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The general

insurance sector:
big benefits but
overburdened
Prepared for
Insurance Council of Australia
Centre for International Economics
Canberra & Sydney
August 2005
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Centre for International Economics 2005
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Contents
Summary v
1 Context and introduction 1
2 General insurance: a major industry 2
Affects everyone 2
Provides high value services 4
Makes a substantial contribution to GDP 10
Involves many businesses 12
Employs a large number of people 13
So it makes a weighty contribution 14
3 Plays a critical role 15
Works by pooling risk 15
Helps to manage risk 15
Mobilises savings 17
Facilitates strategic investments 18
Contributes in many other ways 19
So it is fundamental to the economy 20
4 Burdened by uneven taxes 21
Facing a punitive tax burden 21
Paying more tax than overseas 23
Creating revenue dependency in government 25
Imposing extra costs on the community 27
Creating an under-insured community 32
Avoiding costs from underinsurance 33
So raise value by lowering punitive taxes on insurance 35
5 Handicapped by distorted competition 37
Facing uneven regulation 37
Stepping toward a level playing field 40
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C O N T E N T S
Seeking further change 41
Exposing implications of not changing 43
Sodistortions should be fully ironed out 45
6 Conclusion 47
References 49
Boxes, charts and tables
2.1 General insurance product segmentation 3
2.2 Average general insurance premiums per policy 5
2.3 Insurance premium rate changes 5
2.4 Tort reforms overview and impact 6
2.5 Estimated expenditure on insurance by industry 9
2.6 Expenditure on insurance as a share of industry value added 9
2.7 Comparison of industry contributions to GDP, gross value
added 10
2.8 Relative share of insurance industrys contribution to GDP 11
2.9 Comparison of average annual rates of industry growth 12
2.10 Distribution of general insurance employees by state 13
2.11 General insurance employees per $ billion of gross state
product 14
3.1 Industry investment assets by area 18
4.1 Summary of taxes on general insurance to households 22
4.2 State taxes as a percentage of home insurance premiums 22
4.3 State taxes as a percentage of business insurance premiums 23
4.4 International comparison of taxes on property insurance
premiums 24
4.5 Insurance tax revenue by state excluding GST 25
4.6 Taxation revenue by product 26
4.7 Taxes on the price of alcohol and tobacco compared with
insurance 27
4.8 Economic welfare gain from reduction in state taxes 32
4.9 Economic impacts of a disaster with and without insurance 35
5.1 Findings of the Potts Review: key features of DMFs and
DOFIs 39
5.2 Regulatory and taxation environment: post implementation
of the Potts recommendations 41
v
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Summary
THE INSURANCE INDUSTRY IS A MAJOR INDUSTRY in its own right.
This sector makes a significant contribution to national output and plays an
important role in the economy. Key aspects of the Australian general
insurance sector are that it:
comprises 157 entities and businesses (IBISWorld 2005);
employs approximately 20 000 employees and pays over $1.3 billion in
salaries and wages each year (IBISWorld 2005);
earned gross premiums of $32 billion in 200304 (IBISWorld 2005);
paid out $12.4 billion in net claims in the year to March 2005 (APRA
2005);
has improved its financial performance over the last couple of years:
higher profitability has been influenced by enhanced underwriting
performance and recent higher investment returns;
provides protection for a substantial amount of Australias assets.
Australian households, governments and businesses have $47.6 billion
worth of current and future claims against the reserves of general
insurance companies (APRA 2005);
provides insurance to every sector of the economy; and
contributed $14.6 billion to Australian gross domestic product in gross
value added terms in 2003-04 (ABS data).
The services provided by the insurance industry play an important role in
ensuring the smooth operation of the national economy, as well as in
encouraging innovation.
An insurer is better able to price risk and can absorb any losses against
the pool of premiums. This effective management of risk allows
individuals to engage in more risky activities, like starting a business or
purchasing a large item, fostering higher levels of economic activity.
The collection of premiums by insurance companies also provides a
mechanism by which savings are mobilised. The general insurance
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
industry now accounts for nearly 4 per cent of the total assets held by
financial institutions in Australia (RBA 2004).
Despite the unique importance of insurance in the Australian economy,
current tax arrangements place a punitive burden on the industry that is
out of line with tax levels in other countries.
In addition to direct taxes, the Australian insurance industry is subject
to: a fire services levy (FSL) in New South Wales, Victoria and
Tasmania; to the goods and services tax (GST); and to stamp duty.
These taxes are applied in a cascading manner, with the GST calculated
on top of the FSL and stamp duty being applied on the premium
including both of these taxes.
In 2003-04, all levels of government in Australia collected $3.2 billion in
tax revenue from the insurance industry (ABS 2005b).
Despite the benefits of insurance, current tax arrangements in some
states have a similar impact on the final price as do taxes on cigarettes
and alcoholic spirits.
Studies indicate that reducing tax on insurance would have relatively
high welfare gains. The key impact of high tax levels is widespread
under-insurance, with studies indicating that 21 per cent of consumers
are currently under-insured. This level of under-insurance can impose
future hardship on the community (Mason 2005).
Despite recent reviews of competition in the market for general insurance, a
number of entities providing general insurance in the Australian economy
operate at an advantage, with their particular arrangements exempting
them from regulatory requirements and insurance-related taxes. These
entities include discretionary mutual funds (DMFs) and direct offshore
foreign insurers (DOFIs).
The small share of the market held by DOFIs and DMFs today obscures the
potential significance of the distortions. The recent reviews noted that
market share for these competitors was increasing reflecting the regulatory
advantages that they enjoy. The magnitude of the distortion can be
expected to grow and the costs will escalate and compound in the future.
While the precise shape of market outcomes will reflect many choices and
decisions to be taken by key market participants and governments, a
reasonable scenario is that the favoured competitors will cherry pick key
markets, shrinking the insurance and premium pool for general insurers.
This would start a vicious cycle of raised premiums, reduced demand for
general insurance, and underinsurance. This would lead to higher
demands and budgetary costs to be faced by governments in Australia.
1
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
1
Context and introduction
CIE HAS BEEN COMMISSIONED by the Insurance Council of Australia
(ICA) to undertake a study into the benefits of the general insurance
industry to the Australian economy. The three core areas of the analysis are
to:
identify the contribution of the general insurance industry to the
Australian economy;
assess the benefits of removing the potentially distortionary tax burden
on insurance; and
assess the impact of a level playing field in which distortionary
advantages enjoyed by discretionary mutual funds (DMFs) and direct
offshore foreign insurers (DOFIs) are removed.
The focus of the study is upon the general insurance industry with brief
references to the health and life insurance sectors.
This report is structured as follows. The economic contribution of
Australias general insurance sector is outlined in chapter 2. A profile of the
industry is presented, followed by an outline of the magnitude of its
economic contribution in value added and employment terms.
Chapter 3 discusses the role played by the insurance industry in the
economy and the ways in which it facilitates an improved allocation of
resources and economic growth.
The uneven taxation burden placed on the general insurance sector is
explored in chapter 4.
Chapter 5 reviews the non-level playing field between Australian insurers
and between Discretionary Mutual Funds (DMFs) and Direct Offshore
Foreign Insurance (DOFIs) owing to potentially different regulatory and
tax treatment afforded to them.
Conclusions from the study are provided in chapter 6.
2
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
2
General insurance: a major
industry
THE GENERAL INSURANCE INDUSTRY makes a major contribution to
the Australian economy. This chapter provides an overview of this
contribution reporting on key indicators referring to:
the nature of services provided;
the value of services provided;
the contribution to national output; and
employment offered.
Affects everyone
The general insurance industry is defined by the services it provides. The
Australian New Zealand Standard Industrial Classification (ANZSIC)
system used in the official statistics in Australia defines it as units
mainly engaged in providing motor vehicle, fire, marine, comprehensive
household or insurance cover [not elsewhere classified] n.e.c.. Major
activities include, but are not limited to:
fire and Industrial Special Risks (ISR);
household;
motor vehicles (commercial, domestic and Compulsory Third Party
(CPT));
marine and aviation;
engineering and construction;
professional indemnity;
public and product liability;
employers liability;
mortgage; and
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
travel.
The top three products and services provided by insurers, measured by
premiums received, are employers liability, domestic motor vehicle and
CTP motor vehicle. The relative size of the general insurance market by
product is demonstrated in chart 2.1.
2.1 General insurance product segmentation 2005
0 5 10 15 20 25 30
Employers liability
CTP motor vehicle
Inward treaty
Fire and ISR
Public and product liability
Marine and aviation
% of total premiums received
Domestic motor vehicle
Householders/House owners
Commerical motor vehicle
Other
Professional indemnity
Mortgage
Data source: IBISWorld (2005).
The Australian New Zealand Standard Industrial Classification (ANZSIC)
defines the insurance industry using three classes:
health insurance (I7421);
general insurance (I7422); and
life insurance (I7411).
1
Broadly, general insurance includes nearly all insurance activities other
than life and health. The general insurance industry (I7422) is the focus of
this study.

