Investment profile 

Taxation

Examining the practical and transfer pricing issues arising from Pan European insurance hub structures

Erica Howard - partner, Global Transfer Pricing Services, KPMG UK and Sebastian Ma'ilei - manager, Global Transfer Pricing Services, KPMG Switzerland

Regulatory developments and the changing legal framework in the EU

Multinational insurance groups are now restructuring their operations in light of the changing legal framework in the EU and the subsequent implementation of Solvency II. Currently, the EU Life and non-Life insurance Directives, further supported by the introduction of the EU Reinsurance Directive allow direct insurers and pure reinsurers to enjoy passporting rights, where they may underwrite business in other EEA member countries whilst being subject to regulation by their Home State regulator for all business underwritten in the EEA. Mandatory implementation for all EEA member states was required in December 2007

Increasingly, we are now seeing many multi-national insurance groups taking advantage of the passporting freedom under the Directives by devoting their energies to rationalising their legal operating structures around a single EEA hub model. Traditionally, multi-national insurance groups would have a structure based around the locally incorporated subsidiaries, each holding individual regulatory capital in their respective jurisdiction. In contrast, a few non-EEA groups have operated instead with branches of the parent insurer. But these have generally been subject to the same constraint the need to hold regulatory capital in the host jurisdiction. Established names in the market that have adopted the single EEA hub model (often referred to as the risk carrier) include XL Capital with their Dublin based operations and Swiss Re with the announcement of its Luxembourg carrier and its new operating structure. Other large multi-national insurance groups are also contemplating reorganising their continental European operations with a view to achieving a cohesive governance and management structure in anticipation of the Solvency II directive.

Practical benefits of a single EEA model

The single EEA hub model enables insurers to establish a single underwriting company in an EEA state and operate branches in other EEA states through a single ‘European Passport’ under the freedom of establishment rules. The capacity to streamline in this way brings regulatory and operational benefits including a single European supervisor and the opportunity to optimise regulatory capital – and offers firms the potential to operate from a larger platform. This also further improves the group’s liquidity management, risk and investment flexibility which potentially leads to future operational efficiencies. Most groups also take the opportunity to locate their pan-European insurance carriers in an EU state that is perceived to be ‘regulatory friendly’ such as Ireland or Luxembourg and which then underwrites risks through branches in EEA member countries.

Regulatory constraints in the Life and Non-Life Directives prohibit an insurer (other than a pure reinsurer) from carrying on any commercial business other than insurance business and activities directly arising from that business (eg insurance mediation in respect of the insurer’s own insurance products). Consequently, where an insurance group has more than one insurer eg, a life insurer and a general insurer, employees of one company are prohibited from undertaking activities for the other. As a result, multinational insurance groups which have life and non-life operations when restructuring to a Pan European hub tend to incorporate a service company (Service Co) which employs the staff to enable the risk carrier to underwrite the business assumed by the various branches.  

Under a Pan European model, the head office group (HO) would allocate profits and other costs (routine services, IT, licence fees) to the risk carrier and its branches and intra group reinsurance treaties are normally put in place between the HO and the risk carrier. The premiums and recoveries including overrider commissions in connection with the intra group reinsurances are also attributed between the risk carrier and its branches. Arguably this is because the reinsurance treaty provides a potential benefit to the PE by achieving a cession of insurance risk assumed by the PE. The transfer pricing of intra group reinsurance has been covered in an earlier article by KPMG in the December, 2007 issue of the Instant Newsletter.

Transfer pricing considerations

The ability for insurance groups to streamline their operations in this way through a single European Passport raises important transfer pricing issues such as the location of the assets, functions and risks and the need for arm’s length pricing for inter company transactions within the group. This is against a background of fiscal authorities becoming increasingly focused on transfer pricing issues in the financial services industry, particularly in the insurance sector where they are using more stringent and sophisticated transfer pricing techniques.

This scrutiny is likely to increase further following the publication of the final OECD report on the Attribution of Profits to Permanent Establishments on July 17, 2008. Part IV of the OECD report (Part IV) outlines the allocation of risk and capital to insurance PEs, specifically focusing on the importance of supporting these allocations with a functional and factual analysis. More recently, the draft OECD paper on business restructuring (the OECD restructuring paper) released on September 18, 2008 discusses in detail the implications of moving the profit making components of the value chain between related parties as part of a restructuring. The OECD restructuring paper has a strong emphasis on people functions requiring risk restructuring to be supported with economic substance. This guidance adopts a people centric approach which echoes the KERT and the Significant People function principles articulated in the OECD Report on the Attribution of Profits to Permanent Establishments.

