Conditions in Washington make it likely that 2017 will bring significant changes to how U.S. domiciled insurance companies will be taxed. Proposals to cut corporate tax rates and to change how income from outside the U.S. is taxed will, if enacted:
- Leverage the impact of underwriting income on surplus creating an advantage for those writing profitable business and increasing the value of reinsurance that mitigates underwriting loss
- Change how insurance companies invest
- Impact balance sheets, liquidity and reserving decisions, and
- Make the U.S. more attractive as a headquarters for new global insurance or reinsurance enterprises
Change on the horizon
Proposals to change the U.S. corporate tax regime come up every year, but with Republicans controlling both Congress and the White House the prospects for actual change to be enacted and in place, possibly as soon as 2018, appear high.
Both the President and the Republican-controlled House Ways & Means Committee have published proposals that would comprehensively change current tax law. A full and comparative analysis of these proposals is beyond the scope of this post and there is still substantial uncertainty as to what, if anything, will be enacted. However, there are certain changes that appear in each that could substantially impact the insurance industry. This post will discuss two of the major proposed changes and how they may affect insurance and reinsurance companies domiciled in the U.S.
A lower statutory tax rate
By far the most important proposed change is a cut in the corporate tax rate. The current U.S. statutory corporate tax rate is 35% (the highest among G-8 countries) and has been at that level since 1992 (before that it was at 33% dating back to 1986 so there hasn’t been much movement in the past 30 years). Plans from both the President and the House propose much lower rates, 15% and 20% respectively.
Keep in mind that the statutory rate under law is not necessarily the same as the effective rate that companies actually pay. There are differences between accounting income (whether computed under statutory insurance accounting or GAAP rules) and taxable income.
Some of these differences are permanent – income that is never taxed or expenses that are never deductible (e.g., “tax-free” municipal bond interest or a portion of meals and entertainment expense).
Other differences are temporary — the timing of the recognition of income or the deductibility of an expense differs but sooner or later the item is taxed or deducted.
For the insurance industry the two most important timing differences are:
- the recognition of unearned premiums (20% of which is taxed before it’s earned for accounting purposes) and
- the deductibility of reserves (which are deducted on a discounted basis which reverses over time as losses are paid)
Permanent differences change a company’s effective tax rate from the 35% statutory rate; a company with a substantial amount of muni bond interest will report an effective tax rate less than 35%.
Temporary differences don’t change the effective rate but may result in an acceleration or deferral of the payment of taxes, i.e., current taxes payable may exceed 35% of accounting income but the company will pay less than 35% in some future period.
Regardless of the drivers of the difference, changes to the statutory rate will generally move effective rates in the same direction.
A lower statutory tax rate will have several consequences for insurance and reinsurance companies:
A leveraging of underwriting income
Underwriting income is taxed at an effective rate of 35%. In essence this means that the government has a 35% “quota share” of every company’s results whether good or bad. Cutting the corporate tax rate from 35% to the proposed 20% or 15% reduces this “quota share” and leverages up the impact of underwriting results on surplus; companies “retain” on an after-tax basis a higher percentage of underwriting gains and losses.
This leveraging may be material: a 15% statutory tax rate has the same effect on surplus as growing premium volume by 31% under a 35% tax rate ($100 of underwriting income taxed at 15% produces an $85 increase in surplus, the same as $131 of underwriting income taxed at 35%).
This leverage effect may lead companies to reevaluate their corporate risk appetite and result in an increased demand for reinsurance as a hedge against the wider swings to surplus that underwriting results will produce as downside losses would have a greater impact on capital position.
This may be particularly the case in cat layers where the potential downside of retaining the risk is much higher than the upside of retaining more profit; companies may seek to increase the placement of partially retained layers or lower their current retentions.
A decreased advantage for “tax-free” investments
While all underwriting income is currently taxed at an effective rate of 35%, the tax rate applied to investment income varies depending on the source. Interest on most bonds and on capital gains is fully taxed at 35%, but 70% of dividends from stocks and 100% of muni bond interest is permanently excluded from taxable income.
