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 no commercial imperative to seek a credit rating nor to optimise their return on capital in order to attract investors. Reasonable adjustments may need to be made to ensure that the comparable investment return is restricted to the capital that the captive insurance needs under relevant regulatory requirements (plus a reasonable operating buffer to minimise the possibility of inadvertently breaching the regulatory requirement) to accept the insurance risk rather than the level of capital that might be needed by an independent insurer. Adjustments may be needed to account for differing capital adequacy requirements between different regulators and different categories of insurance business.
TPG2022 Chapter X paragraph 10.221
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By OECD
Category: OECD Transfer Pricing Guidelines (2022), TPG2022 Chapter X: Transfer Pricing Aspects of Financial Transactions | Tag: Capital adequacy requirements, Captive insurance, Combined ratio and return on capital, Financial transactions, Pricing captive insurance
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