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Custom Financial Guarantee Insurance Essay

Financial guarantee insurance refers to an insurance policy that covers an entity against the financial loss emanating from the inability of the borrower to settle the loan (McKnight, n.d). The policy might also cover the entity against losses incurred from reduced interest rates that adversely affect the lender.  Moreover, the policy can cover an enterprise against losses resulting from the exchange rate changes. In addition, financial guarantee insurance might cover an entity against losses that occur when the entity’s funds are withheld in another country due to restrictions imposed by the government (McKnight, n.d). Furthermore, the policy could cover a firm against losses that might emanate from price fluctuation of certain commodities or assets. It should be noted that some states in the USA do not have the financial guarantee insurance for mortgages and some types of credit lines. Monoline insurers issue contracts that are aimed at protecting the municipal bond issuer against the financial loss resulting from the default (McKnight, n.d). The contract requires the insurer to realize a liability for premium revenue that is unearned at the inception of the contract. The insurer is obligated to pay a claim when the default occurs. There are two advantages of the financial guarantee insurance for the bond issuer. First, the bond issuer benefits from the liquidity of the bond in secondary markets. Second, the bond has a greater credit rating. This second benefit is the origin of the credit enhancement that is used to describe financial guaranty products. Thus, the credit enhancement insurance is purchased in order to increase the credit rating of the issued debt. In most cases, investors are likely to accept lower interests on debt instruments whose credit rating is higher. This is why, most firms issuing debts strive to increase their credit rating in order to reduce the interests demanded by investors.

The first financial guarantee insurance emerged in 1971 with the insurance of the first municipal bond by Ambac. In the 1970s, the financial guarantee insurance insured mainly municipal bonds. The significance of the financial guarantee insurance was realized in the 1980s. For instance, the financial turmoil that would have emerged due to the rise of the municipal bond defaults in the 1980s was alleviated by the financial guarantee insurance. The most notable one was the 1983 Washington Public power Supply System default. Between 1992 and 2007, several municipal bond issues were insured to up to 50%. However, following the lowering of the credit rating of the financial guarantee insurance in 2008, the demand for municipal bond has declined since concerns were raised over the role of this insurance. Ambac and MBIA are the oldest financial guarantee insurance insurers. All financial guarantee insurers are permitted to transact business in the State of New York and therefore, most regulations in New York are determined at the state level. The most significant regulation was passed in 1989 and requires that the financial guarantee insurance is given by the monoline insurers. It restricts the practice and delineates between the financial guarantee, fidelity, and surety lines of the insurance. Although the financial guarantee insurers were initially involved in the insurance of municipal bonds, it changed in the 1980s. In the 1980s, financial guarantee insurers started to underwrite structured finance. Thus, these insurers protect public finance credit and provide credit enhancement for the structured finance. There were many structured finances in 2001.

Financial Crisis and the Financial Guarantee Insurance

The US housing sector is said to be the main source of the 2008-2009 financial turmoil. Many institutions in the OECD countries were involved in this crisis. The developing countries were only affected after the crisis developed into the worldwide economic downturn.  The economic crisis of 2008 impacted the financial guarantee insurance portfolio, guaranteed investment contracts, credit default swaps, and investment portfolios.  Financial guarantee insurers collect earnings from their products. Their products include municipal bonds and structured finance. The percentage of structured finance for financial guarantee insurers increased in the 1990-2007 period. For instance, when regulators relaxed restrictions on services provided by bond insurers, structured finance for MBIA increased to account for more than 50% of its products by 2007. The engagement of the financial guarantee insurers in credit default swaps increased the exposure of these insurers to the risks associated with the structured finance. Firms involved in swaps summarized the swaps’ notional amount and reported them in footnotes. The assets and liabilities linked to these swaps were also reported in footnotes and balance sheets by the sellers. It was also difficult to value the swaps. Moreover, bond insurers were downgraded. It triggered swap payments that impacted negatively the value of swaps. Bond insurers used to report that prior to 2008 swaps were based on the assumption that downgrading of bond insurers was unlikely. However, the 2008 downgrading of the bond insurers resulted in the revaluation of these debts. For instance, in 2008 MBIA was downgraded and was required to undertake the swap payment that exceeded its profits. The 2008 financial crisis also affected the investments of the financial guarantee insurers. Investments usually enhance the writing of the financial guarantee insurers. The insurer’s surplus enables bond insurers to write new business. Stating investments at the market price often overstates the assets of the financial guarantee insurer, especially when the insurer invests in the self-insured projects.

In 2008, most financial guarantee insurers including MBIA overstated their assets because they did not adjust their self-insured investments. It reduced their ability to write new businesses. For instance, during 2009 only Assured Guaranty and its subsidiary (AGM) actively wrote new businesses. In 2008, Berkishire Hathaway Assurance Corporation actively wrote new businesses. It stopped in 2009 and provided only secondary market wraps. On the other hand, MBIA, Ambac, and CIFG had stopped operating essentially by 2009. FGIC and Syncora were required to suspend all claims payments until the time they had a strong plan to settle claims at a deep discount.

