Strategic restructuring and re-domestication for insurers

Transcription

1 Strategic restructuring and re-domestication for insurers Whitepaper for insurers with operations in Europe ADVISORY

2 1 Strategic restructuring and re-domestication for insurers Foreword Many insurers have legal, operational and capital structures that have evolved over several years, making them inefficient and impacting their financial performance. Tackling this through strategic restructuring and re-domestication may offer significant competitive advantages, and is becoming increasingly popular. The fundamental regulatory and fiscal changes expected to take place over the coming years mean that this trend is set to continue, and insurers and reinsurers with European businesses, wherever headquartered, are already seeking to understand the impact of these developments on their group and capital structure. KPMG firms have extensive experience gained over many years of working with insurance groups with European operations that wish to understand the impact of the regulatory and tax changes in prospect, the inefficiencies in their structure, and the scope for improvement. Our firms multidisciplinary, cross border teams have supported numerous insurers and reinsurers in taking a strategic approach to structuring their group so as to deliver efficiencies on many levels having regard to the regulatory, fiscal and business concerns and drivers. This white paper is the first in a series that KPMG is producing to examine the key elements in insurance entities' finance agendas. This agenda has effective capital management at its centre and encompasses performance management, financial management and risk management. Strategic restructuring and re-domestication touches on all these elements. This whitepaper seeks to explain the issues and current trends, with particular focus on insurers with operations in Europe, and aims to support insurance executives in understanding the opportunities and challenges involved for their organisations Frank Ellenbürger and Tony Hulse

3 Strategic restructuring and re-domestication for insurers 2 Contents Page 1 Executive summary 3 The issues and challenges facing European insurers today 3 The opportunities and the benefits 4 Implementing structural change 8 Taking action 9 Conclusion 10 2 The business outlook 11 European market overview 11 Competition and the impact on European insurers 15 Restructuring and the executive agenda 16 3 The regulatory dimension 17 The challenges and opportunities presented by regulation 17 European regulatory overview 18 Regulatory capital 19 The wider impact of European regulatory change 23 The business impact of the Reinsurance Directive 24 Solvency II looms 25 4 How tax is influencing insurance structures 27 The global tax environment and how this is affecting Europe 27 Residence and the impact on restructuring 29 Indirect tax 33 The fiscal impact on global structures 35 The tax practicalities of the reorganisations - how the mergers Directive can help 35 5 Market trends in insurance restructuring and re-domestication 37 Consolidation and streamlining 39 Re-domestication 42 Group holding and capital structure 47 6 From strategy to implementation: what s involved? 51 Approach 51 Dealing with approvals and technicalities 54 Managing the process 54 How much will it cost? 54

4 3 Strategic restructuring and re-domestication for insurers 1. Executive Summary The issues and challenges facing European insurers 1 today Market pressures The insurance industry is facing pressures on many levels. On the one hand stakeholders, whether shareholders, members or policyholders continue to demand enhanced value, whilst on the other insurers both across the globe and in Europe must cope with, increasing regulatory intensity, extra tax complexity and competition. For European businesses this competition arises both internally within European markets and also from offshore. European insurance and reinsurance companies constitute a long established and globally recognised industry operating across, and domiciled in, as many as 30 countries. The markets where the largest insurers and reinsurers are based and which contribute the highest proportions of insurance premiums to the European economy are the UK, Germany, France and the Netherlands. Switzerland, whilst not a member state of the European Union (EU) or European Economic Area (EEA), is also a major insurance economy. Many of the issues and challenges faced by the global insurance industry today are common across the major European players. Within domestic European markets, however, this is not necessarily the case, and differences exist as to the impact of, and response to, market pressures. This is a result of variations in local laws and regulations, business culture and history across the region, giving rise to different competitive constraints and drivers specific to individual countries. Inefficiencies leading to structural change One common theme is that many insurers, including both international groups and domestic companies, have legal entity, operating and capital structures that have evolved organically over time, partly as a result of mergers and acquisitions and partly from piecemeal initiatives. These legacy structures can be complex and unwieldy involving multiple underwriting platforms, administration and service companies, and out-dated holding and finance company structures which themselves lead to inefficiencies. Such inefficiencies include, for example, tax 1 In this paper reference to insurers should generally be taken to include reinsurers

5 Strategic restructuring and re-domestication for insurers 4 and dividend traps, additional regulatory and compliance burdens, fragmented reporting and increased operating costs. Many insurers are also concerned to improve their group risk governance, and to address constraints in their ability to attract business for example due to insufficient capital in insurance operations, and fragmented distribution and product offerings. All of these issues point to the need to use capital efficiently, a topic that is high on the executive agenda 2. Insurers are seeking to optimise the quantum, allocation and profile of their capital structure with a view to reducing the cost of capital, satisfying stakeholder demands and financing new business initiatives. Strategic restructuring and re-domestication are potential routes for achieving this optimisation. The opportunities and the potential benefits afforded by strategic restructuring and re-domestication Structuring opportunities arise through reviewing carefully the regulatory, tax and cultural environment and, where alternative domiciles are being considered, recognising how these different elements interface on a cross border basis. In spite of the existence of the European single market, the relative freedom across Europe for countries to shape their conduct of business and tax requirements to fit their local domestic market and cultural outlook gives rise to considerable variations in approach and an ever changing environment. Local markets evolve as changes in the economy, legal and social framework lead to variations in policyholder demands and needs; and regulatory and fiscal authorities respond to this by introducing new requirements and practices. 2 Findings from KPMG International s Global Survey: Risk and Capital management for Insurers 2006: Efficient capital management is one of the biggest challenges facing the insurance industry. In an increasingly volatile environment, insurers will need to show a greater understanding of the risks that they face and the capital needs of the business, and not just because it makes good commercial sense. With tougher new regulations on the way, those that fail to implement rigorous risk and capital management on time face having higher requirements imposed.

6 5 Strategic restructuring and re-domestication for insurers The impact of regulation on group and capital structure Within Europe, insurance regulation is underpinned by European Directives (Directives) dealing with insurance, reinsurance and intermediation. Despite this common framework, a wide array of different national practices and policies has emerged, creating arbitrage opportunities and competition issues. Insurers that want to access the European market have a wide range of options in terms of how their business should be capitalised, structured and controlled within the broad framework of the Directives. Different member states have chosen to implement different options Figure 1: Restructuring and re-domestication: The executive agenda Effective access to markets Appropriate platforms in most efficient domiciles delivered through most effective group and capital structure Fiscal implications Operational efficiency Effective distribution and well managed, efficient operations to support client requirements Business effectiveness Market perspective Regulatory environment Efficient use of capital Appropriate level of risk capital allocated and managed most effectively and comprising an efficient mix of capital instruments contained within the Directives. Furthermore, additional prudential capital rules are imposed in many instances, from simplistic asset admissibility restrictions to sophisticated risk-based capital overlays. Also, supervisory approaches and practices vary greatly from country to country, from the strict and formalistic to those that value openness and a constructive dialogue with regulated firms. The existing framework will radically change under the Solvency II regime when it is introduced in approximately five years time. Some of these changes may already be anticipated in the application of the Reinsurance Directive to international groups, especially those headquartered in lightly regulated jurisdictions. These changes reinforce the need for all groups to review their structure and consider the operational and regulatory capital implications if certain jurisdictions are deemed not to operate an equivalent regime. Under both the existing and future regimes, the right to passport cross border business is a fundamental building-block of European regulation. Passporting presents significant opportunities for insurers providing a range of structural and distribution mechanisms through which they can freely access the European market. At the same time insurers can structure their business to avoid the need to comply with multiple regulatory regimes, with the added benefit of a larger capital base, and a single regulator. Despite the obvious advantages, passported business continues to represent only a relatively small proportion of European insurance premiums. However, the enthusiasm and rapid response of the reinsurance sector to its newly-established

7 Strategic restructuring and re-domestication for insurers 6 passporting rights under the Reinsurance Directive should stimulate insurers generally to look afresh at the opportunities available. Several international reinsurers have established a highly efficient hub-andspoke European structure over the last two years, whereby a single subsidiary is put in place in an optimal jurisdiction, which then conducts all of its EEA business on a freedom of establishment (branches) basis and/or freedom of services basis. In some instances, non-european business is also being written from the European hub. Clearly the reinsurance sector is aided by the relative lack of conduct of business rules in each jurisdiction. Fiscal impacts The corporate income tax regime in Europe is characterised by competition between states based on the free market, rather than a harmonised regime imposed by the European Commission. As a result, differences in corporate income tax rates and the diversity within the global fiscal environment are leading to considerable opportunities for insurers to improve the tax efficiency of their structure. Many aspects of taxation are relevant to restructuring. In particular, for insurance groups with cross border operations, the interaction of multiple tax regimes is complex and the tax cost implications of different country combinations can be extremely wide ranging. In assessing the structural opportunities it is relevant to consider not only the corporate income tax rates and the availability of low tax jurisdictions, but also the existence and terms of double tax treaties between jurisdictions, tax residency issues, the relative taxation of branches and subsidiaries and controlled foreign company legislation. Other taxes such as value added tax, insurance premium tax, and the personal taxation implications for employees and individual policyholders (in particular in the case of cross border life investment business) must all form part of the full analysis. Consideration should also be given to the implications of court interventions, particularly the European Court of Justice (ECJ), which deals with member states adherence to their European Union (EU) treaty obligations to free trade within the region. For cross border groups there are clear incentives to establish a group structure that avoids the potential for double taxation of foreign subsidiaries and branches. Two broad approaches have been adopted to date by fiscal authorities for dealing with cross border corporate income tax. One approach, for example taken by the UK and the US, involves taxing the whole of an entity s worldwide profits and allowing a credit for foreign taxes against the tax due. In essence the overall tax is topped up to the home country tax rate. The other approach is to exempt from tax profits of a foreign permanent establishment. This latter approach can sometimes confer an advantage where profits arise in lower taxed branches since there is no top up of the overall tax rate. As insurers increasingly adopt group structures involving the separation of capital, distribution and skills, many fiscal authorities are now pushing hard to secure what they believe is their fair share of the tax. One by-product of this is the greater prominence given by tax authorities around Europe to transfer pricing regimes aimed at ensuring intra group transactions take place on an arm s length basis. This has resulted in a review of the taxation of permanent establishments, with the latest indications suggesting that in future tax will be levied by reference to skills rather than capital. These changes will undoubtedly influence future choices for group structure. As far as taking a strategic approach to group and capital structure is concerned, it is not only the different tax and regulatory treatments by local domiciles, and new business opportunities that have stimulated restructuring activity. Changes have also taken place in the legislation surrounding European cross border mergers. This has introduced procedures to facilitate the legal transition from one domicile to another, as well as providing clarity as to the tax implications of so doing, and also some relief. A key feature is the introduction of the European Company (Societas Europaea) 3. 3 Draft Part IV of the OECD report on the taxation of permanent establishments 2007

8 7 Strategic restructuring and re-domestication for insurers Strategic restructuring and re-domestication trends As global insurers strive to achieve scalability, flexibility and efficiency in their operating and market access platforms and capital structures, a series of established and new trends is emerging. These trends in restructuring and re-domestication may be grouped into three broad categories: consolidation and streamlining, re-domestication, and group holding company and capital restructuring Consolidating and streamlining makes for a simpler, more manageable group structure. It involves striking off redundant companies and consolidating others, having regard to the most effective platforms from which to access European business and seeking finality for run-off business. Many insurers are reconsidering the relative merits of European branches versus subsidiaries. Lloyd s of London has recently regained popularity with foreign insurers wishing to access London market and international business, benefiting both from Lloyd s rating and its network of international licenses. Consolidation and streamlining activity can be structured to deliver greater capital efficiency and an improved control environment and to release resources for new business opportunities. Re-domestication exploits the arbitrage opportunities which arise from regulatory and fiscal differences, and places them in the context of the business development opportunities that have emerged. Two broad re-domestication trends have emerged. The first involves redomesticating the entire business and insurance underwriting platform (including capital and its centre of management and control) to a preferable domicile, and utilising passporting to access distribution in local markets. The second involves using reinsurance to repatriate results, perhaps to low tax domiciles outside Europe. To date, re-domestication has occurred predominantly in the non-life market, especially personal lines and wholesale market business, with the UK experiencing most activity. On the life side, due to domestic market differences in the legal system and social provision, and complexities in relation to cross border policyholder and corporate income taxes, it is likely to be some time in the future before a truly pan European life insurer providing a single suite of products is formed. Notwithstanding this, initiatives are emerging for niche life products where specific benefits derive from writing these cross border. As regards the use of reinsurance to repatriate risks and results, this type of structure has a long history among major European groups as well as being common in the Lloyd s markets. In each case benefits can

9 Strategic restructuring and re-domestication for insurers 8 include lower regulatory capital and a reduced effective tax rate although from a group perspective the major commercial benefit is usually the pooling of large risks and the ability to manage external reinsurance more effectively. Group holding and capital structures can give rise to a host of problems for example, dividend traps, solvency impairment, complexities in reporting requirements as well as administrative burdens. Insurers which structure themselves optimally can benefit from lower capital through diversification, improved fungibility, as well as performance enhancement through better capital allocation and measurement techniques. Trends in this area include tax efficient holding and finance structures to save tax on capital supporting underwriting operations and careful structuring of operations falling under any European level holding company to limit the consequences of requirements imposed by the Insurance Groups Directive. Increasingly insurers are replacing equity capital with more flexible and tax efficient forms of capital, as well as using more innovative techniques for managing capital contributions and withdrawals. New reinsurance structures are also being developed to manage risk and capital. Implementing structural change Restructuring, with or without re-domestication, offers huge potential benefits, but these projects can be massive in scope and scale. To be successful, each stage needs meticulous planning, sound technical and market expertise, and close attention to detail. Ensuring the right result It is critical to approach a potential restructuring of a group in a logical and considered manner, ensuring the involvement and engagement at the appropriate time(s) of all of the relevant parties in the organisation. There is no one solution or special formula to determine the most appropriate structure and each organisation will have its own set of circumstances driving its optimal structure. It is vitally important therefore that account is taken of the business aims and the drivers, and that any constraints and deal breakers are identified at the outset and used as a reference point in benchmarking any restructuring options. The key is to ensure that the correct decision is taken and the implications understood. Our member firms experience helps to show that there are many steps involved to ensure a successful outcome essentially these include strategic analysis and feasibility, detailed design and programme planning, followed by implementation. As cross border restructuring projects progress so the team will evolve from a small centralised group of specialists to more widespread engagement in the business. Communication and stakeholder management is essential.

