A Practical Look at Bond Insurers

A bond insurer provides credit protection by giving its guarantee to pay any unpaid principal and interest payments in a default. By giving its guarantee, a debt security can then be issued with a higher rating, usually AAA, and this lowers the interest cost of the debt. Now, I'd argue that if you take a close look at the competitive forces these companies face, you'll come to the conclusion that this is a mediocre business at best.

The most obvious competition is from other bond insurers and there really is no moat within this group. The AAA credit-rating is favorable because it lowers the cost of guaranteed securities to almost government treasury rates, but there are a few insurers who have this rating. Otherwise, the business is strictly based on how much capital you have and what price you are willing to pay. MBIA mentions in their annual report that it "also competes with other forms of credit enhancement, including senior-subordinated structures, credit derivatives, over-collateralization, letters of credit and guarantees."

But an even more significant competitor is "Mr. Market" himself. An issuer of debt likes bond insurance because it diminishes the investor's risk, and so it can potentially lower the issuer's interest costs. It all depends on cost of the insurance, and the spread between what the market will charge the issuer and what the market will charge its guaranteed security. If the cost of insurance is less than the spread, then the bond insurer gets new business and the issuer lowers his borrowing cost. But if the cost of insurance is more than the spread, then there is no transaction- the issuer would be better off selling the debt directly to the market. Thus, we see that credit insurers are competing against the market's perception of risk. Effectively, the bond insurer is saying that they have expertise and can profit by being better judges of a security's risk than the overall market.

Now that is plausible. But for one, these insurers are doing this with a large amount of money, making it more difficult to earn out-sized returns. And two, before the recent turmoil in the credit markets, spreads on risky securities were at unprecedentedly low levels.


So taking into account the competition, the large capital base, and the credit spread tightening, you would think that these companies would have been marginally profitable recently. But instead, these companies have been recording record profits with very healthy margins.

MBIA, 2002- 2006 ratios

Loss and LAE ratio

9.7 % 10.0 % 10.0 % 10.0 % 10.5 %

Underwriting expense ratio

26.6 24.7 21.5 22.2 22.9

Combined ratio

36.3 34.7 31.5 32.2 33.4

So that begs the question of how a credit insurer was able to underwrite so profitably(loss reserves at 10% of premiums) in an environment where "Mr. Market" was so willing to buy risky debt. And I guess you can say part of the answer lies in the fact that a bond insurer's loss reserves are very much up to judgment. In traditional property and casualty insurance, you typically have a very good sense of what your total losses will be by the second year. But in bond insurance, the time horizon is much longer. For example, we know that the average of MBIA's insured debt outstanding is over 10 years. That means that at anytime within those 10 years, a credit contraction could reveal that their reserves are drastically inadequate. This makes investing in a bond insurer sort of like a black-box, because you never really know what you are getting without knowing their loss assumptions.

Many bond insurers have lost 50 to 75 percent of their stock value in the last 6 months. (See MBI, ABK, AGO) Perhaps at these prices they are actual values, and maybe I am missing some factor that allows them to underwrite so effectively. All I know is based on these competing forces and the leeway available in their accounting, that it is very likely they have been under-provisioning for future losses, and that I can not tell you by how much. As I was writing this though I did come across this post on Calculated Risk- Egan Jones: Expect "Massive" Losses for Bond Insurers.