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Why to Simplify Corporate Structures

With their variety of business strategies and product innovations, financial services organizations often have very complex corporate structures. The mix of regulated operating, distribution, investment, holding and dormant companies – together with various special-purpose vehicles – means that few employees fully know the complexity of an enterprise’s legal entity structure.

Generally, management prefers simplicity and accountability. Accordingly, it typically organizes enterprises into distinct, separately managed, strategic business units (SBUs), which are overlaid on top of the existing legal entity structure, with the SBUs sharing various legal entities. This management approach creates a simplified internal view of financial performance relative to the legal entity structure; however, it often masks the considerable extra work (and therefore potentially avoidable cost) associated with the corporate structure within an organization’s corporate accounting, tax and other back-office functions.

Few organizations start off with a complex corporate structure or seek to achieve one, but a combination of factors can lead to complexity:

  • Growth by acquisition – Entities inherited as part of an acquisition and entities (such as holding companies) formed to make acquisitions;
  • Tax strategies – Entities formed to minimize multi-jurisdictional taxation, preserve the utility of tax attributes (such as basis, losses and credits) or effectively manage product state taxes;
  • Historical regulatory requirements – Companies formed to facilitate various regulated pricing tiers (particularly in property and casualty (P&C) insurance); and,
  • Business line expansion and reorganization – Organic growth into new product areas, alignment within different market segments (sometimes under reinsurance pooling arrangements), discontinued business, etc.

Complexity adds to administrative costs and can slow production of management information. In the capital structure work that PwC performs, we frequently find that a company’s structure is out of date; for example, the original rationale for a tax planning structure is no longer applicable because of a change in law, or a legal entity structure established to facilitate a line of business has survived even though the line of business has not. As another example, an entity that was established before the advent of the entity classification election regime (i.e. “check the box” rule) now may be unnecessary to achieve the intended tax benefits. Accordingly, organizations should examine the costs and benefits of maintaining current structures.

The complexity of corporate structures in financial services is evident in the insurance industry’s use of legal entities. As the table below shows, among P&C and life and health (L&H) insurers, the top 25 insurance groups hold a majority of industry capital (69% in P&C, 58% in L&H). Despite this concentration, there is evidence that inefficiencies exist: There is a high number of dormant entities relative to total legal entities and the number of domiciles some groups are managing. The number of domiciles tends to be five or fewer for most insurers, but in some extreme cases there are as many as 12 domiciles for P&C companies and 31 for L&H companies (primarily because of health maintenance organization (HMO) entities). When factoring in the potential costs (real and opportunity costs) of maintaining unused or underutilized legal entities, the impact on the industry as a whole is very real.

Insurance industry capital is relatively concentrated
P&C L&H
Groups ~330 ~250
Legal entities ~2,700 ~1,800
Capital in top 25 groups 69% 58%


But there are indications of inefficiency

Dormant entities 150+ 300+
Fronting entities 500+ 100+
Range of domiciles/groups 1-12 1-31


Source: SNL, PwC Analysis

Legal entity cost

Organizations rightly consider the costs of administering legal entities a normal part of doing business. Such frictional costs vary by organization and entity usage and typically include:

  • Financial reporting costs – Licensed insurance companies require separate annual and quarterly financial statement preparation in their state of domicile. The time spent on statement preparation correlates to complexity. The greater the number of legal entities, the greater the complexity and the higher the risk
    of misstatement.
  • Auditing costs – These costs will vary with the size and complexity of the balance sheet. Again, costs tend to be correlated with complexity (e.g., degree of intercompany transactions, complex reinsurance structures, investments/financial products, etc.).
  • State assessments – Premium or loss-based assessments for a variety of state programs will vary in size relative to the business written in the legal entity. It is important to recognize that minimum assessments also can apply even when business is no longer written on a direct or net basis.
  • Regulatory exams – State regulators conduct both market conduct exams and financial exams of insurance companies domiciled in their respective jurisdictions. Market conduct exams occur on an as-needed basis and relate to examination of operational (sales, underwriting, claims) business practices. Certain domiciles are more challenging than others. Financial exams occur every three to five years, at the insurance company’s expense.
  • Tax – Each legal entity in the structure adds to the company’s overall compliance burden, as insurance companies are required to prepare and file forms with state and federal tax authorities on a periodic basis even when dormant. A company also may be required to respond to periodic inquiries about its activities, or lack thereof, and may be subject to minimum taxes and filing fees. Active operating companies must monitor and manage the interplay of premium tax rates and retaliatory taxes, which arise when states in lower tax jurisdictions increase state taxes to match the level of the domicile state, if it is higher.
  • Management time – Spans all of the above areas. The more complex a legal entity structure, the more time middle management and, in some cases, senior management have to spend on issues related to excess legal entities.

