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HMRC internal manual

General Insurance Manual

HM Revenue & Customs
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Reinsurance and other forms of risk transfer: financial reinsurance and alternative risk transfer (ART): tax treatment: examples

The type of case that may come within GIM8310 is, for example, where a multi-year spread loss (GIM8210) or similar contract is used to create a money box for the cedant or to mimic the effect of an equalisation reserve. Two examples follow which demonstrate this. They are illustrative only. Real world contracts would be both more complex and less obviously open to challenge. For example, the profit commission might take the form of an entitlement to a dividend on a special class of shares relating particularly to the cedant’s private ‘fund’ in the reinsurer. Payment of such a dividend may be implicit in the arrangements, even though there is nothing in the documentation to compel payment, so it would be easy for an auditor to miss the significance of the shareholding.

Example 1

An insurer believes that there is a 0.5 per cent chance that its aggregate losses from property insurance in any given year (net of reinsurance recoveries) will exceed £100 million. It pays financial reinsurance (GIM8200) premiums of £50 million per annum for five years to obtain stop loss (GIM8060) cover in excess of aggregate claims of £100 million per annum. The reinsurer’s liability is limited to a total of £500 million over the five years. The insurer is entitled to a profit commission equal to 98 per cent of the amount of the premiums paid, plus interest earned on them by the reinsurer, less claims paid under the policy at the end of the five years. A side letter provides that in the event of claims being paid in excess of the premiums previously paid under the policy such additional premiums are payable as will eliminate the excess over the remaining term of the policy.

Here, the expectation is that no claims will be paid under the policy, and, in economic terms, it functions as a deposit account. But if the insurer can persuade its auditors that the very small risk of loss that faces the reinsurer in the event of a claim arising under the policy is nevertheless significant (which may be easier if the auditor does not know about the side letter) the premiums may be accounted for as expense items.

Example 2

An insurer believes that there is a 20 per cent chance that, in any given year, a wind storm will result in claims that break through the top layer of its excess of loss reinsurance cover. It expects that when this happens the un-reinsured claims will be somewhat in excess of £50 million. It enters into a spread loss contract with a reinsurer under which it pays £11 million per annum over five years to obtain cover of £50 million. The contract provides for a return of premiums, or some other form of refund in the light of experience, in the event that no claim is made; but here the expectation is that a claim will be made at some time during the life of the policy. The reinsurer carries no underwriting risk, but it can lose money if there is a claim within the first couple of years or so because of the timing risk that it has assumed. This risk is reduced by a side letter that requires the cedant to pay interest on any amount by which claims exceed the fund of premiums, and also to provide a guarantee or letter of credit before such claims are paid. From the insurer’s point of view it has substituted certain regular premiums of £11 million per annum for a likely charge of £50 million against its profits at an uncertain time. Such an arrangement might arguably be legitimately accounted for in the same way as conventional reinsurance, and once again this will be more likely if the auditor does not know of the side letter.