janeiro 07 2021

OECD Guidance on Financial Transactions: Captive Insurance

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In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. The OECD expects that the Guidance should contribute to consistency in the application of transfer pricing and help to avoid transfer pricing disputes and double taxation. The Guidance addresses specific issues related to the pricing of financial transactions, such as treasury functions, intra-group loans, cash pooling, hedging, and guarantees. Those issues are the subject of separate posts. This post covers captive insurance.

The term “captive insurance” is intended to refer to an insurance undertaking or entity substantially all of whose insurance business is to provide insurance policies for risks of entities of the MNE group to which it belongs. The term “reinsurance” refers to a reinsurance undertaking or entity the purpose of which is to provide reinsurance policies for risks of unrelated parties that are in the first instance insured by entities of the MNE group to which it belongs.

Captive Insurers may be self-managed from within the MNE group, or managed by an unrelated service provider (often a division of a large insurance broker). Typically this management would include ensuring compliance with local law, issuing policy documents, collecting premiums, paying claims, preparing reports and providing local directors. If the captive insurance is managed from within the MNE group it is necessary to determine which entity manages it and to appropriately reward that management.

In order to consider the transfer pricing implications of a transaction with a captive insurer, the initial question will be whether the transaction under consideration is one of insurance. This analysis requires consideration of whether the risk has been assumed by the insurer and whether risk diversification has been achieved. Where the captive insurer insures the risk and reinsures it in the open market, it should receive an appropriate reward for the basic services it provides.

With respect to pricing of premiums, comparable uncontrolled prices may be available from comparable arrangements between unrelated parties. These may be internal comparables if the captive insurer has suitably similar business with unrelated customers, or there may be external comparables. Alternatively, actuarial analysis may be an appropriate method to independently determine the premium likely to be required at arm’s length for insurance of a particular risk. The remuneration of the captive insurer can also be arrived at by considering the arm’s length profitability of the captive insurer by reference to a two-staged approach, which takes into account both profitability of claims (the “combined ratio”) and return on capital.

Background. In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. The OECD expects that the Guidance should contribute to consistency in the application of transfer pricing and help to avoid transfer pricing disputes and double taxation.

The Guidance is divided into several parts. First, the Guidance elaborates on how “accurate delineation” analysis applies to the capital structure of a Multinational Enterprise (“MNE”), which was the subject of a prior post. Regarding accurate delineation, the Guidance makes clear that it does not seek to prevent countries from implementing approaches to address capital structures under domestic legislation. Subsequent sections of the Guidance address specific issues related to the pricing of financial transactions, such as treasury functions, intra-group loans, cash pooling, hedging, and guarantees. Those issues are the subject of separate posts. This post covers captive insurance.

For MNE groups, the management of group finances is an important and potentially complex activity where the approach adopted by individual businesses will depend on the structure of the business itself, its business strategy, place in the business cycle, industry sector, and currencies of operation, among other factors. Different treasury structures involve different degrees of centralization. In the most decentralized form, each MNE within the group has full autonomy over its financial transactions. At the opposite end of the scale, a centralized treasury has full control over the financial transactions of the MNE group, with entities within the MNE group responsible for operational but not financial matters. A key function of corporate treasury may be to optimize liquidity across the MNE group to ensure that the business has sufficient cash available and that it is in the right place when it is needed and in the right currency. Other activities that treasury may have responsibility for include raising debt (through bond issuances, bank loans or otherwise) and raising equity, and managing the relationship with the MNE group’s external bankers and with independent credit rating agencies. Generally, the treasury function is part of the process of making the financing of the MNE group as efficient as possible.

Captive Insurance and Reinsurance Generally. There are many ways that MNE groups manage risks within the group. They may choose to set aside funds in reserves, pre-fund potential future losses, self-insure, acquire insurance from third parties or simply elect to retain the specific risk. In other cases, the MNE group may choose to consolidate certain risks through “captive” insurance. The term “captive insurance” is intended to refer to an insurance undertaking or entity for which substantially all of its insurance business is to provide insurance policies for risks of entities of the MNE group to which it belongs. The term “reinsurance” refers to a reinsurance undertaking or entity the purpose of which is to provide reinsurance policies for risks of unrelated parties that are in the first instance insured by entities of the MNE group to which it belongs. Captive insurance may be subject to regulation in the same manner as other insurance and reinsurance companies.

