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ANALYSIS: The future of life insurance taxation

The changes to the regulatory measurement of policyholder liabilities pose many uncertainties from a tax perspective, but also provide an opportunity to develop a simpler tax regime, argues Dewald van den Berg

A number of factors are driving possible changes to the corporate tax regime for life insurance companies in South Africa. The main driver for change is the implementation of Solvency Assessment and Management (SAM), which will be effective from 1 January 2016.

As a result of the implementation of SAM, the current regulatory measurement basis for policyholder liabilities will change. This raises a number of issues. Foremost of these is whether it will be feasible to continue to use the current statutory valuation method (SVM) as a basis for valuing policyholder liabilities for tax purposes.

Most affected parties will agree that the SAM economic measurement basis is not appropriate for tax purposes. Another catalyst for change is the perception that the life insurance tax regime is outdated and requires review. Will these drivers result in wholesale changes to life insurers’ corporate tax regime? What could some of these changes be?

In addition to the measurement changes arising from SAM, insurers will in all likelihood also have to implement two new accounting standards, which will affect the accounting for policyholder contracts with effect from 1 January 2018.

The first of these International Financial Reporting Standards (IFRS), IFRS 9 Financial instruments, which will be applicable to savings products, is not expected to have a significant effect on the current accounting treatment. However, the second standard, IFRS 4 Phase II, which deals with insurance contracts (as defined in IFRS), is expected to have a far more significant effect on the measurement of insurance contract liabilities.

At present, the taxation of life insurers is presently based on the SVM for determining policyholder liabilities. This regulatory measurement is the same in many respects as the financial soundness valuation (FSV) as described in Statement of Actuarial Practice 104, which is used for IFRS reporting on insurance contracts.

One of the key differences between the current two measurements relates to the profit recognition profile. Under the SVM, unlike the FSV, profit recognition for some insurers is often deferred by eliminating negative liabilities (as valued using a discounted cash flow technique) through setting this value/negative liability to zero (also referred to as zeroising of negative liabilities).

Other differences between IFRS and the SVM relate to the deferral and amortisation of upfront investment management fees and incremental acquisition costs incurred to secure these investment/savings contracts (often referred to as deferred acquisition costs, or DAC).

In terms of a wider review of the tax framework, one possibility is that the tax basis could ultimately make use of the IFRS 4 Phase II measurement basis for insurance contracts. What makes IFRS 4 Phase II appealing from a tax perspective is that it should result in a more consistent measurement of insurance contract liabilities across all life insurers in South Africa. This is something that the FSV/SVM does not achieve, mainly as a result of differences in setting the level of discretionary or second-tier margins.

IFRS 4 Phase II strives to align the presentation and recognition principles of insurance contract revenue with that in other industries. Under the proposals, an insurer should present as insurance contract revenue the consideration for insurance services provided under the insurance contract in a given period. However, the insurer would not present amounts “deposited” by customers as revenue – that is, amounts that will be repaid to policyholders even if the insured event does not occur.

Profits expected to be derived from issuing an insurance contract will be recognised on a systematic basis that best reflects the transfer of services over the expected duration (coverage period as determined by the contract boundary) of the insurance contract.

In developing IFRS 4 Phase II, the International Accounting Standards Board (IASB) has determined that for information reported about insurance contracts to be useful, it needs to be based on a current-value approach with a fulfilment objective that maximises the use of observable market information and presents the performance of the entity over time.

IFRS 4 Phase II therefore strikes an appropriate balance between a robust measurement of the rights and obligations under insurance contract liabilities as well as setting principles for profit recognition that are comparable with the principles that will be applied by other industries.

IFRS 4 Phase II will eliminate much of the discretion that is applied today in setting the profit recognition patterns on insurance contracts. This should have the effect of making profit recognition profiles more comparable across different insurers for similar products written. IFRS 4 Phase II will also prescribe increased and more transparent disclosures.

The recently completed third South African Quantitative Impact Study’s (QIS3) technical specifications indicated that, for the interim period, until the implementation of IFRS 4 Phase II, the SAM framework may adopt the current SVM basis for taxation. However, this approach has not yet been agreed to with National Treasury.

In the interim, some of the latest thinking around the measurement of policyholder liabilities for tax purposes is focused on adopting an adjusted IFRS basis to eliminate some of the current inconsistencies between the FSV and SVM approaches and between different insurers, as highlighted above.

Although there are some concerns about the differing level of discretion used in the FSV/SVM approaches, these differences exist within the tax regime today and will not be newly introduced. Adjusted IFRS could be used as a mechanism to start migrating to a more consistent measurement treatment.

National Treasury communicated in the February 2014 Budget Review its intention to amend the current four-funds tax system by proposing to tax all risk products within the corporate fund in a similar manner to short-term insurers. This will ensure that the corporate fund, rather than one of the policyholder funds, will be taxed on the risk policy business and profits.

Government will also review the fairness of the taxation of the individual policyholder fund, where a 30% tax rate is currently applied, irrespective of the income level of policyholders.

Another important aspect is whether existing tax provisions will be grandfathered for existing business. In the UK, where similar reform has taken place, a period of ten years was granted to transition to many of the new proposals, but this might be excessive. However, this remains an important consideration because products in issue were priced with, for example, specific expected expense relief in mind. Applying new tax legislation to an existing product could have an unforeseen financial effect for the insurer and policyholders.

A difficult matter to resolve will be what the exact scope and definition of risk products should be. This is important because certain policies have both risk and investment components. The definition should ensure the most appropriate tax basis is used when determining the taxable profits of products. If not, National Treasury’s aim of preventing the subsidisation of investment products with the excessive expenditure generated by risk policies may not materialise. However, the proposals should ensure that life insurers are able to continue to write their business on competitive terms.

One aspect that will require careful consideration is whether a phased approach to life insurance tax reform should be adopted or whether a comprehensive once-off overhaul of the life insurance tax regime should be implemented.

The changes to the regulatory measurement of policyholder liabilities pose many uncertainties from a tax perspective. But they also provide an opportunity to develop a simpler tax regime that is more aligned with the commercial position of life companies, the IFRS accounting treatment and the tax basis of companies generally, and which will make administration and compliance easier.

There is little time before SAM will be fully implemented. Having multiple measurement bases for accounting, taxation and regulatory purposes is not an ideal situation and it is important that the life insurance industry be provided with sufficient certainty about the shape of the future tax regime.

Not only is a shared vision of the end game for life insurance tax critical for strategic planning purposes, it will also enable the industry to constructively contribute to its development. To achieve this, transparent consultation with insurance industry members, representative bodies, advisors and other interested parties will be imperative to achieve the most efficient and effective changes to the life insurance tax regime. ❐

Author: Dewald van den Berg CA(SA) is Partner: Financial Services at PwC