longevity canada oct11 final
TRANSCRIPT
Economic Research & Consulting
October 2011
Longevity risk and protection for Canada
Published by:
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Dr Milka KirovaTelephone +1 212 317 5639
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Order no: 271_0211_en
Executive summary 2
Introduction 3
Longevity risk solutions 8
The global market for longevity risk solutions 12
Longevity risk in Canada 17
Market outlook 24
1
Table of contents
2
Executive summary
People are living longer. Life expectancy at birth in the developed world has risen from around 65 years in 1950 to over 75 years now, or one extra year every six years, and is currently projected to rise to more than 88 years by the end of this century. In Canada, the estimated life expectancy at birth is expected to rise to over 90 years by 2100. An increase in longevity is a wonderful thing for all of us, but it poses a challenge to pension funds and insurance companies with annuity blocks of business, particularly if the in‑crease is unexpected. A longevity assumption that is one year off the actual experience can add a substantial 5% to liabilities.1
Longevity is a systematic risk – it is undiversifiable. Whereas buying ten corporate bonds provides diversification and thus some protection in the portfolio against default risk, aggregating pension funds through mergers would provide no diversification benefits from longevity. Systematic risks may not be diversifiable, but they can be hedged or transferred. Transferring risks obviously will not diminish the societal problem of providing for an ageing population, but spreading longevity risk to a wider range of market partici‑pants will allow society to more easily absorb the risk.
Pension plans and annuity books of business have two major risks: asset risks and lon‑gevity risk. The latest asset‑liability techniques provide a great deal of protection against asset risk but until recently bulk annuitisation was the only means to transfer longevity risk. Newer risk solutions include longevity re/insurance, which exchanges a ‘floating’ set of payments based on the actual longevity experience of the plan being hedged for a fixed series of payments based on forecasted liabilities for a pension plan or an annuity book of business. The fixed payments are the insurance premium, and the floating payments the claims paid to the insured. A longevity swap similarly protects the buyer from longevity risk, but it is written as a derivative contract where the ‘floating’ payments may either be based on the actual longevity experience or a specified longevity index which is independent of – but closely aligned to – the buying plan’s participants. Lon‑gevity re/insurance can provide substantial protection against a worst case longevity loss.
The potential demand is huge for instruments that hedge and/or transfer longevity risk. Pension assets globally are a little over USD 20 trillion (CAD 20 trillion),2 with over USD 1 trillion (CAD 1 trillion in 2010) of that in Canada.3 Reserves backing immediate annuity books of business are in excess of USD 660bn (CAD 637bn) globally, with about USD 52bn in Canada (CAD 59.8bn in 2009).4 The UK has been the most active market so far, both for bulk buy‑outs, buy‑ins, longevity re/insurance and swaps. However, a few deals of each type have been done in other countries, and international activity is projected to pick up in the near future. In Canada, there has been one publicly disclosed longevity re/insurance transaction, and some buy‑out activity.
The market for longevity risk solutions continues to develop, with market participants es‑tablishing the Life and Longevity Markets Association (LLMA) to create transparency and liquidity in the longevity market. In addition, one longevity trend bond has been issued successfully by Swiss Re. Ultimately, such capital solutions are necessary to spread lon‑gevity risk to the broader capital markets. The market for longevity risk solutions – includ‑ing buy‑outs, buy‑ins, longevity re/insurance, longevity swaps, and longevity bonds – is expected to grow to USD 185–325bn (CAD 180–315bn) in total assets transferred by 2020.5 This volume of transactions, assuming Canada shared proportionally in the total volume of deals, would imply a notional outstanding amount of around USD 10–20bn (CAD 10–20bn) for longevity risk transferred in Canada over the decade to 2020.
1 Matt Singleton, Torben Thomsen, Costas Yiasoumi, “A short guide to longer lives: Longevity funding issues and potential solutions,” Swiss Re, 2010.
2 Throughout this publication, currency conversions are done using the June 30th 2011 closing rate.3 OECD Global Pension Statistics, from OECD – Pension Markets in Focus – July 2011 – Issue 8.4 The 2009 payout annuity assets in Canada totalled CAD 59.8bn according to CLHIA, and the CAD/USD
exchange rate for that year was 1.14.5 Swiss Re ER&C projection based on industry data.
Life expectancy in the developed world is rising fast.
Longevity is a systematic risk, but it can be hedged or transferred to allow society to more easily absorb the risk.
Longevity re/insurance and longevity swaps are new risk solutions that specifically target longevity.
Global assets exposed to longevity risk exceed USD 20 trillion (CAD 20 trillion), including USD 1 trillion (CAD 1 trillion) in Canada, ...
… encouraging the continued development in the market for longevity risk solutions.
3
Introduction
The four key stakeholders in longevity risk are individuals, the insurance industry, employ‑ers and governments. For an individual, longevity risk entails outliving one’s assets. It is difficult for prospective retirees to predict how long they will live, to anticipate health care expenses, and to estimate the future impact of inflation on their assets. Life insurers offer individuals a solution to insure longevity risk through various types of annuities, long‑term care insurance and other innovative products. Retirees are also partially protected from longevity risk through any defined benefit (DB) pension payments that they are entitled to through employer‑provided pension plans or government social security. Such plans pay out a fixed stream of income for the entirety of a retiree’s life.
The entities that provide individual longevity risk solutions also face longevity risk them‑selves. Life insurance companies run the risk that the individuals they sold annuities to live longer than expected, so that they have to pay out more in benefits than predicted. Similarly, employers and governments that offer pension guarantees or provide health care for individuals in retirement face the risk that they miscalculate mortality and mor‑bidity assumptions and their actual liabilities for these obligations turn out to be greater than projected.
Demographics
Life expectancy at birth in the developed world has risen from around 65 years in 1950 to over 75 years now and is expected to rise to more than 88 years by the end of the century.6 Figure 1 displays life expectancy for selected countries. In Canada, the estimat‑ed life expectancy at birth is expected to rise to over 90 years by 2100. Increased life ex‑pectancy is a blessing, but creates challenges for society to provide for older members. For pension funds and insurers, the upward trend puts added pressure on funding levels, especially in the environment of volatile stock markets and low interest rates.
30
40
50
60
70
80
90
100
World
India
China
Europe
US
Canada
20
95
–2
10
02
09
0–
20
95
20
85
–2
09
02
08
0–
20
85
20
75
–2
08
02
07
0–
20
75
20
65
–2
07
02
06
0–
20
65
20
55
–2
06
02
05
0–
20
55
20
45
–2
05
02
04
0–
20
45
20
35
–2
04
02
03
0–
20
35
20
25
–2
03
02
02
0–
20
25
20
15
–2
02
02
01
0–
20
15
20
05
–2
01
02
00
0–
20
05
19
95
–2
00
01
99
0–
19
95
19
85
–1
99
01
98
0–
19
85
19
75
–1
98
01
97
0–
19
75
19
65
–1
97
01
96
0–
19
65
19
55
–1
96
01
95
0–
19
55
Years
Source: United Nations, World Population Prospects, 2010 Revision – medium variant.
6 United Nations, World Population Prospects, 2010 Revision – medium variant.
Individuals are partially protected from longevity risk through defined benefit pensions, annuities and other insurance products …
… transferring their exposure to entities that provide those solutions.
Life expectancy in the developed world is rising …
Figure 1Past, present and future life expectancies in selected countries
4
Introduction
Previous forecasts of life expectancy have been consistently too low. For example, the 1975 UK Office of National Statistics projection for male life expectancy in 2005 was 71 years, whereas actual life expectancy for males in the UK in that year turned out to be around 77 years (see Figure 2).
