Insurance newsletter

Europe
EIOPA commences work on infrastructure investments

The European Insurance and Occupational Pensions Authority (EIOPA) announced in early February 2015 that it was commencing consultation on how infrastructure investments are treated by insurers under the Solvency II framework. With bond yields increasingly being outstripped by capital growth in infrastructure investments, some insurers are turning towards infrastructure investments for a better return. EIOPA hopes that the consultation, and any subsequent regulation, will facilitate safe investments in infrastructure which may in turn benefit the wider European community.

EIOPA will consult public authorities, insurers, infrastructure specialists, asset managers and academics.

EIOPA intends to develop a definition of infrastructure investments that offer predictable long-term cash flows and whose risks can be properly identified and managed by insurers.

There is currently no timetable in place for completion of the consultation, but EIOPA will be conducting a "Roundtable" with stakeholders and it is expected that the initial stages of the consultation will be completed by mid-2015.

BEPS Action 7 (Preventing Artificial Avoidance of PE Status) and Insurance Enterprises

The concept of a "permanent establishment" (PE) is central to the allocation of taxing rights between the contracting states under a double tax treaty.

Almost invariably, under the "Business Profits" article of a double tax treaty between State A and State B, the general business profits of an "enterprise" that is tax resident in State A cannot be subject to tax in State B unless those profits are attributable to a PE of that enterprise in State B.

At the request of the G20, the Organisation for Economic Co-operation and Development (OECD) has developed an action plan to address perceived weaknesses in the international tax rules and to combat harmful tax practices – referred to as "base erosion and profit shifting" (BEPS).

In something of a surprise move, proposals specifically targeting the cross-border arrangements of insurance businesses were included in the OECD's Action 7 discussion paper which proposed options for modifying the definition of PE in the OECD's Model Tax Treaty to prevent the artificial avoidance of PE status.

Although captive insurance arrangements were subject to some focus in relation to Action 3 (Controlled Foreign Company Arrangements), Action 4 (Interest Deductions and Other Financial Payments) and Action 9 (Risks and Capital), the OECD's BEPS Action Plan did not suggest any insurance- specific PE proposals for Action 7.

The concern
The discussion paper refers to the concern in some OECD member countries that insurers may conduct a significant volume of business in a state without having a PE (and therefore a taxable presence) in that state.

While some OECD member countries have included specific provisions in their treaties to address this (by deeming an insurer to have a PE in circumstances where under the general PE rules it would not), thus far insurance-specific provisions have not been included in the OECD Model Tax Treaty.

The proposals
Following a discussion of more general proposals to address perceived weaknesses in the current PE definition, the discussion paper set out two alternate approaches to address BEPS concerns related to the artificial avoidance of PEs by insurers.

If either proposal were adopted by State A and State B in their double tax treaty, it would be more difficult for an insurer that is tax resident in State A and writing business in State B to claim the benefit of the double tax treaty to avoid taxation of its business in State B (or vice versa).

Approach 1 – specific insurance PE rules
The current definition of a PE contains a provision (the Agency PE Provision) which deems an enterprise of State A to have a PE in State B where a person other than an independent agent (a Dependent Agent) exercises authority to conclude contracts in the name of the enterprise in State B. This proposal would extend the Agency PE Provision to include situations where the Dependent Agent merely collects insurance premiums or enables the insurer to insure risks situated in State B.

By dispensing with the requirement for the agent in State B to be concluding contracts in the name of the insurer resident in State A, this approach lowers the threshold of the Agency PE Provision for insurers.

Approach 2 – the application of the general PE rules, as modified by BEPS
Several of the general changes to the PE definition proposed in the discussion paper would have the effect of lowering the threshold for the creation of a deemed PE under the Agency PE Provision by:

1. supplementing the requirement for contracts to be concluded in the name of the principal with an alternative requirement that the Dependent Agent merely "negotiates the material elements of contracts"; and
2. narrowing the definition of "agent of independent" status to exclude automatically persons who act "exclusively or almost exclusively for one enterprise or associated enterprises".

This latter change could be problematic for captives and insurance groups with exclusive or near exclusive relationships between their onshore agents and offshore insurance companies, particularly if similar changes were made to the domestic definition of PE in the jurisdictions concerned.

A related note – the UK's "diverted profits tax"
The UK Government intends to introduce a "diverted profits tax" (DPT) with effect from April 2015. The DPT seeks to impose a tax charge on profits resulting from sales in the UK where a UK PE has been avoided and certain other conditions are satisfied (further detail is available here).

