Captives and Transfer Pricing: A Captivating Affair

Executive summary:

Transfer pricing for captive insurance companies presents unique challenges due to the central role of risk in this business. Therefore, this analysis cannot be approached like that of a typical captive in other sectors. Further, although, the Comparable Uncontrolled Price (‘CUP’) method is an option for determining the arm’s length pricing, its application is rarely straightforward. This article highlights key issues and practical strategies for tackling Transfer Pricing for captive insurers.

Setting the context:

For a jurisdiction like Malta, the relevance of the insurance sector cannot be overstated. Companies looking for an insurance solution have traditionally favoured the jurisdiction for its numerous tax and regulatory advantages, along with other benefits this jurisdiction offers in terms of ease of doing business.

With the Malta Transfer Pricing Framework becoming effective from basis years commencing on or after 1 January 2024, it is opportune to address the complexities involved while tackling the Transfer Pricing considerations specifically applicable to this space.

Generally, the intra-group transactions of a captive insurance company are in the nature of premium charged to Group companies for risks insured and settlement of their claims (in case the risks crystallise). Other generic transactions involving, amongst others, management fees, intra-group loans and other service charges are not specifically addressed in this article, since these transactions are not specific to the captive insurance or even the insurance space in general.

Determination of the arm’s length price:

This brings us to the crux of the matter, which is how should one proceed with the arm’s length determination for a captive insurer and what are the dos and don’ts around the same?

• Ensure that the economic substance of the transaction/genuineness of the transaction is documented in sufficient detail:

While this seems to be one of the most basic points, it is also one of those points that is often ignored. Economic substance is the heart of Transfer Pricing and any analysis with respect to a transaction that lacks an economic substance could fall flat. The OECD Transfer Pricing Guidelines, 2022 sufficiently captures the relevance of accurate delineation of a transaction and ensuring that the transaction has genuine economic substance.

Specifically, in this case, it shall therefore become essential for the taxpayer to demonstrate in sufficient detail the following:

• Nature of the business operations of the captive insurance company;
• The core expertise and experience of its team;
• The nature of risks assumed and whether these are those risks that an independent insurer would have assumed, the possibility of the risks actually crystallising, i.e., a real possibility of losses being suffered;
• The benefits obtained by other Group members by passing on these risks to the captive insurer;
• The fact that other regulatory requirements are being adhered to;
• Demonstrate that it has a portfolio of diversified risks which is generally the case if the captive insurer assumes various risks of a large MNE Group.

Once, the economic substance is sufficiently demonstrated, the next step is to proceed with the arm’s length evaluation.

• Arm’s length evaluation:

Should NOT be confused with a non-insurance captive:

The benchmarking strategy for a captive insurance company should not be confused with any other general captive operating in any other industry (for instance let’s say technology). This is primarily because a captive company operating in any other industry is by default risk insulated. The typical benchmarking strategy for such captives being an arm’s length markup over and above their total operating cost base. On the other hand, risk assumption is at the heart of an insurance business and in fact the very objective of setting up a captive insurance company is to centralize the risk assumption at the level of the said company. Therefore, adopting a full cost-plus markup strategy to benchmark the transactions of a captive insurer may not be ideal. While the emphasis is laid on captive insurers, these principles are equally applicable even for re-insurers.

CUP – The obvious choice but what about its implementation?

Using an internal or an external CUP to benchmark the premium charged often appears to be the first choice because it’s direct and price based. However, its application may not be as easy. This is because, being a price-based method, it is less flexible and requires the comparability parameters between the controlled or tested transaction(s) and the uncontrolled transactions to be almost identical or largely similar. Such pricing information about uncontrolled transactions with almost identical or largely similar comparability parameters is often not available. Further, while comparability adjustments are theoretically possible to eliminate the differences in comparability parameters, incorporating those adjustments for every single comparability parameter which is different is often significantly complex rendering the entire process impractical and unrealistic.

Valuation Report backed with corroboration – The most practical yet robust approach

In light of the above, a valuation report therefore seems to be the most realistic and practical approach for determining the arm’s length price of the premium charged by a captive insurance company. A valuation report issued by an independent actuary usually captures the basis of valuation of the premium charged. The typical factors being expected losses considering the nature of the risk(s) and the frequency of its crystallisation, the costs associated with underwriting and administration of the said risks including dealing with claims, the expected arm’s length return on capital amongst other factors.

The above approach could then be strengthened/further corroborated with benchmarking the return on total capital employed of the captive insurer against its comparable companies identified by way of an independent search exercise conducted using an independent third-party database.

The OECD Transfer Pricing Guidelines, 2022 also discusses the concept of a combined ratio and return on investments which could also be used as a corroborative approach which basically aggregates the following:

• Arm’s length underwriting profit of the captive insurance company - Derived by calculating the profit element generated by the comparable companies over claims payable or expressed as claims payable as a percentage of premiums receivable; and
• Arm’s length investment return on the intra-group investments made by the captive insurance company

Summing up:

In a nutshell, Transfer Pricing for captive insurers requires a much more tailored approach which  should be comprehensively documented in the Transfer Pricing Local File as well as other back up documentation to not only ensure compliance but also defendability.

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