Captives and Employee Benefits. The Insider s Perspective

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1 Captives and Employee Benefits The Insider s Perspective


3 Captives and Employee Benefits The Insider s Perspective Table of Contents Foreword: The Insider s Perspective 4 The Coca-Cola Company: A Leader in Unlocking the Potential of Captives by Stacy Apter 5 Positioning the Captive as a Key Part of a Reward Strategy by Bill Fitzpatrick 7 Should a Company s Organizational Structure Affect Its Employee Benefit Financing? 10 How GM Uses a Captive to Reduce Employee Benefit Costs by Walter Ralph and Brian Quinn 12 Alternative Ways to Finance Pensions: What s Been Happening in Europe? by Mitchell Cole 15

4 Foreword: The Insider s Perspective Effective risk management should include the identification, quantification, cost-effective financing and control of all those risks that have potential for adversely affecting an enterprise s shareholders, its customers, its employees and the general public. Increasingly, employee benefits are being included within the scope of risk management. Indeed, companies are turning to risk managers and those in positions with benefit financing responsibility to take charge of the rising costs and adverse risk of employee benefits. Some of the world s leading multinational companies have addressed the cost and risks of their employee benefits with boldness and creativity. In spite of difficult financial times, they have found new ways to manage risk, improve investment returns and exercise greater control all while providing plan participants with greater-than-ever security. As the global economic crisis enters its second year, more and more companies are looking for new ways to manage and mitigate the financial risk of employee benefits. One particularly useful tool is the company-owned captive insurance company. The captive can provide a range of benefits, including dramatically reduced costs and greater control. In this fifth installment of our series on captives and employee benefits, this compendium of articles provides a window into success stories of how captives at The Coca-Cola Company, Deutsche DHL Net and General Motors have been put to work with great effect. In these examples, written by executives of the companies, captives have been used to moderate, finance or control risk. We think these cases can provide a blueprint for companies to follow to achieve their own success in employee benefit financing. We welcome your questions and thoughts on the articles. To learn more about Towers Watson and how we help organizations improve performance through effective people, risk and financial management, please visit us at For more information, please contact: Mitchell Cole For more details, visit: 4

5 The Coca-Cola Company A Leader in Unlocking the Potential of Captives By Stacy Apter, Senior Global Benefits Consultant, The Coca-Cola Company The Coca-Cola Company has been managing property & casualty risks through the use of captives since the early 1990s with positive results. In 2006, the company began reviewing other risks that might benefit from similar financial efficiencies. We didn t have to look far, as many types of employee benefits are typically managed through insurance and the risk transferred to the external insurance market. Employee benefit risk is more predictable and less severe than casualty risks. If the company was comfortable reinsuring casualty risk in a captive, why would we not manage employee benefits under the same risk management philosophy? Our initial analysis indicated that non-u.s. employee risk benefits (e.g., life, disability, health) were a very good place to begin. Over the years, we had developed two global pools that provided a range of medical, life and disability benefits to our international employees. At the height of the program, the pools included more than 100 contracts in some 50 countries. So we had a good start at an infrastructure that allowed us to manage our programs on a global basis to leverage that size and scale. We predicted that a captive model would have several advantages over a pooled model. For example, pools typically are passively managed, resulting in a delay in the availability of relevant data. This makes it difficult to utilize the information for active management of claim experience. We expected that moving to a captive model would allow us to take this from a passively to an actively managed program, resulting in more efficient pricing, more detailed claim data to manage utilization and a more detailed framework for managing programs on a global scale. In 2006, The Coca-Cola Company established its first U.S.-domiciled captive, Red Re, Inc., in South Carolina. The strategy here had multiple objectives related to tax efficiency, taking advantage of government-reinsured programs for terrorism coverage and managing our employee risk benefits. With help and guidance from Towers Watson, we issued an RFP for global insurers willing to work in a fully reinsured captive environment for employee risk benefits and ultimately selected two global partners as fronting companies for this program. The fronting insurers were asked to adapt the policy language, terms and conditions from previous policies in order to achieve a seamless transition for employees. The transition from pooling to the captive model began in And although in our first year, we had shifted only 7% of the premium formerly in the pools, the results were immediate. Depending on the market, we reduced premium 15% to 25%. Moreover, the captive model provided us with claim and financial data that we never had before. With these data, we could manage our program much more actively, begin to focus on how to use such information to align with our health and wellness strategy for the future, and improve program design. The captive model has also streamlined the renewal process. Under the old pooling arrangement, by the time we received year-end results, it was too late to do anything meaningful with that information. Now we are able to review claim experience for potential rate changes in August, finalize renewal rates by November and issue premium invoices to business units by December. By 2008, Red Re was reinsuring about 50% of the premium formerly held in the multinational pools. In 2009, we are at about 80%. Given that local medical inflation in many countries is double digit, we are positioned to manage our utilization most effectively. Captives and Employee Benefits 5

