OECD Recognizes the Legitimacy of Captive Insurance

The word Legitimate is highlighted in pink and defined in a dictionary

M. Kristan Rizzolo , Christopher W. Schoen | March 04, 2020 |

The word Legitimate is highlighted in pink and defined in a dictionary

On February 12, 2020, the Organization for Economic Cooperation and Development (OECD) released a report titled Transfer Pricing Guidance on Financial Transactions.1 One chapter of the report deals specifically with transfer pricing issues related to captive insurance arrangements (captive chapter).

Such guidance is not controlling but generally is considered when evaluating cross-border transactions. The guidance likely will have limited relevance in the case of captive insurance companies owned by US-based groups, in part because the United States already has well-developed transfer pricing standards and guidance. Nevertheless, the framework in the captive chapter for determining whether a transaction is a genuine insurance transaction bears note because, although similar to the US framework, it includes some factors that are unclear and potentially problematic.

The OECD Acknowledges Valid Business Reasons for Captive Insurance

The captive chapter discusses the numerous business (nontax) reasons why a multinational enterprise (MNE) group might utilize a captive insurance company to manage risks within the MNE group, including stabilizing premiums, benefiting from tax and regulatory arbitrage, gaining access to reinsurance markets, mitigating the volatility of market capacity, or minimizing costs for risk management by retaining risks within the group.

Significance of Appropriate Insurance Analysis

The captive chapter notes that a frequent concern when considering whether "insurance premiums" paid to a captive insurance company are appropriate is whether the transactions with the captive insurance company genuinely constitute insurance. If a captive insurance company is undertaking a genuine insurance business, all, or substantially all, of the following indicators will be present, according to the captive chapter.

  • There is diversification and pooling of risk in the captive insurance company;
  • The economic capital position of the entities within the MNE group has improved as a result of diversification, and therefore there is a real economic impact for the MNE group as a whole;
  • Both the captive insurance company and any reinsurer are regulated entities with broadly similar regulatory regimes and regulators that require evidence of risk assumption and appropriate capital levels;
  • The insured risk would otherwise be insurable with a commercial insurer outside the MNE group;
  • The captive insurance company has the requisite skills, including investment skills, and experience at its disposal; and
  • The captive insurance company has a real possibility of suffering losses.

The requirements for some of these indicators are unclear, such as the meaning of "broadly similar regulatory regimes." For example, it is unclear whether a US captive subject to statutory accounting principles and an offshore reinsurer subject to generally accepted accounting principles would be considered to be regulated entities with broadly similar regulatory regimes. It is interesting that two of the six indicators involve risk distribution, given the recent focus in US captive insurance cases on how best to measure risk distribution (such as whether to measure the distribution of risk based on the number of insureds or the number of risk units) and on what constitutes sufficient distribution. The captive chapter does not address those issues.

Separately, the captive chapter addresses how some of the functions of the captive insurance company, including the underwriting function, may be outsourced. However, it indicates that in those situations where the captive insurance company outsources some of its activities that constitute its underwriting function, "special consideration" of the "retention of the control functions" in the underwriting process would be required in order to conclude that risk has been allocated to the captive insurance company. Although it is somewhat unclear what precisely the "control functions" are, in general they include the underwriting decision making and oversight of the acceptance of and response to risk. However, setting aside the ambiguity of the scope of "control functions," it is not entirely clear why the captive chapter predicates the assumption of insurance risk on whether a captive insurance company retains certain underwriting functions. Nevertheless, the captive chapter indicates that a captive insurance company that outsources "all aspects of the underwriting process without performing control functions would not assume the insurance risk...."

The captive chapter also indicates that many legitimate captive reinsurance companies may operate through fronting arrangements and appears to accept the business value of fronting arrangements.

Pricing of Captive Insurance Arrangements

The captive chapter addresses transfer pricing issues that arise in the context of a captive insurance arrangement. The captive chapter notes that comparable uncontrolled pricing (CUP) may be available from comparable arrangements between commercial insurers and unrelated parties. However, it notes limitations on the use of a CUP method because of the potential differences between controlled and uncontrolled pricing that may affect the reliability of the comparables. For example, if the commercial insurer has distribution and sales costs that cause the commercial insurer to incur additional costs, that could, for example, account for the higher premiums charged by the commercial insurer. Additionally, the captive insurance company may be required to hold less capital or may be permitted more discretion in determining how to invest. Finally, if an MNE group provides synergies that enhance buying power when the captive insurance company purchases reinsurance, the benefit of the synergies should inure to the group members rather than to the captive insurance company. Therefore, adjustments may be needed to account for these differences between captive insurance arrangements and conventional insurance.

Finally, the captive chapter considers situations where a captive insurance company issues coverage to third parties through the assistance of another member of the MNE, for example, a situation in which a technology consumer goods company offers insurance coverage (to be provided by the captive insurance company) at the point of sale to third-party customers of the technology products. The captive chapter notes that the insurer should receive a premium in line with the benchmarked returns for insurers that insure similar risks, with the remainder of the profits allocated to the technology company.

For captive arrangements involving at least one party in the European Union that are subject to reporting under EU Directive 2018/822/EU (commonly known as DAC6), failing to satisfy the OECD's guidance could heighten the potential for further scrutiny. The implications of how the OECD guidance and DAC6 will interact will become more clear as both regimes develop further. The OECD guidance is another indication that the question of what constitutes a valid insurance arrangement is not limited to the United States and presents a challenge for tax and nontax insurance regulators globally.


Footnote

  1. OECD (2020), Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS Actions 4, 8-10, OECD, Paris. Available on the OECD website.

M. Kristan Rizzolo , Christopher W. Schoen | March 04, 2020