The lower corporate tax rate and its application to underwriting profits ceded to foreign affiliates, as proposed in the House Republicans’ tax plan, could act as a mini Border Adjustment Tax.
Offshore reinsurers and higher-margin U.S. lines of business that are ceded to foreign affiliates such as P&C are expected to be the most negatively impacted, according to Morgan Stanley and Keefe, Bruyette & Woods analysts.
The proposed House bill calls for a corporate tax rate that’s reduced from 35% to 20%, which could lift earnings of domestic P&C companies by 14% on average.
Morgan Stanley analysts said “provisions on excise tax and intercompany debt could have negative implications for global P&Cs, but the impact is manageable, in our view.”
Past versions of the “Neal Bill” proposed eliminating the tax deduction for premiums ceded to offshore affiliates as a way of levelling the playing field between domestic and foreign re/insurers.
However, analysts believe the current bill – which applies a 20% tax rate to profits shifted to affiliated foreign firms from U.S. cedants – will now apply to all industries.
Keefe Bruyette & Woods analysts said re/insurers that write more volatile, higher-margin lines of business, such as p/c reinsurers, on U.S. paper, and then cede that to foreign affiliates are most vulnerable to the proposed changes.
Morgan Stanley warned that offshore re/insurers are likely to experience a negative impact from the excise provision which calls for 20% tax on payments to foreign affiliates.
This resembles a mini version of the Border Adjustment Tax (BAT) and is similar to the Neal Bill which levies taxes on premiums ceded to offshore affiliates.
“Companies can elect to pay U.S. tax on the foreign earnings rather than the gross receipts.
“Among our coverage, RE, ACGL, AXS, CB, XL and RNR, have 6-42% total premiums ceded to foreign affiliates. A weighted average of their current tax rate and 20% US tax rate could lead to ~1%-5% earnings downside.
“We think the potential impact is manageable and there could be mitigation factors such as US tax treaties with foreign jurisdictions. Under a worse case scenario of full 20% U.S. tax, the earnings impact varies from -4% to -19%,” said Morgan Stanley.
Currently, cessions to affiliates incur an excise tax that is roughly 1% of ceded premiums, so taxing 5% underwriting margins at 20% would produce more or less the same tax bill.
“Since their targeted margins are necessarily high to compensate for the volatility just seen in 3Q17, 20% of expected underwriting profits should represent significantly more than 1% of premiums.
“We think this perceived exposure explains the Bermudian (re)insurers’ underperformance on Thursday,” explained Keefe, Bruyette & Woods.
Insurers focused on lower-margin lines of business, even those using foreign affiliates, are not expected to see much disruption as a result of the tax reform.
Insurers with both domestic and international operations that don’t cede significant U.S. business to foreign affiliates are expected to see the same benefits – in proportion to their domestic business.
For purely domestic insurers, lower corporate tax rates appear to be a clear positive; for cedants of U.S. p/c business to foreign affiliates, however, the future impact of the reforms on earnings and thus reinsurance rates appears volatile.
Analysts added that proposed tax reform plan is a starting point and not the final product, and details of the bill are likely to change in the coming weeks.
