24' Regulation and taxation in Insurance Markets

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24. Regulation and taxation in Insurance Markets

• Dr. Jan-Juy Li
• Dept. of Risk Management and Insurance
• ETP course, CNCCU

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Introduction

• Insurance regulation
• Taxation in insurance

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• Insurance Regulation

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Evolving International Insurance Markets (Figure
24.1)
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Insurance Regulation Trends

• Countries worldwide began moving toward more
  liberal (i.e., freer) markets and away from more
  circumscribed markets.
• Countries have moved from more to less
  restrictive insurance markets.
• They have increasingly embraced competition and
  eschewed special interest regulation.
• The great majority of the worlds largest 50
  insurance markets are more liberal today.

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Mechanisms of Insurance Regulation

• Legislative
• Formation and licensing of insurers
• Licensing of agents and brokers
• Filing and approval of insurance rates
• Filing and approval of proposal material and
  policy forms
• Unauthorized insurance and unfair-trade practices

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Mechanisms of Insurance Regulation

• Legislative
• Insurer financial reporting, examination and
  other financial requirements
• Rehabilitation and liquidation of insurers
• Guaranty funds
• Insurance product and company taxation

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Mechanisms of Insurance Regulation

• Judiciary
• It resolves disputes between insurers and
  policyholders.
• It enforces insurance laws through orders
  supporting the insurance supervisor and by
  assessing civil and sometimes criminal penalties
  against those who violate insurance law.
• Insurers and intermediaries occasionally resort
  to the courts seeking to overturn arbitrary or
  unconstitutional statutes, administrative
  regulation and orders promulgated by regulators.

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Mechanisms of Insurance Regulation

• Executive
• Policymakers commonly delegate this authority to
  a ministerial department of the government.
• A formal advisory body assists regulatory
  authorities in most countries (but not typically
  in the U.S.).
• The regulatory situation in the E.U. is unique.

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Mechanisms of Insurance Regulation

• In most countries, a special department or
  subordinate institution of the relevant ministry
  carries out insurance regulatory oversight. The
  department can be
• Explicitly for insurance regulation and
  supervision
• Part of a larger institution that also oversees
  banking
• Part of the bigger financial supervisory agency

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Approaches to Regulation

• Ex-ante regulation
• To prevent any offensive activity from occurring
  before the fact
• Ex. Licensing
• In some countries, premium rates and policy
  wordings are subject to regulatory approval
  before insurers use them.

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Approaches to Regulation

• Ex-post regulation
• Government intervention into the market only
  after an offensive activity
• Ex. Insurers may set their own rates, and are
  subject to regulatory review only if theyre
  deemed excessive

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Areas of Regulation

• Access to the Market
• Balancing competition against consumer protection
• Detecting insurer financial difficulty
• Responding to insurers in financial difficulty
• Protecting insureds of an insolvent insurer

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Areas of Regulation (Figure 24.2)
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Regulation -- Controlling Access to the Market

• The role of government as a supplier of insurance
• Government should serve as a supplier of
  insurance only where the market has failed to
  respond adequately
• Privatization the process of allowing the
  private sector to provide services formerly
  provided by government or of converting a
  government-owned asset to private ownership

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Regulation -- Controlling Access to the Market

• Licensing requirement
• Admitted vs. nonadmitted insurers
• Nondiscrimination no countrys firms obtain
  better market access than any other countrys
  firms.
• National treatment foreign entrants into a
  market are accorded treatment no less favorable
  than that accorded domestic companies.

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Regulation -- Controlling Access to the Market

• Permitted organizational forms
• Simplicity no artificial distinctions among
  otherwise similar firms
• Economic neutrality treating organizationally
  different insurers in a way that does not
  advantage one from over others.
• Ownership restrictions
• No restriction on insurance ownership

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Regulation -- Controlling Access to the Market

• Restriction on business scope
• Restriction to the conduct of insurance business
• Separation of classes of insurance business
• Right of appeal
• An applicant denied an insurance business license
  has a right to appeal the denial

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Regulation Balancing Competition

• Rate and product regulation
• Financial regulation
• Intermediary regulation
• Competition policy regulation

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Regulation Balancing Competition

• Rate and product regulation
• Rates are not excessive, unfairly discriminatory
  or inadequate.
• Types
• Tariff markets
• Prior approval system
• Flexi-rate system
• File-and-use (use-and-file) system
• Open competition

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Regulation Balancing Competition

• Financial (prudential) regulation
• More restrictive financial regulation is
  associated with more secure insurers.
• Nevertheless, extensive restrictions stifle
  competition and innovation and, thereby, can
  lower consumer value and choice.
• The more competitive a market, the more important
  is prudential regulation.

