Tag Archives: taxes

An Open Letter on the Oklahoma Option

I’m the founder and CEO of WorkersCompensationOptions.com (WCO), a company dedicated to workers’ compensation (WC) and its legal alternatives. This letter is intended to quell the concerns of employees in our client companies—employees who may have been distressed by the recent (mostly negative) publicity from ProPublica and NPR regarding options to WC in Texas and Oklahoma.

In case you only saw one installment from the Insult to Injury series, I’ll provide a quick summary. In 2014, the project’s authors started to assimilate massive amounts of data from their research concerning each state’s (and the federal government’s) WC system. In March 2015, the authors began releasing articles with an indisputable premise: Collectively, these systems need improvement.

That commendable beginning eventually gave way, however, to a hypothesis that is supported neither by reality nor by the overwhelming quantity of data the authors provide. Their conclusion (that employers are in cahoots with insurers to pressure attorneys, anonymous doctors and legislators into discarding the lives of an unfortunate few for the sake of bolstering corporate profits) completely misses the mark in pinpointing why so many WC systems are broken beyond repair. In fact, attorneys and doctors put at least as much pressure on WC systems as insurers, and any attempt to depict the medical and legal communities as innocent bystanders in the WC feud is simply too naive to be taken seriously.[1] I do not doubt the authors’ sincerity in addressing a serious societal problem, but I also do not believe they are equipped to understand the problem they sought—however earnestly—to demystify for their readers. Worse yet, I fear they have positioned themselves in the WC space in a manner that is only likely to retard the implementation of practical solutions.

This letter is prompted by the article on Oct. 14, 2015, which painted an inaccurate—even an irresponsible—picture of both Texas nonsubscription (TXNS) and the Oklahoma option (OKO). As that article’s title (“Inside Corporate America’s Campaign to Ditch Workers’ Comp”) is lengthy, I’ll shorten it to CDWC going forward.

Texas Nonsubscribing Employees: What Can We Learn?

Texas is exceptional in the WC world because it has, for more than a century, offered employers a viable alternative to WC. Of approximately 380,000 employers in Texas, roughly two-thirds subscribe to a traditional WC system; the other third are nonsubscribers who develop their own models. That’s about 120,000 different systems, and there is plenty to be learned. We’ve seen various organically grown components develop from these disparate systems, many of which superficially resemble WC. Despite those similarities, however, industry experts understand how counterproductive it is to make unilateral comparisons between TXNS and WC.

The authors of CDWC didn’t get that memo.

Of all the various lessons learned from diverse TXNS models, one runs counter to conventional WC dogma: Employers can protect themselves while delivering superior care for employees at a fraction of the cost of WC. Eliminating the inflated costs associated with abusive practices that run rampant in WC is a critical component of that particular lesson.

Because the CDWC authors insist on judging TXNS through the lens of WC, TXNS looks to them like a system that would appeal to skinflint employers who simply do not care whether their employees get hurt. However, because employees of nonsubscribing companies can sue their employers for tort, the decision to opt out of WC is likely to be penny-wise and pound-foolish for employers who do not take measures to ensure the safety of employees. The CDWC authors’ failure to unpack the importance of tort negligence means many readers will come away from the article without understanding that a typical $50,000 payout in WC could easily be either $0 or $5 million in TXNS—depending on who is at fault for the accident. Even more disappointing is CDWC’s attempt, in a one-sentence paragraph, to gloss over one of WC’s most dangerous shortcomings: the extent to which the no-fault arrangement between employers and employees has removed incentives for safety in the workplace throughout the country.

If you are an employee of one of our Texas nonsubscribers, rest assured that your employer has every reason to minimize workplace accidents and to take very good care of you if an occupational injury occurs.

In a nutshell, your interests are aligned with your employer’s—another critical lesson we’ve learned from TXNS.

Oklahoma Option Employees: A Whack-a-Mole WC System Led You Here

ProPublica and NPR harp on a consistent theme throughout the Insult to Injury series: WC is broken. We at WCO agree, and Oklahoma may provide the single best example of how and why a state’s WC system becomes unsustainable.

