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Laura Bazer 1.212.553.1653Patrick FinneganArthur FliegelmanKeven MaloneyAndrew EdelsbergRobert RiegelDebra Perry

Summary OpinionGeneral American Life Insurance Company’s (General American) recent inability to meet thedemands of its 7-day put contract investors offers the company, its investors, and the market ingeneral an unfortunate example of the pitfalls of managing liquidity risk. Moody’s has frequentlyexpressed its opinion on the risks inherent in these contracts for the insurer and for investors.1We have also discussed our concerns with General American’s significant exposure to the 7-dayput short-term funding agreement product in our published research on the company.2

We believe that the 7-day put short-term funding agreement product, when sold in largequantities by an insurer, exposes the company to a considerable degree of liquidity risk that isextremely challenging to manage. For a 7-day put contract business to succeed, it is imperativethat the issuer both invests in highly liquid securities and possesses the ability to liquidate theportfolio in a short period of time.

Moody’s believes the product creates both liquidity and event risk concerns. Funding agree-ment holders are likely to exercise put options en masse when a market or credit event negative-ly affects the issuing insurance company, especially if such an event triggers a ratings downgrade.

In Moody’s view, General American’s extensive use of short-term putable funding agree-ments increased its liquidity risk and left it more exposed than any other insurer to related mar-ket pressures and investor response. We estimate that the company had $5 billion in 7-day con-tracts outstanding, amounting to approximately 60% of the entire 7-day put short-term fundingagreement market issued by the insurance industry. While certain other insurers also participat-ed in this market, their exposure was much more limited than that of General American.Therefore, we believe the potential for a similar liquidity crunch caused by put funding agree-ment contracts at other life insurers is low.

General American: A Case Study InLiquidity Risk

Special Comment

1 Moody’s Special Comment, "Funding Agreements - The New Frontier of Stable Value," issued April 1998.2 Moody’s Insurance Credit Report, General American Life Insurance Company, issued December 1998.

continued on page 3

2 Moody’s Special Comment

© Copyright 1999 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN ISCOPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISEREPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FORANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIORWRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility ofhuman or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes norepresentation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents inconnection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of thepossibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information containedherein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NOWARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OFANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or otheropinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user mustaccordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it mayconsider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (includingcorporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay toMOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.

Authors

Keven MaloneyArthur Fliegelman

Editor

Deborah Primiano

Senior Production Associate

Maria T. Ramos

Moody's Insurance Research Internet Address:www.moodys.com/insurance

Recent EventsIn early August, General American Life Insurance Company encountered a “run on the bank,” which ledthe company to be placed under voluntary administrative supervision by regulators in its state of domicile,Missouri. Among life insurers, the company was unusually exposed to such an event due to the high-risknature of its liability structure.

General American had issued approximately $6.8 billion of funding agreements that were marketed tolarge institutional investors, primarily money market mutual funds. Of these liabilities, about $5 billioncontained 7-day put provisions. These puts gave investors the right to request the return of their investedfunds from the contract’s issuer at any time with 7 calendar-days’ notice.

During the last two weeks, a large number of investors exercised these puts, thereby requiring GeneralAmerican to raise a significant amount of cash within a short time frame. Unable to meet these near-termobligations due to insufficient liquidity resources, the company sought the protection of the Missouriinsurance regulators.

Risks Inherent In The Funding Agreement ContractsIn the past two years, U.S. money market funds have rapidly increased their investments in putable short-term funding agreements issued by life insurers - the market totaled over $35 billion at mid-year 1999.Drawn to the market by the funding agreement’s competitive yields, the money market funds look toputable funding agreements as an alternative to other short-term investments, such as commercial paper.The putable funding agreement market has been a strong source of revenue and asset growth for certainlife insurers in response to the secular decline in their pension-GIC business.

Moody’s has closely observed and monitored the rapid growth of the funding agreement business. Wehave publicly stated our concerns (see Appendix I) about the putable funding agreement business in partic-ular and about all institutional spread management businesses in general.

Moody’s has frequently stated that the 7-day put short-term funding agreement product, when sold inlarge quantities by an insurer, may expose the company to a considerable degree of liquidity risk that canbe extremely challenging to manage. In early 1998, we commented that the put option granted to confi-dence-sensitive and credit-sensitive institutional investors creates liquidity concerns and event risk. This isbecause funding agreement holders are likely to exercise put options en masse when there is a negativemarket or credit event, especially if such an event results in a ratings downgrade.