10 9 Strategic restructuring and re-domestication for insurers The practical steps involved Implementing a restructuring and re-domestication project can present many challenges and the costs need to be balanced against the potential benefits. It is vital that organisations identify early on what the critical success factors are. Examples include key man retention, obtaining the support of policyholders, rating agencies and capital providers as well as maintaining business continuity throughout the transition. On a practical level, common implementation hurdles include: data requirements and systems migration, policyholder circularisation, logistical issues such as new offices, the ability to move both people and the company s head office infrastructure, as well as changes to governance and reporting. These are in addition to potentially complex regulatory, legal and tax approvals, and the opinions and information required to support these. The costs of the transition also need careful investigation, not only in resourcing terms but also in achieving financial and capital efficiency during the transition. Planning and programme management are critical. Issues need to be captured and managed from the outset, including coordinating interdependencies and managing resource requirements and costs. Taking action Retaining unwieldy group structures and inflexible capital profiles is potentially highly damaging to performance. Taking a strategic view of the group organisation and capital structure can offer significant competitive advantages and restructuring of this type is becoming increasingly common. KPMG firms view is that a regular reappraisal of company and group structure should be part of insurers business as usual strategy as the industry continues to evolve. Restructuring is not a one-off, once-a-decade activity. Regular structural review should be part of every insurance firm s business as usual strategy as the industry evolves. Figure 2: Critical questions and actions for insurance leaders Questions to ask Strategic analysis considerations Have we considered the cost associated with our structure? Is our business capital constrained or capital rich? Are our underwriting and distribution channels working effectively? Is our structure damaging our efficiency and financial performance? Are we using our capital most effectively? Is it fungible? What are our preferred operating platforms and where should they be located? Could we make savings by consolidating and streamlining? Are we making use of European passporting opportunities? Is our holding company structure tax efficient could it be improved? Can we improve our capital profile and make it more flexible, regulatory and tax efficient? Do we allocate and manage our capital most effectively? Should we be discontinuing certain lines? Is re-domestication an option - how might we benefit? How will Solvency II affect our group? What are our business requirements, strategic drivers and constraints and how could we change our structure to best deliver these? Many organisations are asking themselves these questions, leading them to review the opportunities and benefits of taking a strategic approach to determining their optimal structure

11 Strategic restructuring and re-domestication for insurers 10 Conclusion The international insurance industry continues to transform itself in response to changes in the shape of insurance markets, their convergence with the capital markets, the interface between underwriting and distribution, and new business opportunities which are emerging around the world. Fundamental changes to regulation are also on the way that will undoubtedly have a global impact, particularly Solvency II, the aims of which have now been embodied in IAIS standards. It is widely anticipated that within Europe these changes will lead to considerable restructuring of the market and this will encourage insurers with European operations to restructure in order to remain competitive and take advantage of new opportunities. As current trends and widespread activity shows, many insurers have identified substantial scope for improvement through restructuring. Whilst in the past insurers and their stakeholders may have tolerated inefficiency, perhaps in the group structure, its capital or operations, competitive forces are unlikely to allow this to continue. Restructuring is no longer a clean up exercise, performed once a decade. For insurers to maintain their performance and competitive edge, it should become an iterative process. Insurers which act now to improve their structures can expect to generate both immediate rewards, such as improved returns and market value, and opportunities for the future, including the ability to respond to changing market conditions, the opportunity to self-fund new investment, and the benefit of a simpler structure through which to implement Solvency II and cope with other regulatory, accounting and fiscal changes.this paper seeks to explore further the issues and forces involved for insurers, and aims to support management thinking about how they might benefit from restructuring and re-domestication, and the factors that need to be considered to reach the right solution. We investigate the internal and external challenges insurers face in seeking to adopt a more efficient structure, and we outline the steps involved in doing so. We would welcome contributions to advance the debate about the issues discussed here.

12 11 Strategic restructuring and re-domestication for insurers 2. The business outlook Operational efficiency Effective access to markets Fiscal implications Business effectiveness Market perspective Regulatory environment Efficient use of capital European market overview Insurers in many countries are under fierce pressure to enhance value for shareholders, or in the case of mutuals, their members. To meet these demands, their managers need to ensure that the business models adopted are competitive and responsive to new opportunities, whilst maintaining the right balance between investment and return on capital and between cost and risk. The European insurance market comprises a diverse mix of insurers and reinsurers, operating through different distribution, carrier and ownership structures. They serve a range of markets from local consumers to sophisticated global corporates. It is no surprise then that the impact of market pressures varies according to the nature of specific markets served, as well as the circumstances of the insurers themselves. For example, local domestic insurers have a different set of challenges from foreign insurers selling commercial insurance into the European market. Likewise, a mutual faces different pressures from an insurer financed by private equity, a life insurer compared to a non life insurer, and so on. Within Europe, the most established insurance markets have traditionally been regarded as the UK, Germany and France. Insurers domiciled in these countries not only serve domestic markets but also have a significant wider European presence. A number of Swiss insurers are also influential across Europe, notwithstanding that Switzerland technically falls outside the European Economic Area 4 (EEA). In other countries, such as Spain, Italy and the Netherlands, the focus of the major domestic insurers has largely been on the local market, with only a few groups operating on a truly multinational basis. In contrast, countries such as Ireland, Gibraltar, Malta and Luxembourg have emerged as home to many cross border insurers wishing to access the wider European market on a tax and capital efficient basis; in these cases relatively little business generally relates to domestic risks, or to business underwritten locally. A brief overview of the UK, German, French, Dutch and Swiss insurance markets highlights the variety of factors and developments that are relevant to considering what restructuring and re-domestication mean to each market. 4 EEA comprises: Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Republic of Ireland, Italy, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, the Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the UK

13 Strategic restructuring and re-domestication for insurers 12 UK market The UK insurance market is the largest in Europe on the evidence of recent statistics 5. Its growth and significant change over the last 40 years reflect the impact of factors as diverse as the ending of the tariff regime, globalisation, the advent of direct writers, and latterly the internet as a distribution mechanism. In the life insurance market, the relatively limited provision of state social security benefits has encouraged private provision through insurance and pension contracts, whilst the nature of savings products has been transformed over recent years from traditional with-profits contracts to collective investment products, wrapped in an insurance contract. These changes have been accompanied by high levels of consolidation within the industry and restructuring within groups. None of the dominant UK non-life companies of the mid-1990 s remains in similar form today, and only a few of them reflect significantly their origins, albeit legacy structures still constrain their development in some respects. Many of the major UK non-life companies are now owned by banks or have foreign parents, including the largest European groups; in the London Market and Lloyd s, foreign ownership predominates. Profitability has been cyclical, and at various stages several of the major UK companies have had to shore up their balance sheets because of the coincidence of poor stock market performance, economic factors and natural catastrophes. In contrast, innovators such as the direct writers have achieved high returns over long periods. This is in spite of the market becoming considerably more demanding for them recently, in the face of cyclical trends in personal lines business and the impact of aggregators, whose internet sites have commoditised parts of the market, especially private car insurance 6. The consistent impact of these changes on the UK market has been to increase competition and to force insurance companies to explore the available options for increasing profitability and reducing the amount of capital required to underwrite the same amount of business. Restructuring and re-domestication fit within this trend. The legacy of the way in which many major UK groups were created through merger and acquisition has been the need to streamline the businesses subsequently. There has frequently been an unnecessary duplication of capital provision in multiple insurers, which can be eliminated through group reorganisations. Improvements in regulation, especially the recent move to individual, risk based capital assessments, has accelerated this trend. The other trend, particularly in the non-life sector, is towards re-domestication. The use of offshore centres, typically in Ireland, Gibralta and Bermuda as the location for the head offices of insurers has increased substantially in recent years in the wholesale, reinsurance and Lloyd s markets. There are also a number of cases of UK retail business exploiting this model for the regulatory and tax advantages it brings. The scale of change and the willingness to explore new routes to market reflect at the same time the strength and weakness of the UK insurance market. 5 Swiss Re Sigma 6 Insurance aggregators are web based solutions for consolidating up to the minute insurance information so as to enable potential customers to compare products

14 13 Strategic restructuring and re-domestication for insurers German market The German insurance market is highly mature but operates differently from the UK market in a number of important respects. Although the third largest market in Europe, the level of insurance penetration per capita and relative to gross domestic product (GDP) was only 12th in Europe in This is partly explained by Germany s relatively generous state benefits and consequently relatively low level of life insurance premiums. Nonetheless the structure of the German insurance industry has changed in recent years, reflecting some of the factors also seen in the UK, for instance increasing mergers and acquisition activity, globalisation and substantial internal reorganisation. However the market is considerably less concentrated than elsewhere in Europe. Though the single largest group is more dominant than in any other major European market, much of its business is international. Beneath this and a couple of global reinsurers headquartered in Germany, the market retains a substantial body of mutual insurers and public insurers (i.e. local authority or state owned) which continue to operate successfully. Size, corporate form, regional focus and product specialisation lead to differing structural considerations for each of these types of insurer. In particular, many of them focus on maximising market share and policyholder benefit for a given level of capital in contrast to the proprietary companies predominant (if not always successful) focus on maximising return on capital to shareholders. The German insurance regulator and legal system have reinforced this bias, with their emphasis on market stability, consumer protection and policyholder rights. Currently, in advance of Solvency II, new requirements have been introduced for appropriate enterprise risk management systems. This reflects a rigorous and perhaps intrusive regime that has generally avoided the insolvencies and financial crises which have motivated the forced acquisitions and restructurings elsewhere. Nevertheless German regulation has not been hostile to foreign ownership nor mergers and acquisitions where policyholder rights have been secured or enhanced. 7 Swiss Re Sigma

15 Strategic restructuring and re-domestication for insurers 14 The restructuring and consolidation of the German domestic market have primarily reflected particular features of that market. A number of the major mutuals have formed unions and subsequently restructured under common holding companies, allowing greater flexibility in capital raising whilst retaining the policyholder benefits of mutuality for their members. Foreign companies, particularly Swiss, Italian and French ones, have made acquisitions in Germany although little business is transacted through branches of foreign companies. The substantial and highly acquisitive German reinsurance industry has expanded well beyond its original boundaries, including ownership of, or close links, with direct writers. Notably, until the implementation of reinsurance regulation in 2004, the German reinsurance industry was itself unregulated but regulated indirectly by its cedants. In contrast to the UK, direct writers have been slow to make an impact, distribution being multichannelled albeit dominated by tied and independent agents. Leaving aside large risks, captives and reinsurers, only one sector has paid particular focus to the opportunities for re-domestication and that is the highly specialised case of variable life annuities. Here the motivator for cross border sales has been the conservative German regulatory requirements that make it more efficient to offer the product from other EEA states. Accordingly, some of the concepts and assumptions that underlie this paper may take some time, or more probably need adaptation to suit the German insurance market. French market The second largest in Europe, the French insurance market is heavily dominated by its life sector which has expanded greatly in the retirement, savings and healthcare markets and now represents over 75% of the total market. A dominant feature of the market in recent years has been the trend towards consolidation, involving both mergers and acquisitions and the establishment of various alliances. Thus many of the mutuals have merged to form larger entities capable of operating in the highly competitive local environment, but proprietary companies have also consolidated, some of them as a result of cross border acquisitions. The market is distinguished by the closeness of association of insurance companies with banks, notably in the life insurance business, both through ownership links and joint trading arrangements. Over 100 branches operate in the French market, more than half of them come from three countries: the UK, Germany and Belgium. In addition, nearly 900 companies are authorised to offer their products in France under EEA rules on mutual recognition, mostly for non-life business, and over half from the UK, Ireland and Germany. However the scale of business written through branches and on a services basis is small compared to that written by locally established companies. Thus, whilst there is potential for the expansion of cross border business, established local insurers and existing distribution mechanisms, especially tied agents, are very dominant. A pattern which is reinforced by French conduct of business rules. Dutch market The Dutch insurance industry is substantial and mature serving one of the top five markets globally in terms of premiums as a percentage of GDP and ranked only slightly lower in terms of per capita premium income. Like the UK market, the Dutch market has traditionally been less heavily regulated than the German one. The primary drivers of change have been economic, with increasing concentration in recent decades both for the industry as a whole and for individual classes of business, especially life insurance. However more recently, regulatory change has become a significant driver with the transfer of health insurance entirely into the private sector from 2006 and the adoption of the new Financial Supervision Act, which consolidates legislation on the supervision of financial service providers. Dutch insurers have undertaken some restructuring in recent years but this has reflected primarily merger and acquisition activity, the impact of bancassurance models and cost reduction rather than a response to capital shortages and perceived new structural opportunities in the market. Swiss market Switzerland has a sophisticated insurance market, with one of the highest levels of premium volume both per capita of population and relative to GDP in the world. The scale of the market reflects a combination of domestic financial stability and prosperity over many years, and the number of multinational companies headquartered in Switzerland, especially in the region of Zurich. It also reflects the need for Swiss companies to look abroad if they are to achieve expansion. Thus, over two thirds of the business of Swiss-based companies is conducted internationally, primary writers mostly using branches and subsidiaries abroad, reinsurers additionally trading heavily on a cross border basis. There is also heavy concentration of premiums being written with relatively few companies. Over two thirds of the total Swiss premiums in 2007 were written through only three companies.

16 15 Strategic restructuring and re-domestication for insurers The Swiss insurance industry shares with Germany a tradition of close regulation of participants in the local market. This includes insurance companies prudential regulation, insurance contract regulation and intermediaries regulation. The industry has encouraged close cooperation with the European Union (EU) so that Swiss regulation has many equivalent features. These have led to agreement with the European Commission allowing Swiss non-life insurers to benefit from certain reciprocity arrangements. More recently, the Swiss Federal Office of Private Insurance (FOPI) introduced its risk based Swiss Solvency Test (SST) which anticipates the requirements of the forthcoming European Solvency II regime. Again, the objective here is equivalence with a view to allowing Swiss insurers to benefit from the wider European market when Solvency II is implemented across Europe. The largest Swiss groups are monitoring trends in restructuring and redomestication closely. Some are already adapting trading and group structures to improve access to European markets and to increase efficiencies. Solvency II is likely to encourage Swiss insurers to consider further the optimum structures for their international business and maybe also for their domestic business. Competition and the impact on European insurers The emergence of new insurance markets and distribution channels, changes in the regulatory and fiscal environment, together with the demands posed by clients, investors and rating agencies are having an impact on insurance structures, creating opportunities but also potentially threatening insurers that do not act. European insurers face significant competition not only from their European counterparts, but also increasingly from their offshore competitors. Within Europe, competition exists both within local domestic markets and across the wider European region. In recent years the major domestic markets have experienced consolidation on many levels, with the emergence of increasingly large insurers through mergers and acquisitions, as well as organic growth and a series of new entrants to the market. Increasingly this competition is becoming a cross border issue. Significantly, the free market access afforded by European Directives has brought about regulatory and tax arbitrage opportunities. This has led to the separation of capital, skills and distribution for those firms selling non-life personal lines insurance, such as motor and household, which are seeking capital and tax efficiency. This freedom has also paved the way for the introduction of new products to traditional markets for example, in Germany traditional life policies must now compete with variable annuities sold from other EEA member states. Furthermore, as if local competition is not enough, European insurers in certain markets face increasing competition from offshore insurers. With a plentiful supply of capital and low tax rates, insurers based in countries such as Bermuda have a clear cost advantage over their European counterparts. Together with higher European regulatory capital requirements, this is driving a potentially significant differential in the overall return on capital. It is also leading to the emergence of some new and innovative ways of accessing and structuring the business, approaches which are not simply restricted to the commercial markets. A number of insurers of personal lines business have adopted value-enhancing business models, using innovative off shore structures.