1
ANZSIC includes a fourth class, services to insurance (I7520). The class includes
units mainly engaged in providing insurance broking or agency services, or
other services to insurance such as consultant, claim assessment, or adjustment
services. This class also includes foreign based insurance underwriters mainly
engaged in insurance broking (not carrying) domestically.
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Clearly the general insurance sector provides a wide range of services that
have implications for the everyday lives of most people. The broader role
that insurance plays by meeting these needs is discussed in more detail in
chapter 3 of this report.
Provides high value services
Customers place a high value on insurance
The cost of insurance to the customer provides a conservative measure of
the value of that insurance. Policyholders would generally not buy
insurance if they viewed that the price exceeded its worth to them. Looking
across the industry at large, this provides an indicator of the value placed
upon insurance on a willingness-to-pay basis.
Gross premiums collected by the general insurance industry in Australia
amounted to $31.9 billion in 200304 (IBISWorld 2005). They increased
from $23.7 billion in 198999, with an average real rate of growth of
5.4 per cent per annum over that time (IBISWorld 2005).
General insurers provide their products and services to a range of
commercial and residential clients. Most premiums are paid by consumers
as opposed to commercial customers. That is, most demand for general
insurance is comprised of final demand rather than intermediate or
derived demand.
Premiums for policies have been relatively volatile. They increased over the
three years to 2001
2
(chart 2.2). Prior to this, average premiums showed a
declining trend per policy from $497 in 1997 to $401 in 1999. However,
average premiums up to 2001 were still lower than the 1997 figure. The
increase or hardening of premiums has been argued to be much needed
by some industry observers following a decade of weak pricing, whilst
insurers relied on investment gains to fund their underwriting losses
(KPMG 2003).

2
The data on average premiums is based on the most recent publicly available
ACCC review of insurance industry pricing (ACCC 2002).
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2.2 Average general insurance premiums per policy 2001 values
0
100
200
300
400
500
600
$

p
e
r

p
o
l
i
c
y

.
.





.
.
.
.
1997 1998 1999 2000 2001
Data source: ACCC (2002).
Since 2001, there are signs that premium prices have continued to follow an
upwards trend on average. According to KPMG (2003), on average insurers
increased premium rates between 2001 and 2003. Personal lines of
insurance (including home insurance and compulsory third party)
increased by around 3 per cent in 2004. These premiums are forecast to
continue to grow over the next two years (chart 2.3).
In contrast, premiums upon commercial lines have declined on average
during 2004 by 4 per cent. Further falls in commercial premium prices are
expected over the next two years.
2.3 Insurance premium rate changes
-5
-4
-3
-2
-1
0
1
2
3
4
2004 2005 2006
%

-
-
-
-
-
-

Weighted average change (personal) Weighted average change (commercial)
Data sources: Lawson (2005) and JP Morgan-Deloitte (2004).
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Recent government initiated tort law and other reforms aimed at
improving the affordability and availability of public liability and
professional indemnity insurance appear to be having a positive
downward impact on the price of premiums for these types of insurance
(box 2.4).
Claims paid are of a high value each year
Policyholders buy insurance in return for the payment of claims, or the
potential need to pay claims. The amount of claims paid across the
community in a year provides another indicator of the value of insurance to
the economy at that time.
In the year ended March 2005, the general insurance industry in Australia
paid out $12.4 billion in net claims (APRA 2005).
Of course, the amount of claims paid depends on what happens in a given
year and is influenced by the vagaries of the weather, bush fires and other
events. In a broad sense, the difference between net claims and premiums
drives the rate of return for capital invested in the insurance industry and
changes in the financial reserves of the industry.
2.4 Tort reforms overview and impact
Since 2002, Commonwealth and state level governments have pursued measures to lower and contain legal and
claims costs in the areas of public liability and professional indemnity insurance. This occurred in response to growing
concerns over rising premiums and reduced availability of these types of insurance.
Between 1997 and 2002, the ACCC found that public liability claims costs rose significantly. Average claims size
increased by 75 per cent. Average premiums increased by 19 per cent in 2001 and by 44 per cent in 2002.
Professional indemnity claims costs rose substantially over the five years to 2002. From 1997 to 2002, the average
size of claims increased by 195 per cent. Average premiums rose by 21 per cent between 1997 and 1999, and then
jumped by 125 per cent to 2002 (ACCC 2003).
An expert report submitted to a ministerial meeting found that the main factors contributing to rising premiums and
lower availability of public liability insurance were as follows:
changing community attitudes to litigation;
change in the courts view of what constitutes negligence;
increased compensation for bodily injury claims;
previous under-pricing and poor profitability of the insurance industry;
the collapse of HIH, a significant player in the public liability market; and
a decision by insurance companies to be more selective about the risks that they cover (Coonan 2002).
(Continued on next page)
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Large value of assets protected
Another indicator of how important insurance is to the Australian economy
is the value of assets protected. One way of obtaining a broad estimate on
the size of the communitys assets protected is by examining insurers
liabilities. Based on APRA data, at the end of March 2005, Australian
households, governments and businesses had $47.6 billion worth of claims
against the reserves of general insurance companies (APRA 2005). This
figure includes $35.3 billion of outstanding claims provisions, which
account for the potential cost (to insurers) of settling claims incurred at the
reporting date but may not yet have been paid. Premium liabilities of
$12.3 billion are also included, which indicates future claims that may arise
from future events under current policies.
2.4 Tort reforms overview and impact (continued)
The main types of reforms implemented as at 30 June 2004 include the capping of damages for economic loss (loss
of past and/or future income), non-economic loss (pain and suffering) and legal costs. Other reforms encompass the
introduction of minimum thresholds of impairment for access to non-economic loss, limitation periods for personal
injury claims, provision for good Samaritans and volunteers, waivers for risky activities and provisions disallowing
exemplary or punitive damages. In addition, proportionate liability for economic loss, and professional standards
legislation, have been implemented in some jurisdictions (ACCC 2005).
There is mixed evidence on the impact of reforms to date; it is likely to be too early to observe the full effect of
reforms at the moment. However, there are some positive early signs. In the six months to June 2004, the average
size of public liability claims settled fell by 11 per cent and premiums for this class of insurance decreased by
15 per cent (ACCC 2005). At an industry forum held by the ICA in February 2005, claims managers in New South
Wales, Queensland and Victoria have observed a fall in the number of claims (ICA 2005). Many in the industry
perceive that social behaviour towards negligence matters is beginning to change in a positive direction (JP Morgan
and Deloitte 2004).
A recent review of government services indicated that civil claims fell across Australia by more than 43 000 over the
past three years (Oldfield 2005). In New South Wales, the number of civil cases pending in the District Court has
fallen substantially due to the introduction of tort law reforms (Steering Committee for the Review of Government
Service Provision 2005).
For professional indemnity insurance, the average size of claims settled rose by 21 per cent, but average premiums
fell by 17 per cent. Based on a survey, insurers did not expect reforms to have an impact on professional indemnity
insurance claims costs and premiums during 2004, particularly as reforms enacted to the end of June 2004 mainly
focused on personal injury and death claims (ACCC 2005). Proposed reforms on amendments to the Insurance
Contracts Act 1984 and the introduction of Commonwealth professional standards legislation are expected to have
an impact on professional indemnity insurance claims and premiums in the future (ACCC 2005).
A number of surveys by stakeholder have found indications that availability of public liability and professional
insurance has improved (see ICA 2005).
The full impact of reform is likely to be observed in a few years time. In October 2004, several industry players
indicated that it might take 2 to 3 years before tort reform effects are completely understood (JP Morgan and Deloitte
2004).
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
According to the ABS, Australian households alone had $33.1 billion of
claims against health and general insurance reserves as at March 2005 (ABS
2005a).
Current and future claims against insurers is likely to underestimate the
true value of all assets protected, because it is based on the sum insured
multiplied by the probability of a claim occurring. The value of all assets
insured under all policies would be a more useful indicator of the value of
insurance. Regretfully, reliable indicators of the value of assets insured are
not widely available.
Insurance is essential for business
Insurance is a fundamental part of business. The most recently available
Input-Output tables published by the ABS
3
indicate that Australian
producers spent an estimated $1.83 billion on insurance, which includes life
and health insurance. That data also shows that every sector of the
economy purchased insurance as part of their business. Industry
expenditure on insurance is portrayed in chart 2.5.
Manufacturing and retail trade are the two largest purchasers of insurance
as indicated in chart 2.5. This reflects the relative size of these sectors,
which are among the largest sectors of the economy.
Chart 2.6 illustrates the amount of insurance purchased by each sector of
the economy taking into account the size of that sector. This suggests that
there are differences between industries in the intensity of their reliance
upon insurance. From this perspective it appears that service sector
activities use more insurance per unit of value added than manufacturing
and other goods-oriented activities, such as agriculture and mining. The
accommodation, cafes and restaurants sector is the most intensive user of
insurance.
It is likely that the sectors that are intensive users of insurance would be
most reliant upon the continued availability and affordability of insurance.
Reductions in the availability or affordability of insurance would clearly be
a significant concern for many service sector activities that have been the
mainstay of Australias economic growth and employment over recent
decades.

