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Tax reform to weigh on upcoming annual US statutory insurance statements

The forthcoming release of key annual statutory statement pages will only tell part of the story about the effects of federal tax reform on the U.S. insurance industry — and life insurers in particular.

Many publicly traded insurers have issued guidance on the immediate effects of a lower federal corporate tax rate on their deferred tax assets and liabilities on GAAP and statutory bases in their fourth-quarter 2017 earnings reports. Though the magnitude of those write-downs generally appears to be manageable for most of the companies that have discussed the issue, several insurers have warned of a more significant impact down the road should the National Association of Insurance Commissioners revise its method of calculating companies' risk-based capital ratios to incorporate the new 21% rate.

The timing of the changes brought by the legislation, which President Donald Trump signed into law Dec. 22, 2017, has created a layer of challenges for the industry as companies prepare their year-end financial reports. But no such ambiguity pertains to companies' calculations of their deferred tax assets and liabilities.

According to recent guidance from an NAIC working group, Statement of Statutory Accounting Principles No. 101 specifies that deferred tax assets and liabilities be measured using the enacted tax rate that is expected to apply to taxable income in the periods in which it is expected to be settled or realized — i.e., 21% as of year-end 2017.

Revising RBC

The NAIC developed its RBC formula nearly three decades ago in response to a series of insurance company insolvencies. The formula is intended to assist state regulators in identifying weakly capitalized insurers by measuring a company's capital adequacy in relation to its risk profile. It applies factors to various items in financial statements in seeking to measure risks relative to assets and underwriting activities. The NAIC employs factors ranging from 26.25% to 35% in adjusting the components of risk for taxes.

The lower corporate tax rate comes as the NAIC is targeting the implementation by year-end 2019 of a new and more granular RBC structure for capital charges pertaining to fixed income assets. This is intended to add transparency to the evaluation of credit risks associated with insurers' investment portfolios. A recently posted NAIC document indicated that the Capital Adequacy Task Force would need to consider revising the tax factors associated with the RBC formula, but there is uncertainty in the industry as to whether such a change would take effect in 2018 or 2019.

Several companies have recently discussed the prospective impact of such a change, whenever it might take effect, on their U.S. life units' company action level RBC ratios.

Prudential Financial Inc., for instance, cautioned that the capital levels of its domestic units may fall below its internal target to maintain a level consistent with AA financial strength ratings. Torchmark Corp. estimated that its consolidated company action level RBC ratio might decline by 45 points at the end of 2018 on top of an expected reduction of about 30 points at year-end 2017 that would result from a reduction in deferred tax assets.

Transamerica Life Insurance Co. parent Aegon NV projected that its U.S. life group's RBC ratio would remain well above the midpoint of its targeted range of between 350% and 450%, assuming a prospective NAIC formula revision. But that would, in theory, mark a decline from a year-end 2017 ratio that is estimated to come in above the high end of that range.

CNO Financial Group Inc. estimated in its 10-K that its insurance units would face a 65 point decrease to their RBC ratio in the event the NAIC revises the embedded tax rate assumptions, resulting in an increase in required capital of $80 million. Lincoln National Corp. estimated during a recent call that its RBC ratio could see a negative impact of about 60 points in 2018 associated with prospective NAIC changes to the formula, but it noted that the NAIC could "consider taking a more holistic view and make refinements to calculations" to potentially reduce the size of the hit.

The industry is also awaiting definitive guidance from the rating agencies as to how lower RBC ratios resulting from revisions to the formula may or may not alter their views on capital adequacy.

"So," said CNO Financial CFO Erik Helding during a recent call, "it's TBD."

Navigating Note 9

Several pages of the 2017 annual statements will help provide a glimpse into the impact of tax reform on the industry's statutory-basis net deferred tax assets and liabilities. Most jurisdictions require the filing of the key annual statement pages, which include balance sheets and the applicable note, on or before March 1.

U.S. property and casualty insurers, based on a consolidation of results reported in combined annual statements and among standalone entities, reported a net deferred tax liability position of $2.12 billion as of year-end 2016. Net admitted deferred tax assets among U.S. life insurers exceeded deferred tax liabilities by nearly $37 billion, so the impact of the lower tax rate is likely to be far larger for that sector.

