UK: Deloitte Insurance Market Update (Part 2 of 3) - Pensions, Regulation and Strategy, Tax Risk Management

Last Updated: 21 February 2005
Article by Icki Iqbal

Most Read Contributor in UK, August 2017

Simple pensions, simple administration

The implementation of a new legislative framework for pensions in April 2006 heralds a new era for the industry. Merging eight regimes into one will fundamentally change the UK pension market but it’s not just the sales side that will benefit. Simplification is also a chance for providers to radically overhaul their administrative platforms and tackle systems and operational issues. Andrew Power reviews the opportunities and highlights some of the key considerations.

All change

It has been a busy time in the pension market with recent legislative moves to merge eight pension regimes into one by A Day – April 6th 2006. The new regime offers a lot of appeal in reducing the complexity of pensions. They should be easier to sell and to administer.

We believe the changes will have a significant impact on the UK pension market:

  • Products will be fewer and simpler (more transparent).
  • In short term charges increase above 1.5% but not far.
  • Investment performance will become increasingly important.
  • Focus will increase on individual based plans and individual support.
  • Consolidation of individual "pots" will become more popular.
  • Nature of advice will shift (more information, more aggregation, more investment reporting). 
  • Role of employer will lessen as defined contribution becomes predominant.
  • Role of employee benefit consultant will change to broader HR role.

As the government has hoped the changes could have a radical impact on the pensions market, changing the industry structure and competitive positioning.

A lot of attention has been focused on the sales benefits of pensions’ simplification. With greater simplicity, less advice will be required enabling products to be developed that have lower charges. As a result it is hoped this will encourage individuals, especially those with moderate income, to save and contribute to bridging the so called £27 billion savings gap in the UK. Much uncertainty exists over the impact on sales given the public’s recent disaffection with pensions and the public’s continuing lack of understanding of financial products.

Current pension administrative challenges

Less attention has been paid to the advantages in pension providers being able to simplify their pensions’ administration. Today large pension providers might have 5-10 legacy platforms administering pensions. The same product may be administered on multiple platforms and many policyholders will have pensions with one provider split across multiple platforms. As a result of this, many customers receive poor service on their pensions. There may be no integrated view of a customer’s holdings; operational processes will be designed around the quirks of the platform not the needs of the customers or operational efficiency, and much manual intervention is required to undertake even routine pension transactions.

Changes will impact systems functionality and processing across a broad range of processes, many of which will be embedded within existing business systems. The legislation is retrospective, additional work will be required to migrate existing pensions data to new record structures necessary to process the changes. Complexity is increased if a number of different systems support pensions processing and the interfaces between them. As illustrated below, the new legislation has impacts on at least thirteen dimensions e.g. new limits, and effects employers, individuals, providers and distributors.

Such large scale change in the structure and feature of pensions’ products will have an impact on the day to day operations in respect of:

  • new and revised business and compliance processes;
  • changes in the volume and nature of enquiries;
  • organisation and training of staff in the new legislation;
  • additional data collection and transmission across the organisation.

For any organisation, these changes will cut across:

  • all group companies engaged in processing pensions;
  • sales channels – direct sales forces; intermediary channel management; broker networks and bancassurance;
  • 3rd party and off-shore service providers;
  • operations – sales & marketing; customer servicing; pensions administration;
  • support – IT; compliance; tax; finance, actuarial; legal;
  • communication channels - call centres; internet services; employer/employee intranets.

As is clear the changes are broad ranging and significant. Indeed, we believe the nature of these changes have been underemphasised by most providers, who naturally have tended to focus on the product and market impact.

The opportunity for administrative simplification

Just as the response to Year 2000 allowed companies to deal with many long standing operational and systems issues, pensions simplification offers the same potential. It really will be viable to consider migrating all pension administration to a single platform, thereby improving consistency and avoiding the cost of changing multiple systems in response to future pensions’ legislation. This will drive obvious benefits in operational efficiency and lower IT development and maintenance.

