Tag Archives: taxation

Implications for Insurance Taxation?

Election-year politics are dominating legislative action this year as both parties lay down policy agendas for 2017 and beyond. President Obama and the Republican leaders of Congress are offering competing plans on how to reform the U.S. tax system and how to promote other policies intended to increase economic growth and make American companies more competitive. At the same time, both Democratic and Republican candidates seeking their party’s presidential nomination are advancing tax reform plans.

During his final year in office, President Obama likely will continue to rely on his administration’s regulatory authority and the presidential veto to preserve the 2010 Affordable Care Act (ACA)—as well as other legislative and regulatory actions taken during his years in office.

Obama administration action

On Feb. 9, President Obama submitted an FY 2017 budget to Congress that reaffirmed his support for “business tax reform” that would lower the top U.S. corporate tax rate to 28%, with a 25% rate for domestic manufacturing income.

Significant international tax increase proposals that have been re-proposed include a 19% minimum tax on future foreign income and a one-time mandatory 14% tax on previously untaxed foreign income. The president’s budget, again, reserves revenue from a large number of previously proposed tax increases to support business tax reform—including specific proposals affecting insurance taxation (discussed below)—but his budget identifies only part of the revenue that would be needed to support his proposed corporate rate reductions.

Congressional action

House Speaker Paul Ryan (R-WI) has called for House Republicans to vote in 2016 on comprehensive tax reform legislation and on changes to federal entitlement programs as a way to define and build support for a conservative legislative agenda. Senate Majority Leader Mitch McConnell (R-KY) is also expected to advance a conservative legislative agenda with a focus on demonstrating an ability to govern and with an eye on protecting the Republican Senate majority.

See Also: 19 Specific Taxes Directly Related to Healthcare Reform

House Ways and Means Committee Chairman Kevin Brady (R-TX) recently outlined his goals for producing a blueprint for comprehensive tax reform and plans to “move forward immediately to draft international tax reform legislation.” Chairman Brady has said he hopes the Obama administration and Congress can reach common ground on some policies and build on the momentum from the last year’s “tax extender” legislation, which included a provision making permanent Subpart F exceptions for active financing income.

Chairman Brady said comprehensive tax reform “will not happen until we have a new president,” but he is “hopeful that, next January, we will have a president—Republican or Democrat—who is committed to making pro-growth tax reform a reality for the American people.” The chairman outlined several principles for comprehensive tax reform, including a “competitive tax rate” and a “permanent, modern territorial-type system that helps American companies compete and win overseas.” He also said the Ways and Means Committee will look, “with fresh eyes,” at a range of tax ideas, including “consumption tax, cash flow tax, reformed income tax and any other approach that will be pro-growth.”

On international tax reform, Chairman Brady said “developments in the global environment demand our immediate attention.” He pointed to OECD  “base erosion and profit shifting” (BEPS) proposals that “disproportionately burden American companies” and the European Commission anti-tax avoidance package that would provide EU member countries with an “arsenal of new revenue-grabbing tax measures.” He also discussed the growing number of corporate inversions and foreign acquisitions involving U.S. companies: “We will send a clear signal to American companies and shareholders that help is on the way—that we won’t stand idly by while our tax code drives them overseas or makes them a target for a foreign takeover.”

Senate Finance Chairman Orrin Hatch (R-UT) has said he “doubts very much” that international-only tax reform can be enacted this year. The Finance Committee Republican majority staff has been working on options for corporate integration tax reform proposals that would seek to eliminate the double taxation of corporate earnings. Corporate integration proposals generally have focused on approaches providing that any distributions made by such entities would either be deductible by the entity (dividends paid deduction) or would be excludable by the recipient (dividend exclusion). A December 2014 report prepared by the Senate Finance Committee Republican staff stated that a dividends-paid deduction “would generally be easy to implement and would largely equalize the treatment of debt and equity.” Chairman Hatch recently asked Treasury Secretary Jack Lew to “keep an open mind” to a corporate integration proposal that might help to make U.S. corporations more competitive globally and could reduce inversions.

