What is a Guaranteed Investment Contract (GIC)?
A Guaranteed Investment Contract (GIC) is a clause by an insurance company that guarantees a certain rate of return in exchange for keeping the deposit for a certain period of time. GICs appeal to investors as an alternative to savings accounts or U.S. Treasuries, which are government bonds guaranteed by the U.S. government. GIC is also known as a funding agreement.
- A Guaranteed Investment Contract (GIC) is an agreement between an investor and an insurance company.
- Insurance companies guarantee investors a certain rate of return in exchange for holding deposits for a period of time.
- Investors attracted to GICs often look for alternatives to savings accounts or U.S. Treasury bonds.
- GIC is a conservative and stable investment with a generally short maturity period.
- GIC values may be affected by inflation and deflation.
How Guaranteed Investment Contracts Work
GICs are sold in the United States and are structured like bonds. GIC pays higher interest rates than most savings accounts. However, they are still one of the lowest rates available. The lower interest is due to the stability of the investment. Lower risk equates to lower return on interest payments.
U.S.-issued GICs are not the same as Canadian guaranteed investment certificates, which have the same acronym. Canadian certificates sold by banks, credit unions and trusts have different attributes.
Insurance providers offer GICs that guarantee the owner repayment of principal at a fixed or variable rate over a predetermined period. Investments are conservative, and the maturity period is usually short-term. Investors buying GIC typically seek stable and consistent returns with little price volatility or low volatility.
Buyers of Guaranteed Investment Contracts
Insurance companies often market GICs to institutions that qualify for favorable tax status, such as churches and other religious organizations.These organizations are tax exempt Section 501(c)(3) tax law, due to its non-profit and religious nature.Insurance companies are typically companies that manage retirement or pension plans and offer these products as conservative investment options.
Often, sponsors of pension schemes sell guaranteed investment contracts as pension investments with maturities ranging from 1 to 20 years. When GICs are part of a qualifying plan as defined by the IRS tax code, they can withstand withdrawals or qualifying distributions without incurring taxes or penalties. Qualified plans allow employers to make tax deductions for their contributions to the plan, including deferred payment plans, 401(k)s, and some individual retirement accounts (IRAs).
AIG used some emergency funds it received from the Federal Reserve in 2008 to pay for the GIC it sold to investors. New York Times reports.
Risks of holding GICs
The word guarantee in guaranteed investment contracts – GIC can be misleading. Like all investments, investors in GIC also face investment risks. Investment risk is the opportunity that an investment may lose value or even become worthless.
Investors face the same risks associated with any corporate obligation, such as certificates of deposit (CDs) and corporate bonds. These risks include company bankruptcy and default, i.e. failure to repay investors. If the insurer’s assets are mismanaged or declared bankrupt, the buying institution may not receive a return on the principal (initial investment) or interest payments.
GIC may be backed by assets from two potential sources. The insurer may use ordinary account assets, or a separate account from the company’s ordinary funds. A separate account is dedicated to funding GIC. Regardless of the source of the asset backing, the insurer will continue to own the invested assets and will ultimately be responsible for backing the investment.
Inflation or price increases and deflation are other factors that can affect the value of guaranteed insurance contracts. Because these investments are low-risk and low-interest, inflation can easily outpace their performance. For example, if GIC pays 2% interest over the product’s 10-year life, but inflation averages 4%, the buyer will lose money.
Real Example of Guaranteed Investment Contract
Suppose URobot Inc., a biotech company, wants to invest in its employees participating in the company’s pension plan and decides to purchase a Guaranteed Investment Contract (GIC) from New Year’s Insurance Company. New Year Insurance provides a GIC, which guarantees that URobot will recoup its initial investment and pay a fixed or variable interest rate at the end of the contract.
URobot can choose to have a separate account, where New Year Insurance will manage their funds on its own, or a general account, where New Year Insurance will mix URobot’s funds with other general account customers’ funds. URobot chooses a normal account. URobot has tentatively agreed to a fixed rate at the end of the contract, assuming interest rates are likely to remain low.
Unfortunately, during the holding period, the economy accelerated, causing the central bank to raise interest rates to help moderate the pace of growth. Because URobot opts for a fixed rate, it won’t benefit from a rate hike. It will still see the return on its investment promised at a fixed rate, but it will lose the bigger return it would have noticed if it opted for a variable rate.