Reinsurance and corporate taxation in the United Kingdom life insurance industry

Abstract

There are two main tax-related arguments regarding the use of reinsurance - the income volatility reduction and the income level enhancement arguments. The income volatility reduction argument contends that firms facing convex tax schedules have incentives to hedge in order to reduce the volatility of their annual taxable income and thereby lower expected tax liabilities [Smith, C.W., Stulz, R.M., 1985. Optimal hedging policies. Journal of Financial and Quantitative Analysis 19, 127-140]. The income level enhancement argument, advanced by Adiel [Adiel, R., 1996. Reinsurance and the management of regulatory ratios and taxes in the property-casualty insurance industry. Journal of Accounting and Economics 22, 207-240], is more specific to hedging via reinsurance. This perspective holds that reinsurance enhances current reported earnings via the receipt of reinsurance commissions and so increases tax liabilities. Consequently, insurance firms with high marginal tax rates should use less reinsurance than those with low marginal tax rates if tax matters. Prior studies using data on financial derivatives have produced mixed results on the validity of the first argument, while Adiel (1996) finds the second argument insignificant in his study of the use of reinsurance by a sample of United States (US) property-liability insurance firms. This study tests the two tax-related arguments using 1992-2001 data for a sample of United Kingdom (UK) life insurance firms. We find that UK life insurers with low before-planning marginal tax rates tend to use more reinsurance; in contrast, tax convexity is found to have no significant impact on the purchase of reinsurance and so the volatility-reduction argument is not supported. © 2007 Elsevier B.V. All rights reserved.