Although there is bipartisan agreement that the U.S. corporate tax rate should be lowered significantly and that our international tax system should be updated, there is significant disagreement over key business tax issues, including how to offset the cost of a corporate rate reduction.

See Also: How a GOP Congress Could Fix Obamacare

Insurance-related revenue raisers

The Obama administration’s FY 2017 budget re-proposes several revenue-increasing measures specific to insurance companies. The proposed legislative changes generally would apply for tax years beginning after Dec. 31, 2016.

Among the insurance-related measures are provisions that would:

  • Disallow the deduction for non-taxed reinsurance premiums paid to affiliates — This proposal would disallow any deduction to covered insurance companies for the full amount of reinsurance premiums paid to foreign affiliated insurance companies with respect to reinsurance of property and casualty risks if the premium is not subject to U.S. income taxation. The proposal would provide a corresponding exclusion from income for reinsurance recovered, with respect to a reinsurance arrangement for which the premium deduction has been disallowed. The proposal would also provide an exclusion from income for ceding commissions received with respect to a reinsurance arrangement for which the premium deduction has been disallowed. The exclusions are intended to apply only to the extent the corresponding premium deduction is disallowed. The proposal would provide that a foreign corporation that is paid a premium from an affiliate that would otherwise be denied a deduction under this provision may elect to treat those premiums and the associated investment income as income effectively connected with the conduct of a trade or business in the U.S. If that election is made, the disallowance provisions would not apply.
  • Conform net operating loss rules of life insurance companies to those of other corporations — This proposal would modify the carry-back and carry-forward periods for losses from operations of life insurance companies to conform the treatment to that of other taxpayers. Under the proposal, losses from operations of life insurance companies could be carried back up to two taxable years prior to the loss year and carried forward 20 taxable years following the loss year.
  • Modify rules that apply to sales of life insurance contracts, including transfer for value rules — This proposal would create a reporting requirement for the purchase of any interest in an existing life insurance contract with a death benefit equal to, or exceeding, $500,000. The proposal would also modify the transfer for value rule to ensure that exceptions to that rule would not apply to buyers of policies.
  • Modify dividends received deduction for life insurance company separate accounts — This proposal would repeal the present-law proration rules for life insurance companies and apply the same proration regime separately to both the general account and separate accounts of a company. Under the proposal, the policyholders’ share would be calculated based on a ratio of the mean of the reserves to the mean of the total assets of the account. The company’s share would be equal to one less than the policyholders’ share.
  • Expand pro rata interest expense disallowance for company-owned life insurance (“COLI”) — This proposal would curtail an exception to a current law interest disallowance of a pro rata portion of a company’s otherwise-deductible interest expense, based on the un-borrowed cash value of COLI policies. As modified, the exception would apply only to policies covering the lives of 20% owners of the business. The proposal would apply to contracts issued after Dec. 31, 2016, in tax years ending after that date.
  • Repeal special estimated tax payment provision for insurance companies under section 847 — This proposal would repeal IRC Section 847 and would include the entire balance of an existing special loss discount account in income in the first tax year after 2016. Alternatively, the proposal would permit an election to include the balance in income ratably over four years. Existing special estimated tax payments would be applied.

Insurance Developments: Judicial and Administrative

A number of judicial and administrative developments occurred in 2015 concerning insurance companies.

