Over the past 6 years there has been significant publicity regarding changes to the U.S. tax law that would negatively affect Reinsurance companies doing business in Bermuda. This column will explore why this is an issue and what is currently happening in Congress.

The Issue

Insurance companies based in the United States are currently able to claim a deduction on their corporate tax return for the amount of reinsurance premiums paid to a Bermuda affiliate. In turn, the Bermuda affiliate invests these funds which grow on a tax free basis.  The issue is that these United States based insurance companies are using reinsurance to reduce their overall U.S. tax burden, which gives them a competitive edge over United States based insurance companies that do not engage in this practice.

As a simplistic example suppose we have U.S. insurance company A that does not have a Bermuda affiliate and U.S. insurance company X that does have a Bermuda affiliate. Both are asked to submit a bid on a reinsurance proposal. If A bids $100 and wins they will have $100 in income, theoretically pay $35 in U.S. corporate income tax and have $65 to invest to pay a potential future claim. Investment income earned on the $65 would also be subject to U.S. corporate income tax each year. The problem is that X could bid $80, wins the proposal and immediately pays its Bermuda affiliate an $80 premium. So on its U.S. corporate tax return X has $80 in income, offset by an $80 deductible premium. The Bermuda affiliate now has $80 to invest, which will grow tax free. Clearly X has a competitive advantage.

Representative Richard Neal (D-Mass.) has been a longtime proponent of limiting the ability of United States based insurance companies to deduct excess reinsurance premiums from their U.S. income. Neal has introduced a bill in the House of Representatives that would deny the deduction of the premium paid to the Bermuda affiliate on the U.S. based insurer’s corporate income tax return. It has been projected that this would raise about $18 billion over 10 years.

In his 2011 budget President Obama opted for curtailing the tax deduction for reinsurance premiums. This option would still permit reinsurance premiums to be deductible, but would bar companies from deducting reinsurance premiums that exceed 50% of the total premiums that the insurer received for each line of business.

On July 14, 2010 the House Ways & Means subcommittee on select revenue measures held a hearing on Neal’s bill to eliminate the so-called Bermuda reinsurance tax loophole. Consequently, the risk that Congress will close this so-called loophole in order to use the projected revenue of $18 billion to offset additional spending or tax cuts is growing more prevalent.

At the July 14, 2010 hearing Deputy Treasury Secretary Stephen Shaw called for support of President Obama’s plan to limit the tax benefit of Bermuda reinsurance. Chubb Vice Chairman John Degnan argued that the Bermuda reinsurance loophole hurts domestic insurers that pay U.S. taxes and the insurance consumer advocate in Florida’s Department of Financial Services contended that further taxing reinsurance will result in higher premiums for consumers in his state.

On August 4, 2010 the Senate passed a bill that includes $10 billion to support teacher employment and Federal matching money for Medicaid. The tax offset to this bill was a restriction that limited the amount of foreign tax credit that U.S. Global corporations can use against their U.S. income tax. It is projected that the limitation of the foreign tax credit will generate $10 billion in income taxes over time.

What has this to do with Bermuda? The foreign tax credit limitation had originally been proposed as a means of paying for another bill to extend a variety of expiring business tax credits. Now that the foreign tax credit limitation has been used, where will Congress come up with more than $10 billion to pay for the expiring business tax credits? Conjecture in Washington is that a prime candidate is the Neal bill that would target United States based insurance companies reinsuring through Bermuda affiliates and potentially raise $18 billion dollars in income tax.

This issue will likely again be raised when Congress reconvenes in mid September. There is consensus that if either the Neal bill or the Obama proposal is passed, that insurance premiums in the United States will increase. Given the current state of the economy the question is whether the politicians have the will to do so just before the November election.

From a Bermuda viewpoint, if United States based insurance companies are limited in their ability to deduct excess reinsurance premiums paid to Bermuda based insurers from their U.S. income, will they stop reinsuring in Bermuda?

And if there is no longer an advantage to being in Bermuda, what will the reinsurance companies do?
 
Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.