After two years of record performance, the bond insurance industry is now confronted by an environment with rising interest rates, declining municipal issuance, and increasing competition within the industry.
The result will likely be reduced growth or a possible decline in earnings for some insurers, as well as increased pressure to lower premium rates to maintain market share. Despite these conditions, the overall picture for the bond insurance industry is very bright, and Duff & Phelps Credit Rating Co expects the industry to maintain its high credit quality.
The low interest rates of the last two years drove municipal bond volume to record levels and triggered unprecedented levels of refundings. These circumstances led to large amounts of accelerated premium earnings, capital gains and increased core earnings from the unearned premium reserve. The result was a 27% growth of insurers' statutory net income to $716 million in 1993.
The outlook for 1994 is not the same. Higher interest rates are already beginning to put the brakes on refundings, lowering municipal bond issuance and, thus, the volume of insured bonds. With refundings substantially lower and capital gains disappearing, there will be pressure on the insurers' statutory earnings. Insurers fighting to maintain market share in this environment could be tempted to engage in intense competition to lower insurance premiums, especially for low-risk general obligation bonds.
However, if the industry sticks to the basics of credit quality and risk based pricing, none of these concerns should lead to problems for the primary insurers or reinsurers.
Fundamentally, the bond insurance industry has never been stronger. In the municipal marketplace itself, increased federal and state tax rates should lead to a steady investor appetite for insured municipal bonds. Bond insurers can also look forward to an increase in core earnings, strong investment income, moderately increasing leverage levels and capital strength within their own financial structures. Unearned premium reserves have increased at an annualized rate of 17% since 1989, to $3.8 billion. Statutory capital was $5.3 billion as of December 31, 1993, as $185 million of new capital was invested in bond insurers during the year. Due to the new capital and the runoff of exposure from refundings, the average leverage ratio declined to 134:1 from 135:1.
Demand for Insurance
Looking forward, Duff & Phelps expects municipal bond issuance this year to be in the $180 billion - $190 billion range, down from $289 billion in 1993. Although insured bonds are expected to maintain a 35-37% market share, the volume of insured bonds should drop to approximately $65 billion in 1994, down from $107 billion in 1993. Although rising interest rates will continue to dampen refunding volume, new money issuance should increase from $99 billion in 1993. Extensive infrastructure improvements are needed throughout broad sectors of the U.S. economy, and recent tax hikes increase the likelihood that future financing needs will be met by debt issuance.
Ownership of municipal bonds will continue to be dominated by individuals, either directly or through funds. With top marginal tax rates in high-tax states approaching 50%, demand for tax-exempt securities by individuals is gaining. Demand will continue to grow as the oversupply caused by the 1993 boom eases, and as the Federal Reserve continues to "stair step" short-term rates. Property and casualty insurance companies may also be generating increased demand for tax-exempt securities as they return to profitability. However, they are not typically in the market for insured bonds.
One side effect of the decline in refunding volume is likely to be a small decline in the insured share of the market. Refunding and combined refunding/new money bonds tend to have a higher insured share than new money issues. In 1993, for example, 39.9% of the bonds sold for refunding purposes were insured, and 44.0% of the bonds sold for the combined use of refunding/new money purposes were insured. However, only 30.8% of the bonds sold only for new money purposes were insured.
One possible reason for this is that it is relatively cheaper to insure refunding issues than new money issues. On a refunding transaction, issuers can frequently include the cost of insurance in the calculation of the yield that can be earned on escrowed funds. Thus, a higher yield is earned on the funds, which reduces the cost of insurance. Additionally, there is often a credit, implicitly or explicitly, given by the bond insurers on transactions in which the refunding issue is replacing a previously insured issue.
Although total earnings at some insurers are down in the first quarter of 1994 due to lower refunding volume, core earnings will continue to grow as insurers recognize unearned premiums on bonds previously insured. Driven by the large volume of issuance and insurance in 1992 and 1993, the unearned premium reserve (UPR) grew to $3.8 billion at December 31, 1993, for the industry as a whole, a 40% increase over 1991. As issuance returns to sustainable levels, the growth rate of the unearned premium reserve will slow. However, earned premiums in the foreseeable future should remain strong. Bond insurers that record an explicit refunding credit, transferring some of the unearned premium reserve from the refunded issue to the refunding issue, should be in the best shape to maintain their earnings growth.
Bond insurers' investment earnings totaled $641 billion in 1993, representing 48% of revenues: $523 million from interest income and $117 million from capital gains. A decline in accelerated earned premium from refundings will result in an increased emphasis on investment earnings. As interest rates increase, the earnings power of the invested assets will increase. The importance of investment returns in the determination of premium rate and the profitability of individual transactions is often underestimated. Since insurance premiums are usually collected up front, the investment income generated from these funds is critical component in the profitability of each insurance transaction.
The approximately 50 basis-point increase in the municipal bond index that occurred from December 31 to March 31 means that the bond insurers ca be somewhat more competitive on premium rates, while maintaining the same level of profitability on an individual transaction. However, interest rates are a double-edged sword. While the bond insurers recognized $117 million of capital gains in 1993, the $517 million of unrealized gains at December 31, 1993 had dwindled to approximately $150 million at March 31, 1994.
The operating efficiency of the primary bond insurers has dramatically improved over time. While net written premiums increased 28% annually from 1989, operating expenses increased just 9%. It requires a certain level of infrastructure (i.e. systems, accounting, etc.) to operate a bond insurance business. As volume increases, it is necessary to increase the number of credit and surveillance analysts, but the infrastructure of the insurer grows only marginally. In the high-volume environment of the past two years, primary insurers were able to lower their expense ratios to 22% in 1993 from 42% in 1989. Reinsurers were not able to take advantage of these economies of scale, since the bulk of their costs are commission, directly attributable to the volume of business they assume. With the expectation of lower volume in 1994, Duff & Phelps expects the average expense ratio for the primary insurers to increase to 30% or more.
