The financial guarantee insurance industry has changed dramatically since AMBAC Indemnity Corp.'s predecessor wrote the first municipal bond policy in 1971 and Financial Security Assurance Inc. was founded in 1985 to insure asset-backed and structured corporate debt.
Financial guarantee insurance has come of age - and then some. Let's take a look at the changes we have witnessed.
First, financial guarantee insurance is no longer a plain-vanilla product offered to guarantee the performance of a plain-vanilla general obligation municipal bond.
Second, while still not a household word, bond insurance is becoming better known. Articles in the financial press frequently reference bond insurance.
Third, public, shareholders now own more than $2 billion, or 43%, of the bond insurance industry's equity. Sophisticated institutions are no longer the sole owners of financial guarantee insurers. Fitch Investors Service predicts that additional public equity offerings will soon bring public ownership over 50%.
Public ownership brings increased industry scrutiny by the Securities and Exchange Commission, the New York Stock Exchange, and the investment community. It also means public shareholders are now interested not only in whether their insured obligations are money good, but also in whether their investments in the insures themselves are money good.
As more equity in the financial guarantee industry is owned by the public, questions include: Has our industry reached full growth? Will the pie get bigger? Will the flavors multiply?
I am here to preach the gospel of the potential for virtually unlimited growth, in products as well as revenues, for financial guarantee insurers. We at Enhance Financial Services Group Inc. are convinced that even in its present highly developed state, financial guarantee insurance is not a fixed pie in size or in product line.
As an example: Merrill Lynch designed and implemented the first Cash Management Account. After it had been launched, the most-often asked question was, "Why had it taken so long for it to be offered?"
Who would have predicted in 1981, when 11% of municipal bonds were coming to market backed by letters of credit and 4% of new municipals were coming to market insured, that 10 years later, in 1991, less than 5% of municipals would be backed by LOCs, while almost 30% would be backed by insurance?
Growth in issuance and insurance of asset-backed obligations has been strong, though not a straight line. Asset-backed issuance grew from $25 billion in 1989 to $51 billion in 1991.
Insurance of asset-backed obligations has risen from $7 billion in 1989 to $10 billion in 1990. The percent of insured asset-backed new-issue debt decreased slightly in 1991 compared with 1990.
But there is little doubt insurance of asset-backed obligations will continue to grow. Prudent management of asset-backed insured growth will be a major determinant of the long-term health of our industry.
Though financial guarantee insurers vary wide widely in their business strategy, competition for insurance of asset-backed and structured corporate deals is becoming increasingly fierce. FSA and Capital Markets Assurance Corp. no longer have that arena to themselves.
Municipal Bond Investors Assurance Corp. and Financial Guaranty Insurance Co. are pressing to increase their participation in the asset-backed insurance marketplace. As of now, AMBAC has not entered the asset-backed insured market.
While acknowledging municipal insurance as the mother of the industry and asset-backed insurance as its closest relative, financial guarantee insurers are exploring other opportunities.
Page one of The Bond Buyer's March 1992 credit enhancement supplement references new financial guarantee insurance products in the headline: "Financial Guarantors Hit Warp Drive, Set Foot on GIC and LOC Planets."
The lead sentence reads, "Bond insurers are now advancing into futuristic new territories, augmenting the staid, rather Victorian municipal guarantee with bold -- yet symbiotic -- moves into various financial services."
Such direct initiatives of the insurers themselves share newsprint with offshoots of the insurers, such as MBIA's CLASS program and the liquidity facility provided by GE Capital, FGIC's parent.
Let's look at what has happened to financial guarantee insurance products.
New markets are being carefully created where markets for financial guarantee insurance did not exist. Methods are diverse. They include creation of or partnerships with firms outside the United States, such as Credit Re's offshore reinsurer.
If and when U.S. banks show themselves ready to implement rigorous risk-based deposit insurance premiums, the financial guarantee insurance industry probably will seek a role in providing that insurance.
This is a potentially vast market which will change the nature and scope of our industry. It will be the primaries themselves that will be the reinsurers.
The reinsurers may become retrocessionaries also on a new scale. An industry that has not operated on an actuarial basis will have to develop some sort of actuarial underpinnings.
Meanwhile, Asset Guaranty's limited primary insurance business is also tapping new markets.
Similarly, in a bad commercial real estate market, the niche of tax-exempt bonds backed by multifamily housing turns out to be a good source of business.
