OECD rules – are insurance captives still economically viable?

By Rehana Box, Partner; Peter McCullough, Partner; Sanjay Wavde, Partner; Paul Glover, Counsel and Edwina Wang, Graduate.

28 Sep 2020

Originally published 24th July 2020, reposted with permission from WiBF Corporate Member, Ashurst.

Insurance captives may no longer always be financially viable or desirable owing to tax implications pursuant to recent OECD transfer pricing guidance.

What is an insurance captive?

An insurance captive is generally a wholly-owned subsidiary of a non-insurance company group that provides insurance to other companies within the group.  Insurance captives are designed as a long-term risk management strategy.  While the insured group is required to inject capital and the captive usually relies on reinsurance in the early years of a captive’s establishment, the build-up of capital in the insurance captive captured from underwriting profits is intended to result in lower reliance on reinsurance over time for many captives.

In the longer term, insurance captives ideally improve the overall financial performance of the corporate group.  The group may also receive financial and strategic benefits through the insurance captive’s operation, including greater control over risk and policy terms, access to reinsurance markets at wholesale prices and coverage for risks that are not insurable in commercial insurance markets. Some insurance captives are established from inception as a result of the unavailability of commercial insurance at all or on acceptable commercial terms.

From an income tax perspective, insurance captives can in some situations create tax advantages, with premiums being tax deductible to an insured and not necessarily taxed (at least up front or in full) in the hands of the captive.  While insurance captives have been considered to be an effective risk management tool, the viability of some captives is being challenged by the operation of new OECD transfer pricing guidance.

The OECD transfer pricing guidance

Broadly speaking, transfer pricing rules in most major trading nations require that cross border dealings between related parties comply with the ‘arms-length principle’, such that commercial or financial dealings reflect pricing that would be expected between independent parties undertaking the same or similar dealings.  In February 2020, the OECD issued “Transfer Pricing Guidance on Financial Transactions” (the Guidance) as a follow up to the 2015 BEPS Action Plan reports on Action 4 (Limiting base erosion involving interest deductions and other financial payments) and Actions 8-10 (Aligning Transfer Pricing Outcomes with Value Creation).  The purpose of the Guidance is to contribute to consistency in the application of transfer pricing among OECD member states and help avoid transfer pricing disputes and double taxation.

The principles delineated in the Guidance are designed to prevent base erosion and profit shifting by transferring risk or allocating excessive capital to group members in a way that does not reflect the economic reality of value creation. OECD commentary on matters such as this is generally highly influential in determining the approach taken by taxation authorities in relation to transfer pricing matters.

Implications of the Guidance for insurance captives

Captive insurance arrangements have long been the subject of scrutiny by tax administrators.  For example, the Australian Taxation Office has published guidance (Practice Statement PS LA 2007/8) on captive insurance arrangements which sets out factors to help determine the commercial legitimacy of captive insurance arrangements and whether an actual insurance business is being conducted for the purposes of applying, amongst other provisions, the general anti-avoidance rules in the tax law.

The Guidance can, therefore, be seen as a further step in the analysis of the commercial rationale and substance of captive insurance arrangements, in this case through the particular lens of international transfer pricing rules.

Common cross-border transactions involving captive insurers to which the transfer pricing rules may apply include the flow of insurance premiums and returns and loan-backs of capital ordinarily injected into the insurance captive entity upon establishment.

At its core, the purpose of the Guidance is to help distinguish between a captive insurer that is carrying on a genuine insurance business and entering into insurance transactions that would occur at arm’s length (and so should be remunerated as an insurer) and a captive insurer that is merely a provider of risk mitigation services (and should be remunerated as such).

