Session 17 Longevity Risk Hedging for Pension Plans. Aleem Qureshi, Canada Life
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1 Session 17 Longevity Risk Hedging for Pension Plans Aleem Qureshi, Canada Life
2 Agenda Purpose of longevity insurance How it Works Longevity Insurance vs Annuities Assessing Longevity Risk for Smaller Pension Plans Reasons for longevity arrangements being restricted to larger transactions Tailoring the arrangement for smaller pension plans What happens at Wind-up Novation 2
3 Purpose of Longevity Insurance Longevity insurance protects a pension plan against the financial risk of plan members living longer than expected Commonly referred to as a longevity swap outside of Canada (the term swap describes the underlying mechanics of the arrangement) 3
4 How it Works Plan without Longevity Hedge Plan with Longevity Hedge 4
5 How it Works Insurer Actual Benefits Periodic Premium Pension Plan Actual Benefits Pensioner 5
6 Longevity Insurance vs Annuities The key difference between longevity insurance and an annuity (buy-in) is timing of when premium is paid This varies the degree of control on plan assets (and therefore asset credit and mismatch risk) between the pension plan and insurer Longevity Insurance Annuity (Buy-in) Insurer Insurer Actual Benefits $ Premium paid overtime Actual Benefits $$$ Premium paid all at once Pension Plan Pensioner Pension Plan Pensioner Actual Benefits Actual Benefits 6
7 Longevity Insurance vs Annuities: Asset Risk/Control Both Longevity and Annuity arrangements transfer longevity risk Longevity insurance leaves the assets with the plan and allows flexibility in how the funds are invested In an annuity the assets and associated risks are effectively transferred to the insurer The insurer typically invests the proceeds in matching fixed income assets which drives the price of the annuity An annuity can then effectively be thought of as specific case of a plan entering longevity insurance where assets are invested 100% in fixed income. 7
8 Longevity Insurance vs Annuities: Counterparty Risk In an annuity, a pension plan is exposed to credit risk from insurer This is mitigated by reserve and capital insurers are required to hold over best estimate liabilities In longevity insurance, since the premium is not paid up front by the pension plan, the plan s credit risk exposure is reduced From the insurer s perspective there is now possibility that the full premium schedule will not be paid, and while the insurer may not be responsible for future claim payments, it results in a loss of future profitability for insurer. Collateral requirements are therefore a common provision in longevity arrangements (particularly large ones) 8
9 Longevity Insurance vs Annuities: Summary Longevity Insurance Annuities Asset Risk/Control Held by Plan Sponsor Transferred to Insurer Longevity Risk Transferred to Insurer Transferred to Insurer Counterparty Risk Higher from Insurer perspective Lower from insurer perspective 9
10 Components of Longevity Risk Level Trend Volatility Risk that current mortality rates have been misestimated Risk that future improvements on mortality rates have been misestimated Risk arising due to timing of individual member death (nonsystematic) 10
11 Assessing Longevity Risk for Smaller Plans Level Trend Volatility Risk mitigated through base mortality models which use rating factors like postal code Use of plan specific experience helps further Smaller plans typically more exposed to base mortality risk since plan specific experience is limited Analysis often generic based on population tables Risk similar for large and small plans Matters less for larger pension plans since risk is diversifiable (nonsystematic) Smaller plans more exposed to volatility 11
12 Reasons longevity solutions have historically been restricted to larger deals High consulting cost for development of contracts (contracts are often long and complex) High administration costs Frequent net cash flow settlements (monthly typically) Collateral provisions require frequent valuation of at least expected claim payments adjusted for plan experience. 12
13 Tailoring the arrangement for smaller pension plans Simplify collateral provisions to adapt to the risk in the transaction Cash flows settled net on less frequent basis (annual for example) Results in a simplified more standardized contract Benefits Reduced time to transaction Allows smaller plans access to longevity solutions 13
14 What happens at Wind-up? Terminating the contract at wind-up to purchase an annuity may be costly Termination value is essentially the difference between PV of fixed premium schedule and expected benefit payments + termination fee. Insurer may offer conversion to annuity Price theoretically should then be PV of longevity premium schedule with a charge for ceding investment risk only - similar to pricing a certain annuity The discount rate would depend on yield on assets insurer would use to back liability 14
15 What happens at Wind-up? Traditional Route to Plan Wind-up Transfer Longevity and Asset Risk together at Wind-up Route to Plan Wind-up with Longevity Insurance Transfer Longevity Risk first Transfer Asset Risk at Wind-up 15
16 Novation Pension Plan may not want to be beholden to a single insurer when they want to wind up the plan in the future. Novation of the contract (from Pension Plan to another insurer) allows the Pension Plan the ability to transact the asset risk with a different insurer and transfer the longevity contract to the new insurer. 16
17 Questions? 17
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