3
Although the data is from 1998-99, the Input-Output tables still provide a
reasonable reflection of the structure of Australias economy. This is because it
takes a significant period of time for structural changes to occur and therefore be
apparent in the data.
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
2.5 Estimated expenditure on insurance by industry 1998-99
0 50 100 150 200 250 300 350 400
Agriculture, forestry and fishing
Manufacturing
Construction
Retail trade
Transport and storage
Finance and insurance
Government administration and defence
Health and community services
Personal and other services
$m
Mining
Property and business services
Communication services
Accommodation, cafes and restaurants
Wholesale trade
Electricity, gas and water supply
Cultural and recreational services
Education
Data source: ABS data.
2.6 Expenditure on insurance as a share of industry value added 1998-99
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6
Agriculture, forestry and fishing
Manufacturing
Construction
Retail trade
Transport and storage
Finance and insurance
Government administration and defence
Health and community services
Personal and other services
Expenditure on insurance as % of value added
Mining
Property and business services
Communication services
Accommodation, cafes and restaurants
Wholesale trade
Electricity, gas and water supply
Cultural and recreational services
Education
Data source: ABS data and CIE estimates.
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Makes a substantial contribution to GDP
The contribution is already substantial
Assessment of the size of the economy or of the contribution of a specific
sector often focuses upon its value added. That is, the difference between
the value of product and the cost of making it. Gross Domestic Product
(GDP) is the sum of every industrys value added.
The value added statistics, compiled by the ABS, groups general insurance
with other types of businesses within the finance and insurance division
(within the ANZSIC framework which underpins the national accounts).
This division makes the fourth largest contribution to GDP (in gross value
added terms) out of all industries (chart 2.7).
There is some data about the specific contribution of insurance within the
finance and insurance division. Insurance (including general, life and
health insurance) accounts for about 36 per cent of the value added by the
division. The general insurance sector produces most of this. The relative
share of life, health and general insurances, as measured by industry gross
value added is illustrated in chart 2.8. By itself the general insurance
component of the division contributed nearly 2 per cent, or $14.6 billion, of
Australian GDP in gross value added terms in 2003-04.
2.7 Comparison of industry contributions to GDP, gross value added 2003-04
0 2 4 6 8 10 12
Manufacturing
Ownership of dwellings
Construction
Retail trade
Transport & storage
Mining
Agriculture, forestry & fishing
Personal & other services
Accommodation, cafes & restaurants
% of GDP
Property and business services
Government, administration & defence
Education
Wholesale trade
Health and community services
Finance and insurance
Communication services
Cultural & recreational services
Electricity, gas & water
Data source: ABS (2004a).
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2.8 Relative share of insurance industrys contribution to GDP 2003-04
Life insurance
28%
General insurance
70%
Health insurance
2%
Data source: ABS data.
The contribution is growing
The finance and insurance division has sustained a rapid rate of growth.
Over the ten years from 199192 to 200102, Australias average annual rate
of growth (measured by GDP) was 3.9 per cent. In contrast the insurance
and finance division maintained an average annual rate of growth of
4.3 per cent. In the two subsequent years, 2002-03 and 2003-04, the industry
has sustained similar growth. Chart 2.9 shows average growth rates across
all industries (or ANZSIC Divisions).
Chart 2.9 also illustrates the transformation in economic activity away from
goods-oriented activities, such as agriculture and manufacturing, towards
services activities. The sustained rapid rate of growth in finance and
insurance is part of this transformation.
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Involves many businesses
Australias general insurance sector comprised 157 insurers at the end of
June 2004 (IBISWorld 2005).
Within the general insurance sector, there are both private and public
general insurers. Of these, 90 per cent are private; the remaining 10 per cent
are public general insurers. These entities are classified as one of four types
of insurers:
direct underwriters, which represent the majority of insurers;
mortgage insurers;
captive insurers; and
reinsurers.
The large number of organisations involved is an indication of the choice
that consumers have and the level of competition that there is in delivering
general insurance services.
2.9 Comparison of average annual rates of industry growth 1991-92 to 2001-02
0 1 2 3 4 5 6 7 8 9
Communication sevices
Wholesale trade
Finance & insurance
Personal & other services
Construction
Ownership of dwellings
Mining
Manufacturing
Education
GDP
Average annual rate of growth
Property & business services
Transport & storage
Accommodation, cafes & restaurants
Agriculture, forestry and fishing
Health & community services
Retail trade
Cultural & recreational services
Government, administration and defence
Electricity, gas & water supply
Data source: ABS (2004a).
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Employs a large number of people
According to some estimates, by the end of 200304, the general insurance
sector employed nearly 20 000 workers and paid $1.3 billion in wages
(IBISWorld 2005).
Employment has been falling over the last six years, from 19992000 to
20032004 (IBISWorld 2005). The slight fall in employees reflects a wide
range of factors including industry rationalisation and continued
productivity gains.
All Australian states and territories have a portion of their labour force
working in this sector (chart 2.10). The number of employees in each state is
loosely associated with the size of its economic activity, measured by Gross
State Product (GSP), as illustrated in chart 2.11. The states of New South
Wales and Victoria are exceptions. These states appear to have a
concentration of employees probably reflecting the location of headquarters
and other service functions in those states.
2.10 Distribution of general insurance employees by state 2004
0
1500
3000
4500
6000
7500
9000
10500
NSW VIC QLD SA WA TAS NT ACT
N
u
m
b
e
r

o
f

e
m
p
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y
e
e
s
Data sources: ABS data and IBISWorld (2005).
14
2 G E N E R A L I N S U R A N C E : A M A J O R I N D U S T R Y
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
2.11 General insurance employees per $ billion of gross state product 2004
0
5
10
15
20
25
30
35
40
NSW VIC QLD SA WA TAS NT ACT All states
E
m
p
l
o
y
e
e
s

p
e
r

$

B
i
l
l
i
o
n

o
f

G
S
P




Data source: ABS (2004b) and IBISWorld (2005).
So it makes a weighty contribution
The general insurance industry forms an important part of the economy in
its own right over a range of dimensions. It provides:
a broad range of services that affects most people in their day-to-day life
while every business sector relies to some extent upon insurance in
their business;
high value that customers value at $31.9 billion in terms of premiums
paid in 2003-04;
a significant contribution to economic performance where general insurance
amounts to about 2 per cent of GDP each year and is part of the finance
and insurance sector which is the forth largest in the economy at large;
and
a large number of jobs employing about 20 000 people, with these jobs
spread throughout the country.
15
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
3
Plays a critical role
THE TRUE VALUE OF THE INSURANCE INDUSTRY lies in the unique
nature of the services that it provides. This chapter reviews the broader
economic contribution of the industry.
Works by pooling risk
At its most basic, insurance is an agreement where, in exchange for the
payment of a premium, the insurer agrees to pay the policyholder a
defined amount in the event of a specific loss.
The premiums paid by an individual policyholder become part of an
insurance pool which is at the disposal of the insurer. In setting premiums,
the insurer considers the expected losses across the insurance pool and the
potential for variation. The aim is to charge premiums that, in total, will be
sufficient to cover all of the projected claim payments for the insurance
pool. This involves balancing a complex range of factors (Anderson and
Brown 2005).
Helps to manage risk
Risk management is a key contribution of the industry. Uncertainty and
risk accompany most economic activities. The acquisition of assets that
characterises most investments also implies the acquisition of risk. Physical
assets in particular are subject to unexpected but costly damage. New
endeavours, which are particular drivers of economic growth, are typically
accompanied by even more risk.
Many individuals are risk averse and prefer to avoid or minimise risk. Even
entrepreneurs in new businesses prefer to shed risk in areas that are
outside of their control if they can.
16
3 P L A Y S A C R I T I C A L R O L E
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Insurance frequently provides the answer to risk management issues. Many
authors identify this as a central contribution:
the possibility of shifting risks, of insurance in the broadest sense, permits
individuals to engage in risky activities which they would not otherwise
undertake. (Arrow 1970, p. 137)
Insurance provides the vital market function of allocating and pricing risk
The efficient pricing of risk and its transfer to those best equipped to handle it
contributes significantly to resource allocation and economic growth. And
without a reliable mechanism for pooling and transferring that risk, much
economic activity just simply wouldnt take place. (Costello 2004, p. 1)
insurance facilitates innovation within an economy by offering to
underwrite new risks. (Ward and Zurbruegg 2000, p. 491)
Insurers enable risk to be managed more efficiently in three ways, through:
risk pricing;
risk transformation; and
risk pooling and risk reduction.
In their insurance activities, insurers evaluate potential losses the greater
the potential loss, the higher the price of insuring that risk. Insurers pricing
of risks provides information to policyholders about the consequences of
their activities that will assist in the efficient allocation of resources (Webb
2000).
Insurance enables individuals to transfer their risk to insurers,
transforming the insureds risk profile. Insurance provides an important
way of transferring risk from risk-averse individuals to companies that
specialise in evaluating and dealing with risk. Insurance companies play a
critical role as specialists in information about risks and in risk
management (ACCC 2002).
Insurance companies are not simply firms that specialise in risk. Rather, in a
world of informational asymmetries, they are specialists in gauging,
monitoring and most particularly managing risk. It is this expertise that
enables insurance firms to cope with difficulties such as moral hazard and
adverse selection. (ACCC 2002, p. 125)
The ability of insurers to transfer risk facilitates the purchase of significant
items, such as motor vehicles and real estate. As a result, insurance
coverage can have positive externalities
4
, including increased purchases,