The proposed introduction of DPT is surprising, as it unilaterally pre-empts the outcome of the OECD's ongoing BEPS project, which is supported by the UK Government and targets similar practices.

Conclusion
Insurance companies (in particular those with captive insurers or insuring risks outside the jurisdiction in which they are resident) will need to consider the impact BEPS Action 7 will have on their arrangements when the recommended proposals are published in September 2015.

EIOPA publishes final report on Level 3 Guidelines on System of Governance

On 2 June 2014, EIOPA published Consultation Paper CP14/017 which contained the proposed Solvency II Level 3 Guidelines on System of Governance (the Guidelines).

This consultation closed on 29 August 2014, and on 28 January 2015 EIOPA published:

• its responses to comments received from stakeholders; and
• its Final Report on CP14/017 and the Guidelines.

EIOPA now intends to issue the Guidelines (and in all the official EU languages) in April 2015. They will then apply from 1 January 2016.

Within two months of the issue of the Guidelines, national supervisors must report to EIOPA as to whether they comply, intend to comply, or do not comply with them. When reporting non-compliance, each national supervisor must state the reasons for non-compliance. EIOPA has an obligation to list in its Annual Report the national supervisors that report non-compliance.

Outsourcing
In August 2014, we published a briefing paper commenting on the draft Guidelines contained in CP14/017.

The main point raised in our briefing paper was that the proposed Guidelines in relation to outsourcings were much more onerous than current UK requirements. In particular:

• we noted that Guideline 14 requires firms to make fitness and propriety checks on any person employed by a service provider to perform an outsourced "key function";
• we questioned whether EIOPA's view that Article 42 of the Solvency II Directive also applied to outsourced "key functions" was correct, on the basis that the person who "has" the "key function" is actually only an employee of the firm and the service provider is performing the "key function" on behalf of the firm;
• we questioned whether Guideline 14 would require firms to undertake fitness and propriety checks in relation to service providers who are themselves regulated entities (such as asset managers) and presumably (in the case of the UK at least) have already had their key employees assessed as fit and proper by their regulator; and
• we commented that if the Guidelines remained unchanged, firms should ensure that their outsourcing contracts for "key functions" give them sufficient contractual rights to allow the firm to apply the fitness and propriety checks to employees of the service provider.

We raised some of these points with EIOPA as a response to CP14/017. In response, EIOPA has stated that:

• it views "having" and "performing" a "key function" as being "synonymous", as are "key function holder" and "person responsible for a key function". EIOPA therefore reaffirms its view that fitness and propriety checks also apply to outsourced "key functions";
• firms will be required to undertake fitness and propriety checks in relation to employees of service providers who are themselves regulated entities. Rather strangely, the justification EIOPA gives for this is that, just because a national supervisor has found the relevant individuals at the regulated entity that is providing the outsourced service to be fit and proper, it does not necessarily mean that the firm outsourcing the key function will subsequently reach the same conclusion; and
• if a service provider refuses to allow a firm to undertake fitness and propriety checks on employees of the service provider, the firm "would have to terminate the contract". This is obviously unhelpful, as the response fails to recognise that, depending on the relevant contractual terms, the firm may not have a right to terminate the contract in these circumstances.

The assumption must be that unless the Prudential Regulation Authority (PRA) takes account of representations from stakeholders, the PRA will confirm to EIOPA its intention to comply with the Guidelines (including the onerous requirements in Guideline 14) given that they are substantially the same as the 2013 preliminary Guidelines (which are currently in force) and which the PRA has stated are "generally consistent with good practice in the United Kingdom" (see Supervisory Statement SS4/13).

UK
Remedies proposed following FCA's retirement income market study

In February 2014, the UK's Financial Conduct Authority (FCA) launched a market study under its competition powers to assess whether competition in relation to the provision of retirement income products (with a focus on annuities and income drawdown) was working well for consumers. The FCA revised its terms of reference to adopt a more forward-looking approach as a result of the significant reforms to the pension and retirement income landscape announced by the Government in the 2014 Budget.

The FCA has now published its Interim Report and provisionally concluded that competition in the retirement income market is not working well for consumers. In particular, the FCA found that many consumers are missing out on a higher return by staying with their existing pension provider, which weakens the competitive discipline on the incumbent providers and makes it harder for challengers on the open market to compete.

