Professional Pensions 18 December 2024
Argyll Covenant’s Paul Galpin and Richard Hall explore the ‘new type of BPA structure’
There has been no shortage of employers and trustees wanting to transfer their defined benefit (DB) pension obligations to an insurer, viewed by many as the “endgame”.
This allows the employer to sever links with what is a potential source of risk and trustees to find a secure home for members’ benefits, wholly independent of the covenant of the employer.
But not all employers and trustees are convinced and may be reluctant to buyout, for example because:
- There is a concern that too much of the pricing premiums charged by the insurers, and paid for by the schemes and employers, will run off over time as profit for the insurers
- There could be a potentially negative impact on the employer’s balance sheet from the loss of the pension scheme asset
- Discretionary benefits such as pension increases have to be hard coded (and priced into the premium) or abandoned.
For these and other reasons many schemes have decided to run on instead, at least for the time being.
However, as we saw recently, a new breed of bulk purchase annuity (BPA) transaction may be emerging in the form of a profit-share (or value-share) transaction. This case, believed to be the first of its kind, involved Prudential Assurance Company, a subsidiary of M&G, and the creation of a ‘captive’ reinsurance company i.e. a reinsurer owned by the employer for the sole purpose of insuring its DB pension scheme liabilities.
The benefits of profit share
The premise with profit-share BPA is that the employer shares in the profits that may be released from the captive over time, although the employer would also potentially remain exposed to its share of any losses experienced by the captive should they arise. Unlike a traditional BPA transaction, therefore, the employer remains involved in its pension scheme post-buyout. In addition to allowing the sponsor to participate in any positive (and any adverse) experience variances that may arise in the scheme run-off, this also allows changes to be made, such as granting discretionary pension increases from profits, which would not be possible under traditional contracts.
Also, the existence of an income stream clearly has value that can compensate employers for the loss of the pension scheme surplus as a balance sheet asset.
Ultimately, even if the initial pricing is comparable to traditional buyout transactions, a profit-share transaction should be more cost effective as the margins that would normally be charged by the insurer for prudence and profit, will be shared between the employer and the insurer.
How does profit share work?
Taking M&G’s captive transaction as an example, in that case a separate reinsurance vehicle was created. For traditional BPA transactions, risks are essentially pooled within the insurer’s balance sheet and backed by its aggregate capital resources.
This would make a profit-share arrangement very complicated, not just from an administrative perspective, but also because part of the capital backing all insured lives would potentially be deployed disproportionately for the benefit of just a subset of those lives – i.e. those covered by the profit-share agreement.
However, the insured liabilities held within a special-purpose reinsurer such as a captive would effectively be segregated, since the captive’s sole purpose would be to reinsure one scheme. The profits or losses as they emerged would then clearly be identified in relation to that one scheme.
The details of this case are naturally confidential, but typically transactions of this nature involve the reinsurer insuring the liabilities retained on the primary insurer’s balance sheet. The primary will pay a premium to the reinsurer for the reinsurance. Over time as excess capital is released this will be shared between the employer and the insurer.
The captive needs to be based in a territory that permits captives and/or protected/segregated insurer cell companies (the UK does not). Also the territory ideally needs to be subject to the Solvency II regime for comfort and transparency, and to have insurance passporting links with the UK allowing the business to be ceded to the reinsurer without material additional regulatory risk or constraint. We understand the captive in the M&G case was based in Guernsey.
In addition to a potentially lower operating cost structure, a captive structure may also offer additional regulatory advantages. For example, these may be reflected in lower capital requirements and/or greater investment flexibility, allowing the captive to hold less liquid assets that would not be so attractive for a mainstream insurer to hold.
Alternative profit share structures
Captives will not be attractive for all schemes, not least because there will be a minimum case size which will exclude many schemes. They are also more complex and more costly to set up than some other alternatives. From a practical perspective the employer may also be the majority owner of the reinsurer which could make decision-making between the employer/reinsurer and the primary insurer more complex.
Over the next few months, we are aware of alternative structures that are likely to emerge offering the same ability to share profit, but which may be more like traditional BPA transactions in being entirely separate from the employer. In particular the profit share reinsurance arrangement might be set up within a protected cell company structure, where each transaction has its own ‘cell’ and the set-up and operating costs of the platform can be spread between all users of that platform. Again, there will be pros and cons versus the captive approach, but these should be easier and more cost effective to set up. However, at least initially, they are likely to be available only to schemes of a similar size to the M&G transaction.
How will this impact due diligence?
Although the primary insurer is likely to be a mainstream BPA insurer, a proportion of the transaction’s risks are passed to a reinsurance arrangement. Consideration of the financial strength of the structure would need to take account of both the primary insurer and the reinsurer, and would also require a thorough understanding of the profit/risk sharing mechanism. Certainly, employers who participate in profit-shares will want to undertake comprehensive due diligence on the entities involved.
Financial information on a newly formed captive is likely to be very limited, at least initially, while access to Solvency II or other regulatory reports (if available at all given the captive’s jurisdiction) are also unlikely to be available until after a transaction has closed. Moreover, since the reinsurer in each case will most probably have been established to reinsure a single transaction, it is also highly unlikely to have a credit rating. As such any analysis of the reinsurance structure is going to require a deeper level of regulatory investigation and insurance expertise than a mainstream insurer.
Paul Galpin is head of insurance services and Richard Hall is head of covenant advisory at Argyll Covenant
