Where an insurance contract is not sold directly from insurer to insured, recompense will usually be due to the party who arranges the original sale. In certain circumstances a higher rate of profit might be earned on the third party sale than would otherwise be expected from comparison with similar transactions. Where the sales agent and insurer or reinsurer are associated, any comparability analysis as part of the process of determining the arm’s length level of reward for the parties would need to consider the circumstances that give rise to the high level of profit. Competition would usually work to limit the amount of profit which can be earned on a transaction both on the part of the sales agent and on that of the insurer or reinsurer. The availability of alternative providers may also influence the ability of each party to negotiate a higher level of profit as part of the overall transaction ...

For example, a manufacturing MNE group has 50 subsidiaries in different locations around the world, all in locations with substantial risk of earthquake, each insures against earthquake damage at its manufacturing plant, with each plant in a different location, assessed on its individual level of risk. The MNE group sets up a captive insurance which accepts the risk from all of the subsidiaries and reinsures it with independent reinsurers. By bringing together a portfolio of insurance risks across different geographical zones, the MNE group already represents a diversified risk to the market. The synergy benefit arises from the collective purchasing arrangement, not from value added by the captive insurance. It should be allocated amongst the insured according to the level of premium they contributed ...

Where a captive insurance is used so that the MNE group can access the reinsurance market to divest itself of risk through insuring risk outside the MNE group, whilst making cost savings over using a third party intermediary, by pooling risks within the MNE group, the captive arrangement harnesses the benefits of collective negotiation on any reinsured risks and more efficient allocation of capital in respect of any risks retained. These benefits arise as a result of the concerted actions of the MNE policyholders and the captive insurance. The insured participants jointly contribute with the expectation that each of them will benefit through reduced premiums. This is similar to the type of group-wide arrangements that might exist for other group functions such as purchasing of goods or services. Where the captive insurance insures the risk and reinsures it in the open market, it should receive an appropriate reward for the basic services it provides. The remaining group synergy benefit should be allocated among the insured participants by means of discounted premiums ...

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 ...

The remuneration of the captive insurance can be arrived at by considering the arm’s length profitability of the captive insurance by reference to a two staged approach which takes into account both profitability of claims and return on capital. The first step would be to identify the captive insurance’s combined ratio. This can be determined by expressing claims and expenses payable as a percentage of premiums receivable. The benchmarked combined ratio achieved by unrelated insurance companies indemnifying similar insurance risks can be identified. The benchmarked combined ratio can then be applied to the tested party’s claims and expenses paid to arrive at an arm’s length measure of annual premiums and thus underwriting profit (premiums receivable less claims and expenses). The second step is to assess the investment return achieved by the captive insurance against an arm’s length return. This step requires two further considerations: (a) the amount of capital held by the captive insurance, and (b) to the extent to which the captive insurance invests in controlled investments (e.g. intra-group bonds, loans, etc.), the rate of investment return achieved by the captive insurance on those investments. The sum of underwriting profit from step one and investment income from step two gives total operating profit (see Section B.5 of Chapter III on multiple year data) ...

Alternatively, actuarial analysis may be an appropriate method to independently determine the premium likely to be required at arm’s length for insurance of a particular risk. In setting prices for an insurance premium, an insurer will seek to cover its expected losses on claims, its costs associated with writing and administering policies and dealing with claims, plus a profit to provide a return on capital, taking into account any investment income it expects to receive on the excess of premiums received less claims and expenses paid. The practical application of actuarial analysis may be a complex exercise. In evaluating the reliability of actuarial analysis to determine the arm’s length price of premiums it is important to note that actuarial analyses do not represent actual transactions between independent parties and that, therefore, comparability adjustments would be likely required ...

The application of the CUP method to a transaction involving a captive insurance may encounter practical difficulties to determine the need for and quantification of comparability adjustments. In particular, account should be taken of potential differences between the controlled and uncontrolled transactions that may affect the reliability of the comparables. Those differences may refer, for instance, to situations where the functional analysis indicates that a captive insurance performs less functions than a commercial insurer (e.g. a captive insurance that only insures internal risks within the MNE group may not need to perform distribution and sales functions). Similarly, differences between the captive insurance and the potential comparables in business volume or in the level of capital between the captive insurance and unrelated parties may require comparability adjustments (see paragraph 10.221) ...

Comparable uncontrolled prices may be available from comparable arrangements between unrelated parties. These may be internal comparables if the captive insurance has suitably similar business with unrelated customers, or there may be external comparables ...

The following paragraphs outline different approaches to pricing intra-group transactions involving captive insurance and reinsurance. Each case must be considered on its own facts and circumstances and in each case accurate delineation of the actual transactions in accordance with the principles of Chapter I will be needed before any attempt to decide on an approach to pricing a transaction. As in any other transfer pricing situation, the most appropriate method should be selected under the guidance of Chapter II ...

In considering how the conditions of the transaction between A and B differ from those which would be made between independent enterprises, it is important to consider how the high level of profitability of the insurance policies is achieved and the contributions of each of the parties to that value creation. The product sold to the third party is an insurance policy substantially the same as that which any other insurer in the general market could provide. The sales agent has the advantage of offering the insurance policy to its customer alongside the sale of the goods to be insured. It is the advantage of intervening at the point of this sale which provides the opportunity to earn a high level of profit. A could sell policies underwritten by another insurer and retain most of the profit for itself. B could not find another agent that has the advantage of point of sale contact with the customer. The ability to achieve the very high level of profit on the sale of the insurance policies arises from the advantage of customer contact at the point of sale. The arm’s length remuneration for B would be in line with the benchmarked return for insurers insuring similar risks and the balance of the profit should be allocated to A ...

