CRS Reports on Insurance Revenue-Raisers in White House Budget

                       CRS REPORT FOR CONGRESS

[1] President Clinton's fiscal year (FY) 2001 budget includes $101.7 billion in gross tax cuts over 5 years that would be partly offset by $92.2 billion of revenue raising items, for a net tax cut of $9.5 billion. Included among the revenue raising proposals are 6 provisions that would apply to insurance and that are the subject of this report. Together they would increase revenues by $12.8 billion over 5 years, according to the Administration's estimates: about 14% of the added revenue from all the proposed revenue-raisers. The specific insurance proposals are: added restrictions on interest deductions related to corporate owned life insurance (COLI), increased restrictions on deferred acquisition cost (DAC) deductions of life insurance companies, taxation of previously tax-deferred policyholder surplus accounts (PSAs) of life insurance companies, an increase in the proration percentage of property and casualty insurance companies, more stringent reporting rules for transactions involving viatical companies, and tighter requirements for tax-exempt small insurance companies. All but the last two of the proposals were previously set forth by the Administration in the FY2000 budget. Last year's budget, however, proposed insurance tax increases totaling $7.3 billion over 5 years -- $5.5 billion less than this year's plan. Most of the increase over last year's proposals would come from modifications in the DAC proposal and in the proposal applying to policyholder surplus accounts. This report will be updated as legislative developments occur.

CORPORATE-OWNED LIFE INSURANCE (COLI)

[2] The Administration's COLI proposal would add to current law's restrictions on interest deductions related to insurance policies corporations purchase. In tightening the restriction, the proposal would reduce the availability of a tax benefit associated with insurance policies corporations acquire using borrowed funds.

[3] In some cases, the death of a firm's employee, officer, or debtor may inflict a financial loss on the firm. A firm's president, for example, may possess irreplaceable expertise. Corporations thus have a legitimate business reason to insure certain individuals and are permitted to do so under state laws. However, COLI can also generate tax savings. The savings has two parts; one stems from the tax deductibility of interest. Absent special restrictions (and certain of these exist under current law) interest on debt a firm uses to acquire life insurance policies on its employees or officers can be deducted just like other interest and generates tax savings.

[4] The second part of COLI's tax savings is based on the federal tax benefit that applies to the so-called "inside build-up" of life insurance policies. The inside build-up is a savings component that accrues in an insurance policy when its premiums exceed the cost of insurance, are invested by the insurance company, and earn a return that is credited to the policy, thus increasing its cash value. The inside build-up is not taxed as it accrues. Further, death benefits on most policies are not taxed, or when a policy is cashed, a firm is not taxed on the premiums it has paid on the policy. Thus, when a firm borrows to buy an insurance policy, the two parts of the benefit combine so that a firm can earn interest deductions on an investment whose return is itself either tax-exempt or tax-deferred.

[5] The difference between the tax-free return and the tax deductible borrowing costs can make an otherwise unprofitable investment attractive. In effect, the interest deductions shield the return to debt-financed investment from corporate tax; in the case of COLI, this shield is provided to a return that itself is tax deferred or tax exempt. In general, the return on investment in life insurance policies is not high enough to make them a good investment for businesses on a pre-tax basis. But the two-part tax savings can make the policies an attractive investment. ¹

[6] The tax benefit associated with COLI has been subject to progressively tighter legislative restrictions in recent years. Recent measures included those in the Health Insurance Portability Act of 1996 (P.L. 104-191), which denied an interest deduction for indebtedness specifically linked to life insurance policies; the Act made an exception for a limited number of a company's "key persons" -- officers and owners of 20% or more of the firm's stock. However, money is fungible and therefore a loan may be used to make a purchase in economic substance even if it is not explicitly linked to the purchase. Thus, the Taxpayer Relief Act of 1997 (PL. 105-34) instituted a so-called "pro rata disallowance rule" to supplement existing provisions. Under its terms, a portion of a firm's interest deductions are denied, based on the ratio of the cash value of a firm's insurance policies to its assets. An exception, however, was made for insurance policies on officers, directors, employees, or persons owning at least 20% of the firm; such policies were not included in the disallowance ratio.

[7] The COLI proposal in the FY2001 budget is essentially the same as that in last year's. According to Administration estimates, it would increase revenues by $1.97 billion over 5 years.

DEFERRED ACQUISITION COSTS (DACs)

[8] DACs are the costs an insurance company incurs in acquiring its policies, and consist chiefly of commissions paid to agents and their supervisors. The tax issue they present centers on timing -- when insurance companies can deduct them. There are two keys to understanding the tax issue. The first is the basic economic principle that money has a "time value" -- that is, a given unit of money is worth more to a firm in the present than the identical amount at some point in the future, because if a firm controls the funds immediately it can, in principle, invest them and begin earning a return that much sooner. In the context of taxes, a deduction of a given amount and the savings it generates more value to a firm the sooner it is claimed. In the context of DACs, the sooner they can be deducted, the more valuable the deductions are to a firm.

