NU Online News Service, July 7, 2:38 p.m. EDT

Property and casualty insurers remain the most exposed sector among financial institutions to volatility within the municipal-bond market, holding about $355 billion in municipal bonds, but the overall level of risk should be manageable, Moody’s says.

In a Special Comment, Moody’s says municipal bonds represent 60 percent of the industry’s equity capital base, as measured by policyholders’ surplus. This figure is down from the prior year, when the industry held about $370 billion in municipal bonds, representing about 70 percent of policyholders’ surplus.

Describing the risks, Moody’s states, “The municipal-bond sector continues to be under stress due to macroeconomic pressures and the attendant budgetary strains.” Moody’s adds that it expects more muni-bond downgrades than upgrades in 2011, and it expects muni defaults to rise.

For insurers, Moody’s says that although exposure has come down over the last year, it still remains high. Additionally, Moody’s says muni-bond portfolios generally have long durations, with an average duration of six years, exposing companies to interest-rate risk and greater market volatility. “We note, though, that insurers generally do not need to liquidate portfolios to pay claims, and so are able to withstand investment market volatility...,” Moody’s says.

Insurers also have “material exposure” to general obligation bonds for high-risk states, or from local entities within high-risk states, according to Moody’s.

But the rating agency says the risk for insurers is manageable, as insurance-company municipal-bond portfolios have high credit quality and are well diversified both by geography and bond type.

Moody’s also says that, as part of its stress-testing of P&C insurers, it projected losses on muni-bond portfolios under both baseline and downside scenarios, and in both cases credit losses were manageable.

The baseline scenario, Moody’s explains, assumes a continued sluggish economic recovery. Under this scenario, credit losses were projected to be $300 million for P&C companies rated by Moody’s, and $500 million for the entire U.S. P&C industry over a five-year horizon.

For the downside scenario, which assumes significant credit deterioration consistent with multi-notch downgrades across the muni sector and high default rates, credit losses could approach between $2 billion and $3 billion, Moody’s says.

“These stress tests help support our thesis that even in a downside scenario, credit losses from P&C companies’ muni portfolios are likely to be manageable,” Moody’s says. “This is especially true in context of the investment returns which we estimate to be in excess of $10 billion per year given current yields, easily absorbing credit losses under our downside scenarios.”