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Insurers to Endure a Hitch Before Tax Reform Gains

The U.S. Senate passed The Tax Cuts and Jobs Act of 2017, marking President Donald Trump’s first major legislative victory. The reform, which brings down the tax rate to 21% from 35%, is anticipated to be an overall positive for the corporate sector.

Trump noted that such a bill is a “big, beautiful Christmas present” for families, while the White House press secretary said that “a simple, fair, and competitive tax code will be rocket fuel for our economy, and it's within our reach.”

Notably, this biggest ever one-time drop in business tax will likely be conducive to economic growth. However, insurers and companies in the finance sectors, such as banks, will have to endure some short–term pain before enjoying the benefits.

Initial Impact Not So Glossy

The initial impact of tax reduction to be borne by companies in the insurance sector will be in the form of a write-down in deferred tax assets (DTAs). This is also likely to a take a hit at their risk-based capitalization levels.

DTAs arise when an insurer records an asset equal to the expected future amount of the tax deduction, because of the requirement to discount loss and unearned premium reserves.  

Rating agency Standard & Poor's estimates that its rated U.S. life insurers had about $35 billion of DTA on their statutory balance sheets as of Sep 30, 2017.
The new tax bill requires some insurers to write down DTAs to align their balance sheets to the new tax regime.

Per the S&P, the reform will lead to an aggregate write-down of about $14 billion of life insurers’ DTA, representing 4% of statutory capital. Consequently, this will hit the capitalization levels of some insurers. Deterioration in Risk Based Capital at regulated subsidiaries would also impact subsidiaries’ ability to pass on dividend capital to the holding company.

Reinsurer RenaissanceRe Holdings Ltd. RNR recently announced an estimated $40 million of reduction in its net income on account of DTAs write-down.

MetLife estimates its RBC to be down by 65 basis points. Prudential Financial Inc. PRU expects an around 100-point impact to the RBC at the PICA level. Torchmark estimated a reduction of around 50 basis points on the assumption that the tax rate would go down to 25% but the magnitude of decline has been more than anticipated.

The S&P also stated major changes from the tax bill to multinational entity taxation rules. Shift to a territorial tax system and the base erosion tax provisions will affect U.S. insurers with international operations as well as foreign reinsurers with admitted domestic subsidiaries.

The rating agency expects some degree of repatriation of offshore retained profits to bring cash into the country (from foreign subsidiaries). Conversely, the increased excise tax may result in reinsurers and certain insurers, which use offshore reinsurance captives, adjusting their capital optimization strategies or product pricing due to the higher taxes.

Long-Term More Attractive

While the near-term impact on insurers is not all positive, the long-term effects would definitely be more attractive. A lower tax rate would flow through the bottom line and aid margins directly. Apart from boosting margins, the tax-rate reduction will also make U.S insurers more competitive globally.

In addition to the above, the tax reform, which includes lower domestic tax rates on repatriation of income stashed offshore, will well serve foreign insurers that moved abroad the profit generated in the United States to avoid tax.

The bill looks like a major legislative achievement, having been supported widely by industry groups. The Coalition for American Insurance, which represents major U.S.-based insurance groups (Alleghany, The Allstate Corp. ALL, American Family, American Financial Group Inc., Berkshire Hathaway, Cincinnati Insurance, CAN, EMC Insurance, Liberty Mutual, The Hartford, Travelers and W.R. Berkley Corp.WRB, has also endorsed this historical reform.

Since the passage of this bill, the industry has grown 0.2%, outperforming the S&P 500’s increase of 0.1%.

 

Going Forward

The year 2017 had been an eventful one for insurers given huge catastrophe losses on the one hand and the tax reform on the other. We expect 2018 to be smooth for the players as they adjust to the new tax regime and ultimately reap the benefits of a lower tax rate.

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