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Report to the Congress 

on Property and Casualty 

Insurance Company Taxation 

I' 

I 

Department of the Treasury 

April 1991 

tIBRARV ·TREASURY 
• 

DEPARTMENT OF THE TREASURY 

WASHINGTON 

ASSISTANT SECRETARY 

April 1991 

The Honorable Lloyd Bentsen 

Chairman 

Committee on Finance 

United States Senate 

Washington, o.c. 20510 

Dear Mr. Chairman: 

Section 1025 of Public Law 99-514, the Tax Reform Act of 

1986, directs the secretary of the Treasury or his delegate to 

conduct a study of (1) the treatment of policyholder dividends by 

mutual property and casualty insurance companies, (2) the treatment 

of property and casualty insurance companies under the minimum tax, 

and (3) the operation and effect of, and revenue raised by, the 

property and casualty insurance tax provisions of the Tax Reform 

Act of 1986. Pursuant to that directive, I hereby submit this 

"Report to the Congress on Property and casualty Insurance company 

Taxation." 

I am sending a similar letter to Senator Bob Packwood. 

~lJ.J;J__ 

Kenneth W. Gideon 

Assistant Secretary 

{Tax Policy) 

Enclosure 
DEPARTMENT OF THE TREASURY 

WASHINGTON 

ASSISTANT SECRETARY 

April 1991 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

U.S. House of Representatives 

Washington, D.C. 20515 

Dear Mr. Chairman: 

Section 1025 of Public Law 99-514, the Tax Reform Act of 

1986, directs the Secretary of the Treasury or his delegate to 

conduct a study of (1) the treatment of policyholder dividends by 

mutual property and casualty insurance companies, (2) the treatment 

of property and casualty insurance companies under the minimum tax, 

and (3) the operation and effect of, and revenue raised by, the 

property and casualty insurance tax provisions of the Tax Reform 

Act of 1986. Pursuant to that directive, I hereby submit this 

"Report to the Congress on Property and casualty Insurance Company 

Taxation." 

I am sending a similar letter to Representative 

Bill Archer. 

Sincerely, 

~cJ'4'p_, 

Kenneth W. Gideon 

Assistant Secretary 

(Tax Policy) 

Enclosure 
TABLE OF CONTENTS 

1. Introduction and Summary l 

2. The Tax Reform Act of 1986 3 

2. 1 Introduction 3 

2.2 Changes in Property and Casualty Insurance Company Taxation 3 

2.3 Corporate Alternative Minimum Tax 7 

3. Effect of the Tax Reform Act of 1986 on Tax Liabilities 11 

3. 1 Introduction 11 

3.2 Revenue Estimates Prepared in 1986 11 

3. 3 Impact of the Property and Casualty Insurance Company Tax Provisions on 

Regular Tax Liabilities: 1987 15 

3.4 Alternative Minimum Tax Liabilities for Property and Casualty Insurance 

Company Consolidated Returns: 1987 23 

3.5 Conclusion 23 

4. The Tax Treatment of Policyholder Dividends Paid by Insurance Companies 27 

4.1 Introduction 27 

4.2 Policyholder-Level Taxation of Policyholder Dividends Paid by Property 

and Casualty Insurance Companies 29 

4.2.1 Policyholder Dividends by Line of Business 29 

4.2.2 Policyholder Dividends for Personal Coverage 32 

4. 3 Arguments Relating to Differences between Property and Casualty Insurance 

and Life Insurance 3 8 

4.4 Summary and Conclusion 39 

Appendix 1 Requirement for the Report 41 

Appendix 2 Description of the Sample and Methodology 43 

Bibliography 45 
LIST OF TABLES 

Table / Page 

3.1 Revenue Estimates for the Property and Casualty Insurance Company 

Tax Provisions Under the 1986 Act 14 

3.2 Comparison of Actual and Estimated Changes in Tax Liabilities from the 

Property and Casualty Insurance Company Provisions under the 1986 Act: 

Calendar Year 1987 16 

3. 3 Reconciliation of Actual and Estimated Effect of Selected Property and 

Casualty Insurance Company Tax Reform Provisions on Changes in Taxable 

Income, Losses, Tax Credits, and Tax After Credits: Calendar Year 1987 17 

3.4 Net Written Premiums for Schedule P and O Lines: 1978-89 19 

3.5 Net Written Premiums and Unearned Premiums for Property and Casualty 

Insurance Companies: 1973-89 21 

3.6 Alternative Minimum Tax Base and Liabilities by Tax Status of Companies 

Filing P&C Consolidated Tax Returns 24 

4. 1 Policyholder Dividends and Premiums Earned for Property and Casualty 

Insurance Companies by Line of Business: 1989 30 

4.2 Policyholder Dividends and Premiums Earned for Stock and Mutual Property 

and Casualty Insurance Companies by Line of Business: 1989 31 

4.3 Policyholder Dividends and Premiums Earned for Property and Casualty 

Insurance Companies for Personal and Commercial Coverage: 1989 33 

4.4 Policyholder Dividends and Net Written Premiums for Stock and Mutual Property 

and Casualty Insurance Companies for Personal and Commercial Coverage: 

1989 34 

4.5 Policyholder Dividends and Premiums Earned by Line of Business for Stock 

and Mutual Property and Casualty Insurance Companies that Paid Policyholder 

Dividends for Personal Coverage: 1989 36 

4.6 Number and Percent of Property and Casualty Insurance Companies that Paid 

Policyholder Dividends for Personal Coverage: 1989 37 

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CHAPTER 1. INTRODUCTION AND SUMMARY 

The Tax Reform Act of 1986 (Public Law 99-514) (the 1986 Act) changed substantially the taxation 

of corporate income by reducing the top corporate tax rate from 46 percent to 34 percent, broadening 

the corporate income tax base, and adopting an alternative minimum tax. In addition to those 

general changes, the 1986 Act contained specific provisions that changed the taxation of property 

and casualty insurance companies. In order to monitor the effect of the specific provisions on 

property and casualty insurance companies, the Congress required the Treasury Department to study 

the property and casualty insurance tax provisions and to examine whether the revenue targets 

projected for the provisions were met.

1 

The 1986 Act also required the Treasury Department to study the tax treatment of policyholder 

dividends paid by property and casualty insurance companies. Under present law, mutual and stock 

property and casualty insurance companies may deduct dividends and similar distributions paid to 

their policyholders, but stock property and casualty insurance companies may not deduct dividends 

paid to shareholders. The Congress recognized that it may be appropriate, as in the case of life 

insurance companies, to treat a portion of the policyholder dividends of mutual property and 

casualty insurance companies as a distribution of earnings on equity of the company. However, the 

Congress also recognized that the rule that applies this concept to life insurance companies is both 

controversial and complex. Thus, the 1986 Act required the Treasury Department to study the tax 

treatment of policyholder dividends paid by mutual property and casualty insurance companies before 

the life insurance company rule or similar rule is considered for property and casualty insurers. 

This report responds to the Congressional mandate contained in the 1986 Act. The principal 

findings and conclusions of this report are the following: 

0 The 1986 Act changes in the taxation of property and casualty insurance companies 

increased liabilities for the regular tax for calendar year 1987 by approximately the 

estimated amount ($1.5 billion). It was not possible to calculate the effect of the 

alternative minimum tax (AMT) on property and casualty insurance companies, because tax 

return data generally contain AMT information only on a consolidated basis. 

0 Although the specific property and casualty insurance company tax provisions were either 

over- or underestimated, estimating errors were largely offsetting. These errors are 

related largely to the difficulty in forecasting taxpayers' responses to the significant 

changes enacted under the 1986 Act and to limitations in the available data. 

0 The Treasury Department recommends that Congress not extend a limitation on the 

deduction for policyholder dividends to property and casualty insurers because the 

conceptual basis for such a limitation is flawed. The "prepayment" analysis shows that 

mutual company policyholder dividends should be fully deductible to provide equal 

corporate-level tax treatment of equity-like returns to mutual and stock company 

investors. 

1 Appendix 1 contains the requirement for this study. 

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0 The prepayment analysis does not address the problem that investment returns to certain 

policyholders of mutual and stock insurance companies may enjoy a policyholder-level 

advantage because policyholder dividends are not generally taxable income to 

policyholders but dividends are taxable income to shareholders. An exception to this 

policyholder-level advantage arises when the policyholder is a business rather than an 

individual. Businesses deduct premiums paid but include policyholder dividends in 

income. 

0 While the disparity in the treatment of policyholders and shareholders at the individual 

level could justify a corporate-level proxy tax on the equity-like returns contained in 

policyholder dividends, this disparity is considerably smaller for property and casualty 

insurance companies than for life insurance companies. Policyholder dividends paid by 

property and casualty insurers are substantially less and are paid primarily to business 

policyholders. The imposition ofa proxy tax would impose a compliance burden but would 

have a modest revenue yield. Therefore, the Treasury Department does not recommend the 

imposition of a proxy tax at this time. 

The remainder of this report is organized as follows. Chapter 2 describes prior tax law and the 

changes in property and casualty insurance taxation and the alternative minimum tax under the 1986 

Act. Chapter 3 examines the effects of the property and casualty insurance company provisions 

enacted under the 1986 Act on tax liabilities of property and casualty insurance companies for 

calendar year 1987. Chapter 4 evaluates the tax treatment of policyholder dividends paid by 

insurance companies and presents the Treasury Department's recommendation with respect to 

policyholder dividends paid by property and casualty insurance companies. 
CHAPTER 2. THE TAX REFORM ACT OF 1986 

2.1 Introduction 

, / 

Toe Tax Refonn Act of 1986 (the 1986 Act) changed substantially the taxation of corporations and 

their shareholders. The 1986 Act adopted base-broadening measures designed to increase the overall 

level of corporate income taxes, while at the same time reducing the maximum corporate tax rate from 

46 percent to 34 percent. Toe corporate base broadening was accomplished primarily by limiting 

depreciation deductions, reducing the dividends received deduction, enacting the corporate 

alternative minimum tax, and adopting important changes in accounting rules. The 1986 Act also 

repealed the investment tax credit. In addition to the general base-broadening measures that affect 

the tax liabilities of all companies, the 1986 Act included several provisions that specifically 

affected the measurement of taxable income of property and casualty insurance companies. 

This chapter provides background for the evaluation of the revenue effects of the changes in the 

1986 Act on property and casualty insurance companies contained in Chapter 3. The chapter describes 

in detail the 1986 Act's changes in the taxation of property and casualty insurance companies 

(Section 2.2). The chapter also includes a detailed discussion of the alternative minimum tax 

(Section 2.3). The tax changes described in this chapter became effective for taxable years 

beginning after December 31, 1986. 

2.2 Changes in Property and Casualty Insurance Company Taxation 

The 1986 Act changed the taxation of property and casualty insurance companies by requiring: 

(1) discounting of unpaid losses; (2) the inclusion in income of 20 percent of unearned premiums; 

(3) prorating of tax-exempt income; (4) repeal of the protection against loss account (PAL) for 

mutual property and casualty insurers; and (5) adoption of a single deduction for all small 

companies. These provisions are discussed below. 

Discounting of Unpaid Losses 

Under tax rules prior to the 1986 Act, property and casualty insurance companies were allowed a 

deduction for losses paid during the taxable year and for the net increase (from year-end to 

year-end) in losses incurred but unpaid (unpaid losses) and for loss adjustment expenses (LAE). 