There are multiple reasons for an MNE group to use captive insurance, such as to stabilize premiums paid by entities within the MNE group, to benefit from tax and regulatory arbitrage, to gain access to reinsurance markets, to mitigate the volatility of market capacity, or because the MNE group believes that retaining risk within the group is cost effective. Another possible reason for the use of captive insurance by an MNE group is the difficulty or impossibility of getting insurance coverage for certain risks. According to the OECD, when such risks are insured by a captive insurance company, this may raise questions as to whether an arm’s length price can be determined and whether such an arrangement is commercially rational.

Delineation of Captive Insurance and Reinsurance. Captive Insurers may be self-managed from within the MNE group, or managed by an unrelated service provider (often a division of a large insurance broker). Typically this management would include ensuring compliance with local law, issuing policy documents, collecting premiums, paying claims, preparing reports and providing local directors. If the captive insurance is managed from within the MNE group it is necessary to determine which entity manages it and to appropriately reward that management. A frequent concern when considering transfer pricing of captive insurance transactions is whether the transaction concerned is genuinely one of insurance, i.e., whether a risk exists and whether it is allocated to the captive insurer. The following are indicators, all or substantially all of which would be found if the captive insurer was found to undertake a genuine insurance business: (1) there is diversification and pooling of risk in the captive insurance; (2) the economic capital position of the entities within the MNE group has improved as a result of diversification; (3) both the captive insurer and any reinsurer are regulated entities with broadly similar regulatory regimes; (4) the insured risk would otherwise be insurable outside the MNE group; (5) the captive insurer has the requisite skills, including investment skills, and experience at its disposal; and (6) the captive insurer has a real possibility of suffering losses.

In order to consider the transfer pricing implications of a transaction with a captive insurer, it is first necessary to identify the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations in order that the actual transaction is accurately delineated. The initial question will therefore be whether the transaction under consideration is one of insurance, as defined above. This analysis requires consideration of whether the risk has been assumed by the insurer and whether risk diversification has been achieved.

Assumption of Risk and Risk Diversification. Insurance requires the assumption of insurance risk by the insurer. In the event of a claim, the insured does not suffer financial impact of potential economic loss to the extent that insurance risk has been assumed by the insurer, because the loss is offset by the insurance payment. From the captive insurer’s perspective, the fact that the captive insurer is exposed to the downside outcome of the insured risk and to the possibility of significant loss could be an indicator that the insurance risk has been assumed by the captive insurer. In addition, the assumption of the insurance risk can only take place if the captive insurer has a realistic prospect of being able to satisfy claims in the event of the risk materializing.

Insurance also requires risk diversification. Risk diversification is the pooling of a portfolio of risks by which the insurer achieves an efficient use of capital. Large commercial insurers rely on having sufficiently large numbers of policies with similar probabilities of loss to allow statistical laws of averages to apply and permit accuracy of modeling of the likelihood of claims. Risk diversification is at the core of the insurance business. A captive may achieve risk diversification by insuring not only internal risks of its MNE group, but also including within its portfolio a significant proportion of external, non-group risks. Alternatively, risk diversification may be achieved by covering internal risks when the breadth and depth of the MNE group allows the captive insurer to cover non-correlated or less than fully correlated risks and varied geographic exposures. According to the OECD, in situations where the captive insurer lacks the scale to achieve significant risk diversification or lacks sufficient reserves to meet additional risks represented by the relatively less diversified portfolio of the MNE group, the accurate delineation of the actual transaction may indicate that the captive insurer is operating a business other than an insurance one.

Assumption of the Economically Significant Risks. In the process of accurately delineating the actual transaction involving captive insurance, the economically relevant risks associated with issuing insurance policies, i.e. underwriting, must be identified with specificity. Those risks include insurance risk, commercial risk or investment risk. The accurate delineation of the actual transaction in scenarios involving captive insurance requires identifying whether the captive insurer is performing control functions regarding the economically significant risks associated to the underwriting function, in particular the insurance risk, to  determine whether those risks should be allocated to the captive. Activities that form part of the underwriting function include setting the underwriting policies, classifying and selecting the insured risk, setting the premiums, the analysis of risk retention and the acceptance of the insured risk. According to the OECD, when the captive insurer does not have access to the appropriate skills, expertise and resources and, therefore, the captive insurer is not found to exercise control functions related to the risks associated to the underwriting, an analysis may conclude that the risk has not been assumed by the captive insurer or that another MNE is exercising these control functions. According to the OECD, in this latter case, the return derived from the investment of the premiums would be allocated to the members of the MNE group that are assuming the risk associated with the underwriting.

