Panacea or Boondoggle? U.S. officials are taking a new look at tax-deferred reserves for catastrophe claims, but questions remain about whether they strengthen or harm the private insurance market.

Tax-deferred catastrophe reserves for insurers in the United States is an idea that has been around for more than a decade. But with the perceived risks of more Katrina-like mega-disasters, many parties are giving the old idea another look. One report is that a working group of insurance commissioners has initiated "high-level" talks with the U.S. Treasury Department.

The reserves would work somewhat like an Individual Retirement Account, except that companies would be saving for natural catastrophes rather than retirement. Under such a plan, the federal government would allow insurance companies to stash away tax-deductible money up to established limits. The contribution would be an expense on the company's income statement, thus reducing net income and taxable income. Should a catastrophe occur, the company would liquidate the reserve, and the amount would count as taxable income. The benefit? Insurers would be better capitalized to cope with mega-disasters.

The idea is only part of a public policy debate that has intensified following record insured catastrophe losses in 2004 and 2005. Other ideas include state or regional catastrophe pools that provide reinsurance, a national fund amounting to a federal backstop, and even tax-free individual homeowner accounts to cover catastrophic losses. Bills that would amend the tax code to establish tax-deferred catastrophe reserves for insurers are H.R. 2668, sponsored by Rep. Mark Foley, R-Fla., and S. 3116, sponsored by Sen. Bill Nelson, D-Fla.

Caution Abounds

Despite the tax advantages, many in the insurance industry are cautious. So are federal and state officials. Insurers worry how the details might affect their businesses. Reinsurers generally favor private-market insurance solutions, but might not oppose the legislation. Regulators, for whom insurer solvency is a top concern, have struggled to reach a consensus. Lawmakers and the Treasury Department, meanwhile, worry about a loss of tax revenue in a period of annual budget deficits. Many elected officials are reluctant to be perceived as handing out tax favors to the insurance industry.

The report about "high-level discussions" with the Treasury Department came from John Oxendine, Georgia insurance commissioner and chairman of the National Association of Insurance Commissioners' Tax Policy Working Group. Oxendine said there is "no downside" to tax-deferred catastrophe reserves and argues that the pending bills wouldn't exempt reserves from taxation, but rather change the timing. Oxendine said in late July that talks between his working group and the Treasury slowed during the transition from former Treasury Secretary John Snow to new secretary Henry M. Paulson.

Oxendine stopped short of saying the department is interested in tax-deferred reserves, but added that its willingness to discuss the concept "is something very different and radical for them." He said the Treasury might have the power to allow for such reserves, but a Congressional law would require the Treasury to do it.

Under the tax code and Generally Accepted Accounting Principles (GAAP), insurers do not have reserves set aside specifically for catastrophes. When disaster occurs, they pay claims from surplus, and they book losses, which they are then allowed to carry over against future profits. They can usually charge higher rates after big losses, which helps them to recapitalize.

"But if you start having a couple of years of losses, you start really jeopardizing the financial solvency of the company," said Oxendine. "Then it comes back to the taxpayers. If a company goes under, it's going to be that everyone else is going to pay, whether it's through a guaranty fund or FEMA [Federal Emergency Management Agency] coming in and bailing people out."

To Oxendine, the logical solution is to let the insurance industry "save money in advance" without having to pay tax until the triggering event. "Should there be a limit? Yes. You should not allow a company to put unlimited resources into a cat fund because you run the risk of a company excessively retaining earnings for tax avoidance, and that's wrong," he said. His proposal would be that state regulators work with the Treasury Department to develop a risk-based-capital type of formula uniform across all states that would depend on the size of the company and the nature of its risks. "Once companies reach that threshold, they stop, and they can't reserve more than that. Down the road, if they never have a catastrophe and want to use the money for anything [else], the money then becomes ordinary income."

Tax-Revenue Effects

Lawrence Mirel, formerly insurance commissioner in the District of Columbia, argues that tax-deferred reserves would not only improve the industry's capacity, but would actually bring more tax revenues into the United States. Mirel currently heads a unit on regulatory activities--primarily insurance--at the D.C.-based law firm of Wiley Rein & Fielding LLP. He said he has no client in this area, does not speak on behalf of any company and bases his comments on his experience as a regulator.

The reason tax-deferred reserves could generate tax revenues is that most of the reinsurance that backs up risk in the United States is provided by companies that are offshore, Mirel said. And they are offshore, in places such as Bermuda, the Cayman Islands and Guernsey, because they don't have to pay taxes on accumulated surplus on a year-by-year basis. Mirel argued that offshore reinsurance provides "much of the financial underpinning of the insurance business."

