Tag: Financial transactions

TPG2022 Chapter X paragraph 10.221

It is important to recognise that the capital adequacy requirements of a captive insurance are likely to be significantly lower than an insurer writing policies for unrelated parties. This factor should be considered and, if necessary, adjusted for in order to determine the appropriate level of capital to use when calculating the investment return. Differences in capital adequacy between captive insurance and arm’s length insurers typically arise because of regulatory and commercial factors. Insurance regulators frequently set lower regulatory capital requirements for captive insurances. A primary commercial driver for arm’s length insurers is capital efficiency. In order to attract investors and customers, arm’s length insurers will target a strong credit rating by holding a level of operating capital which is in excess of the regulatory minimum. At the same time, arm’s length insurers will attempt to maximise their return on capital results. They will try to hold the optimum amount of capital to meet these opposing drivers. Captive insurances have ... Read more

TPG2022 Chapter X paragraph 10.220

The remuneration of the captive insurance can be arrived at by considering the arm’s length profitability of the captive insurance by reference to a two staged approach which takes into account both profitability of claims and return on capital. The first step would be to identify the captive insurance’s combined ratio. This can be determined by expressing claims and expenses payable as a percentage of premiums receivable. The benchmarked combined ratio achieved by unrelated insurance companies indemnifying similar insurance risks can be identified. The benchmarked combined ratio can then be applied to the tested party’s claims and expenses paid to arrive at an arm’s length measure of annual premiums and thus underwriting profit (premiums receivable less claims and expenses). The second step is to assess the investment return achieved by the captive insurance against an arm’s length return. This step requires two further considerations: (a) the amount of capital held by the captive insurance, and (b) to the extent to ... Read more

TPG2022 Chapter X paragraph 10.219

Alternatively, 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. In setting prices for an insurance premium, an insurer will seek to cover its expected losses on claims, its costs associated with writing and administering policies and dealing with claims, plus a profit to provide a return on capital, taking into account any investment income it expects to receive on the excess of premiums received less claims and expenses paid. The practical application of actuarial analysis may be a complex exercise. In evaluating the reliability of actuarial analysis to determine the arm’s length price of premiums it is important to note that actuarial analyses do not represent actual transactions between independent parties and that, therefore, comparability adjustments would be likely required ... Read more

TPG2022 Chapter X paragraph 10.218

The application of the CUP method to a transaction involving a captive insurance may encounter practical difficulties to determine the need for and quantification of comparability adjustments. In particular, account should be taken of potential differences between the controlled and uncontrolled transactions that may affect the reliability of the comparables. Those differences may refer, for instance, to situations where the functional analysis indicates that a captive insurance performs less functions than a commercial insurer (e.g. a captive insurance that only insures internal risks within the MNE group may not need to perform distribution and sales functions). Similarly, differences between the captive insurance and the potential comparables in business volume or in the level of capital between the captive insurance and unrelated parties may require comparability adjustments (see paragraph 10.221) ... Read more

TPG2022 Chapter X paragraph 10.217

Comparable uncontrolled prices may be available from comparable arrangements between unrelated parties. These may be internal comparables if the captive insurance has suitably similar business with unrelated customers, or there may be external comparables ... Read more

TPG2022 Chapter X paragraph 10.216

The following paragraphs outline different approaches to pricing intra-group transactions involving captive insurance and reinsurance. Each case must be considered on its own facts and circumstances and in each case accurate delineation of the actual transactions in accordance with the principles of Chapter I will be needed before any attempt to decide on an approach to pricing a transaction. As in any other transfer pricing situation, the most appropriate method should be selected under the guidance of Chapter II ... Read more

TPG2022 Chapter X paragraph 10.215

In accurately delineating fronting arrangements, the same principles stated for captive insurance apply. It is important to note, however, that fronting arrangements represent particularly complex controlled transactions to price as they involve the participation of a third party that is indifferent to the levels of the price of the insurance and reinsurance transactions. The key issues which are likely to arise in fronting cases are whether the transactions involved amount to genuine insurance or reinsurance and, if there is genuine insurance, whether the premiums payable (ultimately to the reinsurance captive) are on arm’s length terms ... Read more