The WC ecosystem is made up of five major communities: insurance, medical, legal, employer and employee. Abuse within the system by any of these communities leads to adjustments to the boundaries of the system. Throughout the Insult to Injury series, the authors go out of their way to sidestep the discussion of systemic abuse. They even attempt to dismiss fraud by citing a study that minimizes its role. Abuse and fraud in WC are, in some ways, analogous to speeding on the highway: Almost all drivers abuse the speed limit, but very few are issued citations. Similarly, the cases of clear-cut fraud in WC only reflect a small portion of the amount of abuse going on. But even if we allow the authors to exclude all instances of clear-cut fraud from the WC conversation, we are still left with rampant abuse driven by insidious systemic incentives.

For decades, abuses and inefficiencies within the WC system have led to each of the five communities touting the need for major reforms—at the others’ expense. Real reform threatens each community, which leads to stalemates in negotiations. Major upheaval has been avoided via the compromise of pushing and pulling the system’s boundaries, resulting in a decades-long game of whack-a-mole being played across the nation. If one voice cries, “Data shows an alarming trend in opioid abuse,” that mole gets swatted by requiring more medical credentials for prescribing pain killers. When another shrieks, “Overutilization is surging,” that mole is whacked through costly and time-consuming independent medical examinations. When someone else observes, “Our disability payouts are higher than neighboring jurisdictions,” that mole prompts us to lower disability payouts. Immediately, a fourth voice shouts, “Pharmaceutical abuses make up 8.4% of total costs,” and that mole persuades us to introduce drug formularies. But there isn’t even a moment of silence before another voice remarks, “Our analysis shows dismemberment payouts in this jurisdiction are lower than those of our neighboring jurisdiction.” That mole gets whacked by proposing legislation to increase dismemberment payouts—legislation that is dead on arrival.[2] At some point, we have to realize the moles are multiplying faster than we can whack them. (If my commentary doesn’t apply to other jurisdictions, I’m happy to restrict it to Oklahoma and Texas because writers can best serve their readers by acknowledging the limitations of their own expertise.)

Even if we concede that the changes detailed in the paragraph above aren’t necessarily bad (which I’m not conceding; I’m just trying to be polite and move the argument along), they demonstrate a persistent pattern of outcomes, inclusive of abuse, inherent in any hierarchical bureaucratic system. Regulators are busy reacting to entrenched abuses while market participants find new and exciting ways to game the system. This futile game of whack-a-mole is endless.

The Sooner State had a front row seat to witness what TXNS accomplished—both the good and the bad.[3] With that first-hand knowledge, the Oklahoma legislature has finally provided the state—and the country—with an opportunity to see whether real change can restore function to a malfunctioning system. While WC stakeholders assure us they are only a few more whacks-at-the-mole away from making WC hum, Oklahoma lawmakers have written a new chapter in the history of workplace accident legislation. The OKO is neither WC nor TXNS.

The brilliance of the OKO is that it doesn’t attempt to overhaul a broken WC system. The legislators effectively stepped away from that decades-old stalemate. Instead of an all-out overthrow, they left WC in place and created an option for employers who were willing to try something new—which is exactly how WC itself was introduced a century ago.

Because the OKO is substantially modeled on TXNS, it is easy to see why the CDWC writers conflated the two in their analysis. The errors in CDWC concerning ERISA’s applicability, employee benefits and appeals committee processes in Oklahoma are all presumably honest mistakes made by writers who, in their zeal to distinguish TXNS and the OKO from WC, failed to distinguish TXNS and the OKO from each other.

Nevertheless, it’s important for employees to understand that TXNS varies dramatically from one employer to another, and many of the rules concerning TXNS do not apply north of the Red River.

