ALESCORMS.COM BASE EROSION AND PROFIT SHARING (BEPS) THE IMPLICATIONS FOR CAPTIVES 1 - http://www.oecd.org/ctp/beps-actions.htm In September 2018, the Organisation for Economic Co-operation and Development (OECD) published a draft discussion paper 1 on the transfer pricing aspect of financial transactions as part of the Base Erosion and Profit Shifting initiative (BEPS – Actions 8-10) with a focus on Multi National Enterprises (MNEs) and intra-group transactions. The discussion paper invited comments from the industry for the paper’s section on captive insurance companies. NOVEMBER 2018 The OECD paper recognises that captives can be established and used for various commercial reasons including: • Stabilisation of insurance premiums • Tax and regulatory arbitrage • Access to reinsurance markets • Risk retention (when retaining risk ‘in-house’ is considered more cost effective) • Obtaining insurance coverage for certain risks considered difficult or impossible in the commercial insurance market. The position of the paper is interesting because it reflects the more recent shift in attitude that captives are a legitimate, formal, self-insurance vehicle offering genuine insurance benefits - rather than being simply established for solely tax reasons. The OECD also debated the difference between risks the insured has no control over (such as property damage), and those where there is an element of control (such as product recall) to consider if insuring such risks in a captive can be considered ‘real’ insurance with risk transfer. In fact, the vast majority of insurance contracts have an element of control for the insured. Risk managers across all industries will often point to self-insurance as a motivating factor to reduce claims by the introduction of formal health and safety training and enterprise-wide risk management practices. The following indicators are generally used to consider if a captive is providing independent insurance: • The diversification and pooling of risk • Whether the economic capital position of the group has improved as a result of diversification of risk (typically by the captive writing some non-group risks or by reinsuring the risks it insures outside the group) • Whether the captive insurer (or reinsurer) is a regulated entity under regulatory regimes that require evidence of risk transfer and appropriate capital levels • If the insured risk would otherwise be insurable outside the group • Whether the captive has the skills (including investment skills) and experience to write and manage the risk portfolio - including whether it has employees with specific underwriting expertise • The real possibility of the captive suffering claims.
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ALESCORMS.COM
BASE EROSION AND PROFIT SHARING (BEPS) THE IMPLICATIONS FOR CAPTIVES
1 - http://www.oecd.org/ctp/beps-actions.htm
In September 2018, the Organisation for Economic Co-operation and Development (OECD) published a draft discussion paper1 on the transfer pricing aspect of financial transactions as part of the Base Erosion and Profit Shifting initiative (BEPS – Actions 8-10) with a focus on Multi National Enterprises (MNEs) and intra-group transactions. The discussion paper invited comments from the industry for the paper’s section on captive insurance companies.
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NOVEMBER 2018
The OECD paper recognises that captives can be established and used for various commercial reasons including:
• Stabilisation of insurance premiums
• Tax and regulatory arbitrage
• Access to reinsurance markets
• Risk retention (when retaining risk ‘in-house’ is considered more cost effective)
• Obtaining insurance coverage for certain risks considered difficultorimpossibleinthecommercialinsurancemarket.
Thepositionofthepaperisinterestingbecauseitreflectsthemore recent shift in attitude that captives are a legitimate, formal, self-insurance vehicle offering genuine insurance benefits-ratherthanbeingsimplyestablishedforsolelytaxreasons.
The OECD also debated the difference between risks the insured has no control over (such as property damage), and those where there is an element of control (such as product recall) to consider if insuring such risks in a captive can be considered ‘real’ insurance with risk transfer.
In fact, the vast majority of insurance contracts have an element of control for the insured. Risk managers across all industries will often point to self-insurance as a motivating factor to reduce claims by the introduction of formal health and safety training and enterprise-wide risk management practices.
The following indicators are generally used to consider if a captive is providing independent insurance:
• Thediversificationandpoolingofrisk
• Whether the economic capital position of the group has improvedasaresultofdiversificationofrisk(typicallyby the captive writing some non-group risks or by reinsuring the risks it insures outside the group)
• Whether the captive insurer (or reinsurer) is a regulated entity under regulatory regimes that require evidence of risk transfer and appropriate capital levels
• If the insured risk would otherwise be insurable outside the group
• Whether the captive has the skills (including investment skills) and experience to write and manage the risk portfolio-includingwhetherithasemployeeswithspecific underwriting expertise
• The real possibility of the captive suffering claims.
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2-https://www.ferma.eu/sites/default/files/2018-09/FERMA%20response%20to%20OECD%20BEPS%20Public%20Discussion%20Draft%20-%20FULL%2007.09.18.pdf
3 - https://www.ferma.eu/sites/default/files/2018-02/FERMA-Captives%20in%20a%20post-BEPS%20world.pdf
The OECD report appears to highlight some concern where local regulators are imposing a lighter regulatory regime to captives writing group business, compared to insurers providing policies tothirdpartyconsumers.ThisisapointthattheFederationofEuropeanRiskManagementAssociations(FERMA)takesissue with claiming that, ‘the regulatory regime is not lighter. It is proportional in that captives and other traditional but less complex insurance carriers have to meet all the regulatory requirements that a commercial insurer does, but captives and other small entities have proportionality in how they meet those requirements.’2
To establish arms’ length pricing, the ability to benchmark prices (rates) with comparable arrangements was proposed - provided adjustments for volume and other differences are taken into account.Forlargercaptives,actuarialanalysiswasconsideredto be an appropriate method to independently determine thepremium.Forsmallercaptivesatwostageapproachof assessing the combined loss ratio and return on capital/investment could also be used to determine reasonable pricing.
