What Does It Mean for Insurers?
by Jason Simkin, CPA and Peter Wirtala, CFA
Updated November 21, 2017: US taxpayers have waited on tenterhooks all year for details of the Republican’s proposed tax reform bill, and we finally got a detailed first draft both the House of Representative and Senate’s bills to review. On 11/2 the House Ways and Means Committee released the text of HR1, the “Tax Cuts and Jobs Act” (hereafter “TCJA”), the first actual text of a formal tax bill released since this debate over tax reform began. The Senate followed with its version that had very significant differences that will need to be reconciled with the House bill before a final bill is presented to the President. While passage of a bill is by no means certain (or may take several years), we now have a detailed picture of Congress and the White House’s priorities on the issue that we can analyze and discuss. In this paper we will review key provisions of the bills relevant to the insurance industry, and consider in particular how investment strategies should evolve in response to the changing tax landscape. While the TCJA includes many major changes to individual income tax calculations (and we encourage readers to familiarize themselves with them), we will focus on reforms affecting corporate taxes generally, and the insurance industry in particular.
Probably the most central feature of the House version of the TCJA for Corporations is the flattening and simplification of the current set of tax brackets. For most corporate taxpayers, the current 4 brackets would collapsed to a single 20% flat rate, a major reduction from the 35% rate currently prevailing for corporations with over $18.3 million in taxable income. Stated goals of this reduction include aligning US rates with prevailing international tax structures, and discouraging US companies from moving economic activity overseas. The Senate version has a similar corporate tax rate but delays implementation of the 20% rate one year.
Secondly, the TCJA repeals the Alternative Minimum Tax, a complex secondary tax calculation that applies a flat 20% tax rate to a broader base of income to discourage over-use of deductions and exemptions. This has historically been a key feature limiting the use of tax-exempt municipal bond income for insurers. As such, the elimination of the second tax calculation combined with many other features of the law may substantially change the appetite for tax-free municipals. This will be discussed in more detail below.
Other noteworthy general corporate tax provisions in the House bill include:
• Immediate expensing of a large category of business property and fixed capital investments
• Limitation of deductions for net interest expense to 30% of adjusted taxable income
• NOL carrybacks would be disallowed (with certain exceptions), and could only reduce current-year taxable income by up to 90% (current AMT offset limitation)
• Significant reduction in deductibility of business entertainment expenses and employee fringe benefits not counted as personal taxable income
• Interest on private activity bonds is currently excluded from taxable income (though included in AMT taxable income). Under the new law such income on newly-issued PAB’s would be fully taxable.
In addition to sweeping corporate tax reform, the TCJA also has an entire section dedicated to the insurance industry (specifically Subtitle H, which interested parties are encouraged to review). Under these provisions:
• The small life insurance company deduction (which shields a portion of income from taxation for life insurers below $500 million in assets) would be repealed.
• For life and health insurers, the original proposal had three major additional computational changes
- Elimination of the concept of “Federally Prescribed Reserves” and revaluation for tax purposes at 76.5% of statutory reserves. This change would have significantly accelerated taxable income for affected companies.
- Capitalization rates on life insurer policy acquisition costs are being increased, allowing a greater share of such costs to be amortized over time instead of being expensed immediately.
- Life insurers’ share of stock dividends and tax-exempt municipal bond income (i.e. the percentage of such income they are allowed to exempt from taxable income) would be permanently set at 40%. The current share is calculated by formula, but is significantly lower than this for many insurers.
The proposal was subsequently adjusted prior to vote by the House to eliminate the above provisions and instead provide a 8% surtax on life insurance income such that life insurance companies may have a 28% effective rate (20% corporate rate + 8% surtax). Note that the proposed bill specifically calls the surtax a placeholder while the Committee continues to evaluate how to tax life insurance companies.
– For life and health insurers, changes in methods of measuring reserves that would have previously been spread over 10 years would now be spread over only 4 years for reserve weakening and over 1 year for reserve strengthening.