These developments affected insurers in various lines of business:

  • Life insurers: The most significant development for life insurers was not solely a tax development. Life principal-based reserves (PBR) will be effective when 42 states representing 75% of total direct written premiums amend their standard valuation law. At the current rate of adoption, Life PBR is expected to be effective Jan. 1, 2017, for contracts issued on or after that date. Life PBR will implicate a number of tax issues, and, for the first time, the IRS and Treasury included guidance on Life PBR in its annual Priority Guidance Plan. Also during 2015, the Tax Court decided in Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015) that a policyholder was liable for taxes on income earned on assets supporting a variable life insurance contract based on the policyholder’s control over the assets. The case accorded deference to a number of the IRS’s “investor control” revenue rulings and could result in closer attention to variable life insurance and annuity contracts that are privately placed.
  • Non-life insurers: In 2015, the Tax Court addressed what qualifies as insurance risk for purposes of classifying contracts as insurance contracts. In R.V.I. Guaranty Co., Ltd v. Commissioner, 145 T.C. 9 (September 21, 2015), the court held that residual value insurance (RVI) contracts that protect against an unexpected decline in the market value of leased personal property qualify as insurance contracts for federal income tax purposes. The case’s reasoning relies heavily on the treatment of the contracts by non-tax regulators, and it provides taxpayers further guidance for distinguishing between investment risk and insurance risk.
  • Health insurers: In 2015, a Treasury Inspector General for Tax Administration (TIGTA) report criticized the IRS for the “finality” requirement that prevents the service from assessing health insurers that inadvertently or otherwise were not assessed the correct amount (or any) of the health insurance provider fee, which is apportioned among all covered health insurers. Other health insurance providers still wait for the IRS to act on refund requests of the fee in 2015. The ultimate resolution remains uncertain.
  • Captive insurance companies: During 2015, the IRS issued two Chief Counsel Advice (CCA) that analyze whether specific types of policies issued by captive insurance companies constitute insurance for federal income tax purposes. In CCA 201511021, the IRS determined that contracts indemnifying the policyholder for loss of earnings resulting from foreign currency fluctuations did not satisfy the three-prong test to be considered insurance because foreign currency risk is not an insurance risk. The CCA was issued before the tax court’s decision in R.V.I. Guaranty Co., Ltd., so it did not take the tax court’s approach into account. In CCA 201533011, the IRS concluded that excess loss policies issued by a captive insurance company that covered healthcare risks of members of unrelated HMOs are not insurance contracts because they lacked the requisite element of risk shifting. Based on the facts as presented, the CCA analyzed the arrangement as an interest-bearing deposit, but it then concluded that receipts were included in income and deductions were allowed for future claim payments when made. Also in 2015, the IRS issued IR 2015-19, which added section 831(b) companies to the “Dirty Dozen” list of tax scams, indicating the IRS would target these companies in examination.
  • PFIC exception for income derived in the active conduct of an insurance business: Again during 2015, the IRS proposed regulations that would provide guidance on investment income that is treated as derived in the active conduct of an insurance business and, therefore, not treated as “passive income” under the passive foreign investment company (PFIC) rules. In particular, Prop. Reg. §1.1297-4 would provide that “active conduct” requires that an insurer conduct its activities through its own officers and employees and that investment income be earned on assets held to meet obligations under insurance and annuity contracts. Several comments were submitted on these issues and on the use of a bright line test for whether assets are held to meet obligations under insurance contracts.
  • Cross-border reinsurance: The Court of Appeals for the District of Columbia Circuit ruled in Validus Reinsurance, Ltd v. United States of America, 786 F.3d 1039 (2015) that the Federal Excise Tax (FET) on insurance premiums does not apply to retrocessions between two foreign insurers, regardless of whether the underlying risks are U.S.-based. Accordingly, the IRS issued Rev. Rul. 2016-3, 2016-3 I.R.B. 282, which revokes the ruling setting forth the IRS’s prior position on the application of FET on a cascading basis to either reinsurance or retrocession arrangements between two foreign insurers. The Validus decision and Rev. Rul. 2016-3 mark the end of the controversy with the IRS on this issue, and most companies already have submitted claims for refund of previously-paid excise tax on a cascading basis, or they plan to do so.
  • Inversions: In 2014, the Treasury Department and the IRS issued Notice 2014-52, which describes regulations the Treasury and IRS intend to issue concerning transactions sometimes referred to as “inversions.” The notice included a “cash box” rule, which targeted taxpayers who engage in certain inversion transactions with foreign corporations and their subsidiaries with substantial liquid assets. As a follow up to that notice, the Treasury and IRS issued Notice 2015- 79, providing more information about the intended regulations. In particular, Notice 2015-79 describes regulations that the IRS and the Treasury intend to issue addressing transactions that are structured to avoid the purposes of §7874 (concerning expatriated entities) and addressing “post-inversion tax avoidance transactions.” The latter notice clarifies that property held by a U.S. insurance corporation and a foreign corporation that is engaged in the active conduct of an insurance business will be exempted from the “cash box” rule. As in prior years, the IRS and Treasury jointly issued a Priority Guidance Plan outlining guidance it intends to work on during the 2015-16 year. The plan continues to focus more on life than property and casualty insurance companies. The following insurance-specific projects were listed as priority items. Many carried over from last year’s plan, including:
  • Final regulations under §72 on the exchange of property for an annuity contract. Proposed regulations were published on Oct. 18, 2006;
  • Regulations under §§72 and 7702 defining cash surrender value;
  • Guidance on annuity contracts with a long-term care insurance feature under §§72 and 7702B;
  • Guidance under §§807 and 816 regarding the determination of life insurance reserves for life insurance and annuity contracts using principles-based methodologies, including stochastic reserves based on conditional tail expectations;
  • Guidance under §833 (expected to address de minimis MLR relief);
  • Guidance on exchanges under §1035 of annuities for long-term care insurance contracts; and
  • Guidance relating to captive insurance companies.

