Chapter Outline

1
Chapter Outline

• 10.1 Tax Benefits Defined
• 10.2 Progressivity in Corporate Income Tax Rates
• Overview
• Numerical Example and Additional Insights
• Progressivity of US Corporate Income Tax Rates
• 10.3 Tax Treatment of Insurers versus
  Non-Insurance Companies
• Overview
• Example and Additional Insights
• Tax Benefit with Overstated Loss Reserves
• 10.4 Insuring Depreciated Property
• Overview
• Example and Additional Insights
• Retention
• Insurance and Recognition of a Capital Gain
• Insurance and Deferral of the Capital Gain

2
Chapter Outline

• 10.5 Insurance and Interest Tax Shields on Debt
• 10.6 Insurance Premium and Excise Taxes
• 10.7 Regulatory Effects on Loss Financing
• Compulsory Insurance
• Restrictions on the Choice of Insurance
• 10.8 Financial Accounting Influences on Loss
  Financing
• Financial Accounting for Insurance Premiums and
  Uninsured Losses
• Cash Flow Impacts of Financial Accounting Numbers
• 10.9 Summary
• Appendix Tax Benefits when Insurers Overstate
  Loss Reserves

3
Tax Benefits Defined

• Definition of a tax benefit
• A transaction provides a tax benefit if the
  present value of expected tax payments of the
  parties involved is lowered.
• Expected tax payments vs. ex post tax payments
• Present values
• Nominal recipient versus actual incidence
• Tax minimization does not always imply
  shareholder wealth maximization

4
Tax Effects of Loss Financing Decisions

• Main tax benefits from insurance arise for four
  reasons
• Progressivity in tax rates (also applies to
  hedging)
• Different tax treatment of insurers and
  non-insurance firms
• Tax treatment of depreciated property
• Risk reduction allows for greater use of debt,
  which creates additional tax shields (also
  applies to hedging)

5
Progessivity in Tax Rates

• Intuitive explanation of the effect of hedging
• Oil producer subject to oil price risk
• In years when oil prices are high gt high
  taxable income gt tax rate is high
• In years when oil prices are low gt low taxable
  income gt tax rate is low
• Effect of hedging
• Lower taxable income when oil prices are high
  (and tax rate is high) and increase taxable
  income when oil prices are low (and tax rate is
  low)
• Essentailly, hedging transfers income to years
  when it is taxed at a lower rate

6
Example of the Effect of Progressive Tax Rates

• Probability Before-tax income After-tax income
• 0.5 10m 7.0m
• 0.5 2m 1.3m
• Expected Value 6m 4.15m
• Eliminate uncertainty at no cost
• gt before-tax income 6m after-tax
  income 4.2

After-tax income
7 4.2 4.15 1.3
Before-tax income
2m 6m 10m
7
Different Tax Treatment of Insurers

• Description
• Insurers can deduct incurred losses
• paid losses
• change in PV of estimated unpaid losses (change
  in PV of loss reserve)
• Non-insurance firms can deduct paid losses
• Implication
• Insurers can move tax deductions for losses
  forward in time relative to non-insurance firms

8
Example of Different Tax Treatment of Insurers

• Example
• Due to events in year 1, Crocker expects loss
  payments
• Year 1 Year 2
• Loss payments 2m 2m
• Assume opportunity cost of capital 8, tax
  rate34
• Without insurance,
• PV of tax shields 1.213m

9
Example of Different Tax Treatment of Insurers
10
Example of Different Tax Treatment of Insurers

• PV of tax shield for insurer
• 3.852(0.34)/1.08 0.148(0.34)/1.082
  1.256m
• Difference between insurer and non-insurer
• 1.256m - 1.213m 0.043m 43,184
• Important insight
• Difference arises because the insurer implicitly
  does not pay tax on interest earned on funds set
  aside to pay future losses

11
Example of Different Tax Treatment of Insurers

• Calculate the tax savings on implicit interest
• Amount of money at time 1 needed to pay future
  losses 1.852m
• Interest earned on these funds 1.852 (.08)
  148,148
• Tax that would be paid on the interest
  0.34(148,148) 50,370
• PV of the tax saving 50,370/1.082 43,184

12
Insuring Depreciated Property

• Intuitive Explanation
• Assume that
• (1) the value of existing property has been
  depreciated to zero
• (book value 0)
• (2) that future depreciation expenses resulting
  from replacement of damaged property are the same
  whether the firm is insured or uninsured
• (3) that the premium loading is zero
• (4) income tax rate gt capital gains rate

13
Insuring Depreciated Property

• Tax effects of purchasing property insurance
• (1) the firm is able to deduct the insurance
  premium when calculating taxable earnings,
  regardless of whether a loss occurs.
• (2) if a loss occurs the firm will have to
  recognize a capital gain equal to the insurance
  indemnity payment.
• The first effect gt expected value of the second
  effect when the income tax rate exceeds the
  capital gains rate
• That is, the income tax savings from deducting
  the premium exceeds the expected capital gains
  tax payment.

14
Interest Tax Shields on Debt

• Optimal amount of debt is determined by the
  advantages and disadvantages of debt financing
• Advantages
• Interest tax shields
• Reduce agency problem between managers and
  shareholders
• Disadvantages
• Expected bankruptcy costs
• Expected costs due to
• underinvestment problem
• overinvestment in risky projects (asset
  substitution)

15
Interest Tax Shields on Debt

• Disadvantages of debt increase as probability of
  financial distress increases
• Decrease risk gt decrease probability of
  financial distress gt borrow more gt gain
  additional interest tax shields

16
Other Tax Issues

• State premium taxes
• generally, 2
• some variation across states
• Federal excise taxes
• 1 on reinsurance
• 4 on primary insurance

17
Regulatory Effects

• Compulsory Insurance
• why?
• Restrictions on the choice of insurers
• Amitted insurers
• Excess surplus lines market
• Fronting

18
Financial Accounting Effects

• Riskier cash flows gt
• more volatile reported income
• more volatile balance sheet numbers
• Who cares?
• Contracts depend on reported numbers
• managerial contracts
• debt contracts
• Less volatility makes assessing managers easier