4
An externality occurs when an activity has an indirect effect on other activities
that is not directly reflected or encompassed in the price of the initial activity.
3 P L A Y S A C R I T I C A L R O L E
17
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
profits and employment. These arise not only from within the insurance
sector but also outside it (Ward and Zurbruegg 2000).
As noted above, insurers cover individuals against losses or manage risks
by pooling risks. Aggregation brings other benefits. By insuring a large
pool of individuals who are facing similar risks, insurance companies can
predict with greater accuracy the likelihood of an event occurring. This is
based on the law of large numbers, which states that although single events
can be random and largely unpredictable, the average outcome of many
similar events can be ascertained more easily than the outcome of a one-off
event. The greater the number of policyholders, the more stable and
predictable is the insurers portfolio. This can lead to lower volatility, in
turn enabling insurers to charge smaller risk premiums and maintain more
stable premiums (Skipper, Starr and Robinson 2000).
Mobilises savings
In meeting insurance needs, insurance companies also act as financial
intermediaries. In collecting and managing a pool of insurance premiums,
insurers are part of the group of institutional investors which have become
key holders of financial assets and have an increasingly important role in
todays capital markets (OECD 2004).
Insurance companies also play a secondary but increasingly important,
intermediation role. They take funds from policyholders and invest them in
financial and real markets. (Hodgson 1999, p. 3)
Insurers help mobilise savings in three ways (Webb 2000). First, insurers
lower transaction costs associated with drawing together savers and
borrowers compared with direct lending and investing by policyholders.
Second, they create liquidity. Insurers invest funds from customers to make
long-term loans and other investments. Whereas policyholders have ready
access to loss payments and savings, borrowers do not have to repay their
loans immediately. Hence if individuals carried out the similar direct
lending, the proportion of their personal wealth held in long-term, illiquid
assets would be much higher.
Third, by gathering small sums from large numbers of policyholders,
insurers are often able to provide finance on a scale required for large
infrastructure projects. This assists the national economy in expanding the
set of feasible investment projects and encouraging economic efficiency. In
the United States, insurers provide financing for one-third of all corporate
debt (Skipper, Starr and Robinson 2000).
18
3 P L A Y S A C R I T I C A L R O L E
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Facilitates strategic investments
Reflecting its savings mobilisation role, the insurance sector now manages
significant funds. Out of $2 516 billion total assets held by Australian
financial institutions, general insurance industry assets accounted for
nearly 4 per cent or over $90 billion at the end of September 2004 (RBA
2004). This compares to 3 per cent for finance companies and general
financiers, nearly 50 per cent for banks (excluding the RBA), and 15
per cent for the growing superannuation funds.
Drawing on the asset side of their business, Australias general insurance
industry undertakes considerable investment. At the end of March 2005,
the industry had total investment assets of $52.9 billion (APRA 2005).
The majority of industry investment assets are in interest bearing
securities almost 70 per cent of total investment (APRA 2005). Following
the recent strengthening in equity markets and improved returns, many
insurers are beginning to move more investments back into equity
holdings. Investments in equity and property trusts are also on the rise
(APRA 2004). Holdings of investment assets by area are depicted in
chart 3.1.
The industry earned $4.2 billion in investment income in the 12 months to
March 2005 an increase of 33 per cent from the previous year (APRA
2005).
3.1 Industry investment assets by area March 2005
Interest
69%
Property
1%
Indirect investments
5%
Loans and advances
4%
Equity
11%
Other investments
10%
Data source: APRA (2005).
3 P L A Y S A C R I T I C A L R O L E
19
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Contributes in many other ways
The insurance industry also facilitates economic growth through other
mechanisms as follows.
Promoting financial stability. This occurs through insurers covering
those who suffer loss. Without this assurance individuals and firms
could incur significant losses and not engage in activities to create
wealth. Insurance allows risk to be transferred to an entity that is better
able to deal with it, allowing individuals and firms to specialise and
undertake more risky projects (Das et al. 2003).
Substitutes for and complements government welfare programs. This is
relevant for activities such as compulsory third party insurance for
motor vehicle accidents and life insurance. Insurance covering personal
injury care and rehabilitation costs can assist in reducing government
expenditure on these costs. Studies have found that higher private
expenditure on life insurance has been associated with lower
government expenditure on social insurance programs (see Webb
2000).
Facilitating trade and commerce. Several products and services are
made and sold only when adequate insurance is provided. In the case
of high risk new business ventures, the provision of financing is often
contingent upon assets and the entrepreneurs lives being adequately
insured. Banks (and governments) frequently require people buying a
home with a small deposit to obtain mortgage insurance. The diversity
of insurance products and insurers ability to price different risks
means that insurance can be considered as a lubricant of commerce
facilitating investment.
Encouraging loss mitigation. This can occur, for example, by insurance
companies requiring some policyholders to undertake loss
management activities, such as fire prevention and occupational health
and safety activities. Any reduction in losses can benefit the
community at large.
Fostering more efficient allocation of capital. Insurers spend time
collecting information to evaluate projects, firms and individuals in
their decision to issue and price insurance and in their investment
activities. By comparison, individual savers and investors typically do
not have the time, resources or ability to collect this information. In
addition, activities of insurers in continually evaluating and monitoring
risks provides markets with information on the likelihood of losses
which can lead to improved resource allocation (Webb 2000).
20
3 P L A Y S A C R I T I C A L R O L E
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
More sophisticated and efficient financial sectors with a range of products
and services on offer can aid economic growth by facilitating the allocation
of capital. A study using data from 55 countries found that higher levels of
banking and insurance in an economy positively impacted on economic
growth (Webb, Grace and Skipper 2002). According to that study, the two
sectors jointly provided a greater impact on economic growth than the sum
of each sectors individual impact with synergies between financial
intermediaries. For example, more efficient bank payment systems can lead
to lower administrative costs for insurers. Also, growth in one type of
financial intermediary can also have positive spillover effects on the
demand for services offered by other financial intermediaries as consumer
sophistication increases (Webb, Grace and Skipper (2002).
So it is fundamental to the economy
General insurance underpins key aspects of society by providing security
and protection to individuals, communities and businesses. Through
general insurance, entities are protected against bearing the full costs of an
economic loss. It allows risk to be transferred and shared among many
players, thereby reducing the burden of loss.
It provides coverage for all aspects of modern living, from professional
indemnity and public liability to natural disasters and personal property.
Without it, fewer businesses could operate, jobs would be lost and families
would not have protection against adversity.
Insurers are also financial intermediaries and play an important part in
mobilising savings and investment and in improving the allocation of
resources.
21
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
4
Burdened by uneven taxes
DESPITE THE ROLE THAT INSURANCE PLAYS in supporting economic
activity and its pervasive role in protecting people from hardship, a
punitive tax burden is applied to insurance in Australia. This chapter looks
at the range of taxes applied to insurance in Australia. It compares taxes
applied in Australia with those in other countries. The chapter also
compares taxes between different jurisdictions in Australia, and reviews
the evidence about the inefficiencies that result from the heavy tax burden
applied to insurance in Australia.
Facing a punitive tax burden
Insurance is subject to a large number of taxes. Insurance businesses pay
direct taxes such as the company tax rate of 30 per cent. In addition, there
are a number of indirect taxes applied by the Commonwealth and state
governments. These include:
Fire services levy (FSL) This is applied to a range of general insurance
products. The FSL is intended to raise funds for brigade fire services.
The states of New South Wales, Victoria and Tasmania currently apply
FSL.
Goods and Services Tax (GST) applied at a rate of 10 per cent to final
customers, as it is to most other goods and services in the economy.
Stamp duty contracts of insurance are subject to this tax. The rate is
set on an arbitrary basis and differs from state to state.
As noted above the rate of taxes applied to insurance differ in each state.
Data from the most recent publication comparing state taxes imposed on
household general insurance across Australia is summarised in table 4.1.
5

5
It is notable that the NSW budget for 2005-06 released in May 2005 raised the
stamp duty rate from 5 to 9 per cent in that state. The table also includes the
latest FSL rates, which were recently increased in Victoria and New South Wales.
22
4 B U R D E N E D B Y U N E V E N T A X E S
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
The challenging aspect of taxation applied to insurance is that it cascades.
The GST is calculated with FSL in the base. Stamp duty is then applied to
premiums, the FSL, and the GST amount. This is a now rare example of tax
cascading that the reform process involved in the introduction of the GST
was supposed to eliminate.
Reflecting the tax rates applied and the impact of tax cascading, indirect
taxation applies a weighty burden on the price of insurance. It is estimated
that the three main state taxes combined can add to the cost of insurance to
households by between 44 per cent in Victoria and 18 per cent in
Queensland. This is calculated by comparing the taxes that would be paid
on an insurance contract for home insurance across the states and
4.1 Summary of taxes on general insurance to households 2005
Jurisdiction NSW NT ACT QLD WA SA TAS VIC
% % % % % % % %
Metro Country
Stamp duty 9 10 10 7.5 10 11 8 10 10
FSL 15 0 0 0 0 0 0 15 19
GST 10 10 10 10 10 10 10 10 10
Source: ICA data, NSW Treasury (2004) and NSW Treasury (2005).
4.2 State taxes as a percentage of home insurance premiums 2005
0 5 10 15 20 25 30 35 40 45 50
VIC country
VIC metro
NSW
SA
NT
WA
ACT
TAS
QLD
% of premium
FSL
GST
Stamp
duty
Data source: ICA data and CIE calculations.
4 B U R D E N E D B Y U N E V E N T A X E S
23
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
territories. The proportion paid in taxes represents a significant impost on
consumers in all states, but it is particularly heavy in New South Wales and
Victoria.
State taxes impose an even higher cost on insurance bought by businesses.
The proportion of state taxes on premiums ranges from a significant 82
per cent in regional Victoria to 18 per cent in Queensland (chart 4.3).
In addition to these main three taxes, the New South Wales Government
imposes a levy on insurance companies to contribute to funding shortfalls
in coverage after the collapse of HIH. It levies an Insurance Protection Tax
on insurers according to their share of total yearly premiums. Under the
legislation this cost is to be borne by insurers, and they are prevented from
passing it on to policyholders.
Paying more tax than overseas
By international standards, taxes on general insurance in Australia are
high. Tax as a percentage of commercial and household insurance
4.3 State taxes as a percentage of business insurance premiums 2005
0 10 20 30 40 50 60 70 80 90
VIC country
VIC metro
NSW
TAS
SA
NT
WA
ACT
QLD
% of premium
FSL
GST
Stamp
duty
Data source: ICA data and CIE calculations.
24
4 B U R D E N E D B Y U N E V E N T A X E S
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
premiums in a variety of jurisdictions is depicted in chart 4.4.
6
Taxes on
property insurance in most Australian states and territories are higher than
in the majority of the comparator countries. International taxes as a
proportion of premiums are as low as 2 per cent in Ireland and Singapore
and 2.4 per cent in the USA (California).
Australian taxes on property insurance are particularly high compared
with international competitors in the area of business insurance. Premium
taxes on commercial insurance in country Victoria are more than 16 times
greater than those imposed in the United Kingdom. Taxes in both
Tasmania and New South Wales are more than 10 times higher.
The level of taxes on household premiums in many Australian states and
territories is above those in countries such as South Africa, Germany and

