APPENDIX 19
Memorandum submitted by the Association
of British Insurers (ABI) (CP 17)
1. SUMMARY
1.1 The Association of British Insurers
represents around 450 insurance companies, which between them
account for over 95 per cent of the business of UK insurance companies.
The Association's members handle 96 per cent of life insurance
and personal pensions business and 91 per cent of general insurance
business.
1.2 The Association's response focuses on
the role that private insurance can play as an alternative model
for welfare delivery.
1.3 The "pure" contributory principle,
that contributions be levied on an actuarially calculated basis
to reflect the benefits received, has never operated in the UK
state benefit system. Often the "contributory benefit"
received bears little relation to the contributions paid.
1.4 In contrast to the National Insurance
(NI) system, private insurance operates a "purer" contributory
principle. That is, benefits paid (or claims received) are based
on an actuarially fair basis.
1.5 If premiums are closely related to benefits
then people are less likely to perceive them as taxation. This
in turn would reduce economic distortions, particularly in the
labour market. Increased private provision could, therefore, improve
economic efficiency. The diminishing relationship between contributions
and benefits may also increase conflict between contributors and
beneficiaries. This could undermine some state benefits if contributors
become less willing to honour the obligation imposed on them because
they see little return on the contributions that they have made.
Private insurance with its "purer" contributory principle
suffers much less from such conflict.
1.6 While private insurance can increase
the contributory principle, it is not the case that the private
sector can simply take over all the functions of the welfare state.
If certain key principles are absent, then it is unlikely that
a private insurance market can exist. In effect, the state provides
compulsory insurance.
1.7 In the state system considerable redistribution
of income occurs. Insurers operate in a competitive market place
and are not able to decide as a matter of policy to redistribute
income from one group to another. However, the industry is currently
undertaking a number of initiatives to try to increase financial
inclusion and provide private insurance to those currently without
cover.
1.8 It is often the case that the insurance
industry tailors its products around what is already available
through the state. Therefore, if state provision is to be successfully
transferred to the private sector, then that transition has to
be managed in consultation with the insurance industry.
1.9 The Association believes that the state
needs to increase public awareness of the contributory state benefit
entitlement conditions and also to simplify the NI benefit system.
Both initiatives would enable individuals to make a more informed
decision on their mix of state and private insurance cover.
2. INTRODUCTION
2.1 On 6 April 1999, the Association of
British Insurers received an invitation to respond to the Social
Security Select Committee's inquiry into the future of the contributory
principle.
2.2 The impetus for this inquiry comes from
the Government Green Paper on welfare reform: "New Ambitions
for Our Country: A New Contract for Welfare", which stated
that:
"Changes to the National Insurance scheme
provide an opportunity to update the contributory principle. We
will examine the link between paying contributions and earning
entitlement to benefits with a view both to simplifying further
administration of the scheme for employers and emphasising the
link between work and earning benefit entitlement".
2.3 The Social Security Select Committee
intends to consider the following areas:
— What is meant by the contributory
principle?
— The role of contributory benefits
in the social security system: origins and developments since
Beveridge.
— Current developments affecting the
future of the principle.
— Public awareness and attitudes towards
National Insurance and the contributory principle.
— The advantages and weaknesses of
the contributory principle and the benefits to which it gives
rise.
— Does the contributory principle have
a future? Are there other models of welfare delivery, for example
better integration of tax and benefits, which better reflect today's
social realities?
— Could the contributory principle
be modernised to provide for challenges of the next millennium?
2.4 This paper is the response of the Association
of British Insurers to the Social Security Select Committee. The
Association represents around 450 insurance companies, which between
them account for over 95 per cent of the business of UK insurance
companies. The Association's members handle 96 per cent of life
insurance and personal pensions business and 91 per cent of general
insurance business.
2.5 The Association's response focuses on
the role that private insurance can play as an alternative model
for welfare delivery. The Association believes that the insurance
industry is already well placed to act in this role. Taking the
private insurance "equivalents to contributory benefits,
the industry currently manages £225 billion invested in personal
pensions; £105 billion in insurance administered occupational
pension funds; and £300 billion in life insurance funds.