17 Strategic restructuring and re-domestication for insurers 16 This external competition is compounded by the fact that many insurers have legal, domicile, operational and capital structures that have evolved over many years, leading to inefficiencies and lowering operational performance. In some instances these legacy structures are giving rise to competitive disadvantage, in particular in the corporate sector where many insureds now demand seamless global coverage for their insurance programmes. The corporate, reinsurance and credit sectors are also facing the challenges of heavier demands from rating agencies, the switch in focus to the need to deliver short-term returns as new forms of capital enter the market, and for non-life insurers, the need to deliver consistently throughout the cycle. The trend towards restructuring Complex group structures, multiple operating platforms and an inflexible capital profile are common features of insurers looking to restructure. Many are concerned about operational inefficiencies and constraints in their ability to attract business for example due to insufficient capital in local insurance operations, and fragmented distribution and product offerings. These and other inefficiency indicators - such as a relatively high effective tax rate are some of the key drivers causing insurers to restructure. Many insurers are examining their strategy to find new and innovative ways to derive business value and to ensure that they remain competitive. Most are looking into ways of improving their insurance service offerings. For example, in the case of global corporate clients, insurers are considering how their group insurance operations can best be integrated to allow them to provide the necessary, comprehensive level of insurance cover across the globe. Some are focusing on improved risk management and more dynamic capital allocation, including restructuring their capital to offer improved security to clients. Others have taken more drastic action, turning to tax and regulatory arbitrage to achieve enhanced returns. All of these trends are leading insurers to restructure their business arrangements and market access platforms more efficiently, and to create a complementary, flexible capital structure. KPMG firms have seen these trends at work in recent heavily-publicised reorganisations by a broad cross section of insurers and reinsurers around the world; most of the major groups and a significant number of middle market players have undertaken some form of restructuring. For example, a number of insurers have changed their organisational structure to improve the way in which they deliver to clients, and to enhance their capital position in order to secure more business. In addition, a number of insurers operating in the Lloyd s market in London, which comprises a mix of UK, European and international players, have sought to reduce their tax charge by re-domiciling their head office operations to Bermuda. Another growing trend has been for personal lines insurers to change their legal structure to operate on a more efficient pan-european basis through a branch, rather than subsidiary, network. Increasingly these insurers are also moving their domicile to, or else establishing subsidiaries in, jurisdictions like Luxembourg, Ireland, Gibraltar and Malta, which are lighter on regulation and taxes than some of their European counterparts, or else using cost efficient reinsurance structures in such countries. On a national level other restructuring trends are emerging for example, many mutuals now prefer to have a mutual holding company with the insurance operations in subsidiaries. During 2007, following the implementation of the Reinsurance Directive, a number of global reinsurance groups based outside the EEA announced their intention to restructure their European operations into a single pan European reinsurer citing capital, regulatory, and operational efficiencies as their change drivers. Restructuring and the executive agenda Insurers across the globe are facing challenges on many levels. As the industry evolves and external factors, such as the regulatory and tax environment continue to change, businesses are becoming more open to structural change, recognising the benefits and facing up to the challenge of what is involved. As viable routes continue to emerge, optimisation of organisational and legal entity structures is increasingly appearing on the executive agenda and, as time passes, its reconsideration is likely to become a regular feature.

18 17 Strategic restructuring and re-domestication for insurers 3. The regulatory dimension Operational efficiency Effective access to markets Fiscal implications Business effectiveness Market perspective Regulatory environment Efficient use of capital Regulation plays a vital role in insurance groups organisational strategy, presenting a range of opportunities and challenges for insurers in determining the most effective overall structure. This section seeks to explain in turn the current status and anticipated developments in the regulatory landscape across Europe and more widely, and the impact this is having on insurers, and to highlight the opportunities and hurdles presented by restructuring. The challenges and opportunities Regulation of insurance business in Europe is all encompassing. Insurers, reinsurers and insurance intermediaries all fall within the scope of regulation and are subject to licensing, capital, prudential and conduct of business requirements. The key elements of the regulatory framework are discussed in more detail over the following pages together with consideration of the impact of expected future regulatory developments. Improved performance through regulatory efficiency is driving strategic and structural change. Regulatory opportunities presented by restructuring and re-domestication include: lower regulatory capital and improved fungibility, greater regulatory freedom and market access, as well as reduced compliance and supervisory burden. Critical hurdles and challenges to restructuring include the ability to transfer business and to finance the transition, avoiding holding dual capital and incurring tax charges as the business is reorganised. The effect on customers, reinsurers and the insurer s rating, together with the impact on staff, are vital issues for insurers to understand early on.

19 Strategic restructuring and re-domestication for insurers 18 European regulatory overview In the EEA, insurance regulation is underpinned by various European Directives which aim to set minimum equivalent standards for European insurers carrying out insurance business, opening the doors for insurers to operate freely across Europe 8. These include three main Non-life Insurance Directives and a Consolidated Life Directive (collectively referred to herein as the Solvency I regime), which prescribe requirements relating to the prudential supervision of insurance companies (governing the capital and internal control aspects of the insurer). A more recent directive, the Reinsurance Directive (RID), provides similar requirements for reinsurers. In addition, the Insurance Mediation Directive (IMD) introduced in 2005 provides a prudential and conduct of business supervisory regime for the sale of non-life insurance and reinsurance, as well as pure protection products. The Insurance Directives have been in effect for many years and have generally been implemented in full, although variations in policy and supervisory standards exist. A forthcoming directive (Solvency II) is being developed, with one of its aims being to achieve common implementation across the EEA, with no regional variances. In contrast to the Insurance Directives, the implementation of the IMD across the EEA has been mixed with different approaches, and some countries yet to implement the requirements in full. Whilst the IMD is applicable to intermediaries, a number of member states have applied the regime to insurance companies also, reflecting differences in national practices regarding the sale of insurance. In a number of cases there is no regulator per se, rather oversight rests with a trade body. Under the European Insurance Directives, a wide array of different national practices and policies has emerged, creating arbitrage opportunities and competition issues. Insurers that want to access the European market have a wide range of options in terms of how their business should be capitalised, structured and controlled within the broad framework of the Insurance Directives. The existing framework will radically change under the Solvency II regime when it is introduced in approximately five years time. This further reinforces the need for groups to rethink their structure. 8 Note that Switzerland is outside the EEA and hence Insurance Directives do not apply

20 19 Strategic restructuring and re-domestication for insurers Passporting Passporting provides a range of structural and distribution mechanisms through which insurers can freely access the European market. At the same time insurers can structure their business to avoid the need to comply with multiple regulatory regimes, with the added benefit of a larger capital base, and a single regulator. The opportunities The Directives provide freedom for insurers and reinsurers to operate across the EEA (known as passporting). Passporting is a key benefit enjoyed by European based insurers and provides an opportunity to structure the business to access the wider European market under the supervision of a single prudential supervisor. Two mechanisms exist through which an insurer authorised in one EEA member state can apply to its home state supervisor to access business in another state (known as the host) freedom of establishment and freedom of services. The key difference is that under freedom of establishment there is a permanent presence of the insurer, either in the form of a branch or dependant agent, whose relationship with the insurer satisfies specified criteria. Whilst freedom of services provides insurers with the opportunity to write business across Europe, it offers less flexibility in terms of distribution mechanisms to access the market. However there are some advantages, such as fewer local regulatory conduct of business implications and avoiding liability to local corporate income tax. Under both mechanisms it is important to consider the wider regulatory consequences and, critically, the impact of intermediary sales regulation. By appropriately structuring distribution and underwriting arrangements, whether intra group or with third parties, insurers can minimise the number of regulatory licenses required and the associated compliance burden involved. Potential constraints There are constraints to passporting. First, it is only available for insurers headquartered within the EEA; foreign insurers with European branches do not qualify. Secondly, cultural practices, regulatory and legal differences can sometimes lead to a preference to use a local insurance company, which in certain circumstances may constitute a barrier to market entry. For example, for some types of life business, passporting can lead to added complexities which need to be managed. These include, in particular, the interface of corporate and personal income taxes. The key is balancing all the competing factors and establishing the most effective arrangements to access a particular market, whilst seeking to minimise any adverse regulatory and tax consequences. Many insurers use passporting extremely successfully and, increasingly, foreign insurers are moving towards a hub and spoke structure for their European operations, the hub being an EEA authorised subsidiary and the spokes its branches. Regulatory capital In the EEA, the regulatory capital regime for insurers and reinsurers is governed by the Insurance and Reinsurance Directives. Despite this, a number of different approaches have emerged and regulators are increasingly developing new policies and practices for assessing the regulatory capital of insurers under their supervision. These range from applying percentage loadings to the Solvency I requirements,

21 Strategic restructuring and re-domestication for insurers 20 through to risk weighting of assets and liabilities, and in the UK, a risk based capital approach. Increasingly insurers in Europe are taking advantage of these regulatory arbitrage opportunities and are choosing to establish their businesses in less capital intense environments. European regulatory capital requirements in a nutshell The Directives aim to ensure that insurers can meet their policyholder obligations as they fall due. Thus insurers must hold sufficient capital in a form that provides a satisfactory degree of security and permanence, and that capital must be invested in suitably diversified, well-matched and appropriately liquid assets. In addition, insurers must have fit and proper management who manage the business in a sound and prudent manner to ensure that external challenges and threats are dealt with in an appropriate way, above all so as to minimise the risk of loss to policyholders. European regulatory capital requirements have evolved over many years and are currently governed by the Solvency I and Insurance Groups Directives (IGD). These provide for a solo company and group level solvency test, with the requirements for group solvency building from the solo rules. The IGD does not require that the group capital must exceed the group solvency requirements, but does require supervisors to take appropriate measures, which can require new capital to be injected if it does not. It is therefore sometimes referred to as a soft (i.e. non mandatory) requirement. Under Solvency I, the amount of regulatory capital required is calculated differently for life and non-life companies. For life companies it is determined by reference to the insurance reserves held for regulatory purposes, and for non-life companies it is calculated by reference to the levels of premiums and claims, both with an allowance for reinsurance. In assessing the coverage of the regulatory capital requirement, insurers are required to value their assets on a prudent basis applying strict admissibility rules and concentration limits. More flexibility is, however, available for pure reinsurers. Evolving practices in regulatory capital Whilst some regulators apply these Directive requirements verbatim, most require insurers to hold a higher level of capital on a solo basis. For instance, this has been standard practice in the UK for many years, initially by requiring insurers to hold a multiple of the % rate of taxation 40% 20% 100% 150%* 150%** 100% Directive requirement (using a rule of thumb of up to two times depending on the business written), and by making group solvency a hard test at EEA holding company level. More recently, the UK s Financial Services Authority (FSA) has introduced a risk based solo solvency test, in addition to the Solvency I Directive test, to reflect the risk inherent in the business, in the way it is managed and controlled, and additional risks arising from its group membership. The requirement (which applies at solo level only), is called the Individual Capital Adequacy Standards (ICAS) and is regarded by many as the precursor to the planned new solvency regime for Europe (Solvency II). Figure 3: Regulatory and tax benchmarking for selected countries 150% 100% 100% + Swiss Solvency Test 100% + Individual Capital Adequacy Standards Germany Gibraltar Ireland Luxembourg Malta Netherlands Switzerland UK Corporate Income Taxes Insurance Premium Taxes Value Added Taxes Note: # reflects effective tax rate for Malta for profits on risks outside Malta and the tax rate anticipated for Gibraltar insurers (Source: Government of Gibraltar 12 February 2008) Indicative regulatory solvency based on KPMG s recent experience of core regulatory capital policy as % of Solvency I. The overall capital is assessed by reference to a range of respective regulators factors and may be subject to restrictions / loadings. Each case is assessed on its merits. Regulatory policy tends to vary according for new start ups and on an ongoing basis for established operations. Notes: *predominantly relates to motor / short tail **200% at authorisation, for reinsurers 100% Indicates risk based capital regime and bespoke regulatory capital Source: KPMG International s Corporate and Indirect Tax Rate Survey 2007

22 21 Strategic restructuring and re-domestication for insurers Other EEA regulators are also reviewing their capital and other standards and many impose requirements above the Insurance Directives basic Solvency I 9 criteria. For example, the Swedish regulator has implemented risk-based elements to its capital approach, whilst several other regulators now apply a Solvency I capital loading, for example 50 percent in Ireland and Malta 10. The German regulator, the Bundesbank and German Financial Supervisory Authority (BaFin), whilst retaining the Solvency I capital requirement for non-life insurance, prescribes specific rules, for example, for the treatment of certain life business making the capital requirements higher than the Directive minimum. The BaFin has also recently introduced a new standard in governance and risk management. Turning to groups, the IGD provides for various calculation methodologies and, in practice, regulators have adopted a range of approaches. This has resulted in the potential for different outcomes, depending on which local rules are applied. It is these differences, at both solo and group level, that are leading to regulatory arbitrage opportunities. How insurers are facing up to the challenges of risk based capital The implementation by some local regulators of a risk based solvency approach has led, in some cases, to an increase in regulatory capital above the Solvency I requirement on an individual insurer basis. Those requirements may also include capital loadings for reasons such as poor governance and risk management, inadequate controls and unmitigated reinsurance credit risk For some, these changes in approach to regulatory capital were initially unwelcome in the affected jurisdictions, and were viewed as an unnecessary and costly intrusion into the way that business is run. For a number of insurers such approaches have proved to be painful, resulting in significant capital loadings, and on rare occasions has even threatened their business model. For example, a number of UK life organisations needed to raise new capital to meet the FSA s standards. 9 Solvency I Insurance Directive prescribes minimum capital requirements for insurers 10 The actual solvency capital requirement is, in all countries determined by reference to the specific circumstances of the insurer in question. Local policy for established and start-up insurers also varies.

