STATEMENT OF WILLIAM J. ANDERSON, DIRECTOR, GENERAL GOVERNMENT DIVISION, U.S. GENERAL ACCOUNTING OFFICE, ACCOMPANIED BY NATWAR M. GANDHI, GROUP DIRECTOR, TAX POLICY

Mr. ANDERSON. Thank you, Mr. Chairman.

Good morning, ladies and gentlemen.

I think it is important to start off here trying to explain somewhat the credentials the GAO has to speak here on this subject today.

I know that you have spoken to Dr. Gandhi in the past, Mr. Chairman, but with your permission, I would like to tell the rest of the folks a little bit about him.

Dr. Gandhi is a well recognized authority on taxation of the insurance industry. He has addressed seminars at the Hartford Institute on Insurance Taxation and other insurance industry meetings on tax issues. Previously he has taught at several universities, including the University of Pittsburgh, where he was on the faculty of the Graduate School of Business. He has had consulting assignments with corporations such as IBM and Jones & Laughlin Steel. Currently he teaches at the University of Maryland as an adjunct professor in the College of Business and Management and regularly conducts executive development seminars in finance and accounting for several business and industry organizations. Dr. Gandhi has published numerous papers and articles in professional journals on accounting and taxation matters.

I should point out that I was second in my class at Georgetown School of Business Administration. I have an MBA. I have taught accounting at Montgomery College, and I have great difficulty in following Dr. Gandhi's explanation of these matters from time to time, but GAO protocol has me here as lead witness and with your permission, I would like to go slowly through my entire statement, which is relatively short, and make sure that we all understand exactly what the issues are as GAO views them.

Mr. STARK. From a person who was second from the bottom of my class at MIT, I appreciate that.

Please proceed.

Mr. ANDERSON. We are pleased for the opportunity to assist the committee in its deliberations on taxation of the insurance industry. We have had an active interest in this area for the past 6 years. In 1981, we submitted a report to the Congress on taxation of life insurance companies. Earlier in 1985, we issued to the Senate Finance Committee a report on taxation of the property/ casualty insurance industry. Today I will focus on the latter. However, I will be pleased to answer whatever questions you may have on taxation of the life insurance industry as well.

I would like to point out that GAO did not pick on these particular industries at random. In fact, the work that was done in the life insurance area was originally exploratory work that Natwar undertook to try and understand how the Tax Code was influencing organizational behavior out there. The life insurance industry presented a convenient subject for that study since it had its own separate set of rules and could be examined, more or less, in isolation.

Senator Dole, when he was chairman of the Senate Finance Committee, was interested in the work Natwar did and it was at his request that we undertook a review of the property casualty insurance companies, so it is not a case of GAO trying to single these out in any fashion.

We believe that the Congress should reexamine several aspects of the Tax Code dealing with property/casualty insurance companies. These aspects include the deduction for loss reserves, the deduction for acquisition expenses, and the protection against loss account.

Before explaining why we believe certain parts of the Tax Code should be reexamined, I would like to provide some background information on property and casualty insurance company pricing strategies, a financial overview of the industry, and the impact on the industry of certain current tax provisions.

A property/casualty company derives its income from underwriting gains-the excess of premiums over claims and expenses-and investment gains. Because of investment gains, a property/casualty company can still have net income even though its premiums alone are not large enough to cover claims and expenses. Thus, even though a company has a ratio of claims and expenses to premiums in excess of 100 percent, which normally would indicate the company had suffered an operating loss, it may well have a positive net income.

The ability to offset underwriting and investment income has played an important role in a company's pricing strategy-that is, the amount of premiums it charges for the lines of insurance that it offers. For a number of years, the companies have been willing to charge lower premiums to compete for certain insurance lines, even though they will have ratios of claims and expenses to premiums in excess of 100 percent. For example, in some major lines of business, such as medical malpractice and other liability, these ratios have been more than 150 percent. The companies expect to make up the premium shortfall through investment income. Through the incremental volume of premiums resulting from this pricing approach, companies are able to generate a larger amount of net cash flow which they can then invest to earn additional investment income. For instance, in 1983 when the industry had a combined ratio of claims and expenses to premiums of about 112 percent, which produced an underwriting loss of about $11 billion, it still had a net gain of about $9 billion and generated a total of about $12.1 billion in net cash flow, as reported by Best's Management Reports, an industry publication.

While in past years investment gains have exceeded underwriting losses by a fairly wide margin, in more recent years the gap has narrowed. For example, in 1984, underwriting losses for the industry were $20.5 billion, while investment income and realized capital gains were $20.8 billion, that is income of less than $300 million. As the margin has narrowed, many companies have reacted by raising premiums. Given this, it does not seem unreasonable to expect the gap to widen again as companies within the industry implement new pricing strategies.

