General Insurance-big Benefit but Overburdened

8/11/2019 General Insurance-big Benefit but Overburdened

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The generalinsurance sector:big benefits butoverburdened

Prepared for

Insurance Council of Australia

Centre for International EconomicsCanberra & Sydney

August 2005


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Centre for International Economics 2005

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iii

C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S

Contents

Summary v

1 Context and introduction 1

2 General insurance: a major industry 2Affects 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 15Helps 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


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iv

C O N T E N T S

Seeking further change 41

Exposing implications of not changing 43

Sodistortions should be fully ironed out 45

6 Conclusion 47

References 49

Boxes, charts and tables

2.1 General insurance product segmentation 3

2.2 Average general insurance premiums per policy 5

2.3 Insurance premium rate changes 5

2.4 Tort reforms overview and impact 6

2.5 Estimated expenditure on insurance by industry 9

2.6 Expenditure on insurance as a share of industry value added 9

2.7 Comparison of industry contributions to GDP, gross value

added 10

2.8 Relative share of insurance industrys contribution to GDP 11

2.9 Comparison of average annual rates of industry growth 12

2.10 Distribution of general insurance employees by state 132.11 General insurance employees per $ billion of gross state

product 14

3.1 Industry investment assets by area 18

4.1 Summary of taxes on general insurance to households 22

4.2 State taxes as a percentage of home insurance premiums 22

4.3 State taxes as a percentage of business insurance premiums 23

4.4 International comparison of taxes on property insurance

premiums 24

4.5 Insurance tax revenue by state excluding GST 25

4.6 Taxation revenue by product 26

4.7 Taxes on the price of alcohol and tobacco compared with

insurance 27

4.8 Economic welfare gain from reduction in state taxes 32

4.9 Economic impacts of a disaster with and without insurance 35

5.1 Findings of the Potts Review: key features of DMFs and

DOFIs 39

5.2 Regulatory and taxation environment: post implementation

of the Potts recommendations 41


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v


Summary

THE INSURANCE INDUSTRY IS A MAJOR INDUSTRY in its own right.This sector makes a significant contribution to national output and plays animportant role in the economy. Key aspects of the Australian general

insurance sector are that it:

comprises 157 entities and businesses (IBISWorld 2005);

employs approximately 20 000 employees and pays over $1.3 billion in

salaries and wages each year (IBISWorld 2005);

earned gross premiums of $32 billion in 200304 (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 underwritingperformance and recent higher investment returns;

provides protection for a substantial amount of Australias 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 2003-04 (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


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vi

S U M M A R Y


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 2003-04, 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 imposefuture 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 higherdemands and budgetary costs to be faced by governments in Australia.


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1Context 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

Australias 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.


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2General insurance: a major

industry

THE GENERAL INSURANCE INDUSTRY makes a major contribution to

the Australian economy. This chapter provides an overview of thiscontribution 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 everyoneThe 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


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2 G E N E R A L I N S U R A N C E : A M A J O R I N D U S T R Y

3


travel.

The top three products and services provided by insurers, measured bypremiums 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 2.1.

2.1 General insurance product segmentation 2005

0 5 10 15 20 25 30

Employers liability

CTP motor vehicle

Inward treaty

Fire and ISR

Public and product liability

Marine and aviation

% of total premiums received

Domestic motor vehicle

Householders/House owners

Commerical motor vehicle

Other

Professional indemnity

Mortgage

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.

1ANZSIC 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 adjustmentservices. This class also includes foreign based insurance underwriters mainlyengaged in insurance broking (not carrying) domestically.


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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 inchapter 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 buyinsurance 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 200304 (IBISWorld 2005). They increased

from $23.7 billion in 198999, 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 20012(chart 2.2). Prior to this, average premiums showed a

declining trend per policy from $497 in 1997 to $401 in 1999. 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 availableACCC review of insurance industry pricing (ACCC 2002).


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2.2 Average general insurance premiums per policy 2001 values

0

100

200

300

400

500

600

$perpolicy..

....

