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Paul Kelly and Mitchell Cole discuss why captive reinsurance companies can be useful tools in dealing with DB pensions

The role of captive insurance companies is evolving. They are increasingly used to deliver employee benefits, in particular death, disability and healthcare, in both Europe and the USA. With defined benefit pensions continuing to be a challenge for large organisations, captives are now being looked at and used as a vehicle to finance DB pensions.

Today’s shareholders want their company to achieve a better balance between their rights and those of participants. Trustees and changes in funding regulations have over the past 25 years gradually shifted the balance in favour of plan articipants.Shareholders are looking for management to stand behind company promises, but to do so in a way that their economic interests are not subverted to those of pension scheme members, as well as other corporate uses of cash that do not build economic value for the enterprise. In many organisations the cause of corporate governance isn’t being well served since the HQ has very limited control over how subsidiaries’ pension plans are invested due to trustee control. Now, after declines in asset values due to investment losses, pension contributions are required.

Another issue is that sponsors find cash trapped in their pension plan, at a time when cash is in short supply. Funding regulation means that money is continually being injected into the plan to offset deficits, which are growing to troubling levels. However, when a plan does achieve a surplus, taking the extra money out of the plan is effectively impossible. Capital trapped in this way carries a high cost for employers. Also, trustees are taking a more conservative approach to investing, which runs up cost.

Adapting a company’s (usually existing) captive insurer to deliver pensions can help resolve these issues. Firstly, a captive can address the problem of money becoming trapped in the plan. Whereas a conventional pensions surplus cannot be recovered by the employer, and usually ends up being spent on benefit improvements, if there’s truly surplus, a captive is able to pay these funds back to the parent company as dividends. This creates a symmetrical relationship between risk and reward for the participants and for the shareholders.

By using a captive, employers are also able to secure control over the pension plan’s asset strategy. The board of the captive insurer will be responsible for the scheme’s investment activity, and this will help the company match the scheme’s investments and liabilities.

Finally, if the captive is being used for pensions in more than one country, it will also deliver asset pooling benefits. In other words the increased purchasing power of the pooled pensions across borders will allow greater asset choice and better fee deals.

One challenge is that trustees may be reluctant to relinquish control. To overcome this, sponsors need to be able to demonstrate to trustees that a captive can help provide members with additional security. Trustees will actually have contractual guarantees from two parties: not only the captive itself, but also the fronting insurer, which provides the trustees with an annuity contract. This ‘belt and braces’ cover should provide considerable reassurance.

Another issue is that this approach requires the employer to have available cash and financial strength. The process involves the purchase of an annuity at market prices, which won’t be cheap. If the plan’s current funding level is far below the cost of a buyout, this approach may prove too expensive. A fronting insurer will only agree to enter one of these arrangements if it is confident that the captive has the financial strength to pay out — a strong credit rating is a big advantage.

However, despite the cost of captive arrangements, they are still cheaper than a full buyout/buy-in. When using a captive, the annuity premium will be set at a market cost, but without the profit and other margins the insurer would normally add. Companies that run captives tend to be so large that they are just as financially strong as marketplace insurers, so wouldn’t lean towards a buyout on security grounds. The difference between these two arrangements is that a captive isn’t designed to settle the liabilities once and for all - the employer retains the risk, but gets more control of how to manage that risk.

There is also the issue of getting sign-off from the various relevant stakeholders. Senior management need to remember that they will need buy-in from local subsidiaries, as well as at group level. Local management will need reassurance that the capital to pay for the captive arrangement will come from headquarters, and will therefore not impact cash flow at a local level. They should also be made aware that (unlike a buyout) accountants do not consider a captive to be a settlement, which can avoid local P&L taking a nasty hit.

Once a company has decided that using a captive for delivering pensions is a viable option for them, they need to look at the following steps. Firstly, management needs to understand the ROI. One issue is that captives only really work for large scale liabilities; without more than £100m of liabilities, the returns are unlikely to outweigh the costs. Also, the organisation needs to have looked at all its defined benefit goals, and be confident that a captive fits their needs better than the other options on offer.

Thorough communication with group and local stakeholders will also be crucial. These include trustees, regulators (both for the pensions plan and also the insurance regulator where the captive is located), the board of the captive, advisers, and departments such as tax, accounting and HR. The regulators can be very useful for helping reassuring the trustees - if the approach is wrong the regulators will not sign it off.

The employer also needs to understand that using a captive will not neutralise pensions risk. If markets perform badly, or longevity expectations are insufficient, then it will still need to increase payment into the plan. Furthermore, it needs to be confident that the board of the captive is capable of effectively delegating the fund management side.

The use of captives to deliver DB pensions gives employers another option in efforts to contain pension deficits, and a chance to take control of their plan’s assets. Interestingly some employers do not see this point as an issue, believing that they are able to exert control over the trustees’ investment activities without resorting to a captive. This confidence is likely to be misplaced however, and is a hangover from an age when trustee relationships were far less adversarial. These days, sponsors will simply not be able to pull a trustee’s strings when it comes to investment, and in some cases a captive may be a perfect solution.

Paul Kelly and Mitchell Cole are principals at Towers Perrin


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