6 The Coca-Cola Company filed an application with the Department of Labor for what we believe is a revolutionary new way to fund retiree medical benefits. So, by adopting the captive model, we have maintained or improved the quality of employee benefits we offer, actively managed those benefits and realized substantial savings for the local Coca-Cola businesses. U.S. Employee Benefits Based on our positive experience with non-u.s. employee benefits, The Coca-Cola Company is now considering some interesting opportunities in the U.S., where employee benefit costs are much higher. In January of this year, we filed an application with the Department of Labor for what we believe is a revolutionary new way to fund retiree medical benefits. Under the plan, developed with the help of Towers Watson, The Coca-Cola Company would use the funds from a VEBA trust to purchase medical stop loss policies for retirees from a large, highly rated insurer. The insurer, in turn, would use the premiums to reinsure 100% of the risk with Red Re. For retirees, it would mean a lifetime guarantee on reimbursement for claims within a defined corridor of claim value, regardless of any changes that might be made to the health plan. For The Coca-Cola Company, the captive model could result in much better claim data, reduced administrative costs and the ability to participate in investment gains. Implementation is still pending regulatory approvals. Taking Captives to the Next Level For multinational companies, captives offer tremendous potential. Until now, we ve concentrated on risk benefits. But lately, we ve been looking at ways we can take our captives to the next step pensions. The Coca-Cola system has pension funds throughout the world. Some of them, like our U.S. pension fund, are very large. Others, like those in Ireland and the U.K., are medium-sized. And still others are small. However, all of them have one thing in common. They are all difficult and costly to administer. 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? Perhaps such potential exists with our captive structure and strategy. All in all, the captive strategy allows for an infrastructure to manage our employee benefit programs and risks on a global basis. With the tremendous scale of our business in more than 200 countries around the world, managing on a global basis could realize great efficiencies and benefits for The Coca-Cola Company. Stacy Apter is a Senior Global Benefits Consultant at The Coca-Cola Company, responsible for captive reinsurance initiatives for employee benefit programs. She can be reached at or 6

7 Positioning the Captive as a Key Part of a Reward Strategy By Bill Fitzpatrick, Vice President, Corporate Risk Benefits, Deutsche Post DHL Deutsche Post DHL (DP DHL) is the world s leading postal delivery, package express and logistics group. We deliver to 120,000 locations from 10,500 offices in 229 countries. With more than 500,000 employees, we are one of the world s top-10 employers. For a service company like DP DHL, a quality workforce is key. More than salary, employee benefits is one of the most effective tools in attracting and retaining talented and productive employees. DP DHL is usually one of the first transport and logistics companies to enter new markets. For example, we currently have long-standing operations in both Afghanistan and Iraq. And despite the difficult circumstances that exist in these countries, competition in the transport and logistics sectors is fierce. For that reason, a competitive and affordable employee benefit offering has become a fundamental part of our growth strategy. Benefits, even in the developing world, are expensive, especially within today s global economic crisis. However, by using our captive as a way to minimize insurer profit and frictional costs, we are typically able to provide those benefits for 20% to 25% less than if these plans were purchased through a local commercial carrier. Like many other companies, DP DHL initially formed its captive for property & casualty risks. But before long, it was realized that a captive could be equally effective for employee benefits. In 1996, we decided to expand our current captive s license to include life-based products in an effort to provide locationspecific employee benefits (group medical, life, accident and disability). Today, many would agree that our program is one of the premier examples of creative and effective uses of captives for employee benefit insurance plans. Tailoring Insured Benefits to Subsidiary Needs Our captive-based model enables us to manufacture benefit packages that are required in order to compete in most local markets. We coordinate our efforts closely with HR, which benchmarks the types and levels of benefits typically offered in a new market within the transport and logistics sector. It is the function of HR to advise us as to the types and levels of benefits that are needed for a particular market. But it s the role of the DP DHL Risk and Insurance Team in London to manufacture the needed insurance plans by utilizing the captive to achieve breakeven pricing, thereby maximizing cost efficiencies for DP DHL s local business unit. As insurers create benefit products to complement the social security and tax system within a particular country, demand for each product is created at the country level. What our employees in Canada require is very different from what is provided to our employees in Hong Kong or France, ultimately requiring our captive to offer a unique solution that is conducive to each particular country in which we operate. On occasion, due to our unique risk profile and the need to meet exposures in 220-plus countries around the world, we include plan provisions that are normally excluded by a local insurer. For example, many insurers exclude death or accident claims that are attributable to non-fare-paying passengers for air travel. As DP DHL is a transportation and logistics company operating one of the world s largest fleets of aircraft, there is the potential for an employee to utilize one of our 400-plus aircraft, creating the need to provide that employee with the appropriate coverage. Captives and Employee Benefits 7

