For a variety of reasons, many multinationals are now beginning to investigate the plausibility of using their existing insurance infrastructures to finance defined benefit (DB) pensions. While usage is in its infancy as a concept, it is Mercer’s view that more and more corporations will choose to finance their legacy and continuing DB arrangements using such captives.

A captive is an insurance or reinsurance company established by a corporate entity or group of entities that is typically used to internally insure or reinsure its own risks, including employee benefits. Most multinationals that use captives do so with a view toward saving on third-party insurer costs, usually domiciling the vehicle in a tax-efficient jurisdiction. The overwhelming majority of captives are used for non-life insurance and reinsurance, with very few licensed to carry long-term life risks.
 
This article explores these motivations and developments, shows what a captive solution for DB plans would look like, highlights the key benefits from the corporate perspective and outlines the challenges that need to be overcome by corporations that are considering this route.

Captives

According to our sister company’s findings, noted in its Marsh’s 2010 Global Captives Benchmarking Report, the number of established captives globally now exceeds 5,000 with owners located in almost all major developed market economies. Bermuda, Vermont, Cayman Islands and Hawaii are favored domiciles for captives that finance US risks, while Luxembourg, Ireland, Guernsey, the Isle of Man and Malta are favored domiciles for captives that finance EU risks.

The graph below highlights the diversity of risks currently borne by single-parent captives. The dominant risks are property, general and third-party liability, and employer liability and workers’ compensation. We can infer from the graph that only a small percentage of captives assume employee benefit risks, with the overall percentage of Health/Medical and Life lines totaling 10%.  (See Figure 1)

 
(Source: Marsh Captive Solutions “Single Parent Captive Benchmarking: Capital and Collateral,” 2010)

Captive usage has been driven by a number of diverse motives, including many cost, risk management and tax perspectives. From a governance perspective, captives facilitate centralized risk management and oversight, a theme that features strongly in the rationale for their use in financing DB arrangements. They can also enhance control (for example, through the information gathering in claims management) and flexibility. 

Extending the rationale for captives to DB plans

Among today’s key challenges are the efficient financing and risk management of DB plans, which are often legacy arrangements and not cornerstones of future talent attraction and retention. Proposed changes to International Financial Reporting Standards (IFRS) standards will see full recognition of DB funding positions brought onto the corporate balance sheet with no scope for volatility smoothing. Advanced credit for investment performance in the P&L is likely to be phased out.

Furthermore, pensions legislation has been evolving in directions rarely favorable for employers that are sponsoring DB plans, and increases in life expectancy show no signs of abating. Changes such as these expose companies to significant balance sheet risks.  Adverse market developments that have an impact on pensions (especially through investment, interest rate and longevity risks) can affect the capital structure, credit rating, borrowing costs, demands on cash flow and, ultimately, the share price. These risks are often outside corporate control, with fiduciaries, notably in the UK, overseeing investments and often having considerable power to extract valuable cash from the corporate sponsor. It can be difficult to integrate fiduciary governance with broader enterprise risk management agendas. Pensions have notoriously created issues for corporations that wish to divest businesses – especially in the UK, where fiduciaries can have the power to trigger a significant debt for the employer.

Fiduciary responsibility centers on maximizing the security of accrued benefits, generally enacted through investment and funding policy, while complying with local regulatory and fiduciary requirements. Fiduciaries are often grappling with significant deficits and their approach to both risk and financing may differ substantially from that of the sponsor. From the fiduciary perspective, a clear means to safeguard member benefits is through buy-out or buy-in of pensioner and non-pensioner liabilities with a financially sound insurance company. However, this is often excessively costly, not the least because annuity business is capital-intensive for insurers.

Using captives to reinsure the liabilities of an annuity provider offers corporations a solution that simultaneously meets fiduciary expectations while increasing the value of the corporate balance sheet, centralizing governance and improving financial flexibility. The key question is at what cost?

A captive straw man for DB plans

A captive solution for a DB plan might look something like the following (we use the UK as an example) (See Figure 2):

Consider a UK subsidiary of a multinational with a DB plan. This plan probably has a deficit, but certainly is unlikely to be funded to annuitization levels. The corporation now contributes additional financing to the plan and the fiduciaries then agree to enter into a bulk annuity transaction with a strong fronting insurer. Depending on corporate and fiduciary perspectives, the annuity transaction could be a buyout (full settlement of the liability in which members would individually become policyholders of the fronter) or a buy-in (in which the annuity contract would be a plan investment and the covenant of the employer would continue to support member benefits).