In 1997, £3 billion was paid out in death claims on life
insurance, £0.9 billion was paid in death claims from annuities
and pensions (and a further £18 billion was paid out on life
policies due to maturities, surrenders and refunds). In the area
of sickness and disability provision, over 3.5 million individuals
are covered by individual and group Income Protection (IP) Insurance
(formerly known as Permanent Health Insurance). The maximum insured
benefits on individual IP policies alone is almost £11 billion
per year.
3. BACKGROUND
3.1 A number of social security benefits
are subject to the contributory principle. That is, in order to
be eligible to receive the benefit, one condition is that certain
NI payments must have been made (the actual NI criteria vary between
benefits).
3.2 The main benefits affected are:
— the contributory element of the Jobseeker's
Allowance (JSA);
— Incapacity Benefit (IB);
3.3 Spending on contributory benefits was
£43.2 billion in 1997-98, over three-quarters (about 78 per
cent) of which arose from retirement pensions (£33.5 billion).
17 per cent is Incapacity Benefits, while 2 per cent is for Widow's
Benefits and 1 per cent is on contributory Jobseeker's Allowance.
3.4 Some elements of contributory benefits
include an earnings-related element; in particular, State Earnings
Related Pension Scheme (SERPS) and Widow's Additional Pension.
3.5 Many more benefits do not have NI contributions
as a condition of receipt. These include the major means-tested
benefits (Income Support, Housing Benefit, Council Tax Benefit).
Total spending on non-contributory benefits was £50.9 billion
in 1997-98.
3.6 Contributory benefits are becoming less
significant as a proportion of total benefit expenditure. They
represented 56 per cent of total benefit expenditure in 1983-84,
compared to 46 per cent in 1997-98.
3.7 This does not necessarily reflect a
move away from the contributory principle as such, because of
changes in the relative magnitude of various sections of the benefit
population. Thus, for example, expenditure on Housing Benefit
(non-contributory) has increased, while expenditure on the unemployed
(for example the contributory element of JSA and its predecessors)
has fallen. However, spending on the sick and disabled, of which
Incapacity Benefit is the largest section, has risen.
4. THE CONTRIBUTORY
PRINCIPLE IN
PRACTICE
4.1 The "pure" contributory principle,
that contributions be levied on an actuarially calculated basis
to reflect the benefits received, has never operated in the UK
state benefit system. Often the "contributory benefit"
received bears little relation to the contributions paid. For
example, the basic state pension is paid at a flat rate, but contributions
are based on earnings within an upper and lower limit. Price indexation,
reduced NI contributions, Home Responsibility Protection and contribution
credits reduce the contributory principle within the basic pension
even further. Another example is Incapacity Benefit. When IB replaced
invalidity benefit, entitlement conditions were tightened and
benefit rates reduced to lower rates. Further reductions were
introduced in the Welfare Reform and Pensions Bill. The lack of
relationship between contributions and benefits means that NI
contributions are simply another tax.
4.2 In contrast to the NI system, private
insurance operates a "purer" contributory principle.
That is, benefits paid (or claims received) are based on an actuarially
fair basis. However, it is important to recognise that it would
be prohibitively expensive for an insurer to calculate the exact
risk faced by each of its policyholders. Segmenting the market
through underwriting brings the price a person pays nearer to
the actual level of risk they face. To the extent that some people
in the risk pool are charged more than their actuarially fair
premium, and some are charged less, a degree of cross-subsidisation
does occur. However, competitive forces have combined with advances
in information technology so that the sophisticated underwriting
procedures now embraced by the insurance industry mean that the
gap between the actual and the actuarial premium has narrowed
significantly in many markets, most notably in the car and home
contents markets.
4.3 Recent research by the Centre for Research
in Social Policy found that most people had little knowledge of
the NI scheme. However, when given some information about funding
of social security and the benefits received there is a strong
commitment to the contributory principle. The research also found
that individuals saw little distinction between paying contributions
and paying taxes, and tended to regard them as flowing into the
same overall pot of resources.
5. THE CONTRIBUTORY
PRINCIPLE: STATE
OR PRIVATE
PROVISION?
