2009: A YEAR OF RECOVERY

FCM's stable value management has utilized diversified portfolios of traditional guaranteed investment contracts (GICs) issued by major life insurance companies throughout our twenty-three year history. In general, GIC issuers represent the most creditworthy segment of a mature, highly regulated industry that exhibits strong credit fundamentals including: solid capital levels, diversified revenue and earnings sources, consistent operating cash flows, and conservative balance sheets. Since the financial crisis began in late 2007, GIC issuers' credit profiles have held up reasonably well through what has likely been one the worst periods for financial markets since the great depression. That said, the unprecedented turmoil within the credit and equity markets did place significant pressures on the credit fundamentals of GIC issuers. This environment became even more challenging as frozen capital market conditions made it very difficult for issuers to raise new capital. Over the past year, the substantiaL recovery of the financial markets has eased many of these pressures and has resulted in significant improvements in earnings and capital. Issuers have raised sizable amounts of new capital through debt and equity offerings, the proceeds of which have augmented liquidity positions and improved financial flexibility.

To improve the credit profiles of their institutions, management teams have implemented strategic initiatives to reduce risk exposures including increasing hedging activities, de-risking certain equity-linked product offerings, repositioning investment portfolios, exiting more capital-intensive product lines, and divesting non-core businesses. After experiencing downgrades in 2008 and 2009, issuer credit ratings have stabilized in 2010 with several issuers being reaffirmed and some rating outlooks changed from negative to stable. In addition, Moody's has recently changed its outlook for the life insurance industry to stable from negative as a result of more favorable trends.

As of year-end 2009, GIC issuer capitalization remained sound with statutory surplus totaling $112.6 billion, up 13% from 2008. As a result, the median ratio of surplus to general account assets for FCM's GIC issuer universe increased from 7.7% to 8.8%, which is in line with historic levels. On a risk-adjusted basis, capital ratios remain solid with our issuer universe reporting an average NAIC Risk-Based Capital ratio of 429%, which is significantly above regulatory minimums and just below the historic high of 445% in 2006. Earnings results improved significantly in 2009 with our issuer universe reporting an aggregate statutory net operating gain and net income of $15.6 billion and $3.4 billion, respectively, compared to sizable net losses in 2008. Overall, operating earnings performance was positively impacted by the recovery of the credit and equity markets resulting in higher asset-based fee revenue and lower reserves for variable annuity guarantees. Although improved from 2008, net income continued to be depressed by elevated levels of realized investment losses, the bulk of which were taken in the first half of the year.

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. Investing activities are primarily focused in diversified bond portfolios representing approximately 70% of 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 2009, below investment grade (BIG) bond holdings increased to 9.2% of total bonds on average, which is in line with the levels experienced during the last credit downturn in 2002. The increase in BIG holdings has largely been driven by rating agency downgrades of non-agency mortgage related securities and to a lesser extent by "fallen angels" in the corporate bond segment. Commercial mortgages comprise the second largest investment allocation representing 12% of the average issuer's invested assets. In general, GIC issuers have demonstrated expertise in managing this asset class and typically invest in conservatively underwritten and well diversified mortgage portfolios. This asset class continues to perform well with the average level of non-performing mortgages to total mortgages reported at only 0.1% as of year-end 2009. Although the level of problem assets is currently very manageable, commercial real estate (CRE) market fundamentals have weakened considerably and losses are expected to increase in 2010. Overall, FCM considers issuer CRE exposure to be manageable given current expected loss projections, although the size and nature of exposure varies amongst issuers and some issuers will be impacted more than others.

GIC issuers have experienced elevated investment losses driven largely by write-downs on housing related structured securities (Subprime and Alt-A MBS), corporate bonds, and equity securities. Losses from these investments have moderated and are trending down as the financial markets have recovered significantly from their March 2009 lows. As losses from these asset classes have subsided, losses from CRE holdings are expected to increase as we move through the credit cycle. Despite higher CRE losses, overall investment losses are expected to continue to trend downward given the improved economic outlook and more stable financial market conditions. In general, FCM believes that further investment losses, particularly from real estate related assets, should be manageable given available resources including improving operating earnings and excess capital positions. That said, we continue to face uncertain times including the possibility of a double-dip recession. In summary, we expect GIC issuers to continue to face some near-term financial pressures, but FCM believes that long-term credit fundamentals remain favorable relative to high-grade fixed income alternatives.

David J. Molin, CFA

Historical GIC Issuer Universe Trends (Graphs)