The financial guarantee business can best be characterized as intensely competitive--not only among the financial guarantors but also from alternative forms of credit enhancement--based on Standard & Poor's Ratings Services' midyear 2006 profitability studies and comments received from senior industry management. In light of this current environment, we're often asked about the likelihood of consolidation among bond insurers. We do not see a case for consolidation in the near term.
Standard & Poor's now rates seven primary financial guarantee companies 'AAA', compared with a peak of eight in 1988. This current group of seven is composed of four large and established companies--
MBIA Insurance Corp. (MBIA),
Ambac Assurance Corp. (Ambac),
Financial Guaranty Insurance Co., and
Financial Security Assurance Inc. (FSA)--as well as three newer and smaller firms:
XL Capital Assurance Inc.,
CIFG Companies, and
Assured Guaranty Corp. (AGC). Four of the eight 'AAA' companies in existence in 1988 were acquired within the next 10 years, leaving the large "big four" players, each with significant market positions, and AGC, which had just begun to transform itself from a reinsurer into a primary insurer.
Why Consolidate?
To begin to evaluate the potential for consolidation, we first have to examine why consolidation occurs. Listed below are four factors we've identified as reasons for consolidation:
Owners' changing strategic priorities,
Owners' changing financial circumstances,
Lagging performance or development, and
Hostile takeover.
Of these, only "lagging performance" is easy to spot--and may be the strongest predictor of consolidation. Even here, the owner's timeframe to achieve success could allow several years of lagging performance before a decision to sell is taken. The point being: it's easier to identify "who" than it is to identify "when."
In terms of identifying a likely candidate for consolidation, it can be useful to look back at the acquisitions that have taken place in the industry and examine them in the context of the market conditions at that time. Those companies that were acquired include Bond Investors Guaranty Insurance Co. (BIG), Capital Guaranty Insurance Corp., Connie Lee Insurance Co., and Capital Markets Assurance Corp. (CapMAC).
Past Consolidations
Bond Investors Guaranty Insurance Co.
BIG, which began operations in 1985 focusing on the U.S. public finance market, was acquired by MBIA in 1989. The company met its demise as a result of changing owner priorities: Bankers Trust New York Corp., Government Employees Insurance Co., and Solomon Inc. were evolving in a way that caused them to reconsider their ongoing participation in the public finance business. American International Group Inc. then decided it didn't want to be the sole remaining strategic investor in the company with Xerox Credit Corp. as a financial investor. At the time of its sale to MBIA, BIG was not a struggling or lagging performer: it was a solid franchise that had achieved a significant market share and was generating competitive returns. At the time of the BIG acquisition, growth in new-issue volume within the U.S. public finance market was moderate and growth in insurance penetration was solid.
Capital Guaranty Insurance Co.
In 1995, FSA acquired Capital Guaranty. Founded almost a decade earlier in 1986, Capital Guaranty had maintained the highest quality insured public finance portfolio of any bond insurer during its existence. The company struggled to achieve critical mass and competitive trading value, however, making slow progress in improving on its 3% market share and below-average returns to investors. FSA, given its formation as an insurer of structured finance transactions and its slow penetration in the U.S. public finance market, also had trading value issues within the U.S. public finance market. It was FSA that proposed the mutually beneficial merger: FSA would benefit from an acquired insured portfolio of approximately $9 billion and increased production capabilities, while Capital Guaranty would benefit from the economic efficiencies of a larger organization. At the time of acquisition, the growth of new-issue volume in the U.S. public finance market was steady and insurance penetration exceeded 40%.
Connie Lee Insurance Co.
Ambac acquired Connie Lee in 1997. Connie Lee, which began operations in 1988, was a struggling franchise that, in 1997, attempted to broaden its sector participation following its privatization. The company's historically narrow underwriting focus on the higher education and teaching hospital sectors made it difficult to generate attractive returns due to critical mass issues. However, its owners justified the results as a price to be paid to support the company's mission of helping support education. Once the focus of the company changed, combined with changing owner priorities, that justification was no longer valid. In addition, once Connie Lee announced it was exploring strategic alternatives, its franchise became threatened. The company had a market share of less than 1% when Ambac acquired it, and the U.S. public finance market at the time had gone through two years of decline in new-issue volume, although insurance penetration was improving.
Capital Markets Assurance Corp.
MBIA made its second acquisition within the industry in 1998, when it acquired CapMAC. Having commenced operations in 1987, CapMAC was the second primary financial guarantee company to focus principally on the structured finance market. Financial turmoil in Asia beginning in late 1997 had a major effect on CapMAC due to the company's significant exposure to the region and reliance on Asian Securitization and Infrastructure Assurance (PTE) Ltd (ASIA Ltd) for reinsurance or first-loss protection. Standard & Poor's also lowered its rating on Asia Ltd as a result of deterioration in the company's insured portfolio. This double-whammy drove CapMAC's capital adequacy results to unacceptable levels, causing it to seek additional soft capital from MBIA (its eventual merger partner) to shore-up capital and avoid having its rating being placed on CreditWatch. At the time of its acquisition by MBIA, CapMAC had a 17% market share in the structured finance market. More significantly, however, CapMAC and MBIA essentially competed in different structured finance sectors. The incorporation of CapMAC's asset-backed expertise and market position was complementary with respect to MBIA's existing operations. The amount of structured finance par written for the industry represented 40% of total par written in 1997, and the industry was on the verge of a global expansion into the structured finance business that would test its underwriting discipline.
Results of prior consolidations
The average age of the four companies that exited the business was nine years old. In each of the acquisitions, the usual drivers of consolidation--the elimination of excess capacity and the demise of weaker competitors of the acquirer--were not present. Rather, the factors responsible (to varying degrees) were lagging performance, changing owner priorities, and market forces. In none of these examples, however, did the then-current management initiate a change in ownership due solely to lagging performance. In three of these instances, the elimination of a company had virtually no effect on the competitive dynamics of the industry. In the case of the MBIA-CapMAC merger, the industry remained as competitive, if not more competitive, than before consolidation.
Likelihood Of Future Consolidations
In today's highly competitive financial guarantee market, the only way for a less-established company to succeed is to build market share, expand its business into new areas, or for the market to grow at a rate significantly greater than the growth in existing capital. It is unlikely that there will be any significant market expansion in the near term. In addition, the "big four" will likely compete vigorously to sustain their business while the newer companies will continue to seek growth. While all of the newer entrants into the industry have had success in establishing themselves, with each reporting positive momentum in terms of adjusted gross premiums and par written, they've only been in existence for three to six years and have not had a long enough history to be judged as either an unqualified successes or failures. Therefore, a decision by an owner that its bond insurance business will be unsuccessful would appear to be premature based on the facts. Taking into account these circumstances, Standard & Poor's sees a highly competitive financial guarantee industry, but not a case for consolidation in the near term.
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