Implications

  • Election year politics and disagreements between President Obama and Congressional Republicans (notably on how to offset any corporate tax reductions) make domestic or international tax reform unlikely in the coming year.
  • President Obama’s FY2017 budget proposes several revenue-increase measures specific to insurance companies. However, it remains to be seen which, if any, of the measures will come into effect.
  • Multinational insurers and reinsurers should closely monitor legislative and regulatory developments pertaining to taxation of overseas profits. Both the PFIC regulation and the promised regulations on inversions could have a significant effect on some companies and their shareholders.
  • Life insurers should consider the effect of Life PBR tax issues on product development, financial modeling and compliance as they prepare for the Jan. 1, 2017, effective date.
  • Non-life insurers with non-traditional lines of business should consider the effect, if any, that the R.V.I. Guaranty Co. case and the two chief counsel advice memoranda on the nature of insurance risk and the presence of risk shifting may have on insurance qualification.
  • Captive insurers should be prepared for additional IRS scrutiny as a result of the Priority Guidance Plan item promising guidance, and the inclusion of §831(b) companies in the IRS “Dirty Dozen” list.

Why to Simplify Corporate Structures

With their variety of business strategies and product innovations, financial services organizations often have very complex corporate structures. The mix of regulated operating, distribution, investment, holding and dormant companies – together with various special-purpose vehicles – means that few employees fully know the complexity of an enterprise’s legal entity structure.

Generally, management prefers simplicity and accountability. Accordingly, it typically organizes enterprises into distinct, separately managed, strategic business units (SBUs), which are overlaid on top of the existing legal entity structure, with the SBUs sharing various legal entities. This management approach creates a simplified internal view of financial performance relative to the legal entity structure; however, it often masks the considerable extra work (and therefore potentially avoidable cost) associated with the corporate structure within an organization’s corporate accounting, tax and other back-office functions.

Few organizations start off with a complex corporate structure or seek to achieve one, but a combination of factors can lead to complexity:

  • Growth by acquisition – Entities inherited as part of an acquisition and entities (such as holding companies) formed to make acquisitions;
  • Tax strategies – Entities formed to minimize multi-jurisdictional taxation, preserve the utility of tax attributes (such as basis, losses and credits) or effectively manage product state taxes;
  • Historical regulatory requirements – Companies formed to facilitate various regulated pricing tiers (particularly in property and casualty (P&C) insurance); and,
  • Business line expansion and reorganization – Organic growth into new product areas, alignment within different market segments (sometimes under reinsurance pooling arrangements), discontinued business, etc.

