In the first article of our series, I explored the growing interest in captives in managing defined benefit (DB) pension schemes and their advantages. In this second part, I examine the various structures captives can take and the factors that determine their suitability for different companies.

Captive Structures

Understanding the various structures that captives can take is essential. Two primary structures commonly used are captives with a fronting insurer and captives without.

1. Captives With a Fronting Insurer

In this structure, the scheme, and the fronting insurer, typically an established UK buy-in provider, execute a buy-in with the option to convert to a buy-out in the future.  Following the buy-in, the insurance premium (net of any assets retained by the fronting insurer), is transferred to the captive as a reinsurance premium.

In terms of ongoing operations, liability payments are made by the captive to the fronting insurer, who then disburses the funds to the scheme members. If the captive performs as anticipated, or exceeds expectations, any surplus capital can be re-allocated to the sponsoring company group.

• Captives Without a Fronting Insurer

In contrast, captives without a fronting insurer assume full responsibility for managing pension payments. These captives have complete control over their operations but require more resources and expertise to manage effectively. While they offer maximum flexibility, they also come with a greater administrative burden and regulatory scrutiny.

This structure is ideal for companies with extensive risk management capabilities and a desire for complete control over their DB scheme.

In summary, captives with a fronting insurer leverage the expertise and regulatory approval of established providers, with surplus capital benefiting the sponsoring company group. On the other hand, captives without a fronting insurer provide maximum control but require more resources and expertise to manage effectively.

Understanding Suitability

Despite the potential benefits, several challenges have limited the widespread adoption of captives. 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.

1. Regulatory Complexity

The regulatory landscape surrounding captives can be complex, requiring companies to navigate stringent requirements imposed by regulatory bodies such as the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). Compliance with these regulations necessitates a significant investment in time, expertise, and resources, which may not be feasible for all companies, particularly smaller companies with limited resources.

• Upfront and Ongoing Costs

Establishing and operating a captive requires substantial upfront costs, including legal and administrative expenses. These costs, combined with ongoing operational expenses, may present a barrier for companies with constrained budgets or those prioritising immediate cost savings over long-term risk management benefits.

Despite these challenges, captives are particularly well-suited for companies with strong balance sheets and well-funded schemes. Medium to large-sized companies, where the costs and complexities of captives can be offset by the expected returns, are often the most suitable candidates. These companies typically have the financial resources and risk management expertise necessary to establish and operate captives successfully.

Captives offer the greatest value when viewed as a long-term strategic investment rather than a short-term cost-saving measure. Companies willing to make the initial investment and commit to implementing robust risk management practices can reap significant benefits from captives.

In the next article of our series on captives, I will examine the recent Options for DB consultation from the Department for Work & Pensions, which closed in April. Stay tuned for an in-depth analysis of its implications.

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.