1997 1998 1999 2000 2001

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 2003. Personal lines of

insurance (including home insurance and compulsory third party)increased by around 3 per cent in 2004. 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

-5

-4

-3

-2

-1

0

1

2

3

4

2004 2005 2006

%-

-----

Weighted average change (personal) Weighted average change (commercial)

Data sources: Lawson (2005) and JP Morgan-Deloitte (2004).


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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 positivedownward 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 2002.

Professional indemnity claims costs rose substantially over the five years to 2002. 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)


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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 communitys 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 arisefrom future events under current policies.

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 (lossof 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 Morganand Deloitte 2004).

A recent review of government services indicated that civil claims fell across Australia by more than 43 000 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 1984and 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).


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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 ABS3 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 Australias economic growth and employment over recent

decades.

3 Although the data is from 1998-99, the Input-Output tables still provide a

reasonable reflection of the structure of Australias economy. This is because ittakes a significant period of time for structural changes to occur and therefore beapparent in the data.


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2.5 Estimated expenditure on insurance by industry 1998-99

0 50 100 150 200 250 300 350 400

Agriculture, forestry and fishing

Manufacturing

Construction

Retail trade

Transport and storage

Finance and insurance

Government administration and defence

Health and community services

Personal and other services

$m

Mining

Property and business services

Communication services

Accommodation, cafes and restaurants

Wholesale trade

Electricity, gas and water supply

Cultural and recreational services

Education

Data source: ABS data.

2.6 Expenditure on insurance as a share of industry value added 1998-99

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6


Manufacturing

Construction

Retail trade

Transport and storage


Government administration and defence


Personal and other services

Expenditure on insurance as % of value added

Mining



Accommodation, cafes and restaurants

Wholesale trade

Electricity, gas and water supply

Cultural and recreational services

Education

Data source: ABS data and CIE estimates.


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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 industrys 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 2003-04.

2.7 Comparison of industry contributions to GDP, gross value added 2003-04

0 2 4 6 8 10 12

Manufacturing

Ownership of dwellings

Construction

Retail trade

Transport & storage

Mining

Agriculture, forestry & fishing

Personal & other services

Accommodation, cafes & restaurants

% of GDP


Government, administration & defence

Education

Wholesale trade




Cultural & recreational services

Electricity, gas & water

Data source: ABS (2004a).


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2.8 Relative share of insurance industrys contribution to GDP 2003-04

Life insurance

28%

General insurance

70%

Health insurance

2%

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 199192 to 200102, Australias 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, 2002-03 and 2003-04, 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.


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Involves many businesses

Australias 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.

2.9 Comparison of average annual rates of industry growth 1991-92 to 2001-02

0 1 2 3 4 5 6 7 8 9

Communication sevices

Wholesale trade

Finance & insurance

Personal & other services

Construction

Ownership of dwellings

Mining

Manufacturing

Education

GDP

Average annual rate of growth

Property & business services

Transport & storage

Accommodation, cafes & restaurants


Health & community services

Retail trade

Cultural & recreational serv ices

Gov ernment, administration and defence

Electricity, gas & water supply

Data source: ABS (2004a).


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Employs a large number of people

According to some estimates, by the end of 200304, the general insurancesector employed nearly 20 000 workers and paid $1.3 billion in wages

(IBISWorld 2005).

Employment has been falling over the last six years, from 19992000 to

20032004 (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 isloosely associated with the size of its economic activity, measured by Gross

State Product (GSP), as illustrated in chart 2.11. 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.

2.10 Distribution of general insurance employees by state 2004

0

1500

3000

4500

6000

7500

9000

10500

NSW VIC QLD SA WA TAS NT ACT

Num

bero

femp

loyees

Data sources: ABS data and IBISWorld (2005).


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2.11 General insurance employees per $ billion of gross state product 2004

0

5

10

15

20

25

30

35

40

NSW VIC QLD SA WA TAS NT ACT All states

Employeesper$BillionofGSP

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 servicesthat 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 2003-04;

a significant contribution to economic performancewhere 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 jobsemploying about 20 000 people, with these jobs

spread throughout the country.


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3Plays 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 insurancepool. 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. Newendeavours, 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.


