The law of unintended consequences?

In June 2017, FERMA (the association of  European Risk Managers)  released a paper on captives entitled “FERMA information paper to OECD and national tax authorities to better comprehend the concept of captive insurance and reinsurance companies” as part of its ongoing initiative to educate tax authorities as to the validity of the captive model. This is in response to concerns that captives may be viewed with suspicion under BEPS scrutiny.

 FERMA states the purpose of the paper is to “help OECD and national tax authorities to better comprehend the concept of captive insurance and reinsurance companies” with a view to arrive at a proportional level of scrutiny and reduction in level of requests for information from tax authorities.  It then advises the ” recommendations should be seen as a set of examples and meaningful principles” and “FERMA’s aims is not about providing a comprehensive checklist of documents to be reported”

The motive is to be applauded and the paper contains some useful commentary and analysis but I am left wondering whether FERMA may have scored an own goal here. The use of the word “recommendations” rather than a less prescriptive  term such as guidance or principles makes a stronger case for any captive to be required (and able) to demonstrate full compliance. Whilst advising it did not want to provide a detailed list of required documented evidence as to the captive’s activity, that is exactly what FERMA has done in Section 3. If I were a national tax authority, I now know exactly what I would ask to see and I have a ready prepared checklist to aid my audit of the captive’s records. I suspect there is also now the opportunity for national tax authorities outside Europe to adopt this checklist when reviewing captives parented by non European companies.

But it is not all gloom. The recommendations (or if you prefer guidelines/principles) reflect good business practice and I would expect well managed captives (either with in-house management or outsourced to captive managers) would have in place the necessary operating processes and governance framework to evidence compliance. Certainly the investment of time and systems to prepare for the implantation of the Solvency 2 regime will pay dividends for those EU based captives. Earlier responses by management to historic scrutiny of a captive’s “mind and management” and fairness of transfer pricing should also facilitate compliance. But does every captive (especially those remote from Europe) demonstrate this level of discipline? I suppose the risk is of a few lightly managed captives tainting the global industry’s reputation.

The first section is a good commentary of the role of the captive and the benefits captive participation can provide. One area of research lacking in the captive space is a considered and a robust assessment of the value a captive delivers (both quantitatively and qualitatively). This paper is a good starting point as it identifies some areas for further scrutiny.

I found the statistics contained in Section 2 fascinating but I worry as to the validity of the conclusions drawn due to the lack of granular data, For example, it appears the sample used by Stern Business School to arrive at the European Insurance industry benchmark was based on just 4 reinsurers and 22 general insurers. A quick review of a selection of European (re)insurers’ financial reports confirms a broad range of financial ratios.

Marsh has just released its 2016 review of captives under its management and it would be interesting to see whether the financial and solvency ratios have moved materially from those of 2015 contained in the FERMA paper. The captive solvency assessment is a little crude, comparing GWP to net assets. A M Best has just released its analysis of the financial and solvency condition reports of the European captives it rates. For the year 2016, these show risk based solvency positions (under Solvency 2) of between 160-240%. For non Solvency 2 regimes, typically there is solvency relief for outward reinsurance premiums which would improve the solvency position stated in the paper. Nevertheless, the conclusion that captives are operating in a similar financial and fiscal ballpark as commercial insurers is reassuring

Cutts-Watson Consulting has always advocated higher standards in the captive industry .FERMA, through its regional initiative, may have inadvertently prompted the introduction of global captive operating and governance standards.  We think this is a good thing but is it part of FERMA’s mandate? Maybe CICA, on behalf of all captives worldwide, should pick up the baton at this point.

Founder and MD

Cutts-Watson Consulting Limited