Rob Lant

Rainer Schick

Frédéric Martineau

A number of pressures have influenced the increasing focus attributed to capital management since the turn of the 21st century:

• In the general insurance industry:

• • corporate insolvencies, such as the HIH Insurance group with debts of A$5 billion ($3.73 billion);

  • the losses arising as a result of the attacks on the World Trade Center in September 2001;

  • the various natural disasters that have occurred since then;

  • the subsequent hardening of the general insurance cycle; and

  • the consequent increase in the number of start-ups looking to take advantage of rising premium rates.

• And in the life insurance industry:

• • the collapse of Equitable Life, one of the oldest and most prestigious UK life insurers, under the weight of unprovided guaranteed annuities; and

  • the huge loss of excess assets in the tumbling markets following 9/11.

In combination, these events have significantly prioritized good capital management. Many stakeholders expect the insurer of the 21st century to be cognizant of the broad range of risks and adverse events facing the business and to hold capital of optimal efficiency to help mitigate those risks.

Having commenced regulatory reform in Europe with the introduction of Solvency I (which started the process of harmonizing the assessment of regulatory capital across member states), the EU's proposed introduction of Solvency II continues the focus on good capital management. The benefits of Solvency II are expected to include a better allocation of capital to the true risks of the insurance business, and harmonization of regulation across the EU. In response, the insurance industry may have to manage the expectations of stakeholders by identifying opportunities to raise quality capital in a cost-effective manner.

Solvency II

An insurer's regulatory capital position in many jurisdictions has traditionally been assessed using a comparison of assets and technical provisions. Admissible assets have been required to exceed the technical provisions by a minimum margin (the "solvency margin") and that solvency margin has been based upon a fixed ratio of reserves, rather than complex risk-based modelling.

While this approach is relatively simple, arguably it does not adequately address the variety of risks inherent in an insurance business. In contrast, Solvency II is fundamentally based upon the assessment and allocation of capital in the context of those risks.

With an anticipated implementation date of 2009, Solvency II is still firmly in the development phase. However, the expected structure is known to dispense with the regulatory asset versus liability approach and adopt a "three pillars" methodology. The three pillars are:

• Pillar 1 – a calculation and allocation of regulatory capital based upon an assessment of, inter alia, the insurance, credit, market and operational risks to which the business is exposed.

• Pillar 2 – the regulator's supervisory function which also encompasses an advisory overlay.

• Pillar 3 – disclosure and market discipline, ensuring there is sufficient transparency in the market.

Impact of Solvency II on member states

The introduction of Solvency II will have a varying degree of impact between jurisdictions. This section considers the possible impact in the UK, France and Germany.

With effect from January 1 2005, the UK introduced a regulatory capital system that closely reflects Solvency II.

The new system incorporates a risk assessment against which an insurer's regulatory capital position must be aligned. As with the proposals under Solvency II, a three pillars approach has been adopted whereby the insurer self-assesses the particular risks in its business, and the allocation of capital to mitigate those risks. The self-assessment is reviewed by the Financial Services Authority (FSA) (issuing amendments where necessary) and there are similar provisions around transparency and market disclosure.

The tax system in the UK for life businesses is based heavily on the regulatory measures of profit and, as such, is following the regulatory regime as it moves towards the Solvency II model.

In France, prudential supervision of the insurance industry is currently based upon the accounting standards resulting from European directives (for example, 91/674/EEC and 98/78/EEC), which seem reasonably well suited to the regulator's principal goal of protecting the interests of policyholders.

However, the goal of the regulators may not always be consistent with that of the tax authorities, who want to assess taxes on a certain result in accordance with a body of tax laws that is separate and distinct from insurance regulations. In this regard, it is already possible to anticipate certain subjects that are likely to be dealt with under Solvency II, three of which have the potential to have tax implications:

• Technical reserves - there may be some uncertainty as to the tax deductibility of a portion of the reserves determined under Solvency II, especially the prudential margin.

• Reinsurance - The securitization vehicles sometimes used by insurers and reinsurers to lighten their solvency margin constraints are now expressly referred to as being potentially subject to member states' solvency requirements (Article 46 of the 2005/68/EC Directive), even though the said requirements are not harmonized. Mechanisms for guaranteeing against the risk of reinsurer default (that is, letters of credit and pledges) will therefore now be replaced by the reinsurer's solvency margin requirement. This change in the make-up of the balance sheets of ceding insurers and retro-ceding reinsurers should remain neutral for tax purposes.

• The impact of International Financial Reporting Standards (IFRS) on solvency – certain insurance contracts may be reclassified under International Accounting Standard (IAS) 39 and treated as financial instruments with knock-on tax effects.

It is clear that such tax issues will need to be considered alongside the obvious regulatory aspects of Solvency II.

