The general insurance sector: big benefits but overburdened

Transcription

1 The general insurance sector: big benefits but overburdened Prepared for Insurance Council of Australia Centre for International Economics Canberra & Sydney August 2005

2 The Centre for International Economics is a private economic research agency that provides professional, independent and timely analysis of international and domestic events and policies. The CIE s professional staff arrange, undertake and publish commissioned economic research and analysis for industry, corporations, governments, international agencies and individuals. Its focus is on international events and policies that affect us all. The CIE is fully self-supporting and is funded by its commissioned studies, economic consultations provided and sales of publications. The CIE is based in Canberra and has an office in Sydney. Centre for International Economics 2005 This work is copyright. Persons wishing to reproduce this material should contact the Centre for International Economics at one of the following addresses. CANBERRA Centre for International Economics Ian Potter House, Cnr Marcus Clarke Street & Edinburgh Avenue Canberra ACT 2601 GPO Box 2203 Canberra ACT Australia 2601 Telephone Facsimile cie@thecie.com.au Website SYDNEY Centre for International Economics Suite 1, Level 16, 1 York Street Sydney NSW 2000 GPO Box 397 Sydney NSW Australia 2001 Telephone Facsimile ciesyd@thecie.com.au Website

3 iii Contents Summary v 1 Context and introduction 1 2 General insurance: a major industry 2 Affects everyone 2 Provides high value services 4 Makes a substantial contribution to GDP 10 Involves many businesses 12 Employs a large number of people 13 So it makes a weighty contribution 14 3 Plays a critical role 15 Works by pooling risk 15 Helps to manage risk 15 Mobilises savings 17 Facilitates strategic investments 18 Contributes in many other ways 19 So it is fundamental to the economy 20 4 Burdened by uneven taxes 21 Facing a punitive tax burden 21 Paying more tax than overseas 23 Creating revenue dependency in government 25 Imposing extra costs on the community 27 Creating an under-insured community 32 Avoiding costs from underinsurance 33 So raise value by lowering punitive taxes on insurance 35 5 Handicapped by distorted competition 37 Facing uneven regulation 37 Stepping toward a level playing field 40

4 iv CONTENTS Seeking further change 41 Exposing implications of not changing 43 So distortions should be fully ironed out 45 6 Conclusion 47 References 49 Boxes, charts and tables 2.1 General insurance product segmentation Average general insurance premiums per policy Insurance premium rate changes Tort reforms overview and impact Estimated expenditure on insurance by industry Expenditure on insurance as a share of industry value added Comparison of industry contributions to GDP, gross value added Relative share of insurance industry s contribution to GDP Comparison of average annual rates of industry growth Distribution of general insurance employees by state General insurance employees per $ billion of gross state product Industry investment assets by area Summary of taxes on general insurance to households State taxes as a percentage of home insurance premiums State taxes as a percentage of business insurance premiums International comparison of taxes on property insurance premiums Insurance tax revenue by state excluding GST Taxation revenue by product Taxes on the price of alcohol and tobacco compared with insurance Economic welfare gain from reduction in state taxes Economic impacts of a disaster with and without insurance Findings of the Potts Review: key features of DMFs and DOFIs Regulatory and taxation environment: post implementation of the Potts recommendations 41

5 v Summary THE INSURANCE INDUSTRY IS A MAJOR INDUSTRY in its own right. This sector makes a significant contribution to national output and plays an important role in the economy. Key aspects of the Australian general insurance sector are that it: comprises 157 entities and businesses (IBISWorld 2005); employs approximately employees and pays over $1.3 billion in salaries and wages each year (IBISWorld 2005); earned gross premiums of $32 billion in (IBISWorld 2005); paid out $12.4 billion in net claims in the year to March 2005 (APRA 2005); has improved its financial performance over the last couple of years: higher profitability has been influenced by enhanced underwriting performance and recent higher investment returns; provides protection for a substantial amount of Australia s assets. Australian households, governments and businesses have $47.6 billion worth of current and future claims against the reserves of general insurance companies (APRA 2005); provides insurance to every sector of the economy; and contributed $14.6 billion to Australian gross domestic product in gross value added terms in (ABS data). The services provided by the insurance industry play an important role in ensuring the smooth operation of the national economy, as well as in encouraging innovation. An insurer is better able to price risk and can absorb any losses against the pool of premiums. This effective management of risk allows individuals to engage in more risky activities, like starting a business or purchasing a large item, fostering higher levels of economic activity. The collection of premiums by insurance companies also provides a mechanism by which savings are mobilised. The general insurance