In light of these frictional costs, the expense of administering an overly complex legal entity structure can be considerable. Eliminating redundant or unused entities through merging companies, outright sale of the insurance company (or companies) or clearing out the liabilities and selling a “shell” company can result in significant savings.

Improving access to capital

Moving capital through legal entities can be complicated by regulatory constraints and often involves frictional costs such as sub-optimal tax consequences (e.g., withholding taxes on dividends from a foreign subsidiary and excise taxes on premiums paid to a foreign affiliate). Capital trapped in dormant or underutilized entities will provide sub-optimal returns and therefore serve as a drag on the overall group return on equity. For example, an organization with a 15% corporate required rate of return and a 5% average investment portfolio rate of return has a 10% opportunity cost of maintaining the capital in a redundant legal entity. Accordingly, one of the few positive outcomes of the financial crisis has been insurers’ streamlining their corporate structures to simplify internal access to capital and gain capital efficiency.

One method of improving capital deployment in a dormant or underutilized entity is through merger with a continuing entity. However, before merging a licensed company out of existence, insurers need to consider the marketability of the unwanted entity in terms of the number and location of state licenses, the degree to which the company has gross liabilities, the type of liabilities (e.g., excluding asbestos and environmental), the domicile state, the credit quality of the counterparty backing the reinsurance contract or contracts used to create the shell, etc. In light of the regulatory hurdles and time delays that accompany the obtainment of state licenses, there is a market for selling licensed companies as “shell” companies. The process typically requires transferring insurance liabilities out of the legal entity through indemnity – or preferably assumption – reinsurance. This market has yielded significant value to its customers. That said, it is critical to gain proper restructuring advice before entering into these transactions because undesirable accounting and risk-based capital outcomes can result from poorly structured reinsurance transactions.

Simplifying corporate structure: Opportunities & challenges

Eliminating unnecessary organizational complexity and reducing associated frictional expenses are the main reasons to undertake a corporate simplification program. The benefits of corporate simplification are:

  • Streamlined financial management across a manageable number of entities;
  • Removal of unnecessary frictional costs;
  • Reduced overall state tax burden, leading to competitive advantages in market pricing;
  • Consolidation of entities within favorable state regulatory environments;
  • Identification of alternative capital structures or mechanisms to free trapped capital for the top-tier company to use for other purposes;
  • Generation of capital through the sale of unnecessary licensed companies as “shell” companies.

However, the simplification program does present some challenges:

  • Internal resource constraints may limit design and implementation of the simplification;
  • Regulatory approvals for material changes may prolong implementation;
  • Product filings may need to be updated;
  • Re-domestication of entities may present political or regulatory issues (including perceived or real job losses or transfers, closed block regulatory requirements, etc.) that can delay the process;
  • Changes in legal entity structure can affect near-term business operations and supporting technology platforms. For example, changes in legal entities used by the insurance underwriting organization may require process changes in the distribution channel as new and renewal business is mapped to different entities;
  • Selling or merging active operating companies can also present challenges for management, including: identifying intercompany accounts between merged entities; updating intercompany agreements, such as intercompany reinsurance pooling agreements, to reflect the changes; cleaning up outstanding legal entity accounting reconciliations, if any; re-mapping ledgers for historical data; re-mapping upstream company eliminations; creating and maintaining merged company historical financials for statutory and GAAP/IFRS financial statements; locating and analyzing details of historic tax attributes (such as basis and earnings and profits) and studying qualification for tax-free reorganization; potential reversal of subsidiary surplus impacts from asset purchase/sale transactions within the holding company structure; and potential scrutiny over differing methodologies, if any, used for accounting (e.g., deferred acquisition cost) or actuarial reserve methodologies used by the entities to be merged.