Complexity adds to administrative costs and can slow production of management information. In the capital structure work that PwC performs, we frequently find that a company’s structure is out of date; for example, the original rationale for a tax planning structure is no longer applicable because of a change in law, or a legal entity structure established to facilitate a line of business has survived even though the line of business has not. As another example, an entity that was established before the advent of the entity classification election regime (i.e. “check the box” rule) now may be unnecessary to achieve the intended tax benefits. Accordingly, organizations should examine the costs and benefits of maintaining current structures.

The complexity of corporate structures in financial services is evident in the insurance industry’s use of legal entities. As the table below shows, among P&C and life and health (L&H) insurers, the top 25 insurance groups hold a majority of industry capital (69% in P&C, 58% in L&H). Despite this concentration, there is evidence that inefficiencies exist: There is a high number of dormant entities relative to total legal entities and the number of domiciles some groups are managing. The number of domiciles tends to be five or fewer for most insurers, but in some extreme cases there are as many as 12 domiciles for P&C companies and 31 for L&H companies (primarily because of health maintenance organization (HMO) entities). When factoring in the potential costs (real and opportunity costs) of maintaining unused or underutilized legal entities, the impact on the industry as a whole is very real.

Insurance industry capital is relatively concentrated
P&C L&H
Groups ~330 ~250
Legal entities ~2,700 ~1,800
Capital in top 25 groups 69% 58%


But there are indications of inefficiency

Dormant entities 150+ 300+
Fronting entities 500+ 100+
Range of domiciles/groups 1-12 1-31


Source: SNL, PwC Analysis

Legal entity cost

Organizations rightly consider the costs of administering legal entities a normal part of doing business. Such frictional costs vary by organization and entity usage and typically include:

  • Financial reporting costs – Licensed insurance companies require separate annual and quarterly financial statement preparation in their state of domicile. The time spent on statement preparation correlates to complexity. The greater the number of legal entities, the greater the complexity and the higher the risk
    of misstatement.
  • Auditing costs – These costs will vary with the size and complexity of the balance sheet. Again, costs tend to be correlated with complexity (e.g., degree of intercompany transactions, complex reinsurance structures, investments/financial products, etc.).
  • State assessments – Premium or loss-based assessments for a variety of state programs will vary in size relative to the business written in the legal entity. It is important to recognize that minimum assessments also can apply even when business is no longer written on a direct or net basis.
  • Regulatory exams – State regulators conduct both market conduct exams and financial exams of insurance companies domiciled in their respective jurisdictions. Market conduct exams occur on an as-needed basis and relate to examination of operational (sales, underwriting, claims) business practices. Certain domiciles are more challenging than others. Financial exams occur every three to five years, at the insurance company’s expense.
  • Tax – Each legal entity in the structure adds to the company’s overall compliance burden, as insurance companies are required to prepare and file forms with state and federal tax authorities on a periodic basis even when dormant. A company also may be required to respond to periodic inquiries about its activities, or lack thereof, and may be subject to minimum taxes and filing fees. Active operating companies must monitor and manage the interplay of premium tax rates and retaliatory taxes, which arise when states in lower tax jurisdictions increase state taxes to match the level of the domicile state, if it is higher.
  • Management time – Spans all of the above areas. The more complex a legal entity structure, the more time middle management and, in some cases, senior management have to spend on issues related to excess legal entities.

In light of these frictional costs, the expense of administering an overly complex legal entity structure can be considerable. Eliminating redundant or unused entities through merging companies, outright sale of the insurance company (or companies) or clearing out the liabilities and selling a “shell” company can result in significant savings.

