This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: The Financing of Catastrophe Risk Volume Author/Editor: Kenneth A. Froot, editor Volume Publisher: University of Chicago Press Volume ISBN: 0-226-26623-0 Volume URL: http://www.nber.org/books/froo99-1 Publication Date: January 1999 Chapter Title: The Influence of Income Tax Rules on Insurance Reserves Chapter Author: David F. Bradford, Kyle Logue Chapter URL: http://www.nber.org/chapters/c7953 Chapter pages in book: (p. 275 - 306) 7 The Influence of Income Tax Rules on Insurance Reserves David F. Bradford and Kyle D. Logue One of the most important components of the balance sheet of a property- casualty insurance company is the loss reserve. In spite of what the term may suggest, a loss reserve is not a pot of funds set aside for the uncertain future. It is an accounting entry, a liability on the balance sheet. More precisely termed the unpaid-losses account, the loss reserve expresses the amount the company expects to pay out in the future to cover indemnity payments that will come due on policies already written for losses that have already been incurred and to cover the costs of dealing with the associated claims. The latter category of costs, which includes, for example, the litigation costs associated with settling claims, is called loss-adjustment expenses. I If loss reserves were determined solely on the basis of pure insurance- accounting theory, they would reflect only those factors that affect the size, frequency, and pattern of future claim payments and loss-adjustment expenses. Such factors would include changes in patterns of actual claim payments; changes in inflation rates, weather patterns, and technology; and, particularly David F. Bradford is professor of economics and public affairs at Princeton University, a re- search associate of the National Bureau of Economic Research, and adjunct professor of law at New York University. Kyle D. Logue is professor of law at the University of Michigan. During his work on the paper, Bradford enjoyed the hospitality of the Center of Economic Studies at the University of Munich and helpful discussions there with Michael Reiter, Christian Thimann and Richard Amott. Logue’s work on this project benefited from numerous conversations with his colleagues at the University of Michigan Law School. He gives special thanks to Jeffrey Lehman, who provided both useful substantive suggestions and wise counsel throughout this proj- ect. He also thanks Stuart Thiel for several helpful discussions. In addition, helpful comments and suggestions were received from David Cummins, James Hines, Sean Mooney, Ralph Winter, and Mark Wolfson. James Bohn was helpful on matters of aggregation. Ryan Edwards and Ning Zhang provided exceptionally able research assistance. Financial support was provided by the Woodrow Wilson School, Princeton University, and the NBER Project on the Financing of F’ropertyKasualty Risks. The usual caveats apply. 1. Our discussion of insurance accounting and solvency regulation draws primarily from Moo- ney and Cohen (1991), Salzmann (1974), Peterson (1981). and Troxel and Bouchie (1990). 275 276 David F. Bradford and Kyle D. Logue significant in the context of liability insurance, trends in tort doctrines and jury awards. In practice, however, loss reserves are influenced by other considera- tions as well, considerations such as how the reported reserves will affect the likelihood of regulatory scrutiny, the perceptions of investors, and the firm’s income tax liability. In this paper, we begin to examine the effects of income tax rules on property-casualty reserving practices. Although insurers can choose from a number of different approaches to cal- culating their loss reserves, all these approaches share some common charac- teristics. The insurer generally begins by collecting information about its own loss experience as well as information about the rest of the industry’s loss expe- rience. With respect to the latter, industrywide data are collected and distrib- uted to insurers through rating bureaus such as the Insurance Services Organ- ization. These data include information about the severity, frequency, and timing of past claim payments and claim-expense payments as well as informa- tion about changes in trends and patterns of payments. Once these data have been collected, the insurer’s actuarial department ap- plies various statistical techniques designed to generate predictions about the insurer’s future loss claim payments and loss expenses. Typically, the actuarial department will recommend a range of loss reserves. Then, from within this range, someone in management (e.g., the chief financial officer) will choose the actual number that will be reported on the insurer’s books. In any event, the choice of the reported loss reserve inevitably rests with management, and it is undisputed that management has some measure of discretion in setting those reserves (Peterson 1981). In