Course 210: Municipal Bond Insurance
How Municipal Bonds Are Insured?
In this course
1 Introduction
2 Why Insure Municipal Bonds?

A municipal bond is an obligation of debt issued by states and city and local governments to raise money for the public funding of projects and services such as schools and housing. Municipal bond insurance is an insurance policy on the bond and is underwritten by a private insurance company.

Insurance provides investors with the security that no matter what happens to the finances of the government that issues the bond, the bond's interest and principal payments will be made.

Like other bonds, municipal bonds have certain risks associated with them. A bond's primary risk is that it could default. If a bond defaults, it means the government that issued the bond does not have the funds to make timely payments of interest and principal.

Municipal bonds also count on the projects they finance to bring in expected revenues. The governments that issue municipal bonds often rely on these revenues to pay back the bonds they issue. Municipal bonds therefore also run the risk that these projects will fail to produce the revenue needed to pay off the bonds. Insurance provides investors with the security that no matter what happens to the finances of the government that issues the bond, the bond's interest and principal payments will be made.

Bonds with low default risk are given high credit ratings, which influence the market prices of the bonds. A bond that is insured will have a higher credit rating than a non-insured bond. Insured bonds receive the highest credit rating possible: AAA. The higher credit rating enables the bond issuer to pay a lower interest rate on the bonds when they are sold. There are four major agencies that provide bond credit ratings. These agencies are the following:

  • Moody's Investors Service
  • Standard & Poor's Corporation
  • Fitch IBCA, Inc. 
  • Duff & Phelps Credit Rating Co.

Insuring a municipal bond also increases the bond's marketability. The insurance helps smaller issuers who are unknown or do not issue bonds frequently to be taken seriously by investors.

[subsection What Does Municipal Bond Insurance Cover?

3 What Does Municipal Bond Insurance Cover?
4 How Municipal Bonds Are Insured?
5 Drawbacks of Insuring Municipal Bonds
6 Municipal Bond Insurers
7 Should You Buy Insurance?

Before a municipal bond is insured and sold, it is purchased by an underwriter firm (or financial guaranty company), insured, and then resold to investors. Underwriting is a risk assessment process by the insurance company. In the underwriting process, the insurer decides whether and on what basis it will issue a policy on a bond. Most insurance companies that insure municipal bonds are called "monoline" insurers. This means the insurance company insures only debt securities, eliminating the risks that come from insuring any other types of products or services. These insurance companies are closely scrutinized by the same credit rating agencies that rate the bonds.

Once a bond is insured, its performance is closely monitored by its insurer through a process called surveillance. During surveillance, the insurer examines the financial statements and reports of the bond issuer to make sure the issuer's credit will remain stable.

After the underwriting process, which takes about a month, the bond is given a new rating by a rating agency. It is also assigned an identification number called a CUSIP. The CUSIP number is used to identify the security when it is traded and settled.

Next: Drawbacks of Insuring Municipal Bonds >>


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