“My driving instructor told me never to drive with two feet, strange things can happen when you hit the gas and the brake at the same time.”
In the video below, Reed Nuttall, AAM’s CIO talks about some uncertainties in the marketplace, accompanied by sector commentary by Elizabeth Henderson, Scott Edwards, and Greg Bell.
What Does It Mean for Insurers?
by Jason Simkin, CPA and Peter Wirtala, CFA
Updated December 22, 2017: The speculation, negotiations, and Congressional votes are over, and the tax reform bill has passed. At this writing President Trump has just signed the bill in a private event, concluding a political roller coaster that has made headlines repeatedly throughout the year. So, which provisions made it into the final bill, and which were modified or dropped?
First, as widely expected, corporate tax rates have fallen to a flat 21% rate, bringing them much closer to the average of other developed nations. Individual tax brackets have been significantly readjusted as well, though that is not our focus in this paper. The new rates will go into effect for tax year 2018, as the 1-year delay proposed by the Senate was ultimately rejected.
Secondly, the bill repeals the corporate Alternative Minimum Tax, a feature of the tax law that historically limited the use of tax-exempt municipal bond income for insurers. Existing AMT credits can be used to reduce regular taxable income in future years according to a simple formula. The repeal of the AMT is one of several provisions likely to significantly alter the relative value of tax-exempt municipal bonds for insurers. This will be discussed in more detail below.
Other noteworthy general corporate tax provisions that survived into the final version include:
– Immediate expensing of a large category of business property and fixed capital investments
– Limitation of the deduction for net interest expense to 30% of adjusted taxable income
– NOL carrybacks generated from 2018 onward are no longer permitted for life insurance or noninsurance companies; however, they can be carried forward indefinitely to reduce taxable income up to a limit of 80% taxable income. Property/casualty insurers’ NOL carryback (2 years) and carryforward (20 years) limits remain unchanged in the final bill.
– Significant reductions in deductibility of business meal and entertainment expenses and certain employee fringe benefits.
– Modest reduction in the percentage of dividend income eligible for the Dividends Received Deduction
– Public company executive compensation disallowance has been expanded significantly
In addition to sweeping corporate tax reform, the final bill also has a number of provisions specifically affecting the insurance industry. These include:
For life insurers:
o The small life insurance company deduction (which shields a portion of income from taxation for life insurers below $500 million in assets) is repealed.
o Tax-deductible reserves are set at 92.81% of actuarial reserves
o The policyholders’ share of investment income is set at 30%, and company share at 70%. Previously this required a complicated formula to calculate.
o Capitalization rates on policy acquisition costs are being increased by approximately 20%, and the 120 month amortization period is being extended to 180 months.
o Changes in methods of measuring reserves will be amortized over a time frame consistent with other general changes in accounting methods instead of 10 years.
o Remaining Policyholder Surplus Account deferred tax is accelerated and payable in 8 annual installments.
For P&C insurers:
o The company’s share of tax-exempt investment income declines from 85% to 75%
o A number of changes are made to the computation of tax reserves that are likely to increase taxable income, including:
Using the corporate bond yield curve instead of historical industry payment patterns
Extension of loss payment pattern computations
Repealing the election to use company-specific, rather than industry-wide, historical loss payment patterns
– Though not a specific provision of the new law, the change in corporate rates will require revaluation of deferred tax assets/liabilities, in addition to affecting future development of the interest maintenance reserve and asset valuation reserve. For most insurance companies (small life companies being a notable exception) the revaluation will result in a substantial decrease in the net deferred tax asset/liability reported in surplus.
– For many insurance companies one unexpected consequence could be a further reduction in statutory surplus due to a decrease in the admitted DTA beyond that caused by the rate change. This can occur due to the statutory computation of the admitted asset. While complex and outside of the scope of this memo, generally deferred tax assets may be admitted based on a three-prong computation, one prong of which is a hypothetical carryback to recover taxes paid in the prior year. As mentioned above, the ability to carry back net operating losses is being repealed for life insurers, so their maximum admitted net deferred tax asset will now be limited to the other two prongs of the computation. P&C companies won’t be affected by this issue since they retain NOL carrybacks in the new law.
– Relatedly, for life insurers reporting under GAAP/IFRS accounting, 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.
– Finally, 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 above are the key provisions of interest to US insurers. Companies with significant overseas operations and cross-border affiliate transactions will be affected by the switch to a more territorial tax regime, cash repatriation opportunity, and base erosion minimum taxes, but we omit detailed discussion of these provisions for brevity.
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, whereas life insurers have mostly avoided the sector due to limited ability to benefit from the tax exemption. This latter limitation is changing, as the “company share” of life insurer investment income is now being set at 70% (vs now 75% for P&C insurers), meaning both types of companies will have similar ability to benefit from municipals. However, demand for municipal bonds is typically set at the margin by taxpayers in the highest brackets, who have the most to gain from the exemption.
Under the new law all corporate income is taxed at 21%, but the highest individual rate is 37%. 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 will potentially set market yields on munis at levels that are less attractive to insurers relative to other bond sectors (which are now subject to a much lower tax rate).
To illustrate this effect, it is common for insurers to calculate a “gross-up factor” to compare after-tax yields on tax-exempt bonds vs. after-tax yields on taxable bonds. Under the previous regime, for an insurer paying a 35% tax rate this factor was 1.4577, so a tax-exempt bond yielding a nominal 2.50% and a taxable bond yielding 3.64% produced the same level of after-tax income. Under the new regime this factor will decline to 1.200 (1.186 for life insurers), because while the tax-exempt bond produces the same after-tax yield as before (the change in proration offsets the change in the tax rate), the taxable bond now has a much lower rate than before. To compete with the 3.64% taxable bond, the tax-exempt bond must now yield 3.03%. But yields may not rise that far in practice, since the top rate for individual taxpayers (who comprise the majority of the market) isn’t moving much, so their supply/demand calculus may not change much.
