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2004: A MORE STABLE TIME FOR GIC ISSUERS

David J. Molin, Assistant Vice President - Research
Fiduciary Capital Management, Inc.

Throughout our eighteen-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 and the life insurance industry as a whole strengthened in 2004, continuing the improving trend from the difficult environment back in 2001 and 2002. After a strong rebound in 2003, financial market conditions continued to stabilize in 2004 resulting in the reversal of many of the negative trends that had depressed industry results. This translated into solid improvements in earnings and capital positions for GIC issuers, benefiting from the improved equity and credit markets, along with steadily higher interest rates. In response to the healthier operating environment and improved financial performance, all of the major credit rating agencies now maintain a "stable outlook" for the life insurance industry and the vast majority of GIC issuers have stable outlooks for their financial strength ratings (typically AA or higher).

As of year-end 2004, the universe of GIC issuers that FCM follows reported solid improvement in aggregate capital positions in 2004 with total statutory surplus increasing by 8.0% from year-end 2003 to $102 billion. The median ratio of total surplus to general account assets remained relatively unchanged at 8.7%, as surplus augmentation continued to keep pace with asset growth. On a risk-adjusted basis, capital ratios improved significantly with FCM's GIC universe reporting an average NAIC Risk-Based Capital (RBC) ratio of 406% (total adjusted capital to company action level), an increase from 353% at year-end 2003. Overall, the improved capital positions were driven by solid earnings retention, along with net realized capital gains. During 2004, GIC issuers reported strong gains in statutory earnings with total after-tax operating income increasing 25% to $12.7 billion and net income increasing 41% to $13.6 billion. Operating earnings benefited from the improved performance of the equity markets, which translated into higher asset balances and fee income on equity-linked products, along with higher demand for variable products. Statutory net income also benefited from the much improved credit environment during 2004. According to Moody's Investors Service, the global default rate for all corporate issuers, on a dollar volume-weighted basis, fell to 0.4% in 2004 from 1.0% in 2003 and a record high 5.3% in 2002. As a result, GIC issuers continued to experience lower realized investment losses, and the GIC universe reported an aggregate statutory net capital gain (realized and unrealized) of nearly $3 billion in 2004, compared to a net capital loss of $7.7 billion in 2002.

GIC issuers for the most part have traditionally maintained conservative investment portfolios. Since the commercial real estate problems of the early nineties, issuers have increasingly focused their investing activities into diversified bond portfolios, which currently represent almost 75% of the average GIC issuer's invested assets. 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 2004, average below investment grade (BIG) bond holdings decreased to 6.7% of total bonds from 8.4% in 2003 and 9.1% in 2002, as a result of lower levels of "fallen angels" and strategic decisions to reduce exposure to this asset class due to historically high valuations. Moreover, the majority of BIG holdings are in the highest BIG rating class of BB. That being said, FCM considers current BIG positions to be 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 10% 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 holding at only 0.2% as of year-end 2004. Going forward, the commercial real estate markets may weaken as vacancy rates rise and higher interest rates deflate property values. 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 view recent operating trends as further supporting credit fundamentals.

GRAPHS:

Statutory Earnings History

Average Below Investment Grade Bonds/Total Bonds

Median Surplus/General Account Assets

Average Non-Performing Mortages/Total Mortgages