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Operational Impacts of the 2017 Tax Cuts

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.

See also: Tax Reform: Effects on Insurance Industry?  

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.

See also: U.S. Insurance Deals: Insights on 2H 2017  

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.

Implications

  • 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.

A Caribbean Hospital: Healthcare’s Solution?

Health City Cayman Islands (HCCI) is a three-year-old, 104-bed Caribbean hospital outpost of the Bangalore, India-based Narayana Health System. Just an hour’s flight from Miami, its island location is comfortably familiar to Americans, is English-speaking and is modern.

Specializing in complicated or severe conditions, HCCI has developed care and business models that are so focused on quality and efficiency that it could radically change the standards by which U.S. hospitals are judged. Most importantly for patients and employers, it provides very high quality care — it has been awarded the coveted Joint Commission International (JCI) quality credential at one-half to one-sixth of U.S. pricing.

HCCI’s performance is the culmination of a deep commitment to access, efficiency and excellence. Narayana Health’s (NH) founder, Dr. Devi Shetty, who, earlier in his career was Mother Teresa’s personal physician, began with the mission-driven awareness that healthcare is an essential need that must be affordable to be accessible. He spearheaded an enterprise-wide focus on process optimization to deliver the best care possible at the lowest possible price.

The results have been remarkable. Fifteen years ago, NH’s bundled costs for open heart surgery in India averaged about $2,000. Now, they are about $1,400, or about 1% of the average U.S. costs.

The costs at the Caribbean hospital are higher, but they are still low compared with U.S. standards. A coronary artery bypass graft that typically costs about $151,000 in the U.S. is $32,000 at the Caribbean hospital. Heart valve replacements, about $174,000 here, are $31,000. Hepatitis C treatments, which run about $75,000 here, are $19,000. Knee replacements, which cost $60,000 here, are $16,000.

See also: A Hospital That Leads World on Transparency  

A relentless willingness to rethink

HCCI’s capacity to consistently deliver low costs and high-quality outcomes is rooted in a relentless willingness to rethink and execute better, more pragmatic approaches. Hospital common spaces — atriums and open areas — are smaller than we’ve come to expect in U.S. hospitals, significantly reducing overhead. Each patient room has its own heating and air conditioning unit and ducting, isolating the room’s air flow, which dramatically reduces infection. Operating rooms are connected to the laboratory by pneumatic tubes, so surgeons can get immediate information about patient specimens. Equipment, supplies and drugs are purchased in Europe or India at a fraction of U.S. prices. Rather than receive a bewildering array of bills, HCCI uses bundled, all-inclusive pricing that is so simplified that its billing department needs only three people. Every aspect of hospital function and care process is open to re-examination, which facilitates lots of minor (and sometimes major) improvements. Just after HCCI’s gala opening in April 2014, Robert Pearl MD, the CEO of the 19,000 physician Permanente Medical Group, wrote in Forbes: “Based on everything I saw in the Cayman Islands, the operational approaches in Dr. Shetty’s hospital are about 10 years ahead of those used in the typical U.S. hospital.”

HCCI’s health outcomes and pricing represent an opportunity for self-insured employers and unions — as well as for self-pay patients — to get genuinely superior care at far more affordable rates. While getting employers to consider sending patients outside U.S. borders for care has been a challenge, the trickle of those who have become convinced that the quality is strong enough to merit their consideration is growing rapidly.

Imagine how local and state governments, financially strapped by excessive healthcare costs, could benefit from a higher value resource such as this. Florida’s Medicaid program, for example, has some 20,000 patients with Hepatitis C. Even with a discounted U.S. rate of, say, $54,000 each, HCCI’s bundled rate of $19,000 — a difference of $35,000 per patient — could save the state about $700 million, funds that surely could be used more productively.

It is important to acknowledge that there are U.S. hospitals that have achieved superb quality or very notable cost streamlining. But rarely do we see a single-minded organizational emphasis on both affordable cost and quality excellence that is consistently delivered. That is HCCI’s innovation.

See also: Survivor: Hospital Edition  

The bottom line

Against a backdrop of systemic healthcare excess, American employers will increasingly opt for equal or better care at lower cost from facilities such as HCCI. This could force domestic hospitals to follow suit and could help to bring American healthcare back into balance.

This article originally appeared on Jacksonville.com.

India’s Secret to Low-Cost Health Care

A renowned Indian heart surgeon is currently building a 2,000-bed, internationally accredited “health city” in the Cayman Islands, a short flight from the U.S. Its services will include tertiary care procedures, such as open-heart surgery, angioplasty, knee or hip replacement, and neurosurgery for about 40% of U.S. prices. Patients will have the option of recuperating for a week or two in the Caymans before returning to the U.S.

At a time when health care costs in the United States threaten to bankrupt the federal government, U.S. hospitals would do well to take a leaf or two from the book of Indian doctors and hospitals that are treating problems of the eye, heart, and kidney all the way to maternity care, orthopedics, and cancer for less than 5% to 10% of U.S. costs by using practices commonly associated with mass production and lean production.

