INTM207700 - Controlled Foreign Companies: The CFC Charge Gateway Chapter 6 - Trading Finance Profits: Factors relevant to the capitalisation of insurance companies

This looks at the factors that are relevant to capitalisation levels within the insurance industry. It aims to assist in determining the circumstances in which a CFC carrying on insurance business (‘an insurance CFC’) may be over-capitalised.

An insurance company holds excess capital or assets only to the extent that its free capital or its free assets exceed the amounts that it is reasonable to suppose would be held by a company carrying on the same business if it is was not the 51% subsidiary of another company.

The overcapitalisation tests are set out in steps 1 and 2 of TIOPA10/371FA(1) (see INTM207300). The CFC’s ‘free capital’ at step 1 is its equity funding. Its free assets at step 2 are its total assets less any debt. Most insurance companies will hold both free capital and amounts derived from insurance premiums, but typically no significant debt funding. As a result, both of these tests broadly encompass a test of the overall level of assets held by the CFC.

It is therefore necessary to consider a comparison of the assets an uncontrolled company would hold, determined by the needs of the particular business, with that of the CFC. Factors that influence the levels of capital and assets held by such a company include:

• the requirements of its insurance regulator
• the group’s capital management policy, which will set the levels of capital, how long it should be held and when and what should be done with it,
• the expectations of credit rating agencies
• other commercial drivers, including market pressures on insurance companies requiring them to hold particular levels of capital or financial instruments (such as letters of credit).

It is important to establish, understand and consider the commercial purposes for which an insurance company holds capital before concluding it is over-capitalised. Some of these purposes are discussed in more detail below. In cases of uncertainty, please liaise with your International Issues Manager (IIM) and/or Base Protection Policy Team contact as appropriate.

Regulation

Insurance Regulatory regimes vary widely from territory to territory. Some rely on simple mathematical formulae while others are based on complex risk modelling. Some regulators may require levels of capital substantially in excess of the capital normally required to be held under normal commercial conditions. In reaching a decision point on the capitalisation levels you will need to factor in, amongst other things, the local regulator’s requirements.

In doing this it is necessary to consider whether the CFC is holding more capital or assets than it is reasonable to suppose it would hold if carrying on insurance business and was not controlled by any other company. It is only possible to arrive at the conclusion that it is holding more capital or assets than is reasonable if it can be shown that the amounts held are not reasonably required for the purposes of its own insurance business i.e. they are held to support a separate trade or investment activity.

It is not possible to set out the requirements of all insurance regulatory regimes within this guidance. So, in order to provide an overview of the reasons and driving forces behind an insurer’s capital levels, the guidance below outlines regulatory principles that are widely adopted in the UK and elsewhere. The terms and principles set out below may differ from regime to regime, so you will need to focus primarily on the local regulatory regime requirements but the following guidance will assist in understanding the wider principles.

The regulatory principles set out below will be present to some extent in the majority of regulatory regimes. However, it is possible some regimes will apply bespoke or flat capital requirements, or calculations that are less detailed than those in the UK. In light of this the limited presence, or total absence, of the following regulatory principles should not be taken as an automatic indicator of a heightened risk of over-capitalisation but may be such an indicator where a CFC is resident in a beneficial tax territory.

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UK Insurance regulation

The UK’s FSA applies both a simple mathematical formula - ‘Minimum Capital Requirement’ (MCR) - and a risk based model - ‘Solvency Capital Requirement’ (SCR). The MCR and SCR are levels of capital calculated and set in order to reduce the risk of insolvency for the insurer. They also act as regulatory floors to which the insurer must pay careful attention.

It is important to note that whichever factors an insurance CFC chooses to manage its capital levels by, it will hold an additional capital buffer. This buffer is to provide a safety net to cater for fluctuations in capital levels so as to minimise the risk of a ratings downgrade, a breach of regulatory requirements or to protect against market volatility. The extent (if at all) to which a buffer is considered as excess free capital or excess free assets will depend on the facts of each case.

a) MCR

This sets the lowest level of capital an insurer should keep to support its business. It is calculated by reference to a percentage of premiums or claims. Where the capital resources of the insurance company fall below the MCR, it is likely the FSA will remove authorisation for the company to underwrite insurance business.