Unpaid losses were reduced (and the reduction included in taxable income) when future losses were 

actually paid. For tax purposes, unpaid losses and LAE were calculated on a nominal (undiscounted) 

basis, that is, without reference to the fact that the present value of future liabilities (unpaid 

losses) is less than their nominal value. The net effect of this tax treatment allowed property and 

casualty insurance companies a current deduction for future costs. This deduction effectively 

understated a property and casualty insurance company's income by the difference between the nominal 

value and the present value of the company's liability to pay its unpaid loss claims. 

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The 1986 Act continued to allow the current deduction of unpaid losses and loss adjustment 

expenses. However, the Act required that such amounts be calculated as the discounted value of 

unpaid losses as defined by section 846 of the Internal Revenue Code. The discounting of unpaid 

losses generally reduces the current tax deduction for unpaid losses. The 1986 Act required the 

Secretary of the Treasury to calculate discount factors annually for each line of business shown on 

annual statements filed with the National Association of Insurance Commissioners (NAIC) using 

certain interest rate and loss payment patterns.

1 These factors are used by companies to determine 

their deduction for unpaid losses. 2 

The rules outlined in The General Explanation of the Tax Reform Act of 1986 call for relatively 

slower loss payment pattern assumptions for the five lines of business included in Schedule P of the 

annual statement -- auto liability, other liability, workers' compensation, medical malpractice, and 

multiple peril -- than the relatively fast loss payment assumptions of the lines of business 

contained in Schedule 0.3 The discounting rules specify maximum loss payment periods of 15 years 

for the unpaid losses of the Schedule P lines and 3 years for unpaid losses of Schedule O lines. 

The General Explanation also indicates that loss payment patterns used for the calculation of 

discount factors for each line of business are to be redetermined every five years. 

In each loss payment pattern determination year, loss payment patterns for each line of business 

are generally assumed to follow loss payment patterns based on the most recently published aggregate 

loss payment data illustrated in examples in The General Explanation. 4 Discount rate factors for 

unpaid losses in various future years are then calculated for the losses incurred each year using 

the determined loss payment patterns and the statutory interest rate for discounting. For any 

calendar year, the interest rate to be used for discounting is the average of the Federal mid-term 

interest rates in the 60 months preceding the beginning of the year, as illustrated in The General 

Explanation. The discounting rules were generally expected to have a relatively greater effect in 

reducing unpaid losses -- and the associated tax deductions -- for Schedule P lines because of the 

longer loss payment patterns for these lines. 

1 The details are contained in Joint Committee on Taxation, The General Explanation of the Tax 

Reform Act of 1986 (May 4, 1987), pages 600 - 618. 

2 Schedules in the annual statements show loss payment patterns for the unpaid losses of each 

accident year shown on the schedules, ~, the schedules show the amount of loss incurred in 

certain prior years but unpaid at the beginning of the current year as well the amount of these 

losses that are paid during the current year for each line of property and casualty insurance 

business. 

3 Under certain circumstances companies may also elect to use their historical experience for 

determining discount factors. 

4 Beginning in 1989, the NAIC annual statements combine Schedule O and Pinto Schedule P. 
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This change was intended to correct the prior overstatement of the true economic value of the 

insured Joss. Without discounting, the longer the period between the claim and the actual payment, 

the greater the overstatement. Since prior law failed to reflect the time value of money, it 

permitted companies to understate their income. 5 

Inclusion in Income of 20 Percent of Unearned Premiums 

The underwriting income of a property and casualty insurance company begins with earned 

premiums. Prior to the 1986 Act, in determining premiums earned, the increase in unearned premiums 

shown on the NAIC annual statement was deductible from gross income. However, expenses incurred, 

including acquisition expenses attributable to unearned premiums, were currently deductible. As a 

result, prior law mismatched income and expenses by permitting a deferral of an undiscounted portion 

of unearned premium income while allowing a current deduction for the associated costs of earning 

the deferred income. 

The 1986 Act reduced the current deduction for the increase in unearned premiums, which has the 

same effect as denying current deductibility for a portion of the premium acquisition expenses. 

6 

The 1986 Act generally required property and casualty insurance companies to reduce their deduction 

for unearned premiums by 20 percent, which was deemed to represent the expenses incurred in 

generating the unearned premiums. 7 The Act also provided for the inclusion in income of 20 percent 

of unearned premiums outstanding prior to January 1, 1987. 8 

Prorating of Tax-Exempt Income 

Prior to the 1986 Act, property and casualty insurance companies were subject to a tax on 

investment income which generally included interest, dividends, and rents. However, a property and 

casualty insurance company that included tax-exempt interest in income was allowed to deduct this 

interest. Property and casualty insurance companies were also allowed deductions for dividends 

received. 

These companies were also taxed on their underwriting income which consisted of premiums earned 

reduced by losses (and expenses) incurred. The deduction for losses incurred generally reflected 

the losses paid during the year plus any increase in losses incurred but unpaid. No reduction in 

the deduction for unpaid losses was required to take account of the fact that deductible increases 

in unpaid losses could be funded with tax-exempt income. 

5 See The General Explanation, pages 60 l and 602. 

6 See The General Explanation, page 595. 

7 The 1986 Act generally required the deduction for unearned premiums for insuring bonds to be 

reduced by 10 percent. 

8 For bond insurance, the inclusion factor for the six years is 10 percent. 
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The 1986 Act reduced the deduction of property and casualty insurance companies for losses 

incurred b¥ 15 percent of the insurer's: (l) tax-exempt interest income, and (2) dividends received 

deduction. This tax change is often referred to as prorating of tax-exempt income. 

Protection Against Loss Account 

Prior to the 1986 Act, mutual property and casualty insurance companies were permitted 

deductions for contributions to protection against loss (PAL) tax accounts. The intent of the PAL 

provision was to provide mutual companies with a source of capital in the event of a catastrophic 

loss, since mutual companies, unlike stock companies, are unable to raise capital in capital 

markets. 

The amount of the deduction was generally one percent of the underwriting losses incurred for 

the year plus 25 percent of the underwriting income, plus certain windstorm and other losses.10 In 

general, contributions to PAL accounts were taken into income over a 5 year period. The PAL account 

thus produced a 5 year deferral ofcertain mutual company underwriting income. However, PAL account 

rules required the reduction of PAL balances for each dollar of NOLs used to offset current taxable 

income. Subractions from PAL account balances increased taxable income, dollar for dollar, until 

the PAL account balance was zero. 

The 1986 Act repealed the deduction for contributions to PAL account balances. Congress 

believed that the deduction for contributions to the PAL account was not serving its intended 

purpose principally because the PAL account provided the greatest benefit where least needed, i.e., 

for mutual companies with current taxable income that could benefit from deferral.11 -

Small company provisions 

Under prior tax law, mutual property and casualty insurance companies with less than $150,000 in 

gross receipts were exempt from tax. Mutual companies with gross receipts from $150,000 to $500,000 

could generally elect to be taxed only on investment income.12 Mutual property and casualty 

insurance companies with gross receipts between $500,000 and $1,110,000 generally benefited from 

9 The 1986 Act also requires inclusion in income of any excess of the required reduction in the 

deduction for discounted unpaid losses over the increase in discounted unpaid losses. These changes 

do not apply to the income from stock or obligations acquired before August 8, 1986. 

10 Additions to PAL accounts were zero for companies for which the sum of investment income and 

underwriting income was negative. 

11 

See The General Explanation, pages 618 and 619. 

12 In addition. companies that elected to be taxed on investment income could benefit from a 

special rule which phased in regular tax on investment income as gross receipts increased from 

$150,000 to $250,000. 
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special prov1s1ons that lowered their tax liabilities. Mutual property and casualty insurance 

companies with gross receipts exceeding $1,110,000 were generally taxed like other corporations. 

There were no special tax provisions for small stock companies. 

The 1986 Act repealed these rules and, in their place, exempted net written premiums or direct 

written premiums from tax for mutual and stock property and casualty insurance companies with less 

than $350,000 of net written premiums or direct written premiums (whichever is greater). The 1986 

Act also allowed property and casualty insurance companies with net or direct written premiums 

(whichever is greater) between $350,000 and $1,200,000 to elect to be taxed only on investment . l3 

mcome. 

These changes were intended to simplify the prior law rules applying to certain small and 

ordinary mutual companies. The changes also eliminated the distinction between small mutual and 

other companies by extending the benefits to all eligible companies, whether stock or mutual.14 

2.3 Corporate Alternative Minimum Tax 

In general, under prior law, corporations paid a minimum tax of 15 percent on certain tax 

preferences, to the extent that the aggregate amount of these preferences exceeded the greater of 

the regular corporate income tax or $10,000. This tax was paid in addition to the corporation's 

regular tax. The items treated as tax preferences included accelerated depreciation in excess of 

straight line depreciation; percentage depletion in excess of basis; a portion of net capital gains; 

and excess bad debt reserves of financial institutions. 

The purpose of the minimum tax was to ensure that no taxpayer with substantial economic income 

could avoid significant tax liability by using exclusions, deductions, and credits. Congress 

concluded, however, that the prior minimum tax was inadequate because it was not designed to define 

a comprehensive income tax base. Moreover, since many important tax preferences were not included 

or were defined narrowly, Congress concluded that even with the add-on minimum tax, corporations 

were not being taxed on their economic income. Congress also concluded that the goal of taxing 

corporations with substantial economic income could not be achieved by broadening the list of tax 

preferences and wanted to ensure that whenever companies publicly reported earnings they would pay 

some tax for the year. 

In order to address these perceived deficiencies in the corporate minimum tax, the 1986 Act 

repealed the existing minimum tax and created a new minimum tax for corporations known as the 

alternative minimum tax (AMT). The AMT was designed to ensure that in each taxable year the 

taxpayer generally must pay a significant tax on an amount more nearly approximating economic 

13 

To determine net and direct written premiums for the purpose of these tests, premiums of 

affiliated companies generally must be taken into account. 

14 See The General Explanation, page 620. 
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income. In addition, the Act addressed the concern that companies that reported suhstantial 

earnings paid no tax. It required that corporations include in the AMT tax base an adjustment based 

on financial statement income reported by the taxpayer pursuant to public reporting requirements or 

in disclosures made for non-tax reasons to regulators, shareholders, or creditors. This "book 

income adjustment" was required for taxable years beginning in 1987 through 1989. For taxable years 

beginning after 1989, the book income adjustment is replaced by an adjustment based on a broad, but 

statutorily defined, measure of economic income known as adjusted current earnings (ACE). 

Generally, the tax base for the corporate AMT is the corporation's taxable income, increased by 

tax preferences for the year and adjusted in a manner designed to negate the deferral of income or 

acceleration of deductions resulting from the regular tax treatment of certain items. The resulting 

amount ofalternative minimum taxable income (AMTI), reduced by an exemption amount, is subject to a 

20 percent tax rate. The exemption amount is $40,000, reduced by 25 percent of the amount by which 

AMTI exceeds $150,000. The amount of minimum tax liability so determined may then be offset 

partially by the minimum tax foreign tax credit, and to a limited extent by investment tax credit 

carryovers. A corporation is effectively required to pay the higher of the AMT or the regular tax 

for the taxable year. 

