Taxation principles

Tax affects the value a policyholder receives and the profit an insurer makes. This page considers why governments tax life insurance in different ways, how premiums, investment earnings and benefits can be treated, and the main approaches to taxing insurance companies.

Government perspective

Aims of taxation

The general aim of taxation is to raise revenue with which the needs of citizens may be met (e.g. to pay for hospitals, pensions, etc).

Governments will need to balance many competing priorities when deciding how to allocate tax revenue. Governments will generally set out high-level principles which reflect how they intend to balance these competing priorities and whether they intend to promote any particular economic or social goals via the tax system. For example, a possible goal might be to have taxation which is broadly neutral between equivalent companies, products, and services. Equivalent companies means companies which are effectively doing the same thing, even though they might be in different sectors (e.g. supermarkets selling insurance may be taxed in the same way as insurers).

Complexity

Most countries will have detailed taxation frameworks setting out the taxation treatment of companies in that country and the products/services they sell.

In developed countries, the overall tax framework may have evolved over many years and may be very complex. It is important to ensure that the tax framework is not excessively complex for the tax authorities to administer or for companies/individuals to comply with. Changes in the taxation framework need to be considered carefully to ensure they are not overly onerous to comply with and do not have unintended consequences (e.g. giving rise to tax loopholes).

International considerations

Governments need to consider how comparable their country's tax framework is to those of other (similar) countries. In particular, they must consider whether they wish their own taxation to be more or less onerous.

For example, a country may wish to consider how onerous their taxation is in relation to the taxation frameworks of other countries within trading unions to which they belong (e.g. the EU).

Consideration also needs to be given to the taxation of domestic companies and foreign-based companies selling in the country. For example, the government of a country which does not have a strong domestic insurance market may offer favourable tax treatment to foreign-based insurers to encourage them to sell within their country. Alternatively, the government of a country with a strong domestic insurance market may impose more penal taxation on foreign-based insurers to protect its domestic insurers.

Governments should also consider any external drivers which may impact their country's taxation framework. A country may participate in international tax agreements which set limits on certain aspects of member countries' taxation frameworks (e.g. minimum tax rates). For example, the Global Anti-Base Erosion (GloBE) model rules are designed to ensure that in-scope large multinational groups face a minimum effective tax rate in the jurisdictions in which they operate, subject to the rules and exclusions of the framework.

Overview of life insurance taxation

The taxation framework for life insurance business in a particular country will set out the tax treatment of both:

• policyholders (and other policy beneficiaries, such as policyholders' dependents).

• life insurers (in respect of the business they have sold).

The level and form of life insurer taxation may vary significantly between different countries.

Adjustments needed for life insurance

Life insurance business has particular features which mean that adjustments may need to be made to the standard taxation rules. Particular such features include:

• the long-term nature of insurance business.

• the potential need for customer incentives.

Long-term nature

Determining a life insurer's profit is difficult relative to many other types of company. Profits on life insurance business may emerge many years after it was actually sold.

Similarly, a policyholder may not receive any payout on a life insurance product until many years after the policy was purchased.

Incentives

Governments may choose to offer beneficial tax treatment as a means of incentivising their citizens to purchase life insurance.

This is due to the important economic and social role of such products in a country. For example:

• Life insurance can provide financial protection against the adverse financial consequences of death or illness.

• Life insurance can allow individuals to save for particular events, such as to provide an income in retirement.

• Life insurance may relieve pressures on a country's social welfare systems, since the proceeds of such products may reduce individuals' reliance on the State (particularly for pensions).

Where favourable tax treatment is offered in relation to life insurance business, it is common for limitations to be imposed. For example:

• Different forms of life insurance business may receive different tax treatment.

• Only certain sub-groups of policyholder could be permitted to access tax-advantaged products (e.g. age restrictions, means-testing, etc).

• There could be limits on the sum assured or contributions for favourable tax treatment on some products (e.g. upper limits on tax-advantaged contributions into pension products).

Other considerations

Similar products

Governments must carefully consider whether tax treatment of life insurance business gives it an advantage (or disadvantage) relative to other equivalent products. The taxation environment can significantly impact life insurance business due to its impact on the attractiveness of such business relative to products offered by other types of financial institution which are subject to different tax rules.

Product design

Life insurance product design will often be influenced by the taxation environment. For example, adding a specific feature to a product (e.g. a minimum death benefit) could enable the policyholder to receive favourable tax treatment.

Complexity

Life insurers in developed countries with adequate infrastructure may be able to comply with a complex taxation framework, but this may not be the case for insurers in less developed countries with less developed life insurance frameworks.