TPG2022 Chapter X paragraph 10.214

A reinsurance captive is a particular type of captive insurance which does not issue policies directly but operates as a reinsurance under an arrangement known as “fronting”. Captive insurance may not be able to underwrite insurance policies in the same way as traditional insurance companies. For instance, certain insurance risks must be placed with regulated insurers as a legal requirement. This may lead to the use of a fronting arrangement in which the first contract of insurance is between the insured member of an MNE group and an unrelated insurer (the fronter); the fronter then reinsures with the captive insurance most or all of the risk of the first contract. The fronter may remain responsible for claims handling and other administrative functions or these functions may be handled by a member of the same MNE group as the captive. The fronter retains a commission to cover its costs and to compensate for any portion of the insured risk which it ... Read more

TPG2022 Chapter X paragraph 10.213

In many cases, outsourcing certain aspects of the underwriting function would be inconsistent with the minimum regulatory standards required to operate an insurance business. However, in those situations where the captive insurance is permitted to outsource some of the activities that constitute the underwriting function (for instance, a captive insurance may be allowed to outsource the acceptance of insurance risk to an associated enterprise that acts as a broker and receives an arm’s length remuneration), special consideration of the retention by the captive insurance of the control functions would be required in order to conclude whether the risk is allocated to the captive insurance. A captive insurance that outsources all aspects of the underwriting process without performing control functions would not assume the insurance risk under Chapter I analysis ... Read more

TPG2022 Chapter X paragraph 10.212

When the captive insurance does not have access to the appropriate skills, expertise and resources and, therefore, the captive insurance is not found to exercise control functions related to the risks associated to the underwriting, an analysis under Chapter I, based on facts and circumstances, may conclude that the risk has not been assumed by the captive insurance or that another MNE is exercising these control functions. In this latter case, the return derived from the investment of the premiums would be allocated to the member(s) of the MNE group that are assuming the risk associated with the underwriting in accordance with the guidance in Chapter I ... Read more

TPG2022 Chapter X paragraph 10.211

Part IV of the Report on the Attribution of Profits to Permanent Establishments describes the activities that form part of the underwriting function such as setting the underwriting policies, classifying and selecting the insured risk, setting the premiums (pricing), the analysis of risk retention and the acceptance of the insured risk. These activities would imply, inter alia, deciding to underwrite a risk or not and under what terms and conditions, or whether reinsurance protection should be purchased or not. On prevailing facts and circumstances, those activities may be considered as control functions as described in paragraph 1.65 of Chapter I and, if exercised by a captive insurance that possesses the financial capacity to assume the risk, would lead to the allocation of risk to the captive insurance under Chapter I analysis. Notably, the mere setting of parameters or the policy environment for the risk would not qualify as control functions for this purpose (see paragraph 1.66 of Chapter I, and ... Read more

TPG2022 Chapter X paragraph 10.210

The accurate delineation of the actual transaction in scenarios involving captive insurance requires identifying whether the captive insurance is performing control functions regarding the economically significant risks associated to the underwriting function – in particular the insurance risk – to determine whether those risks should be allocated to the captive ... Read more

TPG2022 Chapter X paragraph 10.209

In the process of accurately delineating the actual transaction involving a captive insurance, the economically relevant risks associated with issuing insurance policies, i.e. underwriting, must be identified with specificity. Part IV of the Report on the Attribution of Profits to Permanent Establishments provides a description of those risks that include, inter alia, insurance risk, commercial risk or investment risk. These descriptions remain valid for the purpose of this guidance ... Read more

TPG2022 Chapter X paragraph 10.208

In situations where the captive insurance lacks the scale to achieve significant risk diversification or lacks sufficient reserves to meet additional risks represented by the relatively less diversified portfolio of the MNE group, the accurate delineation of the actual transaction may indicate that the captive insurance is operating a business other than an insurance one (see guidance in Chapter VII) ... Read more