5.1 An increase in the contributory principle
may improve economic efficiency. The reason for this is that as
the link between benefits and contributions diminishes, contributions
are increasingly seen as taxation. Taxation creates distortions,
particularly in the labour market. Private insurance premiums,
on the other hand, are closely related to benefits and thus people
are less likely to perceive premiums as taxation. Therefore, increasing
private insurance provision could reduce economic distortions,
thereby improving economic performance.
5.2 The diminishing relationship between
contributions and benefits could also increase the conflict between
contributors and beneficiaries, thereby undermining some contributory
state benefits. If individuals see the benefit from their contributions
declining then they may become less willing to continue payments.
This in turn could lead them to apply pressure on government to
either abolish the benefit (and reduce their contributions) or
enhance the link between contributions and benefits. An example
where this could be applicable is the basic state pension. The
current state pension system is financed on a Pay As You Go (PAYG)
basis, that is, current expenditure is financed out of contemporary
receipts. In other words, workers pay the pensions of those in
retirement—no money is set aside to meet future liabilities.
With an ageing population and scheme maturation the link between
contributions and the pension ultimately paid becomes very weak.
According to academic research[71],
men born after 1955 in the UK will actually see a negative return
on their contributions. A negative return on contributions may
result in future generations of taxpayers being less willing to
honour the obligation imposed on them. In contrast, private funded
pension provision allows each individual to receive benefits that
are actuarially related to their contributions. This diminishes
the scope for conflict between earlier and later generations.
5.3 However, while private insurance can
increase the contributory principle, thereby improving economic
efficiency and reducing conflict between contributors and beneficiaries,
it is not the case that the private sector can simply take over
all the functions of the welfare state. For a risk to be insurable
a number of factors must hold (see Annex 1 for details of these
conditions). If these key principles are absent, it is unlikely
that the private insurance market can provide cover.
5.4 A good example of where private insurers
have not yet been able to offer cover is for the risk of unemployment.
No private insurance equivalent currently exists because: the
risk of unemployment is greatest among those least able to pay;
unemployment risk is subject to cyclical and sectorial trends
that are difficult to predict and may cause workers to opt-out
of insurance when economic times are good and; adverse selection
and moral hazard are particularly severe with respect to unemployment
e.g. individuals who have a high risk of unemployment are more
likely to take out insurance, while some individuals may choose
a period of unemployment if they perceive that they will receive
adequate income.
5.5 In markets where a voluntary insurance
system is not viable, compulsion is needed in order to compel
low risk individuals to remain in the risk pool. In the absence
of compulsion the risk pool will contain mainly high risk individuals
resulting in prohibitive premiums. A compulsory insurance system
is, however, just taxation by another name. Even in a compulsory
insurance system there will always be individuals too poor to
pay their own contributions (this would be the case even if the
premiums were not risk based, but rather flat rate).
5.6 The decision of how to provide insurance
for those who cannot afford it is crucial to deciding where the
boundary between the private and public sector lies. Assistance
for those who cannot afford insurance cover could be arranged
in a number of forms. The state could provide the insurance, or
alternatively, the state could pay the risk based premiums to
private sector providers, with payments funded through taxation.
Both systems have their merits, but the former would leave a group
of people excluded from private provision on the basis of their
income—a two tier vision of the future that has been rejected
in the Green Paper. Commentators have suggested that flat rate
premiums in the private sector, or premiums based on the ability
to pay, could be the way forward. Again, this is simply taxation
by another name. The decision rests on which sector could provide
the service at the lowest cost. This is by no means clear. The
costs depend essentially on the policy and regulatory framework
governing the product.
5.7 In the state system considerable income
redistribution occurs. However, it is not open to insurance companies
to decide as a matter of policy to redistribute income from the
rich to the poor, or, indeed, between any two groups. The private
insurance market is extremely competitive, with premium rates
usually based on the level of risk an individual brings to the
pool, although, as mentioned above, because it is prohibitively
expensive to calculate the exact risk faced by each policyholder,
some degree of cross-subsidisation does occur. Any insurance company
that attempted to charge the same premium to both low and high
risk groups would soon find itself "undercut' by competitors
and experience strong adverse selection.
