Financial guarantees
Guidance is given on how to accurately delineate and price financial guarantees, most typically where a guarantor provides a guarantee on a loan taken out by a fellow group member from an unrelated lender.
The effect of group membership on determining the arm’s length price of guarantees is discussed. Situations involving explicit guarantees (an indicator of which would be whether a commitment provides a lender legal rights of enforcement) are distinguished from the implicit support arising from non-binding commitments e.g. attributable to the borrower’s group member status. In general, the benefit of any such implicit support would not arise from the provision of a service for which a fee would be payable. Even in respect of an explicit guarantee, a borrower would not generally be prepared to pay for a guarantee if it did not expect to obtain an appropriate benefit beyond the implicit support of other group members, and examples are provided showing how implicit support is taken into account before determining the impact and pricing of an explicit guarantee.
Where the effect of a guarantee is to permit a borrower to borrow a greater amount of debt, it is necessary to consider: (i) whether a portion of the loan should be accurately delineated as a loan from the lender to the guarantor (followed by an equity contribution from the guarantor to the borrower); and (ii) whether the guarantee fee paid with respect to the remaining portion of the loan is arm’s length. The financial capacity of the guarantor to fulfil its obligations in case of default would also need to be examined.
Five different approaches to pricing guarantee fees are described: the CUP method (although it’s noted that it can be difficult to find sufficiently similar guarantees between unrelated parties); the yield approach; the cost approach; the valuation of expected loss approach; and the capital support method.
Captive insurance
The report includes guidance on the application of the arm’s length principle to captive insurance and reinsurance arrangements. It notes that a group may choose to pool certain risks through a group member, the captive insurance company, for a number of commercial reasons e.g. to stabilise premiums paid by group entities; gaining access to reinsurance markets; mitigating the volatility in the group’s operating results due to unforeseen insurance events; because the group considers that retaining the risk within the group is more cost effective; or the difficulty or impossibility of getting insurance coverage for certain risks.
A frequent question is whether an intra-group transaction results in a real transfer of insurance risk. Guidance on how to determine this through accurate delineation of the transaction is provided, including: setting out a number of indicators of a genuine insurance business; indicators that a group captive has assumed insurance risk, and has achieved the necessary diversification of risk resulting in an improvement in the net economic capital position of group entities; whether the captive insurer or another entity is performing the risk control functions associated with its underwriting; the effects of outsourcing certain underwriting activities to unconnected parties; and the applicability of the guidance to reinsurance ‘fronting’ arrangements - where risks are typically ceded by the operating company through a fronting company (usually an insurance broker or agent) which in turn reinsures the risk to the group captive.
Further comments are provided on: the pricing of premiums, including arriving at a comparable uncontrolled price through considering the combined ratio of the classes of business insured - which can be difficult given the lack of publicly available data - and return on capital; possible use of actuarial analysis as an appropriate method to independently determine an arm’s length premium; group synergies; and the effect of agency sales.
Risk-free and risk-adjusted rates of return
When a lender is not exercising control of the risks associated with an advance of funds, or does not have the financial capacity to assume the risks, the risks should be allocated to the entity exercising control and with financial capacity. In such circ*mstances, the lender will be entitled to no more than a risk-free return.
Additional general guidance is provided, for insertion in Chapter I of the OECD Guidelines, on how to determine risk-free rates. The approach widely used is to treat the interest rate on certain government-issued securities as a reference rate for risk-free returns. Key considerations include: comparing instruments with the same currency and maturity, and ideally issued at the same time; and the use of the reference security with the lowest rate of return where there are multiple governments issuing bonds in the same currency.
Approaches to calculating risk-adjusted rates of returns – applicable where an entity provides funding and exercises control of the associated financial risks, but does not assume any other specific risks – are also included, such as adding a risk premium to a risk-free return based on similar financial instruments issued in the market.
Deloitte EMEA Dbriefs webcast
Deloitte’s EMEA Dbriefs webcast programme will cover the new guidance on Wednesday 19 February 2020 at 12.00 GMT (13.00 CET). To register for the webcast please go to deloi.tt/2STCpt2 or www.emeadbriefs.com.
