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Mr. ANTHONY. I yield back the balance of my time, Mr. Chairman.
Mr. STARK. Mrs. Kennelly.
Mrs. KENNELLY. I want to thank you for your report. When I read it, I thought it was a little complicated but when I began to work with the QRA, I went back to yours with ease.
In the report you recommend that loss reserves be discounted by the individual companies pretax rate of return on investments. I have a two-part question on that.
Wouldn't this cause distortions between the same type of taxpayers? I mean if two companies have a risk and they each carry 50 percent of the risk, how do we determine the present value of that loss and shouldn't the estimate of the liability be the same for both companies?
Wouldn't this argue for a federally prescribed discount rate as we have currently for the life insurance industry?
Mr. GANDHI. We do have problems about that in that we wanted to recognize the company's own profitability and their own investment return to be the guide of discounting. However, as to what is appropriate to the extent that it is a pretax rate, we are willing to consider some kind of an industry average or some kind of a mandated rate such as a T-bill rate or something else but given the information that we had, we thought that a company's own investment experience would be an appropriate way to determine the rate by which the discounting should be done.
Mrs. KENNELLY. Doctor, when I talked to Treasury about how they came up with the QRA, because it is an obviously complicated answer to a question, they tell me there is a mismatch between income and deduction and this is their answer to correct it.
Should I accept that? Why don't we look for a more simplified answer to the situation?
Mr. GANDHI. In current practice there is indeed a mismatch. However, the question is how do you correct that mismatch.
Mrs. KENNELLY. That is what I am trying to get at.
Mr. GANDHI. Our analysis and recommendation is that if we were to match the revenues and expenses to produce an appropriate income to tax, then the GAO method of discounting which is a pure discounting method would be an appropriate matching of revenues and expenses by recognizing the time value of the money.
Mrs. KENNELLY. Let me ask you one more question.
Doesn't your use of an individual company investment return rate for discounting, and this would be true with the QRA proposal as well, raise all the problems of allocating expenses between underwriting and investment income that resulted from the 1959 act, which we fixed last year in the life insurance area?
Mr. GANDHI. Yes, that is correct.
Mr. GANDHI. We do believe that after all this allocation there is an investment rate of return that has to be recognized. All allocations are arbitrary, no matter how done, but at the same time companies do know what their investment experience is and what the investment return is and that should be the rate at which some discounting has to be done.
Without discounting I do not think the companies themselves can operate in the insurance business. It is already being done. The issue is an explicit recognition of that in the Tax Code, nothing more than that.
Mrs. KENNELLY. Let me approach it one more way. When I meet my colleagues walking across the street they know we are in these hearings and what we are looking at. What they say to me is, Barbara, how much are premiums going to go up. When we get into this kind of complicated discussion and we have these charts is it worth it if premiums do go up to the extent we think they might under both proposals?
Mr. GANDHI. I think so. Under our method, the increase in premiums is marginal but to what extent do we want to recognize appropriate cost of insurance. What happens apparently is that insurance premiums are indeed subsidized. The question is how do we remove the subsidy.
Mr. ANDERSON. Premiums have been lower than they appropriately should have been in prior years and we are only catching up to what is right.
Mrs. KENNELLY. There is always an argument between subsidized and affordable.
Thank you, gentlemen.
Mr. GANDHI. May I just add that in our report we have examined various situations, and under the current tax practice, a company can make a profitless transaction into a profitable transaction simply by using the Tax Code.
All we want to do is to remove this ability of a company to do just that. If it is a profitless transaction, it should remain so after the tax system intervenes.
Mrs. KENNELLY. I accept that explanation, but you know, I get back to the simplistic argument, if it isn't broken, don't fix it. Thank you very much, Doctor.
Mr. STARK. Mr. Frenzel wants to inquire.
Mr. FRENZEL. Gentlemen, thank you for your testimony. I am sorry I was not here to hear you deliver it in person.
On page 3 of your testimony, you indicate that as the margin has narrowed for P&C's, companies have reacted by raising premiums, and therefore, “it is not unreasonable to expect the gap to widen again as companies within the industry implement new pricing strategies."
Has any of that happened?
Mr. ANDERSON. We understand that the new pricing strategies have already started. However, the latest industry information is that 1985, like 1984, is going to prove to be a tough year for the industry.
The point that we made earlier on, though, sir, was that the industry's own studies would indicate that this is a cyclical type of business, and there are peaks and troughs and we are deep in a trough now, and I think our position is that the existence of the current profitless situation should not dictate what is right in the long run.
Mr. FRENZEL. Well, perhaps, but those of us whose duty it is to work on tax policy can't be indifferent to matters that are beyond tax policy.
The trouble with your analysis there is that it doesn't indicate anything you do when you have underwriting losses, and that is to stop writing certain lines, to stop writing certain lines in certain areas, to stop writing for certain risks.
I noticed on my television last night that day care centers are now not able to buy insurance, and all of those things have to be taken into account when we make our decisions.
Is it not true that certain kinds of risks are being cut out, certain size of companies?
Mr. ANDERSON. Yes, sir; I understand, obviously, some of the claims are so far, getting so out of hand as a result of some court-
Mr. FRENZEL. Well, toxic waste, for example. How about when prices go up on insurance, is it not likely that certain small insureds are going to say it ain't worth it, and will indulge in a relatively high-risk insurance program?
Mr. ANDERSON. Again, that is a possibility, sir; yes.
You discussed PAL's, didn't you, in your testimony already, and your conclusion was that that was an additional tax deferral that was unnecessary?
Mr. ANDERSON. No, sir; if I understand it correctly, we suggested there that the Congress ought to consider whether in fact the purpose for which the PAL was established originally is still a valid purpose. We very purposely did not recommend this as we did in the case of the other two items that we write about that the Congress should do something.