More importantly, operational changes will be necessary to ensure a pension provider remains competitive, or better yet steals a march on its competitors. The new pension regime will change the basis of competition in pensions.

In any less complex markets commodity pricing becomes prevalent, and the winners are scale providers. Scale can only be achieved through greater standardisation in both operations and systems. While the pensions market is a long way from being a pure commodity market, it is moving in that direction. The bespoke pension platforms and operational processes will no longer cut the mustard and returns from the pension market will plummet unless operations are cleaned up and streamlined.

At the same time, with the advent of annual and lifetime limits, individual record keeping will emerge as a potential key success factor in pensions’ administration. The most attractive providers will be those that aggregate pension holdings to show an integrated pension statement. Even better will be those who can then link these administrative capabilities to multi-manager platforms, thus allowing an individual to change asset allocation under one pension wrapper. As a result those with retail brand names and administrative efficiency will begin to win market share.

In addition, technology can be applied to provide better support to distributors and customers. For example, planning tools can be developed that allow individuals to select the optimum asset allocation for their level of risk tolerance and specific retirement needs. Straight through processing can be designed directly with employers and with distributors.

The way forward

Work between the business, operations and IT must occur to get a clear understanding of scope, volume of work and risks:

  • the legislation will require interpretation, and will continue to be clarified right up to A Day;
  • business thinking will evolve and expectations and change must be well managed. There will be a tendency to keep all options open, but this tends to lead to design of excessive operational and technology complexity;
  • strong facilitation to achieve an early baseline of good quality requirements; and
  • linkage between the provider’s strategy and its operational and IT initiatives. If pensions simplification is considered just a response to a mandatory regulatory requirement then the company will miss a great chance to reposition itself strategically to capitalise on growing individualism in pensions and growing scale economies.

When the scope is understood, IT will need to:

  • find solutions that work across the group to minimise cost and reduce risk – implement once not several times;
  • coordinate IT changes and releases into the business – some business area may want/need to move quicker than others. It will be critical to understand and recognise this in release planning to prevent some business units being put at a competitive disadvantage;
  • ensure impact assessment and identification of areas of change is rigorous particularly around legacy systems;
  • provide sufficient IT resources (internal and external). While, over the long term, a simplified pension administrative platform holds out the prospects of more efficiency, unravelling the secrets of existing legacy systems will be a major effort. Many providers will lose patience and seek only to put new pensions business on a uniform platform;
  • manage these changes alongside existing IT development portfolio and BAU activity. Pensions simplification is but one of the major regulatory, mandatory initiatives effecting life & pensions providers in the UK. It demands must be coordinated with the response to depolarisation, Prudential Source Book, IFRS etc; 
  • work with the business to prioritise the delivery of IT changes, in order to do this, some planned projects may need to make way. 

In making these changes the organisation will need to consider: 

  • setting clear benchmarks for operational performance and IT return on investment;
  • documentation of the design and changes to new processes to replace the patchwork of inefficient, unique processes of today;
  • fit with existing technology strategy to ensure correct prioritisation of application spend in line with value created and the leveraging of a common infrastructure; and
  • training requirements to respond to a growing volume of customer questions about the new legislation and related products.

In summary, the pensions’ simplification legislation implies a major change in the way UK pensions are administered. Apart from basic housekeeping to ensure the legislative requirements are met, providers need to raise their game to seek strategic advantage from the operational and IT changes they will make. Key factors to consider include:

  • Straight through processing and full IT integration into operations.
  • On-line internet access to employers, employees/individuals and distributors, linked with value added tools such as financial planning.
  • Enhanced communications both to cover the new limits, rules etc. but also to account for the greater individual record keeping and decision making.
  • Supporting new products and features e.g.:
  • - Flexible retirement options and processing.
    - Revenue reporting.
    - Lifestyle fund processing.
  • Addressing how to rationalise legacy products and systems. 

Providers can focus on doing the minimum necessary to comply with pensions’ simplification or they can use it as a call to revamp their pensions approach.

