Q7iii of September 2009 discusses how the assumptions under embedded value compare to those used to calculate any supervisory reserves. For tax it says "the embedded value would need to allow for shareholder tax on profits, but this would not be appropriate for the calculations of supervisory reserves. 1. What is meant by shareholder tax on profits? 2. Is this income tax at the shareholder's marginal rate of tax for any dividends received? 3. Does it also include any capital gains tax on any gain on the capital value of any share price increase? If indeed a share can be treated as a capital gain in relation to share price rises? 4. Are there any other taxes allowed for in the calculation of embedded value - for instance is their corporation tax incurred on the present value of future profits? I am also studying for SA2 so will appreciate replies even if they do not fall under the scope of SP2. Thanks in advance.
The SP2 course is deliberately not very detailed when it comes to discussions of tax. Tax calculations vary by jurisdiction and can be very complex. The SP2 course just requires an understanding that tax will have an impact. The SA2 course though goes into great detail for the tax calculations performed in the UK. Taking your points: 1. and 4. Insurers will pay tax on their profits just like any other company, so the shareholder tax on profits is the corporation tax. As an embedded value includes the present value of future profits, it will be reduced by the tax paid on these profits. 2. No the EV calculation does not look at the tax a shareholder would pay when they receive dividends from the insurer. Different investors are taxed in different ways so the insurer cannot consider this. The EV only looks at tax directly paid by the insurer. 3. I'm not sure what you mean here. If you mean the tax that an investor would pay if they make a capital gain by holding the insurer's shares, then no, we don't include this in the EV calculation for the same reason as 2. If you mean the capital gains made by the insurer on their assets, then this would form part of the profit calculation in 1. Best wishes Mark
Hi Mark, May I clarify this one. As EV calculation has two components. a) PV of future profits on existing insurance business. I consider this part as profits yet being released to shareholders. We would need to allow for corporate tax to calculate net profits. And this is taxed each year, which is like the corporate tax shown in the annual report if the company has earned some profits in that year. (Is there a requirement for EV valuation basis? as different bases may impact the profits and tax payments) b) Net assets that are separately attributable to shareholders. (Is this part of fund has already been allocated to shareholders?) For example, insurers invest shareholders' fund into equity and bond assets, which may have capital gain and income. Will the company pay capital gain or income tax as an institutional investor or still pay corporate tax (consider the profits are arising from investments, similar to profits arising from insurance business in a))? Many thanks
Hi Damien Yes, the EV calculation has two parts. Tax considerations will impact the calculation of a), the present value of future profits. The present value of future profits is the present value of the future premiums less claims less expenses plus investment returns less increase in reserves. So an EV calculation requires two bases: one to calculate the reserves (this will be on the same basis as the regulator requires for the reserves) and one to project future claims, expenses etc (often insurers are free to use whatever basis they wish here although there are some rules to follow for companies calculating the CFO Forum's EEV and MCEV calculation - more on this in SA2). The net assets and the shareholder fund are not the same thing. Often insurers will have separate insurance funds and a shareholder fund. The shareholder fund belongs to shareholders and can be a holding point for funds to pay dividends and so on. However, some of the insurance funds also add value for the shareholders, so the EV includes any assets in excess of the regulatory reserves, as these funds could be transferred to shareholders at a later date. How investment return is taxed is complex and country dependent. For that reason it is well beyond the P2 syllabus. It may matter what fun d the investments sit in. For SP2 it is sufficient to know that tax may need to be deducted from the profit calculation in a) but it will not directly affect the net assets in b). However, I've ignored the impact of solvency capital requirements in all this - often there is a third component to EV that looks at the capital less the cost of holding that capital - tax considerations may impact on the cost of holding the capital - again this is an issue for SA2. Best wishes Mark
