The general business environment

[Anaayaa Khemka]

Example In a certain country, taxation of life insurance policies was known to be as follows:
premiums are tax deductible up to a certain amount
premiums incur a 2½% premium tax investment return is gross the
benefit is taxed at 12½% of excess of benefit over premiums paid.

Overall, this represented a subsidy on savings effected in the form of a life insurance policy compared with other savings channels such as banks or direct investments. (As a result, many banks established their own life insurance subsidiaries in order to offer their customers these advantages over normal bank deposit account savings

I am having difficulty in understanding how is there a subsidy in saving for a life insurer rather than other savings channel in this example.

Also could you please explain the paragraph below
“As with the regulatory environment, product design will want to make the best use of any opportunities provided by the fiscal environment. On the other hand, the ability to maximise favourable taxation treatment may force constraints on product design. For example, tax authorities may be keen that pure savings business should not be ‘dressed up’ as life insurance in order to secure favourable tax treatment where this exists. If so, they might therefore specify minimum levels of life cover necessary to secure tax concessions. This would then represent both an opportunity and a constraint. The tax concessions might allow a competitive product to be produced, but the design would have to include at least the minimum level of life cover. It should be noted that both the taxation and regulatory environments are very significant drivers of product design in the insurance industry. ”

thanks.

 

[Mark Willder]

Example In a certain country, taxation of life insurance policies was known to be as follows:
premiums are tax deductible up to a certain amount
premiums incur a 2½% premium tax investment return is gross the
benefit is taxed at 12½% of excess of benefit over premiums paid.

Overall, this represented a subsidy on savings effected in the form of a life insurance policy compared with other savings channels such as banks or direct investments. (As a result, many banks established their own life insurance subsidiaries in order to offer their customers these advantages over normal bank deposit account savings

I am having difficulty in understanding how is there a subsidy in saving for a life insurer rather than other savings channel in this example.


thanks.

Hi Anaayaa

Thank you for these questions. I'll answer them in separate posts.

To answer the question above, we'd have to make some assumptions about how the bank products might be taxed. One possibility is that the policyholder pays the premium to the bank from their taxed income, there is no premium tax, and either the return is net of tax or the benefit is taxed. This would lead to a much higher tax rate for most investors than the insurance contract.

A numerical example will help.

A policyholder is subject to tax at 40% on their income from employment and their benefits from bank products. They are paid 100 gross from their employment that they want to invest for one year. Investments earn 10%.

Insurance - the premium is tax deductible, so they can invest the full 100 into the policy. But they pay 2.5% premium tax, giving 97.5. Investment return is gross giving 97.5 x 1.1 = 107.25. The excess benefit is taxed at 12.5%, so tax is 7.25 x 0.125 = 0.91. So the benefit is 107.25 - 0.91 = 106.34.

Bank - the premium is payable from taxed income, so they can only invest 60. There is no premium tax, so still 60. This grows with interest at 10%, but subject to 40% tax, so interest of 6%. This gives 60 x 1.06 = 63.6.

So we see that the insurance policy is very tax efficient in this case. The answer depends on the assumptions we've made about the bank. But a tax rate of only 12.5% sounds very low and the ability to make premiums tax deductible will be very valuable. In contrast, the 2.5% premium tax is tiny. So the insurance contract will be better than the bank product for most people.

I hope this helps to clarify the example.

Best wishes

Mark

 

[Mark Willder]

Also could you please explain the paragraph below
“As with the regulatory environment, product design will want to make the best use of any opportunities provided by the fiscal environment. On the other hand, the ability to maximise favourable taxation treatment may force constraints on product design. For example, tax authorities may be keen that pure savings business should not be ‘dressed up’ as life insurance in order to secure favourable tax treatment where this exists. If so, they might therefore specify minimum levels of life cover necessary to secure tax concessions. This would then represent both an opportunity and a constraint. The tax concessions might allow a competitive product to be produced, but the design would have to include at least the minimum level of life cover. It should be noted that both the taxation and regulatory environments are very significant drivers of product design in the insurance industry. ”

thanks.

By the fiscal environment, we mean the taxation of products. We need to think why the tax authorities would give tax advantages to life insurance contracts. Presumably it is because the government wants to encourage people to take out life insurance so that their dependants will not become reliant on State benefits after the policyholder's death. So it only makes sense to offer the tax concessions if there is a genuine insurance element.

Consider a unit-linked endowment assurance. The premium buys units that will grow with investment return - this is the savings element. There will also be a guaranteed minimum sum assured payable on death - this is the protection element. A policyholder could invest a large sum to get the tax efficient savings benefits, but choose a very low sum assured to reduce the cost of the life cover. This would not achieve the governments aims of encouraging insurance. So the government will restrict policy design to make sure that the life cover is substantial compared to the premium.

I hope this example helps.

Mark