Funding agreements (FAs) are short-term debt instruments issued by insurance companies. Specifically, a funding agreement is a contract issued by an insurance company that provides the policyholder the right to receive the coupon payments as scheduled and the principal on the maturity date. These contracts are guaranteed by the insurer’s general account or a separate account. FAs are not publicly traded and therefore are less liquid than other money market instruments such as commercial paper. In recent years, medium-term notes (U.S. MTNs and Global MTNs) have become increasingly popular. These are securitizations whose cash flows are backed by a portfolio of FAs. Moody’s estimates in 2000 the amount of securities outstanding backed by FAs was approximately $20 billion.4
Coupon rates may be either fixed or floating. Reference rates have included U.S, Treasury rates, LIBOR, commercial paper rates, the federal funds rate, and the prime rate. The unique feature of FAs is that the holder of this security has an embedded put option with a 7, 30, 90, 180 day or year expiration. Therefore, FAs are putable back to the issuer at par. Yields offered on FAs depend on the credit quality of the issuing insurer, the structure of the embedded put option, and the term to maturity.
Like many financial instruments, FAs have had setbacks. Specifically, there is credit risk and a major default increases the concerns of investors about the product. In August 1999, General American Life Insurance Co. failed to meet its required interest and principal redemption when investors put back the FAs the company issued. The option was putable in seven days. The exercise of the put option by investors followed the downgrading of the insurance company by several rating agencies. Investors eventually received their payments when Metropolitan Life Insurance Company Co. acquired General American Life Insurance Co. and satisfied the obligation. Since this incident, life insurance companies issuing FAs have made every effort to address the concerns investors have had with these contracts. Specifically, prior to 1999, most FAs were putable in seven days. The contracts now tend to have longer-dated puts. In addition, there is increased use of FAs backing medium-term notes that are typically sold without puts.
The major investors in FAs are money market mutual funds—both institutional-oriented funds and retail-oriented. Short-dated putable FAs are structured to qualify as 2a-7 eligible money market mutual fund investments because they are illiquid investments since as we noted earlier they are not publicly traded. Seven of the largest institutional money market funds held FAs as of mid 2001. The top four issuers of FAs sold to institutional money market funds are Transamerica Occidental Life, Monumental Life, New York Life, Allstate Life, and Jackson National Life. The major issuers of FAs sold to retail-oriented money market funds are Monumental Life, Travelers, Metropolitan, GE Life and Annuity Assurance Co., and Pacific Life. Five of the top ten retail-oriented money market funds invest in FAs as of mid 2001. A study by Moody’s in October 2001 investigated the reasons why money market mutual funds invest in FAs. The following reasons were cited:
1. FAs are attractive short-term investments.
2. FAs are highly rated and are “stable value”–type products
3. Investors like FAs as an established product.