8 Since DP DHL operates in more than 220 countries, we work with one of two global fronting companies that maintain an extensive network of country benefit operations throughout the world. It is through these networks that we are able to secure a local presence through carriers that are licensed to write employee benefit business within that market. We rely on their local actuarial and underwriting expertise to help set premium pricing consistent with the local market. We then apply a 20% to 25% discount to this pricing to achieve a breakeven premium rate for the local DP DHL business unit. With the premium already determined by the captive, the fronting insurer is then tasked to handle all claims, billing and administration by utilizing their service platform, which operates in local currency and language. Why would a large multinational insurer want to voluntarily reduce its profits, which are typically greater under locally written plans? There are a number of differences when comparing a captive program to a pooling arrangement, with the main differentiator being that 100% of the fronting company s risks and premium is transferred to our captive. Taking 100% of the risk allows DP DHL to assume 100% of the decision-making authority over the pricing of that business. By pricing our benefit business on a breakeven basis and passing the savings along to our local business units, we attain the ultimate goal of our captive model, which is to eliminate the frictional costs that exist within a majority of insurance products. In any given country, savings can range anywhere from 10% to 35%. Our overall average cost saving is 21% when compared to commercially purchased policies. While the advantages to the captives are clear, I m often asked, What s in it for the insurers? Why would a large multinational insurer want to voluntarily reduce its profits, which are typically greater under locally written plans? There are two reasons. First, by dealing with DP DHL, network insurers are dealing with an organization with operations in 229 countries. So we generate a tremendous volume of business operating in multiple locations at a reduced acquisition cost, compared to locally written plans. In fact, we write more than 40 million with just one fronting company. The second reason is retention. Since the actual products are manufactured on a breakeven basis by DP DHL rather than under the insurer s profit-driven model, which most likely includes intermediaries that normally charge commissions of 10% or more, there is no need to market this business. Locally underwritten plans will, over the long term, continue to seek a return. As long as the fronting insurer is providing services at levels that are consistent or better than local market standards, they will most likely retain the local account. In fact, we have been using a number of our local service providers for more than 12 years. That length of retention is quite uncommon in today s insurance industry. So while an insured s short-term margin may be reduced, the savings in acquisition costs combined with increased retention results is a winning combination for our network of insurers. Managing Benefit Costs With Data While the primary intention of employing our captive is to bring cost efficiency and transparency to our individual business units, an unexpected, but much welcome, dividend is the chance to collect reams of actionable data. In a pooling arrangement, claim data for the previous year will usually arrive six months into the next pooling period. But by then it s too late to apply anything that was learned from this information. When first analyzing potential network partners, a great deal of emphasis was placed on their ability to meet our quarterly reporting needs. Receiving quarterly up-to-date claim and premium information allows for greater risk assessment and case management within the overall program. This rich stream of data also enables us to assess the performance of individual countries and see how they are performing compared to others from 8

