A.M. Best Special Report - Market Update: Funding Agreement-Backed Securities.

OLDWICK, N.J. -- U.S. life insurers are being challenged by the current macro environment, making the task of finding cost-effective financing for funding agreement-backed securities (FABS) programs an exhaustive process. As evidenced by the decline in volume for 2005, an A.M. Best Co. special report indicates the environment has even forced insurers to table a portion of their annual issuance and wait on the sidelines until conditions improve.

To tighten funding costs and expand financing sources, many U.S. life insurers have introduced FABS programs registered with the U.S Securities and Exchange Commission. SEC-registered FABS programs possess the benefit of a broader institutional investor base and access to retail investors. However, recent SEC scrutiny has, for the time being, halted the issuance of a popular retail product that has been a sizable volume generator for issuers with registered FABS programs.

Corporate fundamentals have improved to the point where spread arbitrage programs are being adversely impacted. As companies have cleaned up their balance sheets, spreads on credits that insurers typically purchase to back their spread lending programs have tightened significantly. With credit spreads remaining tight throughout the year relative to funding costs, insurers opted to put less business on the books and wait on more favorable conditions. Of the business that was issued, nearly 60% was for finance terms of three years or less.

The heavy amount of short-term financing is telling of the difficulty insurers were experiencing in achieving profit hurdles. Ideally, insurers would prefer longer liabilities to improve or maintain their liquidity profile. However, insurers looking to maximize earnings will access the short end of the curve, as it is an extremely deep market with capital continuously available from security lenders and 2a7 funds.

To addresses the profitability and liquidity issue simultaneously, a few insurers have been issuing extendible liquidity securities (EXLs) as part of their FABS programs. The security combines funding costs reflective of short-term financing with a five- or seven-year final maturity. The trade-off is that the insurer takes some option risk into its liability portfolio.

FABS issuance totaled $31.6 billion for 2005, decreasing more than 10% from 2004. Nearly 50% of the FABS issued in 2005 were by five insurers. The top five were Met Life with $3.9 billion, Allstate with $3.7 billion, New York Life with $2.8 billion, Principal Life with $2.6 billion and Monumental Life with $2.5 billion.

A.M. Best views FABS programs as a reasonable activity for highly rated companies with diverse business lines, considerable expertise in asset/liability and investment management, and sufficient financial flexibility.

However, the greater an insurer's exposure to these liabilities, the greater the stress on an insurer's liquidity profile, especially in certain situations such as a rating downgrade or a contract containing negative covenants. Therefore, A.M. Best is most comfortable when FABS do not constitute a large portion of general account liabilities.

Since the net proceeds from FABS issuances are used in matched funding operations, A.M. Best considers the notes outstanding as operating leverage, not as financial leverage. A.M. Best's analysis will incorporate the organization's overall ability to support the institutional and retail spread lending business in establishing limits for these products on a company-by-company basis. Companies that issue substantial volumes of "stable value" products, or that have the majority of their liabilities in institutional investment products, may experience downward pressure on their ratings.

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A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.