Take Two – BEPS and Solvency II Update: Preparing for Regulatory Review and Unlocking Opportunities

Base Erosion Profit Shifting or BEPS for short, is becoming an increasingly talked about subject in the captive world – one that both the insurance industry and captive owners need to understand and prepare themselves to address.  

At the heart of the issue are the Organisation for Economic Co-operation and Development’s (OECD’s) proposed changes to international tax law. The changes, known as the BEPS recommendations or principles, are designed to tackle aggressive tax planning strategies that exploit gaps and mismatches in tax rules in order to reduce a company’s tax burden. The BEPS principles cover many areas, including captives.  Therefore, going forward captives will likely come under greater scrutiny from tax authorities worldwide.  

Preparation at an industry level

Before proceeding with any changes, it is critical that the OECD fully understands the commercial rationale as to why so many multinational companies use captives. Marsh Captive Solutions has been engaging with risk management associations (such as the Federation of European Risk Management Associations (FERMA)) to help educate the OECD and to assist with the creation of guidelines for national tax authorities with respect to captive arrangements. Our goal is to ensure a more proportionate and consistent implementation of the BEPS principles for captives.

Preparation by captive owners

Captive owners should be ready to demonstrate their compliance with the proposed BEPS principles of transparency and economic substance or face potential reputational damage and financial penalties. It is anticipated that four areas of the BEPS principles could have direct or indirect implications for captive owners.

In the area of Commercial Rationale, for example, although owners know the reasons why they have a captive, quite often they do not have up-to-date documentation setting out that rationale.

In the area of Substance and Governance, it is advised that a captive owner compare key captive operating functions against best practices within the industry. It is our recommendation that a company should document why it established its captive in its particular domicile. A captive owner also should be prepared to demonstrate and document how its captive is delivering risk management and business efficiencies.

Taking early action in these areas will help ensure that a captive owner is ready to take part in constructive dialogues with regulators and tax authorities when required and could mitigate financial penalties that might arise from future tax audits.

Trends in Solvency II

During the second full year of Solvency II, captive managers and advisors have been on the frontline as captive owners address evolving aspects of the regulation.  

Regulatory feedback indicates that captive owners who have invested heavily in the area of data analytics and IT have fared best with compliance efforts as the quantitative aspects of Solvency II in particular have proved quite challenging for many captive owners.  

The use of data analytics can help captive owners align their structures to minimize component risk and related capital charges under Solvency II. Throughout the Own Risk Solvency Assessment (ORSA) process, captive owners have needed to evaluate potential adverse scenarios and develop appropriate remediation plans. Similar scenario testing techniques can be used to explore potential positives and enhancements to existing programs.

Attitudes towards capital and investments also have changed under Solvency II. In the past, captive owners tended to adopt more traditional and simple strategies around asset class, reinsurance, and internal risk transfer. Solvency II presents an opportunity to deploy dynamic, multi-dimensional strategies to enhance and support risk management processes. The most engaged captive owners now realize that what was efficient under the previous regime is not necessarily efficient under Solvency II.  Owners and risk managers are advised to seek benchmarking data to better understand how peer organizations are benefiting from a more efficient capital structure.

Regulatory changes provide opportunities

In considering how the BEPS principles and other regulations may affect captive utilization and management, captive owners should evaluate their current program structures and ensure compliance requirements are being met. Such actions can also support businesses’ efforts to manage increased pressure from shareholders and optimize return on capital. Marsh’s optimization capabilities, including the Marsh Solvency Tool for Analytics and Reporting (MASTAR) and diagnostic “Health Check,” have enabled captive owners to explore scenarios and implement programs that achieve a higher level of captive and capital efficiency, seize opportunities in the marketplace, and meet their stakeholders’ expectations.