Increasing pressure on Bermuda
Bermuda faces pressures as a perceived tax haven, especially as a revenue-hungry US government scrutinises what are seen as tax advantages for onshore subsidiaries of offshore companies. Of particular interest is HR 3424, a bill in the US House of Representatives sponsored by Representative Richard Neal (Democrat, Massachusetts).
The measure, which has made little headway on its own but could find its way into broader tax legislation, would limit the tax deductibility of reinsurance premiums paid by US-based, foreign-owned insurers to non-US affiliates. Supporters say it would be a more equitable system, eliminating what they see as the unfair advantages that foreign-owned companies gain by moving premiums offshore.Opponents note that when premiums go offshore, so do the risks, providing critical relief to US domestic insurers. They fault the Neal Bill as protectionist, a violation of existing tax treaties and trade commitments, and potentially harmful to the US reinsurance market, given its high dependence on foreign-based capacity. They cite the threat that some foreign-owned companies might leave the US market rather than shoulder a higher tax burden, noting that measures such as the Neal Bill would affect offshore companies regardless of domicile. Their pullback from the US market would leave more risk onshore, along with its cost to insureds, opponents argue. As for tax advantages, opponents of the Neal Bill note that US insurers are able to invest in tax-free municipal bonds, an option not open to foreign companies.
Proponents of the bill make an inverse argument: with little need for tax-exempt income, foreign groups will only continue to take funds offshore that might otherwise help to support the tax-exempt bond market. They also argue that the measure would not affect capacity because it would specifically exempt third-party reinsurance. The law instead would apply to related-party reinsurance among affiliated companies that forms a part of the parent organisation’s capital management strategy. Supporters also say that with the market awash in excess capital, the Neal Bill would be unlikely to have any adverse effect on capacity or pricing. Concerning treaty obligations, the bill’s backers say it would be permissible because it addresses a “tax relevant difference” between foreign and US-based insurance groups, rather than conferring any tax advantage on domestic companies.
To the extent that Bermuda is the focus of negative attention for its tax policies, insurers on the Island may be forced to choose between access to the vast US market and whatever benefits flow from a Bermuda domicile. Some companies already have made the choice: a handful of Bermuda reinsurers have pulled up stakes for domiciles such as Ireland and Switzerland that enjoy a better perception in some circles. Short of full redomestication, other companies, such as Catlin and Lloyd’s insurers Amlin plc and Novae Group plc, have opened Swiss subsidiaries, in part to seize tax and regulatory advantages. Lowtax but not tax-free, such domiciles can help to blunt accusations of tax dodging, and they project an image of regulatory solidity. The financial implications can be powerful, especially if a non-US company is deemed to have a permanent establishment onshore, and branch taxes on subsidiaries can vary widely, depending on the parent organisation’s country of domicile.
A number of factors drove Bermuda’s development as an insurance hub, including the nature of the insurers and lines of business that first flourished there. Many were reciprocals, which enjoyed tax advantages similar to those of mutuals. The regulatory structure was built for speed, allowing them to open for business and bring their specialised, inventive policies to market with little delay. But many of the advantages that made Bermuda attractive have eroded somewhat, while domiciles such as Switzerland, Ireland, the Netherlands, Singapore and Luxembourg offer competitive perks. The tax and regulatory burdens on Bermuda-based companies are heavier than before and still growing with the approach of Solvency II, though Bermuda continues to offer superior speed to market.
Island domiciles also pose practical challenges on the ground. Bermuda’s government, for example, presses companies to give priority to hiring locally before bringing in foreign talent—a challenge, given the limited pool of qualified, home-grown candidates. And once expatriates clear the hurdles of getting permission to work on the Island, they face a high cost of living, stresses in accommodating their families and formidable barriers to owning property.
The pattern of company formations in Bermuda has meanwhile become so familiar that its reinsurers are grouped into classes by the years of various triggering events—Hurricane Andrew in 1992, September 11, 2001, and hurricanes Katrina, Rita and Wilma in 2005. As predictably as private equity flows in to replace capital depleted by such events, it seeks to exit at about five years. The Class of 2005 has been no different, but actually making that exit has been more difficult than for past classes. Some of these companies have begun to return capital to shareholders through repurchases or dividends, as well as through mergers. But the latter course has become especially challenging.
Consolidation: A will but little way
Excess capital and a soft market typically make ripe conditions for consolidation, and there have been some significant transactions over the past 18 months—most notably, PartnerRe and Paris Re, Max Capital and HarborPoint, and Validus and IPC. But a bleak outlook for profitability has reinsurers across the board trading at similar valuations, near or below book value. This means that there are bargains to be had, but little currency for completing them at the premium sellers’ investors normally would expect. The rationale for transactions then becomes less numbers-driven, and based more on companies having compatible visions and strategies, and a shared expectation of a longterm pay-off.
The constrained market for mergers and acquisitions comes at an awkward time, particularly for smaller reinsurers that are running up against primary insurers’ increasing interest in the balance sheet size of their reinsurance counterparties. At the same time, primary companies are looking to diversify their reinsurance programmes, making the placement of coverage a balancing act for all parties. Some reinsurers are meeting the perceived demand for greater scale through mergers and acquisitions such as those mentioned above, while others are resisting the pressure and holding to specialist strategies.
A handful of reinsurers are looking to diversify their business away from a monocline property catastrophe model, and they are reaching a crossroads: do they pursue some form of merger or acquisition to achieve that diversification, or do they retreat to their established niches? Organically reaching a critical mass of premium volume and experience in new lines of business is difficult.
Some companies are pursuing organic growth by establishing new platforms, particularly in continental Europe and at Lloyd’s. Europe is particularly challenging to outsiders, as established players often have long-standing relationships with primary writers that are hard to break. Lloyd’s, meanwhile, offers a well-rated platform with a solid distribution model. Allied World and Chubb are among those establishing new syndicates. These may bring new business to Lloyd’s, but that business also may be cannibalised from other markets.
A.M. Best’s website is: www.ambest.com