High ho: It's off to work they go
The fourth European Captive Forum, held in Luxembourg and organised by the European Captive Insurance and Reinsurance Owners` Association (ECIROA) and Captive Insurance Companies Association (CICA), gave the European captive industry, and some US representatives, a chance to gather and discuss challenges currently looming over the industry.
Solvency II and the Organisation for Economic Co-operation and Development’s (OECD) base erosion and profit sharing (BEPS) package emerged as the biggest causes for concern throughout the event.
In one session, Ciaran Healy, director of consulting for the global captive practice at Willis, explained that the instability driven by these issues has seen a migration of captives to offshore domiciles to avoid Solvency II, while others have moved onshore in order to embrace the directive. He suggested that captives have left European onshore domiciles for the likes of Guernsey or even the US.
Similarly, some captives are considering their substance and location rationale in reaction to BEPS and the potential implications of the UK’s exit from the EU.
Healy said: “The result of all this is that there is already some relocation occurring, with many more considering a domicile review. The overall landscape in Europe is going to change. How dramatic that change is going to be we will have to see, but I predict there will be movement.”
In his presentation, Healy revealed that 94 percent of captive entities in Europe are located in ‘traditional’ captive domiciles. Some 63 percent in Europe are not subject to Solvency II.
He went on to say 36 percent of captive entities in Europe are cell captives, while 11 percent of captive entities in Europe are located in the same jurisdiction as their parent headquarters. Healy noted that this last point took Sweden and Switzerland into consideration. If they were removed, the 11 percent figure could drop to approximately 4 percent.
With not many captives located in the same jurisdiction as their parents, Healy pointed out both advantages and disadvantages of home-based captives.
An advantage is that the captive will be aligned with BEPS expectations, he explained, and the substance and economic rationale for location are addressed.
Also, the captive will be embedded to a greater extent within the group, allowing for increased visibility of the captive internally.
On the other hand, a negative implication of domiciling ‘at home’ is that it requires the captive to operate with a self-managed or semi self-managed approach, meaning less outsourcing availability.
Healy also explained that it could mean a lack of familiarity with the captive business model from regulators, which could consume more time and potentially result in more onerous compliance requirements.
Reasons for captives to steer clear of their parents’ domiciles include the fact that captive expertise still focuses around traditional domiciles, which may not necessarily be where the parent is based.
Healy also pointed out that if the home location does not have captive legislation in place, there could be a significant risk associated with being the first to domicile a captive in that location.
He said: “The decision to establish in a non-traditional captive domicile would require a material change in captive strategy, including investment in time, people, processes and systems. Service providers will also need to start thinking about this, as well as everyone in the whole captive lifecycle.”
“This trend can be described as a green shoot. There are only two captives that I know that have moved from a traditional captive domicile to their home domicile. I don’t think there will be any drastic changes but the figures may change a little bit.”
Healy concluded: “BEPS will impact on captives, it will be naive to think it won’t affect us. Rightly or wrongly, other offshore locations will be affected. There are equal opportunities for Guernsey and the Isle of Man in the cell captive business. Guernsey is by far the largest domicile in Europe and those captives by large are there to stay.”
In another panel discussion, industry professionals called for proportionality and harmonisation in the implementation and enforcement of Solvency II.
Fabrice Frère of Aon Global Risk Consulting focused on the Pillar II requirements. He said that the system of governance for Solvency II must not be seen as simply a “paper” exercise, and noted that there is a level of comfort for captives in being in full control of what is happening.
While captives have always practiced self-governance, the new rules have caused them to approach this more proactively.
But Frère suggested that some regulators are not being proportionate in their governance of captives, noting that many have been “adamant on the implementation of key functions”.
Implementing additional requirements for board members and head of key functions can lead to these positions being promoted to ‘officer’ level, which is unnecessary for a captive, he said.
This could lead to work being completed and checked multiple times, creating inefficiencies in the reporting process.
While accepting that reporting key functions to the board is an important safeguard to make sure Solvency II is followed, Frère said: “I would like to call for proportionality on that.”
