Alternative Risk

Captive Pensions

Using a captive for pensions can mitigate longevity and investment risks, but the regulatory hurdles are substantial.
By: | June 1, 2015 • 10 min read
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Mitchell Cole was there at the get-go, back in 2003. As he tells it, the Stamford, Conn.-based director at Towers Watson and his colleagues had contemplated the puzzle of managing defined-benefit pension obligations through a captive insurance vehicle.

They batted the question around with insurance companies and investment banks. They didn’t get answers. They ran into walls.

The more questions they asked of external experts, Cole remembers, the more they wondered why they didn’t just keep the conversation internal.

Then a client came along that wanted an answer to that same question: Could it use captive insurance for its global pension risk management? Cole and team were determined to find the answer.

They established some ground rules. First, they didn’t want pensioners to be any less protected than they were before the transaction.

They also wanted to ensure pension regulators knew about the transaction, and if reinsurance ended up being used, they would notify insurance regulators too (even though they didn’t need their approval).

And they would fully explain it to the pension trustees. If they objected, the captive experiment would not move forward.

The transaction is not sleight of hand. It is not a move of funds from one pocket to another, not a tax play. No change in risk occurs.

“The risk is the risk,” Cole said.

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What changes is simply how the risk is handled financially. Instead of 10 buckets of funds managed separately, it becomes, say, one bucket. It’s cost effective and more rational. It took 18 months to develop and test out with various legal counsel.

And it became a success.

Another company — a very well-known one, Coca-Cola — followed that pioneer and in 2011, it went public with its similar arrangement. Call it a pension captive.

Very few companies have followed in their footsteps.

“This is a very unique and niche area,” even for people involved in the captive insurance industry, said Lorraine Stack, business development leader, EMEA Asia Pac, at Marsh Captive Solutions Group.

The costs and uncertainties of defined-benefit pensions are of course far from new — and are only more pressing in the near-zero interest rate (or negative interest rate) investment climate.

Even when pension plans are frozen, as many corporations do, the legacy responsibilities still threaten balance sheets with volatility and uncertainty.

In its 2013 analysis of pension asset allocation for Fortune 1000 firms, Towers Watson estimated these firms hold more than $1.8 trillion in pension assets. Multinationals compound their pension issues through acquisitions, picking up plans around the world that are all managed differently and more than likely, not efficiently.

Even when pension plans are frozen, as many corporations do, the legacy responsibilities still threaten balance sheets with volatility and uncertainty.

Companies can transfer the risk to insurers through what are called buy-ins and buy-outs. In a buy-out, the insurer takes on the full responsibility for the obligation and the assets. A buy-in is a partial, part-time agreement on the insurer’s part to pay out benefits.

A third option is a longevity swap — a shorter-term hedge against longevity risk through an insurer or capital markets partner. All three beg the same self-insurance question that companies consider for P/C exposures: What if we use our captive insurer instead?

Worth the Climb?

Coca-Cola was motivated to establish its pension captive because it had the cash to cover its liabilities but the parent company lacked control over its obligations due to the fact that its U.K. and Ireland pensions were run by third-party trustees.

“We are a cash-rich organization, so we want to use the assets to cover the obligations rather than have debt sit on our balance sheets. But if you fund up too much in a plan where the company doesn’t have control, then you risk building up surplus,” one of its senior benefit consultants, Stacy Apter, said at a public risk management summit a few years ago, as reported by the trade press at the time.

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To change that reality, the beverage titan arranged for a fronting insurer to write annuities to fund its pension commitments in the U.K. and Ireland, and then have its Dublin-based captive, Coca-Cola Reinsurance Services Ltd., reinsure them.

At the time, according to trade media reports, the total value of the annuities was $400 million, and the structure encompassed four pension plans. (Coca-Cola declined to comment for this article.)

You can sense the excitement building over the pension captive possibilities in a piece that Apter wrote for a 2009 Towers Watson report: “What if we could aggregate some of those small and medium-sized pensions? We could achieve improved investment results and efficiencies. What if we were able to add those small and medium pensions to our bigger pensions? That would be more interesting still. And what if we were to take this thinking to its logical conclusion — a global pension pool?”

