What A.M. Best Says
Briefing Examines Tax Reform and Captive Ratings
Best’s Briefing: Tax Reform: No Impact on Captive Ratings Anticipated (June 14, 2018)
- A.M. Best Company
- August 2018
The signing of the Tax Cuts and Jobs Act (TCJA) into law on Dec. 22, 2017 resulted in broad changes to the U.S. tax code not seen in over 30 years. It also made what is normally a busy year-end even busier, as management teams assessed the TCJA's impact on their companies and prepared the necessary disclosures.
We summarized some of the key aspects of the tax reform on insurers in our Dec. 21, 2017, briefing, First Look—Tax Reform 2017. In this briefing, we discuss some of the effects of the TCJA on captives, including how A.M. Best incorporates the effects of tax reform into the rating process. This briefing is the expressed view of A.M. Best and does not constitute tax advice, nor does it encompass all elements of tax reform.
Captives vary in size and complexity, and are incorporated in jurisdictions all over the world. U.S. parents may have domestic or non-U.S. captives, and in some cases they may have both. Because of the vast differences in corporate formations, the ways in which business is transacted, and the jurisdictions in which the companies operate, a one-size-fits-all analogy as to how tax reform has impacted captives is impracticable. Below, we outline how certain provisions of TCJA may affect captives:
Although the new tax law changes apply to the 2018 tax year, the reduction in the corporate tax rate from 35% to 21% benefits U.S.-taxpaying companies in 2017, including captives, as the rate reduction required that captives revalue their deferred taxes at the new lower corporate tax rate of 21%. (The alternative minimum tax—AMT—was repealed.)
Net operating loss carryforward and carryback rules remained at 20 and two years, for P/C companies (allowed on up to 100% of taxable income); the carryback rule for L/A companies was repealed. Loss carryforwards for life companies are permitted for 15 years, limited to 80% of taxable income. For P/C companies, the impact on loss carryforwards is neutral.
The valuation of reserves changed for both P/C and life companies. Companies are no longer able to elect their own historical loss patterns to determine loss reserves, but must use the aggregate industry patterns prescribed by the IRS. The effects of this change will vary depending on each company's loss experience, reserve philosophy, as well as the size of its reserve base.
The interest rate P/C companies use for discounting loss reserves changed from the midterm Applicable Federal Rate (AFR) to the corporate bond yield curve. For both P/C and life companies, the net impact of discounting is considered less favorable, as the recognition of profit is accelerated because discounted reserves will increase based on higher corporate bond yields.
Life insurance reserves for contracts are the greater of the net surrender value or 92.81% of the NAIC required reserve. Tax reserves cannot be less than the contract's cash surrender value or greater than the statutory reserve.
In 2017, the amount of premiums allowed for eligibility under Section 831(b) was increased from $1.2 million to $2.2 million. Companies who made the election under Section 831(b) are taxed only on investment income. Small captives who made this election may see an increased tax liability if they previously had a 15% tax rate.
For some U.S. corporations with foreign subsidiaries, there is a minimum tax on payments to foreign subsidiaries if the corporation's receipts are over $500 million and payments to its foreign subsidiaries are greater than 3% of total deductible payments. This Base Erosion Anti-Abuse Tax, or BEAT, would not apply to a foreign subsidiary that elects to be taxed as a U.S. taxpayer under Section 953(d). Other provisions have been put in place to repatriate overseas income and profits if a company was previously able to defer tax on them.
A passive foreign investment company (PFIC) has either more than 70% passive income or more than 50% of its assets generating passive income. The exception to the PFIC exception continues to apply to entities engaged in the active conduct of insurance business.
Qualifying insurance corporations must have insurance liabilities (loss reserves and loss adjustment expenses) greater than 25% of total assets. Shareholders of PFICs must file a specific tax form with the IRS.