Regulation and strategy – achieving alignment

Tackling the flood of regulation in the insurance industry is a strategic rather than a tactical issue. Companies that recognise this and move from passive compliance to adopting an integrated response will put themselves ahead of the competition. We look at the strategic significance of new regulations and suggest a portfolio approach is the way forward.

Insurers are dealing with a plethora of regulatory change which is being imposed on an unprecedented scale with different drivers generating significant overlapping and interdependent impacts on the various functions of the business. Each regulatory driver has significant costs associated with it, with real impact on the business and its infrastructure. There may also be affects on the business strategy including the core markets which are serviced. The changes arising are too numerous to cover in this article but some of the key changes including the Prudential Sourcebook (PSB) and IFRS are amongst those considered.

Many organisations are managing the approach to this change in silos, with a focus on compliance rather than the business impact and strategic implications. Insurance businesses need to adopt a more holistic approach to these changes, which may involve much more fundamental re-thinks than have previously been required.

They need to re-evaluate business strategy and take the opportunity to challenge and in some instances transform current infrastructure.

This article sets out to explore some of the major regulatory and legislative changes and ways in which insurers can embrace the change to create real competitive advantage and drive shareholder value.

Prudential Source Book impacts

One of the key regulatory drivers is the PSB, which represents a fundamental change in the approach to the regulation of financial strength and capital adequacy, including impacts on the systems and controls within all financial firms. From a systems and controls perspective the greatest areas of change for insurers are likely to be is the new and sharper focus on operational risk and formalisation of the expectations for the management of credit risk. The teams dealing with these risks will need to monitor key risk indicators, have consistent event and loss reporting processes and provide meaningful risk information to support decision making. Furthermore, rating agencies such as Moody’s are increasingly looking at operational risk as an important element in assessing firms. This focus on better risk management is consistent in many ways with other risk focused legislation such as Sarbanes Oxley. This indicates a need to consider these changes in a holistic manner.

Regulatory timetables are generally business critical as non compliance could result in licenses being withdrawn to write business. Therefore regulatory programs need to focus on ensuring that execution risk is minimised and that timetables are adhered to especially with PSB. Interestingly a recent Deloitte survey revealed that many firms do not currently have the ability to calculate their ICA.

International Financial Reporting Standards

Insurance is an increasingly global business and insurance accounting varies considerably across jurisdictions. Most listed UK insurers are now well advanced in the production of the IFRS financial statements processes, as of 1st January 2005 most insurance companies will need to produce consolidated accounts in line with these standards.

IFRS will have a number of significant impacts both to the way that insurance and non-insurance transactions are accounted for, but also to the way they are disclosed which will be especially significant for companies wishing to access the capital markets. This has the potential both to harmonise accounting practice and thus make accounts more usable, but also it may alter perceptions of the industry as a potential investment. For example where fair value concepts result in more volatile earnings this may exacerbate the existing ebb and flow of capital into the insurance market, caused by the underwriting cycle. In addition any increased volatility in earnings may also result in increased volatility in tax charges.

Intermediation regulation impacts

Recent changes to insurance and mortgage intermediation regulation have been numerous including the adoption of insurance and mortgage distribution regulation by the FSA and depolarisation in the life/pensions/investments distribution markets.

These changes are at the heart of some fundamental restructuring occurring across the industry such as:

  • Transition by many distributors from one regulatory model to another (such as single tie to multi tie, and less so IFA to multi tie).
  • In some cases the separation of manufacturing from distribution and the move towards a multi-tie model for large networks.
  • Major investment from insurers into distribution and networks of distributors.
  • Acquisition and investment in mortgage distribution as a fundamental way to secure protection markets through mortgage related cross sales.

One area of commonality with these changes and other "risk focused" regulation is that Principals supporting Appointed Representatives (ARs) will now be responsible for advice of their ARs for mortgage and general insurance. This creates a need for insurers to assess and understand this new operational risk which arises from what is non-core for many life assurance firms.

