Part C. Property and Casualty Insurance Copanies This Part discusses proposals to curtail favorable tax rules for property and casualty ("P&C") insurance copanies. The syste of reserves for unpaid losses would be revised to assure correct treatent of the underwriting and investent incoe earned by P&C copanies. Special provisions that reduce the effective tax rate on P&C copanies would be eliinated. Specifically, the deduction for contributions to a protection against loss account would be repealed. Special tax exeptions, rate reductions, and deductions of sall utual P&C copanies would be repealed. The deduction for policyholder dividends by utual P&C copanies would be liited in confority with the deduction allowed utual life insurance copanies. - 265 -
REVISE TREATMENT OF LOSSES BY PROPERTY AND CASUALTY INSURANCE COMPANIES AND ALLOW DEDUCTION TO CERTAIN OF THEIR POLICYHOLDERS Current Law General Explanation Chapter 10.10 Property and casualty ("P&C") insurance copanies are allowed a reserve deduction for "losses incurred" during a taxable year. The deduction includes the copany's estiate of "unpaid losses," whether or not unpaid losses have accrued under noral tax accounting rules. Unpaid losses include aounts that will be paid in connection with clais filed with the copany during the taxable year as well as aounts that relate to clais expected to arise fro events occurring during the taxable year that have not been reported to the copany. The deduction for these clais generally is not discounted to reflect the fact that they will not be paid until soe tie in the future. Moreover, the reserve does not grow over tie to reflect the investent incoe earned on the reserve. A copany is also peritted to set up an unearned preiu reserve for preius received during one taxable year that relate to coverage to be provided in subsequent years. In the case of taxpayers who sustain losses, the tax treatent of the losses depends upon a nuber of factors, including whether the loss is a business or a personal loss, whether the loss is to the person or property of the taxpayer or is a tort or other liability to a third party, and whether the loss is covered by insurance. First, ost personal losses are nondeductible. For exaple, individual taxpayers can clai a deduction for casualty losses to personal property only to the extent the losses exceed ten percent of the individual's adjusted gross incoe; deductions for edical expenses are liited to those in excess of five percent of adjusted gross incoe. Second, otherwise deductible tort arid siilar liabilities to a third party generally are not treated as incurred (and hence are not deductible) until payent is ade to the third party. Third, although certain uninsured losses sustained by a taxpayer are deductible at the tie the loss is incurred, no deduction is allowed at this tie if the loss is insured. In general, no account is taken of the taxpayer's loss of the tie value of oney resulting fro any delay between the tie the loss is incurred and the tie the insurance clai is paid. Often, as part of the settleent of a liability to ake payents for personal injury daages, a property and casualty copany or an uninsured defendant will agree with the injured party to assign the liability to ake periodic settleent payents to another person, such as an affiliate of a life insurance copany, who will fund the "structured settleent" by purchasing an annuity contract. Third-party assignees who assue other persons' liabilities to ake periodic payents as personal injury daages or settleents ay exclude fro gross incoe aounts received in consideration for such
assuptions, to the extent such aounts are invested in annuity contracts to fund the liabilities. The third-party assignees' basis in the annuity contracts is reduced by the aount of excluded incoe. Third-party assignees recognize incoe as they receive payents on the annuity contracts but ay deduct periodic payents to the injured parties. Reasons or Change The deduction by P&C copanies of reserves for clais to be paid in the future, unadjusted for the investent incoe that will be earned on those reserves, results in deferral of P&C copanies' tax liability and reduces their effective tax rates. In other cases where tax deductions for reserves are allowed, either the allowable reserves are discounted for the expected future investent earnings on the reserve funds (as is the case with life insurance reserves) or the investent incoe earned on the reserve is added to the reserve (as is the case with nuclear decoissioning trust funds). The current tax treatent of P&C insurance reserves distorts the choice between self-insurance and third-party insurance. P&C copanies deduct currently the full aount of the future liability for any casualty losses that would not be deductible currently by a self-insurer. Because a current tax deduction is ore valuable than a future deduction, individuals and businesses are encouraged to insure against risks with a P&C copany in order to take advantage of this favorable tax treatent. With respect to persons sustaining losses covered by insurance, current law is inaccurate in failing to recognize the effect of a delay between the tie a loss is incurred and the tie an insurance clai for such loss is paid. Even a taxpayer who suffers a loss of property that is fully insured for its current fair arket value suffers an uninsured loss easured by the loss of the value of the property during the period the incurred loss reains unreibursed. If the current syste of taxing P&C copanies were changed without correcting this defect, the tax syste would