Insurers and reinsurers in the US have reignited the debate surrounding offshore reinsurers’ ability to dodge US income tax. Ronald Gift Mullins reports.

If the infamous Bermuda Triangle does exist, reinsurers in Bermuda and the Cayman Islands must fervently wish the allegation that they are avoiding paying their share of US income taxes would disappear into it.

Once again, a tempest has arisen alleging that US affiliates of reinsurance parents based in offshore jurisdictions with low or no corporate income taxes are avoiding paying US income taxes on premiums earned in the US. Current US law allows foreign-domiciled insurers with US affiliates to use related-party reinsurance transactions to move underwriting and investment activities out of the reach of the US to a more favourable tax jurisdiction.

The foreign-domiciled insurance group pays a 1% excise tax on the reinsurance premiums paid from the US member to its offshore parent. Once those assets are located in the low-tax or no-tax country, any income earned is taxed at the local rate only, which is nothing in Bermuda or the Caymans. US insurers and reinsurers pay no excise tax, but must pay current taxes on all of their appropriate income from premiums and investments.

Unless legislation is enacted to close this loophole in the US tax code, some industry observers predict that the already substantial transfer of (re)insurance capital to offshore domiciles will accelerate, eventually threatening the viability and facility of the US (re)insurance industry. Today, as the result of mergers, acquisitions and run-offs over the past decades, and the paucity of new reinsurance company formations, there is no major independent, publicly-traded reinsurance company domiciled in the United States.

Bermudian reinsurers say they already pay substantial US taxes, and assert there are other reasons, rather than avoiding income taxes, that premiums from their US affiliates are transferred to their Bermuda parents. It spreads risk and funds diversification, allows capital to not be trapped in specific jurisdictions or companies and helps build the capital of reinsurance parents so that it is available when most needed, such as for catastrophes and terrorism, they assert.

Big increases

According to the Reinsurance Association of America (RAA), $54.7bn of US premiums were ceded to offshore reinsurers in 2006, $22.2bn of which was ceded to unaffiliated offshore reinsurers and $32.5bn of which was ceded to affiliated offshore reinsurers. These amounts compare to approximately $37.3bn ceded to offshore reinsurers in 2001, $21.5bn of which was ceded to unaffiliated offshore reinsurers and $15.9bn of which was ceded to affiliated offshore reinsurers. Hence from 2001 to 2006, total premiums ceded to offshore reinsurers grew by 46.7%, of which premiums ceded to unaffiliated offshore reinsurers grew by 4.7% and premiums ceded to affiliated offshore reinsurers grew by 104.4%.

A study prepared by the staff of the US Congressional Joint Committee on Taxation found that markets for reinsurance have become global. Historically, London has been an insurance and reinsurance centre, and very large reinsurers are located in Germany and Switzerland. Increasingly, though, Bermuda has developed into a large global reinsurance market. Between 1983 and 2001, net premiums written in the Bermuda insurance market grew from $4.7bn to $41.4bn, and total assets in the Bermuda insurance market grew from $17.1bn to $172.7bn. Capital grew 24% to $65bn in 2006 among a group of Bermuda reinsurers, according to the study, a doubling of their capital since 2002. Bermuda is considered to have insurance regulatory rules favourable to insurance companies and products, the study continued.

“No one seems to have even a broad estimate of how much income tax has gone uncollected due to the practice of transferring premiums

Don’t agree on much

Testifying before the Senate Finance Committee in late September 2007, William Berkley, CEO of WR Berkley, said he represented the Coalition for a Domestic Insurance Industry (CDII), a group of 11 large domestic commercial lines and financial guarantee insurers. He stressed that the law that allows US affiliates to transfer premiums to their offshore parents needs to be changed to remove a competitive benefit that US insurers and reinsurers don’t have.

Related party reinsurance ceded to Bermuda companies by their US affiliates has increased ten-fold from $1.8bn in 1996 to $18.5bn in 2006, Berkley explained. “This rapid growth in related party reinsurance,” he said, “is seen as evidence of deliberate manipulation by offshore reinsurers to avoid taxes in the United States.”

