There was a good WSJ on this last week.
If I recall, the bond insurance market is not very regulated at all, and was likened to a bunch of people making side bets on fights.
The current worry is that some of the folks writing policies on bonds issued by the companies don’t have the assets to cover the bets. If a large number of companies go under, the value of the assets used to underwrite the bond insurance goes down as well, calling into question whether they can pay.
On top of that, as companies ratings go down, the policies themselves go up in value, and are TRADED. The tighter a company’s circling the drain, the higher the value of the bond insurance policy on a company. The holder of the bond can sell it to somebody else.
Insider trading? Why not? You can hold a bond, or an option on a bond, and no stock, and profit on either the health or death of a company.
Anyway, its complex, and not a lot is known about it, and there are trillions of dollars involved.
You're thinking of credit default swaps (CDS), which is not the same as bond insurance. MBIA-type bond insurance is used by municipalities that may not have stellar credit to obtain AAA grade financing. They buy AAA rated insurance for the bonds they issue (that's what's meant by "wrapping" the bond) and then the overall bond gets the AAA rating, lowering the interest rate.
OTOH, CDS is unregulated and can be entered into by just about anyone - hedge funds, banks, insurance companies, corporations... To enter a CDS one party "insures" a company's bond against default by paying an upfront fee and then an annual charge for the promise to be paid the face value of the bond in the event of default. But if the entity that made that promise is insolvent, the "insurance" is worthless. That's known as counterparty risk - the risk that the other side of your financial contract can't live up to the contract's terms.
In the first of many of these writeoffs to come, Merrill Lynch just wrote off about $3.2 billion of CDS that were entered into with ACA Capital Holdings. Last I had read, there were about $45 of CDS covering only $15 billion or so of corporate debt (that's the side bet aspect) and hundreds of billions of CDS covering CDOs issued by companies such as ACA. Many of these CDS will prove to be worthless.
Now to confuse matters a bit more, the bond insurers such as MBIA didn't get involved in CDS. And the municipal bonds they insure is still a good business (which is why Buffet is getting into it.) But they did get into insuring CDOs and many of those are going bad, which is impacting their capital structure. The 75bp rate cut likely won't help much here. Not when MBIA had to pay 14% interest to be able to sell a $1 billion issuance last week. BTW, that was rated AA by the bond rating agencies. 14% interest and an AA rating...