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Stable Value and GICs
a chapter for the Pension Investment Handbook
III. Stable Value Contracts from the Issuer's Perspective
III. Stable Value Contracts from the Issuer’s Perspective
Q15 What risks do stable value contracts pose for the issuer? Return to top
Risks are assumed by a GIC or synthetic wrap issuer whenever a guarantee of interest or principal is made on an investment contract. The table below lists asset and liability risks which are commonly covered in traditional GICs and which may be covered by synthetic wraps:
Table 2 Stable Value Contract Risks from the Issuer’s Perspective
Asset risks
default
The risk of default or underperformance of the assets which are backing the contract.
call/extension
The risk that an asset’s principal is paid more quickly than expected when market rates fall or more slowly if rates rise, so that the income from the asset and the market value are inadequate to support the guarantee.
reinvestment
The risk that income on the assets backing the contract will be invested at a rate lower than the guarantee rate
Liability risks
contribution
The risk that deposits at the guaranteed rate of interest during the window period of a contract will differ from expectations. If market interest rates rise, the guaranteed rate will seem less attractive to participants who may reduce their contributions, forcing the issuer to sell fixed income assets at a loss. If market rates drop substantially, contributions may rise, forcing the issuer to buy additional, lower-rate assets to back the contract.
withdrawal
The risk that participant withdrawals from the contract exceed expectations when interest rates have risen, forcing the issuer to sell assets at a loss.
Q16 How do stable value issuers protect themselves against stable value risks? Return to top
Insurance companies and banks participating in the stable value market use a combination of risk underwriting and sophisticated asset/liability matching techniques to protect themselves from losses on the risks assumed. When a contract is issued, a risk charge is assessed based on the underwriter’s estimate of the likely contribution and withdrawal rates. The issuing company determines the likely pattern of inflows and outflows on the contract and estimates its effective duration. Assets are acquired to match the duration and/or expected cash flows of the contracts. Issuers have elaborate computer systems to monitor and project the duration, convexity, and cash flows of their asset and liability portfolios. Most do the process on a stochastic basis that varies the cash flows under different interest rate scenarios. Generally issuers don’t match a single contract with a single asset but work with a portfolio of assets that is internally dedicated to their stable value contracts. The portfolio approach provides diversification and better flexibility to handle liquidity needs. However, the issuer’s full asset and capital base are available to support its guarantees.
The right to withdraw from the contract at book is an option issued by the financial institution providing benefit-responsiveness to the participant. Estimating the exercise efficiency of this option - the likelihood of withdrawal at various levels of interest rates - is a highly subjective exercise. Most issuers use a combination of option techniques and probabilistic scenario testing. The underwriting process is also designed to limit this risk by screening out plans containing excessive arbitrage risks, such as those that allow unrestricted investment transfers to a competing fund (see Q21). Good contract design is also important in reducing risk.
Rating agencies and others evaluating the risk of stable value issuers routinely analyze the risks assumed in the contracts and the matching techniques used to protect against those risks as a part of the rating agencies’ credit review process (see Q28).
Q17 How are stable value contracts priced? Return to top
Stable value contracts include both asset fees for asset management and custody and wrap fees for administrative expense, risk charges, and profit to support the capital to support the risk. In a traditional GIC, the investor is quoted a guaranteed rate that is net of all the insurance company’s expense, risk and profit charges. In a synthetic structure, the investor negotiates fees with both the asset manager and the wrap provider which are then deducted from the earnings on the synthetic portfolio. Wrap fees usually range from 10 to 25 basis points depending on the size of the deal and the risks covered; standard fixed income asset management fees apply.
Traditional GIC issuers generally price their products based on the yield available for investments of the appropriate duration for the contract being quoted. Deductions are made for the estimated credit and call risk in the asset, and the yield is then converted to the annual effective basis credited in stable value contracts. Investment and administrative expenses are deducted as well as a plan-specific risk charge for the liability risks assumed. The life company also deducts a profit charge for a return on capital, a charge that increases with the amount of risks assumed. Total GIC risk charges and fees are generally in the 75 to 90 basis point range depending on the risks assumed and the types of assets utilized by the issuer.
The plan can choose whether to self-insure against risks in its stable value assets and liabilities by buying participating contracts or whether to purchase insurance for those risks by having the issuer assume them. The issuer can diversify many of its risks, thus reducing the charge below the effective cost to the plan. By self-insuring, however, the plan avoids paying for the issuer’s capital costs and profit taxes.
Q18 What is underwriting for a stable value contract? Return to top
Stable value issuers evaluate the interest rate risks posed by each plan requesting the contract bid. This evaluation process is called underwriting the contract or bid. The firms analyze the bid specifications provided by the prospective purchaser (see Q21) to determine how likely participants are to change their deposit and withdrawal patterns in response to interest rate changes by looking at the financial sophistication of the participants, the other investment options in the plan, past investment behavior, the plan’s allowed transfer frequency, the composition of the stable value fund, etc. Underwriters are concerned about the presence of any competing funds (see Q19) and large investments in company stock because changes in the price of the stock can mean large inflows or outflows for the stable value fund. Another key factor is the proportion of assets belonging to retirees or terminated vested employees, because these can be rolled over into IRAs or removed from the plan without a severe tax penalty. The underwriter assesses a risk charge based on each plan’s circumstances and the length of the requested contract term, and this charge is deducted from the credited rate.
On a synthetic GIC, the underwriting process also includes evaluating the market value risk posed to the wrap provider by the assets being wrapped. Important considerations include the duration of the asset, its credit, liquidity, and the amount of call and extension risk. The synthetic GIC underwriting process also includes an in-depth analysis of the investment manager’s ability to appropriately manage the assets backing the stable value fund.