discourage the purchase of insurance with respect to losses that would otherwise be deductible (priarily business property losses and large personal casualty losses). Finally, in the case of third-party assignees, the current tax treatent of aounts received fro assignors and aounts paid to injured parties effectively exepts fro tax the investent incoe on the aount assigned. This exeption is not warranted nor is it required by the exclusion fro injured parties' incoe of periodic payents received as personal injury daages pursuant to structured settleents. That is, the rationale for the tax treatent of injured parties is not to allow the tax-free investent of daage awards, but rather to reove a tax disincentive to injured parties who accept payent in the for of a structured settleent as an alternative to a lup su. Just as injured parties are taxed on incoe fro the - 261 -
investent of daage awards once received, third-party assignees should be taxed on incoe fro the investent of funds prior to payent to injured parties. Proposal The deduction by P&C copanies for unpaid losses during a taxable year would be coputed under the "qualified reserve account" ("QRA") ethod. Under this ethod, the copany would establish reserve accounts for clais to be paid in an aount estiated by the copany to be sufficient to fund payent of the clais, taking into account the copany's estiates of the aount of the clais, the tie of payent of the clais, and the copany's after-tax rate of return on its investent assets. Separate reserve accounts would be established by line of business and year of policy issuance. In other words, one account would be established for all clais under all policies in a particular line of business issued in a particular taxable year. This account would take the place of the current separate reserve accounts for unearned preius, incurred but not reported ("XBNR") losses, and reported clais. The initial aount deductible with respect to a given reserve account could not exceed the cobined statutory unearned preiu reserve, IBNR reserve, and clais reserves on policies covered by that account. Beyond this, the copany would not be subject to federally prescribed rules in establishing the reserve account. Each reserve established by the copany would be increased annually by a percentage equal to the after-tax rate of return actually earned by the copany on its investents during that year. To prevent the copany's investent incoe fro being sheltered fro tax, no additional reserve deduction would be allowed for the annual increase in the reserve accounts attributable to the allocation of investent incoe. The after-tax rate of return for a copany during a given taxable year would be equal to the total net investent incoe of the copany (including tax-exept incoe) for that year, reduced by taxes attributable to that incoe, divided by the average total surplus and reserves of the copany for the year. Thus, in effect, the QRA proposal would prorate the taxable and tax-exept incoe aong all the reserves and surplus of the copany. To the extent a P&C copany is able to increase its after-tax incoe through investent in tax-exept securities, its reserves would grow ore quickly. This would require the copany either to take saller initial reserve d.eductions or realize greater incoe fro the release of reserves when clais are paid. The copany would be allowed a deduction each year for the full aount paid to satisfy clais, but would be required to include in taxable incoe an offsetting aount released fro the appropriate reserve account. If the reserve was insufficient to cover all clais, - 260 -
the excess clais would be deductible when paid. Conversely, if any aount reained in a reserve account after payent of the last clai in that account, that aount would be included in taxable incoe. A copany would be peritted to strengthen a reserve it deterined was insufficient to cover future clais and a deduction would be given for additional aounts placed into a reserve. However, the copany would be required to establish the need for reserve strengthening by a showing of objective factors affecting the aount needed to fund the payent of clais. Such factors would include a strengthening of the copany's reserves on its annual stateent or a decline in prevailing interest rates. Copanies also would be free to release into incoe additional aounts fro reserves it felt to be excessive. This would allow copanies to avoid a bunching of incoe in a single year fro the release of an excessive reserve. A copany would not be able to aintain a reserve indefinitely. Rules would be established liiting the axiu life of a reserve, depending on the line of business. Any reserve balance at the end of the axiu life would be released into incoe. Any subsequent clais under policies covered by that reserve would be deductible when paid. This proposal would also apply to reserves for unpaid losses not included in life insurance reserves held by life insurance copanies. Thus, a life insurance copany issuing accident and health policies would be required to use the QRA ethod to account for unpaid losses on such policies. Taxpayers suffering losses covered by insurance would be peritted to elect to clai a deduction with respect to those losses without regard to the prospect of recovery fro the insurance copany. In other words, electing taxpayers would be allowed to deduct the loss in the taxable year the loss is incurred as if the loss were uninsured. Insurance proceeds would be taxable incoe when received, but an exclusion would be given equal to the aount of any portion of the loss that