6 vi SUMMARY industry now accounts for nearly 4 per cent of the total assets held by financial institutions in Australia (RBA 2004). Despite the unique importance of insurance in the Australian economy, current tax arrangements place a punitive burden on the industry that is out of line with tax levels in other countries. In addition to direct taxes, the Australian insurance industry is subject to: a fire services levy (FSL) in New South Wales, Victoria and Tasmania; to the goods and services tax (GST); and to stamp duty. These taxes are applied in a cascading manner, with the GST calculated on top of the FSL and stamp duty being applied on the premium including both of these taxes. In , all levels of government in Australia collected $3.2 billion in tax revenue from the insurance industry (ABS 2005b). Despite the benefits of insurance, current tax arrangements in some states have a similar impact on the final price as do taxes on cigarettes and alcoholic spirits. Studies indicate that reducing tax on insurance would have relatively high welfare gains. The key impact of high tax levels is widespread under-insurance, with studies indicating that 21 per cent of consumers are currently under-insured. This level of under-insurance can impose future hardship on the community (Mason 2005). Despite recent reviews of competition in the market for general insurance, a number of entities providing general insurance in the Australian economy operate at an advantage, with their particular arrangements exempting them from regulatory requirements and insurance-related taxes. These entities include discretionary mutual funds (DMFs) and direct offshore foreign insurers (DOFIs). The small share of the market held by DOFIs and DMFs today obscures the potential significance of the distortions. The recent reviews noted that market share for these competitors was increasing reflecting the regulatory advantages that they enjoy. The magnitude of the distortion can be expected to grow and the costs will escalate and compound in the future. While the precise shape of market outcomes will reflect many choices and decisions to be taken by key market participants and governments, a reasonable scenario is that the favoured competitors will cherry pick key markets, shrinking the insurance and premium pool for general insurers. This would start a vicious cycle of raised premiums, reduced demand for general insurance, and underinsurance. This would lead to higher demands and budgetary costs to be faced by governments in Australia.

7 1 1 Context and introduction CIE HAS BEEN COMMISSIONED by the Insurance Council of Australia (ICA) to undertake a study into the benefits of the general insurance industry to the Australian economy. The three core areas of the analysis are to: identify the contribution of the general insurance industry to the Australian economy; assess the benefits of removing the potentially distortionary tax burden on insurance; and assess the impact of a level playing field in which distortionary advantages enjoyed by discretionary mutual funds (DMFs) and direct offshore foreign insurers (DOFIs) are removed. The focus of the study is upon the general insurance industry with brief references to the health and life insurance sectors. This report is structured as follows. The economic contribution of Australia s general insurance sector is outlined in chapter 2. A profile of the industry is presented, followed by an outline of the magnitude of its economic contribution in value added and employment terms. Chapter 3 discusses the role played by the insurance industry in the economy and the ways in which it facilitates an improved allocation of resources and economic growth. The uneven taxation burden placed on the general insurance sector is explored in chapter 4. Chapter 5 reviews the non-level playing field between Australian insurers and between Discretionary Mutual Funds (DMFs) and Direct Offshore Foreign Insurance (DOFIs) owing to potentially different regulatory and tax treatment afforded to them. Conclusions from the study are provided in chapter 6.

8 2 2 General insurance: a major industry THE GENERAL INSURANCE INDUSTRY makes a major contribution to the Australian economy. This chapter provides an overview of this contribution reporting on key indicators referring to: the nature of services provided; the value of services provided; the contribution to national output; and employment offered. Affects everyone The general insurance industry is defined by the services it provides. The Australian New Zealand Standard Industrial Classification (ANZSIC) system used in the official statistics in Australia defines it as units mainly engaged in providing motor vehicle, fire, marine, comprehensive household or insurance cover [not elsewhere classified] n.e.c.. Major activities include, but are not limited to: fire and Industrial Special Risks (ISR); household; motor vehicles (commercial, domestic and Compulsory Third Party (CPT)); marine and aviation; engineering and construction; professional indemnity; public and product liability; employers liability; mortgage; and

9 3 2 GENERAL INSURANCE: A MAJOR INDUSTRY travel. The top three products and services provided by insurers, measured by premiums received, are employers liability, domestic motor vehicle and CTP motor vehicle. The relative size of the general insurance market by product is demonstrated in chart General insurance product segmentation 2005 Employers liability Domestic motor vehicle CTP motor vehicle Householders/House owners Inward treaty Other Fire and ISR Commerical motor vehicle Public and product liability Professional indemnity Marine and aviation Mortgage % of total premiums received Data source: IBISWorld (2005). The Australian New Zealand Standard Industrial Classification (ANZSIC) defines the insurance industry using three classes: health insurance (I7421); general insurance (I7422); and life insurance (I7411). 1 Broadly, general insurance includes nearly all insurance activities other than life and health. The general insurance industry (I7422) is the focus of this study. 1 ANZSIC includes a fourth class, services to insurance (I7520). The class includes units mainly engaged in providing insurance broking or agency services, or other services to insurance such as consultant, claim assessment, or adjustment services. This class also includes foreign based insurance underwriters mainly engaged in insurance broking (not carrying) domestically.