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3 P L A Y S A C R I T I C A L R O L E


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 wouldnt 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 oftheir activities that will assist in the efficient allocation of resources (Webb

2000).

Insurance enables individuals to transfer their risk to insurers,

transforming the insureds 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 aworld 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 externalities4, including increased purchases,

4An externality occurs when an activity has an indirect effect on other activitiesthat is not directly reflected or encompassed in the price of the initial activity.


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17


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 insurers portfolio. This can lead to lower volatility, in

turn enabling insurers to charge smaller risk premiums and maintain morestable 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

todays 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 readyaccess 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 corporatedebt (Skipper, Starr and Robinson 2000).


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18



Facilitates strategic investments

Reflecting its savings mobilisation role, the insurance sector now managessignificant 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, Australias 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 toMarch 2005 an increase of 33 per cent from the previous year (APRA

2005).

3.1 Industry investment assets by area March 2005

Interest

69%

Property

1%

Indirect investments5%

Loans and advances

4%

Equity

11%

Other investments

10%

Data source: APRA (2005).


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19


Contributes in many other ways

The insurance industry also facilitates economic growth through othermechanisms 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 formotor 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 entrepreneurs 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 insurers 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 thecommunity 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).


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4Burdened 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 taxesapplied 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

directtaxes 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 4.1.5

5 It is notable that the NSW budget for 2005-06 released in May 2005 raised thestamp duty rate from 5 to 9 per cent in that state. The table also includes thelatest FSL rates, which were recently increased in Victoria and New South Wales.


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4 B U R D E N E D B Y U N E V E N T A X E S


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 taxcascading that the reform process involved in the introduction of the GST

was supposed to eliminate.

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 paidon an insurance contract for home insurance across the states and

4.1 Summary of taxes on general insurance to households 2005

Jurisdiction NSW NT ACT QLD WA SA TAS VIC

% % % % % % % %

Metro Country

Stamp duty 9 10 10 7.5 10 11 8 10 10

FSL 15 0 0 0 0 0 0 15 19

GST 10 10 10 10 10 10 10 10 10

Source: ICA data, NSW Treasury (2004) and NSW Treasury (2005).

4.2 State taxes as a percentage of home insurance premiums 2005

0 5 10 15 20 25 30 35 40 45 50

VIC country

VIC metro

NSW

SA

NT

WA

ACT

TAS

QLD

% of premium

FSL

GST

Stamp

duty

Data source: ICA data and CIE calculations.


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23


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).

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 Taxon 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

4.3 State taxes as a percentage of business insurance premiums 2005

0 10 20 30 40 50 60 70 80 90

VIC country

VIC metro

NSW

TAS

SA

NT

WA

ACT

QLD

% of premium

FSL

GST

Stamp

duty

Data source:ICA data and CIE calculations.


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24



premiums in a variety of jurisdictions is depicted in chart4.4.6 Taxes on

property insurance in most Australian states and territories are higher than

in the majority of the comparator countries. International taxes as aproportion 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 andterritories is above those in countries such as South Africa, Germany and

6 A basic premium of $100 is assumed and does not account for different coststructures insurers might have across and within jurisdictions.

4.4 International comparison of taxes on property insurance premiums2005

0 10 20 30 40 50 60 70 80 90

VIC - Country

NSW

France

ACT

WA

Colombia

Germany

Trinidad and Tobago

Switzerland

USA (California)

Singapore

Japan

% of tax-exclusive premium

Commercial insurance

Household insurance

VIC - Melbourne

TAS

SA

NT

QLD

Canada (Ontario)

Ireland

Chile

UK

South Africa

Hong Kong

Data sources: ICA data, Spratt (2005) and CEA (2005).


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25


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 200304, 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 2003-04

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

NSW VIC QLD SA WA TAS NT ACT

%

oftota

ltaxation..

.

Data source: ABS (2005b).


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26



Taxing goods and bads

Earlier chapters of this report outlined ways that the existence of insurancebenefits the economy and the community at large, for example by

providing a means to transfer and mitigate risk. Despite these benefits

insurance is taxed at rates that meet or exceed tax levels applied to goods

with serious negative externalities or costs to society these items can be

viewed as bads rather than goods.

