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2007:
A Stable Time for GIC Issuers
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Throughout our twenty-one year history, FCM has primarily focused its stable value investment activities in diversified portfolios of traditional guaranteed investment contracts (GICs) issued by major life insurance companies. We have found several relative value advantages in using GICs over other stable value products including their policyholder status and superior yield premiums relative to other comparable high-grade obligations. In general, GIC issuers represent the most creditworthy segment of a high quality, mature industry that exhibits strong credit fundamentals including: solid capital levels, diversified revenue and earnings sources, consistent operating cash flows, and conservative balance sheets. The credit fundamentals of FCM's GIC issuer universe remained solid
in 2007, continuing the steadily improving trend from the difficult
environment back in 2001 and 2002. Although the fallout from the problems
within the subprime mortgage market increased volatility during the
fourth quarter, financial market conditions were relatively stable for
most of 2007 with historically low levels of corporate defaults and
positive equity market returns. This translated into strong earnings
performance for GIC issuers and improved balance sheet profiles with
capital positions ending the year at historically high levels. Going
forward, FCM expects some reversal of this trend in 2008 given the negative
economic outlook and less favorable equity and credit market conditions.
That said, FCM believes that GIC issuers are well positioned for this
challenging environment given their extensive financial resources and
the ability of their business profiles to historically withstand changing
economic conditions. In recognition of this financial strength, all
of the major credit rating agencies currently maintain a "stable
outlook" for the life insurance industry and almost all GIC issuers
individually have stable outlooks for their financial strength ratings
(typically AA or higher). As of year-end 2007, GIC issuers continued to report strong capitalization with statutory surplus totaling $110.6 billion, up 11% from 2006 and well above the previous high of $100.3 billion in 2004. Moreover, individual issuer capital positions remained very favorable with the median ratio of total surplus to general account assets increasing to 9.8% in 2007, as surplus augmentation remained in line with asset growth. On a risk-adjusted basis, capital ratios also remained solid with FCM's GIC universe reporting an average NAIC Risk-Based Capital (RBC) ratio of 443%, significantly above regulatory minimums and in line with the historic high of 445% at year-end 2006. GIC issuers continued to report healthy statutory earnings in 2007 with total net operating gain and net income increasing 27% and 14% to $11.5 billion and $11.0 billion, respectively. Overall, earnings performance continued to benefit from low realized investment losses, higher fee revenue driven by market appreciation and strong sales of asset accumulation products, and stabilizing net interest spreads. GIC issuers for the most part have traditionally maintained conservative investment portfolios. Investing activities are primarily focused in diversified bond portfolios, which currently represent almost 75% of the average GIC issuer's invested assets. Bond portfolios are typically comprised of 60 to 70% corporate bonds, with the remaining 20 to 30% invested in structured securities including mortgage-backed and asset-backed securities. In general, GIC issuer bond portfolios are conservatively managed with over 90% invested in investment grade securities and significant diversification by individual issuer and sector. As of year-end 2007, average below investment grade bond holdings was reported at only 6.2% of total bonds, compared to just over 9% in 2002. Moreover, the majority of these bonds are in the highest below investment grade rating class of BB. In addition, GIC issuers have limited exposure to subprime mortgage related securities with the average issuer exposure representing approximately 2% of invested assets. This exposure is focused in highly rated residential mortgage-backed securities (RMBS) with only a very small percentage in more volatile collateralized debt obligations (CDOs). Moreover, over 90% of total GIC issuer exposure to subprime is in bonds rated AA or AAA, which benefit from significant structural support from subordinated tranches within the deals. Overall, FCM considers current positions in subprime related assets to be very manageable given the sizable financial resources available to GIC issuers to absorb potential losses. After bond holdings, commercial mortgages comprise the second largest investment allocation representing approximately 11% of the average GIC issuer's invested assets. Over the past few years, this asset class has performed very well with the average ratio of non-performing loans to total mortgages at less than 0.1% as of year-end 2007. Going forward, the commercial real estate market is likely to weaken given the possibility of slowing economic growth and difficult credit market conditions. Nonetheless, a moderate degree of deterioration would have only a negligible impact on overall GIC issuer asset quality. In summary, we expect GIC issuers to continue to be one of the most
creditworthy segments of the high-grade fixed income market and FCM
views recent operating trends as further supporting credit fundamentals. GRAPHS: HISTORICAL GIC ISSUER UNIVERSE TRENDS
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