To enable the insurer to hold sufficient capital resources for its business needs and also the regulators requirements, it will factor in the probability of things such as ‘significant risk events’, rating agency requirements and market volatility when considering the levels of capital resources to hold. You are therefore unlikely to see levels of capital resources being held at, or close to, the MCR level given the increased business risk and regulator intervention the insurance company would be exposed to.

b) SCR

This sets a higher level of capital than MCR. It reflects a level of capital that enables the insurance or reinsurance company to absorb potentially significant losses whilst still giving its policyholders reasonable assurance their liabilities or payments will be met. Insurers will normally hold capital above the SCR. This may be due to the need for a capital buffer (as detailed below) and/or to ensure the requirements of its credit rating agency are met.

The insurer uses stochastic models to calculate the level of capital required to absorb ‘significant risk events’ that take place once every 200 years. The model is called an Individual Capital assessment (ICA). The FSA examine and approve the model and the insurer is required to endeavour to maintain capital in excess of the amount calculated by the model. If the insurer fails to maintain the required amount, the FSA will intervene in the business of the insurer and seek to agree a plan for it to restore capital levels within a reasonable time frame. However, it is likely insurers will at times hold capital at levels where this intervention will not happen.

Solvency II

Solvency I is due to be replaced by a new pan-European regime called Solvency II. There are some similarities between the current SCR and the Solvency II requirement. However, Solvency II is expected to have an impact on the levels of capital most insurers will be required to hold. In anticipation of its introduction and potential impact some of the insurers, to which it will apply, are holding increased levels of capital than they would normally hold were it not a factor to be considered.

Rating Agency Ratings

Insurance companies seek credit rating agency ratings for a number or reasons. For example, a rating may enable the insurer to enter a particular insurance market, to be able to write specific types of insurance business or underwrite the risks of particular customers. For reference, the capital required for an insurer to meet its SCR is broadly equivalent to a Standard and Poor’s rating of BBB. However, for the reasons noted above an insurer may be required to seek a higher credit rating to enable it to write specific types of insurance business. Such factors need to be taken into account when considering the capitalisation position of a company which holds more capital than that normally required by its local regulator.

An insurance group and the principal companies within an insurance group are likely to have a rating from one or more of the major credit rating agencies. The rating agencies take into account similar factors to those taken into account by the FSA in its consideration of an insurer’s SCR; each will seek to analyse the risks the company is exposed to and assess its levels of capital in relation to its own assessment of those risks.

In addition to the above some insurers will be seeking a higher credit rating than they currently have. Since improvements in credit ratings can take time, it is likely that higher levels of capital are required to be held for some time before the uplift in credit rating is achieved.

The work underpinning the provision of a rating by an agency is detailed and takes into account a significant number of factors. Whilst the factors may differ depending on the specific agency and rating sought, they are likely to include an assessment of:

• the company or group risk management procedures e.g. how it monitors and adjusts for mistakes, frequency of its risk monitoring;
• quality and stability of reinsurance vehicles used;
• size and impact of relevant risk categories on the insurer e.g. credit risk, investment risks, and interest rate risk.

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Other commercial factors underpinning capitalisation levels

Insurers generally generate profits in one of two ways: firstly, through their underwriting activities, and secondly, by way of the investment of the premiums collected from that activity. The profit split between these will depend on the insurer and its type of insurance line(s). It can also be influenced by investment returns and the general health of the economy the insurer operates within.

i) The need for a capital buffer

As noted above, whether the insurer uses a capital benchmark by reference to either its SCR or the level set by a rating agency, it would be very unusual for it to not also include a capital buffer. This buffer acts as a safety net to ensure reasonable fluctuations in capital levels do not result in a breach of the capital benchmarks for example SCR or Credit Rating. Capital buffers are generally calculated on a risk, rather than a quantum/percentage of MCR/SCR basis. This is in order to minimise the risk of approaching the regulatory floors and attracting a regulator’s attention.