9 a premium versus claim standpoint. If there is an irregularity, we can investigate the reasons for the anomaly and work with the local office to correct the situation. In regard to shock losses (large, unpredictable claims), the ability to identify large claims allows for the increased use of a variety of techniques intended to reduce the cost of providing health benefits while simultaneously improving the quality of care. Early access to such data accelerates the early identification of trends and gives us the opportunity to proactively intercede on needed cases, allowing us to better control subsequent rate adjustments to the business unit. Access to the data also enables the risk team to develop wellness programs and deliver such programs to the local business units. As we deal with a number of different countries with varying degrees of product sophistication, the centralized control mechanism employed by the captive allows our risk team to share best practices with each of the business units. In addition to the removal of intermediary involvement at the country level, business units are required to pay premiums annually in advance to the local fronting insurer, which results in a simplification of the administration process. Local HR departments no longer have to deal with monthly invoicing or issuing checks. Paying the entire premium once a year typically translates into an investment income that we credit back to the business unit through the breakeven discount mechanism previously described. While the focus is primarily on providing local business units with competitive benefits at belowmarket costs, the parent company benefits as well. The captive model provides DP DHL control over a large portion of the premium and reserves that would normally be held and invested by the local insurer. Once premiums have been collected and the appropriate reserves have been established, a portion of the funds can be loaned back to the parent company. On the individual country front, the Department of Labor recently approved DP DHL s application to use our captive to reinsure U.S. employee benefit risks. As the margins are smaller for U.S. health care benefits, the savings generated by reinsuring through the captive are not as large as in other markets. However, there is still a tremendous amount of savings that can be realized when you consider the premium and reserve volumes in writing longterm disability cover for 20,000-plus U.S.-based employees. The captive model provides DP DHL control over a large portion of the premium and reserves that would normally be held and invested by the local insurer. All totaled, DP DHL s captive now writes 52.4 million in net employee benefit premium. That same coverage, if bought locally, would cost approximately 65 million. Our captive program results in a savings of 11.9 million, more than 18% below local market pricing. Going forward, we feel our captive will continue to develop and add value. Subduing health care expenditures continues to be a primary aim for most large multinationals. The increases in life expectancy are rapidly outpacing our ability to properly budget for health care costs. As many countries continue to shift medical costs to the private sector, it becomes vitally important that companies are ready to shoulder the additional burden. For DP DHL, our captive is not only a proven method to save money on benefits, it s a way to make us much more competitive through greater employee productivity and retention. Bill Fitzpatrick is Vice President of Corporate Risk Benefits for Deutsche Post DHL, overseeing the company s global benefits program. He is located in London and can be reached at or Captives and Employee Benefits 9

10 Should a Company s Organizational Structure Affect Its Employee Benefit Financing? Over the past several years, there has been a trend among multinational companies to centralize their organizational structure. For many, this makes sense. Centralized structures are inherently less costly. Historically, companies tend to centralize when times are tight and decentralize when times are good. But should a company act differently in its approach to benefit financing depending upon whether it s centralized or decentralized? Evidence suggests not. The key factors for a successful benefit financing program are the same regardless of how a company might structure and manage itself. Centralized or decentralized, there are 10 best practices for being successful in the implementation of a global benefit financing program and five best practices for maintaining that success. 10

11 Best Practices for Successful Implementation 1. Global insurers should be selected through a process that includes an initial screening of qualified insurers, competitive bidding by and interviews of two or three prospects, and execution of a servicelevel agreement prior to execution. 2. Whenever possible, more than one global insurer should be used to maintain a level of competition. 3. A local company i.e., sponsor liaison with local insurer is needed. 4. Regular communication with local sponsors is essential for fact finding and to ensure smooth implementation. 5. Dedicated full-time staff resources are required to lead and direct implementation. 6. Weekly progress on implementation should be tracked against specific goals of the company, insurer(s), local companies of insurer(s) and local operating companies. 7. Management information on cessions, claims and claim payments must be quarterly, no later than 30 days post-quarter close, and should be defined and agreed upon before execution of contracts. 8. Implementation should strive to achieve the highest possible penetration as soon as possible by following the 80/20 rule: 80% of the premium is usually held by 20% of the local companies. 9. Premium payment should ideally be annual, in advance, but no less than quarterly. 10. Reserves should be ceded and held by the captive where legally permitted. Best Practices for Maintaining Success 1. Establishment and rollout of governance framework and guiding principles 2. Formation of advisory committee to a captive board made up of relevant stakeholders 3. Dedicated full-time staff with clear roles and responsibilities 4. Annual price checks 5. Monitoring of the service-level agreement Unfortunately, centralizing management often leaves no one on the ground to catch mistakes and ensure local vendors are fulfilling their commitments. So what can headquarters executives do when there s no one locally to manage things full time? Make one or more managers partly responsible for the most important jobs to get done locally. Pay for performance that is, provide incentive pay tied to maintaining an amount of realized savings. Change the positions that have part-time responsibility at periodic intervals. Organizational change is important for corporate renewal. But that doesn t mean successful benefit financing programs should be dismantled to match an organizational model. Rather, benefit programs should adapt to the structure in ways that do not sacrifice essential factors that make it successful. Captives and Employee Benefits 11