15 

The computation of corporate AMTI is a two-step process. First, taxable income is adjusted to 

reflect specific statutory adjustments and preferences. Second, the resulting amount of AMTI is 

adjusted further to take into account the book income adjustment for taxable years beginning in 1987 

through 1989, or the ACE adjustment for taxable years beginning after 1989. 

The more significant adjustments and preferences include those related to accelerated 

depreciation, depletion, intangible drilling costs, mining exploration and development costs, 

long-term contracts, installment sales, tax-exempt interest, and charitable contributions. The 

adjustment for the net book income of corporations is computed by increasing AMTI by 50 percent of 

the amount by which the net book income of a corporation exceeds unadjusted AMTI, i.e., AMTI 

determined without regard to the book income adjustment or the AMT net operating loss deduction. 16 

The net book income for this purpose generally is the net book income shown on a taxpayer's 

applicable financial statement. 

15 Technically the regular tax continues to be imposed, and the excess of the tentative minimum 

tax over the regular tax is added on. Corporations are allowed a minimum tax credit to the extent 

the excess of the AMT over the regular tax is attributable to preferences or adjustments involving 

the timing of a deduction or income inclusion. This credit is allowed as a reduction of regular tax 

liability of the taxpayer in any subsequent taxable year, but may not be used to reduce regular tax 

below AMT for the subsequent year. 

16 The amount of the AMT net operating loss for any taxable year generally is equal to the amount 

by which the deductions allowed in computing AMTI for the taxable year ( other than the deduction for 

carryovers to the taxable year of AMT net operating losses) exceed the gross income includable in 

AMTI for the taxable year. In computing AMTI, NOLs available for reducing AMTI are limited to 90 

percent of AMTI before NOLs. 
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For taxable years beginning after 1989, the book income adjustment is replaced by the ACE 

adjustment. The ACE adjustment is equal to 75 percent of the amount by which the adjusted current 

earnings of a corporation exceed unadjusted AMTI, i.e., AMTI determined without regard to the ACE 

adjustment and the AMT net operating loss deduction. Ifunadjusted AMTI exceeds ACE then AMTI is 

reduced by 75 percent of the difference. However, this reduction is limited to the aggregate amount 

by which AMTI has been increased by the ACE adjustment in prior years. Generally, ACE is the 

corporation's unadjusted AMTI increased by items includable in computing earnings and profits but 

excluded from unadjusted AMTI and items deductible in determining unadjusted AMTI but not 

deductible in determining earnings and profits. ACE also includes various rules governing the 

treatment of specific items. 
CHAPTER 3. EFFECT OF THE TAX REFORM ACT OF 1986 ON TAX LIABILmES 

3.1 Introduction 

At the time of the 1986 Act, the specific property and casualty insurance tax changes were 

estimated to increase regular tax receipts by $7.5 billion between fiscal years 1987 and 1991.1 In 

order to monitor the effect of these provisions and the alternative minimum tax (AMT) on property 

and casualty insurers, Congress required the Treasury Department to study the regular and minimum 

tax and to examine whether the revenue targets projected for the property and casualty insurance 

company tax provisions were met. 

This chapter presents the results of the Treasury Department's analysis of the effect of the 

property and casualty insurance company tax provisions on regular tax liabilities for calendar year 

1987. It compares the increase in tax liabilities in 1987 attributable to the 1986 Act's property 

and casualty insurance tax provisions with estimates made when tax reform was enacted. It 

reconciles the difference between changes in actual tax liabilities for 1987 and the estimates and 

discusses reasons for the differences. 

This chapter also examines minimum tax information provided on consolidated tax returns filed by 

property and casualty insurance companies and their affiliates. 2 It is not possible to compare 

actual AMT liabilities to an AMT revenue estimate for property and casualty companies, because AMT 

receipts were not estimated separately for each industry when tax reform was enacted. 

3.2 Revenue Estimates Prepared in 1986 

Revenue estimates associated with changes in tax legislation are measures of the differences 

between expected tax revenues under the new law and the amount that would have been collected in the 

absence of the change in law. However, only the actual collections after the tax law change are 

observable. The collections that would have occurred in the absence of the change in law are not 

observable. Thus, it is never possible to know with certainty the actual revenue effect of enacted 

legislation, because only one of the two amounts required to determine that revenue effect is 

directly observable. 

1 The revenue effect for the property and casualty insurance company provisions excludes the 

effect of the 1986 Act's changes in the taxation of Blue Cross-Blue Shield companies. The revenue 

effect from changes affecting these companies was reported separately and included in the total for 

life insurance companies. 

2 Regular and minimum tax liabilities and related information for 1987 are based on a sample of 

1987 tax returns filed by property and casualty insurance companies and companies filing 

consolidated tax returns with property and casualty insurance companies. Appendix 2 contains a 

description of the sample of tax returns .used in this report. 

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Estimates of the effect of tax law changes require estimates of both the base level of 

co11ections (i.e .. estimates of col1ection levels that would have occurred absent the change in law) 

and the effect of the change in law on that base. The estimates of the property and casualty 

insurance company tax changes of the 1986 Act were the result of this two-stage estimating process. 

Comparisons of the initial revenue estimates of a change in tax law with subsequent estimates of the 

actual effects (the subject of this chapter) are complicated by the need to disentangle the effect 

of the change in law, changes in the baseline forecast, and interactions between the two. 

Estimating the revenue effects of proposed tax legislation requires accurate forecasts of many 

different factors, including the following: (1) the level of economic activity, including both the 

macro-economic national forecast and the market share of the particular economic activity affected; 

(2) the taxpayer's economic situation, including types of products sold, portfolio choice, and form 

of organization; (3) the effect of specific changes in the tax law on particular taxpayers' economic 

situations independent of behavioral changes; and (4) the taxpayers' reaction to the tax law 

changes. If these factors are misspecified or forecasted incorrectly, estimated receipts will 

differ from actual collections. 

Forecasts of these factors for the revenue estimates for the property and casualty insurance 

company tax provisions were generally based on historical data from annual financial statements 

filed with the National Association of Insurance Commissioners and tax returns. 3 These data were 

difficult to use as the basis for forecasting for two reasons. First, the Tax Reform Act of 1986 

significantly changed income taxation and the rules that apply specifically to property and casualty 

insurance companies. These changes were likely to affect historical relationships among financial 

variables and trends in financial data. Second, the available data from annual financial statements 

and tax returns define the property and casualty insurance industry differently, and use different 

rules to measure income and to consolidate affiliated companies. Moreover, the available corporate 

tax return data were outdated. 

The potential misclassification of property and casualty insurance companies in the available 

data sources is a possible source of estimating errors. For regulatory purposes, companies are 

classified as life or property and casualty insurance companies based upon the type of charter for 

which they originally applied. However, because of the legal definitions of life insurance 

companies and property and casualty insurance companies for Federal income tax purposes, some 

companies chartered as life insurance companies file property and casualty insurance tax returns 

(1120PC) and some companies chartered as property and casualty insurance companies file life 

insurance tax returns ( l 120L). Thus. the use of annual statement data may misclassify certain 

companies for Federal income tax purposes. Moreover, the tax return data from the IRS Statistics of 

Income (SOI) program may misclassify some property and casualty insurance companies because 

consolidated tax returns are classified by industry group based on the industry group from which the 

largest percentage of total receipts is derived. 

3 Annual statement data are compiled by A.M. Best Co. 
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Another difficulty is that measures of income differ for tax and financial accounting purposes. 

For example, annual statement rules allow a deduction for the nominal increase in unpaid losses of 

property and casualty insurers, whereas the tax rules limit the deduction to the change in 

discounted unpaid losses. Thus, the use of annual statement data requires adjustments to account 

for these differences and such adjustments are a potential source of error. 

Consolidation rules differ for annual statement and tax reporting. Annual statement reporting 

rules do not allow consolidation with non-property and casualty insurance companies, whereas tax 

rules generally allow such consolidation. As a result, annual statements lack reliable data on net 

operating losses (NOLs) and current losses of companies filing consolidated tax returns with 

property and casualty insurance companies. These amounts were estimated from tax return data. 

In addition, special rules for consolidation between life insurance and nonlife companies can 

limit the amount of revenue from the property and casualty insurance company changes. The rules 

limit the losses of a property and casualty insurance company that can be used to offset life 

insurance company income to the lesser of 35 percent of life insurance income or 35 percent of the 

property and casualty insurance company losses. Because of these limitations, it is possible that 

the 1986 Act's changes could have no current effect on consolidated taxable income. 

4

The 1986 Act contained six changes in property and casualty insurance taxation. The Act 

required: 

(I) discounting of unpaid losses; 

(2) the inclusion of 20 percent of the annual increase in unearned premiums in taxable income 

(10 percent for bond insurance); 

(3) the inclusion of 20 percent of the 1986 year-end unearned premiums in taxable income (10 

percent for bond insurance income) over the six year period beginning in 1987; 

(4) a reduction in deductions for losses by a specified proportion of tax-exempt interest and 

dividends received (the proration rule); 

(5) repeal of protection against loss (PAL) accounts; and 

(6) adoption of a single tax rule for small property and casualty insurance companies. 

Table 3. 1 contains the revenue estimates made at the time of 1986 Act for the six provisions 

described above. The Treasury Department and the Joint Committee on Taxation (JCT) estimated that 

the provisions would increase regular tax receipts by $7.5 billion between fiscal years 1987 and 

1991. 

4 These changes are discussed in Chapter 2. 
-14-

Table 3.1 

Revenue Estimates for the Property and Casualty Insurance Company Tax Provisions 

Under the 1986 Act 

($ millions) 

Fiscal Years 

Provision 1987 1988 1989 I 1990 1991 Total 

Treasury Estimates: 

Discounting of unpaid losses 374 667 757 714 566 3,078 

Changes in unearned premiums: 

Inclusion in income of 

20 percent unearned premiums 230 318 255 234 245 1,282 

Unearned premiums for 

outstanding balances 254 432 469 512 495 2,162 

Proration rule 19 74 156 258 358 865 

Repeal of PAL account 58 76 68 44 24 270 

Adoption of small company 

provision -14 -33 -27 -25 -24 -123 

Total 921 1,534 1,678 1,737 1,664 7,534 

Joint Committee on Taxation 

Estimates: 

Total 871 1,454 1,636 1,745 1,842 7,548 

Department of the Treasury 

Office of Tax Analysis 

April 1991 
-15-

Approximately 41 percent of the revenue was estimated to result from the unpaid loss discounting 

change. The temporary and permanent unearned premium changes were expected to account for 29 

percent and 17 percent of the revenue increase, respectively. The proration rule and PAL account 

changes were expected to account for 11 and 4 percent of the revenue increase, respectively. The 

small company changes were estimated to lower the total revenue gain by approximately 2 percent. 

The revenue estimates for the property and casualty insurance company provisions were calculated 

after taking into account corporate tax rate reductions. Since the estimates sought to determine 

the amount of receipts that would result from the property and casualty insurance company tax 

changes, they take into account losses, NOLs, and credits of all companies filing consolidated 

returns with property and casualty insurance companies. 

The revenue estimates exclude the effect of the property and casualty insurance company tax 

provisions on corporate minimum tax receipts. These effects were included in the estimate of total 

corporate minimum tax receipts which were reported separately by Treasury and the JCT. 

