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HMRC internal manual

General Insurance Manual

Non-resident insurers: scope of UK taxing rights: section 11 ICTA & Article 7 OECD Model: OECD Report on the Attribution of Profits: internal and external reinsurance

Internal reinsurance, that is the purported reinsurance of risks by the permanent establishment as ‘cedant’ with the rest of the entity as ‘reinsurer’, is highly problematic as a potential ‘dealing’. Insurance companies commonly buy reinsurance from both related and unrelated reinsurance companies. Under the authorised OECD approach, no dealing that internally transfers insurance contracts or associated insurance risk is recognised unless it can be demonstrated that another part of the enterprise has performed the relevant key entrepreneurial risk-taking (KERT) function. As a general proposition, the risk management function of deciding whether to reinsure contracts held by an enterprise after insured risks have been assumed does not involve sufficiently active decision taking to be regarded as a KERT function. It would not cause economic ownership of the contracts or related risk to be transferred, and performance of the function would attract an arm’s length fee. On the other hand, if

  • the permanent establishment enters into contracts which on a separate enterprise basis it would not have been able to enter into, or not to the same extent, and
  • it is acting essentially as a conduit for business which truly belongs in the rest of the enterprise

the passing of those contracts by way of such ‘internal reinsurance’ may be accepted, subject to an arm’s length reward being given to the permanent establishment for carrying out this ‘fronting’ function.

Thus, in the large majority of cases, the risk management function of deciding whether to reinsure externally or retain risks assumed by the permanent establishment will not give rise to an internal reinsurance dealing, although if advice and analysis is provided from specialists located outside the permanent establishment but within the insurance enterprise such services should be regarded as a legitimate expense of external reinsurance acquired by the permanent establishment attracting arm’s length compensation. Traditional transaction methods will normally be appropriate but a full comparability analysis may show whether a profit method would be consistent with the arm’s length principle.

External reinsurance will give rise to adjustments, including

  • allocation of premiums paid, which may present particular difficulties in dealing with excess of loss
  • effect on the need for provisions and surplus
  • allocation of recoveries.