We wrote in our 1998 U.S. Life Insurance Industry Outlook that “some insurers may be unrealistic intheir assessment of the potential for these options to be exercised.” U.S. money market funds are credit-sensitive debt investors that will quickly exercise their available puts if an event triggers sufficient concern.In terms of the put option, our concerns have always focused on the 7-day contracts because “the shorterthe put, the less room there is to maneuver if problems develop.”3 Adequate liquidity resources are essen-tial to issue short-term puts and “the less liquid and lower quality the asset portfolio, the higher the poten-tial for losses and increased probability of the funding agreement issuer becoming troubled.” 4

Other Life Insurers Only Modestly ExposedWe believe the potential for a similar liquidity crunch caused by putable funding agreements at other lifeinsurers is low. Other life insurers do market similar instruments, but it is Moody’s belief that GeneralAmerican’s exposure to these 7-day funding agreement contracts was unique for the industry, in terms ofboth absolute amount and relative to its balance sheet and capital.

We estimate that life insurers rated by Moody’s have about $36 billion of putable funding agreementcontracts outstanding, of which about $8 billion, or 22%, is in 7-day put contracts. Including ARM’s rein-sured liabilities, General American had about $6.8 billion of putable funding agreements outstanding (a19% market share), of which $5 billion (60% market share) contained 7-day put provisions.

3 Moody’s Special Comment, "Funding Agreements - The New Frontier of Stable Value," issued April 1998.4 See above.

Moody’s Special Comment 3

We believe that the majority of the remaining $3 billion of 7-day putable contracts have been issuedby a few large, highly rated insurance companies with ample liquidity resources. These insurers participatein the 7-day contract market to a much more limited extent than General American’s exposure.

General American’s Involvement In The 7-Day Put MarketThe case of General American indicates the critical importance of understanding the implications of theput option and of maintaining appropriate liquidity to meet potential cash demands.

Reliance On A Weaker Reinsurance Partner General American’s foray into funding agreements began through a reinsurance contract with a smaller,weakly capitalized insurance holding company, ARM Financial Group, Inc. (ARM), and its insurance sub-sidiary, Integrity Life Insurance Company. Under the reinsurance agreement, first signed in 1995, ARMwould act as a distributor of the short-term “putable” funding agreements, all of which would be writtenon General American’s paper.

In Moody’s opinion, General American was involved in the process because it was unlikely that ARM’slife insurance subsidiary would be able to directly market these contracts to institutional investors basedon its own credit strength. The reinsurance arrangement, known in the industry as “fronting,”5 enabledARM to use the larger balance sheet and higher credit ratings of General American to market this busi-ness with institutions that might otherwise be unwilling to do business directly with ARM.

ARM would then assume through reinsurance 50% of the business that had been written by GeneralAmerican, effectively transferring the assets and ceding the liabilities to ARM’s balance sheet. However,General American retained an economic risk as the obligor on the insurance contracts. GeneralAmerican had a reinsurance recoverable from Integrity Life for the amount of the transferred assets.Under the transaction, General American assumed the risk that ARM might become unable to meet itsobligations.

Over the past four years, the book of business grew to an ultimate $6.8 billion outstandings at its peak,with half of the assets and liabilities related to this business on ARM’s balance sheet. Moody’s expressedthese very concerns about “fronting” in a Special Comment on life reinsurance, issued in June 1999.

In Moody’s opinion, ARM’s assets were managed in a more aggressive manner than GeneralAmerican’s share of the business. ARM managed its portfolio using less liquid and riskier assets, such asnon-agency mortgage-backed securities and emerging market debt, and ARM also actively traded theportfolio. This arrangement left General American exposed to risks assumed by ARM and to ARM’s cred-it risk as a whole.

Moody’s analysis of ARM indicated concerns with the “rapid growth of, and greater emphasis on,institutional GIC products - including funding agreements, with 7- to 90-day puts…These contracts -whose sales are concentrated with a few large distributors and investors - are highly credit- and market-sensitive and expose the group to significant liquidity and business risks...In addition, the company’s weakstatutory and GAAP capitalization ratios have continued to decline, while its above-average exposure tomortgage-backed securities (MBS) has risen. MBS expose the company to extension and prepayment risksand to price and liquidity volatility.”6

Moody’s had maintained a Baa1 insurance financial strength rating (with a negative outlook) onIntegrity Life in 1998 and much of 1999. Last month, the rating was downgraded to Baa3.