The concerns identified by the FCA relate to the lack of customer awareness and engagement in the process at retirement, known biases in the way customers make their decisions, and perceived barriers to shopping around. The FCA also concluded that the recent Budget reforms are likely to mean that savers reaching retirement will face a landscape that is more complex with much greater choice, which could weaken competitive pressures further.

To address these concerns, the FCA has proposed a package of remedies to stimulate competition and help consumers make better and more informed decisions. These remedies include:

• requiring annuity providers to provide quote comparisons that include the open market option (e.g. using an annuity comparison website);
• recommendations to the pension guidance service and providers to take account of framing effects and other biases when designing tools to support customer decision-making;
• a review of alternatives to "wake-up" packs to provide greater clarity to consumers, and the FCA will consult on replacing the ABI Code of Conduct with its own rules; and
• the development of a "Pensions Dashboard" to enable consumers to view all their lifetime pension savings in one place, which the FCA notes has been successful in other countries.

The FCA will also continue to monitor the market as it evolves using a combination of consumer research, market data and ongoing sector supervision, and it may take further steps if it sees competition weakening, or if it sees inappropriate products, distribution arrangements, or charging structures emerging. The FCA will produce its final report later this year.

A more detailed summary can be found here.

Employment update

Holiday pay: should overtime be included in holiday pay?
On 4 November 2014, the Employment Appeal Tribunal (EAT) handed down judgment in three key cases (Bear Scotland Ltd & Others -v- Mr David Fulton and Others; Hertel (UK) Ltd -v- Mr K Woods and Others and Amec Group Ltd -v- Mr Law and Others) (Fulton, Woods and Law) concerning whether certain overtime payments (and other allowances) should be included in the calculation of holiday pay and making important findings on how far back employees can claim.

The EAT held that payments for overtime which the employees were required to work, though which their employer was not obliged to offer as a minimum (non-guaranteed overtime), is part of normal remuneration and should be included in the calculation of holiday pay in respect of the minimum four-week period of holiday required by EU law. However, helpfully for employers, in terms of backdated liability, the EAT held that claims will be out of time if there has been a break of more than three months in any alleged series of deductions.

Unite, which represented the employees in the Woods and Law cases, has confirmed that it is not appealing the decision. The Fulton case has been remitted to the Employment Tribunal. At this time, it seems highly unlikely that there will be any appeal by the employers in these cases.

While this means that employers will now have to take payments for non-guaranteed overtime (and certain allowances) into account when calculating holiday pay in respect of the minimum four-week period of holiday required by EU law, the fact that the employees are not appealing the decision relating to how far back they can claim is good news for employers. Employers have been concerned that claims could stretch back for years. In practice, the EAT's findings may significantly restrict the ability of workers to create an "unbroken" series of underpayments and bring retrospective claims. It seems that, at least for now, employers have some useful clarity on this key point, albeit future case law on this issue seems inevitable given its importance and the scope for challenge.

Employers need to act now and look at their holiday pay practices and policies, and consider whether changes are required. The case still leaves open the position in relation to purely voluntary overtime. Employers will need to carefully consider what approach they wish to take in this regard. For more information, please click here to access our briefing on the above rulings, together with a look at other key recent holiday pay decisions.

Shared parental leave
As we have previously reported, a new shared parental leave scheme will apply to parents of babies due on or after 5 April 2015, or children placed for adoption on or after that date. Eligible employees will be entitled to a maximum of 52 weeks' leave and 39 weeks' statutory pay upon the birth or adoption of a child, which can be shared between the parents. Please click here for our briefing on the new regime.

Employers need to review their maternity, paternity and adoption policies to bring them in line with the new legislation. In particular, they will need to consider what approach they want to take in relation to paternity pay, and whether this is to match any enhanced maternity pay offered. Employers should take advice on potential risks and possible options.

Please click here to see our report on a recent case in this area (Shuter -v- Ford Motor Company Ltd).

Spain
Countdown to the privatisation of CESCE

The impending privatisation of Spanish insurance company Compañía Española de Seguros de Crédito a la Exportación (CESCE) has already attracted significant interest and a good number of potential investors, according to sources close to the process.

CESCE is in charge of managing the so-called "State Coverage of the Internationalisation Risks of the Spanish Economy": basically, this stands for credit risk cover for Spanish exports which is provided by the Spanish State. This activity has, so far, been undertaken by CESCE on an exclusive basis, on behalf of the Spanish State; however, CESCE is also an active private insurance company which holds an authorisation to carry out credit and suretyship insurance activities – insurance classes 14 and 15. In fact, its activity as a private insurer represents around 85.6 per cent of its total business, the other 14.4 per cent corresponding to the export credit cover provided on behalf of the Spanish State.

