the U.S. insurance industry to maintain a competitive balance with its foreign counterparts. As indicated in Sec 30 tion IV above, foreign insurers are very substantial participants in this portion of the market. 31 Discounting of loss reserves will either force domestic insurers to raise their prices or force them to pay the additional taxes out of surplus, thus reducing the coverage they can provide. However, discounting will have no economic effect on foreign excess and surplus lines insurers as they are generally not subject to U.S. income tax. Thus, the foreign participants in the excess and surplus lines markets will be placed in a position that allows them to increase their market share because of the economic detriment that discounting imposes on U.S. companies. These comments apply equally to the U.S. direct placement and marine and aviation markets. One obvious response to the argument that the discounting proposals place U.S. insurers at a competitive 30 See, e.g., PLR 8507003 (Nov. 6, 1984). Indeed, the Service has even concluded that the excise "tax" is not really a tax at all, in the traditional sense. 31 Id. Although discounting proposals have been considered by other countries from time to time, they have not been adopted. If the QRA or the GAO proposal were enacted, the United States would be the first major industrial country to have adopted such a regime. disadvantage would be to increase the Federal excise tax on both insurance and reinsurance premiums to offset the economic advantages that would accrue to foreign insurers and reinsurers by virtue of the imposition of the discounting proposal. This solution would be in accord with the purpose of the tax, as reflected by its legislative history and I.R.S. interpretations, but would create other problems which raise questions as to the wisdom of such a solution: • First, any unilateral change in the excise • Second, such an increase in the tax is obviously a protectionist measure which raises international trade problems. ••• Third, it would not affect competition through branches or domestic subsidiaries which would be exempt from the imposition of the excise tax, and continue to achieve advantages through the tax credit mechanism of the home country or a U.S. tax treaty. .... Fourth, to the extent that the increased tax did cause the withdrawal of foreign participants from U.S. markets, it would force insureds either to accept significant premium increases or to self-insure part of their risks in order to stabilize their premium costs. Large-scale self-insurance is not socially desirable in that it minimizes the spread of risks and increases the volatility and impact of individual losses. C. Foreign Reinsurers. Foreign reinsurers are generally not subject to U.S. income tax. Thus, the discounting proposals will have no economic impact on them. However, since the proposals will have an economic impact on U.S. reinsurers, domestic reinsurers will be required either to raise prices or to suffer surplus reductions in the same manner as domestic excess and surplus lines carriers. Thus, a foreign participant in the U.S. reinsurance markets will be in a position to increase its market share because of the economic detriment that discounting imposes on its U.S. counterparts. 11 A significant effect of the discounting proposal is that it may become more profitable for domestic companies to reinsure with foreign reinsurers than to bear risk in their own right. Generally, when a reinsurance premium is paid from a direct insurer to a reinsurer, the direct insurer reduces its earned premiums by the amount of the reinsurance premium; concomitantly, it reduces its reserves by its estimate of the losses attributable to the risks reinsured. Most reinsurance arrangements provide for a ceding commission to be retained by the reinsured to reimburse it for its expenses in acquiring the original insurance. The 32 But see discussion of Federal excise tax at pages 2527, supra. ceding commission is treated as a miscellaneous income item. Thus, reinsurance allows a carrier to reduce its reserves while increasing its "miscellaneous" income. To the extent that reserves are reduced, the effect of discounting is avoided. The use of foreign reinsurance to increase the profit of the ceding company is illustrated by the following example: Example. Assume that a U.S. insurer customarily insured a particular risk for $4,000,000, established a $3,600,000 loss reserve with respect to that business prior to QRA, and had acquisition expenses of $400,000 associated with the risk. If it reinsured 50 percent of the risk for $2,000,000 less a ceding commission of $200,000, its income statment for tax purposes would show $2,000,000 earned premuim less a $1,800,000 reserve less $400,000 expenses plus $200,000 ceding commission,' i.e. $0. After QRA, as discussed above, the cost of the premium would increase to the U.S. market, but not to the foreign reinsurance market and all or a part of that increase would be available to be paid to the U.S. insurer as ceding commission. For example, if the "loading" the U.S. market required to absorb QRA were $500,000, the total premium would be $4,500,000, and the reinsurer could pay a ceding commisson of up to $450,000 (i.e. a $250,000 profit) to the U.S. insurer without being economically disadvantaged. Since all U.S. insurers would be in the same tax position, it is likely that reinsurances would be placed with non-U.S. reinsurers whose tax authorities allow a full current deduction or with U.S. branches of foreign reinsurers if the reinsurer received credit in its home country for U.S. tax. In either instance, as the above example indi cates, the reinsurer would not need the "loading" that may have been added to the premium to cover the tax on the discount, and more cash would be available to be paid to the direct insurer as a ceding commission. This could lead to a situation where members of the U.S. insurance industry would be, in large part, "fronting" for foreign reinsurers. Thus, U.S. companies concerned with preserving the integrity of their balance sheets could well decide to substantially increase their purchase of foreign reinsurance on longtail lines of business. In effect, this would leave the U.S. public dependent upon unregulated foreign insurers for its insurance coverage. Contrary to the assertion in the GAO Report (See pp. 7 and 8, supra), we doubt that section 845 of the Code can be used to inhibit this type of reinsurance Section 845 authorizes the Commissioner of Internal Although this language is rather broad, it is highly (Footnote continued) |