– For life and health insurers with an existing Policyholder Surplus Account, the applicable deferred tax would be accelerated and payable in 8 annual installments.
– For P&C insurers, the proposal had the following major computational changes:
- The company’s share of tax-exempt income would decline from 85% to 73.75%
- P&C insurers would have number of changes to the computation of tax reserves which would be expected to increase taxable income including:
- Using the corporate bond yield curve, instead of historical industry payment patterns
- Extension of loss payment pattern computations
- Repeal the election to use company-specific, rather than industry-wide, historical loss payment pattern
– Though not a specific provision of the new law, the change in corporate rates would require revaluation of deferred tax assets/liabilities, in addition to affecting future development of the interest maintenance reserve and asset valuation reserve. For many insurance companies the unexpected consequence could be in the computation of the admitted asset test, which determines the amount of deferred taxes included in Statutory surplus. While complex and outside of the scope of this memo, generally Statutory admitted deferred tax assets may be admitted to the extent a deferred tax asset could hypothetically be carried back to recover taxes paid in the prior year. The elimination of the option to carryback net operating losses in the proposed law would eliminate the ability to admit deferred tax assets in the hypothetical carryback component of the admitted asset test. Furthermore, for GAAP/IFRS accounting insurers, 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.
– Additionally, 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 Senate version of tax reform includes many of the same general provisions, some with meaningful differences. In addition to the 1 year delay in implementation of the 20% tax rate, the following are a few additional items of interest to the insurance industry in the Senate Bill:
– The proposal reduces the 70 percent dividends received deduction to 50 percent and the 80 percent dividends received deduction to 65 percent.
– For life insurance companies there would be no surtax like the House bill, but the capitalization rates on life insurer policy acquisition costs would be increased substantially (ex. 7.7% existing rate on most policies would increase to 13.97%). Further, the amortization period would be increased from 10 years to 50 years.
– Retains the current NOL carryback and carryforward rules for P&C Companies
– Retains the current P&C reserve discounting provisions
These are many of the facets of the proposed House and Senate bills that could impact insurers. However, there are many other major provisions in both the House and Senate bill that we anticipate will affect subsets of the insurance market which we have omitted for brevity (ex. Publicly-traded company compensation disallowance, taxation of foreign operations and subsidiaries, etc).
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, and this market would likely be dramatically altered by the proposed law. First, demand for municipal bonds is set at the margin by taxpayers in the highest brackets, who have the most to gain from the exemption. Under the new regime corporate tax rates would max out at 20% (28% with surtax for life insurers under the House Bill), while individual rates would top out at 35% (technically 39.6% for incomes over $1 million in the House bill). 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 could drive yields to levels that are less attractive to insurers relative to other bond sectors.
Compounding this effect are the changes to proration of tax-exempt income for P&C insurers. As an illustration, the gross-up factor for a P&C company with 15% proration and a 35% tax rate is 1.4577, so a bond yielding a nominal 2.50% actually yields an effective 3.64% once the exemption is accounted for. Under the new regime our P&C insurer would have 26.25% proration and a 20% tax rate, leading to a gross-up factor of 1.1844 and an effective yield of 2.96% on that same bond.
For this reason, we would expect the largest impact of the law to be a reduction in tax-exempt municipal holdings by insurers, though this will partly depend on how the market ultimately adjusts to the various changes in practice. It’s also worth mentioning that the proposed limit on deductibility of interest expense could significantly impact the supply of corporate bond issuance, which would in turn affect supply and demand across all other bond sectors. This issue will merit detailed analysis if that provision of the law survives through to passage.
We emphasize again that this bill is likely to change, may not pass into law, and even if it does pass, it may take years. However, to the extent the current proposal is implemented it will be the largest tax overhaul in many years and will significantly impact many aspects of the insurance industry and investment markets. We will continue to follow this developing story and provide updates as events warrant.
Debate continues, and at least one Republican senator (Ron Johnson) has stated he will not support the Senate version of the bill. Handicapping the odds of what, if anything, will pass, remains difficult but the process is now moving quickly and we will likely know the result by Christmas.
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