Chapter Outline

1. Chapter Outline 10.1 Tax Benefits Defined 10.2 Progressivity in Corporate Income Tax Rates Overview Numerical Example and Additional Insights Progressivity of US Corporate Income Tax Rates 10.3 Tax Treatment of Insurers versus Non-Insurance Companies Overview Example and Additional Insights Tax Benefit with Overstated Loss Reserves 10.4 Insuring Depreciated Property Overview Example and Additional Insights Retention Insurance and Recognition of a Capital Gain Insurance and Deferral of the Capital Gain

2. Chapter Outline 10.5 Insurance and Interest Tax Shields on Debt 10.6 Insurance Premium and Excise Taxes 10.7 Regulatory Effects on Loss Financing Compulsory Insurance Restrictions on the Choice of Insurance 10.8 Financial Accounting Influences on Loss Financing Financial Accounting for Insurance Premiums and Uninsured Losses Cash Flow Impacts of Financial Accounting Numbers 10.9 Summary Appendix Tax Benefits when Insurers Overstate Loss Reserves

3. Tax Benefits Defined • Definition of a tax benefit • A transaction provides a tax benefit if the present value of expected tax payments of the parties involved is lowered. • Expected tax payments vs. ex post tax payments • Present values • Nominal recipient versus actual incidence • Tax minimization does not always imply shareholder wealth maximization

4. Tax Effects of Loss Financing Decisions • Main tax benefits from insurance arise for four reasons: • Progressivity in tax rates (also applies to hedging) • Different tax treatment of insurers and non-insurance firms • Tax treatment of depreciated property • Risk reduction allows for greater use of debt, which creates additional tax shields (also applies to hedging)

5. Progessivity in Tax Rates • Intuitive explanation of the effect of hedging • Oil producer subject to oil price risk: • In years when oil prices are high ==> high taxable income ==> tax rate is high • In years when oil prices are low ==> low taxable income ==> tax rate is low • Effect of hedging: • Lower taxable income when oil prices are high (and tax rate is high) and increase taxable income when oil prices are low (and tax rate is low) • Essentailly, hedging transfers income to years when it is taxed at a lower rate

6. Example of the Effect of Progressive Tax Rates Probability Before-tax income After-tax income 0.5 $10m $7.0m 0.5 $2m $1.3m Expected Value $6m $4.15m Eliminate uncertainty at no cost ==> before-tax income = $6m & after-tax income = $4.2 After-tax income 7 4.2 4.15 1.3 Before-tax income $2m $6m $10m

7. Different Tax Treatment of Insurers • Description • Insurers can deduct incurred losses = paid losses + change in PV of estimated unpaid losses (change in PV of loss reserve) • Non-insurance firms can deduct paid losses • Implication: • Insurers can move tax deductions for losses forward in time relative to non-insurance firms

8. Example of Different Tax Treatment of Insurers • Example: • Due to events in year 1, Crocker expects loss payments: Year 1 Year 2 Loss payments $2m $2m • Assume opportunity cost of capital = 8%, tax rate=34% • Without insurance, PV of tax shields = = $1.213m

9. Example of Different Tax Treatment of Insurers

10. Example of Different Tax Treatment of Insurers • PV of tax shield for insurer = $3.852(0.34)/1.08 + $0.148(0.34)/1.082 = $1.256m • Difference between insurer and non-insurer = $1.256m - $1.213m = $0.043m = $43,184 • Important insight: Difference arises because the insurer implicitly does not pay tax on interest earned on funds set aside to pay future losses

11. Example of Different Tax Treatment of Insurers • Calculate the tax savings on implicit interest • Amount of money at time 1 needed to pay future losses = $1.852m • Interest earned on these funds = $1.852 (.08) = $148,148 • Tax that would be paid on the interest = 0.34($148,148) = $50,370 • PV of the tax saving = $50,370/1.082 = $43,184

12. Insuring Depreciated Property Intuitive Explanation: Assume that (1) the value of existing property has been depreciated to zero (book value =0) (2) that future depreciation expenses resulting from replacement of damaged property are the same whether the firm is insured or uninsured (3) that the premium loading is zero (4) income tax rate > capital gains rate

13. Insuring Depreciated Property Tax effects of purchasing property insurance: (1) the firm is able to deduct the insurance premium when calculating taxable earnings, regardless of whether a loss occurs. (2) if a loss occurs the firm will have to recognize a capital gain equal to the insurance indemnity payment. The first effect > expected value of the second effect when the income tax rate exceeds the capital gains rate That is, the income tax savings from deducting the premium exceeds the expected capital gains tax payment.

14. Interest Tax Shields on Debt • Optimal amount of debt is determined by the advantages and disadvantages of debt financing • Advantages • Interest tax shields • Reduce agency problem between managers and shareholders • Disadvantages • Expected bankruptcy costs • Expected costs due to • underinvestment problem • overinvestment in risky projects (asset substitution)

15. Interest Tax Shields on Debt • Disadvantages of debt increase as probability of financial distress increases • Decrease risk ==> decrease probability of financial distress ==> borrow more ==> gain additional interest tax shields

16. Other Tax Issues • State premium taxes • generally, 2% • some variation across states • Federal excise taxes • 1% on reinsurance • 4% on primary insurance

17. Regulatory Effects • Compulsory Insurance • why? • Restrictions on the choice of insurers • Amitted insurers • Excess & surplus lines market • Fronting

18. Financial Accounting Effects • Riskier cash flows ==> • more volatile reported income • more volatile balance sheet numbers • Who cares? • Contracts depend on reported numbers • managerial contracts • debt contracts • Less volatility makes assessing managers easier