SOA 2010 Life & Annuity Symposium May 17-18, 2010. Session 31 PD, Federal Income Tax Modeling and Reporting Issues

SOA 2010 Life & Annuity Symposium May 17-18, 2010 Session 31 PD, Federal Income Tax Modeling and Reporting Issues Moderator: Michael J. LeBoeuf,FSA, MAAA Presenters: Trevor C. Howes, FSA, FCIA, MAAA Edward L. Robbins, FSA, MAAA

Session 31 Federal Income Tax Modeling and Reporting Issues Michael LeBoeuf, FSA, MAAA Managing Director LECG-SMART A global expert services company providing expert testimony, authoritative studies, and strategic advisory services to clients including Fortune Global 500 corporations, major law firms, and governments worldwide. www.lecg.com 2 Panel Introductions Ed Robbins, FSA, MAAA Senior Managing Director LECG - SMART Trevor Howes, FSA, FCIA, MAAA VP & Actuary GGY AXIS 1

3 Federal Income Tax Modeling Survey 2006 American Academy of Actuaries Life Capital Adequacy Subcommittee s C3 Phase II Survey Most respondents did not directly model tax reserves New Survey currently being conducted by the Taxation Section of fthe Society of factuaries To ascertain how federal income tax is being reflected in modeling work 4 Preliminary Survey Results What we know to date. 2

Society of Actuaries Life and Annuity Symposium May, 2010 Session 031 Federal Income Tax Modeling and Reporting Issues Edward L. Robbins A global expert services company providing expert testimony, authoritative studies, and strategic advisory services to clients including Fortune Global 500 corporations, major law firms, and governments worldwide. www.lecg.com 6 Deferred Tax Agenda 1. Purposes of deferred taxes 2. Theoretical results of proper deferred tax treatment 3. Current statutory guidance re deferred taxes & problems associated therewith 4. Possible long-term solutions 3

7 Purposes of Deferred Taxes To account for differences between future book income and future taxable income To account for future tax credits Proper deferred tax treatment facilitates comparisons between companies. Focus of presentation: accounting for differences between future statutory income and future taxable income, with respect to policyholder liabilities. Theoretical Results of Proper Deferred Tax Treatment Assume the following: - 35% Marginal tax rate - Insurer remains fully taxable for the foreseeable future - No discounting of future tax deductions or income 8 4

Theoretical Results of Proper Deferred Tax Treatment (cont d) Pattern of Emergence of Post-Tax Book Profit (Illustration) Expected Pre-Tax Res, Beg.of Year Actual - Cash Book Tax DTA Actual Inv.Inc. on Book Expected Year Flows* Reserve Reserve Beg.of Yr. C.Flows Book Res Profit Cash Flows Ratio 1 (100.00) 523.96 445.37 27.51 (90.00) 26.20 6.50 10.00 65.0% 2 (90.00) 450.16 382.64 23.63 (81.00) 22.51 5.85 9.00 65.0% 3 (81.00) 382.67 325.27 20.09 (72.90) 19.13 5.26 8.10 65.0% 4 (72.90) 320.80 272.68 16.84 (65.61) 16.04 4.74 7.29 65.0% 5 (65.61) 263.94 224.35 13.86 (59.05) 13.20 4.26 6.56 65.0% 6 (59.05) 211.53 179.80 11.11 (53.14) 10.58 3.84 5.90 65.0% 7 (53.14) 163.05 138.60 8.56 (47.83) 8.15 3.45 5.31 65.0% 8 (47.83) 118.06 100.35 6.20 (43.05) 5.90 3.11 4.78 65.0% 9 (43.05) 76.14 64.72 4.00 (38.74) 3.81 2.80 4.30 65.0% 10 (38.74) 36.90 31.36 1.94 (34.87) 1.84 2.52 3.87 65.0% 9 10 Statements We Can Make Reserves should be calculated pre-tax. Post-tax book profit equals 65% of pre-tax book profit. If the reserve itself is adequate, then the reserve less the proper DTA is adequate (at 65% of the pre-tax level of book profit). From an accounting perspective, the actual tax expense on pre-tax book profit equals the expected tax. 5

