Professional Insight

Tax Reform Creates New Challenges for Actuaries

The passing of tax reform in the U.S. late last year set off a scramble as corporations, including property-casualty insurers, had to adjust their tax calculations at year-end. Now companies have begun planning how to hone their business models in response to the changes, a trio of tax experts said at a session of the Casualty Actuarial Society Spring Meeting in Boston.

A $1.5 trillion tax cut was the most prominent feature of the reform, which cut the corporate tax rate to 21 percent from 35 percent.

The new law makes the U.S. statutory tax rate closer to the average of most nations reporting to the Organization for Economic Cooperation and Development (OECD). The U.S. corporate rate (federal and state combined) fell to 25.75 percent, just above the 23.75 percent average of other OECD countries. Before reform, the rate had been 38.9 percent.

But the reform was complex. A number of reforms increased taxes. The issue is important for actuaries, who are often close to the financial calculations that determine how much an insurer pays. Actuaries also include estimates of income taxes in ratemaking, so the changes directly affect that work.

The law passed so quickly, said Kevin Johnston of PricewaterhouseCoopers, that most companies had to “race to get to year-end financials.” Only by spring did companies have a chance to consider how to retool operations to respond to the reforms, he said.

“I think companies are really starting to think more strategically,” he said. “You’re starting to see companies address operations more.”

The impact of the law varies by the type of insurer. U.S. multinational insurers benefit, as do most domestic insurers, though circumstances vary. Foreign multinationals, though, are likely to see increased costs.

While the overall rate fell, the law also includes a new minimum tax, the Base Erosion and Anti-Abuse Tax, or BEAT. That tax is designed to discourage the movement of profits out of the United States to avoid the U.S. income tax.

The BEAT would likely apply to companies that cede reinsurance to an offshore affiliate, said Lynne Bloom, FCAS, a director at PricewaterhouseCoopers in Philadelphia. In 2006, $48 billion, or 35 percent of all ceded premium by U.S. domiciled companies, was ceded to offshore affiliated insurance companies. Beginning in 2018, such premiums may be subject to the tax, she said.

The way the law was written, Johnston saimovd, magnifies its effect on insurers. The tax is applied to the premium ceded rather than underwriting profit.

Actuaries could likely become involved in strategic work around a company’s internal reinsurance policies to minimize the BEAT’s impact, with one such potential option being moving away from quota share reinsurance, in which a company cedes a set proportion of premium and losses.

To lower their tax bill, Bloom said, ceding companies could replace the quota share with a stop-loss treaty, in which the reinsurer becomes responsible for losses when the program’s loss ratio hits a certain level. Stop-loss treaties can provide downside risk protection, and thus capital relief, while ceding significantly less premium, thereby reducing the amount subject to the BEAT. It should be noted, however, that tax reduction is not the sole purpose for internal reinsurance cessions, as companies use offshore affiliates for capital purposes as well.

Another change that could affect actuaries concerns the discounting of loss reserves. Insurance companies pay taxes based on discounted loss reserves, and the new law makes several changes to the discounting procedure, said Ian Sterling, FCAS, a senior actuarial advisor for EY in Philadelphia.

In the past, companies could elect to utilize a payment pattern from their own historical data or use one provided by the IRS. Now they must use the IRS-provided pattern, which is based on industry aggregate data.

The payment pattern that used to be limited to 15 years will move to 24 years and will affect only certain lines of business.

Finally, the interest rate will be higher, as the rates had been based on federal midterm rates but will now be based on high-quality bonds.

The net effect of the discounting changes will likely increase insurers’ taxable income. Insurers writing long-tail lines, like workers’ compensation or products liability, will be affected the most.

Other changes extending beyond the U.S. will have an impact.

Generally in the past, every dollar of income that a U.S. company made anywhere in the world was subject to income tax. Now only the income made in the U.S. is subject to tax. This left more than $2 trillion overseas, according to Fortune magazine, waiting for a tax break to move it to the U.S.

The new tax law considers all that money to be repatriated, and companies have eight years to pay the taxes on it. The change affects multinationals based in the United States.

“For U.S. multinationals, this is a big, big deal,” Johnston said.

The law adds a tax on global intangible low-taxed income, known as GILTI, for U.S. shareholders of controlled foreign corporations. It’s a “big deal” for financial services companies because, Johnston said, “this tax will hit you harder if you have limited tangible assets outside the United States.”

Proration of tax-free securities changed in offsetting ways, to no net effect. Insurers, major buyers of tax-free municipal bonds, actually paid tax on 15 percent of tax-free bond income under the old law. With the corporate rate falling to 21 percent, the taxable portion of tax-free securities rose to 25 percent. The two changes offset so the effective tax rate on tax-free securities remains 5.25 percent.

There are also new rules for life insurers and other corporations regarding the application of net operating losses in one year to offset profits in other years. Starting this year, those entities cannot use new losses generated to offset more than 80 percent of income in any given year, but those losses can be carried forward indefinitely for use in future years. However, they can’t be carried back to offset income in prior years.

Non-life insurers, though, still have their old rules, and are able to offset going back two years and going forward 20 with no limitation.

This creates a fair amount of uncertainty for insurers that have both life and non-life operations, Johnston said. The IRS will eventually provide guidance, he said, but it doesn’t seem to be a high priority.

Though the impact varies by type of insurer, Sterling said some common themes were emerging.

In pricing, there is a perception among some U.S.-based insurers that the BEAT may level the playing field by removing the tax advantage that some believed companies with foreign affiliates enjoyed. Some of the tax benefit is likely to be passed to policyholders through lower rates. A few regulators are checking specifically on that point.

In addition to policyholders, company personnel may stand to benefit, perhaps through increased wages, benefits or training. Companies may also be likely to invest in technology infrastructure to enhance operations.

Yet another common theme is that reinsurers subject to the BEAT are revisiting their reinsurance strategy. They are looking at the aforementioned stop-loss treaties, organizing an offshore entity that pays U.S. tax, or even canceling treaties with offshore affiliated entities.

“It will take a couple of years for this to shake out,” Sterling said.

James P. Lynch, FCAS, is chief actuary and director of research for the Insurance Information Institute. He serves on the CAS Board of Directors.