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Regulation Balancing Competition

• Areas
• Ongoing capital regulation
• Asset limitations and valuation
• Liability regulation
• Accounting standards

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Ongoing Capital (Solvency) Regulation

• Solvency margins
• Within the E.U. (and many other countries),
  minimum ongoing capital and surplus requirements
  are set out.
• Solvency I
• Solvency II
• Risk-based capital
• As in the U.S. and several other countries,
  minimum acceptable capital for business
  continuation of an insurer

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Asset Limitations and Valuation

• Authorized (admitted) investments
• The typical classes of investment permitted to
  back policyholder liabilities
• Government-backed securities, corporate bonds,
  mortgage and other loans, common and preferred
  stock, deposits and real estate.
• Diversification
• Prohibit insurers from excessive investments in a
  single asset category

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Asset Limitations and Valuation

• Currency matching (congruence)
• Match their liabilities denominated in one
  currency with assets denominated in the same
  currency
• Localization
• Assets are located in the insurers domiciliary
  jurisdiction

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(Accounting) Liability Regulation

• Life insurance
• In some countries, the regulator prescribes in
  detail the methods and assumptions used to derive
  life insurer technical (mathematical) reserves
• In other, the regulator relies on an actuarial
  valuation.
• Nonlife insurance
• National laws are more general for nonlife
  insurers

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(Accounting) Liability Regulation

• Appropriate loss reserve establishment has been a
  regulatory challenge.
• The discounting of loss reserves is not, in
  general, practiced.
• Some countries make no provisions for claims
  incurred but not reported (IBNR) losses.

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Accounting Standards

• Statutory accounting principle (SAP)
• Detailed accounting conventions
• Generally accepted accounting principle (GAAP)
• Less detailed than the former
• International Accounting Standard Board (IASB)
• For standardization of accounting principles
  internationally

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Intermediary Regulation

• The services of knowledgeable intermediaries are
  important in highly competitive than in more
  restrictive markets.
• Because individuals and businesses rely on the
  advice as well as risk management and insurance
  services of such intermediaries, they should be
  knowledgeable, trustworthy advisors.

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Intermediary Regulation

• Minimum qualification requirements in most
  countries
• U.S. ES (Excess and Surplus) broker license as
  an example of a special case
• The importance of intermediary regulation as
  financial services sectors converge.

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Competition Policy (Antitrust) Regulation

• Typical elements of competition law
• Collusive practices
• Horizontal collusion
• Vertical collusion
• Conglomerate collusion
• Mergers and acquisitions determining whether a
  proposed merger or acquisition tends to create
  market power
• Abuses of dominant position national laws
  discourage major market suppliers from using
  their dominant positions to restrain competition

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Competition Policy (Antitrust) Regulation

• International legal norms
• Countries usually take a pragmatic position to
  enforcement.
• The effectiveness of competition regulation
  depends on both the law itself and the stringency
  of its enforcement.
• Competition law in the E.U. and the U.S. cannot
  be evaded by initiating the anti-competitive
  behavior outside the relevant territories.
• Effects doctrine

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• International legal norms
• Two principles
• The principle of prohibition
• Enumerated behavior is deemed anti-competitive
  and automatically illegal
• Like ex-ante regulation
• The principle of abuse
• An inquiry into the economic effects of the
  alleged offensive behavior is required
• Like ex-post regulation

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Regulation Detecting Financial Difficulty

• Solvency surveillance
• Reporting requirements
• Most countries require all licensed insurers
  yearly to file detailed financial statement
• Financial examination
• On-site examination
• Oversight by professions
• Regulators rely on the accounting and actuarial
  professions

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Regulation Responding to Insurers in Difficulty

• Four options
• Informal actions
• The regulator may attempt to work with company
  management to identify and deal with the sources
  of difficulty
• Formal actions
• Obtain state approval infuse capital
• Limit its new business writing
• Infuse capital
• Cease certain business practice

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Regulation Responding to Insurers in Difficulty

• Rehabilitation
• Return the insurer to the marketplace as a fully
  functioning insurer
• Liquidation
• The winding up of the companys entire business

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Regulation Policyholder Protection

• Two philosophies
• No protection based on true laissez-faire
  economics
• Guaranty fund benefits
• Guaranty funds
• Pre-insolvency assessment to all licensed
  insurers in the line(s) of business
• Post-insolvency assessment

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Regulation Policyholder Protection

• Guaranty funds diminish market discipline to some
  degree by creating moral hazard.
• If consumers are aware that they will be made
  whole if there were an insolvency, they have less
  incentive to monitor solvency.
• Researchers have proposed alternatives to the
  flat-assessment approach.

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• Taxation in Insurance

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Principles of Taxation

• General purposes of taxation
• To raise revenue
• To promote economic goals
• To promote social goals
• Desirable traits of tax policy
• Equity
• (Economic) neutrality also called horizontal
  equity
• Simplicity

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Principles of Taxation

• Systems of taxation
• Tax bases
• The broader the tax bases, the better.
• Tax exemptions, deductions and credits
• Modifying a tax system to accomplish social and
  economic goal
• Tax rates
• Determining the relative tax on taxpayers

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Life Insurance Taxation

• Consumers
• Many countries provide tax relief to
  policyholders for premiums paid for qualifying
  life insurance policies. ? Table 24.2
• Dividends are not considered as taxable income,
  as they are chiefly a return to the policyholder
  of his or her own funds.
• Countries generally do not directly tax interest
  credited on policy cash values.
• When taxed, the build-up is considered as part of
  benefits.

