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Stable Value Industry Sees Ample Wrap Capacity Despite Fewer Providers

Like the premature rumors of Mark Twain's death, fears that the stable value industry is running out of wrap capacity appear to be exaggerated.

Wraps are contracts that guarantee investors will be able to make withdrawals from their stable value funds at the book value of the underlying investments (principal plus accumulated interest), regardless of their market value. Without them, stable value products would not exist. While the number of banks and insurance companies selling wrap contracts has declined in recent years, there remains ample capacity to meet the volume needs of stable value managers, most industry participants agree. They concede, however, that the shrinking universe of providers means that stable value managers cannot always parcel their business out among as many different providers as they might like for purposes of risk diversification.

Speaking at SVIA's Forum, Kelli Hueler, President of stable value research firm Hueler Analytics reported that the number of providers in its pooled fund universe declined by half in the five years since December 31, 1998, when there were 50 Guaranteed Interest Contracts (GIC) providers and 34 wrap providers. An even smaller number of providers dominate the business. Hueler said eight providers wrap approximately 70 percent of all synthetic contracts, and that each holds seven percent or more of the market. By contrast, only three providers wrapped five percent or more of the market five years ago.

This shrinking of the provider community comes at a time when stable value products are increasingly popular with investors. Data compiled by the consulting firm Hewitt Associates shows that at year-end 2003, stable value products, including traditional Guaranteed Investment Contracts, accounted for more than 23 percent of the assets in 401(k) plans, second only to equity funds. That was down from 27 percent at year-end 2002, but up from 17.5 percent as recently as year-end 2000. And Hueler Analytics reports that the pooled funds it tracks had total assets of $67.9 billion at mid-year 2004, up from $63.4 billion 12 months earlier and just $32.7 billion as recently as June 30, 1999.

Robert Whiteford, Managing Director of Global Structured Products for Bank of America, cited several reasons for the declining number of wrap providers, including the growing size of financial institutions. As banks and insurers merged with one another over the past few decades, he noted, stable value came to represent, for some of them, an immaterial portion of their business. For some other firms, the problem was just the opposite: as their stable value business took off, senior management began to worry that it was representing too much of their total book of business, and thus presented too concentrated of a risk. Finally, the presence of so many players in the market in years past led to competitive price-cutting, which produced thinner margins and convinced some providers to exit the business.

While managers of stable value funds say they would like access to more wrap providers, Whiteford observed that they do not appear willing to do two things that would attract more participants: pay higher fees for the wrap contracts they buy, or retain more of the risk now shouldered by their wrap providers. Nor, he said, is it likely that many new firms will try to enter the business due to significant barriers to entry. Those barriers include the time and cost involved in developing a risk model, the travails of navigating the approval process with senior managers who may not understand the stable value market, setting up the middle office needed to monitor risk and manage work flow, and developing market credibility. Most stable value managers, Whiteford said, prefer to work with larger, established wrap providers. "The bigger you are," he observed, "the more credibility you have and the more business walks through the door."

Competitive markets and thinning margins have actually shrunk the traditional GIC marketplace, according to Joe Celentano, Vice President of Accumulation Products for Pacific Life Insurance Co., although its losses have been more than offset by the growth in pooled funds. Joining Whiteford in a roundtable discussion of wrap capacity, Celentano said GICs were a $16 billion business as recently as 1997, but last year totaled only $12.4 billion. Issuers, he said, face many of the same problems faced by managers of pooled funds, compounded by the problem of having to compete with the increasing popularity of the latter vehicles. However, he identified the principal problem in the GIC market as dwindling margins. "We borrow at double-A rates, invest at triple-B rates, and profit from the spread," Celentano explained. "At one time, our margin was about 100 basis points. Today, it's 50. The market has cut our spread in half." Accordingly, he said, GIC issuers are branching out into other credit-spread businesses that offer the chance for higher returns. They include annuities, medium-term notes, funding agreements and other structured finance vehicles.

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