Sarbanes Oxley impacts

Sarbanes Oxley will be yet another driver of the need to enhance a public firm’s control environment. This is to ensure that management are responsible and accountable for, the accuracy and integrity of accounting records procedures and controls.

A synergy of this regulation with PSB is that some of these control related drivers will help to manage and reduce the risk of fraud, error and mis-statement in the financial statements, thereby helping reduce operational risk.

Other regulatory drivers

In addition, other major areas of imposed regulatory changes are FRED 34, Pensions Act 2004, and good practice measures advocated by the FSA such as TCF. Furthermore, the IFRS and FRED 34 may allow or tempt companies to implement methods of smoothing profits for example by hedging or product design.

Tax is another area that will be impacted by regulatory change. For example, the new Enhanced Capital Requirement may lead to increased tax charges in relation to investment income for UK branches of overseas insurers. The interaction of regulatory and tax demonstrates the need for a multi disciplinary approach with both teams being aware of the wider potential impact of their area.

In summary, it is likely that the increased awareness imposed by the consultation processes of techniques such as risk based capital, stochastic capital analysis, and operational risk analysis will result in insurers who are better able to monitor and manage the risks inherent in their business, beyond the core insurance portfolio. Tackling the above changes would be challenging enough without mentioning other regulatory pressures such as financial crime, market abuse directives, and anti-money laundering legislation to name just a few.

Strategic Impact of regulatory drivers on insurance companies

One of the key challenges facing insurance firms is getting financial implications of Internal Capital Assessment, Realistic Balance Sheet and International Financial Reporting Standards aligned with strategy. Realistic Balance Sheet methodology is a risk based approach to statutory reporting. Although the Realistic Balance Sheet methodology only impacts "with profits" funds greater than £500m, a recent Deloitte survey revealed that this could result in an increased capital requirement of around £6.6 billion for the whole industry.

In order to maximise risk adjusted return, make best use of capital and minimise the probability of insolvency insurers may find themselves considering a number of strategic actions, for example:

  • Reducing exposure to high risk lines/adjusting product mix where the returns do not justify the risk or additional capital burden of certain lines.
  • Withdrawing from some product lines permanently.
  • Merger and acquisition activity driven by the quantification of previous holes under the Realistic Balance Sheet.
  • Transforming operational strategy to both avoid significant operational risk exposures but also rebuild infrastructure both to deliver the regulatory change but also to improve efficiency. This could include significant reinforcement/ overhaul of control environments.
  • Restructuring their reinsurance strategy based on internal risk models rather than waiting for a ratings downgrade to be published.

Each of these would suggest that a company is better informed and able to take decisions based upon the increased risk based analysis they have performed. However many insurance firms are experiencing difficulties in making strategic decisions as they are not sure that the numbers they are looking at are safe to base decisions on, as regulation is continually evolving.

Shareholder value impacts

Many analysts have often perceived the insurance market as "worth a punt", but "not a long term investment", in particular because of earnings volatility caused by the insurance cycle for non-life insurers, and the major impacts that investment returns have on life insurers. In addition the entire industry has faced increasingly competitive pressures such as price competition in general insurance and a depressed investment return heavily affecting life insurance markets, thus placing pressure back on cost control.

Regulatory change is frequently seen as a necessary cost of doing business which reduces margins. Whilst the cost implications cannot be avoided an integrated portfolio approach should minimise the costs and assist in identifying commercial opportunities and benefits arising from the imposed change. Overall however the costs will erode margins in the insurance industry, and therefore this will devalue this and other regulated industries relative to non-regulated industries.

In some cases improved risk management procedures may have a number of significant impacts on shareholder value such as: • Where credit rating agencies take favourable view of new risk management processes, this may result in a rating upgrade. For business to business insurance such as Reinsurance, Fronting, Affinity and White-labelling, this may increase the likelihood of securing new contracts or distribution deals.