In 200304, taxation revenue from insurance accounted for 1.3 per cent of

the total revenue of government in Australia (including revenues of the

Commonwealth, state and local governments). This level of contribution to

total government revenue is more than that from alcohol excise, whichprovided 0.9 per cent of all revenue. It is similar to the level of taxation on

gambling which raised 1.6 per cent of all government collections and is not

much lower than the collections for tobacco which came to 2 per cent of all

government collections (chart 4.6).

4.6 Taxation revenue by producta 2003-04

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

Alcohol excise Tobacco excise Gambling Insurance

%c

ontr

ibutiono

ftota

lrevenue..

aExcludes GST revenue which is isolated as a separate total amount.

Data source: ABS (2005) and Treasury (2005).

This revenue is in addition to the revenue collected via the standard tax

that applies to most goods and services. This background level of tax is the

GST of 10 per cent, which is a value added tax and levied on most goods

and services in the Australian economy.

The discussion at the beginning of this chapter highlighted how state level

taxes alone add significantly to the cost of insurance to consumers and

business. To put this in perspective, it is useful to compare average taxes on


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27


insurance premiums to those on the prices of selected products producing

negative externalities.

Evidence prepared by other analysts indicates that high levels of tax are

applied to bads. Looking at cigarettes, for example, taxes (inclusive of

GST) add an average of 68 per cent to the retail price (VCTC 2004). Tax as a

percentage of the retail price is approximately 67 per cent for alcoholic

spirits, 33 per cent for ready-to-drink (RTD) alcoholic beverages and

23 per cent for bottled wine. By comparison, taxation on insurance for

businesses in country Victoria accounts for about 82 per cent of the price of

a premium, placing it in an even higher taxing bracket than cigarettes and

spirits (see chart 4.7).

4.7 Taxes on the price of alcohol and tobacco compared with insurance

0

10

20

30

40

50

60

70

80

90

Loose

tobacco

Cigarettes Spirits RTDs Bottled

wine

Vic

country

business

NSW

business

Vic

country

home

NSW

home

Taxpercentageo

fprice

...

Data source: DSICA (2005), Crosbie (2005), VCTC (2004), ICA data and CIE calculations.

Imposing extra costs on the community

The key question is whether or not a tax is efficient. That is, does the

community at large pay because of excessive reliance upon a particular tax?

An efficient tax is one that minimises distortions in economic behaviour

that alters the allocation of resources. Generally the efficiency loss from

taxation will be greater where:

demand is sensitive to changes in price;

supply is sensitive to changes in price;


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28



it is easier to relocate the transaction being taxed to a lower-taxing

jurisdiction; and

high rates of taxation are applied (PC 1998).

Historically, raising revenue through tax on insurance was sometimes

considered by some to be efficient, because it was held that demand for

insurance was relatively inelastic. For example, it is argued that overall

demand for general insurance is relatively price inelastic, because it can be

difficult for consumers to pool risk without it.

Evidence from overseas, particularly the US, on the price elasticity of

demand for insurance appears to be mixed. Demand for insurance appears

to be responsive to price to a degree. According to a study by Feldblum

(2001) policyholders are sometimes not highly responsive to price changes

due to perceived difficulties in making price comparisons or lack of

awareness of price-cutting by other insurers. However, price increases do

encourage some policyholders to search for better rates elsewhere.

Other work by Grace, Klein and Kleindorfer (2002), examining data for

Florida and New York over a four-year period, found that insurance

demand was price sensitive. Their study found that a 10 per cent increase

in the price resulted in a reduction in quantity demanded of 14 per cent.

Note that this estimate incorporated demand for non-catastrophe andcatastrophe (eg in the event of hurricanes and earthquakes) home insurance

products, where the latter tends to be more responsive to price.

Studies in Australia are providing evidence that demand for insurance is

price responsive. These note that demand is only inelastic where there is no

choice. In a submission to the Victorian Review of Business Taxes, Access

Economics (2000) observed that consumers have a variety of options in

determining whether or not to purchase insurance, including self-

insurance, insurance through lower cost competitors and especially for

large corporations, purchasing insurance in other jurisdictions. Australiananalysts also note that prices do influence consumers and that even

relatively small amounts can influence their decisions.