The insurers willing to participate in these buy-in/buy-out captive insurance arrangements are on the cutting-edge, and realize it.

Captives aren’t commonly used for pensions, since so many of them are devoted to property/casualty risks.

However, according to Anne de Lanversin, head of sales investments solutions for AXA Pension Market in Paris, using an insurance contract for a group pension which is reinsured by a captive is an innovative risk management solution.

The truth of the matter is that not all multinationals or insurers have the derring-do to pull it off.

Take Coca-Cola. Its pension captive is but one captive that has garnered attention. In 2013, Coca-Cola’s Apter and colleague Laurie Solomon, director of risk management, took home the Award of Excellence from the World Captive Forum not just for pension work in U.K. and Ireland, but also for using its South Carolina captive Red Re Inc. to fund retiree health care benefits.

Red Re also reinsures international life, health and disability benefits, and at the time of the award, Coca-Cola was applying to the DOL to have it reinsure group life in the U.S. (which by 2013 it got permission to do for AD&D coverage).

And as Marsh’s Stack said, there are a limited number of companies with the assets needed to set up a pension captive.

“It takes significant resources and operational will to push something like this through,” Stack said.

According to a presentation given at the World Captive Forum in February 2015, only 10 defined-benefit plans are involved in pension captives: three in Ireland, three in the U.K., and one each in Canada, Germany, France and the Netherlands.

To provide some context, the total number of employee benefit captives globally is estimated to be as high as 133.

Captives with the lowest savings potential but also the lowest difficulty to implement include international group life, long-term disability and accident, although difficulty and savings increase as captive owners transfer those risks for their U.S. populations.

On this scale, post-retirement medical benefits and defined-benefit plans rank the highest. Yet the total premiums paid to these captives is at more than $4.7 billion.

An estimated $3.3 billion of that is paid in pension captives. The next closest category is international benefits with $700 million in premiums, followed by retiree medical at $440 million and U.S. life and long-term disability at $260 million.

In other words, it’s a tiny subset of a small subset of the captive world in terms of formations — but not in premium.

Pension captives can provide corporations with investment control of funds previously out of a parent’s reach, with the ability to repatriate surplus, while also providing trustees with additional security through the financial strength of a highly rated insurer.

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“These benefits might be worth it for the few with sufficient critical mass and ability,” Stack said.

Towers Watson executive Mitchell Cole added that he believes only a “cadre of companies” will ever employ the pension captive strategy.

Guernsey to the Rescue

What is taking hold faster than buy-in/buy-out pension captives, said Stack, is a second option. Not a pension captive per se, but more of a “synthetic front” for hedging longevity. It’s an incorporated cell captive (ICC) which allows pension trustees to access reinsurance markets directly for a longevity swap. This lowers fronting costs and affords more flexibility in how pension trustees can set aside money.

“It’s the old P/C captive story evolved into a brand new area.” — Lorraine Stack, business development leader, EMEA Asia Pac, Marsh Captive Solutions Group

Either the trustee creates its own ICC or purchases a cell in an ICC built and sponsored by a third party.

“It’s the old P/C captive story evolved into a brand new area,” said Stack. “We expect to see more movement in this area.”

The main domicile for this longevity movement is the Bailiwick of Guernsey, the No. 1 captive domicile in Europe and the fourth biggest worldwide with about 800 insurance entities.

This past July, Guernsey announced a $24.16 billion longevity risk transfer transaction.

In it, the Guernsey-based captive of the BT Pension Scheme entered into a reinsurance deal with Prudential Insurance Co. of America. To give a sense for the size of this deal, Towers Watson estimated the value of all longevity swaps in 2014 to be $48.32 billion.

Why Guernsey for such a massive deal?

“Law firms, accountants and especially the managers locally have developed considerable skill over many years in this area,” said William Simpson, partner in the law firm representing Prudential in the transaction, Ogier Legal.

Experts are calling for these swaps to grow in popularity. Towers Watson is banking on it, having just launched a new incorporated cell captive in Guernsey.
Interested pension schemes can purchase an insurance cell in the facility, allowing it to write its own insurance and reinsurance and purchase directly from reinsurers. The size of the liabilities in an individual cell will be on the more modest side; merely $1.51 billion to $4.53 billion of pension liability.

