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Q

In light of the subprime mortgage problems, what would happen if an insurer were to go bankrupt? Is it like other insurance, where there are insurance pools that would step in and take over?

A

James A. Klotz responds:

Keep in mind that bond insurers remain strong. S&P recently published a technical article that analyzed the impact of an unlikely high-stress scenario resulting from the insurers’ exposure to subprime mortgages. In all cases, it was found that the insurers could easily handle a level of defaults far beyond that rationally expected.

Clearly, the subprime mess is taking its toll on financial institutions everywhere.  However, the largest stress is due to the need to re-price mortgage based securities downward because of market imbalances. The increased default rates of subprime mortgages have been far exceeded by their drop in price. This, in turn, has required many lenders to post increased collateral since they are highly leveraged. In the bond insurance business, the impact has been different. Bond insurers are not required to post collateral like other financial institutions. And, bond insurers generally hold securities on their books to maturity when they will be worth par.

While we consider an insurer’s bankruptcy as highly remote, the chances are that the rest of the bond insurance industry would most likely step in to provide a remedy. There are no formal “insurance pools” in existence for this purpose, to the best of our knowledge. But it is likely that the rest of the industry would do whatever was in its power to avoid such a calamity in order to prevent a loss of confidence in bond insurance in general. This could mean a takeover of the defaulting insurer’s business by a stronger entity, or assembling a pool similar to what you mentioned.

We would expect that an insurer in trouble would never get close to a default, since the above steps would be taken far in advance. Remember, too, that state regulators would take a strong interest in such a situation and would likely use their powers and authority to seek a solution.

Of course, all of the above is speculation only. In the few cases that do exist of bond insurers losing their credit rating, they were all absorbed by other players in the industry and investors were never in harm’s way. I hope this helps.