Current Issues in General Insurance, Insurance Council of Australia’s 2010 Regulatory Update, Sydney

February 17, 2010

I have always found insurance to be a fascinating concept. The notion of spreading risk, the payment of a premium for a benefit for an event which my never occur is an interesting one.

By chance I was at Lloyds of London on the day of the stock market crash of 1987. There was an almost surreal intersection of modernity and the past.  The commercial world was in melt down yet within the then space age Lloyds building where the trappings of an industry steeped in history.   There was the ships bell that was rung at the time of a maritime disaster and the massive ancient book which recorded the loss of the Signet with all hands in 1872.

As you would know the industries historical roots predate Lloyds by almost 4000 years. There have been forms of insurance around since around 2000BC when traders would take out a loan against the safe arrival of their caravans.  I understand that insurance policies for individuals (ie not bundled with loans or other kinds of contracts) were invented in Genoa in the 14th century.

Genoa was a major trading centre and also provided ships for those travelling to the Crusades, the ships returning with booty.  The first contract was apparently signed in 1347.  The backers of the contract would each write under their name the amount of risk they were prepared to cover, became the first underwriters.

At that time, Genoa must have seemed like a good place for an aspiring insurer. Genoa had established itself as the principal Maritime Republic, over Venice, Pisa and Amalfi. Trade, shipbuilding banking were all well-developed and were supporting the largest navy in the Mediterranean. But just think about the risks that the Genoese underwriters had to assess.

First, the domestic political situation was by no means stable as there was a history of feuds between the Republic’s ruling families.  Although the other Republics had recently been defeated, there was no guarantee that hostilities would not resume.   They were insuring shipping and cargoes with none of the advantages of modern-day weather forecasting.  As their foreign colonies increased, they not only had to take into account their domestic political situation but also the politics of their colonies in an era when it could take weeks, if not months, for news to travel from one to the other.   A heavily-insured cargo could well be despatched when its destination had already been invaded or experienced a coup.

It would be a brave merchant who traded without insurance, once it became available; and a brave insurer who provided the cover.  You could argue whether the world was more or less risky or unstable than it is now, but certainly the flow of information was much slower and it would certainly have been much more difficult to assess risk.   Indeed, it took some time before the industry developed from that first Genoese contract.

From its humble beginnings as protection for ships and their cargo, insurance has transitioned has evolved into a sophisticated product entrenched in the global financial system.

Insurance wrapping is an example of the complexity that can be involved in insurance products. Almost anything can be wrapped with insurance.  Prior to the Global Financial Crisis, companies like American Insurance Group (AIG) were heavily involved in insurance wrapping products on Mortgage Backed Securities. At the end of 2007, the global value of Credit Default Swaps was $57.9 trillion.

Companies selling the insurance product of Credit Default Swaps, like AIG, did not hedge against the possibility that sub-prime house prices might dramatically fall in value.  When these investments did fall in value, AIG had their credit rating downgraded. The lower credit rating forced AIG to find additional collateral as part of its obligations to its default swap trading partners.

The results were catastrophic. AIG failed to meet its insurance obligations against a growing number of sub-prime defaults and the US Government was forced to provide an $85 billion bailout. The loss of liquidity contributed to the Global Credit Crisis. In March 2009, AIG posted the largest quarterly loss in corporate history of over $61 billion. Its share price had fallen by 95 per cent.

The Financial Crisis showed us that modern finance is the lifeblood of the global economy and insurance is the lubricant that allows finance to flow. But insurance is still a form of risk management. The insurance industry has evolved a long way from Genoa to the point where any financial product can be insured against risk. Insurance companies are trading in a market for risk, where demand is contingent on the level of risk and the cost of insurance.

In a market economy, participants need to have the confidence to use their assets without fear of undue loss. Insurance needs to be encouraged by Government as a tool for self-reliance. However, the global importance of insurance in the financial world means that Government must approach policy in a responsible, competent way. The fact that everything from household items to sophisticated financial products can be insured requires Government to have a detailed knowledge of the sector.

