On November 6, 2018, the Internal Revenue Service (IRS) and the Treasury Department (Treasury) issued proposed regulations that address amendments to the rules for discounting unpaid losses under section 846¹ that were enacted as part of the law commonly known as the Tax Cuts and Jobs Act (TCJA).² The proposed regulations principally address how to compute the annual rate for discounting purposes based on the corporate bond yield curve. The proposed regulations also provide guidance on other TCJA amendments to section 846. The proposed regulations are relevant for both property and casualty (P&C) and life insurance companies.

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. The discounting rules also apply to the unearned premiums of title insurance companies. Discounted reserves are computed by line of business and accident year and then aggregated to determine the total discounted reserve.

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.” A determination year occurs every five years, with 2017 being the most recent 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 loss payment experience.

There are different loss payment patterns for “long-tail” lines of business (which include auto liability, general liability, medical malpractice, worker’s compensation and multiple peril lines) and for “short-tail” lines (which include any other line of insurance). For long-tail lines, the law prior to the TCJA generally provided that unpaid losses were treated as paid in the accident year plus the following 10 years (with a possible extension of five additional years), while short-tail lines were treated as paid in the accident year and the three calendar years following that year.

Tax Cuts and Jobs Act

The TCJA left the structure of section 846 largely unchanged, but revised the discount rate and, in some cases, extended the loss payment patterns. The TCJA amended section 846(c) to provide a new definition of the “annual rate” to be used by taxpayers for discounting purposes. The TCJA also 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.

The TCJA replaced the average applicable federal interest rate with a rate based upon the corporate bond yield curve (defined as a yield curve reflecting average monthly yields for the preceding 60-month period on investment grade corporate bonds in the top three quality levels available, at varying maturities). Historically, corporate bond rates are higher than the applicable federal interest rate; thus using a corporate bond yield curve will result in a higher discount factor yielding smaller deductions for discounted loss reserves and lower reserves.

Under the TCJA, in certain cases, the periods for determining loss payment patterns were extended, which will increase the period over which the discounts for each accident year will accrete. For short-tail lines of business, the loss payment pattern rules were not changed. However, for long-tail lines of business, the computational rules for loss payment patterns were extended, resulting in a maximum of 14 more years (i.e., up to 24 years for the previous 10-year payment pattern).

Proposed Regulations

The focus of the proposed regulations is on the computation of the annual rate for purposes of section 846.

Annual Rate

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. Since the TCJA does not specify how to determine the annual rate for any calendar year based on the corporate bond yield curve, the proposed regulations provide this guidance.

The proposed regulations provide 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 provide that the annual rate for any calendar year is determined on the basis of a yield curve that reflects the average of the monthly spot rates with times to maturity of not more than 17.5 years. The IRS and the Treasury selected the 17.5-year maturity range because they believe it will result in the smallest aggregate difference in tax result from a multiple rate approach.

The proposed regulations request comments on other possible methods for determining the annual rate on the basis of the corporate bond yield curve and the legal basis for such alternative methods.

Additional Provisions

Although the proposed regulations focus on the changes to the annual rate in section 846(c), the proposed regulations also address other amendments to section 846, noted above.

• The proposed regulations indicate that the Treasury plans to adopt a methodology to smooth loss payment patterns, which are derived from the National Association of Insurance Commissioners’ (NAIC) annual statement loss data, in order to avoid negative payment amounts and otherwise to produce a stable pattern of positive discount factors less than one. The preamble to the proposed regulations describes a seven-step approach that the IRS and the Treasury may adopt in future published guidance for making smoothing adjustments to loss payment patterns. 
• In the preamble to the proposed regulations, the IRS proposes to discontinue the composite method for discounting unpaid losses with respect to accident years not separately reported on the NAIC annual statement. Instead of using a separate set of composite discount factors, taxpayers in this situation would compute discounted unpaid losses with respect to the relevant year using the discount factors published for that year for the appropriate line of business. 
• The preamble to the proposed regulations describes the approach Treasury intends to adopt for discounting estimated salvage recoverable by applying the unpaid loss discount factors for each line of business to the estimated salvage recoverable in that line of business.
• The preamble to the proposed regulations specifically requests comments on the application of section 846, as amended, with respect to non-proportional reinsurance and international lines of business.

Comments are due December 7, 2018, a month from the release of the proposed regulations, instead of the usual 90 days, which likely reflects the fact that the rules would apply for the 2018 calendar year.

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¹ All section references are to the Internal Revenue Code of 1986, as amended.

² PL 115-97.

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