The difference between these longevity risk transfers and a pension captive is that they only address the risk that a pension has underestimated the lifespan of its members (i.e., longevity risk). Others, such as the Coca-Colas captive, which are buy-in/buy-out captives, address longevity and investment risks.

An International Story

All this talk of Guernsey and Coca-Cola’s Irish captive may lead a reader to wonder where the U.S. domiciles and U.S. pension plans are in this story.

Nowhere right now.

Karin Landry, managing partner, Spring Consulting

Karin Landry, managing partner, Spring Consulting

The champion for pension captives to come to the United States is Karin Landry, managing partner at Boston-based Spring Consulting. She sees such arrangements coming to the U.S. soon. More and more companies are interested in terminating their pensions, she said, especially after the large discount rate drop as of Dec. 31, 2014.

Meanwhile, plans have begun using a new mortality table with longer life expectancies leading to increased liability.

What’s more, the Pension Benefit Guaranty Corporation (PBGC) is now charging a premium of $57 per plan participant to every U.S. defined-benefit plan, up from the mid-$30s just a few years ago, Landry added.

“It’s a big charge now, so you want to get rid of that,” she said.

Yet as Cole explained, multiple regulatory regimes in any one country weigh in on the feasibility, such as pension, insurance, taxes and accounting. In the U.S., pension captives face high regulatory and political hurdles — which is why Cole believes pension captives are unlikely to happen stateside any time soon.

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The U.S. Department of Labor and PBGC are currently facing a number of questions — complicated public policy questions — about pension transfer risk.

“[Captive insurance] is part of a much bigger set of questions that have to get answered first,” Cole said.

Even after answers are found, because of the newness of the innovation, interested companies would still face a lengthy DOL approval process.

Any ERISA-based benefit needs a special DOL exemption in order to be underwritten in a captive.

Will that climb worth the view? Stay tuned for the next chapter of the story to see if a select cadre of companies takes on the challenge.

Matthew Brodsky is editor of Wharton Magazine. He can be reached at [email protected]
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Risk Insider: Terri Rhodes

Ten Tips for Leave Management

By: | May 19, 2015 • 3 min read
Terri L. Rhodes is Executive Director of the Disability Management Employer Coalition (DMEC). Prior to returning to DMEC, Terri was an Absence and Disability Management Consultant for Mercer delivering strategic absence and disability management solutions to clients of all sizes, Director of Absence and Disability for Health Net and Corporate IDM Program Manager for Abbott Laboratories.

The environment for leave management has become increasingly complex—and potentially costly to those not in compliance with the growing number of leave laws and regulations. The Family Medical Leave Act (FMLA), Americans with Disabilities Act (ADA), and the myriad of state and local laws have made managing leave, while remaining in legal and regulatory compliance, more difficult and complex.

Leave laws not only create risk. They also create opportunity.

There is good news. A large and growing number of conferences, webinars and other resources are available to help guide risk managers and others through the ever changing leave landscape. DMEC’s recent Compliance Conference addressed many of the issues surrounding leave management and the ever-changing landscape.

During the RIMS annual conference, Karen English of Spring Consulting Group and I offered the following leave management tips at one session.

One: Training is critical. Managers must understand the leave process and their responsibilities under it and the law and uniformly administer leave policies. We don’t expect them to be experts but they need to understand how an employee might evoke their rights under FMLA or ADAA.

Two: HR and other staff must be qualified. Appropriate leave and HR administrators need to be up to date on all absence management programs and be prepared to answer employee questions about their rights for leave and job accommodation.

Three: Collaboration across business units is key. Leave programs across organizational boundaries; HR, disability, legal and other departments need to work collaboratively. Removing barriers between disciplines creates efficiencies and limits liability.

Four: Implement clear and consistent processes and policies. FMLA and ADA policies should be as uniform and applied as consistently as possible across the organization regardless of size or geography, allowing for some flexibility. Stakeholders need to engage with consistent correspondence, tracking, management, decision-making and communication.

Five: Centralize administration of the leave function. Employees and managers should have one source for questions and answers.

