Financial Interest Cover

Transcription

1 Financial Interest Cover This document aims to provide interested readers with an overview of key considerations regarding the provision of financial interest cover. 1

2 Table of Contents 1. Background How does Financial Interest Cover work? Key Considerations Loss Assessment Approach Summary and conclusion of 6

3 1. Background In today s business, global policyholders, intermediaries and insurers, go to great lengths to respect regulatory requirements and at the same ensure that they are able to offer legally compliant products and services. Compliance involves alignment with guidelines, regulations and/or legislation and policyholders, brokers and insurers must ensure that they respect domestic regulations and in particular (when dealing with international insurance solutions) local regulatory laws. The biggest risk for internationally active market participants is the violation of so-called non-admitted insurance regulations. Non-admitted insurance is commonly defined as a policy that is issued by an insurer in one country that covers exposures in other countries where this insurer is not licensed nor has a licensed operation. In practice, this means that there is no policy issued locally and the coverage is structured in a standalone manner (i.e. single policy providing coverage worldwide) or it may be constructed as part of an international insurance program in the form of a Master Policy including DIC/DIL cover. However, the legal status of nonadmitted varies from country to country and can be depicted as follows: Permitted in some countries, lines of business or certain circumstances Strictly prohibited in many Non-Admitted Insurance Regulators have as yet no official position on the issue Permitted but subject to prior approval from regulator Permitted if registered locally and subject to premium taxes Non-admitted cover and compliance are not new topics, but what has evolved over the years is the way in which market participants, regulators and tax authorities are scrutinizing these issues. What complicates the matter even further is the fact that there is no common approach and governments are continuously looking for new ways of generating tax revenues willfully putting at risk the insured s subsidiaries located worldwide. Given the diverse nature of this topic, no single coverage solution appears to suit the needs of all. A combination of perfect compliance and cost effective program structure is not entirely possible due to the uncertainties of local regulations. In order to ensure compliance, market participants have (theoretically) three options: 1) Stop business activities in countries where non-admitted business is prohibited; 2) Deliberately ignore non-admitted regulations; 3) Develop alternative insurance products. Having said that, today the most common market approach in trying to overcome these uncertainties is through: 1) Local (fronting) policies issued by locally admitted insurers or 2) The provision of financial interest clauses (as part of the master policy). 2. How does Financial Interest Cover work? Financial Interest Cover is promoted as a legally compliant, cost-efficient and easy to handle solution that provides coverage for risks located abroad. It is aimed at insuring the parent company against financial losses to its balance sheet stemming from incidents arising from its subsidiaries/joint ventures located around the world. Additionally, the parent company is intended to have a financial operational and strategic interest in a continued existence of these entities. The structure of insurance is considered as pure self-insurance of the parent company as the parent is the only legal entity covered under the financial interest clause (insured). In 3 of 6

4 addition, financial interest clauses often require that it be clearly stipulated that the subsidiary is not being covered by the non-admitted portion of the master policy and that only the parent s financial interest in its subsidiary is covered. From an administrative point of view, the subsidiary is not involved in any part of the transaction or in any subsequent activities related to the master policy. In practice, when a loss occurs, the value of the subsidiary diminishes which results in a decrease of the parent s balance-sheet and can therefore be interpreted as the insured having suffered an insurable financial loss. 3. Key Considerations Before developing and offering a financial interest clause to one s client, insurers should consider the following: 3.1 Non-admitted risk location - Regulators may consider financial interest cover as a violation of nonadmitted regulations or as an activity that is being carried out by an unlicensed / unregistered insurer. Financial interest cover remains untested from a judicial and regulatory perspective and could result in proceedings under criminal or civil law against the insured, the broker as well as the insurer. Moreover, the local insured or broker is at risk of losing their business license. Regulators have yet to come forward and declare that this type of coverage exempts the local subsidiary from local restrictions and does not breach local regulatory requirements. 3.2 Uninsured sums insured - The local insured may misinterpret the coverage structure and feels sufficiently covered by the parent s financial interest cover and insists on lowering sums insured locally to minimize the local premium expenses. Consequently, the local subsidiary is considered to be underinsured and regulators could argue that the higher share of coverage in the parent company s policy increases the potential danger for the local insured to be covered predominantly by an untrustworthy and not properly capitalised insurer outside of the local jurisdiction (consumer protection) 3.3 Evaluating "insured interest" - Correct evaluation of the insured interest and insurable negative impact on the parent company s financial balance sheet largely depends on The parent s investment share in the local entity i.e. coverage can only be provided up to the share of the parent s investment (caution: Joint Ventures!). In other words, as the financial interest of the parent share can only be insured, it is not possible to insure 100% of the subsidiary if the parent s own share is less than 100%). Tax and accounting laws The parent s share on the local loss impairing the parent s balance sheet. 3.4 Tax Regulation - The financial interest cover is subject to the insurance tax regime of the country of the parent company. The insurance tax rates might be significantly higher than those applicable at the level of the subsidiary. Any payment from the parent company s country to the local subsidiary may trigger undesirable tax consequences on these payments (e.g. Capital Investment Tax). This also includes claims proceeds received by the parent company and transferred to their local entity. Apart from that non-admitted insurers are not allowed to collect and pay local (insurance) taxes. Additional questions that may occur: what will be the correct tax rate applicable and who will ultimately be responsible for making the payment? 3.5 Liability - Local defense costs incurred cannot be taken into consideration as these are not impacting the value of the investment held locally. 3.6 Obligations of the policyholder - As there is no local policy issued, all local insurance obligations of the local insured need to be transferred to the parent company. The financial interest clause should clearly state that the parent company has to fulfil these obligations. 3.7 Reputational Risk - An insurer may be put into an uncomfortable position whereby it would have to explain to its long-standing customer that the insurance product sold is completely or partially void and as a result exposes the insured to criminal prosecution. 4 of 6

