Proposal: A More Cogent Way to Measure Municipal Bond Insurers' Fiscal Strength
If you are inside a windowless building and someone tells you that it's 74 degrees outdoors, that information alone won't give you a very complete picture of the weather. The day could be sunny, cloudy, or humid and it could be breezy or calm. It might even be raining. So knowing the temperature alone provides an incomplete, even misleading answer to, "How is it outside?"
In the world of financial guarantee insurance, many analysts rely on the so-called risk-to-capital ratio to judge an insurer's relative financial strength. This ratio compares a company's capital base, consisting of its statutory capital and contingency reserves to all of its insured portfolio obligations.
Unfortunately, this can be a misleading test for evaluating an insurer's ability to pay losses. And ultimately, it provides an insufficient answer to the question on many minds: "If a large number of issuers default, will the insurer have enough money to make principal and interest payments as they come due?"
I suggest that a more meaningful measurement for evaluating an insurer's financial capability is the comparison of its insured portfolio to its total claims-paying resources, or what I call the "risk to capital resources ratio."
This ratio is more relevant, because it compares the outstanding insured debt service to the aggregate claims paying resources available to the insurer.
These claims-paying resources include the capital base, unearned premium reserve, value of future installment premiums and other standby resources, if any. All of these components constitute a financial guarantor's claims-paying strength.
Although it is a traditional measurement, the risk-to-capital ratio is not a useful standard for comparing financial soundness for two reasons.
First, this ratio violates a fundamental accounting principle - the matching concept - because it compares today's capital base with future debt service.
In a default, the insurer will only be required to make payments as they come due. Principal and interest payments due on the bonds will not be accelerated.
This is one reason why, in my view, the risk-to-capital ratio has as much validity as adding up all of the mortgage payments due on a home over the years and comparing the total with a homeowner's currently available cash.
Second, the risk-to-capital ratio overlooks other very substantial claims-paying resources the insurer can call upon in addition to its present statutory capital base.
To provide a better understanding of the individual building blocks that comprise these claims-paying resources, let me review briefly the unique accounting principles that govern municipal bond insurers.
In the financial guarantee industry, on most of its business, the insurer collects a full nonrefundable premium covering a liability which could span a period as long as 30 or 40 years. At the same time, all of the debt service guaranteed over the entire life of the issue is immediately added to the insurer's aggregate exposure.
The premium collected at the outset becomes a component of the investment income. However, the premium itself is not recognized as revenue and does not immediately contribute to the company's capital, but is recorded as part of the unearned premium reserve which earns slowly as the liability is extinguished.
Thus, the unearned premium represents "hidden capital" on the balance sheet. The investment income and premium earnings it generates provide stable growth over the life of the insured risks, matching the liability payment profile of the undiscounted aggregate exposure.
Because premiums are earned over many years, the unearned premium reserve will accumulate and grow for insurers as they write new business. The greater the new business writings from year to year, the faster this reserve will increase.
In the risk-to-capital ratio, the unearned premium reserve and its future contributions to capital growth are ignored. Let me illustrate why this results in a misleading measure of strength.
If two municipal bond insurance companies start operations at the same time with the same amounts of capital, the one that insures substantially more debt service will always have a risk-to-capital ratio significantly higher than the insurer which writes lesser amounts of business. It will also have a larger unearned premium reserve.
Because its unearned premium has not yet contributed to the capital of the company, the larger writer's "financial strength" will appear to be disproportionately diminished by the greater amount of insured obligations on its books.
For this reason analysts should consider the unearned premium reserve as part of the financial base when comparing the relative strengths of municipal bond insurance companies, instead of merely using the present value of the liability stream.
In a portion of their business, financial guarantee insurers do not receive premiums on an up-front basis, but in periodic installments over the life of the issue. This stream of future premiums is not reflected on the balance sheet as unearned premiums.
However, as noted, the related insured debt service for this business is included in the aggregate measurement of debt service outstanding from the time the issue is insured. Income from these future premiums, like that generated by the unearned premium reserve, will increase future capital and claims-paying resources.
Some may question whether it is appropriate to include installment premiums as a claims-paying resources since their value is estimated based on the outstanding life of the related bond issues.
These premiums are paid periodically based on the outstanding amounts of the bonds. If bonds are refunded or prepaid before maturity, future collections will be less than anticipated. However, when this happens there would also be a corresponding reduction in total liability.
Although the essence of a municipal bond insurer's financial strength is its capital, contingency and unearned premium reserves, and installment premiums, some guarantors strengthen their claims-paying ability further by arranging special standby lines of credit from banks.
These irrecovable and non-recourse lines provide additional resources after an insurer's claims reach a certain threshold.
It seems essential, therefore, that standby resources, future installment premiums, and the unearned premium reserve should be part of a ratio that measures financial strength. It should be noted that since installment and unearned premiums are elements of future earnings, we recognize their after-tax value. Installment premiums should be present valued since they are funds that will be received in the future. A reasonable discount rate would be a company's opportunity cost of capital.
In judging a guarantor's financial capabilities, there is another very important factor that can aid in the assessment which is not captured in either the traditional or the proposed capital resource ratio - the quality composition of the insured portfolio.
By examining the types of bonds that are insured, their underlying quality and the geographic dispersion of the portfolio, a judgment can be made about the likelihood of default.
The rating agencies use sophisticated models which also include an analysis of the quality of the insured portfolio to determine a bond insurer's financial strength. However, other financial observers have tended to look at the risk-to-capital ratio since it is easy to compare and they believe it can be used to compare the relative strength of companies.
In conclusion, no single ratio should substitute for a complete qualitative and quantitative analysis of a company. However, if a single measure must be used, the most useful ratio is the one which compares the insurer's insured portfolio to its entire claims-paying resources.
In short, the risk-to-capital resources ratio is a better way to compare a bond insurer's capacity to overcome any bad weather ahead.
Ms. Tehrani is senior vice president and controller of Municipal Bond Investors Assurance Corp.