An important aspect of a bond insurer's financial strength is the quality of its invested assets. About 60% of bond insurers' total revenues are generated from investment income including realized capital gains. Approximately 70% of the insurers' investment portfolios consist of municipal bonds. Economic adversity resulting in insured defaults might cause a deterioration in asset quality and revenue base. Accordingly, the investment portfolio is one of the five major areas Fitch analyzes in assessing a bond insurer's claims-paying ability.
Growth in Invested Assets
As of June 30, 1992, monoline financial guaranty insurers and reinsurers had over $7 billion of invested assets, up 9% from year-end 1991. Over the last 3.5 years, the industry's investment portfolio grew at a compounded annual rate of 14.2%. There are two principal sources of a bond insurer's investment portfolio: (1) The unearned premium reserve, consisting of premiums received but not yet recognized into income. (2) Qualified statutory capital, comprised of policyholders' surplus (capital and retained earnings) and contingency reserves. Record insured municipal new issue volume has enabled the insurers grow unearned premium reserves to nearly $3 billion at mid-year 1992, an annual growth of 14.9% since 1988. Most premiums for municipal bond insurance are paid as a single upfront fee. Only a small portion of the premium collected is earned in the first year, with the remainder going into the unearned premium reserve, to be earned over the life of the issue. The growth in qualified statutory capital reflects strong earnings, but also capital infusions from a variety of sources including the public debt and equity markets and owners contributions. Statutory capital has grown 12.3% annually since 1988, nearing $4 billion on June 30, 1992.
Investment performance cannot be evaluated based solely on yields. Returns should be considered in conjunction with the composition of the investment portfolio, credit quality and diversification, the company's tax and capital gains strategies and the average maturity of its fixed-income portfolio. The conservative investment strategies of the financial guarantors emphasize preserving capital, maintaining sufficient liquidity and generating a steady flow of income. The resulting investment portfolios, relative to other industries and risk providers, represents a major source of financial strength for the bond insurers. The industry's overall portfolio consists predominantly of high-quality fixed-income securities. Long-term bonds account for about 90% of invested assets, of which about 70% are in tax-free bonds (see "Double Jeopardy" below), 20% Treasury and government agency securities, and the balance in corporate obligations. Another 7% of invested assets are cash and short-term investments. There are limited holdings in stocks and real estate.
Fitch evaluates an insurer's investment strategy and examines the portfolio to ensure adequate diversity and credit quality, reviewing single risk and geographic concentrations of investments. Liquidity characteristics of securities are evaluated to assess how easily investments can be turned into cash to pay claims. (These assessments are incorporated into Fitch's capital adequacy stress tests, which form an integral part of our evaluation.) The average credit quality of the bond insurers' investment portfolios is strong at ~AA+', with over 98% of holdings rated ~A' or higher.
Bond insurers mostly guaranty municipal bonds. They also invest in municipal bonds, albeit much higher quality ones than they tend to insure. Over the last five years, to minimize tax liabilities, many insurers shifted a higher portion of their investments into the municipal sector. This poses a potential risk in that the same adverse economic conditions that would cause insured bonds to default could also cause a deterioration in the investment portfolio, resulting in realized capital losses when it becomes necessary to liquidate assets to pay claims. A portfolio consisting of anything other than Treasuries or agencies would experience a similar deterioration. As in FGIC's case, this "double jeopardy" risk can be mitigated by very high quality ("AA", or better) municipal portfolio, geographical and bond sector diversification, and prudent limitations on size per issuer (FGIC's claims paying ability is rated ~AAA' by Fitch). Also, geographic and bond sector concentrations in the insured portfolio, should not be amplified by similar concentrations in the investment portfolio.
Bond Insurers' Investment Portfolios
Percent of Long-term Bonds in Municipals
Yearend 1988 Yearend 1991
AMBAC 44 52
Asset Guaranty 98 53
Capital Guaranty 68 0
CapMAC 9 53
Capital Re 0 68
Connie Lee 1 27
Enhance Re 86 62
FGIC 74 93
FSA 37 81
MBIA 77 71
Total industry 60 69
Bond insurers' portfolios are diversified by maturity. Given the long-term nature of the obligations insured, asset-liability matching is not as critical as it is for life or property and casualty insurers. Since there is no obligation for insurers to accelerate the payment of principal and interest on defaulted bonds, an insurer's cash flows received from interest, redemptions, and maturities generally parallel potential losses that may be paid on insured bonds. Still, spreading out the bond maturities in the portfolio lessens the reinvestment risk.
Investment Yields and Capital Gains
Conservative investment portfolios are characterized by moderate and stable returns. investment income for the first half of 1992 was $234 million, representing 48% of total revenues, the balance being earned premiums. This followed $434 million of investment income in 1991, 50% of total revenues. The industry's net investment yield (net investment income, excluding capital gains, divided by average invested assets) averaged 7.3% over the last 4.5 years. However, yields declined steadily since 1989, as interest rates fell. To compensate for low yields, some insurers are trading a portion of their investment portfolios. Many took advantage of the low interest rates in 1991 and 1992 to harvest historically higher capital gains. Collectively, they realized $53 million of capital gains in 1991, 6% of total revenues and another $42 million in the first six months of 1992. These capital gains are a mixed blessing, however. While they provide a boost to current earnings and therefore additional capital against which new business can be written, bonds sold to produce these gains generally carry higher coupon rates than are available for reinvestment, thereby dampening future investment income.
Area to Watch
Bond insurers' investment portfolios are an area to watch, especially as pressures to generate higher returns could result in a loosening of the reins on the traditional conservative strategies. Also, with the dramatic growth in the investment portfolios many insurers will bring the management of the investments in-house, and perhaps solicit portfolios from other companies outside the industry. This would achieve significant economies of scale and enable insurers to diversify their business activities and leverage their extensive fixed income analytical expertise.
Brady N. Tournillon, (Assistant Vice President, Fitch Investors Service, Inc.), contributed to this article.