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Downward deferred tax asset adjustment a glancing blow for US life insurers

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Downward deferred tax asset adjustment a glancing blow for US life insurers

U.S. life insurers' prospects to achieve a 10th consecutive year of growth in their absolute level of surplus in 2018 will do little to allay concerns about what impending regulatory changes might mean for their relative levels of capitalization in 2019.

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Some life insurers may also look to amass capital as they brace for the negative impact from changes to the National Association of Insurance Commissioners' formula for calculating risk-based capital ratios, an event that a number of industry participants expect to take effect for year-end 2019 statutory financial statements. The industry's 2017 net income more than offset the large negative changes in deferred income taxes that resulted from U.S. federal tax reform, and overall surplus expanded by 3.6% year over year — approximately the same growth rate it achieved in the prior year. More expansion is likely in the cards for 2018 as companies' income statements should benefit from the new lower corporate tax rate and rising interest rates.

Those changes may include the adjustment of the formula to account for the lower federal tax rate as well as long-planned revisions to the formula's bond factors. The American Council of Life Insurers has warned that the changes would cause even the industry's strongly capitalized companies to see significant declines in RBC ratios, with several large publicly traded insurers cautioning about the potential for double-digit declines.

Principal Financial Group Inc. said in April that it intends to maintain its company action level RBC ratio above its targeted range of 415% to 425% as it awaits additional guidance from the NAIC as to the timing of a prospective update to the formula to reflect the lower tax rate — an outcome that the company estimates would reduce its ratio by between 40 and 50 percentage points.

Looking backward and forward

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The industry's net change in deferred income taxes served as a drag on surplus in 2017, as was expected given the timing of the enactment of federal tax reform. The $31.86 billion negative net change in that item represented the largest swing for the industry since there was a positive change of $35.46 billion in 2008.

But life insurers found relief in the form of rising net income, which totaled $42.10 billion, up from $39.40 billion in 2016. Federal tax reform provided an immediate benefit to a number of insurers in the form of positive changes in unrealized capital gains. Several large life insurers also benefited from unusually large positive changes in nonadmitted assets with roots in federal tax reform.

U.S. life insurers' statutory results have been significantly impacted by their entry and/or recapture of large reinsurance transactions for a number of years. And that trend is likely to continue as several companies engaged in material changes in how certain of their life and/or annuity risks are reinsured during the first quarter, including in response to the Base Erosion and Anti-Abuse Tax, or BEAT, that was enacted as part of the broader tax reform legislation.

Nevertheless, the largely offsetting nature of certain of those recaptures in combination with expected favorable comparisons in net investment income earned and federal and foreign income taxes should permit the industry to continue to generate positive net income in 2018. Lower pretax operating income and additional net realized capital losses in a challenging first quarter from the perspective of equity and corporate bond markets more than offset the benefit of lower taxes in the first quarter, and the industry's net income fell to an estimated $4.82 billion from $8.58 billion year over year. Surplus among those U.S. life groups and standalone entities for which data was compiled through May 31 increased to $394.29 billion as of March 31 from $393.91 billion at year-end 2017.

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Federal taxes recoverable through carrybacks represented the area in which the industry's net deferred tax assets were most dramatically impacted in 2017. A provision of the legislation generally eliminated life insurers' ability to carry-back net operating losses, and the industry's total carrybacks plunged by nearly 87.1% year over year. At $2.76 billion, carrybacks amounted to only 5% of the industry's admitted adjusted gross deferred tax assets as of Dec. 31, 2017, down from 30.8% on the same date a year earlier.

TIAA's Teachers Insurance & Annuity Association of America reported some particularly dramatic movements within its capital and surplus account even as its surplus rose by a comparably modest 2.1% year over year. In addition to $1.02 billion of net income, the company reported a $1.17 billion positive net change in unrealized capital gains, a $1.04 billion increase in surplus notes and a $3.40 billion positive change in nonadmitted assets, the latter two of which were the highest for an individual entity in the industry. Those changes were partially offset by the company's $4.55 billion negative change in deferred income taxes, which also was the largest amount for any individual life entity. TIAA attributed $3.79 billion of the change in net deferred taxes to their remeasurement in the aftermath of the enactment of tax reform.

Yet while the absolute level of surplus for the TIAA life group and many other life insurers increased in 2017, RBC ratios as calculated by S&P Global Market Intelligence fell for that group and at least eight of the nine other largest life groups fell albeit from levels that would generally be considered very high. Their levels of authorized control level risk-based capital increased at a faster rate than did their total adjusted capital.

A new reality

Industry representatives have emphasized throughout the debate that tax reform has not materially impacted the actual financial strength of most life insurers even as it has the potential to meaningful hit their RBC ratios and, in certain cases, cause companies to raise capital.

"RBC ratios ... are reasonable relative measures of strength," said Lincoln National Corp. CFO Randal Freitag during a recent conference call, "but they are not what defines capital adequacy." Rather, he opined, capital adequacy represents the amount of capital on a company's balance sheet in the context of the challenges it might face in stress scenarios such as a deep recession, large declines in equity markets, very low interest rates, large credit losses or "stagflation."

The ACLI, in a February letter to the NAIC, advocated a recalibration of expectations of appropriate life insurer capitalization, given that the expected reductions in RBC ratios would occur without a commensurate decrease in financial strength. The benefit of the lower corporate tax rate in the form of higher current after-tax earnings "must be considered," the group argued, as opposed to a sole reliance on what it characterized as a "point-in-time" measure of capital.

Still, some companies are making preparations for the hit to their RBC ratios that they expect will materialize. Torchmark Corp. ended 2017 with a company action level RBC ratio of 314.6%, as calculated by S&P Global Market Intelligence, relative to an internal target of 325%. The company has expressed confidence that it maintains more than sufficient liquidity to make additional contributions to its life insurance subsidiaries as may be necessary. It further noted that the year-end 2017 RBC ratio represented 6.3x the amount of capital required by the life units' regulators.

Torchmark and others in the industry continue to await the NAIC's release of final guidance, and they have maintained ongoing dialogues with rating agencies and regulators regarding the impact of potential forthcoming changes.

A number of companies continue to wait for additional clarity regarding whether to retain or relax their internal RBC targets.