10 4 2 GENERAL INSURANCE: A MAJOR INDUSTRY Clearly the general insurance sector provides a wide range of services that have implications for the everyday lives of most people. The broader role that insurance plays by meeting these needs is discussed in more detail in chapter 3 of this report. Provides high value services Customers place a high value on insurance The cost of insurance to the customer provides a conservative measure of the value of that insurance. Policyholders would generally not buy insurance if they viewed that the price exceeded its worth to them. Looking across the industry at large, this provides an indicator of the value placed upon insurance on a willingness-to-pay basis. Gross premiums collected by the general insurance industry in Australia amounted to $31.9 billion in (IBISWorld 2005). They increased from $23.7 billion in , with an average real rate of growth of 5.4 per cent per annum over that time (IBISWorld 2005). General insurers provide their products and services to a range of commercial and residential clients. Most premiums are paid by consumers as opposed to commercial customers. That is, most demand for general insurance is comprised of final demand rather than intermediate or derived demand. Premiums for policies have been relatively volatile. They increased over the three years to (chart 2.2). Prior to this, average premiums showed a declining trend per policy from $497 in 1997 to $401 in However, average premiums up to 2001 were still lower than the 1997 figure. The increase or hardening of premiums has been argued to be much needed by some industry observers following a decade of weak pricing, whilst insurers relied on investment gains to fund their underwriting losses (KPMG 2003). 2 The data on average premiums is based on the most recent publicly available ACCC review of insurance industry pricing (ACCC 2002).

11 5 2 GENERAL INSURANCE: A MAJOR INDUSTRY 2.2 Average general insurance premiums per policy 2001 values $ per policy Data source: ACCC (2002). Since 2001, there are signs that premium prices have continued to follow an upwards trend on average. According to KPMG (2003), on average insurers increased premium rates between 2001 and Personal lines of insurance (including home insurance and compulsory third party) increased by around 3 per cent in These premiums are forecast to continue to grow over the next two years (chart 2.3). In contrast, premiums upon commercial lines have declined on average during 2004 by 4 per cent. Further falls in commercial premium prices are expected over the next two years. 2.3 Insurance premium rate changes % Weighted average change (personal) Weighted average change (commercial) Data sources: Lawson (2005) and JP Morgan-Deloitte (2004).

12 6 2 GENERAL INSURANCE: A MAJOR INDUSTRY Recent government initiated tort law and other reforms aimed at improving the affordability and availability of public liability and professional indemnity insurance appear to be having a positive downward impact on the price of premiums for these types of insurance (box 2.4). Claims paid are of a high value each year Policyholders buy insurance in return for the payment of claims, or the potential need to pay claims. The amount of claims paid across the community in a year provides another indicator of the value of insurance to the economy at that time. In the year ended March 2005, the general insurance industry in Australia paid out $12.4 billion in net claims (APRA 2005). Of course, the amount of claims paid depends on what happens in a given year and is influenced by the vagaries of the weather, bush fires and other events. In a broad sense, the difference between net claims and premiums drives the rate of return for capital invested in the insurance industry and changes in the financial reserves of the industry. 2.4 Tort reforms overview and impact Since 2002, Commonwealth and state level governments have pursued measures to lower and contain legal and claims costs in the areas of public liability and professional indemnity insurance. This occurred in response to growing concerns over rising premiums and reduced availability of these types of insurance. Between 1997 and 2002, the ACCC found that public liability claims costs rose significantly. Average claims size increased by 75 per cent. Average premiums increased by 19 per cent in 2001 and by 44 per cent in Professional indemnity claims costs rose substantially over the five years to From 1997 to 2002, the average size of claims increased by 195 per cent. Average premiums rose by 21 per cent between 1997 and 1999, and then jumped by 125 per cent to 2002 (ACCC 2003). An expert report submitted to a ministerial meeting found that the main factors contributing to rising premiums and lower availability of public liability insurance were as follows: changing community attitudes to litigation; change in the courts view of what constitutes negligence; increased compensation for bodily injury claims; previous under-pricing and poor profitability of the insurance industry; the collapse of HIH, a significant player in the public liability market; and a decision by insurance companies to be more selective about the risks that they cover (Coonan 2002). (Continued on next page)

