Captive Insurance Buy-Ins: An Alternative to Traditional Buy-Out

For pension schemes where buy-out might be prohibitive due to cost or size, or where the sponsor wants/has the capability to retain some economic exposure, a captive insurance arrangement may present a viable alternative.

This approach enables the trustees to transfer all of the risks to an insurance structure, while accommodating the strategic preferences of the sponsor. The sponsor retains the risk through a buy-in via a captive insurer arrangement. It benefits from retaining the surplus, and equally, may still be liable if a deficit appears.

This is an attractive solution for the sponsor as it can enable a regular profit stream over the lifetime of the pension scheme, unlocking value that itself has been created through funding over time. The cash inflow comes through a release of profits from investment returns and the unwinding of prudence as the scheme matures.

In terms of the set-up of the arrangement, the pension scheme enters into a bulk annuity transaction with a fronting insurer (buy-in), which then reinsures the pension liabilities to the sponsor’s captive insurance company.

The diagram below illustrates how captive insurance works.

A captive insurance buy-in solution provides a similar level of security for members as a buy-in but without many of the associated costs as well as the flexibility to change course over time.

For a well-funded mature pension scheme, transferring to a captive arrangement offers some significant advantages over a buy-out transaction:

• Potential to access a greater level of surplus overtime which can be shared between the sponsor and members.
• Potentially lower regulatory hurdles.
• Cost to the scheme is lower as there are no insurer profit loadings.
• Greater sponsor control.
• Maintains the relationship between members and the sponsor.

Furthermore, a third-party insurance settlement often requires the sponsor to recognize a significant accounting cost. In comparison, transferring to a captive arrangement enables the sponsor to draw an income stream and avoids the accounting cost.

The charts below show one of the modelled investment strategies and the corresponding results of the cumulative Net Present Value (NPV) of net return (surplus extracted minus deficit contributions). This is a key metric a sponsor should be considering with this type of solution.  

Scheme: The pension scheme in this study is 105% funded on a low-dependency basis of gilts+0.5% p.a. The liability value is £3bn on the same valuation basis.

• Captive insurance domicile: Bermuda
• Additional capital: We assume an extra £1bn of capital is held in surety bonds from inception to ensure the captive insurer’s solvency level is in line with its operating solvency target. This £1bn is modelled in our stochastic ALM tool (GLASS) as a separate balance sheet item. It is not invested and is used solely in the solvency calculation.

Surplus extraction rule:

• 100% of surplus is distributed back to the sponsor in the form of dividend payments when the Solvency Capital Ratio (SCR) is over 135% at the year-end; and
• The sponsor needs to provide sufficient capital to the captive insurer to bring the SCR back to 125% when it falls below. 

Note that the NPVs shown exclude fronting insurer fees, captive set up costs, tax, and expenses. These items can vary significantly depending on factors such as captive size, investment approach, and domicile.

Given the sensitivity of outcomes to these assumptions—as well as differences in scheme design and stakeholder risk appetite—the results can vary significantly. This highlights the importance of performing a scheme specific stochastic ALM analysis to assess the value of a captive insurance solution for each case.

Our latest research paper uses GLASS (Ortec Finance’s ALM tool) to dive deeper into the analysis above, comparing multiple risk frameworks.

Interested to know more?

Download the whitepaper for a full comparison of endgame options where we evaluate the options using GLASS.

This article is the fourth in our series on rethinking the endgame for UK defined benefit pension schemes,

Our first article Is Buy-Out Still the Default Endgame for DB Pension Schemes? can be found here

Our second article Comparing Three Endgame Routes for DB Schemes: Buy-Out, Captive Insurance and Run-On, can be found here

Our third article, Running On a DB Pension Scheme, can be found here