Anecdotal evidence from insurers suggests consumers may be willing to

change insurer for a $5 difference in premium. (Wallace et al 2000, p. 182)

If demand for insurance is responsive to changes in prices then high levels

of taxation on this product will give rise to efficiency losses.

There is more certainty regarding the price elasticity of supply for

insurance. The supply side of insurance is likely to be price sensitive. Thisreflects factors such as the presence of economies of scale in several


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29


operational aspects and the nature of the business that involves the pooling

of risks (Access Economics 2000).

If, as seems likely, supply or demand is sensitive, the high level of taxation

on premiums will distort activity leading to further efficiency losses.

Consequences of this are factors such as underinsurance and

non-insurance, which will be discussed later.

Need for change

There have been many calls for the abolition of stamp duties on efficiency

grounds from a range of independent sources. As noted above, stamp

duties are one of the taxes increasing the cost of premiums to consumers.

The Victorian Review of State Business Taxes conducted in 2001

recommended the abolition of stamp duties. It noted:

The conclusion of studies (by groups including the Productivity Commission;

The Heads of Treasuries State Taxes Working Group, comprising

representatives of all state and territory Treasuries; and Access Economics) is

that stamp duties and transaction taxes are among the most distortionary of all

taxes available to the states. The Committee believes such duties and taxes are

therefore ripe for abolition, and that abolishing them now would nurture

business activity and growth. (State Business Tax Review Committee 2001, p.

16)

The Intergovernmental Agreement on Commonwealth-State Financial

Relations (IGA) negotiated in 1999 included discussion on the impediment

presented by stamp duties on economic growth (Department of Treasury

1999). Consequently, a number of stamp duties and other taxes were

abolished. Under the IGA agreement a Ministerial Council was required to

review the need to retain a number of remaining stamp duties by 2005.

However, stamp duty on insurance was not included as part of this review.

The HIH inquiry recommended that state and territory government shouldabolish stamp duty on general insurance (HIH Royal Commission 2003).

The recent Productivity Commission (2005) inquiry into first home

ownership also commented on the inefficiencies of stamp duties. The latest

OECD economic survey of Australia commented on the need for further

progress in tax reform including reform of remaining stamp duties. One of

the priorities for tax reform should be:

A rapid abolition of reining distorting State taxeswould further increase the

efficiency of the Australian tax system and improve resource allocation.

(OECD 2005, p. 14)


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The different rates of stamp duties and possible applicability of FSLs

between states and within states (in the case of Victoria) increase

compliance costs for businesses operating in multiple regions of Australia.

Other analysts have noted the cascading aspect of taxes on insurance as a

particular concern. According to a survey of business by the New South

Wales State Chamber of Commerce and the NRMA, although the public

liability insurance crisis has shown some signs of easing, they are still

concerned about the general cost of insurance.

The cascading nature of tax on insurance is a real issue for business.

Currently, the fires services levy, stamp duty and GST are all calculated on top

of one another. In fact, taxes make up almost half (49%) of the cost of general

business insurance premiums. (State Chamber of Commerce (NSW) 2003, p. 1)

NSW Treasurys (2003) submission to the Review of Fire Services Funding

argued that the FSL had several deficiencies which outweighed any

positive attributes such as simplicity in government administration and

providing a robust source of funding. Some of its deficiencies included the

weak link between fire risk and fire services levy contributions, and

importantly that those who do not take out insurance still benefit from fire

services. Despite the notion that insurance is unavoidable, it is being

recognised that there is considerable potential (and, given high rates of tax

on insurance, incentive) to free ride and fail to insure appropriately.

The recent Western Australian experience highlights many key points.

Western Australia replaced its FSL with a property based Emergency

Services Levy collected by local government authorities in July 2003. In

2004, an audit of insurance companies in Western Australia was conducted

for the state government. The audit found that insurers had passed on the

savings from removing the FSL to consumers and that its removal

contributed to the state having one of the more price competitive insurance

markets across Australia. Insurance coverage taken out by consumers was

also found to increase as a result of the cost savings (Sigma Plus Consulting2004). This evidence undermines the theory that demand for insurance is

price inelastic and that these taxes do no harm.