66
68
70
72
74
76
78
80
822004 proj
2002 proj
1998 proj
1992 proj
1991 proj
1989 proj
1985 proj
1981 proj
1977 proj
1971 proj
Actual
20
31
20
26
20
21
20
16
20
11
20
06
20
01
19
96
19
91
19
86
19
81
19
76
19
71
19
66
Life expectancy at birth (years)
Source: UK Office of National Statistics, 2007
As a recent Swiss Re report indicated, “Underestimating life expectancy by just one year can increase a pension fund’s liabilities by up to 5%.” For a pension plan with CAD 1bn of assets, an extra CAD 50 million would need to be funded.7
In a 2010 Canadian pension plan survey by Aberdeen, an asset management company, two‑thirds of plans reported using UP‑94 tables for their mortality assumptions.8 These tables were compiled by the United States Society of Actuaries (SOA) and based on the mortality experience of the US Civil Service in the second half of the 1980s. Canadian life expectancy, however, has been consistently above that of the US, as can be seen in Figure 1. The UP‑94 tables do have different extrapolations that can be chosen for accounting for future improvements in longevity. Yet of the pension funds surveyed, less than 10% are using the most conservative mortality projection. Recent mortality experience suggests that even that projection may be too low.
7 Matt Singleton, et al, op. cit., Swiss Re 2010.8 Aberdeen Pensions Intelligence White Paper, “Living with Longevity,” November 2010.
… though predicting the actual rate of increase is proving elusive.
Figure 2Actual and expected life expectancy for UK males
Choosing an appropriate actuarial table to estimate pension liabilities is difficult …
5
The Canada Pension Plan (CPP) has increased its assumptions of life expectancy in each of its three most recent Actuarial Reports. The change in the mortality assumption alone added CAD 7.7bn to unfunded liabilities from 2006 to 2009 (see Figure 3). The 2006 Report listed the 2000–02 Life Tables for Canada with future improvements as the source for mortality assumptions – an increase in life expectancy at age 65 in 2007 for Canadian males of 1.7 years over the previous report published only three years earlier.9 By the latest Report in 2009, a further 0.6 years had been added to the age 65 male life expectancy with the adoption of the Canadian Human Mortality Database 2006.10
Years CAD billions
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
Change in Female Life ExpectancyChange in Male Life Expectancy
2009 Report2006 Report2003 Report
18
16
14
12
10
8
6
4
2
0
Increase to Unfunded Liabilities from Mortality Change (Right Axis)
1.8
10.9
7.7
Source: OSFI, “Actuarial Report on the Canada Pension Plan” for 2003, 2006 and 2009.11
9 The 21st Report in 2003 directly preceding the 2006 Report used mortality assumptions based on the 1995–97 Life Tables for Canada with future improvements. See OSFI, “21st Actuarial Report on the Canada Pension Plan as at 31 December 2003,” November 2004; and OSFI, “23rd Actuarial Report on the Canada Pension Plan as at 31 December 2006,” October 2007.
10 OSFI, “25th Actuarial Report on the Canada Pension Plan as at 31 December 2009,” November 2010.11 Reports are issued every three years. The change in life expectancy for the 2003 report refers to at‑birth
life expectancy. For the other reports, it refers to life expectancy at age 65.
… and providers such as the Canada Pension Plan continually have to re‑evaluate their assumptions.
Figure 3Changes in Canada Pension Plan mortality assumptions and resultant increases in unfunded liabilities
6
Introduction
Improvements in life expectancy
Canadian life expectancy has been increasing, and the increases show no sign of slow‑ing down (see Figure 4). For example, in 2001, out of 10,000 sixty year old males alive at the start of the year, 100 were expected to die during the year. However, by the end of the year, only 97 were expected to die – a 3% reduction in mortality.12 Cumulatively, these high levels of improvements can be material. If improvements of 2‑3% a year per‑sist over a 10 year horizon, then after 10 years, 20–30% fewer people will be expected to die at the age of sixty.
The Canadian Institute of Actuaries (CIA) recently instituted a minimum standard for mortality improvements.13 A variety of concerns described in the Actuarial Standard Boards’ memorandum were received in response to the initial communication of the new standard, reflecting the disagreement that exists on this topic. Acknowledging the differing views, the new standard allows actuaries to “use rates that result in larger liabilities than the ones produced by the minimum prescribed rates.”14
When projecting forward, many actuaries average the improvements over the calendar years for a particular age, say 25‑year olds or 90‑year olds. In the figure below, that would imply averaging annual improvements horizontally at a particular age level. Doing so, however, ignores potentially important cohort effects, which instead suggest consid‑ering a forward projection along a line at an angle (such as the black arrow in Figure 4). Additionally, since the late 1990s, individuals aged 65 and older are seeing mortality im‑provements of 3‑4% a year, as evidenced by the widening blue area near the top right side of the figure. This suggests that retirement‑age individuals may continue to see po‑tentially substantial mortality improvements.
100959085
807570656055504540
35302520
1966 1971 1976 1981 1986 1991 1996 2001 2006
–1.0%–0.0% 0.0%–1.0% 1.0%–2.0%
2.0%–3.0% 3.0%–4.0% 4.0%–5.0%
Source: Swiss Re calculations.
12 These mortality numbers for sixty year old Canadian males are in line with mortality rates from the Human Mortality Database, www.mortality.org.
13 Canadian Actuarial Standards Board Memorandum, July 12, 2011.14 Ibid.
Canadian life expectancy has been increasing, and the increases show no sign of slowing down ...
... however, there are differing views on the path of future rates among actuaries.
Recent improvements are particularly significant for (early) retirement‑age individuals.
Figure 4Annual improvement in male mortality rates in Canada, 1966–2006
7
Most of the affected institutions and individuals will suffer financially as longevity in‑creases. For example, in 2005, with a strengthening of the mortality basis for solvency valuations, many Canadian pension plans experienced a one‑time increase in solvency liabilities of 5% to 10%.15
Pension fund awareness of longevity risk is increasing – a 2010 survey of 100 major Canadian funds by Aberdeen Asset Management ranked longevity risk as third behind investment risks and interest rate/discount rate risk, putting it in front of inflation risks. Around 40% of respondents to the survey indicated longevity risk is “extremely impor‑tant” or “very important” for them.16 Similarly, a 2010 MetLife survey of pension fund trustees in the UK reported that 81% of trustees surveyed rank longevity among their top three risk concerns, with 39% saying it is their number one concern.17
Insurance company exposure to longevity risk is also rising with growing sales of various types of annuity products. For insurers, the latest changes in regulatory and accounting rules are a factor in increased attention to longevity exposure. Under some proposed Solvency II rules, insurers must hold significant extra capital to back their annuity liabili‑ties if longevity risk is deemed unhedgeable. Although Canada is not adopting the European capital testing standards, Canadian subsidiaries of European insurers – as well as European units of Canadian insurers – will be affected. Moreover, the Office of the Superintendent of Financial Institutions (OSFI) is in the process of developing new relat‑ed Own Risk and Solvency Assessment (ORSA) guidelines expected to be released in about a year.18 Further regulatory and accounting uncertainty arises from the adoption of IFRS standards in 2011, as the International Accounting Standards Board is currently in the process of updating several relevant standards.19
The combination of aging populations, changing accounting standards, evolving actuarial assumptions and challenging market conditions have led to low funding levels in many pension funds and to increases in reserves for annuity books of business. These problems, in turn, have focused pension fund managers’ and life insurers’ attention on managing longevity risk in addition to asset risks. With increased awareness among these and other market participants, various solutions for longevity risk hedging and transfer have been developed.
In this report, longevity risk solutions will be reviewed, focusing primarily on longevity re/insurance. Although longevity re/insurance is sometimes referred to as an ‘indemnity style longevity swap,’ the longevity‑targeted products really come in two distinct forms – an indemnity‑based re/insurance agreement and a derivative financial product. The dif‑ference between the two will be discussed in more detail later in the report. After an overview of all the available solutions, the global market for longevity risk transfer will be assessed, followed by an examination of that market in Canada. Finally, the market pros‑pects for longevity risk transfer will be evaluated.
15 Jasenka Brcic and Chris Brisebois, “An age‑old story,” May 25, 2010, Benefits Canada Report.16 Aberdeen Pensions Intelligence White Paper, “Living with Longevity,” November 2010.17 MetLife, “2nd Annual Trustee Survey – Executive Summary,” 2010.18 See for example, Stuart Wason (OSFI), “ORSA for Insurers – A Global Concept,” presentation at the Enterprise
Risk Management Symposium, March 2011.19 Insurers will mainly be impacted by Phase 2 of IFRS 4 Insurance Contracts, for which a new review draft is ex‑
pected towards the end of 2011 or early 2012. An amended IAS 19 Employee Benefits, issued in June 2011, affects pension funds. Additionally, IFRS 9 Financial Instruments, parts of which are currently under review, will impact both insurers and pension funds. For more information and a specific timeline, see the IFRS web‑site at www.ifrs.org, or Deloitte’s IAS Plus website at www.iasplus.com.