Understanding the regulatory framework is critical to understanding the transfer pricing issues that insurance groups face today, particularly if they are considering going down the Pan European hub route. To address many of these issues in more detail will entail a full factual and functional analysis. This will determine where the Key Entrepreneurial Risk-Taking Function (KERT) function is performed and identify whether there are any Split KERTs. It will also determine whether the risk carrier has sufficient economic substance such that it is in control of the risks assumed, the amount of investment assets and income that would need to attributed between the risk carrier and its branches, and the allocation of external reinsurance premiums receivables and other non-income bearing assets. A clear understanding of the function performed in each jurisdiction is also necessary to address the Dependent Agent PE threshold under Article 5 of the OECD model convention.

Factual and Functional analysis

Under the authorised OECD approach (AOA), the first step in the attribution of profits to a PE is to determine the profits, as if it were a distinct and separate legal enterprise engaged in the same or similar activities under the same or similar conditions. The functional and factual analysis forms a starting point for the attribution of profits from between the risk carrier and its branches. It does this by determining the extent of the functions performed and the assets employed to support the insurance risks assumed by each branch. In this case, where changes have been made to the group structure a functional analysis is required of the situation pre and post restructuring.

Importantly, the functional analysis should also establish where the KERT function is performed which is the assumption of insurance risk. This will typically equate to the performance of the underwriting function, which is broadly defined as setting the underwriting policy, selecting the underlying risk, pricing of the risk, risk retention and acceptance of the insured risk.  However, the OECD recognises in Part IV that a contrary conclusion may be warranted if in the particular facts and circumstances the activity performed is more in the nature of ongoing operational day to day active decision-making as to the acceptance of insurance risks. For example, this may well be true in the life assurance industry, where investment bonds are dependent more on active management of investment risk and asset/liability matching after the risk is assumed than on the initial risk assumption itself.

Split KERTs issues

Additionally, special consideration may need to be given by insurance groups to cases where the KERT function is performed in more than one jurisdiction as this may give rise to split KERT issues. For example, the risk may be priced and selected in one country while underwriting policies are set in another. The best approach would be to perform a functional analysis for each branch to determine exactly where the KERTs are situated and to mitigate, manage and understand any split asset situations. This analysis can take as a starting point the generic functional analysis of the insurance industry outlined in Part IV to establish a matrix which will allow identification of where the split KERT issues could arise.

In our experience, split KERT functions can potentially result in profit split methods where profits are attributed by reference to the relative value of their economic contributions. This has been a common issue in the banking industry upon the implementation of Part II of the OECD Report. For example, many banks experienced practical difficulties when interest rate swaps portfolios were sold in a number of PE’s jurisdictions but the risks were managed, priced and structured in the HO.
The functional analysis should determine and document whether the risk carrier has sufficient economic substance such that it is in control of the assumed risks reinsured from other parts of the enterprise. As such, the risk carrier should have the necessary expertise such as chief underwriters, reinsurance managers and experienced pricing actuaries to perform the underwriting function.  In summary, the functional analysis should ideally set out and document which entities in the structure:

• perform the underwriting function which leads to the assumption of insurance risk-the analyses should also encompass the whole of the insurance value chain functions from business strategy and management through to support services;

• own which assets eg investments and intangibles such as internal pricing models or distribution rights;
bear which risks eg credit risk in respect of retrocessions, longevity and mortality risk, liquidity risk, reserving risk, legal and underwriting risks.

The functional analysis should also document that the risk carrier has a functionality profile equivalent to that of a third party insurer or reinsurer assuming similar risks and performing similar functions under comparable circumstances.

Attribution of investment assets (representing reserves and surplus) between the risk carrier and its branches

An important aspect of Part IV to consider is how profits are to be attributed between the risk carrier and its branches in accordance with the arm’s length principle. One of the key components within the profits to be attributed between the risk carrier and its branches is investment assets which in turn determine the amount of investment income to support the insurance risk assumed by the branches. It is argued that the insurance risk assumed will reside in the PE so that the ownership of the supporting assets and the associated investment income backing that risk resides in the PE. However, as these components are inter-related, they cannot adequately be dealt with in isolation when attributing profits between the HO of the risk carrier and its branches.

