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Exploring Captives – A Rising Trend in Managing Defined Benefit Pension Schemes for UK Corporates

In the complex landscape of corporate pension management, defined benefit (DB) pension schemes have long posed challenges for companies seeking to mitigate their risks whilst ensuring the security of members’ benefits. Various strategies have emerged to address these challenges, with insurance-led solutions like buy-in and buy-out rising to prominence and becoming the preferred solution.

However, there is growing interest in alternative risk management tools such as consolidators, capital-backed arrangements and captives. In this three-part series, I explore why captives are increasingly becoming more appealing to UK corporates navigating the complexities of DB pension scheme management.

Understanding the Landscape

DB pension schemes, which guarantee their members a monthly income at retirement, expose companies to significant financial risks due to factors like increasing life expectancy, fluctuating investment returns, and volatile interest rates. As a result, many companies have sought ways to de-risk their pension obligations.

Traditionally, solutions such as buy-in and buy-out have been the favoured options for managing DB pension scheme risks. In a buy-in, the company purchases an annuity contract from an insurer to cover part or all the pension liabilities in its scheme, while a buy-out involves transferring all the pension liabilities to an insurer, thereby eliminating the pension risk entirely from the company’s balance sheet.

The Advantages of Captives

Despite the popularity of buy-in and buy-out, captives are emerging as a compelling alternative for corporates. Captives, which are essentially insurance companies owned by the company itself, offer several advantages that resonate with the evolving needs and preferences of UK corporates.

1.Value Retention

Captives offer a significant advantage by retaining value within the company rather than transferring profits to an external insurer. By establishing a captive, companies can avoid paying the full profit premium to third-party insurers and instead keep potential profits within the corporate structure. This internal retention of value includes benefiting from investment returns and reducing longevity risk over time.

Additionally, unlike traditional pension regimes, captives allow for the distribution of ongoing excess assets as dividends to the company. This can be particularly appealing to Group Treasurers focused on maximising financial efficiency.

2. Customisation and Diversification

One of the key attractions of captives is the ability to tailor the structure to the specific needs and risk appetite of the company. Unlike traditional buy-in and buy-out, captives provide greater flexibility, allowing companies to customise features such as investment strategies and risk-sharing arrangements (for example by consolidating various pension schemes under a single structure). This flexibility enables companies to tailor their approach to pension risk management to better align with corporate objectives.

Captives can also be used for the coverage of a broader range of risks beyond pension liabilities, including non-life risks (e.g. property or general liability), thereby enhancing overall risk management and diversification.

3. Greater Control

Captives provide companies with greater control over their pension assets and liabilities. Through their ownership of the captive, companies can maintain oversight and decision-making authority. This becomes especially notable when considering the trustees’ objectives. Captives can help in aligning with the trustees’ objectives, for example by enhancing the security of member benefits via a fronting insurance setup, thereby garnering trustee and member approval.

4. Capital Efficiency and M&A Flexibility

For companies with strong balance sheets and risk management capabilities, captives offer an opportunity to optimise capital efficiency. By self-insuring a portion or all their pension liabilities through a captive, companies can allocate capital more efficiently, potentially freeing up resources for other strategic initiatives or investments. In addition, captives provide the ability to separate the pension scheme from the company if required in the future.

Despite the potential advantages of captives, several challenges have limited their widespread adoption. While exact figures vary, the number of captives established for managing DB pension schemes remains relatively low compared to other risk management strategies like buy-in and buy-out. Factors such as regulatory complexity, the need for robust risk management frameworks, and the upfront costs associated with setting up captives have deterred some companies from pursuing this option.

Next week’s article will explore these topics further by delving into the suitability and considerations of various captive structures.

If you are interested in learning more about captives and how they can benefit your company’s pension management strategy, we welcome you to reach out to us for further discussion and insights. Our team is here to provide expert guidance and support tailored to your specific needs and objectives.