Most of those affected will suffer financially as longevity increases.
Awareness of this risk is increasing among pension funds ...
… while insurers with annuity books of business face a changing regulatory landscape, boosting their attention to longevity risk solutions as well.
Various solutions to longevity risk hedging and transfer have been developed.
In this report, the primary focus is on longevity re/insurance.
8
Longevity risk solutions
There are several options for pension funds and insurers to protect themselves from longevity risk. The most common solutions are a buy‑out, a buy‑in, longevity re/insurance and longevity swaps.
Buy-out
In a buy‑out, the pension scheme transfers its entire relationship with plan members over to an insurance company in return for the payment of an upfront premium to the insurer. Thereafter, each member will have an individual annuity with the insurer. All risks, not only longevity, are transferred away from the pension fund. Typically the pension scheme is wound up after a full buy‑out and the sponsoring company is free from any further liability with respect to the pensions.
This is the most expensive longevity de‑risking option and cannot be undertaken if the fund is grossly underfunded. According to the Mercer Pension Buyout Index for the UK, the cost of a full buy‑out (that is, including the retired as well as active and deferred members of a plan) in February 2010 when the Index was launched was around 44% higher than the accounting value of the pension fund’s liabilities.20 The cost has declined over the last year, down to approximately 36% above liabilities by April of 2011 for the “representative” fund.21 However, the present cost is still unaffordable for most pension funds.
Types of annuities
An annuity is a contract that promises to make a regular series of payments over a person’s lifetime or for a fixed time period. Annuities come in many varieties to meet the needs of retirees. An annuity certain makes payments over a set period of time. A life annuity makes payments throughout the life of the annuitant, or can continue to provide payments as long as either of two or more people lives (joint‑and‑survivor annuity). An annuity may begin to pay out immediately upon purchase (immediate annuity) or at some later date (deferred annuity). It can be purchased with either a single payment or a series of pay‑ments. Its payout can be set at inception (fixed annuity), or linked to the performance of an investment portfolio (variable annuity) or the rate of inflation (inflation‑linked annuity).22
Buy-in
With a buy‑in, the pension scheme purchases a bulk annuity as an investment. The annuity is held by the pension trustee, who still pays the pensions of scheme members. Thus, unlike with a buy‑out, the liabilities and assets remain in the pension plan.
This option generally requires a lower premium than a full buy‑out, but it provides only partial de‑risking. In a majority of cases, it does not cover deferred or non‑retired mem‑bers of the fund. Therefore, the pension fund still retains investment and inflation risk for that uninsured portion of their liabilities. As reported in Lane Clark & Peacock’s 2011 Pension Buyouts report, buy‑in pricing for the pensioner‑only portion of a fund in the first quarter of 2011 was about 15% over the company accounting reserves.23
20 The index can be found at http://uk.mercer.com/articles/pension‑buyout‑index.21 The Mercer index website notes that pricing is lower for a buy‑out that involves a pensioners‑only portfolio.22 Swiss Re, sigma No 4/2008.23 Lane Clark & Peacock LLP, “LCP Pension Buy‑Outs 2011,” June 2011.
The most common longevity risk solutions are a buy‑out, a buy‑in, longevity re/insurance and swaps.
A buy‑out transfers all risks over to an insurance company …
… but it is the most expensive de‑risking option.
An annuity promises to make regular payments over a lifetime or a fixed time period.
With a buy‑in, a bulk annuity is purchased as an investment …
… typically covering the plan’s retired members only.
9
Longevity re/insurance
A ‘longevity swap’ is a commonly used term for both re/insurance and derivative style longevity contracts, although there are certain differences between the two. An indem‑nity‑style longevity contract – also known as longevity re/insurance – indemnifies the holder of longevity risk by exchanging a fixed sequence of payments (the premium) for a ‘floating’ one (claims paid). For pension funds or insurer annuity books, pre‑agreed fixed payments are made to a re/insurer or other counterparty based on forecasted fund liabilities, and payments are received based on actual longevity experience. In practice, only the net difference is exchanged (see Figure 5).
Longevity derivative contract
A derivative style longevity swap also transfers the longevity risk liabilities from the hold‑er of risk to a counterparty, but it is written as a derivative contract. The setup of both a longevity re/insurance contract and a longevity swap is discussed in more detail below.
Annual pension payments
Scenario 1: Net difference paid by insurer to the pension plan
Scenario 2: Net difference paid by the pension plan to insurer
Year
Annual premiums ie “fixed leg”
Scenario 1*: Illustrative increased annual pension payments if life expectancy improves
Scenario 2*: Illustrative lower annual pension payments if life expectancy worsens
* ie “floating leg”Simulated figures = Not based on any actual pension plan
Source: Swiss Re
The concept of longevity re/insurance or a longevity swap is similar to hedging interest rate and inflation risks. Viewed as an added component of liability driven investment, such a longevity risk solution can be a great diversifying asset. With longevity re/insur‑ance or a longevity swap, the fund retains control of its investments and assets and the associated risks and returns. In contrast to a bulk annuity or a buy‑out, the payments are made over the lifetime of the agreement and do not involve a large up‑front cost. Long trades are common – a re/insurance contract or a swap that covers the entire span of the lives of the retirees may have a duration of 60 years.
There is certainly always a possibility that plan members do not live longer than expect‑ed. Thus, as with any hedge, while the protection buyer insures against plan members living longer than predicted, they relinquish any potential financial gain should this not be the case. The benefit for the insured, though, comes from reducing a risk which they cannot in any way control and may not want to hold.
Longevity re/insurance indemnifies the holder of longevity risk.
A longevity swap also transfers longevity‑only risk, but in a derivative format.
Figure 5Longevity re/insurance and swap payment structure
Both longevity risk solutions allow protection buyers to retain control of their investments and assets.
Longevity re/insurance reduces a specific risk which the insured may not want to hold …
10
Longevity risk solutions
Removing longevity risk leaves the “scheme to set its investment strategy with more confidence.”24 Without longevity risk, the cash flow target for the protection buyer is much more certain, allowing them to create a better match between assets and liabilities in the rest of the investment portfolio and potentially permitting them to capture higher returns and even recapture the risk premium paid for insuring longevity risk. This is be‑cause by reducing the longevity risk, asset managers might feel more comfortable with increasing their asset risk by re‑allocating the risk to other asset classes.
Bespoke vs. index solution: The ‘floating’ leg of the payments for the re/insurance contract or swap can be based on the actual longevity experience of the pension fund or annuity block or on an agreed‑upon index. A bespoke or indemnity‑based solution fully hedges the buyer against longevity risk. Pricing for such a product involves fund‑specific mortality rates. In comparison, an index swap ties the floating payment to a specific mor‑tality measure based on official government mortality data (see box). To date, a majority of the solutions have been indemnity‑based, with the index solutions remaining a small niche market.25
Mortality measures for potential index-based solutions
Index‑based swaps might be based on one of three basic mortality measures: mortality rate, survival rate or life expectancy. For the first measure, a longevity risk solution could be created from a portfolio of traded contracts based on mortality rates. Each underlying contract would pertain to specific age ranges and a few standardised maturity dates to promote liquidity. As an example, a contract may pay off based on the realised mortality rates of Canadian females aged 50–59 in the year 2020. Under such a forward rate con‑tract, one counterparty would make a payment based on the realised mortality rate at maturity in exchange for a fixed payment agreed to at inception. Then a number of such contracts with different ages, genders and maturities could be combined to create a hedge that more accurately matches the specific longevity exposure of a pension plan or a portfolio of annuities.
For more details, see Swiss Re, sigma No 4/2008, “Innovative ways of financing retire‑ment,” pp.43–44.