Part IV further stipulates that investment assets must be attributed to the branch equal to the sum of its surplus and technical reserves. The yield on these assets must be determined and attributed to the branch. The OECD recognises that it is unlikely that a single allocation key can be found to allocate the total assets of a diversified insurance enterprise. Therefore, it is open to taxpayers to determine a method that will best approximate an arm’s length allocation in accordance with the specific facts and circumstances. In some cases, it may be helpful for multi-national insurance groups to seek one or more APAs in one territory with a sophisticated tax authority which could then be used as a basis for negotiation with other Fiscal authorities.

Broadly, Part IV recognises two general approaches to identifying the amount of investment assets to be attributed to a PE which are analogous to the capital allocation and thin capitalisation methods applied to Part II of the report.

The capital allocation approach necessarily results in the sum of all surplus and reserves in the branches being equal to the surplus and reserves of the entity as a whole, unless there are good reasons to conclude that part of the surplus does not support the insurance business. The surplus to be allocated would include capital held in addition to the regulatory minimum in order to maintain the company’s credit rating and this capital would be allocated to the risk carrier and its branches in order for the branches to carry out its operations.  A thin capitalisation approach is where the amount of capital is determined by reference to a third party assuming similar risks under similar or the same conditions in the host jurisdiction. In practice, this could result in the sum of the branch balance sheets being greater or less than that of the entity as a whole and therefore remains a largely conceptual approach. For example, there is a risk that the sum of the branches would be greater than the whole if the effects of diversification and economies of scale cannot be fully taken into account under this method.

Attribution of external reinsurance premium receivables and other non-income bearing assets
In either case, the allocation method should allow the impact of non-income bearing assets to be taken into account, thus providing a sound basis for attributing profits. In response to industry representation on this particular issue, the Part IV report recognises that in practice, many companies may not cover risk within a PE solely by holding interest-bearing assets; they may also do so through holding reinsurance receivables or other non income bearing assets. The allocation of reinsurance receivables and accrued premiums may be relatively straightforward for proportional reinsurance such as a basic quota share treaty which would be allocated in proportion to the underlying risks assumed by the branches although the attribution of ceding and profit commissions may not be straight forward.

However, difficulties are encountered in practice in the attribution of accrued premiums and reinsurance receivables under a non-proportional reinsurance treaty such as an aggregate excess of loss or a stop loss treaty which may in some cases require stochastic modelling to determine the probability of the reinsurance triggering (attachment and exhaustion points) and the associated costs and claims arising under different stressed claim scenarios. This could incorporate modelling scenarios which are less extreme which occur 1 in every five year events (80th percentile) to the extreme end which occurs 1 in every 250 years depending on the net retention limits in each layer retroceded.

Services provided by other parts of the enterprise should be remunerated at arm’s length
Consideration should also be given to the rewarding of specific insurance functions performed by the HO or another part of the group which are then recharged or allocated to the risk carrier and its branches. These could include the provision of back office functions, sales and marketing and management services. Furthermore, the various back office functions would need to be considered when attributing profit to the various parts of the enterprise. In some cases, Comparable Uncontrolled Prices (CUPs) are unlikely to be available so that cost plus methods will tend to be particularly relevant.

HO costs which represent general and administrative costs are to be allocated at cost under the current commentary to Article 7 of the OECD Model treaty as these are costs which the branch would have borne had it been a standalone entity. In contrast, HO costs in relation to the provision of routine services should be recharged at an arm’s length price. This is often determined to be cost plus a mark-up in the region of 5-10%.

It is worth noting that Part IV states that non KERT functions are not necessarily low value adding functions and therefore special consideration should be given as to how these functions should be remunerated in accordance with the arm’s length principle. For example, the asset management function can cause some practical difficulties in a life insurance context in which funds are invested in longer term investments rather than seeking trading profits by actively trading in the market. The method applied in pricing the arm’s length range of prices for the functions will be determined in accordance with the OECD Transfer Pricing Guidelines.

Dependent Agent PE

Under a typical Pan European hub structure, the risk carrier may be selling insurance in overseas jurisdictions through agents or brokers who may be seen to create a PE in that country if the activities conducted by the agent fall within the definition of a dependent agent under Article 5(5) of the OECD Model Convention,7 The so-called Dependent Agent Permanent Establishment (“DAPE”). It is important to bear in mind that this is not limited to members of the group: a third party agent or broker with a binding authority could still fall to be a DAPE.

