Ch3 - Taxation of General Insurance

Taxation of General Insurance Business

• Taxation impacts policyholders, general insurance companies (mutual and proprietary), and Lloyd's syndicates with their members
• Regulatory, legislative, and taxation environments affect the insurance market and how general insurance companies operate

Introduction to Taxation of General Insurers

• Taxation details vary across jurisdictions, but the goal is to provide an overview of common areas impacting general insurers
• Focus primarily on UK experiences
• Tax considerations affect product pricing and profit reporting for insurers
• Exam questions require taxation consideration
• Corporation tax, insurance premium tax, and value-added taxes are all factors
• Stamp duty, employment-related taxes/duties, and anti-avoidance measures are not covered
• Proprietary general insurers are considered first, followed by mutual insurers and the Lloyd's market
• Other taxation forms relevant to general insurers are also investigated

Taxation of Proprietary General Insurers

• Incorporated companies may be tax residents if incorporated locally or overseas and managed/controlled in the country
• Tax-resident companies may be subject to corporation tax on worldwide profits
• Option to elect not to be taxed on profits from foreign permanent establishments (branches) may exist
• In the UK, this election must apply to all of the company's foreign permanent establishments
• Actuarial calculations should consider all potential taxes
• Tax profits may differ from financial statement profits
• UK companies are taxed on the prior accounting year's profit
• Starting point for taxable profit is statutory returns based on standard accounting principles, adjusted for tax accounts
• Differences between published and tax accounts relate to investment return, underwriting result, other items like depreciation and disallowable entertaining, and foreign profits

Investment Return

• A general insurer's investment return includes income and gains from government and corporate bonds, deposits, equities, collective investment schemes, real estate, and stock lending fees
• Some regions do not differentiate between investment income and gains for tax purposes, taxing both as income
• Mutual companies may be treated differently from proprietary companies
• Can broadly distinguish the investment return arising from loan relationships and equities
  • Loan relationships: Technical tax term describing money debts from lending, like corporate/government debt, deposits, and collective schemes predominantly investing in loan relationships
  • Authorised accounting methods can be used to calculate the return from loan relationships
  • An example of this is fair value basis
• Dividends may not be taxed under some regimes, regardless of origin, but are subject to anti-avoidance measures
• Gains on equities, whether local or overseas, may be taxed as income when accrued in financial statements or only upon realisation
• Miscellaneous income like stock-lending fees are generally taxed when earned and recognised in financial statements
  • Stock lending fees are paid to bodies which will lend stock without actual transfer of ownership, potentially generating income

Underwriting Result and Provisions

• General insurers determine underwriting results using local Generally Accepted Accounting Principles (GAAP)
• UK GAAP principles focus on deferral and matching of assets and liabilities, which can deviate from reality
• Deferral of acquisition costs is acceptable but arguably not realistic
• Regulators are concerned that UK GAAP principles are unfair, leading to rectification efforts
• Insurers are working toward compliance with IFRS 17, effective January 1, 2023
  • Not all countries will adopt these standards
  • The original implementation date was January 1, 2021, but was delayed for two years
• Insurance companies may want to defer tax payments by setting up large reserves, but tax authorities like HMRC will scrutinize unnecessarily large reserves
• The key question is whether the reserves are appropriate
• Insurance technical provisions are typically deductible if calculated under local or International GAAP
• Tax legislation might limit tax deduction to the appropriate amount
  • Insurers file tax returns based on financial statement figures, but tax authorities may inquire into these figures
  • The appropriate amount depends on whether the company has a written opinion supporting the financial statement figure
    • If supported by an actuarial opinion and confirmed in the tax return, financial statement figure will stand for tax purposes
    • If not, the appropriate amount may be changed
  • UK example: Changed to undiscounted best estimate, if less, and excess is disallowed for tax purposes
    • Disallowance may be allowed to reverse in the next year, subject to further disallowance
• Actuarial opinion must comply with actuarial standards and confirm the amount is not excessive based on information at the time the financial statements are adopted
• Additional powers could be used to commission an independent report but is uncommon, and enquiries are usually resolved based on provided information
• Equalisation provisions are not strictly technical provisions.
• Transfers to and from equalisation provisions may be dealt with under different rules.
• Reported claims provisions are generally allowable, with potential requirements from local tax authorities like case estimates or statistical projections
• Statutory returns show claim payment amounts and reserve changes, split by underwriting, origin year, and class
• Comparing reserve changes with payments can indicate persistent over-reserving.
• Provisions for unearned premiums (UPR) should be calculated accurately and may be subject to certain conditions
• Acquisition costs relating to unearned premiums may be deferred through a deferred-cost asset
• Circumstances leading to disagreements between insurer and tax authority over UPR size:
  • Poor data quality (e.g., business sold through building society)
  • Non-uniform risk spread over the year
  • Allowance for deferred acquisition costs: Bigger allowance = higher reported profit
• The term used is URR and AURR
• Remember that the term can be used in either way, so always define it
• Is the insurer setting up an AURR justified accounting-wise
• Is the tax authority justified in not allowing AURR
• AURR complies with the concept of prudence but goes against the principle of accruals.
• Provisions for IBNR are usually acceptable under tax regimes but may be subject to justification for the existence and extent of such claims.
• This would be most difficult in classes subject to great claim variation, particularly those where latent claims may exist.
• CHE provisions may be allowable under different tax regimes and may be subject to the extent that the expenses relate directly to claims for which claims provisions have been accepted by the local tax supervisor.
• Tax supervisors examine claims handling expense provisions to test if the provision is calculated with sufficient accuracy to enable the provision to be considered 'specific' and therefore tax deductible.
• Insurance technical provisions claimed for tax purposes are usually net of amounts recoverable from reinsurers
• It may be necessary to assume that all amounts due will be recovered for tax purposes
• A deduction may be allowed for specific provisions for amounts estimated to be irrecoverable from reinsurers, but a general provision is not allowed
• A provision set aside for a specific reinsurer can only be deducted for tax purposes if there are doubts over their ability to pay specific recoveries
• Rules governed to the reserve (which were tax deductible, unless the company elected otherwise) and transfers from the reserve (on which tax was payable, unless the company elected not to claim a tax deduction when it was set up).
• The charge to tax on the release of provisions held at 1 January 2016 is spread over a six-year period, with the insurer having an option to pay the full amount remaining at any stage in the six-year period.
• Provisions for future catastrophe losses are not allowable under Solvency II, although they may still be allowed in some other jurisdictions
• They were previously deductible under the equalisation reserve rules in many EU countries
• A catastrophe reserve might be thought of as a specific example of a claims equalisation reserve
• The money is released from a catastrophe reserve only when a specified event occurs