He added that documentation and clear audit trails are key to this, and suggested that additional scrutiny from external auditors, along with additional disclosures and reconciliations, can quickly become over-burdensome and non-proportionate.
According to Frère, regulators must work with the industry to find the right balance, and a “proactive approach to the regulator does pay off”.
He added that “effective” governance is “much more efficient than comprehensive”.
With regards to Pillar III requirements, Derek Bridgeman of Marsh Captive Solutions noted that, although it is earlier in the implementation process than Pillars I and II, so far, proportionality in Pillar III has been applied.
There is a risk that this could change, with some domiciles choosing to bring in validation checks at regular intervals.
The Netherlands, for example, is insisting on audit requirements on its reported data, which Bridgeman said has proved “troublesome”.
Bridgeman suggested that the regulators should cooperate to publish guidance on how proportionality is being implemented in different domiciles, suggesting that such a comparison could help achieve more harmonisation going forward.
Another concern in the captive insurance industry is the OECD’s BEPS initiative. Although the plan was released in October 2015, there is still much uncertainty around the impact it is likely to have on captives.
In a session on the transfer pricing principle under the BEPS initiative, Loic Webb-Martin of PwC UK addressed the challenges facing the captive industry coming from the tax authorities, suggesting that the key to success is to be prepared.
He quoted the OECD’s definition of the transfer pricing principle, saying: “Commercial or financial relations [must not] differ from those which would be made between independent enterprises.”
This means that transactions within a group must be the same as with an outside insurer. However, as captives tend to not offer insurance outside of their own groups, trying to achieve this comparison is “not an easy exercise”.
According to Webb-Martin, captives should consider substance, capital, commerciality, allocations, premiums and risks covered. If these issues are all handled correctly, transactions will work as they would with a third party, and “you will be able to prove it to a tax authority”.
To prove its activity constitutes a “bonafide commercial transaction”, a captive has to be able to prove it has the ability to assume and manage the risks it takes on, and show that the price its insured is paying is ‘arm’s length’, reflecting what is happening in the overall insurance market.
The captive will also have to show that the profit made on the captive is ‘reasonable’ and relative to the capital required to support the business.
In another session on BEPS, Frère highlighted the country-by-country tax reporting requirements, saying it will trigger audits everywhere.
Captives will face increased scrutiny in these audits, he said, and they must be prepared to answer difficult questions.
Captives must be able to demonstrate that good commercial reasons are behind their existence, and that they have strong governance, and fair pricing, capitalisation and documentation.
Frère said: “Anything that is not documented does not exist.”
Another speaker, Praveen Sharma of Marsh, suggested that captives have to evolve with the issues and adapt to changes in regulation, even though some of those in the OECD “don’t understand captives”.
While tax benefits may once have been the primary reason to launch a captive, and commercial aspects were a bonus, the commercial aspect is now generally the primary reason for a captive and any tax benefits are “the icing on the cake”, Sharma said.
Captives must have competent and experienced professionals at a decision-making level to question the validity of transactions, document activity, and consider expected losses, profit margins and expenses, in order to be able to prove their position with regards to commercial viability.
To fight against threats the captive insurance industry is currently battling, the industry’s big captive associations suggested that collaboration could be a “powerful tool”.
Speakers Udo Kappes and Guenter Droese, representing ECIROA, and Dennis Harwick and Peter Hagnauer, representing CICA and SIRCA, respectively, pinpointed the BEPS initiative as an example of where they can achieve more by working together.
The CICA president referred back to a case in 2008, in which the Internal Revenue Service tried to ban single-parent captives.
The industry joined forces to put a stop to it before the new rule was signed into law. Harwick noted that when a strong coalition comes together it can be powerful.
The benefits of such an approach can include the ability to pool resources, according to Kappes.
He said: “We have already started the approach and we are trying to extend the relationship with other associations such as the Federation of European Risk Management Associations, which also expressed their concern on the BEPS topic.” CIT