Insurance players reaction to the imposition of service tax are mixed, says Venkatachari Jagannathan

Chennai: Even as the CEOs of life insurance companies and the president, Actuarial Society of India (ASI), Liyaquat Khan, have expressed their opposition to the finance minister's proposal to bring the life insurance sector under the service tax net (See Insurance at a premium and ) there are industry experts holding contrary views.

Says R Ramakrishnan, a consulting actuary and former executive director, Life Insurance Corporation of India (LIC) and member, Malhotra Committee on Insurance Reforms and chairman, Reserve Bank of India's advisory group on insurance regulation, "There is nothing wrong in imposing some additional tax on life insurance. When compared to other countries, the rate of income tax in the case of life insurance industry in India is quite low."

Continuing, he makes an interesting observation, "And even this is not being paid properly by private players and no action seems to be taken for that. The amount of tax rebate availed by life insurance policyholders is far higher than the taxes collected from the insurers."

But actuaries like Heerak Basu of Watson Wyatt hopes, "Given the extent of under insurance in the country the government may wish to revisit this proposal."

While ASI president Khan argues that insurers - life and general - sell a financial product and cannot be termed to render a service to attract the service tax, Shriram Mulgund, an actuary has a different view.

"Life insurance works on the principle of pooling of risks. From this perspective, providing life insurance can be considered to be a form of service and taxing this service may not be inappropriate," he remarks.

It should be noted that insurance premium is made up of components like contribution to mortality (risk premium), savings, insurer overheads and profits. It is on the risk premium on which the government has proposed to charge the service tax.

Reasons Mulgund, "To maintain equity with other financial entities and their products, the investment component should not be taxed. Similarly splitting the expenses portion of the premium towards investment and risk will end up in complications in calculations, hence it is preferable to leave that out."

"If the government finds that the tax contribution by the industry does not meet their expectations, they can always modify the tax rate. And any profits passed on to the shareholders will be taxed separately," he adds.

As such, the remaining component is the risk portion of the premium. Before one goes further as to what constitutes risk premium for service tax means, Mulgund says that one should be clear about the term 'sum at risk'.

For a given policy, the sum at risk is equal to excess of the money payable on death over the reserve that is being held in respect of that policy.

Consider a policy with a death benefit of Rs1,000, i.e. if the insured were to die within the next year, the insurer will pay a benefit of Rs1,000. Assume that the insurer is holding reserve of Rs300 for this policy. (The reserve is built from the premium paid in earlier years that were not used to pay claims and were set aside to meet future claims including any maturity benefits). If the insured were to die, the amount of Rs300 held by the insurer can be released for payment. So, the true risk / true sum at risk is only for Rs700.

For a 25-year endowment policy for a sum assured of Rs1,000, the sum at risk immediately after issue is Rs1,000 (reserve is zero). Just before the maturity, it will be almost zero (the reserve would be almost Rs1,000 so that the maturity benefit can be paid), explains Mulgund.

For a term insurance for five years, no meaningful reserve gets accumulated. Hence the sum at risk will be close to Rs1,000 for all years.

Finally the risk premium is equal to the sum at risk multiplied by the probability that the person will die within the next year. This could be considered to represent the cost of service provided.

"The proposed tax will be 10 per cent of this cost of service. The risk premium should be calculated as long as there is some sum at risk. Thus, this calculation would be required not only for the first year but also for the renewal years," adds Mulgund.

It should be noted that the probability factors for death consists of aspects like age, the kind of policy, nature of underwriting evidence (non-medical, medical, etc.), underwriting standards employed by the insurer, type of market and others. And these will differ from insurer to insurer and even between policyholders of an insurer.

Further, a life insurer can resort to measures that increase the expenses head while reducing the mortality component in a premium and thereby slash the service tax liability.

Given this possibility would it not be better for the government or the Insurance Regulatory Development and Authority (IRDA) to arrive at common factors for different policies so that the insurers can apply the same to determine the service tax? It should be noted that most of the life insurers use a standard mortality table.

The views for this idea are mixed. Responds Mulgund, "A common table of factors if stipulated by the government may cause inconsistencies. The probability factors will depend on the valuation basis used by the appointed actuary of a company. Accordingly, it may be equitable to permit the insurers to use their own tables of factors. If, for some reason, the insurer is not able to use its own factors, some common table can be used."

On the other hand Ramakrishnan says, "The idea is excellent. Insurers do not follow the same rates and even within a company the rates are different for different products. Lower rates are charged in the case of high net worth individuals."

Ramakrishnan differs with many other actuaries including Mulgund when he says that the tax should be charged on the life cover being provided and not on the sum at risk as detailed above.

"The latter will become negligible with the increase in duration and will tend towards zero as the policy nears the maturity date," he reasons out.

But what about single premium policies and the rider covers like critical illness and others? According to one actuary the premium paid for the add-on covers / riders can be the basis for calculating the service tax liability. Similarly single premium policies should be considered separately.

Here again Ramakrishnan has a different view. "Even rider premium consists of different components and they have to be apportioned. And in the case of single premium policies, though the premium is collected in advance, the insurance cover extends over several years. Logically the tax incidence should also be spread through the policy."

Another actuary who doesn't want to be named offers a different solution to arrive at the risk premium. "Life insurers could be directed to use age-wise mortality incidence rates as per product filing with IRDA and multiply this rate with the sum at risk at the beginning of each quarter. The sum is to be divided by four to get the quarterly tax liability. For group term, a similar approach is fine but with suitable modifications based on the experience rating."

However actuaries are unanimous in saying that the tax should be charged on all the premia - the first and the subsequent renewals. "Taxing only the first year premium will yield very little revenue," replies Ramakrishnan.

Adds Mulgund, "The new tax is to be charged on the business underwritten prospectively. Levying the tax on the present business will cause lot of hardship. Life insurers will be able to pass on the new tax to the 'with profit' policyholder through reduced bonuses. But for the non participating (without profits) business, the insurer cannot increase the premium."

To address the concern of increased cost of insurance Mulgund suggests that sum at risk over a certain minimum (say over Rs25,000) may be taken into account for the new tax..

"Ideally, such minimum benefits should be made available per person. Since people hold multiple policies (with the same insurer or different insurers), computing such minimums per person will be impossible. It may be best to exclude a specified amount of net sum at risk per policy."

But is there an alternative to the method of charging service tax on life insurance premium that is simple and away from terms like risk premium, sum at risk and complicated calculations?

Reacts Ramakrishnan, "The government can charge a flat tax rate say half a per cent on the gross premium earned by a life insurer. The method is simple and will yield better revenue for the government. On the other hand concepts like risk premium and sum at risk will pave way for litigation."

It should be said that a similar concept is adopted in the non-life sector. Even though the non-life premium does consist of components like overheads, profits and risk rate, service tax is applied on the gross premium.

But there is one complication here. Once the government levies a differential tax rate on any one sector instead of the uniform rate, there will be a demand to reduce the tax rates in different sectors. Instead, the name of the flat tax suggested above could be changed to 'insurance tax' rather than service tax and the insurers could absorb this themselves.

Concludes KS Gopalakrishnan, appointed actuary, Birla Sun Life Insurance Company Limited, "Life insurance products have quite a variety and any system should be equitable and easy to administer. The tax should be easy to calculate by the insurers and easy to verify by the tax authorities."