  • Increase expected profit by setting up a cost efficient risk management framework which avoids overlaps in activity and strips out excessive or obsolete controls and avoids unnecessarily constraining the business.
  • Reducing volatility in earnings by reducing both expected and unexpected losses through an early warning mechanism to highlight change in the operating and external environment or changes in the effectiveness of controls.
  • Effective use of capital by allocating capital to business units and measuring their performance on a risk adjusted basis.
  • Establish a strategic competitive advantage by enhancing outsourcing and risk transfer decisions and factoring all risk classes into the pricing of products and services.

Conclusions and recommendations

Many insurers are dealing with these changes in a tactical, rather than a strategic manner and some do not yet have an integrated programme approach responsible for delivering all regulatory change. In addition there should be a clear link from overall business strategy to the risk strategy which should be at the heart of the regulatory change program.

An integrated portfolio approach should be employed which will address these changes holistically. This should reduce implementation costs and address business and systems impact issues. Part of the integrated portfolio approach will encompass the consideration of the interactions of these different imposed regulatory and legislative changes.

In particular there is a need to:

  • Consider commonalities such as drivers under PSB, Sarbanes Oxley and COBS to improve control environment and risk management.
  • Understand conflicts such as improved risk management under PSB may stabilise some earnings patterns, whereas IFRS may destabilise other earnings patterns.
  • Pre-empts pitfalls such as deploying team resources in silos, implementing multiple technological or architectural solutions where one may suffice, or implementing tactical/short term only, with no migration path to get to strategic solutions in a sensible time frame. When constructing an integrated approach to the regulatory drivers the programme should be structured to:
  • Provide senior management with a clear view of the aggregated position and interaction across a series of mandatory change programmes to determine issues and priorities, and support decision making.
  • Ensure appropriate and adequate resources and skill sets are obtained to meet the requirements within the timescales and balancing the availability and scheduling of these across operational needs and different parts of the programmes.
  • Assist in managing stakeholder relations, explaining the impact on capital requirements and earnings, and managing the relationship with the regulator.

In addition where businesses are long overdue in upgrading financial and MIS processes, structures and systems these changes will provide an ideal time to maximise on the investment in new infrastructure and develop areas such as accounting and risk systems, improving automation and data integrity as well as making access to this information more efficient through best practice in management information.

The portfolio approach will be a major challenge, therefore it is essential to attain the right balance between project management/ process and technical knowledge. In order to neutralise these issues effective communication is essential, also careful selection and allocation of resources will be paramount. Delivery will in most cases need to be accelerated by augmenting existing resources and capabilities where necessary with external resources, methodologies and tools thereby benefiting from the experience of others and reducing timescales and delivery risk.

Deloitte has developed an integrated approach to assisting clients with these changes which draws from all of our service lines to provide support from regulatory and legislative advice through to programme management and financial transformation. In addition it provides specialist advice on strategy which will allow clients to plan ahead for multiple possible future scenarios resulting from regulatory change. Overall the insurance firms that address these changes effectively will be able to drive towards competitive advantage both through cost effectiveness but also risk effectiveness, which after all should always be a core competence for an insurer.

Tax risk management – a new champion

As pressure on margins increases and the FSA’s focus on risk management intensifies, tax risk management looks set to step out of the shadows and enable tax departments to add value like never before. Alan MacPherson reviews the theory and benefits of tax risk management and highlights some of the issues you are likely to face in implementing best practices.

Risk management in general is an area of increasing concern to senior management of UK life assurance companies, not least because of the considerable importance placed on this by the FSA. A developing area of risk management, explored below, addresses tax risk and how to identify, manage, account for and document such risk.

How does tax risk fit in?

Risk in UK life insurance may be divided into five broad categories – insurance risk, policy risk, credit risk (including liquidity risk), market risk and operational risk. Tax risk is usually considered to fall into the catch-all operational risk category which can be defined as failures from process and procedures. Some of the risks arising from tax also may be seen as market risk, notably where tax forms a key element of a policy or product and the tax treatment is crucial to the viability or margin of that policy.