At least some of these reinsurers would reportedly like to relocate to the United States, and they would bring with them a lot of business now performed outside the country, Mirel said. These companies would create jobs with payroll taxes, real estate taxes, building taxes, and taxes on activities that are ancillary to any financial institution.

Mirel admitted that the insurance industry ably handled the 2005 catastrophes, which generated $57.7 billion in insured losses, according to the Insurance Information Institute. But he argued that the nation will need to encourage the growth of capacity to cover the rare but devastating event that could overwhelm the entire system.

"What if we have three Katrinas in one year, or a Katrina and a couple of big terrorist attacks?" he asked. "The well might go dry, and you'd have companies going belly-up. That used to be almost inconceivable."

Securitizations could be an alternative, but they have been modest so far in their impact. "If you want to take care of the problem in the short run, and do it through the existing system, tax-deferred reserves would be much quicker and more effective," said Mirel.

An industry concern is that the Treasury Department might have an income target in tax revenue from the insurance industry and that the department would try to make up any revenue loss in some other way, said Mirel. "That leaves the industry very nervous about coming out four-square for this," he said.

Also hampering the industry is "lack of a champion at the federal level," said Mirel. "The NAIC doesn't fit the bill for that; it just doesn't have the clout with Congress that the Federal Reserve Board does." In fact, the NAIC has had a contentious relationship with Congress, and more contentious times may be ahead over state regulation, he said.

First, Do No Harm

Joseph Sieverling, a senior vice president at the Reinsurance Association of America, said his group's chief concern is that enactment of a tax-deferred reserve law would cause the federal government to eliminate the net operating carry-back rule, which he said performs the same function as would the catastrophe reserve. "In many individual instances, and Sept. 11, 2001, was the most recent, Congress extended the rule to five years, which allowed companies to go back to taxes they had paid in profitable years," he said. "So you could essentially smooth out your taxable earnings over time by using the carry-back or carry-forward rules that were extended or liberalized for a period of time."

The RAA has no specific position on the current bills or tax-deductible reserves in general, and it has not opposed the concept at the NAIC or federal levels, Sieverling said. But the association has some guiding principles.

One is that the trigger point should be high enough to allow the private reinsurance market to develop and operate underneath. An NAIC model regulation a few years ago, for example, had a very high trigger: "Suffice it to say that insurers could add to their reserves, but could only take them down in the event of a major cat event," said Sieverling. "That encourages companies to use the private reinsurance market and other mechanisms, such as securitizations, for its everyday catastrophe risks."

Congress, however, scores bills on how they might affect tax revenues, and catastrophe reserves left untapped for long periods could be expected to reduce tax collections.

Another principle is that setting a reserve ought to be voluntary. Insurers that don't have a lot of coastal or earthquake exposure should not be required to put money into a catastrophe reserve, Sieverling said.

Sieverling pointed out that even last year, the worst year the industry ever had, it still made money. "Yes, the rates have gone higher, and that poses a hardship for a lot of people, and I don't want to minimize that at all, but the private market works," he said. "And we're concerned that more public fixes to the private market are going to create more problems in the way we view that they have with respect to the state cat funds, for example, in Florida. They've essentially artificially kept down the price of insurance, but ultimately, you have to pay the piper, and depending on how this cat reserve could be structured, if it's too low, and encroaches on the private market, then you have the same thing. It's essentially, ultimately, subsidizing catastrophe risk. And when you start messing with the private market, there can be unintended consequences."

A tax-deferred reserve would not change anything about the actual risks in today's world, Sieverling said, and he rejected the idea that reinsurance is the cause of higher insurance rates. "It's a fact that there's a recognition in the market by the rating agencies, by the insurers and by the reinsurers that there's more risk now than there was," he said.

That's part of how the market works. Another part involves supply and demand, and demand for reinsurance is currently high. But the good news is that there's a lot more insurance and reinsurance capacity coming on line, Sieverling said. "These unfortunate dislocations over time have a tendency of balancing out. It the price is too high, there's going to be a lot of money from the capital markets and elsewhere as they look to participate in those profits. That's how the free market works, and we think that's a good thing."

In theory, tax-deferred reserves might sound like a great thing for direct writers. "You can see in the public literature that CEOs have attraction to this," said Debra Ballen, executive vice president, public policy management, at the American Insurance Association. "But when you talk to technical people, they realize this is a much more complex issue. It may not be as good as it sounds."