Other Considerations for Proprietary Insurers

• Tax law may require adjustments to profits or losses in financial statements, like disallowing business entertaining expenses.
• Depreciation and some amortisation charges are not allowed either.
• Special rules exist for calculating capital allowances (allowable tax depreciation) and tax deductions for amortisation of certain intangible fixed assets
• A general insurer carrying on business through a permanent establishment outside its local region may be liable for foreign taxes.
• Foreign withholding tax on dividends and interest may be suffered on foreign investments
• Foreign taxes may be credited against local corporation tax or allowed as a deduction in computing taxable profits, subject to complex rules.
• Resident companies may elect (irrevocably) not to be taxed locally on profits or losses attributable to foreign permanent establishments, removing these from tax consideration
• If the company elects for the branch exemption, foreign taxes that relate to exempt foreign branches may not be credited or deducted against the local tax.
• Proprietary general insurance companies typically pay corporation tax on taxable profits with credit relief potentially available for foreign tax
• Corporation tax is paid in a set way, with interest for late payments and penalties may arise from underestimations.
• The rate of UK Corporation Tax is 19% but is due to increase to 25% in April 2023
• Proprietary general insurance companies sustaining a tax loss may not have to pay corporation tax
• Common ways to relieve trading losses:
  • Carried back and set against the previous year's profits
  • Carried forward and set against future trading profits
  • Surrendered to other companies in the same regional tax group and offset against their taxable profits, subject to branch restrictions within a group
• The amount of losses that can be transferred or carried may be restricted depending on the regional tax decisions
• Losses can also be allowed for in the calculation of capital under Solvency II and is called the loss absorbency capacity for deferred tax

Taxation of Mutual Insurers

• Key features include the following:
  • Underwriting losses and profits from mutual trading may be exempt from tax, and tax relief may not be given for expenses related to the mutual trade
  • Investment return is taxed independently, with loan relationships potentially taxed differently from other investments
• If a mutual insurer has an underwriting loss, it may not be offset against the gross investment return
• Few mutual general insurance companies exist
  • Many Protection and Indemnity Clubs have special arrangements with local tax authorities
• Long-tail classes of business are likely to be uncompetitive for mutual insurers
  • Investment income is more significant, and the underwriting result is negative