It is likely insurers will always include a capital buffer, so its presence should not be taken as an automatic indication of overcapitalisation. The aim should be to firstly establish whether it is reasonable to suppose that an uncontrolled company would hold a buffer and secondly what the level of that buffer would be.

The above requires an analysis of the facts of the case, which will take into account both the size of the buffer and the length of time it is held at a particular level. Factors include, but are not limited to:

• the explanations given by the company as to how the buffer is calculated and what factors are taken into account in determining its size;
• whether the buffer held is in line with wider group capital management policy i.e. whether it is higher in the CFC than within other companies within the wider group;
• the capitalisation of other insurers within the same territory and market place;
• volatility in the market i.e. when assets and liabilities are recorded at fair value volatility in the market place can have a material impact on the levels of capital held.
• local regulatory concerns i.e. is the company retaining capital in preparation for changes in the local regulatory regime;
• business planning. Are they retaining capital for business growth i.e. expanding its underwriting levels or looking to make acquisitions.

ii) Territory-specific issues

Factors specific to the particular territory within which a CFC operates may be beyond its control and also influence the level of capital it is required to hold. Factors could include:

• regulatory requirements - certain regimes may require high levels of capital for particular types of insurance business or they may require capital to be held locally in order to minimise any risk of default in their territory;
• exchange controls - some regimes may prohibit the repatriation of certain profits.

iii) Group’s capital levels

It is unlikely for an insurance group to hold excess capital for long periods without paying it out to its shareholders, using it within the business for its trading activities, or ring fencing it for a particular purpose. This will primarily be driven by the group aiming to achieve its required return on capital employed (ROCE) from the capital it holds. What constitutes a long period will differ and will depend on the facts of each case. You will need to take into account a range of factors in establishing the purposes for which it is being held and also the extent of control the CFC and group have over its movement and use.

For example, a CFC may have retained capital as a ‘war chest’ for an acquisition of another company Where such capital is held to facilitate that acquisition for only a short period, HMRC are not likely to argue it is either excess free capital or excess free assets. However, if this war chest is built up over a number of years it is arguably excess and chargeable within Chapter 6 (as it is supporting shareholder activity and not the CFCs own insurance business).

There will undoubtedly be a variety of reasons as to why high levels of capital are held. The focus should be on firstly identifying whether the levels of capital resources includes excess free capital and/or excess free assets and secondly (to the extent there are also UK connected capital contributions) the factors supporting that excess.

One useful indicator to the CFC’s capitalisation could be to compare it to the SCR and/or rating agency levels within the wider group. This information may be disclosed within the group accounts, or alternatively by the group setting out the group’s capitalisation position.

iv) Capital ring fenced for the payment of dividends

An insurance company may hold capital in excess of what its insurance activities require in preparation for paying the excess to its parent company via a dividend. Where capital is ring fenced for this purpose and it is due to be paid within 12 months of its having arisen, it is unlikely for that capital to be considered excessive and thereby within the charge of Chapter 6.

In determining the above, it will be necessary to consider when the profits arose and whether the internal corporate documentation indicates that a dividend has been, or is shortly to be, declared. The group may point towards factors outside its control that influence the length of time profits are held, which mean the reference point of 12 months is inappropriate. In these circumstances it will be necessary to assess the relevance of the points the insurer may raise, which may include:

• local regulatory restrictions. Some territories may require all distributions to be agreed at an annual general meeting. If one has just passed they may have no option but to wait for the next one,
• delays in the provision of external advice to which the dividend relates,
• unexpected market volatility which requires capital to be retained for a longer period to protect against the breach of capital benchmarks.

v) Capital held to support the underwriting of new insurance business.