Policyholder taxation

Policyholders (or other policy beneficiaries) may be taxed on the life insurance products they have purchased.

The form of taxation can vary considerably between countries and even between different types of life insurance product (e.g. savings vs protection) in a country.

The tax treatment of the following components of insurance products need to be considered:

• The premiums paid.

• Investment income earned on premiums and funds within the insurance company.

• The benefits received.

• Any additional taxation.

Premiums paid

The premiums paid into a life insurance product can be taxed in different ways. For example:

• Premiums may be paid out of policyholders' post-tax earnings (i.e. no tax relief is given on premium payments).

• Premiums may be paid on pre-tax earnings (i.e. premiums reduce policyholders' income tax bill). The benefit depends on the way relief is delivered; a deduction from taxable income alone would only benefit policyholders who pay income tax.

• Additional tax may be levied on premiums paid by the policyholder (although, in most countries, premiums for life insurance policies are exempt from insurance premium tax). This approach is more common for short-term insurance products, such as general insurance and medical insurance. In the UK, insurance premium tax (IPT) applies to premiums paid for products such as motor, home, pet, and travel insurance.

Where tax relief is given on premiums paid, there will often be restrictions.

Such restrictions are often imposed with the following aims:

• To ensure that individuals are not exploiting the tax advantages.

• To avoid more affluent individuals gaining disproportionately.

For example:

• Limits may be imposed on the amount of any tax relief that is available, such as restrictions on the amount of annual premiums that can receive tax relief.

• Tax relief may only apply to certain types of product. For example:

  • Premiums paid for products whose main purpose is to provide death benefits may not get tax relief.

  • Products whose main purpose is to save for retirement may receive tax relief to encourage policyholders to save (thus reducing the burden on the State of supporting individuals in retirement).

• Tax relief may only apply to certain contributions. For example, tax relief may only apply to contributions made by the individual and not those made by their employer. In other cases, premiums paid by employers may be counted as a deduction for corporation tax purposes.

Investment earnings

Investment returns earned on premiums by an insurer can also be taxed in different ways. For example:

• Investment returns could accrue free of taxation (known as a 'gross roll-up basis').

• Investment returns could be subject to taxation, possibly after the deduction of the insurer's expenses.

Where investment earnings are tax-free for certain products, certain asset classes (e.g. residential property held within pension schemes) may still be excluded from this tax relief.

Benefits received

The approach to taxation of benefits received by life insurance policyholders (or other policy beneficiaries) can vary between countries.

For example:

• Policyholders may receive the benefit from the life insurance policy without any further taxes.

• Part of the benefit may be taken tax-free.

• Tax may be payable on the full benefit.

• Tax may be payable on the excess of the benefit received over premiums paid (i.e. on the 'chargeable gain').

Type of benefit

Different types of benefit may be taxed differently. For example, in some jurisdictions, contractual death or maturity benefits on some products may be tax-free, but tax may still be payable on surrender benefits.

Tax rate

Where additional tax is payable on benefits, the rate of tax payable may be one of the following:

• The policyholder's normal (marginal) rate of income tax.

• The excess (if any) of the policyholder's marginal income tax rate over a basic rate of income tax.

• The rate of tax applied to capital gains.

• A different, specified, rate.

Marginal tax rates

In many countries, individuals will pay a different level of tax depending on their level of income.

For example:

• No tax on income may be payable up to a certain threshold.

• A first tax rate may apply to the next band of income above that threshold.

• A higher tax rate may apply to income in the next band, and so on.

Individuals only pay each specified tax rate for each band of income. An individual's marginal tax rate is the rate they pay on an additional unit of income (which will normally be the tax rate payable on the highest band into which their total income falls).

Where policyholders are liable to pay only the excess of their marginal income tax rate over the basic income tax rate, this may be because the insurance company has effectively paid tax at the basic rate on the 'policyholder profit'. In this case, the total amount of tax collected is broadly the same as if the policyholder had been taxed at their full marginal rate, but the insurer was not paying basic rate income tax on policyholder profit. The cost of tax on policyholder profit is normally passed on to policyholders through product pricing.

Limits

Where tax advantages are given in relation to a particular product (e.g. pension savings) there may be limits on the amount of benefits that may be purchased or accrued within that tax-advantaged environment. Additional tax charges may be applied to amounts in excess of that limit. The 'lifetime allowance charge' on UK pensions business, which was in place until April 2023, is an example of this.

