Accounting, regulatory and taxation issues must be considered early in the construction process for ART solutions

The alternative risk transfer (ART) market has come a long way from the dim and distant days when the Lloyd's market offered 'time and distance' policies. Since then, the ART market has evolved to the point that it now aims to provide customised solutions to multinational groups for risks that the conventional market is unable to insure. The interest in such highly sophisticated products has been brought about mainly by the volatility and lack of capacity in the traditional insurance market. Additionally, multinational groups are becoming more sophisticated and judicious in their overall risk management and as such are shying away from 'pound swapping' deals. Instead, they are demanding tailor-made integrated risk management techniques aligned with their financial and strategic goals.Whilst it is accepted that any ART solution must be commercially sound and capable of achieving the long-term risk management objectives of the multinational group, there is also an increasing need for such solutions to comply fully with the relevant accounting, regulatory and taxation rules - the other 'ART'. These rules can be critical to the successful implementation of any ART solution.

AccountingFrom 2005, all publicly traded companies resident in the EU must use the International Financial Reporting Standards (IFRSs) when preparing their consolidated accounts. The International Accounting Standards Board (IASB) is in the process of publishing all the IFRSs prior to that date.Additionally, in October 2002 the IASB entered into an agreement with the Financial Accounting Standards Board (FASB) on a formal plan of action for the convergence of the US and international accounting standards.This is a significant step as it has the potential to eliminate certain differences between the two standards and thus produce consistent and comparable financial statements. Although there is increasing concern that over time the IFRSs could move towards US GAAP, we should be comforted by the fact that the IASB has chosen to adopt a principle-based rather than rules-based approach in all the IFRSs.

Accounting for contractsExposure Draft 5 Accounting for Insurance Contracts (ED 5), issued in July 2003, will form the basis for a transitional IFRS published this spring, and companies will be expected to apply this IFRS from 1 January 2005. Phase II will cover full recognition and measurement of insurance contracts, and the IASB expects the final standard to be applied with effect from 2007/2008.With ART solutions, it is imperative that the insurance contract satisfies the definition of what is a contract of insurance as provided in ED 5.A contract of insurance is defined as a contract under which the insurer accepts significant insurance risk from the policyholder by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder. This definition, which is very broad and may indeed differ from the definitions in the existing local accounting, regulatory and tax rules, requires the insurer to accept significant insurance risk from the policyholder. According to ED 5, an insurance risk is significant if - and only if - an insured event could cause an insurer to pay (on a gross basis, i.e. excluding any reinsurance recoveries) significant claims in any scenario, other than a scenario that lacks commercial substance.Unfortunately, there is no prescriptive guidance provided in ED 5 about what would constitute a significant risk transfer.In order to assess whether the contract meets this definition, an insurer should consider the economic substance of the contract rather than its legal form. If a contract meets the definition, then insurers may use existing appropriate local accounting rules (subject to certain modifications) during the transitional phase until the final standard is issued some time in 2007/2008.Where an ART contract does not satisfy this definition it would be treated as a financial instrument and, as such, premiums payable would not be regarded as revenue income or expense. Instead, the contract would be dealt in accordance with IAS 39 Financial Instruments and valued at either amortised cost or fair value.

UnbundlingAn ART contract may contain insurance and deposit elements. ED 5 states that these elements may have to be unbundled and the deposit element accounted for separately under IAS 39 Financial Instruments. This may be particularly appropriate where the cash flows from the insurance element are unaffected by the cash flows from the deposit element. For instance, where a financial reinsurance contract consists of two separate and unconnected elements where the cash flows from the insurance element would not be directly affected by the cash flows from the deposit element, these would probably need to be separated. Unfortunately, it is unclear at this stage to what extent or how the unbundling requirement will be applied to insurance contracts.