13 7 2 GENERAL INSURANCE: A MAJOR INDUSTRY 2.4 Tort reforms overview and impact (continued) The main types of reforms implemented as at 30 June 2004 include the capping of damages for economic loss (loss of past and/or future income), non-economic loss (pain and suffering) and legal costs. Other reforms encompass the introduction of minimum thresholds of impairment for access to non-economic loss, limitation periods for personal injury claims, provision for good Samaritans and volunteers, waivers for risky activities and provisions disallowing exemplary or punitive damages. In addition, proportionate liability for economic loss, and professional standards legislation, have been implemented in some jurisdictions (ACCC 2005). There is mixed evidence on the impact of reforms to date; it is likely to be too early to observe the full effect of reforms at the moment. However, there are some positive early signs. In the six months to June 2004, the average size of public liability claims settled fell by 11 per cent and premiums for this class of insurance decreased by 15 per cent (ACCC 2005). At an industry forum held by the ICA in February 2005, claims managers in New South Wales, Queensland and Victoria have observed a fall in the number of claims (ICA 2005). Many in the industry perceive that social behaviour towards negligence matters is beginning to change in a positive direction (JP Morgan and Deloitte 2004). A recent review of government services indicated that civil claims fell across Australia by more than over the past three years (Oldfield 2005). In New South Wales, the number of civil cases pending in the District Court has fallen substantially due to the introduction of tort law reforms (Steering Committee for the Review of Government Service Provision 2005). For professional indemnity insurance, the average size of claims settled rose by 21 per cent, but average premiums fell by 17 per cent. Based on a survey, insurers did not expect reforms to have an impact on professional indemnity insurance claims costs and premiums during 2004, particularly as reforms enacted to the end of June 2004 mainly focused on personal injury and death claims (ACCC 2005). Proposed reforms on amendments to the Insurance Contracts Act 1984 and the introduction of Commonwealth professional standards legislation are expected to have an impact on professional indemnity insurance claims and premiums in the future (ACCC 2005). A number of surveys by stakeholder have found indications that availability of public liability and professional insurance has improved (see ICA 2005). The full impact of reform is likely to be observed in a few years time. In October 2004, several industry players indicated that it might take 2 to 3 years before tort reform effects are completely understood (JP Morgan and Deloitte 2004). Large value of assets protected Another indicator of how important insurance is to the Australian economy is the value of assets protected. One way of obtaining a broad estimate on the size of the community s assets protected is by examining insurers liabilities. Based on APRA data, at the end of March 2005, Australian households, governments and businesses had $47.6 billion worth of claims against the reserves of general insurance companies (APRA 2005). This figure includes $35.3 billion of outstanding claims provisions, which account for the potential cost (to insurers) of settling claims incurred at the reporting date but may not yet have been paid. Premium liabilities of $12.3 billion are also included, which indicates future claims that may arise from future events under current policies.

14 8 2 GENERAL INSURANCE: A MAJOR INDUSTRY According to the ABS, Australian households alone had $33.1 billion of claims against health and general insurance reserves as at March 2005 (ABS 2005a). Current and future claims against insurers is likely to underestimate the true value of all assets protected, because it is based on the sum insured multiplied by the probability of a claim occurring. The value of all assets insured under all policies would be a more useful indicator of the value of insurance. Regretfully, reliable indicators of the value of assets insured are not widely available. Insurance is essential for business Insurance is a fundamental part of business. The most recently available Input-Output tables published by the ABS 3 indicate that Australian producers spent an estimated $1.83 billion on insurance, which includes life and health insurance. That data also shows that every sector of the economy purchased insurance as part of their business. Industry expenditure on insurance is portrayed in chart 2.5. Manufacturing and retail trade are the two largest purchasers of insurance as indicated in chart 2.5. This reflects the relative size of these sectors, which are among the largest sectors of the economy. Chart 2.6 illustrates the amount of insurance purchased by each sector of the economy taking into account the size of that sector. This suggests that there are differences between industries in the intensity of their reliance upon insurance. From this perspective it appears that service sector activities use more insurance per unit of value added than manufacturing and other goods-oriented activities, such as agriculture and mining. The accommodation, cafes and restaurants sector is the most intensive user of insurance. It is likely that the sectors that are intensive users of insurance would be most reliant upon the continued availability and affordability of insurance. Reductions in the availability or affordability of insurance would clearly be a significant concern for many service sector activities that have been the mainstay of Australia s economic growth and employment over recent decades. 3 Although the data is from , the Input-Output tables still provide a reasonable reflection of the structure of Australia s economy. This is because it takes a significant period of time for structural changes to occur and therefore be apparent in the data.

15 9 2 GENERAL INSURANCE: A MAJOR INDUSTRY 2.5 Estimated expenditure on insurance by industry Agriculture, forestry and fishing Mining Manufacturing Electricity, gas and water supply Construction Wholesale trade Retail trade Accommodation, cafes and restaurants Transport and storage Communication services Finance and insurance Property and business services Government administration and defence Education Health and community services Cultural and recreational services Personal and other services $m Data source: ABS data. 2.6 Expenditure on insurance as a share of industry value added Agriculture, forestry and fishing Mining Manufacturing Electricity, gas and water supply Construction Wholesale trade Retail trade Accommodation, cafes and restaurants Transport and storage Communication services Finance and insurance Property and business services Government administration and defence Education Health and community services Cultural and recreational services Personal and other services Expenditure on insurance as % of value added Data source: ABS data and CIE estimates.

