Mr. CAMPBELL. But that strategy would be an increase in premium costs, right?

Mr. ANDERSON. No, sir, I guess what I am saying

Mr. CAMPBELL. They are going to pay more taxes

Mr. ANDERSON. If they could protect themselves against the additional tax, their costs would not go up.

Mr. CAMPBELL. How would they protect themselves? Let me give you another example.

How are they going to protect themselves against foreign insurance companies? What do we do when we are talking about the effect, if any, on the ability of U.S. insurers to compete with foreign insurance companies?

Mr. ANDERSON. We understand that most of the foreign insurance companies that do business in this country, in fact, organize an American subsidiary and are paying taxes just like other American insurance companies. To the extent that they are in the reinsurance market-I will perhaps turn to Dr. Gandhi for help on this-there is a provision of the code-I can't remember the citation now-845-but in any event that also tends to decrease any gain, any advantage as a result of this that foreign companies might have.

Dr. Gandhi tells me that that is a bogeyman and truly not a problem we have to concern ourselves with. Let me ask him to elaborate.

Mr. GANDHI. That is a problem to which we have not been able to provide adequate study, in fact, because of the lack of available data. We just don't know as of now as to how much the entire industry's business is going abroad.

Our guess at this moment, because of the lack of data, is that it would be minimal. We have talked with the various insurance experts in this area, and they do indicate that it has been minimal.

Mr. CAMPBELL. Isn't it true if you are a multinational company you don't care where you place your insurance, you go where it is cheapest?

Mr. GANDHI. Yes.

Mr. CAMPBELL. And, therefore, we could have an adverse impact on the ability of domestic companies to compete in this international market place, is that true?

Mr. GANDHI. Yes, to some extent.

Mr. CAMPBELL. Your proposal appears to have a premise that property and casualty insurers offer reserve for losses. Is this actually the case or not?

Mr. ANDERSON. Let me try that. I think one thing we have found, sir, is that the industry would hold that in practice the amounts that have been set aside for loss reserves in recent years have proven insufficient, that there has been de facto discounting as a result of unanticipated high settlements in any number of lines. Mr. CAMPBELL. Is it a social factor such as jury awards?

Mr. ANDERSON. That is a fact. We don't dispute that at all. I think the solution is that they are learning from these experiences and they are going to be more appropriately deciding on the amount of anticipated claims somewhere along the way and I think at that point in time that our recommendations would make sense.

Mr. CAMPBELL. If we are underreserving already under your proposal, how are you going to raise additional revenues?

Mr. GANDHI. It is said by some industry experts that the industry as a whole on an aggregate basis is underreserved to the extent of about 10 percent of the total reserves.

Mr. CAMPBELL. Is that in any particular area or overall, because when you get up into your deficiency and some of your liability insurance, aren't you under-reserved at a higher rate than that?

Mr. GANDHI. Yes. Many companies have adequate reserves. We want companies to provide adequate reserves. The problem is only to the extent that companies should recognize the time value of the money. Indeed, a company cannot operate without recognition of time value of the money, so our suggestion here is that Treasury should do the same.

Mr. CAMPBELL. Let me then ask you this. Assume that—and I don't assume this because I think that it will hurt us in international competition. I think it is going to cause premiums to go up and I cannot buy the premise that you have that we can come out of this thing by the companies protecting themselves.

Assume that I did buy it. Wouldn't the implementation of this be extremely difficult?

Mr. GANDHI. Not the GAO method. I think the GAO method is simple. It requires that the companies estimate reserves, which they already do. It is a highly mechanical procedure, that has to be applied after the companies have already estimated their reserves.

Mr. CAMPBELL. Haven't your estimations, particularly in your long tail lines, proven to be very unpredictable and won't this require precise, very precise predictions?

Mr. GANDHI. No. I would not think so because, sir, the insurance industry deals in the future and to the extent that they deal in the future they have to estimate. Even today without discounting, they have to estimate their reserves.

Mr. ANDERSON. Another way of putting it would be a new reality has emerged with respect to what is anticipated to happen. I anticipate the industry would do a much better job of anticipating claims in some of these areas that have proved hard to estimate in the past.

Mr. CAMPBELL. Under the administration a reserve deduction proposal, separate reserves are going to be established based upon a line of business in a year of policy insurance, if I am correct on that.

Can you describe for me briefly how a line of business is going to be described and whether this type of reporting is going to be administratively difficult to apply?

Mr. GANDHI. As far as the administration's proposals are concerned, we do believe that it will be difficult to administer, though we do believe also that it can be done by companies. However, our fundamental difference here with the administration is that there is a situation where under the QRA method, the administration's proposal, there may be tax when there is no income. In many ways it is a premium tax in disguise.

We believe that the GÃO method does not penalize the companies by taxing where there is no income whatsoever.

So on practical grounds, as well as on more appropriate business grounds, we believe that the GAO method is the appropriate method of discounting because it is pure discounting.

Mr. CAMPBELL. I go back to the bottom line premise that you put into your statement on the administration proposal, that you do believe it is a premium tax in disguise?