Although the CDWC authors misleadingly couple TXNS and the OKO with respect to ERISA’s applicability, ERISA plays no direct role in occupational accidents in the OKO.[4] We’ll be happy to get you a legal opinion on that, but for our purposes regarding CDWC, take my non-legal opinion as on the record. If others disagree, they should go on the record, as well. While ERISA has served employers and employees well in TXNS, its role in the OKO is only implied (if that). We are free to use it where we wish, as long as we are compliant at the state level.

Presumably tied to their ERISA misapplication, the CDWC authors assert that “benefits under opt-out plans are subject to income and payroll taxes.” Such tax advice is unusual from investigative journalists without citation, and I have asked the authors to share their source. Although the jury is still out on this tax issue, it is a point the CDWC authors must distort to substantiate their otherwise baffling claim that the workplace accident plans of OKO employers “almost universally have lower benefits.”[5] If any OKO plans really do offer benefits that aren’t at least as good as those provided by WC, they’re illegal. That’s how the legislators have written the law, and it’s what they’re dedicated to achieving for workers, regardless of obfuscations invoking TXNS, ERISA and unresolved tax implications.

The authors of CDWC also completely misrepresent appeals committees for at least a majority of OKO employers. The authors overlook a dramatic improvement to employee protection that the OKO makes to TXNS when they claim that appeals committees in Oklahoma work analogously to appeals committees in Texas: “Workers must accept whatever is offered or lose all benefits. If they wish to appeal, they can—to a committee set up by their employers.” That’s dead wrong. Executives at each of our OKO employers are fully aware that, in case of an employee appeal, the employer has nothing to do with the selection of the appeals committee panel members or the work they complete. The process is independent from the employer and extremely fair.[6] The CDWC authors would do well to read Section 211 of the law more carefully.

On the subject of benefit denials, I’ll share a single data point from our OKO book: To date, we have denied exactly one claim. This is a nascent system, so we must be very careful in drawing actuarial conclusions. Still, our company has led more employers from traditional WC into the new OKO than any other retailer, so we have a bit of credibility to offer on this subject. The point of the system isn’t to deny benefits to deserving employees but to ensure benefits are delivered more efficiently. The system is working.

The CDWC authors only provide one OKO case study, Rachel Jenkins. Strangely, they lump Jenkins in with four TXNS case studies. The Jenkins case is still being tried. We will withhold opinions—as we hope others would—until a more appropriate time.

As a reminder, while the OKO law is stronger today than ever, if it were to be deemed unconstitutional by the Oklahoma Supreme Court, we would have 90 days to get everyone back into traditional WC (per Section 213.B.4.).

Next: Vigilance and Diligence

My comments are mine and mine alone. I do not speak for any associations or lobbyists. I have no interest in debating those who inexplicably assume that any alternatives proposed to a failing system must stem from sinister motives. However, I encourage anyone (from prospective clients to employees of existing clients) with questions or concerns to call me.

Another option for learning more is to click here and watch a formal debate regarding the OKO. This footage was shot in September 2015. It features Michael Clingman arguing against the OKO while I, predictably, argue for it. One thing you can’t miss in that video is my desire to oust most attorneys from the scene. To help explain, I’ll adapt a quotation from John F. Kennedy (who was discussing taxation) to my own area of concern (the well-being of employees): “In short, it is a paradoxical truth that employee outcomes from increased WC protections are worse today, while economic results suffer, and the soundest way to create higher and better standards of living for employees is to eliminate these abused protections.” For philosopher kings, the theory of the OKO may not sound as good as the theory of WC, but when it comes to practical realities the results demand everyone’s attention.

To summarize my primary criticism of Insult to Injury, it simply hasn’t done enough. The story it tells is insufficient and smacks of partisanship and ideology, two biases that ProPublica’s journalists allegedly avoid. WC is substantially more complex than a corporation-out-to-exploit-its-workforce short story. Ignoring abuse in each of the communities in a five-sided WC debate demonstrates a lack of journalistic impartiality and a stunning deficiency of perception. Moreover, to my knowledge, ProPublica hasn’t crafted any relevant suggestions for legislation, simply leaving its readers with the vague and implicit notion that federal oversight is needed. If that is the goal of Insult to Injury—to provide one-sided, emotional yarns alongside a treasure trove of data, hoping it will all spur some federally elected officials to create real change at long last—then I suspect ProPublica will still be holding this subject up to the light of opprobrium upon the retirement of each of the series’ authors.

