The Office of the Superintendent of Financial Institutions (Canada) (OSFI) recently issued a draft Policy Advisory entitled “Longevity Insurance and Longevity Swaps”. The draft Advisory sets out OSFI’s expectations with respect to longevity insurance or longevity swap contracts for federally-regulated pension plans. This is an important development as OSFI has conveyed a qualified approval of, and articulated its expectations with respect to, the use of these products. The Advisory is also relevant to provincially-regulated plans, in light of the absence of policy statements from provincial regulators, since comparable fiduciary obligations apply. Comments on the draft Advisory are to be submitted to OSFI by December 6, 2013.
OSFI has also issued a memorandum regarding a draft consultation paper released by the Joint Forum entitled “Longevity Risk Transfer Markets: Market Structure, Growth Drivers and Impediments, and Potential Risks”. OSFI has stated that it supports the development of international principles and standards to help promote a level playing field and limit the arbitrage of regulatory rules between jurisdictions. OFSI is encouraging comments on this draft consultation paper be made directly to the Joint Forum.
This Bulletin provides an overview of:
- longevity insurance and longevity swap contracts (referred to collectively as longevity risk hedging contracts);
- OSFI’s expectations as set out in the draft Advisory; and
- legal issues that need to be considered in connection with longevity risk hedging contracts.
Longevity Risk and Longevity Risk Hedging Contracts
Longevity risk hedging contracts are designed to reduce longevity risk of pension plans (i.e., the risk of people living longer than expected). In these contracts, the pension plan administrator agrees to provide a counterparty with periodic payments from the pension plan based on agreed upon mortality assumptions. In return, the counterparty provides the pension plan with periodic floating payments based on either the pension plan’s actual mortality experience (an indemnity-based longevity contract) or an agreed upon mortality index (an index-based longevity contract). The sponsor remains directly responsible to pensioners and retains the investment risk (although this and other risks can of course be transferred pursuant to derivative contracts).
While longevity insurance policies and swaps can both be used to transfer longevity risk, there are some important differences between the two types of transactions. Longevity insurance policies are idemnity-based and are insurance. As such, they can only be offered by companies licensed to carry on insurance business. Longevity swaps are index-based and are not insurance. As such, they can be offered by non-insurers, such as banks. Longevity swaps would typically involve standard ISDA documentation and require the posting of high-quality liquid securities as collateral. A bank that enters into a longevity swap transaction may transfer the risk to a reinsurer in a separate transaction.
There is a developed market for longevity risk transfer in some jurisdictions, particularly the U.K. The Joint Forum has estimated that the total global amount of annuity- and pension-related longevity risk exposure ranges from $15 trillion to $25 trillion.
A Canadian market for longevity risk transfer has yet to develop. Nevertheless, longevity risk is a major issue for Canadian defined benefit pension plans, and so it is expected that there is demand for longevity risk transfer solutions in Canada. In this regard, it is noteworthy that the Canadian Institute of Actuaries recently released a draft report on Canadian Pensioner Mortality (July 2013) that provided updated mortality tables showing that the life expectancy of Canadian pensioners continues to increase.
There are other types of transactions that can be used to transfer longevity risk, including buyout transactions and buy-in transactions. In 2012, OSFI released a Policy Advisory regarding Buy-in Annuity Products. There are also longevity bonds where the payout depends on the longevity experience of a given population. The Joint Forum Paper states that, to date, there has been no successful longevity bond issuance.
The draft Advisory states that OSFI would have no objections to a pension plan administrator entering into a longevity risk hedging contract provided that the investment is permissible under the terms of the pension plan and the plan’s Statement of Investment Policies and Procedures, that it complies with the Pension Benefits Standards Act, 1985 (PBSA) and associated regulations, including Schedule III regarding Permitted Investments, and that the administrator exercises proper due diligence. Additionally, the draft Advisory states that there is no requirement that plan administrators obtain approval from OSFI to enter into such contracts.
Risks for a Pension Plan
The draft Advisory identifies the following risks of longevity risk hedging contracts to pension plans:
Counterparty Risk - The risk to the pension plan that the counterparty to the longevity risk hedging contract will not live up to its contractual obligations, taking into account the term of the contract, collaterization and the regulatory regime applicable to the counterparty.
Rollover Risk - If the duration of the hedging contract is shorter than the duration of the liabilities covered, the risk that entering into a new longevity risk hedging contract upon the expiration or termination of a similar such contract will be more expensive for the pension plan as a result of changes in mortality expectations over time.
Basis Risk - For index-based hedging contracts, the risk stemming from the possibility that the mortality experience of the pension plan may differ from that of the index on which the contract is based.
Legal Risk - Given the complexity of these types of contracts, OSFI expects that legal advice will be obtained before entering into a longevity risk hedging contract so that the terms and risks of the transaction are fully understood.
OSFI’s Expectations for Pension Plan Administrators Entering into Longevity Risks Hedging Contracts
Before entering into a longevity risk hedging contract, OSFI expects plan administrators to do the following:
- Understand the impact of longevity risk on their pension plan.
- Determine whether entering into the longevity risk hedging contract is in the best interest of beneficiaries and is in accordance with the plan’s terms and Statement of Investment Policies and Procedures, the standard of care required in administering the pension plan and a pension fund under the PBSA, and the requirements of the PBSA and associated regulations.
- Determine whether the longevity risk hedging contract offers value for the cost of entering into the contract.
- Consider the risks noted above to the pension plan associated with investing in a longevity risk hedging contract.
- Ensure that laws concerning data privacy are followed.
- Develop adequate control and oversight to manage these risks.
- Understand the longevity risk hedging contract and its implications for the plan’s actuarial valuations.
OSFI expects that individuals with the appropriate level of knowledge will be involved in the decision-making process and/or advice is received from individuals with experience in this market, that the longevity risk hedging contract is monitored and reviewed on a regular basis and that the above measures are well documented.
A longevity risk hedging contract is a sophisticated arrangement, whether structured as insurance or a swap, and either party will benefit from the advice of experienced legal counsel, as OSFI has reccommended.
From a pension law perspective, a key issue is whether the particular pension fund is permitted by its governing documents and applicable legislation to enter into and carry out the transaction. This would likely involve a review of:
- plan text (as amended to date);
- trust agreement (as amended to date);
- Statement of Investment Policies and Procedures; and
- other investment policies of the plan.
Both the plan administrator and the counterparty may need advice regarding the authority of the pension fund to enter into the hedging contract and, if applicable, to pledge pension fund assets as collateral.
If the transaction is collateralized, consideration will need to be given to the adequacy of the security/collateral package, including with respect to the potential insolvency/default of the counterparty. A legal opinion regarding the enforceability of security/collateral arrangements may be prudent.
Insurance and Bank Regulatory
In the case of a longevity swap, questions may arise as to whether the transaction involves insurance. If, for example, the counterparty is a bank, it will only be permitted to enter the transaction if it is not insurance. The structure of the transaction needs to be considered in this regard, including whether the transaction is indemnity or index based. The question of whether a transaction is characterized as insurance can also be relevant for tax purposes.
If a (re)insurer or bank that is not licensed in Canada was to be the counterparty to a longevity risk hedging contract, consideration would need to be given to how to ensure the transaction is structured to not involve insuring in Canada risks for the purposes of Part XIII of the Insurance Companies Act or carrying on business in Canada for the purposes of Part XII of the Bank Act, as applicable.
Consideration would need to be given to privacy and data protection, including whether transfer of personal information contemplated by the transaction is permitted under applicable legislation.