The role of bond insurance in the municipal market has evolved in the past few years from simple credit substitution to credit enhancement with a mix of functions, according to an analyst at Moody’s Investors Service.

“You could have made the argument a few years ago that people were thinking about bond insurance as a pure credit substitution product,” said Stanislas Rouyer, senior vice president at the credit rating agency. “Either you had faith in the bond insurer or you [didn’t]. Now, the situation is a bit more subtle. No bond insurer can claim to be riskless or close to riskless.”

Before the credit crisis, eight triple-A rated insurers competed to guarantee more than 50% of new issuance. Rouyer said it was distressing back then that so many investors treated the guarantors on an all-or-nothing basis.

“Some people barely paid attention to the underlying [rating] once they knew who the bond insurer was,” he said.

Issuers would pay the guarantors to substitute the enhanced insurer rating for their own credit rating, and the market would often ignore the underlying credit. Demand for credit enhancement has shrunk to a single-digit share of new volume in the wake of the credit crisis, when most insurers collapsed.

Those investors still interested in financial guarantees no longer think of insurance as risk-free, Rouyer said. Instead they value a mix of other functions.

“The credit underwriting, negotiated terms, surveillance, and remediation we provide over and above our guarantee adds substantial value for U.S. municipal issuers in terms of cost savings and access to the capital markets,” Dominic Frederico, chief executive at Assured Guaranty Ltd., told investors earlier this month.

Rouyer said investors who value insurance increasingly think of the product in such terms. That shift in perception could be a desperately needed sign of hope for a bond insurance industry in basic survival mode for much of the past three years.

In February, Moody’s insurance team said the outlook for the financial guarantee industry was negative and that 2010 would be a pivotal year in determining its future. As the year comes to a close, Rouyer said the recovery process for the industry has played out more slowly than anticipated.

BondFactor Co. and Municipal and Infrastructure Assurance Corp., the two startups that hoped to launch this year and reinvigorate the market, each failed to raise enough capital or obtain high enough ratings to begin writing insurance.

National Public Finance Guarantee Corp., the muni-only insurer created by former market leader MBIA Inc., is still awaiting the outcome of litigation contesting its February 2009 restructuring.

Assured, operating without competition, hasn’t managed to broaden demand for its services. Assured has wrapped 1,527 separate issues so far this year totaling $23.3 billion, a 6.6% market share according to Thomson Reuters. That’s a smaller penetration rate than Financial Guaranty Insurance Co. — the fourth-ranked guarantor — enjoyed in 2006, when it insured 374 issues totaling $28.3 billion for a 7.3% share of the market.

In a presentation Tuesday to key investor WL Ross & Co., Assured emphasized that it is making progress building demand despite a number of market setbacks. Those setbacks include the financial instability of its former competitors, which has hurt the perceived value of all “enhanced” credits; the existence of Build America Bonds, which has siphoned away supply of tax-exempt paper; and the recalibration of public finance ratings by Moody’s and Fitch Ratings, a move that gave thousands of issuers a higher rating.

Assured was stripped of its triple-A rating by Standard & Poor’s last month, leaving the bond insurance industry without a gilt-edged player for the first time in 35 years.

Rouyer said Assured has garnered “a reasonable amount of demand” in this difficult climate.

“I don’t think we’re materially more negative than we were a year ago,” Rouyer said. “BABs have taken away some of the potential opportunities for Assured, so this changing environment could be a positive for them. It’s hard to know.”

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