The nine Indian hospitals we studied are not cheap because their care is shoddy; in fact, most of them are accredited by the U.S.-based Joint Commission International or its Indian equivalent, the National Accreditation Board for Hospitals. Where available, data show that their medical outcomes are as good as or better than the average U.S. hospital.

The ultra-low-cost position of Indian hospitals may not seem surprising — after all, wages in India are significantly lower than in the U.S. However, the health care available in Indian hospitals is cheaper even when you adjust for wages: For example, even if Indian heart hospitals paid their doctors and staff U.S.-level salaries, their costs of open-heart surgery would still be one-fifth of those in the U.S.

When it comes to innovations in health care delivery, these Indian hospitals have surpassed the efforts of other top institutions around the world, as we discussed in our recent HBR article. Today, the U.S. spends $8,000 per capita on health care; if it adopted the practices of the Indian hospitals, the same results might be achievable for a whole lot less, saving the country hundreds of billions of dollars.

A key to this is that, faced with the constraints of extreme poverty and a severe shortage of resources, these Indian hospitals have had to operate more nimbly and creatively to serve the vast number of poor people in need of medical care in the subcontinent. And because Indians on average bear 60% to 70% of health care costs out of pocket, they must deliver value. Consequently, value-based competition is not a pipe dream but a reality in India.

Three major practices have allowed these Indian hospitals to cut costs while still improving their quality of care.

A Hub-and-Spoke Design

In order to reach the masses of people in need of care, Indian hospitals create hubs in major metro areas and open smaller clinics in more rural areas which feed patients to the main hospital, similar to the way that regional air routes feed passengers into major airline hubs.

This tightly coordinated web cuts costs by concentrating the most expensive equipment and expertise in the hub, rather than duplicating it in every village. It also creates specialists at the hubs who, while performing high volumes of focused procedures, develop the skills that will improve quality. By contrast, hospitals in the U.S. are spread out and uncoordinated, duplicating care in many places without high enough volume in any of them to provide the critical mass to make the procedures affordable. Similarly, an MRI machine might be used four to five times a day in the U.S. but 15 to 20 times a day in the Indian hospitals. As one CEO told us, “We have to make the equipment sweat!”

U.S. hospitals have been developing similar structures, but there are still too many hubs and not enough spokes. Moreover, when hospitals consolidate, the motive often is to increase market power vis-à-vis insurance companies, rather than to lower costs by creating a hub-and-spoke structure.

Task Shifting

The Indian hospitals transfer responsibility for routine tasks to lower-skilled workers, leaving expert doctors to handle only the most complicated procedures. Again, necessity is the mother of invention; since India is dealing with a chronic shortage of highly skilled doctors, hospitals have had to maximize the duties they perform. By focusing only on the most technical part of an operation, doctors at these hospitals have become incredibly productive — for example, performing up to five or six surgeries per hour instead of the one to two surgeries common in the U.S.

This innovation has also reduced costs. After shifting tasks from doctors to nurse practitioners and nurses, several hospitals have even created a lower tier of paramedic workers with two years’ training after high school to perform the most routine medical jobs. In one hospital, these workers comprise more than half of the workforce. Compare that to the U.S. system, where the first cost-cutting move is often to lay off support staff, shifting more mundane tasks such as billing and transcription onto doctors overqualified for those duties — precisely the wrong kind of task shifting.

Good, Old-Fashioned Frugality

There is a lot of waste in U.S. hospitals. You walk into a hospital in the U.S., and it looks like a five-star resort; half of the building has no relation to medical outcomes, and doctors are blissfully unaware of costs. By contrast, Indian hospitals are fanatical about wisely shepherding resources — for example, sterilizing and safely reusing many surgical products that are routinely discarded in the states after a single use. They have also developed local devices such as stents or intraocular lenses that cost one-tenth the price of imported devices.

These hospitals have also been innovative in compensating doctors. Instead of the fee-for-service model, which creates an incentive to perform unnecessary procedures and tests, doctors at some Indian hospitals are paid fixed salaries, regardless of how many tests they order. Other hospitals employ team-based compensation, which generates peer pressure to avoid unnecessary tests and procedures.

Innovation has flourished in the U.S. in the development of new pills, clinical procedures, devices, and medical equipment, but in the field of health care delivery, it appears to have been frozen in time. In too much of the U.S., system, health care is viewed as a craft and each patient as unique. But by applying principles of mass production and lean production to health care delivery, Indian doctors and hospitals may have discovered the best way to cut costs while still delivering high quality in health care.

Authors

Ravi Ramamurti collaborated with Vijay Govindarajan in writing this article which first appeared in the Harvard Business Review. Vijay Govindarajan is the Earl C. Daum 1924 Professor of International Business at the Tuck School of Business at Dartmouth College and a Distinguished Fellow at The Dartmouth Center For Healthcare Delivery Science.