3.3 Impact of the Property and Casualty Insurance Tax Provisions on Regular Tax 

Liabilities: I 987 

When tax reform was enacted, the Treasury Department estimated that the change in calendar year 

liabilities for the regular tax attributable to the property and casualty insurance company 

provisions would be $1.5 billion for calendar year 1987. Table 3.2 shows that the actual changes in 

liabilities nearly equaled the estimate ($1.5 billion). Although the actual change in liabilities 

for certain provisions differed substantially from the estimate, these differences were largely 

offsetting. 

Actual tax liabilities attributable to the 1986 Act's changes were $1,472 million for calendar 

year 1987, about $63 million (4 percent) lower than the $1,535 million of estimated liabilities. 

Table 3.2 compares actual and estimated changes in liabilities for each provision for calendar year 

1987. The unpaid loss discounting provision and proration rule increased liabilities by a larger 

amount than estimated. The unearned premium changes and the PAL account change increased 

liabilities by less than estimated, and the small company change provision reduced liabilities by a 

smaller amount than anticipated. 

Reconciliation of Actual and Estimated Receipts 

Table 3.3 reconciles the actual and estimated effects of the discounting of unpaid loss 

discounting, the proration rule for tax-exempt income, and the temporary and permanent changes in 

the deduction for unearned premiums on taxable income and tax after credits. These provisions were 

estimated using a detailed computer model. The PALaccount and small company changes were projected 

separately and are also discussed below. 
Table 3.2 

Comparison of Actual and Estimated Changes in Tax Liabilities from the Property and Casualty 

Insurance Company Provisions under the 1986 Act: Calendar Year 1987* 

Actual I Estimated I I Actual IEstimated 

Change in I Change in I Difference I Share I Share 

I Liabilities I Liabilities! (1) - (2) lof Total I of Total 

I ( $ millions) 1($ millions)!($ millions) I (percent) I (percent) 

( 1 ) ( 2 ) ( 3) ( 4) ( 5) I I I I I 

Discounting of unpaid losses 947 623 324 64 41 

Changes in unearned premiums: 

Inclusion in income of 

20 percent unearned premiums 139 383 -244 9 25 

Unearned premiums for I-' 

I 

O'I outstanding balances 324 423 -99 22 28 I 

Proration rule 60 32 28 4 2 

Repeal of PAL account 1 97 -96 0 6 

Small company provision ** -23 23 0 -1 

Total 1,472 1,535 -63 100 100 

Department ortlie Treasury AJ?ril 1991 

Office of Tax Analysis 

* Excludes the minimum tax. Details may not add to totals because of rounding. 

**Less than $1 million revenue loss. 
change 

-17-

Table 3.3 

Reconciliation of Actual and Estimated Effect of Selected 

property and Casualty Insurance Company Tax Reform Provisions 

on Changes in Taxable Income, Losses, Tax Credits, 

and Tax After Credits: Calendar Year 1987 

($ millions) 

Actual Estimated 

Effect Effect Difference 

( 1 ) ( 2 ) (1) - (2) 

in: 

Taxable income (before 

turrent losses and 

NOLs) attributable to 

~- Discounting of unpaid losses 6,213 

2. Inclusion in income of 

20 percent unearned premiums 916 

3. Inclusion in income of 

20 percent of beginning of 

year unearned premiums 2,134 

Proration rule 397 

Total 9,661 

Current losses and NOLs 4,861 

Taxable income after .NOLs and current losses 4,800 

Tax before tax credits 1,800 

Tax credits 328 

· Tax after tax credits 1,472 

;~•Partment o f t he Treasury Office of Tax Analysis 

Note: Details may not add to totals because of 

3,515 

1,978 

2,198 

95 

7,786 

3,845 

3,941 

1,462 

0 

1,462 

rounding. 

2,698 

-1,062 

-64 

302 

1,875 

1,016 

859 

338 

328 

10 

April 1991 
-18-

Table 3.3 shows that the change in taxable income before current losses and NOLs attributable to 

unpaid loss discounting, the changes in the unearned premium deduction, and the proration mle were 

underestimated by $1. 9 billion. However, the use of NOLs and current losses were underestimated by 

$1.0 billion and tax credits were underestimated by $0.3 billion. The und.erestimate of the change 

in taxable income was largely offset by the underestimates of the changes in the use of NOLs, 

current losses, and tax credits. These effects are discussed in detail below. 

Discounting of unpaid loss 

The impact on taxable income of the requirement to discount unpaid losses was underestimated by 

$2. 7 billion (Table 3.3). This underestimate resulted from errors in the forecasts of the growth in 

undiscounted unpaid losses and loss expenses and the impact of discounting on the tax deduction for 

these amounts. 

The estimated change in undiscounted unpaid losses was $31. 8 billion compared to the actual 

change of $33.8 billion. Growth rates for unpaid losses have varied considerably over time and thus 

are difficult to predict. The model estimated that the 1987 discounting calculations would reduce 

the tax deduction for the increase in unpaid losses to 88.9 percent of its undiscounted value. The 

actual reduction factor was 81. 6 percent. 

The discounting factors in the model were based on 1984 loss payment patterns and distribution 

of losses between various lines of business. The actual discounting factors were based on the 1987 

distribution of unpaid losses by line of business and 1985 loss payment time patterns, both of which 

resulted in a general lengthening of the time distribution of loss payments relative to the loss 

payment patterns implicit in the model's calculations. Typically, the Multiple Peril and Auto 

Liability lines of business have relatively short payout patterns compared to the Workers' 

Compensation, Medical Malpractice, and Other Liability lines of business. Table 3.4 shows that net 

written premium growth for the shorter payout lines generally exceeded the growth for the longer 

payout lines in the years preceding 1984 (the most current year for which annual statement data was 

available at the time the estimates were made). 5 From 1985 through 1987, premium growth was 

generally more rapid for lines of business with longer loss payout periods. Table 3.4 also shows 

that Schedule O lines, which generally have faster loss payment patterns, had smaller average growth 

rates than the Schedule P lines in 1985 and 1986. 

Longer loss payment patterns result in greater discounting of unpaid losses and therefore a 

smaller tax deduction. In addition. the discount rate assumed by the model was 7.0 percent compared 

to the actual discount rate of 7 .2 percent. Higher discount rates reduce the discounted value of 

future losses and thus reduce the deduction for discounted unpaid losses. Further, the discounting 

Premium information by line of business in the table is limited to lines of business for which 

Schedule P Annual Statement information was available in 1987. The impact of discounting is 

generally greatest for these lines since the discounting calculation rules for Schedule P lines 

assume losses are paid out over longer periods of time than other ~, Schedule 0) categories of 

unpaid losses. 

5 
-19-

Table 3.4 

Net Vritten Premiums for Schedule P and O Lines: 1978-89 

Schedule P Llnes I 

Faster Paiout Lines Slower Paiout Lines I I Huldple I I All I 

Auto I Peril Other I Yorkers I Medical !Schedule P !Schedule O 

Year Liabilit Lines Liabilit Com sation Hal ractice Lines Lines 

( 

1978 20,383 14,057 6,490 11,300 1,216 53,446 25,293 

1979 22,102 15,977 6,612 13,164 1,204 59,060 27,857 

1980 23,319 17,261 6,415 14,238 1,276 62,508 31,221 

1981 24,395 18,269 6,046 14,616 1,338 64,666 32,800 

1982 26,226 19,425 5,668 13,945 1,490 66,756 35,249 

1983 28,080 20,496 5,679 14,005 1,568 69,829 37,140 

1984 30,217 22,229 6,479 15,107 1,775 75,807 38,832 

1985 36,087 26,933 11,544 17,048 2,769 94,380 38,267 

1986 44,081 32,241 19,365 20,431 3,492 119,609 46,335 

1987 49,205 34,774 20,874 23,429 4,004 132,285 56,240 

1988 52,520 35,636 19,077 26,135 4,028 137,397 62,242 

1989 56,024 36,084 18,434 28,241 4,278 143,061 63,181 

Growth Rates (percent~ 

1979 8 14 2 16 (1) 11 10 

1980 6 8 (3) 8 6 6 12 

1981 5 6 (6) 3 5 3 5 

1982 8 6 (6) (5) 11 3 7 

1983 7 6 0 0 5 5 5 

1984 8 8 14 8 13 9 5 

1985 19 21 78 13 56 25 (1) 

1986 22 20 68 20 26 27 21 

1987 12 8 8 15 15 11 21 

1988 7 2 (9) 12 1 4 11 

1989 7 1 (3) 8 6 4 2 

Department of the Treasury Apdl 1991 

Office of Tax Analysis 

Source: A.H. Best Company, Aggregates and Averages, Properti and Casualti 1984-89 Editions. 
-20-

computations may have overestimated the value of the election under Section 846(e) of the Internal 

Revenue Code that allowed some companies to use their own loss payment patterns to compute discount 

factors by line of business rather than published IRS discount factors. All these factors 

contributed to underestimating the effect of the rules requiring the discounting of unpaid losses. 

Unearned Premium Changes 

The effect on taxable income of including 20 percent of the increase in the unearned premiums 

was overestimated by $1.1 billion (Table 3. 3). Historically, growth rates in unearned premiums have 

varied greatly from year to year, closely tracking the growth in net written premiums (Table 3.5). 

The model used aggregate net written premium growth rate assumptions to estimate the change in 

unearned premiums. For 1987, a net written premium growth of 15 percent was assumed while the 

actual premium growth was 9 percent. This difference accounts for most of the overestimate. 

The estimate for the effect on taxable income of including 20 percent of 1986 end of year 

unearned premiums in taxable income ratably over the next six years was underestimated by $64 

million. Estimates of 1987 unearned premium levels were based on estimates of average net written 

premium growth rates. Annual premium growth rates are more variable (Table 3.5). 

Proration Rule 

The model underestimated the effect on taxable income of the proration rule -- including 15 

6 

percent of certain previously tax-exempt income in taxable income -- by $0.2 billion (Table 3.3).

Property and casualty company purchases of tax-exempt bonds increased in response to the 1986 Act 

changes. Interest income from tax-exempt bonds declined from $6.4 billion to $6.3 billion from 1984 

to 1985, and then grew to $7.3 billion in 1986 and $9.1 billion in 1987.7 The discounting and 

unearned premium changes caused some property and casualty companies to be regular taxpayers. The 

general lowering of tax rates reduced the spread between taxable and tax-exempt bonds. The combined 

impact of these changes provided incentives for purchases of tax-exempt bonds by property and 

casualty companies. Most of the underestimate of the proration rule on taxable income is explained 

by the underestimate of the impact of the 1986 Act changes on the purchase of tax-exempt bonds by 

property and casualty companies. The remainder is attributable to underestimates of tax-exempt bond 

yields and the dividends that were subject to the proration rule. 

NOLs and Current Losses Used 

The increase in the use of NOLs and current losses was underestimated by $1.0 billion. The 

estimates of NOLs and losses underestimated the use of losses of consolidated affiliates and NOLs to 

6 The income from tax-exempt bonds purchased after August 7, 1986, and the tax deductible portion 

of dividends received on stock purchased after August 7, 1986, were subject to proration. 