We said there that we have not really-we do not know what the effect of changing that would be on small mutuals. We haven't studied it.
Without understanding what the impact of terminating the PAL might be on that group of organizations, we say nothing. We say it is something the Congress may wish to consider further, because we do have some question regarding the utility of it anymore, especially for the larger, more profitable mutuals.
Mr. FRENZEL. I take it from your paper that you view it as a duplication?
Mr. ANDERSON. Well, we view it as conceptually not making too much sense at this point in time, that in fact, mutuals, like their stock company brethren, can put aside moneys, have the equivalent of a retained earnings account with their own surplus account, and we really don't see why they should have this distinctive treatment in that regard.
Mr. FRENZEL. Thank you very much.
Mr. Anderson, you alluded to my question. My question was doing to be, are P&C companies historically cyclical? You just said a minute ago that they were. Can you give me some history on that?
How cyclical are they? How deep are the cycles?
Mr. ANDERSON. Let me give you some numbers, sir. I will run you though 1974 through 1983, that 10-year period, and show you the swings. I will just take some of the extreme swings.
In 1974, the industry lost $2 billion on the underwriting side and lost $3 billion on the investment side for a net loss of $5.3 billion. That was the net loss,
In 1978, 4 years later, from a $5.3 billion loss, the industry went to a $11.2 billion gain, so there was a real swing as we view it, and we don't pretend to be experts on that. We were citing a study that an industry expert had performed that in fact if we went back before 1974, we would find the same kind of
Mr. SCHULZE. Over the past 4 years or so, it has been cyclical. There are a lot of other industries, the chemical industry and others that are fairly cyclical.
Mr. ANDERSON. We can provide information if you would like for the record that would take these numbers back.
Mr. SCHULZE. I think that would be fairly important to us.
Mr. SCHULZE. Because the industry doesn't seem to be in good shape right now, we don't want to deal any kind of devastating blows to them, if we know that these are going to even out, and they are going to ride out the storm.
In your opinion, are there any other overriding reasons for their nonprofitability or lack of profitability right now?
Are there any trends in the future that will remain the same or change, or didn't you look into this?
Mr. ANDERSON. No; we are probably no more aware than the average well-informed layman on that score. I guess the extreme competition that has existed in the last couple of years, as the companies have all sought to get that dollar to invest, and all at once, I guess.
Mr. SCHULZE. That is pretty much a matter of survivability is what we are saying.
Mr. ANDERSON. That is correct, sir.
Mr. SCHULZE. When we looked into the taxation of the life insurance industry a couple of years ago, we did not take time to step back and say what role does this industry play in our society?
Is it of general benefit to the society? Should we encourage or discourage life insurance? We haven't done this with P&C either. In your opinion, what should the role of the property and casualty insurance be in our society?
Mr. ANDERSON. In our report, sir, we bring out quite strongly the national importance of the industry, in order to spread the risks associated with any number of potential adverse problems.
We also point out the role of the industry as another supplier of investment funds, truly another financial intermediary that is helping meet the capital needs across a lot of the Nation, so we recognize that as a consideration that the Congress is going to have to keep in mind.
Mr. SCHULZE. On the PAL account, instead of repeal, are there any other interim methods of dealing, phasing, or reducing any other compromise for the benefits to be reduced? How would you handle that?
Mr. GANDHI. I think there is a view here held by Treasury which says that all companies should be treated alike, and that the mutual companies, even the small mutual companies, have available to them the provisions to carry back and carry forward losses, and also the money that was put aside because of the PAL account is not necessarily earmarked for that particular purpose.
So what is the guarantee that the PAL account indeed assures that the company would have money available to them when the catastrophe occurs?
I think our contention here is that there is no link between the PAL account and the availability of those funds, so if there is no link there, then what is the justification of the PAL account?
Mr. SCHULZE. Isn't it just an extra safeguard?
Mr. GANDHI. It is, indeed, sir. However, the point is, what about the small stock companies? If there is a catastrophic event that occurs, would the stock company be able to go to the market and raise funds? That is the question that we had addressed ourselves to.
Mr. SCHULZE. At the end of 5 years, isn't the PAL account kind of a wash?
Mr. GANDHI. It is indeed a wash, but there is a part of the PAL account that stays with the company, and larger mutual companies have taken advantage of that and have a substantial amount of money available to them just on the side.
Mr. SCHULZE. When we talk about the time value of money, in a way, we are just saying we want to collect taxes now. I am generalizing, but most of the time we say we want to collect the taxes now, instead of later. I don't know that we necessarily should do that.
Do you have any arguments on one side or the other? In other words, we are going to get it eventually. Why do we necessarily say we have got to have it today? It is like speeding up cash flow, I understand that, but I don't know that it is always correct.
Mr. ANDERSON. I think that Dr. Gandhi can lead you through his explanation of the fact that this is supposed to be a profitless transaction from the standpoint that we have a premium, we have a claim that is certain to arise somewhere down the road.
We are establishing a loss reserve. All things aside from that part of premium that represents profit, that part of premium that represents return on investment, the rest of the transaction should balance out, both on the debit side and the credit side, and the point that Nat will make is that because of the tax treatment afforded the loss reserve today that we find that a profit is actually being generated on what should be a nonprofit transaction.
Nat, can you help me?
Mr. GANDHI. The whole issue you have here, sir, is the measurement of appropriate economic income, and we have no problem with the reserves or the reserve deduction.
The issue here is what should be the amount of the reserve deduction. If you are going to pay $10 after 10 years, shouldn't the deduction be less than $10 today rather than the full $10? That is all we are saying.
Mr. SCHULZE. Thank you, Mr. Chairman.