TPG2022 Chapter X paragraph 10.207

Notably, internal risk diversification might generate lower capital efficiencies than those achieved through external risk diversification. Therefore, the remuneration of a captive insurance that exclusively covers internal risks might be lower than when risk diversification is achieved by insuring external, non-group risks, or by reinsuring a significant proportion of the MNE group’s risks outside of the group. In addition, when the accurate delineation of the actual transaction indicates that the capital efficiencies achieved through the pooling of internal risks in the captive insurance arise from the result of group synergies created through deliberate concerted group actions, the benefits of such synergies should generally be shared by the MNEs that contributed to the creation of those synergies (see Section D.8 of Chapter I and paragraphs 10.222 and 10.223) ... Read more

TPG2022 Chapter X paragraph 10.206

Alternatively, risk diversification may be achieved by covering internal risks when the breadth and depth of the MNE group allows the captive insurance to cover non-correlated or less than fully correlated risks and varied geographical exposures. Situations where a captive insurance only covers internal risks require a thorough analysis under Chapter I guidance to determine whether risk diversification actually occurred, i.e. whether a sufficient quantum and variety of risks are covered by the captive insurance. In this context, determining whether risk diversification occurred is a question of threshold and the conclusion of the analysis would be dependent upon the specific facts and circumstances ... Read more

TPG2022 Chapter X paragraph 10.205

A captive insurance may achieve risk diversification by insuring not only internal risks of its MNE group, but also including within its portfolio a significant proportion of external, non-group risks (while still staying within the definition of captive insurance in paragraph 10.190) ... Read more

TPG2022 Chapter X paragraph 10.204

Risk diversification is at the core of insurance business. Combining non-correlated risk and varied geographical exposures lead to an efficient use of capital, allowing the insurer to have a lower level of capital than that the insured parties would have been required to maintain to face the consequences of risk materialisation ... Read more

TPG2022 Chapter X paragraph 10.203

Insurance also requires risk diversification. Risk diversification is the pooling of a portfolio of risks by which the insurer achieves an efficient use of capital. Large commercial insurers rely on having sufficiently large numbers of policies with similar probabilities of loss to allow statistical laws of averages to apply and permit accuracy of modelling of the likelihood of claims. The insurer also maintains a portfolio of risks for which it has a capital reserve based on regulatory needs and rating agency requirements ... Read more

TPG2022 Chapter X paragraph 10.202

From the captive insurance’s perspective, the fact that the captive insurance is exposed to the downside outcome of the insured risk and to the possibility of significant loss could be an indicator that the insurance risk has been assumed by the captive insurance. In addition, the assumption of the insurance risk can only take place if the captive insurance has a realistic prospect of being able to satisfy claims in the event of the risk materialising, i.e. the captive insurance needs to have access to funding to bear the consequences of the playing out of the insured risk. Determining whether the captive insurance has the financial capacity to assume the risk requires consideration of the capital readily available to the captive and its options realistically available. In particular, when the captive insurance invests the premiums into the insured entities within the MNE group, the relation between the captive insurance’s capacity to satisfy the claims and the financial positions of those ... Read more

TPG2022 Chapter X paragraph 10.201

Insurance requires the assumption of insurance risk by the insurer. In the event of a claim, the insured does not suffer the financial impact of a potential economic loss to the extent that insurance risk has been assumed by the insurer, because the loss is offset by the insurance payment ... Read more

TPG2022 Chapter X paragraph 10.200

In order to consider the transfer pricing implications of a transaction with a captive insurance, it is first necessary to identify the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations in order that the actual transaction is accurately delineated. The initial question will therefore be whether the transaction under consideration is one of insurance, as defined above. This analysis requires consideration of whether the risk has been assumed by the insurer and whether risk diversification has been achieved ... Read more

