Recent turbulence in the bond insurance industry has led to a change of policy in how Fitch Ratings will look at insured bonds, and to a consideration of how a solution to the financial guarantors’ capital concerns might look.
Fitch Friday announced a change in policy regarding bonds insured by downgraded monoline bond insurers. It says it will withdraw its rating in cases where Fitch does not assign an underlying rating and the insurer is downgraded below an underlying rating assigned by Moody’s Investors Service or Standard & Poor’s.
One idea gaining traction among market watchers would have the bond insurers seek additional reinsurance. In the normal course of managing their capital profiles, monoline insurers insured obligations to reinsurers under agreements, known as treaties.
It is an idea already tested in the context of the current crisis — Ambac Assurance Corp. in December ceded $29 billion in its book to Assured Guaranty Ltd.’s reinsurance arm, double-A rated Assured Guaranty Re Ltd., freeing up $255 million in capital on its books — and one that bond insurance executives have said would be preferable to other options.
At a small conference in late November, executives from Ambac, MBIA Inc., and Security Capital Assurance Inc., a subsidiary of XL Capital, said reinsurance would be their first option in looking to boost capital levels. If unable to raise the necessary capital, the bond insurers would most likely have to start to runoff, or stop writing new business and replenish capital reserves through investment income and the maturation or call of bonds they insure.
MBIA Inc., as parent of bond insurer MBIA Insurance Corp., recently raised $2 billion in capital through an equity infusion from Warburg Pincus LLP and a sale of $1 billion of surplus notes. The performance of those notes, however, which have lost as much as one-quarter of their value in trading in the secondary market, and the apparent reluctance of other investors to pledge equity, makes reinsurance an even more attractive possibility.
There is some question about whether there is enough capacity in reinsurance in the market to provide all of the capital that bond insurers would need to regain their triple-A ratings and stable outlooks.
Sabra Purtill, managing director for investor relations and strategic planning for Assured Guaranty, said the sheer amount of capital needed to shore up the insurers — estimated at between $7 billion to $10 billion — will require additional capital from other sources.
“If reinsurance is going to be the sole solution to the industry, then additional capital would need to come into the industry,” Purtill said.
Assured Guaranty, for example, sold $300 million in equity that it put directly into Assured Guaranty Re, Purtill said. The reinsurance deal with Ambac caused Assured to take a capital charge of roughly $360 million on the deals, freeing up $255 million of capital reserves for Ambac because of Assured Guaranty Re’s AA rating, said Standard & Poor’s analyst Dick Smith.
There is also some concern about the types of credits that insurers will cede to reinsurers.
“There are all sorts of moving parts like sector distribution, ratings distribution, and municipal versus structured distribution,” Smith said. “All those things matter.”
While bond insurers have solid municipal credits on their books, they also have poorly valued subprime residential mortgage-backed securities and credit derivatives. Many reinsurers would prefer to take over the financial guarantors’ muni credits, which could leave the bond insurer with only lesser credits.
Smith said that while Standard & Poor’s would not worry about the concentration of reinsurance held by one company, there would be concerns about the bond insurers’ exposure to the reinsurer.
“There is also a natural limit on how much exposure an Ambac can have to Assured or [Financial Security Assurance Inc.] or any other company,” Smith said. “There is not an unbound ability to take reinsurance from one entity.”
All of this suggests the possibility of either an outside reinsurer — like Channel Re, which reinsures MBIA, RAM Re, or Swiss Re, in which Warren Buffett’s Berkshire Hathaway Inc. recently bought a stake — playing a bigger role in the market or a new player entering the market.
The New York State insurance superintendent Eric Dinallo met with Wall Street banks last week in an effort to organize funds to bail out the insurers. Those funds could go to seed a reinsurance company that would act as an independent entity.
Outside players could also become more heavily involved. Berkshire Hathaway Assurance Corp., Buffett’s financial guarantor, obtained a license last month to operate in the muni market. Buffett appointed Ajit Jain, a man who Celent analyst Donald Light called “the reinsurance guru,” to run it. Wilbur Ross, chief executive officer of WL Ross & Co., said earlier this week he may get involved.
And private equity investors may yet play a larger role. Warburg Pincus made a splash by backing MBIA, illustrating that there is a place for private equity in the business. However, with the questions surrounding the quality of the structured finance credits on the bond insurers’ books, private equity may choose to form a new company.
There is some historical perspective. After the Sept. 11, 2001, terrorist attacks and several natural disasters, private equity firms formed what have become profitable reinsurance companies. The unique characteristics of these companies, for which private equity firms would have to hire a management team and a few actuaries without worrying about retail operations, might be good alternatives for private money.
Regarding Fitch’s policy change, in the absence of an underlying rating, the agency would assign a rating that corresponded to the insurer’s rating. David Litvack, managing director at Fitch, said it had become apparent that in some cases that the insured rating was too low to appropriately reflect the issuer’s credit rating.
“We want our ratings to be accurate, and we thought under the old policy that would not necessarily be the case,” Litvack said.
He explained that the limitations of the old policy became apparent in the case of financial guarantor XL Capital Assurance, which Fitch downgraded to A from AAA last week.
Litvack would not comment on whether issuer complaints led in part to the change.