(Bloomberg)—U.S. property/casualty insurers, which hold more than $369 billion in municipal debt, face minimal default risk by state and local governments, FBR Capital Markets said.

“Even in a Draconian scenario such as the Great Depression, we believe that there is no outsized risk in the municipal bond market,” Bijan Moazami, an insurance analyst with FBR, said Tuesday in a research note. “States and municipalities are so dependent on capital markets for their financing needs that they would not want to risk financial suicide and would default only in most extreme circumstances.”

Property/casualty companies, which invest in municipal bonds to fund future claims on home and commercial property policies, are counting on states and local governments to honor their obligations even as the economic slump curbs tax revenue. Allstate Corp., which owns about $20 billion of municipal debt, cut its holdings for three straight quarters through the end of March and blamed local governments for not bolstering their finances.

The “worst-case scenario” for municipal defaults would lower shareholders' equity by 1.8% at Allstate, by 1.9% at Chubb Corp. and by 2.4% at Travelers Cos., Mr. Moazami said.

“Despite increased concerns about state budget deficits, muni bond prices continue to hold up well,” Mr. Moazami said. While concerns about insurers' municipal holdings “are certainly not unfounded, our analysis indicates that they are somewhat overblown.”

Big weighting

Municipal bonds accounted for about 27% of insurers' investment securities as of March 31, Mr. Moazami said. That's down from about 31% at the end of 2008, according to FBR. At the end of December, Travelers had about 62% of its investments in municipal bonds, compared with 43% for Chubb and 25% at Allstate, according to FBR.

Travelers, the insurer added to the Dow Jones Industrial Average last year, said in May that municipal bond investors may be spared defaults as politicians and taxpayers demand budget cuts. Travelers held more than $40 billion of municipal debt at the end of March.

Billionaire Warren Buffett, whose Berkshire Hathaway Inc. sells auto policies and catastrophe coverage, told the Financial Crisis Inquiry Commission last month that municipal bonds faced a “terrible problem.” The U.S. government may be compelled to rescue at least one state facing default, he told shareholders at Berkshire's annual meeting May 1.

‘No intestinal fortitude’

“Nobody has the intestinal fortitude to actually move forward to try to change anything,” Allstate CEO Thomas Wilson said of government debt at the federal, state and local levels in a July 6 Bloomberg Television interview. “They’re just sort of sitting there waiting for disaster to happen.”

Property/casualty companies cut their holdings of municipal debt 3.3% to $369.4 billion in the 12 months ended Dec. 31, according to the Federal Reserve. U.S. banks added more than $84 billion to their holdings since 2003, according to the Fed.

Allstate, New York-based Travelers, Chubb of Warren, N.J., Progressive Corp. and Hartford Financial Services Group Inc., which are the biggest U.S. property/casualty insurers covered by Mr. Moazami, held about $95 billion of municipal debt as of March 31, according to FBR.

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