Today, I will break the Coalition’s approach to insurance down into three questions.

First - what role does Government play in the insurance industry?

Second - what can Government do to help the industry?

Third - what are the areas in the industry where Government needs to get out of the way?

What role does Government play in the insurance industry?

As I mentioned, insurance is a tool of self-reliance and should be encouraged by Government. To obtain insurance, consumers are required to forego the purchase of an alternative, tangible asset to obtain a future benefit after an event that the consumer wishes not to occur. In consequence, consumers are often unenthusiastic about insurance and will not seek protection where they judge the costs as being too high.

High levels of taxation are a major deterrent to people taking out insurance and, I believe a significant contributing factor to under-insurance. Unfortunately, this is the current role Government plays in the sector: to tax and deter consumers form being adequately insured. Government has become very reliant on the taxation collected from the insurance industry. In Victoria, 10.1 per cent of all state taxes collected in 2006-07 were taxes on insurance. In New South Wales the figure was 6.9 per cent. The Coalition introduced the GST with the State’s agreeing that inefficient state taxes would be abolished. Unfortunately, many inefficient state taxes still exist.

The imposition of fire service levies and stamp duty in addition to GST is clearly a failure of good policy. The situation is unacceptable. In New South Wales, insurance companies must also pay the Insurance Protection Tax, which protects policy holders from insurance collapse. It is obvious that each Commonwealth and State tax increases the cost of premiums for policy holders.

In New South Wales, premium costs are increased for homeowners by over 43 per cent as a result of taxes. Business premiums are increased by over 65 per cent. The largest increase is imposed on businesses in rural Victoria, where taxes add over 91 per cent to the cost of premiums. I find this a staggering statistic. States are required to collect an additional quota of taxation from business insurance under the fire services levy. This increases the amount that needs to be levied on individual business.

Taxes on insurance in Victoria and New South Wales are the highest in the world. The average rate on all premiums in our two largest states is over 30 per cent. Germany comes in third place with 28 per cent. So the current role Government plays in the sector is the excessive taxation of insurance contracts; to actively deter people from insurance; to reduce self-reliance and to encourage under-insurance. The evolution of insurance into increasingly complex products means that the industry does not need government adding to the complexity.

Government must also encourage insurance for those who need it most – individuals and households. This is how Government can help the industry.

What can Government do to help the industry?

Legislation was introduced into the Parliament last week that would finalise COAG’s decision to create a Uniform Credit Code, with mortgage broking, margin lending and non-deposit lending institutions moving under a Commonwealth jurisdiction. This will leave the insurance sector as the only financial service sector operating under both State and Federal supervision.

It is time that Government looked at how to simplify insurance taxation su that insurance should bear no greater taxation burden than any other good or service for which consumption is encouraged. Recent modelling by the Australian National University measured how elastic the demand is for insurance products. The ANU’s research show that if all State taxes were removed, an additional 300,000 Australian households would hold contents insurance and an additional 69,000 households would hold home insurance.

The point estimates for the elasticity of demand for contents insurance are between 0.45 and 0.6. This means that a ten per cent fall in price will equal around a 5.25 per cent increase in quantity demanded. Removing tax burdens on insurance premiums will result in more Australians having coverage and benefiting from the security of insurance.

The policy question is raised – if demand in the industry is this elastic, then the government’s goal to encourage insurance could be achieved by simplifying taxation costs. Also, why should insurance policy holders in some states pay a fire service levy when all property owners benefit from fire protection services?

Red-tape in the industry also adds to the costs of premiums. I support the recent Johnson Report’s recommendation that the standardisation of insurance regulation needs to occur across States. The Insurance Council of Australia has estimated that the industry is spending over $100 million each year on the amount of time spent working through Government regulation. Compliance costs due to red-tape, taxation and reporting requirements push industry costs upwards and must be passed on to policy holders.

For example, given the amount of taxation imposed on the insurance sector, there are an excessive number of advisory notices issued by the ATO and the State bodies on the taxation treatment of insurance. A 2009 study by UTS found that insurance firms are less willing to invest in systems that will reduce compliance costs if the regulatory environment is constantly changing. Insurance firms need the certainty of consistent regulation and government approach.

