive the insurance company's rating. As a result of obtaining a better rating with the bond insurance, the issue will carry a lower interest cost.
Bond insurance is a tool which greatly simplifies an otherwise complicated security arrangement so that investors can understand and evaluate the risks involved.
Disadvantages
Issuers must pay an insurance premium to obtain insurance coverage. Unless the savings resulting from reduced interest costs exceed the cost of the insurance, this form of credit enhancement is not useful.
An issuer can enhance its creditworthiness by purchasing bond insurance from a private company. Bond insurance is an unconditional promise by the insurer to meet the principal and interest payment obligations of the issuer, should the issuer be unable. Unlike a letter of credit, this obligation lasts for the life of the bond issue. The obligation is unconditional, irrevocable, and not subject to cancellation by the insurer. Bond insurance does not cover insolvency or negligence of the trustee or paying agent.
The purchase of bond insurance enables the issuer to get a higher credit rating on the bonds, and therefore pay a lower interest rate. Issues covered by bond insurance receive the insurance company's rating, typically a triple A rating. In theory, insured issues will trade at rates available on triple A bonds. In practice, however, although the insurance buys the higher triple A rating, investors may still distinguish between a true triple A issue and an insured triple A issue with an underlying double or single A rating.
The actual amount of the savings from the lower interest rate depends on the level of interest rates, and the interest rate spreads between grades of bonds. Insurance also provides greater liquidity for issues in the secondary market, for bonds of unknown or infrequent issuers, and for bonds with unusually complex repayment sources.
Bond insurers, when evaluating the creditworthiness of an issuer, will have different considerations than those of the bond rating agencies. Bond insurance is a long-term commitment. The insurer cannot change the rating or cancel the insurance if the financial condition of the government worsens in the future. Generally, the bonds must already be investment grade (triple B or higher) for insurance to be provided.
Insurance Premiums
The premiums companies charge for bond insurance generally range from 0.1% to 2% of combined principal and interest payable over the life of the issue. The premium reflects costs to the insurer, profitability considerations, market conditions, and competition. Costs incurred by the insurer include rating agency capital requirements and servicing costs such as administration, data processing, reporting, and credit oversight.
These costs can vary significantly depending on the type of bond being insured. For instance, hospital revenue bonds require complicated and frequent credit analysis and greater capital reserves, so they are typically more costly to insure and will carry higher premiums.
When considering the purchase of insurance, the bond issuer must compare the premium to the expected savings achieved from a lower interest rate. Because the premium is paid up front at the time of issue, the interest cost savings should be compared to the premium in present value terms. Additionally, competition among the insurers has increased and many issuers have begun to ask for competitive bids on insurance in order to save money on premiums.
Bond Insurance Companies
There are currently five bond insurance companies, with three companies dominating the market. These three are American Municipal Bond Assurance Corporation (AMBAC), Financial Guaranty Insurance Company (FGIC), and Municipal Bond Investors Assurance Corporation (MBIA). Companies are typically owned by property and casualty insurance companies or financial institutions. The bond insurance companies are regulated by state insurance commissions.
The insurance companies themselves are rated by Standard Poor's and Moody's. They are evaluated on their ability to withstand both systematic economic decline, with its related financial stress, as well as the financial stress of individual losses unrelated to a recession or depression. The rating agencies consider the insurer's level of capitalization, future access to capital, cash flow, diversity of the insured portfolio, and the quality of the portfolio. The main insurance agencies have all been rated triple A.