A treasure awaits those holding the keys for unlocking Luxembourg’s main assets within the insurance industry. According to the regulator’s latest annual report, reinsurers have built up €9.3bn (£7.8bn) in equalisation reserves in the country.
The possibility to defer taxes and a booming finance industry have lured many investors into setting up insurance captives for financing of risks during the past decades. Those wishing to disinvest from their corporate vehicles now, in view of additional burdens, for example from Solvency II , face a dilemma in repatriating the savings.
Currently, around 200 Luxembourg reinsurance captives - not direct writers - are required to contribute premiums to an equalisation reserve up to a level defined by law. The maximum amount is fixed as a multiple of earned premiums. The entire technical profit and financial result on investments have to be attributed to the equalisation reserve until they reach 30% of the stipulated maximum amount. Between 30% and 100%, the technical result and part of the financial result have to go to the equalisation reserve.
In essence, this mechanism leads to a forced accumulation of profits in the grand duchy and prevents captives from paying dividends to their shareholder. Consequently, some Luxembourg captives are bursting with capital force, whereas corporate reinsurers in many other domiciles operate with minimum financial strength.
Contributions to the equalisation reserve are exempted from tax and this is where the trouble starts, when captive owners want to move or close their captives. Release of the equalisation reserve triggers taxation at the corporate rate, which stands at 19% in 2017. The reserve cannot be transferred tax-free to other countries, as the rules are unique to Luxembourg and International Financial Reporting Standards prohibit an overly prudent reserving policy on grounds of the “best estimate” principle.
Consuming the equalisation reserve for what it was originally designed for, claims, would unlock the equalisation reserve elegantly. Should premiums of a given year not suffice to pay claims, the balance may be taken from the equalisation reserve. The local prudential authority is believed not to tolerate permanent underfinancing of claims ceded to the captive with the aim of eroding the equalisation reserve. Large catastrophic losses do not yet happen when needed, so this approach will rarely provide a solution in the moment when it is needed.
Cleaning the captive by commutation
Dissolution of an insurance entity in Luxembourg means first clearing the company of any technical insurance risk. To get rid of insurance exposures, captive reinsurers will in most cases transfer them back to the ceding company by means of a commutation agreement. Cedants will not normally be confronted with unbearable exposures, but rather ‘money-swapping’ layers of corporate insurance programmes with limited volatility, under which they originally kept related excess portions anyway. In other words, the cedants will be familiar with the risk they are supposed to take back. Priced at a discount in favour of the cedant, commutations are normally unproblematic for short-tail policies. In the market, such agreements with the cedants are considered the most cost-efficient solution to get rid of insurance risks. Transfers to third parties are typically more costly.
Selling the entire captive could be an alternative. The Luxembourg regulator would allow the transfer of an entire captive company with insurance risks still on its books, however only to buyers from the insurance or runoff industry. Investors that are not insurance specialists themselves will only get permission to buy a cleared captive. If the risks for transfer have a long tail or are otherwise ‘toxic’, they can be transferred to another captive, if the owner has one.
Bringing the treasure up not for free
What remains are assets covering an often sizable equalisation reserve. Selling the shell to a solvent investor should no longer trigger any objection from the regulator. As the vehicle is still a licensed insurance company and a potential buyer can continue to use the captive, the Luxembourg regulator will make sure that the owner’s premium expenditure is commensurate with the size of the equalisation reserve. In other words, a company with annual premiums of €1m ceded to the captive will unlikely be allowed to purchase a company with a €100m equalisation reserve. The regulator will make sure the financial strength of the buying party is strong enough to support the captive. A business plan has to be submitted to prove this.
If the transaction has received the green light, the supervisor will reassess the multiple premiums fixing the upper limit of the equalisation reserve. If lower than before, part of the equalisation reserve can be dissolved and the corresponding amount enters into the profit of the captive. The proceeds are fully taxable. Knowing this, the purchaser will not pay the face amount of the equalisation reserve, but make a deduction from the offered price commensurate with the tax payable on releases from it.
American company Amtrust has specialised in such transactions, buying Luxembourg captives with swollen equalisation reserves at a discount. It has acquired half a dozen entities in recent years and dissolved them all. A few years ago, it confirmed to investors it was consuming equalisation reserves by ceding losses from its own books of business. Has it found an effective way to unlock the treasure in an orderly way? Amtrust’s representative in Luxembourg declined to comment on the topic.
In any case, none of the exit options is simple. Tax and legal advice is required in all cases – together with an open discussion with the regulator and tax authorities.
Trading liquidity of assets
What is traded in a captive stripped of insurance risks is basically a deferred tax liability. The Luxembourg parliament last year voted to cut the corporate income tax rate in two steps from 21% to 18% by 2018. So some market players may speculate on lower taxes in the future holding onto their equalisation reserve for a few more years. Timing and need for cash play key roles in the bargaining game between seller and buyer.
Luxembourg has smartly allured assets to its finance system, making the grand duchy the largest EU captive domicile by number of entities. Being overly strict on release of accumulated reserves may make the country less attractive for future investors. The number of captive entities has already shrunk over the past years. The equalisation reserve dilemma will continue to get attention in finance departments of large European companies with captives in the country. Quick fixes are not in sight. Resurfacing buried treasures can take some time.
Look out for the next article in this series tomorrow.
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