12 February 2008 Taxation of Life Insurance c/- Deputy Commissioner, Policy Policy Advice Division Inland Revenue Department PO Box 2198 WELLINGTON Dear Sir REVIEW OF LIFE INSURANCE TAXATION This submission is made by the New Zealand Society of Actuaries ( the Society ), the professional body representing Actuaries practising in New Zealand, in response to the government discussion document Taxation of the life insurance business: proposed new rules. As stated in our previous submission during the informal consultation process, the Society believes that the general direction of the proposed changes is reasonable. However, as more detail has become available there are several issues that persist or have arisen. 1. Timing The Society previously expressed a concern that there needs to be time to fully consider all the implications of a new regime. As much of the detail only became publicly available late in December 2007 we do not believe that this has occurred. The discussion document is unclear in many instances and lacks the detail needed for us (and others) to fully understand all of the implications of the proposals. This submission seeks to add some detail in a few areas but, given the submission timeframe, it has been impractical to address all areas of concern. 2. Completeness The Society raised as an issue in our last submission the lack of detail in regard to the proposed tax treatment of annuity and participating business. The treatment of participating business is discussed in more detail later in this submission but it is disappointing that annuity business has not been covered in the discussion document. Annuities must be considered a critical component of New Zealand s future retirement framework we now have KiwiSaver as a vehicle for the accumulation of savings and the drawdown phase needs just as much attention. Given that much of the justification of the review is that life insurance products should be operating from a level playing field with other financial vehicles, it is surprising that more attention has not been given to a product that should be playing a critical role in retirement.
3. Potential impact on solvency and the public The Society had previously noted with concern the impact of the new regime on business that is already in force. The proposed transitional terms ameliorate these concerns to a large extent, especially our original concerns around company solvency. However, it will still be the case that significant premium rate increases are likely - immediately in the case of business sold after the 1 April cut-off date and at some point in the future for certain policies sold before this date depending on the exact transitional arrangements that apply. The resulting increases to premium rates will make life insurance less affordable. 4. Requirement for actuarial certification There are a number of areas noted in the paper where actuarial certification is recommended, and other areas where we think certification may be appropriate. The form of the certification and the nature of what is required are unclear from the discussion paper. The Society would be pleased to work with officials in regard to how these certifications are to be made, as the proposals become clearer. To ensure that certifications are consistent amongst actuaries, Professional Standards need to be developed by the NZSA to specify the processes underlying certification. However, we are concerned about the practicalities of developing what could be a reasonably large number of standards over a short timeframe, given that we are such a small profession. We note that the Society s current practice is to develop mandatory standards only. There is no longer a second class of guidelines or guidance notes that are intended to assist members but are not mandatory. 5. Fundamental change (9.26 and 9.27) There are a number of opinions on what would constitute a fundamental change to a policy and hence make it subject to the terms of the proposed regime rather than the transitional rules. Given the importance of this matter and the likely divergence in practices if it is not tightly defined, we would recommend that care is taken in this definition. Whereas regular increases that form part of a policy s features at point of sale do not constitute a fundamental change, even this type of change can vary in detail and application. Regular increases may be index-related or at a fixed rate. As a matter of equity to policyholders who purchased contracts under the current tax basis the Society believes that decreases to policies should not be considered a fundamental change. There are a number of grey areas that require more thought such as: future insurability riders, increases on policies that have previously decreased and reinstatement from lapse. Consideration should be given to whether a principles based approach (such as the need for underwriting automatically resulting in a fundamental change) could be used or if a more prescriptive regime covering all circumstances is required.
6. Risk reserves We find the discussion paper confusing in the way it refers to products in relation to the distinction between the UPR and PSR approaches to reserving. The Society believes that the overall principle that needs to be applied is that of matching the revenue earned against the risk borne. Where premium rates increase annually with age, a PSR is not necessary and the simpler UPR can be used. The issue of whether the premium rates are guaranteed or not (i.e. the insurer does not or does have the ability to change the rates for policies already in force) is irrelevant. Generally when a policy has premiums that are expected to be held level for longer than a year a PSR would be appropriate. However, this isn t necessarily true for all products as premiums on some individual risk products can be charged on a basis more akin to unit-rated group life. In these cases, although the premiums charged are level, a UPR would still be used. Creating a definition to be able to separate these policies out from those that have level premiums and should use a PSR may prove troublesome. The important issue is to capture the principle of matching within any definition. The usage of the word guarantee confuses issues as a guarantee doesn t necessarily imply level premiums. The calculation of the PSR will necessarily entail separate projections from those used in financial statements. Thus a set of tax valuation rules will need to be created. Rules to cover matters such as how to deal with changes in assumptions will also need to be prescribed. Any specific reference to the current accounting rules, which are based on a Margin on Services (MoS) methodology, would prove troublesome going forward as the current MoS regime is likely to be replaced in the next few years. It may prove simpler for some companies to use a PSR where a UPR would normally be used, so avoiding setting up multiple valuation processes, and we recommend that companies be allowed to calculate a PSR in place of a UPR. To be consistent with current practice the OCR should include claims reported but not yet admitted and should be calculated net of reinsurance. The UPR formula is incorrect as t should relate to the period of premium frequency rather than assuming an annual premium payment period. To be consistent with current practice the UPR should also be net of reinsurance. 7. Participating business We have concerns with the proposed basis for taxing participating business but understand that there are further discussions under way to further develop this proposal. In light of this, we have not commented on the proposal in the discussion document but would certainly wish to comment on any future proposal whether it alters from its current form or not. It is important that any existing tax balances be fairly allocated between policyholders and shareholders, and that any tax benefit that is reasonably expected to accrue in the future under the current rules not be lost. Under any approach, the definition of participating policy will need to be carefully considered to ensure the business captured is only what is intended. In particular, it may be necessary to have a process by which the rules of any new funds that are set up have to be reviewed by Inland Revenue before being accepted as participating funds for tax purposes.