11 Discounting of DTAs Discounting is the theoretically correct approach, but it is complicated for many and not required under current US guidance. Under actuarial asset adequacy analysis, DTAs are being effectively discounted. Economic DTA = [Pre-tax PV(Profits)]x(.65) [Post-tax PV(Profits)] 12 Current Statutory Guidance Guidance can be found in SSAP 10, superseded by SSAP 10R. First, calculate gross DTA & gross DTL values. Th d th DTA t bt i Then, reduce the gross DTA to obtain Adjusted Gross DTA (i.e., DTA minus a Valuation Allowance ). Call it AGDTA. 6

Current Statutory Guidance (cont d) Admissibility of DTA for electing and eligible companies under SSAP No. 10R: 1) Amount of reversals in next 3 years that can be carried back under federal tax rules. 2) AGDTA remaining after (1), on next 3 years reversals or 15% of surplus if less. 3) AGDTA remaining after (1) and (2) that can be offset against Gross DTLs. [Need to analyze separately between Ordinary items and Capital items.] 13 Current Statutory Guidance (cont d) Period changes to admitted DTAs not included in Summary of Operations. Rather, they go directly to Surplus Account. 14 Certain statutory balances are exempted from deferred tax treatment, including: AVR IMR Schedule F Penalties 7

15 The Guard Rails - Currently companies under 250% RBC ratio cannot use the 3-year and 15% approach. - CAL RBC is increased by 5% of the elective enhancement of admissible DTA. 16 SSAP No. 10R Overview Passed December 7, 2009 at NAIC Winter Meeting Adds Valuation Allowance concept to Gross Deferred tax Assets. Expands the admitted Asset test only apply to companies that meet an RBC threshold 250% of authorized control level RBC. Expansion of disclosures Effective 12/31/09 & sunsets after 2010 Change is a change in accounting principle 8

17 SSAP No. 10R Valuation Allowance New Para. 6.e Adds Valuation Allowance concept akin to GAAP FAS 109 Determined in accordance w/fas 109 (para. 20-25) Applies to Gross Deferred Tax Assets (before admitted d asset test) t) Reduces Gross DTA s to the amount that is more likely than not to be realized. New term: Adjusted Gross DTA = Gross DTA Valuation Allowance 18 SSAP No. 10R Expanded Admitted Asset Test Expands the admitted Asset test so as only to apply to companies that meet RBC thresholds gauge Auditors will now need to consider auditing RBC calculations. Enhanced Admissibility is elective and can be changed by reporting period Three part admissibility as proposed: New Para 10.e.i admittance tied to IRS loss carryback provisions (not to exceed three future years of reversals) New Para. 10.e.ii admissibility to the extent benefit is realized within three years (temp. diff reversal in three years) offsetting taxable income subject to 15% surplus limitation An Auditor review of the three year reversals/forecast will be required Part 3 DTL offset 9

19 SSAP No. 10R Expanded Admitted Asset Test Presentation Para 10.f.: Increases in admitted DTA, that is: Gross DTA (admitted gross DTA for 10.e [10.a to 10.c]): Separately reported in Aggregate g write-ins of special surplus funds line in Liabilities, Surplus and Other Funds 20 SSAP No. 10R Expanded Disclosures Para. 17: Disclosure regarding the entity s Statutory Valuation Allowance shall follow GAAP disclosure format. Valuation Allowance components of the gross DTL/DTA balance. The net change during the year in the total Valuation Allowance also shall be disclosed. Adjustments of the beginning-of-the-year balance of a Valuation Allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years. 10

21 SSAP No. 10R Expanded Disclosures Para. 18: Disclosures modified to break down DTAs and DTLs by tax character. Total of all DTAs by tax character (ordinary vs. capital in nature): Gross DTAs Adjusted Gross DTAs Nonadmitted DTAs Total of all DTLs by tax character (ord. vs. capital) Election of additional admitted DTA under 10.e: Disclose if entity elected the addition admittance under para. 10.e., and if election differs from prior reporting period. Increased amount (by tax character) and change of the admitted gross DTAs resulting from use of para. 10.e. 22 SSAP No. 10R Expanded Disclosures Para. 18 (Continued): The amount of each result/component of the computation, by tax character of: Para. 10.a. Para. 10.b.i. Para. 10.b.ii. Para. 10.c. Para. 10ei 10.e.i Para. 10.e.ii.a. Para. 10.e.ii.b. Para. 10.e.iii. Risk Based Capital (RBC) Level used in Para. 10.d. 11