Improving access to capital

Moving capital through legal entities can be complicated by regulatory constraints and often involves frictional costs such as sub-optimal tax consequences (e.g., withholding taxes on dividends from a foreign subsidiary and excise taxes on premiums paid to a foreign affiliate). Capital trapped in dormant or underutilized entities will provide sub-optimal returns and therefore serve as a drag on the overall group return on equity. For example, an organization with a 15% corporate required rate of return and a 5% average investment portfolio rate of return has a 10% opportunity cost of maintaining the capital in a redundant legal entity. Accordingly, one of the few positive outcomes of the financial crisis has been insurers’ streamlining their corporate structures to simplify internal access to capital and gain capital efficiency.

One method of improving capital deployment in a dormant or underutilized entity is through merger with a continuing entity. However, before merging a licensed company out of existence, insurers need to consider the marketability of the unwanted entity in terms of the number and location of state licenses, the degree to which the company has gross liabilities, the type of liabilities (e.g., excluding asbestos and environmental), the domicile state, the credit quality of the counterparty backing the reinsurance contract or contracts used to create the shell, etc. In light of the regulatory hurdles and time delays that accompany the obtainment of state licenses, there is a market for selling licensed companies as “shell” companies. The process typically requires transferring insurance liabilities out of the legal entity through indemnity – or preferably assumption – reinsurance. This market has yielded significant value to its customers. That said, it is critical to gain proper restructuring advice before entering into these transactions because undesirable accounting and risk-based capital outcomes can result from poorly structured reinsurance transactions.

Simplifying corporate structure: Opportunities & challenges

Eliminating unnecessary organizational complexity and reducing associated frictional expenses are the main reasons to undertake a corporate simplification program. The benefits of corporate simplification are:

  • Streamlined financial management across a manageable number of entities;
  • Removal of unnecessary frictional costs;
  • Reduced overall state tax burden, leading to competitive advantages in market pricing;
  • Consolidation of entities within favorable state regulatory environments;
  • Identification of alternative capital structures or mechanisms to free trapped capital for the top-tier company to use for other purposes;
  • Generation of capital through the sale of unnecessary licensed companies as “shell” companies.

However, the simplification program does present some challenges:

  • Internal resource constraints may limit design and implementation of the simplification;
  • Regulatory approvals for material changes may prolong implementation;
  • Product filings may need to be updated;
  • Re-domestication of entities may present political or regulatory issues (including perceived or real job losses or transfers, closed block regulatory requirements, etc.) that can delay the process;
  • Changes in legal entity structure can affect near-term business operations and supporting technology platforms. For example, changes in legal entities used by the insurance underwriting organization may require process changes in the distribution channel as new and renewal business is mapped to different entities;
  • Selling or merging active operating companies can also present challenges for management, including: identifying intercompany accounts between merged entities; updating intercompany agreements, such as intercompany reinsurance pooling agreements, to reflect the changes; cleaning up outstanding legal entity accounting reconciliations, if any; re-mapping ledgers for historical data; re-mapping upstream company eliminations; creating and maintaining merged company historical financials for statutory and GAAP/IFRS financial statements; locating and analyzing details of historic tax attributes (such as basis and earnings and profits) and studying qualification for tax-free reorganization; potential reversal of subsidiary surplus impacts from asset purchase/sale transactions within the holding company structure; and potential scrutiny over differing methodologies, if any, used for accounting (e.g., deferred acquisition cost) or actuarial reserve methodologies used by the entities to be merged.

The corporate simplification process

Many large insurance organizations have some level of corporate simplification on their annual to-do list, but the initiative often gets pushed aside because of gaps between corporate and business priorities and available resources. The corporate simplification process requires a champion who can take into account and balance varying points of view, call upon required resources, facilitate project management and authorize access to subject-matter expertise. Moreover, a corporate simplification program must balance corporate (tax, regulatory, governance and financial reporting costs) and business (customer, distribution, products, process and technology) needs and considerations. Depending on the complexity of the organization and underlying challenges, a simplification initiative can take several months to well over a year.