TPG2022 Chapter X paragraph 10.199

A frequent concern when considering the transfer pricing of captive insurance transactions is whether the transaction concerned is genuinely one of insurance, i.e. whether a risk exists and, if so, whether it is allocated to the captive insurance in light of the facts and circumstances. The following are indicators, all or substantially all of which would be found if the captive insurance was found to undertake a genuine insurance business: there is diversification and pooling of risk in the captive insurance; the economic capital position of the entities within the MNE group has improved as a result of diversification and there is therefore a real economic impact for the MNE group as a whole; both the captive insurance 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 outside the MNE group; the captive insurance has the requisite skills, including ... Read more

TPG2022 Chapter X paragraph 10.198

Captive insurances may be self-managed from within the MNE group, or managed by an unrelated service provider (often a division of a large insurance broker). Typically this management would include ensuring compliance with local law, issuing policy documents, collecting premiums, paying claims, preparing reports and providing local directors. If the captive insurance is managed from within the MNE group it is necessary to determine which entity manages it (if such management is not exercised by employees of the captive insurance) and to appropriately reward that management ... Read more

TPG2022 Chapter X paragraph 10.197

The insurer is carrying out a risk mitigation function in respect of the insured party’s risk but not actually assuming that risk. It is assuming the risk of insuring (i.e. mitigating) the insured party’s risk. That risk will be controlled by either the insurer or (more likely in a captive insurance scenario) another entity within the MNE group that makes the decision that the risk should be assumed by the insurer. (See paragraph 10.223). The insurer (or other entity) can make decisions as to how to respond to this risk – in accordance with paragraph 1.61 (ii) – by, for example, further diversifying its portfolio of insured risks or by reinsuring ... Read more

TPG2022 Chapter X paragraph 10.196

Although the quantum of the risk reward for the insured party and the insurer might be dependent upon exactly the same events in both cases, that quantum could be significantly different (for example, if the insured risk materialises and a claim is made, the insured party could potentially receive significant upside relative to the premium paid whereas the insurer’s income will be limited to the insurance premiums and investment income it has received regardless of the quantum of risk reward received by the insured party) ... Read more

TPG2022 Chapter X paragraph 10.195

The principles of accurate delineation of the actual transactions and allocation of risk detailed in Chapter I of these Guidelines apply to captive insurance and reinsurance in the same manner that they apply to any other intra-group transactions. However, this section addresses mainly captive insurance (as well as captive reinsurance – fronting). In particular, it should be borne in mind that: the carrying on of risk mitigation functions falls within the wider concept of risk management but not within that of control of risk (see paragraphs 1.61 and 1.65); there is a difference between the specific risk being insured (the party taking the decision to insure – i.e. mitigate – or not, controls this risk; that party will usually be the insured but may be another entity within the MNE group) and the risk taken on by the insurer in providing insurance to the insured party ... Read more

TPG2022 Chapter X paragraph 10.194

Another possible reason for the use of a captive insurance by an MNE group in addition to those listed is the difficulty or impossibility of getting insurance coverage for certain risks. Where such risks are insured by a captive insurance this may raise questions as to whether an arm’s length price can be determined and the commercial rationality of such an arrangement (see Section D.2 of Chapter I) ... Read more

TPG2022 Chapter X paragraph 10.193

There are multiple reasons for an MNE group to use a captive insurance such as: to stabilise premiums paid by entities within the MNE group; to benefit from tax and regulatory arbitrage; gaining access to reinsurance markets; mitigating the volatility of market capacity; or because the MNE group considers that retaining the risk within the group is more cost effective ... Read more

TPG2022 Chapter X paragraph 10.192

Captive insurances may be subject to regulation in the same way as other insurance and reinsurance companies. The precise requirements of insurance regulation will vary from one jurisdiction to the next but typically include certain actuarial, accounting and capital requirements. While insurance regulation is intended to protect policyholders, local regulators may impose a lighter regulatory regime where the captive insurance provides insurance exclusively to members of the MNE group ... Read more

