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Companies turn to captives to tackle pension liabilities

Posted On: Mar. 29, 2015 12:00 AM CST

The use of captive insurance companies or captive cells to transfer pension longevity risk is a relatively new but potentially cost effective and efficient way for employers to access reinsurance capacity to reduce their pension liabilities.

Last year, the British Telecom Pension Scheme — the U.K.'s largest defined-benefit pension plan transferred £16 billion ($18.47 billion) of liabilities, about 25% of the fund's exposure to longevity — to the reinsurance market via a wholly-owned captive set up in Guernsey specifically for the purpose.

The liabilities in the captive then were reinsured by Prudential Insurance Co. of America.

This landmark deal, which also was unusual because only one reinsurer was involved, likely has sparked interest among other pension plans in the U.K. and Europe that are seeking to reduce their exposure to longevity risks, experts say.

Although no U.S.-based pension funds have yet carried out a transfer of pension longevity liability using a captive, such transactions are expected.

While the British Telecom deal was “an enormous transaction — a one off,” London-based consulting firm Towers Watson & Co. realized that “it is a repeatable transaction” and set up an incorporated cell captive company in Guernsey, known as Longevity Direct, said Martin Best, managing director of Willis Management (Guernsey) Ltd.

In January, the trustee of the U.K.-based Merchant Navy Officers Pension Fund announced that it had hedged £1.5 billion ($2.31 billion) — about 55% of the fund's total liabilities — via a cell in Longevity Direct, MNOPF IC Ltd.

Those liabilities then were reinsured by Pacific Life Re Ltd.

In February, Artex Risk Solutions Inc., which worked as the insurance manager on the British Telecom deal, announced it had set up a Guernsey-based incorporated cell company, Iccaria ICC Ltd., in conjunction with PricewaterhouseCoopers L.L.P., to enable pension funds with liabilities as low as £250 million ($385 million) to access the reinsurance market.

The ability to use a captive, or a captive cell, as a vehicle to transfer pension longevity risk can offer the trustees of pension plans an alternative route to reinsurance markets rather than using an insurance company or investment bank.

“What is driving innovation in the use of captives for pensions is companies' needs to manage the legacy issues of their defined-benefit plans,” said Lorraine Stack, business development leader for the Europe, Middle East and Africa region and for Asia Pacific at Marsh Captive Solutions Group, a unit of Marsh L.L.C., in Dublin.

The sponsoring employers of many defined-benefit pension plans are faced with greater longevity risk as plan members live longer, while many reinsurers have heavy exposure to mortality risk.

Many pension plans, particularly those based in the United Kingdom, have been seeking ways to access the reinsurance market to transfer some of their longevity risk for about the past 10 years. And for reinsurers that have large exposure to mortality risks, taking on risk that people will live longer offers a natural hedge, they say.

Trustees of U.S. defined-benefit plans also are facing a longevity challenge as more retirees live longer.

“We believe it is possible for U.S. pension funds to use captives to transfer longevity risk, as British Telecom has done,'' said Amy Kessler, senior vice president and head of longevity reinsurance at Prudential Retirement, part of Prudential Insurance.

Pension plans, however, cannot enter into direct contracts with reinsurers, and reinsurers cannot write contracts of direct life insurance, so there needs to be a vehicle in the middle to transform the risk.

Typically, this role has been taken by an insurance company or investment bank, which has acted as an intermediary in the transaction, as well as offering administration services and credit protection, among other things.

While there are many benefits to using an insurer or a bank as an intermediary in this way, in some cases, notably those where the trustees of the pension plan are comfortable with their calculations and risk tolerance, among other factors, a cost benefit analysis may show that using a captive or captive cell is a viable alternative, said Martin Bird, a senior partner at Aon Hewitt in London, who advised British Telecom on its pension plan's risk transfer deal.

While using a captive in this way may reduce some of the fees a pension fund must pay for transferring longevity risk, the trustee assumes different risks in such deals such as management of the captive and management of the reinsurance contract, Mr. Bird said.

In addition, he said, captives often are set up in offshore domiciles for capital and tax efficiency reasons, so pension plans that set up such captives need “carefully designed governance protocols.”

While many pension plans will continue to go down the intermediary route, using a captive or incorporated cell captive company “gives another option,” said Shelly Beard, a senior consultant at Towers Watson in Bristol, England, who worked on the Merchant Navy Officers Pension Fund deal.

Guernsey was chosen as the location for the Longevity Direct cell captive company because of the ability to set up incorporated cells there but also because of the domicile's capital regime, Ms. Beard said.

Guernsey, which is a U.K. Crown Dependency, is not a member of the European Union and, therefore, not subject to the Solvency II risk-based capital regime for insurers and reinsurers that will be effective Jan. 1, 2016.

This means that in cells where the risk has been reinsured — and there is, therefore, no risk left in the cell — the cell owners are not required to hold large amounts of capital, Ms. Beard said.

Once trustees have a captive in place, it gives them added flexibility to undertake buy-out or buy-in deals using the captive in the future — say in 10 years' time or so when the risk profile of the plan may have changed, said Stewart McLaughlin, account director at Willis Management (Guernsey) Ltd.

Sources say there likely will be more pension transfer deals involving captives or cells in coming years.

“We are convinced that there is further business out there,” Willis' Mr. Best said, noting that “there is no cap on the amount that you can put through an ICC cell.”

“Particularly at the larger end of the scale” — plans with liabilities of above £2 billion ($2.31 billion) — trustees will be exploring whether this is a route they can take, said Adrian Richardson, head of risk financing at Aon Global Risk Consulting, a unit of Aon P.L.C.

Experts say that pension plans from outside of the United Kingdom also could use captives as a way to transfer pension longevity risk to reinsurers and noted particular interest from plans in Canada and the Netherlands.

“We expect to see many more pension funds from many more countries pursue longevity risk transfer through captives,'' Ms. Kessler said. “This solution is a cost effective way for pension funds to gain access to the deep and competitive global reinsurance market for longevity risk, where the largest players use longevity to balance their mortality exposures.''