Moody’s also expressed concerns about “General American’s exposure to these [funding agreement]liabilities, which are highly credit- and market-sensitive. In the event of a ratings downgrade or capitalmarket disturbance, General American, as the direct writer, would be the first in line to fund surrendersand is exposed to substantial business and liquidity risk.”7

5 Moody’s Special Comment, "Life Reinsurance: What Goes Around Comes Around," issued June 1999.6 Moody’s Insurance Credit Report, Integrity Life Insurance Company, issued November 1998.7 Moody’s Insurance Credit Report, General American Life Insurance Company, issued December 1998.

4 Moody’s Special Comment

Moody’s insurance financial strength rating on General American was downgraded in March 1999 toA2 from A1, in large part because of our concerns with its funding agreement business.

Deteriorating Financial Condition Of Reinsurance Partner Weakens GeneralAmericanARM’s recent financial problems began with the fixed-income market dislocations last fall. This resultedin ARM’s reporting unrealized losses on its balance sheet. Last month, ARM released its second quarterearnings, after two delays, and the company reported a $174 million loss. This reported loss reducedGAAP common shareholders’ equity (inclusive of the adjustment for FAS 115) to $33 million (excluding$75 million of preferred stock) on assets of over $10 billion, which include the $3.4 billion of fundingagreements assumed from General American.

After the reported loss, ARM was left with GAAP equity of less than 1% of liabilities. This very mod-est cushion could easily be erased by any further rise in interest rates. The equity markets reacted swiftlyby dropping ARM’s already distressed stock price from $9.50 to less than $3.00 per share over the severaldays following the earnings announcement.

In the same press release, ARM also announced that General American intended to recapture thefunding agreement business assumed by ARM’s Integrity Life insurance subsidiary. The recapture essen-tially entailed the transfer of the assets (which were held in trust) backing the $3.4 billion of fundingagreements that had been reinsured by Integrity Life from General American.

However, regardless of ARM’s ability to pay its share of the liability, General American remained fullyresponsible to contractholders for any funding agreement obligations. Owing to the significant adversedevelopment in ARM’s financial situation and to the possibility that ARM’s insurance subsidiaries couldcome under some regulatory action if there was further financial deterioration, General American was atrisk of having to make full payment on the $6.8 billion of funding agreement contracts with the recover-ability of its reinsurance from Integrity Life uncertain.

On July 30, Moody’s downgraded the insurance financial strength rating of Integrity Life to Baa3from Baa1 (keeping the rating under review for further possible downgrade), citing the significant write-down and the resulting low level of capital supporting the business. Later, on August 4, we downgradedIntegrity Life’s insurance financial strength rating to Ba3 from Baa3.

On July 30, we also lowered the insurance financial strength rating of General American one notch toA3 from A2, because of the significant deterioration in its partner’s financial condition, concerns aboutthe timely transfer of the assets backing the reinsured funding agreements to General American, and con-cerns about the liquidity and value of the assets that General American was trying to recapture from ARM.In addition, we kept the rating under review for possible further downgrade as we monitored the develop-ing situation. The quickly changing and deteriorating situation at ARM and our assessment of its potentialimpact on General American contributed to our downgrade of General American’s rating.

The recapture of the reinsured business was closed on August 3, 1999, and the related assets weretransferred back to General American’s balance sheet. It is our opinion that the volatility characteristicsand liquidity profile of the transferred assets differed materially from General American’s own assets forthis business.

Market Response To Deteriorating Financial ConditionsAs the events of the last week of July and first week of August unfolded, it became clear that several 7-dayfunding agreement contractholders (over $4 billion) had exercised their puts. Some money market fundsmay have reacted to ARM’s earnings announcement; others may have reacted to Moody’s downgrade ofboth companies. In any case, these actions prompted General American to attempt to liquidate a signifi-cant amount of assets within a short time period.

Moody’s Special Comment 5

Liquidity at General American Proved to Be InadequateGeneral American did not have enough time to mobilize sufficient liquidity resources from its balancesheet or from other sources. It is possible that General American may have anticipated that some putswould be exercised and, consequently, may have started to liquidate certain assets to meet these cash flowneeds. Unfortunately, the bond markets were very uncooperative, with poor market liquidity resultingfrom fairly wide spreads. Moreover, while General American may have planned for the possibility of someinvestors exercising the put provisions, the company could not react quickly enough to generate sufficientcash to pay back all of the institutional investors, especially in view of the time required to settle trades inthe bond market.

Moody’s became increasingly concerned about General American’s liquidity and about the company’sability to meet its obligations in such a short period of time; therefore, on August 9, we downgradedGeneral American’s insurance financial strength rating to Ba1 from A3.

