How Tax Reform May Affect Insurers’ Investment Strategies

H.R. 1, commonly known as the Tax Cut and Jobs Act of 2017 (TCJA) signed into law late last year, contains several provisions that target insurance companies specifically. Beyond its immediate tax consequences, the new law is likely to have a significant effect on many insurance companies’ long-term investment and financial management strategies.

  

Insurers in all lines should plan to devote adequate time, attention, and resources toward evaluating how the new tax law will affect them in order to adjust their investment strategies accordingly.

 

While the overall effects of the rate reductions in the 2017 tax reform law are likely to be positive for most businesses, certain provisions of the law could offset the benefits slightly for some insurers. The most significant changes from a broad perspective include the rate restructuring that replaces the previous graduated rate system with a new flat tax rate of 21 percent for most corporations. Equally significant for many companies is the elimination of the corporate alternative minimum tax (AMT).

 

This general reduction in corporate taxes could have a significant effect on the value of deferred tax assets and deferred tax liabilities, with a corresponding effect on an individual insurer’s surplus. Other important provisions include changes in expensing rules and limitations, limits on net interest deductions, and reductions in the dividends received deduction (DRD).

 

The law also changes the way most net operating losses (NOLs) are handled, but the provisions for property and casualty (P&C) carriers have not changed and are now different from the rules for life insurers and most other businesses. Starting with their 2018 returns, life insurers, like most corporations, no longer will be able to carry back losses and apply them to prior years’ returns. They still can carry forward losses, however. Although the carryforward amount will be limited to 80 percent of their taxable income, the 20-year limitation has been eliminated, and NOLs can now be carried forward indefinitely.

 

Note, however, that these changes in NOL provisions do not apply to P&C companies, which still will be subject to the two-year carryback and 20-year carryforward rules. Moreover, P&C companies will not be subject to the 80 percent limitation on NOL carryforwards. Having separate NOL rules for various lines of business obviously complicates tax preparation and financial planning for multiple lines carriers and holding companies. The variations also could affect future merger and acquisition or consolidation plans.  

In addition, P&C loss reserve discount factors will now be determined on the basis of the corporate bond yield curve, which is expected to produce steeper discounts and reduced deductions. The discount period for certain long-tail lines of business is also extended from 10 to 24 years. For life insurance companies, the tax discount rate generally now is set at 92.81 percent of their statutory reserve. Overall, these changes in P&C and life insurance reserve calculations are expected to have a negative effect on the industry.

 

Life insurers also face some potentially negative effects from the new law. One prominent example is the elimination of the small life insurance company deduction, which previously allowed qualified small insurers to deduct up to $1.8 million in taxable income. This is another change that affects life and P&C carriers differently, since a similar deduction for P&C companies was not eliminated.

 

The new law also makes several changes to the methods and timetables that life insurers can use to capitalize their policy acquisition costs. The net effect of these various changes is expected to be an increase in taxable income for life insurers in the future.

 

One new provision that is generally viewed as a positive development for life insurers is a change in the proration rules for the exclusion of tax-advantaged investment income. The new rules replace the various formulas that were used in the past, and instead fix the company’s share at 70 percent and the policyholders’ share at 30 percent.

 

Inevitably, the new tax law’s many wide-ranging and sweeping changes – both positive and negative – will have significant impact in the investment community as well. The municipal bond market, in particular, has seen generally higher yields and wider spreads in the months since the new law was signed. For their part, insurers are expected to find value in longer maturities, but short- and intermediate-term bonds will be less attractive in terms of tax equivalent yields.

 

Several provisions of the tax law will affect P&C companies’ investment strategies, particularly as they relate to municipal bonds, since the overall rate reduction will increase after-tax income and thus make tax-advantaged income less valuable. These effects could be offset somewhat by other provisions, however.

 

For example, eliminating the corporate AMT removes a major constraint on municipal bond allocations. In addition, increasing proration will have the effect of maintaining a 5.25 percent effective tax rate on municipal bond income. The net result of these changes might be a general decline in P&C insurers’ municipal bond holdings during the remainder of 2018.

 

A preliminary analysis suggests that most P&C insurers may choose to reallocate 10 to 25 percent of their municipal bond portfolios to other investments. The largest portion of this reallocation likely would move to corporate bonds. In general, insurers are expected to find greater value in longer maturity municipal bonds, since short- and intermediate-term securities generally will offer less attractive tax equivalent yields.

 

Other alternatives to corporate bonds also may be attractive. These include commercial mortgage loans, collateralized loan obligations, privately placed corporate bonds, and taxable municipal bonds.

 

Life and health insurers’ investment strategies are also changing as a result of the new law. As with P&C companies, life insurers are likely to find the combination of reduced corporate tax rates, a lower DRD, and changes to the proration formula will affect the relative attractiveness of investments in common stock and tax-exempt municipal securities.

 

For example, although life and health insurers historically have allocated only about 1 percent of their unaffiliated bond investments to tax-exempt municipals, that allocation is likely to increase as a consequence of the new tax law. Even though it might appear reduced corporate tax rates and a smaller DRD would lessen the appeal of tax-exempt municipal securities, the new proration formula is expected to counteract these effects since it increases the company’s share of tax-exempt interest and dividends to a fixed 70 percent. That represents a sizable increase from the 30 to 50 percent share that was common under the earlier formulas.

 

On the other hand, when viewed from a tax-equivalent-yield perspective, the same combination of factors – that is, a higher company share but lower tax rates and smaller DRD – is expected to produce little net change in the relative attractiveness of common stock. As a result, the tax law changes are not expected to have a material impact on life insurers’ overall equity allocations.

 

Taking a broader view of the new tax law’s impact, it must be recognized that some of the law’s insurance-specific provisions will temper the positive tax effects of general rate reductions and the repeal of the corporate AMT. Nevertheless, the overall effect is still likely to be a net positive for most insurers.

 

The benefits are not necessarily direct or automatic, however. In addition to adapting their tax strategies to comply with the new law, insurers of all types and lines also should carefully evaluate the law’s impact on their investment portfolios. By reviewing their overall investment strategies and adapting their investment allocations as necessary to reflect the changed environment, insurers can be better positioned to optimize the positive effects of the new law on their businesses.