Despite the abundant risks facing U.S. property/casualty carriers these days, exposure to municipal bond losses is one that shouldn’t be keeping insurers up at night.
While muni bonds make up 27% of P&C insurers' invested assets, Moody's Investors Service says credit losses would be manageable even under a severe stress scenario. As published in its new report, "U.S. P&C Insurers Face Manageable Credit Risks in their Muni Bond Portfolios," the ratings agency also believes that municipal credit quality will remain generally resilient even through a period of economic stress.
"Numerous concerns have been raised about U.S. municipal bonds, and the potential impact that disruptions in the muni sector could have on P&C insurance company investment portfolios," says Paul Bauer, an analyst and author of the report. "While recognizing that public finance in the United States is under strain, we nevertheless view P&C insurers' muni bond exposure as manageable."
Bauer believes that under a baseline scenario, which assumes a slow and gradual economic recovery, there should be minimal credit losses, given the sector’s superb credit quality. In order to estimate potential losses in a more difficult environment, Moody's says that it projected expected losses on P&C insurers' muni bond investments under a range of simplified, yet extreme, scenarios to approximate the impact of various levels of municipal credit stress.
"We believe the P&C industry's muni bonds losses could be in the $2 billion to $4 billion range in a severely stressed environment," Bauer says. "However, in context, even these estimates from an extreme stress test would be moderate given that we expect investment income of more than $10 billion per year from the industry's sizable $370 billion muni bond portfolio, more than offsetting our stress case losses."
P&C insurers' high allocation to municipal bonds stems from their preference for fixed-income securities, and their desire to minimize fixed-income credit risk and take advantage of the tax benefits the bonds offer, the report says. Bauer also highlights that despite P&C insurers’ considerable muni bonds holdings, these holdings are well diversified by both bond and obligor type, as well as geographically. Additionally, he says approximately 75% of the securities are of the highest quality, which is reflected in their Aaa or Aa ratings.
However, Moody’s makes mention of a major caveat: a scenario in which losses resulting from a catastrophe, such as a major hurricane or earthquake, could force insurers to sell investments in a depressed market in order to satisfy claims, which could result in realized investment losses.
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Corrected November 22, 2010 at 11:58AM: yes