Tax Reform: Effects on Insurance Industry?

“The smart money bets against tax reform — always and everywhere. But every once in a while — usually a long while — the smart money is wrong.” –Joseph Thorndike, noted tax scholar. On Nov. 2, the House Ways and Means Committee released the “Tax Cuts and Jobs Act,” a major overhaul of the U.S. tax system. The proposal is a significant step forward in a years-long effort to reform our nation’s outdated tax code. While the House legislation is only the beginning of the proverbial “sausage-making” process, it is important to understand the bill’s effect on the insurance industry, because (1) the effect is significant; and (2) the chances of tax reform actually happening are as high as they’ve been in many years. Summary Tax reform is always an exercise in trade-offs, and this time is no different. At a high level, the House proposal would lower the maximum corporate tax rate to 20% and move the U.S. to a territorial tax system. Pass-through entities such as partnerships would be subject to a maximum tax rate of 25%. While the most significant provisions in the bill apply to businesses, the proposal also consolidates the seven tax brackets for individuals down to four, maintains the highest individual rate of 39.6%, doubles the standard deduction and curtails popular individual deductions such as the state and local tax deduction and the mortgage interest deduction. As with every previous tax reform proposal, the House legislation creates, or is perceived to create, winners and losers. At the highest level, the legislation poses a trade-off between lower corporate tax rates and a more globally competitive tax regime for U.S. businesses and the elimination or reduction of popular tax breaks on both the individual and the corporate side. The House bill costs $1.5 trillion in foregone revenue over 10 years. This is likely the outer limit of the deficit spending to fund tax reform. In other words, the need to identify “pay-for” provisions that increase taxes on one group to pay for cuts in another area will only grow as the bill moves through the legislative process. As detailed below, the tax bill raises almost $40 billion in revenue from the insurance industry via changes to its corporate tax treatment. This basic approach is not likely to change significantly during the legislation process. Insurance CEOs considering whether to support this effort will ultimately need to answer the question of whether a 20% corporate rate and territorial tax system is worth the trade-off in terms of changes to key insurance corporate tax provisions. Life Insurance The current tax treatment of insurance companies reflects their unique business model and state regulatory regime. Perhaps owing to the complexity of life insurance product and corporate taxation, life insurers have sometimes been subject to a misperception of being too lightly taxed. The current House proposal arguably reflects that perception. On balance, life insurers (and insurers in general) were affected to a larger degree than other sectors through negative changes to their corporate tax treatment. In fact, with the exception of a single provision hitting banks' deductions of their FDIC premiums, insurers were the only segment of the financial services industry specifically singled out via pay-fors to finance the proposal’s tax reductions. To provide a glass-half-full perspective, prior tax reform proposals included negative changes to certain life insurance and retirement products. In a win for the life insurance industry, the current House legislation does not reflect those prior proposals and makes no change to inside buildup, the tax treatment of corporate-owned life insurance or the tax treatment of retirement plans and products. Having said that, the corporate tax changes specifically targeting life insurers raise significant revenue (almost $25 billion in total) and bear close watching. See also: Why Fairness Matters in Federal Reforms   Most notably, the House bill would clip the life insurance reserve deduction by requiring that life insurers take into account a prescribed percentage of the increase or decrease in reserves for future un-accrued claims when calculating taxable income. This provision alone is estimated to increase the taxes life insurers would pay by $14.9 billion over 10 years. In fact, this estimate may dramatically understate the true effect of this provision on the industry. In a provision that raises $7 billion, the bill would change the expensing rules for life insurance policy acquisition costs. The bill would also restrict the timing of when reserve increases or decreases are taken into account and would limit the dividends-received deduction by prescribing a flat 40 % company share. The proposal would change the net operating loss rules to restrict the number of years that life insurers’ losses can be carried back (from three to two) and forward (from 20 to 15). The legislation would also repeal the special tax rules for distributions to shareholders