Insurance TP and IFRS 17 has been saved
Insurance TP and IFRS 17
The Insurance industry is facing challenges
The increase of new entrants to the business, some of which non-regulated entities with lower operating costs, the digital era consumer demands as well as the persistency of low interest rates, challenge insurance firms to stay relevant in the new environment. On top of that the implementation of IFRS 17 requires accounting changes in liability valuation and revenue/profitability recognition for insurance contracts which could inadvertently also impact existing transfer pricing policies.
Insurance and TP
Insurance being a highly specialized industry, up to date tax audits were not always perceived as industry focused. However, as transfer pricing auditors become more industry skilled and the OECD TP Guidance on Financial Transactions (“OECD Guidance”) issued back in February 2020 broadens its application, it is prudent to understand what transfer pricing auditors are looking at now, also considering the increase of appetite to push for additional tax income due to the covid-19 support measures offered by governments.
OECD Guidance on insurance captives
With the publication of Chapter X of the OECD TP Guidelines, for the first time the OECD is providing direct guidance on how to deal with captive (re) insurance arrangements. It defines captive insurance as the insurance of the risks of entities of the Group the captive belongs to. It also clarifies that reinsurance refers to the insurance of risks of non-related entities that have insured the risks of entities which are related parties to the Captive, as depicted below:
Albeit the OECD Guidance mentions the FS industry, it states that it focuses on the insurance captives of non-insurance Groups (non FS industry) and it also mentions that local regulators may impose a lighter regulatory regime where the captive provides insurance exclusively to members of the MNE Group to which it belongs.
Accurate delineation of captive (re) insurance
The main element highlighted by the OECD Guidance is to perform a comprehensive analysis of the commercial and financial relations among the parties involved in the transaction, with special consideration of whether a risk transfer has occurred and the extent of risk diversification. These analyses would not only affect the pricing of the transaction, but would also enable to conclude if the captive insurance company is in fact operating as an insurance company rather than under another form of business.
In particular, the following should be borne in mind when delineating captive insurance, captive reinsurance and fronting:
- Risk mitigation functions fall within the risk management concept but not within that of control of risk, which is closely related to the key entrepreneurial risk taking function (“KERT”) concept as per Part IV of the OECD 2010 Attribution of Profits to Permanent Establishments Report (“the APPER”).
- There is a difference between the specific risk being insured and the risk taken on by the insurer in providing insurance. The insurer is mitigating the insured party’s risk but not actually assuming that specific risk. The risk of insuring is controlled by the insurer, either a captive or another entity of the Group, by taking decisions on how to respond to this risk by, for example, diversifying the portfolio of insured risks or by reinsuring.
- Is the transaction genuinely one of insurance? Indicators to be considered:
a. Is there a risk to be insured?
b. Can the insurer take decisions on the insured risk? Does it have
i. the needed capital muscle to respond (and potentially incur losses)?
ii. the appropriate resources, skills and expertise (including those of investment) to take decisions?, and
iii. Does it exercise control functions related to underwriting?
c. Does the economic capital position of the entities of the Group improve as a result of diversification?
In other words, insurance requires: (i) the assumption of insurance risk by the insurer (the amount of risk to be insured is to be considered based on the capacity of the insurer to respond to potential claims and/or access to funding to bear such claims), and (ii) control functions related to underwriting/risk diversification: the insurer should account for appropriate material and personal means to take decisions on underwriting as well as on pooling the risk portfolio in order to achieve an efficient use of capital, deciding to which extent it should retain or cede it to the market (and which under conditions), and how it should combine non-correlated and varied geographical exposures.
For insurance, it is thus important that not only the premium is at arm’s length, but also that the overall transaction is structured at arm’s length (terms of the contract, amount of risks to be assumed/ceded under what terms and conditions considering the capacity of the insurer to respond and/or access funding and to control functions related to underwriting).
From IFRS 4 to 17
IFRS standards are established in order to have a common accounting language, so business and accounts can be understood and compared from company to company and country to country. IFRS 4 explains how to disclose insurance contracts, but there are issues to make a good comparison among insurance companies and to compare an insurance company to a non-insurance company. Therefore, it will be replaced by IFRS 17 which includes fundamental changes to accounting in liability valuation and revenue/profitability recognition for insurance contracts.
Under IFRS 4, entities were free to derive their own interpretations of revenue recognition and calculation of reserves. IFRS 17 basically includes 3 models to measure liability of insurance contracts:
Building Block Approach (“BBA”): this is the default model applied in IFRS 17. It is based on the contractual services margin (“CSM”) which is calculated at inception of the insurance contract considering the expected profit to be earned.
The CSM takes into account the tenor of the contract, the upfront premium as well as the expected claims to be paid out in order to estimate the sum of future cash flows (building block 1). A discount rate is used to reflect the timing value of cash flows (building block 2) and a risk adjustment is applied to measure uncertainty of insurance contracts (building block 3). Those three blocks allow to obtain the CSM or expected profit (yet unearned) of the insurance contract (building block 4). The CSM is the economic benefit of the insurance contract to be amortized on a straight line basis during the life of the contract.
While changes in cash flow and risk adjustment relating to future services are recognized by adjusting the CSM amortization, those relating to past and current services flows are to be reflected in P&L. Changes in discount rates can either be recognized in Other Comprehensive Income or P&L. The tax impacts
Variable Fee Approach: it’s a variation of the BBA that applies to specific contracts such as unit linked, equity index-linked sheet, life and pension contracts, etc. This approach links liability to the underlying assets invested. Changes in assets are recognized in the CSM.
Premium Allocation Approach: used for some short term contracts (< 1 year). Current liabilities are calculated based on acquisition cost and unearned premium reserve. As insurers are gradually released from risk as times goes by, unearned premium flows from liability to revenue account.
IFRS 17 requires a major data collection, storage and processing as requires much more granular measurement. It also requires more advanced forecasting and simulation capabilities.
Transfer pricing impact
Changes of valuation methods of current and future insurance contracts directly impact the balance sheet and the P&L of the businesses, which will hit the entity’s financial position, financial performance and cash flows.
This will impact return on equity and combined indexes (which are common profit level indicators of insurers) on a local and consolidated basis.
Because that could also impact the pricing of insurance and reinsurance, reinsurance transfer pricing policies and allocation keys used in intercompany contracts could be impacted.
The quantum of intercompany recharges and other flows in the context of the profitability of the local operations under IFRS17 is to be assessed.
With an effective date of January 1 2023 it would thus be prudent for insurers to also assess the tax and transfer pricing implications that might result from the implementation of IFRS 17. With such a comprehensive overhaul of the accounting for insurance contracts and related data requirements, the tax and transfer pricing implications might not be top of mind. However, losing sight thereof might create additional issues down the road.