Premium Taxation of Finite Risk

Premium Taxation of Finite Risk Insurance

Robert C. Herrick, MBA, CPCU

 

The opinons expressed herein are my own, and do not represent those of my employer. 

An interesting issue in Finite Risk Insurance is the disconnect that is often present between income tax treatment of such insurance and its treatment for the purpose of insurance premium tax (IPT) or surplus lines tax (SLT).  This disconnect will be most apparent in those cases where accounting advisors require full deposit accounting or where they bifurcate the contract.  In such cases, the reasonable expectation that a client or practitioner will hold is that the deposit portion of the premium will not be deductible for federal income tax purpose until used to cover claims payments that would otherwise qualify as a deductible expense.  

On the other hand, state insurance regulators will customarily expect initially to collect IPT on the gross premium where the insurer is admitted or SLT tax, also on the gross premium, where the insurer is not admitted.  In practice, both insurers and surplus lines brokers pay on the net of premium less return premium, but this is not relevant at inception for any given policyholder.  We discuss implications of this shortly.   

This practice opens up the process to allegations of discrimination when state income tax authorities take the view that part of the premium is not deductible for tax purposes while another state agency takes the view that it all is subject to levy.  This discrimination is a material issue.  State IPT and SLT generally run on the order of 3% of premium, and are a frictional cost that can often tip the decision away from use of a finite risk program.  Non-US programs could see even higher IPT rates, compounding the problem overseas if the treatment is not nuanced.  

In the specific case of finite risk programs that contain an experience account with some notional interest imputed and a reasonably long duration, the practice of collecting IPT and SLT on the net of premium paid less return premium might lead to the strange result of the state paying a net IPT or SLT back to a commuting buyer that had made no claims or low claims against the contract. Some finite risk policies go so far as to stipulate that both claims payments and commutation payments are a return of premium.  In the case of such policies, it might even be routine for a net negative IPT or SLT to result.  Since return payments by finite risk insurers rarely or ever include the return of IPT or, even more rarely, the return of more IPT than originally charged, it should be clear that insurers have an arbitrage position that should be given greater consideration than presently customary.  Surplus Lines Brokers should also be careful to assure that return premiums of whatever nature are properly accounted for. 

One solution is to purchase the program in parts, and only use the insurance market for excess risk transfer, and place the remainder in some vehicle that does not attract either IPT or SLT.  This solution is often available, but not always.  In those cases where the placement of a finite risk component is the inducement needed to extract risk transfer coverage, as is occasionally the case, the buyer has no way to avoid the IPT or SLT in ordinary circumstances.  

A second, and fair solution, is to exempt the experience account portion of finite risk policies from IPT or SLT, in effect treating them as an investment or deposit.  This approach has recently been enacted into law in California for a small, but important subset of insurance policies, non admitted environmental remediation coverage for state and federal Superfund sites.  

AB 1088 was signed into law with immediate effect on September 30, 2008.  The Legislative Counsel's Digest reads as follows: 

AB 1088, Carter.  Surplus Lines brokers: taxation

Existing law provides that every surplus line broker shall annually pay to the commission a tax of 3% of the gross premiums less return premiums upon business done by him or her during the preceding calendar year, excluding premiums for specified business.  

This bill would also exempt the risk portion of any blended finite risk product used in the financing element of state or federal Superfund environmental settlements, as specified, from the 3% premium tax on surplus lines brokers.

See the bill itself for definitions of terms, but the summary is that the 'financing element' closely matches the concept of 'experience account' as that term is used in finite risk.  

Since one of the few active areas for finite risk in the current environment is just such placements, this change should lead to a greater interest in finite risk solutions for California Superfund sites.  

Note that this approach provides incentives for ploys:  

1. Design the finite risk with a zero or even negative notional interest rate to push as much premium into the financing part as possible.  Regulators will want to pay attention to those programs where the the notional interest rate is not roughly equivalent to a US treasury rate for investments of a duration similar to the finite risk program's expectation.

2. Use a surplus lines carrier in preference to an admitted carrier in California, since the admitted program does not appear to be subject to the exemption in AB1088.