The fronting insurer now partly or fully reinsures its liability to the multinational’s captive. In addition to a reinsurance premium, the corporation would need to ensure that the captive is capitalized both to regulatory standards and to the satisfaction of the fronting insurer. A key determinant of the solvency capital requirement is the proposed investment strategy of the captive. It is likely that fiduciaries, corporations and fronting insurers alike will require security above that provided by regulatory standards and oversight, in part given the long-term nature of an annuity contract. Assuming optimal regulatory capital treatment for the reinsurance contract and satisfactory security, the fronting insurer has a hedge for its liability and as a result, a lower capital requirement. This lower capital requirement means that the fronter is essentially compensated with a structuring fee, likely to be considerably less as a percentage of the liability than the margin potentially paid for outright risk transfer. Key here, from the fiduciary perspective, is that the fronter is liable for the insured benefits.

Benefits in implementing a captive solution

From the corporate perspective, the initial outlay involves financing the premium payable to the fronter (including its fee), solvency capital in the captive, documentation/structuring costs and management overhead. From a pure economic perspective, the return on this outlay is dividend payments from the captive on favorable investment performance, subject to meeting capital requirements, and return of capital once the liability has been discharged. This contrasts with traditional insured solutions.

A key benefit of captive usage is now apparent: It can be difficult to extract surplus (if such emerges) from plans in many geographies, whereas a captive redresses this risk/reward asymmetry. It has the potential for upstreaming dividends. 

The pooling of liabilities can also result in greater bargaining power with service providers and can avoid having actionable deficits in some plans when the aggregate funding position over the collection of employer-sponsored plans is strong.

Risk management and governance will be in more transparent corporate control in the captive. In particular, the corporation has the ability to change the risk profile in line with its own preferences and can opportunistically approach markets including reinsurance and longevity transfer. It is likely that pension governance costs will be lowered, as headquarters can manage risk centrally and thus avoid the potential cost duplication arising through local oversight. Removing liabilities from subsidiary companies allows more corporate freedom, especially with regard to potential M&A activity.

Captives facilitate the integration of pensions risk into broader enterprise risk management and indeed, adding pensions to an internal insurance program could result in the capital-saving diversification benefits one would expect from a commercial insurance firm. Some firms may additionally benefit from the ability to leverage in-house resources, for example, fund management businesses. 

Challenges in implementing a captive solution

Implementing a captive solution for DB pensions is likely to be challenging; however, not least because of the lack of overlap between insurers comfortable with longevity risk and those happy to front rather than retain risk. Mercer’s expectation is that the fronting capacity will emerge if warranted by demand. 

While the broad concept is relatively straightforward, there is considerable complexity in the details. In pure economic terms, initial structuring/documentation outlay is likely to be material and the opportunity cost of financing premium and solvency capital must be considered. Captive infrastructure needs adapting and regulatory interfacing to ensure that it is suitable for the purpose.

From an accounting perspective, the impact on local accounts, the consolidated group accounts and the captive’s accounts all need consideration. Tax impact is also likely to be key. For each geography involved, pensions regulatory, insurance regulatory and insolvency laws are all relevant and require appropriate legal input. Without doubt, there are significant challenges in some jurisdictions. Further, in the EU the introduction of Solvency II in 2013 will have a major impact on insurance and reinsurance firms.

Documentation drafting, negotiation and interfacing with fronters, administrators and regulators are all likely to be time consuming. The difficulty of getting fiduciary engagement is never to be underestimated, and it is critical that this be approached correctly from the outset in order to achieve good outcomes for all stakeholders.

Challenges, but opportunities

Our view is that many of the motivations for captives in short-term employee benefits and other P&C risks extend naturally to DB pensions. However, there are some important differences, most obviously contract length. Key benefits for the corporation are in meeting employee and fiduciary expectations while simultaneously leveraging the value of the balance sheet, enhancing flexibility and improving governance. The potential is there to keep profits that would otherwise be locked in or flow to insurers.

The challenges are not insignificant, but it is our firm belief that it can be done and has significant rewards for those that choose to embrace these challenges. We expect more of this activity among large corporations, especially with regard to legacy DB arrangements, and new fronting insurers to enter the market.