A recent report by Deloitte Research estimates that by 2010, outsourcing (including offshoring) could save a typical large financial institution almost £1.5bn annually, with an average cost reduction of 37% for each process relocated to an external provider.

In particular, the insurance outsourcing sector is one of the most advanced in Europe, employing between 12,000 and 13,000 in Britain alone. The outsourcing businesses are estimated to administer 9% of life and pension funds and 5% of insurance policies.

However, the outsourcing industry suffered a recent blow in respect of the insurance market. The European Court of Justice decision in Staatssecretaris van Financien v Arthur Andersen & Co Accountants held that certain back-office activities provided to an insurance company by an outsourced service provider do not qualify for exemption from VAT.

A result of this decision is that the cost effectiveness of UK and European outsourcing could be significantly reduced.

HM Revenue & Customs has recently finished a consultation exercise (which closed on 30 September 2005) in respect of the this case to amend UK VAT legislation and bring it in line with the court's judgment, and was likely to be implemented in January 2006.

But the Chancellor, Gordon Brown, announced in his pre-Budget report last week that he would delay implementing the legislation in the UK until a European Commission review of financial services is completed.

Since recommendations of the review will need the unanimous approval of the Council of Ministers, the VAT legislation is unlikely to be implemented here for several years.

If VAT were chargeable on many of the outsourced insurance related services it would be irrecoverable.

For existing contracts, much if not all of the burden of the new VAT ruling is likely to fall on the insurers themselves, leaving the original business case for the outsourcing project somewhat undermined.

This is symptomatic of a wider problem associated with long term outsourcing arrangements, whereby a deal which appears sound at the date of signature rapidly becomes less attractive as laws or circumstances change or develop over time.

There are however various mechanisms underpinning many outsourcing contracts that can (if correctly drafted) be utilised to prevent an outsourcing arrangement from becoming overpriced and uncompetitive.

There are also a number of 'hidden' areas in any outsourcing contract which unless correctly negotiated and managed during the life of the contract, may lead to significant price creep.

The following are some of the key areas where caution should be taken when negotiating any outsourcing arrangement in the insurance services sector:

Change Control
No matter how well the contract may be drafted, no one has a crystal ball. Accordingly, the contract needs to be sufficiently flexible to cater for changes in both technology and the customer's requirements.

However, such changes (particularly material ones) need to be agreed through a formal change control procedure and should be considered with the same degree of rigour as the initial pricing proposal.

From a customer perspective it is often desirable to seek to set some parameters within which pricing might vary if circumstances change (e.g using a pre-agreed formula for the recalculation for the price of certain foreseeable changes/additions to the services).

Benchmarking
One of the major challenges in any long term outsourcing arrangement is to capture the need for the services to evolve so that they remain competitively priced, of high quality and justify the customer's initial decision to outsource.

Under a benchmarking process, the price paid for specified services performed to set service levels is compared with a representative sample of similar contracts/projects.

The aim is to ensure that the cost and level of service remains in line with the market over time, and not just upon contract signature.

So for example, in the light of the VAT ruling, an insurance company whose outsource supplier has declined to share in any of the 'pain' associated with the VAT ruling may be able to effectively compel a price reduction, if other suppliers were offering their clients such price relief.

If benchmarking provisions are to be included in an insurance-related outsourcing contract, it is imperative that the benchmarking arrangements include an obligation on the supplier to implement the findings of the benchmarking exercise (as opposed to simply being a trigger for 'discussions'). In the event of seriously adverse results, a right of termination may be appropriate.

Continuous Improvement
Continuous improvement provides a basis by which a supplier is obliged to identify and implement improvements to the services during the lifetime of the contract. Successful drafting of a continuous improvement clause in an insurance-related outsourcing context will usually involve:

  • Identifying the types of improvement which the customer is looking to achieve (such as improvements to services, technological innovation and reduced costs)
  • Putting in place methods for identifying and monitoring the achievement of such improvement (such as. reporting requirements and management/governance provisions).
  • Addressing the consequences of implementing such improvements on other aspects of the contract (such as whether the supplier can charge for them, and if so on what basis)
  • Aligning the improvements with any other related mechanisms set out in the contract (such as regarding pre-agreed improvements to service levels, business transformation initiatives and shifting processes offshore).
  • One of the main factors in a successful continuous improvement regime, is ensuring that sufficient internal resources are provided by both parties to manage any proposed ideas are properly tracked and improvements are followed through the agreed process.

    If this commitment is not made, simple ideas may never develop into concrete improvements and this may in the long-term have a de-motivating effect on both parties.

    The customer should also insist that where the implementation of a continuous improvement plan results in the reduction of the supplier's costs in providing the services, the resulting savings made by the supplier should be passed onto the customer through a reduction in the charges.

    In conclusion, if ever implemented, the impact of the VAT ruling will have a significant cost impact on outsourcing in the insurance industry. It will accordingly be essential to ensure that competitive pricing in respect of such contracts is maintained through whatever means are available.

    However, the case undoubtedly threatens the VAT exemption for any large-scale business process outsourcing in the insurance sector in the UK/EU.

    But there remains a possibility that, where an insurer has outsourced its back-office operations to a non-EU location (for example India), the ruling will not have such a detrimental impact on the business case for the project.

    This is because under the current EU 'place of supply' rules, insurance administration services potentially can be deemed to be supplied where the supplier is based and therefore services provided from (for example) India will be outside the scope of the UK/EU VAT rules. This creates a further potential competitive advantage for offshoring outside of the EU. IT

    ' Kit Burden is a partner in the technology media & communications department of DLA Piper Rudnick Gray Cary

    The case that led to the VAT ruling
    Under Article 13(B) of the Sixth VAT Directive (77/388/EEC), EU member states cannot charge VAT on exempt insurance and reinsurance transactions (including related services performed by insurance brokers and insurance agents). With VAT in Europe generally ranging between 15% and 25%, this constitutes a significant saving.

    For many years, a view was taken that outsourcing back office functions would constitute the performance of "related services" by an insurance agent within the meaning of Article 13(B) above, so as to enable the outsource service provider to avoid the impact of VAT.

    Arthur Andersen & Co Accountants (now Accenture) provided various back-office services to a life assurance provider in the Netherlands. These included amending and managing policies, managing claims, setting and paying agents' commission, providing IT services and dealing with third parties (such as tax authorities).

    Arthur Andersen shared premises with the life assurance company and Arthur Andersen staff were trained in the life insurance business.

    In the contractual arrangement between Arthur Andersen and the life assurance provider, there was an exclusivity clause prohibiting Arthur Andersen from performing similar back-office services for other life assurance businesses.

    The question of whether Arthur Andersen's back office outsourced services were exempt from VAT under Article 13(B) was referred to the European Court of Justice.

    In March 2005, the court ruled that Arthur Andersen's services did not constitute insurance transactions by an insurance agent, as Arthur Andersen had no contractual relationship with the insured parties.

    In determining whether the services were "insurance related", it was noted that the exclusivity agreement between Arthur Andersen and the life assurer prevented Arthur Andersen from being described as an insurance broker under the Insurance Directive (720-92-EEC).

    Although Arthur Andersen's services "contributed" to the activities of an insurance company, the court accordingly held that ArthurAndersen's back-office services "do not constitute services that typify an insurance agent", and was not performing the "essential aspects of the work of an insurance agent" (for example, finding prospects and introducing them to the insurer).

    Accordingly, Arthur Andersen's services did not fall within the VAT exemption.

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