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Is Bond Insurance Magical?

A few months ago, we beat upa 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]