Bond Insurance Regulation

Insurance is usually regulated at the state level. Many legal attempts have been undertaken to regulate insurance activities at the level of the federal government. For instance, a Supreme Court ruled in 1869 that insurance ought to be regulated by the federal government. In 1945, it was held that it was the responsibility of the federal government to regulate insurance. It prompted the Congress to pass the 1945 McCarron-Ferguson Act that required states to regulate insurance activities. Regulation of the insurance industry entails financial regulation, formation and licensing of firms, the licensing of agents and brokers, marketing methods, product approval, disclosure requirements, investment restrictions, on-site examinations, and rehabilitation and liquidation of firms.

Financial guarantee insurances were regulated under the property/casualty insurance in 1970s and 1980s. The financial guarantee insurance firms were governed more like other surety firms. The entry of large casualty and property insurance firms into the industry in 1980s resulted in a significant growth of the sector. The much publicized collapse of issuers during this period fueled demand for monoline insurers.  The regulators became concerned with potential exposures of monoline insurers as bond issuer defaulters increased. The exposures could result in insolvencies among monoline insurers since a single default could imply huge loses (Gallagher 2000). Moreover, several collapse of a single monoline product could expose the business to inordinate risk. For instance, economy decline and tax reforms of 1986 contributed to multiple failures of the limited partnership bond (Gallagher 2000). This entrapped the firms that issued the bonds. Surety firms issued financial guarantee bonds to save limited partnership firms. However, the sudden decline in the economy and tax reforms resulted in the collapse of many partnership enterprises. This alerted the regulators for the need to enact legislation that could govern monoline insurers differently from the surety companies.

As a consequence, regulators started to craft and draft special statutes and regulations for monoline insurers. In 1985, the Financial Guaranty Insurance Study Group was mandated to develop regulations for the industry (Gallagher 2000). The group released its first draft in December 1985. This resulted in the adoption of the Financial Guaranty Insurance Model Act in 1986. This was amended in 1987. The Act established that monoline insurance is a separate and distinct form of insurance (Gallagher 2000). In addition to this Act, in 1986, the National Association of Insurance Commissioners (NAIC) started demanding all insurance firms to report their monoline business as a separate line of enterprise from traditional insurance. Various states became impatient with NAIC slow process and began to enact legislation to govern monoline insurance as a separate form of business (Gallagher 2000). One notable state was New York. The various regulations enacted by different states have enabled the financial guarantee insurance to evolve into a diverse and complex enterprise. Currently, the industry has three main markets: the international, the municipal bond and the asset-backed market. The municipal bond is the main business of monocline insurers. The credit rating of the monoline insurers is lent to bonds and notes issued by other public institutions such as hospitals, universities, states and utility districts. The saturation of the bond market resulted in the establishment of the asset backed market (Gallagher 2000). Asset backed market consists of structured financing where the issuing entity’s assets act as security to the debt. Some of the assets that are used as security include credit card, mortgage backed securities, auto loan receivables and home equity loans. The international market presented monoline insurers with another opportunity to diversify their products. The international bonds emerged in 1996.

The developments of 1980s resulted in various legislation in different states for regulating monoline insurance industry. As a consequence, regulatory requirements for running monolines vary from state to state (Bayley and Pelosi 2001). Just like other insurance firms, monoline insurance firms are regulated by the state or the insurance authorities. The regulations require the insurance firms to make some organizational or financial disclosures. Moreover, the insurance firms are required to make advance approval of any changes to be undertaken in the management and ownership of the firm. In addition, the regulation requires that any transactions between insurance firms, their subsidiaries and their parents be approved in advance.

The law governing monoline insurers in New York is one of the most outstanding statutes in the USA. The New York regulation provides single risk restrictions that can be applied by a single entity’s obligations and supported by a single income source. Each obligation (asset backed or municipal) has specific restrictions. The restrictions provide a comparison between the mean annual debt service and the qualified legal capital of the insurer. Regulations and statutes in different sates restrict single and aggregate asset backed securities and municipal bond risks covered by monoline insurers on a net basis. The states which have many monoline operations (New York, Florida, Connecticut, Illinois and California) restrict insured mean annual debt service to 10% of the contingency reserves and surplus of the policymakers.

