Transfer pricing perspectives: Winds of Change - PwC

Why would a business agree to sucha mechanism?There are innumerable instances ofparties seeking to limit their risk at arm’slength.What they are prepared to payin order to do so depends on the natureof the risk being minimised, and thetechniques used will vary depending on thecommercial circumstances.In instances where parties are transactingwith one another from an operationalperspective, the risk can be managedthrough the contractual terms. In principalstructures, risk can be determined inthe contract and through the pricingmechanism, much in the way that it wouldbe in any arm’s-length sub‐contractingsituation, such that the sub‐contractorsdo not bear risks over which they do nothave control.Where the parties are not transactingwith one another operationally, then aseparate mechanism is required to rewardor penalise the party taking the risk. Atarm’s-length, the kind of mechanismsavailable will range from traditionalinsurance (which mitigates, rather thantransfers risk) to complex risk-sharingmechanisms included in Public PrivatePartnership (PPP) contracts.In the case of PPP contracts, significantrisks may be transferred from governmentto a private sector company. The PPPcontract will often set out in detail thepotential risks, which risks each partyshould bear, who is responsible forarranging insurance, and the process forrisks that become uninsurable.In a typical insurance case, the insurerwould not necessarily have control over therisk that is being underwritten, whereas theOECD Guidelines state that in arm’s-lengthtransactions it generally makes sense forparties to be allocated a greater share ofthose risks over which they have relativelymore control.One may argue that in practice, for sometypes of insurance, the underwritingparty will try to exert some control overthe risk by way of conditions attached tothe insurance (e.g. requiring to activatea burglar alarm in a home each timeone leaves the house, the minimumrequirements for locks, the use of firealarms). However, in a commercial context,traditional insurance will not play amajor role in controlling the risks whichit has underwritten. But, it is importantto remember that insurers are involved inmany situations where risk events occurand insurance claims are made. This wealthof information and experience meansinsurers are often able to provide guidancearound common risk causes and effectivemitigation or control approaches. A goodrelationship with an insurer may enable oneto tap into that experience to help reducerisks, become more attractive to insurersand hopefully achieve a lower premium.Increasing outsourcing of services alsoallows transfer of some risks to theproviders of these services. However, it’simportant to recognise that not all risks canbe ‘outsourced’ and that some risks, evenif managed by third parties, will ultimateremain with the company. A clear exampleof this is reputational risk.Where the parties are not transactingwith one another operationally, a separatemechanism is required to reward orpenalise the party taking the risk38 Transfer Pricing Perspectives. October 2011