Canadian insurers that want to design hedging programs to back their long-term life insurance reserve liabilities have limited options due to the structure of the Canadian fixed income market.

The availability of public bonds is greatly limited at the long end of the yield curve, particularly for corporate bonds that provide incremental spread over their government counterparts. This results in insurers having to invest in long government bonds with low incremental spread above the risk-free rate – a strategy that can be particularly expensive in today's low interest rate environment.

Without access to private market instruments or specialized investment strategies, life insurers could struggle to generate returns in their liability-backing portfolios. This could increase the amount of statutory reserve held, decrease investment income generated and limit the insurers' ability to provide competitive product pricing.

A new in-depth paper from TD Asset Management Inc. (TDAM) called New Frontiers: Backing Long-term Insurance Liabilities with Non-fixed-income Assets discusses how this complex issue could be solved through a carve-out strategy which compensates for the limited availability of long-term credit in the Canadian market.

The strategy relies on using non-fixed-income (NFI) assets, such as equities, real estate or infrastructure investments, to back long-term liability cash flows after a certain number of years.

The authors explain that when evaluating the suitability and trade-offs of carve-out strategies, it is important to consider the objectives and constraints which are unique to Canadian insurers, such as economic benefits, capital efficiency and financial statement impact.

For more details, read the full paper here.