Since investment income is so significant for insurance companies, special rules apply to reduce these benefits; 15% of the otherwise excluded income is taxed at the statutory 35% rate. This results in an effective tax rate of 5.25% on muni bond interest (15% of the interest is taxed at 35%) and 14.175% on dividends (30% of the dividend is taxed normally at 35% as is 15% of the 70% otherwise excluded).
Because investment decisions are usually made on an after-tax basis, muni bonds can pay a nominal interest rate lower than a corporate bond of similar credit quality and duration and still result in a higher after-tax yield. A decrease in the tax rate means that a muni bond has to pay more to maintain this parity. Under a 35% corporate tax rate a muni bond only has to pay 2.06% to match the after-tax yield of a corporate bond paying 3% (3% x (1 – 35%) equals 2.06% x (1 – 5.25%)): under a 15% corporate tax rate it has to pay 2.62% (3% x (1 – 15%) equals 2.62% x (1 – 3%)).
This means insurance companies that currently have significant muni bond holdings will be disadvantaged compared to peers that favor taxable bonds. Muni bonds will also be less attractive as an investment choice going forward, and the lower demand could push required yields even higher, putting a strain on issuers.
An advantage for companies that generate underwriting profits
Insurance companies typically rely on both underwriting and investments to produce income. The combination of the prior two effects (the leveraging of underwriting income and a decreased advantage for “tax-free” investment income) will result in an advantage for companies with a larger percentage of net income coming from underwriting vs. investment income as the spread between the effective tax rates on these two components decreases.
Potential direct impacts on balance sheets
As discussed above, taxable income may differ from accounting income due to temporary differences that reverse over time. These temporary differences, which will result in lower or higher tax payments in the future as they reverse, are tax-effected (multiplied by the statutory tax rate) and carried on balance sheets as deferred tax assets and liabilities respectively.
For insurance companies, the most common deferred tax assets (DTAs) typically arise through the discount applied to reserves (deferring a portion of the deduction until the loss is actually paid) and the acceleration of unearned premiums into income. While the latter applies to all companies, long-tail casualty writers will typically have much higher reserve DTAs than property writers.
The most common deferred tax liabilities (DTLs) are usually net operating loss carryforwards (NOLs) — excess losses that are carried forward and may be used to offset taxable income in future years — and unrealized capital gains. Companies may have both DTAs and DTLs at the same time.
These assets and liabilities are currently recognized using a 35% statutory tax rate. Any change in that rate will cause those items to be revalued, resulting in changes to surplus. A lower statutory tax rate will help companies in a net DTL position; the carried liability will be reduced and surplus increased since that deferred income will be taxed at the new lower rate. In the same way it will hurt companies in a net DTA position; the carried asset and surplus will be reduced since the future tax savings from the prior acceleration of income or deferral of expense will be recognized at the new lower rate.
Potential indirect impacts on balance sheets
If corporate tax rates are expected to decrease and a company is not in an NOL position then a deduction taken currently at 35% is more valuable than a deduction taken in the future at 15%. Insurance companies have a degree of latitude when setting reserves so there may be value in taking a more conservative view in 2017 rather than potentially strengthening reserves in the future.
A decrease in the corporate tax rate will likely reduce the market value of muni bonds as prices decline in order to generate the higher yield required to maintain after-tax parity with taxable bond yields. While this is not of consequence if the muni bond is held to maturity, it is if the holder has to sell at a depressed price before maturity to fund loss payments.
A change to a territorial tax system
The U.S. taxes corporations on their world-wide income, no matter where earned (but allows a credit for taxes paid in foreign jurisdictions). Every other major country uses a territorial system: the company pays taxes where the income is earned. Since the U.S. also has the highest corporate tax rate in the developed world, this may not make it a very attractive option if you’re planning on setting up a global insurance or reinsurance business.
Combined with the lower proposed corporate rate, the move to a territorial system may spur future start-ups to look to the U.S. as their place of incorporation rather than Bermuda or Switzerland.
Ken Kruger, EVP, is the Head of the Customized Solutions practice for Willis Re North America. Before joining Willis Re he served as Tax Director at a global reinsurance company and continues to serve as a member of the RAA’s Tax Committee. This was adapted from a Briefing Note that he wrote for our brokers to share with clients.