Financial Guarantee / Derivatives / Securitization

Financial Guarantee Insurance

A form of insurance that first appeared in the 1930s as mortgage guaranty insurance and returned in the 1970s in several different forms (municipal bond guaranty insurance, limited partnership investor bond insurance, residential value insurance, etc.). Today, most states exclude mortgage guaranty and consumer-oriented credit insurance from their definition of financial guaranty insurance. It is a descendant of suretyship and is generally recorded as surety on the annual statement that insurers file with regulators. Loss may be payable in any of the following events: the failure of an obligor on a debt instrument or other monetary obligation to pay principal, interest, purchase price or dividends when due as a result of default or insolvency (including corporae or partnership obligations, guaranteed stock, municipal or special revenue bonds, asset-backed securities, consumer debt obligations, etc.); a change in interest rates; a change in currency exchange rates; or a change in the value of specific assets, commodities or financial indices. These contracts usually involve sophisticated insureds, and therefore rates may be exempt from general statutory standards.

Act of God bond
A bond issued by an insurer with repayment terms linked to the company’s losses from natural disasters. Investors are paid a higher rate of return than on most corporate bonds, and they share the insurer’s risk of catastrophe losses. Interest on the bond may be a certain number of points above U.S. Treasury bonds or other benchmark investments. If a large disaster strikes, bondholders may be required to forgive some or all of the principal, or the bonds might be automatically converted into stock of the insurer.

Derivative
A financial contract the value of which is derived from another (underlying) asset, such as an equity, bond or commodity.

Equipment value insurance
A policy covering leased equipment, guaranteeing its value on a specific date (usually, but not necessarily, the lease’s termination date). If the equipment’s fair market value is less than the value stated in the policy on the agreed date, the insurer would pay the difference.

Investment return insurance
Insurance against the risk of loss for the value of the redeemable securities of an insured investor.

Limited partnership investor bond insurance
A form of financial guaranty insurance that guarantees fulfillment of the obligations of a person investing in a limited partnership. If the person ceases making payments, the insurer will pay the outstanding amount in installments over the remaining payment period. The insurance is irrevocable and will remain in full force until all of the insured obligations are paid. Example: If the partnership has agreed to purchase a building, and each partner agrees to pay $1,000 a month for mortgage payments, this insurance would respond if one of the partners is unable to continue her required payments.

Manufacturer’s penalty insurance
A commercial policy covering losses due to the unavailability of a product the insured has contracted to supply or manufacture. Coverage is purchased in amounts based on the contract between the insured and the buyer of the product. The objective is to protect the insured against responsibility for delays in completion due to non-delivery. Coverage is usually a percentage (i.e., 90%) of the penalty amount, but excludes coverage for delays due to a labor dispute.

Mortgage guarantee insurance
Insurance purchased by a lender to provide indemnification in case a borrower fails, for whatever reason, to meet required mortgage payments. Typically, the mortgagee must report to the insurer when the mortgagor is two months in default. Should foreclosure be required, the mortgagee usually must acquire title to the property before the claim is paid.

Movie completion bond
A form of surety bond that provides assurance to the financial backers of a motion picture that it will be completed on time.

Municipal bond guarantee insurance
Coverage that guarantees bondholders against default by a municipality. This form of financial guaranty was introduced in the early 1970s. Municipalities embraced it because their offerings took on the credit rating of the company that wrote the insurance, rather than their own ratings. It meant that most municipal bond offerings were elevated to AAA, and municipalities could raise money at lower interest. For investors, it made municipal bonds less risky.

Mutual fund insurance
A form of financial guarantee insurance that guarantees the repayment of the principal invested in a mutual fund.

Oil and gas deficiency insurance
A form of guaranteed performance insurance that indemnifies the insured if an oil or gas field’s
actual output falls short of engineering report projections. Coverage is generally limited to fields with proven reserves with at least three currently producing wells.

Residual value insurance
A form of financial guarantee insurance that protects a lessor against unexpected declines in the
market value of leased equipment (automobiles, aircraft, heavy machinery) upon termination or expiration of the lease agreement.

Securitization
1. Securing the cash flows associated with insurance risk. Securitized insurance risk enables entities which may not be insurance companies to participate in these cash flows

2. Securitization is a process whereby assets are pooled and security interests in the pool are sold-typically to institutional investors. Assets created in this manner include mortgage-backed securities which are backed by residential mortgages, and asset-backed securities which are backed by credit card receivables orconsumer installment loans.

In a typical arrangement, the assets are transferred to a trust [see footnote] and security interests are sold to investors. While various arrangements are used, typically, principal and interest cash flows are paid directly to investors. In this way, the investors incur the prepayment risk of the underlying assets.

Most deals entail some sort of credit enhancement. This may include over-collateralization, a third party guarantee, or other enhancements. For this reason, the securities tend to have excellent credit ratings.

The originator of the underlying assets may continue to proces the assets-communicating with borrowers and collecting their payments. They subtract a fee for doing so. Alternatively, the originator may sell these “processing rights” to a third party.

For loan originators securitization is a means of removing risky assets from their balance sheet, freeing up capital to support further loan writing.

For investors, the securities offer yields that exceed those on comparable corporate bonds. Because the deals are usually large and have high credit ratings, the securities tend to be liquid-most are actively traded on secondary markets.

Suretyship
The function of being a surety. It is the obligation of a surety to pay the debts of or answer for the default of another. A three-party contract is the basis for a suretyship: One party (surety) undertakes to answer to a second party (obligee) for the debt or default of a third (principal) resulting from the third party’s failure to pay or perform as required by an underlying contract or legal obligation.

System Performance – Energy-Related Risks Insurance
This program is a third-party contract and expressed in a liability form. Other approaches are first-party and as professional liability, because of failure to perform, which may be traced to design error or omission. Basic coverage requested is for loss resulting when the system does not perform up to the designed level. Specifications and underwriting decisions differ as to specific coverage application, with alternates and combinations of the following: expense to repair or replace part or parts; loss of use (per diem, but out-partial, and combination); and liquidation. Underwriting considerations such as design credibility and financial stability are pertinent in considering available limits, as are policy provisions requiring non-cancellation and coverage terms of up to 7-10 years. Primarily application for this coverage is for energy-related risks.

Top of page

Financial Guarantee Markets

(General – Not necessarily accessible by TCIM)

Top of page

Securitization

Derivatives / Futures / Options

Other Resources

NEXT SUBJECT > < PREVIOUS SUBJECT
Contact us for assistance