The OECD accept that there will be differences between the level of capital held by a captive compared to a commercial insurer and this in turn has an impact upon investment return. The most difficultareastillappearstobedetermininganarm’slengthpriceandthecommercialrationalityof‘uninsurablerisks.’Manybuyers and captive managers are dismissive of the OECD’s suggestion that if a risk cannot be insured in the commercial market then it cannot be considered an ‘insurable’ risk. The rapid expansion of the cyber insurance market in recent years is an example of a risk that all the main carriers are now offering to cover for - yet there was effectively no commercial insurance capacity a few years ago.
InaseparatebriefingissuedinJune20183,FERMAnotedthree main aspects of good practice and transparency that demonstrate a good captive with a genuine enterprise risk management purpose:
1. COMMERCIAL RATIONALEThe captive owner should be able to show how the captive is used as part of its enterprise risk management programme to managethetotalcostofrisk(TCOR).Forexample,thecaptivemayincreasetheefficiencyoftheenterprise’srisktransferprogramme or add capacity that is not easily available in the commercial market, especially where the exposure is beyond thecompany’sriskappetite.Formultinationals,reducingthenumber of local policies can save on premium spend and reduce the likelihood of duplication of coverage.
2. SUBSTANCE AND GOVERNANCEThe captive may outsource its day to day management, but it needs to demonstrate that it is an operating entity with direction from the owner, including underwriting and investment policies, and a physical link to its domicile.
The number and volume of contracts and claims activities are key criteria for deciding whether the captive should hire employeesoroutsourceservices.FERMAsuggestathresholdof1,000hoursoftechnical(re)insuranceactivitiesperfinancialyear above which it would be necessary to hire a full-time employee.
The captive needs to comply with Solvency II or another risk-based regulatory regime acceptable to the International Association of Insurance Supervisors (IAIS) and have a suitable corporate governance code. It should make regular andtransparenttechnicalandfinancialreportstothelocalinsurance regulator.
3. APPROPRIATE TRANSFER PRICING Risk pricing needs to be documented and transparent; it should be comparable with commercial transactions, adjusted according to appropriate factors. This can be done by reference to quotes or benchmarking from third parties or models using standard actuarial methodologies, considering the exposure, loss history and cost of capital.
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TheLondonmarket’sperspectiveAgoodcaptiveisanefficientriskmanagementtool,asithelpsto expand the scope of available risk transfer, manage the total cost of risk, mutualise risks across the group, and strengthen the negotiating position with commercial insurance providers. At the same time, the expenses of owning and running a captive have to be taken into account – they are not right for every corporate.
Some insurers are no doubt sensing an opportunity as captive insurers are being encouraged to enter into arm’s length quota share arrangements in a bid to satisfy increased transfer pricingscrutinycomingfromtheOECD’sBaseErosionandProfitShifting(BEPS)initiative.
An arm’s length quota share pricing can provide an independent risk assessment from a commercial insurance company of the risk transfer that a captive is taking from its corporate parent. The independence and credibility of the (re)insurer is key and the strong technical and actuarial skills they can deploy. Alternatively, an independent actuarial analysis can be provided from consultants or brokers usually charging a separate fee for this work.
It is already relatively common for captives to participate in quota share arrangements with (re)insurance partners as a way to structure their programmes. This approach could become more popular, however, as documentation to provide to tax authorities becomes more valuable. The documentation should describe the costing methodology, loss expectations, premium composition and price accuracy with regards to the insurance cycle.
Summary At this stage the OECD paper is still very much at a preliminary stage,andwilllikelyundergosignificantrevisionasthecaptiveindustry and various risk management associations continue to provide feedback. To an extent, some industry bodies such asFERMAbelievethatwhilsttherehasbeensomeprogress,it is still not clear whether the OECD fully understands the complexities of captive business and is taking into account the regulatoryburdenalreadyimposedbySolvencyIIandIFRS17etc.
Forcompanieswithcaptivesthisremainsanareatobemindfulof potential future developments. As such, in response, Alesco has developed a risk transfer pricing tool, initially for Energy risks, which integrates an actuarial pricing methodology with other exposure-based methods. The outputs and documentation from this model can be used by captives to support and document the transfer pricing process.
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Energy expertise in the heart of London
Insurance brokers across the world working with clients spanning the full spectrum of the energy industry recognise thattheLondonmarketstilloffersvitalexpertiseandcapacityfor large and complex energy risks. That’s why having a specialist,Londonmarketbrokerthatyoucanpartnerwithisessential. Alesco’s Energy division has one of the largest teams inLondonwhichhascontinuedtogrowdespitethevolatilityin the energy industry. We continue to attract broking talent, which in turn means more companies are making the switch to work with us. We pride ourselves on doing things differently; using senior brokers on all accounts, regardless of size or premium paid, using the outputs of our Energy Risk Consulting team to differentiate our clients’ risks in the market, and keeping our claims specialists as an integrated part of our offering.
FOR MORE INFORMATION, PLEASE CONTACT:
Direct: +44(0)2072048575 Email: [email protected]
DEREK THRUMBLE, PARTNER
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