16 10 2 GENERAL INSURANCE: A MAJOR INDUSTRY Makes a substantial contribution to GDP The contribution is already substantial Assessment of the size of the economy or of the contribution of a specific sector often focuses upon its value added. That is, the difference between the value of product and the cost of making it. Gross Domestic Product (GDP) is the sum of every industry s value added. The value added statistics, compiled by the ABS, groups general insurance with other types of businesses within the finance and insurance division (within the ANZSIC framework which underpins the national accounts). This division makes the fourth largest contribution to GDP (in gross value added terms) out of all industries (chart 2.7). There is some data about the specific contribution of insurance within the finance and insurance division. Insurance (including general, life and health insurance) accounts for about 36 per cent of the value added by the division. The general insurance sector produces most of this. The relative share of life, health and general insurances, as measured by industry gross value added is illustrated in chart 2.8. By itself the general insurance component of the division contributed nearly 2 per cent, or $14.6 billion, of Australian GDP in gross value added terms in Comparison of industry contributions to GDP, gross value added Manufacturing Property and business services Ownership of dwellings Finance and insurance Construction Health and community services Retail trade Wholesale trade Transport & storage Education Mining Government, administration & defence Agriculture, forestry & fishing Communication services Personal & other services Electricity, gas & water Accommodation, cafes & restaurants Cultural & recreational services % of GDP Data source: ABS (2004a).

17 11 2 GENERAL INSURANCE: A MAJOR INDUSTRY 2.8 Relative share of insurance industry s contribution to GDP Health insurance 2% Life insurance 28% General insurance 70% Data source: ABS data. The contribution is growing The finance and insurance division has sustained a rapid rate of growth. Over the ten years from to , Australia s average annual rate of growth (measured by GDP) was 3.9 per cent. In contrast the insurance and finance division maintained an average annual rate of growth of 4.3 per cent. In the two subsequent years, and , the industry has sustained similar growth. Chart 2.9 shows average growth rates across all industries (or ANZSIC Divisions). Chart 2.9 also illustrates the transformation in economic activity away from goods-oriented activities, such as agriculture and manufacturing, towards services activities. The sustained rapid rate of growth in finance and insurance is part of this transformation.

18 12 2 GENERAL INSURANCE: A MAJOR INDUSTRY 2.9 Comparison of average annual rates of industry growth to Communication sevices Property & business services Wholesale trade Transport & storage Finance & insurance Accommodation, cafes & restaurants Personal & other services Agriculture, forestry and fishing Construction Health & community services Ownership of dwellings Retail trade Mining Cultural & recreational services Manufacturing Government, administration and defence Education Electricity, gas & water supply GDP Average annual rate of growth Data source: ABS (2004a). Involves many businesses Australia s general insurance sector comprised 157 insurers at the end of June 2004 (IBISWorld 2005). Within the general insurance sector, there are both private and public general insurers. Of these, 90 per cent are private; the remaining 10 per cent are public general insurers. These entities are classified as one of four types of insurers: direct underwriters, which represent the majority of insurers; mortgage insurers; captive insurers; and reinsurers. The large number of organisations involved is an indication of the choice that consumers have and the level of competition that there is in delivering general insurance services.

19 13 2 GENERAL INSURANCE: A MAJOR INDUSTRY Employs a large number of people According to some estimates, by the end of , the general insurance sector employed nearly workers and paid $1.3 billion in wages (IBISWorld 2005). Employment has been falling over the last six years, from to (IBISWorld 2005). The slight fall in employees reflects a wide range of factors including industry rationalisation and continued productivity gains. All Australian states and territories have a portion of their labour force working in this sector (chart 2.10). The number of employees in each state is loosely associated with the size of its economic activity, measured by Gross State Product (GSP), as illustrated in chart The states of New South Wales and Victoria are exceptions. These states appear to have a concentration of employees probably reflecting the location of headquarters and other service functions in those states Distribution of general insurance employees by state Number of employees NSW VIC QLD SA WA TAS NT ACT Data sources: ABS data and IBISWorld (2005).

20 14 2 GENERAL INSURANCE: A MAJOR INDUSTRY 2.11 General insurance employees per $ billion of gross state product Employees per $ Billion of GSP NSW VIC QLD SA WA TAS NT ACT All states Data source: ABS (2004b) and IBISWorld (2005). So it makes a weighty contribution The general insurance industry forms an important part of the economy in its own right over a range of dimensions. It provides: a broad range of services that affects most people in their day-to-day life while every business sector relies to some extent upon insurance in their business; high value that customers value at $31.9 billion in terms of premiums paid in ; a significant contribution to economic performance where general insurance amounts to about 2 per cent of GDP each year and is part of the finance and insurance sector which is the forth largest in the economy at large; and a large number of jobs employing about people, with these jobs spread throughout the country.