Six: Evaluate your program. Inventory the system used, are you tracking or managing your program. If an organization has internal system to manage or track its leave program, it should be regularly evaluated for effectiveness. If you choose a software system or outsource administration make sure that your vendor has ongoing compliance support.

Seven: Outsource if necessary. Outsourcing has increased over the last three years, there are more options than ever, and the list continues to grow. But it doesn’t fit every culture or organization; choose what works best for your company.

Eight: Evaluate your vendor. Just because a company outsources leave management, it does not mean it outsources its legal responsibilities.   Even with outsourcing, an organization must establish a process to update its leave programs to meet its changing business and staff needs.

Nine: Measurement, tracking and reporting should be actionable. Key metrics like lost time, costs, return-to-work rates, abuse and productivity are useful to the degree they enable managers to change leave programs to better meet the needs of employees and the organization.

Ten: Create a culture of continual improvement. While legal and regulatory compliance is essential, it is not enough to ensure a leave program helps advance strategic business goals. That requires that managers—and executives–view leave programs as an arena for new investment and training to catalyze change to maximize returns.

Leave laws not only create risk. They also create opportunity.

Planned and implemented in a thoughtful and strategic way, effective leave management can be a competitive advantage in the battle for the best talent. Take advantage of the resources out there and become educated on both the risks and opportunities offered by the new world of employee leave.

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Sponsored: Lexington Insurance

Pathogens, Allergens and Globalization – Oh My!

Allergens and global supply chain increases risk to food manufacturers. But new analytical approaches help quantify potential contamination exposure.
By: | June 1, 2015 • 6 min read
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In 2014, a particular brand of cumin was used by dozens of food manufacturers to produce everything from spice mixes, hummus and bread crumbs to seasoned beef, poultry and pork products.

Yet, unbeknownst to these manufacturers, a potentially deadly contaminant was lurking…

Peanuts.

What followed was the largest allergy-related recall since the U.S. Food Allergen Labeling and Consumer Protection Act became law in 2006. Retailers pulled 600,000 pounds of meat off the market, as well as hundreds of other products. As of May 2015, reports of peanut contaminated cumin were still being posted by FDA.

Food manufacturing executives have long known that a product contamination event is a looming risk to their business. While pathogens remain a threat, the dramatic increase in food allergen recalls coupled with distant, global supply chains creates an even more unpredictable and perilous exposure.

Recently peanut, an allergen in cumin, has joined the increasing list of unlikely contaminants, taking its place among a growing list that includes melamine, mineral oil, Sudan red and others.

Lex_BrandedContent“I have seen bacterial contaminations that are more damaging to a company’s finances than if a fire burnt down the entire plant.”

— Nicky Alexandru, global head of Crisis Management at AIG

“An event such as the cumin contamination has a domino effect in the supply chain,” said Nicky Alexandru, global head of Crisis Management at AIG, which was the first company to provide contaminated product coverage almost 30 years ago. “With an ingredient like the cumin being used in hundreds of products, the third party damages add up quickly and may bankrupt the supplier. This leaves manufacturers with no ability to recoup their losses.”

“The result is that a single contaminated ingredient may cause damage on a global scale,” added Robert Nevin, vice president at Lexington Insurance Company, an AIG company.

Quality and food safety professionals are able to drive product safety in their own manufacturing operations utilizing processes like kill steps and foreign material detection. But such measures are ineffective against an unexpected contaminant. “Food and beverage manufacturers are constantly challenged to anticipate and foresee unlikely sources of potential contamination leading to product recall,” said Alexandru. “They understandably have more control over their own manufacturing environment but can’t always predict a distant supply chain failure.”

And while companies of various sizes are impacted by a contamination, small to medium size manufacturers are at particular risk. With less of a capital cushion, many of these companies could be forced out of business.

Historically, manufacturing executives were hindered in their risk mitigation efforts by a perceived inability to quantify the exposure. After all, one can’t manage what one can’t measure. But AIG has developed a new approach to calculate the monetary exposure for the individual analysis of the three major elements of a product contamination event: product recall and replacement, restoring a safe manufacturing environment and loss of market. With this more precise cost calculation in hand, risk managers and brokers can pursue more successful risk mitigation and management strategies.


