(November 7, 2013) —There are four major risks plan administrators should consider and plan for when entering into a longevity risk hedging contract, according to the Canadian federal pensions regulator.
The Office of the Superintendent of Financial Institutions Canada (OSFI) has published a draft policy advising plan administrators how to mitigate the risks associated with longevity insurance and swaps.
The four risks identified were counterparty, rollover, basis, and legal.
The first considers whether the counterparty in the longevity risk hedging contract will default on the contract. To mitigate this, OSFI recommends the plan administrator should look at the credit ratings for the company, check whether there are any difficulties with enforcing legal rights if the counterparty is based outside of Canada, and identify the regulatory capital requirements.
With rollover risk, the challenge is whether you will be rolled into a new contract when the original contract expires. Administrators should check whether any subsequent contracts are likely to be more expensive due to changes in mortality expectations, OSFI said.
Basis risk is the risk under an index-based contract that the mortality rate of plan beneficiaries deviates from the index on which the contract is based. And finally, administrators should ensure they fully understand the terms and risks of the transaction, and seek legal advice before entering into a longevity risk hedging contract.
Investors should also consider the costs and value of the longevity hedge contracts, OFSI said, and determine the appropriate duration and flexibility of a proposed longevity risk hedging contract.
OSFI is soliciting comments on the draft policy until December 6, 2013—you can read its full statement here.
Dealing with longevity risk has been rising up the agenda for investors for the past few years. In September, AXA Investment Management (AXA IM) reported that longevity risk had become such an important issue that it had caused an asset liability management shift across the pensions sector.
To combat rising life expectancy figures, pension funds were being forced to move further into equities, AXA IM said, driven by the low yielding environment and the prospect of a generation of baby boomers retiring soon.
“In order to pay additional annuities in the short term, pension funds need to invest in higher return assets such as equities or real estate,” AXA IM’s report said.
“With increased pressure on the short-term horizon of their liability and a chase for yield that delivers in the longer term, pension schemes are caught in a duration mismatch which keeps widening as the new demographic, post baby-boom, is getting closer.”
Tilting the balance towards equities would hopefully compensate for depressed bond yields, a tactic which the report said was already being employed by some major fund managers, which were shifting their retail communications targeting new retirees and workers about to retire.
Related Content: Is Hedging Longevity Risk About to Get Easier? and Longevity Hedging: A Gap in the Market