Insurance Trades Address Proposed Regs on Discounting Rules

December 7, 2018

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable William M. Paul
Acting Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Ms. Kathryn M. Sneade
Assistant Branch Chief
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

RE: Industry Comments Regarding Proposed Regulation 103163-18 — Modification of Discounting Rules for Insurance Companies

Dear Messrs. Kautter, Paul and Ms. Sneade:

The American Insurance Association, National Association of Mutual Insurance Companies and the Property Casualty Insurers Association of America (the Trades) appreciate the opportunity to comment on Proposed Regulation 103163-18, Modification of Discounting Rules for Insurance Companies, which concern changes to Section 846 of the Internal Revenue Code as enacted under Pub. L. No. 115-97, commonly referred to as the Tax Cuts and Jobs Act (TCJA). The Trades collectively represent the great majority of insurance companies issuing property and casualty (P&C) insurance throughout the United States.

Determination of the Annual Discount Rate

Prior to TCJA, Section 846 required the use of the mid-term rate, defined as debt instruments with terms of over 3 years but not more than 9 years (3.5–9 years). The Trades do not see any clear congressional intent to use maturities other than 3.5–9 years but recognize Treasury needs to interpret the meaning of “varying maturities.”

If the final regulations follow the position stated in the preamble to Proposed Regulation 103163-18 regarding use of a single discount rate, the Trades believe the annual discount rate should be computed using the segment of the high-quality corporate market bond (HQM) yield curve that best coincides with the industry's bond interest yield related to unpaid loss reserves.

Legislative history requires the use of a corporate bond yield curve that reflects “the average . . . of investment grade corporate bonds with varying maturities. . . . ” Further, the Proposed Regulations state that Congress's decision to use the corporate bond yield curve “indicates that the annual rate should be determined in a manner that more closely matches” insurers' investments in bonds.

Over the last 10 years, the average maturity of bonds held by the P&C insurance industry was between 6 and 7 years. That is very close to the prior law average of 3.5–9 years of the yield curve, but much lower than the 9-year average of the .5–17.5 range in the proposed regulations.

Moreover, the HQM spot interest rate is the equivalent of the yield on a zero coupon corporate bond. Because all cash flows occur at maturity, the zero coupon bond has greater reinvestment risk as well as a higher duration and a higher interest rate. However, P&C insurers typically hold coupon paying bonds and hold few zero coupon bonds. Consequently, the HQM spot rates artificially inflate the bond interest income of the P&C industry and is another reason to define the HQM range as 3.5–9 years.

Therefore, we believe the intent of Congress can be best effectuated by the Secretary utilizing his discretion under Section 846, as amended by the TJCA, to select the appropriate corporate bond yield curve segment that best coincides with the industry's bond interest yield. Like prior law, we believe that segment is best represented by a range of 3.5–9 years.

Yield Curve Guardrails

The Trades recommend that any range of varying maturities selected by Treasury be easily determinable, predictable, and not volatile over time. Many insurers have internal models that compute and predict both interest rates and discount factors. These models are critical in planning for and managing regulatory capital, as a relatively minor change in interest rate could cause a material increase or decrease in admitted surplus and solvency requirements. The Trades are concerned that their members will not be able to replicate the model Treasury proposed.¹

Should Treasury decide to select maturities other than 3.5–9 years, the Trades request a fixed definition of the range. With respect to predictability and volatility, the Proposed Regulations specify a fixed upper bound (17.5 years), but they do not specify that the range of maturities will always include a half-year lower bound. The Trades recommend that Treasury specify appropriate lower as well as upper bounds. Finally, the Trades recommend that any selection of maturities, if subject to change, not change more frequently than each determination year under Section 846(d)(4).

When prescribing the specified segmentation under Section 846, the Trades encourage the Secretary to employ objective guardrails to enable P&C companies to simply forecast and predict changes in interest rates for loss discounting that are consistent with the industry's investment returns. This is a critical item for industry regulatory capital planning. Given the modeling complexity and short comment period, we are discussing other potential objective guardrails and would like to follow up with further comments.

Discontinuance of the Composite Method

The Proposed Regulations discontinue the composite method for discounting unpaid losses with respect to accident years not separately reported on the NAIC annual statement. As a result, insurers would be required to compute discounted unpaid losses with respect to the relevant year using the discount factors published for that year for each line of business.

Discontinuing the composite method would cause burdensome reporting requirements for insurers. Given the limitations of company data for older accident years and legacy information technology systems, compiling the required data may prove to be exceedingly difficult for some insurers. Therefore, the Trades believe the IRS should continue to provide composite factors and allow companies to apply them to the aggregated “All Prior Years” reserve balances.

Smoothing Adjustments and the Replacement of Salvage and Subrogation Factors with Loss Discount Factors

The Trades support the smoothing adjustments outlined in the Proposed Regulations. We agree that a smoothing approach is necessary “to avoid negative payment amounts and to otherwise produce a stable pattern of positive factors less than one.” In addition, the Trades support the proposed use of the discount factors applicable to unpaid losses as the discount factors for salvage and subrogation.

Treatment of Non-Proportional Reinsurance and International Lines of Business

Treasury also requested comments on the length of loss payment patterns for non-proportional reinsurance and international lines of business. Prior to the TCJA, pursuant to section 846(d)(3)(E), these lines of business had been treated as long-tailed lines for purposes of discounting of unpaid losses. However, the TCJA repealed former section 846(d)(3)(E). In addition, the TCJA also repealed former section 846(d)(3)(F), which provided the Secretary authority to make appropriate adjustments if annual statement data with respect to payment of losses was available for longer periods after the accident year than the periods assumed under section 846(d). Without these provisions, the Trades do not believe there is statutory authority to treat non-proportional reinsurance and international lines of business as anything other than short-tail lines of business.

We appreciate your consideration of these comments and welcome the opportunity to discuss these issues further.

Sincerely,

David Pearce, Jr.
Vice President and Director of Tax Policy
American Insurance Association
dpearc@aia.org
202-828-7114

Don Griffin
Department Vice President
Policy, Research & International
Property Casualty Insurers Association of America
donald.griffin@pciaa.net
847-553-3743

Jon Bergner
Assistant Vice President, Federal Affairs
National Association of Mutual Insurance Companies
jbergner@namic.org
317-875-5250