Insurers offshore BOUND

Several months ago Northern Telecom shook the Canadian business community when it announced plans to relocate to the U.S., mainly due to the high personal income tax structures in Canada which make it difficult if not impossible to compete against American companies for employee talent. In mid-June, Finance Minister Paul Martin broadly addressed the “brain drain” issue in a media interview stating that federal taxes need to be reduced. Similarly, Martin concedes that Canadian company taxes are making the country uncompetitive across several industries. Not least of which is the property and casualty insurance industry which is not only facing a heavy tax burden but cost-intensive regulation at both the federal and provincial fronts. The result is many underwriters are considering moving head-offices offshore in a bid to remain competitive on the world stage.

Hampering taxes and redundant regulation is an analogous reality which general industry — including the property and casualty insurance sector — has faced for many years, regardless of who and which party has occupied political office. Over the years this has, according to business community representatives, led to both “capital” and “brain” drains from the Canadian economy.

The fact that federal Finance Minister Paul Martin has indicated a willingness to now address this weakening of Canada’s business sector is an encouraging development. However, as insurance commentators note, whatever concessions Ottawa finally makes could prove to be too little too late.

In addition, the obstacles in front of insurers are not only about profit and taxes, but include inhibiting and costly regulatory systems which in many instances limit onshore registered operators from competing against their offshore counterparts. This is particularly so with regard to new financial risk mechanisms which can be easily registered and operated from Barbados or Bermuda, but which would require an army of lawyers to implement within Canadian or U.S. boundaries. This presents a danger to onshore based insurers who are effectively not competing on a level playing field with global players like ACE and XL, warns Vincent Dowling, managing partner of Dowling & Partners Securities (a widely held expert on the U.S. p&c insurance industry).To survive in the current cost-conscious business environment, North American insurers may be left with little choice but to go offshore, he states.

It is no secret that growth — let alone of a profitable variety — was very much in shortage in North America in 1998 with respect to the insurance industry. However as noted previously in CU (April 1998 issue: captive growth), there has been a booming business in the formation of offshore captives. In many instances, this has involved partnerships between corporations and insurers/reinsurers. In addition to which, several Canadian insurers have indicated or embarked on plans to shift part of their business operations south — the U.S. is currently regarded as being a more tax-fair and lucrative market than Canada.

Other than the obvious issue of tax, what are the factors driving companies offshore? How are regulators viewing this development? When Canadian companies began moving operations (and capital resources) offshore in the late 1970’s, there were specific tax benefits — many of which have been subsequently closed. For example: banks used to set up creditor life business (when residential mortgages are issued there are accompanying life insurance policies associated with them) in the Bahamas, then through the captive, re-insure, capturing the profit offshore and untaxed. This once very popular tax loophole no longer exists.

The endless game

But in the endless game of cat and mouse with Revenue Canada, insurers have found new wrinkles. What is allowable and presently executed is the swapping of portfolios. Let’s say that a Canadian insurer has a pool of 40,000 policies in its life insurance portfolio. If it can find a European insurer (for instance) with a similar risk profile, it will swap the risk through its operations in Bermuda or Barbados. Therefore instead of paying the tax on its profits at Canadian corporate rates which may be anywhere from 25%-40%, it takes the same gross and enjoys the 5% Bermudan rate.

In addition, there is a tax treaty between Canada and Barbados which allows a Canadian company to re-insure non-Canadian business and “dividend” the money back — tax-free. No similar treaty exists between Canada and Bermuda, however Canadian insurance companies often re-insure their domestic business there and enjoy a tax advantage in doing so. Money can be borrowed at the holding company level (and written off as an expense against earnings), thus lowering taxable income without hurting “profit”. This particular deduction is allowed because Revenue Canada believes that such insurance business would not be generated without this tax break, hence there is no cost to the national coffers. Bill Star, CEO of Kingsway Financial, has moved some of his company’s operations to Barbados virtually solely to benefit from this “loophole”.

Another alternative: Set up an “international business company” (IBC) in one of those friendly domiciles. Then take advantage of “transfer” pricing rules in order to shift profits. For an insurance company this would mean “exporting” its sales at wholesale prices to its IBC/captive. The captive can then record the sale at retail prices and capture the profit, enjoying the similar tax benefit described above on its premiums.

Problematic Canadian tax law

One way that Canadian tax laws (other than the higher rates) make it more difficult for Canadian companies to compete on the international stage is through the treatment of “pooling of interests”.

Buyouts and mergers are an on-going reality in a world economy where size truly matters, particularly in industries like insurance which in many respects is a commodity business. In the U.S., GAAP (generally accepted accounting principles) allow companies to pool their interests, while in Canada it is necessary for one company to in effect buy out the other, and carry the goodwill on its books which must be amortized, reducing profit in the following way:

Imagine two American insurers, each with $1,000,000,000 in assets, each of whom make a 10% ROE. They merge. After “pooling” their assets, the new entity has $2,000,000,0000 in assets and makes $200,000,000 in profit — a 10% return.

Assume a similar situation involving two Canadian p&c companies. If one company bought another, the purchase price would not be $1,000,000,000 — there is virtually always a premium paid which is reflected on the new consolidated balance sheet as goodwill. Say the purchase price would, as a result, be $1,250,000,000, so even though the newly formed company would reflect an asset base of $2,250,000,000 –$2,000,000,000 of tangible assets and $250,000,000 of Goodwill — it still only makes $200,000,000. Already the ROE has declined from 10% to 8.8%.

