Why Do Insurance Companies Discount Unpaid Loss Reserves?
Editor's Note: Since 1986, non-life insurance companies have discounted loss reserves using the annual discount factors and interest rates released by the IRS. Here, Johnson Lambert provides insight as to why the adjustment is required and how to account for it annually.
Disclaimer: The content contained herein is provided solely for educational purposes and should not be relied upon as accounting, tax, or business advice because it does not take into account any specific organization's facts and circumstances. Tax rules can be complex and require specialized knowledge.
The Tax Reform Act of 1986 (the Act) envisioned creating a more uniform tax structure for insurance companies, changing several rules related to their taxation. Insurance companies are allowed to take a current deduction for unpaid losses, which is an expense that is paid over time. This is a benefit that other corporations do not have. Tax guidance only allows corporations that are not insurance companies to take a tax deduction once the expense has been paid unless the expense meets certain exceptions.
Without the deduction for unpaid losses, the tax code would be exceedingly burdensome for insurance companies as income would be taxed upfront, while tax relief from deductible expenses would stretch out over a much longer period of time.
The Act allowed insurance companies to keep the benefit of deducting the accrued unpaid losses but required insurance companies to discount their unpaid losses to reflect a present value of the anticipated expense. IRC Section 846 calculates the allowed tax deduction based on a present value method that uses the applicable interest rate and industry loss payment patterns by line of business. In 1992, the final regulations also allowed non-life insurance companies with sufficient data to use their own loss payment patterns rather than the patterns based on industry data.
How did the Tax Cuts and Jobs Act of 2017 (TCJA) change loss discounting?
The TCJA implemented a change in methodology for calculating loss discount factors. Modifications to the historical IRC Section 846 included the following.
- Change the applicable discount rate from a federal mid-term interest rate to the corporate bond yield curve, which more closely aligns with the investments that a non-life insurance company would use to fund reserves
- Allow the IRS to use smoothing provisions to extend loss payout patterns and smooth out negative payment patterns
- Simplify salvage and subrogation calculations by using the same discount factors that apply to unpaid losses
These revisions caused a cumulative difference for most taxpayers. The difference was required to be included either as income or a deduction over an 8-year period. Further, the TCJA disallowed insurance companies from using their own historical data, meaning that all insurance companies must follow the information released by the US Treasury.
Loss Discounting—An Annual Look
Loss discounting is one of the many complex tax rules that insurance companies are required to follow. As the industry is ever-changing, the non-life discount factors are updated annually by the US Treasury. Each year, taxpayers must adjust their calculation of tax basis unpaid losses with recent loss discount factors. In order to make sure you have the most up-to-date information, Johnson Lambert tracks the changes in our Discounting Factors Table, published annually following the release of the factors.