7 A. M. Best Co., Best's Aggregates and Averages, Property-Casualty, 1985-88 Editions. 
-21-

Table 3.5 

Net Written Premiums and Unearned Premiums for 

Property and Casualty Insurance Companies: 1973-89 

I

Change 1n 

Net Net Change in 

Written Written Unearned Unearned 

Premiums Premiums Premiums Premiums 

Year ($ millions) (percent) ($ millions) (percent) 

1973 42,480 18,944 

1974 45,152 6.3 19,881 4.9 

1975 49,967 10.7 21,529 8.3 

1976 60,959 22.0 24,850 15.4 

1977 73,030 19.8 28,387 14.2 

1978 82,341 12.7 31,375 10.5 

1979 91,359 11.0 34,585 10.2 

1980 96,556 5.7 36,446 5.4 

1981 100,294 3.9 37,816 3.8 

1982 104,038 3.7 40,126 6.1 

1983 109,247 5.0 42,302 5.4 

1984 118,591 8.6 45,832 8.3 

1985 144,860 22.2 56,850 24.0 

1986 176,993 22.2 67,374 18.5 

1987 193,689 9.4 72,302 7.3 

1988 197,885 2.2 76,831 6.3 

1989 220,620 11. 5 79,941 4.0 

Department of the Treasury April 1991 

Office of Tax Analysis 

Source: A.M. Best, A~gregates and Averages, Properti and Casual ti, 1975-90 Editions. 
-22-

offset increases in the income of property and casualty insurance companies resulting from the 1986 

Act changes to the property and casualty insurance company tax rules. This error resulted from lags 

in the availability of tax return data combined with tax reporting conventions and data limitations. 

particularly about current losses of companies in other industries filing consolidated returns with 

property and casualty insurance companies. 

Tax Credits 

The use of tax credits was underestimated by $0.3 billion. This estimating error resulted 

primarily from data limitations related to the definition of the industry for SOI tax statistics 

( discussed above). Many of the credits used against the income of property and casualty insurance 

companies were earned by companies in other industries filing consolidated returns with property and 

casualty insurance companies. The SOI tax statistics include these credits in the totals for other 

industries. Some of the credits used were investment tax credit (ITC) carry-overs from 1986, the 

year the ITC was repealed. 

PAL Account and Small Company Changes 

In addition to the four tax changes discussed above, the 1986 Act repealed PAL accounts, which 

allowed mutual property and casualty insurance companies to defer tax on a portion of their income. 

It also liberalized the rules that exempted some small property and casualty insurance companies 

from tax and allowed others to elect to exclude their underwriting income from taxable income. The 

1987 calendar year estimates for the repeal of PAL accounts and the small company changes were $97 

million and -$23 million, respectively. Based upon the data from the sample of tax returns in the 

SOI corporate tax data base for 1987, it appears that the combined effect of these provisions on 

liabilities was $1 million. 8 

Since reliable data on the magnitude and distribution of NOLs were unavailable at the time 

estimates for these provisions were made, the estimates exaggerated the revenue loss attributable to 

these special tax deferral and tax reduction measures in pre-tax reform periods. Thus, the revenue 

increase from the repeal of PAL accounts was overestimated. The overestimates of revenue effects of 

the repeal of the PAL accounts and the changes in small company provisions were also largely 

attributable to underestimates of available NOLs. PAL account balances and the associated tax 

deferral are reduced dollar for dollar by NOLs used. In addition, the larger exclusion for small 

companies did not reduce revenues by the amount estimated because the use of NOLs by such companies 

was underestimated. 

8 The SOI corporate data base was used to evaluate actual receipts for these provisions, because 

companies in the special sample (described in Appendix 2) had minimal PAL balances and generally 

had net or direct written premiums that exceeded the small company thresholds. 
-23-

3.4 Alternative Minimum Tax Liabilities for Property and Casualty Insurance Company 

Consolidated Returns: 1987 

This section presents infonnation on minimum tax liabilities of property and casualty insurance 

companies and companies in other industries that file consolidated returns with property and 

casualty insurance companies. Because minimum tax liabilities are detennined on a consolidated 

basis, it was not possible to estimate the minimum tax liability attributable to companies in the 

property and casualty insurance industry. Data from tax returns generally included only the 

infonnation needed to compute minimum tax liabilities on a consolidated basis, such as minimum tax 

adjustments, preferences, and NOLs. Moreover, it is not possible to compare estimated receipts for 

the property and casualty insurance companies with actual liabilities because only aggregate 

corporate minimum tax receipts were estimated for the 1986 Act. 

The minimum tax liabilities for property and casualty insurance companies and affiliated 

companies were $175 million for 1987 (Table 3.6). Approximately 32 percent of the property and 

casualty insurance companies' consolidated tax returns in the sample had minimum tax liabilities. 

Table 3. 6 provides information on the composition of the alternative minimum (AMT) tax base by 

tax status of the consolidated returns. Companies that paid only the minimum tax (and no regular 

tax due to the property and casualty insurance company changes) owed approximately $115 million. 

Generally, these companies had no regular tax liability because NOLs offset the increase in taxable 

income before NOLs attributable to the property and casualty insurance companies tax changes. 

Because the use of NOLs to offset alternative minimum taxable income is limited, these companies 

paid AMT. The minimum tax paid by these companies is largely attributable to the book income 

preference, which accounted for 64 percent of the minimum tax base before NOLs. 

Returns in the sample that paid both regular tax and minimum tax paid $60 million in alternative 

minimum tax. Generally these companies paid the minimum tax because NOLs reduced regular tax 

liability below minimum tax liability, but were insufficient to eliminate regular tax liability. 

Approximately 55 percent percent of the consolidated returns in the sample paid only regular tax. 

For these companies, the tax effect of the larger minimum tax base was more than offset by lower 

minimum tax rate. 

The remaining 13 percent of returns in the sample with no minimum tax had no regular tax 

liability attributable to the property and casualty insurance company tax changes. Most of these 

companies were not taxable because current losses before NOLs more than offset minimum tax 

preferences. Some companies that paid no taxes due to the property and casualty insurance company 

tax changes filed consolidated returns with life insurance companies and paid tax on their life 

insurance income. 

3.5 Conclusion 

The actual increase in regular tax liabilities for calendar year 1987 for the property and 

casualty insurance company tax provisions nearly equaled the amounts estimated at the time of the 

1986 Act. The specific provisions, however, were either over- or underestimated. These errors are 
-24-

Table 3.6 

Alternative Minimum Tax Base and Liabilities 

by Tax Status of Companies Filing P&C Consolidated Tax Returns* 

($ millions) 

Minimum I Minimum 

Tax Paid; !Tax Paid; 

No Regular I Regular 

Tax From I Tax From 

P&C Tax I P&C Tax 

Changes Changes I 

Regular taxable income before NOLs 1,192 1,785 

Minimum tax adjustments 730 39 

Minimum tax preferences** 119 42 

Book income preference 3,615 744 

Minimum tax base before NOLs 5,656 2,610 

Alternative tax NOLs 3,892 846 

Exemptions *** *** 

Alternative minimum taxable income 1,764 1,764 

Tentative minimum tax 353 353 

AMT foreign tax credit 220 34 

Tentative minimum tax 133 319 

Income tax before credits 

Minus foreign tax credit**** 8 259 

Alternative minimum tax 115 60 

Percent of companies 24 8 

Department of the Treasury 

Office of Tax Analysis 

* Details may not add to totals because of rounding. 

** Excludes book income preference. 

*** Less than $1 million. 

No Minimum 

Tax Paid; 

Regular 

Tax From 

P&C Tax 

Changes 

15,287 

220 

117 

1,418 

17,042 

3,949 

*** 

13,093 

2,619 

492 

2,127 

4,383 

0 

55 

No Minimum 

Tax Paid; 

No Regular 

Tax From 

P&C Tax 

Changes 

177 

6 

29 

469 

681 

734 

*** 

402 

80 

2 

78 

112 

0 

13 

April 1991 

**** Includes regular tax on income not attributable to the property and casualty 

company tax changes. 
-25-

related largely to the significance of the changes enacted under the Tax Reform Act of 1986 and to 

limitations in the available data, particularly with respect to NOLs and credits. Estimating errors 

were largely offsetting, so that the aggregate estimated change in liabilities for the property and 

casualty insurance tax provisions nearly equaled the actual change in liabilities for 1987. 
CHAPTER 4. THE TAX TREATMENT OF POLICYHOLDER DMDENDS PAID BY 

INSURANCE COMPANIES 

4.1 Introduction 

Under present law, mutual and stock insurance companies generally are allowed to deduct 

dividends and similar distributions paid to their policyholders. These distributions are included 

in the income of the recipient only after the full amount of premiums paid has been recovered 

(unless the policyholder deducted the premiums). Dividends paid to individual shareholders by stock 

insurance companies are not deductible by the company and are included in the income of the 

shareholder.l 

An exception to the general rule that provides for deductibility of policyholder dividends paid 

arises for mutual life insurance companies. Under the Deficit Reduction Act of 1984 (the 1984 Act} 

mutual life insurance companies must reduce the deduction for policyholder dividends paid. 

Congress enacted this limitation because it believed that a portion of the policyholder dividends 

paid by mutual life insurance companies is a distribution of corporate earnings to the policyholders 

as owners. Absent such a limitation on the deduction for policyholder dividends, it was argued, 

mutual life insurance companies would be provided a tax advantage because stock life insurance 

companies cannot deduct amounts paid to their shareholders as dividends. 

Although Congress significantly overhauled the tax treatment of property and casualty insurance 

companies under the Tax Reform Act of 1986 (the 1986 Act), it did not extend the application of a 

limitation on the deductibility of policyholder dividends to mutual property and casualty insurance 

companies. Congress recognized that the limitation on the deduction for policyholder dividends as 

applied to life insurance companies has been both complex and controversial. 3 Thus, the 1986 Act 

required the Treasury Department to study the tax treatment of policyholder dividends paid by mutual 

property and casualty insurance companies before a limitation on the deductibility of policyholder 

dividends or other approach is considered for such insurers. 

The appropriate tax treatment of policyholder dividends is problematic because in the insurance 

industry customers (policyholders) often also participate as owners or part owners of the business. 

since they provide capital to the business that earns income. A major difficulty in taxing the 

income of mutual and stock insurance companies is that the total income of companies selling 

"participating" policies cannot be identified directly. A "participating" policy is one through 

l See generally, Sections 808(a)(2), 832(c)(ll), 72(e)(5)(c), 301(c) of the Internal Revenue 

Code. 

2 See Internal Revenue Code Section 809. 

3 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, May 4, 1987, 

p. 621. 

-27-
-28-

which a policyholder effectively buys not only insurance protection, but also an equity-like 

interest in the insurance company. The return that a participating policyholder may receive on the 

equity interest is difficult to identify or measure because the return can be received in many 

forms. including increased policyholder dividends, reduced premiums, or increased amounts credited 

to policy cash values. Further, policyholder dividends may blend together many elements, including 

price reductions, interest payments (reflecting the companies' use of any redundant premiums between 

receipt and repayment), repayment of the policyholder's investment principal, and equity-like 

returns. Not all of these items are appropriately taxed at the corporate level. Moreover, the 

identification and measurement of equity-like returns to participating policyholders is even more 

difficult in the case of stock companies because these policyholders share the equity risk with 

stock company shareholders. 

The 1984 Act required the Treasury Department to study the effects of the Act's life insurance 

tax provisions, including the tax treatment of life insurance company policyholder dividends. The 

Treasury Department's Final Report to the Congress on Life Insurance Company Taxation (the Final 

Report) included an evaluation of the limitation on the deduction for policyholder dividends paid by 

mutual life insurance companies and concluded that the limitation is conceptually flawed. This 

conclusion relies to a large extent on the "prepayment analysis," which shows that under certain 

assumptions the full deductibility of policyholder dividends does not confer a tax advantage on 

mutual life insurance companies. 

