On 1 July 2022, the Dutch State Secretary of Finance issued an update of the Transfer Pricing Decree (‘Decree‘). The update aims to align the decree with the 2022 version of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘TPG 2022‘), including the new Chapter X in the TPG on financial transactions.
The Decree, besides a notable update on the treatment of (back-to-back) financial service entities (dienstverleningslichamen), includes an updated section on the transfer pricing aspects of captive insurance companies, paragraph 9.2, of which an unofficial translation can be found here.
Historically, the Dutch Tax Administration have been very critical of the use of captive insurance because they consider it as a means of profit shifting to (often) low tax jurisdictions, not as a tool for risk management. The administration’s traditional position has been that:
a) An independent company acting at arm’s length would not be willing to buy insurance coverage from an insurance company with a relatively small and thus not sufficiently diversified portfolio (lack of diversification).
b) A captive mostly lacks the sufficient functionality to manage the insured risks and therefore usually functions as an administrative service company. According to the Decree, for a captive that centralises external insurance coverage, the captive functions as a procurement service hub, the synergetic advantages of which must be shared among the participating group companies; and/or
c) In case of retail insurances sold to external customers, diversification is not achieved through the captive but by the insured entity in the client portfolio and for that reason, according to the Decree, the captive cannot be allocated the profits from sales of these retail insurances.
The Decree largely reconfirms these positions. Nevertheless, in line with the more nuanced views of the TPG 2022, the Decree’s wording is significantly less sharp and more nuanced than the previous versions. We highlight the three positions and provide some comments and suggestions.
Third party prices generally do not qualify as a benchmark for captive insurance premiums, as they are based on a higher degree of diversification than that of the captive. The captive’s diversification level should be reviewed individually.
Lack of diversification
The Decree states:
“As regards diversification, it should be considered that generally a captive insurance company has a lower degree of diversification than an external insurer insuring similar risks, due to its smaller circle of insured persons. In principle, a lower degree of diversification demands that the captive should charge a higher premium for assuming the insured risk. Without such a higher premium, the captive would not generate sufficient return to bear the risks incurred and to realise the remuneration for its risk capital.
A reduction of risk capital, possibly resulting in a lower premium, neither would make the insurance transaction possible from a rational economic perspective. This reduced capital would be insufficient to cover all the expected damages if the insured risks materialise, so that the insured persons would partly themselves assume the risk. The higher premium that would have to be charged from the captive’s perspective, would make the insured entity better off by insuring the risks with an unrelated more diversified insurer. The insurance transaction with the captive will therefore not materialise in such a situation.”
(i) The qualitative statements in the Decree can hardly be understood without thorough quantitative background. For numerical examples explaining the effect of diversification in insurance, please refer to Verrechnungspreise für Eigenversicherer (Captives), Der Betrieb, No. 7 14.02.2022 (article in German) or Verzekeren binnen concern en de nieuwe OECD Transfer Pricing Guidelines, WFR 2021/175 (article in Dutch).
Hybrid captive arrangements will ensure that the captive will be able to cover the losses whilst at the same time diversification is ensured between the participants.
(ii) In general, the statements in the Decree about diversification are correct, but they lack sufficient nuance. Indeed, in captive insurance the level of diversification must be (quantitatively) established and sufficient strategies may be required to ensure that the coverage sought is beneficial for both the insured entities and the captive. These strategies may include hybrid forms of captive insurance in which participants buy coverage from the captive at premiums based on fully diversified coverage, whilst achieving the economic relevant level of diversification through advance cross capital commitments by all participants towards the captive. In this way, the hybrid captive arrangements ensure that the captive will be able to cover the damages whilst at the same time diversification is ensured between the participants. The tax effects of these hybrid arrangements must be thoroughly considered, as they may deviate from the traditional captive arrangements.
Key take away
Make sure that you review the diversification effects of your captive insurance arrangement. The use of comparables derived from third party insurance contracts will not be sufficient as a benchmark: these premiums are usually based on a higher degree of diversfication than is achieved by the captive. Huygens can help your captive assess and develop strategies that will ensure that the adequate degree of diversification is achieved.
The captive is an administrative service company
The Decree dubs situations where the captive functions as an administrative service company as “passive poolers”, stating:
“In a so-called passive pooler, only group risks are pooled, or bundled and placed on with unaffiliated (re)insurers. In the former situation, this is often the excess that the group itself wishes to retain and/or to which it is obliged by external insurers. Usually, the passive pooler is an extension of the head office risk management department.
