Capital Backed Products: What Is The General Consideration?

2nd June, 2023

  • Capital backed end-games: they are in fact essentially all the same construct and therefore present Sponsors and Trustees with the same advantages.  

    Core to any transaction is the reliance on post-transaction oversight of the capital supplier.  Some focus is put on the insurance/PRA framework, but the same issues prevail on any proposed solution which includes a capital injection.


    There has been much industry debate over the “end game” for defined benefit (DB) schemes.  Remarkably, and probably the subject of much further debate, is the relative (or some might say, complete) absence of a discussion on “run off” as a viable end game.  To the extent run-off is considered, it looks unchanged from the current status quo.  Given some of the horror stories emanating from the LDI crisis, a sponsor might question if trustee Business As Usual (BAU) really is a good strategy for a scheme where they don’t want any more surprises. 

    The approach as to what constitutes “run off” today just may not be fit for purpose. But that is a subject for a separate article and debate.  This article is about what can be done better within and under the Pensions Regulator’s (tPR) framework.

    In this article I will summarise all the constructs which include “capital”, be they the vibrant (as the Bank of              England (BoE) might suggest) insurer-backed life policies, insurance proxies thereof such as captives or those coming out of eg Gibraltar or similar regulatory environments, or the myriad of capital backed journey plans (CBJP’s).  Having looked at and reviewed a broad sweep of the market with colleagues, it becomes clear that any plan or proposal which involves a capital injection can all be summarised as follows 1 :

    • There are only two sources of capital: from the sponsor or from a third party.
    • We can define capital as essentially being a loan (the Loan) to the scheme:
      • The Lender (or provider in more common terminology) will want its money back. The sponsor, in particular, does not want to generate any more “trapped” assets.
      • The Lender will want a return on the Loan
      • To generate a return on the Loan in excess of the generic yield of the asset portfolio, the asset yield has to increase (and economic theory suggests with increased yield comes increased risk) and
    • By giving the Loan, the Lender expects some terms and conditions to attach to the entire or a major portion of Trustees’ asset pool. These tend to have both economic and control characteristics and can include:
      • moving to a different regulatory environment and/or
      • moving to a specific investment vehicle and/or
      • terminating or changing the relationship with the existing trustee arrangement and/or
      • terminating the sponsor covenant and/or
      • investing is different asset classes or with different managers with or without Trustee approval being required.

    I believe every “capital product” can be characterised as a Loan, including a Solvency II buy-in/out risk transfer exercise. And the driving purpose of this article is to demonstrate that despite structural differences, they can all be analysed from a simple set of base principles.  It’s a bit like the car market: lots of different cars but really, they are all just boxes with a wheel at each corner and a source of motive power.

    From an initial glance, there are two “game changers” to be factored upfront into the consideration, as referenced above:

    Does the regulator change and, much more relevant for a corporate, is whether it can sever its relationship with the scheme? There is no doubt that the majority of UK plc never intended to have to run an off-balance sheet life assurance company: it is not a core business to most sponsors 2.  This corporate mismatch can be the primary driver to the sponsor thinking along the lines of Henry II: “Will no one rid me of this turbulent priest?”.  Today, apparently and unfortunately, the only credible solution to severing the link is risk transfer.

    But even in this channel of thought, is the sponsor given full disclosure on embedded costs, alternatives and reputational matters?

    This article does not explore in detail the legal structures used to inject or lend capital into a DB scheme, but it does highlight core implications and considerations for the scheme’s trustees and their members which cover most  variants of this theme.  Sponsors may also find the thought process here a useful benchmark to discuss with their advisers.

    What does manifest itself is the role of the regulator.

    It becomes increasingly clear that the role of the regulator going forwards is central to any governance transfer from trustee to oversight provided by eg the Prudential Regulation Authority (PRA) or increased surveillance by the Pensions Regulator (tPR).  Connected, if you change regulators (or believe that some non-trivial oversight powers have been ceded away from the trustee to a third party), what should you do to satisfy yourself that the new regulatory arrangement has your back (or your members’ backs), so to speak?

    Types of Capital Injection

    There are several ways in which capital can be injected into a DB scheme. These include:

    1. Scheme Sponsor

    If the scheme sponsor has sufficient financial resources (and an appealing construct is proffered), it may decide to inject capital into the scheme provided these funds do not become trapped in the way that a normal contribution might do 3. This injection can be done via various financial industry standard structures: by way of example, the assets of the scheme could be transferred into a bankruptcy remote cell and the sponsor lends to that cell and takes a subordinate position in the cell’s capital structure.  The cell is not the pension fund.  That additional step is the basis for a captive insurance solution for instance.

