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The Actuary The magazine of the Institute & Faculty of Actuaries

Taxation of disability business

Although disability business is basically taxed on
a gross basis, a number of surprising issues
arise. It is most unusual for this business to
be written on a with-profits basis, hence this is not considered here.

Disability business, largely permanent health insurance and critical illness, is taxed on a case I profits basis at the corporation tax rate (currently 30%) using Companies Act report and accounts figures, ie UK GAAP basis (generally accepted accounting principles).
Three major issues are:
– profit includes movements in deferred acquisition costs (DAC);
– unrealised gains are excluded;
– tax computations are based on the reserves in the accounts which are likely to differ from the FSA reserves used for mean fund and modified mean fund apportionment.
As regards gains, realised gains on equities are calculated on a ‘book’ basis with no indexation, and bond gains are taxed under loan relationship rules, again with no indexation, even for index-linked bonds.
Note that historically the valuation of bonds in UK GAAP could be on either a market value basis or an amortised cost (accruals) basis. If the former, there was an election in the tax computation to substitute an accruals basis for any or all bonds. This election was intended to be temporary and has not been extended beyond 31 March 2000.
There is significant flexibility to offset losses against other profits in a corporate group. Losses can be group relieved, or carried forward against future disability profits, or offset against profits of any description in the current year or the previous year.
In computing profit, mismatching reserves, contingency reserves, etc are disallowed and UK dividend income is excluded from taxable income.

Practical issues
– The presence of DAC defers tax relief on initial expenses, so consideration needs to be given to this in pricing.
– Where one has a unit-linked disability contract, it is likely that the fund link will be shared by a BLAGAB contract, so that the fund will be treated as ‘mixed-linked’ and not ‘sole-linked’. Thus income and gains of that fund are apportioned by reference to the liabilities of that fund, giving rise to potential tax distortions not likely to be reflected in unit pricing. In principle these are the same distortions as those which occur in mixed-linked BLAGAB/
pensions unit funds.
– There are further issues around situations where policies have benefits which are partly in the BLAGAB fund and partly in the disability fund, for example a flexi whole life product with a disability component. How does one split revenue between the funds? On the one extreme, the disability fund might only receive the disability risk premium component of the product, or it might receive a fully loaded share of the premium. Similarly, how do you charge the related expenses to the different funds? There may be tax advantages in establishing one method rather than another because of expense relief or because of the incidence of profits tax.
– Some products have disability benefits as riders, eg waiver of premium, permanent total disability. It is possible, but not essential, to include these benefits in the fund to which the major part of the policy’s benefits belongs. Again, there could be tax advantages or disadvantages in taking a particular approach, although one might decide that the system/administration costs outweigh the benefit of splitting the figures.
– For notional case I calculations PHI profit is excluded on an FSA return basis, with investment returns allocated on a mean fund basis. If there is more than one fund, this will be done by reference to the funds with PHI business. This can lead to considerable distortions if there is a large tax investment reserve, because the allocation of taxable income and realised gains is on a modified mean fund basis by reference to the long-term business as a whole, although recent changes in legislation have reduced the distortion.
The above does not constitute a full description of the taxation of disability business, but is intended to highlight the most important issues which may arise.