We do not aspire to win over the authors or even their followers. We will focus our energies each day on providing the best workplace accident programs for employers and employees alike. Our results should speak for themselves.

Finally, I am not an attorney, and nothing in this letter should be taken as legal advice.

Sincere regards,

Daryl Davis

Footnotes:

[1] With medical providers, overutilization is always a concern. Click here and watch the video from the 12-minute to the 15-minute mark for a detailed description of rampant WC abuse by surgeons who provide unnecessary and damaging back procedures. If the workers weren’t disabled prior to the surgeries, many were afterward. As for the legal community, simply view slide 73 of the NCCI’s 2013 Oklahoma Advisory Forum. WC disability payments, which is where attorneys get their cut, were 38% higher in Oklahoma than in neighboring states—not because jobs are 38% more dangerous in Oklahoma than in Kansas or Texas but because Oklahoma attorneys are 38% more effective at gaming the state’s WC system.

[2] Alabama SB 330—which was prompted by Insult to Injurynever got out of conference. From what I could gather, lengthy negotiations between several different interest groups led nowhere, with the Alabama Medical Association at the center of this particular stalemate. Not surprisingly, the two special sessions called by Alabama Gov. Bentley in 2015 were strictly focused on the state’s budgetary crisis; this bill was never discussed.

[3] The final Texas case study offered in CDWC deals with Billy Walker, who fell to his death while on the job. The upside to TXNS is his estate’s common law right to pursue a tort lawsuit against his employer. The employer could have been ordered to pay Walker’s estate a settlement in the millions, but the employer filed bankruptcy before any such judgment could be awarded, which is plainly an unacceptable outcome. This demonstrates a lack of surety—the single biggest problem in TXNS. OKO addresses this issue in various ways, most notably in Section 205 of Title 85A, which guarantees surety for injured workers.

[4] For the non-occupational components of your OKO program, ERISA does apply.

[5] Per Section 203.B. of the statute, compliant plans “shall provide for payment of the same forms of benefits included in the Administrative Workers’ Compensation Act for temporary total disability; temporary partial disability; permanent partial disability; vocational rehabilitation; permanent total disability; disfigurement; amputation or permanent total loss of use of a scheduled member; death; and medical benefits as a result of an occupational injury, on a no-fault basis, with the same statute of limitations, and with dollar, percentage and duration limits that are at least equal to or greater than the dollar, percentage and duration limits contained in Sections 45, 46 and 47 of this act.” (Emphasis mine.)

[6] Details of OKO appeals committee procedures are generally misunderstood—for now—by plaintiffs’ attorneys (and, apparently, investigative journalists). Attorneys frequently assume that, because the employer foots the bill, the employer controls the process. For a peek at how the appeals committee process really works for a majority of OKO employers, those curious should watch this video.

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.

Commercial Insurers Face Tough Times

Beyond the secular forces we described in our “Future of Insurance” series, more immediate and cyclical issues will be shaping the insurance executive agenda in 2016. Commercial insurers (including reinsurers) face tough times ahead, with underwriting margins that are being pressured by softening prices and a potentially volatile interest rate environment.

Recently, reserve releases, generally declining frequency and severity trends, as well as lower-than-average catastrophe losses have allowed commercial insurers to report generally strong underwriting results. However, redundant reserves are being (or have been) depleted, and the odds of a continued benign catastrophe environment are low. For example, one insurance executive recently observed, “The odds of this long of a lucky streak occurring is less than 1%.”

The commercial insurance market has, in recent years, had generally strong underwriting results, but this could change—potentially, very soon.