6
A basic premium of $100 is assumed and does not account for different cost
structures insurers might have across and within jurisdictions.
4.4 International comparison of taxes on property insurance premiums
2005
0 10 20 30 40 50 60 70 80 90
VIC - Country
NSW
France
ACT
WA
Colombia
Germany
Trinidad and Tobago
Switzerland
USA (California)
Singapore
Japan
% of tax-exclusive premium
Commercial insurance
Household insurance
VIC - Melbourne
TAS
SA
NT
QLD
Canada (Ontario)
Ireland
Chile
UK
South Africa
Hong Kong
Data sources: ICA data, Spratt (2005) and CEA (2005).
4 B U R D E N E D B Y U N E V E N T A X E S
25
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Switzerland. In contrast to the approach in Australia, household premiums
in Japan are tax-deductible (Spratt 2005).
Creating revenue dependency in government
Budget is heavily dependent on insurance tax revenue
Reflecting high tax rates, insurance forms a significant source of revenue
for Australian governments. In 200304, all levels of government collected
$3.2 billion in revenue from tax on insurance (ABS 2005b). The revenue
obtained from this tax has grown by 51 per cent over the last 5 years.
The total figure for government taxation on insurance reported by the ABS
does not include the GST levied on premiums. GST levied on all goods and
services is separately identified in this set of statistics (ABS 2005b).
On average, indirect insurance taxes provide almost 7 per cent of state
governments own-source revenues. Some states are particularly reliant on
this source of revenue, such as Victoria, South Australia and Tasmania
where insurance taxes generate between 7.6 and 7.9 per cent of tax
revenues (chart 4.5).
4.5 Insurance tax revenue by state excluding GST 2003-04
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
NSW VIC QLD SA WA TAS NT ACT
%


o
f

t
o
t
a
l

t
a
x
a
t
i
o
n
.
.
.
Data source: ABS (2005b).
26
4 B U R D E N E D B Y U N E V E N T A X E S
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Taxing goods and bads
Earlier chapters of this report outlined ways that the existence of insurance
benefits the economy and the community at large, for example by
providing a means to transfer and mitigate risk. Despite these benefits
insurance is taxed at rates that meet or exceed tax levels applied to goods
with serious negative externalities or costs to society these items can be
viewed as bads rather than goods.
In 200304, taxation revenue from insurance accounted for 1.3 per cent of
the total revenue of government in Australia (including revenues of the
Commonwealth, state and local governments). This level of contribution to
total government revenue is more than that from alcohol excise, which
provided 0.9 per cent of all revenue. It is similar to the level of taxation on
gambling which raised 1.6 per cent of all government collections and is not
much lower than the collections for tobacco which came to 2 per cent of all
government collections (chart 4.6).
4.6 Taxation revenue by product
a
2003-04
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
Alcohol excise Tobacco excise Gambling Insurance
%

c
o
n
t
r
i
b
u
t
i
o
n

o
f

t
o
t
a
l

r
e
v
e
n
u
e



.
.
a
Excludes GST revenue which is isolated as a separate total amount.
Data source: ABS (2005) and Treasury (2005).
This revenue is in addition to the revenue collected via the standard tax
that applies to most goods and services. This background level of tax is the
GST of 10 per cent, which is a value added tax and levied on most goods
and services in the Australian economy.
The discussion at the beginning of this chapter highlighted how state level
taxes alone add significantly to the cost of insurance to consumers and
business. To put this in perspective, it is useful to compare average taxes on
4 B U R D E N E D B Y U N E V E N T A X E S
27
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
insurance premiums to those on the prices of selected products producing
negative externalities.
Evidence prepared by other analysts indicates that high levels of tax are
applied to bads. Looking at cigarettes, for example, taxes (inclusive of
GST) add an average of 68 per cent to the retail price (VCTC 2004). Tax as a
percentage of the retail price is approximately 67 per cent for alcoholic
spirits, 33 per cent for ready-to-drink (RTD) alcoholic beverages and
23 per cent for bottled wine. By comparison, taxation on insurance for
businesses in country Victoria accounts for about 82 per cent of the price of
a premium, placing it in an even higher taxing bracket than cigarettes and
spirits (see chart 4.7).
4.7 Taxes on the price of alcohol and tobacco compared with insurance
0
10
20
30
40
50
60
70
80
90
Loose
tobacco
Cigarettes Spirits RTDs Bottled
wine
Vic
country
business
NSW
business
Vic
country
home
NSW
home
T
a
x