For this reason, we expect the new law may lead to a gradual decline in tax-exempt municipal holdings by insurers, though this will partly depend on how the market ultimately adjusts in practice. Partly offsetting this potential is that, to the extent insurers continue to hold munis, life insurers may find this sector now makes sense in their portfolios where previously it did not. It’s also worth mentioning that the proposed limit on deductibility of interest expense could impact the supply of corporate bond issuance in certain sectors, which would in turn affect supply and demand across other bond sectors. This possibility will bear close attention as we move into 2018.
After months of speculation and uncertainty the saga of the tax reform of 2017 has drawn to a close, and insurers can now evaluate the impact of the law on their tax planning strategies, deferred tax assets/liabilities, and investment portfolios.
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
AAM continues to monitor important regulatory changes affecting the insurance industry. Below we summarize some recent developments of interest:
P&C: After several years of profitable underwriting, the P&C industry produced an underwriting loss in 2017 with the re-emergence of catastrophe losses, decline in favorable reserve developments, and increased pricing competition (especially in commercial lines). Investment income declined slightly amidst continued low market rates, though strong stock market returns continue to help support the bottom line as the industry’s exposure to unaffiliated common stock as a % of surplus set a new long-term high at over 37%. Meanwhile total surplus grew at a respectable 2.6%, reversing the small decline in 2015 and maintaining the surplus/assets ratio at the 38% level where it has hovered for several years running. Looking ahead to 2017, significant developments are likely to include: the Fed’s program of increasing interest rates, growing interest in cybersecurity and terrorism-related insurance products, the potential for self-driving car technology to impact the commercial auto insurance market, and the ongoing deployment of personal and commercial drones and related growth opportunities.
Life/Annuity: The life insurance industry enjoyed healthy profitability in 2016, posting a 10.6% return on surplus, slightly below the last couple years but well above the single-digit gains posted following the 2008 financial crisis. A main driver of the generally strong profitability remains the gradual run-off of unprofitable “legacy” blocks of business, though in 2016 this effect led to a modest decline in total life and annuity premiums. The industry’s average bond yield slide from 4.72 to 4.65 during the year, though the prospect of multiple Fed rate hikes in 2017 could suggest that we are nearing the bottom on this front (knock on wood). Unfortunately, even with improved reinvestment rates available it will likely take a number of years to meaningfully increase the industry’s average bond returns, due to the prevalence of long-dated maturities held by life insurers. Looking at other investment trends we continue to see a modestly increased allocation to credit and liquidity risk as a means of boosting returns (including growing exposure to floating-rate CLO securities), though insurers also seem to remain wary of “reaching for yield” with the impairments of 2008/09 still fresh in mind. As ever, the direction of interest rates will be the most important driver of 2017 returns, along with the demographic impacts of an aging population, the challenges of marketing to tech-savvy Millennials as their need for life insurance products grows, and the deployment of improved technologies to increase efficiencies in underwriting, marketing, and distribution.
In recent years many Florida homeowners’ insurers have seen their underwriting results negatively impacted by the rise of “assignment of benefits” (AOB) lawsuits and claims. This specifically refers to cases where insureds who have experienced non-weather-related water damage assign their legal standing to receive a claims payment to the contractor performing repair/remediation work (or their representatives). Insurers contend that vendors use these cases to inflate the cost of repairing the water damage, frequently neglecting to report the claim until the repairs are already complete. In any case state residual insurer Citizens Property has pointed out that these cases have necessitated >10% premium increases for multiple consecutive years in certain regions, despite minimal storm activity. The issue has also discouraged private insurers from moving into affected regions (primarily Broward, Palm Beach, and Miami-Dade counties), further straining the existing insurance markets there.
Attempts at legislative relief in the 2016 state legislature session hit a dead end, so insurers are now seeking administrative solutions in conjunction with the state’s Office of Insurance Regulation, including premium incentives for insureds who use vetted contractors for repair work. Whether these measures will be approved, or will be effective in curbing AOB losses, remains to be seen. In the mean time 11 Florida insurers have received outside capital contributions to shore up their balance sheets in the face of AOB costs, per a recent report by S&P Global Market Intelligence. Ratings agency Demotech has been discussing this issue with many affected companies during ratings reviews, and has warned that AOB-driven surplus deterioration could lead to downgrades in the absence of clear mitigation strategies. Unfortunately, despite last year’s hopes of a decisive resolution to the AOB problem, it now looks likely to remain a live issue for the foreseeable future.
A tax reform bill will likely be undertaken by Congress in the very near term, though much uncertainty around the details and prospects for passage remain. We won’t recap the recent flurry of rhetoric and speculation on the issue, except to observe that a general reduction in corporate rates, concurrent with the elimination of various deductions, is still seen as one of the most probable outcomes of any eventual bill. Some measure to penalize companies for manufacturing goods abroad and shipping them into the US is also likely to be included. However, the divisions within the House evidenced during the recent attempt to pass health insurance reform legislation may presage a tough road to passage for any major tax reform bill.
This topic was discussed in NAIC Investment RBC Working Group conference calls in February and March. Discussion points included proposed modifications to the asset concentration adjustment piece of the RBC formula, the possibility of modifying the proposed bond RBC factors to incorporate the findings of the ACLI’s study from late last year, and the emerging consensus that P&C and Health insurers will also have the granularity of their bond RBC factors increased. In part because of this last point, the working group is now targeting year-end 2018 for financial statement implementation of these changes. We expect further updates on this topic at the Spring NAIC meeting in April.
Written by:
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