thinking about the role played by reserves as liabilities in the financial, regulatory, and tax accounting of the insurance company, it is useful to keep in mind the generic connection between a balance sheet and an income statement. In general terms, income, a flow concept, equals the sum of the increase in an associated stock concept, which is net worth, and amounts distributed to the company’s owners during a given period. And net worth is the excess of a company’s total assets over its total liabilities at a given time. For reporting purposes, the flow concept (income) is recorded on the income statement, and the stock concept (net worth) is recorded on the balance sheet. Thus, in theory, a company’s reported income for a given period is simply the increase in the company’s net worth during the period. (If there is a distribution to owners during the period, this statement is modified in an obvious way.) As for the specialized case of insurance accounting, the concept of net worth is called surplus, and it is reported on the insurer’s year-end balance sheet as the dif- ference between total assets and total liabilities. Likewise, net changes in sur- plus are reflected on the insurer’s income statement as an operating gain or loss. This is where an insurer’s loss reserves come into the picture. Loss reserves are typically the largest single liability on an insurer’s balance sheet. Therefore, owing to their sheer magnitude, even relatively small percentage changes in 277 The Influence of Income Tax Rules on Insurance Reserves loss reserves can significantly affect an insurer’s surplus (i.e., the company’s stock picture) and its operating results or income (i.e., the company’s flow pic- ture). State insurance regulators specify the accounting conventions that insurance companies must use in the reports that they file for purposes of regulatory oversight. Collectively, these conventions are known as annual statement or statutory accounting. Statutory accounting has traditionally required-and, in most states, still requires-that loss reserves be reported on an undiscounted basis, both on the balance sheet and on the income statement. That is, despite the fact that an insurer’s loss reserves represent the insurer’s expected future claim payments and loss expenses, which one might expect to be discounted to a present-value equivalent, statutory accounting requires the insurer to cal- culate the balance-sheet entry using the simple sum of those future outlays. In addition, until 1986, insurers were required to use statutory accounting- including undiscounted loss-reserve calculations-for the purpose of calculat- ing their federal income tax liability. As part of the Tax Reform Act of 1986 (TRA86), however, insurers were required to discount their loss reserves for federal tax purposes. The details and the importance of this change are dis- cussed below. In the modern view of the firm, managers are modeled as making managerial decisions that serve their own interests. These interests will coincide with the interests of the firm’s owners if the managers are appropriately socialized or if appropriately structured compensation schemes are in place (Fama 1980; Jen- sen and Meckling 1976). The management of an insurance company has an interest in the results reported on the company’s balance sheet and income statement. Additionally, with respect to some elements of the balance sheet and income statement, management has considerable discretion. That is, for such accounting elements, the information that is available to management re- garding the company’s performance and financial position does not translate automatically into accounting data that can be reported. For these elements, the exercise of managerial judgment is not only feasible but necessary. The insurer’s loss reserve is one such accounting variable, the setting of which can be understood as a managerial decision. In addition to playing an essential role in determining the insurer’s annual financial and tax-accounting income, loss reserves are used in measuring an insurer’s overall financial strength. All else equal, including a fixed and positive relation between reported loss reserves and a “best estimate” of future payment liabilities, a larger loss reserve is associated with an increased risk of the insur- er’s insolvency. If this risk becomes sufficiently large, state insurance regula- tors may increase their level of surveillance or intervene in some way. State regulators monitor specifically the insurer’s ratio of surplus to premiums writ- ten. If this ratio falls below a given threshold, the regulator will require that steps be taken by the company to improve its financial position. In the extreme case, if the insurer is on the brink of insolvency, the regulator may take over 278 David F. Bradford and Kyle D. Logue the company and run it. For obvious reasons, the financial condition of the insurer is also important to investors and to policyholders.