Insurance companies will at times retain capital in preparation for a drive to write new insurance business. This may involve moving into a new insurance line, or taking advantage of a part of a business cycle where market place premiums are expected to be high. Where capital is said to be held for this purpose, it will be necessary to review factors such as whether the internal and external communications supports this i.e. has the marketing for such an increase in business commenced?

vi) Use of insurance ‘sidecar’ structures

Insurance sidecars increased in prominence after the significant events of September 11th 2001 in New York and the 2005 hurricane season. Sidecars are generally set up as special purpose vehicles (SPV’s) which enable participating investors (e.g. hedge funds and private equity due to the high level of capital they have at their disposal) access to insurance underwriting participation. The SPV insurance investment company offers them access to potentially high level returns on capital (RoC). They are attractive, as the investor is not exposed to the wider legacy risk of the principal insurer.

The investors assume the risk and potential return of a small and limited category of insurance policies through the sidecar. The arrangement will generally last for between one and three years, thereby limiting the investor’s exposure. The arrangement benefits the (re)insurer as it is able to write higher levels of business at particular risk periods, without having to increase the level of capital it holds or negatively impacting on its credit rating.

The CFCs level of capital should not increase where it fully transfers the risk exposure from this additional business to the sidecar. As the sidecars are usually fully collateralised, the CFCs risk exposure should be negligible and it should not be required to hold higher levels of capital than it otherwise would. However, it is possible to encounter certain structures where the increased business underwritten by the CFC is not all fully within the sidecar, thereby increasing the amount of capital the CFC is required to hold.

Relevance of the group’s capital management policy

A consideration of the group’s capital management policy may make it unnecessary to carry out a detailed review of the factors set out above for each separate CFC. A suitable policy will ensure that CFCs are not over-capitalised and so it is reasonable to consider advance agreements with a group concerning the way that the capitalisation of their subsidiaries is managed. If a policy is reasonable, it should be possible to accept that the CFCs are not over-capitalised provided that the policy is adhered to.

Before reaching such agreement, it will be necessary to review the capital management policy of the group and how it is applied to the CFC(s) in question. Any agreement will need to be based upon the group’s statement of these policies. The ultimate aim of the review is to ensure that the group’s policy does not permit the retention of excess capital within a low tax jurisdiction. The review must ensure the policy is sufficiently robust and contains a suitable monitoring process so the CCM can ensure it is being adhered to.

An agreement may remain in place for a number of years provided there are no major changes to the group’s policy or its business. It should be reviewed periodically - for example, every 3 years - to ensure it is giving fair results.

Many insurance groups will choose to have their capital centrally held within the ultimate parent of the insurance group or a regional holding company of a sub-group. The group’s capital management policy should include details on when the capital held is in excess of that required to support the risk exposure of the company, how long that excess should be held for and what should be done with it.

For example, some groups will look to have their capital centrally held by their parent company. Others may have a cash-rich parent company and therefore choose to leave excess capital where it arises. The latter scenario increases the likelihood that profits will be caught by Chapter 6, but this will depend on what the local companies do with the excess capital and the extent to which UK connected capital contributions arise within it.

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Example

Group A has a capital management policy that includes a requirement for all insurance companies to include an appropriate capital buffer above that required to achieve both its chosen agency’s credit rating and also its internal assessment of market volatility. One of its insurance CFCs (Company B) has an SCR of £200m, an ‘AA’ Agency Rating capital requirement of £300m and a capital buffer (which includes its market volatility assessment) of £74m. To be in line with group policy Company B must ensure it holds capital of at least £374m.

The capital held by Company B fluctuates between £365m and £420m during its accounting period. At the year end the capital held is £410m. Our review shows that the capital levels held during the year have not been manipulated for avoidance purposes, so it is reasonable to base our assessment under Chapter 6 on the year-end balance.

Where this £36m excess (£410m - £374m) is paid out as a dividend within the next 12 months it is unlikely to be caught within Chapter 6. However, to the extent Company B retains the whole, or part, of the £36m (and its UK connected capital contributions are shown to at least equal this amount) it will need to be able to show the balance is being retained for its insurance business

In addition to assessing the reasons supporting the retention of the £36m, comfort must also be gained on the extent to which the £74m capital buffer is comparable to the hypothetical position of company B not being a 51% subsidiary.