Ballen said the association, which represents 400 property/casualty insurers writing $120 billion a year in premiums, recently began a "rigorous internal analysis" to determine whether its member companies would be better off economically. "The difficulty is that it is one thing to talk about this in theory, but in practice, it can get more difficult," said Ballen. The House and Senate bills lack enough specificity to determine whether they propose a workable way to establish a reserve or not, she said.

What are the chances a tax-deferred catastrophe reserve would become a reality in the United States? Not much, according to the RAA. "This type of bill has been introduced almost every year almost since Hurricane Andrew," said Sieverling. "The NAIC finalized its model in 2002; that was the second revision of the model. We're not expecting any immediate action by Congress to adopt this."

Mirel said the idea has "always been fought vigorously by the Treasury." He added that Congress might be more open to a reserve for terrorism risks than natural catastrophes because of the difficulty of being able to predict them and because there is no certainty about where terrorists would strike.

Key Points

* Support for allowing tax-deferred catastrophe reserves in the United States is tepid at best among insurers, reinsurers, regulators and legislators.

* Major issues revolve around keeping the private insurance market healthy.

* Government is reluctant to take action that might put it more into the insurance business than it already is.

* European countries have allowed or required tax-deductible reserves, but future international accounting standards may curtail or eliminate them.

ALL GOOD: John Oxendine, Georgia insurance commissioner and chairman of the National Association of Insurance Commissioners' Tax Policy Working Group, said there is "no downside" to tax-deferred catastrophe reserves.

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Reserving in Europe

European countries have a history of permitting insurers to establish tax-deductible reserves for potential losses in catastrophic events. The U.S. Government Accountability Office in 2004 studied six such countries. Each differs in how it allows reserves to be set up and used. Germany and the United Kingdom have standards that govern contributions and withdrawals, while France, Italy, Spain and Switzerland do not. Catastrophe reserves are intended for catastrophic losses. Equalization reserves are for random fluctuations of claim expenses for some types of insurance contracts such as hail insurance, according to the GAO's February 2005 report.

In Germany, Italy and the United Kingdom, reserves are mandatory.

Action by the International Accounting Standards Board, which is trying to establish a single set of global accounting standards, may by next year prohibit catastrophe and equalization reserves. In March 2004, the board issued International Financial Reporting Standard 4 Insurance Contracts, Phase I, which includes guidance that effectively prohibits the reserves, according to the GAO report. The second phase, to be in effect by 2007, will address broader conceptual and practical issues. Under the new international standards, insurers can accrue loss reserves only if the event has occurred and the related losses are estimable. The board is independent and privately funded; it works with national accounting standard setters.

One of the board's arguments against tax-deferred reserves is that they do not necessarily qualify as liabilities because the losses have not yet occurred, and treating them as if they had "could diminish the relevance and reliability of an insurer's financial statements," said the GAO report. In November 2004, the European Union endorsed the board's standards. However, the Union specified that only companies listed on their respective national stock exchanges and those with listed debt be required to prepare financial statements in accordance with the standards. The European Union gives member states the option of permitting or requiring affiliates or subsidiaries to follow those requirements in preparing their financial statements, the GAO report said.

Reserve Policies in Selected European Countries

                                                    Standards governing
                                                      contributions and
                                                       withdrawals from
                 Overview of reserve                            reserve

France           Catastrophe and equalization                        No
                 reserves can be used for storms,
                 hail, nuclear, pollution,
                 aviation and terrorism.
Germany          Catastrophe reserve is required                    Yes
                 for nuclear, pharmaceutical
                 liability, and terrorism risks.
                 Equalization reserve is required
                 for other natural catastrophes.
Italy            Catastrophe reserve is required                     No
                 for nuclear risk and natural
                 catastrophes, such as earth-
                 quakes and volcanic eruptions.
                 Equalization reserve is required
                 for hail and other climate
                 risks.
Spain            Catastrophe reserve can be used                     No
                 for natural catastrophes and
                 terrorism risks.
                 Equalization reserve can be used
                 for other liability risk such as
                 automobile risk.
Switzerland      Catastrophe reserve is allowed                      No
                 in Switzerland for all types of
                 catastrophes provided the Swiss
                 insurance supervisory authority
                 approves a justification of the
                 reserve.
United Kingdom   Equalization reserve is required                   Yes
                 for property and other types of
                 insurance.

Source: U.S. Government Accountability Office