According to the prepayment analysis, a limitation on the deduction for policyholder dividends 

is unnecessary because any deduction of corporate earnings through mutual company policyholder 

dividends is exactly offset by the additional tax due from mutual companies when they raise capital 

through premiums by selling participating insurance policies. Stock companies, in contrast, are not 

required to include in income capital contributions of their shareholders. Under the prepayment 

analysis, a tax on paid-in capital combined with the full deductibility of the return to 

contributors (policyholder dividends) provides the same after-tax return at the company level and 

the same tax to the government in present value as the exclusion of paid-in capital combined with no 

deduction for dividends paid to shareholders. Since the prepayment analysis shows that the 

conceptual basis for a limitation on the deduction for policyholder dividends for mutual life 

insurance companies is flawed, extending this approach to mutual property and casualty insurance 

companies is inappropriate. 

The prepayment analysis does not address the problem that policyholders enjoy a tax advantage at 

the investor level. The following section discusses the policyholder-level tax advantage and 

evaluates its significance for investors in property and casualty insurance companies. 

4 See the Department of the Treasury, Final Report to the Congress on Life Insurance Company 

Taxation, (August 1989), Chapter 5. A study by the General Accounting Office also reached this 

conclusion. See United States General Accounting Office, Allocation of Taxes Within the Life 

Insurance Industry (October 1989). 
-29-

4.2 Policyholder-Level Taxadon of Policyholder Dividends Paid by Property and Casualty 

Insurance Companies , ,,,,_. <' £, 

Policyholders enjoy a tax advantage at the investor level because returns to, capitail '~ ~t~t~tf 

in policyholder dividends generally are excluded from taxable income but shareholders• dividends are , ·. 

taxed when received (and stock appreciation is taxed when the stock is sold). This tax advantage 

accrues to participating policies issued by both stock and mutual insurance companies. 

An exception to the policyholder-level tax advantage occurs when the policyholder is a business 

rather than an individual. Businesses are permitted to deduct premiums paid, but include fully in 

taxable income policyholder dividends received. 5 To the extent that a portion of premiums 

represents an equity-like contribution through a redundant premium, the current deduction of the 

redundant premium and the later inclusion in income of policyholder dividends is equivalent in 

present value to the absence of a deduction for share purchases and the exclusion from income of 

shareholder dividends received by corporations. 6 Thus, policyholder equity generally has no 

policyholder-level tax advantage over shareholder equity when the policyholder is a business. The 

following sections examine data on policyholder dividends paid by property and casualty insurers for 

business and personal coverage. 

4.2.1 Policyholder Dividends By Line of Business 

Data on policyholder dividends for property and casualty insurance companies by line of business 

for 1989 show that most policyholder dividends were paid on workers' compensation policies, which 

are sold primarily to businesses (Table 4.1). Property and casualty insurance companies paid 63 

percent of policyholder dividends in the workers' compensation line, 17 percent in the personal auto 

lines, and 20 percent in all other lines. For the workers• compensation line, policyholder 

dividends were 6 percent of premiums. Policyholder dividends as a percent of premiums were 2.3 

percent or less for all other lines. 

Table 4.2 shows the breakdown of policyholder dividends for stock and mutual property and 

casualty insurance companies by line of business for 1989. Policyholder dividends in the workers' 

compensation line predominate for both stock and mutual property and casualty insurance companies. 

5 See generally Internal Revenue Code Sections 162, 61, and 63. 

6 Equity investments in a mutual company and in a stock company are not fully equivalent because 

up to thirty percent of shareholder dividends received by corporations are taxable. See Internal 

Revenue Code Section 243. 
-30-

Table 4.1 

Policyholders Dividends and Premiums Earned for 

Property and casualty Insurance Companies by Line of Business: 1989 

I Poiicinoider Dividends Premiums Earnea Dividends/ 

I Amount I Percent 

I($ millions) I of Total 

Fire 17.8 0.7 

Allied Lines 10.4 0.4 

Farmowners Multi Peril 7.9 0.3 

Homeowners Multi Peril 83.0 3.1 

Commercial Multi Peril 64.3 2.4 

Ocean Marine 3.7 0.1 

Inland Marine 9.7 0.4 

Financial Guaranty 0.0 o.o 

Medical Malpractice 95.1 3.5 

Earthquake 1.8 0.1 

Group Accident &Health 0.0 o.o 

Credit Accident &Health 0.0 o.o 

Other Accident &Health 0.1 o.o 

Yorkers' Compensation 1,715.1 63.2 

Other Liability 86.3 3.2 

Auto Liab. (Private) 267.2 9.8 

Auto Liab. (Commercial) 108.6 4.0 

Auto Damage (Private) 197.5 7.3 

Auto Damage (Commercial) 27.8 1.0 

Aircraft o.o o.o 

Fidelity 0.8 o.o 

Surety 10.6 0.4 

Glass 0.3 o.o 

Burglary and Theft 1.5 0.1 

Boiler and Machinery 0.9 o.o 

Credit 0.0 o.o 

International o.o o.o 

Reinsurance (A,B,C, &D) 1.2 o.o 

Yrite-ins 1.5 0.1 

Total 2,713.1 100.0 

Amount I Percent 

($ millions) I of Total 

4,675.7 2.3 

2,054.8 1.0 

922.7 0.4 

17,349.7 8.4 

17,402.2 8.4 

1,222.5 0.6 

4,324.1 2.1 

351.0 0.2 

4,222.7 2.0 

360.1 0.2 

2,739.6 1.3 

243.0 0.1 

1,532.2 0.7 

28,069.0 13.6 

18,522.6 9.0 

43,073.9 20.9 

11,934.7 5.8 

29,397.4 14.3 

5,196.3 2.5 

583.7 0.3 

942.1 0.5 

1,693.6 0.8 

21.2 o.o 

103.3 0.1 

621.4 0.3 

899.0 0.4 

170.3 0.1 

7,063.1 3.4 

550.0 0.3 

206,242.2 100.0 

Premiums 

(percent) 

0.4 

0.5 

0.9 

0.5 

0.4 

0.3 

0.2 

o.o 

2.3 

0.5 

o.o 

o.o 

o.o 

6.1 

o.s 

0.6 

0.9 

0.7 

0.5 

o.o 

0.1 

0.6 

1.3 

1.5 

0.1 

o.o 

o.o 

o.o 

0.3 

1.3 

Department of the Treasury April 1991 

Office of Tax Analysis 

Source: A. M. Best Company 
- - .@ ••llaimm 11111 nm:r rnn ill • • II UIII llllllliU!Wlll)llt 11111 ·' lillllffll I rn• Iltlllllllllilrlfi :atli'l''lf 

- 'ii, 

Table 4.2 

Policyholder Dividends and Preaiuas Earned for Stock and Mutual 

Property and Casualty Insurance Coapanies by Line of Business: 1989 

Stock Coapanies I Mutual Companies 

Policyholder Dividends! Preaiuas Earned IDividends/lPolicyholder Dividends! Premiuas Earned !Dividends/ 

Alllount I Percent I Alllount !Percent I Preaiuas I Alllount !Percent I Alllount !Percent I Preaiuas 

(~~illionsJ! of Total!($ millions)jof Total! (percent)!($ aillions)iof total i($ millions)jof Total! (percent) 

Fire 5.0 0.4 2,903.6 2.3 0.2 12.9 0.9 1,772.1 2.2 0.7 

Allied Lines 2.9 0.2 1,396.9 1.1 0.2 7.4 0.5 657.9 0.8 1.1 

Faraowners Multi Peril 0.0 0.0 332.8 0.3 o.o 7.9 0.6 589.9 0.7 1.3 

Homeowners Multi Peril 1.6 0.1 8,192.5 6.5 o.o 81.4 5.6 9,157.3 11.4 0.9 

co-ercial Multi Peril 47.0 3.7 12,682.6 10.1 0.4 17.3 1. 2 4,719.6 5.9 0.4 

Ocean Marine o.o 0.0 1,075.9 0.9 o.o 3.7 0.3 146.5 0.2 2.5 

Inland Marine 0.4 0.0 3,234.9 2.6 0.0 9.3 0.6 1,089.1 1.4 0.9 

Financial Guaranty o.o o.o 343.1 0.3 o.o 0.0 o.o 7.8 o.o 0.0 

Medical Malpractice 9.0 0.7 2,106.9 1. 7 0.4 86.1 6.0 2,115.8 2.6 4.1 

Earthquake 0.0 o.o 190.6 0.2 o.o 1.8 0.1 169.4 0.2 1.1 

Group Accident• Health 0.0 o.o 1,202.5 1.0 0.0 0.0 o.o 1,537.1 1.9 o.o 

Credit Accident• Health 0.0 0.0 207.9 0.2 0.0 0.0 o.o 35.1 0.0 o.o 

Other Accident• Health 0.0 o.o 541.8 0.4 0.0 0.1 o.o 990.4 1.2 o.o I 

w 

Workers• Coapensation 1,065.6 84.0 19,773.1 15.7 5.4 649.6 45.0 8,295.9 10.3 7.8 I-' 

I 

Other Liability 30.7 2.4 15,549.5 12.3 0.2 55.7 3.9 2,973.1 3.7 1.9 

Auto Liab. (Private) 7.9 0.6 19,037.2 15.1 0.0 259.3 18.0 24,036.7 29.9 1.1 

Auto Liab. (Co-ercial) 58.5 4.6 8,889.8 7.1 0.7 50.1 3.5 3,044.9 3.8 1.6 

Auto Daaage (Private) 4.4 0.3 13,196.5 10.5 0.0 193.1 13.4 16,200.9 20.2 1.2 

Auto Damage (Co-ercial) 22.9 1.8 3,962.0 3.1 0.6 4.8 0.3 1,234.3 1.5 0.4 

Aircraft 0.0 0.0 503.7 0.4 0.0 0.0 0.0 80.0 0.1 0.0 

Fidelity 0.7 0.1 817.4 0.6 0.1 0.0 o.o 124.7 0.2 0.0 

surety 10.3 0.8 1,527.2 1.2 0.7 0.2 o.o 166.4 0.2 0.1 

Glass 0.3 o.o 16.8 o.o 1.6 0.0 0.0 4.4 o.o 0.2 

Burglary and Theft 1.5 0.1 81.1 0.1 1.8 0.1 0.0 22.3 o.o 0.3 

Boiler and Machinery 0.4 o.o 404.6 0.3 0.1 0.5 o.o 216.8 0.3 0.2 

Credit 0.0 0.0 889.6 0.7 0.0 o.o 0.0 9.5 0.0 0.0 

International 0.0 0.0 111.2 0.1 0.0 0.0 0.0 59.0 0.l 0.0 

Reinsurance (A,B,C, • DI 0.1 o.o 6,281.2 5.0 0.0 1.1 0.1 781.9 1.0 0.1 

Write-ins 0.l o.o 530.5 0.4 o.o 1. 4 0.1 19.5 0.0 7.3 

Total 1,269.3 100.0 125,983.6 100.0 1.0 1,443.8 100.0 80,258.6 100.0 1.8 

Department of the Treasury April 1991 

Office of Tax Analysis 

Source: A. M. Best Company 
-32-

The workers' compensation line accounted for 84 percent of policyholder dividends paid by stock 

companies and 45 percent ofpolicyholder dividends paid by mutual companies. For mutual companies, 

private auto lines accounted for 31 percent of policyholder dividends. On average, mutual companies 

pay more policyholder dividends as a percent of premiums than stock companies. The ratio of 

policyholder dividends to premiums in 1989 was 1. 8 percent and 1.0 percent for mutual companies and 

stock companies, respectively. 