12 How GM Uses a Captive to Reduce Employee Benefit Costs By Walter Ralph, Manager, International Benefits, General Motors and Brian Quinn, Chief Underwriting Officer, General International Limited Even during a worldwide economic downturn, competition in the global auto marketplace is fierce. Employee benefits remain an important and necessary, albeit expensive, tool in attracting and retaining valuable human capital. Fortunately, General Motors (GM) has been able to dramatically reduce the cost of health insurance, life insurance and other employee risk benefits by using our captive insurance company, General International Limited, as a way to control the cost of risk and recoup margins built into industry rates. Indeed, using our captive has enabled us to make use of economy of scale a fundamental tool of the auto industry to reduce costs and streamline our employee benefit programs to their most essential elements: claim payment and administration. Today, our captive-based program, which covers some 50,000 non-u.s. employees and 125,000 dependents in more than 40 countries, saves GM 35% annually when compared to the dozens of multinational pools and uncoordinated locally sourced plans it replaced. Before transitioning to the captive program, GM relied on a patchwork of local insurers to provide employee benefits to its non-u.s. employees around the world. In many cases, we needed more than one insurer per country. Moreover, as we continued to expand, we realized things would get even more complicated. We have a saying here at GM: Promise what you must to attract and retain employees. But pay only for what you promised. Our promise to employees has always been that their claims would be paid. No more, no less. And we believe that is all that they appreciate, so why would we pay for more? In addition to paying their claims, we saw that the premiums we were paying the local insurers were also going to frictional costs of all kinds, such as company profit, broker s fees and the cost of risk all multiplied many times over. Needless to say, it was very inefficient and costly. And of all these extraneous costs, it was the local provider s cost of risk, and its attendant volatility, that was the big cost driver. We realized that, if we could somehow reduce that cost of risk, we could dramatically reduce the cost of coverage. But how? The answer lay in General International Limited, the captive GM founded in 1981 to aid in the provision and financing of property, liability, marine and sundry other non-life risks. Unlike other captives, GM s captive is a self-managed (by GM employees) entity, led by Brian Quinn, its Chief Underwriting Officer, who shares leadership responsibility for this program with Walter Ralph, Manager, International Benefits. Under the plan, first proposed by Towers Watson, GM contracts with a fronting insurance company to provide benefits in each local market. The local insurer then transfers 100% of its risk to GM s captive, which acts as a reinsurer. Claims paid by the fronting insurer are reimbursed by the captive. The goal is to underwrite the risk across the globe to a breakeven annual result and not make a profit on the program. Unlike other captives, GM s captive is a self-managed entity. While simple in theory, putting the plan into practice was another story. We assigned a twoperson team one from Finance, the other from HR to spearhead the initiative. Their first order of business was finding the fronting insurers with a global footprint similar to GM s that were also willing to transfer 100% of the premium and risk to the captive. The number of insurers with that kind of international coverage is small. However, after 12

