IRS Issues Final Guidance on Insurance Discounting

By Daniel J. Kusaila, CPA, and Leah E. McQueeney, CPA
| 9/23/2019

The IRS recently published final regulations and three revenue procedures that modify discounting rules for insurance companies. The guidance, which reflects changes made by the Tax Cuts and Jobs Act of 2017 (TCJA), is largely favorable for taxpayers. 

The guidance is effective for taxable years beginning after Dec. 31, 2017. As a result, insurance companies will need to recalculate their tax discounting for the 2018 tax year as well as for 2017. The changes to the discount rates as a result of tax reform require the revaluation of discounting prior year reserves to be added into taxable income or expensed over eight years.

Lead-up to the new guidance

Property and casualty insurance companies apply the discounting rules in IRC Section 846 to determine discounted unpaid losses and estimated salvage recoverable for federal income tax purposes. The rules also are used to determine discounted unearned premiums of title insurance companies and discounted unpaid losses of life insurance companies.

In November 2018, the IRS and the U.S. Department of the Treasury issued proposed regulations for Section 846, which the TCJA had amended. It subsequently released Revenue Procedure 2019-06 to provide the unpaid loss discount factors and salvage discount factors for the 2018 accident year and 2017 and prior accident years. Together, the new guidance covers several critical areas and includes substantial revisions in response to comments received on the proposed regulations and Revenue Procedure 2019-06.

Determining applicable related interest

The applicable interest rate used to determine the discount factors associated with any accident year and line of business is the annual rate. Under the final regulations, the annual rate for any calendar year is the average of the corporate bond yield curve’s monthly spot rates with a maturity range from 4.5 to 10 years, computed using the most recent 60-month period ending before the beginning of the relevant calendar year. 

The maturity range in the final regulations is more favorable than the 0.5 to 17.5-year range provided in the proposed regulations. Commenters had expressed concern about that wide maturity range, particularly when the bond yield curve is unusually steep. Based on the final rules, the current applicable interest rate for 2018 is 2.94% compounded semiannually, down from the proposed annual rate of 3.2% compounded semiannually. 

Composite method

Taxpayers generally use the composite method to discount loss reserves for accident years 10 and prior. The proposed regulations would have discontinued the use of the method.

Commenters indicated that some insurers would find it difficult to compile the data required to compute discounted unpaid losses for accident years not separately reported on the National Association of Insurance Commissioners (NAIC) annual statement (that is, for accident years 10 and prior). The final regulations therefore continue to allow the use of the composite method. The IRS also will continue to publish composite discount factors annually.

Smoothing adjustments

The smoothing adjustments allow the IRS to adjust the loss payment pattern for any line of business if necessary to avoid negative payment amounts and produce a stable pattern of positive discount factors less than one. The proposed regulations provided that the loss payment pattern determined for each line of business generally is determined by reference to the historical loss payment pattern applicable to that line of business. The final regulations adopt this provision as proposed.

Determining estimated discounted salvage recoverables

The preamble to the proposed regulations requested comments on whether the estimated salvage recoverable should be discounted by using the published discount factors applicable to unpaid losses. This change would allow taxpayers to net unpaid losses and salvage recoverables with the same factor. Previously, the IRS had published a separate discount factor for salvage recoverables.

Commenters generally welcomed this change, and the preamble to the final regulations adopts it. The IRS expects the change to reduce compliance complexity and costs.

Reinsurance and international lines of business

The TCJA amended Section 846 so that it no longer explicitly provides for determining loss payment patterns for nonproportional reinsurance and international lines of business extending beyond three accident years. The proposed and final regulations remove the tax regulation that corresponded with that provision of Section 846.

Change in method of accounting

For changes made for taxable years beginning after Dec. 31, 2017, and ending on or before Dec. 31, 2019, Revenue Procedure 2019-30 provides simplified procedures for changing the accounting method for discounting unpaid loss reserves. One major simplification is waiver of the requirement to file Form 3115, “Application for Change in Accounting Method,” to obtain IRS consent to change the method of accounting.

On Aug. 6, 2019, the IRS released Revenue Procedure 2019-34 to provide simplified procedures under IRC Section 446 and Treasury Regulation Section 1.446-1(e) for an insurance company to obtain automatic consent of the IRS Commissioner to change its method of accounting to comply with IRC Sections 807 and 848.

The simplified procedures generally are consistent with those provided in Revenue Procedure 2019-30, waiving the requirement to file Form 3115, but apply to any insurance company that changes its:
  1. Method of computing life insurance reserves to comply with amendments to Section 807
  2. Method of computing amounts under Section 807(c)(3) to comply with TCJA amendments to Section 807 (excluding those companies already complying with the procedures in Section 26.04 of Revenue Procedure 2018-31 or its successor)
  3. Methods of capitalizing and amortizing specified policy acquisition expenses to comply with amendments to Section 848

It is important to note that the procedures provided in Revenue Procedure 2019-34 are available for only one taxable year. Given the timing of its issuance, the revenue procedure also provides certain “accommodations” for an insurance company that already prepared its tax return for the first taxable year beginning after Dec. 31, 2017.

Revised discount factors

Revenue Procedure 2019-31 revises the unpaid loss discount factors for discounting 2018 loss reserves and for revaluation of loss reserves for 2017 and prior years. It also allows a taxpayer to use the revised discount factors provided in Revenue Procedure 2019-31 or the factors provided in Revenue Procedure 2019-06 for the 2018 tax return, as long as the taxpayer is consistent with using the proposed or revised factors for both the 2018 discounting and for revaluation for 2017 and prior tax years. 

Regardless, taxpayers must use the revised discount factors in Revenue Procedure 2019-31 for tax years after 2018. Fiscal year filers must use the revised factors for tax years ending on or after June 17, 2019.

In addition, if the proposed factors are used, the revised discount factors in Revenue Procedure 2019-31 must be used when computing any supplemental adjustment to account for the difference between the discount factors determined under the two revenue procedures. The taxpayer has the option to take this supplemental adjustment into account in 2018 or spread the adjustment over the remaining six years (after 2017 and 2018) of the eight-year spread.

Revenue Procedure 2019-31 also prescribes discount factors for the 2019 accident year – a gift to insurance companies, which do not normally receive the factors so early in the year.

Proceed with caution

Overall, the changes in response to comments on the proposed rules and Revenue Procedure 2019-06 benefit taxpayer insurance companies. The lower discount factors should translate to more favorable tax adjustments, and other changes should reduce the computational burden.

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Daniel Kusaila
Daniel J. Kusaila
Leah McQueeney