The privatisation of CESCE, which formally started in 2012, is now due to gather speed as a result of the implementation of Royal Decree 1006/2014 of 5 December 2014 (RD 1006/2014), which develops the provisions of previous Act 8/2014, of 22 April 2014 (Act 8/2014). Prior to the enactment of these rules, State cover with respect to Spanish exports continued to be governed by an act dated 4 July 1970, which entrusted CESCE (a company controlled by the State) with such role on a permanent basis. Post-privatisation, after an initial grandfathering period of eight years, CESCE will need to bid for that role, as and when appropriate, in competition with other eligible bidders.

In this context, the Spanish State's interest of 50.25 per cent of CESCE's share capital is being offered (through an auction process) to prospective buyers, the other shareholders being Banco Santander (21.07 per cent), BBVA (16.3 per cent) and some other Spanish banks and insurance undertakings (12.38 per cent).

The auction process is expected to start immediately (during February 2015), and it is foreseen that it will take approximately seven months.

The following paragraphs summarise the main features of the CESCE privatisation opportunity.

1. Appointment of CESCE as "Management Agent" of the State Cover.

CESCE has been appointed as "Management Agent" of the State Cover of the Internationalisation Risks of the Spanish Economy for an eight-year period starting from the date on which the Spanish Government ceases to hold a majority stake in the share capital of CESCE. The purpose of this appointment is to provide potential purchasers of shares in CESCE with some level of certainty about the continuation of that line of business in the future (at least for eight years).

Once this term expires, a new "Management Agent" will be appointed by means of a competitive tender (CESCE will no longer be guaranteed the role). The rules for the appointment process are contained in RD 1006/2014 (article 19): only companies which are duly authorised to carry out credit and suretyship insurance and reinsurance activities in Spain can bid, and they must be free from any "conflict of interest" (to which we refer below).

2. Prohibition of any conflict of interest

The "Management Agent" must remain free of any conflicts of interest during the tenure of this function. A conflict of interest arises if the "Management Agent" is directly or indirectly controlled by any entities which manage the same type of cover on behalf of other States or if there is a close link with those entities (article 4.7 Act 8/2014 and articles 20 and 21 RD 1006/2014).

It must be noted that in order to participate in the privatisation process, bidders will have to previously obtain a statement from the Spanish State Secretary for Trade (Secretaría de Estado de Comercio, an administrative body within the Spanish Ministry of Economy and Competitiveness), evidencing that they are not subject to such type of conflict of interest. This will exclude from the privatisation process certain companies which currently manage the same type of cover on behalf of other States.

3. Risks Committee

Act 8/2014 creates the Committee in relation to risks borne by the State (Comisión de Riesgos por Cuenta del Estado, the Risks Committee): an administrative body in charge of the control, follow-up and participation of the Government in the management of the State Cover carried out by the Management Agent. The Risks Committee will therefore have a monitoring role with respect to the Management Agent's activity.

4. Management Agreement

The rights, obligations and functions of the Management Agent will be determined by a management agreement (Convenio de Gestión) to be entered into with the Spanish Government, which will include, among other provisions: (a) the obligation to follow the instructions of the Risks Committee; (b) the liability regime applicable to the Management Agent; (c) the statement of the Management Agent that it is not subject to any conflict of interest; (d) the obligation of strict separation between the activities of the company as a private insurer and its functions as manager of the cover provided by the State; and (e) the consideration payable to the Management Agent in exchange for the provision of its services.

No doubt it will be key for potential bidders in the privatisation process to know the terms of this agreement, which will govern the "State Cover line of business" of CESCE in the coming eight or more years.

5. Reserve Fund of the Internationalisation Risks

Act 8/2014 also created the so-called "Reserve Fund of the Internationalisation Risks", which is the pool of assets earmarked to finance the State Cover activity. Such assets include the economic rights and premiums collected, after deduction of the Management Agent's consideration, refunds obtained in respect of claims paid, fees and returns of underlying investments.

It must be noted that this reserve fund will not be managed by CESCE or the subsequent "Management Agents", but by the Spanish Insurance Compensation Consortium (a public entity which also acts as an insurance guarantee fund).

For the next steps in the privatisation process, click here at the website of Sociedad Estatal de Participaciones Industriales (SEPI).