The three stages of such an initiative include:

  1. Assess – The ultimate goal of a corporate simplification process is a streamlined corporate structure that corresponds to business core competencies and strategy. This structure will have an efficient balance of cost, risk, regulatory, tax, capital, governance and operational parameters that aligns business operations with the legal entity structure. In the initial phase of the initiative, representatives from corporate and business areas must come together to review the current use of legal entities and create the desired future organizational structure, as well as take into account the existing corporate environment (rather than what existed in the past). If the simplification effort is part of a broader business unit re-alignment, the assessment and design phase will require a significant commitment of time and effort to redefine the desired business strategy. If the simplification is taking place within a well-defined business unit structure, then the focus can be limited to streamlining and reducing overall cost within the existing business unit strategies.

A complete inventory of legal entities should be created outlining information such as the business use, applicable business unit, domicile, direct and net business written (for insurance companies only), required/minimum capital, actual capital, potential for elimination, and other information as defined by the group. Furthermore, to complete the assessment of the simplification effort, a business impact analysis that includes a premium tax analysis by state domicile and a regulatory domicile analysis should occur at this stage. Companies also need to carefully look at their portfolio of companies to ensure they have the entities they need today and for the near future.

  1. Design – As the plan starts to take shape, the project team must conduct a deeper analysis of accounting, business and technology transition issues. The deliverable will be a proposed road map that:
  • Outlines a streamlined legal entity organization structure with greater capital efficiency and alignment with business strategy;
  • Identifies the proposed combinations/eliminations of insurance and non-insurance entities;
  • Describes the proposed movement of capital (including extraordinary dividends required) and reinsurance transactions to effectuate the change (if applicable); and
  • Establishes a communication plan within a high-level timeline.

This outline of proposed changes must be well vetted internally before the organization approaches regulators, rating agencies and other constituents.

  1. Implement – Once the design is ready, project management and subject-matter expert resource requirements must be confirmed. Program and change management and associated governance structures are critical throughout the planning and implementation phases as the number of work streams, constituents, interdependencies and issues can be substantial for larger-scale simplification programs. Once the team is in place, it must create detailed implementation project plans, identify quick wins, establish an effective communication plan and establish an issue/dependency management process. Communication to all constituents – employees, sales force/agents, regulators, rating agencies and policyholders – is vital in any simplification initiative.

Following the design phase, those entities that have common activities, objectives, operational process or customer segmentation can be merged, which should effectively align business and legal entity structure. The remaining, redundant legal entities should be eliminated, sold as-is or sold as a shell. This final step will result in cost savings and the raising of new capital through the sale of licensed shell companies.

chart 2

Conclusion: Corporate simplification is a priority

In light of the need to be nimble while reducing costs, corporate simplification should be at the top of the corporate to-do list. A well-managed corporate simplification program provides strategic alignment of entities, reduces costs and facilitates more efficient use of capital. The companies that execute an effective corporate simplification process and maintain a commitment to simplification over time will succeed in reducing costs and be able to devote their time and attention to valuable activities.

The 13 Oddest Aspects of Reinsurance

Looking behind the curtain of reinsurance, you find a most unusual business. Here are 13 anomalous features:

–Reinsurance is for the most part unregulated, but users — insurance companies — are regulated.

–Insurers must use a system of accounting that makes reinsurance attractive: If a reinsurer gives insurers a discount off a list price (ceding commission), they may show on their books that they paid the list price and may treat the discount as income.

–Reinsurance may be marketed by independent brokers that owe the insurance companies no fiduciary duties. The broker leads insurance companies to believe that it has their best interests at heart, but courts have ruled that the broker does not even have a duty to not inflate its commissions. The broker’s relationship with the reinsurer is much more important than the broker’s relationship with the insurers.

–The reinsurer can insist that all disagreements must be arbitrated, and that the arbitration does not set precedent or provide guidance should a similar issue arise in the future. That way, the reinsurer can argue the same issue over and over and over. The findings of arbitration are not only not recorded, they are often confidential.