It is worthy noting that the NAIC Model Act was used by New York a prototype for the monoline legislation adopted in the state of New York in 1989. However, this was amended the same year to yield Article 69 that is used to govern monoline insurance as a distinct form of insurance. The article requires any insurer that issues financial guarantee insurance to be a monoline insurer corporation. The legislation provides that monoline insurance can only be written by financial guarantee insurer. Therefore, surety insurers could not issue bonds whose definition lies outside the permitted surety bonds. Article 69 defines monoline insurance as a distinct type of insurance. The Article authorizes the formation and licensing of monoline insurance corporations which would also be allowed to write residual value, surety and issue credit insurance. In addition, the legislation established a transition period that surety firm required to convert to financial guarantee insurer. Furthermore, the Article specified that monoline insurance firms could write both corporate and municipal bonds. Finally, the article distinguished surety and fidelity insurance. This allowed monoline insurance firms to write surety coverage, but prohibited fidelity insurers from doing so. This also redefined the activities of monoline insurers.

In 2007, the New York State Department of Insurance enacted other legislation to govern monoline insurers. The regulations encouraged new entrants of the bond insurance market. The target entrants were those with the solid capital basis to transact business in the New York state. The regulations were to protect the public and policyholders via the stabilization of the insurers’ credit ratings and the reduction of adverse financial impacts. The regulations were also aimed at developing new standards for the financial guarantee insurers. As a consequence of these regulations, the New York State Department of Insurance directed its efforts to rescue financial guarantee insurers. For instance, the regulations allowed MBIA to reinsurer a municipal bond valued at $184 billion that had been previously insured by the Financial Guaranty Insurance Co..  The department also established the best practice standards in 2008 that were expected to streamline the monoline insurance industry. The best practice standards restrict the monoline insurers from issuing policies that back CDOs of the asset backed securities. The department has also been critical of the monoline insurers’ move to cover and write CDSs using minimally capitalized SPVs.

In addition, FAS 163 requires monoline insurers to determine the current value of the premiums. The premiums are expected to be collected at a discounted rate to reflect the risk free rate at the time the contract is incepted (Bragg, 2012). FAS requires that this discount should accrete receivable premiums via earnings of the period covered by the contract. The discount rate can only change to reflect the current risk free rate when the assumptions of the prepayment change. A claim liability is recognized by the insurer if the claim loss exceeds the revenue of the unearned premium. In instances when the probability of the default increases to exceed the unearned premium, the entity is required to recognize a claim liability. It should be updated to the current risk free rate. FAS 163 also requires monoline insurers to undertake extensive disclosures.

The economic recession of 2008, prompted the federal government and the US treasury to administer the Emergency Economic Stabilization Act that was passed by the Congress in 2008. The Act required the Treasury to administer capital injections into financial institutions that were troubled in exchange for common equity stakes and preferred stock. The Act also prompted the Federal government and treasury to bail out of the AIG. In addition, the act required the Treasury and the Fed to lower interest rates continuously while increasing the liquidity. Furthermore, the Act required the Fed to ease credits through the mortgage backed securities and buying of treasury bills. The Act also temporarily suspended the short selling of the financial firms by the Securities and Exchange Commission. The Act required for a Homeowner Affordability and Stability Plan to be established. It was intended to aid struggling homeowners to refinance their mortgages. This Act was followed by the $787bn American Recovery and Reinvestment Act that was aimed at reinvigorating demand in the US economy.

The Current Status of Financial Guarantee Insurance

Majority of monoline insurers were left without AAA rating by the end of 2008. Various financial guarantee firms exited the market. The downgrading of the bond insurers resulted in the subsequent downgrade of the bond issuers (Scorsone et al., 2012). Most bond issuers were unable to get insurers for their bonds. Prior to 2008, the bond insurance industry had grown into a major sector. By 2010, only two firms were actively writing insurance and new issues were only about 9%. Most bond issuers were downgraded because their rating was tied to the rating of firms that insured the municipal bonds. Thus, the credit of issuers was greatly damaged. The credit rating of municipal bond issuers is continuously declining. This contrasts the increasing credit enhancement witnessed between the years 2001 and 2007.

The Future of Financial Guarantee Insurance

It is predicted that the insured market might continue to shrink due to the ratio of the outstanding debt. It is also anticipated that investors will prefer to buy bonds on the basis of the underlying issuer’s credit in the future. It is argued that these issues might pressurize monoline insurers to increase transparency in terms of disclosures and financial statements at the state and local levels .

Conclusion

Financial guarantee insurance allows bond issuers to liquidate their bonds in the secondary markets and to increase their credit rating. The first financial guarantee insurance emerged in 1971. The 2008-2009 financial crisis had devastating effects on the financial guarantee insurance. Some argue that regulations of the financial guarantee insurance at the state level could have catapulted the effects of the financial crisis in the sector. Following the crisis, the federal government and the Treasury intervened with various measures that were aimed at rescuing the sector. Treasury has been pushing for the regulation of the financial guarantee insurance to be undertaken at the federal level. These efforts have been unsuccessful. The state of the financial guarantee insurance at the moment is still uncertain. It is anticipated that the shrinking market and the preference of buyers to purchase bonds on the basis of the credit rating of the issuer might induce regulatory changes.

Custom Financial Guarantee Insurance Essay

Code: Sample20

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