23 Strategic restructuring and re-domestication for insurers 22 Risk based capital is both an opportunity and a threat. For insurers that embrace the regime it is merely a step towards performance-enhancing integrated enterprise risk management. In contrast, insurers who fail to implement a satisfactory risk based capital framework will see their regulatory capital increase. In time, the consequences could be far-reaching, leading to a competitive disadvantage. A desire to create more effective risk management is just one of the factors driving firms to restructure. However, many of those same insurers are now welcoming the challenge of a risk based approach as being essentially sound commercially, and where deficiencies are identified, they recognise the value of improving their risk management practices and their understanding of the potential financial impact of risk in their business. Taking this a step further, some insurers now view a risk based regulatory capital approach as an opportunity to improve business performance and capital management; ultimately they envisage the regulatory requirement being a stepping stone towards, and ultimately a bi-product of, integrated and total enterprise risk management. Restructuring subsidiary structures into branches has also provided some insurers with the platform to enforce a more integrated and consistent approach to risk management across the organisation. With risk management standards now being reviewed by the rating agencies, the stakes are rising considerably for some insurers, for example corporate and credit insurers and reinsurers, such that it is the rating agencies that have become the ultimate drivers of capital and risk management. A desire to enhance risk management, and the fact that this is intrinsically linked to capital management, will drive an increasing trend in restructuring. Opportunities arising from changes to regulatory capital As the European regulatory capital regime evolves it is giving rise to opportunities, challenges and threats. At the most basic level the variety of regulatory practices has created significant arbitrage opportunities as insurers strive to minimise the basic regulatory capital to remain competitive. Whilst this has led some insurers to re-domicile in less capital intensive jurisdictions, for a few insurers the introduction of risk based capital in some countries has resulted in a lower regulatory capital requirement than they had previously been required to hold using less scientific a rule of thumb basis. For insurers taking a strategic approach, this has led to improvements in capital allocation and the identification of further scope to improve capital efficiency, for instance through diversification and more dynamic capital management techniques. In addition, reviewing the capital structure and working effectively with the regulatory rules at solo and group level has presented opportunities for insurers to manage the cost of capital and its tax efficiency, for example through the use of preference shares and subordinated debt, as well as other more innovative forms of capital.

24 23 Strategic restructuring and re-domestication for insurers The wider impact of European regulatory change As regulatory regimes across Europe evolve, many foreign insurers are restructuring their European operations to optimise their capital and organisational structure. Solvency II will have far reaching impacts on insurers based outside the EEA whose regulatory regimes fail to meet the new European standards. This is causing international regulators as well as recognised professional and supervisory bodies, such as the International Association of Insurance Supervisors (IAIS), to look to Europe for guidance and compatibility in developing their regulatory regimes. Within Europe, the UK FSA has probably been one of the most active regulators in developing its regulatory approach. The FSA s latest initiatives include Principles-Based Regulation, an enhanced monitoring regime (Arrow II) and the risk-based ICAS. The FSA s approach has increased regulatory intensity for insurers in the UK significantly over recent years and it can be reasonably anticipated that the Solvency II regime will take this further throughout the EEA. As the Solvency II framework develops, other European regulators are increasingly looking at risk management and developing their supervisory approach accordingly. The new approaches in Europe are also reverberating across the globe, with early indications of a trend amongst non-eea regulators, and recognised regulatory and industry bodies, to develop more harmonised global standards in insurance regulation. These changes are already causing insurers to contemplate their structures. Examples of developments in foreign regulatory regimes include: Switzerland, a special case because of its recognition within the EEA, has just implemented its Swiss Solvency Test, a risk-based capital approach aimed at aligning the regime to Solvency II. The Bermuda Monetary Authority (BMA) is beginning to implement a risk-based capital regime for its Class 4 insurers and reinsurers, reflecting the build up to Solvency II equivalence.

25 Strategic restructuring and re-domestication for insurers 24 The Australian regulator APRA has for some time adopted a risk-based approach, which was introduced in response to the lessons learnt from the insolvency of some major insurers in the late 1990s and early 2000s. It is now developing this for groups. Finally the US, which adopts a state by state approach to insurance regulation, is contemplating a move to a federal regime. The New York regulator has also recently announced it is following in the steps of the UK FSA by adopting a Principles based approach. These changes in the regulatory environment have brought and will continue to bring about significant changes in how groups are capitalised, structured and controlled. For global groups in particular, the challenge is to understand the various regulatory requirements, to recognise the opportunities they pose, and to formulate a structure that allows the business to maximise the benefits whilst at the same time minimise any adverse regulatory implications. Insurers that fail to keep up run the risk of being penalised by both regulators and rating agencies, and could see their reputation and business suffer as a result. The business impact of the Reinsurance Directive The Reinsurance Directive has caused European and foreign reinsurers to become authorised and this is influencing their choice of structure and domicile this is evidenced by some recent moves by some of the large global reinsurers to alternative European jurisdictions. The Reinsurance Directive (RID), which had to be implemented across Europe by December 2007, requires all reinsurers to be authorised. Prior to this a range of approaches were in place. In the UK, similar standards for insurance and reinsurance have applied for many years. In Germany the traditionally strong reinsurance industry was relatively unregulated until the BaFin introduced regulation in 2004, whilst Ireland elected for early adoption of the RID in For most countries, the RID introduces new regulation. It also allows reinsurers to operate freely, in effect to passport, across Europe as authorisation is effective throughout EEA without the need for the host state notifications required by the direct insurance directives. Many reinsurers are taking a strategic view of the most appropriate operating structure, given the wider European business opportunities presented by the Directive. Ireland, in particular, which promotes itself as having a reputable and pragmatic regulatory regime, an attractive tax rate and close proximity to key European markets, has become a favoured destination for some foreign and European reinsurers wishing to develop a platform to access the London market and wider European business. This is evidenced through a series of high profile reinsurance business re-domestications to Ireland. However, the domicile of choice also varies according to the specific circumstances and interest is also been shown in certain other jurisdictions, for example Luxembourg. The RID also gives Member States the option to implement a European regime for Insurance Special Purpose Vehicles (ISPV), a form of reinsurance that provides an innovative way for new capital to access the market. Essentially the ISPV acts as a reinsurer, but is backed by fully committed debt to the level of the indemnity. Depending on the country, and provided that the ISPV and arrangements between the parties meet specified criteria (including the need for risk transfer), no solvency margin is required by the ISPV and the cedant may receive solvency credit for the reinsurance to the special purpose vehicle 11. Similar types of arrangement exist in a number of offshore territories (for example in the form of sidecars and cat(astrophe) bonds) and have proved to be a valuable risk, capital and capacity management tool. Indeed the use of such structures is increasing, as insurers look to more innovative capital structures. Notwithstanding this, the take up of ISPVs in European countries has been slow or nil, primarily due to the higher tax rates applicable and hence the relative unavailability of cost efficient capital. In addition insurers have tended to choose to use securitisations such as ISPVs to provide soft capital at a higher level than the regulatory minimum hence their preference for the lower cost of capital offshore rather than opting for the solvency margin credit. For life business, establishing an ISPV for investment business, which is in any event fully funded, may be a useful solvency management tool and hence more such structures may emerge in the future. 11 Note the potential amount of solvency credit varies according to local country implementation

26 25 Strategic restructuring and re-domestication for insurers Solvency II looms Solvency II will generally raise insurance regulatory capital requirements across Europe 12 and fundamentally change the way in which insurance businesses with a European presence are organised, managed and reported. It will bring about major restructuring in insurance groups to take advantage of opportunities, such as diversification and group capital fungibility, and to minimise the potential burdens. Solvency II what, when and how The EU Parliament is currently aiming for Solvency II to be implemented in 2012, although there are already indications that this may be delayed. The Directive will fundamentally change prudential regulation applying to insurance and reinsurance entities and groups across Europe, introducing harmonised, risk-based capital requirements, changes to qualifying solvency capital components and revising the treatment of groups and foreign insurers. The framework for Solvency II is based on a three pillar approach: Pillar I prescribes the quantitative capital requirements Figure 4: Enterprise risk management: Findings by Standard and Poors 2006 rating review According to Standard and Poors 2006 review of 241 insurers across the globe only 13 percent of firms enterprise risk management is rated excellent or strong with 82 percent at adequate The key question is whether adequate will be good enough to avoid a capital loading under Solvency II Adequate 82% Strong 10% Weak 5% Excellent 3% (i.e. assets, technical provisions, the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR), Pillar II deals with the qualitative supervisory review, and Pillar III concerns disclosure. Solvency II will: introduce new supervisory approaches (allowing supervisors to require insurers to hold capital tailored to the risks inherent in the business), require insurers to demonstrate high standards of governance and risk management, as well as comprehensive reporting and disclosure requirements. Insurers and reinsurers will be required either to compute their capital requirements using a standardised approach, or else to use their own model (where prior supervisory approval has been obtained). In addition to meeting the new risk based capital amount at a solo level, insurers and reinsurers will be subject to a group solvency capital requirement. This will require that, at an EEA holding group level, sufficient regulatory capital is available to cover the group SCR at all times. Opportunities and threats arising from the new solvency regime The regime is not expected to change the overall regulatory capital position across Europe, although there will be a significant redistribution of capital 13. In addition to the changes arising from an insurer s own capital assessment, the scope for supervisory add-ons under Pillar II could lead to additional capital requirements. Where an insurer wishes to use an internal model to determine its SCR, the supervisor will need to review the extent to which it is used within the business as part of the prior approval process. The Pillar II 12 As explained by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) in its report on its third Quantitative Impact Study (QIS3) for Solvency II, the financial impact of Solvency II cannot be estimated by simply comparing the calculated solvency capital requirement (SCR) with the Solvency I capital requirement. However, in general, the calculated QIS3 solvency ratio for most participating undertakings is lower than the Solvency I solvency ratio. 13 The CEIOPS QIS 3 report referred to previously, notes that The regime does not require extra capital in the European insurance market as a whole. However, there will be a redistribution process as a consequence of introducing a risk oriented system where capital requirements will be in line with the risks assumed by the undertaking and the way in which they are managed and controlled. In 30 percent of undertakings, the available surplus (i.e. the excess of available capital over the SCR) would increase by more than 50 percent, whereas in 34 percent of undertakings the available surplus would decrease by more than 50 percent. In addition, 16 percent of undertakings would have to raise capital to meet their SCR.

27 Strategic restructuring and re-domestication for insurers 26 review includes an assessment of the effectiveness of the insurer s use of its risk based capital model (the Pillar I internal model (where applicable) and the Pillar II own risk and solvency assessment (ORSA) in the running of its business. If practices do not meet the regulatory standard, capital loadings may be applied. For groups, some relief for diversification benefit may be obtained within the group SCR calculation. In addition, if the group support proposals remain within the Directive, then some groups may be able to hold solvency capital at the group level, reducing the amount of capital required to be held in the operating entities to the level of the MCR. The scope for such capital fungibility will be subject to satisfying certain criteria in respect of group-wide risk management and internal control mechanisms, and the need for the parent to legally commit to providing capital up to the amount of the excess of the SCR over the MCR of affected subsidiaries as and when required. For groups, a single group-wide lead supervisor will oversee the group solvency. The proposals have significant implications for group structures and groups will benefit where they are able to use the group requirements and related changes to capital components to adopt a much more flexible capital structure. This will allow them greater freedom to respond to changes in market conditions and to take advantage of emerging market opportunities. Impact on foreign insurers The Directive will also introduce the concept of equivalence of overseas regulatory regimes and foreign insurers that are subject to equivalent local supervision (at solo and group level) will benefit from reciprocity and mutual recognition arrangements. The European Commission is expected to assess a regulator s equivalence on the basis of there being a satisfactory risk based approach, high quality supervision and an appropriate degree of cooperation with European supervisors. However, the detail of this aspect of the regime is still being developed. The implication of non-equivalence is that foreign insurance organisations with European operations may face higher group capital requirements in their European insurance operations than their European and equivalent regime counterparts. The European supervisor will also potentially have the power to mandate the creation of an EEA holding company and to impose capital charges on cedants in relation to business reinsured with non-equivalent reinsurers. A key issue still to be determined is whether insurers headquartered in equivalent countries will be exempted from the need to hold solvency capital (SCR) at European individual entity or European group level, or whether the European Commission will permit fungibility at the level of the ultimate foreign parent for equivalent insurers. This would afford significant capital flexibility to such organisations. The outcome of this debate could have a significant impact on how foreign insurers access the European market and the legal entity and holding company structures adopted. Whilst there is considerable uncertainty at present as to the ultimate outcome of the Directive in this area, it is clear that the potential impact on groups is one of the most controversial aspects of Solvency II. It is also driving regulators around the world to reassess their regimes. 14 Switzerland and the race for equivalence Through its new solvency test, Switzerland currently has a head start over many other countries in the quest for Solvency II equivalence. However, a number of questions remain regarding the nature of the reciprocity arrangements expected under equivalence. Switzerland could be particularly affected. For example, if Solvency II were to extend full equivalence and capital fungibility to insurance holding companies based in Switzerland, opportunities could be created for foreign insurance groups to establish efficient legal entity structures involving Switzerland. 14 Further information on Solvency II can be found in KPMG publication, Solvency II Briefing edition 3 February 2008.

