Financial Guaranty Insurance
Financial guaranty insurance is a specialized insurance product that guarantees the timely payment of principal and interest on bonds and other securities, and provides many other benefits to issuers and investors.
Financial Guaranty Insurance
Financial guaranty insurance is:
- a specialized insurance product that guarantees the timely payment of interest and principal on a bond or other security;
- a form of credit enhancement that provides an extra layer of protection for bondholders, who also benefit from the guarantor’s credit selection, underwriting, surveillance and remediation activities; and
- a means of facilitating capital market access, broadening distribution and reducing borrowing costs for bond issuers.
Financial guaranty insurers are also known as “monoline” insurers because, by law, they are permitted to write only this single line of insurance (and related lines which may include surety, residual value and credit insurance) serving the financial markets – they are not exposed to risks from any other lines of business, such as life, health, or automobile insurance.
How Does it Work?
A financial guaranty insurance policy can be issued at the time a bond is issued in the primary market, or it can be issued to an investor who owns a bond that is already trading in the secondary market.
- In a primary market transaction, the insurance premium is paid by the bond issuer, in return for a lower interest rate for the life of the bonds, and the insurance provides default protection to all investors in the bond.
- In a secondary market transaction, the insurance premium is paid by the investor and protects that investor’s investment.
In the event of full or partial non-payment of an insured bond’s debt service, the financial guaranty insurer pays insured bondholders to make up any shortfalls in the principal and interest payments – as they come due. The insurer then “steps into the shoes” of those bondholders and may exercise on its own behalf the bondholders’ rights and remedies for recovery.
Why use it?
Financial guaranty insurance benefits both bond issuers and investors.
Benefits for insured issuers include:
- Lower borrowing costs. An insured bond is generally issued at a lower interest rate than if it were not insured, due to the additional security of the guaranty. The insurance premium would be a portion of those cost savings.
- Improved access to capital markets. Financial guaranty insurance can help small and medium size issuers access capital markets, which can be particularly challenging if they are not well known.
- Broader distribution. Many investors limit the amount of bonds they will hold at various rating levels and per issuer. The higher credit rating insurance typically confers, together with the additional obligor/guarantor, expands the universe of investor portfolios for which the bond will qualify.
- Single point of contact. Through its surveillance activities, a bond insurer may spot developing credit problems early and work with an issuer to resolve them before they become serious. The insurer may have more flexibility than a bond trustee or a group of investors to waive covenants, grant temporary forbearance or agree to restructuring terms, and the issuer has only one “investor” to interact with for the life of the insured transaction.
Benefits for investors in insured bonds include:
- Timely payments. When the issuer of an insured bond fails to make a scheduled payment, all insured bondholders are paid on time and in full, so only the insurer needs to seek recovery. This is true whether the non-payment was due to a natural disaster, like Hurricane Katrina, or a municipal bankruptcy, like Detroit’s.
- Stringent underwriting standards. The guarantors maintain disciplined credit selection and underwriting standards. They have the resources to evaluate the unique risk of each issuer and to conduct due diligence. They may also be able to negotiate stronger terms and conditions than those of an uninsured bond.
- Surveillance and remediation. Bond insurers’ evaluation of their insured risks doesn’t end when the bond is issued. They scrupulously monitor the financial health of every issuer for the life of the insured bonds, including surveillance of broader economic trends and emerging political issues. They can work with an issuer before problems become serious and, should restructuring ever become necessary, remove the burden of negotiations and litigation from investors.
- Improved market liquidity. Because hundreds of millions of dollars of insured bonds are traded daily, the insurer’s “brand” may be better known than the issuer’s. While bond insurance does not guarantee investors a specific market value for insured bonds, insured bonds from a distressed issuer have typically held their trading value better than that issuer’s comparable uninsured bonds.
Issuers, investors, and the financial markets benefit from strong regulation. Financial guaranty insurers:
- must meet the requirements of insurance regulators in every state where they do business;
- are primarily regulated under Article 69 of the Insurance Law of New York State, where the industry is headquartered; and
- are subject to intense scrutiny from those rating agencies that evaluate and assign ratings to insured transactions.
Understanding the Claims Process
See AFGI Document: Understanding the Claims Process When an Insured Municipal Bond Defaults