For example Company A is a high street retailer of high value new technology consumer goods. At the point of sale, A offers insurance policies to third party customers which provide accidental damage and theft cover for a 3-year period. The policies are insured by Company B, an insurer which is part of the same MNE group as A. A receives a commission with substantially all of the profit on the insurance contract going to B. A full factual and functional analysis shows that the insurance contracts are very profitable and that there is an active market for insurance and reinsurance of the type of risks covered by the policies. Benchmarking studies show that the commission paid to A is in line with independent agents selling similar cover as a standalone product. The profit B earns is above the level of insurers providing similar cover ...

Where an insurance contract is not sold directly from insurer to insured, recompense will usually be due to the party who arranges the original sale. In certain circumstances a higher rate of profit might be earned on the third party sale than would otherwise be expected from comparison with similar transactions. Where the sales agent and insurer or reinsurer are associated, any comparability analysis as part of the process of determining the arm’s length level of reward for the parties would need to consider the circumstances that give rise to the high level of profit. Competition would usually work to limit the amount of profit which can be earned on a transaction both on the part of the sales agent and on that of the insurer or reinsurer. The availability of alternative providers may also influence the ability of each party to negotiate a higher level of profit as part of the overall transaction ...

For example, a manufacturing MNE group has 50 subsidiaries in different locations around the world, all in locations with substantial risk of earthquake, each insures against earthquake damage at its manufacturing plant, with each plant in a different location, assessed on its individual level of risk. The MNE group sets up a captive insurance which accepts the risk from all of the subsidiaries and reinsures it with independent reinsurers. By bringing together a portfolio of insurance risks across different geographical zones, the MNE group already represents a diversified risk to the market. The synergy benefit arises from the collective purchasing arrangement, not from value added by the captive insurance. It should be allocated amongst the insured according to the level of premium they contributed ...

Where a captive insurance is used so that the MNE group can access the reinsurance market to divest itself of risk through insuring risk outside the MNE group, whilst making cost savings over using a third party intermediary, by pooling risks within the MNE group, the captive arrangement harnesses the benefits of collective negotiation on any reinsured risks and more efficient allocation of capital in respect of any risks retained. These benefits arise as a result of the concerted actions of the MNE policyholders and the captive insurance. The insured participants jointly contribute with the expectation that each of them will benefit through reduced premiums. This is similar to the type of group-wide arrangements that might exist for other group functions such as purchasing of goods or services. Where the captive insurance insures the risk and reinsures it in the open market, it should receive an appropriate reward for the basic services it provides. The remaining group synergy benefit should be allocated among the insured participants by means of discounted premiums ...

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 ...

The remuneration of the captive insurance can be arrived at by considering the arm’s length profitability of the captive insurance by reference to a two staged approach which takes into account both profitability of claims and return on capital. The first step would be to identify the captive insurance’s combined ratio. This can be determined by expressing claims and expenses payable as a percentage of premiums receivable. The benchmarked combined ratio achieved by unrelated insurance companies indemnifying similar insurance risks can be identified. The benchmarked combined ratio can then be applied to the tested party’s claims and expenses paid to arrive at an arm’s length measure of annual premiums and thus underwriting profit (premiums receivable less claims and expenses). The second step is to assess the investment return achieved by the captive insurance against an arm’s length return. This step requires two further considerations: (a) the amount of capital held by the captive insurance, and (b) to the extent to which the captive insurance invests in controlled investments (e.g. intra-group bonds, loans, etc.), the rate of investment return achieved by the captive insurance on those investments. The sum of underwriting profit from step one and investment income from step two gives total operating profit (see Section B.5 of Chapter III on multiple year data) ...

Alternatively, actuarial analysis may be an appropriate method to independently determine the premium likely to be required at arm’s length for insurance of a particular risk. In setting prices for an insurance premium, an insurer will seek to cover its expected losses on claims, its costs associated with writing and administering policies and dealing with claims, plus a profit to provide a return on capital, taking into account any investment income it expects to receive on the excess of premiums received less claims and expenses paid. The practical application of actuarial analysis may be a complex exercise. In evaluating the reliability of actuarial analysis to determine the arm’s length price of premiums it is important to note that actuarial analyses do not represent actual transactions between independent parties and that, therefore, comparability adjustments would be likely required ...

The application of the CUP method to a transaction involving a captive insurance may encounter practical difficulties to determine the need for and quantification of comparability adjustments. In particular, account should be taken of potential differences between the controlled and uncontrolled transactions that may affect the reliability of the comparables. Those differences may refer, for instance, to situations where the functional analysis indicates that a captive insurance performs less functions than a commercial insurer (e.g. a captive insurance that only insures internal risks within the MNE group may not need to perform distribution and sales functions). Similarly, differences between the captive insurance and the potential comparables in business volume or in the level of capital between the captive insurance and unrelated parties may require comparability adjustments (see paragraph 10.221) ...

Comparable uncontrolled prices may be available from comparable arrangements between unrelated parties. These may be internal comparables if the captive insurance has suitably similar business with unrelated customers, or there may be external comparables ...

The following paragraphs outline different approaches to pricing intra-group transactions involving captive insurance and reinsurance. Each case must be considered on its own facts and circumstances and in each case accurate delineation of the actual transactions in accordance with the principles of Chapter I will be needed before any attempt to decide on an approach to pricing a transaction. As in any other transfer pricing situation, the most appropriate method should be selected under the guidance of Chapter II ...