Insurance companies went into the tax reform process hoping to emerge winners, or at least to avoid being big losers. Like most businesses, they stood to benefit significantly from Congress’ planned reductions to the corporate tax rate. However, the money to pay for the rate cut needed to come from somewhere, and the industry, which benefits from special tax rules for both insurance companies and their customers, had been flagged as a target in prior reform proposals. The Tax Cuts and Jobs Act (TCJA) dramatically lowered the headline corporate tax rate, but it also included revenue-raising changes to a number of insurance-specific tax rules and targeted certain non-US insurance companies and cross-border transactions. Weighing the good and the bad, insurance companies generally have reported the effect of the TCJA as a net plus. However, not all taxpayers were affected equally, and parties evaluating a transaction in the insurance space should carefully consider the impact of the various changes on an insurance company’s particular tax profile.
The reduction of the corporate tax rate from 35% to 21% and elimination of the corporate alternative minimum tax generally will improve after-tax earnings of domestic insurers. Although it is difficult to complain about a rate cut, the reduction does carry negative knock-on effects for some taxpayers. First, the lower rate creates a one-time haircut to the value of deferred tax assets. This reduces valuations and, if the diminished tax asset was being used to satisfy regulatory balance sheet requirements, could require the insurer to obtain more expensive financing to replace the asset. On the other hand, the rate change also reduced deferred tax liabilities, and many insurers have reported large GAAP financial statement benefits. Second, the National Association of Insurance Commissioners is implementing changes to the “risk-based capital” (RBC) formula to reflect the lower corporate tax rate. RBC is a key measure of an insurance company’s required capital cushion and currently uses a fixed 35% rate to estimate the offsetting tax impact of the incurrence of a particular risk. Changing these rules to move to the 21% rate could adversely affect RBC levels. To the extent that RBC levels are reduced across the industry as a result of the change, it is unclear whether the market will accept a lower baseline ratio or require insurers to maintain more capital. Perhaps most importantly, it also is not clear whether the market ultimately will require some or all of the rate benefit to be passed onto policyholders in the form of more favorable pricing for new policies. For existing business, the benefit generally should stay with the insurance company.
US insurance companies operate under a special tax regime that takes into account the particular character of the industry. For example, life insurance companies may deduct increases to their reserves supporting future claim payouts, whereas a typical corporation would not have a deduction until the underlying liability becomes fixed. The TCJA made numerous technical changes to the special rules that apply to insurance companies, reflecting a view that the prior tax regime was overly generous. Even with the changes, many insurers are reporting expected effective tax rates that are lower than the 21% headline rate, preserving their advantage. However, each company’s sensitivity to the impact of each change will depend on its business and history.
NOLS. Life insurers can no longer carry back net operating losses (NOLs) and can use NOLs to offset only 80% of income, placing them under the same rules that currently apply to other corporations. These changes tend to reduce the value of NOLs, which are tax assets. In particular, the loss of carryback potential makes it more difficult to use NOLs to satisfy regulatory capital requirements, as NOLs are less likely to be monetized in the short term. Property and casualty (P&C) companies successfully argued that carrybacks were essential given the volatility of catastrophe and other types of insurance they write. As a result, P&C companies can still carry NOLs back two years and forward 20 years, as under prior law.
Reserves. Life insurers’ deduction for increases to reserves associated with their insurance contracts is fixed at 92.81% of the statutory reserve under the TCJA. This generally will lower deductions as compared with the prior approach, causing a timing tax cost that is reversed as the reserve runs off. The effect may be particularly significant for lines of business that operate with high reserves and thin profit margins. To mitigate the effects of this change, a phase-in provision applies to existing reserves over 8 years. P&C companies will also make some tax payments sooner than under prior law as a result of changes to their deductions for unpaid losses.
DAC. Changes to the tax deferred acquisition cost (DAC) rules will also accelerate tax payments by companies that write or reinsure life, annuity and certain accident and health policies, by increasing the tax DAC rates and increasing the amortization period from 10 to 15 years.
Dividends Received Deduction. Tax reform simplified the tax rules for life insurance companies’ investment income. Their dividends received deduction (DRD) is now set at 70% of investment income from dividends, replacing complex “proration” rules that disallowed a portion of the deduction. This change may be helpful or harmful for a given life insurance company, depending on how the prior rules played out for it. The 70% approach generally is seen as a positive for the industry; prior to the enactment of the TCJA, some conservative buyers evaluating M&A deals had modeled total loss of the deduction. Relatedly, rules that prorate a portion of P&C companies’ deductions for tax-exempt interest, DRD and cash value of insurance were tightened, partially offsetting the benefit of the rate reduction. Unlike the changes to the reserve and DAC rules, these changes create a permanent difference in tax liability.
Base Erosion. The Base Erosion and Anti-abuse Tax (BEAT) limits the ability of US companies to reduce taxable income through deductible payments to offshore affiliates. The BEAT rules specifically target premiums paid to non-US reinsurers. Many groups with cross-border reinsurance transactions have restructured operations to mitigate the BEAT. One option is for the US insurer to seek to recapture business reinsured offshore. Another is to have the affiliated reinsurer elect to be taxed as a US company (a so-called “953(d) election”), which turns off the BEAT but also takes away any US tax benefit associated with the reinsurance. Buyers should diligence what measures are being taken by insurers, particularly those which previously utilized quota share treaties to reinsure significant amounts of US business offshore, and understand the projected effect on effective tax rates.
CFC/GILTI. Tax reform significantly increased the potential for income derived by foreign subsidiaries to be currently included in US owners’ income, both by expanding the existing controlled foreign corporation (CFC) rules and by adding the new “global intangible low-taxed income” (GILTI) regime. (See GILTI by Association: Tax Reform in the International Arena on page [_] for a more detailed discussion.) Voting cutbacks, which are commonly employed in the non-US insurance space, no longer work to prevent CFC inclusions because the CFC rules now apply to US shareholders that own 10% or more of a foreign company by vote or by value (previously only voting power was tested). In addition, insurers who relied on the “same country” exception to the CFC income rules for local business must now treat that business as generating GILTI, even if highly taxed. In general, virtually all of the income of a non-US insurance business (including asset management activities) will be taxed currently to a US 10% shareholder under either the old CFC “subpart F” rules or the new GILTI rules, although lower rates apply to GILTI.
PFICs. Tax reform has made it harder to meet the exemption from classification as a “passive foreign investment company” (PFIC) for active insurance companies, increasing the risk of adverse tax treatment for US owners (including carried interest recipients). To qualify, insurance companies must now carry specified insurance liabilities (loss and loss adjustment expenses and certain life and health reserves) that are in excess of 25% of balance sheet assets. Unearned premiums are not counted toward the liability test, potentially harming even active P&C companies that write volatile business such as catastrophe insurance. While targeted at so-called “Hedge Fund Re” structures where an alternative asset manager forms an insurance company in order to manage its investment assets, the application of the new rule is uncertain, and many companies are still evaluating whether they expect to constitute a PFIC in 2018. A private equity sponsor considering an acquisition of a non-US insurer should scrutinize its side letter obligations with respect to PFICs, which may require requesting information that the company is unwilling to provide.