S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Bond Insurancereinsurance as described above is not counted assoft capital.Concentrations of soft capital providers aremonitored as well, using guidelines designed tolimit the effect of a nonperforming soft capitalprovider. An insurer’s reliance on a single providerof soft capital is measured using an alternativemargin of safety test, which assumes the default ofone soft capital provider. Reliance on a single softcapital provider is excessive if, under the alternativemargin of safety test, the default of thatprovider would cause a bond insurer’s margin ofsafety to drop five basis points or more below theminimum margin of safety required at the insurer’scurrent rating level. For purposes of this test, exposuresto soft capital providers under committedcapital facilities are included in soft capital but notassumed to default, and collateralized reinsuranceis excluded from soft capital.Financial performanceThe quality, level, and predictability of underwritingand investment income are important factors inthe analytical process. The insurer’s pricing policyshould demonstrate that premium levels provide asufficient return in relation to the capital requiredto support that issue. The predictability of underwritingincome is based, in part, on market conditionsand the composition of premium income (thatis, new issue, secondary market, unit investmenttrust, or mutual fund). The profitability of a startupcompany initially could be restricted because ofstatutory accounting conventions.Standard & Poor’s evaluation of investmentactivities focuses on the performance and risk characteristicsof the portfolio, including a discussion ofits composition, credit quality, and concentrationby issuer, industry, and geography. Another considerationis the relationship between the maturity ofthe investment portfolio and the average maturityof the insured bonds. Finally, liquidity resources areevaluated and measured against potential needs forfunds to pay claims (see “Liquidity uses andresources” section).The insurance operating company’s financialstatements produced under conservative statutoryaccounting principles are the primary source ofinformation for analyzing its financial strength andperformance. Consolidated holding companyresults, reported under GAAP accounting, also containuseful information—particularly for assessingmanagement’s conservatism, as evidenced in howthe company exercises judgment in the applicationof accounting practices and the company’s access tocapital based on its comparative returns on equityand use of debt leverage.DiversificationDiversification within the bond insurance industrycan take two forms: (1) diversification of the financialguaranty business plan and (2) holding companydiversification into noninsurance businesses.With respect to a company’s financial guarantybusiness plan, significant challenges face thoseorganizations that would seek to enter the business.Many start-up proposals have not successfullypassed the ratings process because of the difficultyof developing a credible business plan.The keys to success—and for achieving high ratings—includea well-diversified business plan andunderwriting strategy that today must at least targetboth structured finance and public finance inthe public and private markets with proper sector,market, and geographic diversity. We feel a diverseunderwriting strategy would enable a bond insurerto deploy capital to those markets that offer thebest growth prospects and returns on capital asthe capital markets change. Because of the emphasisplaced on a diverse financial guaranty businessplan, bringing a significant amount of capital tothe rating process is necessary, but not sufficientfor a start-up to attain a high rating. Solely relyingon investors’ desire for greater guarantor diversityis not an appropriate foundation to prove the economicviability of a company. It should be notedthat the sheer number of existing monolinesalready in the market has changed the businessdynamics for those firms that wish to follow. InStandard & Poor’s opinion, it will be more difficultfor start-up firms to earn an ‘AAA’ financialstrength rating if they only wish to do business ina single business segment. The need to convincinglydemonstrate the viability of the proposed businessplan will carry greater weight in our analysisgoing forward.In years past, bond insurance holding companiessought to diversify to enhance growth prospectsand seek higher profitability. For some companies,diversification efforts centered on financial services,such as money management, municipal investmentcontracts, and swaps. From a benefits perspective,alternative products’ contribution to consolidatedincome could relieve pressure on management toforge ahead in financial guaranty sectors that nolonger present attractive risk/reward dynamics.While these alternative products can contribute toconsolidated income, they can also present risk tothe bond insurer.For those activities that involve new productsand skills that are not consistent with traditionalbond insurance risks and skills, risk-managementpractices and staff capabilities receive addedwww.standardandpoors.com299