was not deductible. Current law would continue to apply to nonelecting taxpayers. Third-party assignees of liabilities to ake personal injury daage payents would include the full aount of consideration received fro the assignor in gross incoe. An assignee purchasing an annuity contract to fund its liabilities to an injured party would be treated as the owner of the annuity and would be taxed on the incoe coponent thereof. The assignee would be peritted to elect either to treat the purchase of an annuity used to fund its liabilities to an injured party as a deductible expense at the tie of the purchase or to treat each payent to the injured party as deductible at the tie the payent is ade. Effective Date The proposal would be effective or all losses incurred in taxable years beginning on or after January 1, 1986 that are insured under policies issued on or after January 1, 1986. The proposal on - 269 -
third-party assignents of personal injury liability would be effective for all assignents entered into on or after January 1, 1986. Analysis Under the proposal, P&C copanies would still be peritted to use the reserve ethod to atch incoe and losses occurring in different taxable years. The QRA ethod, however, would take into account the tie value of oney. A current deduction of $1,000 is worth considerably ore than a future deduction of $1,000 because investent incoe will be earned on the tax saving produced by the deduction. For the sae reasons, less than $1,000 needs to be held in reserve to fund a future liability of $1,000. For exaple, if interest incoe accuulates at an after-tax rate of six percent, a reserve of only $792.09 is needed to provide sufficient funds to satisfy a liability four years in the future of $1,000. If a fund of $1,000 is set aside and deducted, it is appropriate to recognize the growth of that fund to $1,262.48 and to include the excess aount of $262.48 in incoe when the clai is paid. The syste of qualified reserve accounts does not require the discounting of reserves. This feature of the proposal avoids the difficult proble of choosing a andatory discount rate in an environent where investent returns vary widely fro copany to copany and fro year to year. Copanies are free to discount reserves using any set of assuptions as to future interest rates (e.g., the assuptions used in pricing the policies) or even to establish undiscounted reserves. This flexibility is possible because the QRA ethod assures that the ultiate after-tax return that a copany realizes on a group of policies does not depend on the aount the copany places into the reserve for those policies, assuing that the copany's tax rate is constant over tie. The copany would not have a tax incentive to overreserve since any excess tax deduction would be recaptured when the clais are ultiately paid with an interest factor equal to the copany's actual after-tax rate of return on investent assets. Conversely, copanies that underreserve would receive additional deductions at the tie they pay their clais to ensure that they will not be penalized for underreserving. This feature of the QRA ethod is not present in a syste that requires re-tax discounting of reserves and grants additional deductions+or investent incoe earned on reserves. Such a syste, while clearly an iproveent over present law, would penalize a copany for underestiating the aount of a clai or overestiating the length of tie until payent of the clai. Conversely, a copany would receive a windfall on any clai that was overestiated or whose payent was delayed. More significantly, such a syste would continue to undertax P&C copanies since investent incoe on reserves held by P&C copanies would not be taxed. Such a syste thus fails to tax the entire incoe of P&C copanies and continues the distortionary effect of current tax law that favors third-party insurance over self-insurance. - 270 -
A substantial portion of the clais paid by P&C copanies are paid in years subsequent to the year in which preiu incoe is received and a deduction for losses paid or incurred is claied. Table 1 shows the average period of loss payent for all insurance written by P&C copanies and for several ajor lines of business. As shown on the table, over 60 percent of all losses of P&C copanies are paid after the year of deduction. The actual discounted value of these losses at the tie the preiu incoe is received, assuing a six percent discount rate, is approxiately 91 percent of their undiscounted value. In the case of edical alpractice insurance, a line of business where long delays in the payent of clais are coon, ore than one-half of all losses are paid beyond the fourth year after the year of deduction and the discounted value of the losses at the tie the preiu is received is only approxiately 76 percent of their undiscounted value. It has been argued by soe that the present syste of undiscounted clais reserves results in "rough justice" since it allows a deduction to soe taxpayer in the full aount of an econoic loss (of either the policyholder or a third party to who the policyholder is liable) when the loss is incurred. Arguably, it is proper to atch the tie of the P&C copany's deduction to the tie the underlying econoic loss is sustained. However, except in the case of business property losses, a large portion of property and casualty liabilities would not be deductible losses to the party suffering the underlying econoic loss. To the extent losses would be deductible by the person suffering the loss if uninsured, the proposal would allow a deduction for insured losses and insurance proceeds would be included in