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important. We are not talking about future losses. We are talking about an accident or loss that has already occurred and is only waiting to be paid.

Discounting reserves rests on a basic assumption that a company need not hold a full reserve.

The ability of the States to regulate to ensure solvency would be greatly harmed if any discounting method is enacted for tax purposes. It is easy to say that the regulators could continue to enforce the rules requiring full reserving, no matter what is done for tax purposes. The reality, however, is otherwise.

State regulation rests upon specific regulatory rules, but the rules rest upon common acceptance of underlying concepts. If a concept is adopted which holds that a larger part of the aggregate receipts from premiums and investments belongs to the company as its income, then a smaller part of those aggregate receipts will be held as reserves.

Financially marginal companies will press for the extension of such a rule. Regulators will find it difficult, if not impossible, to resist income concepts that are endorsed by the Federal Treasury. Consequently, policyholders and claimants will have less protection.

The regulator's ultimate enforcement tool is to take over control of a company, but whether the regulator has the right to do so will depend upon whether the company is insolvent which, in turn, will depend upon the question of whether its true liabilities are to be measured on a discounted or undiscounted basis.

P&C companies have no right to use as their own those amounts which are required to be reserved to pay in full the claims known presently to exist. Consequently, those amounts are not taxable income to such companies.

Erosion of that principle will seriously undermine the financial integrity and jeopardize the resources not only of the companies, but also of millions of policyholders and claimants.

Second, discounting of loss reserves for tax purposes--whatever method might be adopted-would be a nightmare to administer.

The QRA method is highly theoretical and would require complex recordkeeping and computation.

Much has been said this morning, even by the representatives of the GAO, with respect to the administrative problems of the QRA, and I will not waste the committee's time further by going into further comments with respect to the administrative problems that would be raised by the institution of a QRA account.

I would merely say in summary that the NAII is opposed to all four of the administration's proposals to change the manner in which P&C companies are taxed. Such proposals would seriously affect the solvency of the industry and would undercut the States' ability to regulate for solvency. Furthermore, the proposals are extremely complicated, theoretical and difficult to implement.

Thank you very much.
[The prepared statement follows:]

STATEMENT OF BRADFORD W. MITCHELL, CHAIRMAN, NATIONAL ASSOCIATION OF

INDEPENDENT INSURERS Mr. Chairman and distinguished members of the committee, I am Bradford W. Mitchell, chairman of the National Association of Independent Insurers (NAII).

The NAII has filed a full statement, explaining in detail the reasons why we believe all four of the administration's proposals relating to property and casualty insurance companies are fundamentally wrong. I will comment here on only two basic points made in our written statement.

Three of the administration's four proposals deal with mutual insurance companies. While those proposals will be discussed by other members of the panel, it is important that you know that NAII, on behalf of all its members, both stocks and mutuals, has concluded that all the proposals relating to mutual companies are wrong.

Turning now to the two substantive points I wish to discuss.

First the "qualified reserve account,” proposal rests on a new and novel reserving theory. The new system is based on the assumption that the "correct” reserve is not the full reserve, but a lesser, discounted amount. The GAO report that you heard about earlier finds the administration's proposal incorrect and too complicated.

The first point I wish to make is that the discounting of reserves, under any method of discounting, is conceptually wrong. Such a system would seriously undercut the ability of State regulatory agencies to insure safe and sound fiscal operations of the P/C Companies. If an insurance company's solvency constituted a danger only to company owners, the adverse impact on solvency regulation might not be as serious. But the insolvency of an insurance company is a threat primarily to the policyholders and claimants whose money the insurance company is holding, not its owners. That is why the system of State regulation for solvency is so important.

State insurance laws dictate the amounts a company is required to hold for the benefit of its policyholders and claimants. The tax law has since 1921 based the computation of insurance companies taxable income on the reality that amounts held for the benefit of others is not taxable income of the P/C Company.

Since the largest part of the assets held by P & C companies are held for the account of policyholders and claimants. It is the policyholders and claimants who will lose the most if a company becomes insolvent. Other P & C companies are also at risk because under so-called guaranty statutes enacted in every State, all companies writing similar coverage in the State are subject to assessment to pay the claims of an insolvent company.

The fundamental solvency safeguard is the maintenance of adequate reserves to cover losses that have already happened. That is important. We are not talking about future losses-occurrences-we are talking about an accident or loss that has already occurred and is only waiting to be paid.

Discounting reserves, and any tax regime based on discounting, rests on a basic assumption that a company need not hold a full reserve.

Regulation to ensure solvency is presently entrusted to State regulatory agencies. The ability of the States to regulate to ensure solvency would be greatly harmed if any discounting method is enacted for tax purposes. It is easy to say that the regulators could continue to enforce the rules requiring full reserving, no matter what is done for tax purposes. But reality is otherwise.

State regulation rests upon specific regulatory rules; but the rules rest upon common acceptance of underlying concepts. If a concept is adopted which holds that a larger part of the aggregate receipts from premiums and investments belongs to the company as its income. A smaller part of those aggregate receipts will be held as reserves against which claimants and policyholders have rights. Financially marginal companies will press for the extension of such a rule, administratively and in court. Regulators will find it difficult, if not impossible, to resist income concepts that are endorsed by the Federal Treasury. Consequently, policyholders and claimants will have less protection.

The regulator's ultimate enforcement tool is to take over ontrol of a company, but whether the regulator has the right to do so will depend upon whether the company is insolvent which, in turn, will depend upon the question of whether its true liabilities are to be measured on a discounted or undiscounted basis. One need only look to recent insolvency actions to see that litigation over the concepts applicable to valuing liabilities is a serious and constantly recurring problem.