FINANCIAL OVERVIEW OF THE PROPERTY-CASUALTY INDUSTRY

We developed a financial overview of the property/casualty insurance industry by studying financial data for stock and mutual companies for the 10-year period 1974 through 1983. We obtained these data from Best's Aggregates and Averages. While Best's reports omit figures for many small and/or new companies, we believe that the data are sufficiently representative of the overall financial results of the property/casualty industry for our purposes here today.

In tables 1 through 5, we show sources of income, broken out by underwriting gains, investment gains, and total gains. We also show disposition of income, broken out by the increase in surplus, dividends to stockholders, and the combined total. Federal income taxes are also shown. In other words, a report card on the health of the industry.

We show in table 1, which is before you as well as on page 4 of our prepared statement, that while property/casualty companies had about $28 billion in underwriting losses from 1974 through 1983, they had about $110 billion in investment gains during this period, resulting in a total gain of about $82 billion for those years. From 1974 through 1983, property/casualty companies paid $1.5 billion in Federal income taxes, an amount equal to about 2 percent of the industry's total gains for the period.

[The table follows:]

TABLE 1.-STOCK AND MUTUAL COMPANIES 1974 THROUGH 1983

Mr. ANDERSON. Table 2 shows that about $54 billion of property/ casualty companies' income from 1974 through 1983 went to an increase in surplus, and about $22 billion to stockholders in the form of dividends. These two items totalled about $76 billion, and the $1.5 billion paid in Federal income tax during this time equal two percent of this total.

[The table follows:]

TABLE 2.-STOCK AND MUTUAL COMPANIES 1974 THROUGH 1983

Mr. ANDERSON. The figures in tables 1 and 2 refer to mutual and stock companies combined. Since only stock companies give divi

dends to stockholders, we developed table 3 to show some ratios solely for stock companies.

We show in table 3 that from 1974 through 1983, stock companies had total gains of $59 billion and, as we previously mentioned, distributed about $22 billion to stockholders as dividends. During this period, stock companies paid $200 million in Federal income taxes, an amount equal to 0.3 percent of their total gains and to 0.9 percent of their dividends paid.

We also wanted to see how the 20 largest companies compared with the other companies. Tables 4 and 5 provide results separately for stock and mutual companies.

[The table follows:]

Mr. ANDERSON. Tables 1 through 5 have shown that from 1974 through 1983 the industry as a whole, in spite of its underwriting losses, had positive net gains yet paid a small percentage of these gains, 1.8 percent, in Federal income taxes. For stock companies, the percentages of taxes paid were lower than for mutual companies-0.3 percent for stock companies and 5.7 percent for mutual companies. For large companies, the percentages of Federal income taxes paid were lower than for smaller companies. For stock companies, the 20 largest companies had an income tax rate of minus 5.1 percent as compared with 3.1 percent for the smaller companies. For mutuals, the 20 largest companies paid 5.2 percent as compared with 7.1 percent for the smaller companies.

As previously mentioned, tables 1 through 5 each cover the 10year period ending in 1983. Information is not yet available for updating all of the tables through 1984. However, preliminary information shows that the property/casualty companies had a record underwriting loss in 1984 and, as we indicated, investment gains— including capital gains-were approximately equal to the underwriting losses.

Using data from our table 1 and from the preliminary information that has been published for 1984, we constructed table 6 to cover the 10-year period 1975 through 1985 to advance our 10-year period by 1 year to pick up the 1984 data.

[The table follows:]

TABLE 6.-STOCK AND MUTUAL COMPANIES 1975 THROUGH 1984

Mr. ANDERSON. The figures show that from 1975 through 1984, the investment gains exceeded the underwriting losses by over $87 billion while $171 million was paid in taxes, a rate of 0.2 percent of the total gains.

IMPACT OF CURRENT TAX PROVISIONS

Our analysis of the foregoing financial data gives insight into how current tax policy affects the property/casualty insurance industry. As a result of certain tax advantages, many property/casualty companies have not paid Federal income taxes for a number of years and, in fact, have qualified for refunds or the ability to carry back or carry forward losses for tax purposes. In addition to the tax deferrals resulting from the treatment of loss reserves, the treatment of acquisition expenses, and the protection against loss account, property/casualty companies can also, obviously, use tax provisions available to other taxpayers. These include excluding interest income from tax-exempt securities and deducting 85 percent of the dividends received from domestic corporations. Between 1975 and 1982, about 42 percent of the gross investment income of all property/casualty companies was tax-exempt investment income. The dividends received deduction during this period represented about 20 percent of the gross income of the companies. Overall, about 60 percent of the investment income was protected from taxes.

While we presented and discussed these facts in our report, we did not recommend any changes in the application of the exclusion of tax-exempt interest or the dividend received deduction to property/casualty companies. We limited our study to those provisions of the Tax Code which applied only to property/casualty companies. I will briefly cover those now.