RegulatoryWhilst there is increasing co-operation between the various insurance supervisors, insurance companies are still required to operate within their local regulatory framework. This means that there is potential for differences in interpretation of, and approaches to, ART solutions, and perhaps 'regulatory arbitrage'. Such differing treatments could have an impact (favourable or otherwise) on the solvency margins of an insurer depending on the jurisdiction in which it is resident.Nevertheless, insurance supervisors throughout the world are making a concerted effort towards tighter regulations, such as improvements in the regulation of reinsurance companies. The International Association of Insurance Supervisors (IAIS) has set up a special task force, the Task Force on Enhancing Transparency and Disclosure in the Reinsurance Sector, also known as Task Force Re. Its remit is to consider the present concerns over potential gaps in the supervisory system for reinsurers, market developments (such as risk transfer) and weak reinsurance companies, huge discrepancies in national GAAP, lack of capital requirements and lack of information requirements. It is anticipated that the conclusions of the Task Force will lead to a consistent treatment and disclosure.The European Commission has published draft proposals for the Solvency II directive, adopting a Basel-type three-pillar structure for the establishment of minimum capital and solvency margins for insurance companies. The third pillar relates to disclosures to be made by an insurer in its accounts, and in this respect the European Commission is awaiting the publication of the final IFRS on Accounting for Insurance Contracts. There is, therefore, a possibility that eventually, at least in the EU and certain other jurisdictions, there will be a consistent approach to accounting and regulation, particularly with regard to future insurance contracts.

TaxationThe tax implication of any ART solution will depend generally on the accounting treatment. In order to ensure that the premium paid qualifies for tax relief, the tax authorities generally would expect the insurance arrangement to be on an arm's length basis and that significant risk transfer exists. Where there are no specific standards in the local jurisdiction dealing with the accounting for insurance contracts, the tax authorities would generally look either to US GAAP or to IFRSs for guidance.The question that is increasingly being raised is, "what would be the tax impact if the entity's accounts were produced in accordance with IFRSs rather than local GAAP?" At present, the individual entity accounts are generally required to be produced in accordance with local accounting principles for regulatory and tax purposes. Presumably from 2005, the tax liability of an entity would continue to be based on its local accounting and tax rules unless the local jurisdiction specifically required the accounts to be prepared under IFRSs.Notwithstanding this, there would be an expectation that in most countries the tax treatment of an insurance transaction should follow the accounting treatment, whether under local GAAP or IFRSs. For example, presently a reinsurer based in Luxembourg would be permitted tax relief on equalisation reserves set in accordance with local rules. However, the tax authorities reserve the right to challenge the accounting treatment, if, in their view, correct treatment has not been followed.

Transfer pricingAny insurance arrangement and the corresponding premium paid to a connected party such as a captive insurance company must be on an arm's length basis.The Organisation for Economic Co-operation and Development (OECD) has produced transfer pricing guidelines that most jurisdictions either have incorporated or are in the process of incorporating in their respective tax legislation. As such, the insurance arrangements must follow these guidelines and appropriate documentation must be put in place to support the rationale for the insurance arrangements to minimise any adverse impact of any challenge from the tax authorities.Insurance premium tax could be a frictional cost that could affect the viability of any ART solution, particularly as the premium tax rates can vary from 0% to nearly 22% depending on the jurisdiction. All global insurance arrangements should be properly and objectively allocated to the risks located worldwide. In this respect, the use of an appropriate premium allocation methodology is paramount in any risk financing strategy to ensure that the correct premium tax liability is paid by the insured.

ConclusionWhen assessing the efficiency and viability of a customised ART solution, multinational companies must not ignore the effect of the other ART - accounting, regulation and taxation. These must be considered as early in the structuring process as possible. Between now and when the final IFRS is published, currently projected at some time in 2007 or 2008 following the completion of phase II of the project, multinational companies and their insurers must ensure that the contract meets the definition in ED 5 and that there is significant risk transfer. Care should also be taken in structuring the ART solution to ensure that the principles of unbundling would not affect the commercial rationale.Phase II of the IASB project will deal with the measurement of the insurance contract, which is anticipated to be on a fair value basis. It is difficult to say how this will impact the ART market, although pundits are predicting that the introduction of fair value accounting for insurance contracts is likely to give rise to greater volatility in insurers' accounts.Given that the IFRS for insurance contracts is likely to lead to volatility in earnings due to fair value accounting, and any non-insurance contracts may have to be treated as a financial instrument, companies should ensure that all transactions could be justified from a commercial perspective.This would entail reviewing the profitability of the contract, considering optimal and arm's length premiums for the type of risk, using robust actuarial methodologies to set claims provisions and adopting an appropriate investment strategy.