Bond insurers' expansion into new businesses like cash management and guaranteed investment contracts are not currently a threat to the insurers' triple-A ratings, but they do have a cost, according to a report released yesterday by Standard & Poor's Corp.
"Even though these companies are perceived as low risk, [there is] no free ride" with expansion, said Richard P. Smith, managing director at Standard & Poor's. "I don't think they're being reckless, [but] there are costs of being in these businesses."
The report focused on AMBAC Indemnity Corp.'s expansion into guaranteed investment contracts and the effect that has had on AMBAC's margin of safety.
It's "the first time we've tried to put any perspective on these diversifications," Smith said.
Standard & Poor's defines the margin of safety as the ratio of losses incurred during a theoretical four-year depression plus statutory capital at the end of the depression, divided by depression losses incurred. A higher margin of safety, which the report describes as "S&P's principal measure of capital strength," denotes a stronger ability to handle a prolonged downturn.
AMBAC's margin of safety would be 1.4 to 1.5 times instead of 1.3 to 1.4 times if the firm's investment contract subsidiary, AMBAC Capital Management Inc., or ACMI, were capitalized to the triple-A level, the report said.
Because ACMI is not capitalized to a triple-A level, the policies that AMBAC writers for the unit's transactions add "more risk on the insurance company's books, which brings down the margin of safety," Smith said.
"Our view is that we want to have a portfolio of low risk products that are a natural extension of what we're good at and offer a return to our shareholders with low risk and low volatility to earnings," said Phillip B. Lassiter, AMBAC's chairman, president, and chief executive officer. "I feel very positive about it, and we're very comfortable with it."
Affiliates of Financial Guaranty Insurance Co. and Municipal Bond Investors Assurance Corp. also are active in guaranteed investment contracts. Smith said the forces pressuring AMBAC's margin of safety are applicable to the rest of the industry. "Other players are [getting] involved" in the investment contracts business and are "essentially doing it the same way," Lassiter said. "They're going to have to deal with exactly the same issues."
The report concentrated on AMBAC's expansion efforts, Smith said "because they've done the most business in that area [and] are out in front in terms of using the insurance company in their diversification."
Also, "AMBAC's current business plan provides for the possibility of a start-up derivatives product company in 1994," the report said, which would necessitate generating external capital "to prevent a further margin of safety decline."
"Clearly it is our intention to get into the pure plain vanilla municipal swaps business sometime this year, but we're not looking at [forming] a broad-based derivatives company," Lassiter said. "I personally do not view that there is any question we will maintain high, attractive capital [ratios] after getting into this area. I see this evolving relatively slowly and don't think it'll have a material impact on capital levels in the next 12 months."
In addition to examining the impact of expansion on financial strength, the report contained a "continuation of themes we've been playing on," Smith said, including bond insurers' "new frontiers," continued triple-A strength, earnings outlook, and structured finance activity.
"Bond insurers are well positioned to build on their hard-earned successes of the recent past," a press release accompanying the report said.
The release also said that the expected drop in municipal bond issuance "may be a blessing in disguise for the bond insurance industry, as it will allow [the firms] to improve operating leverage."