23 SSAP No. 10R Expanded Disclosures Para. 18 (Continued): Total amount of: Admitted DTAs Admitted assets Statutory surplus, and Total adjusted capital Resulting from the calculation of: Para. 10.a Para. 10.b, and Para. 10.c., and The increased amount of DTAs, admitted assets and surplus resulting from the use of Para. 10.e., if applicable 24 SSAP No. 10R Expanded Disclosures Para. 20 Significant components of income taxes incurred, expanded to include: Adjustments to gross deferred tax assets because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset, and the reason for the adjustment and change in judgment (change in Valuation Allowance) 12

25 SSAP No. 10R Effective Dates Effective 12/31/09 Sunsets after year end 2010 A subgroup of the SAWPG has been formed to provide recommendation for appropriate determination for admitted DTAs for periods after 12/31/10. If new guidance is not adopted by 12/31/10, SSAP 10 is reinstated effective 1/1/11. Would assume this would be treated as a change in accounting principle. 26 SSAP No. 10R Change in Accounting Principle Impact of Implementation of SSAP 10R is a change in accounting principle Revisions to paragraphs 10 and 11 that result in a change in admitted assets are considered a change in accounting principle. Direct surplus adjustment. Applicable disclosures required. 13

27 DTA Management DTA is more meaningful beginning 12/31/09 than before. DTA is a statutory issue not a tax issue. Pure enhancement to statutory surplus. DTA increases embedded value. Consider DTA in pricing and statutory projections (appraisals, etc.). In Asset Adequacy testing under AOMR, test reserve minus policyholder liability DTA against cash flow testing reserve. 28 DTA Management (cont d) 3 possible situations of DTA vs. DTL: - DTL >DTA. A/S will show DTL-DTA as net DTL. - Non-admitted gross DTA < DTL<DTA. A/S Net DTA = Admitted gross DTA [DTL non-admitted gross DTA]. - DTL < Non-admitted gross DTA Net admitted DTA = Gross admitted DTA. [I.e., any acceleration of deductions does not affect net admitted DTA.] 14

Problems with Current Guidance Constraints t still very conservative, don t allow for proper comparisons between entities Concern is with respect to both balance sheet and statutory income Period changes in DTAs should go into Summary of Operations. Formula reserves (pre-tax) are compared to AAT reserves (post-tax). 29 30 Next Steps ACLI will be recommending the 3-year and 15% solution for beyond YE 2010. AAA will be formulating a recommendation as to the proper adjustment to CAL RBC formula as a function of admissible DTA. No efforts being made on other issues. Hopefully, efforts will be made later on to reduce the disclosure requirements. 15

31 Long-Term Thoughts Put period change in DTAs through Summary of Operations. Put change in Net Non-admitted DTA in Surplus Account. Build out the tax module in all AAT reserves so that a true economic DTA can be obtained. 16

Supplement to Session 031 on Deferred Taxes Life & Annuity Symposium May 17, 2010 1 Global Results of Enhanced DTA Admissibility Estimated * Actual ** Fall 2009 Winter 2010 2009 A/S Net Admitted DTA 25,871 34,464 33,870 Net DTA 71,144 83,435 83,986 Ratio of: Estimated Incremental DTA, over Total Capital & Surplus 4.40% 4.90% 3.20% * ACLI industry survey data ** A.M. Best's Global Insurance and Banking Database [Figures in millions] 2 1

Current Events SAPWG established subgroup to evaluate and recommend long term solution. Final meeting of NAIC committees in October. ACLI met in Feb, Mar, Apr and recommended extension of 3 yrs, 15% approach AAA subgroup expected to recommend an approach to RBC charge: Preliminary report, June Final report, September 3 Current Events (Cont d) SAPWG DTA subgroup 10 members, OH and VA chairs Wants additional information to better understand DTA and reversal patterns: Draft data call exposed for comments in late April 4 2

Current Events (Cont d) Resolution, difficult to predict at this time. 5 3

SOA Life & Annuity Symposium Tampa May 17, 2010 Session PD31 Federal Income Tax Modeling Issues Trevor Howes, FCIA, FSA, MAAA Agenda Importance of Tax Modeling Special Tax Issues Asset Modeling Issues Aggregation and Tax Payments Current and Future Tax Issues Fundamental Model Prerequisites it Modeling Multiple Frameworks Conclusion Session 31 PD - Trevor Howes 2 1