On August 10, General American announced that, although the company believed that it remainedsolvent, it was unable to meet contractually required payments on the short-term funding agreements.Subsequently, Missouri insurance regulators placed the company under “administrative supervision”.Moody’s then downgraded General American’s insurance financial strength rating to B1 from Ba1 onAugust 12 to reflect the regulatory intervention and the missed payments.

General American’s primary problem was the combination of a short-term liability run in conjunctionwith unfavorable debt markets and an inability to raise sufficient cash resources in a limited time frame. Itappears that General American did not have available the liquidity resources and alternative liquidityoptions that the company thought it had controlled.

Moody’s has published reports indicating that the funding agreement business is a confidence-sensitivewholesale banking business. This business is highly credit- and confidence-sensitive, and participants willquickly react when they have credit concerns. Insurers participating in this market must provide for ampleliquidity in all circumstances - similar to issuers of commercial paper - especially in a difficult capital mar-ket environment.

Lessons LearnedThe case study of General American reiterates some important lessons:

• Solvency isn’t enough — Access to sufficient liquid resources is essential. Although GeneralAmerican appeared to have sufficient capital to maintain its solvency, the company could not pay itsobligations when they became due because it did not have adequate liquidity. Seven calendar days is avery short period of time to sell a significant amount of securities, especially if capital markets areunfavorable. Therefore, alternative sources of funding for immediate or very short-term obligationsshould be available. Moody’s ratings refer to timely payment of claims, in addition to assessing thecapital resources available to meet obligations.

• Reinsuring with weaker companies is risky. General American had a significant credit exposure(reinsurance recoverable) to ARM’s subsidiary, and General American’s risk profile increased asARM’s financial situation deteriorated. Having a significant reinsurance risk with a weaker credit willdirectly impact the credit fundamentals of the primary company.

6 Moody’s Special Comment

Appendix I: Excerpts of Moody’s ResearchBelow are some excerpts from our published research, the earliest of which is dated November 1997, thathighlight our concerns with putable funding agreements:

“Moody’s believes that the put option sometimes extended to FA holders creates liquidity con-cerns and event risk. This is the case because it is likely that FA holders will exercise put options,en masse, if the FA writer gets downgraded. Therefore, it is important that a company under-

writing putable FAs have a good grasp of asset/liability management, model the quick roll-off ofall putable FAs, and maintain adequate sources of liquidity.”

—Moody’s Special Comment, “Funding Agreements - The New Frontier of Stable Value,” issued April 1998.

“Simply stated, the shorter the put, the less room there is to maneuver if problems develop…Astrong level of liquidity is required, especially for those providers offering put options with veryshort terms…The less liquid and lower quality the asset portfolio, the higher the potential for

losses and increased probability of the FA issuer becoming troubled.” —Moody’s Special Comment, “Funding Agreements - The New Frontier of Stable Value,” issued April 1998.

“We believe that some companies may be unrealistic in their assessment of the potential forthese (funding agreement) options to be exercised.”

—Moody’s 1998 U.S. Life Insurance Industry Outlook, issued October 1998.

“While an FA put run has not yet occurred, there is nonetheless the possibility that one couldarise from a market and or credit event that negatively affects an insurance company’s confi-dence-sensitive and credit-sensitive markets. A credit event such as a short-term rating down-grade of an insurer, by itself, or in conjunction with other events, could serve as a trigger for

money funds holding that insurer’s FAs to engage their put options.” —Moody’s Special Comment, “High Yields, Stable Value Attract U.S. Money Market Funds to Funding

Agreements,” issued December 1998.

“These strengths are offset by ARM Financial’s rapid growth of, and greater emphasis on,institutional GIC products - including funding agreements, with 7- to 90-day puts…These con-tracts - whose sales are concentrated with a few large distributors and investors - are highly cred-

it- and market-sensitive, and they expose the group to significant liquidity and business risks.” —Moody’s Insurance Credit Report, Integrity Life Insurance Company, issued November 1998.

“We are concerned about General American’s exposure to these (funding agreements) liabili-ties, which are highly credit- and market-sensitive…In the event of a ratings downgrade or capi-tal market disturbance, General American, as the direct writer, would be the first in line to fund

surrenders, and is exposed to substantial business and liquidity risk.” —Moody’s Insurance Credit Report, General American Life Insurance Company, issued December 1998.

“We note the significant shift in the (ARM) companies’ business mix from individual annu-ities to GICs since their acquisition by ARM Financial in 1993…We are somewhat concerned

about this rapid growth…These GIC products are highly confidence-sensitive, short-term fund-ing agreements with short-term out options (i.e., 7 days).”

—Moody’s Insurance Credit Report, Integrity Life Insurance Company, issued November 1997.

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