Technical provisions: general
In accident year accounting, paid claims are adjusted by movement on the provision for claims outstanding (calculated at each year end) to arrive at a figure of incurred claims in the revenue/technical account. The accounts may show a global figure for reported claims and claims incurred but not reported (IBNR) (see GIM6100). The regulatory return forms give these two items separately.
The importance of the outstanding claims amount, and its relationship to paid claims, will depend on the type of business being carried on by the company. Where most claims are likely to be settled promptly, for example in domestic property business, the outstanding claims may be fairly insignificant. Where major claims are likely to be litigated, or reported late, and also in the case of most reinsurance, the tail of outstanding claims may be much larger than the claims paid in the year. This presents difficulties for the insurer in calculating the provision. For periods prior to the introduction of FA00/S107, it also raised issues of what could be deducted for tax purposes.
Leaving aside the effect of FA00/S107 (GIM6145+) and FA07/SCH11 (GIM6500+) technical provisions have to satisfy the two tests set down by Lord Radcliffe in Owen v Southern Railway of Peru, 36TC602, subject to the principles on the interaction of law and accountancy (see BIM3180+). As for other businesses, insurance companies’ provisions are tax deductible to the extent that they are a sufficiently reliable estimate of future liabilities. This is difficult to apply in practice, and depends on the facts of each particular case. An insurance company has in principle to be able to demonstrate that its provisioning is reliable, but there is limited guidance on that, and company reporting law concentrates on sufficiency rather than potential excess.
Owen v Southern Railway of Peru also addressed discounting. The company lost its appeal mainly because of its failure to discount provisions that had been made for future superannuation benefits related to current employment. The Revenue did not immediately seek to apply the same reasoning to the reserves of insurance companies, but eventually it came to the view that the discounting of reserves for outstanding claims was appropriate in certain circumstances, irrespective of the accounting treatment. However, as the relationship between tax and accountancy developed, it became apparent that, as the use of undiscounted figures was not contrary to the relevant accounting practice, they could not be adjusted for tax purposes. Moreover the extent to which discounting is permissible in accounting was further reduced by the Insurance Accounts Directive (IAD).
It used to be thought that the 3 or 4-year funded bases then in use were adequate without need for outstanding claims provisions, on the footing that by the time the balance of profit was struck most claims would have been paid. Increasing delays in claims settlement, and the growing significance of claims under liability policies that related to events that only come to light many years after they occurred (such as the onset of an industrial disease) made this assumption unrealistic. From 1978 the Revenue accepted a provision to cover claims that were still outstanding when the balance of profit was struck at the three or four-year point.