13 18 months of due diligence, we were able to narrow it down to two global companies that had a presence in all the countries we operate in. These fronting insurers were then asked to develop policies that were identical in terms, benefits and conditions to the policies being replaced. Naturally, benefits varied markedly country by country, and even within a country between different business units. For example, coverages in the U.K. were very different from those in Ecuador. But in all cases, we wanted to make the transition from the old insurer to the new insurer as seamless as possible. Using local market practice as well as inflation indicators, the fronting insurers calculated a premium rate for the local programs. The captive underwriter then reviewed the locally developed premiums and, using GM s own financial models, calculated a captive rate that was generally considerably lower, as the model is not looking for profit, and frictional costs have been stripped out. Once a local program is in place, local GM business units pay their premium to the fronting insurers, just as they did before. The fronting insurers use those premiums to pay current claims and remit the remainder on a quarterly in-arrears basis to GM s captive. The captive reimburses the fronting insurer for any claims paid in excess of premium collected in any quarter. The program is designed so that annual claims, plus the cost of administration, should approximate the annual premium paid by the global business units participating in the captive program. To ensure accurate premium pricing, the team occasionally undertakes local benchmarking exercises using brokers, consultants or local insurers on a fee-only basis to provide pricing and coverage comparisons versus our peer group. A Benefit Program That Pays Benefits Consolidating all of GM s disparate international benefit programs under our own captive has resulted in significant benefits. Cost savings: Transferring all the volatility risk from local insurers to our captive removed the single greatest cost driver. And, as GM owns the captive, cost savings rather than profit are the primary goal. When compared to the cost of the unconsolidated, locally sourced programs it replaced, GM s new captive-based system saves about 35% annually off the structural cost of the employee benefit programs. Elimination of frictional costs: Since the captive is managing the premium to a claim-plusadministration cost level, there is no need for brokers, which typically add anywhere from 10% to 25% to the local cost. Flexibility: GM is able to provide a highly customized level of service and benefit offerings attuned to the needs of local employees and markets. Unlike self-funded programs, the captive-based program is equally effective in markets in which GM has a small number of employees. Indeed, it is the smaller business units that often experience the greatest (relative) savings. Improved governance: The captive-based program generates detailed reports/claim data from the local business units that was not made available before. These additional data enable GM to compare local programs, develop improvements, implement wellness programs and develop other loss-prevention strategies. The voluminous data also enable GM to better understand its long-tail/latent liabilities and find better ways to mitigate them. Ability to actively manage funds: The captive-based reinsurance structure provides a host of financial advantages to its corporate parent. For starters, the captive has access to premium cash flow before claims are paid from loss reserves. Any excess of premium over claims throughout the year is invested by the captive in its funds inder management as appropriate. In addition, investment income further reduces benefit costs to GM units as investment earnings are also used to pay claim and administration costs. Finally, investments can be managed with a greater degree of control. Captives and Employee Benefits 13

14 Slow Start Despite its savings potential, the captive-based program got off to a slow start. Local business units were reluctant. Many had relationships with local insurers. Others feared employee benefits would be negatively affected. For some, it was just plain inertia. For a captive-based program to succeed, it is vital that Risk Management and HR work together very closely or be coordinated by a proven team of project managers. In 2002, our first year of operation, savings on the $4 million total premium written was $500,000. But as participating business units saw their premiums continue to drop, managers at nonparticipating business units started to take notice. By 2008, total global premium had grown to $70 million. Greater participation generates greater savings. Today, the captive-based program provides benefits to approximately 85% of our non-u.s. employees and saves GM more than $35 million annually. Said another way, absent the use of the captive, GM s annual global premiums would have been $105 million. Moreover, we ve been able to achieve these savings with no loss in benefit or service quality. In some cases, where required, we have been able to improve benefits at no extra cost. Detroit. For a captive-based program to succeed, it is vital that Risk Management and HR work together very closely or be coordinated by a proven team of project managers. Needless to say, our team has been highly successful. Together, they have become internationally renowned experts in captive employee benefit programs and financing. Despite its success, we do not use the captivebased structure for GM s domestic insurance liabilities for two reasons. First, because of the huge scale of GM s benefit programs in the U.S., costs are already very close to that of selfinsurance. And second, even if we did want to adopt the captive reinsurer structure here in the U.S., it would require Department of Labor approval. Owing to the size of GM s programs, that would be a long and tedious process for both GM and the Department of Labor. In summary, our international experience with a captive-based program has been excellent and has the full support of the senior leadership of the new GM. It will be a key part of GM s HR financing strategy into the future as GM expands and grows globally. Walter Ralph is Manager, International Benefits, at General Motors. He is located in Detroit and can be reached at or Brian Quinn is Chief Underwriting Officer at General Motors captive, General International Limited. He is located in Bermuda and can be reached at or Though it generates enormous savings for GM, the captive-based program is administered by just two employees Brian Quinn, the captive underwriter/ manager located in Bermuda, and Walter Ralph, GM s international benefits manager located in 14