Defining tax risk is, in itself, worth considering. Tax risk typically arises in a number of areas and can have various effects on a large group of stakeholders. It is increasingly recognized that tax risk is not merely an issue between the tax authorities and the insurer – it can affect the corporate reputation of the insurer, with a consequent effect on actual or potential customers. Both above and below the line taxes are vital drivers in shareholder value and earnings per share and in arriving at any assessment of capital adequacy or embedded value. Further, relationships with governments and regulators are being increasingly constrained by tax risk issues; in the UK through the different perspectives of these bodies but internationally also, notably in the US through the tax shelter regulations, in the Far East and in emerging markets.

The nature of and developments in the market for life insurance means that there is increasing pressure on margins, for simplified (and cheaper) products, and currently a reluctance on the part of insurers to offer and consumers to buy with-profits products due to uncertainties over future returns. For the insurers this creates additional risk in respect of profit and capital allocation, and employee taxes. Operational taxes, including transaction taxes and indirect taxes, have resulted in increased risks and costs because of various reforms.

Against this, the market for financial products ought to expand with the onus on retirement planning and provision increasingly being transferred from the state and the employer to the individual. However, competitiveness in today’s market environment places more pressure on marketers to innovate and increase profitability, sometimes leading to greater uncertainty and questions around quality of earnings.

Are there benefits to managing the tax risk?

While operational risk is sometimes defined as things that go wrong, it is also necessary to consider how advantage can be taken of risk to produce positive results, such as lower effective tax rates or innovative products. In tax planning, as well as in more routine or compliance matters, there is almost always an opportunity to change the structure or process to limit the downside (tax cost or process inefficiency) or increase the upside (e.g. tax saving). Realising the upside generally involves an element of risk – the risk of a challenge to tax structuring for example, but if tax risk is managed well it is possible to be more secure in predicting outcomes and make the risk pay off.

The relationship between risk management and tax benefits can be expressed mathematically or through tools such as the tax risk curve. The key messages from any such exercise are:

(1) managing tax risk means less net risk is created for any given tax benefit; and

(2) the more effective the risk management, the greater the tax benefit that can be achieved.

Some of an insurer’s tax risk capacity or appetite will always be allocated to day-to-day operational tax risk, but this can also be reduced by strong risk processes to provide more space for upside in resource terms as well as quantifiable risk terms.

Regardless of the quality of risk management, every organization has a tax risk threshold, i.e. a point at which the decision is taken that no more risk can reasonably be shouldered. Very rarely is this point actually defined, although external auditors may be beginning to ask the question whether the tax accounting provisions are reaching particular levels relative to cash flow. However, this threshold can be effectively increased and more beneficial structuring undertaken if there is an effective tax risk management strategy in place.

Successful tax risk management strategies

The first step in a successful tax risk management strategy is to identify risk. Risk identification should consider not only what has happened or is happening, but what could happen. Further, tax risk is not limited to making mistakes that lead to tax costs; tax risk also should focus on where opportunities for tax upside or increasing shareholder value could be overlooked or where efficiencies of process could be generated.

The greatest challenge in risk identification is discovering the hidden risks. Doing so is, of course, a challenge for risk consulting in all areas, and the best practical way of addressing this has been to start at the very top, including all possibilities as risks until they are judged not to be so following analysis. This inclusive method means that, in theory, nothing should be omitted. Of course, the universe of tax risks is huge and to keep this manageable, any tax risk review team will need, initially at least, to focus on the key areas on which the insurer operates and where the margin for error is perhaps greatest. This should result in identification of specific concerns, e.g. completion of chargeable events certificates by customer service units or the process for determining the amount of quarterly tax payments. These specific concerns may be identified and sourced back to their causes. However, the review process should not be limited to issues which are arising but extend also to issues which could arise.

