The Impact of Offshore Affiliate Reinsurance Tax Proposals on the U.S

The Impact of Offshore Affiliate Reinsurance Tax Proposals on the U.S. Insurance Market

An Updated Economic Analysis

PREPARED BY

Michael Cragg, The Brattle Group Jehan deFonseka, The Brattle Group Lawrence Powell, The University of Alabama Bin Zhou, The Brattle Group

January 23, 2017

This report was prepared for the Coalition for Competitive Insurance Rates and funded by the Association of Bermuda Insurers and Reinsurers (ABIR). All results and any errors are the responsibility of the authors and do not represent the opinion of The Brattle Group or its clients.

Table of Contents

Executive Summary ...... ii I. Introduction ...... 1 II. P&C Insurance and the Role of Reinsurance ...... 4 A. The U.S. Exposure to High-Severity Low-Frequency Risks ...... 4 1. Natural Catastrophes ...... 5 2. Commercial Liability ...... 9 B. Reinsurance For U.S. P&C Risks ...... 11 C. The Role of Foreign Insurers for the U.S. Catastrophic Risks ...... 16 III. The Economics of Reinsurance and Affiliate Reinsurance ...... 20 A. Reinsurance and Insurance Risk Management ...... 20 B. The Non-Tax Business Purposes of Affiliate Reinsurance ...... 23 C. Tax Treatment of Offshore Affiliate Reinsurance: Current law and Proposed Change ...... 27 IV. Analysis of Economic Impact ...... 29 A. Impact on the Supply of Reinsurance (Step One) ...... 29 B. Impact on the Supply of Insurance (Step Two) ...... 32 C. Impact on the Price of Insurance (Step Three) ...... 35 D. Border Tax Adjustment Analysis ...... 36 V. State-Level Impact ...... 40 A. Linear Allocation of Nationwide Impact ...... 40 B. Modified Three-Step Analysis Using Tail Risk ...... 41 VI. Conclusion ...... 44 Appendix A. Regression Analysis and Simulation ...... A-1 Regression Analysis #1: Substitution for affiliated reinsurance ...... A-2 Regression Analysis #2: Impact of Reinsurance and Surplus on Insurance Premiums A-7 Simulation Analysis: Interaction of Reduction in Industry-wide Premiums and Change in Reinsurance and Capital Levels ...... A-10 Regression Analysis #3: Pricing Impact of reduction in Insurance Premiums ...... A-12 Appendix B. State-Level Increase in the Cost of Insurance for Selected Lines of Business ...... B-1

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Executive Summary

Tax legislation proposed in the last decade targeted reinsurance that a foreign-owned U.S. insurance firm buys from an offshore affiliate. These proposals arose from pressure from some U.S.-owned insurance groups that portray offshore affiliate reinsurance as a tax- avoidance strategy. These groups argue that the proposed tax is necessary to level the playing field and will not harm U.S. consumers. Two of the co-authors of this report wrote prior reports in 2009 and 2010 to evaluate the economic impact of the tax.

The previously proposed legislation would have denied the deduction of reinsurance premiums ceded to offshore affiliates in excess of certain industry averages. The latest proposal, the Warner/Neal proposal, would still disallow foreign-owned insurers from deducting premiums that they cede to their offshore affiliate reinsurers. However, when the risks materialize and reinsurance recoveries come back to the U.S. insurers, these recoveries would be excluded from taxable income. If implemented, the new proposal will negatively impact insurance consumers (purchasers of insurance), especially those who rely on natural disaster coverage. We were asked by a coalition of insurance firms and insurance consumers opposed to the legislation to update our previous analyses to explain the industry and consumer effects, and estimate the economic impact of the Warner/Neal proposal. We summarize our conclusions below.

Reinsurance is critical to risk management in the property and casualty (P&C) insurance industry, particularly for natural catastrophes and other infrequent but high-loss events.  Approximately hal