Why the rules need to be changed

2.1 The current rules for taxing life insurers have applied since 1990 and are no longer appropriate for the modern insurance and savings environment. Although a number of submissions on the suggestions set out in the earlier officials’ paperagreed that change to the current rules was necessary, a small number of submissions disagreed, arguing that the current rules accurately taxed the economic income of all stakeholders.

2.2 Therefore, before outlining the proposed new rules, this chapter discusses why the current taxation of life insurers requires change in the context of two key principles: that economically equivalent entities, products and services, should be taxed equivalently (often referred to as neutrality), and all taxpayers should contribute their fair share in taxes (equity).


The current rules

2.3 Although the current rules do not contain explicit tax concessions for policyholders, term life insurance products are effectively under-taxed. Individuals generally cannot claim a tax deduction or get a tax credit for life insurance premiums paid (as happens in some countries) but, on the other hand, they are not taxed on insurance proceeds. In its 1989 report, the Consultative Committee considered this to be the correct treatment.[2]

2.4 The current rules tax life insurers on a two-tier basis. The first tier, the life office base (LOB), taxes the income earned for the benefit of both shareholders and policyholders of the life insurer (and a re-insurer) as a whole. It consists of:

· gross income (including realised gains on equities and other property but not premiums from policyholders or life reinsurance claims);· less expenses (with the exception of reinsurance premiums and claims credited to policyholders);
· plus underwriting income.

2.5 Underwriting income arises from three sources (as laid down by statutory formulas):

· profit on mortality, being the expected death strain (EDS) (in simple terms, the expected claims), less the actual death strain (in simple terms, actual claims);
· profit on termination risks; and
· premium loading, deemed to be 20 percent of the EDS and one percent of reserves released on death in the case of life annuities. The formula is intended to bring in as income the profit and expenses of the life insurer from providing the risk spreading service to the policyholder.

2.6 Income accruing to policyholders is taxed to the life insurer on a proxy basis under the policyholder base (PHB). Income is calculated by a formula equal to the increase in reserves plus benefits (such as claims) paid plus underwriting income less premiums. The tax base is grossed up by (1 – the LOB tax rate) to arrive at the before-tax amount necessary to provide the after-tax benefit implicit in the policy. Tax paid on the LOB generates imputation credits that can then be used to meet the PHB liability (thus avoiding double taxation) or as tax credits on dividends paid to shareholders.

2.7 There are two fundamental problems with these rules. The first is that they under-tax term insurance profits. The second is that they over-tax savings income.
Life insurance tax reform: Officials’ paper No 2 – suggestions for reform, published by the Policy Advice Division of Inland Revenue, February 2007.
“4.3.2 Policies covering private risks.
In respect of premiums paid to cover private or non-business risks, a fairly strong case can be made for non-deductibility. This is the current treatment of all policies covering private risks except disablement policies providing replacement income. The Committee considers that such premiums should, in theory, be non-deductible. Claims would of course become non-assessable.” Tax Treatment of Life Insurance and Related Areas: August 1989; Report of the Consultative Committee.
The reinsurance components of the claims and premiums are netted only when the reinsurer is taxed in New Zealand.