A financial guaranty insurance policy acts much like a surety bond, insurance policy or as an indemnity contract when issued by an insurer. It’s an insurance policy that covers financial loss resulting from default or insolvency, changes in interest rates, currency exchange rate changes, restrictions imposed by foreign governments, or changes in the value of specific goods or products.
A financial guarantee is a non-cancellable indemnity bond backed by an insurer to guarantee investors that principal and interest payments will be made. Several insurers specialize in financial guarantees and similar products that are used by debt issuers as a way of attracting investors. A bank guarantee, on the other hand, is a promise from a bank or other lending institution that if a particular borrower defaults on a loan then the bank will cover the loss.
Why guarantees attract investors
Traditionally, bond insurers have provided guarantees of payments on municipal bonds, where defaults have been very limited. But since the late ‘90s they have become increasingly involved as guarantors of elements of various structured financial products. This includes the credit enhancements provided by these entities that have played an important role in making securities based on sub-prime loans attractive to a wide range of investors.
Despite the growing role of financial guarantee insurance in the secularization process that has come to characterize modern financial markets, the entities providing this specific financial service received relatively limited attention until early 2008, when several rating agencies began scrutinizing the role of bond insurers in structured finance.
In most cases, financial guarantors disclose the scope and intent of their guarantees in financial statement notes. Guarantees issued between parent companies and their subsidiaries do not have to be recorded as liabilities on a balance sheet. For example, in the case of a parent company’s guarantee of a subsidiary’s debt to a third party or a subsidiary’s guarantee of the parent company’s debt to a third party or another subsidiary, neither would have to list these obligations on a balance sheet.
However, all financial guarantees must be disclosed, including the nature of the guarantee, including any terms, recent history, as well as events that would activate the financial guaranty insurance policy, the maximum liability along with any provisions that could enable the guarantor to recover funds paid out in a guarantee. This is complex language that should be discussed with your insurer.