Although member states have not yet agreed on a final legal framework concerning Solvency II, Germany has already partly changed its solvency provisions. In 2005, section 53c of the Insurance Regulatory Act (Versicherungsaufsichtsgesetz) was amended, in particular with regard to the use of insurance hybrid capital such as deeply subordinated debts (nachrangiges Fremdkapital).

This amendment of law is a further step towards Solvency II. Insurance companies are now encouraged to use the additional opportunities granted by the German regulatory framework to be well-equipped for Solvency II.

The Financial Regulatory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, "BaFin") in Germany meanwhile follows the concept of risk-orientated supervision in all areas and new investment guidelines (BaFin-Circular 15/2005 of August 20 2005) have become effective.

Among other things, insurance companies are now obliged to establish appropriate reporting and control mechanisms to guarantee that investments are in line with the companies' investment guidelines as well as legal and regulatory prerequisites.

BaFin consequently aligns supervisory actions and the allocation of resources to the actual risk. By increasing its orientation towards the risk of those being supervised, BaFin is in line with the international trend. Solvency II will make risk-orientation a requirement of insurance supervision.

Capital instruments

The remainder of this article considers cost-effective capital structures that have been adopted in Europe in recent years and which are likely to become more common while capital remains a priority issue.

"Innovative Tier 1 capital" is the name given to hybrid capital instruments which, while legally debt, are treated as equity due to their deep subordination and other equity-like characteristics.

Characteristics

To qualify as innovative Tier 1 capital, an instrument must have characteristics akin to other Tier 1 capital such as ordinary shares. As a minimum, an instrument would be expected to have the ability to absorb losses, a degree of permanence, deep subordination and a coupon carrying no fixed entitlement.

Innovative Tier 1 structure adopted in the UK

Diagram 1: Innovative tier 1 instrument

A typical innovative Tier 1 instrument is illustrated in Figure 1.

An innovative Tier 1 instrument of the type structured in Figure 1 will usually be issued as a deeply subordinated Eurobond that is redeemable at the issuer's call after a minimum of 10 years. Where a call option is included, the instrument will often allow for a step-up in the coupon where the option is not exercised. The existence of the step-up is an incentive for the issuer to redeem on that date. Some instruments will only allow redemption through an issue of further share capital.

The instrument will typically have a defined coupon which can be withheld or, if the terms of the coupon are cumulative, deferred. Deferred coupons must be discharged by the issue of ordinary shares and it is not uncommon to have a 'dividend stopper' provision, which prevents dividends from being paid on ordinary shares until all the deferred coupons have been discharged.

The debt instrument can be structured as a Eurobond to allow the interest to be paid gross of withholding tax.

Potential benefits

An obvious benefit of innovative Tier 1 instruments is the provision of a secure form of Tier 1 capital at a cheaper cost than traditional Tier 1 instruments, such as ordinary shares. There are however a number of other benefits:

• It should be easier to redeem an innovative Tier 1 instrument (which is a debt) than it is to repurchase ordinary shares, thus providing the issuer with more flexibility.

• The issue of an innovative Tier 1 instrument creates double leverage, since it both increases Tier 1 capital (within the 15% limit) and also increases the capacity for the issuer to raise further (potentially tax deductible) Tier 2 capital.

• The additional Tier 1 capital may provide more flexibility in investment options (for example, permitting a higher proportion of investment in equities).

• In some jurisdictions the coupon on the instrument may be tax deductible, thereby reducing the cost of funding.

The gross coupon on an innovative Tier 1 instrument is likely to be higher than the coupon payable on an Upper Tier 2 debt, to reflect the additional risk borne by the investor.

Tax issues

An innovative Tier 1 instrument is typically a legal debt. In jurisdictions where the tax treatment of an instrument broadly follows the form, such as the UK, this may result in a tax deduction to the issuer for the coupon paid on the instrument. The tax deduction may be subject to satisfying the revenue authorities that the instrument has been issued for a commercial purpose and not as part of a scheme or arrangement to avoid tax.

The views of the revenue authorities in this regard can be quite strict. For example, in the UK, HM Revenue & Customs is of the opinion that where an innovative Tier 1 instrument is issued to replace non-deductible Tier 1 capital (say, preference shares), then the issue is for tax avoidance purposes and the coupon should not be deductible. There are also provisions in the UK to prevent cross-border arbitrage.

France

The European non-life and life directives (73/239/EEC and 2002/83/EC) authorize insurers to include up to 50% of their subordinated instruments in the calculation of their solvency margin. These provisions have been effectively transposed into French domestic law.

This principle applies, in particular, to indefinitely subordinated debt and deeply subordinated debt instruments (passed into French law in 2003). Several major French insurers have recently issued this category of instruments on the market.