Asia
Risk-based capital framework in Hong Kong

Introduction
The process of introducing a risk-based capital (RBC) framework in Hong Kong was officially launched on 16 September 2014 when the Hong Kong Insurance Authority published a Consultation Paper. The RBC regime is expected to be finalised and implemented in the next five years, and will significantly affect the way insurers operate and fund themselves. The consultation period ended on 15 December 2014 and the industry is now awaiting the Government's conclusions.

Currently, the solvency test used in the Hong Kong insurance industry is a simple rule-based minimum capital requirement. The new RBC framework will be in line with international standards and the Insurance Core Principles (ICPs) which were agreed in 2011 by the members of the International Association of Insurance Supervisors. Inspiration will also be drawn from the EU's Solvency II regime which is due to come into force in January 2016.

By international standards, Hong Kong is late in adopting an RBC regime. This is partly due to the fact that the new insurance regulator (the new Insurance Authority) which will be responsible for preparing the legislation and undertaking the necessary administrative tasks has yet to be established.

Being a latecomer may, however, play to Hong Kong's advantage, as the Government has drawn on experiences from other jurisdictions.

The delay will also enable the new Insurance Authority to align the RBC with the expected changes to accounting policies, notably IFRS 4 (Insurance Contracts) and IFRS 9 (Financial Instruments).

The framework
The requirements under the proposed RBC regime will fall under three "Pillars", closely resembling the Solvency II regime:

Pillar 1
Pillar 1 (quantitative aspects) concerns capital adequacy and valuation of assets and liabilities. It will contain two solvency control levels: a higher "warning level" called the Prescribed Capital Requirement (PCR), and a lower "enforcement level" called the Minimum Capital Requirement (MCR).

There will be a standardised approach to calculating capital adequacy for the purpose of the PCR and MCR. However, internal models may be permitted subject to regulatory approval. International insurers who have already invested in Solvency II-compliant models and Enterprise Risk Management (ERM) systems should take note of this option.

At present, only equity capital tends to qualify for the solvency calculation. This is likely to change as the consultation paper signals a shift to a tiered approach which permits insurers to categorise a wider range of funding (including subordinated debt) as capital. This will create a demand for new bespoke debt instruments, as insurers seek to optimise their capital structure.

Pillar 2
It is often said that Pillar 2 (qualitative aspects) should logically come first, as robust internal governance, systems and controls would enable insurers to comply with the quantitative requirements under Pillar 1 and disclosure obligations under Pillar 3.

The consultation paper places particular emphasis on the Own Risk and Solvency Assessment (ORSA). The ORSA is the internal process used by insurers to assess risks and solvency position. To ensure that insurers conduct a comprehensive ORSA, insurers will be required to submit their full ORSA documentation annually for review and the new Insurance Authority will be able to apply capital add-ons if the ORSA or ERM framework of the insurer is inadequate.

Pillar 3
Hong Kong insurers are currently not under any obligation to make public disclosures. The disclosure obligations of insurers are likely to change upon implementation of the RBC framework and ICP 20 on Public Disclosure. ICP 20 requires, among other things, a wide range of quantitative and qualitative information on technical provisions, capital adequacy, financial instruments and associated risks to be disclosed to the public.

Group-wide supervision
The consultation paper proposes that the new Insurance Authority be given explicit powers to supervise the insurer's entire group. This proposed group-wide supervisory framework would represent a complete shift from today's regulation of licensed entities on a stand-alone basis.

The supervisory approach would distinguish between three different types of insurance groups. The first type would be Hong Kong-based insurance groups which would be subject to complete supervision by the new Insurance Authority. The second and third types of insurance groups would be exempt from certain requirements on the basis that they are subject to separate capital requirements of other regulators or have sufficient group-wide supervision in their home jurisdiction.

Regulation of branches
The solvency margin requirement currently applies to all Hong Kong incorporated insurers at the company level. The consultation paper notes that many other jurisdictions, such as Australia, Singapore and Canada, require branches of overseas jurisdictions to file the same regulatory returns as locally incorporated insurers. A similar treatment is proposed in Hong Kong. This will require separate rules governing capital resources for branches of overseas companies.

Summary
The RBC framework will have a profound impact on both local and international insurers in Hong Kong. First, insurers will have to assess whether their current operating model complies with the new regime. Secondly, insurers may be required to invest in new systems, processes and human resources to implement the infrastructure required to enable ongoing RBC compliance. Finally, the board and senior management team will need to adopt a risk- based mind-set to decision-making, in accordance with the processes under Pillar 2 of the RBC regime.