Law Times

Law Times • augusT 18, 2014 Page 11 www.lawtimesnews.com Longevity insurance debated as OSFI weighs in Policy sparks questions on whether plans can truly transfer risk By Julius Melnitzer For Law Times ongevity insurance and swaps are currently en- joying heightened at- tention as a de-risking mechanism for defined-benefit pension plans. What may disturb plan ad- ministrators contemplating such transactions is that the Office of the Superintendent of Financial Institutions' approach to the is- sues seems inconsistent with the concept of a true risk transfer. "As is the case generally when a plan administrator of an on- going plan purchases buy-in or buyout annuities, a plan admin- istrator that enters into a longev- ity-risk hedging contract retains the ultimate responsibility for paying pension benefits," the regulator noted in the final ver- sion of its longevity insurance and longevity swaps advisory policy released in June. In other words, if the insurer experiences financial difficul- ties, 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 To- ronto office. "Right now, I'm not really sure what it is." However that may be, lon- gevity insurance certainly isn't for everyone. "First and foremost, mortal- ity risk is hard to quantify, as is the appropriate payment for get- ting rid of it," says Kathryn Bush of Blake Cassels & Graydon LLP's Toronto office. And mortality hedging may be affordable only for large com- panies. "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 trans- action that echoed billion-dollar deals in the United States by General Motors Co. and Veri- zon Communications Inc. with Prudential Financial Inc., the Canadian Wheat Board and Sun Life Financial Inc. agreed to a $150-million annuity poli- cy that transferred some of the pension risk to the insurer. Soon after the announce- ment, Brent Simmons, senior managing director of defined- benefits solutions at Sun Life Fi- nancial, estimated that de-risk- ing transfers could amount to a $10-billion business in Canada by 2016. By August 2013, the regu- lator had released a draft ver- sion 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 Cana- dian pensioners has continued to increase and is boosting the funding requirements inherent in pension plan ob- ligations. Consequently, the regu- lator noted, pension plans around the world were seek- ing ways to hedge mortality risk, something in which life insurance and reinsurance companies have traditionally played a significant role. Reg- ulators, of course, were look- ing into the phenomenon. "Some jurisdictions al- low longevity insurance and swaps and some don't," says Frazer. For its part, the regulator allowed the practice. "The su- perintendent'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 regula- tor 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 ad- visory 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; consider- ations for plan administrators contemplating such arrange- ments; and the regulator's ex- pectations for plan adminis- trators 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 con- tracts introduce new challenges for plan administrators who must consider their complexity, costs, and resulting risks," the advisory noted. Quite apart from counter- party risk, plans administra- tors 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 con- tract once the original arrange- ment 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 con- tracts. As opposed to indem- nity-based contracts based on a plan's actual mortality expe- rience, index-based contracts consider an agreed mortal- ity 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 ne- gotiated 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 abil- ity 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 per- spective, then, the primary considerations for adminis- trators 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 lon- gevity hedging contracts ab- sent an active market to trade longevity swaps; and actuarial value implications. While the regulator doesn't require prior approval to en- ter into a longevity hedging contract, the advisory makes it clear it expects plan adminis- trators to assess the impact of longevity risk on their pensions; determine whether such con- tracts 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 under- stand the contract itself. To these ends, plan admin- istrators should ensure knowl- edgeable 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 Cana- dian Wheat Board transaction has been sluggish in Canada, that could easily change if inter- est rates go up. 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