Discounting effect

Justine

I don't understand the purpose of calculating the effect of discounting the asset for future income taxes nor do I understand the formula. Is this discounting effect an asset? Should we remove it from APV or premium labilities? Should we consider it in the calculation of equity? I'm kinda lost :S

chrisboersma

It's arbitrary:

As detailed in Part XIV of Canadian Income Tax Regulations, the income tax deduction in respect of an insurer’s claim liabilities is equal to 95% of the lesser of the reported reserve and claim liability.

Regulation XIV: Policy Reserves

For the purposes of paragraphs (1)(a) and (2)(a), the amount determined under this subsection in respect of an insurer for a taxation year is the amount, which may be positive or negative, determined by the formula

A + B + C + D + E + F + G + H + I + J + K + L

D : equal to 95% of the lesser of reported reserve and the total of the claim liabilities.

You're only taxed based on 95% of your claim liabilities. Basically the government is giving you a 5% discount on CURRENT taxes (unpaid claims), but you still have to pay full taxes on FUTURE liabilities (once paid). So we are trading PV.Tax for Current Tax. What's the value of this trade?

Tax Timing Benefit = Current Tax - PV.Tax = [Tax] x ( 1 - PV.factor)
[Tax] = (reported reserves - 95% of lesser of ... ) x [Tax Rate]

Put it all together:
(reported reserves - 95% of lesser of ... ) x [Tax Rate] x ( 1 - PV.factor)

We only want to adjust for the TIMING benefit (we cannot create an asset for future taxes).

Two important statements at the beginning state clearly that the liability portion doesn't matter.

Section 2130.15: The insurer’s accounting policy may report amounts related to the relevant policies and the assets which support their policy liabilities, such as [… ] future tax liabilities and assets (for example, those in connection with the timing differences between accounting and tax liabilities).

Section 2210.02: Notwithstanding Section 2100 and this Section 2200, until standards have been developed, the actuary may ignore taxes in determining policy liabilities for property and casualty insurance.

graham

Here's the big picture for how I make sense of this formula:

• You don't have to pay taxes on your losses or liabilities, but in insurance you don't know what your losses are until the claims are closed.
• So, they make you pay taxes on a small portion of your current reserves, roughly 5%, just in case your reserves are a little too high and some of it is eventually released into income. In this case, you've effectively prepaid a portion of your taxes.
• But let's say your reserves turned out to be correct. Having paid this 5% means you've paid too much tax. This amount is then treated as an asset. Since it's an asset, it would show up somewhere on the balance sheet.

In terms of an exam question, it ties into the calculation of APV of claims liabilities because that's one of the terms in the formula, and that's how you get the discount factor. The discounting part of the formula is just the regular discounting that gets applied to any liability or asset where the time value of money is material.

As long as you can state the definition and can do the calculation, you should be prepared for anything they might throw at you.