Loss ratios have averaged under 12% for the last five years, with 1993 recording $12.7 million in losses incurred. At the primary insurers, recoveries on past losses reduced losses incurred to negative $8.1 million. However, the reinsurers recorded $20.8 million in losses, primarily on cessions of commercial real estate from Financial Security Assurance Company (FSA) to Enhance Reinsurance Company (Enhance Re) and Asset Guaranty Insurance Company. Outside of the small amount of commercial real estate exposure remaining and for the instances in which case-basis reserves have been established for certain problem credits, there is little reason to anticipate any serious problems in the near term.
To the extent capital adequacy is measured by leverage, the industry is in excellent financial shape. The leverage ratio actually declined in 1993 to 134:1 from 135:1 in 1992. This was the result of $185 million of new capital being invested in the industry, $622 million of statutory capital internally generated and retained, and the heavy volume of refundings that served to both increase earnings and reduce exposure. As of December 31, 1993, there was total statutory capital of $5.3 billion supporting $709 billion of exposure outstanding. Assuming that no additional capital is added to the industry and that municipal issuance grows (from a 1994 base of $180 billion) at its historical rate, then we expect leverage to increase to approximately 155:1 over five years. At this point, the capital generated internally would be sufficient to maintain leverage ratios at fairly constant levels. These levels do not take into account the more than $1 billion of soft capital, primarily non-recourse lines of credit and stop-loss agreements, which the industry has accessed.
In an environment where municipal issuance is expected to return to historical growth rates, with relatively low refunding levels, the bond insurers and reinsurers are moving to diversify their revenue sources. Two areas where growth was anticipated are the non-municipal sector and off-shore expansion. Both of these areas appear to have developed more slowly than anticipated just a few years ago.
The non-municipal sector includes asset-backed and mortgage-backed securities (ABS and MBS), for which FSA and the Capital Markets Assurance Corporation (CapMAC) launched insurance when they were formed in 1985 and 1987, respectively. It wasn't until the last few years, when Financial Guaranty Insurance Company (FGIC) and the Municipal Bond Investors Assurance Corp. (MBIA) joined the fray that this sector has gotten competitive. In 1993, over $18 billion of ABS and MBS were insured (includes public and privately placed securities). While the insurers have made little penetration into the biggest sectors -- credit cards and auto receivables -- they are a major factor in home equity loans, insuring more than 80% of public issuance, and have a growing presence in the MBS market. While this sector has been adding some incremental revenues to the bond insurers, it has been slower to develop than was expected a few years ago.
In the offshore arena, it was again FSA and CapMAC leading the development. These were the first two insurers to have a presence in Europe. While some business has been developed it has been slow and costly. In May, MBIA insured the largest structured finance transaction in history: a $1.5 billion ATLAS Capital Ltd. transaction. To insure a transaction this size, MBIA needed reinsurance from not only the Capital Reinsurance Company (Cap Re) and Enhance Re, but also some of the other monoline primary insurers. However, while transactions such as these have been insured, a reliable stream of business has yet to develop.
In the last few years, the bond insurers began focusing on money management as a source of incremental revenue. As the invested assets of the largest companies -- AMBAC, FGIC and MBIA -- have grown to $1.9 billion, $1.9 billion and $3.0 billion, respectively, these insurers have sought ways to leverage their asset base, analytical expertise and client relationships. Over the last few years, each of these insurers has established subsidiaries that issue investment contracts for municipal issuers. While these subsidiaries may not be capitalized to the triple-A level, insurance on the individual contracts bestows the triple-A rating on each contract.
MBIA has also established an investment management service for government issuers, and FGIC recently registered short-term money market funds with the SEC to manage tax-exempt money. To the extent that they add incremental revenue and reduce the pressure on the insurance companies to compete for business, these products are a plus.
Ironically, perhaps the most successful diversification effort has been recently undertaken in the mortgage insurance area not by a primary, but by a reinsurer: Capital Re. Capital Mortgage Reinsurance Company, Capital Re's subsidiary, wrote $13.7 million of premiums in the first quarter of 1994, earnings $5.2 million. Just as Enhance Re and Cap Re are dedicated to bond insurance, the mortgage subsidiary is a monoline reinsurer dedicated to mortgage insurance.
The bond insurers ended 1993 with solid capital structure, good credit quality in the insured portfolios, and excellent quality of invested assets.
The $5.3 billion of statutory capital, $9.3 billion of invested assets, and $3.8 billion of unearned premium reserve place the industry in a sound position for 1994 and beyond. Whereas credit quality overall declined in the early 1990s, the bond insurers were able to maintain the quality of their portfolios by insuring 60% of the ~A' and ~BBB' credits. The industry has also placed more emphasis on sophisticated and comprehensive surveillance procedures that are designed to minimize claims and identify problem areas.
In 1994, insured volume will decline as issuance decreases to a level below $200 billion. Earnings growth will also slow down as refundings decline. This combination will put pressure on insurers to lower premium rates to maintain volume and market share. Competition from within the industry will rise as Capital Guaranty and FSA try to increase their presence.
However, if the industry maintains credit quality and risk-based pricing, the bond insurers can avoid problems that have plagued other insurance sectors. As new products and services are developed, the same discipline of quality and pricing is necessary. It is important to keep in mind that core earnings from the unearned premium reserve will continue to be strong, even if insured volume declines in the near future.
Donald H. Paston is group vice president, Duff & Phelps Credit Rating Co.