21 15 3 Plays a critical role THE TRUE VALUE OF THE INSURANCE INDUSTRY lies in the unique nature of the services that it provides. This chapter reviews the broader economic contribution of the industry. Works by pooling risk At its most basic, insurance is an agreement where, in exchange for the payment of a premium, the insurer agrees to pay the policyholder a defined amount in the event of a specific loss. The premiums paid by an individual policyholder become part of an insurance pool which is at the disposal of the insurer. In setting premiums, the insurer considers the expected losses across the insurance pool and the potential for variation. The aim is to charge premiums that, in total, will be sufficient to cover all of the projected claim payments for the insurance pool. This involves balancing a complex range of factors (Anderson and Brown 2005). Helps to manage risk Risk management is a key contribution of the industry. Uncertainty and risk accompany most economic activities. The acquisition of assets that characterises most investments also implies the acquisition of risk. Physical assets in particular are subject to unexpected but costly damage. New endeavours, which are particular drivers of economic growth, are typically accompanied by even more risk. Many individuals are risk averse and prefer to avoid or minimise risk. Even entrepreneurs in new businesses prefer to shed risk in areas that are outside of their control if they can.

22 16 3 PLAYS A CRITICAL ROLE Insurance frequently provides the answer to risk management issues. Many authors identify this as a central contribution: the possibility of shifting risks, of insurance in the broadest sense, permits individuals to engage in risky activities which they would not otherwise undertake. (Arrow 1970, p. 137) Insurance provides the vital market function of allocating and pricing risk The efficient pricing of risk and its transfer to those best equipped to handle it contributes significantly to resource allocation and economic growth. And without a reliable mechanism for pooling and transferring that risk, much economic activity just simply wouldn t take place. (Costello 2004, p. 1) insurance facilitates innovation within an economy by offering to underwrite new risks. (Ward and Zurbruegg 2000, p. 491) Insurers enable risk to be managed more efficiently in three ways, through: risk pricing; risk transformation; and risk pooling and risk reduction. In their insurance activities, insurers evaluate potential losses the greater the potential loss, the higher the price of insuring that risk. Insurers pricing of risks provides information to policyholders about the consequences of their activities that will assist in the efficient allocation of resources (Webb 2000). Insurance enables individuals to transfer their risk to insurers, transforming the insured s risk profile. Insurance provides an important way of transferring risk from risk-averse individuals to companies that specialise in evaluating and dealing with risk. Insurance companies play a critical role as specialists in information about risks and in risk management (ACCC 2002). Insurance companies are not simply firms that specialise in risk. Rather, in a world of informational asymmetries, they are specialists in gauging, monitoring and most particularly managing risk. It is this expertise that enables insurance firms to cope with difficulties such as moral hazard and adverse selection. (ACCC 2002, p. 125) The ability of insurers to transfer risk facilitates the purchase of significant items, such as motor vehicles and real estate. As a result, insurance coverage can have positive externalities 4, including increased purchases, 4 An externality occurs when an activity has an indirect effect on other activities that is not directly reflected or encompassed in the price of the initial activity.

23 17 3 PLAYS A CRITICAL ROLE profits and employment. These arise not only from within the insurance sector but also outside it (Ward and Zurbruegg 2000). As noted above, insurers cover individuals against losses or manage risks by pooling risks. Aggregation brings other benefits. By insuring a large pool of individuals who are facing similar risks, insurance companies can predict with greater accuracy the likelihood of an event occurring. This is based on the law of large numbers, which states that although single events can be random and largely unpredictable, the average outcome of many similar events can be ascertained more easily than the outcome of a one-off event. The greater the number of policyholders, the more stable and predictable is the insurer s portfolio. This can lead to lower volatility, in turn enabling insurers to charge smaller risk premiums and maintain more stable premiums (Skipper, Starr and Robinson 2000). Mobilises savings In meeting insurance needs, insurance companies also act as financial intermediaries. In collecting and managing a pool of insurance premiums, insurers are part of the group of institutional investors which have become key holders of financial assets and have an increasingly important role in today s capital markets (OECD 2004). Insurance companies also play a secondary but increasingly important, intermediation role. They take funds from policyholders and invest them in financial and real markets. (Hodgson 1999, p. 3) Insurers help mobilise savings in three ways (Webb 2000). First, insurers lower transaction costs associated with drawing together savers and borrowers compared with direct lending and investing by policyholders. Second, they create liquidity. Insurers invest funds from customers to make long-term loans and other investments. Whereas policyholders have ready access to loss payments and savings, borrowers do not have to repay their loans immediately. Hence if individuals carried out the similar direct lending, the proportion of their personal wealth held in long-term, illiquid assets would be much higher. Third, by gathering small sums from large numbers of policyholders, insurers are often able to provide finance on a scale required for large infrastructure projects. This assists the national economy in expanding the set of feasible investment projects and encouraging economic efficiency. In the United States, insurers provide financing for one-third of all corporate debt (Skipper, Starr and Robinson 2000).

