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Spread Lending Strategies

The stable value industry grew up around Guaranteed Investment Contracts (GICs): a low risk, benefit-responsive instrument that fits the needs of both participants and sponsors looking for a conservative investment option in defined contribution plans. Capitalizing on that expertise, providers developed other stable value products to meet the needs of an evolving marketplace. Today, stable value options are the largest conservative investment in defined contribution retirement plans, with over $396 billion in assets.

Insurance companies that have grown and maintained GIC operations share several characteristics. A strong balance sheet and solid marks from major rating agencies are the backbone of a GIC capability. Over the years, leading issuers have also developed keen asset-liability management, underwriting, and pricing expertise. A natural outgrowth of these endeavors was the development of sales and marketing efforts that forged solid relationships with institutional fixed income investors. As the GIC market matured, issuers expanded these capabilities into alternatives creating what is now a flourishing stable value market with products that include GICs, Synthetic GICs, Guaranteed Separate Accounts, etc.

While the stable value option remains a mainstay of 401(k) plans, insurance companies continue to seek ways to expand this capability into other markets. Seeking further growth and the utilization of an established skill set, insurance companies turned to “spread lending,” a concept rooted in stable value competency, as a viable growth opportunity. By leveraging their general account to back the guarantees and taking advantage of asset management capabilities, insurers have crafted a variety of products that share stable value characteristics. Success stories include the development of Funding Agreement, Municipal GIC, FHLB participation, and Medium Term Note (MTN) programs.

The concept of spread lending is very simple: invest money at a higher rate than the guaranteed rate and “pocket the spread” to cover expense, risk, and profit margins. Of course, like the golden rule of investing, “buy low, sell high,” there is some art to doing it successfully. Asset-liability management expertise, as well as a demonstrated ability to effectively invest in multiple asset classes (i.e. public bonds, private placements, commercial real estate) is paramount. Among the other issues insurance companies consider in pursuing spread lending are the current spread environment, return on investment, the effect of the business on reserving requirements, and the view rating agencies take of the programs.

Rating agencies always cast a “weather eye” concerning the impact of new strategies on the financial health of issuers. Although they have been generally approving of spread lending, Moody’s has specified guidelines regarding the appropriate allocation of general account capacity (20 to 30 percent of total liabilities) required to maintain the AA-or-better rating most spread lenders enjoy.

Overall, the infrastructure used to successfully develop and grow a strong stable value business is sufficient to move into spread lending. Issuers can leverage existing resources (i.e. credit, asset-liability management) to contribute a greater amount to the company’s bottom line. They can participate in a number of markets when internal return hurdles are met and rating-agency constraints are satisfied. This allows providers to issue opportunistically across a broader spectrum while maintaining a focus on optimizing profitability as well as the impact of the asset/liability mix on capitalization ratios and other financial measures.

Some providers create a broad product set that fits their goals and constraints and maintain a presence in multiple markets. However, their footprint may vary in those markets. For example, a company may have only a foothold in Muni-GICs while being a major player in the MTN market. The goal is to be able to tap opportunities when they present themselves, while drawing on a well-diversified liability base by both product and investor on an ongoing basis.

Others take a single product focus. They establish a strong presence in one market and channel their resources into that effort. This enables them to further streamline their commitment of resources and refine their competency.

While there is some difference among issuers regarding tactics, they share similar philosophies, goals, and concerns. Having demonstrated a long term commitment to stable value, they see spread lending as a logical extension of that commitment.

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