Modified Coinsurance and Its Use by Some Life Insurance Companies To Reduce Taxes

GAO was asked to analyze the characteristics of modified coinsurance transactions and the extent of their use by life insurance companies. Modified coinsurance is an arrangement in which insurance companies share risk. By entering into these arrangements, some insurance companies, primarily large mutual companies, are able to convert their investment income, on which they pay tax, into underwriting income, on which there is little if any tax.

In a sample of 42 large life insurance companies, modified coinsurance increased from approximately $7 billion in 1979 to about $147 billion in 1980. The 10 largest mutual companies accounted for approximately 80 percent of this amount. These companies reduced their tax burdens in 1980 from the prior year by about $625 million. The 10 largest mutual companies accounted for 90 percent of this reduction. An estimate of the entire industry's tax burden indicates a 1980 revenue loss of approximately $1.5 billion, a drop of nearly 37 percent from what the companies would have paid had they not used modified coinsurance. The 1981 revenue loss estimate is approximately $3.4 billion, or about 74 percent. The Internal Revenue Service has proposed rules that would, if made final, prevent companies from converting investment income into underwriting income to the extent now permitted to prevent further use of a section of the Internal Revenue Code to reduce taxes. Elimination of this section would no doubt eventually correct the current reduction of enormous amounts of Federal income taxes. However, its elimination would reintroduce the problem of double taxation. Furthermore, the problem should be viewed in the larger context of the Life Insurance Company Income Tax Act and in the light of the substantially changed economic conditions in which the industry currently operates.