24 18 3 PLAYS A CRITICAL ROLE Facilitates strategic investments Reflecting its savings mobilisation role, the insurance sector now manages significant funds. Out of $2 516 billion total assets held by Australian financial institutions, general insurance industry assets accounted for nearly 4 per cent or over $90 billion at the end of September 2004 (RBA 2004). This compares to 3 per cent for finance companies and general financiers, nearly 50 per cent for banks (excluding the RBA), and 15 per cent for the growing superannuation funds. Drawing on the asset side of their business, Australia s general insurance industry undertakes considerable investment. At the end of March 2005, the industry had total investment assets of $52.9 billion (APRA 2005). The majority of industry investment assets are in interest bearing securities almost 70 per cent of total investment (APRA 2005). Following the recent strengthening in equity markets and improved returns, many insurers are beginning to move more investments back into equity holdings. Investments in equity and property trusts are also on the rise (APRA 2004). Holdings of investment assets by area are depicted in chart 3.1. The industry earned $4.2 billion in investment income in the 12 months to March 2005 an increase of 33 per cent from the previous year (APRA 2005). 3.1 Industry investment assets by area March 2005 Loans and advances 4% Other inv estments 10% Property 1% Indirect investments 5% Equity 11% Interest 69% Data source: APRA (2005).

25 19 3 PLAYS A CRITICAL ROLE Contributes in many other ways The insurance industry also facilitates economic growth through other mechanisms as follows. Promoting financial stability. This occurs through insurers covering those who suffer loss. Without this assurance individuals and firms could incur significant losses and not engage in activities to create wealth. Insurance allows risk to be transferred to an entity that is better able to deal with it, allowing individuals and firms to specialise and undertake more risky projects (Das et al. 2003). Substitutes for and complements government welfare programs. This is relevant for activities such as compulsory third party insurance for motor vehicle accidents and life insurance. Insurance covering personal injury care and rehabilitation costs can assist in reducing government expenditure on these costs. Studies have found that higher private expenditure on life insurance has been associated with lower government expenditure on social insurance programs (see Webb 2000). Facilitating trade and commerce. Several products and services are made and sold only when adequate insurance is provided. In the case of high risk new business ventures, the provision of financing is often contingent upon assets and the entrepreneur s lives being adequately insured. Banks (and governments) frequently require people buying a home with a small deposit to obtain mortgage insurance. The diversity of insurance products and insurer s ability to price different risks means that insurance can be considered as a lubricant of commerce facilitating investment. Encouraging loss mitigation. This can occur, for example, by insurance companies requiring some policyholders to undertake loss management activities, such as fire prevention and occupational health and safety activities. Any reduction in losses can benefit the community at large. Fostering more efficient allocation of capital. Insurers spend time collecting information to evaluate projects, firms and individuals in their decision to issue and price insurance and in their investment activities. By comparison, individual savers and investors typically do not have the time, resources or ability to collect this information. In addition, activities of insurers in continually evaluating and monitoring risks provides markets with information on the likelihood of losses which can lead to improved resource allocation (Webb 2000).

26 20 3 PLAYS A CRITICAL ROLE More sophisticated and efficient financial sectors with a range of products and services on offer can aid economic growth by facilitating the allocation of capital. A study using data from 55 countries found that higher levels of banking and insurance in an economy positively impacted on economic growth (Webb, Grace and Skipper 2002). According to that study, the two sectors jointly provided a greater impact on economic growth than the sum of each sector s individual impact with synergies between financial intermediaries. For example, more efficient bank payment systems can lead to lower administrative costs for insurers. Also, growth in one type of financial intermediary can also have positive spillover effects on the demand for services offered by other financial intermediaries as consumer sophistication increases (Webb, Grace and Skipper (2002). So it is fundamental to the economy General insurance underpins key aspects of society by providing security and protection to individuals, communities and businesses. Through general insurance, entities are protected against bearing the full costs of an economic loss. It allows risk to be transferred and shared among many players, thereby reducing the burden of loss. It provides coverage for all aspects of modern living, from professional indemnity and public liability to natural disasters and personal property. Without it, fewer businesses could operate, jobs would be lost and families would not have protection against adversity. Insurers are also financial intermediaries and play an important part in mobilising savings and investment and in improving the allocation of resources.

27 21 4 Burdened by uneven taxes DESPITE THE ROLE THAT INSURANCE PLAYS in supporting economic activity and its pervasive role in protecting people from hardship, a punitive tax burden is applied to insurance in Australia. This chapter looks at the range of taxes applied to insurance in Australia. It compares taxes applied in Australia with those in other countries. The chapter also compares taxes between different jurisdictions in Australia, and reviews the evidence about the inefficiencies that result from the heavy tax burden applied to insurance in Australia. Facing a punitive tax burden Insurance is subject to a large number of taxes. Insurance businesses pay direct taxes such as the company tax rate of 30 per cent. In addition, there are a number of indirect taxes applied by the Commonwealth and state governments. These include: Fire services levy (FSL) This is applied to a range of general insurance products. The FSL is intended to raise funds for brigade fire services. The states of New South Wales, Victoria and Tasmania currently apply FSL. Goods and Services Tax (GST) applied at a rate of 10 per cent to final customers, as it is to most other goods and services in the economy. Stamp duty contracts of insurance are subject to this tax. The rate is set on an arbitrary basis and differs from state to state. As noted above the rate of taxes applied to insurance differ in each state. Data from the most recent publication comparing state taxes imposed on household general insurance across Australia is summarised in table It is notable that the NSW budget for released in May 2005 raised the stamp duty rate from 5 to 9 per cent in that state. The table also includes the latest FSL rates, which were recently increased in Victoria and New South Wales.