However, having a list of 500 tax risks, for example, is of limited value until the risks are prioritized to allow focused action. Risk mapping allows tax risks to be considered by reference to their significance (including monetary, reputational, management time and regulatory impact, among others) and their likelihood of occurrence (given the issue concerned and the current internal controls the company has in place). The risks can be grouped into risks that are unacceptably high and that require immediate attention, those that are being acceptably managed, and those issues where, on a risk weighted basis, there are too many resources being devoted that could be redeployed elsewhere. The tax risk map becomes a management tool for the tax function and can be updated as progress is made in mitigating the highest risks or as new significant risks appear on the radar screen.

Managing the risks

While the risk map provides a picture of the most significant issues, the challenge remains to manage those issues and mitigate the risk. Before considering the creation of new controls in specified areas, the impact of specific actions should be considered. Some of the highest risks may be permanently high, regardless of the actions taken – for example, the risk of a change in tax legislation. Other factors, such as available resources, the trade off between risk and reward, and the permanence or otherwise of risk causing behaviour need to be taken into account in deciding where action will be most effective. Each risk area should be analyzed by reference to a matrix of these factors to identify those where the insurer may need to take appropriate action.

The strategies for mitigating risk will be as diverse as the risks themselves, e.g. a risk of tax planning implementation failure may require development of a secondary or withdrawal strategy whereas the risk of legislative tax change may require additional tax linkage to existing investment management processes. Some themes will dominate throughout as new business processes are created. Early warning systems can be created to alert the tax department to changes in ratios, behaviour or other events. Tax "Disaster Recovery Programmes" can be initiated to deal with "what if?" scenarios and mitigate the impact of unexpected or unplanned actions. Additionally, training and communication is often the key to raise tax awareness in business operations.

Although life insurance companies have long been used to managing policy risk, e.g. mortality or morbidity risk, they have not been so familiar with the broader range of risk strategies and management. By way of comparison, banks often have an advantage over insurers with respect to tax risk management because there is usually a powerful risk management function, although this may not historically have been greatly involved in tax risk management. Risk management IT systems and databases can be adapted to include tax risk issues, and additional leverage over tax risks can be generated by the use of internal audit and assurance personnel where complex tax risk has been decoded to identify the source of risk other than the specific tax impact.

Decision-making and tax risk policy

Most UK life insurance companies have yet to develop a complete tax risk policy to the same extent as decisions on investment management risk, e.g. in setting parameters on the use of derivatives in compliance with regulatory guidelines, or to the extent developed in the banking sector in setting clear parameters for decision-making within the context of an overall philosophy on tax risk. Instead, decisions have tended to be made on a case by case basis.

Tax decisions or input to strategic commercial decisions, such as appropriate or tax-efficient financing structures, or what amounts will be put at risk, are complex decisions that call on tax executives to use all their professionalism, judgment and experience. Also, given the inherently highly specialist technical nature of the decisions, conveying the rationale to non-tax executives can be difficult. The tax decision-maker is, therefore, in position of trust and authority. From a governance point of view, the tax executive is a control over a major risk source, and it is desirable to express in some detail how that control is exercised.

The best practice approach is to create a tool to express the policy, which is used to make decisions and communicate the basis for that decision-making. Identifying the factors that go into a complex tax decision is a necessary part of decision-making; these factors will be different in every company but tend to include such key issues as:

  • Tax technical position – does the idea work to the head of tax’s satisfaction?
  • Ability to execute – is this a product or structure that involves only simple execution of legal documents or does it require a major change in the way certain parts of the business operate?
  • Reputational risk – does the proposition carry an unacceptable level of reputational risk? Could this proposal lead to difficulties in relations with customers?
  • Boldness – is the insurer, for example, willing to exploit temporary loopholes or drafting errors but unwilling to pursue planning areas where the tax authority and judiciary support litigation?

