The Fastest Growing Captive Market: LATAM Captives

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Alexandra Booker
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1 The Fastest Growing Captive Market: LATAM Captives

2 Panel Introductions Speakers: Luis Portillo, Underwriter, Latin America JLT Insurance Management Alejandro J Santos, SVP Analytics & Captives LAC, Marsh Global Analytics & Captive Solutions Javier Ordoñez-Namihira, Senior Associate (Tax) Baker & McKenzie, Mexico City Esperanza Borja Mead, Principal, Actuarial Factor LLC Moderator: Giulianna Molero Solari, Senior Manager, PwC

3 Agenda Introduction Latin Captives Market Status - Domicile Selection - Why Bermuda - Captive Formation - Challenges and Opportunities Empowering Confident Decision Making in an Uncertain World Fronting in Mexico: Key Tax and Regulatory Environment - Issues to Consider. Case of Study LATAM Companies Conclusions

4 Luis Portillo JLT Insurance Management

5 Latam Captives Market Status Ø Latin America continues to show a steady growth in captives creation Ø For the last three years, at least, we have seen an average 10% -12% growth Ø Leading Industries are: Manufacturing Energy Financial Institutions Food and beverages

6 Drivers for captive creation in Latam Ø Sophistication of Risk Management Ø Growth of Multilatinas Ø Optimize the Risk Financial Transfer Ø More efficient access to reinsurance Ø New source of revenues Ø Writing unrelated risk as an additional line of business

7 Main countries in Latam Ø Colombia: 40% Ø Mexico: 30% Ø Chile: 10% Ø Peru: 10% Ø Other: 10% Guatemala Argentina Ecuador

8 Commonly written lines

9 Domiciles Ø Bermuda remains as the most important domicile for Latin American captives Ø Other domiciles such as Barbados and Cayman are also used Ø TIEAs give transparency and improve reputation of domiciles

10 Challenges Ø Admitted and Non-Admitted insurance Ø Fronting fees Ø Few insurance companies with international operation willing to front captives, what becomes an issue for Multilatinas Ø Local currency devaluation

11 Challenges

12 Challenges Local Currency devaluation Index against USD Source: Pacific Exchange Rates

13 What we need Ø Fronting Insurers Ø Fronting Reinsurers Ø Spread the knowledge about captives in the region

14 Alejandro J Santos, SVP Analytics & Captives LAC, Marsh Global Analytics & Captive Solutions

15 MARSH ANALYTICS PLATFORM: MAP Empowering Confident Decision Making in an Uncertain World

16 Risk Financing Optimizing Retained Risk Typical Client s Insurance Program Risk Transfer Retained Risk Not to Scale All Risk Property Cargo Stock Throughput Excess Cyber Liability Cyber Liability Crime Workers Comp. Excess Liability Excess Liability Excess Liability Umbrella Liability GL Auto Non- US Environ mental EPL D&O Fiduciary Non- Owned Aviation NBCR Terrorism Trade Credit Political Product Risk Recall

17 Risk Financing Optimizing Retained Risk Optimized Client s Risk Treatment Program Risk Transfer Retained Risk Captive Is there value in structuring the retained risk in a more formalized way? For Risk Transfer, is there a more efficient way to structure your program? Not to Scale All Risk Property Cargo Stock Throughput Excess Cyber Liability Cyber Liability Crime Workers Comp. Excess Liability Excess Liability Excess Liability Umbrella Liability GL Auto Non- US Environ mental EPL D&O Fiduciary Non- Owned Aviation NBCR Terrorism Trade Credit Political Product Risk Recall

Marsh Analytics Platform (MAP) A Holistic View of Your Signature Risks Probabilistic Modeling (imap) Loss Distributions Risk Tolerance LOB or Enterprise-wide Perspective on Retained Loss

Predictive Pricing ACTUARIAL POINT ESTIMATES imap HOW DOES THIS ANALYSIS IMPACT MY INSURANCE PROGRAM?

