XSI vs XSE in pricing

[chloe3705]

In the exam paper of April 2010, question 2 (iv), a question was asked about how the change in tax position would impact writing new business.
The answer suggested "When taxed on XSI basis will result in competitive premiums as expenses receive tax relief. If the company moves to XSE basis, this may result in uncompetitive premiums as investment income and expenses will be assumed to be gross within the pricing basis."
I'm very confused by this statement why XSI results in more competitive premium than XSE, as some where in notes says XSE actually defers tax payment which is a benefit to the company. So what does the exam report means? Where is "investment income and expenses will be assumed to be gross within the pricing basis" coming from?
Many thanks!

 

[Lindsay Smitherman]

Being XSE is only a 'benefit' to the company if it ever becomes XSI again. If it remains XSE forever, then it will never get any tax relief on its expenses, which is a bad thing. Before 2013 (when the tax regime was changed), companies writing protection business (which is what this part of the exam question is asking about) often found themselves becoming stuck as XSE. Later in the solution, beyond the part that you quote above, it talks about the company needing to consider whether it will be XSE forever or whether this is just temporary - a key consideration.

For term assurance business (which is what this part of the solution is talking about), you would expect to have E>I. If the company is XSI overall, this means that the excess E generated by term assurance business can be offset against excess I being generated by other products - hence the expenses can be considered to be net for all products (ie it can be assumed that tax relief can be obtained on all expenses). Net expenses in pricing calculations means lower expenses, hence lower premiums and hence more competitive business.

However, if the company is XSE overall then the high expenses generated by term assurance business cannot gain tax relief. In that situation, rather than pricing on a 'net I, net that part of E which equals I, gross rest of E' basis (where net and gross refer to being net and gross of tax), pricing would be done on a 'gross I, gross E' basis. As you can hopefully see, this comes down to the same thing - but the latter (gross I, gross E) is more practicable to do.

Bear in mind that, since 2013, protection business is now taxed as non-BLAGAB and hence taxed only on profits - so these arguments are no longer relevant to pricing new term assurance business.

 

[chloe3705]

Thanks Lindsay. Very grateful.

 

[GauravT]

Hi Lindsay,
So if the company is XSE( with becoming XSI in say 5 years), on what basis the pricing is done?
Is it (gross I, grossE) till 5 years and (net I, netE) after 5 years and if yes how this change in tax treatment is reflected in premium? Is the product repriced after 5 years or the premium at starting takes into account this change?
Or is it (net I, netE) from starting?
I am asking from the perspective that if pricing is done only once with starting premium taking into account change in position from XSE to XSI, then company runs a risk that it may not turn XSI in assumed time and end up charging lower premium. Is my thinking correct?

Another question I have is for a savings product where I is very significant compared to E unlike protection product, will pricing on net basis produce uncompetitive premiums as we will be netting down Investment income by more than relief on expenses?

Thanks

 

[Lindsay Smitherman]

If the company believes that it would become XSI again in the not-too-distant future, as you suggest, then it might be able to use up its carried forward XSE at that point. Therefore it could decide to price on a net/net basis.
Premiums are not normally reviewable, so the pricing basis chosen would impact all of the premiums throughout the term.
Yes, the company's view of whether it will be XSI or XSE in future is an estimate. If it is wrong, there may be a tax profit/loss falling to the shareholder (in the same way as any experience variance of actual vs expected).

 

[Lindsay Smitherman]

Another question I have is for a savings product where I is very significant compared to E unlike protection product, will pricing on net basis produce uncompetitive premiums as we will be netting down Investment income by more than relief on expenses?
Thanks

Premium rates are higher for a savings product when taxed on an XSI net/net basis rather than an XSE gross/gross basis, but this is unlikely to mean that the product is "uncompetitive" because competitor companies are also likely to be pricing on an XSI basis.
[The issue about competition arises for protection products because we are comparing companies writing only protection business (XSE) with companies writing a mixture of protection and savings (XSI).]

 

[GauravT]

Thank you.