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Funding Agreement Update

Editor’s note: Funding agreements are principal protected products issued in alternative markets outside of the retirement plan market. In this first of a two part series, the author discusses recent events in one such alternative market—the short-term institutional market. The second part of this series will address the importance of funding agreements to institutional investors and how issuers manage the liquidity risk inherent in the product.

The sale of funding agreements to money market funds and other short-term institutional investors dates back into the 1980s, but in the 1990s this became a high profile business. After a period of rapid growth in the late 1990s, the demand by money market funds and other short-term institutional investors was shaken by the demise of two major issuers, General American Life and ARM Financial, in the summer of 1999.

The typical funding agreement sold to short-term investors offers an indexed rate reset periodically, with a choice of various money market indices (including one month and three month LIBOR). Short-term investors are attracted to funding agreements because of competitive spreads, liquidity demand features that allow redemption of principal within a specified time period, industry diversification and customization to the buyer's specifications.

GIC issuers found a significant growth opportunity in the sale of funding agreements to money market funds and other short-term institutional investors. Taxable money market funds alone are a $1.5 trillion market. The stagnant conditions in the market for GICs among qualified retirement savings plans, and the opportunity to diversify funding sources, combined to draw numerous GIC issuers to this market.

According to Townsend & Schupp, the sale of funding agreements to money market funds, securities lending pools and other short-term investment funds grew to $18.2 billion in 1998 from $10.9 billion in 1997. Account balances grew to $36.9 billion from $30.1 billion over the same period.

The market for funding agreement sales to short-term investors hit a snag in 1999 when two major issuers, ARM Financial (ARM) and General American Life, encountered financial difficulties. Since 1995, ARM and General American had an agreement whereby ARM would sell funding agreements issued by General American. Although General American reinsured 50% of the business back to ARM, it retained risk as the issuer of the contracts.

In July, 1999, ARM terminated its arrangement with General American and transferred its funding agreement assets and liabilities back to General American. After ARM's withdrawal, General American had $6.8 billion of short-term funding agreement obligations, of which $5 billion could be recalled by investors with seven days notice. The availability of this short notice period, at these volumes, was unique to General American and contributed significantly to its downfall.

Following ratings downgrades by several rating agencies, General American experienced a high level of redemptions by clients, which it was unable to meet. On August 10, General American sought protection from the Missouri Insurance Department.

Despite the fact that General American’s exposure to short-dated puts was unique for the industry, the confidence of investors was shaken. While the majority of short-term funding agreement issuers reported modest levels of surrenders, sales momentum slowed dramatically. According to a Townsend & Schupp survey, funding agreement account balances dropped during 1999 by 7% for money market funds, 44% for securities lending pools and 9% for other short-term investment funds.

Since July, 1999, the number of buyers and issuers has dropped. Some buyers reduced holdings while others discontinued new purchases and allowed existing contracts to mature and pay out. Most of the issuers have discontinued shorter dated puts, particularly seven-day and thirty-day puts, in favor of longer dated puts or contracts with no advance liquidity. At least one issuer has withdrawn from the business entirely.

Rating agencies have cautioned insurers against offering shorter dated put contracts, and have encouraged restraining "institutional spread-based" business (GICs and funding agreements) to certain percentages of general account liabilities. However, it is recognized by rating agencies that properly managed growth of funding agreement business helps diversify insurers' funding sources and is appropriate for experienced issuers.

So far, the market for short-term funding agreements has seen a modest recovery in 2000. Although the landscape has changed, with reduced availability of more liquid contracts, the appeal of competitive spreads with strong credit still exists.

It is difficult to demonstrate that the demand for funding agreements by short-term funds is recovering from the events of last year but our own experience indicates that buyer interest is growing modestly. Further, issuers have been able to turn to their European Medium Term Note conduits to sell floating rate notes backed by funding agreements. LIMRA/SVIA survey results showed $5.8 billion of funding agreement sales to short-term investment funds through June, 2000 - by comparison, the survey results for 1999 indicate sales were $11.4 billion for the full year, the vast majority of which were undoubtedly in the first six months of the year. While a recovery may be underway, sales data do not show it to be a strong recovery.

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