U.S. Tax Aspects of Asset/Liability Matching for Insurance

At the March 2014 Investment Symposium, Dave Bell, Aditi Banerjee and Peter H. Winslow participated in a panel presentation (Session E2) titled “Tax Aspects of Asset/Liability Matching.” The presentation discussed key tax issues that exist under current law with respect to asset rebalancing and hedging transactions that an insurance company might undertake. As a follow-up to that presentation, and in an effort to convey the information to a broader audience, this article summarizes the substance of that discussion for the readers of Risks & Rewards. Readers who would like to learn more about other tax issues of interest to individuals in the insurance industry can find informative articles in TAXING TIMES, the Taxation Section’s newsletter.

SOURCES OF TAX CHARACTER AND TIMING MISMATCHES ON ASSET/LIABILITY BALANCING TRANSACTIONS

The fundamental tax quandary faced in insurance company asset/liability balancing transactions is a capital/ordinary mis-match in tax treatment. An insurance company’s liabilities are reflected in tax reserves, which are ordinary in character for tax purposes (i.e., increases and decreases in tax reserves generate ordinary deductions and income, respectively). On the other hand, the assets used to satisfy these liabilities are capital in character for tax purposes. Moreover, income earned on capital assets is generally ordinary in nature while gain and loss on the underlying assets is capital in nature. This causes tax inefficiency, because capital losses on assets cannot generally be used to offset previous ordinary income earned on the assets.

This tax inefficiency is exacerbated in a credit loss environment. Credit losses are generally recognized for tax purposes only upon sale or maturity and are generally treated as capital losses. However, the income earned on the bond prior to sale or maturity would be ordinary in character. Moreover, a purchase of a distressed debt instrument at a discount often generates “market discount” income, which treats the discount in purchase price as ordinary interest income for tax purposes. In effect, a taxpayer is required to recognize ordinary interest income for tax purposes that it may never collect if the debt is of poor credit quality.

LIMITATIONS ON USE OF CAPITAL LOSSES

Capital losses can only offset capital gains. Any unused capital losses can only be carried back three years and carried forward for five years. In a rising interest rate environment, a large amount of capital losses may be generated without offsetting capital gains within the relevant carryback/carry-forward period. For statutory accounting purposes, loss carryforwards are reflected as deferred tax assets (DTAs) on the balance sheet. However, there are limitations on the ability to admit DTAs as capital. DTA admittance is limited by the amount of taxes paid by the company in the current year and the prior two years. Thus, at a time when substantial capital losses are generated, the company may be able to admit only a minimal amount of DTAs if it has been in a loss position in the past few years.