Is Bond Insurance Magical?

A few months ago, we beat up a couple of Portfolio writers on the subject of municipal bond insurance until it got so easy we started to feel bad for them. Their contention was that bond insurance was a scam perpetrated by a conspiracy of investment bankers, ratings agencies and insurance companies. We argued that bond insurance persisted because of genuine market demand for lower risk investments.
At the heart of the Portfolio position, however, was a genuinely important insight: municipal bond default rates were so low that insuring the bonds seems irrational. Do you really need to purchase insurance for a class of bonds that have a 0.5% historical default rate?
An article by one of favorite New York Times writers, John Tierney, points out that irrationally insuring against small risks is not confined to muni bonds. “We buy insurance not just for peace of mind or to protect ourselves financially, but because we share the ancient Greeks’ instinct for appeasing the gods,” he writes.

Last year, tens of millions of people bought life insurance for scheduled flights of airlines in the United States. Not one of those insured passengers died in a crash — and this was not just a coincidence, at least not to many of the people who bought the insurance.

Of course, buying an insurance policy does nothing to hold planes aloft, strengthen airplane mechanics or sober up pilots.* But studies by psychologists reveal that this kind of magical thinking is widespread. The reason the shrinks give for this is interesting: “Because calamities are so vivid and easily brought to mind, we tend to overestimate their probability when we intuitively judge what will happen if we tempt fate,” Tierney writes.
Individual retail investors make up most of the buyers in the municipal bond market and, for the most post, they do not actively trade the bonds. It’s not too much of a leap to suspect that this class of investor might be particularly prone to the kind of magical thinking that enriches the flight insurance industry. If the bonds are insured, they won’t default, the thinking goes.
Actually, when it comes to muni bonds, this line of thought is a little less superstitious than the kind that goes into buying many other types of insurance. Bond insurers actively work with issuers to help prevent defaults, and provide monitoring functions that can catch problems before they metastasize. They don’t do this out of a charitable instinct, of course. They do it to minimize the risk of paying out on bond insurance policies.
To the extent, however, that at least part of the demand by muni investors for bond insurance is fueled by the same psychology that fuels other insurance, there should be profit opportunities for investing in uninsured muni bonds. We’d expect those to be underpriced relative to insured comparable assets. The main problem, however, is that realizing the profit is likely to be slow-going. With nothing to trigger a dissipation of investor magical thinking, you’ll have to realize the gains over the entire life of the bond.
Appeasing the Gods, With Insurance [New York Times]

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Comments (11)

  1. Posted by guest | May 6, 2008 at 4:40 PM

    I can see why that tickled your classically trained funny bone, JC.
    Insurance is a funny thing. Nobody likes buying it, but getting caught without it when you needed it is worse.

  2. Posted by guest | May 6, 2008 at 4:47 PM

    I didn’t get renters insurance when I got my first post-college apartment. It promptly burned down 8 months later.
    Moral of the story : Get the insurance.

  3. Posted by Debter | May 6, 2008 at 4:56 PM

    Here is why insurance on muni bonds persisted. It allowed non-traditional buyers (hedge funds, arbs, and small towns in Norway) to eliminate what they perceived as credit risk (they git confused and thought elimination of credit risk would equal the elimination of basis risk), lever the f*ckers up and reap pretty decent income. It’s all about the carry trade. This was ata time when the rest or the world’s yield curves were practically flat, or flat enough that they could not overcome the fees (remarketing and such) for leverage to work. Anyway, basis blew out last summer, and you guys know the rest of the story.

  4. Posted by diablo | May 6, 2008 at 4:58 PM

    Regarding retail investors, keep in mind that during this decade hedge funds are really messing up with the muni bond market big time, and there’s no insurance against that. That means retail investors will need to get a little more involved and trade more. Even today many muni bonds are underpriced.
    The real issue with muni bonds is their ratings without insurance. That fight is on.

  5. Posted by Investorcluzo | May 6, 2008 at 5:15 PM

    a) most profitable insurance in the business – trip insurance (followed by cell phone insurance); if you want to start a business, those have better margins than that $15 martini you had last night…
    b) perhaps the government of california has a point to go after the agencies alleging that they (s&p/moody’s) rate them (municipalities) differently than corporates – which, in itself, is an issue given that muni’s can tax the people!
    c)everyone hates insurance until they need it – any florida citizens out there?
    the end.

  6. Posted by guest | May 6, 2008 at 5:25 PM
  7. Posted by Anal_yst | May 6, 2008 at 5:30 PM

    …jesus
    sykes gives shameless self-promoters everywhere a bad name

  8. Posted by Investorcluzo | May 6, 2008 at 5:42 PM

    timmmay! are you sure you didn’t study marketing? you have indeed taken your self promotion to new heights and I applaud your steadfast efforts. as don king says: “only in america”…but seriously, do we have to continue to read about it here? not hatin’ on you timmay (I’ll save that for the others), just askin’ @5:25…

  9. Posted by onetwo | May 6, 2008 at 5:51 PM

    1) The muni business is going to be the ultimate black swan. No one defaults now, but when they start defaulting en masse it’s going to get ugly (think about the pensions, slowing economy, tax competition, and falling real estate prices). Mark my words.
    2) In the same vain, has anyone analyzed the principal-agent (moral hazard)problem of the municipalities NOT having to protect their credit rating until they need to refinance, which is someone else’s problem.

  10. Posted by guest | September 24, 2008 at 6:08 PM

    One more point on muni bond insurance, it helps provide liquidity in the market. People do not have the time or the interest in understanding the risks associated with the tens of thousands of municipal issuers. Monoline insurers do the work for you and take a piece of the spread.

  11. Posted by guest | February 23, 2009 at 3:29 AM

    How can anyone call a bond insurance policy a scam? I do not agree with this at all. The contention that bond insurance was a scam perpetrated by a conspiracy of investment bankers, ratings agencies and insurance companies is not at all true. There has been no proper proofs given by them to justify their statement. I am also an insurance analyst, i havent come across this type of situation ever in my lifetime.
    Thanks and Regards
    Max Ray
    http://www.ampminsure.org