The corporate simplification process

Many large insurance organizations have some level of corporate simplification on their annual to-do list, but the initiative often gets pushed aside because of gaps between corporate and business priorities and available resources. The corporate simplification process requires a champion who can take into account and balance varying points of view, call upon required resources, facilitate project management and authorize access to subject-matter expertise. Moreover, a corporate simplification program must balance corporate (tax, regulatory, governance and financial reporting costs) and business (customer, distribution, products, process and technology) needs and considerations. Depending on the complexity of the organization and underlying challenges, a simplification initiative can take several months to well over a year.

The three stages of such an initiative include:

  1. Assess – The ultimate goal of a corporate simplification process is a streamlined corporate structure that corresponds to business core competencies and strategy. This structure will have an efficient balance of cost, risk, regulatory, tax, capital, governance and operational parameters that aligns business operations with the legal entity structure. In the initial phase of the initiative, representatives from corporate and business areas must come together to review the current use of legal entities and create the desired future organizational structure, as well as take into account the existing corporate environment (rather than what existed in the past). If the simplification effort is part of a broader business unit re-alignment, the assessment and design phase will require a significant commitment of time and effort to redefine the desired business strategy. If the simplification is taking place within a well-defined business unit structure, then the focus can be limited to streamlining and reducing overall cost within the existing business unit strategies.

A complete inventory of legal entities should be created outlining information such as the business use, applicable business unit, domicile, direct and net business written (for insurance companies only), required/minimum capital, actual capital, potential for elimination, and other information as defined by the group. Furthermore, to complete the assessment of the simplification effort, a business impact analysis that includes a premium tax analysis by state domicile and a regulatory domicile analysis should occur at this stage. Companies also need to carefully look at their portfolio of companies to ensure they have the entities they need today and for the near future.

  1. Design – As the plan starts to take shape, the project team must conduct a deeper analysis of accounting, business and technology transition issues. The deliverable will be a proposed road map that:
  • Outlines a streamlined legal entity organization structure with greater capital efficiency and alignment with business strategy;
  • Identifies the proposed combinations/eliminations of insurance and non-insurance entities;
  • Describes the proposed movement of capital (including extraordinary dividends required) and reinsurance transactions to effectuate the change (if applicable); and
  • Establishes a communication plan within a high-level timeline.

This outline of proposed changes must be well vetted internally before the organization approaches regulators, rating agencies and other constituents.

  1. Implement – Once the design is ready, project management and subject-matter expert resource requirements must be confirmed. Program and change management and associated governance structures are critical throughout the planning and implementation phases as the number of work streams, constituents, interdependencies and issues can be substantial for larger-scale simplification programs. Once the team is in place, it must create detailed implementation project plans, identify quick wins, establish an effective communication plan and establish an issue/dependency management process. Communication to all constituents – employees, sales force/agents, regulators, rating agencies and policyholders – is vital in any simplification initiative.

Following the design phase, those entities that have common activities, objectives, operational process or customer segmentation can be merged, which should effectively align business and legal entity structure. The remaining, redundant legal entities should be eliminated, sold as-is or sold as a shell. This final step will result in cost savings and the raising of new capital through the sale of licensed shell companies.

chart 2

Conclusion: Corporate simplification is a priority

In light of the need to be nimble while reducing costs, corporate simplification should be at the top of the corporate to-do list. A well-managed corporate simplification program provides strategic alignment of entities, reduces costs and facilitates more efficient use of capital. The companies that execute an effective corporate simplification process and maintain a commitment to simplification over time will succeed in reducing costs and be able to devote their time and attention to valuable activities.

How to Find Capital, Operating Efficiencies

Companies should review their use of intercompany reinsurance, through either individual or pooled quota share agreements. If insurance companies (particularly in the property & casualty (P&C) sector and possibly health maintenance organization (HMO) sector) can do this correctly, they can achieve capital and back-office operational efficiencies without disrupting “business-as-usual” front office operations.

Inter-company reinsurance efficiency opportunities

PwC sees opportunities for:

  1. Companies that have intercompany reinsurance pools or quota share agreements in place to become more efficient, and
  2. Companies that do not currently use or have limited intercompany pooling and quota share to expand the use of these concepts.

