Public Policy Analysis & Opinion
California to review whether lower federal taxes should mean lower insurance prices
When Congress and the Trump Administration lowered corporate tax rates in January, insurance trade associations cheered.
Certainly, most insurance agencies will benefit from the temporary 20% reduction in tax rates applied to “pass-through” businesses. But that favorable treatment of S-corporations and sole proprietorships will sunset in 2025.
With the marked exception of California, most states have adopted a superstitious belief in “the magic of the market” to “regulate” insurance rates and forms—contrary to the Congressional intent of the McCarran-Ferguson Act.
The carriers stand to receive a bundle of material, favorable, and permanent tax treatments. Furthermore, a coalition of property/casualty insurers succeeded in closing a loophole that offered a subsidy to Bermuda and Cayman Islands reinsurers.
Yet if we believe a follow-up statement issued by the American Insurance Association (AIA) and the Property Casualty Insurers Association of America (PCI), the actual impact of the tax cuts on the insurance sector is too complex to judge at this time, so the sector might not be a big winner.
Nothing to see here, folks! Please move along.
Along came Jones
One elected official in California wants to take a closer look at the insurance sector’s tax situation. Insurance Commissioner Dave Jones ordered his staff to launch a review of the impact of the tax cuts on insurers. Commissioner Jones observed: “The recent revision to the Federal Tax Schedule for 2018 reduced the corporate tax rate from 35% to 21%. That means that, nationally, insurers will now be able to retain even more of policyholder premiums as profit.”
The commissioner announced: “I have directed my staff to commence a regulatory review of these insurers’ rates, given the major tax windfall under the new federal tax rules.” Commissioner Jones explained that California’s regulatory framework establishes a prior approval process “that applies to property and casualty insurance rates and limits insurer profits.”
To give credit where credit is due, Commissioner Jones made his announcement after receiving a letter jointly signed by J. Robert Hunter, director of insurance of the Consumer Federation of America (CFA), and David “Birny” Birnbaum, executive director of the Center for Economic Justice (CEJ), that called for regulatory review of insurance pricing.
The consumer advocates contend that there is “something to see here” after all. The CFA-CEJ letter asserts: On a property/casualty industrywide basis, the windfall to insurers from the tax changes are massive. Five percent of the $539 billion in premiums collected is over $25 billion. For longer-tailed lines, like medical professional liability, the increase in investment income on reserves and surplus will be much greater than average because of the reduction in tax rates.
Furthermore, the CFA-CEJ letter slams a change in policy recommendations by the National Association of Insurance Commissioners (NAIC). “The changes to the tax laws also call into question the wisdom of the changes made by the NAIC a few years ago extending the period of time for evaluating deferred tax assets. Recent reports indicate massive reductions for many insurers in deferred tax assets, suggesting these so-called assets were illusory.”
Commissioner Jones explained that his department would review more than just the effect of the tax cuts on prices. “I have also directed staff to consider and identify possible actions in other lines of business where insurers will benefit from the tax cut, to see if we can enable their policyholders to also benefit from the lower corporate taxes paid by their insurers.”
The slowdown
It appears that the aim of the AIA and PCI is to slow down the process recommended by the CFA and CEJ. The insurance trade groups write, “The CEJ/CFA letter misleadingly oversimplifies and overstates the impact of federal tax changes in a number of ways. Specifically, the letter refers to the impact on insurance companies as ‘massive’ and a ‘windfall.’ In truth, the impact of lower federal taxes will vary greatly for each insurer, in each state, and for each line of business. Therefore, we respectfully ask you to consider the following facts before responding to the CEJ/CFA letter.”
The AIA-PCI letter attacks the consumer advocates’ description of the insurance pricing frameworks in the United States: “The CEJ/CFA letter erroneously compares insurers to utility companies.”
In truth, the consumer advocates referenced a story from the January 9, 2018, edition of the conservative-leaning Washington Examiner. “We call your attention to the fact that, in another regulated industry, many utility companies have already announced plans to cut rates due to the ‘expected windfall they plan to receive when corporate taxes are cut.’”
In addition, the insurance lobbyists’ dismissal of the CFA-CEJ’s comparison to another regulated industry runs against the stream of American history and legal precedent. Public regulation of insurance pricing leans on the experience of Robert “Fighting Bob” La Follette, the former Governor of and U.S. Representative from Wisconsin who used his experience regulating railroad rates to regulate insurance rates.