Associations representing the property and casualty insurance industry (both stock and mutual 

companies) argue that the importance of policyholder dividends in the workers' compensation line 

reflects a form of price competition in a regulated market. Base rates for workers• compensation 

coverage are established by state law and insurers generally are prevented from charging less than 

the base rates without regulatory approval. Policyholder dividends provide a mechanism for reducing 

the effective price of a workers' compensation contract because insurers are prevented from 

adjusting premiums when the contract is sold. Thus, it is argued that policyholder dividends are 

7

the result of price competition and are not return on equity. 

The extent to which policyholder dividends comprise price rebates, returns on equity. or return 

of capital cannot be determined with available data. As noted above, however, the prepayment 

analysis shows that when policyholders are businesses, as appears to be the case for workers· 

compensation policyholders, the present tax treatment of policyholder dividends does not confer a 

policyholder-level tax advantage. The lines of business for which a policyholder-level tax 

advantage may be relevant are the personal lines. 

4.2.2 Policyholder Dividends for Personal Coverage 

It is not possible to measure precisely policyholder dividends for personal coverage, because 

the available data on policyholder dividends generally do not distinguish between personal and 

commercial lines of insurance business. The exceptions are homeowners multiple peril, private 

passenger auto liability, and private passenger physical damage, which are identified personal 

lines. However, other lines that may be viewed as primarily commercial include some personal 

coverage, such as accident and health, fire, and allied lines. Thus, the data for homeowners 

multiple peril and the personal auto lines provide an indication of the importance of policyholder 

dividends for personal coverage. 

Table 4.3 shows that policyholder dividends for the three lines of business that are primarily 

personal (homeowners multiple peril and the private auto lines) were $548 million in 1989, or 20 

percent of total policyholder dividends paid by property and casualty insurers. Table 4.4 shows 

that mutual companies paid $534 million in policyholder dividends for personal coverage (97 percent 

of the industry total) compared with $14 million for stock companies (3 percent of the industry 

total). Policyholder dividends for personal coverage averaged 1. l percent of premiums for mutual 

companies and were insignificant for stock companies. 

Alliance of American Insurers, National Association of Independent Insurers, and National 

Association of Mutual Insurance Companies, Report Concerning Taxation of Mutual and Stock Property 

and Casualty Insurers (January 8, 1990), pp. 8-9. 

7 
-33-

Table 4.3 

Policyholder Dividends and Premiums Earned for Property and Casualty 

Insurance Companies for Personal and Commercial Coverage: 1989 

Policyholder Dividends Premiums Earned !Dividends/ 

Amount I Percent I Amount I Percent I Premiums ($ millions) I of Total I($ millions) I of Total I (percent) 

Total Personal Lines: 547.7 20.2 89,821.1 43.6 0.6 

Homeowners MP 83.0 3.1 17,349.7 8.4 0.5 

Auto Liab (Priv.) 267.2 9.8 43,073.9 20.9 0.6 

Auto Phys (Priv.) 197.5 7.3 29,397.4 14.3 0.7 

Total Commercial Lines: 2,165.4 79.8 116,421.1 56.4 1.9 

Yorkers' Comp 1,715.1 63.2 28,069.0 13.6 6.1 

Other 450.3 16.6 88,352.1 42.8 0.5 

Total All Lines 2,713.1 100.0 206,242.2 100.0 1.3 

Department of the Treasury April 1991 

Office of Tax Analysis 

Source: A.H. Best Company 
Table 4.4 

Policyholder Dividends am Net 'Written Pran:iuns for Stock am tlltual Property am Casualty 

Insurance Q:Jqmrles for Persooal am Catmarcial Coverage: 1989 

I Stock Calpmies I tlltual Q:Jqmrles 

I Policyh>lder Dividends! Net 'Written Pran:iunsl !Policyholder Dividends! Net 'Written Pran:iunsl 

I Anwnt I Percent I Amtnt !Percent !Dividends/I Amtnt !Percent I Amtnt !Percent IDivi<iEntsl 

I ($ millioos)I of Total.I($ millims)!of Total.I Premiuns 1($ millims)lof total !($ millioos)!of Total! Premiuns 

Total Persooal Llnes: 13.9 1.1 40,718.4 32.2 o.o 533.8 37.0 50,514.6 61.6 1.1 

lbla7.lners HP 1.6 0.1 8,261.5 6.5 0.0 81.4 5.6 9,400.4 11.5 0.9 

Auto Llab (Priv.) 7.9 0.6 19,))2.8 15.3 o.o 259.3 18.0 24,673.7 30.1 1.1 

Auto R>ys (Priv.) 4.4 0.3 13,154.0 10.4 o.o 193.1 13.4 16,431.4 20.1 1.2 

I 

Total Catmarclal Lines: 1,255~4 98.9 85,721.7 67.8 1.5 910.0 63.0 31,433.3 38.4 2.9 w 

t 

Yorkers' Call) 1,065.6 84.0 19,738.3 15.6 5.4 649.6 45.0 8,503.1 10.4 7.6 

Other 189.8 15.0 65,983.4 52.2 0.3 260.5 18.0 22,930.2 28.0 1.1 

Total Ul Lines 1,269.3 100.0 126,440.1 100.0 1.0 1,443.8 100.0 81,947.9 100.0 1.8 

Source: 
-35-

The data presented in Tables 4.3 and 4.4 include both companies that paid policyholder dividends 

and those that did not. As a result, the average ratio of policyholder dividends to premiums 

understates the average for companies that actually paid such dividends. Table 4.5 provides data on 

policyholder dividends and premiums for companies that paid policyholder dividends, i.e., it 

excludes companies that did not pay policyholder dividends for the particular line of business. 

Table 4.5 shows that policyholder dividends for personal coverage averaged 2 percent for mutual 

companies that paid such dividends, compared with 0.2 percent for stock companies. For mutual 

companies policyholder dividends as a percent of premiums for personal coverage varies by line of 

business. Policyholder dividends as a percent of premiums were more than twice as large for 

homeowners multiple peril than for the personal auto lines for mutual companies that actually paid 

policyholder dividends for those lines. 

Industry representatives argue that, if policyholder dividends for personal coverage contain an 

element of return on equity that confer a tax advantage, they would be significant and paid 

primarily by mutual companies.8 Table 4.3 shows that policyholder dividends for personal coverage 

are less than one percent of premiums. However, mutual companies account for virtually all 

policyholder dividends for personal coverage and pay them at a higher rate than stock companies 

(Table 4.4). Approximately 7.6 percent of the mutual companies that wrote business in the personal 

lines paid policyholder dividends for personal coverage, compared with 2.5 percent of stock 

companies (Table 4.6). Thus, these data provide some support for the industry view that 

policyholder dividends are small relative to premiums and are paid by a relatively small fraction of 

companies that provide personal coverage. 

Industry representatives also note that the ratio of policyholder dividends to premiums varies 

among personal lines and policyholders, and suggest that policyholder dividends reflect a firm's 

circumstances in a particular market. 9 If mutual company policyholder dividends are a return on 

equity, it is argued, they would be paid proportionately to all policyholders, as is the case with 

respect to dividends paid to shareholders of the same class of stock.10 

However, differences in the rate at which policyholder dividends are paid among lines of 

business may reflect differences in the degree of risk. In addition, differences in the rate at 

which policyholder dividends are paid may reflect the fact that policyholder dividends are not a 

precise measure of the returns that a participating policyholder receives on his equity interest. 

8 Letter to Kenneth Gideon, Assistant Secretary for Tax Policy, Treasury Department, from 

Alliance of American Insurers, National Association of Independent Insurers and National Association 

of Mutual Insurance Companies, May 31, 1990. 

9 Ibid. p. 7. 

10 Alliance of American Insurers, National Association of Independent Insurers, and National 

Association of Mutual Insurance Companies, Report Concerning Taxation of Mutual and Stock Property 

and Casualty Insurers, p. 10. 
Table 4.5 

Policyh:>lder Dividetds and PremillllS Famed l7J Line of Business for Stock and }titual Property and Qlsualty 

Insurance ~es that Paid Policyoolder Dividetds for Persooal. Coverage: 1989 

Stock Coopmies I }titual Calpmles

I Policyholder Dividetdsl Premitms Famed IDividetds/lPolicyoolder Dividetdsl PremillllS Famed IDividerds/

I Ann.nt I Percent I Ann.nt !Percent I PremillllS I Annnt !Percent I Anwnt !Percent I Premiuns I ($ millioos)! of Total.I($ millioos)jof Total! (percent)!($ millims)lof total !($ millioos)lof Total.I (percent) 

Total Persaial Lines: 13.9 1.1 6,317.8 6.2 0.2 533.8 37.0 24,727.6 36.8 2.2 

HP 1.6 0.1 800.3 0.9 0.2 81.4 5.6 1,574.2 2.3 5.2 

Auto Liab (Priv.) 7.9 0.6 3,490.9 3.4 0.2 259.3 18.0 13,969.7 20.8 1.9 

Auto Phys (Priv.) 4.4 0.3 1,946.6 1.9 0.2 193.1 13.4 9,183.7 13.7 2.1 I 

w 

Total Camercial Lines: 1,255.4 98.9 95,916.9 93.8 T 1.3 910.0 63.0 42,532.9 63.2 2.1 

\lorkers' OJ1') 1,065.6 84.0 19,137.5 18.7 5.6 649.6 45.0 8,007.1 11.9 8.1 

Other 189.8 15.0 76,n9.3 75.1 0.2 260.5 18.0 34,525.8 51.3 0.8 

Total All Lines 1,269.3 100.0 102,234.6 100.0 1.2 1,443.8 100.0 67,260.5 100.0 2.1 

!Rpartnalt of tie Treasury April 1991 

Office of Tax Analysis 

Source: A. H. Best CCIIpmy 
-37-

Table 4.6 

Number and Percent of Property and Casualty Insurance Companies 

that Paid Policyholder Dividends for Personal Coverage: 1989 

Total 

Num er Percent 

Total Personal Lines: 17 2.5 33 7.6 50 4.5 

Homeowners MP 5 0.7 26 6.0 31 2.8 

Auto liability (private) 12 1.8 19 4.4 31 2.8 

Auto physical (private) 11 1.6 19 4.4 30 2.7 

Department of the Treasury April 1991 

Office of Tax Analysis 

Source: A. M. Best Company 
-38-

As discussed in the previous section, policyholder dividends may blend together price reductions, 

interest payments, and equity-like returns. Moreover, equity returns for participating 

policyholders may be received in a variety of ways, such as through reduced premiums. However, to 

the extent that policyholders change insurers, it is less likely that equity-like/returns would be 

paid in the form of reduced premiums. Both the extent to which policyholder dividends contain 

equity returns and equity returns are received in other forms are impossible to determine 

empirically. 

4.3 Arguments Relating to Differences between Property and Casualty Insurance and Life 

Insurance 

Representatives of the property and casualty insurance industry also argue that a limitation on 

policyholder dividends should not be imposed on property and casualty insurers because property and 

casualty insurance differs from life insurance in several respects. 

