April 3, 2018
Operational Impacts of the 2017 Tax Cuts
by Mark Smith and Chris Joline
The tax law will have wide-ranging impacts on insurers’ business, including corporate structure, regulatory capital and products.
The Dec. 22, 2017, Tax Cuts and Jobs Act is the most sweeping piece of U.S. tax legislation in more than 30 years. It will have wide-ranging impacts on insurers’ business, including corporate structure, regulatory capital and products.
We describe in detail elsewhere the act’s technical details and will continue to address what insurers need to do to comply with this new legislation as its implications become clearer. On a broader level, and as we describe below, the act has clear operational impacts that go far beyond compliance.
The reduced corporate tax rate benefits most insurers but leads to long-term strategic questions
The GOP-sponsored tax reform slashes the corporate tax rate from the headline 35% rate to 21%, bringing the U.S. rate closer to the median when compared with other industrialized nations within the Organization for Economic Cooperation and Development (OECD). A 21% rate on taxable income will increase after-tax profit margins for legacy businesses and capital investment scenario planning considerations.
For the life and P&C industries, this should boost margins on legacy books of business and increase premium revenue if job and economic growth prospects materialize as the act’s sponsors claim. In the near term, insurance companies are focusing on financial statement management considerations, such as how to adjust deferred tax assets and liabilities, required changes to loss reserving methodologies and computations of taxable income and reporting any untaxed foreign earnings and profits for the 2017 year-end statement as part of the repatriation “toll tax.”
However, insurers shouldn’t ignore longer-term considerations related to scenario and strategic planning in response to the rate cut. The corporate tax rate reduction should motivate insurers to consider how to deploy additional after-tax capital. Scenario
planning should first evaluate the overall net impact of tax reform changes and quantify the amount of capital that could be retained by balancing the lower corporate rate against a tightening of deductions and the changes to taxable income computations. Modeling potential implications starting in 2018 and then forecasting mid-term planning and longer-term strategic
initiatives can provide management different views to assess the implications of redeploying additional capital.
With more expected income to deploy, companies should consider the investments they can make to support operations, growth and productivity. Examples include enhancing IT infrastructure, investing in new product lines or capabilities, pursuing opportunities to expand brand presence through acquisition and providing more free cash flow to policyholders and shareholders.
U.S.-based insurers may be more globally competitive
The sponsors of the Tax Cuts and Jobs Act claim it will make the U.S. tax system more attractive on a global scale. The shift to a territorial tax system, complemented by the reduction in the tax rate on non-U.S. profits, is likely to help at least some U.S.-based insurers be more globally competitive. The previous U.S. tax system put U.S.-parented insurers at a tax liability disadvantage compared with foreign-parented firms because all non-U.S. income was taxed at the higher domestic corporate rate. Going forward, foreign subsidiaries of a U.S. company no longer must pay a 35% U.S. rate, which previously may have deterred companies from expanding outside the U.S. or repatriating earnings.
Because U.S. parent companies are no longer taxed on worldwide income, the M&A market could see an uptick with more incentives-based buyers because of the deduction for affiliated inbound transactions from foreign subsidiaries. In effect, global insurers may be more inclined to consider U.S. inbound investment to seek a lower tax domicile. Moreover, with the discontinuance of a higher U.S. tax on all foreign profits, U.S. outbound expansion also could become more common.
The base erosion and anti-abuse tax applies to select offshore tax practices
In alignment with the territorial tax system theme, the act includes a base erosion and anti-abuse tax (BEAT) that imposes a new tax on certain base erosion payments made by a U.S. taxpayer to a foreign affiliate. A minimum tax of 10% (5% in 2018) will be assessed when base erosion payments exceed a modified taxable income amount. The legislation explicitly mentions reinsurance payments as a base erosion payment, and thus is likely to significantly affect reinsurance arrangements between U.S.-domiciled entities and affiliated entities located outside of the U.S., such as in Bermuda and the Cayman Islands.
The classification of reinsurance payments as “base erosion payments” will cause companies to take a look at affiliated reinsurance arrangements in offshore jurisdictions in 2018 and 2019. Companies that use offshore affiliate transactions to manage capital will need to reassess their costs and benefits. The BEAT minimum tax likely will motivate ceding companies to reconsider quota shares with affiliates altogether, reinsure with offshore third party reinsurers instead of affiliated captive reinsurance arrangements, retain or reallocate more risk to the U.S. or elect to be taxed as a U.S. corporation.