Increasingly, regulators are open to these modifications, provided policyholders are not put at a disadvantage.

A well-designed intercompany reinsurance structure can result in a number of efficiencies. Specifically, by establishing 100% quota share or 0% retrocession pooling agreements, a group of P&C companies can move all retention to a single “lead” company. The goal is to have the lead company retain the bulk of the insurers’ capital and investment portfolios while ceding companies maintain only minimum surplus levels. The lead company would become the only company where capital needs to be actively managed and would have a larger, consolidated investment portfolio.

Companies (particularly P&C) that retain a relatively large number of legal entities after simplification may find a single pooling agreement more straightforward than managing multiple affiliated reinsurance agreements. However, multiple quota share agreements may streamline future changes for events such as divestitures and acquisitions. Note that multiple agreements transferring business back and forth between the same legal entities will need review and most likely simplification. In those instances where centralization of capital with the lead company is not possible (e.g. mutual affiliations, regulatory requirements), the pool percentage should follow the capital position of all participants (including the lead company). Even companies that have significantly simplified their corporate structure can tie their remaining legal entities together with a common-sense pooling agreement that supports their operating strategy.

Key benefits

  • Diversification of underwriting results and earnings by legal entity: Pooling enables a larger spread of risk, allowing for less variable earnings and more predictable dividend streams by legal entity. For 0% net retention structures, including 100% quota share, the lead company enjoys the same diversification.
  • Improvement in capital position or financial strength ratings: If this is not the case already, the companies will be rated on a pooled (p) or reinsured (r) grouped basis, reflecting their combined financial strength. Additionally, this increase in financial size and diversification can improve the A.M. Best capital adequacy ratio (BCAR).
  • More efficient capital management: Companies can better centrally manage capital while retaining minimum required capital in pool/quota share participants and allocating premiums based on surplus capacity. This can help insurers manage premium to surplus ratios. Pooling and quota share also provide more efficient access to total capital by centralizing capital and avoiding dividend traps in subsidiaries.
  • Operational efficiencies: Pooling integrates various businesses’ finance and back-office operations, can provide momentum for more standardized and centralized reporting functions and can reduce frictional costs associated with the record-to-report function. Some potential efficiencies include: fewer intercompany agreements; lower audit fees from increased materiality thresholds and a combined statutory audit; consolidated regulatory exam; a more streamlined investment management function; and simplified reporting requirements (for 0% net retention agreements).
  • Marketing and branding: Some companies have been able to go to market as a group entity (particularly by affiliations of mutuals), which carries a larger financial size category (FSC). FSC is particularly beneficial for mid-size companies trying to gain market share in the broker market for commercial lines.

Challenges

While insurers operate within similar structures and against similar pressures, every company is different. There are a few common challenges we have encountered with our clients while designing and implementing intercompany pooling and affiliate reinsurance:

  • Disparate organizational groups, processes, and technologies: Affiliate reinsurance requires results from potentially disparate processes that may have different timing and data quality. Recording pooling entries may prove especially difficult for companies on multiple general ledgers. For the close, the combined pool is only as strong as its weakest link. This will be especially evident with subsidiaries that may have a streamlined close process but are dependent on other participants to close their books. We have seen companies undertake significant close process improvements to operate efficiently in a pooling agreement. This can be somewhat alleviated by structuring multiple affiliate quota share agreements in place of a pooling arrangement.
  • Additional requirements for generally labor intensive processes: It is not uncommon for insurers to have significant manual processes for calculating incurred but not reported losses (IBNR) or producing relevant disclosures such as Schedule P and F. Having distinctly different timing of key calculations and inputs can be a burden that all participants have to share.
  • Data management and quality issues: Companies that generally operate in silos, on separate ledgers, different chart of accounts or even make inconsistent use of chartfield values can find it more operationally difficult to execute pooling and difficult to leverage automated solutions.
  • Blending different businesses within results: Disparate operations and reporting groups that previously performed duties related to specific lines of business may find it difficult dealing with the new assumed business. For example, certain reporting disclosures required only for specific lines may become applicable to all participants in the pool.