[9] The second key to understanding DACs is that they do not represent an immediate loss of value by a firm when it pays them. Rather, they are, in effect, exchanged for insurance policies that produce a stream of revenue (premiums) for the insurance company that pays the DACs. The value that DACs purchase thus diminishes only gradually. And because of the time value of money, to measure income from insurance policies accurately DACs should be deducted only gradually, as the policies they acquire lose their value. To permit them to be deducted immediately confers a tax benefit.

[10] Despite this economic interpretation of DACs, prior to 1990 firms were generally permitted to deduct such costs as they were incurred, and such costs are typically incurred in the early part of a policy's economic life. In 1990, the Omnibus Budget Reconciliation Act (OBRA) implemented a proxy approach to DACs as a substitute for requiring firms to deduct DACs over the economic life of related policies. OBRA required a specified portion of a firm's DACs to be capitalized each year rather than deducted immediately, and to be amortized (deducted gradually) over a period of 10 years. The portion of DACs required to be amortized was set equal to a specified percentage of insurance premiums; the percentage was different for different types of policies.

[11] The FY2001 proposal would change the percentage of premiums required to be amortized for a number of different types of insurance, in most (but not all) cases increasing them. It would:

     o increase to 4.8% from current law's 1.75% the percentage for

[13] While last year's budget plan also proposed an increase in amortization requirements, the current proposal is estimated to raise over twice as much revenue as last year's: $8.3 billion in this year's plan compared to $4.1 billion in last year's. There are several modifications that may account for the higher revenue estimate: the percentages and their effective dates are somewhat different between the two proposals. In addition, firms would be required to adjust their incomes to reflect the change in accounting practices mandated by the increased amortization percentages.

RECAPTURE OF POLICYHOLDER SURPLUS ACCOUNTS

[14] Between 1959 and 1983, stock life insurance companies were permitted to defer payment of tax on the portion of their profits constituting so-called policyholder surplus accounts (PSAs). ³ Amounts in the PSAs were not taxed unless they were distributed or treated as being distributed to shareholders for tax purposes. PSA amounts were generally treated as being distributed if a firm ceased to be a life insurance company, an insurance company in general, or to the extent the PSAs exceeded certain numerical thresholds. The Deficit Reduction Act of 1984 repealed the tax deferral for amounts added to PSAs in 1984 and thereafter. However, firms could continue to defer tax on amounts in PSAs prior to 1984, except to the extent distribution had been triggered under the various distribution rules.

[15] According to the Treasury Department, the PSAs "were intended to allow insurance companies to deduct contingency reserves in case they needed funds in excess of their regular reserves to fulfill their legal obligations under their insurance policies." ⁴ In addition, the Administration has noted that most pre-1984 contracts are no longer in effect. The Administration thus proposes to tax the balances in existing PSA accounts gradually, over a 5-year period. The FY2001 proposal is essentially the same as last year's, except the FY2000 budget would have permitted recapture over 10 years rather than 5. The present proposal's 5 year recapture, however, is "back loaded" -- that is, the percentage required to be recaptured is concentrated in the last few years of the period, which reduces the import of the shorter recapture period. The FY2001 proposal is estimated to increase revenues by $1.828 billion over 5 years. (The estimate in the FY2000 budget was $1.007 billion.)

REPORTING RULES FOR SALES OF PREVIOUSLY-ISSUED LIFE INSURANCE CONTRACTS

[16] According to the Treasury Department, so-called "viatical" companies have increasingly begun to purchase previously-issued insurance contracts where the insured person is not terminally ill, but is expected to die within 20 years. The Treasury cites as typical the case of a transaction between a viatical company and a business that owns an insurance policy on an employee, but that no longer needs the policy because of the person's retirement or separation. In such cases, current law generally imposes income tax on the seller in the case of the initial sale, and on the buyer, when death benefits are ultimately paid.

[17] Notwithstanding the potential applicability of tax, there are generally no reporting requirements in the case of a policy's sale. And according to the Treasury Department, taxable death benefits paid to viatical companies are generally also not reported. The Administration's proposal would impose reporting requirements on purchasers of interests in life insurance contracts exceeding $1 million and would impose reporting requirements on insurance companies when benefits are paid on such policies. The Administration estimates that the proposal would increase revenue by $178 million over 5 years. It was not in last year's budget.

LOSS-RESERVE PRORATION PERCENTAGE FOR PROPERTY AND CASUALTY (P&C) COMPANIES

[18] Like life insurance companies, property and casualty (P&C) insurance firms are permitted to deduct from taxable income additions they make to reserves for losses -- generally, the discounted value of estimated losses they will be required to pay in the future under policies currently in force. At the same time, P&C companies make investments that in some cases yield tax-exempt income -- for example, interest on bond issued by state and local governments and dividends that qualify for the intercorporate dividends-received deduction. Because the firms' loss reserves are funded, in part, by tax-exempt investment income, a double tax benefit is possible -- a loss-reserve deduction linked to tax-exempt income.