Public interest
The Supreme Court in 1914 established the constitutional propriety of the regulation of the “business of insurance” in German Alliance Insurance Company v. Lewis, Kansas Insurance Commissioner. In that opinion, the court found that the business of insurance carries a public interest by drawing from legal precedents that arose from public oversight of grain elevators. Two other bedrock cases of insurance rate regulation, Bluefield Water Works & Improvement Co. v. Public Service Commission (1923) and Federal Power Commission v. Hope Natural Gas Co. (1944), both drew on non-insurance roots.
For that matter, the scientific application of insurance mechanisms arose from the efforts of a possibly mentally ill French priest named Blaise Pascal, who developed probability theory in response to an active interest in gambling. Interests sometimes cross-pollinate.
That said, the consumer advocates’ letter carries a description of insurance rate regulation that exists in only a few jurisdictions. With the marked exception of California, most states have adopted a superstitious belief in “the magic of the market” to “regulate” insurance rates and forms—contrary to the Congressional intent of the McCarran-Ferguson Act.
The consumer advocates’ letter provides a general description of insurance pricing based on a “fair rate of return:”
The changes in the tax law dramatically reduce federal corporate tax rates, which has a direct impact on insurer profitability. The components of an insurance rate include claims, claim settlement costs, sales expenses, general and administrative expenses, and a provision for profit. The profit provision is developed, generally, by taking the target after-tax rate of return, grossing it up to a before-tax rate of return, converting the return on capital to a percentage of premium, and offsetting the indicated profit as a percentage of premium by expected investment income.
The CFA-CEJ letter explains how this framework would generate material profits to insurers that are unrelated to the claims risk:
So, if the target after-tax rate of return is, say, 10%, the before-tax rate with a 35% corporate tax rate is 15.4%. When the tax rate dropped to 21%, the before-tax rate used in developing the profit provision would drop to 12.7%. In addition, after-tax investment income may be taxed at a lower rate, further increasing the profit provision at current rates.
State action
The description of rate regulation provided by the consumer advocates is not wild conjuring drawn from some long-forgotten Soviet five-year plan. The CFA-CEJ description is consistent with what the drafters of the McCarran-Ferguson Act expected the states to do to receive and hold the loaned authority over “the business of insurance.” And “to the extent” that the states do not act, the authority reverts to federal jurisdiction.
(Yes, Virginia, the McCarran-Ferguson Act suggests the “Mother of All Class Action Suits” under federal antitrust law.)
Even if one disagrees with the consumer advocates’ comparison of the construction of insurance pricing with the public utility sector, the AIA-PCI letter contains a touch of hyperbole: “In addition, utilities are typically state-sanctioned monopolies, while insurers must truly compete for business in a marketplace where consumers have many options.”
Of course, insurers do not operate in “the war of all against all” dreamed up by Thomas Hobbes. States place legal impediments—often engineered by parochial insurance interests—in the way of unfettered entry into insurance markets. Often, state law or loan contracts compel consumers to purchase insurance products. The complexity of insurance mechanisms makes informed consumer choice difficult, which runs counter to reasonable definitions of competitive markets.
Furthermore, thanks to the McCarran-Ferguson Act, insurers can act in concert to collect loss data, create products, and establish pricing, without offending federal antitrust enforcement to the extent that these activities are regulated by state law. To the extent that the business is not subject to state regulatory action, insurance comes under the jurisdiction of federal antitrust law and fair-trade enforcement.
As noted above, the consumer advocates provide a logical comparison to the utilities field, because the Supreme Court ruled a century or so ago in the German Alliance decision that insurance holds a public interest—just as do public utilities, common carriers, and even grain elevators. When advocates deny the historical association of the public interest orientation of these enterprises, then “the truth is not in them.”
Even before the Supreme Court ruled that insurance is interstate commerce, the court established the propriety of the public oversight of the public interest inherent in the insurance mechanism that the business of insurance employs.
A problem with the CFA-CEJ explanation relates to changes to the pricing frameworks adopted in the states over the past half-century, which run counter to the McCarran-Ferguson Act. The framework described by CFA-CEJ reflects the assumptions made by Congress when it passed McCarran-Ferguson. Yet the social conservative movement—which includes a group that CFA’s Hunter quietly affiliates with—installed in Congress and state legislatures two generations of lawmakers who rejected the “fair rate of return” pricing model. The phrase “whistling past a graveyard” comes to mind, unless that graveyard is in California.
The California Department of Insurance launched a review of the effect of the tax cuts on insurance carriers. “The purpose of that review is to identify specific legal authority and necessary amendments to rate formulas and the procedures for addressing insurers’ rates to pass the decrease in taxes on to California policyholders where authorized.”
We shall await the outcome of this review, but the action is sound.
The author
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners. Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.