We have also seen a shift from flat-out credit enhancement to leveraging of skills and connections. Financial guarantee insurers are leveraging their know-how in credit analysis and the client contacts they have developed through the years.
In an example of a financial guarantee insurer leveraging its expertise, AMBAC announced in April of this year that its Health Care Investment Analysts subsidiary had acquired Healthcare Knowledge Resources.
An example of a new product heavily dependent on an insurer's contacts is MBIA's CLASS product, rolled out by a subsidiary. CLASS depends on small municipalities' willingness to entrust their funds to an MBIA subsidiary to manage. CLASS provides higher returns on small municipalities' money by pooling their funds.
As the industry expands, it must carefully distinguish between financial guarantee insurance and the types of business, such as CLASS, being conducted either in the name of, or by subsidiaries of or companies related to, financial guarantee insurers. CLASS must not be mistaken for a market-value guarantee provided by MBIA as part of its bond insurance.
As part of heightened public visibility and scrutiny, even those new producers that are solidly or arguably financial guarantee products will have to be carefully presented.
They must not be viewed as so risky by virtue of their innovative nature that they will seriously jeopardize or take down the financial guarantee insurers.
Much time has been spent in careful risk management, extremely conservative investment policies, and impeccable underwriting. The industry's reputation will be squandered if we are perceived as gambling with either policyholders' or shareholders' money.
Other risks also loom. Credit-enhancement competitors, real and perceived, are out there in force. One place is competition from bank LOCs.
In spite of the risk-based capital rules, we may see less insurance as a LOC substitute as U.S. banks finally get their act together. In the recent past, U.S. bank downgrades overwhelmingly surpassed bank upgrades. But bank earnings were up this last quarter.
I suspect that the ratio of U.S. bank upgrades to downgrades will begin to reverse itself in favor of upgrades, though at a relatively slow pace.
How the LOC/insurance mix will evolve in the longer term is difficult to forecast. With risk-based capital requirements in place, banks seeking to re-enter the LOC market will be carefully doing their economic homework. If the banks price LOCs intelligently, our industry will be an effective ongoing competitor.
From where else will competition for the financial guarantee insurers come? One answer emerged in a recent conversation I had with a Wall Street Journal reporter who was writing a piece on tapping public employee pension funds to help the local economy. The mechanism proposed is for the pension fund to get a rating and provide a credit guarantee to help sell municipal bonds.
Applying the insurance version of the duck test - if it doesn't look like a duck and quack like a duck, it's not a duck - to the "guarantee" of debt by pension funds reveals it is not insurance.
Cross guarantees are not insurance. Employees whose pensions depend on the funds will be tying up their capital and exposing themselves to some degree of risk. Down the road, though, pension funds may provide competition if they decide to use public pension money to set up an insurance company to back the credit of municipal bonds.
On the positive side, asset-backed issuance and insurance are still in their infancies. And municipal issuance is likely to remain strong.
But what will happen when the interest rate-driven volume of both refundings and new-money issuance in the municipal and corporate markets begins to decline, and capital spending in the private sector does not shoot up?
One answer is the recent forays of bond insurers into swaps and floaters. In that area, insurance brings its typical benefit of enhancing the marketing effort by cutting through the complexity of the deals for investors and bolstering demand and liquidity.
Secondary market insurance of municipals is also a growing market. Our industry is grappling with how best to make its capacity available to meet the demand for secondary market enhancement.
And if by now secondary market insurance of municipal bonds is an old story, uninsurance is perhaps the most startling new financial guarantee product.
FGIC announced in April 1992 that it will uninsure credits previously enhanced in the secondary market. FGIC saw a need for an insurance-releasing mechanism to give secondary market participants an added option.
The insurer would make a cancellation payment to bondholders who want to remove insurance from their bonds. An attractive financial guarantee insurer benefit is the potential impact on earnings by accelerating the earning of unearned premiums for bonds that have been uninsured.
Going forward, growth and change will drive and characterize the financial guarantee insurance sector of the insurance industry. The rest of the industry will find itself increasingly dealing with financial guarantors as investors, partners, competitors, or all three.
But no matter the nature of change, the mantra for our industry must be to utilize the highest standards of credit analysis and underwriting.
And as the primaries continue to develop and expand, rest assured we reinsurers are delighted to bat cleanup.
Mr. Sellers is president and chief executive officer of Enhance Financial Services Group Inc.
