Regulation & Tax
The evolving rulebook in Europe
Captive International highlights some of the key regulatory and tax-related developments that captives operating in Europe should be aware of.
The regulatory frameworks in the main European captive domiciles are relatively stable, notes AM Best in its European market segment report published in late 2020. Even the most stable regimes are subject to gradual evolution, however, and there have been some regulatory developments of note to captives in Europe.
Among the more exciting of these developments in recent months has been the news that France is pondering the introduction of legislation that would promote the growth of a captive insurance industry within France itself.
“The Ministry of the Economy and Finance is working on a future legislative vehicle for captives including the provisioning system, the tax treatment of the reserves and the regulatory framework, but there is no definite plan in terms of what the government will do to make it happen, with regard to making changes to the regulatory and tax framework,” writes Frédérique De La Chapelle, a partner in the insurance practice at Dentons in Paris.
Even as mere speculation, however, the discussion has caused quite a stir, and any changes to the captives regime in France would mark a significant development.
“Around 120 French companies have captives, but we have only had one captive launch in France in the last 20 years, in January 2020. There has been a lot of pressure from companies and risk managers to create a framework for captives in France and the Ministry of the Economy and Finance wants to make the country a more attractive place to do business.
“Clearly if French companies set up their captives here rather than in places such as Luxembourg and Ireland, that would generate jobs and increase revenues,” says De La Chapelle.
“It is suggested that the review is about ensuring there are sufficient regulatory and financial protections in place, but I suspect bringing more premium income onshore is an even bigger motivation,” notes Oliver Schofield, managing partner at Risk and Insurance Strategy Consultants (RISCS).
How much impact it will have, and over what kind of time horizon, remains to be seen, admits De La Chapelle. “There is an important distinction between attracting new captives and encouraging captives that are based elsewhere to move back to France. I think we can certainly encourage companies to set up new captives here if an attractive framework is created,” she says.
However, De La Chapelle thinks that encouraging existing captives to move to France will likely take longer.
“Countries such as Luxembourg have a long track record in this area and people will want to see that the French framework is stable. It will also require France to have service providers (including lawyers and accountants) to build up their operations here.”
“There is no definite plan in terms of what the government will do to make it happen.”
Frédérique De La Chapelle, Dentons
It remains to be seen whether other EU countries will follow suit. “I suspect this is a bigger concern in France than elsewhere in the EU. France has always been an important market for re/insurance companies, we have more big companies and groups here than in most European countries, and those companies are pushing for a captives framework,” says De La Chapelle.
Meanwhile, the Isle of Man Financial Services Authority’s updated Corporate Governance Code of Practice will apply to all non-life insurers with effect from June 30, 2021. The updated code will require captives to have access to an effective actuarial function that can evaluate and provide advice on technical provisions, premium and pricing activities, and compliance with related statutory and regulatory requirements.
The code exempts captives from the full actuarial function requirements that apply to commercial non-life insurers, and captives are not required to present in writing annual internal audit findings and recommendations to their board.
According to AM Best, captives are exempt from the fair treatment of policyholder requirements when their policyholders are related parties or insurers to which the captive provides re/insurance. They can apply a number of exemptions to the Own Risk and Solvency Assessment (ORSA) requirements. This means that captives can apply a minimum forecasting time horizon of less than three years and elect to provide summary ORSA information to the regulator instead of submitting the full ORSA report.
“Captives regulated by Solvency II give a high level of comfort to the market involved in the overall programme, particularly when it comes to fronting.”
Ronan Ryan, Robus Risk Services
Keeping the rules proportional
The 2020 review of Solvency II and its application to captives domiciled in the EU is ongoing. Of particular interest to captives is the application of proportionality, which Solvency II applies to ensure that regulatory actions are proportionate to the nature, scale and complexity of the risk inherent in the business of a re/insurer.
“As captives are often small and lightly staffed operations, this principle of proportionality is of particular importance in ensuring that the regulatory requirements do not become overly burdensome.
“Some argue that captives should be subject to lighter regulation when their only policyholder is their parent organisation,” says AM Best. In a consultation paper published in October 2019, however, the European Insurance and Occupational Pensions Authority (EIOPA) rejected this option, arguing it would create legal uncertainty.