8. Definitions Within the discussion document there are a number of definitions that are unclear or incorrect which we wish to draw to the attention of officials. Section 4.1 The formulae presented would imply that EI S is deductible twice. Section 5.1 The second formula (C r + RC r E r ) is not correct. It should be (C r - RC r + E r ). Sections 5.5 and 5.6 The tax treatment of reinsurance is stated to mirror the tax treatment of the product reinsured. This may not be true in the case of risk premium reinsurance of a savings-type product. Section 5.8 The definition of participating business cannot include the requirement for surrender values to increase over the duration of the contract. This would exclude e.g. Whole of Life with Endowment Bonuses - there is necessarily a fall in the surrender value after the bonus payment date. Section 5.9 (and 5.16) Many single premium policies are clearly not savings policies under any common-sense definition but there is a return on cancellation of an amount that is not exactly equal to a return of the unexpired premium calculated according to the original and outstanding time periods only. Some further development of the definition of risk business will be required. It should be remembered that unexpired premium here is not the same as the UPR defined for UPR/PSR calculation purposes. Section 5.10 An unbundled product is not necessarily unit-linked. There may be an investment account approach to the savings element, with a calculated interest rate credited to policyholders balances rather than a direct link being made to some unitised asset pool. Thus, the reference to buying units is not appropriate. Section 5.22 It is entirely unclear what the third sentence is trying to say. Section 10.8 It is unclear how a worst-case scenario can be defined in practice. It can be expected that the definition of true reinsurance arrangements will be problematic, and simply cannot be entirely clear cut. This seems to fall into the category of anti-avoidance regulation being required, and the best approach may be to review in detail how other jurisdictions have dealt with the matter.
9. Outstanding issues There are a number of issues that have not been addressed in any detail above but certainly need to be ironed out before any legislation could be drafted. These include: 1. The definition of life insurance business, and whether the regime applies to a type of business regardless of the legal form of the entity writing it. 2. The rules for determining apportionments e.g. I and E 3. Definitions for the various product groups that have different taxation rules, with particular reference to transitional rules and our discussion in section 6 of this document. 4. Whether reinsurance is offered or entered into in New Zealand 5. X (residual category of shareholder income) specification of what items do or do not go into this category may be useful. There may also be some items of outgo in this category. 6. The calculation of implicit fees (7.6). Even the distinction between explicit fees(section 7.3) is not always clear-cut. 7. Allocation of any tax losses carried forward between shareholder and policyholders 8. Which constitutes the most appropriate tax result (9.17) The New Zealand Society of Actuaries would be pleased to discuss these issues with you further. For further information regarding our submission please contact the undersigned. Yours faithfully For New Zealand Society of Actuaries (Inc) Ian New PRESIDENT Hamish Farrar CONVENOR, LIFE COMMITTEE T: (04) 498 1644 T: (04) 474 9709 E: ian_new@westpac.co.nz E: hamish_farrar@bnz.co.nz The Actuarial Profession in New Zealand Fellows of the New Zealand Society of Actuaries adhere to standards designed to ensure competence, impartial advice and the highest standard of business ethics. The FNZSA qualification is obtained by: (1) passing professional exams and meeting the experience requirements of the Institute of Actuaries of Australia or Institute of Actuaries in the UK or other approved examining body recognised by the Society; (2) being resident in New Zealand or doing work that relates to New Zealand; (3) meeting ongoing continuing professional development requirements; and (4) maintaining the highest standard of business ethics as set out in our code of professional conduct and adhering to mandatory practice standards. Typically, it takes about 7 years post-graduate study to qualify as an actuary, with the training providing a thorough grounding for the complex financial analysis that underlies the provision of actuarial advice. Actuarial advice is governed by a code of conduct and relevant standards designed to protect the public interest.
The practice committees which set and review standards comprise experienced actuaries specialising in a practice area. The standards are reviewed by the professional standards committee and Council of the New Zealand Society of Actuaries. Draft standards and revisions thereto are circulated to Fellows as Discussion Drafts and Exposure Drafts before being adopted. The process allows standards to be updated quickly if required to meet changing circumstances and provides for scrutiny and robust debate during the drafting process. The New Zealand Society of Actuaries is a full member of the International Actuarial Association as we meet the international benchmarks for qualification, standards, disciplinary process and continuing professional development. The Society s members are governed by its standards in all work they do whether or not they are remunerated for it. They are required to disclose any potential conflict of interest and to provide advice only if they are competent in that practice area. Members have a collective responsibility for the maintenance of standards. If they become aware of any potential breach which is not rectified, they must bring the matter to the attention of the Society for consideration of further action. The New Zealand Society of Actuaries contributes to debate on various matters from the perspective of the public interest rather than the commercial interests of institutions that employ or contract actuaries.