15 Alternative Ways to Finance Pensions What s Been Happening In Europe? by Mitchell Cole, Towers Watson Some surprising findings emerged from a survey conducted this past spring by Towers Watson and CFO Research Services. The survey found, among other things, that despite the economic downturn, companies will seek ways to ensure their plans long-term viability, and they will do so with a greater focus on mitigating the risks in their pension portfolios. With this in mind, we looked to see what approaches might be useful for U.S. financial executives to consider. In doing so, we turned to several recent developments in Europe that seem worthy of consideration. New Pension Financing Options Figure 1 shows a range of pension financing options currently available to plan sponsors. The horizontal line represents the amount of risk assumed by the sponsor, while the vertical line represents the cost of transferring that risk. The traditional annuity purchase option is found, as expected, in the upper left-hand corner. It can be very costly, but it also transfers all of the plan risk. Other traditional financing approaches like asset immunization can also be costly, but they also remove much of the risk. The figure also displays several new or alternative financing approaches that have been developed to help executives manage pension risk. The central element of these alternatives is a desire to enhance control over the plan to facilitate effective risk management. These new alternative financing options enable sponsors, whose ability to act has historically been very limited, to take control by either removing volatility entirely from the pension investment portfolio, or being in a position to exercise and execute independent judgment over risk management, allocations and even surplus capture. Figure 1. Alternative pension financing Why use alternatives Control Cost savings Cash flow...and why use insurers Capacity Credit risk management Capability High Cost Annuity purchase Buy-ins Traditional asset immunization Custom insurance Interestrate overlay strategy Cashouts/ other exercise of options PensionCAP* Low Control Cross-border pension pooling Low Traditional offering *Patent pending in the U.S. Degree of risk assumption Alternative financing approaches High Captives and Employee Benefits 15

16 Here are a few examples. Pension Buy-Ins and Buyouts One alternative financing strategy that is growing in popularity in the U.K., and could be applied in the U.S., is the pension buy-in, a close cousin to the traditional buyout (Figure 2). Buy-ins and buyouts are both ways for companies to de-risk their pension liabilities. Fundamentally, they are bulk annuity contracts insurance policies that address a number of risks, such as investment, inflation and mortality risk. In a buyout, the company and trustees seek to transfer all of their responsibilities to a third-party insurer. This way they can terminate the plan and discharge their liabilities in full removing pension liabilities from their balance sheets and outsourcing administration of the fund to the insurer. In a buy-in scenario, the annuity is purchased by the trustees at the encouragement of the plan sponsor. The buy-in is treated very much like an investment because it provides a regular stream of income to the plan. A buy-in enables sponsors to match their liabilities, avoid additional contributions for the obligation annuitized under the buy-in due to investment and/or interest-rate volatility and, most importantly, avoid accounting settlement costs. Since 2007, the use of buy-ins in the U.K. has grown about 50%, with much of this growth coming from new insurance industry players. Since summer 2009, buy-ins are being offered in the U.S. for the first time. There is already substantial interest in this new-to-the-u.s. instrument, which we expect to grow in popularity and use. However, the buy-in is more complex than a quick glance might imply. There are accounting, cost and cancellation considerations that factor into whether it makes sense for an individual company. (See Towers Watson s white paper, Emerging Solutions in the U.S.: Investing in Annuities Why Now, What Next? ) Cross-Border Pension Pooling Another pension financing method gaining popularity in Europe is cross-border pension pooling. Made possible by the European Union s Pension Funds Directive of 2003, cross-border pooling provides sponsors with new tools to consolidate and optimize their pensions on a global basis. Figure 3 shows how cross-border pooling can improve governance, improve investment results and provide sponsors with greater control. Across the top in dark red, you will see a range of local country groups. A, for example, is a country defined contribution (DC) plan that is unique and stands alone. Country plans B, C and IMEs (internationally mobile employees) have been combined into a single-entity cross-border platform called an IORP or institution for occupational retirement provision. Country employee group D is a large, efficient plan with no reason to be commingled with any other plan, but that can participate in a cross-border asset-pooling vehicle. On the right-hand side, we have a collection of defined benefit (DB) plans. Some are stand-alone; some have been combined with others into an IORP, and some have joined the cross-border asset pool on their own. Plan E, for example, could be a U.S. pension plan if the pool s sponsor so desired. All of the individual plans respect the tax, labor and social regulations where their participants live, while the cross-border pool enjoys a more favorable funding environment and operates under a unified management. Figure 2. Example buyout and buy-in structures Buyout Buy-in Plan sponsor Plan sponsor Pension plan Annuity premium Insurer Benefit payments Pension Plan Benefit payments Annuity premium Monthly payroll Insurer Plan participants Plan participants 16