Purchase Financing Retained Risk All Lines Value to Clients Industry leading database containing billions of dollars of premiums, limits, and losses Benchmarking and industry insight to ensure

18 Marsh Analytics Platform (MAP) A Holistic View of Your Signature Risks Probabilistic Modeling (imap) Loss Distributions Risk Tolerance LOB or Enterprise-wide Perspective on Retained Loss Positions Deterministic Modeling Structure Analysis Benchmarking Limit, Retention, and Pricing Comparatives BENCHMARKING Carrier Level Sophistication Around Experience and Exposure Rating Predictive Pricing ACTUARIAL POINT ESTIMATES imap HOW DOES THIS ANALYSIS IMPACT MY INSURANCE PROGRAM? BENCHMARKING [Peer comparison] DETERMINISTIC [Given exposures of x and observed losses of y, the expected outcome is z ] PROBABILISTIC [Simulates a range of potential outcomes] Risk Transfer Purchase Financing Retained Risk All Lines Value to Clients Industry leading database containing billions of dollars of premiums, limits, and losses Benchmarking and industry insight to ensure the marketability and price appropriateness of all presented solutions Risk Tolerance Casualty, Property, FinPro specific capabilities Unique stress testing of actual exposures compared to historical loss potential Reflection of insurers valuation of specific exposure Risk Finance Optimization (RFO)

19 Key Analytics Questions How much risk can your company tolerate? What are your company s sources of capital and how do you prefer to deploy those resources to deal with unexpected losses? Are there regulatory pressures on the amount of risk your company can take? Is your company adequately protected against risk? Are your company s limits and deductibles appropriate? Does your insurance structure reflect corporate risk tolerance? Is your company getting the expected value from its insurance purchase? Cost of retaining risk vs. cost of transferring risk (premium)? Whose capital is cheaper: your company s or your insurance carrier s? What volatility would your company be accepting by using its capital? Does my retained risk sit in the appropriate vehicle? Is there a more efficient way to address retained risk? Has your company considered using a captive insurance vehicle for the retained risk?

20 Key Analytics Questions 1 How much risk can your company tolerate? What are your company s sources of capital and how do you prefer to deploy those resources to deal with unexpected losses? Are there regulatory pressures on the amount of risk your company can take? Earnings Miss The Equity Holders View Debt Coverage The Bondholders View Key Performance Indicators (KPIs) Qualitative View Estimates the volatility built into earnings estimates. Arrives at an earnings miss that might cause a drop in share value. Typically discounts intangible assets. Emphasis on interest coverage. Looks at earnings miss required for one or more notch rating downgrade(s). Might look at other loan covenants. KPIs are selected from: Balance sheet. Income statement. Access to other funds. Flexibility allows for reflection of company culture. Appropriate for private companies.

21 Key Analytics Questions 2 Is your company adequately protected against risk? Are your company s limits and deductibles appropriate? Does your insurance structure reflect corporate risk tolerance? High FREQUENCY Low SEVERITY High

22 Key Analytics Questions 3 Is your company getting the expected value from its insurance purchase? Cost of retaining risk vs. cost of transferring risk (premium)? Whose capital is cheaper: your company s or your insurance carrier s? What volatility would I be accepting by using my capital?

23 Total Cost of Risk Looksat Direct Costs Like Premiums and Budgeted Losses

24 Economic Cost of Risk A More Comprehensive View Including the Cost of Volatility

loss activity Extreme scenario analysis Litigation potential by country Market capitatlization

25 Risk Financing Optimization Exploring Loss Potential Potential Considerations Include: Casualty/Finpro: Revenues by business unit Changes in loss exposure New risk initiatives Historical loss activity Extreme scenario analysis Litigation potential by country Market capitatlization Property: Statements of value Loss control Property engineering Natural catastrophe exposure Construction potential Data quality

risk on your company s balance sheet as compared to

26 Risk Financing Optimization Risk Financing Optimization allows you to evaluate the trade-off regarding retaining risk on your company s balance sheet as compared to paying a premium to transfer the risk, e.g., insurance carrier.

Risk Financing Optimization Addressing Retained Risk EVALUATE RETAINED RISKS TO DETERMINE CAPTIVE VALUE High

(Customer, Employees, Vendors, Tenants, etc.

