Subprime Woes May Benefit Public Finance Bond Insurers
The deterioration of the subprime mortgage market and the negative headlines that have plagued bond insurers do not appear to have had much of an effect on their ability to conduct business, a new report from Standard & Poors finds. Instead, as with past events of credit deterioration, strong pricing opportunities may present themselves due to widening credit spreads and the increased value of financial guarantee insurance, S&P says.
The highly competitive conditions and tight credit spreads that have existed for bond insurers for the past few years in the US public finance market were only intensified by a decline in insured penetration in the first half of 2007. Against this backdrop was a general decline in the ‘AAA’ rated companies’ US public finance risk-adjusted pricing indices, with the group average falling to 4.71%, the lowest level in the past six years.
New issue volume in the US public finance market rose 27% for the first six months of 2007 compared with the same period in 2006. Insured penetration, however, dropped to 48% from 50% in 2006. This is quite surprising, S&P says, as the sectors that experienced the strongest growth in issuance volume have traditionally had some of the highest insured penetration rates. This could be an indication of how tight credit spreads have become and the competitive pricing pressure the bond insurers are experiencing.
In the future, the insurers may allocate less capital to the US public finance market as they tap the US structured finance and international markets in search of better growth and pricing opportunities.
To evaluate the economic benefit of the bond insurers’ various books of business, S&P Ratings Services calculates a risk-adjusted pricing index. Formerly known as the profitability index, the risk-adjusted pricing index is calculated for business written in a given time period (usually one year). The risk-adjusted pricing index is a measure that shows how much premium the insurers have charged per unit of risk.
S&P finds that the industry appears to have adhered to tight underwriting standards; the per-period weighted average capital charge declined not only from the first six months of 2006, but also from the 2006 year-end level. While the weighted average capital charge was down 16% for the first six months of 2007 from the same period the previous year, the 24% decrease in the implied premium rate pushed the industry average risk-adjusted pricing index down 10% to 4.71%. In theory, movements in capital charges and premium rates should move in tandem in a world of rational pricing; however, competition and narrowing credit spreads greatly influence pricing, as they did in the first half of 2007.
S&P says it is important for insurers in this environment to exercise self-discipline when writing new business to avoid building up an overly large book of business that would generate only mediocre shareholder returns over 20 or more years. Such restraint would also benefit insurers from a capital adequacy perspective; too much lower-priced business could create a double whammy of inadequate capital generation without an appropriate lower level of theoretical losses.
A disciplined approach to underwriting that would translate into a comparatively lower volume of new business and less damage to imbedded returns and capital generating capability could address long-term capital adequacy concerns.
The full report Economic Woes Continue For ‘AAA’ Bond Insurers’ U.S. Public Finance Business includes individual results for Ambac Assurance Corp., Assured Guaranty Corp., The CIFG Group, Financial Security Assurance Inc., Financial Guaranty Insurance Co., MBIA Insurance Corp. and XL Capital Assurance Inc.
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