I am focused on starting the process of simplifying taxation, removing regulatory burdens and encouraging household insurance. But any reforms have to be completed in a competent and responsible way. I am critical of the way in which the current Government performs reforms in the financial and superannuation sectors. For example, there are currently over twenty reviews being conducted in my portfolio, the biggest being the Cooper Review into superannuation, and the Henry Review into taxation.

I remember a comment made by Tony Abbott when the Rudd Government took office that ‘this Government hit the ground reviewing’. I have expressed the view that market participations such as investors are not able to use markets with confidence because they are unsure as to what the regulatory environment will be like in six months time.

In contrast to the current Government, any reform by a Coalition Government will be positive, purposeful and consultative - but making regulatory changes to an industry as big as insurance requires a ‘light touch on the wheel’.

This brings me to my third question: what are the areas in the industry where the Government needs to get out of the way?

What are the areas in the industry where Government needs to get out of the way?

As I mentioned earlier, the market for insurance is based on risk. As we know, risk is a necessity in financial markets and return is higher according to the level of risk. Any Government alteration of risk will disrupt the market and move the market forces of supply and demand for insurance.

We see in the superannuation sector concern over the direction of government change. Due to the number of reports and review, nobody in the industry knows what the regulatory environment will be in six or twelve month’s time. This is risk caused by Government. The taxation reliance that the States have on the insurance industry creates the situation where insurance will be constantly picked at unless reforms are made to simplify its tax treatment and associated red tape.

Currently no one in the industry knows what recommendations the Henry Tax review will make on insurance. I call on the Government to ‘bring on Henry’ and release their report. The industry has seen its fair share of review recommendations that have not implemented change. The 2001 State Business Tax Review by the Victorian Government and the HIH Royal Commission said that stamp duties should be abolished on insurance.

The 2008 NSW Independent Pricing and Regulatory Tribunal Review of State Taxation argued that stamp duty on insurance be lowered by 4 per cent. The NSW government ignored the report and placed a further tax on insurance used to fund the SES in November of that year.

The Johnson Report’s recommendation 3.7 to ‘remove state insurance taxes and rationalise regulations’ is well worth considering. But the industry deserves to be sceptical about the Government’s intentions.Not only is the industry sceptical, it also fears an increase in red-tape and regulation during 2010.58 per cent of insures polled in the JP Morgan Deloitte General Insurance Industry Survey said they fear regulatory changes in 2010.

APRA is currently consulting with the industry to align prudential reporting with statutory reporting obligations. Whilst the reforms will make future reporting simpler, the industry will need to transition to the new requirements, and Government needs to be mindful of that. Whilst the changes will be welcomed by some in the sector, fundamental reforms are needed to the tax treatment of insurance products rather than fiddling at the margins. The Government must stay away from reforms that will increase the taxation and regulatory burden on the insurance sector, and we mustn’t provide regulatory uncertainty. Doing these things will ultimately increase costs and lower the number of policy holders.

Conclusion

In conclusion, the Coalition believes that there is a disproportionate burden on insurance as a taxable item in Australia. Insurance provides a benefit to consumers and businesses. It protects them against risk and it allows them to use their assets confidently. Both the industry and Government need a commitment to improving the rate of policy holders in Australia – particularly for households.

Today’s regulatory update is evidence of how committed the industry is to finding solutions and improving coverage rates in Australia. As a matter of principle, insurance should be at no greater level of taxation than any other good on the market for which consumption should be encouraged. Whilst the Coalition is quickly progressing on its policy in this area, I welcome any comments and feedback from the industry on the direction that insurance policy should take and the challenges ahead.

In my brief time in this portfolio I would summarise the industry’s top 3 concerns as ‘tax, tax, tax’, and the fourth concern being overregulation. From a policy perspective, we shouldn’t tax seatbelts and airbags at a higher rate than the car.I look forward to helping the industry meet these challenges in a Coalition Government.

 

 

 

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