5 4. Loss Assessment Approach What could be considered as a parent company s financial loss on its balance sheet? A possible answer to could be the value of the investment before and after the loss. Hypothetical local profit at year end (no loss) Less Local profit at year end (loss) = Financial Interest of the parent to be insured However, the hypothetical local profit is difficult to quantify and constantly fluctuating values are changing the insured value regularly. Additionally, a parent company may not be unwilling to reveal such financial information to third parties. This optimistic method of evaluating the financial interest loss of the parent company fails if there is no profit generated locally (e.g. start-up company, loss-making entities) and results in several other disadvantages: 1) Loss experiencing entities: lower profit > lower taxes = financial loss (partially) balanced 2) The parent has to prepare two financial balances/statements to evaluate the financial loss, a real one after loss occurrence and a hypothetical one not considering the loss event. 3) Delay in loss payment as the financial balances of the parent company are usually prepared on defined dates only but these are required to evaluate the actual financial loss. 4) High evaluation costs and efforts 5) High degree of financial expertise required 5. Summary and conclusion There has been a great deal of debate about the legality and efficiency of financial interest clauses and the only concrete conclusion is that there is no certainty in terms of compliance. The most important question to be answered is the financial impact of the loss of the local subsidiary in the parent other company s balance sheet. In other words, the value of the damaged object is not relevant but rather how the damage is affecting the balance sheet of the parent company. These two financial figures differ significantly from each other. Following judgement in the Kvaerner plc Staatssecretaris van Financien 1 case, EU insurers have developed solutions that allow them to pay taxes in other EU jurisdictions. However, this court ruling only provides insight into what rules are applicable within the EU, leaving open the question of what to do elsewhere in the world. In addition, non-eu insurers may not be allocating premium taxes in the same manner as their EU counterparts. Several insurers offer financial interest cover but there remains significant difference in opinion on how the financial interest loss is defined and how taxes are administered as well as the extent of the non-admitted portion of coverage that is actually applicable. As pressure from Regulators in terms of compliance continues to gain momentum, it is likely that insurer practices will eventually converge as they already have within the EU. Unfortunately for the time being, there is no single clear answer to the need for optimization of the legal, fiscal and regulatory challenges. 1 In this case, a Dutch company within the Kvaerner Plc group, being an English company, was insured for risks arising in the Netherlands under a central policy taken out by Kvaerner in the London insurance market for its entire group. Under Dutch tax legislation, tax was due in relation to contracts of insurance covering risks in the Netherlands, and the Dutch authorities required the Dutch company to pay tax on the insurance of these risks. Kvaerner objected to have taxes paid in the UK, and the case went as far as the Dutch Supreme Court, which itself referred certain questions relating to the interpretation of the Second Non-Life Directive (88/357/EEC) (the Directive) to the European Court of Justice. The ECJ held in favour of the Dutch tax authorities, finding that the Directive provided that, if stipulated by the law of a member state, the legislation of the member state where risks are situated may be applied to the extent that that law requires. The case illustrates that despite a contract being placed centrally in London, variations in the tax regimes of different member states can cause unforeseen liabilities. This variation is perhaps more surprising in the EU, where the harmonisation of regulatory frameworks is at one of the most advanced stages of any region in the world. 5 of 6

6 In the end, when designing an insurance program covering global clients, early planning by the insured, in close cooperation with its brokers and legal advisers, should ensure the most appropriate insurance solution is developed for the entity in question. However, the approach that is finally taken will largely depend on the insurer s and insured s risk appetite, the nature of the organisation, its culture as well as business objectives. For the time being, non-admitted insurance and insurance premium tax liability remain as complex as ever and Financial Interest Cover does not solve but results in multiple new challenges and at the same time does not guarantee compliance with existing local laws. Disclaimer Although the greatest care has been taken in the preparation and compilation of Financial Interest Cover white paper, no liability or responsibility of any kind (to extent permitted by law), including responsibility for negligence is accepted by the INI Network Office and its staff. All information gathered is believed correct at August All corrections should be sent to the INI Network Office for future editions. INI Network Office August of 6