    The general advantage of the sponsor making the capital Loan is that the sponsor is likely to have (or thinks it has) a vested interest in ensuring that the scheme remains financially and economically viable, as it remains ultimately responsible for meeting the scheme’s pension obligations.  And as there is no third party looking to be paid, the construct can be seen to be both transparent and economic.  Such products are quantitatively cheaper than handing the liabilities off to an insurer for instance, but the economic savings can accrue over years, not upfront 4.  Reputation risks in such an exercise are generally aligned.

    It is plausible that under such a structure, because the sponsor believes it has an influence or relationship with the trustee board, that the trustee board will have to give up fewer oversight rights and controls than it would have to a third party lender/capital provider.

    We shall address the governance implications further below.

    2. Third-Party Provider (3p-Provider)

    Alternatively, a 3p-Provider may be willing to provide capital to the scheme. This can be done in a number of ways.  At one end of the spectrum, you have FSCS Solvency UK wrapped insurance policies (regulated by the PRA) and then, at the other, CBJPs where the scheme does not leave the regulatory environment of a Trustee board overseen by the tPR.  If that is the X-axis, then the Y-axis is whether the sponsor’s covenant remains in place: if the link to the sponsor covenant does cease, then trustees need to be very comfortable that the 3p-provider and the arrangement is subject to robust and appropriate regulation, where the regulator has the resources, skills and incentive to replace the trustee board’s interests where the trustee board is forced to give up such oversight.  This is a non-trivial step: regulations are there to keep in check capital provider’s enthusiasm to making one turn on its capital too many.  If the link to sponsor’s covenant does not cease, then the sponsor is effectively also underwriting the risk of the CBJP failing (for instance in a buy-in arrangement) so the sponsor also needs to make sure that the regulatory oversight of the CBJP is fit for purpose.

    By introducing a 3p-Provider, it is possible that the provider will claim to have better expertise in managing asset-liability books and risk management than the existing trustee/adviser/asset manager set up.  This may both appeal to the sponsor and be true.  However, the 3p-Provider is going to want some degree of control over the assets and how they are managed, which is a major governance concern for both the scheme’s trustees and the sponsor.  Many believe that oversight provided by the BoE is sound, but even the BoE states “there will be occasions when events will show that the supervisor’s judgement, in hindsight, was wrong.” 5.    

    But apparently this governance transfer is not an impossible mountain to climb: after all £-billions of assets are handed to bulk annuity providers where the trustee rescinds complete control, title, transparency or voice over how the assets are managed from the moment of handing them over.  

    It is worth thinking why the PRA is seen as able to take over the onerous tasks of looking after members’ benefits and whether other entities are suitably equipped: why does the trustee feel so confident about allowing such a transfer of oversight to a third party, either in full through a buy-out or partially in a CBJP?  After all members still need to be paid, and ensuring such is exactly what the Trustee role is/was.   In all transactions, who is the Trustee relying on – the capital provider or the regulator? Or both?

    A Few Observations and Focus on the PRA and Trustee Assumptions

    It is worth noting therefore that the primary rationale for entering into any structure which involves a capital injection has to be a recognition of what reliance is the trustee making on the regulator (e.g. the PRA) and whether it will do and can do the right thing when required to protect members/policyholders (who, in the insurance example, have no rights of redress of their own), which includes monitoring, enforcement and the necessary legal powers therefore 6.

    With the PRA in focus, if a trustee does not have that ultimate confidence in the PRA, then it should not execute a bulk annuity transaction.  Some legal eagles would argue that such sensitivities should not matter to trustees because of the legal exclusion provided by the Pensions Act: once the policy stands between the members and the trustee, the “trustee is off the hook”. It is interesting to note that I have never seen a review of exactly what resources the PRA does have to hand to regulate the entire life insurance industry: the industry (and therefore trustees) appears to assume the PRA will always do its job with apparently absolutely no due diligence being done on the regulator in whose care all the policyholders are being put.  How have trustees got comfortable with the body that effectively replaces them as the “defender of members’ interests” with no information provided? I suspect that reliance is based on a broad presumption about the PRA and that there is some reliance on the “get out of jail” cover provided by the aforementioned specific discharge offered by the Pensions Act 1995, section 74, paragraph (3)(c) 7.   But where does that presumption come from?