28 27 Strategic restructuring and re-domestication for insurers 4. How tax is influencing insurance structures Operational efficiency Effective access to markets Fiscal implications Business effectiveness Market perspective Regulatory environment Efficient use of capital The corporate income tax regime in Europe is characterised by competition between states based on the free market, rather than a harmonised regime imposed by the European Commission. This has brought about a steady decline in tax rates to the current average EU tax rate of 24.2 percent. In contrast, in the US, with its federal tax structure, the effective tax rate has remained consistently high at around 40 percent. These differences in corporate income tax rate and the diversity within the global fiscal environment are leading to considerable opportunities for insurers to improve the tax efficiency of their structure. However, as this section shows, the interaction of multiple tax regimes is complex and insurers need to assess carefully the tax consequences of any foreign operations. The global tax environment and how this is affecting Europe Globally, there has been a marked reduction in the rate of direct tax imposed on corporate profits. In 1993 the KPMG All countries corporate tax rate was 38 percent; in 2007 it stood at 26.9 percent 15. The United States (US) has resisted this trend. The US effective rate, including both federal and state corporate income tax, with a couple of exceptions, has remained constant at 40 percent over the same 15-year time span. In contrast, Canada has been more responsive to the global trend. Its representative combined federal / provincial effective corporate tax rate fell from 44.3 percent in 1993 to the current level of 36.1 percent. However, this is still materially higher than the EU average corporate tax rate, which fell from 38 percent to 24.2 percent over the same period. 16 It is accepted that the comparative absence of tax competition has contributed to this trend difference. 15 KPMG s Corporate and Indirect Tax Rate Survey 2007 at page As for 15 above

29 Strategic restructuring and re-domestication for insurers 28 It is generally not possible to provide insurance to the US from outside the country. Instead, all insurers seeking to access this vast market have to carry on insurance business there through a permanent establishment or subsidiary. Further, Federal Excise Tax (FET) is applied to premiums where the insurance or reinsurance of US situs risks is placed with a non-resident insurer outside the charge to corporate income tax. FET can be eliminated by the terms of a relevant double taxation agreement, but unlike the typical European insurance premium taxes, FET discriminates against non-residents. The European framework how the single market is influencing corporate income tax rates In contrast to the US, the EU has sought to create a single insurance market within the EEA and inevitably states have indulged in some tax competition to better attract inward investment. The bigger EU countries tend to have a higher corporate tax rate than the EU average. Germany, France, the UK and Italy had corporate tax rates of percent, percent, 30 percent and percent for 2007 but, with the exception of France, these are all significantly down from 1993 (59.67 percent, 33.3 percent, 33 percent and 52.2 percent). France s peak year in the period of comparison was 1998 when the rate was percent, so even here the recent trend is downwards. It should also be recognised that the EU average rate is a simple arithmetical mean, which does not weight the contribution relative to the size of the different national economies. Also, the composition of the EU has changed over time - but the trend is undeniable. Seven of the 27 EU member states cut their corporate tax rates in 2007 and there are calls for more cuts. A key factor behind this trend is the drive for businesses to reduce their effective tax rate and the increasing ability to achieve this within the EEA and beyond. The impact of these diverse rates is apparent from the analysis overleaf of the effective tax rate borne by a sample of large listed insurers in Germany, Switzerland, France, Netherlands and the UK. Whilst a few of the insurers have notes to the accounts which identify special circumstances underlying their tax charge, a review of the remainder illustrates a relatively lower tax rate for those European listed groups that have structured their group to take advantage of a low tax domicile, when compared to their European domiciled peers.

30 29 Strategic restructuring and re-domestication for insurers Figure 5: Analysis of 2006 average effective tax rates for selected listed European and Swiss insurers Germany Switzerland France Netherlands Tax rate % UK UK Bermuda parent Allianz Talanx Munich AXA AG ZFS Swiss Re* Re* AXA CNP* Aegon* Chaucer Hardy Brit Beazley Highway RSA Amlin Hiscox Catlin* (*indicated special circumstances causing deviations in effective tax rate from standard) Source: 2006 year end published financial statements Many tax issues are relevant to restructuring. These include the availability of low tax jurisdictions, tax residency issues, taxation of branches (including OECD 17 developments regarding attribution of profits to permanent establishments), controlled company legislation, transfer pricing and the taxation of subsidiaries and dividends. In addition, regard needs to be had for court interventions, particularly the European Court of Justice (ECJ), which deals with member states adherence to their EU treaty obligations to free trade within the EU. Residence and the impact on restructuring A company is a distinct legal personality from its shareholders. This distinction means that any restructuring plan should be considered at both the shareholder and corporate level. A simple example can vividly illustrate this point. A company carrying on business in Bermuda does not suffer any local direct tax, whereas a UK company carrying on its trade in the UK is liable to corporate income tax at 28 percent from 1 April Where the shareholders are higher rate taxpayers resident and domiciled in the UK, approximately half of the corporate tax saving is forfeit where a full distribution policy is followed by the company: 17 Organisation for Economic Co-operation and Development

31 Strategic restructuring and re-domestication for insurers 30 Bermuda Co UK Co Profits before tax Corporate - (28) income tax Profits after tax paid as a dividend UK income tax (32.5) (18) on UK individual shareholders 18 Post tax income In practice most reconstruction analysis of large business corporations stops at a corporate level. This is because with the growing internationalisation of equity markets the composition of the shareholders fluctuates and their tax attributes are far from uniform. For tax purposes the tax borne on dividends and capital gains on the disposal of shares will depend not only on where the shareholder is resident but also on whether the shareholder is an individual, company or (local) tax exempt body such as a pension fund. Thus if the shareholder in the example above were a UK resident company, the post tax income would be the same despite the large tax differential at the underlying corporate level: Bermuda Co Profits after tax/ dividend UK corporate income 28 - on resident corporate shareholder Post tax income UK Co A company may be adjudged as resident in a particular state and liable to taxation there by reason of its domicile (typically, its state of incorporation), residence, place of head or main office, place of management, or some other criterion of a similar nature. The ability of a company to change its residence status depends upon the company and tax law of that territory. However, it is now possible for a European Company (SE) to transfer its registered office between EU member states under Council Regulation (EC 2157/2001) on the Statute for a European Company (Societas Europaea or SE). Broadly speaking, a SE is governed by the law applicable to public limited liability companies (for example, plc, AG, NV) in the member state in which it establishes its registered office. Formation is generally by way of merger, but an SE may also be formed as a holding SE, a subsidiary SE or by conversion of an existing public limited company into a SE. The important point is that it is now possible to change the tax residence of a public limited company within the EU. Whilst the right to levy tax is a matter of national sovereignty, EU member states increasingly recognise that it is economically unwise for their tax rates to be outside the range of what might be described as European normative tax rates. Branch or subsidiary the tax consequences In determining the most appropriate structure, an international group will need to consider whether it prefers to operate through subsidiary companies or branches. There are many commercial reasons that need to be taken into account in comparing the merits and drawbacks of which option to follow. Taxation can distort the commercial comparison, not least because differences in the taxation of international business profits are a major complication when comparing tax systems. Most developed states accept the desirability of avoiding double taxation. There are two predominant methods of achieving this objective. The first, such as followed by the UK 19 and US, is to tax worldwide profits and provide double taxation credit relief for foreign taxes so that they may be offset, within limits, against the tax due. The second, that may be applied generally or perhaps limited to situations where the relevant states have concluded a bilateral double taxation agreement, is to exempt the foreign profits from local tax. In this second case there is no need to formulate a double tax credit relief mechanism. In theory, it is accepted that most states would claim that the measure of profits of a subsidiary and a permanent establishment, such as a branch or dependent agent, should be approximately the same. After all, the typical double taxation agreement attributes to a permanent establishment the profits that it might be expected to make if it were a distinct and separate enterprise, engaged in the same or similar activities under the same or similar conditions, and dealing wholly independently with the enterprise of which it is a permanent establishment. However, the OECD draft commentary on the attribution of profits to 18 Assumes a higher rate income tax payer 19 The UK Government is currently consulting on the possibility of exempting certain dividends from foreign participations from UK corporate income tax

32 31 Strategic restructuring and re-domestication for insurers permanent establishments of insurance companies is suggestive that the risk of double taxation has become more acute, notwithstanding the 1990 EU Convention (the Convention) 20 on the elimination of double taxation in connection with the adjustment of profits of associated enterprises, and the mutual agreement article found in most double taxation agreements. This is because, whilst the division of underwriting results can usually be agreed upon, the level of functional analysis required has become more rigorous. Account must be taken of dealings between the head office and permanent establishments internal to a company, and the allocation of capital and the attendant investment return must be made by reference to key entrepreneurial risk takers, rather than on some formulaic or arbitrary basis. Because each fiscal authority is seeking its fair share or the correct measure of tax, it should be assumed that appropriate adjustments must be made to the financial statements of a company or a permanent establishment where transactions or dealings between associated enterprises are not conducted on an arm s length basis. Corporate income tax on foreign subsidiaries UK legislation, seeking to recover lost tax as a result of UK companies establishing subsidiaries in low tax jurisdictions, has been branded anti-competitive by the European Court of Justice. This has paved the way for European insurers to secure tax advantages through re-domesticating their businesses to more efficient European fiscal environments. Whether a double taxation credit or exemption method is used to avoid double taxation, any movement of assets between permanent establishments and head office or subsidiary and parent will have tax consequences. There may be a branch tax or dividend withholding tax, or the allocation of future investment profits may be affected with a consequential impact on the future effective rate. States that seek to tax worldwide profits subject to credit relief particularly look to the repatriation of capital as a way of reversing tax advantages. The retention of profits in low tax territories may be countered by what is typically known as controlled 20 90/436/EEC EC Convention of 23 July 1990 on the elimination of double taxation in connection with the adjustment of profits of associated enterprises

33 Strategic restructuring and re-domestication for insurers 32 foreign company (CFC) legislation. In such cases, unremitted profits and the associated creditable foreign tax are apportioned or attributed to the shareholders and taxed as they arise so as to deny the benefits of low tax. Apportionment is usually subject to exemptions for genuine commercial operations and for profits from territories where the lower tax rate is within an acceptable range, so that unremitted profits are likely to arise for commercial operational reasons rather than from successful tax planning. The potential impact of differential tax rates has been accentuated by the decision of the ECJ in Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd v CIR (Case C-196/04), which is likely to impair the effectiveness of CFC legislation applied by EU member states. In Cadbury 21 the ECJ held that the UK s CFC rules created a tax disadvantage for a resident company that was contrary to the freedom of establishment 22 sought by the Treaty of Rome 23. The Court determined that the UK legislation could only be justified with respect to wholly artificial arrangements, but not to genuine economic activities. The decision should mean that the advantageous tax treatment of the operating profits of companies based in lower tax jurisdictions cannot be struck out by an imputation to their parent resident in a high tax territory. As a reaction to this judgement some countries with CFC legislation have amended the respective laws to try to achieve conformity with EC law, for example Germany. The UK s legislative response arguably has been inadequate and consultation continues. How differences in corporate income tax are affecting insurers choice of structure and domicile Tax competition has created an uneven playing field that has a significant impact on returns on capital. It is not by chance that territories which have attracted particular interest have tax regimes with features such as a low tax rate (for example, Ireland), exemption of foreign profits earned by a permanent establishment in a treaty country (for example, Luxembourg), or other advantageous features (for example, Gibraltar and Malta). With Bermuda, the Lloyd s and European reinsurance markets face severe competition from a nil tax territory. The essential service provided by insurers is the payment of claims on the happening of an insured event, a matter highlighted in many value chain analyses. Thus where the balance sheet can be located anywhere, a territory with a nil tax rate is undeniably attractive. This is particularly possible with reinsurance where the contact with the customer can be handled in Europe, or particularly in the London market, and the wholesale reinsurance of the European book with a Bermudian reinsurer can be handled by a few skilled professionals. In some instances, UK insurance groups have gone further and used an inversion structure to insert a Bermuda company as the new group parent. This allows the deferral of tax on profits until repatriation to be converted into a permanent advantage when the shares are sold. Transfer pricing To counter the freedom extended to insurers in their ability to establish business in low tax environments, tax authorities around Europe have established transfer pricing regimes aimed at ensuring intra group transactions are on an arm s length basis. As a result many insurers now examine their pricing structure extremely carefully, undertaking market benchmarking or other pricing analysis to support their case. Tax authorities have not been passive in the face of these forces for change and a European Directive has been implemented dealing with transfer pricing for intra group transactions 24. The profits of any company trading with other group companies may be adjusted when the terms of trade are not on an arm s length basis, reflecting the price that would have prevailed if dealing with an independent person. As most countries insist that the adjustment under their domestic law can only go one way, resulting in additional imputed profits, and an adjustment will normally carry related penalties and interest, there is a powerful incentive for taxpayers to apply their pricing with care and fairness. Even where there is a corresponding adjustment provision in a relevant double taxation agreement, broadly there is rarely a treaty requirement for two fiscal authorities to agree the quantum of such an adjustment with each other. However, the Convention applies a cumbersome procedure where the two fiscal authorities are those of member states. As a result, insurance groups usually take good care to maintain their transfer pricing on an arm s length basis. 21 Cadbury Schweppes plc and another v Inland Revenue Commissioners 2006 STC Case C-196/04 ECJ (Grand Chamber) 22 Articles 43 and 48 EC 23 The Treaty of Rome is the primary European legislation underpinning the free market 24 90/436/EEC

34 33 Strategic restructuring and re-domestication for insurers Indirect tax Insurance Premium Taxes are not yet harmonised throughout the EEA or EU and can represent a compliance minefield for insurers wishing to write multijurisdictional risks. Although rates vary between member states, the operation of VAT is generally harmonised. However, differing interpretations of EU VAT law for insurance have led to some significant differences in application between member states, prompting the European Commission to undertake a general review of the law in this area. Insurance Premium Tax (IPT) Tax authorities are free to set their own levels of IPT (or equivalent) which in Europe alone leads to IPT rates varying greatly, from Austria s 1 percent percent on health insurance, to 77.7 percent in Sweden on a group life insurance taken out with a foreign insurer IPT and para-fiscal taxes levied on insurance are fast becoming a serious issue, with insurers which are increasingly seeing the need to review the liabilities that arise with local tax authorities, as policies are sold in multiple jurisdictions and cover global risks. Whilst the freedom of services regime allows EEA insurance companies to write business in any EEA member state without requiring a permanent establishment, IPT is generally charged in the member state in which the risk is located, so from an IPT perspective there is little or no benefit to the insurer situating in one EEA member state over another. However, outside the EEA it is sometimes the case that IPT is charged on the basis of location of the insurer, and not the location of risk. Value Added Tax (VAT) Unlike corporate income tax, VAT rates in Europe have gradually increased over the years. They range from 15 percent in Luxembourg to 25 percent in Sweden. The VAT legislation in EU member states is derived from a single European Directive 25 and member states are required to enact their own domestic law to implement the provisions of the Directive. The domestic law should reflect the scope and coverage of the provisions contained in the European Directive. However some differences exist. The local differences can mean that the domestic provisions are either wider or more restrictive than those contained within the Directive. This is certainly the case for the VAT exemption in relation to insurance intermediary services and this can create a compliance burden when managing VAT and compliance obligations in multiple member states /112/EC

