Longevity insurance and swaps are currently enjoying heightened attention as a de-risking mechanism for defined-benefit pension plans.
What may disturb plan administrators contemplating such transactions is that the Office of the Superintendent of Financial Institutions’ approach to the issues seems inconsistent with the concept of a true risk transfer.
“As is the case generally when a plan administrator of an ongoing plan purchases buy-in or buyout annuities, a plan administrator that enters into a longevity-risk hedging contract retains the ultimate responsibility for paying pension benefits,” the regulator noted in the final version of its longevity insurance and longevity swaps advisory policy released in June.
In other words, if the insurer experiences financial difficulties, the plan administrator is back on the hook.
“I’m not entirely confident that longevity hedging as OSFI sees it is a true transfer of risk,” says Peggy McCallum of Fasken Martineau DuMoulin LLP’s Toronto office.
“Right now, I’m not really sure what it is.”
However that may be, longevity insurance certainly isn’t for everyone.
“First and foremost, mortality risk is hard to quantify, as is the appropriate payment for getting rid of it,” says Kathryn Bush of Blake Cassels & Graydon LLP’s Toronto office.
And mortality hedging may be affordable only for large companies. “It’s too expensive for small plans,” says Mitch Frazer of Torys LLP’s Toronto office.
Longevity insurance first attracted media attention in Canada in June 2013. In a transaction that echoed billion-dollar deals in the United States by General Motors Co. and Verizon Communications Inc. with Prudential Financial Inc., the Canadian Wheat Board and Sun Life Financial Inc. agreed to a $150-million annuity policy that transferred some of the pension risk to the insurer.
Soon after the announcement, Brent Simmons, senior managing director of defined-benefits solutions at Sun Life Financial, estimated that de-risking transfers could amount to a $10-billion business in Canada by 2016.
By August 2013, the regulator had released a draft version of the longevity policy for comment. Citing a report on Canadian pensioner mortality from the Canadian Institute of Actuaries, the regulator noted the life expectancies of Canadian pensioners has continued to increase and is boosting the funding requirements inherent in pension plan obligations.
Consequently, the regulator noted, pension plans around the world were seeking ways to hedge mortality risk, something in which life insurance and reinsurance companies have traditionally played a significant role. Regulators, of course, were looking into the phenomenon.
“Some jurisdictions allow longevity insurance and swaps and some don’t,” says Frazer.
For its part, the regulator allowed the practice. “The superintendent’s position was that longevity insurance was just another way to invest a plan’s assets, which resulted in an open-door policy,” says Bush.
As it turns out, the open door has a series of passwords associated with it. The regulator soon made it clear that it supported “the development of international principles and standards that help promote a level playing field and limit the arbitrage of regulatory rules between jurisdictions.” The advisory that emerged represents its take on the steps necessary to meet international expectations of Canada’s regulatory system while international work on the issue progresses.
The advisory sets out the types of longevity-risk hedging contracts that exist; the risks associated with them; considerations for plan administrators contemplating such arrangements; and the regulator’s expectations for plan administrators that actually enter into them.
What’s clear at the outset is that longevity insurance and swaps are virgin territory for pension plans.
“Longevity-risk hedging contracts introduce new challenges for plan administrators who must consider their complexity, costs, and resulting risks,” the advisory noted.
Quite apart from counterparty risk, plans administrators face rollover risk because changes in mortality rates are covered only for the duration of the contract. There’s also the risk of having to enter a new and perhaps more expensive contract once the original arrangement expires.
Also at play is the basis risk that, in the regulator’s view, could result in a “significant reduction” in the effectiveness of index-based hedging contracts. As opposed to indemnity-based contracts based on a plan’s actual mortality experience, index-based contracts consider an agreed mortality index. The basis risk, then, arises from the possibility that the actual mortality rate will deviate from the index.
Finally, there’s legal risk that arises from the terms of a negotiated rather than a standard contract.
“Plan administrators should fully understand the terms and risks of the transaction and seek legal advice before entering into a longevity-risk hedging contract,” the advisory states.
Issues to consider include the counterparty’s legal ability to enter into the relevant contract and the document’s enforceability against foreign counterparties or those who have a substantial portion of their assets located outside Canada.
From the regulator’s perspective, then, the primary considerations for administrators are cost; acceptability in the sense of being in the best interest of beneficiaries and in accordance with the terms of the plan as well as the relevant legislation and regulations; the contract’s duration and implications; the relative illiquidity of longevity hedging contracts absent an active market to trade longevity swaps; and actuarial value implications.
While the regulator doesn’t require prior approval to enter into a longevity hedging contract, the advisory makes it clear it expects plan administrators to assess the impact of longevity risk on their pensions; determine whether such contracts are in the best interest of beneficiaries; assess the value the contract offers; consider all of the risks; ensure compliance with data privacy laws; develop adequate controls and oversight to manage the risks; and understand the contract itself.
To these ends, plan administrators should ensure knowledgeable individuals participate in the decision-making process, regular monitoring and review of the contract, and that proper documentation evidences these requirements.
Although longevity hedging activity subsequent to the Canadian Wheat Board transaction has been sluggish in Canada, that could easily change if interest rates go up.
“People are not jumping on the bandwagon in a big way yet, but at six per cent, longevity insurance would be the hottest topic around in the pensions world,” says Frazer.