Outsourcing the Underwriting Function. In many cases, outsourcing certain aspects of the underwriting function would be inconsistent with the minimum regulatory standards required to operate an insurance business. However, in those situations where the captive insurance is permitted to outsource some of the activities that constitute the underwriting function, special consideration of the retention by the captive insurer of the control functions would be required in order to conclude whether the risk is allocated to the captive insurer. According to the OECD, a captive insurer that outsources all aspects of the underwriting process without performing control functions would not assume the insurance risk.

Reinsurance Captives: Fronting. A reinsurance captive is a particular type of captive insurer which does not issue policies directly but operates as a reinsurer under an arrangement known as “fronting.” A captive insurer may not be able to underwrite insurance policies in the same way as traditional insurance companies. For instance, certain insurance risks must be placed with regulated insurers as a legal requirement. This may lead to the use of a fronting arrangement in which the first contract of insurance is between the insured member of an MNE group and an unrelated insurer (the fronter); the fronter then reinsures with the captive insurer most or all of the risk of the first contract. The fronter may remain responsible for claims handling and other administrative functions or these functions may be handled by a member of the same MNE group as the captive. The fronter retains a commission to cover its costs and to compensate for any portion of the insured risk which it retains. The majority of the fronter’s premium passes to the captive insurer as part of the reinsurance contract. According to the OECD, fronting arrangements represent particularly complex controlled transactions to price as they involve the participation of a third party that is indifferent to the levels of the price of the insurance and reinsurance transactions. The key issues which are likely to arise in fronting cases are whether the transactions involved amount to genuine insurance or reinsurance and, if there is genuine insurance, whether the premiums payable to the reinsurance captive are on arm’s length terms.

Pricing of Premiums. Comparable uncontrolled prices may be available from comparable arrangements between unrelated parties. These may be internal comparables if the captive insurance has suitably similar business with unrelated customers, or there may be external comparables. The application of the CUP method to a transaction involving a captive insurance may encounter practical difficulties to determine the need for and quantification of comparability adjustments related, for example, to the number and intensity of functions performed (such as distribution and sales) or volume of business.

Alternatively, actuarial analysis may be an appropriate method to independently determine the premium likely to be required at arm’s length for insurance of a particular risk. In setting prices for an insurance premium, an insurer will seek to cover its expected losses on claims, its costs associated with writing and administering policies and dealing with claims, plus a profit to provide a return on capital, taking into account any investment income it expects to earn on the excess of premiums received less claims and expenses paid.

Combined Ratio and Return on Capital. The remuneration of the captive insurance can also be arrived at by considering the arm’s length profitability of the captive insurance by reference to a two-staged approach, which takes into account both profitability of claims and return on capital. The first step would be to identify the captive insurer’s combined ratio. This can be determined by expressing claims and expenses payable as a percentage of premiums receivable. The benchmarked combined ratio achieved by unrelated insurance companies indemnifying similar risks can then be identified. The benchmarked combined ratio can then be applied to the tested party’s claims and expenses paid to arrive at an arm’s length measure of annual premiums and thus underwriting profit. The second step is to assess the investment return achieved by the captive insurance against an arm’s length return. The sum of underwriting profit from step one and investment income from step two gives total operating profit.

Group Synergy. Where a captive insurer provides the MNE group with access to the reinsurance market, which in turn allows the MNE group to divest itself of risk by insuring risk outside the group while also providing cost savings as compared with the alternative of using a third party intermediary, the captive insurer benefits from the collective negotiation on any reinsured risks and more efficient allocation of capital in respect of any risk retained. The insured participants jointly contribute with the expectation that each of them will benefit through reduced premiums. Where the captive insurer insures the risk and reinsures it in the open market, it should receive an appropriate reward for the basic services it provides. The remaining group synergy benefit should be allocated among the insured participants by means of discounted premiums.

Agency Sales. Where an insurance contract is not sold directly from insurer to insured, compensation will usually be due to the party who arranges the original sale. In certain circumstances, a higher rate of profit might be earned on the third-party sale than would otherwise be expected from comparison with similar transactions. Where the sales agent and insurer or reinsurer are associated, any comparability analysis as part of the process of determining the arm’s length level of reward for the parties would need to consider the circumstances that give rise to the high level of profit. This may be the case, for example, with retailers offering extended warranties or service contracts. The ability to achieve a very high level of profit on the sale of the insurance policies may arise from the advantage of customer contact at the point of sale. The arm’s length remuneration due to an insurer that is part of the same MNE group as the retailer would be in line with the benchmarked return for insurers insuring similar risks and the balance of the profit should be allocated to the retailer.

The post OECD Guidance on Financial Transactions: Captive Insurance appeared first on Best Methods.

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