[19] In 1986, the Tax Reform Act required P&C firms to reduce their loss reserve deduction by an amount equal to 15% of tax-exempt interest and the deductible portion of dividends. In 1997, the Taxpayer Relief Act added the inside build-up of certain cash-value life insurance policies owned by P&C firms to amounts subject to the 15% disallowance rule. The Administration's FY2001 budget proposes to increase the proration percentage to 25% from 15%; the proposal is the same as in last year's budget. According to Treasury Department estimates, the proposal would increase revenue by $476 million over 5 years.

QUALIFICATION RULES FOR TAX-EXEMPT PROPERTY AND CASUALTY COMPANIES

[20] Under current law, property and casualty insurance companies are tax-exempt if they have $350,000 or less of premium income; companies with premium income in excess of $350,000 but less than $1.2 million can elect to be taxed on their net investment income. In measuring the $350,000 threshold, all corporate members of the same "controlled group" are combined. The tax code's controlled group concept, however, generally does not include tax-exempt entities or certain foreign-chartered subsidiaries.

[21] The Treasury Department has argued that the tax exemption was intended for small mutual insurance companies, but is used by larger firms to shield investment income from tax. Its current proposal would include investment along with premium income in applying the $350,000 test. The proposal would also extend the election to be taxed on investment income to firms with under $350,000 of premium income. In applying the election's $1.2 million upper threshold, however, the proposal would include tax-exempt and foreign affiliates. The proposal was not in last year's budget. The Treasury Department estimates that it would increase revenues by $106 million over 5 years.

INDUSTRY RESPONSE

[22] The insurance industry vigorously objected to the Administration's proposals in both 1999 and 2000. ⁵ A principal argument that firms have advanced is that the tax increases on life insurance would likely be passed on to policyholders in the form of higher prices for insurance or a lower return on investment -- for example, as increased premiums, lower policy crediting rates, and lower discretionary dividends. They argue that individuals would therefore find it less advantageous to use insurance policies as a means of saving. ⁶

[23] In the case of the DAC proposal, industry representatives have also argued that in setting current law's amortization percentages, it was not Congress's intention to match the actual portion of premiums represented by DACs. In the case of the COLI proposal, they have argued that corporations frequently take out COLIs for the purpose of funding employee fringe benefits, such as deferred compensation and retiree health care. The Administration's proposal, they argue, would cause firms to curtail the benefits. ⁷ It has also been argued that the COLI pro-rata disallowance rules out the deduction of interest payments on debt not used to purchase life insurance. For example, a firm without existing COLI may find part of its interest deductions on pre-existing debt disallowed if it subsequently decides to purchase insurance subject to the disallowance rules.

[24] Opposition to the proposal to restrict the reserve deductions of property and casualty companies has come from bond traders, who argue that such firms have substantial holdings of tax- free municipal bonds. The Administration proposal, they argue, would induce P&C insurance firms to reduce their holdings, thereby raising borrowing costs for state and local governments. ⁸ The industry has also argued that the proposed restrictions on tax-exempt P&C companies are unnecessary and would harm small businesses.

² U.S. Treasury. General Explanations of the Administration's Fiscal Year 2001 Revenue Proposals. p. 171.

³ Between 1959 and 1983, the portion of income equal to 50% of the excess of a life insurance firm's gain from operations over investment income was accounted as part of the policyholder's surplus account. For a more detailed discussion, see: U.S. Congress. Joint Committee on Taxation. Description of Revenue Provisions Contained in the President's Fiscal Year 2000 Budget Proposal. Joint Committee Print JCS-1-99,106th Congress, 1st Session. Washington, U.S. Govt. Print. Off., 1999. p. 268.

⁴ U.S. Treasury. General Explanations of the Administration's Revenue Proposals. p. 154.

⁵ Almeras, Jon. Insurers Irate Over Clinton Proposals. Tax Notes. Feb. 14, 2000. p. 897.

⁶ DeHoff, Michael. Industry Reps: Insurance Proposals Would Add to Retirement Costs. Tax Notes. February 8, 1999. P. 769. Note that the economic merits of providing tax incentives for saving has been one of the most hotly debated tax policy topics of the past several decades, with some arguing they promote capital formation and economic growth and others that they are both ineffective in stimulating saving and inefficient. In addition, some hold that even if a tax policy that promotes saving does benefit the economy, that does not necessarily indicate that savings incentives should be linked to life insurance or defined annuities.

⁷ Ibid., p. 771.

⁸ Bond Traders Criticize Clinton Budget Proposals. Wall Street Journal. Feb. 4, 1999. P. 1.