incoe when received. This would achieve a far ore accurate result than the "rough justice" arguably afforded by present law, since the taxpayer actual1.y suffering the loss is ade whole. Under the current syste, a taxpayer suffering the loss is penalized while the policyholders not suffering losses have a windfall to the extent the P&C copany passes through its tax benefits in the for of lower preius. The P&C copany also has a windfall to the extent it does not pass through the tax benefits. The cobination of the QRA reserve proposal and the proposed change in the tax treatent of third-party assignees assures that the investent incoe on aounts set aside to fund structured settleents would be subject to tax. This change would ake the tax syste a neutral consideration in the choice between structured settleents and lup-su payents while preserving the current rule that plaintiffs should not have to pay tax on any personal injury daage awards. The P&C industry ay argue that the QRA proposal is not appropriate for an industry with large underwriting losses (-$11.0 billion in 1983). However, the large underwriting losses occur priarily because P&C copanies lower preius (discount) for the future investent incoe expected to be earned prior to the payent of clais, while the statutory reserves used in calculating underwriting incoe are not discounted. Total net incoe is the appropriate - 211. -
rl r l. N " 3 z -;r c r. v) " rl ire 2 c C. "d C W U C u rl w o + a I ou 2,% I d d CI) 2 s w w rl w e 0 N W r. V)r w a Eo U & 0 U w rl " N a P a) s 2 Lo a e 0 w u w "! E o w C c o w 0.L(.. w s Y. 0 h w rlc : 0 a ea a, e Y 2 r o Y V u I-' P L4 w w w r Y u e id U a rl w.r( (II rl LI e a 2 Lo rl N.* w r- I4 a g<.. w U a 0 Lo - 212 -
easure of copany profitability, not underwriting incoe. Moreover, even in ties of overall net losses, the tax syste should liit tax losses to properly easured econoic losses and should tax profitable enterprises on their properly easured econoic incoe. The QRA would be only a bookkeeping entry. The QRA reserve syste would increase the tax liabilities of P&C copanies and affiliated copanies but, as described above, the proposal would siply eliinate the deferral of tax liability allowed under current law or ipose an appropriate interest charge on the deferral. P&C copanies could be expected to increase their preius to cover any increased tax liability resulting fro the ore accurate easureent of their taxable incoe. The QRA syste would not affect State law requireents for reserves to protect policyholders against copany insolvency. The aount of tax reserves would be different than the aount of statutory reserves but, because the QRA ethod does not require the discounting of reserves, tax reserves would not necessarily be lower than statutory reserves. State law presuably would continue to require adequate funding of statutory reserves. - 213-476-693 0-85 - 11
Current Law REPEAL HUTUAL PROPERTY AND CASUALTY INSURANCE COMPANY PROTECTION AGAINST LOSS ACCOUNT General Explanation Chapter 10.11 Most utual property and casualty ("P&C") insurance copanies are allowed deductions for net contributions to a protection against loss ("PAL") account. A deduction is generally allowed for contributions to the account in an aount equal to one percent of the losses (both known and estiated) incurred during the taxable year plus 25 percent of the underwriting gain for the taxable year. Copanies that have a high percentage of risks relating to windstors, hail, flood, earthquakes, or siilar hazards ay defer a larger percentage of their underwriting incoe. The portion of the deferred incoe representing one percent of losses incurred and one-half of the deduction for 25 percent of underwriting incoe is brought back into incoe after, at ost, a five-year deferral period. The reaining aount, 12.5 percent of underwriting incoe, continues to be deferred indefinitely, until the copany has underwriting losses. Reasons for Change The special PAL deduction is unrelated to the easureent of econoic incoe. The PAL deduction is allowed in addition to the full deduction that utual P&C copanies receive for estiates of losses to be paid in the future. Furtherore, the PAL account is siply a bookkeeping entry ade for tax purposes; a corresponding reserve account is not required by State regulatory authorities to provide for the financial solvency of the copanies. The tax deferral resulting fro the deductibility of contributions to a PAL account reduces the effective tax rate on utual P&C copanies with underwriting incoe. The lower effective tax rate provides a copetitive advantage to utual P&C copanies vis-a-vis stock P&C copanies and life insurance copanies that offer siilar insurance products. The calculation of the PAL account requires an arbitrary distinction between underwriting and investent incoe. This distinction increases the coplexity of the tax code and increases the possibility that copanies will undertake uneconoic transactions solely to iniize tax liability. - 274 -
Proposal The deduction for contributions to a PAL account would be repealed. Aounts currently held in the account would be included in incoe no later than ratably over a five-year period. Effective Date The proposal would apply to taxable years beginning on or after January I, 1986. Analysis The benefits of the special PAL deduction accrue largely to profitable copanies that do not have underwriting losses and therefore obtain the axiu tax deferral. The special deduction provides little benefit to copanies with periodic underwriting losses. Repeal of the special PAL deduction should have inial ipact on preiu rates. - 275 -