With varying degrees of focus, commercial P&C insurers have been mitigating the risk environment by taking a variety of strategic actions. In 2016 and beyond, they will need to accelerate their strategic efforts in four key areas: 1) core systems and data quality, 2) new products, pricing discipline and terms and conditions, 3) corporate development and 4) talent management.

Core systems and data quality

93% of insurance CEOs—a higher percentage than anywhere else in financial services—see data mining and analysis as more strategically important for their business than any other digital technology. Nevertheless, many commercial insurers operate with networks of legacy systems that complicate the timely extraction and analysis of data. This is no longer deemed acceptable, and leading insurers continue to transform their system environments as a result. Significantly, these transformations do not focus solely on specific systems for policy administration, claims, finance, etc.

To ensure timely quality data across the entire commercial P&C value chain, commercial insurers also focus on how the various systems are integrated with one another.

To put this into context, when a dollar of premium is collected, it not only “floats” across time until it is paid out in claims, it also “floats” across a variety of functions and their related systems: Billing systems process premium dollars; ceded reinsurance systems process treaty and facultative transactions; policy administration systems (PAS) process endorsement changes; claims systems process indemnity and expense payments.

Actuarial systems in disconnected data environments prevent the timely and efficient extraction and analysis of internal data and also complicate the focused and efficient use of external data, especially unstructured data. “Big data” is becoming increasingly popular considering the insights that insurers and reinsurers can derive from it. However, such insights only become actionable to the extent that companies can assess the external environment in the context of the internal environment—in other words, to the extent that big data can enhance (or otherwise inform) the internal data’s findings.

If all functional and systemic codes are not rationalized on an enterprise-wide basis, it is very difficult to efficiently accumulate and analyze data.

New products, pricing discipline and terms and conditions

Commercial insurers and reinsurers are not generally known as product innovators, but they can be. For example, as the profile of cyber-related risks increases, the need for cyber-related commercial insurance grows, thereby offering numerous opportunities for product innovation.

Because cyber is a relatively new exposure, frequency and severity data are nascent, therefore both pricing and risk accumulation models are in various stages of development. As a result, prescient insurers are carefully tracking and comparing their cyber pricing practices and coverage grants with those of key competitors. To be effective, such practices should be consistent with existing price, terms and conditions and monitoring processes. For example, tracking actual-to-expected premiums and rates is a common practice, which leading insurers perform regularly (i.e., at least quarterly, with monthly tracking common).

Insights from this kind of analysis apply to both new and existing products. The underwriting cycle is inherently a pricing phenomenon, and insurers and reinsurers that have greater and more timely product and pricing insights have a competitive advantage relative to those that do not. To explain, in addition to lower rates, the “soft” parts of the underwriting cycle tend to be characterized by the loosening of policy terms and conditions, which can erode profitability as quickly as inadequate prices. Therefore, the most competitive insurers and reinsurers carefully and continuously track the adequacy of policy terms and conditions. Recurring actuarial analyses and standardized reporting can monitor changes in pricing as well as in terms and conditions. However, identifying emerging underwriting risks is inherently qualitative. Therefore, this analysis can be time-consuming, especially for insurers with suboptimal PAS environments. However, almost all companies find the analysis well worth the effort.

Corporate Development

The combination of historically low interest rates, favorable frequency and severity trends and the relative lack of severe catastrophes has resulted in record policyholder surplus across P&C commercial insurance. Executives have a number of options on how to deploy surplus, one of which is corporate development.

Commonly, “corporate development” means mergers and acquisitions, but it can also encompass book purchases/rolls, renewal rights and runoff purchases. Determining the best option depends on many factors, including purchase price, competitive implications and an assessment of how the acquired assets and any related capabilities can complement or enhance existing underwriting capabilities.

Accordingly, some insurers are beginning to augment traditional due diligence processes (such as financial diligence, tax diligence and IT diligence) with underwriting-specific diligence to help ensure value realization over time.