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Life Insurance Taxation

• The inside interest build-up of annuities during
  their accumulation period usually receives the
  same tax treatment as that of other life
  insurance products.
• Most countries seem to tax annuity payouts to
  some degree.
• Most countries exempt death proceeds paid under
  qualifying life insurance policies from income
  taxation.
• Governments commonly levy estate duties (taxes).

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Tax Relief on Life Insurance Premium (Table 24.2)
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Life Insurance Taxation

• Life insurance companies
• Several OECD countries and perhaps most
  developing countries levy taxes on insurers
  premium revenues.
• Premium taxes are the most common.
• Governments tax life insurers on some variation
  of net income or value added and sometimes both.
• When using total income, governments permit
  several deductions in deriving taxable income.

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Nonlife Insurance Taxation

• Consumers
• Premiums paid by individuals for personal nonlife
  insurance policies are not deductible from income
  for tax purposes.
• Exceptions exist.
• Premium payments by businesses to purchase
  compulsory insurance and other business-related
  insurance are commonly tax deductible.

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Nonlife Insurance Taxation

• Consumers
• Benefits received under personal nonlife
  insurance policies are tax free.
• Exceptions exist.
• For benefits received by a business, such
  benefits are tax free in many countries.

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Nonlife Insurance Taxation

• Nonlife insurance companies
• Countries are less reluctant to impose premium
  taxation in nonlife insurance than in life
  insurance.
• Moreover, tax rates with nonlife insurance are
  generally higher.
• Some governments levy other premium-based taxes
  that can greatly increase the effective tax in
  nonlife insurance.
• Table 24.3

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Other Premium-based Taxes on Nonlife (Table 24.3)
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Nonlife Insurance Taxation

• Nonlife insurance companies
• Premium-based taxation is to be paid irrespective
  of insurer profitability.
• Governments usually tax nonlife insurance
  companies as other corporations.

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Nonlife Insurance Taxation

• Nonlife insurance companies
• The great majority of countries seem to allow
  deductions for claims reported but unpaid and
  certain other reserves.
• The tax rates in most countries are the same as
  those applicable to other corporations and as for
  life insurers.

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• Discussion Questions

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Discussion Question 1

• The influence of interest rates on the trend in
  insolvency is not clear a priori, however, as two
  opposite effects exist. On the one hand, assets
  lose value when interest rates rise, which means
  that solvency is reduced. On the other hand, high
  interest rates also mean high current income from
  investments.
• Discuss which of these two effects you believe
  would be the more important. Why?

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Discussion Question 2

• In the U.K. and Germany, no more than 10 of the
  earnings attributable to a stock life insurers
  participating (with bonuses) business may be
  distributed to shareholders. France limits such
  distributions to 15 of investment gains and 10
  of all other gains. Italy limits distributions to
  20 of investment gains. By contrast, the
  Netherlands and most states in the U.S. have no
  similar restrictions
• What public policy arguments support limitations
  on such distributions?
• Why do believe that the Netherlands and many
  other countries have not such limitations?

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Discussion Question 3

• Signatory countries to the GATS bind themselves
  to the fair-trade principles of market access,
  nondiscrimination, national treatment and
  transparency. A provision within the agreement
  reads as followsmember countries shall not
  be prevented from taking measures for prudential
  reasons, including for the protection of
  policyholders . . . or to ensure the integrity
  and stability of the financial system.

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Discussion Question 3

• What is your interpretation of this provision?
• Do you believe that this provision is justifiable
  in view of a competitive insurance market
  internationally?
• Could insurance be the cause of a countrys
  financial system loosing its integrity and
  stability? If so, how?

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Discussion Question 4

• Explain why insurance need to be regulated.
• Address particular lines of business subject to
  less stringent regulation, why?
• What is the major areas of insurance regulation?
• Who is the insurance regulators in your country?
  Who regulates the insurance regulators?
• Describe the concept of prudential regulation.
• Explain the core principle and mechanism of the
  Risk Based Capital (RBC), and Solvency System
  in EU.

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Discussion Question 5

• Examine the insurance act in your country to
  answer the following
• What is the relationship between the insurance
  regulator and the government?
• Summarize the key provisions related to licensing
  insurers, reinsurers and insurance
  intermediaries. Does the act include a
  fit-and-proper person provision or equivalent?
• What information are insurance companies required
  to submit to the regulator?
• Do you find any sections relating to
  anti-competitive practices in the insurance
  industry?
• What are the steps that the regulator is
  empowered to take against insurance companies
  experiencing extreme financial or operational
  difficulty?

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Discussion Question 6

• In your opinion, is an insurance market a perfect
  market? Why and why not?
• If an insurance company fails in your country,
  what measures or action shall be taken by the
  regulators?
• How to balance the insurance market competition
  and government intervention for consumer
  protection?

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Discussion Question 7

• Economies in transition have expressed interest
  in the possibility of stimulating the purchase of
  life insurance through tax concessions to its
  purchase.
• Why might such countries want to promote the
  purchase of life insurance?
• Would you expect such tax concessions to lead to
  increased sales of life insurance?
• What effect might such tax concessions have on
  savings through other financial intermediaries
  and through government?