The world is shrinking, certainly as far as communication is concerned, whether physical or electronic. Before the days of facsimile transmission and e-mail, conventional modes of corresponding usually provided a window of days, if not weeks, between the posting of a letter and its response. Now an e-mail sent today to the other end of the world will likely have an incoming response, also by e-mail, by tomorrow. Conferencing facilities, be they visual or not, connect continents, often obviating the need for days spent in the air or, worse still, in airport lounges.

Communication between fiscal authorities is also, apparently, better (for them) and swifter today than it has ever been. It is, therefore, perhaps not surprising that a measure introduced by one fiscal authority to increase government revenues, is enticing other regimes to consider introducing similar rules in their taxing legislation. A recent example of this is discounting of technical reserves.

As is often the case, it was in the United States that a statutory basis for discounting technical reserves was first introduced. This was as long ago as 1986. The UK's Inland Revenue was of the view that there was no need for a statutory introduction of discounting rules in the UK since discounting, it was claimed, was already enforceable under existing law. In fact it was in 1984 that the British Insurance Association (now Association of British Insurers or ABI) was advised of the UK Revenue's views in this respect and UK insurers have been disagreeing with the Revenue ever since. The UK Revenue was not, however, prepared to test its views in the UK courts and so deduction of reserves on a non-discounted basis, has prevailed in the UK up to the present time.

Recently, discounting of reserves has been introduced for fiscal purposes in Germany. France has a regime, “taxe sur les excédents de provisions pour sinistres à payer”, also known as the “taxe sur boni”, which applies to the excess of claims reserves over the amount of claims paid. Whether it was the result of these regimes in Europe following the US legislative lead, or the Revenue's recent failure before the Commissioners on a related issue, there is now a clause in the UK's Finance Bill which effectively introduces discounting in the UK for insurers with effect for accounting periods that commence on or after 1 January 2000. This article outlines the UK proposals and compares them with the regimes already enacted in Germany, France and the US.

First, it is worth briefly mentioning the recent case before the Commissioners (the primary tax court in the UK) which concerned a syndicate at Lloyd's. Syndicates at Lloyd's conduct their business on an annual basis in underwriting years. To close an underwriting year, a member of a syndicate will reinsure his share of the syndicate liabilities for a particular year usually, but not always, with the same named syndicate for the succeeding year. This reinsurance is known as the reinsurance to close (the RITC). The Taxes Act in the UK provides that the premium for the RITC is tax deductible only to the extent that it is a fair and reasonable assessment of the value of the liabilities reinsured. The statute defines a fair and reasonable assessment of liabilities as one which arrives at a premium which is aimed at producing the result that the reinsurer makes no profit nor loss from the reinsurance. The Revenue argued that in computing such a premium, deductible as an expense for tax purposes, an allowance should have been made for the time value of money either:

(i) by making an allowance for the investment income which was likely to be received pending payment of the claims, or

(ii) by discounting the likely amount of the liabilities to their net present value as at the date of the RITC.

It was submitted for the taxpayer that it would be impossible in the commercial world for the reinsurer to retrocede the liabilities assumed for a premium less than the undiscounted RITC premium and, if the RITC premium were discounted, then the receiving reinsurer could only retrocede the liability to a third party at a loss. The Commissioners were of the opinion that it was neither intended, nor would it be reasonable, for the tax treatment of the RITC premium to be so significantly out of line with commercial reality and actuarial opinion, as would be the case if the premium was discounted for tax purposes. The effect of the Revenue's contention would be to charge the syndicate member with tax on the future investment income although it would not arise until later. This, in the view of the Commissioners, would be both unfair and unreasonable.

Despite the Commissioners' view that discounting would be unfair and unreasonable, Clause 106 of the Finance Bill provides the board of Inland Revenue with powers to make regulations to give effect to the insurance reserves proposals. On 12 April the Inland Revenue issued a consultation document on the subject of the proposals for regulations with a deadline for comments of 25 May. The comments specifically sought, however, concerned the detail of implementing the proposals rather than being on the principle of their introduction. Needless to say, the insurance industry is strongly opposed both to the detail and the principle of discounting itself.

In introducing the consultation, the Inland Revenue states that the reform of the tax rules applying to general insurance companies and Lloyd's members is to make those rules fairer and to bring the tax treatment of these undertakings broadly into line with other companies. It is pointed out that companies other than general insurers must follow accounting standards when making long term provisions and that these standards require a best estimate of the relevant liability, discounted where material. The stated aim of the proposals is to see the result, in broad terms, that general insurers will pay “tax worth” to the Exchequer as if the reserves had been set out exactly at the right level needed to pay the future claims, taking into account a reasonable investment return on the amounts reserved. Thus, in a single swoop, the government proposals will seek “compensation” for insurers claiming tax deductions on a non-discounted basis and for any reliefs obtained for amounts which ultimately prove to be not required, on a discounted basis, to meet ultimate claims payments.

The mechanism for achieving the government's objectives is a review of past deductions for unpaid liabilities, recalculating them with the benefit of hindsight. Where it turns out that too much was deducted, as compared with the discounted amount required to meet the actual claims settled, an addition is to be made to trading profits. This addition to profits is effectively an interest charge on the excessive amount. There is proposed an allowable margin in arriving at the addition to trading profits.

