Congress Should Consider Changing Federal Income Taxation of the Property/Casualty Insurance Industry

GAO examined the provisions of the Internal Revenue Code which are used to determine the taxable income of the property and casualty insurance industry. These companies are similar to other companies in that the premium income is analogous to the sales receipts; however, a difference lies in claim payments which may not be made until a future year, while the premiums are received currently. In examining taxation of the industry, GAO focused on the measurement of taxable income by using the matching principle, which matches each year's revenues with the expenses associated with those revenues.

GAO found that the existing practice does not match revenues with associated expenses and results in an inaccurate measurement of taxable income. About half of the insurance industry's business is contracts involving claims that are paid over a considerable period of time resulting in protracted settlement of claims extending over many years. Reserves are needed to cover these losses to ensure that companies have adequate funds to make future payments on the claims. However, the current practice allows overstatement of the amounts needed to satisfy the claims, which are not being reduced by the investment income that will be earned on the reserves between the time they are established and the time that they are paid out, and result in an understatement of taxable income. One way to remedy this problem would be to discount reserves at a rate based on each company's investment return experience. GAO estimated discounted reserve levels at several discount rates and the additional tax liability that resulted, and it found that, the higher the discount rate, the greater the reduction in reserve deduction and the greater the increase in tax liability. Another income measurement issue is the proper allocation of business expenses related to the sale and renewal of insurance policies. The current practice permits these costs to be deducted immediately regardless of the life of the policy, but premium income is included in revenues only on a pro rata basis each year. According to GAO, expenses should be allocated over the same periods in which the corresponding income is recognized.

Recommendations

Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.

Director: Johnny C. Finch Team: General Accounting Office: General Government Division Phone: (202) 512-7824