The effectiveness of an index swap depends on the realised mortality of the underlying fund members or annuitants relative to the chosen index. Of course the evaluation of hedge effectiveness is model‑dependent, and thus in itself is uncertain. However, any deviation in the mortality experience introduces basis risk, which needs to be acknowl‑edged and can be substantial. Basis risk can be somewhat reduced by calibrating the hedging index to more closely reflect the profile of the fund members in terms of age, gender, socioeconomic class and geography. Nevertheless, the potentially sizeable cost of evaluating, monitoring and incurring basis risk must be taken into account when choosing a longevity risk solution.
24 Daniel Harrison, “LONGEVITY Peace of mind,” PensionsWorld, June 2011.:25 For an overview of longevity/mortality indices see sigma No 4/2009 “The role of indices in transferring
insurance risks to the capital markets.”
… leaving the plan a more certain cash flow target to match with their investment strategy.
The ‘floating’ leg of the re/insurance contract or swap can be based on actual longevity experience or an index.
Index‑based swaps might be based on one of three mortality measures.
Index‑based swaps are subject to basis risk, which can be significant.
11
Derivative contract vs. insurance policy: As discussed above, a longevity risk solution can be set up under a financial derivative contract (a swap) or under a re/insurance agreement. The contract setup determines whether it would come under the supervision of the International Swaps and Derivatives Association (ISDA) or an insurance regulator. The choice depends on the protection buyers’ preferences and their own regulatory conditions.
When entering into any type of longevity hedge – be it a buy‑out, buy‑in, a swap or longevity insurance – the protection buyer cedes its longevity risk but must be mindful of counterparty risk. The longer the term of the contract, the higher the risk. If the product is structured as a derivative, collateral is usually used as security between the counter‑parties. Collateral is not automatically required on insurance deals, since the insurers are holding additional solvency capital in excess of expected claims. Typically, non‑insurance based providers have transferred the acquired risk to reinsurers or investors for deals they have completed thus far.
Member coverage: A longevity risk solution can be structured to include fund members only, or it can be extended to members and their dependents. The term of the re/insur‑ance contract or swap can cover the whole life of the pension fund, until its last member dies, or be of fixed duration. Several successive fixed term contracts can be used in combination to cover the full term of the pension fund liabilities. Most solutions so far have been limited to a pension fund’s retired members only, but including currently active and deferred members is also possible.
The setup of the longevity contract determines which regulator’s jurisdiction the solution falls under.
Buyers must be mindful of counterparty risk when entering into any type of longevity hedging deal.
Various options for member coverage are available on longevity re/insurance contracts and longevity swaps.
12
The global market for longevity risk transfer
The UK is the market leader in longevity deals thus far. It has a rather mature pensions market, with many DB (Defined Benefit) plans and shrinking active members, as most plans are closed to new entry. Participants report that market building and marketing activities for longevity hedging started in the UK in 2006. Table 1 lists longevity trans‑ actions that have been publicised by a counterparty to date.
The UK is the market leader in longevity deals.
Table 1Longevity re/insurance and swaps, 2007–2011
Liabilities transferred, Longevity risk Reinsurer/ultimate Duration Index or Derivative or Date USDbn Longevity risk cedent transferred to longevity risk carrier (years) Indemnity Re/insurance 1 Apr. 3.4 Friends Provident Swiss Re Swiss Re Duration, Indemnity Re/insurance if not whole of life 2 Jul. 3.6 Co‑operative Insurance Swiss Re Swiss Re Indemnity Re/insurance Total 2007 7.0 3 Feb. 0.1 Lucida J.P. Morgan Capital markets 10 Index Derivative 4 Oct. 0.8 Canada Life (UK) J.P. Morgan Capital markets 40 Derivative 5 Dec. 0.4 Australian insurer Swiss Re Swiss Re Indemnity (name not disclosed) Total 2008 1.3 6 Feb. 2.2 Abbey Life Pacific Life Re & RGA Pacific Life Re & RGA Duration, Indemnity Re/insurance if not whole of life 7 Mar. 0.7 Norwich Union RBS Partner Re & capital Indemnity Re/insurance markets 10 8 May, Sep., Dec. 1.8 Babcock International Credit Suisse Pacific Life Re, 50 pension funds Royal Bank of Canada, RGA 9 Jul. 3.1 RSA pension fund * Rothesay Life Pacific Life Re (Goldman Sachs) 10 Oct. 0.4 Second Australian insurer Swiss Re Swiss Re (name not disclosed) 11 Dec. 1.6 Royal County of Berkshire Swiss Re Swiss Re Duration, Indemnity Re/insurance pension fund if not whole of life Total 2009 9.4 12 Feb. 4.6 BMW pension fund ** Abbey Life Hannover Re, Indemnity Re/insurance Partner Re, Pacific Life Re 13 Jul. 2.0 British Airways Rothesay Life Pacific Life Re Indemnity Re/insurance pension fund *** (Goldman Sachs) 14 Q3 1.4 Industrial Alliance: RGA RGA Re/insurance annuity block (Canada) Total 2010 8.0 15 Jan. 0.8 Pension Insurance Not disclosed Not disclosed Re/insurance Corporation 16 Jan. 0.1 Pall pension fund J.P. Morgan Not disclosed 10 Index Derivative 17 Jun. 0.2 Rothesay Life Prudential Retirement Not disclosed Re/insurance (Goldman Sachs) 18 Jul. 1.8 Rothesay Life RGA RGA Duration, Indemnity Re/insurance (Goldman Sachs) if not whole of life 19 Aug. 2.8 ITV pension scheme Credit Suisse Not disclosed 70 Total 2011 YTD 5.7
13
Demand for longevity risk solutions
Pension fund assets in OECD and selected non‑OECD countries were around USD 20 trillion (CAD 20 trillion) in 2010 (see Figure 6).26
Other 2 255 626 USD million
Switzerland 551 450 USD million
Canada 1 017 672 USD million
Australia 1 089 723 USD million
Japan 1 388 329 USD million
Netherlands 1 594 646 USD million
UK 1 943 646 USD million
US 10 587 679 USD million
Source: OECD Global Pension Statistics, Pension Markets in Focus – July 2011 – Issue 8.
According to Towers Watson, an actuarial consultancy, 56% of pension assets globally are in DB plans.27 However, for some countries, such as Canada, Japan and the Nether‑lands, the DB portion is well above 90%.
26 This figure is for autonomous pension funds only, and excludes book reserves, pension insurance contracts, and bank and investment company managed funds. The figure for Switzerland is from 2009.
27 Towers Watson, “Global Pension Asset Study 2011,” February 2011.
Global pension assets exceed USD 20 trillion (CAD 20 trillion).
Figure 6Pension fund assets in OECD and select non-OECD countries in 2010, including both defined benefit and defined contribution plan assets
All transactions in the UK, except where noted. * Asset and longevity swap. Pacific Life Re reinsured a “significant proportion” of the longevity risk assumed by Rothesay Life. ** Abbey Life (owned by Deutsche Bank) will insure longevity risks on the BMW pension scheme and transfer a portion of the risk
to a consortium of reinsurers, including Hannover Re, Pacific Life Re and Partner Re. *** Asset and longevity swap.