Except it gets worse. The $250,000,000 — the intangible asset Goodwill — has to be written down over time, or amortized. This will have a negative effect on profit as what by definition doesn’t exist (that is what makes it intangible) “disappears” from the books. Assuming a straight-line amortization method over 10 years, it writes down the $2,500,000,000 evenly by $250,000,000 each year. Now the company makes $175,000,000 and its ROE is 7.8%.

But the reality vis-a-vis an American competitor would be even worse given the higher Canadian corporate tax rate. George Hutchinson, CEO of brokerage network Equisure Financial is a self-described Canadian nationalist in the new “border-less” and loyalty-free world of high finance. But his combined federal and provincial tax rate is 56.5%. Only regulatory requirements are keeping him from re-locating his operations — and capital.

Looking for leverage

For p&c companies operating on Canadian soil, the “leverage ratio”, that is, the maximum premium volume allowed by regulation measured against the insurer’s capital and surplus i s 3:1. Basically, for every three dollars of business written, there must be at least one dollar of surplus behind it. However, in reality vigilant Canadian regulators ensure that the ratio is maintained at about 1.5 to 1.0.

For a company operating in Bermuda or Barbados, the leverage ratio is 5:1 or even 8:1 if it is short-term property and physical damage insurance. What this means in practical terms is that with the same shareholder’s equity, there can be up to five times the premiums written. This has a powerful and positive effect on profitability and makes moving capital offshore that much more attractive.

Is there a corresponding increase in risk with this additional return? Not necessarily, according to Phil Cook, CEO of the Focus Group: “It should be recognized that many of the insurers/re-insurers operating from offshore locations are writing risks with a high premium level and low frequency and they need the additional flexibility in this area.”

One should not leap to the mistaken conclusion that regulators in Bermuda and the Barbados are not doing their job and representing the best interests of the insured and industry itself. Bill Morgan, ex-chair of the Captive Insurance Association summarizes, “we have the best regulators in the world [Canada], however, remember, the insurance industry is more important to the economy of the Bahamas than tourism. Would they want to jeopardize this business by having a reputation for lax regulations?”

Currently, there is only anecdotal “evidence” and a variety of opinions. However, commencing this fall, the International Monetary Fund and World Bank will be undertaking a comprehensive review of all regulatory regimes and judge according to a common yardstick. Depending on the result, this could have a material effect on the decisions of insurance companies moving forward. Assuming that the offshore centers are given a clean bill of health (which seems to be where the smart money is), this might accelerate the movement of companies and flight of capital.

Are there employment issues associated with the capital drain? Yes — and no. Many companies with an offshore presence only have a mailing address. There is a new requirement in Barbados that an insurance company must have six full-time employees which may be a mixture of Canadians and locals. To a country of 27.5 million, this is not a significant issue.

However, this may only be the tip of the iceberg. Given that the personal tax rate is 0%, the winters are nicer, and with a new era of telecommunications which includes the Internet and video-conferencing, it may be that more significant relocation may occur in the future. This cannot be quantified, it is a cloud which hangs over the domestic economy.

Regulators, at least, seem unconcerned at present. John Palmer, superintendent of the Office of the Superintendent of Financial Institutions (OSFI), says “there is no great wave that we’re aware of,” with respect to moving operations offshore. He notes correctly that big globally operating Canadian companies have had these operations for years and will continue to do so into the future. Maureen Smith, Canadian regional manager of AIG’s property risk management, concurs: “Multi-national companies need global programs. If you’re operating solely in Canada, there may not be enough domestic capacity to meet their various needs.”

The rule of thumb is that if premiums exceed US$1 million, there may be a benefit in setting up offshore. The formal capitalization requirement for Barbados is a minimum US$125,000, and for Bermuda it is $120,000 for Class I, $250,000 for Class II, and $1,000,000 for Class III rated companies. Registration and incorporation fees are modest: for Barbados at $250 for an application and $2,500 for a licensing fee. In Bermuda incorporation expenses range from $4,200 to $9,000 — depending on the amount of capital employed. Which is merely to quantify the fact that moving offshore has a price tag and is not necessarily the right option for everyone.

However, the extent of the market to which going offshore may be attractive could soon rise. Oscar Zimmerman of Scotia Insurance thinks that sophistication rather than size will more and more determine whether businesses move their assets offshore. Mary Ann Godbout, VP of Conning and Company, refers to some interesting market statistics in this regard. In the U.S., she notes, large insurance accounts (defined as having more than 1,000 employees) currently comprise 11% of the total market. 75% of these have a presence offshore. The large middle group (companies with between 50 — 999 employees) have not as of yet explored moving their assets. This, she expects, could change if the pricing environment hardens in North America.

Ironically, a hardening of rates could accelerate the capital flight. A firmer pricing environment — something good for the insurance industry — might entice corporations to investigate self-insurance mechanisms and thereby prompt domestic insurers to chase after the premium dollar by moving offshore.

Where to

George Hutchinson sees the problem as basically a tax issue. He believes in Canada, but also believes that Canadian tax laws are driving both talent and capital south. A flat and lower corporate tax rate would go a long way towards addressing these problems. Moreover, Hutchinson notes that there has been a hidden opportunity cost that tax regulations have put on this country: “If the existing businesses are looking to move their operations, why would anyone presently not look to locate in Canada?”

Bill Star, CEO of Kingsway Financial, concurs. Kingsway, he comments, has operations in Bermuda in addition to Barbados — simply to compete on a level playing field with larger American companies.

It’s an immutable law of physics: that which is in motion, tends to stay in motion. Unless there are significant amendments to Canadian tax law and a more accommodating regulatory regime put in place, the capital drain will continue.