COMMERCIAL Extended warranties Affinity programs CAPACITY Access to reinsurers and pools CONTROL Management of

27 Risk Financing Optimization Addressing Retained Risk EVALUATE RETAINED RISKS TO DETERMINE CAPTIVE VALUE High Frequency/Low Severity Corporate Risks High Severity/Low Frequency Corporate Risks Related Third Party Risk (Customer, Employees, Vendors, Tenants, etc.) FINANCIAL VALUE OPERATIONAL VALUE WHEN The decision to retain risk by the organization has already been taken THEN COMMERCIAL Extended warranties Affinity programs CAPACITY Access to reinsurers and pools CONTROL Management of claims Program design Establish IBNR reserves COMPLIANCE Bridge subsidiary risk appetite Legal and tax certainty COST Commissions Tax efficiency Leverage vs. Commercial COVER Evidence insurance Manuscript policy

28 Javier Ordoñez-Namihira, Baker & McKenzie, Mexico City

29 Fronting in Mexico: Key Tax and Regulatory Environment - Issues to Consider.

30 30 Key Issues to Consider Tax and Regulatory Environment Changes in Domestic Tax Legislation Exchange of Information - TIEA between Bermuda and Mexico New Insurance Law Tax Regime Approach towards OECD BEPS Project General Tax Implications for a Captive Withholding Tax on Reinsurance Premiums Deductibility of Premiums Loans from Captive Taxation on Investment Income derived by Captive CFC Rules: Accrual recognition and Reporting

31 31 Domestic Tax Legislation Domestic tax legislation reflects Mexico s adoption of the same transparency principles and goals sought by G-8 countries, to: automatically exchange tax information on a multinational basis; attack tax evasion; and stop harmful tax competition worldwide. Mandatory e-accounting regime. Rules on assistance in tax collection upon request.

32 32 Domestic Tax Legislation Robust set of rules on Controlled Foreign Corporation (CFC/PTR). Focus on collection and exchange of information. Exceptions to CFC Rules under Income Tax Law. Active Income/ Lack of Control. Whitelist of jurisdiction with recognized ample TIEAs under Guideline Exception for reporting no longer available. Ample TIEAs no longer relieve taxpayers maintaining investments in listed jurisdictions from filing annual informative returns (they remain listed for reporting purposes) under themitl, Transitory Provisions.

33 33 Exchange of Information Increased number of TIEAs and DTTs renegotiated to include clauses on exchange of information. Total: 76. FATCA compliant Model I IGA with the U.S. (effective 2013); flow of information began 9/15 Mexico joined the multilateral tax information exchange pilot program with France, Germany, Italy, Spain and the UK Adopted Common Reporting Standard (CRS) + Signatory of Model Competent Authority Agreement (CAA) early adopter, to exchange information with +90 signatory countries.

34 Mexican Insurance Law Law of Insurance and Bonding Institutions effective April 4, 2015 (published in the Federal Official Gazette on April 4, 2013) Inspired by Solvency II incorporates new legal and technical framework for Mexican insurance institutions to reduce the risk of insolvency. AA investment requirements / FATCA Compliant. Ministry of Finance and Credit Public (Hacienda): Interpretation, application, and administrative solutions. May request opinion from Insurance and Bonding National Commission (CNSF). Reinsurance term defined: agreement pursuant to which a Mexican insurance institution, a foreign reinsurance company or reinsurance entity located abroad assumes, totally or partly, any risk covered by a Mexican insurance institution, or assumes the surplus of damages exceeding the covered amount retained by the direct insurer. Fronting required. Reinsurance General Registry administered by CNSF. 34

35 Tax Regime

36 Tax Reform On 9/8/15, the Executive branch of the Mexican Government submitted the 2016 Tax Bill. This bill was approved by Congress and enacted on 11/18/15. BEPS-inspired provisions were enacted. New informative tax returns for transactions with related parties are triggered in connection with related party transactions. (1) Master related-party informative return. (2) Local related-party informative return. (3) Country-by-country informative return. Exchange of information based on the Common Reporting Standard will iniate in 2017 based on information gathered in 2016.

37 37 General Tax Implications in Mexico for a Captive Withholding Tax on Reinsurance Premiums: General Rule: 2% GAAR: 40% TIEA between Mexico and multiple jurisdictions Deductibility of Premiums: Strictly Indispensable e.g. transfer of risk that commecial insurance market does not usually cover Business Reasons FMV / Transfer Pricing analysis Substance Loans from Captive: Withholding on Interest -15% Deductibility requirements New Form 76-Reporting under Mexican BEPS No Deductions: The Mexican BEPS

38 General Tax Implications in Mexico for a Captive 38 Taxation on Investment Income derived by Captive Watch for potential application of CFC Rules and Reporting. (i) (ii) Consequences for Mexican taxpayers deriving PTR qualifying income from investments abroad: Obligation to recognize said income on an accrual basis; and File an annual informative return (during the month of February each year) reporting any and all PTR qualifying income. Recognition on accrual basis? Informative Tax Return?

