What Does It Mean for Insurers?
by Jason Simkin, CPA and Peter Wirtala, CFA
Updated December 22, 2017: The speculation, negotiations, and Congressional votes are over, and the tax reform bill has passed. At this writing President Trump has just signed the bill in a private event, concluding a political roller coaster that has made headlines repeatedly throughout the year. So, which provisions made it into the final bill, and which were modified or dropped?
First, as widely expected, corporate tax rates have fallen to a flat 21% rate, bringing them much closer to the average of other developed nations. Individual tax brackets have been significantly readjusted as well, though that is not our focus in this paper. The new rates will go into effect for tax year 2018, as the 1-year delay proposed by the Senate was ultimately rejected.
Secondly, the bill repeals the corporate Alternative Minimum Tax, a feature of the tax law that historically limited the use of tax-exempt municipal bond income for insurers. Existing AMT credits can be used to reduce regular taxable income in future years according to a simple formula. The repeal of the AMT is one of several provisions likely to significantly alter the relative value of tax-exempt municipal bonds for insurers. This will be discussed in more detail below.
Other noteworthy general corporate tax provisions that survived into the final version include:
– Immediate expensing of a large category of business property and fixed capital investments
– Limitation of the deduction for net interest expense to 30% of adjusted taxable income
– NOL carrybacks generated from 2018 onward are no longer permitted for life insurance or noninsurance companies; however, they can be carried forward indefinitely to reduce taxable income up to a limit of 80% taxable income. Property/casualty insurers’ NOL carryback (2 years) and carryforward (20 years) limits remain unchanged in the final bill.
– Significant reductions in deductibility of business meal and entertainment expenses and certain employee fringe benefits.
– Modest reduction in the percentage of dividend income eligible for the Dividends Received Deduction
– Public company executive compensation disallowance has been expanded significantly
In addition to sweeping corporate tax reform, the final bill also has a number of provisions specifically affecting the insurance industry. These include:
For life insurers:
o The small life insurance company deduction (which shields a portion of income from taxation for life insurers below $500 million in assets) is repealed.
o Tax-deductible reserves are set at 92.81% of actuarial reserves
o The policyholders’ share of investment income is set at 30%, and company share at 70%. Previously this required a complicated formula to calculate.
o Capitalization rates on policy acquisition costs are being increased by approximately 20%, and the 120 month amortization period is being extended to 180 months.
o Changes in methods of measuring reserves will be amortized over a time frame consistent with other general changes in accounting methods instead of 10 years.
o Remaining Policyholder Surplus Account deferred tax is accelerated and payable in 8 annual installments.
For P&C insurers:
o The company’s share of tax-exempt investment income declines from 85% to 75%
o A number of changes are made to the computation of tax reserves that are likely to increase taxable income, including:
Using the corporate bond yield curve instead of historical industry payment patterns
Extension of loss payment pattern computations
Repealing the election to use company-specific, rather than industry-wide, historical loss payment patterns
– Though not a specific provision of the new law, the change in corporate rates will require revaluation of deferred tax assets/liabilities, in addition to affecting future development of the interest maintenance reserve and asset valuation reserve. For most insurance companies (small life companies being a notable exception) the revaluation will result in a substantial decrease in the net deferred tax asset/liability reported in surplus.
– For many insurance companies one unexpected consequence could be a further reduction in statutory surplus due to a decrease in the admitted DTA beyond that caused by the rate change. This can occur due to the statutory computation of the admitted asset. While complex and outside of the scope of this memo, generally deferred tax assets may be admitted based on a three-prong computation, one prong of which is a hypothetical carryback to recover taxes paid in the prior year. As mentioned above, the ability to carry back net operating losses is being repealed for life insurers, so their maximum admitted net deferred tax asset will now be limited to the other two prongs of the computation. P&C companies won’t be affected by this issue since they retain NOL carrybacks in the new law.
– Relatedly, for life insurers reporting under GAAP/IFRS accounting, the elimination of net operating loss carrybacks may place pressure on or require a valuation allowance against existing deferred tax assets in the company’s equity.
– Finally, many parts of the NAIC’s risk-based capital ratio calculation involve net-of-tax calculations, which will be significantly affected by the change in rates.
The above are the key provisions of interest to US insurers. Companies with significant overseas operations and cross-border affiliate transactions will be affected by the switch to a more territorial tax regime, cash repatriation opportunity, and base erosion minimum taxes, but we omit detailed discussion of these provisions for brevity.
How will tax reform affect insurer investment strategies? Probably in multiple ways, dependent in part on how investment markets respond. Historically P&C insurers have been major investors in tax-exempt municipal bonds, whereas life insurers have mostly avoided the sector due to limited ability to benefit from the tax exemption. This latter limitation is changing, as the “company share” of life insurer investment income is now being set at 70% (vs now 75% for P&C insurers), meaning both types of companies will have similar ability to benefit from municipals. However, demand for municipal bonds is typically set at the margin by taxpayers in the highest brackets, who have the most to gain from the exemption.
Under the new law all corporate income is taxed at 21%, but the highest individual rate is 37%. From this we would expect that high-income individual investors would receive the greatest benefit from munis, and thus be willing to pay the highest prices for them. This will potentially set market yields on munis at levels that are less attractive to insurers relative to other bond sectors (which are now subject to a much lower tax rate).
To illustrate this effect, it is common for insurers to calculate a “gross-up factor” to compare after-tax yields on tax-exempt bonds vs. after-tax yields on taxable bonds. Under the previous regime, for an insurer paying a 35% tax rate this factor was 1.4577, so a tax-exempt bond yielding a nominal 2.50% and a taxable bond yielding 3.64% produced the same level of after-tax income. Under the new regime this factor will decline to 1.200 (1.186 for life insurers), because while the tax-exempt bond produces the same after-tax yield as before (the change in proration offsets the change in the tax rate), the taxable bond now has a much lower rate than before. To compete with the 3.64% taxable bond, the tax-exempt bond must now yield 3.03%. But yields may not rise that far in practice, since the top rate for individual taxpayers (who comprise the majority of the market) isn’t moving much, so their supply/demand calculus may not change much.
For this reason, we expect the new law may lead to a gradual decline in tax-exempt municipal holdings by insurers, though this will partly depend on how the market ultimately adjusts in practice. Partly offsetting this potential is that, to the extent insurers continue to hold munis, life insurers may find this sector now makes sense in their portfolios where previously it did not. It’s also worth mentioning that the proposed limit on deductibility of interest expense could impact the supply of corporate bond issuance in certain sectors, which would in turn affect supply and demand across other bond sectors. This possibility will bear close attention as we move into 2018.
After months of speculation and uncertainty the saga of the tax reform of 2017 has drawn to a close, and insurers can now evaluate the impact of the law on their tax planning strategies, deferred tax assets/liabilities, and investment portfolios.
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