28 22 4 BURDENED BY UNEVEN TAXES 4.1 Summary of taxes on general insurance to households 2005 Jurisdiction NSW NT ACT QLD WA SA TAS VIC % % % % % % % % Metro Country Stamp duty FSL GST Source: ICA data, NSW Treasury (2004) and NSW Treasury (2005). The challenging aspect of taxation applied to insurance is that it cascades. The GST is calculated with FSL in the base. Stamp duty is then applied to premiums, the FSL, and the GST amount. This is a now rare example of tax cascading that the reform process involved in the introduction of the GST was supposed to eliminate. 4.2 State taxes as a percentage of home insurance premiums 2005 VIC country VIC metro NSW SA NT WA ACT TAS FSL GST Stamp duty QLD % of premium Data source: ICA data and CIE calculations. Reflecting the tax rates applied and the impact of tax cascading, indirect taxation applies a weighty burden on the price of insurance. It is estimated that the three main state taxes combined can add to the cost of insurance to households by between 44 per cent in Victoria and 18 per cent in Queensland. This is calculated by comparing the taxes that would be paid on an insurance contract for home insurance across the states and

29 23 4 BURDENED BY UNEVEN TAXES territories. The proportion paid in taxes represents a significant impost on consumers in all states, but it is particularly heavy in New South Wales and Victoria. State taxes impose an even higher cost on insurance bought by businesses. The proportion of state taxes on premiums ranges from a significant 82 per cent in regional Victoria to 18 per cent in Queensland (chart 4.3). 4.3 State taxes as a percentage of business insurance premiums 2005 VIC country VIC metro NSW TAS SA NT WA FSL GST Stamp duty ACT QLD % of premium Data source: ICA data and CIE calculations. In addition to these main three taxes, the New South Wales Government imposes a levy on insurance companies to contribute to funding shortfalls in coverage after the collapse of HIH. It levies an Insurance Protection Tax on insurers according to their share of total yearly premiums. Under the legislation this cost is to be borne by insurers, and they are prevented from passing it on to policyholders. Paying more tax than overseas By international standards, taxes on general insurance in Australia are high. Tax as a percentage of commercial and household insurance

30 24 4 BURDENED BY UNEVEN TAXES premiums in a variety of jurisdictions is depicted in chart Taxes on property insurance in most Australian states and territories are higher than in the majority of the comparator countries. International taxes as a proportion of premiums are as low as 2 per cent in Ireland and Singapore and 2.4 per cent in the USA (California). Australian taxes on property insurance are particularly high compared with international competitors in the area of business insurance. Premium taxes on commercial insurance in country Victoria are more than 16 times greater than those imposed in the United Kingdom. Taxes in both Tasmania and New South Wales are more than 10 times higher. The level of taxes on household premiums in many Australian states and territories is above those in countries such as South Africa, Germany and 4.4 International comparison of taxes on property insurance premiums 2005 VIC - Country VIC - Melbourne NSW TAS France SA ACT NT WA Chile Colombia QLD Germany South Africa Trinidad and Tobago UK Switzerland Canada (Ontario) USA (California) Ireland Singapore Hong Kong Japan Commercial insurance Household insurance % of tax-exclusive premium Data sources: ICA data, Spratt (2005) and CEA (2005). 6 A basic premium of $100 is assumed and does not account for different cost structures insurers might have across and within jurisdictions.

31 25 4 BURDENED BY UNEVEN TAXES Switzerland. In contrast to the approach in Australia, household premiums in Japan are tax-deductible (Spratt 2005). Creating revenue dependency in government Budget is heavily dependent on insurance tax revenue Reflecting high tax rates, insurance forms a significant source of revenue for Australian governments. In , all levels of government collected $3.2 billion in revenue from tax on insurance (ABS 2005b). The revenue obtained from this tax has grown by 51 per cent over the last 5 years. The total figure for government taxation on insurance reported by the ABS does not include the GST levied on premiums. GST levied on all goods and services is separately identified in this set of statistics (ABS 2005b). On average, indirect insurance taxes provide almost 7 per cent of state governments own-source revenues. Some states are particularly reliant on this source of revenue, such as Victoria, South Australia and Tasmania where insurance taxes generate between 7.6 and 7.9 per cent of tax revenues (chart 4.5). 4.5 Insurance tax revenue by state excluding GST % of total taxation NSW VIC QLD SA WA TAS NT ACT Data source: ABS (2005b).