Insurance sector transfer pricing implications in COVID-19 times

KUALA LUMPUR, 15 September – Insurers are responding to the widening COVID-19 outbreak on multiple fronts—as claims payers, employers, and capital managers. Each has its own distinct challenges, not just for the sector, but for the economy and society at large.  In particular, insurance companies are facing significant operational challenges – a key one comes from higher claims being made for certain classes of business, which is leading to liquidity and capital constraints for insurance companies.

Even though the insurance sector is generally well prepared for major loss events, including pandemics, the financial impacts will take time to play out and it is still hard to estimate the final financial impact on the sector. Consensus amongst industry experts and analysts is that this could be one of the costliest events with Lloyd’s of London’s forecast that the sector will suffer losses of US$107 billion in 2020 alone.

From a transfer pricing (TP) perspective, the one thing that insurance companies should not overlook is how COVID-19 repercussions can impact their existing and future intragroup arrangements. Based on experiences across key markets in Southeast Asia (SEA), it is clear that tax authorities and regulators adopt certain specific approaches in TP - analysing the arm’s length nature of and monitoring cross-border payments to related parties.

In Indonesia, Malaysia, Singapore and Thailand, tax authorities have historically focussed on related party management service fee payments for insurance groups. Where management service fee payments are concerned, the focus has been on the “need test” to evidence that service recipients actually need such services, and the tangible evidence to demonstrate the benefits received by the service recipients. With respect to reinsurance transactions, it is not uncommon for tax authorities to question and enquire on the commerciality of such transactions, and challenge the comparable transactions used for TP analysis and adjustments, if any.

Regulators play an important part in managing the capital requirements, controlling cross border payments and enquiring on the level of risks that should be borne locally. As an example, some years ago, the Malaysian central bank requested all insurance players in the local market to obtain certification from the statutory auditors to confirm that all cross-border payments are supported by sufficient evidences on benefits and intercompany agreements, as well as to validate the charging mechanism. Though these requirements were discontinued subsequently, it was an extremely onerous exercise for the taxpayers.

TP implications due to COVID-19

In addition to the existing challenges, other potential TP implications have emerged due to the pandemic, including:

• Impact on existing arrangements. Multinational insurance groups are assessing how potential COVID-19 claims may affect their solvency capital requirements from a regulatory perspective. Furthermore, any increased claims volume is expected to be further compounded by two factors - lower than expected returns due to investment losses and the volatility in the bond, equity and commodity markets; and an all-time low interest rate environment globally. These losses will have a direct impact on related party arrangements in terms of increased scrutiny of management service fee charges, reduced return for asset managers and a need to re-look at fee splits.

• Importance of reinsurance/retrocession arrangements. A positive for the insurance sector from a TP point of view is that the losses reinforce the importance of the reinsurance/retrocession arrangements in managing the risks. Prior to the pandemic, various tax authorities have typically challenged such arrangements on the basis of commerciality. The results due to COVID-19 may potentially be useful rebuttal to the tax authorities’ arguments of a lack of commerciality and risk transfer provided by related party reinsurance/retrocession arrangements.

• Inadvertent creation of Permanent Establishments (PE) and resulting attribution. As a result of the international travel restrictions to control the spread of COVID-19, Key Entrepreneurial Risk-Taking (KERT) functions are performed remotely or from unplanned jurisdiction(s). For example, senior executives who perform underwriting functions from other tax jurisdictions will result in the inadvertent creation of PE and accordingly, impact the group profit attribution. Despite the fact that a large number of countries have issued guidance on certain exemptions from PE creation due to current peculiar circumstances, insurance companies will need to ensure that they maintain accurate data on such developing situations, and take appropriate review and action to mitigate TP and other tax risks which may arise.

• Reprice existing related party transactions and possible new related party transactions. The COVID-19 related claims, investment losses and insurance regulators’ capital requirements may put pressure on surplus. This may require the insurance companies’ parent/affiliates to provide surplus relief through reinsurance, loans or surplus guarantees. Such loans and surplus guarantees may give rise to additional TP compliance in terms of validating interest rates and revisiting thin capitalisation positions. In addition, large losses across reinsurers may lead to stiff market conditions, resulting in higher rates and commissions for future coverage.
  
  SEA insurers who are looking to increase their intra-group reinsurance levels or put in place additional contracts to better manage volatility should maintain adequate documentation to support the commerciality of the arrangements, in particular the reasons the new contracts were introduced or for the changes to the terms that have been made.
  
  Additionally, insurance groups should analyse the impact that the current market conditions may have on the pricing of the ceding and profit commissions for proportional reinsurance and the premium costs in case of non-proportional reinsurance.

• Benchmarking outcomes. Insurance companies should expect that any profit based economic analysis methods may be unreliable due to volatility in earnings of businesses during this period and alternative benchmarking approaches/strategies may be necessary.

We hope to have some direction from the Organisation for Economic Co-operation and Development (OECD) in the coming months to help address some of these challenges as the OECD has already taken up the issues of COVID-19’s impact on TP and is currently analysing challenges faced by taxpayers. Notwithstanding, it is important that insurance companies adopt a proactive planning approach and take a fresh look at TP arrangements, reprice where necessary and develop robust systems to gather internal and external information on the effects of COVID-19 on the business.

By Avik BOSE, Tax Partner at Deloitte Singapore and Vrushang SHETH, Tax Director at Deloitte Malaysia. The views expressed are their own.

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