P/C Companies have no right to use as their own those amounts which are required to be reserved to pay in full the claims known presently to exist. Consequently, those amounts are not taxable income to such companies.

Erosion of that principle will seriously undermine the financial integrity and jeopardize the resources not only of the companies, but also of millions of policholders and claimants.

Secondly, discounting of loss reserves for tax purposes—whatever method might be adopted—would be a nightmare to administer. Conventional discounting would require the determination of a proper discount rate (which would never be clear cut and would always be changing) and of the estimated future payment schedule of the losses (which would necessarily be judgments, based on an array of statistical data.)

The QRA method is highly theoretical and would require complex recordkeeping and computation. It would require “rate of return” calculations which would be subject to extensive judgmental cost allocations, and would require calculations based on policy year by class of coverage.

Either method of discounting would require judgments and estimates that go beyond the competence of ordinary auditors. Companies, State regulators and the IRS will have to retrain their personnel or hire new experts. Smaller companies would no doubt have to go outside for expensive and time consuming consultant and service arrangements. We submit endless controversy will be sure to result.

In summary, NAII is opposed to all four of the Administration's proposals to change the manner in which P & C Companies are taxed. Such proposals would seriously affect the solvency of the industry and would undercut the States' ability to regulate for solvency. Furthermore, the proposals are extremely complicated, theoretical and difficult to implement.

Thank you. I would be happy to answer any questions you may have.

STATEMENT OF
THE NATIONAL ASSOCIATION OF INDEPENDENT INSURERS
BEFORE THE COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES

ON
"THE PRESIDENT'S TAX PROPOSALS

TO THE CONGRESS FOR
FAIRNESS, GROWTH AND SIMPLICITY"

SUMMARY

The National Association of Independent Insurers ("NAII") opposes all four of the Administration's proposals to change the manner in which property and casualty ("P& C") insurance companies are taxed.

Nature of Insurance. P & C insurance is an institution for the pooling of funds to shift and distribute risks among policyholders and claimants. The insurance company serves as an administrator of the pool of funds contributed by policyholders. The pool accounts for all but a fraction of the cash flows and the assets of the insurer, and under state law the insurer takes amounts for its own account (i.e., has "income") only if and when they are released from the pool because no longer needed.

"Reserving" is the mechanism by which the insurer determines the amounts needed to be held in the pool for policyholders. The primary reserve of a P & C company is the unpaid loss reserve, which is the estimated amount that must be paid to or for policyholders for economic losses from events which have already occurred. This reserve differs from a life insurance reserve which is a provision for a future event.

Discounting of P & C Loss Reserves is Inappropriate. Discounting of loss reserves in any form, is wrong. The effect of any discounting procedure would be to tax in advance investment income that will be earned in the future.

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The Administration's "QRA" Discounting Proposal is Particularly inappropriate. The proposal would institute reserving system, using a so-called "Qualified Reserve Account" (QRA). The new system would be based on the assumption that the "correct" reserve would be not the full reserve, but a lesser, discounted amount. The company would have the option of initially excluding the full reserve from its income (as at present), but if it did so, it would incur an additional tax, at a later date, to put it in the same position as if it had originally excluded only the discounted amount.Thus, while the company would not technically be required to use a discounted reserve in the first instance, it would be taxed as if it did.

REASONS NAII OPPOSES THE QRA PROPOSAL :

QRA taxes a portion of investment income twice. QRA would tax a portion of the company's investment income in advance, and then would tax all of it again when actually earned. Tax exempt income would not be taxed when received, but would be taxed in advance on a present value basis by discounting the reserves.

QRA would tax P & C companies on amounts substantially in excess of its economic income--a result which we understand the Treasury to concede. (See Exhibits A-1 A-4.)

QRA would seriously undermine the financial integrity of state regulation and the operating framework of the P & C industry. The laws of every state are designed to assure that adequate funds will be available to pay losses that have already occurred by requiring P & C companies to reserve the full amount to pay those losses. The QRA proposal, on the other hand, is based on the assumption that full reserving is excessive. Therefore, the QRA would undercut the conceptual case for requiring companies to reserve for losses in full, and would thereby hamstring the ability of state regulators to regulate for solvency.

- State Insurance Regulators Object to QRA. The National Association of Insuance Commissioners ("NAIC"), which is composed of the insurance regulators from every state, has adopted a resolution opposing QRA because it would "weaken the tax laws' recognition of state statutory accounting rules and their traditional methods of reserving for policyholder benefits, claims and losses." (A copy of the NAIC resolution is attached as Exhibit B.)

- QRA would reduce the industry's ability to write new business and would harm small companies. The QRA would (1) take needed surplus from the industry, (ii) significantly increase an already sevece capacity problem, and (iii) place a greater penalty on small new and small growing companies by reducing their surplus and capacity to grow.

QRA would disadvantage domestic insurers vis-a-vis foreign insurers. QRA would substantially increase the cost of domestic insurance and cause an increased amount of business to be placed with foreign insurers. It would give foreign insurers an advantage in the U.S. market and would impose on U.S. insurers a disadvantage in foreign mackets.

QRA would be an administrative nightmare. Discounting by any method, including the Administration's "qualified reserve account" method, would impose a substantial and costly administrative burden on taxpayers and would be source of endless controversy with the IRS.

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QRA would substantially increase the cost of insurance protection. Independent studies by A. M. Best Company, a highly respected insurance Financial rating organization show that implementation of QRA would require premium increases by an average of 11 percent. As a result many policyholders would no longer be able to purchase necessary coverages from the private insurance market.

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