35 Strategic restructuring and re-domestication for insurers 34 The recent Insurancewide.com UK Tribunal decision 26 goes some way to illustrate this point, but a better example is the Arthur Andersen 27 case in the ECJ, where the ECJ's rather narrow interpretation was in conflict with the more generous interpretation by some member states (including Netherlands and UK). The main arguments in both decisions centred on whether the parties were insurance agents or brokers (as under both EU and domestic legislation this is the first requirement to be met before considering whether you are providing intermediary services). Interestingly, if the EU review progresses as expected, this requirement will no longer apply. It will be the nature of the services provided that will be key, rather than the status of the provider itself. That said, the services themselves will need to comprise a distinct act of mediation, therefore passive introductory services or administration services which are not specific and essential to the supply of insurance may not necessarily qualify as VAT exempt. Whilst acknowledging that VAT can add significant costs when carrying out transactions in restructuring and re-domesticating insurance business, VAT is rarely the main determinant of where an insurer might locate its business, simply because most if not all supplies made by an insurer will be VAT exempt. However, many of the costs of running the business are likely to be subject to VAT (which most insurers cannot recover), so there may be an incentive to move to a jurisdiction with a lower level of local VAT. There is no particular incentive to leave the EU though, since states like Malta and Luxembourg have low levels of VAT. Also, it is worth noting that when a European based insurance company is writing business outside the EU, it is generally allowed to recover VAT incurred directly in making those supplies. When transferring a business, insurers will want to ensure the transaction attracts the reliefs available for a whole or part transfer of a going concern. This avoids the need to charge VAT on the transfer, which may well be largely irrecoverable in the transferee s hands. This is not something that can be arranged retrospectively so careful planning is advised. There are a number of conditions to be met for the VAT free transfer to apply. These include a requirement that where the transferor is UK VAT registered, the transferee is also UK VAT registered (already or as a result of the transfer). This can result in cross border business transfers not being able to meet the conditions. One of the key points in any restructuring is to consider the charging structures to be employed under the new arrangement. Charges for services supplied between multijurisdiction group companies may create irrecoverable VAT costs. It is important to note that even if the supplier of a cross border service has not charged VAT, the recipient may be obliged to charge VAT to itself the reverse charge. The reverse charge applies where the place of supply is deemed to be in the member state in which the recipient is established not where the supplier is located. In such instances it is the responsibility of the recipient to account for the VAT on the transaction (declaring output tax and recovering, if possible, an element of this charge as input tax). The reverse charge tends to be applicable to services of an advisory nature such as legal and tax advice as well marketing and other similar services. It is worth noting that as of 2010 the place of supply rules in Europe will change and all business to business services (with a few exceptions such as telecommunications, for example) will be deemed to be supplied where the recipient belongs, possibly making lower VAT rate countries more desirable to international businesses. Such charges cannot be avoided by the protection of a VAT group, as cross border VAT grouping is not permitted in any EU member state. Other relieving structures may be available. For example, some member states allow the operation of cross border cost sharing groups, although the conditions for these vary in each state, and the facility is not available in a number of major states such as the UK. However, the decision of FCE Bank 28 has confirmed that supplies in certain circumstances made between a head office and a branch can be ignored for VAT purposes. Although the provision of insurance is normally VAT exempt, many services, which are utilised by insurance companies, are not (such as IT). In certain member states even some insurance related services such as premium collection, fulfilment and claims handling are subject to VAT. The nature of VAT as a tax on transactions between legal entities means that it is usually preferable from a VAT perspective to minimise the number of separate legal entities in the value chain. Often this conflicts with the regulatory requirement for non-insurance activities 29 to be disaggregated from the main insurance activities meaning that careful planning of intra-group supplies can be a vital part of any restructuring proposal. 26 (20394) 27 C-472/03 28 FCE Bank PLC (C-210/04) 29 The Insurance and Reinsurance Directives contain provisions restricting the activities that insurers and reinsurers may undertake. Article 8.1(b) Directive 73/239/EEC, Article 6.1(b) Directive 2001/83/EC, Article 6(a) Directive 2005/68/EC.

36 35 Strategic restructuring and re-domestication for insurers The fiscal impact on global structures The current view of the OECD reaffirms and reinforces the taxing rights of the country where the business is carried on. However, the absence of a common approach to the taxation of foreign operations has led to a range of approaches being adopted for the attribution of profits, which in some cases is causing double taxation. This makes managing the tax implications of global operations complex. Nevertheless there are significant benefits for insurers that take a strategic approach, provided that great care is taken to monitor the effectiveness of the structure and that the implications of unwinding this are understood and mitigated. The determination of the profits attributable to permanent establishments can be difficult, not least because the enterprise of which they are part is a single entity incapable in law of contracting with itself. A common criticism of the model OECD double taxation convention (on which most agreements are based 30 ), when comparing it to the model convention of the United Nations, was that the OECD model unduly favoured the capital providers of the developed world against the host countries in which they invested. This was because, typically, the OECD model provided for reduced rates of withholding tax on dividends and interest, frequently left the taxation of gains to the resident s state and did not allow for withholding taxes on management fees and many forms of knowledge transfer income. If this criticism was valid in the past, in recent years much attention has been given to the taxation of banks and insurers where the use of permanent establishments is particularly extensive. There was a tendency within insurance groups to attribute profits to the backing capital. Draft IV of the OECD report on the Attribution of Profits to Establishments deals with insurance enterprises and emphasises the importance of KERTS (Key Entrepreneurial Risk-Taking functions), in determining where risks and the associated assets investment return should be attributed. This reaffirms and reinforces the taxing rights of the host country where the insurance business is actually carried on. Inevitably, this can lead to issues of interpretation and dispute. The tax practicalities of reorganisations how the Mergers Directive can help The European Mergers Tax Directive 31 (Mergers Directive) was enacted in Member states were required to implement it by 1 January 1992 but the Commission accepted that member states were not obliged to implement the Mergers Directive to accommodate restructurings that were not possible under the relevant national company law. This non-mandatory approach to implementation has resulted in some member states having implemented the Directive in full and others perhaps less perfectly. The consequential impact on cross border restructuring exercises is that the ability to secure the tax reliefs envisaged by the Directive is uncertain in some states and circumstances. 30 The US prefers its own wording, much of which has spilled over into the most recent US-UK Double Tax Agreement 31 Council Directive 90/434 EEC of 23 July 1990 on the common system of taxation applicable to divisions, transfers of assets and exchanges of shares concerning companies of different member states and to the transfer of the registered office of an SE between member states. Substitutes by 2005/19/EC.

37 Strategic restructuring and re-domestication for insurers 36 Since 1990 the Mergers Directive has been amended to cope with cross border restructurings including the formation of an SE. The 10th Company Law Directive: The European Directive on Cross Border Mergers of Limited Liability Companies required national company law to be conformed by 15 December 2007 to permit the various forms of cross border restructuring contemplated by the Directive. Community wide developments in employee representation have been incorporated. The Mergers Directive is the fiscal dimension of this legal framework. It will be interesting to observe whether cross border restructuring increases, using the Mergers Directive to take advantage of the freedoms of establishment and movement of capital. The Mergers Directive was intended to facilitate mergers, divisions, partial divisions, transfers of assets and exchanges of shares concerning companies of different member states. The basic principle is that these restructurings should not give rise to any taxation of capital gains calculated by reference to the difference between the real values of the assets and liabilities transferred and their values for tax purposes. Similarly, a paper for paper merger, division or exchange of shares should not give rise to any taxation of the income, profits or capital gains of shareholders of the transferring or acquired company. Member states were entitled to refuse the benefits of the Directive if a principal objective of the transaction was tax evasion or avoidance or the loss of employee representation. The worth of these reliefs can only be truly appreciated when considering a cross border restructuring in the context of the specific national tax laws involved. However, a permanent establishment carried on through a branch or agency in a member state by a company resident in another state can be transferred for shares or securities of the transferee without giving rise to a capital gain or income charge. The relief is extended where an SE is formed to facilitate the cross border merger of companies of different member states. Member states may have had to introduce accompanying legislation to deal with income charges to tax (rather than capital gains) and to deal with tax depreciation and ancillary matters.

38 37 Strategic restructuring and re-domestication for insurers 5. Market trends in restructuring and re-domestication Operational efficiency Effective access to markets Fiscal implications Business effectiveness Market perspective Regulatory environment Efficient use of capital Market conditions and the opportunities and threats presented by developments in the fiscal and regulatory environment are leading many insurers to review their capital efficiency. A number have already undertaken a strategic review of their organisational structure. In arriving at the best structure for an organisation, there is no such thing as one size fits all, and the particular circumstances of an insurer will have an impact in terms of its optimum structure. Factors to consider include not only those associated with the insurer itself but also the environment and market within which that insurer operates. In this, country norms, local laws and the overall culture become relevant. For example, the way in which local markets have evolved and how progressive they are from a competitive viewpoint means that there are different sets of issues, drivers and appetites for change at individual country level, as well as across the various categories of insurer, whether a direct writer, pure reinsurer, or a personal and commercial lines carrier. The nature of the market and the maturity of the insurers operating within it are also relevant in Germany, for example, many of the direct writing insurers are mutuals, whereas, in the UK, the Lloyd s market has its own special features. It is natural then that this has resulted in different approaches and outcomes in structural optimisation. The relatively new insurance centres, such as Gibraltar and Ireland, compete on an entirely different level and lend themselves to quite dissimilar business models. Also the fact that many European countries have historically operated a tariff system means that historically the battle for competitive advantage has been through cost reduction and acquisition to achieve economies of scale.

39 Strategic restructuring and re-domestication for insurers 38 Typical challenges and concerns Potential restructuring solutions and benefits Notwithstanding these variations, there are some common trends that have emerged and continue to emerge, seen most obviously in the larger European and wider global insurance organisations, as well as those insurers which are newly establishing their European operations. This diagram indicates just some of the challenges and concerns that are leading insurers to pursue a variety of restructuring strategies to improve their business. Complex unwieldy disparate group structure, many European and overseas subsidiaries and branches, leading to capital and administrative inefficiencies, regulatory and tax complexity and costs Multiple European operating entities leading inter alia, to capital inefficiency, capacity constraints and a failure to attract business Discontinued operations in pockets across the organisation leading to capital, claims and cash management inefficiencies Consolidation and Streamlining Legal entity reduction, consolidation and merger Benefits include economies of scale, resources made available for more profitable activity, capital efficiencies Consolidation achieved through exercise of passport rights to create a single European carrier with branch and services operations Benefit includes a larger capital base, centralised control functions and single prudential regulator Consolidation of run off, scheme of arrangement or sale Benefits include release of capital and realisation of economies of scale in claims and cost management Relatively high regulatory capital and effective tax rate leading to increased investor pressure and growth constraints Re-domestication Re-domestication through establishment of a pan European carrier or group reinsurer Benefits include the freeing up of capital for new business investment, lowering the effective tax rate as well as opening up new market opportunities Inefficient insurance holding company structure leading to tax and dividend traps as well as difficulty in meeting group solvency requirement Group and Capital Group and capital restructuring including moving entities impairing solvency out of EEA group solvency chain Benefits are by allowing the payment of dividends and restructure to secure tax and fungibility efficiencies Figure 6: The challenges and drivers, solutions and benefits in taking a strategic approach Inflexible, tax, regulatory inefficient capital with the effect that new capital is required for growth, difficulty in delivering returns through, and taking advantage of, changes in market conditions Restructuring Capital restructuring to include equity release and refinancing through tax efficient hybrid instruments and softer forms of capital e.g. securitisations Benefits include more effective use of capital and the availability of any excesses to be used in developing the business

40 39 Strategic restructuring and re-domestication for insurers This section seeks to describe some of the key trends in restructuring and re-domestication under three broad headings: Consolidation and streamlining this deals with group simplifications for capital and cost efficiency purposes, aimed at reducing the number of legal entities, and considers the alternatives that are available to insurers in terms of the platforms through which to access European markets; Re-domestication this section considers how insurers are seeking competitive advantage by reorganising their operations through efficient domicile structures; and Group and capital structures this covers innovations in group holding company and capital structures and considers how groups are arranging their holding and finance company structures to most efficiently deal with group and solo solvency requirements, and to optimise their capital structure from a tax and regulatory perspective through use of alternative capital instruments and reinsurance structures. Consolidation and streamlining Many insurance groups have legal, operational entity and capital structures that have evolved over the years both organically and through mergers and acquisitions. Due to the inefficiencies that these create, one key trend that has emerged is consolidation and streamlining, with extensive activity throughout the industry. Consolidating and streamlining makes for a simpler, more manageable group structure, selecting the most effective market access and operating platforms, reducing the administrative burden and removing regulatory duplication. Insurers can benefit from a more capital efficient arrangement, an improved control environment and can also improve their business performance through applying freed up resources to new business opportunities. The potential benefits of consolidating and streamlining At the most basic level, insurers are rationalising their group structures to reduce the overall number of companies in the group and to create capital efficiency. This typically means merging operating units and legal entities to create a divisional or branch structure, closing down non-performing businesses, and consolidating run-off into as few entities as possible. This trend extends beyond the underwriting companies themselves and many insurance groups are also looking at streamlining their service and administration companies. Not least, the recent ECJ VAT cases have caused many insurers to review this aspect of their business.

41 Strategic restructuring and re-domestication for insurers 40 Market access platforms One of the key considerations facing insurance groups is the nature of the operating platforms that provide access to markets. In this regard, the regulatory and tax environment is relevant, as well as softer issues such as culture and local practices. Outside Europe many regulators impose conditions as to whether or not business may be conducted in the country via a branch or subsidiary, and there are sometimes special requirements for alien insurers and reinsurers. The US is an example of this and has complex licensing requirements on a state by state basis for insurers wishing to underwrite US risks. Within Europe this is not the case due to the single market regime which helpfully allows insurers to operate cross border in a variety of different ways, subject in practice to any barriers arising from cultural, legal and conduct of business differences. For those insurers whose European businesses lend themselves to operating on a divisional or branch basis, the Insurance Directives facilitate operating as a pan-european carrier via a single company with a passport branch network and therefore the opportunity to benefit from: a larger, more fungible capital base, hence with greater ratings potential the ability to offer multi territory cover a single prudential regulator the opportunity to centralise and tighten governance, risk management, control and finance functions a different group tax profile other economies of scale such as shared services. There is a range of options for accessing the European market, each with its own advantages and disadvantages that need to be matched against the commercial objectives of the insurer. Options include operating as a subsidiary, branch, maintaining a contact office 32 and accessing European and foreign business via a presence at Lloyd s 33. Highlights of the main access mechanisms are set out below: Branch vs subsidiary For European insurers operating in the EEA, the full range of platforms is available 34, and selection between them has been a focus for some time. Comparing the relative merits of branches and subsidiaries, subsidiaries generally have a higher administrative cost structure than branches, although the difference in comparative costs may be immaterial for most large groups. More importantly for an insurance group with a subsidiary structure, the group s capital cannot be replicated at each territorial level. Because of this, intra group reinsurance is often required to enable risks to be written up to group limits. As a rule it is simpler, cheaper and more efficient to manage a single block of capital than several blocks, especially where the latter has to be allocated to particular entities in different jurisdictions. The prospect of a single EU regulator (for example, by exercising passport rights in the EEA) can be very attractive from both an administrative and capital management perspective. Putting aside cultural differences in certain parts of the market which can be a barrier to branch access, the trend continues to move towards operating through the minimum number of insurers; hence the pan European carrier structure, comprising a single legal entity with cross border branches or services, is increasingly the favoured option. For non-european insurers, the benefits and disadvantages of operating via a branch or a subsidiary are somewhat different. Key advantages of a European branch include enjoying the larger capital base and rating of the parent, but this must be balanced against the inability to take advantage of the European passport and more intrusive regulation by the European supervisor. In time, Solvency II equivalence will also influence the choice of structure. Finally, tax is often critical to the decision. The implementation of the Reinsurance Directive has exacerbated the dilemma, since many reinsurers were previously unregulated for their European business. In seeking authorisation, the application by EEA regulators of the equivalence provisions in the RID is relevant to the choice of platform, due to the potential scope for individual regulators to determine the extent of reliance on the foreign regulator. The current trend amongst the non EEA reinsurers operating out of Switzerland and Bermuda has been to establish pan-european carriers and utilise a branch network. In a number of cases, this has involved a wider consolidation exercise. Ireland, and latterly Luxembourg, have recently emerged as key players in the battle for the domicile of choice. 32 A contact office is essentially an introducer of business who may not take further part in the sales process. This route has historically been adopted by foreign firms 33 Lloyd s is an international insurance and reinsurance market based in London, UK 34 Subsidiary, branch, cross border services, contact office