If a corporate development opportunity offers underwriting capabilities that at least align to—and preferably enhance—existing capabilities, it can help facilitate a smooth integration, thereby mitigating underwriting risk (a key cycle management consideration).

Talent Management

For the most part, commercial underwriting decisions cannot be fully automated because they require judgment. Therefore, it is natural for underwriting talent to be a top priority. However, insurance executives have lamented that it is a major challenge for the industry to attract and retain knowledgeable personnel.

Two trends make commercial insurance talent management particularly challenging. First, experienced underwriters are leaving the industry. According to one study, “The number of employees aged 55 and over is 30% higher than any other industry—and that, coupled with retirements, means the industry needs to fill 400,000 positions by 2020.” Second, underwriting talent is relatively difficult to attract. For example, according to the Wall Street Journal, insurance ranks near the top of the list of least-desirable industries—according to recent graduates. The image of the insurance industry is that it is generally behind the times and offers little in terms of career development. Therefore, developing a performance-driven culture that enables the recruitment, development and retention of underwriting talent is more crucial than ever.

To help accomplish this, insurers should employ and should continuously assess tools and resources that educate and empower underwriters through all phases of their careers. This is important because the expectations in commercial underwriting are high, and the nature of the job requires a diverse range of skills (e.g., analytical, relational, sales, financial and risk). Furthermore, the best commercial underwriters are entrepreneurial, which employers should highlight as they recruit and manage their underwriting staffs.

Commercial insurers face a looming talent crunch and have to find ways to present themselves as—and actually be—a place where young people can have rewarding careers.

Implications

  • The relatively strong underwriting results of recent years are likely to soften in the coming year. Accordingly, commercial underwriters will need to accelerate their strategic efforts in:
  1. Core systems and data quality,
  2. New products, pricing discipline and terms and conditions,
  3. Corporate development
  4. Talent management
  • Core systems transformations go beyond individual system competencies. To ensure timely, quality data across the entire commercial P&C value chain, insurers also are focusing on how the various systems are integrated with each another to facilitate the timely and efficient extraction and analysis of internal data and the focused and efficient use of external data (especially unstructured data).
  • There are opportunities to create new products, but, to be profitable, insurers must exercise pricing discipline and must carefully and continuously track the adequacy of policy terms and conditions.
  • Current surplus levels have enabled insurers to invest in corporate development, and some insurers have augmented traditional due diligence processes (such as financial diligence, tax diligence and IT diligence) with underwriting-specific diligence to help promote value realization over time.
  • Commercial insurers have an aging workforce and are facing an impending talent crunch. Automation cannot replace the judgment that is required for effective underwriting. Therefore, it is vital for insurers to develop a performance-driven culture that enables the recruitment, development and retention of underwriting talent over time.

Traditional Insurance Is Dying

Finance. Taxis. Television. Medicine. What do these have in common?

They’re all on the long–and growing–list of industries being turned upside down by disruptive technology. 

The examples are legion. Once-sure-bet investments like taxicab medallions are at risk of going underwater. Bitcoin is giving consumers the power to bypass banks. Traditional television is at risk from online streaming.

Insurance Is No Different

In fact, innovative players have been disrupting the insurance market since before “disruption” was the buzzword it is today. 

Look at Esurance, which in 1999 rode the dot-com wave to success as the first insurance company to operate exclusively online. No forms, no policy mailers–it didn’t even mail paper bills.

By going paperless, Esurance told customers that it was the kind of company that cared about their preferences–and established itself as a unique player in an industry that places a premium on tradition. Insurance isn’t known for being innovative. 

Most insurance leaders operate under the assumption that if it ain’t broke, you shouldn’t fix it. And in a heavily regulated industry, that’s not totally unreasonable. 

But you only have to look at the scrappy start-ups that are taking down long-established players to understand what awaits the companies that aren’t willing to innovate.

Thinking Outside the Box

Take Time Warner–profit fell 7.2% last quarter as industry analysts foretold “the death of TV.” Meanwhile, Netflix’s profits are soaring beyond expectations–even as the risks it takes don’t always pan out. 