South Australia, West Australia and Queensland have replaced the FSL

with a property-based system funded by owners. The ACT and Northern

Territory fund their fire brigade services from consolidated revenue.

Clearly, there are alternatives to the use of distorting taxes. Despite the

inefficiencies and inequities of Fires Services Levies, they continue to be

imposed in New South Wales, Victoria and Tasmania.


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Potential gains lowering taxation on insurance offers big gains to thecommunity

Access Economics (2003) has estimated the gains to community wide

economic welfare resulting from reductions in a number of state taxes. The

analysis is based on a reduction in the revenue obtained by each tax of

$100 million (as a combined total between the states). The economic gains

from each tax reduction are compared against the gains obtained from the

tax reduction with the lowest gains (in effect, the lowest cost tax). This

comparison is reflected as an index score. A score of 100 means that the tax

cut results in the same economic increase as the benchmark set by the least

cost tax in the study. A score of 200 would mean that reducing that tax

would produce double the gains of the benchmark tax (that is, it is anexpensive tax). The results of the analysis are set out in chart 4.8.

The chart indicates that, for Australia as a whole, cutting stamp duty taxes

on insurance would provide almost double the welfare benefit that results

from cutting the lowest cost benchmark tax in the study (stamp duty on

residential property transfers). This indicates that stamp duty on insurance

is a highly inefficient tax, with only stamp duty on the sale of non-

residential properties being more inefficient.

The fire services levy does not perform much better than insurance stampduty. It has an index score of around 136. In other words, it is 36 less

efficient than the benchmark tax used in the study.

The index scores discussed above are essentially an index of the economic

efficiency of a tax. Determining the economic efficiency of a tax is

important because it gives an indication of priority that should be attached

to changes in taxation, or which taxes should be avoided. The economic

analysis shows that taxes on insurance are relatively inefficient and that

reducing these taxes or replacing them with almost any of the others that

government have at their disposal today would lead to large gains ineconomic welfare.

The modelling can also be viewed as a means of ranking taxes. Were the

government considering a tax cut, it could determine which ones would

deliver the best outcomes for economic welfare. Taxes on insurance,

particularly stamp duty, would rank highly in any such consideration.


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Creating an under-insured community

The consequence of high cost imposts from existing taxation levels on

insurance is under-insurance and non-insurance. Under-insurance occurs

where there is a gap between existing insurance coverage and the actual

amount required to fully compensate in the event of loss. Actual levels of

under-insurance and non-insurance can be difficult to estimate. According

to the most recent annual ICA survey, around 21 per cent of consumers

believe they are under-insured (Mason 2005). However, insurance industry

sources comment that the actual figure could be markedly higher.

The cost of insurance influences the take up of insurance and can

exacerbate the potential for under-insurance and non-insurance on non

compulsory classes of insurance (Trowbridge Deloitte 2003). Surveys of

consumers and businesses indicate that cost is the most important driver in

selecting insurance coverage. Cost was the key factor in considering taking

out insurance for 85 per cent of consumers and 90 per cent of businesses

surveyed in 2004 (Mason 2005).

State level survey results for small business in New South Wales indicate

that many find the cost of insurance prohibitive.

4.8 Economic welfare gain from reduction in state taxes

0.0 50.0 100.0 150.0 200.0 250.0

Stamp duty, conv eyancing (non-residential)

Stamp duty motor v ehicles

Land taxes

BAD

Pay roll taxes

Gambling

Value relative to least inefficient tax (set at 100)

Insurance, stamp duty

Insurance, fire brigade levies

Third party insurance

Stamp duty, other

Local government rates

Stamp duty, convey ancing (residentiial)

Data source: Access Economics (2003)


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33


With one in six businesses being either under-insured or without insurance

altogether, these issues warrant a closer look by the Government in order to

provide some relief for NSWs over 300 000 small businesses. (State Chamberof Commerce (NSW) 2003, p. 1)

