Moody's: P&C Muni Losses Likely To Stay Low, But Risks Remain

Credit losses in the municipal bond market for U.S. property and casualty insurance companies are projected to remain low, but the market is still at risk due to high muni exposure, according to a Moody's Investors Service report.

Losses could amount to $500 million for the entire property and casualty muni portfolio, Moody's said, which is a relatively low amount for an industry that has exposure to $355 billion of muni bonds.

Even if there is a stress scenario, losses are projected to be capped at $2 billion to $3 billion, which is modest compared to the $10 billion a year the industry earns in investment income on muni portfolios, said report author Paul Bauer, a Moody's vice president. At year-end 2010, about 24% of total cash in the industry's portfolio was invested in muni bonds.

One of the largest reasons losses will be mitigated this year is that the overall credit quality of muni bond portfolios are high.

"Bonds in the portfolios are rated high single-A to low double-A on average," Bauer said in an interview. "And the portfolios have a well-diversified set of holdings both geographically and by bond type, and the exposure to higher-risk segments of the muni market is fairly low."

Bauer said the average rating is A1 to Aa1. Exposure to the unrated sector of the market is only 3% of entire holdings, while 11% are A-rated credits, 56% are Aa-rated, and 28% are Aaa-rated.

There is also a diversified mix of revenue bonds versus general obligation bonds, with a 60-40 ratio. Of revenue bonds, only 10% are invested in the higher-risk segments, including housing finance and health care. Sewer and water revenue bonds make up 17%, and power and utility follow at 10%. Education revenue bonds are next, with 7% consisting of primary and secondary education, and another 7% consisting of college and university bonds.

But in the GO bonds segment, there is a relatively high exposure to lower-rated credits, which causes some analysts to worry. Bauer noted that 17% of GO bond exposure comes from either California or Illinois, both rated at single-A levels. On the other hand, 80% of bonds are invested in states that exclude the five lowest rated. Texas bonds represent 14%, Washington bonds represents 6%, and triple-A rated Georgia makes up 5%.

Bauer noted the biggest threat to these portfolios comes from the negative pressure on the muni sector as a whole.

"The outlook on the muni bond sector is negative," he said. "It's an area under stress."

"Overall, we expect more muni bond downgrades than upgrades during 2011 ... though we believe defaults will nevertheless continue to be isolated," he said.

But these risks don't appear to be prompting a sell-off. Bauer said companies have not been trying to sell down muni holdings in a major way, but there has been a gradual sell-off that will continue into next year. The decrease in muni holdings is coming from old bonds maturing and companies using that money to invest in other asset classes, as opposed to using that money to reinvest in the muni market.

And while longer duration bonds are more popular with insurance companies than shorter duration bonds, Moody's notes that muni bonds held by property and casualty insurers tend to have a longer tenor in comparison to other investments in a typical fixed-income portfolio.

"The higher muni bond durations expose companies to a greater degree of interest rate risk," Bauer said. "To the extent that interest rates rise over the medium term, which we believe is likely, this could be a source of capital volatility for the industry."

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