TPG2022 Chapter X paragraph 10.191

In contrast, in this guidance the term reinsurance refers to a reinsurance undertaking or entity the purpose of which is to provide reinsurance policies for risks of unrelated parties that are in the first instance insured by entities of the MNE group to which it belongs. (The situation in which risks of entities within an MNE group are insured in the first instance by an unrelated party but then reinsured by an entity within the MNE group is discussed in Section E.2.4) ... Read more

TPG2022 Chapter X paragraph 10.190

In this guidance, the term captive insurance is intended to refer to an insurance undertaking or entity substantially all of whose insurance business is to provide insurance policies for risks of entities of the MNE group to which it belongs ... Read more

TPG2022 Chapter X paragraph 10.189

There are many ways that MNE groups may manage risks within the group. For example, they may choose to set aside funds in reserves, pre-fund potential future losses, self-insure, acquire insurance from third parties or simply elect to retain the specific risk. In some other cases an MNE group may choose to consolidate certain risks through a so-called “captive” insurance ... Read more

TPG2022 Chapter X paragraph 10.188

The accurate delineation of the actual transaction indicates that the enhancement of Company D’s credit standing from A to AAA is attributable to a deliberate concerted group action, i.e. the guarantee provided by Company M. Company D would be expected to be willing to pay an arm’s length guarantee fee to Company M for the provision of the explicit guarantee since Company D is better off than in the absence of the guarantee ... Read more

TPG2022 Chapter X paragraph 10.187

Consider the same fact pattern as described in Example 1, but in this case assume that under the guidance in Section D.2, comparable uncontrolled transactions can be identified showing that the arm’s length price of a comparable guarantee would be in the range of 1% to 1.5% ... Read more

TPG2022 Chapter X paragraph 10.186

In that situation, the analysis under Chapter I may indicate that an independent enterprise borrowing under the same conditions as Company D would not be expected to pay a guarantee fee of 3% to Company M for the provision of the explicit guarantee since Company D is better off in the absence of the guarantee ... Read more

TPG2022 Chapter X paragraph 10.185

Assume that the accurate delineation of the actual transaction shows that the effect of passive association raises Company D’s credit standing from BBB to A, and that the provision of the explicit guarantee additionally enhances the credit standing of Company D to AAA. Assume further that independent lenders charge an interest rate of 8% to entities with a credit rating of A, and of 6% to entities with a credit rating of AAA. Assume further that Company M charges Company D a fee of 3% for the provision of the guarantee so the guarantee fee more than completely offsets the benefit of Company D’s enhanced credit standing derived from the provision of such guarantee ... Read more

TPG2022 Chapter X paragraph 10.184

Company M, the parent entity of an MNE group, maintains an AAA credit rating based on the strength of the MNE group’s consolidated balance sheet. Company D, a member of the same MNE group, has a credit rating of only BBB on a stand-alone basis, and needs to borrow EUR 10 million from an independent lender ... Read more

TPG2022 Chapter X paragraph 10.182

The capital support method may be suitable where the difference between the guarantor’s and borrower’s risk profiles could be addressed by introducing more capital to the borrower’s balance sheet. It would be first necessary to determine the credit rating for the borrower without the guarantee (but with implicit support) and then to identify the amount of additional notional capital required to bring the borrower up to the credit rating of the guarantor. The guarantee could then be priced based on an expected return on this amount of capital to the extent that the expected return so used appropriately reflects only the results or consequences of the provision of the guarantee rather than the overall activities of the guarantor- enterprise ... Read more

TPG2022 Chapter X paragraph 10.181

The valuation of expected loss method would estimate the value of a guarantee on the basis of calculating the probability of default and making adjustments to account for the expected recovery rate in the event of default. This would then be applied to the nominal amount guaranteed to arrive at a cost of providing the guarantee. The guarantee could then be priced based on an expected return on this amount of capital based on commercial pricing models such as the Capital Asset Pricing Model (CAPM) ... Read more

TPG2022 Chapter X paragraph 10.180

Pricing under each model will be sensitive to the assumptions made in the modelling process. Whatever valuation model is used, the evaluation of cost method sets a minimum fee for the guarantee (the minimum amount that the provider of the guarantee will be willing to accept) and does not of itself necessarily reflect the outcome of a bargain made at arm’s length. The arm’s length amount should be derived from a consideration of the perspectives (taking into account options realistically available) of the borrower and guarantor ... Read more