Taxation Within the Lloyd's Market

• Tax is levied on individual and corporate members of Lloyd's
• Each member is taxed in the UK on its worldwide Lloyd's profits, subject to branch exemption election (if a corporate member)
• The taxable profits consists of :
  • Share of profits / losses from syndicate activity
  • Profits / losses from activity outside the syndicate (member-level items)
• Syndicate results are calculated based on the syndicate's Year of Account results with deferral in taxing
  • The Year of Account 2021 result is taxed in 2024
  • If a syndicate does not close after 36 months, the result at 36 months is taxed in Year 4, and the annual movement is taxed each subsequent year until it closes
• The syndicate managing agent is responsible for declaring the tax result, agreeing it with HM Revenue & Customs
  • The syndicate result is then attributed to the participants
• Any challenge by HMRC to the level of technical provisions is made the level of the syndicate result
  • Adjustments need to consider any reinsurance ceded at the member level
• Apart from certain timing rules relating to member-level reinsurance and amounts payable to a syndicate managing agent, the member-level result is generally calculated on a current calendar year basis
• Premiums ceded by corporate members under member-level reinsurances and recoveries made by members under member-level reinsurances are taxed in the same period as the relevant syndicate Year of Account
• Where a member-level reinsurance is entered into for a calendar year, sums must be apportioned to the constituent Years of Account for tax purposes
• Amounts payable by a member to a managing agent are also taxed on a syndicate Year of Account basis
• Members declare in their tax return both their share of the relevant syndicate result and any other (i.e., non-syndicate) income and expenses
• Compared to proprietary general insurers outside Lloyd's market, Lloyd's members have a deferral of taxation on underwriting/related investment return within the syndicate premiums trust fund until the fourth development year
  • The tax benefit on losses is also deferred
• Lloyd's corporate members benefit from the same dividend exemption rules as other UK general insurers and so these are tax exempt where a mark to market basis of valuation is used
• Individual members and partners in members that are partnerships continue to be taxed on dividends
• Lloyd's corporate members were able to set up Claims Equalisation Reserves for tax purposes, existing only for tax and not a regulatory requirement
• Lloyd's Claims Equalisation Reserves tax rules were repealed with the introduction of Solvency II for accounting periods ending on/after January 1, 2016, with a six-year period for taxing accrued provisions
• A significant portion of Lloyd's profits are subject to tax overseas as arising in foreign permanent establishments
• The effective tax rate depends on how corporate members obtain credit relief against UK tax for those foreign taxes
• Generally applicable UK double taxation relief rules are modified to cater for the Lloyd's Year of Account basis of UK taxation

Other Taxation Matters

• Insurance premiums are exempt from VAT/GST in some countries
  • GST is Goods and Services Tax, a type of Value Added Tax (VAT)
• General insurance premiums may be subject to insurance premium tax (IPT)
• Some forms of insurance may be exempt from IPT or in the local domicile if risks are abroad, but may then be in scope of the abroad locations tax regime
• Different tax rates may apply to certain insurance types commonly sold through specific channels, like extended warranties sold with white goods taxed at the same rate as the white goods
• When IPT changes, insurance premiums paid should vary accordingly
  • Insurers may decide to change base rates simultaneously if IPT is not listed separately
  • With IPT increases, insurers may not pass the full increase to consumers due to competitive concerns or to increase market share
• If IPT increases, the insurer will need to pay more tax and so should pass this onto the policyholder by increasing the premium charged
• It may instead choose to leave the total premium charged the same and suffer the extra tax increase itself
• In the UK, IPT is 12%, with a 20% rate for travel/insurance sold with a basic product subject to VAT
• In the UK, insurance for commercial ships/aircraft, international commercial goods, and reinsurance are exempt from IPT
• Value Added Tax (VAT), also known as Goods and Services Tax (GST), is a consumption tax collected at each supply cycle stage
• Suppliers charge/account for VAT on goods/services, with a deduction for input tax on business purchases
• Businesses often do not bear VAT, but are responsible for collecting VAT on the value they add
• A business will only charge VAT on the value that it adds to the product or service it is selling
• Making the business, in effect, a consumer so that VAT becomes a cost
• Businesses cannot recover VAT input tax on costs
• General insurers therefore do not include VAT in the premiums they charge
• The supply of insurance outside the EU is outside the scope of VAT, with the result that, although the business does not have to charge VAT, it is entitled to recover VAT input tax
• Insurers are commonly partially exempt from VAT, making a mixture of VAT-exempt or outside the scope, and VAT-able supplies
  • the amount of VAT that they can recover on their costs depending on the mix of supplies that they make
• VAT is a cost in some instances, and not in others.
• Premiums paid by corporate policyholders may be allowed as a business expense under some regional taxation laws
• Premiums paid by personal policyholders are out of post-tax income, but sole traders/partnerships may deduct insurance premiums as a trading expense
• IPT is charged on all premiums to corporate and personal policyholders
• Businesses can claim total insurance premiums as a running expense
• Claim payments indemnify policyholders, but do not create profit
• Receipt of claims payment will depend on the nature of the risk insured against and whether the premium was tax deductible
• Claims payments are likely taxable for business policyholders where they replace lost profits/diminish deductible expenses
• Consequential loss insurance is an example of a class of insurance where claims payments might be taxable
• For capital gains tax, compensation and insurance moneys may not be treated as a disposal where sums are used to restore/replace the asset
• There can be an interaction between capital gains rules and capital allowances rules
• IPT is a tax on consumption, usually collected by the insurer for both corporate/personal policyholders
• Large IPTs could discourage policyholders
• Mandatory insurance may cause problems
• A large number of uninsured drivers could be on the road, increasing costs to compensate insured drivers
• Passed on to insurers, who pass it on to consumers
• If insurance is not mandatory, it could cause government future problems
• Poorer people may live in more catastrophe prone areas, exposing them to potential losses but also less able to afford the insurance
• The public may put pressure on the government to support those affected which could cost more than the extra IPT they receive