    Is it this simple reliance on the PRA within the “gold standard” aura of insurance or is it just an assumption without basis?  The presumption that any insurance capital provider will be rigorously and continuously overseen, which is the core comfort for trustees being able to hand members over into the insurance regulatory environment, is pivotal. 

    But what about 3p-capital providers outside of the PRA’s purview?

    Once control to any degree is handed over, in any non-PRA overseen 3p-capital backed structure, who exactly is going to make sure the capital provider behaves and does what it says it is going to do?  How can they be monitored on a real-time basis?  Are the right incentives in place to ensure the capital provider will “do the right thing”?  What is the recourse if it does not?  How quickly can the controls be repatriated to the trustee board in the event of a provider that fails or fails to do what they said they would ?  Who is going to tell the trustee board if something has happened?

    Further,  is the trustee board equipped to oversee the capital provider?  Will/can proper risk controls be established and monitored by the trustee?  Does the capital provider have to keep the trustee board informed?  Does the regulatory overseer (whoever that might be) have the resources and competencies to do its job?  This is a broader question than just tPR regulated 3p-capital providers: there are also offshore regulators to think about: Bermuda, Delaware, Guernsey or Gibraltar for instance.  It may be that you can sleep easy  knowing that members have PRA oversight, but can the same be said of all offshore regulators?  These off-shore regulators may be involved directly as being part of the “solution” or indirectly, through “funded reinsurance” transactions, transactions which the BoE pointed out in April 2023 “were of concern”.

    And along the same lines, the fact that the PRA is offered as an infallible regulator, strong enough to warrant allowing such absolute and complete governance transference, then is any other regulator being asked to regulate a 3p-capital provider operating outside of PRA purview definitionally below the “gold standard” PRA?  Whereas no one got fired for buying IBM, a lot of people got fired for buying RadioShack.

    Getting comfortable with the answers to this question of “is the regulatory regime sufficiently robust” is probably why non-PRA regulated CBJP’s have not taken off: who is monitoring the capital provider?  Who is capable of monitoring the capital provider?  Who is capable of detecting when the capital provider has gone rogue?  How much control, using today’s level of asset control as ground zero, is it safe for a trustee to hand over to any CBJP? 

    Put this way, it is challenging to see  how any CBJP (outside of those regulated by PRA itself) is going to overcome this fundamental objection.  And I can’t see many advisers sticking their necks out on this matter either.  However, an interesting thought does arise in that focus since it would appear to me that, the “gold standard” might of the PRA has never actually been subject to any due diligence by the advisers.  Happy to be corrected, but, if correct, where does their confidence come from?

    For trustees, the power of the relevant regulator to control the capital provider/lender is the critical governance consideration.

    For more information or would like to discuss further, contact Paul Brine


    1 This assumes that the scheme in question is “reasonably” funded and is not headed to the PPF.

    2 And if it is, it is worth pointing out that they would be very unlikely to do the same unsecured risk transfer transaction with a third party.  An article on this to follow…..

    3 I assume that all sponsors suffer the same results of putting £1 into the pension fund: no chance of getting it back until the last member dies (or the scheme is past off to an insurer) and should there be a £1 surplus, 35p goes off to HMRC.

    4 I believe some “tax efficient” arrangements can be structured out of, for example, Scottish Limited Partnerships which has the effect of upfronting the tax advantages but little or no actual commercial or financial risk impact.  This paper does not address structures which are primarily driven by “tax efficiencies”, which a sponsor may or may not choose to avail itself.

    5  The Prudential Regulation Authority’s approach to insurance supervision October 2018.  Admittedly, this statement is taken slightly out of the BoE’s context but the BoE admitting oversight fallibility is the key concern here.

    6 Many advisers would comment to the trustee at this point that comfort can be taken in the 100% FSCS cover as well.  There is considerable advice available that relying on FSCS cover should not feature at the forefront of a Trustee’s considerations as the “evidence” for relying on such security is, at best, conjectural.

    7 In the vernacular: “if you hand all your assets and liabilities to a regulated [UK] insurer, you are off the legal hook to look after members’ interests.”  One could argue, therefore, that the only due diligence a trustee needs to do on the insurance product is to confirm that on the date of transaction, the insurer met the requirements of the Pensions Act.

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    • Published byPaul Brine

      Paul has over 16 years’ experience as a trustee (including 10 years as an independent), having served on a variety of schemes from £50mn in assets to £3.5bn, across defined benefit, defined contribution, and hybrid structures. Paul has also chaired...

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