The extent of inadequate insurance in Australia has been observed by the

loss adjusting industry. Loss adjusters operate independently of insurance

firms but are appointed by them (and sometimes by policyholders) to

investigate the circumstances surrounding insurance claims (The Chartered

Insurance Institute 2005). An adjuster acts as an intermediary between the

insurer and the policyholder, assisting the settlement of valid claims. They

are involved in checking the veracity of claims and advising on a settlement

amount that is fair to both the insurer and the insured. One of the worldslargest loss-adjusting firms is Crawford and Company, and they have one

of their largest operations in the Australian insurance market. A senior

executive of the firm notes that a surprising number of claimants in

Australia are under-insured (Spratt 2005).

Avoiding costs from underinsurance

Under-insurance and non-insurance imposes community-wide costs.

Obviously individuals are concerned and often distraught when theirproperty is damaged or destroyed, and they do not have insurance. Clearly

a community damaged by a single large adverse event without adequate

insurance coverage will experience multiplied difficulties.

What is less obvious, perhaps, is the economy wide implications for the

community at large from insurance coverage. A natural disaster can have

severe economic, social and environmental impacts. Widespread insurance

coverage and payment of claims accelerates the recovery process, enabling

faster reconstruction and repair of damaged goods and property. This

restarts investment and retains employment, reducing the costs foreveryone in that community and the economy at large. The absence of

insurance payments results in deeper, more prolonged costs.

Under-insurance leads to greater recourse to government assistance. The

impact of under-insurance on government expenditure after recent

bushfires in Australia is just one case in point where increased reliance is

being placed upon public budgets.

Following the recent bushfires in the ACT, it was estimated that housing

structures were under-insured by 40 per cent and home contents by

between 30 and 50 per cent (House of Representatives Select Committee


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4.9 Economic impacts of a disaster with and without insurance

A study by the Centre of Policy Studies at Monash University in collaboration withGeoscience Australia (Wittwer, 2004) has examined the economics of a major

earthquake upon a large urban area and examined this with and without insurance

payments.

The earthquake is assumed to impact upon Perth. Different magnitudes of earthquake

are examined. The focus of the analysis is upon how the economy recovers from such a

shock. The wider and longer term implications are assessed using a dynamic, multi-

regional general equilibrium model called TERM. TERM is a variant of the ORANI model

used by the Productivity Commission, the Commonwealth Treasury and other leading

economic policy advisers.

In scenario 1 an earthquake of magnitude 6 hits Perth. The damage is significant. Thetotal capital stock in Perth falls by $9.7 billion. During the period immediately after the

earthquake, Perths employment falls by 3 per cent or around 20,000 jobs. Total output

or Gross Regional Product falls by 4.2 per cent for the year of the earthquake, even

allowing for significant activity to repair the damage in that year. This calculation also

highlights a weakness in GDP measures which place defensive expenditure to correct

damage on the same footing as expenditure on say investment or increased

consumption. The net loss to national welfare, measured by aggregate consumption a

better indicator of wellbeing, is also substantial. The damage is also long term. The

reduction in the net present value in national aggregate consumption relative to forecast

(or what would have occurred without the earthquake) over the 20 year forecast period is

$8.9 billion in this scenario.

The impact on Perths economy is not as severe when the model takes into account the

potential for insurance payments. This scenario assumes that 60 per cent of buildings

and contents are insured in Perth, which is conservative relative to ABS and ICA data for

Perth. The inclusion of insurance enables Perth to recover more quickly from the

disaster. The NPV of the loss in national aggregate consumption falls by $6.4 billion

compared with $8.9 billion without insurance. This is entirely due to economic processes

in the model as the analysis does not factor in the potential for accelerated rebuilding

with insurance payments. That is the benefits of insurance for the community have been

estimated in a conservative way.

Other scenarios are analysed with more or less damage and with different assumptions

about insurance coverage. They also highlight the value to the community at large to begained from widespread access to insurance payments in these events.