Mr. GANDHI. Yes, sir.

Mr. CAMPBELL. Thank you, Mr. Chairman. I appreciate your allowing me the extra question.

Mr. STARK. Mr. Anthony.

Mr. ANTHONY. Thank you, Mr. Chairman. I have a question about the qualified reserve account.

In the explanation of Reagan I, I think it states QRA is only a bookkeeping entry, but according to your answer, Mr. Gandhi, it appears that you consider it to be much more than a bookkeeping entry, that it can be a very difficult calculation to manage.

Mr. GANDHI. Yes. But it can be done given the technology available to insurance companies.

Mr. ANTHONY. Are you familiar with the mining reserve for the mining industry?

Mr. GANDHI. To some extent; yes, sir.

Mr. ANTHONY. It is my understanding that they would operate basically the same. In other words, the proposal for insurance would operate basically the same way for the mining industry. Mr. GANDHI. Yes, sir.

Mr. ANTHONY. However, it is my understanding that the administration is also proposing to repeal mining industry reserve on the grounds that it is too complicated and cumbersome and burdensome. If so, my question is what is the distinction?

Mr. GANDHI. I believe that the QRA method as proposed by Treasury is primarily a cash basis accounting. In other words, they are saying that you get a deduction when actually the claims are paid.

We would like the companies to recognize the time value of the money and under the QRA method, the reserving is not necessary and the companies could be taxed into the future when companies recapture the income.

Mr. ANDERSON. We will be glad to examine the mining proposals and come back to you for the record.

Mr. ANTHONY. You anticipated what I was going to ask you to do. If you could give me an analysis and submit it for the record so we can see we are being consistent in our approach here.

Thank you.

[The information follows:]

During our testimony on insurance taxation before the Committee on Ways and Means, Congressman Beryl Anthony, Jr., asked that we provide information for the record on whether the treatment proposed by the Administration in 1985 for dealing with the property/casualty (p/c) insurance loss reserve accounts was consistent with its treatment of reserves for mining reclamation.

This letter responds to his question.

A p/c insurance company, under present law, may take a deduction during the taxable year for the full amount of losses it estimates are likely to be incurred and for the estimated settlement expenses from claims on its policies. The deduction can include amounts expected to arise from (1) claims filed with and paid by the company during the taxable year, (2) claims occurring during the taxable year but not paid until another taxable year, and (3) claims made and paid in future taxable years. Generally, the deduction taken in the taxable year is for the full amount of the estimated loss; therefore, the time value of money is not recognized. It is this time value aspect of the deduction that the Administration proposed to change.

To accomplish this, the Administration proposed to require companies to establish a loss reserve account called a Qualified Reserve Account (QRA). The initial balance recorded in this account could be either a discounted or an undiscounted estimate of the company's losses. The Administration's concept was that the balance in the QRA would be increased annually by an interest rate equal to the company's after-tax rate of return on its investments. The initial reserve amount would be deductible in the taxable year the account was established. Additional deductions would not be allowed until all associated claims were settled and certain. If the level of reserves in the account

ultimately proved to exceed the amount necessary to pay all associated claims, the excess would be considered current income

for tax purposes. Because of the way the account would operate, the ultimate economic effect of instituting the QRA would be to recognize the time value of money by putting the insurance company in the same position as if it were on a cash basis.

Current law governing estimated loss reserves for mining reclamation is similar to current law governing the p/c insurance loss reserve accounts. Section 468 of the Internal Revenue Code permits a company to take a current deduction for the future cost of restoring or reclaiming a mined area. However, as with p/c estimated losses, the time value of money is not considered when taking this deduction. The Administration also proposed to change this aspect of the reclamation deduction. Rather than establishing an account similar to that envisioned for p/c companies, however, the Administration proposed that reclamation costs generally be deducted only when mining sites have been closed and reclamation work has begun. This proposal would require, in effect, cash basis accounting.

Thus, the economic thrust of the Administration's proposals for both the p/c insurance loss reserves and the mining reclamation reserves was consistent. Each proposal's ultimate economic effect was to recognize the time value of money by placing the relevant industry in a position equivalent to cash accounting.

We too believe that the time value of money should be recognized. However, our recommendation concerning the p/c industry loss reserves differs from the Administration's proposal in two respects. First, our recommendation--which is explained in greater detail in our March 1985 report entitled, Congress Should Consider Changing Federal Income Taxation of the Property/Casualty Insurance Industry (GAO/GGD-85-10)--uses the pre-tax rate of return on a company's investments for discounting loss reserves rather than the after-tax rate used in the QRA method. Second, our recommendation would permit companies to deduct the interest that the method required to be added to the reserves annually. The Administration proposal does not.

In answering Congressman Anthony's question, we reviewed the relevant sections of the Internal Revenue Code, President Reagan's May 1985 tax proposal to the Congress, and various statements issued by trade association representatives and public accounting firms on the subject of loss reserve deductions.

If there are further questions, please contact Mr. Natwar Gandhi of my staff on 376-0023. We are also providing a copy of this letter to Congressmen Stark and Anthony.