Such entity is usually forced to accept all insured within the group and is often prohibited from insuring risks of parties outside the group. It does not perform the underwriting function mentioned above, does not itself diversify and does not have the required expertise and experience in relation to the insurance activity and investment of the premiums received.”
(i) Here, the Decree partly repeats its position about the alleged lack of diversification but adds that captives allegedly lack functionality as an insurer. Again, this statement in and of itself is too general. The individual functions of managing a multinational’s insurance risks may practically be scattered over different parts of the organisation, but legally and organisationally, these functions are concentrated in the captive. The staff performing those functions act on behalf and for the account of the captive and this should not be ignored.
(ii) The Decree ignores that a distinction must be made between manageable risks and residual risks that can more easily be concentrated through legal arrangements. Thorough quantitative analysis will reveal which part of the profit stems from the skill of the different risk management functions and which parts can be traced back to external factors and thus can be allocated to the captive under the insurance policy.
(iii) The Decree does not distinguish between the benefits that originate from synergies and those that stem from diversification. To the extent that cost savings are achieved through synergies and scale, these should indeed be shared between the participants, but the Decree ignores that diversification benefits such as the remuneration for risk capital held by the captive should be allocated to it and must not be shared between the participants. Thorough quantitative analysis will allow to distinguish between these two categories and properly allocate these benefits between participants and the captive.
Key take away
Make sure that you break down the technical insurance premium into parts that can be allocated to the captive and parts that either the participants or the head office should retain. Huygens can assist to establish and optimise the allocation.
The Decree states:
There are situations where the insurance is offered as a by-product to buyers of products or services by a group with activities outside the insurance industry, such as a cancellation insurance or insurance for extended guaranty terms. Generally, the relevant customer policy is written by an unaffiliated insurer supervised by a local regulator. The premium, after deduction of a fee for the unrelated insurer, is passed on as the reinsurance premium to the internal affiliated reinsurer.
In practice, it is not the internal reinsurer, but the group entity carrying out the main business of the group, that offers the insurance as a by-product to the unrelated customer. That group entity achieves diversification through its customer base and thereby obtains the insurance benefits for the group. The internal reinsurer generally does not perform the underwriting function described above, neither does diversify itself nor does have the required expertise and experience in relation to the insurance activity and investment of the premiums received. Therefore, the requirements set out above for transactions between the internal reinsurer and the group entity pursuing the main business of the group to qualify as insurance transactions are not met. Such a body performs only a limited administrative function that justifies limited remuneration.
(i) It is true that retailers with a large client base provide diversification at their portfolio and that the captive contributes less to the level of diversification. Again, the statement that this will always be the case is way too general. A captive may enhance the diversification level and thus add value by concentrating risks within the captive. Quantitative analysis will reveal these effects and enable proper pricing.
(ii) The Decree largely ignores the value that a captive creates by the mere fact that, under the European solvency rules, the captive is a regulated entity and is exclusively licensed to operate an insurance business; these rules do not allow retailers to write policies, whilst these rules force professional insurance companies to reinsure their policies with a regulated entity, such as the captive. This license to operate forms an intellectual property for which the captive must be remunerated. Also, the equity remuneration for regulated capital maintained by the captive is to be exclusively allocated to the captive. Quantitative analysis will enable proper allocation of these profits.
Key take away
Make sure that you properly analyse how much the captive contributes to the diversification in agency sales. Quantify the risk capital that the captive must maintain under solvency rules and establish the arm’s length remuneration on that capital, to properly allocate the profits from agency sales between the retailer and the captive. Huygens can assist quantify and optimise the allocation to the captive.
Resolving disputes about captive insurance is inherently a complex matter, be it alone for the complexity of insurance itself. Huygens is specialised in resolving complex captive insurance disputes.
Conclusion and final remarks
For the transfer pricing aspects of captive insurance, the Decree largely follows the TPG and thus has become more nuanced than the previous version. Nevertheless, the Decree largely maintains its presumption that captive insurance is not a feasible tool for risk management. We believe that thorough quantitative analysis will reveal that captive insurance is more feasible than the Decree suggests.
Finally, captive insurance arrangements are a source of disputes between tax administrations and taxpayers. Resolving these disputes is inherently a complex matter, be it alone for the complexity of insurance itself. Huygens is specialised in both quantifying the technical merits of a captive insurance arrangement and in developing and quantifying strategies that will help resolve disputes and decision making.