The Price of Safety: The Evolution of Insurance Value in Municipal Markets

Abstract

Economic theory predicts that bond insurance lowers issuers’ financing costs by resolving asymmetric information and mitigating credit risk. With comprehensive data over the last 36 years, we find increasingly diminished empirical support for these models. The value of insurance in resolving asymmetric information beyond that resolved by credit ratings and other observable characteristics is economically minimal. The average gross value of insurance ranges 4 to 14 bps when bond insurers offer Aaa-rated coverage, with the value of insurance increasing in market competition. However, this gross value becomes insignificant after 2008 when Aaa-rated insurance no longer exists due to widespread downgrades and bankruptcies of bond insurers. Evidence suggests that the lack of insurance benefit in the post-crisis period is likely attributable to the deteriorated creditworthiness of insurance companies. Examining non-interest saving explanations for the continued use of insurance in the post-Aaa insurance market, we find evidence that issuers purchase insurance out of habit (especially those with low governance quality) and for the convenience it affords in a default event, but no evidence that insurance improves secondary market liquidity.