While being partially eligible for inclusion in the calculation of the solvency margin, these debt instruments offer the additional advantage that their coupon can be treated like that of an ordinary loan, and should therefore be tax deductible. As regards deeply subordinated instruments in particular, the studies being conducted under Solvency II are examining the possibility of making them fully eligible for inclusion in the calculation of the solvency margin.

These advantages can be further enhanced if the investor is located in a country whose tax system allows the instrument to be treated as equity (such as in Germany). In such cases, the lender's income may benefit from the Parent-Subsidiary regime (2003/123/EC) in its own country (exemption or quasi-exemption from corporate income tax). However, the rate of deductible interest in France is limited where the investor is a direct shareholder of the French company (4.21% in 2005). This limit would also be applicable to affiliate companies as from 2007, under the new French thin capitalization rules.

Such structures are further facilitated by tax treaties between France and certain countries (including Germany), which provide for a withholding tax exemption on interest and dividends paid by a French company.

The issue of preferred shares, which are partially taken into account in calculating the solvency margin, is also worth considering, although in this case, the French issuer cannot deduct the dividends for tax purposes.

Germany

Innovative Tier 1 capital has gained greater importance in Germany. Similar to the UK and in comparison to traditional Tier 1 instruments, this form of capital contribution provides a flexible way for insurance companies to gain sufficient own funds (Eigenmittel) which are needed to achieve the required solvency margin set out in section 53c of the Insurance Regulatory Act. Among other things, certain prerequisites, such as the duration of the contract exceeding five years, and subordination in the event of insolvency, have to be considered. The instrument also has to be free of third-party rights to qualify as own funds.

The German regulatory provisions offer a second instrument, jouissance rights (Genussrechte), which can be applied by German insurance companies to strengthen their own funds. Jouissance rights are issued on a contractual basis sui generis. In general, they do not grant any form of direct membership rights but do provide participation rights.

From a German tax perspective, the tax treatment of innovative Tier 1 instruments is dependent on their precise structure.

The coupon paid on deeply subordinated debts can generally be treated as tax deductible interest on the basis that the instrument qualifies as a legal debt. Certain tax issues should however be taken into consideration before implementing such a structure. For instance, where there is a group relationship, the German thin capitalization provisions and transfer pricing rules have to be taken into account. For German trade tax purposes, coupons on debts may only be half tax deductible if the interest payments are determined as interest on long-term debts (Dauerschuldzinsen).

Depending on the form of jouissance rights, these are either treated as profit distributions similar to dividends, or as tax deductible interest at the issuing insurance company level.

At the investor level, the tax treatment of deeply subordinated debts and jouissance rights is different. In general, income from coupons is taxed as interest, whereas the taxation of income from jouissance rights mainly depends on the particular structure. If the investor is deemed to participate in proceeds of liquidation, then the income is treated similar to dividend income which is mainly tax-exempted in Germany. If, on the other hand, no participation is granted, the income is taxed as an interest payment.

Life insurance companies can release the value tied up in the long-term business by monetizing the embedded value using a securitization structure.

Such monetization has been achieved using a combination of reinsurance, contingent loans and bond issues, the reinsurance releasing capital in the life company by accelerating surplus and thereby increasing core Tier 1 capital.

Example of monetization of embedded value in the UK

Diagram 2: Monetizing embedded value (in UK)

Figure 2 illustrates a structure that has been developed to monetize embedded value in a life company.

In this structure, the life company pays an annual premium to enter into a reinsurance contract with, say, a Bermudan reinsurer. Simultaneously, an SPV which is wholly owned by a charitable trust issues Eurobonds to the market and uses the proceeds to make a contingent loan to the reinsurer. The reinsurer invests the proceeds of the contingent loan, the resulting investment assets being used to support the liabilities assumed under the reinsurance.

The payment of interest on the contingent loan is funded by the investment return on the investment assets and the premiums receivable from life company. Similarly, the interest received on the contingent loan is used to fund the payment of interest on the bonds.

As future surpluses arise in Life company, it recaptures the reinsured liabilities from the reinsurer. The corresponding reduction in liabilities in the reinsurer will give rise to surplus in the reinsurer which will be used to repay the capital component of the contingent loan.

Potential benefits

One of the principal benefits that arises from the monetization of embedded value is the increase in Tier 1 regulatory capital. However, the advantages over more traditional forms of Tier 1 capital such as ordinary shares are:

• The market can perceive rights issues or further issues of ordinary shares as a weakness in the issuer's capital position. Entering into a reinsurance contract and issuing bonds should not be perceived in the same way.

• The premium paid by the life company under the reinsurance may be tax deductible, thereby reducing the cost of the financing.

Tax issues

Since the reinsurance is effectively accelerating profits, its inception may also give rise to an acceleration of taxable income. However, this may be sheltered by losses brought forward. As future surpluses arise, they may also be sheltered from tax by the recapture of the reinsured liabilities. The life company may also obtain a tax deduction for the payment of the annual premium.

