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2006: A MORE STABLE TIME FOR GIC ISSUERSDavid
J. Molin, Assistant Vice President - Research
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Throughout our twenty-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 2006, continuing the stable trend from the difficult environment back in 2001 and 2002. Financial market conditions continued to be stable in 2006 with historically low levels of corporate defaults, strong equity market returns, and steadily higher interest rates. This translated into solid earnings performance and improved balance sheet profiles for GIC issuers as credit fundamentals continued to improve from the difficult market environment just a few years ago. Moreover, all of the major credit rating agencies currently maintain a "stable outlook" for the life insurance industry and almost all GIC issuers have stable outlooks for their financial strength ratings (typically AA or higher). As of year-end 2006, GIC issuers continued to report sound capitalization with statutory surplus totaling $99.6 billion, up 2% from 2005 and just below the historically high $100.3 billion in 2004. Moreover, individual issuer capital positions remained favorable with the median ratio of total surplus to general account assets increasing to 9.1% in 2006, as surplus augmentation remained in line with asset growth. On a risk-adjusted basis, capital ratios also improved with FCM's GIC universe reporting an average NAIC Risk-Based Capital (RBC) ratio of 445%, an increase from 417% at year-end 2005. GIC issuers continued to report healthy statutory earnings in 2006 with $8.4 billion and $9.4 billion in total net operating gain and net income, respectively. Overall, earnings performance continued to benefit from low realized investment losses, higher fee revenue on augmented asset balances, and stabilizing net interest spreads. Although earnings levels were down significantly from 2005, the drop in earnings was not the result of weaker operating performance, but instead can be largely attributed to substantially lower statutory earnings for one large issuer. This issuer experienced a decline of over $1 billion in statutory earnings, which resulted largely from one-time items including statutory accounting costs related to an acquisition and a large tax benefit realized in 2005. 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. 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 2006, average below investment grade bond holdings decreased to only 6.0% of total bonds, compared to 6.2% in 2005 and just over 9% in 2002. This decline in high yield holdings has resulted largely from the improved credit environment with lower levels of "fallen angels", along with strategic decisions to reduce exposure to this asset class due to historically high valuations. Moreover, the majority of these bonds are in the highest below investment grade rating class of BB. That being said, FCM considers current positions in these higher risk 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 only 0.1% as of year-end 2006. Going forward, the commercial real estate market is likely to weaken somewhat given the historically low level of problem assets and the possibility of slowing economic growth. 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: Average Below Investment Grade Bonds/Total Bonds Median Surplus/General Account Assets Average Non-Performing Mortages/Total Mortgages
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