Life insurance companies hold a unique status under U.S. tax law because of the long-term guarantees and benefits that distinguish life insurance from other financial products. We receive a deduction for the prescribed tax reserves set aside to meet future claims.
This deduction not only plays a role in product design and mix, but it also impacts asset and liability management, corporate structure and timing of business decisions. Any change in the tax code or its interpretation that affects the present value tax rate is of great concern to more than just the tax department.
Principles-based reserving (PBR) proposes significant changes to reserving methodology. Currently, both statutory and prescribed tax reserves for term life insurance are substantially larger than the economic reserves required to mature claims and to support policy risks.
Under PBR, statutory reserves would more accurately reflect the underlying risks. For products that are likely to be included in the initial scope of PBR – variable annuities, universal life with secondary guarantees and level term life insurance – statutory reserves are likely to decrease. A reduction in statutory reserves would most likely reduce the tax deferral as well, and it is possible that nondeductible reserves could increase. These changes could affect the profitability and pricing of product lines.
Tax Treatment at Risk
PBR proposes so many fundamental changes that a risk exists that the U.S. Treasury may ask Congress to revise the tax code instead of clarifying the treatment of tax reserves under the new methodology. These revisions could adversely affect the favorable tax status that the current regime provides.
Reserve deduction rules are a natural pressure point between the industry and tax authorities. Life insurers seek to maximize deductions; tax authorities seek to minimize tax reserves. The reserve deduction has been particularly troublesome when applied to hybrid products that mix the features of investments and insurance. In a time of increasing deficits, Treasury and the Congress may see PBR legislation as a chance to change the rules to restrict the tax reserve deduction.
The current reserve proposals have been written with some intent to fit within existing tax laws; it is probable that further “tax-friendly” changes will be needed. It isn’t clear if those changes will sufficiently address tax concerns, but the industry is very unlikely to support any proposal that has a significant risk of creating tax problems or opening up the tax code. A “Notice of Advanced Rulemaking” from Treasury is expected within the next month or so that should help the industry understand Treasury’s concerns, after which the industry will propose appropriate modifications to the proposals.
Key Areas of Concern
Deductibility of stochastic reserves. Since 1984, tax reserves have been based on a formulaic approach at the policy (seriatim) level. Stochastic reserves under PBR are computed using possible future economic scenarios. This methodology, which uses a conditional tail expectation metric, excludes the “good” economic scenarios and includes only the “bad” (e.g., worst 35 percent) scenarios.
It is possible that stochastic reserves could be ruled contingency reserves, which are not deductible. Assuming stochastic reserves are allowed, another hurdle to clear is applying the appropriate reserve on a seriatim basis. Calculating seriatim reserves stochastically poses a daunting technical challenge. The NAIC has suggested that it would be appropriate to calculate aggregate stochastic reserves and then allocate back across component policies. While this may work for a simple product like term, it is much more problematic for products with investment or credit exposure.
New reserve components. Regulators often question reserves set aside to cover risks beyond those directly related to policyholder benefits (i.e., mortality, lapse and interest rates). One of the tax issues with PBR is that it requires a gross premium valuation, which includes provisions for additional reserve components including future company expenses, non-guaranteed benefits and assumption margins. The current body of tax law would seem to limit tax reserves to amounts established to cover policyholder claims.
Multiple mortality tables. Under the current life insurance proposal, companies would calculate reserves using a blend of industry standard mortality tables and company-specific experience, then convert to an industry standard table. The concern is that Treasury may exploit the existence of multiple tables and require companies to use the table that generates the lowest tax reserve.
Actuarial judgment and sophisticated financial modeling. PBR would create new auditing challenges for regulators and tax authorities. Under the current rules-based code, auditors can assess how much a company should hold in reserves and pay in taxes by ensuring that the prescribed formula and assumptions are used.
Under PBR, both the methodologies and assumptions are based on professional opinion and vetting them requires both better industry and company data and more sophistication on the part of auditors. However, professional judgment and historical experience are used for the taxation of financial institutions other than life insurers (e.g., pricing of illiquid derivatives and other instruments), so there is precedent.
Given the potential for seeing their tax status revisited, life insurers would prefer all PBR concerns to be answered away from Capitol Hill. Critics of the current tax regime, of course, would welcome an opportunity to review the tax code. Concerns about fitting PBR under the umbrella of the existing code are being addressed by industry advocates, and Treasury remains open to discussion, but the issue remains up in the air.