Instead, EIOPA vowed to reinforce proportionality across the three pillars of Solvency II, issuing an opinion as part of its 2020 review that included suggestions of how more proportionality can be applied. This included limitations to the extent of reporting on areas including investments and derivatives, assets and liabilities by currency and variation analysis.
Captives could be made to submit their ORSA every two years rather than annually, while the Solvency and Financial Condition Reports could also be scaled down for captives.
AM Best argues that EIOPA’s reasoning for not allowing a two-tier Solvency II is sound. “Knowing that the full Solvency II regulatory requirements are applied to captives can offer security to various captive stakeholders—be they insurance fronters, legal entities and employee representatives in the parent organisation, or subcontractors and joint venture partners.”
Ronan Ryan managing director at Robus Risk Services (Malta), notes that Solvency II can be viewed as capital-intensive and onerous for captives, but agrees it is better for it to continue to apply to captives.
“From Robus Group’s experience, captives regulated by Solvency II give a high level of comfort to the market involved in the overall programme, particularly when it comes to fronting.”
The details about what will happen with Solvency II have not yet been finalised. The European Commission will make the final decision on any changes, including how proportionality might be applied to captives. Even if such changes are approved, no change is expected in 2021, notes Airmic in a report titled “Captives presented opportunity for greater proportionality under Solvency II”, published in January 2021. However, Airmic believes the captive insurance industry will welcome such changes.
Any regulatory relief is likely to be applied only to smaller, first-party risk captives and will not be applied in all cases even where it does apply, according to the Airmic article. It adds that the process of qualifying for the exemption may be restrictive.
It has been proposed that loans from captives to their parent company do not exceed 20 percent of total assets held by the captive, which in theory could lead to captives paying out more in dividends and eroding their capital base.
“There is far more change happening on the tax side of things than the regulatory side as far as captives in Europe are concerned.”
Victor Fornasier, Hogan Lovells
Tax is where the action is
While captives will be watching regulatory developments at national and EU levels with considerable interest, developments with the tax authorities may be of even greater concern.
“There is far more change happening on the tax side of things than the regulatory side as far as captives in Europe are concerned,” says Victor Fornasier, insurance partner at Hogan Lovells in London.
Hogan Lovells’ London office advises predominantly reinsurers, policyholders and intermediaries on distribution, regulation, dispute resolution and other matters, with most of its captives work relating to structuring, re/insurance arrangements and dispute resolution. It has seen a definite uptick in the interest tax authorities have shown in captives, says Fornasier.
Of particular concern is OECD guidance relating to financial transactions and transfer pricing. This guidance was originally expected in 2018 but was delayed until February 2020. The guidance has been explicitly incorporated into domestic legislation in some countries, but even where it has not been incorporated it is generally followed, says Fornasier.
He notes that there is more activity among tax authorities investigating captives in Europe and the UK. “This doesn’t make the captive insurance proposition impossible by any means, but more hurdles have to be overcome to ensure you can manage and deal with any challenges from the tax authorities.”
This development mirrors the high-profile interest the US Internal Revenue Service (IRS) has shown in captives, and particularly micro-captives, as vehicles for tax evasion, but it isn’t clear that European tax authorities are following the lead of the IRS.
“To some extent their interest appears to originate from an OECD Base Erosion and Profit Shifting Project (BEPS) discussion draft from 2016. But the IRS has certainly been extremely descriptive in laying out the issues in terms of captives and tax, which has given a steer to tax authorities in Europe and elsewhere,” says Fornasier.
Tax authorities in Europe are increasingly interested in understanding how some captive structures deliver a tax benefit, and what the justification for this advantage is, says Fornasier.
“It may not be enough that there is a legitimate, commercial reason for a captive, because (for example) the required coverage is not available in the commercial market. Getting things right from a tax authority’s perspective is likely to significantly reduce the tax benefit that someone might hope to achieve from a captive structure.”
Fornasier emphasises the different outlooks of insurance regulators and tax authorities. An insurance regulator has a relatively binary perspective: a structure is either compliant or it isn’t.
A tax authority, on the other hand, will have more questions about a structure’s value, who benefits from it and how it affects the flow of investments. It will then make adjustments for tax purposes.