Outstanding claims reserve - consequences on transfer

Legislative changes clarify the tax position of general insurance companies following a transfer of business during an income year. Applies from 1 Oct 2012.

Sections DW 4(6), ED 3 and EY 5(4) of the Income Tax Act 2007

Technical changes have been made to the Income Tax Act 2007 to clarify the tax position of general insurance companies when there is a transfer of business partway through an income year.

Background

The Income Tax Act 2007 allows general insurers a deduction for movements in the outstanding claims reserve (OCR) - or income depending on the nature of the actual movement. Changes in the OCR were measured on an income year basis. This meant that the rules did not provide an appropriate closing value if the OCR for a particular line of general or non-life insurance business was transferred at a point in time other than at the end of an income year.

Key features

New section ED 3 sets out a legislative code for the transfer of OCR balances for general insurance.

Detailed analysis

How the rules work

Under the Income Tax Act, a deduction connected with movements in a general insurer's outstanding claims reserve (or income depending on the nature of the actual movement) is calculated on an income year basis. The deduction is allowed (or income derived), by reference to sections CR 4 and DW 4, for general insurers who use IFRS 4 for determining their tax position.

If, in an income year, an insurer (insurer A) transfers its insurance contracts to another insurer (insurer B), insurer A is required to make a part-year calculation of its OCR on the day the transfer occurs to determine its closing value. Any movement between the opening and closing balance gives rise to a deduction or income to insurer A.

The amount calculated by insurer A immediately before the transfer is treated as insurer B's new OCR opening balance. Deductions for any claims underlying the opening OCR balance for insurer B are allowed as the claims are met - section DW 4(5). A consequential change to section DW 4(6) ensures that the capital limitation does not apply to amounts transferred to insurer B for the purposes of section DW 4(5).

If insurer B has a different opinion about the value of the OCR, any adjustment to the value should ultimately be reflected post-transfer through the closing balance for the income year in which the transfer occurred.

Example

As part of a strategic shift in its market position, Insurer A sells a block of its insurance book to another New Zealand insurer (Insurer B).

The opening balance of the OCR for the relevant block of business is $500,000. As part of Insurer B's due diligence work it is agreed that the OCR value for the block of business is $450,000 - the difference arises because legal action regarding the validity of claim falls in favour of Insurer A.

On 29 June, Insurer A transfers the block of business including the relevant OCR balance. Insurer A records the closing balance of the OCR at the time of transfer as $450,000 and recognises income of $50,000 under section CR 4 of the Income Tax Act 2007 ($500,000 - $450,000).

Insurer B records the opening balance of the OCR as $450,000. Shortly after, an appeal against the earlier decision about the claim goes against the insurer and Insurer B increases the OCR balance to $510,000.

During the year, Insurer B meets claims totalling $250,000(deductible under section DW 4(5)) and new insured events arise that add a further $400,000 to the OCR.

At the end of the tax year, 31 March, Insurer B's OCR closing balance is $660,000 ($450,000 + $60,000 - $250,000 + $400,000). As the balance has increased from $450,000, Insurer B is able to claim a deduction for $210,000 (section DW 4(3) $450,000 - $660,000).

Applying the new rules to earlier income years

The changes apply to transfers that occur on and after 1 October 2012.

To facilitate responses by insurers to the enactment of the Insurance (Prudential Supervision) Act on 7 September 2010, insurers have the option to apply new section ED 3 to earlier income years if the transfer occurred on and after 7 September 2010 and:

  • the transfer was to a non-resident who does not carry on a business in New Zealand; and
  • the transfer was made for the purposes of complying with the Insurance (Prudential Supervision) Act 2010.

Consequential change to section EY 5(4)

To mirror the point in time the closing balance should be valued under section ED 3, a consequential change has also been made to the transfer rules of life insurers - section EY 5(4) refers.

Application date

The changes apply to transfers made on and after 1 October 2012, but can be backdated in limited circumstances to 7 September 2010, the date the Insurance (Prudential Supervision) Act 2010 was enacted.