Should reinsurance using foreign affiliates be deductible to US corporations?
by Linda Beale
Should reinsurance using foreign affiliates be deductible to US corporations?
Foreign-owned US insurance companies frequently reinsure through their foreign affiliates and then claim a deduction under section 832(b)(4)(A) for the reinsurance premium paid to the affiliate to reduce the US tax liability of the US company.
Rep. Richard Neal (D-Ma) introduced a bill on October 12 that has been referred to the House Ways & Means Committee, where it now languishes unattended by the Republican chair, David Camp of Michigan. H.R. 3157 amends the Internal Revenue Code to create a new section 849, which disallows the deduction for certain reinsurance premiums and related amounts paid to non-taxed foreign affiliates, defined as members of a controlled group, with 50% rather than the usual 80% used to define a control relationship.
The President’s FY 2012 Budget included a similar proposal for disallowing some affiliated reinsurance premium amounts. Earlier iterations of a disallowance bill were introduced in 2000 and 2001. A bill with somewhat broader disallowance provisions, H.R. 3424, was introduced by Representative Neal in 2010 and did receive a hearing at Ways & Means that year. The Joint Committee on Taxation issued a report on reinsurance with offshore affiliates prior to the hearings on H.R. 3424 in 2010, titled “Present Law And Analysis Relating To The Tax Treatment Of Reinsurance Transactions Between Affiliated Entities”, JCX-35-10 (including a description of HR 3424 and the President’s FY 2012 proposal, beginning at page 22). As noted in the JCT report:
When these assets are shifted from a U.S. insurer to an offshore reinsurer with a foreign parent, these earnings may no longer be subject to U.S. income taxation. If the U.S. insurer and the offshore reinsurer are affiliated, the profits attributable to the reinsured risks remain within the affiliated group, although the earnings on the assets may no longer be subject to U.S.income taxation. (footnotes deleted)
If the offshore affiliate is in a low or no-tax jurisdiction, the result may be almost no tax on the reinsurance premium amounts (other than the applicable excise tax, if not eliminated by treaty). Not surprisingly, the trend over the last few decades has been towards reinsurance arrangements with affiliates: between 2001 and 2008, ceding of insurance of offshore affiliates grew by more than 108%, while ceding of insurance to nonaffiliated offshore entities grew by only 16%. See JCT report at 11, n.21 and accompanying text. Bermuda, a jurisdiction with no corporate tax and one especially friendly to insurers, is the most frequent jurisdiction for these affiliated reinsurance transactions. The JCT report notes that the lack of a market price for affiliate transactions provides an incentive to shift income between affiliates at off-market prices.
Also not surprisingly, lobbyists for these foreign-owned insurance companies have fiercely fought the possibility that this handy tax-reduction technique might be legislated away. The “Coalition for Competitive Insurance Rates” put out a press release on November 29, praising Republican lawmakers from Florida who had joined in a letter, available here, opposing the bill. The claim is that eliminating the tax avoidance technique will be a “punitive tax on reinsurance” that would “lead to higher premium costs” because it would “impose a tariff on international reinsurance firms” and that this would amount to “punitive and anti-competitive taxes.”
The Florida Republican representatives note that 90% of Florida’s insurance is reinsured offshore. The fact that such affiliate reinsurance is widespread does not mean that it is a better means of risk management. The regular amount of US taxes that would be charged on those US affiliates” income is not a “punitive” tax: it is merely the amount of tax that those firms would pay if they do not use affiliates as reinsurers.
Note that moving the insurance to an affiliate doesn’t achieve the risk-shifting that reinsurance is designed to accomplish–it retains the risk within the controlled group. (The IRS litigated a number of captive insurance cases under the theory that a controlled group constitutes a single economic “family” and hence cannot achieve risk-shift or risk-diversification. Although courts were hesitant to adopt this theory, it does seem to capture the essence of the affiliate reinsurance problem. The JCT report noted above also suggests the theory as a means of addressing the tax avoidance technique.) Although lobbyists claim that reinsurance with affiliates is a valuable “risk-management” tool and that reinsurance with affiliates accomplishes the same risk management as reinsurance with non-affiliated parties, it seems that reinsurance within a controlled group does not provide the same risk protection as nonaffiliated reinsurance. A catastrophic event covered by the reinsurer could result in liquidation of its assets, including its interest in the US affiliate.
Insurers using offshore affiliate reinsurers claim that there are nonetheless real non-tax advantages: (i) reducing adverse selection/moral hazard from information asymetry between insurer and reinsurer and (ii) “allowing risk and capital to be moved more easily … to respond to changing market conditions.” See Cragg, Cummins & Zhou, The Impact of a U.S. Tax on Offshore Reinsurance Market, TheBrattle Group , May 1, 2009 (research funded by the Coalition for Competitive Insurance Rates projecting a 2.1 – 2.4% rise in insurance costs upon elimination of the affiliate reinsurance scheme) (also cited in the JCT report for these claims).
These so-called advantages of affiliate reinsurance appear spurious. First, while the interests of the insurer and its affiliated reinsurer are aligned (so that the insurer will have less incentive to select the worse policies for that affiliated reinsurer or to be lax in its policy making for policies it will reinsure with its affiliate), the absence of real risk-shifting would make that alignment of little real value. Alternatively, as the JCT report notes, the aligning of interests may mean that the premium paid to affiliated reinsurers should be lower than the third-party premium, meaning that much of the affiliated reinsurance market may result in understatement of the US company’s income. Furthermore, nonaffiliated reinsurers may well undertake more comprehensive due diligence connected with taking on real reinsurance risk, and thus in fact contribute to a better risk-balanced insurance market.
Second, the claim that reinsuring with offshore affiliates allows for easier movement of capital in response to market conditions is of little real benefit to the U.S. insurance market. The foreign parent that reinsures the U.S. affiliate has received an advantage from having that reinsurance premium as its capital while at the same time reducing its US affiliate’s tax liability, but that merely substantiates the complaint of domestic companies that the ability to reinsure with a foreign affiliate gives an unjust competitive advantage–the double whammy of the tax deduction to the US affiliate and the capital infusion to the foreign company. Further, as we saw in the 2008 financial crisis, globalization of interactions among financial companies can have deeply negative systemic effects.
On balance, eliminating the deduction for affiliate reinsurance premiums is not the creation of an “anti-competitive tax” whenthe insurer is using the affiliate to shift income offshore and avoid paying U.S. corporate taxes. In fact, the ability of some insurance companies to offshore preimums is itself anti-competitive, since it puts wholly domestic U.S. insurance companies at a disadvantage.
What a shock! Another tax dodging scheme supported by Republicans.