Sight. TAX-TRANSPARENT FUNDS for THE insurance industry. line of

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1 line of Sight TAX-TRANSPARENT FUNDS for THE insurance industry Enhancing Investment Efficiencies in the face of growing regulation AND OTHER PRESSURES In the face of a continued low-yield environment and an increasing regulatory burden, insurance companies are looking for ways to maximise efficiencies and eliminate unnecessary drag on investment performance. Now is an optimum time for insurers to decide how to adapt their business structures to address the changes ahead. In particular, Northern Trust believes insurers should increasingly consider using taxtransparent vehicles as valuable tools to meet regulatory and investment challenges through: Tax transparency: elimination of tax drag helps improve investment performance, providing added funds to apply towards the increased cost of doing business. Cost efficiency: streamlined investment structures bring reduced servicing, administration and reporting costs while affording greater purchasing power through fund vehicle consolidation. The use of tax-transparent funds also provides approved fund structures to address the monitoring and reporting challenges posed by heightened global regulation, including Solvency II. Tackling legacy issues: tax-transparent funds often represent a flexible, intelligent solution to deliver investment performance for clients while tackling the problems posed by inefficient or outdated fund structures. January 2013 For insurance companies, the present low-yield environment and growing regulatory requirements have increased the cost of doing business. Faced with these pressures, European insurers will continue to assess and restructure their investment businesses to derive maximum efficiencies from their infrastructures. northerntrust.com Line of Sight: Tax-Transparent Funds for the Insurance Industry 1 of 6

2 EUROPEAN INSURERS: UNDER PRESSURE Insurers face distinct pressures that, combined, are increasing costs and creating a more complex operating environment. Solvency II The European Union s Solvency II directive constitutes the biggest regulatory challenge facing the insurance industry in Europe today. It will impose consistency and transparency across all European insurance companies, forcing a massive change in the solvency and risk management of their firms. As its title suggests, a key focus is on balance sheet strength and the amount of capital EU insurers must hold to reduce insolvency risk. Key sub-components of Solvency II address balance sheet consistency, risk-based capital, risk and solvency assessment, senior management accountability and supervisory assessment. In particular, Solvency II compels insurance companies to reserve more regulatory capital on their balance sheets than currently required, to be commensurate with their investments risk profiles. For insurers, this means sharp increases in the cost of holding equities and other asset classes considered high risk. Instruments with short maturity, high-quality government debt and other bonds with strong credit ratings will, by contrast, be treated more favourably under Solvency II. This is bound to have an impact on asset allocation choices and the structures used by insurers. Investment environment Solvency II requires insurers to hold more capital to guard against the risk of insolvency. However, in a period of low economic growth and uncertainty, the need exists to balance capital requirements with that of delivering income in particular insurers need to deliver income for their legacy book of business, which can include policyholder income guarantees. Striking and maintaining this balance between income generation and risk mitigation is likely to be a long-term challenge. MAXIMIsING OPPORTUNITIES THROUGH TAX-TRANSPARENT FUNDS The use of asset pooling within a tax-transparent fund offers potential solutions to help meet these challenges, while also providing an extremely versatile product solution for insurers. By pooling investments including cross-border assets through a tax-transparent vehicle, insurers can co-mingle different investment assets for investors of multiple domiciles within a single vehicle. Suitable vehicles for doing so include the Irish Common Contractual Fund (CCF), Luxembourg Fonds Commun de Placement (FCP) and Dutch Fonds voor Gemene Rekening (FGR). The United Kingdom has thrown its hat into the ring as well, with the UK Government introducing in its 2011 Budget the first-ever UK fund regime for taxtransparent contractual vehicles the Tax Transparent Fund (TTF), which is expected to come into effect in spring northerntrust.com Line of Sight: Tax-Transparent Funds for the Insurance Industry 2 of 6