Thinking “outside the box” to maximize value

Optimizing the benefits of affiliate reinsurance may result in arrangements that have previously been considered non-traditional, or at least lacking significant industry precedents. We encourage companies to maintain an open dialogue with regulators and rating agencies and believe that demonstrating a positive impact to operations, financial strength and overall policyholder benefits, outweighs lack of precedent.

  1. Centralizing capital and gross written business, where possible, is often the preferred structure for P&C companies: Zero-net-retention arrangements are a way to improve capital efficiency. While we have generally seen these structured as 100% quota share reinsurance, it may also be also possible to structure or modify a traditional pooling agreement to cede 100% of written premium to a lead company, with a 0% or minimal retrocession. Some key benefits we have seen include:
  • Capital management efficiencies – 0% net retention structures allow for minimum retained capital across the legal entities, centralizing on a lead company. This streamlines the capital management process and can simplify asset/liability management.
  • Financial reporting efficiencies – Centralizing net written business on a lead company can significantly reduce overall reporting requirements across the organization. Legal entities with 0% net business can discontinue certain laborious schedules (e.g. Schedule P Parts 2-4) and other reporting requirements for net business. Similarly, by retaining minimum capital on legal entities, investment disclosures can be simplified (e.g., fair value disclosures). Overall, we have seen companies reduce the statutory annual reporting pages by 50%, which can be compelling for larger organizations.

You should work with regulators to shift capital to the lead company in the most efficient way (usually at the inception of the pooling agreement).

  1. There are benefits for certain lines of business that have traditionally not been considered for pooling:
  • HMOsRequirements for HMOs to have legal entity domicile in each state in which they do business yields a corporate structure with a large number of thinly capitalized companies. Pooling can improve the capital efficiency, as well as reduce some other operational burdens. While this does not have significant industry precedent (within affiliated pools), we see no reason an agreement would be disallowed solely because an HMO is involved.
  • Significantly different businessRemoving preconceived constraints allows further expansion of potential opportunities and related benefits. We have assisted companies implementing agreements that have a mix of significantly different lines in the pool and have seen specialty insurance business (e.g. excess and surplus, program, crop, reinsurance, etc.) pooled with mainstream personal and commercial insurance. While there can be related challenges, if there are tangible benefits to diversification, then those challenges can be justified and overcome in the long run.
  1. The lead insurer does not have to be the parent company. In the same spirit of thinking outside the box for pool participants, we have found the lead company may not always be an obvious choice, particularly where all participants share percentage retention in the pool. The selection of the lead company should take into consideration the following:
  • Licensing – Requires licensing in all domiciled states of pool participants, all states of participants for retrocession and for all lines of business.
  • Domicile and regulatory environment – It is preferable to choose a lead company in a state of domicile where the organization has a favorable relationship with the regulator. Existing reinsurance arrangements or recent business restructurings are helpful. It is also critical to maintain open dialogue and communication with the regulator.
  • Capital size and efficiency – For larger companies or those with a more complex corporate structure, this can be a more difficult decision. Consider the efficiency of passing excess capital to an ultimate parent and avoid potential dividend traps. It is not always a parent company or the largest company that is best-suited to be the lead company.
  • Marketing and branding – For some companies, branding and marketing may become a factor in choosing the lead company. Some highly acquisitive companies may find certain lead companies inconsistent with their branding strategy.

Key considerations

We believe that intercompany pooling and quota share arrangements need to align with a company’s objectives and strategy and must be operationally feasible. It is often beneficial to have a third-party perspective that is not biased toward specific ingrained processes or behaviors. In particular:

  • Assess how well your people, process and technology can meet new demands.
  • Look beyond finance to consider various internal stakeholder perspectives, including actuarial, risk, investment, reinsurance and business leaders, as well as external constituents such as regulators, rating agencies and investors.
  • Because of the breadth of people, process and technology that will be affected, we recommend implementing a senior-level steering committee to oversee and drive design and implementation.

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In conclusion

There can be tangible benefits from re-evaluating or implementing intercompany pooling and affiliate reinsurance. This can further streamline the corporate structure, based on pre-determined objectives and supporting parameters. We encourage insurers to keep an open mind when designing pool parameters, including lead company selection. Maintaining an open dialogue with regulators and rating agencies is critical, particularly when setting a precedent with a particular pooling arrangement.