The Guidance states that an insurance captive will be carrying on a “genuine insurance business” where all or substantially all of the following indicators are present:

  • diversification and pooling of risk in the insurance captive;
  • there is a real economic impact for the insured group as a whole as a result of diversification;
  • both the insurance captive and any reinsurer are appropriately regulated entities that are required to provide evidence of risk assumption and appropriate capital levels;
  • the insured risk would otherwise be insurable outside the insured group;
  • the insurance captive has the requisite skills, including investment skills, and experience at its disposal;
  • the insurance captive has a real possibility of suffering losses.

Many traditional insurance captive scenarios may not exhibit sufficient of the above indicators to be characterised as a “genuine insurance business” – for example, where a captive is established as a result of difficulties in insuring the risk outside the group or where all aspects of the underwriting process are outsourced by the insurance captive to a third party service provider without the insurance captive performing “control functions”.

A party has “control” over the risk where they have ‘the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity’ and ‘the capability to make decisions on whether and how to respond to the risks associated with the opportunity’ and they make such decisions. Decision-makers must have the appropriate competence and experience in the particular risk area and should have access to information that directly supports the decision-making process and outcome.  Control over a risk is not sufficiently demonstrated where a party merely formalises the outcome of a decision that has been made by another party (such as an outsourced service provider) or in another location – for example, meetings organised for the formal approval of decisions made elsewhere, minutes of a board meeting and signing of documents related to such decisions.

It is also important that the insurance captive has financial capacity to assume the risks insured.  It will have such capacity where it has ‘access to funding to take on the risk or to lay off the risk, to pay for risk mitigation functions and bear the consequences of the risk if it materialises’.2  In this context, the capital readily available to the insurance captive and its realistic available financing options are important.  Further, if the insurance captive invests its premium income within the insured group, the relation between its capacity to satisfy the claims would be dependent on the financial positions of those other entities.

Finally, if an insurance captive does not engage in risk diversification (i.e. transferring of risk to a third party such as a reinsurer), it will lack an important indicator of a real insurance business.  As mentioned above, this issue will impact an insured group that operates in a business that is unattractive to commercial insurers.3

In summary, if the insurance captive does not exercise control over the risk or does not have the financial capacity to assume the risk, the Guidance states that the risk must be allocated to the associated enterprise or insured group that exercises the most control or such capacity.  Further, if the risk is of a type that cannot be reinsured or the underwriting is outsourced to an external service provider, the insurance captive will also likely not be carrying on a genuine insurance business.

In such cases, from a transfer pricing perspective, the insurance captive is likely to be considered as a service provider that should, for example, be remunerated on a cost plus basis, subject to a “true-up” adjustment (i.e. a partial refund of premiums where annual premiums are too high (due to no or few claims) or additional payment where the premiums are too low (due to significant claims) in any income year.

Overall, this will result in the profits retained by the captive insurer in each income year being limited in effect to a small margin on its costs, thereby nullifying many of the commercial objectives (and associated tax benefits) of captive insurance outlined above.

Application to insurance activities by insurance captives

While it remains possible for insurance captives with outsourced operating models to demonstrate that they do have the necessary control and capacity to assume risk whilst engaging a third party provider to perform day-to-day functions, eg by retaining the Board to execute key decisions in taking on, laying off, declining risk-bearing opportunities in relation to insurance risk, as well as decisions on how to respond to insurance risk, this may incur additional costs that reduce the financial attractiveness of a captive.  However, where there is insufficient diversification (for example, where the risk or risks cannot or are not to be reinsured), there could be difficulties in demonstrating that, from a transfer pricing viewpoint, the captive is carrying on a genuine insurance business such that the risk (and reward) should be allocated to the insurance captive.

Companies should consider the relevant transfer pricing implications likely to apply to their particular circumstances when considering whether to establish an insurance captive and when reviewing their existing captive arrangements in light of the Guidance.

For more information and the latest updates from Ashurst, visit https://www.ashurst.com/en/news-and-insights/

Disclaimer

The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying it to specific issues or transactions.

 

1 Guidance p. 22 at [1.61]
2 Guidance p. 23 at [1.64]
3 Guidance p. 24 at [1.66]