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COMMERCIAL REAL ESTATE

THE NEXT CHALLENGE FOR GIC ISSUERS

Throughout our twenty-three year history, FCM's stable value management approach has utilized diversified portfolios of traditional guaranteed investment contracts (GICs) issued by major life insurance companies. 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, stable liability profiles, 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. Overall, GIC issuers were well positioned to weather this historic credit event due to sizeable excess capital positions built up before the crisis, along with manageable exposures to riskier asset classes and available sources of liquidity. With that said, GIC issuers have experienced elevated investment losses over the last eighteen months which has pressured earnings and capital positions.

These losses have largely been driven by write-downs on housing related structured securities (Subprime and Alt-A MBS), corporate bonds, and equity securities. Over the past few quarters, 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, the commercial real estate (CRE) market is expected to present the next challenge to the credit profile of GIC issuers.

While most issuers have not experienced material losses from their CRE investments, many expect this to change over the next few years as losses from this asset class tend to materialize later in economic cycles. This view has been supported by deteriorating CRE fundamentals over the last couple of years with some surveys estimating that real estate values have declined by more than 30% from their peak levels in 2007. GIC issuers' CRE exposure is primarily focused in commercial mortgage loans (CMLs) and investments in commercial mortgage-backed securities (CMBS), along with modest real estate holdings. In general, FCM considers issuer exposure to these asset classes to be manageable with potential losses being absorbed through operating earnings and excess capital positions. This assumption is based on the relative size and high quality nature of these investments. In addition, our view has been reinforced by recent rating agency studies concluding that US life insurers' exposure to CRE should be manageable under expected loss scenarios. That said, the size and nature of exposure varies amongst issuers and certain issuers will be impacted more than others, especially during a more severe than expected downturn.

GIC issuers have traditionally maintained high quality investment portfolios. Investing activities are primarily focused in diversified bond portfolios representing approximately 70% of invested assets. After bond holdings, CMLs comprise the second largest investment allocation, representing approximately 12% of the average issuer's invested assets as of September 30, 2009. This moderate level of exposure has been relatively stable over the last several years and is much lower than the 20 to 30% reported in the early nineties the last major CRE downturn. This asset class has performed very well in recent years with the average level of non-performing mortgages to total mortgages for FCM's GIC Universe at only 0.1% as of September 30, 2009. GIC issuers have a long history of expertise in commercial mortgage lending and typically maintain conservatively underwritten portfolios that are well diversified by property type and geographic location. CML portfolios are spread throughout the country and across several property types with the largest allocations to the office, retail, industrial, multifamily sectors. Underlying collateral typically consists of established properties with long term lease agreements and stable cash flows, with only modest exposure to more speculative construction and development loans. During the financing boom from 2005 to 2007, issuers maintained their conservative underwriting guidelines and did not significantly grow their loan portfolios to meet increasing demand. As a result, CML portfolios appear to be holding up well despite the decline in property values since 2007 with issuers reporting average portfolio loan-to-value (LTV) ratios in the mid to high 60% range and debt service coverage ratios of 1.5 to 2 times. Moreover, the majority of loans appear to still have good LTV cushions due largely to the fact that portfolios have laddered maturities and are generally well seasoned with large percentages in amortizing loans originated in 2005 and earlier.

In an effort to limit credit risk, while adding attractive yields, GIC issuers became large consumers of CMBS over the last several years with these investments currently representing around 7% of a typical issuer's invested assets. In contrast to issuer CML portfolios, CMBS deals have experienced significant increases in delinquencies over the past few quarters. This has largely been driven by more aggressive underwriting standards, especially for deals originated from 2005 to 2007. That said, GIC issuers, for the most part, have historically taken a conservative approach to this asset class and have focused their CMBS purchases in senior, AAA rated securities. These securities enjoy significant credit protection through the subordinated structure of the deals, in that losses on the underlying collateral are first absorbed by lower rated classes. Moreover, these senior classes typically have subordination levels ranging from 20% to 30%, which provides protection from cumulative losses that are two to three times more than what was experienced during the last major commercial real estate downturn (1986 vintage). In addition, issuers have somewhat limited exposure to higher risk CMBS deals originated in 2006 and 2007 given that these vintages typically represent less than half of total CMBS holdings and the vast majority were AAA rated at the time of purchase.

Moody' Investor Service recently published a report on the life insurance industry's CRE exposure, entitled US Life Insurers' Commercial Mortgage Exposure & Losses Are Manageable. The report concluded that "given the moderate size of the life industry's CRE exposure, its conservative underwriting profile, and expected loss rates in the 1-3% range for CMLs and CMBS holdings, we believed that losses should be viewed as an earnings event as opposed to a capital event; therefore, we see little chance of a broad-based downgrades due to commercial real estate concerns in isolation." By using Moody's current life insurance industry expected loss rates of 3% for CML and 1% for CMBS, FCM estimates total losses for the GIC issuer universe of approximately $4 to 5 billion over the next two to three years. This loss estimate appears to be manageable given that it represents only approximately 5% of total statutory surplus and less than one year of normalized statutory operating earnings, which is projected to be above $10 billion in 2009.

David J. Molin, CFA