p
e
r
c
e
n
t
a
g
e

o
f

p
r
i
c
e


.
.
.
Data source: DSICA (2005), Crosbie (2005), VCTC (2004), ICA data and CIE calculations.
Imposing extra costs on the community
The key question is whether or not a tax is efficient. That is, does the
community at large pay because of excessive reliance upon a particular tax?
An efficient tax is one that minimises distortions in economic behaviour
that alters the allocation of resources. Generally the efficiency loss from
taxation will be greater where:
demand is sensitive to changes in price;
supply is sensitive to changes in price;
28
4 B U R D E N E D B Y U N E V E N T A X E S
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
it is easier to relocate the transaction being taxed to a lower-taxing
jurisdiction; and
high rates of taxation are applied (PC 1998).
Historically, raising revenue through tax on insurance was sometimes
considered by some to be efficient, because it was held that demand for
insurance was relatively inelastic. For example, it is argued that overall
demand for general insurance is relatively price inelastic, because it can be
difficult for consumers to pool risk without it.
Evidence from overseas, particularly the US, on the price elasticity of
demand for insurance appears to be mixed. Demand for insurance appears
to be responsive to price to a degree. According to a study by Feldblum
(2001) policyholders are sometimes not highly responsive to price changes
due to perceived difficulties in making price comparisons or lack of
awareness of price-cutting by other insurers. However, price increases do
encourage some policyholders to search for better rates elsewhere.
Other work by Grace, Klein and Kleindorfer (2002), examining data for
Florida and New York over a four-year period, found that insurance
demand was price sensitive. Their study found that a 10 per cent increase
in the price resulted in a reduction in quantity demanded of 14 per cent.
Note that this estimate incorporated demand for non-catastrophe and
catastrophe (eg in the event of hurricanes and earthquakes) home insurance
products, where the latter tends to be more responsive to price.
Studies in Australia are providing evidence that demand for insurance is
price responsive. These note that demand is only inelastic where there is no
choice. In a submission to the Victorian Review of Business Taxes, Access
Economics (2000) observed that consumers have a variety of options in
determining whether or not to purchase insurance, including self-
insurance, insurance through lower cost competitors and especially for
large corporations, purchasing insurance in other jurisdictions. Australian
analysts also note that prices do influence consumers and that even
relatively small amounts can influence their decisions.
Anecdotal evidence from insurers suggests consumers may be willing to
change insurer for a $5 difference in premium. (Wallace et al 2000, p. 182)
If demand for insurance is responsive to changes in prices then high levels
of taxation on this product will give rise to efficiency losses.
There is more certainty regarding the price elasticity of supply for
insurance. The supply side of insurance is likely to be price sensitive. This
reflects factors such as the presence of economies of scale in several
4 B U R D E N E D B Y U N E V E N T A X E S
29
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
operational aspects and the nature of the business that involves the pooling
of risks (Access Economics 2000).
If, as seems likely, supply or demand is sensitive, the high level of taxation
on premiums will distort activity leading to further efficiency losses.
Consequences of this are factors such as underinsurance and
non-insurance, which will be discussed later.
Need for change
There have been many calls for the abolition of stamp duties on efficiency
grounds from a range of independent sources. As noted above, stamp
duties are one of the taxes increasing the cost of premiums to consumers.
The Victorian Review of State Business Taxes conducted in 2001
recommended the abolition of stamp duties. It noted:
The conclusion of studies (by groups including the Productivity Commission;
The Heads of Treasuries State Taxes Working Group, comprising
representatives of all state and territory Treasuries; and Access Economics) is
that stamp duties and transaction taxes are among the most distortionary of all
taxes available to the states. The Committee believes such duties and taxes are
therefore ripe for abolition, and that abolishing them now would nurture
business activity and growth. (State Business Tax Review Committee 2001, p.
16)
The Intergovernmental Agreement on Commonwealth-State Financial
Relations (IGA) negotiated in 1999 included discussion on the impediment
presented by stamp duties on economic growth (Department of Treasury
1999). Consequently, a number of stamp duties and other taxes were
abolished. Under the IGA agreement a Ministerial Council was required to
review the need to retain a number of remaining stamp duties by 2005.
However, stamp duty on insurance was not included as part of this review.
The HIH inquiry recommended that state and territory government should
abolish stamp duty on general insurance (HIH Royal Commission 2003).
The recent Productivity Commission (2005) inquiry into first home
ownership also commented on the inefficiencies of stamp duties. The latest
OECD economic survey of Australia commented on the need for further
progress in tax reform including reform of remaining stamp duties. One of
the priorities for tax reform should be:
A rapid abolition of reining distorting State taxeswould further increase the
efficiency of the Australian tax system and improve resource allocation.
(OECD 2005, p. 14)
30
4 B U R D E N E D B Y U N E V E N T A X E S
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
The different rates of stamp duties and possible applicability of FSLs
between states and within states (in the case of Victoria) increase
compliance costs for businesses operating in multiple regions of Australia.
Other analysts have noted the cascading aspect of taxes on insurance as a
particular concern. According to a survey of business by the New South
Wales State Chamber of Commerce and the NRMA, although the public
liability insurance crisis has shown some signs of easing, they are still
concerned about the general cost of insurance.
The cascading nature of tax on insurance is a real issue for business.
Currently, the fires services levy, stamp duty and GST are all calculated on top
of one another. In fact, taxes make up almost half (49%) of the cost of general
business insurance premiums. (State Chamber of Commerce (NSW) 2003, p. 1)
NSW Treasurys (2003) submission to the Review of Fire Services Funding
argued that the FSL had several deficiencies which outweighed any
positive attributes such as simplicity in government administration and
providing a robust source of funding. Some of its deficiencies included the
weak link between fire risk and fire services levy contributions, and
importantly that those who do not take out insurance still benefit from fire
services. Despite the notion that insurance is unavoidable, it is being
recognised that there is considerable potential (and, given high rates of tax
on insurance, incentive) to free ride and fail to insure appropriately.
The recent Western Australian experience highlights many key points.
Western Australia replaced its FSL with a property based Emergency
Services Levy collected by local government authorities in July 2003. In
2004, an audit of insurance companies in Western Australia was conducted
for the state government. The audit found that insurers had passed on the
savings from removing the FSL to consumers and that its removal
contributed to the state having one of the more price competitive insurance
markets across Australia. Insurance coverage taken out by consumers was
also found to increase as a result of the cost savings (Sigma Plus Consulting
2004). This evidence undermines the theory that demand for insurance is
price inelastic and that these taxes do no harm.
South Australia, West Australia and Queensland have replaced the FSL
with a property-based system funded by owners. The ACT and Northern
Territory fund their fire brigade services from consolidated revenue.
Clearly, there are alternatives to the use of distorting taxes. Despite the
inefficiencies and inequities of Fires Services Levies, they continue to be
imposed in New South Wales, Victoria and Tasmania.
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Potential gains lowering taxation on insurance offers big gains to the
community
Access Economics (2003) has estimated the gains to community wide
economic welfare resulting from reductions in a number of state taxes. The
analysis is based on a reduction in the revenue obtained by each tax of
$100 million (as a combined total between the states). The economic gains
from each tax reduction are compared against the gains obtained from the
tax reduction with the lowest gains (in effect, the lowest cost tax). This
comparison is reflected as an index score. A score of 100 means that the tax
cut results in the same economic increase as the benchmark set by the least
cost tax in the study. A score of 200 would mean that reducing that tax
would produce double the gains of the benchmark tax (that is, it is an
expensive tax). The results of the analysis are set out in chart 4.8.
The chart indicates that, for Australia as a whole, cutting stamp duty taxes
on insurance would provide almost double the welfare benefit that results
from cutting the lowest cost benchmark tax in the study (stamp duty on
residential property transfers). This indicates that stamp duty on insurance
is a highly inefficient tax, with only stamp duty on the sale of non-
residential properties being more inefficient.
The fire services levy does not perform much better than insurance stamp
duty. It has an index score of around 136. In other words, it is 36 less
efficient than the benchmark tax used in the study.
The index scores discussed above are essentially an index of the economic
efficiency of a tax. Determining the economic efficiency of a tax is
important because it gives an indication of priority that should be attached
to changes in taxation, or which taxes should be avoided. The economic
analysis shows that taxes on insurance are relatively inefficient and that
reducing these taxes or replacing them with almost any of the others that
government have at their disposal today would lead to large gains in
economic welfare.
The modelling can also be viewed as a means of ranking taxes. Were the
government considering a tax cut, it could determine which ones would
deliver the best outcomes for economic welfare. Taxes on insurance,
particularly stamp duty, would rank highly in any such consideration.
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
Creating an under-insured community
The consequence of high cost imposts from existing taxation levels on
insurance is under-insurance and non-insurance. Under-insurance occurs
where there is a gap between existing insurance coverage and the actual
amount required to fully compensate in the event of loss. Actual levels of
under-insurance and non-insurance can be difficult to estimate. According
to the most recent annual ICA survey, around 21 per cent of consumers
believe they are under-insured (Mason 2005). However, insurance industry
sources comment that the actual figure could be markedly higher.
The cost of insurance influences the take up of insurance and can
exacerbate the potential for under-insurance and non-insurance on non
compulsory classes of insurance (Trowbridge Deloitte 2003). Surveys of
consumers and businesses indicate that cost is the most important driver in
selecting insurance coverage. Cost was the key factor in considering taking
out insurance for 85 per cent of consumers and 90 per cent of businesses
surveyed in 2004 (Mason 2005).
State level survey results for small business in New South Wales indicate
that many find the cost of insurance prohibitive.
4.8 Economic welfare gain from reduction in state taxes
0.0 50.0 100.0 150.0 200.0 250.0
Stamp duty, conveyancing (non-residential)
Stamp duty motor vehicles
Land taxes
BAD
Pay roll taxes
Gambling
Value relative to least inefficient tax (set at 100)
Insurance, stamp duty
Insurance, fire brigade levies
Third party insurance
Stamp duty, other
Local government rates
Stamp duty, conveyancing (residentiial)
Data source: Access Economics (2003)
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C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
With one in six businesses being either under-insured or without insurance
altogether, these issues warrant a closer look by the Government in order to
provide some relief for NSWs over 300 000 small businesses. (State Chamber
of Commerce (NSW) 2003, p. 1)
The extent of inadequate insurance in Australia has been observed by the
loss adjusting industry. Loss adjusters operate independently of insurance
firms but are appointed by them (and sometimes by policyholders) to
investigate the circumstances surrounding insurance claims (The Chartered
Insurance Institute 2005). An adjuster acts as an intermediary between the
insurer and the policyholder, assisting the settlement of valid claims. They
are involved in checking the veracity of claims and advising on a settlement
amount that is fair to both the insurer and the insured. One of the worlds
largest loss-adjusting firms is Crawford and Company, and they have one
of their largest operations in the Australian insurance market. A senior
executive of the firm notes that a surprising number of claimants in
Australia are under-insured (Spratt 2005).
Avoiding costs from underinsurance
Under-insurance and non-insurance imposes community-wide costs.
Obviously individuals are concerned and often distraught when their
property is damaged or destroyed, and they do not have insurance. Clearly
a community damaged by a single large adverse event without adequate
insurance coverage will experience multiplied difficulties.
What is less obvious, perhaps, is the economy wide implications for the
community at large from insurance coverage. A natural disaster can have
severe economic, social and environmental impacts. Widespread insurance
coverage and payment of claims accelerates the recovery process, enabling
faster reconstruction and repair of damaged goods and property. This
restarts investment and retains employment, reducing the costs for
everyone in that community and the economy at large. The absence of
insurance payments results in deeper, more prolonged costs.