42 41 Strategic restructuring and re-domestication for insurers Lloyd s of London A one stop shop? The UK s long established London market provides a platform through which to access, inter alia, specialist international business. As a result many of the world s major insurance groups are represented there. One key decision is whether to access the London market via Lloyd s or to set up an insurance company (or indeed a London branch of a European insurance company). Key benefits of Lloyd s include its A+ rating, the ability to use Letters of Credit as a form of capital, and its international licences. Further, pure Lloyd s groups are not subject to group solvency requirements (although a Lloyd s business that is part of an insurance group is) and consequently it is not uncommon to see substantial debt or equivalent instruments in the holding company structure. However, the nature of Lloyd s expense base, additional compliance requirements and exposure to other Lloyd s members underwriting obligations through its Central Guarantee Fund are also relevant factors to the decision. Also, for insurers restructuring to a Lloyd s operation, the mechanism for dealing with the run-off of any previous business will be vital and it should not be assumed that this could be transferred into Lloyd s. Restructuring run off businesses There are often significant efficiencies to be gained through restructuring run-off businesses, sometimes as part of a broader consolidation and streamlining exercise, but also on a stand-alone basis. Legacy business can be a significant drag on a company s performance and drain on its capital, and this has led to a number of high profile consolidations of run off business by European insurers. Thirteen of the twenty non-life insurance business transfers that occurred in the UK during 2006 related to run-off business, surpassing the total number of such transfers of discontinued business that occurred in the preceding five years. In addition to internal restructuring exercises, the sale of non-life run-off business has become increasingly widespread over the past few years, and there has been a growing market for the acquisition of closed life books as run-off managers have identified opportunities to profit from a more efficient run-off. This has led to the emergence of an increasing number of specialist run-off organisations. In the non life sector further trends are emerging, such as entering into a scheme of arrangement ( scheme ) through which an insurer and some or all of its creditors agree to determine and settle all obligations between each other under the supervision of the courts. By the end of 2006, a total of 63 schemes had taken effect in the UK and the opportunities afforded by schemes under English law have also resulted in European insurers transferring their business into the UK so as to take advantage of schemes as a means of early exit. In the light of Solvency II, as more sophisticated capital allocation strategies develop and enhanced modelling techniques for diversification benefits emerge, it is possible that this will inspire European insurers to be more selective as regards their business mix and lines written. If so, this will inevitably lead to increased restructuring, and a wider range of approaches in the closed book market.

43 Strategic restructuring and re-domestication for insurers 42 Re-domestication Regulatory and fiscal differences, and business drivers, are causing insurers to look for arbitrage opportunities to improve their performance. As such, insurers are using a variety of mechanisms to take advantage of the considerable savings that can be generated such as lower regulatory capital, corporate income and indirect tax savings, and reduced regulatory intervention as well as new business opportunities and efficiency savings. Re-domestication also presents many challenges and the benefits need to be balanced against the costs. These may include: data requirements to support business transfers, policyholder circularisation costs, logistical issues such as new offices, and the ability to move both people and the company s head office infrastructure. This is in addition to complex regulatory, legal and tax approvals, as well as the costs of the transition. Despite this however, many companies have found re-domesticating to be extremely beneficial. Re-domestication is a growing trend within and outside Europe, as insurers seek to take advantage of market opportunities and to optimise the tax and regulatory aspects of their business. Two re-domestication trends have emerged for which there continues to be considerable activity. The first relates to re-domestication of insurance businesses to lighter fiscal and regulatory domiciles, whilst at the same time creating an opportunity to develop additional complementary distribution channels to access the local market(s). In effect, this approach takes further many of the techniques already discussed in the context of consolidation and streamlining above. The second mechanism involves redomesticating underwriting results by reinsuring to a group reinsurer, creating opportunities for improved group risk and capital management, whilst at the same time exploiting regulatory and tax arbitrage opportunities. Each is discussed in turn. Re-domesticating insurance business Some insurers with European operations have taken restructuring a step further than simply consolidating and streamlining their business, taking the opportunity to review the most appropriate location for their European domicile, and looking to legal, tax and regulatory opportunities to make further efficiency savings. The provisions in the Directives allowing insurance companies based in the EEA to operate cross border, via freedom of services and freedom of establishment ( passporting ), mean that in addition to the ability to operate from a single domicile, companies are able to choose where to headquarter their business. The criteria used for this assessment may not always be based on minimalism, in other words where the regulation is least intensive, or the tax rate lowest. Insurers will often be equally concerned to select a jurisdiction where regulation is most effectively implemented, for instance the speed with which the regulator makes decisions, the ability of the regulator to understand and help the insurer in implementing its strategy and, above all, the quality of supervision so as to minimise the reputational risk for all market participants in the event of a significant regulatory failure. Tax judgements will sometimes be influenced by a desire to be seen as a responsible citizen in certain jurisdictions, responsibility being judged in this context as paying a fair share of taxes and/or maintaining a low risk profile with the tax authorities. Tax considerations may also lead to a mix and match approach, trading through subsidiaries in jurisdictions with lower tax rates and converting to branches in those with higher tax rates. In this way, the benefit of the lower tax rates can be retained in the subsidiaries, at least until such time as profits are remitted to the parent, whilst in the branches local capital may be minimised and generally tax suffered only on local technical profits (underwriting profits plus investment income on technical provisions) Reference to OECD developments in Section 4 - see page 35

44 43 Strategic restructuring and re-domestication for insurers Other more practical factors that are relevant to a decision to re-domesticate include the availability and costs of suitable human resources and office space, the ability to transact and report business using common systems and currency and the financial and non financial costs associated with the need to comply with the head office requirements, for example travel costs and executive time. European insurers adopting a re-domestication approach are showing a preference to domicile in EEA countries such as Gibraltar, Ireland, Malta, and Luxembourg. All of these countries enjoy relatively low regulatory capital, a favourable tax environment, and relatively lighter touch supervisory requirements compared to other jurisdictions across Europe, particularly Northern Europe. This is partly due to the fact that regulators policies tend to lend themselves to the specific types of insurers operating in their domicile and are subsequently viewed as less intrusive from a business perspective, and are hence less costly to comply with. This is due to a number of factors: the scale of the competitiveness within the UK market together with the combination of regulation 37 and tax burdens that has arguably made the UK less attractive. The value and strength of skill in the UK market is often recognised by re-domesticating underwriting platforms and hence the vast majority of the new structures are framed around the retention of certain UK resources and infrastructure. As markets evolve, similar developments are now being discussed in other jurisdictions such as Germany, and in Switzerland a trend is emerging for foreign insurers to convert their Swiss subsidiaries and branches into branches of EEA based companies. There are many approaches to re-domesticating insurance businesses and consequently, various strategies and niche structures are emerging, reflecting the diversity of the European insurance sector. The next few sections seek to highlight the relevance of re-domestication to certain specific sectors in the market. At the time of writing, the majority of re-domestications across Europe are occurring within the UK market Refer Section 1 concerning European insurance market overview - see page The UK capital regime has resulted in many firms needing to hold more regulatory capital relative to other EU regulators

45 Strategic restructuring and re-domestication for insurers 44 Critical issues in determining viability and structure of a business re-domestication For personal lines business in Europe, re-domestication to another European member state is realistically the only viable option. The ability to access the wider European market rests on the eligibility of the insurer to passport. Passporting is available for insurers headquartered within the EEA and foreign insurers operating in the EEA via branches cannot benefit in the same way. It is vital when operating cross border to understand how differences in the regulatory and tax regimes have a business impact. For example, for life business, country level requirements vary significantly and personal tax implications may arise on cross border insurance. The insurer must maintain its head office in the state of domicile for both regulatory and tax reasons. Depending on the business and the regulatory environment, this may require staff relocation. To secure the full tax benefit, regard must be had to the relevant regimes for the taxation of foreign subsidiaries and measures must be taken to eliminate double taxation. Suitability for non-life insurance personal lines For many insurers that are considering re-domesticating, a preference will often be to operate on a freedom of services basis (and thus avoid branch establishments) in order to simplify the tax, corporate law and regulatory consequences. However, an insurer s ability to operate in this way is highly dependent on the nature of the insurance written and the business model and certain conditions must be met. The freedom of services approach has been popular amongst the non life personal lines sector where it is common to operate a black box approach to underwriting, for example, using IT sales platforms and software incorporating pre-defined rate assessment criteria. This model supports freedom of services and there is greater flexibility therefore concerning the ability to choose the domicile. This is because it facilitates the insurance business being underwritten and committed in the head office where, as an absolute minimum, the rating and acceptance criteria, together with any binding authorities should be determined. Many organisations that have redomesticated in this way also choose to minimise the head office infrastructure, usually because of issues surrounding the transferability of people, skills and other resources. Some jurisdictions have developed an infrastructure of third party insurance managers to whom much head office administration can be outsourced. Furthermore, relatively little local business tends to be written in the country of domicile; most business is conducted via a permanent presence/binding authority in the country (or countries) where the distribution and policyholders are based. Clearly, this leads to unfavourable tax consequences for the insurer if a branch establishment, or even a permanent agency presence, is formed, since a dependent agent can itself be deemed to be a permanent establishment. Over the years, a number of strategies have developed to cope with this situation. Relevance to the life sector The majority of pan-european reorganisations have, to date, focussed on the non-life sector. There have been limited opportunities to sell a single suite of life products cross border. Some multi-national groups have pursued the goal of writing life business on a single pan-european platform with a thin layer of local regulatory and fiscal compliance. In practice they have found that the local fiscal and regulatory compliance is still quite onerous, requiring significant bespoke local systems to sit on top of the pan-european platform. This is largely due to differences in individual countries systems for the provision of savings and investment products, as well as complexities in the personal and corporate tax regimes, and the interface between the two. A further factor is the regulatory position, leading to differing interpretations across Europe as to the nature of the products. For those insurers wishing to extend their product sales to new markets, local laws and cultural variations concerning pension provision and the like can also present barriers. For these reasons, many life businesses across Europe, whether European or foreign owned, have to date remained on a multi-subsidiary basis. There are now early signs of insurers seeking to consolidate these separate businesses, and in some cases to redomesticate and operate on a services basis or via a branch network. For example, Ireland, with its relatively low corporate income tax rate on profits, has attracted a number of life assurance groups seeking to expand their pan European business, in particular writing into the UK and Germany. The attraction for the German market is predominantly because of regulatory differences between the German and Irish requirements,

46 45 Strategic restructuring and re-domestication for insurers provisioning and pricing, whilst the UK offers a different tax regime for insurance bonds sold from Ireland compared to those sold domestically. Notwithstanding these examples, it will probably be some time before a life insurer is able to develop and sell a single suite of common life products across Europe. Re-domesticating run off Another driver behind the growing trend towards re-domestication relates to the skills and resources that are required to support the business and where such resources are located. This is a particular issue in the run-off market, where insurers are seeking to minimise costs by consolidating their run-off operations. Re-domesticating the business to a country where there is established resource and infrastructure for dealing with the run-off can be particularly cost effective. Opportunities provided by re-domestication concerning capital efficiency (for example due to different standards in the application of regulatory solvency and dividend restrictions), together with scope for tax savings, are additional factors influencing the structure through which insurance is most effectively run-off. To date only limited re-domestications of this type have occurred and these relate to organisations where there are already skills in place for dealing with run-off in another jurisdiction, for example the parent company domicile. Outsourcing of run-off activity is, however, common-place. Parent company considerations - securing the tax benefit of operating in low tax territories The tax regimes for foreign subsidiaries, which can impute a large proportion of profits from foreign operations back to the parent to be taxed in the home state, mean that some organisations have also chosen to re-domicile the holding company. This requires careful planning as there are significant hurdles, including exit taxes, local investor tax impacts, listing requirements and cultural implications, especially fit with the brand. Nonetheless, there is a trend emerging here and some insurers have made significant savings for the group and/or their shareholders. European companies option The provisions for European companies, SEs, mean that insurers with companies incorporated under European, rather than local, law can re-domesticate more easily within Europe. This legal freedom does not absolve the company from the need to obtain regulatory and tax approvals, but it can simplify the relocation process and help to secure efficiencies. There are a number of conditions associated with the formation of an SE. A key one is employee representation on the board; others relate to the mechanism through which an SE can be formed. The most common approach is through merger, facilitated by the Mergers Directive 38, which provides for a tax efficient transition mechanism. As yet, only a relatively small number of insurance SEs have been formed in Europe. A few insurance groups have pioneered SE status as part of group restructuring exercises. Whilst this has given rise to complexities in some areas (for example regarding personnel), as structures emerge to cope with some of these, and as the 38 Refer to Section 4 - see page 35

47 Strategic restructuring and re-domestication for insurers 46 rules for SEs become more tried and tested, it may be expected that an increasing number of insurers will look to transition to a new structure using the SE route. Figure 7: Domicile selection the key factors influencing insurers decision-making In contrast, similar provisions already exist outside Europe for example, it is possible to re-domesticate a company from Switzerland to Bermuda. People and governance Cost base and business infrastructure Re-domestication of underwriting results For a long time insurers have adopted internal reinsurance as a risk and cost management tool, using it as a mechanism through which to pool group risks and place them more efficiently into the external market. Indeed, many of the large European and global insurers have such structures in place. Increasingly now, insurers are looking for additional benefits, for example using reinsurance as a mechanism through which to generate regulatory capital and tax efficiencies. Fiscal environment including country interfaces Regulatory capital and supervisory regime Domicile influencers Business Profile Stakeholder influences / reputation Re-domestication of an insurance business as a whole may not be a viable option for some insurers. In particular, for those insurers that need to undertake considerable activity in the homeland, for example, commerical lines, re-domesticating the business may not fit well with the business model and generate sufficient benefit. Hence, for some insurers, an alternative route to securing efficiencies is through the use of internal reinsurance to a wholly owned group reinsurer. Frequently, this will be domiciled in a regulatory-friendly, tax efficient country, which complements that of the head office and perhaps also provides some additional business opportunities. The benefits afforded vary according to the location of the reinsurer and the nature and structure of the arrangements put in place. Critical factors will include the level of capital required to support the reinsurer, and the approach taken by the cedant s regulator in terms of capital credit for reinsurance recoveries. In contrast to insurance business redomestications, internal reinsurance may involve fewer restrictions for some European insurers as the reinsurer does not necessarily need to be based in an EEA country. Bermuda has proved particularly popular because of its flexible regulatory capital regime and the absence of tax on corporate profits, although there are capacity constraints and rising costs. Consequently, European insurers are now considering alternative re-domestication platforms like Ireland and Switzerland, both of which enjoy relatively strong regulatory regimes, close proximity to the European homeland and smaller time differences. Regulatory equivalence under the RID and Solvency II is also relevant to the choice of domicile. One of the areas where re-domestication via internal reinsurance is most common in Europe is in relation to the Lloyd s market, where recently there has been a series of high profile re-domestications involving internal reinsurers based in Bermuda. The structures put in place take advantage of the unique features of Lloyd s constitution, including in particular the market s flexibility in the regulatory capital requirements.