Sources: Economic Research & Consulting and for the various transactions, respectively: 1. Reuters, “UK’s Friends in life expectancy deal with Swiss Re,” Apr. 20, 2007; 2. The co‑operative Annual Review 2007; 3. Total Derivatives, “ UK longevity swap market takes first steps,” 20 Feb. 2008; 4. Reuters News, “Canada Life insurer in JP Morgan longevity deal,” 30 Sept. 2008, Life & Pension Risk,
“Canada Life hedges Equitable longevity with JP Morgan Swap,” Oct. 1, 2008; 5. European Pensions, “Swiss Re agrees first longevity swap,” Dec. 15, 2009, Pensions Management,”Berkshire fund confirms
GBP 1 billion longevity swap deal,” Dec. 15 2009; 5. Insider Quarterly, Spring 2011, Issue 37, p. 45; 6. Best’s News, “Pacific Life Re completes longevity‑only transaction,” 10 Feb. 2009, Abbey Life’s 2009 FSA return; 7. Reuters News, “Norwich Union completes 475 mln stg longevity swap,” Mar. 24, 2009; 8. Financial Times, “Babcock pension to hedge risk of longevity,” 12 May 2009, Business Wire, “Pacific Life Re completes longevity reinsurance
transaction,” 30 June 2009, Lane, Clark & Peacock, “Pensions buyouts 2010,” May 2010, CRO Forum, “Longevity. Emerging Risks Initiative – Position Paper,” Nov. 2010;
9. Business Wire, “Pacific Life Re acts as reinsurer to Rothesay Life in biggest ever pension buy‑in deal,” 15 July 2009; RSA Press Release, “RSA announces next stage of UK defined benefit pension schemes de‑risking,” July 14, 2009; 11. European Pensions, “Swiss Re agrees first longevity swap,” Dec. 15, 2009, Pensions Management,”Berkshire fund confirms
GBP 1 billion longevity swap deal,” Dec. 15 2009; 12. Reuters, “BMW lays off UK pension liabilities with Deutsche Bank,” 22 Feb. 2010; Life & Pensions Risk, “Solvency management provides reinsurance opportunity ,” 26 Apr. 2010; 13. FT.com, “BA strikes deal to offload pension risk,” 2 July 2010; 14. Industrial Alliance interim report 2010 Q3 news release; RGA 2010 Annual report p. III, and p. 46; 15. Pension Insurance Corporation press release, 20 Jan. 2011; 16. Professional Pensions, “Pall scheme completes world’s first longevity hedge for non‑retired members,” Feb. 1, 2011; 17. Business Wire, “Prudential completes first longevity reinsurance transaction ,” 1 June 2011; 18. RGA press release, “Rothesay Life Partners with RGA UK For Longevity Risk Mitigation,” 13 July 2011; 19. Professional Pensions, “ITV completes GBP1.7bn longevity swap with Credit Suisse,” Aug. 22, 2011, Financial Times,
“ITV agrees pensions ‘longevity swap’ deal,” Aug. 22, 2011.
14
The global market for longevity risk transfer
Towers Watson also reports a worsening global asset/liability ratio for DB plans, even be‑fore incorporating changes in mortality.28 Overall DB liabilities have increased over 90% relative to their 1998 values, whereas asset growth has increased by less than 50% rela‑tive to the same year. Similarly, a 2010 OECD report states that unfavourable funding ra‑tios are prevalent among 2,100 publicly traded companies’ DB plans, with the median deficit at 26% as of fiscal year end 2009. For companies headquartered in Canada, the median deficit of DB obligations is reported at around 10%.29
In addition to pension funds, demand for longevity risk solutions also comes from insur‑ance companies with large books of annuities. As demand for annuities grows along with aging populations, insurers’ longevity capacity will be strained. Thus, insurers will be increasingly looking for alternative funding methods. They will prefer longevity re/in‑surance to swaps because insurance companies are likely to get some capital relief from a re/insurance solution.
The UK and the US are the largest markets for annuities, with immediate annuity reserves in excess of USD 200bn (CAD 193bn) in both countries in 2010. In eight selected mar‑kets for which data was available, the total amount set aside for immediate annuity re‑serves exceeds USD 660bn (CAD 637bn) (see Figure 7).
0 50 100 150 200 250
US
UK
Spain
Canada
Switzerland
Ireland
South Africa
Australia
in USD bn
Source: US: ACLI, Product‑Line survey data, total reserves for individual and group immediate annuity business. UK: SynThesys Life, from FSA returns, reserves are net. Spain: ICEA, includes life annuities which may be 70% of premiums; reserves estimated assuming that they are 10x premium. Canada: CLHIA, data is for assets. Switzerland: BPV, estimates, 2007. Ireland: IIF, reserves estimated assuming that they are 10x premium. South Africa: ASSIA, reserves estimated assuming that they are 10x premium. Australia: APRA half‑year bulletin Table 5a.
28 Towers Watson, “Global Pension Asset Study 2011,” February 2011.29 OECD, “Pension Markets in Focus,” July 2010, Issue 7.
Many DB plans have worsening global asset/liability ratios.
In addition, global annuity demand is driving insurer interest in longevity risk solutions.
The UK and the US are the largest markets for annuities.
Figure 7Immediate annuity reserves in USDbn, 2010
15
Supply of longevity risk solutions
Re/insurers have limited capacity for longevity risk, as the diversification benefits that longevity risk provides for their balance sheets are finite.30 Towers Watson estimates the insurance industry supply‑side limit for longevity risk solutions in the UK to be between GBP 10bn and GBP 20bn (CAD 15.5 and CAD 31bn, respectively), which is as little as 1% of the potential market.31 Grant Thornton puts insurer capacity at GBP 12bn per an‑num (CAD 18.6bn), and reinsurer capacity at GBP 20bn (CAD 31bn), for a total re/insur‑ance capacity per annum of GBP 32bn (CAD 50bn).32 These estimates are still in the single‑digit percentages compared to total UK pension market liabilities.
Although investment banks have served as counterparty to many of the announced longevity deals, to date they have had limited or no appetite for directly holding the risk. Typically for their deals the risk is ultimately carried by reinsurers. Reinsurers hold a large amount of mortality risk through providing protection for life insurance companies, creating a financial demand on the company if people die early. Thus, issuing longevity protection will diversify a reinsurer’s portfolio. However, the diversification is not perfect, as the age of cohorts of life insurance policyholders is usually different from that of annuity and pensions policyholders. Additionally, longevity is generally uncorrelated with other types of risks re/insurers hold, such as property damage from earthquakes and hurricanes, providing further diversification benefits to some degree. All in all, re/insurers have finite capacity for longevity risk, since the diversification benefits for their balance sheets diminish as more longevity is written.
There is a large potential demand for longevity risk transfer. Currently, supply is available to meet this demand, but prices for longevity risk solutions may rise in the medium term as this capacity becomes scarce. Supply could be increased substantially if capital market instruments are developed that allow a broad range of investors to participate. Specifi‑cally, a bond based on longevity developments would be ideal for augmenting supply. After providing longevity protection to a number of pension funds, re/insurers could issue such a bond to augment their capacity to absorb longevity risk. Alternatively, pension funds or insurers with annuity blocks of business could sponsor a longevity bond that indemnifies their book of business or whose returns track a longevity index closely tied to their book of business.
Longevity should be of interest to investors because it would be a diversifying asset class, uncorrelated with the credit risk of corporate bonds. Investors tend to favour insurance‑linked securities that are based on indexes as these do not require the same level of in‑depth analysis of a re/insurer’s book of business as an indemnity cover. This eliminates the potential moral hazard and the asymmetric information of an indemnity trigger on a longevity bond.
Not surprisingly, to increase transparency, standardise the issuance of longevity re/insur‑ance and swaps, and promote the development of a liquid secondary market, a number of market participants including Swiss Re established the Life and Longevity Markets As‑sociation (LLMA) in the fall of 2010. In April 2011, the group announced it would use JP Morgan’s LifeMetrics longevity index as a basis for developing LLMA’s own indices, ex‑pected to be launched later this year. Governments can also help by regularly publishing reliable, consistent and granular data on mortality that could be used in such indices as LifeMetrics.
30 Daniel Harrison, “LONGEVITY Peace of mind,” PensionsWorld, June 2011.31 Sophia Grene, “Plan to ease longevity risk asset trading,” January 31, 2010, Financial Times.32 Kelvin Wilson, “DIY Buy‑out,” in Deutsche Bank, “Pension‑Derisking: Longevity Hedging and Buying Out,”
March 2011.
Supply‑side capacity is estimated at GBP 10–32bn (CAD 15.5–50bn) per annum.
Reinsurers are currently the ultimate carriers of risk on most deals …
… but supply could be increased substantially if longevity capital markets develop.
Longevity would be a diversifying asset class for investors.
An industry group has been set up to promote the development of a liquid secondary market.
