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The Impact of the 2017 Tax Reform on life insurance companies
Iowa Actuaries Club
February 20, 2018
PwC
Today’s presenter
Chuck Chacosky, PwC Actuarial Services (AS) Director
(610) 425-8932
PwC
Agenda
Section01 Presentation Overview
02 Brief history of the US Federal taxation of life insurance companies (“LIC”)
03 2017 US Federal taxation of LIC
04 What hasn’t changed under the new tax reform law
05 What has changed under the new tax reform law
06 Open Forum – Questions?
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Section 1 –Presentation Overview
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Objectives
During today’s presentation, I will
• Provide a brief overview of the history of the US Federal taxation of LIC
• Highlight what was in-place for 2017
• Describe what hasn’t changed under the new tax reform law
• Discuss what has changed due to the new tax reform law
• Outline how Tax Reform may impacts 12/31/2017 financial reporting
• Have an Open Forum for Q&A
During today’s presentation, I (nor PwC) will not be giving you any tax advice whatsoever. This is an informational update for discussion purposes only.
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Before we discuss taxes, lets review LIC activesPremiums and investment income are the main sources of income for LIC. Commissions, general expenses, policyholder benefits and reserves are the main LIC costs, but not all of these are fully tax deductible.
1 Premium Collections
Individuals
Companies
Affinity Groups (ex. AICPA members)
Life Insurance Company
2 Payments & Accruals
Reserves backed by Investments
Reinsurers
3 Net Investment Income
Benefits, net of reinsurance ceded
Agent & SellerCommissions
Taxes & General Expenses
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Section 2 –
Brief history of the US Federal taxation of LIC
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US Federal Taxation of LIC before 1958 –The simple years
• At the outset of the federal corporate income tax, LIC were taxed according to the same IRS provisions as other corporations.
• Since the Revenue Act of 1921, Congress has taxed LIC under special rules that differ from those applicable to normal business corporations.
• From 1921 through 1957, Congress avoided the tough issues. LIC were taxed on the “free investment income” approach. Where “free investment income” was their total investment income less a portion deemed to be allocable to the company’s obligations to its policyholders. Under this tax method, LIC were taxed simply on an allocated portion of their investment income.
• Over those decades, Congress made various adjustments to the formulas used to determine that allocation of investment income, but made no fundamental change to the method.
• Effectively, premiums, commissions, general expenses, policyholder benefits and reserves were not a direct part of LIC’s IRS tax returns.
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LIC Income Tax Act of 1959 –The complicated three-phase system of taxation
• Most mutual LIC were taxed under “Phase I” which was based on their share of investment income, after a deduction for policyholder dividends.
• “Phase II” taxes were applied to most stock LIC based upon their “gain from operations” using their own statutory reserves.
• LIC were allowed to deduct certain non-economic “special deductions” and were allowed to defer the taxes on 50% of their remaining underwriting income. The untaxed amounts were then added to the company’s “policyholders surplus account.”
• If, however, the LIC distributed those surplus funds to its shareholders, or if they ceased to be a LIC, the untaxed amounts were included in taxable income as the so-called “Phase III” tax.
• The 1959 Act is considered by all as overly complex. In analyzing a 1978 tax dispute arising under the 1959 Act, Judge Fletcher of the Court of Claims wrote that “these complex and obscure provisions bear all of the earmarks of a conspiracy in restraint of understanding.”
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Tax Reform Act of 1984 –The basic LIC tax method through 2017
• One of the legislative goals of the Tax Reform Act of 1984 was to tax LIC on their total “economic profit”. In the next section, I will discuss how Congress adjusted statutory profits to form taxable income.
• Another goal in 1984 was to raise a predetermined level of revenue from LIC. Congress estimated the projected level of tax revenues under the new structure at the then 46% corporate rate. Those estimates appeared too high, so Congress enacted two extraordinary deductions for LIC:
(a) A “special deduction” equal to 20% of a LIC’s taxable income. This effectively reduced a large LIC’s rate to to a 36.8% rate.(b) A “small life deduction” equal to 60% of a LIC’s taxable income.
• Congress eliminated the 20% special deduction in 1986, after President Reagan reduced the top corporate rate to 34%. In 1993, President Clinton raised the top corporate rate to 35% and it remained there until 2018.
• The 1984 Act also included a special IRC § 809 tax on mutual LIC’s surplus using an “imputed earnings rate”. This was repealed under President Bush in 2004. As such, it is not covered in this presentation.
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The Omnibus Budget Reconciliation Act of 1990 –The last piece of the existing tax method
• In November of 1990, Congress added a new tax on LIC based on premium income. This would become to be known as the “DAC Tax” and is discussed in more detail in the next section.