Under-insurance leads to greater recourse to government assistance. The
impact of under-insurance on government expenditure after recent
bushfires in Australia is just one case in point where increased reliance is
being placed upon public budgets.
Following the recent bushfires in the ACT, it was estimated that housing
structures were under-insured by 40 per cent and home contents by
between 30 and 50 per cent (House of Representatives Select Committee
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into the recent Australian bushfires 2003). The ACT Government
responded by giving a $5000 grant to each affected household without
contents insurance, in addition to a base grant of $5000 to all whose homes
were destroyed by the fires (HIH Royal Commission 2003).
These arguments lead to the conclusion that state and territory governments
should abolish, or at least reduce the incidence of, turnover taxes on general
insurance policies having regard to the overall social utility of insurance
arrangements and the risk of dampening demand for them. At the very least,
international comparisons of tax rates suggest that overall sales and turnover
taxes on general insurance policies in parts of Australia are well above an
optimal level. (HIH Royal Commission 2003, p. 276)
The House of Representatives initiated an inquiry into the bushfires across
Australia in the summer of 2003. This found that taxation on insurance
contributed to the insufficient level of property protection. The high levels
of non-insurance and particularly under-insurance place economic strain
on governments required to provide cash grants to victims (House of
Representatives Select Committee into the recent Australian bushfires
2003).
According to the Council of Australian Governments (COAG) national
inquiry into bushfire mitigation and management, the high taxation of
insurance is counter productive to better risk management and discourages
the community from being adequately insured.
The Australian Government and the state and territory governments impose
taxes on insurance, and all governments could take action to reduce the cost of
insurance and encourage Australians to be better prepared for natural
disasters, including bushfires. (Ellis, Kanowski and Whelan 2004, pp. 180-181)
While the recent experience with bush fires in Australia highlights the
difficulties of underinsurance and its cause, they are less helpful in
measuring the costs. For that, it is useful to know how things would be
different with and without insurance. That requires the use of an economic
model that takes into account the complex interaction of factors. The
findings of a recent economic analysis of a hypothetical natural disaster
with and without insurance using a sophisticated framework are
summarised in the following box 4.9.
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4.9 Economic impacts of a disaster with and without insurance
A study by the Centre of Policy Studies at Monash University in collaboration with
Geoscience Australia (Wittwer, 2004) has examined the economics of a major
earthquake upon a large urban area and examined this with and without insurance
payments.
The earthquake is assumed to impact upon Perth. Different magnitudes of earthquake
are examined. The focus of the analysis is upon how the economy recovers from such a
shock. The wider and longer term implications are assessed using a dynamic, multi-
regional general equilibrium model called TERM. TERM is a variant of the ORANI model
used by the Productivity Commission, the Commonwealth Treasury and other leading
economic policy advisers.
In scenario 1 an earthquake of magnitude 6 hits Perth. The damage is significant. The
total capital stock in Perth falls by $9.7 billion. During the period immediately after the
earthquake, Perths employment falls by 3 per cent or around 20,000 jobs. Total output
or Gross Regional Product falls by 4.2 per cent for the year of the earthquake, even
allowing for significant activity to repair the damage in that year. This calculation also
highlights a weakness in GDP measures which place defensive expenditure to correct
damage on the same footing as expenditure on say investment or increased
consumption. The net loss to national welfare, measured by aggregate consumption a
better indicator of wellbeing, is also substantial. The damage is also long term. The
reduction in the net present value in national aggregate consumption relative to forecast
(or what would have occurred without the earthquake) over the 20 year forecast period is
$8.9 billion in this scenario.
The impact on Perths economy is not as severe when the model takes into account the
potential for insurance payments. This scenario assumes that 60 per cent of buildings
and contents are insured in Perth, which is conservative relative to ABS and ICA data for
Perth. The inclusion of insurance enables Perth to recover more quickly from the
disaster. The NPV of the loss in national aggregate consumption falls by $6.4 billion
compared with $8.9 billion without insurance. This is entirely due to economic processes
in the model as the analysis does not factor in the potential for accelerated rebuilding
with insurance payments. That is the benefits of insurance for the community have been
estimated in a conservative way.
Other scenarios are analysed with more or less damage and with different assumptions
about insurance coverage. They also highlight the value to the community at large to be
gained from widespread access to insurance payments in these events.
So raise value by lowering punitive taxes on insurance
The unique importance of the general insurance industry is not apparent in
the current taxation arrangements that apply in Australia. Not only are
these tax arrangements out of line with other countries, but, in some cases,
the final impact on price places insurance on par with the taxation
arrangements for cigarettes and alcoholic spirits. The high impact of
taxation is a result of the number of taxes that apply to insurance and the
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cascading nature of their application, with GST levied on FSL and stamp
duty levied on both of these.
Studies indicate that the gains in economic wellbeing from reducing the
additional tax burden on general insurance would be significant. In
particular, there is evidence of under-insurance in the Australian market,
generating future costs for the Australian economy. Robust economic
analysis about the interconnected flow on effects from a major natural
disaster indicates that the economy recovers much more quickly with
widespread access and use of insurance than without it. A more suitable
tax arrangement would lower the price of insurance and remove the
distortions leading to abnormally low levels of insurance in Australia.
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5
Handicapped by distorted
competition
THE PLAYING FIELD IN GENERAL INSURANCE IS NOT LEVEL. This
chapter reviews the distortionary advantages that have been enjoyed by
discretionary mutual funds (DMFs) and direct offshore foreign insurers
(DOFIs). It also examines the implications of failing to implement a policy
mix that results in a level playing field.
Facing uneven regulation
Under the Insurance Act 1973 (the Insurance Act) an insurer that carries on
insurance business in Australia must be authorised by the Australian
Prudential Regulatory Authority (APRA). Under that Act, an insurance
business is defined as the business of undertaking liability, by way of
insurance (including reinsurance), in respect of any loss or damage. A
number of entities that effectively provide general insurance are not
encompassed by this definition and are therefore exempt from certain
regulatory requirements and taxes.
In particular, discretionary mutual funds (DMFs) are not classified as
insurance companies, because their decision to pay claims is a discretionary
one. This is despite the fact that, in practice, DMFs almost always pay out,
with refusal only in cases of fraud or severe negligence.
In the case of direct offshore foreign insurers (DOFIs) uncertainty arises
from the requirement in the Insurance Act that insurers need to be
carrying on business in Australia. This means that DOFIs who do not have
a branch in Australia or who do not actively solicit business in Australia
need not comply with the provisions of the Insurance Act.
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Overview of the Potts review
The HIH Royal Commission recommended that the Australian
Government amend the Insurance Act to extend prudential regulation to all
discretionary insurance-like products, having regard to constitutional
limits. The Commissioner also considered the role of DOFIs in the
Australian insurance market but did not make a recommendation.
In response to these issues, the Australian Government commissioned
Mr Gary Potts to undertake a study of both DMFs and DOFIs. The Potts
Review, reported on 28 January 2004, made a number of recommendations.
The key findings of the report and its recommendations were published in
May 2004 (although the full report was not released in order to preserve the
confidentiality of some information contained within it). The Australian
Government accepted the recommendations and indicated that they would
be implemented in full. Draft legislation will be developed in consultation
with industry and has yet to be released.
Findings
The Potts Review (Potts 2004) determined that regulations regarding DMFs
and DOFIs needed to balance two elements:
the benefit that arises in the form of a cost saving due to the exemption
from certain taxes and prudential requirements; and
the role of DMFs in providing specialised insurance cover for
consumers who would otherwise have difficulty in finding cover and
of DOFIs in providing important additional capacity to the Australian
market.
The major findings of the Potts Review in relation to DMFs and DOFIs are
outlined in box 5.1.
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5.1 Findings of the Potts Review: key features of DMFs and DOFIs
DMFs
account for less than half of one percent of the general insurance market;
have been expanding relatively quickly, especially in long-tail (public liability) cover
but are destined to remain a niche part of the overall market;
benefit from significant cost advantages over authorised insurers, because of their
exemption from State taxes (stamp duty and special levies) and, to a lesser degree,
prudential supervision;
the failure of DMFs is unlikely to pose any systemic threat to the industry, but the
withdrawal of their services could affect consumers who have found it difficult to
obtain specialised insurance cover;
while currently not subject to prudential regulation, DMFs are subject to market
conduct and disclosure rules under the Corporations Act 2001 which have been
tightened in recent years (specific exemptions are available depending on the nature
of the product being provided).
DOFIs
represent only about 2.5 per cent of the general insurance market in Australia;
they provide important additional capacity in specialised insurance lines;
DOFIs operate largely out of comparable regulatory jurisdictions and much of the
business written is for large corporate entities less likely to require prudential
regulatory protection for example, in wholesale markets such as maritime, aviation
and other large commercial risks;
at the retail and smaller corporate level, DOFIs have been filling gaps in the long-tail
market in response to the withdrawal of domestic capacity;
DOFIs enjoy significant tax advantages (largely not being subject to State stamp
duties), especially in some insurance classes, over Australian authorised insurers,
which are reflected in lower business costs for Australian companies;
scope exists to improve current prudential regulatory arrangements for DOFIs; this
should seek to avoid prohibiting commercial arrangements that have worked
satisfactorily to date and target areas of highest risk, such as foreign insurance
companies operating out of low status regulatory jurisdictions;
in the absence of changes to prudential supervision, consumer protection is likely to
be enhanced by requirements introduced by the Financial Services Reform Act 2001
(the FSR Act) requiring DOFIs (with some exemptions) to hold AFS licences.
Licensees will be required to meet ASIC financial conditions and information
disclosure/market conduct rules.
Potts limited recommendations
The Potts Review made a number of recommendations in relation to DMFs
and DOFIs. In relation to DMFs, it was recommended that:
discretionary mutual cover be offered as a contract of insurance under
the Insurance Act. This will ensure regulation by APRA. DMFs that do
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not retain any contingent risk that would need to be met by additional
undefined member contributions will be exempt from this requirement;
and
APRA should collect and collate data on business written by DMFs
under the exemption.
In relation to DOFIs, the recommendations were:
allow DOFIs marketing insurance in Australia to be exempt from
prudential regulation in Australia if they are domiciled in a country
APRA considers to have comparable prudential regulation. This would
be subject to a market significance threshold to prevent established
authorised insurers moving offshore. DOFIs not meeting this test will
be able to market insurance in Australia as an authorised insurer,
through a branch or subsidiary;
give APRA enhanced enforcement and investigative powers to
establish whether the nature of a DOFIs operations is such as to
require authorisation under the Insurance Act; and
APRA should assume a data collection role in relation to offshore
insurers.
The Australian Government accepted the recommendations and a
consultation process is currently under way to develop appropriate
legislation.
Stepping toward a level playing field
Following implementation of the recommendations of the Potts Review
APRA authorised insurers, non-exempt DMFs and DOFIs will be operating
on a relatively level playing field in terms of both the taxes these entities
are subject to and the regulatory requirements with which they must
comply. Table 5.2 gives a more detailed outline of the regulatory and
taxation environment following the implementation of the Potts Review.
The situation for exempt DMFs is somewhat different. These entities will
not be subject to the vast majority of taxation or consumer provisions.
While this clearly provides a benefit to such entities in relation to their