Some general insurance business is very long-tail, for example accident liability business or MAT business. The proposals as framed will give rise to much uncertainty as to ultimate tax liabilities and will necessitate provisions being made for deferred tax liabilities. Understandably, insurers are strongly opposed to the proposals. But are they any worse than the regimes operating in other territories?

Germany

The German regime, unlike the UK proposed regime, applies to all companies, not just to general insurers. Discounting is a requirement where reserves do not comprise an interest component, are to endure for more than one year and are not based on prepayments. The discounting is applied using an interest rate, currently, of 5.5%.

In addition to discounting there is a loss reserve limitation for tax purposes. This limitation, unlike discounting, is applicable only to the insurance industry. Under this limitation, the tax deductible loss reserve in any line of business is limited to an amount calculated as the reserve necessary for each line of business using the experience of the five prior years. It is worth noting that the five year averaging period was to be applied regardless of whether or not the average payment date was greater or less than five years. However, in a very recent ruling (issued 18 May 2000), it has been said that the period to be taken into account should be at least five years. It would appear from this ruling that a longer averaging period may be used provided this longer period is used consistently for the class of business.

The loss reserve limitation rules allow a risk margin of 15% to be built into the calculation. A simplified example shows how this loss reserve limitation works:

  • Assume that the 5 year average of prior year loss reserves actually set up amounts to 500;

  • Assume that the average payments in this period were 420;

  • Assume the loss reserves of the current year are 600;

    then the current year tax deductible reserves would be 420 divided by 500 x 600 = 504, plus 15% margin (15% of 504) = 580.

    In Germany, there is also an interest regime applicable where the loss reserves in the accounts exceed the loss reserves deductible for tax on the basis of the 5 years' average. Correspondingly, where the reserves deductible for tax are greater than the accounts provision there will be an interest credit. The interest charge or credit is at the rate of 0.5% per month beginning 15 months after the tax has become due ending on the day the assessment notice is received.

    Unlike the system proposed in the UK, the German regime would seem simple to operate, certain in its impact, reasonable in its risk margin and without any element of retrospection or hindsight.

    France

    Discounting loss reserves for tax purposes is not a requirement of French law. As mentioned earlier, however, there is the “tax sur les excédents de provisions pour sinistres à payer” which charges the insurer for the benefit received from having a tax deduction for a claims reserve in excess of that needed to meet the ultimate amount of claims payment. The tax rate is 0.75% per month and it is chargeable for the period beginning with the deduction of the reserve and ending with the payment of the claim. The tax is applied to the corporate tax due on the reserve excess. Thus, if the reserve deducted in 1999 was 5,000 and the claim was settled in 2000 for 4,500, and the corporate tax rate was 33 1/3%, then the tax payable would be (500 x .333) (0.75 x 12 months) = 15. If the insurance company was in a tax loss position for 1999 such that no tax benefit was obtained from the amount overprovided, then the tax is not due.

    USA

    The US legislation referred to earlier, was introduced by the Tax Reform Act of 1986. This Act required property and casualty insurers, beginning with the 1987 taxable year, to discount unpaid losses to present value when claiming them as a deduction. The rate of discount is defined by statute as the Applicable Federal Rate (AFR). The AFR is set annually. To avoid the requirement by insurers of recognising as income the difference between undiscounted and discounted loss reserves for the 1986 year-end, the Act granted a “fresh start” under which the difference was excluded from taxable income.

    The US system would appear to allow US insurers to set their reserves for accounting and regulatory purposes at a level which leads to reserve redundancies. The IRS, of course, does have the right to conduct an audit on the reserves should they perceive the level of redundancies to be excessive.

    The US system would appear to be considerably less onerous than that proposed in the UK in that, again, there is certainty year on year and no statutory obligation to use hindsight.

    Uncertain and potentially expensive

    The UK regime, if enacted without change, appears to contain all the elements of the combined regimes of Germany, France and the US, and is, prima facie, the most expensive potentially for insurers. Further, it is by far the most uncertain since it involves looking back from when claims payments are actually made.

    In preparing their accounts, UK insurers are required to make provision for all reasonably foreseeable losses. The ABI Statement of Recommended Practice encourages a realistic provision for losses. In the RITC case mentioned earlier, actuarial evidence was that insurers should have at least 90% certainty that they had sufficient reserves. The court found as a fact, however, that the potential for losses on the other 10% is skewed so as to be greater than the potential for profits on the 90%.

    What is certain is that is impossible to make provision for precisely the right amount. To introduce a regime that effectively taxes on this basis by using hindsight, does not make the regime fairer (the stated aim) and certainly does not bring the tax treatment of these undertakings broadly into line with other companies. Taxation using hindsight is not a feature in the taxation of UK companies generally.

    Insurance, particularly reinsurance, is a mobile business, becoming increasingly so in the fast moving e-business environment. It seems that the UK proposals may well force companies to consider reinsurances offshore where reserves may be deducted on a gross basis. It will be interesting to see the developments.

  • Michael Cole is a consultant with PricewaterhouseCoopers primarily in PwC's European and UK insurance tax practice. Tel: +44 (0) 20 7804 7459; e-mail: michael.cole@uk.pwcglobal.com