Additional taxation

In some countries, additional tax may be applied to the proceeds of life insurance policies in certain circumstances. For example, in some countries inheritance tax may be due on the accumulated wealth of a policyholder who has died and the proceeds of any life insurance policies could be included in the policyholder's accumulated wealth.

Relationship between taxation of premiums, investment growth, and benefits

Governments need to consider the combination of tax treatment of premiums, investment returns, and benefits paid on a life insurance policy to ensure that the overall level of tax paid by the policyholder is appropriate.

It would be unusual for governments to be generous in the tax treatment of all premiums, investment returns, and benefits, since this could lead to an over-generous overall position.

It is common for limitations to apply to tax benefits. For example:

• If tax relief is given on premiums paid into the policy, then the benefit payouts to the policyholder will generally be taxable (as is often the case for pension products).

• If premiums paid into a policy are from post-tax earnings (i.e. there is no favourable tax-treatment of premiums), then only benefit payouts in excess of premiums paid would tend to be taxable (rather than the full benefit).

It would also be unusual for governments to impose more taxation on any savings element of a life insurance policy than would be incurred using other savings vehicles, as this would make the life insurance product uncompetitive.

Life insurance company taxation

Life insurers will generally need to pay tax on the business they write.

There are various approaches to taxing the business sold by life insurers.

The most commonly taxed elements of a life insurer’s business include the following:

• The commercial profits made by insurers on the business they have written.

• Investment earnings less some (or all) of the insurers' operating expenses.

• The premium income received on business written.

Life insurers may also be subject to other forms of taxation that apply to any company, including:

• Employment-related taxes.
• Taxes on goods and services purchased.
• Foreign withholding taxes on foreign investment income, levied by an overseas government on investment income received by non-residents.

Classification of business for tax purposes

In some jurisdictions, different types of insurance business may be treated differently for tax purposes.

In such cases, life insurers are required to classify their business into separate categories and ensure that each category is treated appropriately for tax. Tax legislation would include rules on how this categorisation should be done.

Separating business for taxation purposes will also require life insurers to divide and apportion their profit (and other accounting information) between these categories. Although this separation may be clear for some products, judgement may be required to categorise others. Tax authorities may provide information on how to divide such accounting information and the level of granularity needed in this apportionment. This is to avoid distortions in the tax results, such as those which may arise from high-level apportionments of investment returns and expenses between different types of business written. For example, tax authorities would be keen to reduce the scope for insurers' ability to manipulate apportionment of accounting items to minimise or avoid tax.

Taxation of profits

For business where tax is payable on the annual profits arising, the starting point is generally the insurer’s accounting trading profit, adjusted as required by tax law. A change in net assets alone is not the same as profit: capital contributions and distributions also need to be distinguished.

The profit figure used will typically be based on the trading profits arising in the statutory accounts (e.g. under IFRS or local GAAP). As such, profit figures may be materially impacted by changes in accounting policy (such as the introduction of IFRS 17). Tax authorities will often introduce special provisions to alleviate this impact, such as transitioning the change (for tax purposes) over a number of years in order to smooth out any additional tax burden.

The approach of taxing profits is normally associated with business that benefits from the gross roll-up of investment earnings (since it would be overly punitive to tax both investment income and profits).

A simplified cashflow view of trading profit is:

Trading profit = premiums + investment returns − claims − expenses − increase in liabilities.

This is an aid to understanding the sources of profit. The accounting recognition of individual items and the adjustments required for tax depend on the applicable rules.

The tax rate used in this case is typically the corporation tax rate that would apply to the profits of any type of trading company in the country.

If trading losses arise in a year, it may be possible to use these losses to offset taxable profits in future years (and perhaps in other companies in the same group). The extent to which this is possible may be restricted, however. For example, the period over which losses may be carried forwards may be limited to a certain number of years and/or to a maximum proportion of the profits arising.

Mutual life insurers may be treated differently from proprietary insurers because surplus belongs to policyholders rather than shareholders. Mutual status does not, by itself, mean that an insurer pays no tax; the treatment depends on the jurisdiction and the type of income or business.

Taxation of investment earnings minus expenses

'I-E' basis

Determining tax on the excess of investment earnings over expenses may be referred to as the 'I-E' basis or method.

'I' refers to the insurer's total investment earnings, though this may exclude certain items such as dividend income from equities and unrealised gains on equities and property. Dividend income may be exempt from tax since tax is effectively paid on these at source (through corporation tax). In some cases, the tax framework may allow an indexation adjustment to be applied to investment gains so that only gains earned in excess of inflation are chargeable. In this case, any tax offset allowable for losses would still be based on nominal losses rather than real losses.

