Reinsurance and Corporate Taxation in the United Kingdom Life Insurance Industry

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Reinsurance and Corporate Taxation in the United
Kingdom Life Insurance Industry Mike Adams
University of Wales Swansea Philip
Hardwick University of Bournemouth Hong
Zou Lingnan University
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• The main aim of the paper is to investigate the
  tax incentives for using reinsurance in the life
  insurance industry.
• We attempt to test empirically two prominent
  arguments relating to this topic
• the tax enhancement hypothesis
• the tax reduction hypothesis

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The Tax Enhancement Hypothesis This is the
view, proposed by Adiel in 1996, that reinsurance
can increase current tax liabilities for the
ceding life insurer by increasing reported
earnings in the current period. Life reinsurance
treaties tend to be proportional contracts,
whereby the life insurer transfers a fixed
proportion of its policy liabilities to a
reinsurer in return for a proportion of the
premiums received on those policies.
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So, in effect, the ceding life insurer loses
future premiums in exchange for an increase in
current earnings. As a result, managers of life
insurance firms with high marginal tax rates may
be motivated to reduce reinsurance in order to
lower current period tax liabilities. The tax
enhancement hypothesis, therefore, predicts
that H1 Other things being equal, life
insurers facing high marginal tax rates are
likely to use less reinsurance than life insurers
facing lower marginal tax rates.
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Tax Reduction Hypothesis There are studies in
the risk management literature that suggest that
in the presence of the asymmetric treatment of
profits and losses in the corporate tax code,
reinsurance can be an efficient mechanism for tax
management as it helps to mitigate the volatility
of future taxable income. The argument is as
follows
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Given a progressive corporate tax function and
the probability of future losses, then hedging
through reinsurance can help to reduce the future
average taxes of life insurance firms. This is
because reinsurance enables managers of insurance
firms to lock-in to a certain level of future
income that is taxed more favourably than would
be the case if the direct insurer adopted a risk
retention strategy where less tax is paid in the
event of a loss and more tax is paid when there
are no losses
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So if the tax reduction hypothesis is correct,
we would predict that H2 Other things being
equal, life insurers facing high marginal tax
rates are likely to use more reinsurance than
life insurers facing lower marginal tax rates.
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To test these hypotheses, using UK data, we
regress changes in reinsurance on the marginal
tax rate (estimated by three separate proxy
variables) and a number of control variables.
Using panel data for 67 life insurers over the
period 1992-2001, the (random-effects) model to
be estimated is DREINS f (TAX, FAR, SIZE,
HI, RISK, PROF, CLAIM, OF, LIST, BONUS)

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Expected sign Estimated sign
Significance MTR ? - Significant at 5
level FAR - - Not significant SIZE - Signi
ficant at 10 level HI Significant at 1
level RISK Significant at 10
level PROF - Significant at 5
level CLAIM Significant at 5
level OF ? - Not significant LIST ? - Not
significant BONUS - Not significant
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Conclusion Our results imply that the tax
enhancement effect dominates the tax reduction
hypothesis and that lowering (current) tax
liabilities appears to be one of the important
motives for the managers of UK life insurers to
purchase reinsurance. We also find evidence
that the purchase of reinsurance by life insurers
is influenced by each companys degree of
business concentration, earnings volatility and
claims ratio.