Canadian regulator issues advice to pensions on longevity swaps

Canada’s insurance regulator, the Office of the Superintendent of Financial Institutions (OSFI), has issued an advisory note for administrators of defined benefit pension plans that are considering entering into longevity swap or insurance contracts.

In the note, the OSFI describes the broad types of longevity hedging options which may be made available to Canadian pension plans, the risks that pension plans may face when engaging in longevity risk transfer, considerations for plan administrators who are considering entering into a longevity hedge to reduce longevity risk and the regulators expectations of administrators who choose to pursue longevity hedging.

The regulator stresses the importance that Canadian pension plan administrators understand a number of key risks associated with the longevity hedging before entering into any contract.

Firstly the counterparty risk, which can grow over the time of a longevity hedging contract if it moves into the money. The expected pension payments are not at risk here, rather it is the ability of a counterparty to pay any additional payments resulting from the covered pensioners living longer than expected or from any changes in an index underlying the transaction.

Second is rollover risk, the risk that entering into a new longveity hedging contract after the first expires may be more costly to the pension plan sponsor. The OSFI notes that indemnity longevity hedges contain almost no rollover risk as they typically last for the lifetime of the covered population.

Third is basis risk, which any pension plan choosing to enter into an index-based longevity hedge will be exposed to. This involves the difference between the actual mortality exporience of a covered population being vastly different to that predicted by an index unerlying the longevity hedge. It is important that pension plans understand the potential for basis risk and attempt to understand the potential for it through modelling. Again, an indemnity longevity contract would contain no basis risk.

Finally the legal risk associated with entering into a longevity swap or insurance contract. Longevity hedging contracts are legal agreements and are not typically traded on an exchange, meaning that it is vital to seek the appropriate legal advice before entering into any longevity transaction.

In the OSFI’s view; “A longevity risk hedging contract is a permissible investment provided that it is consistent with the terms of the pension plan and the plan’s Statement of Investment Policies and Procedures, that it complies with the PBSA and the Regulations, and that the administrator exercises proper due diligence.”

That means that there is no need for a pension plan administrator to seek permission to enter into a longevity swap or hedge, nor is there a specific requirement to notify plan members of the existence of such a contract.

That opens the door for Canada’s defined benefit pension funds to begin looking for longevity risk transfer and longevity swap counterparties. That could bring a significant amount of new longevity risk into the insurance and reinsurance market, as well as potentially the capital markets.

As new markets open up to longevity hedging the existing incumbent specialists find their potential market growing rapidly. This will require more risk capital in the future as the insurance and reinsurance markets alone will struggle to cope with the volume of longevity risk held by the world’s defined benefit pension plans.

However, before entering into such a contract, the OSFI expects pension plan administrators to:

• understand the impact of longevity risk on their pension plan (e.g. via stress testing – by considering pension liabilities over a range of longevity scenarios);
• determine whether entering into the longevity risk hedging contract is in the best interests of beneficiaries;
• determine whether the longevity risk hedging contract offers value for the cost of entering into the contract;
• consider the risks to the pension plan associated with investing in a longevity risk hedging contract (e.g. counterparty risk, rollover risk, basis risk and legal risk);
• ensure that laws concerning data privacy are followed;
• develop adequate controls and oversight to manage these risks; and
• understand the longevity risk hedging contract (e.g. terms, associated costs, collateral, strength of counterparty, and benefits covered).

Also, in order for plan administrators to demonstrate that they meet OSFI’s expectations, they should ensure that:

• individuals with the appropriate level of knowledge are involved in the decision-making process and/or advice is received from individuals with experience in this market;
• the longevity risk hedging contract is monitored and reviewed on a regular basis; and
• the above items are well documented.