39 39 Former Exceptions to Reporting under Tax Administrative Guidelines No reporting obligations under Article 178(2) of the MITL in the following scenarios: i. Taxpayers deriving income from listed jurisdictions with an effective TIEA recognized as such by Mexico (List for Reporting / List of TIEAs). ii. iii. Indirect investments held in listed jurisdictions through entities located in non-listed countries. Taxpayers deriving income/carrying out transactions through FTE incorporated in a jurisdiction with a TIEA in effect with Mexico, provided that no effective control existed over the investment and to the extent that such TIEA was duly recognized as such by Mexico.

40 Reporting Obligations under PTR Rules 40 Rules (Articles ) apply to income derived through foreign entities or legal figures incorporated abroad. Concepts defined. Income is deemed subject to a PTR in cases where: (i) it is effectively subject to taxation abroad (actual payment of tax is required) at an income tax lower than 75% of income tax payable in Mexico on the same type of income; or (ii) it is generated through foreign fiscally transparent entities (FTE) regardless of the effective tax rate. FTE means those that: i) are not regarded as income taxpayers in the jurisdiction of incorporation, where the main administration or place of effective management is, and ii) derive income but it is attributable to their members, partners, shareholders or beneficiaries.

41 41 Reporting Obligations under PTR Rules Consequences for Mexican taxpayers deriving PTR qualifying income from investments abroad: (i) (ii) Obligation to recognize said income on an accrual basis; and File an annual informative return (during the month of February each year) reporting any and all PTR qualifying income. Annual informative returns (February of each year) must be filed by taxpayers in the following cases: Income derived abroad subject to a PTR [178(1)]; Income obtained from a listed jurisdiction [178(2)]; and Transactions carried out through a fiscally transparent entity [178(2)].

42 42 Reporting Obligations under PTR Rules New amendments have placed Bermuda on the List for Reporting purposes. As such all Bermuda entities are reportable. Standard structures: split trusts unit trusts insurance captives

43 Reporting Obligations under PTR Rules Any structure domiciled in a listed jurisdiction or any structure with transactions carried out through fiscally transparent vehicles in this latter case, even if domiciled in a high tax jurisdiction- will be subject to annual reporting obligation as of Date of Filing: February of each year. Depending on the structure, this reporting would not trigger the obligation to recognize income on accrual basis in terms of the Mexican PTR. 43

44 Approach towards OECD BEPS Project Adoption of a substance-over-form approach. Hot audit topcis include: Detailed review on cross-border related party transactions and business restructurings; Migration of functions; Substance of offhshore structures and recipients of Mexican source payments; Entitlement to Treaty benefits treaty shopping and abuse of of treaty network; Highly focused on documentation kept by taxpayers. Strict application of domestic GAARs. New limits on deductions for cross-border related party payments: The Mexican BEPS. 44

45 45 General Tax Implications in Mexico for a Captive New Limits on Deductions: The Mexican BEPS No deductions allowed for cross-border related-party interest payments to a foreign entity that controls or is controlled by the Mexican entity, if: Recipient is fiscally transparent. Exceptions apply. Payment is deemed nonexistent for tax purposes in the country where the foreign entity resides or is located; or Recipient does not consider payment as taxable income. No deductions allowed for intercompany expenses where these are also taken as deductible by a related party of the taxpayer incurring said expenses, unless accrued in same FY or following. No deductions allowed for payments to LTJs. Exceptions apply.

46 BEPS Action 4: Limiting Base Erosion Invoving Interest Deductions and Other Financial Payments

47 BEPS in the Insurance Sector Captive insurance companies carry out quasi-banking or other financial activities, and as such they must observe BEPS action plans. Captive companies hold financial assests and liabilities as an integral part of their main bussiness activiteis. Solvency II introduces for insurers a similar plan to that of the banking system in which they help mitigate risks which in the past have damaged the insurance system and the economy. Although insurance groups are subject to a strict regulation, not all entities within a group are subject to regulation, and not all entities within a group are subject to the same obligations. 47

48 48 BEPS in the Insurance Sector BEPS by insurance groups could potentially take a number of forms: Regulated entities holding a regulatory capital buffer above the level required to support existing business. Insurance companies typically hold buffers of regulatory capital above the minimum level required, and there are significant commercial drivers to maintain these buffers. Holding capital above the minimum required by regulations allows a group to accommodate changing capital needs, but also provides some opportunities for BEPS. Use of hybrid financial instruments and hybrid entities.