In addition to balance sheet disclosures, insurers are required to populate detailed worksheets of how they arrive at their valuations of deferred tax assets and liabilities, both admitted and nonadmitted, in Note 9 to their annual statements.

The first of the worksheets in Note 9 provides a breakdown of deferred tax assets and liabilities by their character depending upon whether they derive from ordinary income or capital gains. Other worksheets show how a company arrives at a determination of the admissibility of the deferred tax assets, the major components of its income tax incurred and the major components of the deferred tax assets. The final worksheet shows an accounting of the differences between the amount of income taxes a company would have incurred at the current federal income tax rate and the amount of income taxes it actually incurred.

A review of 2016 Note 9 disclosures finds that the results displayed on the worksheets do not always agree with figures reported elsewhere in annual statements. Some entities populated the Note 9 fields with consolidated entries at a group level. Certain others reported paying federal income tax on net capital gains on their income statements but displayed the inverse of the value as a negative entry on the Note 9 worksheet for showing the components of income taxes. Several other companies obtained permitted practices from regulators in their state of domicile pertaining to the effectiveness of their interest rate swaps hedging programs that caused the amount of net deferred tax assets as reported on their balance sheets to differ from those calculated using the Note 9 worksheets.

With the annual statement submission deadline just over two months after federal tax reform was enacted, the NAIC has issued guidance regarding how companies should proceed in making disclosures that may be impacted by the new tax rate. They are required to recognize the recalculation of deferred tax assets and liabilities using the 21% tax rate, and they have been asked to disclose as a "subsequent event" those items where they have been able to make a "reasonable estimate" of the impact of certain tax effects under the legislation. When a reasonable estimate cannot be determined, companies have been asked to avoid recognizing provisional amounts in their 2017 financial statements. All reporting entities will have a period of one year from the enactment date to complete their accounting for changes related to the legislation.

For Note 9, specifically, companies are required to calculate the components of income tax and deferred tax assets and liabilities using the 21% tax rate for the 2017 column, but they will need not make revisions to the data displayed in the 2016 column. Instead, the NAIC has requested that companies provide a written narrative to disclose information on the approximate amount of any changes in deferred tax assets and liabilities resulting from the lowered rate.

MassMutual provides a case study

The Dec. 31, 2017, annual statement of Massachusetts Mutual Life Insurance Co., which the company posted on its website Feb. 27, illustrates how and where the impact of tax reform may be felt.

The company reported that its surplus increased year over year to $15.71 billion from $15.42 billion, despite the $507.4 million reduction in deferred tax assets that it linked on Note 9G of the filing to a post-tax reform re-measurement. The associated $919 million negative change in net deferred income taxes was partially offset by increases in net unrealized capital gains and net unrealized foreign exchange capital gains of $439.6 million and $28 million, respectively.

MassMutual's gross admitted deferred tax assets, overall, fell by 31.2% on a year-over-year basis to $2.63 billion, its total deferred tax liabilities retreated by 15.6% to $1.87 billion, and its net admitted deferred tax assets declined by 52.6% to $761.1 million.

The provision of the legislation that eliminates life insurers' ability to carry-back net operating losses — but not capital losses — appears to have had the greatest impact on MassMutual’s decline in net admitted deferred tax assets. Federal income taxes paid in prior years and recoverable through ordinary and capital loss carrybacks accounted for $486.4 million and $130.7 million of the company’s $3.83 billion in adjusted gross deferred tax assets as of year-end 2016. Capital loss carrybacks represented only $66.7 million of its $2.63 billion adjusted gross deferred tax assets at the end of 2017.

U.S. life insurers combined to report $76.26 billion of gross admitted deferred tax assets on the same part of Note 9 of their 2016 annual statements. Carrybacks accounted for $21.35 billion of that amount, with $19.76 billion pertaining to net operating losses. MassMutual’s ordinary loss carrybacks ranked 10th-highest among individual U.S. life entities as of year-end 2016.

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