Although advance notice was given by the authorities of the VAT before it took effect on 1 January, insurers did not anticipate that they would face the problem or had perhaps expected more clarity on the issue, Mr Sachin Sahni, primary credit analyst at S&P, says.

According to the VAT regulations, all general insurance policies sold last year but with a policy period that runs into 2018 are subject to 5% VAT on the premium on this year's portion of the policy. The main issue, which remains unresolved, is that the insurers are obliged to deposit the tax liability whether they can recover this amount from their customers or not.

S&P estimates the tax liability for the total market to range between AED700 million (US$191 million) and AED800 million based on estimated gross (general insurance) premiums of more than AED30 billion for 2017.

Hurdles

It might be possible for insurers to collect some portion of this amount from their corporate customers who can, in turn, claim this VAT on their tax returns as an input tax. However, considering the large number of insurance policies (especially motor) sold to individual retail customers, it would be practically impossible for insurers to reach out to hundreds of thousands of retail customers to recover the applicable VAT, says S&P.

There is another hurdle. Even if insurers decide to reach out to all of their clients, most insurance policies sold in 2017 did not include any clause for a retroactive claim on VAT, with the exception of the few insurers who started inserting this clause during the latter part of 2017. In the absence of this clause, the customer is under no legal obligation to pay this portion of VAT, unless the customer is a tax-registered entity and can claim the VAT paid to insurers as input tax.

There have been various discussions in the market about this issue and recently, the Emirates Insurance Association appealed to the Federal Tax Authority to allow non­retroactive application of VAT on insurance policies issued last year whose term matures after 31 December 2017. There has been no official notification or clarification on this yet, and hence the tax liability still weighs on insurers.

Liquidity

While S&P expects that insurers might be able to recover a portion of this amount, in any case, insurers will have to absorb a large portion of this tax liability in 2018, which could weaken the performance of some insurers and the overall market's profitability. What's more, the liquidity of certain insurers could come under stress.

Based on VAT regulations, since these policies are liable to the tax, insurers should raise a tax invoice for all such policies at the inception of service or VAT implementation date, that is, 1 January 2018, and the whole amount of tax liability is payable in first­ quarter of this year. Insurers with a turnover above AED150 million have monthly reporting obligations, while those below that amount would report quarterly.

The impact on future claims

General insurers also need to be prepared for another VAT challenge in 2018. With respect to claims, whether for policies written in 2017 or 2018, suppliers' invoices raised in 2018 would include VAT. While the general understanding is that insurers would be able to claim this amount as input tax, this is only applicable when the claim invoice is raised in the insurer's name. If suppliers raise invoices in the name of the insured and not the insurance companies, then insurers won't be able to recover the amount paid for VAT as input tax. It's unclear how insurers will proceed on this, but if this issue is not tackled properly, it could increase insurer's loss ratios and squeeze net underwriting results.

Life insurance

While the VAT challenges apply only to the general insurance business, insurers writing life insurance policies are also not spared. According to VAT regulations, premiums on life insurance are exempt from tax, which means insurers are not allowed to charge VAT. That said, the commissions charged by the brokers on policies sold in 2018 are liable to VAT. Insurers writing life insurance policies can neither recover this VAT from their customer nor they can claim it as input tax since life insurance falls under the exempt category and hence outside the scope of VAT.

A majority of life insurance policies in the UAE are distributed through brokers for which they charge very handsome commissions, sometimes as high as one full year's policy premium. In the current situation, if brokers add a VAT component to their commissions, life insurers would end up absorbing the cost, which means thinner margins and shrinking return on equity. Some insurers in the market are trying to adopt an operating model where they continue to pay the same commissions as before and let the broker bill them inclusive of VAT. However, it is expected that this model would not be too successful and would face strong resistance from brokers as this would squeeze the latter's margins.

Health insurance

Health insurance is the only sector that has been spared from having any kind of impact of VAT on insurers. Premiums on health insurance policies also fall under the general insurance category and hence are subject to VAT. The retail end­-user of health insurance policies would bear the cost of VAT while corporate customers who are tax registered would be able to claim the VAT as input tax. On the other hand, healthcare services (treatments, surgeries, medicines) are zero-­rated and hence would not have any impact on insurers' performance.

Comparison with other sectors

Some sectors like retail and automobiles, whose growth projections are linked to general economic conditions, are still offering their products at prices similar to pre-­VAT levels to attract customers and are therefore absorbing the VAT. Since these sectors generally have higher margins, it might be feasible for them to resort to such marketing strategies and still maintain their profitability. In the recent past, the insurance sector has expanded solidly in double digits, backed by growth in compulsory lines of business (motor and medical). However, because the UAE insurance market is overcrowded, small insurers have the tendency to offer lower prices to gain market share. Under these conditions, if insurers decide to absorb VAT, they could add to price competition and put their underwriting performance at stake.

The impact on administrative costs

The introduction of VAT is increasing general and administration costs for insurers. They have to invest in a VAT­compliant IT infrastructure, external consultant fees for VAT implementation, and ongoing monitoring and reporting, as well as the need for additional resources to manage the workload. It has been over a month since the implementation of VAT, and some matters still lack clarity and some procedural issues are yet to be sorted out. The level of internal as well as external reporting has risen, with composite insurers needing to split the cost between the life and non-­life business as only non-­life business expenses are claimable as input tax under VAT regulations. The regulations also require insurers to report their VAT returns with a full breakdown by each emirate. All of these procedural issues not only increase insurers' general and administration expenses but also the risk of non-compliance, which carries hefty penalties.

Market impact

S&P believes the challenges related to the VAT are negative for the overall UAE insurance market, but does not expect any negative rating action on any of its rated entities at this point because most have declared robust earnings during the recent past and are capable of absorbing this impact. Since most UAE insurers are composite insurers, almost all will feel the impact in one way or another, though the degree might differ from insurer to insurer.

Insurers with a heavy focus on retail lines of business would be hit the most since their clients (mostly walk-­in retail customers) will not be tax-registered and hence would not be ready to share the additional cost, whether in the form of VAT on policies issued in 2017 or VAT charged by claim suppliers. Life insurers may need to restructure their current operating model and negotiate commission terms with their primary distribution channel, brokers, or risk thinner underwriting margins. While S&P expects the challenges on the underwriting side to be met by the market, each individual insurer will have to cope with the procedural and compliance ­related issues.