Remember the “Marco Polo” series that cost a reported $90 million? Neither does anyone else. But for every “Marco Polo” there’s an “Orange Is the New Black.” Highly successful programs on a subscription model show that Netflix’s willingness to take risks is carrying it past industry juggernauts.

The market is changing–and if you want to stay competitive, you need to use every weapon in your arsenal. Millennials aren’t buying insurance at the rate their parents did

To a consumer population weaned on technology like Uber and Venmo, the insurance industry seems positively antiquated. Facebook can advertise to you the brand of shoes you like–so your insurance company should be able to offer a product that you actually want.

The Information Importance

According to Accenture, “Regulated industries are especially vulnerable” to incumbents. When there are barriers to entry based on licensing requirements or fees, competition is lower. Decreased competition, in turn, leads to less incentive to innovate. This can leave regulated industries, such as insurance, healthcare and finance, in a highly vulnerable position when another company figures out a way to improve their offerings.

Other attributes that can make an industry vulnerable, per Accenture’s findings, can include:

  • Narrow focus: If a brand focuses entirely on cost savings, convenience or innovation, it isn’t effectively covering its bases. A disruptor that manages to offer two or three of these factors instead of just one has a near-immediate advantage.
  • Small scope or targets: Failing to expand offerings to all demographics can mean that industries or service providers aren’t able to replicate the broad reach of disruptors.
  • Failing to innovate: Disruptors don’t always get their product right on the very first try. Companies must innovate continuously and figure out ways to build continuous improvement into their business model.

Tech start-ups use information as an asset. How can you tell if information is a valuable weapon in the battle you’re fighting? 

“Big data” isn’t just a buzzword; industry analysts are calling it the wave of the future. At Citi, they’re talking about “the feed”: a real-time data stream that leverages the Internet of Things to reshape risk management. 

Auto insurers are turning to connected cars to let them reward safe drivers. Some life insurers are even offering discounts to customers who wear activity trackers.

It Can Happen to You

For most insurance companies, incorporating an unknown element into the way they operate is daunting. 

But talk to any cab driver, grocery store clerk or travel agent, and they’ll tell you that the only way to survive in a technology-driven world is to innovate.

Look at the insurance technology market to see what improvements you can incorporate into your organization, and think expansively about how you can use information: for agency management, to attract new customers and retain old ones, to expand your profit margins or to streamline operating costs. 

Your survival depends on it.

infrastructure

New Approach to Risk and Infrastructure?

Globally, the World Economic Forum estimates that the planet is under-investing in infrastructure by as much as $1 trillion a year. Since 1990, for example, the global road network has expanded by 88%, but demand has increased by 218%.

With the global population continuing to grow – and urban populations, in particular – the pressure on existing infrastructure is only set to worsen. And in the developed world, that infrastructure is creaking: In the U.K., 11 coal-fired power stations are nearing 50 years old, the end of their operational lives, and replacements have yet to be built; in the U.S., the average age of the country’s 84,000 dams is 52 years old; in Germany, a third of all rail bridges are more than 100 years old; parts of London’s Underground rail system, still in daily use by hundreds of thousands of commuters, run through tunnels that are more than 150 years old.

According to the Report Card on America’s Infrastructure by the American Society of Civil Engineers (ASCE), the U.S. alone will need $3.6 trillion of infrastructure investment by 2020.  The report assigned near-failing grades to inland waterways and levees, and poor marks for the state of drinking water, dams, schools, road and hazardous waste infrastructure.

Europe’s infrastructure is in worse shape. The Royal Institute of International Affairs has suggested that the continent needs $16 trillion of infrastructure investment by 2030, more than any other region in a world.

Taxing Issues, Tragic Consequences

While taxes once covered the cost of building and maintaining public infrastructure, entitlement programs such as Social Security and healthcare have started to claim a larger share of these funds as a percentage of government tax revenue, particularly as the number of people in retirement has expanded.

