Hidden Costs of the HST

Ever since Ontario announced its intent to harmonize its provincial sales tax with the federal GST to form HST beginning July 1, 2010 (and the announcement shortly thereafter that B.C. would do the same), much has been said and written about the potential effects of the move on the financial services sector — and rightfully so.

Without getting into the intricacies of the GST/HST legislation, the impact of harmonization to the financial services sector will be substantial, due largely to the fact that those who operate in this sector are limited in their ability to recover GST/HST paid on their expenses. Therefore, as HST will apply on a broader range of expenses, more unrecoverable tax will be paid by the financial services sector, including the property and casualty industry. For example, office rent paid by an insurer post-harmonization will be subject to 13% HST in Ontario, whereas it was only previously subject to 5% GST pre-harmonization. In many cases, this will become an additional 8% cost on occupancy expenses incurred by insurers. The same can be said of legal, consulting and professional services; marketing services; tech support and call-centre services; and most other services acquired by insurers.

Although the additional tax cost to insurers on the types of expenses mentioned above can be significant, for the most part, these expenses are typically easily identifiable. Therefore, measures can be taken to manage the added costs, or at the very least budget and plan for the added costs. What will come as a surprise to many insurers are the hidden costs that many have overlooked or have attempted but failed to accurately ascertain. The remainder of this article will aim to highlight some of these hidden costs.

RETROACTIVE CLAIMS COSTS

An insurer’s outstanding claims reserve is typically established based on information available when a claim is made, rather than when a claim is actually paid out. Consequently, if a claims reserve is established pre-harmonization and the claim is ultimately paid out post-harmonization, an insurer’s claims reserve will likely be understated, since the reserve will have failed to take into consideration the added cost of HST to the settlement of the claim.

For example, a claim for a broken house window is made pre-harmonization. It is expected that the cost of hiring a contractor to supply and install a replacement window will be $100 plus $5 GST, and therefore a claims reserve of $105 is established. Due to the time required to process and settle the claim, the actual replacement of the window occurs post-harmonization and the cost of hiring the contractor now becomes $100 plus $13 HST. The insurer’s claims reserve in such a case would be understated by $8 and have a resultant impact on its financial statements.

Insurers would be wise to review their claims reserves to ensure that the added HST costs are taken into account to avoid this hidden cost. To further exacerbate insurers, what if premiums charged in the past have not been established with the flexibility of the added HST costs taken into account?

SETTLEMENT OF CLAIMS COSTS

Most insurers track the specific expenses related to the settlement of claims through a claims system that exists and operates outside of an insurer’s standard accounting system, which tracks an insurer’s day-to-day operating expenses. This is relevant because an insurer’s accounting system and accounts payable department will typically have systematic processes and controls in place to track applicable taxes, whereas an insurer’s claims system will typically be managed by claims adjusters and not have the same processes and controls in place to track applicable taxes.

Due to the inherent difference in the function of accounting systems and claims systems, it will be much easier for an insurer to estimate and assess the financial impact of HST on their operating expenses by reviewing the taxes to which they are currently subject. However, since claims systems are generally not designed or intended to be used to produce consistent and reliable tax data, an insurer will have a much more difficult time estimating and assessing the financial impact of HST on their claims settlement costs.

For example, if an insurer knows that it pays professional fees pre-harmonization of $100 plus $5 GST based on its accounting systems, it can easily estimate that it will be paying professional fees of $100 plus $13 HST post-harmonization. However, if an insurer’s claims system indicates that claim file ABC was settled for $100, it would be very difficult to know that the claim involved the payment of a taxable expense, such as a broken window, or an exempt expense, such as a medical bill, or a combination of both. Without this information, it would be difficult to estimate and assess the financial impact of HST to the insurer’s claims expenses.

Insurers will be required to take a much more detailed look at their claims systems in order to determine the financial impact of HST to avoid this hidden cost.

ESTABLISHING PROPER SETTLEMENT PROCEDURES

Insurers settle claims with claimants in two common ways. One way is for the insurer to contract with service providers to provide claims-related services. An example would be hiring an auto body shop, where claimants can bring vehicles for claims-related repairs paid for by the insurer. Another way is for the claimant to incur claims-related expenses on its own, such as bringing a vehicle to the claimant’s usual auto service centre for repairs, and then subsequently submit claims-related expenses to the insurer for reimbursement.

There are special GST rules that address these particular settlement procedures typically used by insurers. Depending on the particular settlement procedures used by an insurer, as well as certain other conditions being met, GST costs can be reduced. In light of harmonization occurring on July 1, 2010, failure to consider the use of proper settlement procedures in the relevant circumstances can result in an additional 13% cost on claims settlement expenses.

To avoid this potentially hidden HST cost to insurers, it will be important for insurers to review all of the claims settlement procedures and ensure that HST efficiencies are being attained where possible.

In addition to the above-mentioned concerns, other issues could have an impact on insurers that go beyond the scope of this article. These should be discussed with your tax advisors.

Although HST will most certainly result in additional tax costs to insurers, proper planning and budgeting now can be key in managing and mitigating the impact of HST to insurers and help reduce the surprise of hidden costs.

———

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity.

———

Insurers will be required to take a much more detailed look at their claims systems in order to determine the financial impact of HST on the insurer’s claims expenses.