17 Figure 3. Cross-border pension pooling structures Defined Contribution Defined Benefit Country employee group A B C IMEs D E F G IMEs H Local country DC plan Local country DC plan Local country DB trust Local country DB trust Local country DB trust IME plan Local country DB trust Cross-border DC platform (e.g., IORP*) Cross-border DB platform (e.g., IORP*) Optimizes fiduciary, compliance and plan governance risks Cross-border asset-pooling vehicle (with subsections) Optimizes financial and demographic risks (in an enterprise context) Optimizes asset management arrangements (governance, cost, return) *Institution for occupational retirement provision, under EU Directive Needless to say, the consolidation of assets as part of a cross-border pension pool can generate significant synergies and efficiencies. Moreover, the use of a cross-border pension structure can also facilitate the use of alternative financing techniques such as buy-ins and buyouts. But the primary benefit of cross-border pension plans remains improved risk management and governance, which continues to become increasingly rigorous on both sides of the Atlantic. Pension Captive or PensionCAP PensionCAP (captive annuity program) makes use of two well-known transactions in the insurance industry. The first is a standard bulk annuity buyout; the second is a buy-in. Here s how it works: If a plan s sponsor and/or trustees want to terminate a plan, they purchase a buyout annuity from a fronting insurer. If they want to immunize a plan, they purchase a buy-in (Figure 4, next page). By prearrangement, the insurance company issuing the annuity purchases a 100% quota share reinsurance policy from the sponsor s captive. The transaction passes the risk through the insurer to the plan s sponsor through the captive. At first blush, it would seem as if no risk has been transferred. So why bother? The answer is control. Most pension plans are governed by corporate oversight, local management, employee representatives and independent trustees. Under these circumstances, executing integrated risk management policies is very difficult and timeconsuming. But by assuming the risk from the insurer, the sponsor places the responsibility of oversight in the hands of its captive s management professionals with the training and expertise to manage global pensions in a consistent and integrated manner. While control is the principal benefit, there is also the potential to realize long-term cost savings. Working with a fronting insurer willing to reinsure with the sponsor s captive, the cost of capital and profits can be stripped out. Essentially, it is a way for the plan sponsor to buy annuities wholesale instead of retail. Moreover, in many countries, the technical rates for annuity prices are set by law and are often very low. Managed under the captive, profits can be returned to the plan sponsor as dividends or used for other projects such as global pension pooling. And because profits revert to the plan s sponsor, this also eliminates the asymmetric risk associated with trapped surplus a problem that can plague pension plans. Captives and Employee Benefits 17

18 While the plan sponsor is responsible for adverse plan deviation, the captive provides a unique opportunity to limit downside risk. If and when necessary, the insurer and captive can agree on plan termination, essentially placing a cap on pension plan obligation. PensionCAP enables clients to reduce the cost of annuities by changing the location where the risks are managed, rather than the risks themselves. It provides clients with a more efficient means of managing those risks and a more effective way of exercising risk management. Closing the Gap When choosing the pension financing approach that s best for their organization, most European financial executives follow a three-step process: 1. Determine how much risk the company is able and willing to assume. They first consider how much risk their company should retain and how much it should transfer. Then, working closely with providers, they look at ways to assume or transfer those risks using traditional and/or new methods. Finally, they set a timetable to get from where they are today to where they want to be. The alternatives described above seem ideal for many U.S. sponsors to consider, especially those sponsors not contemplating the demise of their DB pension plan. These alternatives represent an emerging complement to the traditional, capitalmarket-based strategies available to plan sponsors to mitigate risk in their pension plan. Mitchell Cole is a Principal in Towers Watson s Stamford, CT office and is actively involved in the company s Retirement Risk Solutions practice. He can be reached at or 2. Assess whether refinancing is necessary and how. 3. Set a timetable for achieving the refinancing, possibly using alternatives in combination. Figure 4. How a captive works Benefit plan Annuity premium Claims or Fronting insurer Benefit plan purchases insurance (for a single premium) at a given cost (say the prevailing market cost from AA insurer) Insurer reinsures to captive and passes assets to captive Reinsurance Captive Employer has control of assets and can liberate any emerging surplus 18


20 About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Originally published by Towers Perrin in Copyright 2011 Towers Watson. All rights reserved. NA

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