5.8 This constraint on private insurers
to redistribute income has important social policy implications
when discussing reform of the welfare state. A move from payments
levied through the tax system to premiums based on individual
(or group) levels of risk will undoubtedly generate gainers and
losers. It is, therefore, a matter for society to decide whether
the redistributive effects occurring from such a change are acceptable.
An example of a state benefit where redistribution will occur
if private insurance is introduced is that of Maternity Allowance.
At present, this benefit results in redistribution from men and
older women towards younger women, who are often in part-time
work. Switching to private insurance would curtail this redistribution.
As women would only insure if they wanted children, this adverse
selection could result in prohibitive premiums and, therefore,
to market failure in this area.
5.9 The industry recognises that there are
difficulties in providing insurance cover to certain groups in
society. These groups tend to not have insurance cover either
because the premiums are unaffordable or because the insurance
product does not meet their requirements. The insurance industry
wishes, however, to increase financial inclusion and has undertaken
a number of initiatives to try to help achieve this. One such
initiative is investigating how insurers might provide a policy
with protection and long-term saving elements, that also meets
the identified needs of flexibility, a short-term withdrawal facility
and low cost.
5.10 It also needs to be noted that the
insurance industry often builds on what is available from the
state. Therefore, if state provision is to be successfully transferred
to the private sector, then that transition has to be managed
in consultation with the insurance industry. Any reform of the
state system needs to ensure that all private providers are given
a level playing field in which to compete. No particular private
provider should be favoured over another.
5.11 The Association is supportive of any
measure which maximises the strengths inherent in both state and
private systems and minimises the downsides. The Association believes
that the Government should focus its attention on measures which
minimise the overall burden to society. For example, there is
a major overlap between Widow's Benefits and life insurance and
family income plans. The last two are well-established products
that are widely and cheaply available in the private insurance
market. The recent proposed reforms to Widow's Benefit are welcomed
by the Association as a step in the right direction in reducing
this "overlap".
6. CONTRIBUTORY
BENEFITS: THE
CASE FOR
EDUCATION AND
SIMPLIFICATION
6.1 In addition, the state has a role to
play in educating the general public on the contributory state
benefit entitlement conditions. If individuals have a good understanding
of the NI system then they will be able to make a more informed
decision on whether to rely solely on state benefits or voluntarily
take-up additional private cover. The Association believes that
the majority of people have a very low awareness of how entitlement
to benefits is earned and what those benefits are. It is often
the case that individuals become aware of benefit entitlement
only after the event that initiates the benefits has occurred;
by then it is too late for private insurance to help. The recent
problem involving the government's halving of SERPS for widows,
but not informing anyone that they had done so, is a good example
of this. If individuals had known about this policy change then
they might have increased their private provision. For those who
are now widowed it is too late to alter their private provision.
6.2 Enabling the public to make a more informed
decision on their mix of state and private insurance cover would
also be helped by a simplification of the contributory benefit
entitlement conditions. At present, the NI system is very complex
with different contributory conditions existing for many of the
benefits. The Association would welcome a move to simplify the
system. The recent proposal to bring Incapacity Benefit entitlement
conditions into line with those of the contributory element of
the Jobseeker's Allowance is a welcomed move in the right direction.
7. CONCLUSION
7.1 A pure contributory principle, whereby
benefits are actuarially related to contributions made has never
operated in the UK state benefit system. Generally, the benefit
received bears little relationship to the contributions that were
made in the past.
7.2 In contrast, private insurance increases
the contributory principle, enhancing the link between contributions
and benefits. Increasing private insurance could, therefore, improve
economic performance and reduce conflict between contributors
and beneficiaries. However, increasing the pure contributory principle
will change the balance of redistribution.
7.3 It is probably the case that many people
are making sub-optimal choices on their private/state insurance
mix as a result of inadequate information. Therefore, even without
a move to greater private insurance welfare provision, the state
needs to improve the public's awareness of the state benefit entitlement
conditions so that individuals can make more informed choices.
A simplification of the contributory conditions would also be
a step in the right direction.
13 May 1999
71 Disney, R and Whitehouse, E (1993) `Will younger
cohorts obtain a worse return on their pension contribution?',
in J Creedy and M Casson (eds), Economic Inequality and Industrial
structure: Essays in Honour of P E Hart, Aldershot: Edward
Elgar. Back
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