Where an entity is caught under Article 5(5) the exact functions performed by, or through the dependent agent should be determined and the profit should be appropriately attributed using a functional analysis. Moreover, the KERT analysis is likely to show that risks and therefore capital premium and investment income are attributable to the PE. The appropriate method applied is determined in accordance with the OECD Transfer Pricing Guidelines. In any event, it is unlikely that a risk carrier could argue that there should be no profit attributed to the DAPE above and beyond the arm’s length remuneration payable to the agent or broker. It is worth noting that Part IV does not examine the issue of whether a DAPE exists under Article 5(5) of the OECD Model Tax Convention but discusses the consequences of finding that a dependent agent PE exists in terms of the profits that should be attributed to the dependent agent PE.  

Wider Transfer Pricing implications to consider

The draft Solvency II directive and its interaction with Part IV

Regulatory developments such as the draft Solvency II directive and its interaction with Part IV should be monitored closely as it is implemented. The Solvency II directive is on the horizon for implementation probably in 2013 and introduces a more consistent, risk based European regulatory framework since European Directives which is likely to give more freedom for insurance groups to manage capital cross border. Solvency II adopts a Risk Based Capital (RBC) framework under a three Pillar structure which is in principle similar to the approach adopted under Basel II for banks.

•    Pillar 1 deals with quantitative aspects of the proposed regime (valuation of assets and technical provisions to create an economic value of balance sheet and calculation of capital requirements)

•    Pillar 2 requires insurers to have processes which allow them to conduct own risk assessments and communicate these to supervisor and;

•    Pillar 3 sets out market discipline and disclosure requirements.

Under Pillar 1, the calculation of the technical provisions such as the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR) components of risk-based capital may impact upon the amount of capital held by branches under their existing regulatory allocation methods. Hence, upon implementation there may be scope for the readjustment of capital which will result in changes to the quantum of capital to be attributed to branches under their existing asset allocation methodologies, in particular for jurisdictions that have not yet adopted risk based frameworks. EEA countries that have currently adopted RBC measures include the UK, Switzerland and Sweden. However, clearly all EEA countries will be required to move to this model under Solvency II.

The OECD recognises that the AOA attributes risk and investment assets in accordance with the arm’s length principle, rather than following regulatory approaches for measuring risks or determining assets. Therefore, it is important to ensure that any significant regulatory changes do not affect the reliability of using a regulatory approach as a proxy for measuring the risks attributable to an insurance PE under the arm’s length principle.

Conclusions

All in all, the practical issues arising from Pan European structures are complex and give rises to challenging transfer pricing considerations. Furthermore, increased scrutiny by fiscal authorities coupled with the finalisation of the OECD Report on the Attribution of Profits to Permanent Establishments and the recent introduction of the draft OECD restructuring paper mean that transfer pricing should be moving up the agenda for most multi-national insurance groups. It is essential to carry out and document a full factual and functional analysis to support the pricing of transactions between different members of the group and the head office and branches of a single legal entity. Where changes have been made to the group structure, the draft OECD restructuring paper requires a functional analysis of the situation pre and post restructuring. Where the risk carrier operates through branches, the functional analysis should determine where the KERT function is performed and profits and capital must be allocated accordingly.
The recent draft OECD restructuring paper in final form should impact the way multi-national insurance groups are restructuring their operations going forward. Of particular significance is that any risk restructuring should be supported with sufficient economic substance in the risk carrier.

This would be a pre condition for a strong commercial rationale argument that the transaction could have occurred between third parties.

As commented earlier, multi-national insurance groups may also need to agree with multiple European tax authorities to gain confidence in the Group’s method for attributing profits to branches. This helps in seeking more certainty about the arm’s length nature of the allocation model and the allocation keys. The profit allocation model should factor in the impact of non-income bearing assets and external reinsurance costs which should provide a sound basis for the attribution of profits and capital between the risk carrier and its branches. EU regulatory developments such as the Solvency II directive which is due for implementation in 2013 and its interaction with Part IV should be carefully monitored as Solvency II is implemented. It is important to ensure this does not affect the reliability of the use of the risk carrier’s current transfer pricing methodology.

Finally, it is important to capture and document the pricing of the intra group transactions in a formal transfer pricing documentation to demonstrate that the intra-group pricing on any profit and capital attributions is in accordance with the application of the arm’s length principle.