Having identified these factors in the decision-making process, the company’s policy on each of the taxes must be defined. For example, an idea with a high level of reputational risk may not be acceptable unless it carries a very large potential upside. Conversely, a product with a low risk in terms of ability to execute may be acceptable when execution is considered in isolation but may carry excessive downside risk. For each of these factors, it should be possible to create a detailed policy, generally with appropriate input from other stakeholders in tax decisions (e.g. customer services, the CFO or the head of actuarial function).

Having identified the factors and set policy limits, each new idea can be compared to the matrix. This process simplifies the act of assessing ideas (allowing assessment to be delegated to business units or even to external advisers), generates a consistent approach across all business areas, and forms a risk management tool that can be held up as a key control over tax risk.

Accounting for tax risk

Local GAAP usually requires an accounting provision to be made against the possibility of a liability crystallizing, and tax exposures are no exception. In addition, the current market demands that there are no surprises from tax or any other segment of the company, with unexpected adjustments regarded unfavourably by analysts, investors and management.

The impact of stronger regulation and governance standards globally will undoubtedly lead to intensified focus on this area as shown by the increasing emphasis being placed on risk management by the FSA in, for example, the guidelines within the PSB. There are as yet no firm guidelines stipulated for this and it seems likely that best practice, as in risk identification and decisionmaking, may be informed by risk management techniques developed in other industries and financial services sectors.

Future best practice is likely to adapt these and other techniques so they are relevant and valuable in a tax environment. For example, one approach adopted in the international banking sector has been to assist banks in identifying in greater detail the sources of risk inherent in tax items and analyzing the individual sources and risk factors by reference to the quality of tax risk management processes. This leads to a standard methodology for analyzing tax risk, and the use of weighted averages and consistent processes can give a rigorous and more consistently objective analysis to generate a numerical probability factor. The difficulties inherent in assessing tax risk remain, but methodologies such as these can be used at least as a reasonably objective benchmark.

Also key in the current environment is the ability for tax departments to point to a methodology for accounting for risk, which adheres to the principles of good risk management and governance standards.

Documentation of tax risk

A key tension between best practices in risk management and tax risk is the basic principle that clarity, documentation and analysis of weaknesses leads to good risk management but may be considered a map for tax authorities to challenge tax treatments reflected in corporation tax returns. How can this be resolved? A strong tax risk management strategy will include a number of major focuses, including regular and systematic identification and quantification of risk and potential impact on shareholder value.

The starting point for considering these tensions is the basic principle that it is better to be well organised and aware of risks than to wait for an audit or challenge to discover the weaknesses. In the past, this view may have been debatable; today, however, adoption of a proactive risk management strategy may cut down time lost in fire fighting. In today’s governance environment, ignoring risk until it crystallises is not an option.

But the tension remains. Internal documentation assessing risk definitely is very sensitive and should be treated as such. Specific strategies can be adopted, such as creating legal privilege around the papers, or physically separating documentation from those which tax auditors are legally entitled to see. These issues are not created by a risk management strategy, however – they exist already. Every CFO should want to know periodically what the key tax risks are, and so documentation is created. During statutory audits, these issues are considered and trails of paper or emails become available for potential discovery. In addition, in the product development process the paperwork may include references to weaknesses, problems already created with the product, or references to "what the documentation must not say." The lesson to be learned from this, and the way best practice is developing, is that documentation management must be an integral part of a tax risk strategy; the risks must be assessed and processes put in place to manage these risks. By so doing, companies are becoming better able to limit an increasingly common cause of tax challenge – the "smoking gun" document or comment that was not identified and dealt with because the quality of documentation was not part of the tax risk process.

The future of tax risk management

UK life insurance companies are being challenged as never before on their risk assessment, measurement and management strategies. The tension between the need to create and preserve value while managing risk in a new, integrated and strategic way is adding new dimensions to the role of tax functions. Equally clear is that this challenge genuinely represents an opportunity the improvement of risk management, freeing up resources and creating new parameters for allowing tax people and tax departments to focus on adding value to the business. Existing best practices that have been adapted for tax are available and can be a key part of changing tax risk management processes to meet the challenge and take the opportunities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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