Controlled foreign corporations (CFCs) are determined based on the proportion of holdings by a U.S. shareholder. CFCs were previously defined as U.S. persons who own 10% or more of the voting stock; the definition now also includes U.S. persons who own 10% or more of the value of the stock (even if such ownership was for only one day).
A.M. Best's Credit Rating Methodology (BCRM) provides a comprehensive explanation of the rating process. This interactive process combines both quantitative and qualitative measures to analyze rated organizations' balance sheet strength, operating performance, business profile, and enterprise risk management (ERM). The BCRM is applied to all credit ratings; captive ratings are also subject to the alternative risk transfer criteria. Other criteria may be applied as well, based on the characteristics of the rated entity.
The impact of tax reform is considered throughout the rating process, as follows:
Balance Sheet Strength
Revaluation of certain balance sheet items may have resulted from tax reform. Disclosures related to the impact of tax reform will be considered separately from year-over-year changes related to the business. Although the balance sheet strength of A.M. Best's rated captives tends to fall in the Strong or Strongest categories, these companies also have a number of ways to access additional capital if needed, from capital contributions by its parent or members to LOCs and loan backs.
In many cases, the reduced corporate tax rate has resulted in higher net income, but for others there may have been other changes to the business structure that affected operating performance. Companies provide financial forecasts as part of the rating process, and impacts resulting from tax reform should be highlighted for 2018. BCRM takes into account the sustainability of earnings, keeping in mind that captives focus more on the preservation of capital rather than profits or returns. In some cases, excess profits are returned to the parent or members.
Because A.M. Best's rated captives are domiciled in various jurisdictions, and their size and structures vary greatly, assessing the impact of tax reform on the companies' business profiles is impracticable. Parent companies' BEAT calculations may affect the amount of business ceded to a non-U.S. captive; in several cases, however, these captives have made a 953(d) election and are being taxed as U.S. taxpayers, so the impact is nil.
Parent companies may have also elected to add another captive to their organizational structure, in which case the profile of the original captive may become more limited. In cases in which rated entities have a group rating modifier and an internal cession has been reduced or cancelled, alternative strategies that demonstrate explicit support, as well as other quantitative and qualitative factors, will be considered, to assess the level of rating enhancement afforded under the new structure (as we discussed in our Feb. 5, 2018, briefing, Impact of U.S. Tax Reform on Group Rating Affiliations).
Enterprise Risk Management
ERM is a key aspect of the rating process, as it links balance sheet strength, operating performance, and business profile. In discussions with management during the rating process, A.M. Best obtains valuable insight into how a company identifies, measures, treats, and monitors risk. Single parent captives are assessed in the context of their parent companies' operations, while group captives and risk retention groups (RRGs) are viewed similarly to a commercial writer, with their own ERM framework and management teams.
Management's response to tax reform will be a topic for discussion, because tax reform will affect captives in different ways, the depth of the ERM discussion on this factor will vary.
The foundation of A.M. Best's interactive rating process is ongoing dialogue with company management, which includes the captive's senior management team, captive manager, and parent company representatives. Tax reform is typically included in management meeting discussions, and our discussions with domestic and non-U.S. captives are no different. There may be cases when tax law changes prompt management to take different courses of action, and discussions about management's motivations and objectives are important components in assessing the effects on the captive and its role to its stakeholders. If the level of explicit support is modified or diminished due to the tax law changes, we would look to any new forms of explicit or implicit support that could warrant a comparable level of rating enhancement.
To date, tax reform has not affected A.M. Best's insurance industry ratings, including the captive sector. Overall, the impact of tax reform is a net positive for U.S. insurers, including domestic captives and offshore captives who have made the Section 953(d) election. U.S.-parented captives in foreign domiciles are working to achieve the most efficient solutions from an operations and cost perspective. Management teams considering strategic alternatives in the wake of tax reform continue to include us in discussions, as they contemplate changes to existing business or new corporate formations.
This Best's Briefing is available at www.ambest.com.