Importance of Tax Modeling Tax cash flows are financially significant part of earnings not necessarily 35% of income differences include both temporary and permanent timing differences Session 31 PD - Trevor Howes 3 Special Tax Issues Tax reserve methods and basis Tax reserve limitations DAC Taxes (Revenue Recognition Act) Small vs. large company Direct vs. reinsurer Product line Amortization basis Session 31 PD - Trevor Howes 4 2

Special Tax Issues Investment Income Tax (Canadian) Rationale Formula Modeling issues Planning issues Relevance to US companies? Shelf proposals Session 31 PD - Trevor Howes 5 Special Tax Issues Differential Earnings Tax (historical interest) Capital Taxes Session 31 PD - Trevor Howes 6 3

Asset Modeling Issues Tax exempt assets Allocation issues (company vs. policyholder share) Seriatim vs. modeled assets Multiple framework reporting Tax accounting differences for investments Session 31 PD - Trevor Howes 7 Taxes Paid and Payable Cash flow timing during year Accruals for interim statements Negative vs. positive taxes Tax loss carry-forwards Policy/product line taxes vs. company level Session 31 PD - Trevor Howes 8 4

Future Taxes under PBA Tax reserves for VA s under AG 43 Unresolved issues (IRS Notice 2008-18) Deterministic plus Stochastic add-on Timing of stochastic modeling What are SSA prescribed assumptions? Relevance of SSA asset drop in year 1 Potential tax issues for life insurance and fixed annuities Session 31 PD - Trevor Howes 9 Future Taxes under IFRS? IFRS 4 Insurance Fundamental principle of recognition of time value of money IAS 12 Income Taxes No discounting of future taxes Session 31 PD - Trevor Howes 10 5

Importance of Tax Modeling Product design and actual experience impacts taxes over many years Deferred tax assets & losses carried forward offers opportunities Capital planning is increasingly important especially after recent events After-tax view of required assets Tax planning is important and requires expertise, creativity and good models Session 31 PD - Trevor Howes 11 SOA Survey of Company Practices in Tax Modeling Academy survey 2006 Most respondents did not directly model Tax Reserves for C3 PII New SOA Survey early results? 75% used taxable income for AOMR Over half used explicit Tax reserves Almost all included DAC tax adjustment Few other explicit tax adjustments Session 31 PD - Trevor Howes 12 6

Tax Modeling Good Tax Modeling Accurately reflects business income by calendar period from liabilities Incorporates accurate inforce and current business plans Reflects projected economic scenario Explicitly reflects applicable tax code Facilitates what if analysis Session 31 PD - Trevor Howes 13 Fundamental Model Characteristics Detailed projection of cash flows with reasonably precise timing Accurate handling of policy and calendar year timing Accurate building of inforce models from seriatim data Policy level and higher aggregation Both assets and liabilities Multiple purpose models Session 31 PD - Trevor Howes 14 7

Multiple Financial Frameworks Detailed cash flows are common Stat/GAAP/Tax specific elements: Actuarial benefit reserves and DAC URL/DPL/IMR/AVR Realized & unrealized gains/losses Deferred tax assets and liabilities Stochastic elements Session 31 PD - Trevor Howes 15 Multiple Financial Frameworks Interaction among frameworks Tax Accounting impacts Stat/GAAP DTA/DTL (both Stat and GAAP) Tax cash flows impact reinvestments and future investment income Required and available capital Stat reserves impact Tax reserves Stat capital impacts GAAP planning Session 31 PD - Trevor Howes 16 8

Multiple Financial Frameworks Interaction may be complex e.g. Canadian GAAP accounting Canadian PBA requires discounted provision for future taxes in reserve Canadian GAAP disallows discounting in explicit DTA/DTL Years ago Tax reserves could be lower or higher than Stat reserves Policyholder tax reporting also impact Corporate taxes (IIT) Session 31 PD - Trevor Howes 17 Who can predict Tax Law? Governments need revenue Insurance industry accumulates wealth Goals of solvency protection and revenue preservation conflict Even traditional reserve concepts were difficult to accept for tax Expect lawmakers to be creative Don t expect answers to every question Session 31 PD - Trevor Howes 18 9

Conclusion Detailed flexible Tax Modeling will continue to be an ever increasing priority and a difficult challenge in future years Session 31 PD - Trevor Howes 19 10