So raise value by lowering punitive taxes on insurance

The unique importance of the general insurance industry is not apparent in

the current taxation arrangements that apply in Australia. Not only are

these tax arrangements out of line with other countries, but, in some cases,

the final impact on price places insurance on par with the taxation

arrangements for cigarettes and alcoholic spirits. The high impact oftaxation is a result of the number of taxes that apply to insurance and the


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cascading nature of their application, with GST levied on FSL and stamp

duty levied on both of these.

Studies indicate that the gains in economic wellbeing from reducing the

additional tax burden on general insurance would be significant. In

particular, there is evidence of under-insurance in the Australian market,

generating future costs for the Australian economy. Robust economic

analysis about the interconnected flow on effects from a major natural

disaster indicates that the economy recovers much more quickly with

widespread access and use of insurance than without it. A more suitable

tax arrangement would lower the price of insurance and remove the

distortions leading to abnormally low levels of insurance in Australia.


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5Handicapped by distorted

competition

THE PLAYING FIELD IN GENERAL INSURANCE IS NOT LEVEL. This

chapter reviews the distortionary advantages that have been enjoyed bydiscretionary mutual funds (DMFs) and direct offshore foreign insurers

(DOFIs). It also examines the implications of failing to implement a policy

mix that results in a level playing field.

Facing uneven regulation

Under the Insurance Act 1973(the Insurance Act) an insurer that carries on

insurance business in Australia must be authorised by the Australian

Prudential Regulatory Authority (APRA). Under that Act, an insurancebusiness is defined as the business of undertaking liability, by way of

insurance (including reinsurance), in respect of any loss or damage. A

number of entities that effectively provide general insurance are not

encompassed by this definition and are therefore exempt from certain

regulatory requirements and taxes.

In particular, discretionary mutual funds (DMFs) are not classified as

insurance companies, because their decision to pay claims is a discretionary

one. This is despite the fact that, in practice, DMFs almost always pay out,

with refusal only in cases of fraud or severe negligence.

In the case of direct offshore foreign insurers (DOFIs) uncertainty arises

from the requirement in the Insurance Act that insurers need to be

carrying on business in Australia. This means that DOFIs who do not have

a branch in Australia or who do not actively solicit business in Australia

need not comply with the provisions of the Insurance Act.


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5 H A N D I C A P P E D B Y D I S T O R T E D C O M P E T I T I O N


Overview of the Potts review

The HIH Royal Commission recommended that the AustralianGovernment amend the Insurance Act to extend prudential regulation to all

discretionary insurance-like products, having regard to constitutional

limits. The Commissioner also considered the role of DOFIs in the

Australian insurance market but did not make a recommendation.

In response to these issues, the Australian Government commissioned

Mr Gary Potts to undertake a study of both DMFs and DOFIs. The Potts

Review, reported on 28 January 2004, made a number of recommendations.

The key findings of the report and its recommendations were published in

May 2004 (although the full report was not released in order to preserve theconfidentiality of some information contained within it). The Australian

Government accepted the recommendations and indicated that they would

be implemented in full. Draft legislation will be developed in consultation

with industry and has yet to be released.

Findings

The Potts Review (Potts 2004) determined that regulations regarding DMFs

and DOFIs needed to balance two elements:

the benefit that arises in the form of a cost saving due to the exemption

from certain taxes and prudential requirements; and

the role of DMFs in providing specialised insurance cover for

consumers who would otherwise have difficulty in finding cover and

of DOFIs in providing important additional capacity to the Australian

market.

The major findings of the Potts Review in relation to DMFs and DOFIs are

outlined in box 5.1.


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5.1 Findings of the Potts Review: key features of DMFs and DOFIs

DMFs

account for less than half of one percent of the general insurance market;

have been expanding relatively quickly, especially in long-tail (public liability) cover

but are destined to remain a niche part of the overall market;

benefit from significant cost advantages over authorised insurers, because of their

exemption from State taxes (stamp duty and special levies) and, to a lesser degree,

prudential supervision;

the failure of DMFs is unlikely to pose any systemic threat to the industry, but the

withdrawal of their services could affect consumers who have found it difficult to

obtain specialised insurance cover;

while currently not subject to prudential regulation, DMFs are subject to ma

Documents

General Insurance-big Benefit but Overburdened