In addition, as the cost of social programs grew, governments came under pressure to cut taxes, leaving even less money available to maintain existing infrastructure, let alone invest in the requirements of growing populations. “Too often infrastructure is seen only through the lens of cost, expenditure and not as core to society’s prosperity”, says Geoffrey Heekin, executive vice president and managing director, global construction and infrastructure, Aon Risk Solutions.

“Since the 1950s, investment in infrastructure in developed countries has been declining,” he says. “In the U.S., for example, investment as a percentage of GDP has fallen from around 5% to 6% in the 1950s to around 2% today.”

Tragically, train derailments, road closures, water main breaks and even bridge collapses have become commonplace. “Until situations like the water crisis in Flint or a bridge collapse happens, infrastructure does not hold proper weighting in the psyche of leaders in government,” Heekin says.

This lack of attention to infrastructure is costing developed economies billions of dollars in lost productivity, jobs and competitiveness. Without addressing the infrastructure investment gap, the U.S. economy alone could lose $3.1 trillion in GDP by 2020, according to the ASCE, while one estimate attributes 14,000 U.S. highway deaths a year to poorly maintained road infrastructure.

A Private Sector Solution to Public Sector Under-Investment?

To begin reversing the infrastructure gap, it is likely that governments will need to find ways to encourage private sector investment toward replacing, renewing and upgrading physical infrastructure.

Governments of all political stripes are increasingly supportive of private investment in infrastructure. One model that is now gaining attention is the Public Private Partnership (P3) model.

P3s in one form or another have been used successfully in developed countries for several decades. They are being used to procure everything from public healthcare facilities, schools and courthouses to highways, port facilities and energy infrastructure. While the volume and type of P3 deal can vary widely by country, there continues to be an upward trend for the model’s use by the public sector.

In 2015, for example, Canada procured 36% of its infrastructure with the P3 model. Aon Infrastructure Solutions anticipates that 21 P3 projects will close in Canada in 2016, with a total capital value of US$12.8 billion – the highest value of P3 projects in Canadian history. In the U.S., where adoption of the P3 model is less widespread, 11 projects are expected to close in 2016, with a capital value of US$8.7 billion.

Like traditional design-bid-build procurement, P3 projects involve public authorities’ putting public projects or programs up for competitive tender and selecting a preferred bidder from multiple consortia.

The key difference is that the contractual structure in P3 allows the public authority to transfer a different set of risks to the private party – including (but not always) the financing for the project. The arrangement can allow the private partner that designs, builds and finances construction of the asset to operate and maintain it in return for either a share of the revenue generated by the use of the asset, or a stream of constant payments from the public authority (also called availability payments).

Keeping Focused on the Big Picture

“The public sector benefits from P3 delivery when the model is applied to a project that meets a community need and is procured through a transparent, accountable process,” says Gordon Paul – senior vice president, Aon Risk Solutions and member of Aon Canada’s Construction Services Group executive committee and Aon’s  global PPP Centre of Excellence.

“Public authorities seek ‘value for money’ in a P3 project by looking to the long-term value,” Paul says. This means identifying whether the private sector party is able to design, build, finance, operate and maintain an infrastructure project for a price lower than if the public authority did it on its own over the same period. It’s about the full lifecycle of the project – not just the building costs.

Taking a big picture view is equally important for the private sector party, says Alister Burley, head of construction for Aon Risk Services Australia. He points to the importance of taking a holistic view to P3 projects and investments to enable efficiencies to be built that will carry forward.

If done right, P3 arrangements can be a significant benefit to both the public and private sectors. Public bodies gain a much-needed boost to their infrastructure, often with long-term maintenance included in the deal, reducing the potential negative economic and health consequences of infrastructure failure. And private investors can secure a stable, long-term return through a stake in some of the underlying essentials of our economies.

Whatever route governments take to secure the integrity of our underlying infrastructure, one thing is clear – without a significant increase in infrastructure investment over the coming years, the world’s economy and health could well be put at further risk.