Product Recall and Replacement

Lex_BrandedContentWhether the contamination is a microorganism or an allergen, the immediate steps are always the same. The affected products are identified, recalled and destroyed. New product has to be manufactured and shipped to fill the void created by the recall.

The recall and replacement element can be estimated using company data or models, such as NOVI. Most companies can estimate the maximum amount of product available in the stream of commerce at any point in time. NOVI, a free online tool provided by AIG, estimates the recall exposures associated with a contamination event.


Restore a Safe Manufacturing Environment

Once the recall is underway, concurrent resources are focused on removing the contamination from the manufacturing process, and restarting production.

“Unfortunately, this phase often results in shell-shocked managers,” said Nevin. “Most contingency planning focuses on the costs associated with the recall but fail to adequately plan for cleanup and downtime.”

“The losses associated with this phase can be similar to a fire or other property loss that causes the operation to shut down. The consequential financial loss is the same whether the plant is shut down due to a fire or a pathogen contamination.” added Alexandru. “And then you have to factor in the clean-up costs.”

Lex_BrandedContentLocating the source of pathogen contamination can make disinfecting a plant after a contamination event more difficult. A single microorganism living in a pipe or in a crevice can create an ongoing contamination.

“I have seen microbial contaminations that are more damaging to a company’s finances than if a fire burnt down the entire plant,” observed Alexandru.

Handling an allergen contamination can be more straightforward because it may be restricted to a single batch. That is, unless there is ingredient used across multiple batches and products that contains an unknown allergen, like peanut residual in cumin.

Supply chain investigation and testing associated with identifying a cross-contaminated ingredient is complicated, costly and time consuming. Again, the supplier can be rendered bankrupt leaving them unable to provide financial reimbursement to client manufacturers.

Lex_BrandedContent“Until companies recognize the true magnitude of the financial risk and account for each of three components of a contamination, they can’t effectively protect their balance sheet. Businesses can end up buying too little or no coverage at all, and before they know it, their business is gone.”

— Robert Nevin, vice president at Lexington Insurance, an AIG company


Loss of Market

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While the manufacturer is focused on recall and cleanup, the world of commerce continues without them. Customers shift to new suppliers or brands, often resulting in permanent damage to the manufacturer’s market share.

For manufacturers providing private label products to large retailers or grocers, the loss of a single client can be catastrophic.

“Often the customer will deem continuing the relationship as too risky and will switch to another supplier, or redistribute the business to existing suppliers” said Alexandru. “The manufacturer simply cannot find a replacement client; after all, there are a limited number of national retailers.”

On the consumer front, buyers may decide to switch brands based on the negative publicity or simply shift allegiance to another product. Given the competitiveness of the food business, it’s very difficult and costly to get consumers to come back.

“It’s a sad fact that by the time a manufacturer completes a recall, cleans up the plant and gets the product back on the shelf, some people may be hesitant to buy it.” said Nevin.

A complicating factor not always planned for by small and mid-sized companies, is publicity.

The recent incident surrounding a serious ice cream contamination forced both regulatory agencies and the manufacturer to be aggressive in remedial actions. The details of this incident and other contamination events were swiftly and highly publicized. This can be as damaging as the contamination itself and may exacerbate any or all of the three elements discussed above.


Estimating the Financial Risk May Save Your Company

“In our experience, most companies retain product contamination losses within their own balance sheet.” Nevin said. “But in reality, they rarely do a thorough evaluation of the financial risk and sometimes the company simply cannot absorb the financial consequences of a contamination. Potential for loss is much greater when factoring in all three components of a contamination event.”

This brief video provides a concise overview of the three elements of the product contamination event and the NOVI tool and benefits:

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“Until companies recognize the true magnitude of the financial risk and account for each of three components of a contamination, they can’t effectively protect their balance sheet,” he said. “Businesses can end up buying too little or no coverage at all, and before they know it, their business is gone.”

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This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Lexington Insurance. The editorial staff of Risk & Insurance had no role in its preparation.




Lexington Insurance Company, an AIG Company, is the leading U.S.-based surplus lines insurer.
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