Critics of the BEAT claim it’s a form of double taxation on non-U.S. insurance and reinsurance companies; domestic U.S. insurers seem to favor the provision, because it will discourage offshoring of profits by non-U.S. companies to tax havens. Regulatory and industry efforts have been beginning to push for changes in this direction, but now the legislative tax impact, which took effect beginning Jan. 1, 2018, creates an immediate deadline and thus a sense of urgency to review existing arrangements to assess for options to manage BEAT liability and reporting requirements in later years.
Certain business tax reform changes will affect insurers’ corporate taxes, financing and investment portfolios, namely (i) the repeal of the Alternative Minimum Tax (AMT), (ii) the reduction of the corporate tax rate, (iii) new limiting net interest deductions and (iv) modifications to net operating loss deductions. Insurers expect longer-term after-tax income relief with a lower corporate rate and a repeal of corporate AMT. But, in the near term, they must evaluate what adjustments are necessary in the form of write-downs to deferred tax assets and how the changes to net interest and net operating loss deduction amounts may affect future financial statements.
For example, some finance and accounting functions need to consider future business interest deductions, as the lower overall amount available to deduct could modify intragroup financing strategies for U.S. multinationals, such as intragroup loans by the parent to provide capital to U.S. subsidiaries and shifting debt from highly leveraged U.S. subsidiaries to non-U.S. jurisdictions.
We expect that the reduction in the corporate rate will offset the increase in taxable income, but the changes to specific insurance provisions will have an impact on longer-term financial statements and ultimately how regulators and rating agencies perceive a company’s financial strength. To better understand the scale of beneficial or adverse effects, companies will need to analyze and project the net effect of expected writedowns and limitations to deductions against the expected after-tax income relief from the reduced corporate rate and use of AMT refund credits. Through these exercises, corporate finance, tax and accounting functions can guide business leaders to help inform business strategy by demonstrating the potential benefits of lower corporate taxes against potential negative effects of tightening limitations on previous deductions.
Product pricing will be an area of focus in 2018
We expect product pricing will be an industry focus because the lower corporate tax rate must be balanced against modified provisions that limit deductions and increase taxable income. Higher U.S. corporate tax rates had previously always been a factor in new product pricing for both life and P&C products, and the new reduction in the corporate rate will offer more margin flexibility.
Finance and product leads will have to consider impact on product pricing of not just the new lower corporate tax rate but also an increased deferred acquisition cost (DAC) tax capitalization percentage, as well as changes to tax reserving. In addition, the new minimum tax on reinsurance payments to offshore affiliates will cause companies to examine their capital management strategies and determine if the tax leads them to increase prices to address increased capital pressure.
Given the higher commoditized and shorter-term nature of personal products, price competition is likely to occur sooner than in life, and any decline would subdue some of the bottom line benefits from the lower corporate tax rate. Overall commercial prices probably will continue to result in positive underwriting and favorable returns, but the total benefits will be more favorable for domestic insurers than cross-border ones.
Life companies will have to balance the effect of the lower corporate rate on premium pricing with tax reserving changes, principle-based reserving adoption and other state regulatory initiatives.
- With more expected income to deploy, companies should consider the investments they can make to support operations, growth and productivity. This could include enhancing IT infrastructure, investing in new product lines or capabilities, pursuing opportunities to expand brand presence through acquisition and providing more free cash flow to policyholders and shareholders.
- Because U.S. parent companies are no longer taxed on worldwide income, the M&A market could see an uptick.
- BEAT is likely to significantly affect reinsurance arrangements between U.S.-domiciled entities and affiliated entities located outside of the U.S.
- Changes to specific insurance provisions will have an impact on longer-term financial statements and ultimately how regulators and rating agencies perceive a company’s financial strength.
- Finance and product leads will have to consider the impact on product pricing of a lower corporate tax rate, an increased DAC tax capitalization percentage and changes to tax reserving.
This article was written by Mark Smith, Chris Joline, David Schenck, Tom Swoboda and Ed Hirsh.
You can find the report here.