Business Regulation and Consumer Protection:

Congress Should Consider Changing Federal Income Taxation of the Property/Casualty Insurance Industry

GGD-85-10: Published: Mar 25, 1985. Publicly Released: Mar 25, 1985.

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GAO examined the provisions of the Internal Revenue Code which are used to determine the taxable income of the property and casualty insurance industry. These companies are similar to other companies in that the premium income is analogous to the sales receipts; however, a difference lies in claim payments which may not be made until a future year, while the premiums are received currently. In examining taxation of the industry, GAO focused on the measurement of taxable income by using the matching principle, which matches each year's revenues with the expenses associated with those revenues.

GAO found that the existing practice does not match revenues with associated expenses and results in an inaccurate measurement of taxable income. About half of the insurance industry's business is contracts involving claims that are paid over a considerable period of time resulting in protracted settlement of claims extending over many years. Reserves are needed to cover these losses to ensure that companies have adequate funds to make future payments on the claims. However, the current practice allows overstatement of the amounts needed to satisfy the claims, which are not being reduced by the investment income that will be earned on the reserves between the time they are established and the time that they are paid out, and result in an understatement of taxable income. One way to remedy this problem would be to discount reserves at a rate based on each company's investment return experience. GAO estimated discounted reserve levels at several discount rates and the additional tax liability that resulted, and it found that, the higher the discount rate, the greater the reduction in reserve deduction and the greater the increase in tax liability. Another income measurement issue is the proper allocation of business expenses related to the sale and renewal of insurance policies. The current practice permits these costs to be deducted immediately regardless of the life of the policy, but premium income is included in revenues only on a pro rata basis each year. According to GAO, expenses should be allocated over the same periods in which the corresponding income is recognized.

Matters for Congressional Consideration

  1. Status: Closed - Implemented

    Comments: The Tax Reform Act of 1986 essentially adopted other recommended action by requiring the discounting of loss reserves.

    Matter: To ensure that the property/casualty insurance industry's revenues and expenses are more closely matched for purposes of measuring taxable income, Congress may wish to consider amending the tax code to provide that, in calculating the loss reserve deduction for tax purposes, loss reserves are discounted.

  2. Status: Closed - Implemented

    Comments: The Tax Reform Act of 1986 contains provisions which capture the intent of this recommendation.

    Matter: To ensure that the industry's revenues and expenses are more closely matched for purposes of measuring taxable income, Congress may wish to consider amending the tax code to provide that acquisition costs be allocated over the life of the related contracts.

  3. Status: Closed - Implemented

    Comments: The Tax Reform Act of 1986, which was signed by the President on October 22, 1986, adopted the substance of this recommendation by repealing the protection against loss.

    Matter: Congress may wish to consider whether or not this special tax preference for mutual property/casualty insurance companies should be retained in its present form.

 

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