Effect of Tax, Regulation and Accounting on Risk Management

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Effect of Tax, Regulation and Accounting on Risk
Management

• Progressive tax rates induce firms to reduce risk
• Different tax treatment provides a tax benefit to
  insurers
• Tax treatment of depreciated property provides a
  tax benefit to property insurance
• Risk reduction increases the benefit of debt
  financing
• Government regulations requires business to
  purchase insurance and influences insurers
  choice
• Effect of accounting rules on risk management

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Tax Benefit

• If a transaction lowers the aggregate present
  value of expected tax payments for all parties
  involved in the transaction, it has a tax
  benefit.
• It is defined in terms of expected tax payments,
  not actual tax payments.
• It is defined in present value terms.
• The party that nominally receives a tax break may
  differ from the party that actually obtains the
  tax benefit.

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Tax Benefits

• Tax minimization is not the same as shareholder
  wealth maximization
• Definition of tax benefits ignores any cost of
  obtaining that cost
• E.g. A firm with 34 tax rate makes
  tax-deductible contribution of 1000 to a
  charity, and it will increase the shareholders
  wealth only if the contribution causes other cash
  flows to increase by more than 660!
• A firm can virtually minimize all tax payments by
  giving away all of its profits.

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Tax benefits of insurance v.s. retention

• Corporate tax rates are progressive
• Tax treatment for insurers and non-insurance
  companies are different
• Specific for insurance
• Tax treatment of losses to depreciated property
  depends on whether the property is insured
• Specific for insurance
• Risk reduction provided by insurance may allow a
  firm to increase the use of debt with
  tax-deductible interest payments.

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Progressive Corporate Tax Rates

• When tax rates increase with taxable income,
  after-tax income increases at a decreasing rate
• Numerical examples

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Progressive Corporate Tax Rates (Case Study 1)

• Darcy Co. has a tax rate of 34. It has 2 chance
  to lose a lawsuit that will cost 30 million,
  otherwise it has a taxable earning of 10
  million. It may purchase liability insurance with
  a 30 million limit with a premium of 600,000
  (no premium loading). Should it select an
  insurance?

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Progressive Corporate Tax Rates (Case Study 1)
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Progressive Corporate Tax Rates (Case Study 1)
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Progressive Corporate Tax Rates (Case Study 2)

• Barrese Co. has a tax rate of 34. It has 2
  chance to lose a lawsuit that will cost 30
  million, otherwise it has a taxable earning of
  50 million. It may purchase liability insurance
  with a 30 million limit with a premium of
  600,000 (no premium loading). Should it select
  an insurance?

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Progressive Corporate Tax Rates (Case Study 2)
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Progressive Corporate Tax Rates (Case Study 2)
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Progressive Corporate Tax Rates

• Case 1 v.s. case 2
• Critical difference is Darcy Co. cant fully use
  the tax deduction provided by loss if not
  insured. The value of this deduction is
  23420 million136,000, which is exactly the
  same as the increased after-tax earning by
  insurance!

13
Tax Treatment of Insurers v.s Non-insurance
Companies

• When calculating its taxable income, a
  non-insurance company can only deduct losses that
  were paid during the year, but an insurer can
  deduct the discounted value of incurred losses,
  which equals losses paid during the year plus the
  loss reserve.
• This distinction allows insurers to deduct losses
  earlier than non-insurance companies.
• This tax break may eventually benefit the
  policyholders through lower premiums because of
  competition among insurers.

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Tax Treatment of Insurers v.s Non-insurance
Companies (Case Study)

• Crocker Co. is subject to the risk that it will
  be sued as a result of its operation in year 1
  and the expected value and timing of loss
  payments are 2 million for year 1 and 2 million
  for year 2. What is the difference if Crocker
  retains the risk, or selects Tennyson Insurance
  Co. to insure its loss, assuming that Tennyson
  has the same forecast of expected loss payments
  as Crocker? The tax rate is assumed to be 34,
  and the opportunity cost of capital is 8.

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Crocker Co. Tax Treatment (in millions)
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Tennyson Insurance Co. Tax Treatment (in millions)
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Tennyson Insurance Co. Tax Treatment (in millions)

• Expected present value of the tax shields is

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Tax Treatment of Insurers v.s Non-insurance
Companies (Case Study)

• Even though Crocker and Tennyson have same loss
  streams, their tax shields are different
• Insurers can shield more of their income (in
  present value terms) from taxes than are
  non-insurance companies.
• Tax benefit could be large if there is a long
  claim tail.

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Tax Treatment of Insurers v.s Non-insurance
Companies

• Overstate of loss reserves
• Advantage
• Increases present value of tax shields
• More competitive in the market because of lower
  premium
• Disadvantage
• Decreases reported insurer capital
• May be inferred as higher insolvency risk

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Insuring Depreciated Property

• Assumptions for tax benefit
• The value of existing property has been
  depreciated to zero
• Future depreciation expenses are the same
• Insurance premium has no loading

21
Insuring Depreciated Property

• Tax Effects of Purchasing Insurance
• Insurance Premium is deductible
• If there is a loss, firm has a capital gain from
  insurance indemnity (capital gain tax rate may be
  different from the income tax rate)

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Insuring Depreciated Property (Case Study)

• Gaunt Co. has an income tax rate of 34. There is
  95 chance that no property loss occurs, and 5
  chance that a 4 million property loss occurs.
  Assume the property was bought 3 years ago which
  cost 4 million, and replacement also cost 4
  million, also assume the depreciation takes a
  straight-line format. If insurance is purchased,
  it costs 200,000 (no loading).

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Insuring Depreciated Property (Case Study)

• Retention Case

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Insuring Depreciated Property (Case Study)

• Insured Case
• Assume that capital gain tax rate is 20
• Capital gain is not deferred

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Insuring Depreciated Property (Case Study)

• Insured Case
• Assume that capital gain tax rate is 20
• Capital gain is deferred
• Insurance proceeds will be used to purchase
  property but tax basis for new property is still
  1 million.

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Insuring Depreciated Property

• Insurance provides the tax advantage over
  retention
• Deferral of capital gain may provide greater tax
  shields as
• Capital tax rate is closer to the income tax rate
• Depreciation time becomes longer

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Insurance and Interest Tax Shield on Debts

• Interest payments on debts are tax deductible
• Insurance reduces the risk for financial distress
  and provides more incentives for debt financing,
  in terms of tax shields.

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Insurance Premiums and Exercise Tax

• Premium Tax
• Commonly 2 of premium
• Depends on where the insurer is domiciled
  (in-state or out-of-state)
• Paid by insurer
• Exercise Tax
• Paid by insurance buyers
• Charged when insurer is outside of US
• 1 on reinsurance transactions and 4 on primary
  insurance transactions

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Regulatory Effects on Loss Financing

• Government may require firms to insure
• Government may restrict the pool of insurers from
  whom businesses may buy insurance

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Financial Accounting Influences on Loss Financing

• Insurance generally reduces the variability of
  reported income and balance sheet numbers. Since
  contracts are often based on accounting numbers,
  accounting effects can be important when
  considering loss financing alternatives.