Current Law REPEAL SPECIAL TAX EXEMPTIONS, RATE REDUCTIONS, AND DEDUCTIONS OF SMALL MUTUAL PROPERTY AND CASUALTY INSURANCE COMPANIES General Explanation Chapter 10.12 Nuerous special rules reduce or eliinate the tax liability of certain sall utual property and casualty ( P&C ) insurance copanies. Mutual P&C copanies with taxable investent and underwriting incoe of not ore than $6,000 are exept fro tax; a liitation on the rate of tax on incoe in excess of $6,000 phases out between $6,000 and $12,000. Mutual P&C copanies that during the taxable year receive a gross aount of not ore than $150,000 fro preius and certain investent incoe are also exept fro tax, regardless of the aount of their taxable incoe. Unless they elect to the contrary, copanies that receive a gross aount fro preius and certain investent incoe of ore than $150,000 but not ore than $500,000 are taxed only on their investent incoe (and are not taxed at all if their investent incoe is not ore than $3,000); their underwriting incoe is exept fro tax. A liitation on the rate of tax on the investent incoe of such copanies in excess of $3,000 phases out between $3,000 and $6,000. A further reduction of the rate of tax on the investent incoe of such copanies phases out as the gross aount fro preius and certain investent incoe increases fro $150,000 to $250,000. Finally, utual P&C copanies that receive a gross aount fro preius and certain investent incoe of less than $1,100,000 are allowed a special deduction against their underwriting incoe (if it is subject to tax). The axiu aount of the deduction is $6,000, and the deduction phases out as the gross aount increases fro $500,000 to $1,100,000. Reasons for Change The special tax rules that reduce or eliinate the tax liability of certain sall utual P&C copanies provide copetitive advantages to those copanies vis-a-vis stock copanies and larger utual copanies. The application of these rules requires arbitrary distinctions between underwriting and investent incoe, thereby increasing the coplexity of the tax code. Proposal The special tax exeptions, rate reductions, and deductions of sall utual P&C copanies would be repealed. - 276 -
Effective Date The proposal would be phased in over a five-year period, starting with the first taxable year beginning on or after January 1, 1986. Analysis sall utual P&C copanies would be placed on a par with all other sall corporations. Eliination of preferential rates based on the size of the fir (other than the graduated rates ade available to sall corporations generally) would reduce tax-induced distortions that favor the sale of insurance through sall firs. - 277 -
Current Law LIMIT MUTUAL PROPERTY AND CASUALTY INSURANCE COMPANY DEDUCTION FOR POLICYBOLDER DIVIDENDS General Explanation Chapter 10.13 In general, stock and utual property and casualty ("P&C") insurance copanies are allowed to deduct dividends and siilar distributions paid or declared to policyholders in their capacity as such. These distributions are treated by policyholders as price rebates rather than as taxable distributions. Dividends paid by stock P&C copanies to their shareholders are not deductible by the copany and are includable in the gross incoe of the recipient. In the case of life insurance copanies, the aount of the deduction allowed utual copanies for policyholder dividends is subject to certain liitations. The deductibility constraint stes fro a recognition that policyholder dividends paid by utual copanies are, to soe extent, distributions of the copanies' earnings to policyholders in their capacity as owners of the copany. Consequently, the deduction for policyholder dividends is reduced by an aount deterined to be the owner/policyholder's share of the distributed earnings of the copany. Reasons for Change The different tax treatent of incoe distributed in the for of policyholder dividends by utual P&C copanies and shareholder dividends paid by stock P&C copanies provides a copetitive advantage to utual P&C copanies vis-a-vis stock P&C copanies and other corporations. This copetitive advantage of utual copanies was recognized in the 1984 overhaul of the life insurance copany tax rules, which iposed a liitation on the deductibility of policyholder dividends by utual life insurance copanies. A siilar liitation on the deductibility of utual P&C copany policyholder dividends would reduce the distortion caused by the deduction and by the policyholders' treatent of the dividends as price rebates. Proposal The deduction for policyholder dividends allowed utual P&C copanies would be reduced in a anner siilar to the way in which the deduction for policyholder dividends allowed utual life insurance copanies is reduced under current law. Additional study is needed to deterine the size of the copetitive advantage that the current treatent of policyholder dividends provides to utual P&C copanies and to set the appropriate deduction liitation. - 218 -
Effective Date The proposal would be effective for taxable years beginning on or after January 1, 1986. Analysis The proposal would subject all incoe of utual PLC copanies, including profits distributed to policyholders, to tax at the copany level. Mutual copanies ay distribute a lesser aount of policyholder dividends and charge slightly higher preius as a result of the tax on equity incoe, siilar to the effect of corporate taxes on other copanies. The advantage of utual copanies over stock copanies would be reduced, as would the advantage of utual P&C copanies selling insurance products in copetition with life insurance copanies. - 219 -