Chapter OutlineChapter Outline10.1 Tax Benefits Defined

10.2 Progressivity in Corporate Income Tax Rates

Overview

Numerical Example and Additional Insights

Progressivity of US Corporate Income Tax Rates

10.3 Tax Treatment of Insurers versus Non-Insurance Companies

OverviewExample and Additional InsightsTax Benefit with Overstated Loss Reserves

10.4 Insuring Depreciated PropertyOverviewExample and Additional Insights

RetentionInsurance and Recognition of a Capital GainInsurance and Deferral of the Capital Gain

Chapter OutlineChapter Outline10.5 Insurance and Interest Tax Shields on Debt

10.6 Insurance Premium and Excise Taxes

10.7 Regulatory Effects on Loss FinancingCompulsory Insurance

Restrictions on the Choice of Insurance

10.8 Financial Accounting Influences on Loss FinancingFinancial Accounting for Insurance Premiums and Uninsured Losses

Cash Flow Impacts of Financial Accounting Numbers

10.9 Summary

Appendix Tax Benefits when Insurers Overstate Loss Reserves

Tax Benefits DefinedTax Benefits Defined

Definition of a tax benefit

– A transaction provides a tax benefit if the _______ _________ of expected tax payments of the parties involved is lowered.

Expected tax payments vs. ex post tax payments

Present values

Nominal recipient versus actual incidence

Tax minimization does not always ______ shareholder wealth maximization

Tax Effects of Loss Financing Tax Effects of Loss Financing DecisionsDecisions

– Main tax benefits from insurance arise for four reasons:

___________ in tax rates (also applies to hedging)

___________ tax treatment of insurers and non-insurance firms

Tax treatment of depreciated property

Risk reduction allows for greater use of debt, which creates additional tax shields (also applies to hedging)

Progessivity in Tax RatesProgessivity in Tax Rates– Intuitive explanation of the effect of hedging

Oil producer subject to oil price risk:

– In years when oil prices are high ==> high taxable income ==> tax rate is high

– In years when oil prices are low ==> low taxable income ==> tax rate is low

– Effect of hedging:

• Lower taxable income when oil prices are _____ (and tax rate is high) and _______ taxable income when oil prices are low (and tax rate is low)

• Essentially, hedging transfers ________ to years when it is taxed at a _______rate

Example of the Effect of Progressive Tax RatesExample of the Effect of Progressive Tax Rates

Probability Before-tax income After-tax income

_____ $10m $7.2m

_____5 $2m $1.8m

Expected Value $6m $4.5m

Eliminate uncertainty at no cost

==> before-tax income = $6m & after-tax income = $_____

$2m $6m $10m

After-tax income

Before-tax income

7.24.84.4

1.6

Different Tax Treatment of InsurersDifferent Tax Treatment of Insurers

– Description

Insurers can deduct incurred losses =

paid losses + ________in PV of estimated unpaid losses (change in PV of loss reserve)

Non-insurance firms can deduct ______ losses

– Implication:

Insurers can move tax deductions for losses _______ in time relative to non-insurance firms

Example of Different Tax Treatment of InsurersExample of Different Tax Treatment of Insurers

– Example:

Due to events in year 1, Crocker expects loss payments:

End of End of

Year 1 Year 2__

Loss payments _____ $2m

Assume opportunity cost of capital = 8%, tax rate=34%

Without insurance,

PV of tax shields = (.34*$2M) + (.34*$2M) = $1.212,620

1.08 (1.08)^2

Example of Different Tax Treatment of InsurersExample of Different Tax Treatment of Insurers

Beginning of year 1 End of 1 End of 2 1. Paid losses $2.000 $2.000 2. Loss Reserve $0.00 $2.000 $0.000 3. Change in loss reserve $2.000 -$2.000 4. Undiscounted incurred losses

(1) +(3) $4.000 $0.000

5. Present value of loss reserve

(discounted value of 2) $0.00 $1.852 $0.000

6. Change in present value of loss

reserve $1.852 -$1.852

7. Incurred losses for tax purposes

(1) +(6) $3.852 $0.148

Example of Different Tax Treatment of InsurersExample of Different Tax Treatment of Insurers

– PV of tax shield for insurer

= $______*(0.34)/1.08 + $0.148(0.34)/1.082 = $1.256m

– Difference between insurer and non-insurer

= $1.256m - $______ = $0.043m = $43,184

– Important insight:

Difference arises because the insurer implicitly does not pay tax on ______ ________ on funds set aside to pay future losses

Example of Different Tax Treatment of InsurersExample of Different Tax Treatment of Insurers

– Calculate the tax savings on implicit interest

Amount of money at end of time 1 needed to pay future losses = $_______

Interest earned on these funds = $1.852 (.08) = $148,148

Tax that would be paid on the interest = 0.34($_______) = $50,370

PV of the tax saving = $50,370/1.082 = $43,184

Insuring Depreciated PropertyInsuring Depreciated PropertyIntuitive Explanation:

Assume that

(1) the value of existing property has been depreciated to zero (book value =0)

(2) that future depreciation expenses resulting from replacement of damaged property are _____ ______ whether the firm is insured or uninsured

(3) that the premium loading is zero

(4) income tax rate > capital gains rate

Insuring Depreciated PropertyInsuring Depreciated Property

Tax effects of purchasing property insurance:

(1) the firm is able to deduct the insurance premium when calculating taxable earnings, regardless of whether a _____ occurs.

(2) if a loss occurs the firm will have to recognize a capital gain equal to the insurance indemnity payment.

The first effect > _______ _______ of the second effect when the income tax rate exceeds the capital gains rate

That is, the income tax savings from deducting the premium ______ the expected capital gains tax payment.

Interest Tax Shields on DebtInterest Tax Shields on Debt

Optimal amount of debt is determined by the advantages and disadvantages of debt financing

– Advantages Interest tax shields Reduce ________ problem between managers and

shareholders

– Disadvantages Expected bankruptcy costs Expected ______ due to

– underinvestment problem

– overinvestment in risky projects (asset substitution)

Interest Tax Shields on DebtInterest Tax Shields on Debt

Disadvantages of debt increase as _________ of financial distress increases

Decrease risk ==> decrease probability of financial distress ==> borrow _____ ==> gain additional interest tax shields

Other Tax IssuesOther Tax Issues

State premium taxes

– generally, 2%– some variation across states

Federal excise taxes

– 1% on reinsurance– 4% on _______ insurance

Regulatory EffectsRegulatory Effects

Compulsory Insurance

– _____

Restrictions on the choice of insurers

– Admitted insurers– Excess & surplus lines market

– Fronting

Financial Accounting EffectsFinancial Accounting Effects

Riskier cash flows ==>

– more ______ reported income– more ______ balance sheet numbers

– Who cares? Contracts depend on ________ numbers

– managerial contracts– debt contracts

Less volatility makes assessing managers easier