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The overhaul of the U.S. tax code will lead to changes for the property/casualty insurance sector, including to their fourth-quarter 2017 reserving practices, and eventually lower pricing in some business lines, according to a note by analyst Keefe, Bruyette & Woods Inc.
The U.S. Congress on Wednesday adopted the bill that will, among other things, replace the current structure of corporate income tax rates, which has a top rate of 35%, with a 21% rate, and eliminate what some observers have deemed an unfair advantage or loophole that allowed foreign insurers to move their U.S.-generated insurance profits abroad to avoid tax.
The primary changes for the sector will be the lower corporate tax rate, the likely near-total discontinuation of intracompany cessions to non-U.S. affiliates, the elimination of tax-friendly intracompany debt, and adjustments to deferred tax assets and liabilities, according to a KBW note.
“Domestic fourth quarter 2017 reserve development will carry a 35% tax rate, which implies a smaller after-tax impact on earnings and capital than the same development would in 2018’s lower tax era,” the note said. “We think this will motivate some insurers to either report bigger reserve charges or smaller reserve releases than would happen without the tax bill backdrop. We obviously don’t expect this consideration to be made explicit, and we’re not suggesting explicitly fraudulent behavior, but at the very least, it seems reasonable to expect the timing of reserve development — and, for that matter, other potential charges — to reflect the economics of changing tax rates.”
Property/casualty pricing should eventually reflect lower taxes, according to KBW.
“The speed with which P&C rates will reflect lower tax rates should vary by line,” the note said. “We expect a faster regulatory response — still with significant variation by state — within personal lines than with commercial, especially specialty commercial, lines.”
Lower tax rates should justify rate decreases for profitable lines such as workers compensation and surety, while commercial auto and general liability rates should initially keep rising in response to fading underwriting margins, according to the analyst.
Lower domestic U.S. tax rates will likely roughly offset taxes associated with intracompany cessions, particularly excise taxes and taxes applied to “presumably” profitable ceding commissions that the analyst predicted will largely disappear under the new tax regime, leading to little change in its Bermudian earnings per share estimates, according to the note.
“On the other hand, we think there’s something of a strategic downside to the Bermudians, for two reasons,” the note said. “First, they are losing the pricing advantage embedded in tax rates that had been lower than those anticipated for domestic carriers. Second, and probably less significant, the shrinking difference between U.S. and Bermudian tax rates means an incrementally smaller opportunity for tax arbitrage that should incrementally reduce demand for reinsurance. This is not to suggest that tax arbitrage outranks capital needs and earnings and/or balance sheet protection as a motivation for buying reinsurance. But it seems important to recognize that on the margins, one of the benefits of buying reinsurance from unaffiliated third parties is declining.”
The U.S. Congress has passed a major overhaul of the country’s tax code, but not before a parliamentary rejection of some of the bill’s provisions forced the U.S. House of Representatives to vote on the legislation again Wednesday.