GIC Issuers Report Limited Exposure to Subprime

The fallout from the turmoil within the subprime mortgage market has resulted in highly publicized losses on structured securities by institutional investors, including several hedge fund blow-ups, along with billions in write-downs by the large banking institutions. Although the news has been troubling, we believe that this event will not be a material credit issue for the US life insurance industry, in particular GIC issuers. FCM has performed an issuer by issuer review of exposure to subprime assets within our GIC universe utilizing various resources including regulatory filings, public company disclosures, and direct communications with management.

The results of our review indicate that direct exposure to this asset class is relatively limited within the context of general account investment portfolios and largely concentrated in highly rated securities with significant structural protection. Moreover, it does not appear that any potential losses will have a material impact on the financial strength of our issuers and will be easily absorbed given their substantial financial resources. Our findings are consistent with reviews performed by the credit rating agencies, which have stated that they do not anticipate any downgrades of individual US life insurers as a result of subprime-related credit issues. In addition, insurance company senior management has publicly disclosed that they do not expect material impairments on these investments.

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% in corporate bonds, with the remaining 20 to 30% invested in structured securities including mortgaged-backed and asset-backed securities. Based on our review, the average exposure of GIC issuers to subprime related investments represents approximately 2% of invested assets and 23% of total surplus. The majority of this exposure is through residential mortgage-backed securities (RMBS) with collateralized debt obligations (CDOs) and other assets representing only a very small percentage. Overall, FCM considers this level of exposure to be very manageable relative to earnings capacity and capital positions. In addition, GIC issuers maintain solid liquidity profiles and have the ability to hold these securities without being forced to sell and realize losses during unfavorable market conditions.

As detailed in the chart below, the vast majority of GIC issuer exposure to subprime related securities is focused in the highest quality issues with over 90% in bonds rated AA or AAA and only a very small percentage in bonds rated BBB and below. Through the subordinated structure within the deals, these senior securities are significantly insulated from any losses on the underlying collateral, in that losses are first absorbed by the lower-rated, subordinate tranches. Moreover, losses on AA and AAA rated tranches are very unlikely given that subordination levels are well above current rating agency loss estimations for the underlying collateral. To date, rating agency downgrades have been focused in securities rated BBB and below originated in 2006, which has been the worse collateral origination year in terms of rising delinquencies. Exposure to these lower rated bonds is well controlled with bonds rated BBB and below comprising only 1.8% of total subprime exposure and representing only 0.5% of the average GIC issuer's total surplus. In addition, most issuers have limited their exposure to bonds originated in 2006 with the majority of holdings in better performing collateral years.

Although we do not expect that GIC issuers will be immune from losses as a result of this historic credit event, we believe that potential losses will not have material impact on overall financial strength given the level and nature of their exposure. Going forward, FCM will continue to closely monitor GIC issuer exposure to the deterioration in the residential mortgage market, including the spillover effects to the broader economy and other sectors of the credit markets.