First, representatives of the property and casualty insurance industry contend that the 

resemblance that a mutual company policyholder bears to an owner is closer with a life insurance 

policy than with a property and casualty insurance policy. Because life insurance policies 

generally are longer-term commitments based on relatively predictable mortality rates, they may be 

more closely tied to the company's investment performance. In contrast, property and casualty 

policies are short-term contracts often for more highly variable risks. Whereas certain life 

insurance policies are held for many years, property and casualty insurance coverage tends to have a 

short duration, such as six-months to one year. Thus, it is argued that a property and casualtl 

insurance policyholder's relationship only weakly resembles a traditional ownership relationship. 1 

Although property and casualty insurance contracts are short-term, the extent to which 

policyholders renew their policies with the same company and thus are affiliated with their property 

and casualty insurance company for long periods is unclear. The duration of property and casualty 

contracts may not accurately reflect either the duration of the relationship between the 

policyholder and the insurance company or the closeness of that relationship to a traditional 

ownership interest. 

Representatives of the property and casualty insurance industry argue that property and casualty 

insurance policyholders are unlikely to receive an investment-like return during the term of the 

12 policy because the policies are short term. This argument more appropriately addresses the amount 

and form of payment of any investment-like return. Policyholder dividends for short-duration 

contracts contain an investment-like return because the insurance company invests the redundant 

11 See Emil M. Sunley, Federal Income Taxation of Mutual and Stock Property/Casualty Insurance 

Companies (November 28, 1988), pp. 31-2. 

12 Alliance of American Insurers, National Association of Independent Insurers, and National 

Association ofMutual Insurance Companies, Report Concerning Taxation ofMutual and Stock Property 

and Casualty Insurers. p. 17. · 
-39-

premiums it receives. Thus, policyholder dividends contain an policyholder-level advantage with 

respect to any investment-like element for participating policies of both mutual and stock . 13 companies. 

The duration of an insurance contract may also affect whether the investment-like return is paid 

in the form of policyholder dividends or premium adjustments. Life insurance industry 

representatives point out that life insurance companies may set premiums over a period of years and 

reflect favorable experience through policyholder dividends, while froperty and casualty insurers 

may reflect favorable experience by periodically resetting premiums. 4 

Property and casualty insurance industry representatives also note that unlike many life 

insurance policies, property and casualty policies do not generate a cash surrender value. Thus, it 

is argued that the purchaser of property and casualty insurance is purchasing insurance and is not 

making an investment.15 Although cash value policies are likely to contain larger investment 

returns, short-term policies also earn investment-like returns since property and casualty insurers 

invest the premiums they receive. Thus, policyholder dividends may provide a policyholder-level 

advantage with respect to this investment return, regardless of whether the policy has a cash 

surrender value. 

Finally, it is argued that property and casualty insurance is riskier than life insurance, 

because property and casualty insurance companies cannot measure the magnitude of their risks with 

as much precision. Life insurance policies pay the face amount of the policy when the insured dies 

and life insurers are able to predict the occurrence of death accurately for members of large groups 

of individuals. Property and casualty insurers do not know whether a particular policy will produce 

a loss, the number of losses that will occur with respect to the policy, or the amount of the 

16 loss. Whether property and casualty insurance is riskier than life insurance is beyond the scope 

of this report. Nevertheless, if the industry's argument is accepted, one likely outcome is that the 

expected return on equity will be larger to compensate investors for the greater risk. 

4.4 Summary and Conclusion 

The Treasury Department recommends that Congress not extend a limitation on the deduction for 

policyholder dividends to property and casualty insurance companies because the conceptual basis for 

13 Emil M. Sunley. Op. Cit.. p. 33. 

14 Letter to Kenneth W. Gideon, Assistant Secretary (Tax Policy), Department of the Treasury, 

from Theodore R. Groom and Matthew J. Zinn, dated August 8, 1990. · 

15 Letter to Kenneth W. Gideon, Assistant Secretary (Tax Policy), Department of the Treasury from 

Donald C. Alexander, April 3, 1990. 

16 Alliance of American Insurers, National Association of Independent Insurers, and National 

Association ofMutual Insurance Companies, Report Concerning Taxation of Mutual and Stock Property 

and Casualty Insurers, p. 14-17. 
-40-

a limitation is flawed. The prepayment analysis shows that mutual company policyholder dividends 

should be fully deductible to provide equal corporate-level tax treatment of equity-like returns to 

mutual and stock company investors. According to the prepayment analysis a tax on paid-in capital 

combined with a full deduction of dividends to policyholders is equivalent in pfesent value terms to 

the exclusion of capital contributions combined with no deduction for dividends to shareholders. 

The prepayment analysis does not address the problem that returns to participating policyholders 

of mutual and stock insurance companies may enjoy a policyholder-level advantage because 

policyholder dividends are not taxable income to policyholders but dividends are taxable to 

shareholders. An exception to this policyholder-level advantage arises when the policyholder is a 

business rather than an individual. Since businesses deduct premiums paid but include policyholder 

dividends in income, a policyholder-level tax advantage generally does not arise between 

conventional equity and policyholder equity. 

Data on policyholder dividends paid by property and casualty insurers show that most 

policyholder dividends are paid in the workers' compensation line. Since workers' compensation 

policies are purchased primarily by businesses, it is unlikely that a significant policyholder-level 

tax advantage arises with respect to policyholder dividends on these policies. However, a 

policyholder-level tax advantage arises with respect to the investment-like return contained in 

policyholder dividends for personal coverage, such as the homeowners multiple peril and the personal 

auto lines of business. 

Current law generally does not tax the equity-like income of participating policyholders of life 

insurance companies or property and casualty insurance companies at the individual level. This 

problem is not limited to mutual company policyholders, since both stock and mutual companies issue 

participating policies. The disparity in the treatment of policyholders and shareholders at the 

individual level could justify a corporate-level tax on the equity return contained in policyholder 

dividends as a proxy for the absent individual-level tax. However, as an empirical matter, this 

disparity is considerably smaller for investors in property and casualty insurance companies than 

for life insurance companies because the amount of policyholder dividends paid by property and 

casualty insurers is substantially smaller than that paid by life insurers and policyholder 

dividends paid by property and casualty insurers are paid primarily to business policyholders. 

Since the imposition of a proxy tax on property and casualty insurance companies would impose a 

compliance burden but would have modest revenue yield, the Treasury Department does not recommend a 

proxy tax at this time. 
APPENDIX I - REQUIREMENT FOR THE REPORT 

The Tax Reform Act of 1986 (P.L. 99-514) contains the following reporting requirement: 

"Sec. 1025. STUDY OF THE TREATMENT OF PROPERTY AND CASUALTY INSURANCE 

COMPANIES. 

The Secretary of the Treasury or his delegate shall conduct a study of--

(1) the treatment of policyholder dividends by mutual property and casualty insurance 

companies, 

(2) the treatment of property and casualty insurance companies under the minimum tax, and 

(3) the operation and effect of, and revenue raised by, the amendments made by this subtitle. 

Not later than January 1, 1989, such Secretary shall submit to the Committee on Ways and Means of 

the House of Representatives, the Committee on Finance of the Senate, and the Joint Committee on 

Taxation, the results of such study, together with such recommendations as he determines to be 

appropriate. The Secretary of the Treasury shall have authority to require the furnishing of such 

information as may be necessary to carry out the purposes of this section." 

Section 1 1831 of the Omnibus Budget Reconciliation Act of 1990 (P .L. 101-508) extended the date for 

filing this study to January 1, 1992. 

-41-
APPENDIX 2 - DESCRIPTION OF THE SAMPLE AND METHODOLOGY 

The Sample and Sample Weights 

The estimates of actual 1987 tax liabilities are based on data from a sample of tax returns of 

the largest property and casualty insurance companies. The sample consisted of 96 of the 100 

largest, as measured by net written premiums, affiliated property and casualty insurance company 

groups. For many company groups, some property and casualty insurance companies in the group filed 

separate tax returns so the data collection process involved the assembly of data from multiple tax 

returns. Much of the data needed for the study came from an IRS corporate SOI data tape and a 

special IRS data project. The Treasury Department obtained additional data required for the study 

from the companies. 

The sample companies had approximately 85 .5 percent of net written premiums for the industry in 

1987. The estimates of regular and minimum taxes for the companies not in the sample were 

calculated by multiplying the average of tax to net premiums written for the sample companies by the 

difference between net written premiums for the industry and net written premiums for the sample 

companies. If the ratio between tax and premiums is invariant with respect to the level of 

premiums, these ratio estimates (and therefore the tax estimates for the missing companies) are 

unbiased. The invariance condition was tested by comparing the ratio of the top 50 companies to the 

rest of the sample. It was not possible, at the 95 percent confidence level, to reject the 

hypothesis of invariance. 

Data Checking and Error Resolution Procedures 

The internal consistency of data items required for the computation of the changes in taxable 

income were tested and data errors corrected. For example, in some cases the consistency testing 

resulted in the detection of incorrectly transcribed Schedule E and F data from the 1120PC form, 

which was used to determine the potential effect of the discounting, prorationing, and unearned 

premium reserve changes on the company's taxable income. In these cases, copies of tax returns were 

used to correct the underlying data transcription problems. Net written premiums from each company 

group were compared to net written premiums for the company group Best Company data tapes were used 

to determine company groups which filed multiple 1120PC tax returns. Supplemental tax data were 

collected from such companies when preliminary available data were determined to be insufficient. 

When data on undiscounted reserves were not reported on tax returns, the undiscounted reserve data 

were obtained from Best Co. data tapes. 

Computation Procedures 

Tax return data from the sample companies were used to estimate the maximum potential increase 

in taxable income attributable to the 1986 Act provisions. For each tax return. the actual effect 

of the provisions on the taxable income shown on the return was also determined. The actual effect 

-43-
-44-

could be less than the potential effect if the property and casualty insurance company or any of the 

consolidated companies had current losses or NOI.s that offset the impact of the property and 

casualty insurance company tax changes. In determining the actual effect of the property and 

casualty insurance company changes on the income shown on consolidated tax returns. the 35 percent 

rule for life-nonlife consolidated returns was taken into account. This rule limits the use of 

nonlife losses against life income to the minimum of 35 percent of eligible nonlife losses or 35 

percent of life insurance subgroup income. For several companies in the sample, consolidated 

taxable income was solely attributable to life subgroup income and the use of nonlife losses was 

constrained by life subgroup income. For such companies, consolidated taxable income and tax was 

unchanged by the 1986 Act provisions even though the tax changes reduced the nonlife losses of the 

companies. 
BIBLIOGRAPHY 

Alexander, Donald C., Letter to the Treasury Department, Re Taxation of Property and Casualty 

Companies, April 3, 1990. 

A. M. Best Company, Aggregates and Averages, Property-Casualty, 1984 through 1990. 

Alliance of American Insurers, National Association of Independent Insurers, and National 

Association ofMutual Insurance Companies, Letter to Treasury Department (and attachment), Report 

Concerning Taxation of Mutual and Stock Property and Casualty Insurers, January 8, 1990. 

Alliance of American Insurers, National Association of Independent Insurers, and National 

Association of Mutual Insurance Companies, Letter to Treasury Department Re Policyholder 

Dividends Paid by P & C Companies in Personal Lines: A Supplement to Report Concerning 

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