Expect "partly cloudy skies" for bond insurers over the next five years, Kemper Securities Corp. said this week in its annual report on the industry.

"The industry itself is healthy at the moment, but there are some conditions in place that do have to be addressed by the industry to maintain that good health," said Richard Ciccarone, director of tax-exempt research at Kemper. "We do this annually. The objective is to not get caught by surprise by a deteriorating condition for the industry or an individual insurer."

Chief among Kemper's concerns is the intensifying competition in the industry at a time when tax-exempt volume is waning, Ciccarone said.

Nearing the saturation point in the tax-exempt market, the bond insurers will be hard pressed to match the growth rate experienced in 1992 and 1993, the report said. Declining volume in the tax-exempt market is already putting pressure on the insurers' premium rates and could ultimately lead to a lowering of credit quality standards, the report warned. And Kernper noted that "ways that municipal bond financings could expand dramatically in the next several years are... difficult to achieve."

Faced with their maturation in the tax-exempt market in recent years, most of the bond insurers have sought expansion opportunities in other areas like the asset-backed market, cash management services, guaranteed investment contracts, and derivatives.

But there are potential pitfalls in expansion, Kemper said.

"The risks so far have generally been prudent, but it does concern us that [expansion] has the potential to bear greater risk than bond insurance," Ciccarone said, noting that problems with a subsidiary could hurt an insurer's ability to raise capital or its image in the market

In part reflecting those concerns, Capital Guaranty Insurance Co., a firm that has made limited moves outside of the core municipal market, received the highest rating in Kemper's report card for the individual firms.

Capital Guaranty's "grade point average" of 3.86 was the industry's highest score for 1993. The Kemper grading system rates insurers on ownership, capital adequacy, liquidity, profitability, quality of insured book, loss experience, and reinsurance.

"Capital Guaranty, while obviously pleased that we are ranked the strongest municipal bond guarantor, sees the Kemper report as an essential analytical tool," a spokesman for the firm said. "It is incumbent upon an industry whose fundamental contract is to provide the highest possible credit support for up to 30 years to keep the Kemper credit categories firmly in sight."

At 3.76, Financial Guaranty Insurance Co. received the second highest rating, followed by AMBAC Indemnity Corp. and Municipal Bond Investors Assurance Corp., both at 3.72.

Rounding out the scoring were: Connie Lee Insurance Co. at 3.53, Capital Markets Assurance Corp. at 3.48, Financial Security Assurance Inc. at 3.38, and Asset Guaranty InSuranCe Co. at 3.11.

"Capital Guaranty is a company we believe has a good outlook and strong fundamentals," Ciccarone said "The only factor against them is a small market share."

In part because of a small market share -- Capital Guaranty backed only 2% of the roughly $110 billion of bonds insured in 1993 -- bonds insured by the firm have historically traded five to 10 basis points higher than those guaranteed by FGIC, MBIA, or AMBAC.

Given that spread, Ciccarone believes Capital Guaranty-insured bonds are a value "because we don't see that the company is insuring risks that are any more risky than any other company, and in some factors, it's a less risky portfolio."

A key to that safety, according to Kemper's ranking, is Capital Guaranty's aversion to the asset-backed market.

Asset-backeds "should be the fastest growing component of the bond insurance business in the next five years," but the market's safety record is untested over a long period of time, Ciccarone said.

"I think that there's strong support in the market from the standpoint of holders of insured bonds that they'd be more comfortable having no non-municipal bond risk," he said.

Most industry officials declined to comment on the report, saying they had not had enough time to digest its contents. Privately, however, several said the ongoing expansion efforts are a natural outgrowth of the industry's maturation and are being pursued as cautiously as possible to protect the core business.

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