–The outcome will not be determined by legal construction and interpretive rules but by the “custom and practice” of the industry — but which “custom and practice” is neither written down nor uniformly agreed upon or adhered to by those in the industry. That is, the contract can specifically say one thing, and the wording can be ignored in any arbitration finding if it is not in line with “custom and practice.” A reinsurer can do all this and at the same time argue that the lopsided arrangement is an “honorable engagement.”

–The reinsurance contract likely has an “entire agreement” clause, meaning that nothing from outside the contract can be used to establish rights or obligations. That is, the four corners of the contract supposedly set the parameters of the agreement. You may ask: Isn’t “custom and practice” contained outside the contract? Yes, it is. So, at the same time that there is the argument that the contract is the entire agreement, there is also the provision that unwritten rules outside the contract determine the interpretation of the contract.

–If there is a disagreement as to what the contract says, the dispute must be arbitrated as not a legal obligation — yet the contract says it applies the laws of the state where the insurer is based.

–Who is responsible for writing this convoluted and lopsided contract? Often, that is the broker — which is not a party to the contract.

–If a broker fails to even issue a memorialization of the product to the insurer, nine months after having “sold” the product, it is the insurance company that is punished, not the broker or the reinsurer.

–Even though some states specifically provide that reinsurance falls within the statutory definition of a regulated product, states do not regulate reinsurance directly. Reinsurance should be regulated federally, because it is clearly interstate commerce and falls within the U.S. Constitution’s commerce clause, but the federal government does not actually regulate reinsurance, apart from income tax issues. So, reinsurers do not have to obtain regulatory approval for rates or for products.

–Talk about a lobbying force. Legislatures have been convinced that taxing it would raise the price of everything for the general populace. That argument could be made for any business, because all taxes are ultimately borne by the general populace, but has not caught on for other industries.

–Reinsurance is amazingly simple. It comes in essentially one of two forms: treaty (for groups) and facultative (for individuals). Treaty comes in essentially two varieties: proportional and non-proportional. But reinsurance becomes esoteric by design. It has cloaked itself in mystery by avoiding the courts as a venue and by taking advantage of the fact that few legislators have ever dealt with the product.

–Although with similar financial products, courts would find that third parties might have rights, third parties have no rights under reinsurance.

I have not figured out why reinsurance is not fully regulated, as is insurance. I have heard the logic that the parties to the contract are equally sophisticated, and therefore no regulation is necessary. The problem with that logic is that the premise is false. Many of the parties do not have equal bargaining power; they are not equally qualified to enter into the transaction; and there are no real arm’s-length negotiations. Many small companies spend a great deal on reinsurance each year.

So why not at least tax reinsurance? I have heard the logic that this would be “double taxation,” because the original (the insurance) transaction was taxed. However, that ignores the realities of reinsurance. Reinsurance is not insurance of insurance. It is insurance on the performance of an insurance company’s core business, which happens to be insurance. Why does insurance covering loss from a collection of insurance products get to escape taxation on premiums when insurance covering loss from a fleet of cars does not? The same hurricane can cause loss to the core business of the car dealer and the insurance company, but coverage for the car dealer carries taxes on premiums while coverage for the insurance company does not.

I have also heard that reinsurance is like any other wholesale business, where sales tax is not applied. This logic ignores the realities of reinsurance. Reinsurance is not a commodity that is purchased in bulk to then subdivide into smaller units for sale by insurance companies. Reinsurance is a retail sale; it is not a wholesale transaction.

I am not necessarily advocating for regulation or taxation of reinsurance, but I am advocating for leveling the playing field and bringing transparency to the process of reinsurance.

I think that could be done with the abolition of any mandatory arbitration in reinsurance contracts by the NAIC. The plaintiff’s bar has a history of efficiently “regulating” where no regulation exists, if given the proper venue. Arbitration has not brought lower costs and timely determinations. Indeed, arbitration has proven to have none of the benefits and all of the problems of litigation.

It really is about time that reinsurance is made to come out from the shadows and to fully participate in the 21st century judicial system, rather than allowing it hold on to the faux vestiges of yesterday’s “gentlemen’s agreements.”