48 47 Strategic restructuring and re-domestication for insurers It is important to note that any insurance group contemplating using intra-group reinsurance to pool its insurance risk in a single carrier must ensure that it adopts a sustainable transfer pricing policy from the outset that properly reflects the risks and rewards of the business ceded. Moreover, for many groups, the controlled foreign company regime in the head office territory will impute the profits back to the parent and tax them in its hands, effectively negating much of the tax benefit that might otherwise have accrued. Following the Cadbury Schweppes ruling however, such treatment should have been eliminated within the EU. Group holding and capital structures Capital management is a key challenge facing all insurers. Those organisations that manage capital most effectively can create significant competitive advantage. This section considers some of the key elements involved in formulating an effective group and capital structure including the increasing use of innovative capital and reinsurance structures. Groups considerations For groups wishing to take advantage of emerging market opportunities and to manage capital effectively, fungibility of capital is a key issue. Many groups prefer to manage their capital centrally, retaining any excess at group level rather than allocating it in full to the operating entities. To achieve this, a number of factors need to be considered. These include the requirement for insurers with European subsidiaries to meet regulatory solvency with qualifying capital at group, as well as at individual entity, level. Most insurers choose to hold a buffer over and above the minimum levels to ensure that the requirement can be maintained in times of stress. Other important factors include managing the tax efficiency of the group capital structure in terms of impact on the organisation and its investors, as well as taking into account customers, analysts and rating agencies views. Appropriate legal entity, financing and holding company structures are vital to ensuring that these factors are successfully managed. The impact of group solvency on group structures Ineffective group holding and financing company structures can give rise to a host of problems for example, dividend and tax traps, solvency impairment, complexities in reporting requirements as well as administrative burdens. Insurers who get their structure right benefit from lower capital through diversification, fungibility, and performance improvement through better capital allocation and measurement techniques. In developing the most effective legal entity structure, the European group solvency test is a key consideration. The impact of this test varies depending on the nature of the organisation and its overall financing, in particular how capital is allocated across the group. The regulatory environment of foreign operations is also important. For European groups with foreign subsidiaries, the key is to understand the deviations in local practice from the European regulatory regime and, where possible, to ensure consistent standards exist across the group. In this way, the group can mitigate the risk of its solvency being impaired by foreign businesses that may be subject to entirely different capital and asset admissibility requirements.

49 Strategic restructuring and re-domestication for insurers 48 Foreign groups and financial conglomerates potential mitigation opportunities For foreign groups with European operations, it is often easier to deal with these issues by adjusting the holding company structure, so that entities that potentially impair the group solvency margin (but do not in themselves trigger the requirement) sit outside the European sub-group, which is where the EEA regulators focus generally lies. For financial conglomerates, different considerations will be relevant, in particular at which level capital is required to be fungible. For some groups, for example banking organisations, it may be preferable not to have an insurance holding company, due to the greater flexibility afforded if capital is not locked into an insurance sub-group. Vertical and flat structures Prior to the introduction of the group solvency test, it was common for insurance groups to adopt vertical ownership structures, in other words have one insurance company own another, which owns another and so forth, a structure known as stacking. Such vertical structures meant that firms enjoyed multiple use of capital and could be financed by parent company debt, whilst at the same time meeting solo solvency requirements. This sometimes led to a distorted impression of the overall financial health of the group. Since the implementation of the IGD, many insurance organisations have moved to flatten their structures, as some of the key benefits of the insurance company stacking no longer exist. Worse, stacking can potentially introduce complexities both at a technical level, in terms of calculating the group solvency requirement, as well as giving rise to practical issues such as dividend traps, for example where the solvency of an insurer in the chain becomes impaired, thus preventing the upward payment of dividends. Nevertheless, some groups still adopt stacking and this can be particularly helpful where insurers hold excess capital for rating purposes and want to apply the regulatory excess for the benefit of financing other group insurers. Great care is, however, required to manage and mitigate the potential adverse impacts. Tax opportunities and threats Many groups structures are driven by the desire for tax efficiency. Indeed an effective tax structure can dramatically improve an organisation s financial return, market capitalisation and its ability to attract capital to enable future growth, as discussed in Section 4. Tax structuring can also be a threat if not carefully planned and subjected to dynamic monitoring and management. Complex structuring which is no longer effective can be difficult, costly and in some instances, punitive to maintain or unwind. Group structure simplifications represent the current trend for insurance groups; in contrast many tax efficient structures can add to the overall complexity. The key is achieving a balance. As such, whilst a number of groups are reducing tax complexity, there are a range of structures being adopted by both European and foreign insurers with European operations to keep the overall tax charge as low as possible. Examples include: the use of holding entity structures aimed at minimising withholding taxes on dividend and interest payments; the insertion into these structures of financing companies through which to raise tax efficient capital (for example tax deductible debt); the adoption of a strategic approach to holding company location, for example, the use of a holding company in the EU. Precisely where to locate these structures is determined by reference to the nature and circumstances of the organisation, its tax environment and the extent to which there are double tax treaties in place between the countries concerned. Notwithstanding this, within Europe, Luxembourg is a popular choice for some of these structures; Gibraltar too presents opportunities through its unique status as technically a non EU country but with EEA rights 39. For many groups a key issue is ensuring that group risk is managed and that a sound and prudent control framework is in place across the group. This will also be a regulatory requirement under Solvency II. This has led to the emergence of a range of risk, governance and compliance frameworks being adopted by groups for managing the business. For large groups, and those with unwieldy structures, virtual, matrix style governance arrangements are increasingly common, allowing the parent to oversee regional performance more effectively. In some cases, arguably, this has gone further than oversight and regulators are increasingly expressing concern about group dominance. With Solvency II on the horizon and the opportunities and challenges this is expected to generate for groups, many insurers are focusing on further improvements to risk management and finance systems and controls, both at group and individual entity level. For some, legal entity restructuring is a facilitator to implementing higher standards of group risk governance and this is becoming an additional driver for insurance organisations looking to restructure. 39 Insurers in Gibralter qualify for EEA rights due to the relationship between the UK and Gibraltar.

50 49 Strategic restructuring and re-domestication for insurers 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Subordinated debt / shareholders equity Top European Insurers / Reinsurers by market value Source: FT Europe year end accounts Capital structure Ensuring the overall efficiency of the group capital structure is critical. This means deciding the amount of capital required to support the business and the mechanism for allocating capital across the operating entities. This requires careful consideration, balancing regulation, tax and other commercial and strategic drivers to determine the most effective overall arrangement. Capital components Under the existing Insurance Directives, the key components of qualifying capital are equity and to a limited degree subordinated debt and preference share capital. Other forms of capital are not prohibited, although they can only be used once the solvency margin is covered by the core capital. Despite the fact that hybrid capital counts towards the solvency margin and can have preferential tax treatment because it takes the form of loan capital, a large number of insurers have not taken full advantage of this. Figure 8: Analysis of equity and subordinated debt for major European Swiss insurers and reinsurers ING Allianz AXA Generli ZFS Aviva Group Munich Re Aegon Prudential Swiss Re Old Mutual Legal & General CNP Assurances Sampo Subordinated Loans & Participation Certificates Shareholders Equity (parent) Increasingly optimising capital components is a key focus area for insurers, in particular as part of a wider restructuring exercise. Many insurers are now recognising that there are inefficiencies in the profile of their capital and financing and are seeking to rectify this. This has caused the emergence of a range of capital instruments and structures that aim to generate tax efficiencies whilst at the same time qualifying for regulatory solvency; there are now various types of tax efficient specialised debt instruments available in the market. Contingent capital structures 40 are also now being used in the non-life sector as a mechanism for replenishing capital following a downturn in results, perhaps due to a catastrophe or some other adverse event in the market. It is noteworthy that, currently, contingent capital is non-qualifying for solvency purposes and hence its use may be restricted to the provision of a solvency buffer, or in practice, more usually, to allow insurers to take advantage of improved rating conditions following an event. Under Solvency II however it is possible that contingent capital will qualify at tier three level. Notwithstanding the regulatory and tax opportunities for the larger global insurers, clearly the rating agencies approches have a bearing on the ultimate capital components and structure. Capital release An emerging trend is for insurers to release excess capital, both to reduce the cost of capital and to minimise the risk of a takeover. Such releases also represent an opportunity to change the capital profile so that the structure is more flexible. Currently many of the large listed and global insurance groups are returning capital to their shareholders, for example through share buy backs. For listed groups this 40 Contingent capital structures in the non-life sector needed to be distinguished from so called contingent loans used in life companies where funds are advanced to the company and the repayment is contingent on the emergence of future surplus.

51 Strategic restructuring and re-domestication for insurers 50 can be a drawn out process and may be quite costly to achieve as rating agencies, analysts, regulators as well as investors need to be satisfied with the proposed capital repayment. Reinsurance as capital Reinsurance is frequently used by groups as a mechanism to manage capital, minimising its cost and responding to variable market conditions. Several major European groups, as well as foreign groups with European sub-groups, reinsure subsidiaries underwriting back to the parent for reasons of efficiency and group risk management. Certain regulators, such as the FSA, have focused on the group risk consequences of this practice and mandated capital loadings to cover the credit risk associated with significant unmitigated reinsurance to the parent. Whilst Solvency II builds reinsurance into the model calibration for calculating an insurer s capital requirement, there is hope for some relief from a narrow view of solo solvency capital (as discussed in section 3). However, the equivalence debate continues, so, whilst reinsurance pooling is relatively popular, the long term viability (from a regulatory perspective at least) of significant internal reinsurance for foreign groups to a reinsurer outside Europe is unclear. Alternative forms of reinsurance In addition to traditional reinsurance, over the years insurers have turned to finite reinsurance, where the risk transfer is limited, to assist with capital and earnings management. This has also prompted action by regulators; both the FSA and BaFin have developed explicit principles aimed at ensuring that the treatment of such reinsurance for regulatory purposes reflects its economic substance, which has not always been properly understood and has on occasion been abused. Hence, great care is needed in using this type of reinsurance. There is also a growing preference for other, new forms of reinsurance, such as securitisations via special purpose vehicles. On the non-life side, following the growth of the cat(astrophe) bond market in the 1990s there has been a gradual but increasing trend for insurers to take out such types of reinsurance. More recent developments include the use of sidecars (a form of special purpose vehicle through which the capital markets provide either catastrophe protection, or additional capacity, in the form of reinsurance). These types of soft capital are now much more extensively used in conjunction with, and in some cases as a substitute for, traditional reinsurance. They often afford considerably greater flexibility and control for cedants. Currently, Bermuda appears to be the jurisdiction of choice for these arrangements, as its nil tax rate and regulatory regime are particularly attractive for the capital providers. It is also now possible to purchase off the shelf sidecars. In addition, securitisations involving closed books are also gaining pace amongst the European insurance community, and are particularly prevalent for life insurance. The benefit of such restructuring includes greater certainty of result, together with the ability to free up capital for future business activities. Reinsurance securitisations are just one example of the increasing convergence of the insurance and capital markets and this trend looks set to continue. This is evidenced also by the fact that some insurers are electing to invest in such vehicles as a mechanism to manage and diversify their exposure, for instance through the ability to access niche accounts.

52 51 Strategic restructuring and re-domestication for insurers 6. From strategy to implementation - what s involved? Restructuring, with or without re-domestication, offers huge potential benefits, but these projects can be massive in scope and scale. To be successful, each stage needs meticulous planning, sound technical and market experience, and close attention to detail. be unwound. It is vitally important therefore that an insurer s aims, and the drivers and constraints to any restructuring, are identified at the outset and used as a reference point in benchmarking any restructuring options. These will essentially represent the guiding principles to determining the appropriate structure for an organisation. Effective access to markets Fiscal implications Operational efficiency Business effectiveness Market perspective Regulatory environment Efficient use of capital Restructuring and re-domestication are means by which insurers may implement their strategy effectively and efficiently. The way in which a group is structured is not in itself the business strategy but it can be a vital enabler to its delivery. It is critical therefore to approach a potential restructuring of a group in a logical and considered manner, ensuring the involvement and engagement of all of the relevant parties in the organisation from the outset. Our firms experience shows that where such exercises are led by just a regulatory or tax function, or perhaps operations or finance alone, then unexpected barriers come to light during the transition, or else the business is itself compromised. At worst the structure might need to Approach There is no right or wrong way to approach a restructuring project, and it is important that the framework adopted is appropriate to the culture, expertise and circumstances of the particular organisation in question. Nevertheless, experience shows that projects that have gone smoothly have tended to involve a number of separate phases. For example these might include: Strategic analysis and business case Detailed work to establish feasibility Design of transition steps to move to the proposed new structure

53 Strategic restructuring and re-domestication for insurers 52 Detailed project design and planning Detailed cost benefit analysis Implementation stages involving the careful execution and monitoring of issues by reference to an agreed plan Strategic analysis and feasibility The initial strategic stage involves going back to basics to weigh up the various restructuring options available usually by reference to the guiding principles that derive from the aims, drivers and constraints to any strategic restructuring. Insurers will typically determine which entities can be consolidated and streamlined, consider their preference of operating platforms and location, decide if they want to re-domesticate, and then overlay a new holding company and capital structure. In applying the guiding principles, sometimes different factors will compete, for example tax and regulatory drivers the key is in ensuring the correct decision is taken and the implications understood and catered to. Figure 9: Strategic restructuring and re-domestication - the end to end process Strategic analysis and option evaluation Aims, constraints and stakeholder management Detailed feasibility including step plan and cost benefit analysis Programme design and implementation planning Implementation Programme management, workstreams, step plan and issues log