CRS Reports on Insurance Tax Proposals in President's Fiscal 2000 Budget

                       CRS REPORT FOR CONGRESS

[1] President Clinton's Fiscal Year (FY) 2000 budget proposal would increase revenues by a net amount of $45.8 billion over 5 years, according to the Administration's estimates. Included in the proposed increase are 4 proposals affecting insurance companies and their products, which together would raise an estimated $7.3 billion over 5 years. The specific insurance proposals are: increased restrictions on deferred acquisition cost (DAC) deductions of life insurance companies, added restrictions on interest deduction related to corporate owned life insurance (COLI), taxation of previously tax- deferred policyholder surplus accounts of life insurance companies, and an increase in the proration percentage of property and casualty insurance companies. Most of the tax increases are designed to restrict tax benefits that are in the form of tax deferrals (postponements). In response, the insurance industry has generally argued that the proposals would make it more difficult for taxpayers to save for retirement. Several of the proposals echo, with some changes, Administration proposals in its FY1999 budget that were not enacted by Congress. ¹ 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 they have purchased. 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. ² However, COLI can also generate tax savings. The savings has two parts; one stems from the tax deductibility of interest. Absent special restrictions, 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 with respect to the policy. Accordingly, when a firm borrows to finance 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. ³

[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 Administration's FY1999 budget proposal would have eliminated the exceptions to the 1997 Act's disallowance rule; the proposal was not enacted. The FY2000 budget proposal is slightly less restrictive; it would eliminate the exception to the disallowance rule for all but 20% owners. According to the Administration, the proposal would increase tax revenue by an estimated $1.882 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 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 given amount and the savings it generates has 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 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 diminished 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 in the form of a tax deferral.

[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 an insurance 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, as follows:

     o 1.75% of premiums for annuity policies;

[11] The Administration's FY1999 budget proposal would have restructured the percentages by removing credit life insurance policies from the "group life" category and placing it in the 7.7% category. The proposal was not enacted.

[12] The FY2000 budget proposal is significantly broader than the FY1999 plan, increasing the capitalized percentage for a number of different policy categories, although decreasing it for a few. The proposal would require the following percentages of premiums to be amortized:

     o 4.25% for non-pension annuities in the first 5 years after

[14] The proposal would raise $4.096 billion over 5 years, according to Treasury estimates.

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

[15] Like life insurance companies, property and casualty (P&C) 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.

[16] 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.

[17] The Administration's FY1999 budget proposed doubling the disallowance percentage for P&C companies to 30%; the proposal was not enacted. The FY2000 budget proposal would increase the percentage by 25% rather than 30% as in last year's proposal. According to Treasury Department estimates, this year's proposal would increase revenue by $303 million over 5 years.

RECAPTURE OF POLICYHOLDER SURPLUS ACCOUNTS

[18] 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). ⁵ 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.

[19] 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." ⁶ 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 10- year period. The Administration estimates that its proposal would raise $1.007 billion over 5 years.

INDUSTRY RESPONSE

[20] The insurance industry has vigorously objected to the Administration's proposals. 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. As a consequence, they argue, individuals would find it less advantageous to use insurance policies as a means of saving. ⁷

[21] 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. ⁸

[22] 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. ⁹

² It has also been argued that the tax savings inherent in debt-financed insurance have encouraged firms to insure employees and other associated individuals whose death poses little financial threat to the firm. See, for example, Sloan, Allan. Companies Find a Premium Way to Take an Unjustified Tax Break. Washington Post. October 12, 1995. p. B5.

³ See CRS Report 95-990, Corporate-Owned Life Insurance: Tax Issues, by Jack Taylor.

⁴ U.S. Treasury. General Explanations of the Administration's Revenue Proposals. p. 157.

⁵ 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 for a 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 Congess, 1st Session. Washington, U.S. Govt. Print. Off., 1999. p. 268.

⁶ U.S. Treasury. General Explanations of the Administration's Revenue Proposals. p. 154.

⁷ 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, it should be noted 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.

⁸ Ibid., p. 771.

⁹ Bond Traders Criticize Clinton Budget Proposals. Wall Street Journal. Feb. 4, 1999. P. 1.