16
The global market for longevity risk transfer
Some early attempts to issue longevity bonds failed. In 2004, the European investment bankbnP and Partner Re were involved in a transaction for a GBP 540 million (CAD 837 million) bond with a 25‑year maturity. The bond’s cash flows were to be based on the ac‑tual longevity experience of the English and Welsh male population aged 65, as pub‑lished annually by the UK Office for National Statistics. However, the bond did not take off due to lack of investor interest.33 Likewise, the World Bank tried for several years to launch a longevity bond in Chile, also unsuccessfully. There, lack of regulatory recogni‑tion was cited as an important impediment.34
On the other hand, a market has developed for mortality bonds – bonds which pay out when there is a mortality catastrophe, such as a pandemic. For example, Swiss Re has transferred GBP 1.4bn (CAD 2.2bn) of tail risk since 2003 with Vita cat bonds, Scottish Re issued a USD 155 million (CAD 150 million) Tartan bond in 2006, and French insurer AXA had its USD 442 million (CAD 426 million) Osiris bond placed with investors in the same year. In 2008, Munich Re followed, placing USD 100 million (CAD 96.4 million) of mortality risk with investors through special purpose company Nathan Ltd.35
Mortality bonds and ILS
Insurance Linked Securities (ILS) are financial instruments used to transfer insurance risk to capital markets. Industry loss warranties, natural catastrophe bonds, embedded value securitisations and extreme mortality bonds are the most common examples of ILS. Market development started in the mid‑1990s in response to diminished reinsurance availability following considerable losses from catastrophic events, and has increased significantly to USD 14bn (CAD 13.5bn) in outstanding amounts by the end of 2010.36 Since 1997, more than USD 35bn (CAD 33.7bn) in risks has been securitised.37 Securiti‑sation allows insurance companies to manage catastrophic risks and use their capital more effectively, increasing capacity, while investors get the benefits of portfolio diversifi‑cation and the possibility of above‑average returns.
Mortality bonds are a form of ILS designed to protect the insurer from extreme cata‑strophic events, such as a pandemic. Thus, they are similar to non‑life cat bonds transfer‑ring peak risks to capital markets. They are also fully collateralised. Mortality bonds generally have a duration of 3–5 years and are triggered by movements in an objective portfolio, i.e. a predefined population mortality index, not a specific book of business. If mortality increases substantially over the life of the bond, the bond is triggered and investors suffer a loss of interest, principal or both. If mortality develops as expected, in‑vestors receive a regular interest payment and the return of the principal at maturity. For more information on insurance securitisation, see Swiss Re, sigma No 7/2006.
Swiss Re has also successfully sponsored a USD 50 million (CAD 48.2 million) longevity trend bond, transferred to the capital markets through the Kortis Capital securitisation program.38 This transaction provides cover to Swiss Re against a divergence in mortality improvements experienced between two select populations. The eight‑year bond would trigger in the event there is a large divergence in the mortality improvements ex‑perienced between males aged 75–85 in England and Wales and males aged 55–65 in the US. The bond was fully subscribed, proving there is investor interest in this type of product.
33 Swiss Re, sigma No 4/2008.34 Aaron Woolner, “Bond ambition – The World Bank’s attempts to launch a longevity bond in Chile,”
Life & Pension Risk, June 1, 2010.35 Swiss Re Capital Markets.36 Swiss Re Capital Markets, “Insurance‑linked securities market update,” February 2011.37 Ibid.38 Swiss Re Press Release, “Swiss Re completes first longevity trend bond,” December 23, 2010.
Early attempts to issue longevity bonds failed …
… but a small market has developed for mortality bonds.
Insurance Linked Securities transfer insurance risk to capital markets …
… with mortality bonds protecting the insurer from extreme catastrophic events, such as a pandemic.
Swiss Re was the first to successfully sponsor a longevity trend bond.
17
Longevity risk in Canada
Canada’s pension system
Canada’s retirement income system is multi‑dimensional and contains four major ele‑ments. The first element (also called the First Pillar) consists of direct government subsi‑dies to seniors that guarantee a minimum standard of living. This includes the federal Old Age Security, Guaranteed Income Supplement and similar provincial programs. The sec‑ond major element, or the Second Pillar, is the Canada Pension Plan (CPP, except in Que‑bec, where it is called QPP), which is a joint federal and provincial scheme administered by the Government of Canada. This is a universal public retirement income plan, tied to one’s employment and participation in the workforce. Employers and employees are re‑quired by law to contribute to the CPP and the funds are pooled into a single fund for the purpose of investment. The current contribution rate is 9.9% of earnings.
A third element of the retirement income system in Canada is private defined benefit pensions, usually based on earnings and years of service with an employer. Such plans are offered by many large companies, as well as public services at the federal, provincial and municipal levels. The final component of retirement income provision is composed of individual savings plans. These can be formal plans, such as the Registered Retirement Savings Plan (RRSP), or outside savings that consist of cash, personal property or other assets put aside for the future. RRSPs cannot be held after age 71, but the money can be transferred to a Registered Retirement Income Fund (RRIF) for the payout phase. A RRIF can also be set up before age 71 if the retiree wants to start the payout from their savings earlier.
Acronym Stands for TypeCPP Canada Pension Plan PublicQPP Quebec Pension Plan PublicRPP Registered Pension Plan Private – employer basedRRSP Registered Retirement Savings Plan Private – individualRRIF Registered Retirement Income Fund Private – individual
All of the formal plans, including employer sponsored registered pension plans (RPPs), RRSPs and RRIFs have tax benefits, whereas informal plans do not. These last formal elements together are referred to as the Third Pillar of the pension system in Canada,39 although typically the three pillars are divided into state plans in Pillar 1, occupational plans in Pillar 2, and private plans in Pillar 3.
The CPP is a pay‑as‑you‑go plan, but was moved to a partially funded basis after reforms in the late 1990s, making its first investments in 1999. It had reported assets of CAD 148.2bn under management in the latest fiscal year ending in March 2011,40 or about CAD 4,300 per capita.41 The chief executive of the independent CPP Investment Board predicts that the CPP’s assets will grow to CAD 275bn by 2020 (~CAD 7,200 per capita) and over CAD 1 trillion by 2050 (~CAD 25,000 per capita) (see Figure 8).
39 See for example the Ontario Ministry of Finance presentation “Canada’s Retirement Income System: Issues and Options,” May 2010, available at http://www.fin.gov.on.ca/en/consultations/pension/retirement.html, last accessed June 21, 2011.
40 Pav Jordan, “CPPIB assets under management jump to C$148.2 billion”, Reuters, May 19, 2011.41 Population figures from Statistics Canada ‑ approximately 34 million people in 2010, medium projection of
38 million people by 2021, and over 40 million people by 2050.
Canada’s pension system is multidimensional, with government subsidies and a public pension plan …
… supplemented by employer‑sponsored pensions and individual savings plans.
Table 2Acronyms for the main elements of the Canadian pension system
All formal plans have tax benefits.
The CPP moved to a partially funded basis in late 1990s, and now has CAD 148bn in assets under management.
18
Longevity risk in Canada
0
50
100
150
200
250
300
2020P20112010200920082007200620052004200320022001
in CAD billions
Source: CPP IB website.
Portfolio returns for the past year ending March 31 were 11.9 percent, down from 14.9 percent for the previous year. The CPP is actually the second largest public pension manager in Canada, with Caisse de Depot et Placement du Quebec in the lead. The Caisse, which manages funds for Quebec’s public and private pension funds and insurance plans, reported net assets under management of CAD 151.7bn as of December 31, 2010.42
In comparison to the universal coverage of the first two pillars of the Canadian retirement income system, the participation in private plans is more limited. Statistics Canada fig‑ures for 2009 indicate that about 6 million people, or less than 40% of employees, are covered by a registered pension plan, down from around 44% in 1994.43 Over half of the RPP members are employed by the public sector. The share of employed tax filers con‑tributing to an individual Registered Retirement Savings Plan was about 34% in 2008, down from 41% in 1997. Netting out the overlap between the two groups of employer‑based plans and individual savers, the share of employed Canadian tax filers participat‑ing in a private retirement savings plan was 50% in 2008.44 (See Figure 9).
0%
10%
20%
30%
40%
50%
60%
Any privateretirement plan (2008)
RRSP(Individual, 2008)
RPP(Employer-based, 2009)
39.2%
34.0%
50.0%
Source: Statistics Canada.
42 Figure reported on the Caisse website, at http://www.lacaisse.com/en/lacaisse/Pages/caisse.aspx, last accessed June 20, 2011.
