The Internal Revenue Service (IRS) and the Treasury Department (Treasury) have issued final regulations that address amendments to the rules for discounting unpaid losses pursuant to Section 8461 under the Tax Cuts and Jobs Act (TCJA).2 The regulations were effective on June 17, 2019. The regulations address how to compute the annual rate for discounting purposes based on the corporate bond yield curve. The regulations respond to and incorporate certain comments from stakeholders to the proposed regulations released in November 2018.
Background
Section 846 discounts the amount of an insurance company’s unpaid losses and estimated salvage recoverable to take into account the time value of money, because an insurance company may not actually pay a claim until many years after the loss is incurred.
Prior to the TCJA, the IRS annually computed discount rates for the relevant accident year using an annual rate equal to the average of the monthly applicable federal mid-term rates for the previous five years and loss payment patterns based on the historical aggregate loss payment data applicable to each line of business for each determination year. Alternatively, a company was permitted to compute its own discount factors using the annual rate and loss payment patterns based upon its own historical loss payment experience.
Tax Cuts and Jobs Act
The TCJA revised the discount rate and, in some cases, extended the loss payment patterns. For discounting purposes, the TCJA replaced the use of the average applicable federal interest rate with a rate based upon the corporate bond yield curve. The TCJA amended the computational rules for determining loss payment patterns under Section 846(d) and repealed the election under former Section 846(e) that allowed a taxpayer to use its own historical loss payment patterns instead of the industry loss payment patterns the IRS used to compute the discount factors.
For long-tail lines of business, the TCJA extended the periods for determining loss payment patterns, resulting in a maximum of 14 more years (i.e., up to 24 years for the previous ten-year payment pattern).
| Eversheds Sutherland Observation: Both the increase in the average discounting rate and the extension of the periods for loss payment patterns are expected to yield smaller deductions for discounted loss reserves and lower reserves. |
Final Regulations
The final regulations made important changes to the proposed regulations. For further discussion of the proposed regulations, see the previous Eversheds Sutherland legal alert.
The TCJA’s replacement of the applicable federal interest rate with the corporate bond yield curve for discounting purposes created a need to translate the corporate bond yield curve into an annual rate or rates for purposes of Section 846.
The proposed regulations provided for the use of a single annual rate applicable to all lines of business, rather than different rates for different lines of business. The proposed regulations provided that the annual rate for any calendar year was to be determined on the basis of a yield curve that reflects the average of the monthly spot rates with times to maturity from six months to 17.5 years. The average maturity of the proposed single discount rate was nine years.
The preamble to the final regulations noted that commenters agreed with the single rate approach. In addition, the preamble described the various comments addressing the range of maturities used to develop the discount rate. The main themes of the comments were that the range selected in the proposed regulations does not adequately match the maturities of the bonds held by property and casualty insurance companies, which average six- to seven-year maturities, and that the use of a range that extends out to 17.5 years could cause the discount rate to vary substantially from the property and casualty insurance industry’s investment yield in years in which the bond yield curve is unusually steep. Some commenters wanted the final regulations to provide for adjustments to the discount rate periodically on the occurrence of a trigger; others asked for a fixed range.
The other key area of disagreement reflected in the comments on the proposed regulations was with the proposal to discontinue the use of the composite method and composite discount factors. The preamble to the final regulations explained that commenters were concerned with the potential difficulty posed by the need to compile data with respect to accident years not separately reported on the National Association of Insurance Commissioners’ annual statement.
Accordingly, in the final regulations, Treasury and the IRS adopted a single annual discount rate based on corporate bond rates with times to maturity from 4.5 years to 10 years. This range results in an average maturity of 7.25 years, down from nine years under the proposed regulations. Treasury and the IRS declined to provide for any adjustment to the maturity range, indicating a preference in the comments for a fixed range, notwithstanding that some commenters asked for adjustments.
The final regulations retain the current use of the composite method and provide that the IRS will continue to publish composite discount factors annually. The final regulations retained provisions in the proposed regulations that allowed the IRS to make smoothing adjustments to loss payment patterns. The preamble to the final regulations noted that commenters supported the smoothing adjustments. The preamble also explained that discount factors for salvage recoveries would no longer be computed separately; instead, salvage would be discounted using the same discount factors as unpaid losses. This approach also was supported by commenters.
| Eversheds Sutherland Observation: Overall, the final regulations reflect a high degree of responsiveness on the part of Treasury and the IRS to stakeholder comments. |
1 All section references are to the Internal Revenue Code of 1986, as amended.
2 PL 115-97.
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