49 49 BEPS in the Insurance Sector The fact that the interest income is a major part of an insurance company s income means that EBITDA would not be a suitable measure for economic activity across a group in this sector. Insurance groups are important sources of debt funding for groups in other sectors and as such many are net lenders by a significant margin. This means that the main operating companies in these groups and groups overall, will often have net interest income rather than net interest expense.

50 50 BEPS Risks in the Insurance Sector The main general BEPS risks in the insurance sector (including captives) relate to: Excessive interest deductions in entities that are part of a group with an insurance company. Insurance companies, and entities in a group with an insurance company, using interest to fun non-taxable income. Excessive premiums.

51 Approaching BEPS in Captives According to the BEPS Action 4, Captives should be subject to the best practice approach rules. - These rules may be supplemented with other general or targeted interest limitation rules. 1. Countries must have responses that take into account the unique characteristics of the insurance sector and in particular the evolving regulatory landscape. 2. Key elements of insurance businesses that can impose constraints on the ability of groups to engage in BEPS involving interest, together with limits on these constraints. Consideration of the interest profile of insurance groups, and of different entities in these groups Impact of regulatory capital rules on the ability of insurance companies to have excessive interest deductions or to use interest to fund nontaxable income Impact of group regulation on other entities in banking and insurance groups 51

52 52 Approaching BEPS in Captives 3. It is recommended that each country should identify the specific risks it faces, taking into account the characteristics of insurance groups and the requirements of regulators. 4. Overall, significant regulatory and commercial factors reduce the risks of BEPS involving interest posed by insurance groups, but differences exist between countries and sectors. 5. Where no material risks are identified, for example where potential risks are already addressed by existing regulatory capital rules and/or tax rules, it is not expected that the country should introduce new rules to deal with a risk that does not exist or is already addressed.

53 53 Approaching BEPS in Captives The Best practice approach rules must take into account the particular features of the insurance sector: Work on regulated insurance activities within non-financial groups. Identify whether a rule is likely to be effective in dealing with a particular risk. A cost-benefit analysis. The structure of a country s tax system, including whether entities are taxed separately or on a consolidated or group basis. The impact of a rule on entities which are not engaged in BEPS involving interest. Whether a rule should be restricted to a particular sector or type of entity in order to better target the risks a country faces.

54 Esperanza Borja Mead Actuarial Factor LLC

55 ORIGINAL INSURANCE STRUCTURE Class: Life / Fire Sponsor: Financial group / banks & insurance companies. Policies issued: 5 groups of policies issued to cover a population of more than 50k insureds. Type: Payment: Policy period: Facultative Quarterly Annual

56 RENT A-CAPTIVE BENEFITS Cost efficiency. Faster to implement. Assets & liabilities legally separated. Flexibility & enhancement of insurance products.

57 RENT A-CAPTIVE BENEFITS Sophisticated risk management. Smoother parent company s financials. Direct access to the reinsurance market. Underwriting profits & investment income.

framework Cell in a Segregated Account Company allows payment of insurance profits

58 RENT-A-CAPTIVE Registered Reinsurers Reinsurance contract Premiums and/or profits are paid directly into Cell s bank account Reinsurance Contract Bank of the Group SAC BMA s framework Cell in a Segregated Account Company allows payment of insurance profits directly to the bank account s owner. Local Insurers Insurance Policy Group of Risks to be covered

59 MAIN HURDLES Double fronting. Uncertainty with respect to regulatory changes. Misconceptions of the captive s true purpose. Issues with ultimate beneficiaries.

60 MAIN HURDLES Pressure to reduce costs. Competition with (re) insurers. Lack of long term commitment.

61 BERMUDA CHALLENGES & OPPORTUNITIES Soft market. Minimum capital & surplus requirements. Competition from other domiciles. Tax Information Exchange Agreements (TIEAs). Education to the region LATAM.

62 QUESTIONS MUCHAS GRACIAS!

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