'E' refers to the expenses incurred by the insurer, possibly with acquisition costs being spread over a defined period of time. This may also include a carried forward amount of excess expenses from the previous tax year, referred to as 'excess E' or 'XSE'.

Shareholder and policyholder profit

The aim of the 'I-E' basis is to approximate the overall impact of taxing both shareholder profit (i.e. normal trading profit) and policyholder profit within the life insurance company.

It can be seen that 'I-E' is the sum of shareholder profit and policyholder profit as follows:

• Shareholder profit = P + I − E − C, where P is premiums, I is investment earnings, E is expenses, and C is claims plus the increase in liabilities over the year.

• Rearranging the above gives: Shareholder profit + C - P = I - E.

• Thus, treating policyholder profit here as claims plus the increase in liabilities less premiums, we have the result: Shareholder Profit + Policyholder Profit = I - E.

Thus, if both shareholder and policyholder profits are taxed then the total taxable amount is I-E.

However, if shareholders and policyholders are taxed at different rates then it is necessary to split the amount (I-E) into those two components.

To do this:

• The shareholder profit is broadly taken as the trading profit arising (possibly subject to adjustments or restrictions).

• The policyholder share of profit may then simply be calculated as 'I-E' minus the shareholder profit.

The shareholder profit component would usually be taxed at the normal corporation tax rate. Since the policyholder profit is largely the investment return earned on policyholder assets, this component of profit may be taxed at a policyholder tax rate, which is typically the same as the tax rate applied to individuals' directly earned investment income. This enables tax authorities to collect tax on policyholder profit at the basic rate of tax directly from the insurer, leaving the policyholder to pay any additional tax due if they are a higher rate taxpayer.

In a mutual, I-E would typically be treated as policyholder profit.

Minimum profits test and XSE

Tax authorities may require life insurers to pay a minimum amount of tax, in line with the taxation of any trading company (e.g. corporation tax on trading profits) in order to treat different types of trading company equivalently.

Where this is the case, a 'minimum profits test' may be applied to proprietary companies for any business that is taxed on an 'I-E' basis, whereby the taxable amount is equal to the higher of 'I-E' and the trading profits of the company. It may be possible to carry forward some or all of any losses to reduce profits in future years and thus future years' tax bills. The shareholder profit component remains equal to the adjusted trading profit amount, but if the minimum profit test bites then there is no policyholder profit component.

An overview of this process is as follows:

• A quantity called 'minimum profit' is determined as a measure of the shareholder profit arising for the year. This is broadly equal to trading profit, possibly with some adjustments.

• This amount is typically subject to tax at the standard corporation tax rate.

• The remainder (if any) of the taxable income in the 'I-E' computation is denoted the policyholder profit and is typically taxed at the basic rate of income tax.

Excess E

If the minimum profits test bites, the company is deemed to not have been able to relieve all of its expenses and is permitted to carry the unrelieved amount of 'E' forward into the next tax year.

In other words, the insurer was unable to gain tax relief for all of the expenses in the 'I-E' calculation for the current tax year and may therefore carry forward any expenses for which tax relief was not awarded to be used in the next year's I-E calculation.

This situation will occur for a proprietary company when one or more of the following arises:

• Investment returns (I) are low or negative.

• Expenses (E) are high.

• Minimum profit is high.

In this situation, the company is said to be in an XSE (or 'excess E') position. If the minimum profit test does not bite, the company is said to be in an XSI ('excess I') position.

Examples of occasions where an XSE position may arise include the following:

• Due to significant falls in the market value of bonds.

• If the company is new and thus has a relatively low level of income but large expenditure.

• Due to a significant weakening of the liability valuation basis (creating a large trade profit and thus the minimum profit test to bite).

Unrealised losses may be excluded from the 'I' term, however.

Under an I-E system without a minimum profits test for mutuals, a mutual would be said to be XSE if I < E. In this case, no current I-E tax would arise, but could carry forward the unrelieved expense amount of E-I with the aim of getting tax relief in a future year.

Taxation of premium income

Insurers may also pay tax on premium income, as a type of sales tax.

Premium taxes can be used to protect domestic insurers from foreign insurers by imposing higher rates on the latter. The main advantages of premium-based taxes are that they are simple to calculate and verify. The main disadvantages of premium-based taxes are that they are more onerous for life insurance policies with higher premiums (which will ultimately be passed on to policyholders, resulting in lower average policy size and hence reduced profit). Taxation based on premium income is more common for short-term business such as general insurance and health insurance. It is not common for long-term products with an investment component.