3 Tax transparency Due to their scale, many insurance sector funds are already operating on a cross-border basis. But our experience has shown that more often than not, those structures are taxinefficient with withholding tax applied at the fund level without regard to the underlying investor type or domicile. This may result in investors incurring higher effective tax rates than if they had invested directly in the market. For example, when traditional funds such as the UK open-ended investment company (OEIC) or Irish Variable Capital Company (VCC) are used by insurance companies, investment assets held within them are taxed at the company level. Most tax-transparent funds are structured so that, for tax purposes, the fund s investors are the beneficial owners of the investment assets, not the insurance company. In this way, tax-transparent funds are regarded as fiscally transparent, with withholding tax applied at the fund investor level. The fund s underlying investors are then taxed according to their own domicile, allowing them to benefit from double taxation treaty arrangements that could not be used otherwise. Institutional investors are often eligible for withholding tax relief, but cannot take advantage of it when investments are held in structures that prevent application of tax treaty benefits. The resulting tax drag on collective investment structures exposes investors to significant withholding tax rates (such as equity withholding rates of 30% in the United States or 35% in Switzerland) which often cannot be reclaimed. Thus, through poor choice of fund vehicle alone, investors can experience losses of between 50 and 90 basis points per annum. By restructuring their investment operations in more tax-efficient ways and utilising the tax treaties their clients are entitled to, insurers can maximise investment performance valuable additional revenue in the context of Solvency II s capital requirements, and a low-growth investment environment. Indeed, research has found that a tax-transparent asset pooling vehicle can enhance returns by as much as US$81 million on a US$1 billion portfolio invested in broad market indices over a 10-year period (Figure 1). Figure 1: Additional cumulative returns in Irish Common Contractual Fund over 10-year period (US equities) US$ Million Source: Northern Trust research (Januar y 2012) Cumulative difference CCF less ICVC northerntrust.com Line of Sight: Tax-Transparent Funds for the Insurance Industry 3 of 6

4 Cost efficiencies The expense of Solvency II s capital requirements will accelerate the need for insurers to become more cost efficient. Northern Trust expects EU life and pension reinsurers to consider changing from policyholder to unit-holder models to help mitigate this capital adequacy requirement. In this environment, consolidating fund assets from multiple funds into a single tax-transparent vehicle offers obvious advantages of scale. For example, servicing costs including investment management, custody and audit are potentially reduced by using asset pooling to consolidate fund vehicles, while reporting becomes more streamlined and transparent. For insurers, centralising their pool of assets should enable a similarly streamlined approach to asset administration, monitoring and oversight. Consolidating fund vehicles can also bring insurers greater purchasing power and economies of scale when selecting investment managers and other service providers. In addition to Solvency II, a myriad of regulations are affecting the insurance industry, from the UK s Retail Distribution Review to the US Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as incoming US and European requirements for central clearing of OTC derivatives. In the face of such a cluttered regulatory landscape, maintaining separate compliance and administration processes for every fund is tremendously inefficient. In that regard, the benefits of consolidating funds into a single tax-transparent vehicle are obvious. Legacy issues As insurers look to impose tighter cost and risk management controls, legacy issues are increasingly likely to come to the fore. We expect to see life companies, in particular, take the view that their aging fund structures many of which were built to be efficient for purposes such as individual stamp duties or capital gains tax are now unwieldy, difficult to administer and no longer fit for purpose. In our experience, insurers investment portfolios often include large numbers of individual funds servicing individual markets, with many of these funds having evolved via mergers and acquisitions. No doubt these structures will be increasingly examined, with consolidation considered in order to maximise synergies. Because tax-transparent funds are cross-border in their scope, their use can help insurers become far more efficient in replacing multiple funds. Rather than using a fund for each market, a single tax-transparent fund vehicle can be built to suit various regional market requirements without losing the overall benefits of fund consolidation and taxtransparency. In this way, tax-transparent funds can represent a smarter way for insurers to distribute and deliver investment performance for their clients. northerntrust.com Line of Sight: Tax-Transparent Funds for the Insurance Industry 4 of 6

5 FACING THE FUTURE Across the insurance industry, the increased costs introduced by Solvency II and the range of additional global regulatory changes will be so significant that all European insurers should evaluate whether they have the most efficient structures in place. In this respect, pooling assets in a tax-transparent fund vehicle offers significant advantages that can help insurance companies meet these challenges and better position their investment structures for the long-term. FOR MORE INFORMATION If you would like to learn more about how the use of tax-transparent funds can benefit insurance companies, please contact your Northern Trust representative or visit northerntrust.com. We hope you enjoy the latest presentation from Northern Trust s Line of Sight. By providing research, findings, analysis and insight on the effects and implications of our changing financial landscape, Line of Sight offers the clarity you need to make better informed decisions. northerntrust.com Line of Sight: Tax-Transparent Funds for the Insurance Industry 5 of 6

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