43 Statistics Canada, Pension Plans in Canada and Labour Force Survey, “Percentage of Labour force and employees covered by a registered pension plan (RPP),” available at http://www40.statcan.gc.ca/l01/cst01/labor26a‑eng.htm, last accessed June 17, 2011.
44 Statistics Canada, “Participation in Private Retirement Savings Plans, 1997 to 2008,” March 2010, Catalogue no. 13F0026M, no. 1.
Figure 8Canada pension plan assets under management, CADbn, fiscal years ending in March
Quebec’s Caisse had net assets under management of CAD 151.7bn in 2010.
Around 50% of employees are currently participating in a private retirement plan.
Figure 9Share of Canadian employees participating in formal pension plans, 2008/2009
19
Unlike most other developed markets, Canada’s employer‑provided RPPs are mostly de‑fined benefit (DB) plans: 75% percent of employees with an RPP are in a DB plan, down from around 85% a decade ago.45 However, though the proportion of employees cov‑ered by DB plans is declining, the share of DB plan assets compared to defined contribu‑tion (DC) assets in the occupational assets pie does not seem to be declining. The OECD Pensions Indicators dataset lists the share of traditional and hybrid DB plans at a com‑bined 97% of all occupational assets in 2009, similar to the past 10 years. The asset share in DB funds remains high despite declining DB membership, and the fact that the number of members in DC plans has doubled between 1991 and 2006.46
The market value of assets in RPPs reached CAD 1,098bn in 2009 according to Statis‑tics Canada. This is up 8% from 2008, but still 5% below the high of CAD 1,155bn in 2007.47 From a solvency perspective, Statistics Canada says 83% of all RPPs had un‑funded liabilities for the three‑year period ending in 2009. However, fewer than 30% of RPPs had a solvency ratio below 80% (see Figure 10).48
Funded 17%
Underfunded but above 80% solvency ratio 53%
Solvency ratio below 80% 30%
Source: Statistics Canada
The Certified General Accountants Association of Canada paints a less rosy picture for private sector funds in the year before – it estimates funding deficits for private registered DB plans climbed to around CAD 350bn in 2008, with over 90% of plans in a deficit po‑sition as at December 31, 2008.49 This implies an aggregate solvency ratio of something closer to 65%.
45 Statistics Canada, “The Daily,” May 9, 2011, available at http://www.statcan.gc.ca/daily‑quotidien/110509/dq110509a‑eng.htm, last accessed June 20, 2011.
46 CGA‑Canada, “Gauging the Path of Private Canadian Pensions,” April 30, 2010.47 Statistics Canada, “The Daily,” May 9, 2011, available at
http://www.statcan.gc.ca/daily‑quotidien/110509/dq110509a‑eng.htm, last accessed June 20, 2011. 48 Statistics Canada, “The Daily,” May 9, 2011, available at
http://www.statcan.gc.ca/daily‑quotidien/110509/dq110509a‑eng.htm, last accessed June 20, 2011. 49 CGA‑Canada, “Gauging the Path of Private Canadian Pensions,” April 30, 2010.
Canada’s employer‑provided pension plans are mostly DB.
RPP assets reached a market value of CAD 1,098bn in 2009.
Figure 10Average funding status of RPPs, 2007–2009
Over 90% of private DB plans were in a deficit position at the end of 2008.
20
Longevity risk in Canada
According to Statistics Canada, there were around 11,700 DB plans in Canada in 2010.50 The Top 100 Funds held a total of CAD 753bn in assets, up from CAD 669bn in 2009 (see Figure 11).
Funds outside of Top 100 (estimated based on Top 100 share of total in 2009) 483 020
Funds with under 5 billion assets (70) 195 005
Funds with 5–10 billion assets (12) 85 600
Funds with 10–15 billion assets (7) 92 336
Funds with 15–20 billion assets (5) 85 002
Funds with over 20 billion in Assets (6) 295 423
Source: Benefits Canada, Statistics Canada and Swiss Re ER&C. Count of funds in the first five categories in parentheses.
On the individual plan side, all financial institutions together had accumulated reserves of CAD 371bn for RRSPs by the end of 2009, of which 23.2% were held by life insurers (Figure 12).
The Canada RSP 0.4
Credit Unions 38.0
Banks & Trust Cos 85.0
Life Insurers 86.0
Investment Funds 161.0
Source: CLHIA
In addition to the reserves held by financial institutions, self‑directed Registered Retire‑ment Savings Plans (RRSPs) were valued at approximately CAD 155bn for the same pe‑riod. Furthermore, payout products had assets of CAD 59.8bn in 2009, with group and individual RRIFs making up 30.9%.51
50 Statistics Canada, Registered Pension Plans and Members, available at http://www40.statcan.gc.ca/l01/cst01/famil117a‑eng.htm, last accessed 6/28/2011.
51 CLHIA, “Annuity Business in Canada – 2009.”
The top 100 funds hold more than 50% of all RPP assets.
Figure 11RPP Assets by Fund, 2010, CAD millions
RRSP plans reserves stood at CAD 371bn by end of 2009.
Figure 12RRSP Assets Held by Financial Institutions, CAD bn, 2009
21
Comparatively, then, employer‑sponsored pension plan assets at over CAD 1 trillion, typi‑cally characterised as the Second Pillar, make up the majority of Canadian pension as‑sets. Private pension assets in RRSPs, usually classified as the Third Pillar, have a com‑bined 2009 value of CAD 526bn, or close to 30% of total assets.52 Public pension reserve assets make up less than 15% of all Canadian pension assets (see Figure 13).
0
200
400
600
800
1 000
1 200
Third PillarSecond PillarFirst Pillar
CPP Assets: 128
The Caisse: 131
RPP, DC: 33
RPP Assets, DB: 1 065
Self-directed RRSP: 155
Financial Institution RRSP Reserves: 371
in CAD billions
Source: Statistics Canada, CLHIA, OECD, The Caisse Annual Report and CPP IB News Release. CPP Assets are for the fiscal year ending in March 2010.
Canadian annuity markets
Canadian annuity premiums exceeded CAD 36bn in 2009.53 On the life insurer side, the Canadian annuity market is dominated by Great‑West, Sun Life and ManuLife, who to‑gether account for around 70% of new general fund premiums that totalled over CAD 8bn for the market in 2010 (see Figure 14).54 Segregated fund premiums in Canada amount‑ed to CAD 28.1bn in 2009, the latest year for which CLHIA figures are available. A segre‑gated fund, legally known as an “individual variable insurance contract,” is similar to a mutual fund, but includes a guarantee on the amount of initial investment, regardless of the actual fund value at maturity or death of the investor. The guarantee feature makes it an insurance product.55
Empire Life 240
Desjardins 273
BMO 289
Industrial Alliance 322
Standard Life 582
ManuLife 1 240
Sun Life 1 491
Great-West 2 713
Other 895
Source: MSA Researcher Online. Note: Premiums for general funds only.
52 Assets associated with Registered Retirement Income Funds, a payout product, are included in the Annuities category in Figure 16.
53 CLHIA, “Canadian Life and Health Insurance Facts,” 2010 Edition.54 Based on general fund annuity premiums reported in statutory financials. Great West includes data for Canada
Life and London Life, all of which are under common ownership. Data provided by MSA Researcher Online.55 Morningstar Investing Glossary, at
http://www.morningstar.com/InvGlossary/segregated_fund_definition_what_is.aspx.
Employer‑sponsored pension plan assets make up the majority of Canadian pension assets.
Figure 13Canadian pension assets, CAD bn, 2009
Three Canadian life insurers account for around 70% of general fund annuity premiums.
Figure 14General fund annuity premiums for life insurers in Canada, CAD millions, 2010
22
Longevity risk in Canada
Premiums for payout annuities for life insurance companies reached CAD 4.84bn in 2009 according to CLHIA (see Figure 15). Assets associated with those premiums reached CAD 49.1bn in general funds, and CAD 10.7bn in segregated funds, for a total of CAD 59.8bn (see Figure 16). Individual and group annuity premiums have grown at nearly 12% per year between 2000 and 2009.
0
1 000
2 000
3 000
4 000
5 000
6 000
GroupIndividualRRIF/LIF
200920062006200420022000
in CAD millions
1 959 1 664 1 435 1 987 2 013 1 844
750982 1 061
1 8591 391 1 724
351 303 517
1 059
1 190 1 274
Source: CLHIA, “Annuity Business in Canada” reports for 2000 through 2009.