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Section 3 –2017 US Federal taxation of LIC
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IRC § 807 “Rules for Certain Reserves”
• In determining a LIC’s taxable income, the LIC includes in gross income the net decrease in tax reserves or deducts a net increase in tax reserves. The reserve methods for determining tax reserves generally are based on the methods prescribed by the NAIC, but some assumptions more complicated.
• The change in tax reserves, includes (and does in 2018) six items:(1) life insurance reserves(2) unearned premiums and unpaid losses included in total reserves(3) amounts that are discounted at interest to satisfy obligations under
insurance and annuity contracts that do not involve life, accident, or health contingencies when the computation is made
(4) dividend accumulations and other amounts held at interest in connection with insurance and annuity contracts
(5) premiums received in advance and liabilities for premium deposit funds(6) reasonable special contingency reserves under contracts of group term
life insurance or group A&H insurance that are held for retired lives, premium stabilization, or a combination of both.
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IRC § 807 “Rules for Certain Reserves” - Continued
• For tax purposes, “life insurance reserves” are defined in IRC § 816(b):A. Amounts which are computed or estimated on the basis of recognized
mortality or morbidity tables and assumed rates of interest, andB. are set aside to mature or liquidate, either by payment or reinsurance,
future unaccrued claims arising from life insurance, annuity, and non-cancellable accident and health insurance contracts (including life insurance or annuity contracts combined with non-cancellable accident and health insurance) involving, at the time with respect to which the reserve is computed, life, accident, or health contingencies.
• This definition includes most of the categories of statutory reserves for life and annuity products as well as ALR and DLR for LTC and LTD products.
• Under the 2017 (and current) law:(1) No deduction for asset adequacy or deficiency reserves is allowed(2) On a seriatim basis, the tax reserve cannot exceed the statutory reserve(3) The minimum tax reserve is each contract’s net surrender value
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IRC § 807 “Rules for Certain Reserves” - Continued• Under the 1984 law, 2017 tax reserves are calculated using three rules:
A. The “tax reserve method” at the time the policy was issued, which generally was CRVM for life insurance, CARVM for annuities, 2-year full preliminary term (FPT) for most non-can A&H, and 1-year full preliminary term (FPT) for IRC § 7702B qualified LTC insurance.
B. The discount rate which is the greater of (i) the applicable Federal interest rate (AFR), or (ii) the prevailing State assumed interest rate.
C. The prevailing commissioners’ standard tables for mortality and morbidity adjusted as appropriate to reflect the risks (such as substandard risks) incurred under the contract which are not otherwise taken into account.
• Over time, practical issues arose with these rules, such as: (1) The NAIC made new methods (such as PBR, principles-based reserves)
or retroactive rules (such as AG 43) that did not directly fit in with the seriatim requirement or the prevailing commissioners’ standard table.
(2) Over the last decade, the low interest environment eliminated much (if not all) of the original discount rate differential (which had lowered tax reserves well below stat in the last century).
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IRC § 848 – The DAC Tax
• Since the passage of the 1990 law, LIC have effectively paid a tax based on net premium income, the “DAC Tax”. The “DAC Tax” calculated for a tax year (positive or negative) is added to LIC income. This calculation has two parts: (1) The DAC tax rates times net premiums for the current tax year(2) Amortization (reversal) of DAC tax amounts from prior tax years
• The 1990-2017 DAC tax rates are delineated by three product categories:A. Annuity - 1.75% of the net premiums.B. Group Life – 2.05% of the net premiums.C. All Other – 7.70% of the net premiums.
• For DAC tax over $10 million, the amortization period is 10 years, beginning in the second half of the tax year the premiums were collected.
• Thus, for most large on-going LIC, the DAC Tax effectively was a 10-year interest free loan to the IRS.
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Section 4 –What hasn’t changed in 2018 under the new tax reform law
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Many of the fundamental concepts of the 1984 and 1990 laws remain in-place
• Although, the calculated amounts are affected, under Tax Reform, LIC will continue to determine taxable income by making adjustments to statutory income for tax reserves and DAC taxes.
• There is no change to definition of what the six tax reserves are conceptually, but some ‘life insurance reserves’ will be lowered and a few are raised.
• There is no change to the definition of what a Separate Account reserve is and LIC continue to get a Dividends Received Deduction (“DRD”).
• Under the 2017 and carried over in the current law:(1) No deduction for asset adequacy or deficiency reserves is allowed(2) On a seriatim basis, the tax reserve cannot exceed the statutory reserve(3) The minimum tax reserve is each contract’s net surrender value
• There is little change to reinsurance between two US insurers or with a foreign nonaffiliated reinsurer.
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IRC § 807 “Rules for Certain Reserves”
• In determining a LIC’s taxable income, the LIC includes in gross income the net decrease in tax reserves or deducts a net increase in tax reserves. The reserve methods for determining tax reserves are based on methods prescribed by the NAIC.
