Insurance firms should take fresh look at transfer pricing plans

As published in The Business Times on 18 August 2020.

Written by Avik Bose, Deloitte Singapore Tax Partner and Theppine Kyi, Deloitte Singapore Tax Manager. The views expressed are their own.

The insurance sector is facing significant impact and a number of operational challenges brought on by the global economic crisis resulting from the COVID-19 pandemic. The key challenge comes from higher claims being made for certain classes of business, which is leading to liquidity and capital constraints for insurance companies.

While it is still hard to estimate the final financial impact on the insurance sector, there is consensus among industry experts and analysts that this could be one of the costliest events, with multiple waves of claims across various insurance products as the pandemic unfolds. Lloyd's of London has forecasted that the sector will suffer losses of US$107 billion in 2020 alone.

The one thing that insurance companies should not overlook is how COVID-19 repercussions on businesses and economies can impact their existing and future related-party pricing arrangements. Based on experiences across certain key markets in South-east Asia, it is clear that tax authorities and regulators adopt certain specific approaches in transfer pricing (TP) - analysing the arm's length nature and monitoring cross-border payments of related-party transactions.

Tax authorities in Indonesia, Malaysia, Singapore and Thailand have historically focused 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 needed such services, and the tangible evidences to demonstrate the benefits received by 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.

In Singapore and Indonesia, though the insurance space has not seen significant action as far as TP audits are concerned, regulators play an important part in managing the capital requirements, controlling cross-border payments and enquiring on the levels of risks that should be borne locally. In recent years, it has become a trend for insurance groups to seek advance pricing agreements with tax authorities to ensure certainty on their TP arrangements.

TP Implications due to COVID-19

In addition to the existing challenges, the COVID-19 pandemic has brought about potential TP implications, 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 investments 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 look at fee splits.
  • Importance of reinsurance/retrocession arrangements: From a TP perspective, the losses reinforce the importance of the reinsurance/retrocession arrangements in managing the risks, which is a positive for the insurance sector. Prior to the pandemic, it was not uncommon for various tax authorities to challenge related-party reinsurance/retrocession agreements 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 inadvertently 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.

    South-east Asian insurers who are looking to increase their intra-group reinsurance cession 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 that have been made to the terms, to ensure that the arrangements are commercially supportable.

    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 business during this period, and alternative benchmarking approaches/strategies may be necessary.

The working committee of the Organisation for Economic Co-operation and Development (OECD) has taken up the issues of COVID-19's impact on TP and is currently analysing challenges faced by taxpayers.

Hopefully, we will have some direction from OECD in the coming months that help address some of the challenges faced across industries from impact of COVID-19. Notwithstanding this, 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.

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