0
10 000
20 000
30 000
40 000
50 000
60 000
Segregated funds General funds
200920062006200420022000
in CAD millions
40 091 40 913
5 019 4 813
41 986 41 867 46 544 49 086
5 63210 534
8 88710 695
Source: CLHIA, “Annuity Business in Canada” reports for 2000 through 2009.
In terms of premiums written, payout annuities accounted for 13.2% in 2009, with accu‑mulation products accounting for the remaining 86.8%. Payout annuity assets were 24.2% of the total for the same year.
Payout annuity premiums reached CAD 4.84bn in 2009, backed by CAD 59.8bn in assets.
Figure 15Payout annuity premiums in Canada, CAD millions, 2000–2009
Figure 16Payout annuity assets, CAD millions, 2000–2009
23
Longevity risk solutions in Canada
As seen from Table 1 in the previous section, one confirmed longevity deal has been completed in Canada so far. Specifically, Industrial Alliance reinsured 60% of the longevi‑ty risk for its CAD 2.5bn in‑force block of insured annuities in the third quarter of 2010, as stated in their 2010 Annual Report.
In addition to the one publicly disclosed longevity reinsurance transaction, a 2010 survey of 100 major Canadian pension funds by Aberdeen reports that around 3% of Canadian plans have implemented full buy‑outs, and 30% are considering that option. Between 15% and 20% of plans are considering a buy‑in, and around 10% of plans are consider‑ing a derivative solution for longevity management. In contrast, almost three quarters of plans surveyed agreed (either strongly at 15% or somewhat at 57%) that longevity risk can be managed using total return strategies, including investing in equities.56
The most common barriers that pension funds list to managing their longevity risk are the associated cost, credit risk, complexity of the products, lack of suitable products and regulatory barriers. Of the funds surveyed by Aberdeen, 60% view buy‑outs as expen‑sive. For those plans, longevity re/insurance or derivatives may be a more attractive op‑tion. However, 42% of funds say they are not inclined to use derivatives at all. Therefore, considerable education of pension fund decision makers is necessary to increase their understanding of longevity risk management solutions and explain the value.
The Office of the Superintendent of Financial Institutions (OSFI), the Canadian regulator, is monitoring the developments in the longevity risk market, but has not yet promulgated any regulations on reinsurers regarding longevity transactions. At a reinsurance confer‑ence in April 2010, the OSFI Superintendent Julie Dickson remarked that the regulator sees a need for longevity reinsurance, “especially when that longevity risk is sourced from private pension plans.” She added that for reinsurers, longevity risk can serve as a natural, if imperfect, hedge to mortality risk, but said that OSFI expects the reinsurers to “manage this risk appropriately (as with any other risk), even more so since longevity is being evaluated as a new risk to be assumed.”57 At this year’s International Insurance Society Seminar in June, the Canadian regulator again advised caution in assessing the risk in longevity transactions, similarly to “any other transaction involving risks with limited long‑term information.”58 The speech reiterated that OSFI continues monitoring the developments in the UK, and is still “determining what the impacts may be for the Canadian industry.”
56 Aberdeen, “Living with Longevity,” November 2010.57 Remarks by Superintendent Julie Dickson, OSFI, to the Canadian Reinsurance Conference, Toronto, Ontario,
“Reinsurance in a Rapidly Changing World,” April 29, 2010.58 Remarks by Superintendent Julie Dickson, OSFI, to the International Insurance Society 47th Annual Seminar,
Toronto, Ontario, “A Canadian Perspective on the Global Insurance Industry,” June 21, 2011.
One confirmed longevity reinsurance deal has been completed in Canada ...
… and a few plans have implemented buy‑outs.
Cost, credit risk and complexity are reported as the most common barriers to longevity risk management.
OSFI continues monitoring development of longevity risk markets, but has not yet promulgated any regulations.
24
Market outlook
Global outlook
Solvency II is affecting regulatory programs globally via its equivalence requirement of for non‑EU re/insurers. The proposed Solvency II and other new regulatory programs in‑creasingly recognise longevity risk. Thus, it is more likely that insurers with annuity books and companies with pension plans will begin to actively manage their longevity risk. Also, market participants developing a standardised contract and pricing framework for longevity exposure are expected to release market indices by the end of this year. This should increase awareness of longevity risk solutions among insurers and pension plans.
Nevertheless, for some pension fund trustees and insurers, hedging longevity risk is diffi‑cult to understand, so education by solution providers will be very helpful. Pricing is also improving, as the pricing gap between suppliers and what pension plans and insurers are willing to pay is beginning to close, according to PricewaterhouseCoopers’ pension director.59
The insurance sector may be the best link between pension funds and capital markets.60 Insurance companies could aggregate individual pension schemes’ risk exposure until there is sufficient identifiable risk. Then, the aggregated risks can be more easily pack‑aged into comparable and transparent instruments acceptable for capital markets. The insurers would be the ones holding the basis risk, but they may well be more suited for this than pension funds.
Expansion of the longevity market is expected beyond insurers and reinsurers. Hedge funds, fixed‑income investors and ILS funds are reported to be interested in taking on longevity risk as investors.61 For example, Centurion Fund Managers has launched sever‑al open‑ended longevity funds.62
International activity is also expected to pick up in 2011–2012. Recent life expectancy increases in the Netherlands, for example, are expected to add 8–9% to the liabilities of most Dutch schemes, driving interest in hedging products.63 Thus, the Netherlands will likely be among the next markets to reach a deal. Additionally, longevity insurance activi‑ty is expected to develop soon in countries such as Switzerland and the US.64
Overall, the potential is huge. With a global pension market of about USD 20 trillion (CAD 20 trillion) and a global annuity book of over USD 660bn (CAD 637bn), the market for longevity risk transfer could grow to between USD 185–325bn (CAD 180‑315bn) in notional outstanding issuance by 2020. By early this year, the outstanding notional value of longevity insurance, swaps and bonds was around USD 21bn (CAD 20.2bn), and the value of total assets transferred under all longevity risk solutions was around USD 46bn (CAD 44.4bn).65 This implies an annual average growth rate in total assets transferred of around 22–30%. If the longevity bond market takes off, these figures could be even higher.
Canada-specific outlook
If Canada simply gets its share of this global projection, based on pension assets and immediate annuity reserves, then the market for longevity risk solutions in Canada will be USD 10–20bn (CAD 10‑19bn) in notional value outstanding by 2020. There’s a sig‑nificant opportunity for Canadian pension funds and insurance companies to transfer their longevity risk while the re/insurance industry has available capacity to absorb it. After a longevity cover is in place, buyers would be able to more easily and efficiently take advantage of liability driven investment strategies.
59 Finance Director in Association with Hewitt, “Live Long and Prosper?” in “Decisions – Pensions and Employee Benefits”, March 2010.
60 Aaron Woolner, “Longevity swaps – a new way forward,” Life & Pension Risk, March 2, 2010.61 Sophia Grene, “Plan to ease longevity risk asset trading,” Financial Times, January 31, 2010.62 Bloomberg, “Longevity Swap Issuers Aim to Trade Death Derivatives,” Feb. 1, 2010.63 Theodora Tsentas, “Netherlands heralded as next longevity market,” Life & Pension Risk, February 23, 2011.64 Matt Singleton, et al, op. cit., Swiss Re 2010.65 Cumulative figure of GBP 30bn for assets transferred under all longevity risk solutions by early 2011 from Lane
Clark & Peacock LLP, “LCP Pension Buy‑Outs 2011,” June 2011, with an exchange rate of about 0.65 GBP/USD.
Active management of longevity risk by pension funds and insurers with annuities is likely to increase.
At the same time, pricing on longevity re/insurance and swaps is improving.
The insurance sector may provide a link between pension funds and capital markets…
…though expansion of the longevity market is expected beyond re/insurers.
International activity should pick up in 2011‑2012.
The overall market potential is huge, with possibly USD 185‑325bn (CAD 180‑315bn) in longevity risk transferred by 2020.
Canada also has a huge potential for longevity risk solutions.
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