The reinsurer would potentially make a loss when the liabilities are assumed under the reinsurance, for which there may be value. The loss may alternatively shelter the future profits that will emerge as the reinsured liabilities are recaptured by the life company.

Since the three entities are not connected, there should be no transfer pricing issues.

France

Under article 27 of Directive 2002/83/EC, life insurers are entitled, until December 31 2009, to include up to 50% of their future profits in the calculation of their solvency margin, subject to prior approval by the competent regulatory body.

As noted above, several UK insurers have taken advantage of this by monetizing their embedded value. French regulations have recognized this possibility, and the experiences seen on the British market are being followed with interest.

The work currently in progress under Solvency II will most probably integrate similar opportunities.

Germany

Beneficial securitization schemes such as the monetization of embedded value are also known in the German market. Due to the complexity of the structures, various tax implications may arise under German tax law. Since the tax treatment depends on an overall assessment of the whole scheme, each single structure should be evaluated independently.

The significant insurance losses that have arisen in recent years, particularly as a result of natural disasters and terrorist actions, have forced the insurance industry to consider innovative options for managing the risks they underwrite. Traditional reinsurance has been supplemented by alternative risk transfer structures, as a result of which the risk of loss arising from the potential occurrence of certain events is assumed by third parties outside the insurance industry (for example, the market).

Diagram 3: Catastrophe bond

Catastrophe bond structure adopted in the UK

A good example of alternative risk transfer is the catastrophe bond ("cat bond") structure, which is set out in Figure 3.

The use of this structure is not necessarily confined to catastrophic risks. However, it is assumed in this example that the reinsurance company has reinsured risks pertaining to a specific catastrophic event (say, an earthquake in San Francisco).

The SPV issues bonds in the market that are not repayable if the specific catastrophic event occurs. The proceeds from the issue of the bonds are on-lent to the reinsurance company by way of contingent loan, which itself is only repayable as the unexpired risk reserve is written back (that is, if the risks are realized, the contingent loan is not repayable). As a result of these transactions, the reinsurance company has effectively transferred the risk of underwriting the catastrophe insurance to the market.

The reinsurer pays interest on the contingent loan which is effectively its cost of obtaining the additional capital.

Potential benefits

One of the principal benefits that this structure provides is an increase in core Tier 1 regulatory capital.

The loan structure is flexible and would be relatively easy to unwind. Furthermore, because the proceeds from the bond raising have been provided to the reinsurer on a contingent loan basis, there should be a reduced credit risk. Finally, interest payable on the contingent loan may be tax deductible, thereby reducing the cost of capital.

France

On the French market, several insurers and reinsurers have, through cat bonds, securitized catastrophic risk to transfer to the market a significant bulk of insurance risks whose frequency is very low, but whose high intensity could undermine their capital positions. The advantage for investors lies in the fact that such instruments offer both a high yield and an opportunity to diversify their portfolios by integrating risks that are independent of interest rate and credit risks.

The coupon on the corresponding debt is, in principle, tax deductible for the insurer or reinsurer. However, where the issue is made through an SPV located in a low-tax jurisdiction (for example, Bermuda), the tax treatment must take into account the risk of the potential application of anti-avoidance provisions and/or CFC rules.

These securitizations generally take place after the relevant risks have been bundled into a single portfolio, so that they can achieve critical mass and provide investors with a single interface. This "bundling" takes the form of intra-group reinsurance or retrocessions, thus raising questions of transfer pricing and transfer pricing documentation. These questions should be addressed upstream, upon the bundling of the risks, though they may also arise when allocating the cost of the securitization between the various participating companies.

These securitization operations are not limited to catastrophic risks. Indeed, a major player on the French market has recently securitized an auto insurance portfolio, while guaranteeing the investors a reimbursement of the nominal value of the securities issued.

Germany

In recent years, cat bonds have become an innovative opportunity to increase insurance capacity on the German insurance market. The issue of cat bonds has positive impacts on the solvency of insurance companies.

In comparison to traditional reinsurance contracts, the benefit of cat bonds is that the capital is already fully paid and a guarantee is given that the agreed indemnification can be obtained by the insurance company. As a consequence, the insurance company will need less equity to cover a particular risk because, due to the accrual of capital, a potential insolvency risk can be excluded.

For further information please contact:

Rob Lant

KPMG in the UK

Tel: +44 207 311 1853

Email: rob.lant@kpmg.co.uk

Dr Rainer Schick

KPMG in Germany

Tel: +49 21 2073 1365

Email: rschick@kpmg.com

Frédéric Martineau

Fidal Direction Internationale*

Tel: +33 1 55 68 15 31

Email: fmartineau@fidalinternational.com

*Fidal Direction Internationale is an independent legal entity that is separate from KPMG International and its member firms.