The CDII includes Berkshire Hathaway, The Chubb Corp, The Hartford Financial Services Group and Liberty Mutual. In his prepared testimony, Berkley, commenting on the relationships of the insurers within the CDII, observed dryly that as competitors, “we rarely agree on much. In this case, however, we are united in our belief that this tax inequity must be fixed and soon. Otherwise, the United States is at risk of losing much more of the capital base, and associated tax base, of one of its critical industries.”

Berkley added that failure to address this situation and begin “levelling the playing field” could deprive the US Treasury of billions of dollars in tax revenues from those companies. He also stressed that any proposed legislation “is not meant to effect foreign reinsurers providing third party reinsurance to unaffiliated US insurers. Consequently, it would not affect the market for catastrophe coverage that protects Americans from natural disasters.”

Donald Kramer, CEO of Ariel Re in Bermuda, representing the Association of Bermuda Insurers and Reinsures (ABIR) at the hearing, acknowledged taxation issues do play a role in company decisions to cede premium to offshore parents but added that such issues have been “overblown” as the motive for ceding risks offshore. “All premiums, whether ceded to a Bermuda-based reinsurer or paid by a US-based company buying coverage directly from a Bermuda-based insurer, are subject to an excise tax,” he said, noting this is a gross premium-based tax and must be paid whether the eventual outcome of the coverage results in a profit or loss. “Insurance companies are not always profitable,” he said, “but the excise tax is always there.”

Protectionist measures targeting tax increases at non-US insurers will have counterproductive effects in the US economy, he stated. Assessing these taxes will increase the costs for US businesses and consumers and, he said, will increase prices and reduce the availability of coverage and competition in insurance markets. “Increased tax obligations – simply put – directly reduce an insurance company’s capital and that in turn reduces the amount of insurance coverage that can be provided by that insurer.”

He quoted from a letter sent by the Florida Consumer Action Network that stressed the proposed revenue-raising amendments that promise the US government more tax revenue at the expense of non-US reinsurers are “not a good deal and these amendments should be exposed as protectionist measures by US insurers seeking to grab more business for themselves by increasing taxes on their non-US competitors.”

“Increased tax obligations - simply put - directly reduce an insurance company's capital and that in turn reduces the amount of insurance coverage that can be provided by that insurer

Kramer also read a excerpt from a letter sent by the Risk and Insurance Management Society (RIMS): “We strongly urge you to oppose any legislation that would result in negative implications for the global reinsurance marketplace and more importantly, those US businesses who rely on this market to manage their risk exposure.”

Guarded expectations

From the Senate hearing and in subsequent telephone contacts with principals knowledgeable about the tax issue, no one seems to have even a broad estimate of how much income tax has gone uncollected due to the practice of transferring premiums offshore. Neither are they sure how much would be captured if the law were changed to enforce compliance.

A spokesperson for WR Berkley said there were so many variables associated with the transfer-of-premiums issue that it was difficult to assign a definite figure on how much US income tax had been lost or would be gained if the law were changed.

Bradley Kading, president and executive director, ABIR, observed that determining how much income tax would be collected from premiums shifted overseas would require an exhaustive examination of each companies’ transactions. This would be a laborious process which may not generate enough funds to warrant the process.

A report by the RAA said the total federal and foreign income taxes paid by US reinsurers and affiliates of foreign reinsurers in 2006 were $2.1bn. One insurer, National Indemnity, paid more than half of those taxes itself. Of the 23 companies in the report, four paid no taxes at all, but carried forward previous accessed taxes. Total pre-tax income of the reinsurers came in at $11.8bn, representing a tax rate of about 20%. In 2005, of the 26 reinsurers listed in the report, 11 had carry-forwards that were so large, the industry as a whole paid no taxes at all on pre-tax income of about $871m.

Senator Chuck Grassley, ranking member on the committee, observed that before “we try to figure out how to solve a problem, we need to determine whether or not a problem exists, and, if so, we need to define it.”

Sitting on the committee is Senator Trent Lott. The senator was not pleased with the insurance settlement he received after his Mississippi home was destroyed by Hurricane Katrina. During the hearing, he voiced the belief that “the insurance industry uses the tax code to delay or avoid payouts of claims.” Just as well the hearing was billed as only exploratory, and no immediate further action has been scheduled.