The OECD's latest proposed changes to international tax law take aim at multinational enterprises and intra-group transactions. But what do they mean for the industry?
The Organisation for Economic Co-operation and Development (OECD) published a draft discussion paper 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 MNEs (Multi National Enterprise?) and intra-group transactions .
They start by recognising captives as a formal self-insurance vehicle, and the widespread use of non-conventional insurance, which illustrates a shift in attitude from categorising captives as a general tax vehicle to considering the genuine benefits of a captive in terms of insurance.
Guidelines and outcomes from the paper
The paper does not represent a clear consensus position but it does aim to provide guidelines on four major sections with the first section focusing on a recommended framework to identify and analyse the economically relevant characteristics of a financial transaction and the other three sections providing guidance on determining the arm’s length conditions for treasury activities, intra-group loans, cash pooling, heading and guarantees and captive insurers.
Is your captive insurance transaction legitimate?
The OECD distinguishes between a more commonly viewed insurance contract against matters that MNEs have no control over (such as property damage), and those where there is an element of control (such as product recall) to consider if risks insured in a captive are risk transfer.
Other than true uncorrelated events ‘Acts of God, like the Icelandic volcano (which was famously not covered by commercial travel insurers) the vast majority of insurance contracts have an element of control for the insured. Risk engineers and risk managers can attest to the benefits of formal health and safety training and risk management practice to reduce claims.
The reason this is brought up, however, is concern over whether captive insurance transactions are real insurance; is the risk real? How is the ‘risk’ in its purest sense transferred to the captive – as a premium in the commercial insurance market? Given the USA recent 831b issue, this is an ongoing discussion for captives as to it being a true risk transfer, in the purest sense.
The key indicators of independent insurance from a captive (both insurance and reinsurance captives are specifically referenced) are cited as:
- diversification and pooling of risk
- improvement of group economic capital as a result of diversification of risk
- re/insurer should be a regulated entity under regulatory regimes that require evidence of risk transfer and appropriate capital levels
- the insured risk would otherwise be insurable outside the group
- captive has the requisite skills, including investment skills, and experience at its disposal, including employees with senior underwriting expertise
- the captive could genuinely have claims.
How is your risk being managed in your domicile?
The OECD then move on to discuss the need to either demonstrate adequate self-managing skills in house, or the right level of expertise from your captive manager.
The report seems to highlight concerns with local regulators imposing a lighter regulatory regime to captives that provide insurance exclusively to members of the MNE group compared to insurers who provide policies to third party consumers.
Arm’s Length Pricing:
With regards to pricing and the arm’s length approach, it was noted that 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. It was also mentioned that a two-step approach of assessing the combined loss ratio and return on capital/investment could also be used to determine reasonable pricing where it is not practical for smaller captives to deploy actuaries.
There are also concerns with regards to determining an arm’s length price and the commercial rationality of “uninsurable risks”.
Accurate delineation of transactions was raised as an issue as most captive insurers lack the scale to achieve significant risk diversification and may lack sufficient reserves to meet additional risks represented by having a less diversified portfolio. The OECD suggests that this may indicate that the captive is operating a non-insurance business.
Yet, a typical benefit of a captive is that you can price your own MNE’s risk separately to the insurance market – where the market may respond to large losses by increases in your premium in spite of a good loss history – so this quirk with captives and a lack of diversity could actually strengthen the rational of a captive strategy. It is worthwhile having analysis to support your pricing methods and captive structure – the OECD suggest either if the captive writes similar business to unrelated customers, or another external comparison.
The OECD have delivered a draft at this stage, highlighting the importance of ongoing dialogue between the captive insurance market and the OECD to thoroughly look into concerns around transfer pricing in the context of BEPS.
They have agreed that captives are legitimate insurance transactions, and can provide benefits:
“Potential commercial reasons for an MNE group to use a captive insurer include the following: to stabilise premiums paid by MNEs within the MNE group; to benefit from tax and regulatory arbitrage; gaining access to reinsurance markets; or because the group considers that retaining the risk within the group is more cost effective” (from the OECD’s BEPS Public Discussion Draft on Financial Transactions, p39).
The OECD highlights the importance of the financial capabilities of the captive to assume risk and satisfy claims that may arise. Importantly, they recognise risk diversification as a tool for managing risks assumed, however the draft suggests captives without a diversified portfolio are not really acting in the capacity of an insurer. This is where the discussion of accurate delineation of the transaction can assist in indicating whether the captive is transacting business as an insurer or not. The captive function could be limited if only adhering to a strict definition of when the captive is performing insurance business.
Transfer pricing is expanded upon, and pricing of premiums either through actuarial analysis (suitable for the bigger captives) or via comparing return on capital and combined ratios with independent insurers, are recognised ways of doing so.
More detail will come out of this over the next few months and captive managers, including JLT IM, will keep a close eye on the level of scrutiny expected over the coming years of captive insurance companies.
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