• The change in tax reserves, includes (and does in 2018) six items:(1) life insurance reserves(2) unearned premiums and unpaid losses included in total reserves(3) amounts that are discounted at interest to satisfy obligations under
insurance and annuity contracts that do not involve life, accident, or health contingencies when the computation is made
(4) dividend accumulations and other amounts held at interest in connection with insurance and annuity contracts
(5) premiums received in advance and liabilities for premium deposit funds(6) reasonable special contingency reserves under contracts of group term
life insurance or group A&H insurance that are held for retired lives, premium stabilization, or a combination of both.
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Section 5 –What has changed in 2018 under the new tax reform law
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Tax Reform Act of 2017 – Changes to LIC tax rates
• The top corporate rate drops to 21% down from 35%. Obviously, on a go-forward basis, this is directly beneficial to large profitable LIC. However, many see a sizeable reduction to their December 31, 2017 DTA and foresee potential increases in the 2018 RBC requirements. Entities with projected losses may see the after-tax impact increase.
• The “small life deduction” is eliminated, raising their rates to 21%. Frankly, no one seems to recall why this deduction was in-place.
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Tax Reform Act of 2017 – LIC Changes to NOLs
• Net Operating Losses (NOL) – NOL carrybacks will no longer be allowed and carryforwards aren’t subject to expiration. NOLs generated after December 31, 2017, can only offset 80 percent of regular taxable income in any given year.
• The 80 percent limitation is intended to ensure all companies with current-year taxable income (pre-NOL) will pay some tax. However, NOLs of property/casualty and other non-life insurers will continue to be governed by existing law (two-year carryback, 20-year carryforward and 100 percent offset of regular taxable income).
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IRC § 807 “Rules for Certain Reserves” - Changes• The “tax reserve method” is the NAIC method determined as of the
date the reserve is determined instead of at the time the policy was issued. This generally is CRVM for life insurance, CARVM for annuities, and 2-year FPT or 1-year FPT for LTC. This helps clear-up issues around new methods (such as PBR, principles-based reserves) or retroactive rules (such as AG 43) and fixed a small mismatch for LTC.
• References to AFR discount rate and the prevailing commissioners’ standard tables are eliminated. The discount rate is the “highest rate or rates permitted to be used” by the NAIC for the contract.
• The amount of the life insurance reserves for any general account contract is the greater of: (i) the net surrender value, or (ii ) 92.81% of the reserve determined under the tax reserve method.
• For separate account contract, take the greater of (i) the net surrender value, or (ii ) separate account. Then add to that 92.81% of the excess, if any, of the reserve determined under the tax reserve method.
• The limits remain: the tax reserves cannot exceed statutory booked and no deduction for asset adequacy or deficiency reserves is allowed.
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IRC § 807 - Transitional Rule
• These new provisions applies to taxable years beginning after December 31, 2017.
• However, for the first taxable year beginning after December 31, 2017, the difference in the amount of the reserve with respect to any contract at the end of the preceding taxable year and the amount of such reserve determined as if the proposal had applied for that year is taken into account for each of the eight taxable years following that preceding year, one-eighth per year.
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IRC § 848 – The New DAC Tax
• Since the passage of the 1990 law, LIC have effectively paid a tax based on net premium income, the “DAC Tax”. The “DAC Tax” calculated for a tax year (positive or negative) is added to LIC income. This calculation has two parts: (1) The DAC tax rates times net premiums for the current tax year(2) Amortization (reversal) of DAC tax amounts from prior tax years
• The 2018 DAC tax rates were raised about 20%:A. Annuity – 2.09% up from 1.75% of the net premiums.B. Group Life – 2.45% up from 2.05% of the net premiums.C. All Other – 9.20% up from 7.70% of the net premiums.
• For DAC tax over $10 million, the amortization period is now 15 years, (up from 10 years) beginning in the second half of the tax year the premiums were collected.
• Thus, for most large on-going LIC, the DAC Tax effectively is a 15-year interest free loan to the IRS.
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Tax Reform Act of 2017 – Changes to DRD
• Under Sections 805 and 812, there are dividend proration rules whereby a life insurance company is allowed a dividends received deduction for intercorporate dividends from nonaffiliated entities in proportion to the company’s share of such dividends.
• The new law lowered the company’s share to 70 percent down from 95 percent.
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Base Erosion and Anti-Abuse Tax (“BEAT”) • The corporate tax cut and BEAT will reduce the tax advantage of reinsuring
US risks offshore with more reinsurance business and capital incentivized to stay in the US.
• In 2017, US LIC paid an excise tax on premium payments from the US to offshore affiliates at 4% on direct premiums and 1% on reinsurance premiums. The added BEAT will be at a significantly higher rate: 5% in 2018, then 10% until 2025 and 12.5% thereafter.
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Section 6 – Open Forum
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Thank you
© 2018 PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.
Chuck Chacosky, PwC Actuarial Services (AS) Director
(610) 425-8932