TPG2022 Chapter X paragraph 10.179

There are a number of possible models for estimating the expected loss and capital requirement. Popular pricing models for this approach work on the premise that financial guarantees are equivalent to another financial instrument and pricing the alternative, for example, treating the guarantee as a put option and using option pricing models, credit default swap pricing models, etc. For instance, publicly available data of credit default swaps spreads may be used to approximate the default risk associated to the borrowing and, therefore, the guarantee fee. When using this type of data, the identification of the default event (e.g. bankruptcy) is central to the comparability analysis between the controlled transaction and the potentially comparable credit default swap (See Section C.1.2, on the reliability of credit default swap data) ... Read more

TPG2022 Chapter X paragraph 10.178

This method aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee (loss given default). Alternatively the expected cost could be determined by reference to the capital required to support the risks assumed by the guarantor ... Read more

TPG2022 Chapter X paragraph 10.177

The result of this analysis sets a maximum fee for the guarantee (the maximum amount that the recipient of the guarantee will be willing to pay), namely, the difference between the interest rate with the guarantee and the interest rate without the guarantee but with the benefit of implicit support (and taking into account any costs). The borrower would have no incentive to enter into the guarantee arrangement if, in total, it pays the same to the bank in interest and to the guarantor in fees as it would have paid to the bank in interest without the guarantee. Therefore this maximum fee does not of itself necessarily reflect the outcome of a bargain made at arm’s length but represents the maximum that the borrower would be prepared to pay ... Read more

TPG2022 Chapter X paragraph 10.176

The benefit of implicit support will be the difference between the borrowing terms attainable by the borrowing entity based on its credit rating as a member of the MNE group and those attainable on the basis of the stand-alone credit rating it would have had if it were an entirely unaffiliated enterprise. If the borrower has its own independent credit rating from an unrelated credit rating agency, this will usually reflect its membership of the MNE group and so ordinarily no adjustment would be needed to this credit rating to reflect implicit support ... Read more

TPG2022 Chapter X paragraph 10.175

The next step would be to determine, by a similar process (unless directly observable in the case of a loan from a third party), the interest rate payable with the benefit of the explicit guarantee. The interest spread can be used in quantifying the benefit gained by the borrower as a result of the guarantee. In determining the extent of the benefit provided by the guarantee, it is important to distinguish the impact of an explicit guarantee from the effects of any implicit support as a result of group membership. See Example 2 at paragraph 1.187. The benefit to be priced is not the difference between the cost to the unguaranteed borrower on a stand-alone basis and the cost with the explicit guarantee but the difference between the cost to the borrower after taking into account the benefit of any implicit support and the cost with the benefit of the explicit guarantee ... Read more

TPG2022 Chapter X paragraph 10.174

This approach quantifies the benefit that the guaranteed party receives from the guarantee in terms of lower interest rates. The method calculates the spread between the interest rate that would have been payable by the borrower without the guarantee and the interest rate payable with the guarantee. The first step is to determine the interest rate that would have been payable by the borrower on its own merits, taking into account the impact of implicit support as a result of its group membership. See Section C.1.2 ... Read more

TPG2022 Chapter X paragraph 10.173

An independent entity providing a financial guarantee would expect to receive a fee to compensate it for the risk it is taking in accepting the contingent liability and to reflect any value it is providing to the borrower in respect of the guarantee. However, it must be borne in mind that an independent guarantor’s charges will in part reflect costs incurred in the process of raising capital and in satisfying regulatory requirements. Those are costs which associated enterprises might not incur ... Read more

TPG2022 Chapter X paragraph 10.172

The difficulty with using the CUP method is that publicly available information about a sufficiently similar credit enhancing guarantee is unlikely to be found between unrelated parties given that unrelated party guarantees of bank loans are uncommon ... Read more