competitors, they currently make up less than half of one percent of the
general insurance market. Given their small share of the market, it is
unlikely to have a significant impact on competition in the market.
Nevertheless, in considering legislation to implement the recommendations
of the Potts Review, to ensure the integrity of the system, the Australian
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Government should ensure that exempt DMFs are a carefully defined
(limited) group.
Seeking further change
The ICA has raised a number of concerns about the recommendations of
the Potts Review. These concerns include the consumer protection
outcomes, availability and price, competitive neutrality, market stability,
and image and reputation.
Consumer protection
The ICA views the level of consumer protection as a function of adequate
disclosure, the likelihood that claims will be paid, the enforceability of the
insurance contract, and access of Australian policyholders to an entitys
5.2 Regulatory and taxation environment: post implementation of the Potts
recommendations
Taxes/Regulatory
Provisions Entity subject to the provisions (yes/no)
APRA
authorised
DOFI (exempt and
non-exempt)
a
DMF
(non-exempt)
DMF
(exempt)
Australian Taxes and Levies
Stamp duty Yes Yes Yes No
Fire Services Levy Yes Yes Yes No
Insurance Protection Tax Yes Yes Yes No
GST Yes Yes (if sufficient
connection with
Australia)
Yes Yes
Income/
Withholding tax
b
Yes Yes Yes
c
Yes
c
Consumer Protection
Insurance Contracts Act Yes Yes (likely) Yes No
Terrorism Insurance Act Yes Yes (likely) Yes No
Australian Financial
Services Licence
Yes No (likely) Yes No (likely)
Disclosure Yes Product Disclosure
Statement required.
Yes Product Disclosure
Statement required.
Priority in winding up Yes No No No
Compulsory Dispute
Resolution
Yes Onshore agent
(likely); direct (not
likely)
Onshore agent
(likely); direct (not
likely)
Onshore agent
(likely); direct (not
likely)
a
Exempt and non-exempt refers to APRA supervision;
b
different assessment methods apply;
c
unless the DMF is
offshore.
Source: Information provided by ICA
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assets in the case of insolvency. The ICA notes that the Potts
recommendations, as outlined above, will only address some of these
issues.
It is contended that the primary source of protection for policyholders is
having access to sufficient assets and a prudential buffer in the event of a
failure or unwillingness to pay a legitimate claim. The ICA does not view
this issue as having been adequately addressed by the Potts
recommendations. In particular, it is noted that Australian policyholders
are unlikely to be given priority by a foreign regulator where insolvency
occurs. Consumers of products offered by exempt DMFs will not have the
protection of prudential oversight and will not be regulated by the
priorities set out in the Insurance Act in the case of insolvency.
Availability and price
The Potts recommendations were based on evidence relating to the
availability and price of insurance products for Australian consumers. In
particular, the review concluded that DOFIs and DMFs play an important
role in the industry by providing extra capacity and niche products. The
differing treatment applying to these entities was partially justified on the
grounds of these roles. While the full Potts report has not been publicly
released due to issues of confidentiality, evidence available to the ICA
indicates that availability of insurance is not a problem in the industry.
Competitive neutrality
Under the Potts recommendations, exempt DMFs will be subject to a lower
regulatory burden than other insurance entities. These entities will not be
required to meet minimum capital requirements nor will they have to face
the compliance costs arising from meeting disclosure and reporting
requirements. Exempt DMFs also avoid many of the taxes imposed on the
insurance entity. The ICA expects that this disparity will allow exempt
DMFs to charge lower prices for their products, giving rise to an advantage
in the insurance market. Further, while DOFIs will be subject to the
relevant taxes, the ICA is concerned about the lack of enforcement
mechanisms to ensure that taxes are actually paid.
Market stability
The ICA believes that the potential for DOFIs and DMFs to avoid
prudential regulation, capital requirements, associated compliance costs,
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and taxes, limits competition on the basis of price. This can result in an
unstable market where DOFIs or DMFs dominate a particular sector. While
the impact on the general financial system will be limited, the collapse of a
DOFI or DMF where they dominate a sector would have a significant
impact on a particular group of policyholders. This destabilising effect
could also arise where a dominant DOFI or DMF chose to exit the market.
The ICA contends that this may generate a gap in capacity and expertise of
the market as domestic insurers prepare to re-enter the relevant sector.
Image and reputation
Australian authorised insurers have expressed some concern that the
industry as a whole will suffer, in terms of consumer confidence, in the
event of a failure of a DOFI or DMF. The ICA also considers that the
collapse of a DOFI or DMF could have some impact on the reputation of
relevant government bodies.
Exposing implications of not changing
Maintaining a regulatory environment that is fundamentally distorted in
favour of a few competitors can be expected to have significant economic
implications in the medium to longer term. Anticipating those impacts is
complicated by the range of possible responses available to general
insurers, the favoured competitors and customers.
The CIE has traced the impacts from one possible scenario in the box
below. The highlights of that scenario are that favouring DOFIs and DMFs
could lead to the following.
Cherry picking of key markets by the favoured competitors leading in
time to their dominance of those sectors.
Higher insurance premiums or prices for customers of domestic
general insurers outside of the areas cherry picked by favoured
competitors.
Narrower pooling of risk raising systemic risk for insurers and a
further increment in insurance premiums.
Shrinkage of the insurance revenue base results in a loss of taxation
revenue for the Australian Government and an increase in the rate of
state taxes in order to cover levy requirements.
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A consumer response eschewing general insurance protection because
of its higher cost, leaving many parties in the community and in
business significantly under-insured.
In the longer run, governments face political pressure to meet more of
the cost of various natural disasters and other widespread adversity
which previously would have been covered by general insurance.
5.3 A Split Market in 2010
The Australian general insurance industry has had a bad year in 2010 and the outlook
for the subsequent year also looks bleak. The strong economic growth is not reflected in
the performance of the insurance sector. It is not that the need for general insurance has
disappeared. The fires and floods that swept the east coast over the last 2 years have
shown that. The problem seems to be that business just doesnt buy it.
Problems first became noticable in 2006. Premium growth in key areas of previously
strong demand for insurance in fire and Industrial Special Risk (ISR) stopped. Then the
level of premiums and policies written began to shrink in outright terms. Similarly,
premium revenue in professional indemnity, public and product liability also leveled off,
then declined.
It has taken a little while for this trend to become apparent, and a few years more for the
industry to work out why. Some Australian businesses that owned commercial property
and large specialised assets had started to withdraw from purchasing insurance from
Australian companies. Initially, knowledge about the services offered by Direct Offshore
Foreign Insurers (DOFIs) was a secret of larger companies. These businesses were able
to tap into cheaper insurance coverage, reflecting their ability to search out entities that
were able to take advantage of various tax advantages and other loopholes. Some
smarter smaller businesses followed suit as the word spread through informal business
networks. In recent years the DOFIs have discovered various means of aggressively
marketing their services to key segments of the business market. Most businesses, large
and small, now look to DOFIs for many of their insurance needs.
Similarly many professionals and community groups have been able to obtain lower cost
protection, of sorts, from various mutual organisations (basically clubs) offering
discretionary cover. These groups report lower costs for professional indemnity and
public liability coverage than traditional general insurance.
Industry analysts take the view that Australianbased general insurers are now
essentially excluded from the fire and ISR, professional liability and public liability
segments, which represent about 15 per cent of the total market.
(Continued on next page)
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5.3 A Split Market in 2010 (continued)
Meanwhile, the rest of the general insurance market has sagged and suffered under
problems of higher premiums and higher taxes. Higher premiums were initially a
response to the shrinking premium pool which raised risk and costs. Those higher
premiums encouraged many previous customers to reduce their insurance cover. With a
smaller number of policyholders, insurers were obliged under the insurance levy rules to
raise the amount collected from each policy to meet industy levy requirements (which are
fixed). This resulted in a further round of customer withdrawal from insurance.
Some analysts are raising concerns about the appropriateness of provisions given the
poor performance of some general insurers in recent times, although industry sources
deny that this is a widespread problem.
The state and federal governments have recently announced an inquiry into declining
insurance industry tax collections. Governments have been increasingly frustrated that
insurance revenue collected from a variety of taxes has declined. They are particularly
concerned about those reductions when they are dealing with escalating political
pressure to provide substantial assistance to the communities that were devastated by
last years fires. This is a particularly thorny problem, because many people and
businesses were uninsured.
Sodistortions should be fully ironed out
The Potts Review indicated that, in comparison with authorised insurers,
DOFIs and DMFs were operating at a competitive advantage, because they
were not subject to the same regulatory and taxation arrangements. The
Australian government is currently working towards implementation of
the recommendations of the review. These recommendations are expected
to make some progress towards bringing most DOFIs and DMFS onto a
competitive footing that is level with authorised general insurers.
However, exempt DMFs will not be subject to the vast majority of taxation
or consumer protection provisions. These entities will remain at a
competitive advantage by comparison to the other players in the Australian
insurance market.
The small share of the market held by DOFIs and DMFs today obscures the
potential significance of the distortions. The Potts review noted that market
share for these competitors was increasing, which probably reflects the
regulatory advantages that they enjoy. The magnitude of the distortion can
be expected to grow, and the costs will escalate and compound in the
future. While the precise shape of market outcomes will reflect many
choices and decisions to be taken by key market participants and
governments, a reasonable scenario is that the favoured competitors will
cherry pick key markets, shrinking the insurance and premium pool for
46
5 H A N D I C A P P E D B Y D I S T O R T E D C O M P E T I T I O N
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
general insurers. This would start a vicious cycle of raised premiums,
reduced demand for general insurance, and underinsurance. This would
lead to higher demands and budgetary costs to be faced by governments in
Australia.
47
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
6
Conclusion
THE GENERAL INSURANCE INDUSTRY MAKES a significant
contribution to the Australian economy. In 2003-04, the industry created
$14.6 billion in Australian gross domestic product, provided approximately
20 000 jobs, earned gross premiums of $31.9 billion and generated
$3.2 billion in tax revenue (not including GST).
The insurance market is not operating on a level playing field. Despite
recent reviews of competition in the market, a number of DMFs will
continue to be exempt from current regulatory and taxation arrangements,
allowing these entities to operate at regulatory and cost advantages. As
noted in the Potts review, these advantages are considered contributing
factors to their increasing market share.
Currently, these advantages have resulted in fairly minor distortions, but
largely because DOFIs and DMFs represent a very small share of the
market. As their share increases, the impact of the distortions can also be
expected to grow. These distortion can potentially lead to an growing costs
that compound over time. The precise shape of market outcomes will
reflect many choices and decisions to be taken by key market participants
and governments. However, one reasonable scenario is that favoured
competitors will cherry pick key markets. In turn, this could lead to a series
of negative market dynamics (such as lower demand for general insurance,
higher premiums and under-insurance) that would lead to greater
demands of Australian governments to compensate (in full or part) for the
cost of under-insurance.
Most importantly, despite the direct contribution to the economy and the
unique importance of the insurance industry, current tax arrangements
penalise the industry and its customers. The industry is subject to an array
of burdensome taxes, that cascade together to multiply the final tax take. In
some states, the impact of taxes on the price of insurance is similar to that
for cigarettes and alcoholic spirits. An alarming cost of these high tax levels
is under-insurance, with studies indicating that 21 per cent of consumers
are currently under-insured. This level of under-insurance will impose
future costs on the community.
49
C E N T R E F O R I N T E R N A T I O N A L E C O N O M I C S
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