from pre-1984 policyholder surplus accounts. Congressional revenue estimators believe that these life insurance company taxation provisions would raise more than $24 billion in additional tax revenue over 10 years, and, as noted above, the reserve deduction restriction alone would raise $14.9 billion, and the expensing rule change would raise $7 billion. This revenue estimate, while inherently inexact, indicates the magnitude of the effect on the industry. Property and Casualty The draft legislation also targets property and casualty corporate tax. The proposal modifies the discounting rules for P/C companies, reducing the tax value of unpaid losses. It also restricts the reserve deduction by modifying proration rules. The change to discounting rules alone raises $13.2 billion over 10 years, and, in total, the P/C corporate tax changes raise over $15 billion in the budget window. All in all, the corporate tax changes specific to insurers would raise almost $40 billion. It’s clear that insurance has been identified broadly as a source of pay-fors to fund tax reductions in other parts of the overall package. International Provisions Much of the animus behind the tax reform proposal lies in the drive to make the U.S. tax system more globally competitive. While all multinational insurers would be affected by the bill’s international tax provisions, two provisions in particular would specifically affect insurers and reinsurers. First, the bill would impose a 20% excise tax on U.S. domestic corporation payments to foreign affiliates. Importantly, the purchase of reinsurance by U.S. insurers from foreign reinsurance affiliates would be subject to this tax, which is being interpreted as partly a shot across the bow at offshore reinsurers. In addition to the 20% excise tax, the House bill would restrict the insurance business exception to the passive foreign investment company (“PFIC”) rules. The PFIC exception would apply only if the foreign corporation would be taxed as an insurance company were it a U.S. corporation and if certain other company-specific conditions were met. The 20% excise tax provision raises a whopping $154.5 billion over 10 years, and while it’s being discussed a great deal in the reinsurance world, it is not specific to reinsurance transactions and would have significant implications for many non-insurance multinational corporations. The PFIC provision, which obviously is specific to insurance, raises a much more modest $1.1 billion in the budget window. Lastly, multinational insurance companies should watch the “deemed repatriation” provision, which would subject foreign earnings to a one-time U.S. tax. Prognosis As this legislation winds its way through the House and the Senate, we can expect some changes as a result of the inevitable onslaught of lobbying and strong policymaker preferences. However, the basic approach this bill takes to reform is not likely to change. In terms of timing, the House, with its comfortable Republican majority, is likely to pass some version of the current bill this year with fairly modest changes during committee consideration but likely no amendments permitted during the full House vote. In other words, there is a very narrow window (weeks, not months) to change the provisions in the House bill before it gets voted out of committee, passed by the full House and kicked over to the Senate. See also: Outlook for Taxation in Insurance   The prognosis in the Senate is murkier, because even under the expedited 51-vote process Republicans will use pass tax reform, the GOP can only afford to lose two votes. To get there, leadership has to satisfy divergent voices within the party in what is almost a Goldilocks (“not too hot, not too cold”) exercise. Any “just right” legislation, to garner 51 votes, must placate deficit hawks (McCain, Corker, Flake), moderates (Susan Collins, Lisa Murkowski) and staunch conservatives (Mike Lee, Tom Cotton, Ted Cruz) — not a group that typically treads on common ground in tax reform. Another wild card to watch is Roy Moore, who won the Republican primary for the special election in Alabama to replace Sen. Jeff Sessions. Moore is widely expected to win the December 12 election and, once elected, will be the most far-right member of the Senate and a true wild card vote in tax reform. To sum it up, the path is clear, but the margins are slim. Most insiders believe that the legislation must pass both chambers by June of next year — at the latest — lest the effort collapse under its own weight. So, the billion-dollar question: Will it happen? Prognosticating about tax reform prospects has long been a favorite parlor game in Washington, and, as Joseph Thorndike said, smart money almost always bets against it. This time, it’s a close call, but the desire among Republicans to get tax reform done is at a near all-time-high, particularly after the failure of health care reform. My money (smart or not) is on the passage of a tax bill — with significant reform elements. In short, insurers should watch this space.