Chapter Outline 10.1Tax Benefits Defined 10.2Progressivity in Corporate Income Tax Rates Overview Numerical Example and Additional Insights Progressivity of US Corporate Income Tax Rates 10.3Tax Treatment of Insurers versus Non-Insurance Companies Overview Example and Additional Insights Tax Benefit with Overstated Loss Reserves 10.4Insuring Depreciated Property Overview Example and Additional Insights Retention Insurance and Recognition of a Capital Gain Insurance and Deferral of the Capital Gain

Chapter Outline 10.5Insurance and Interest Tax Shields on Debt 10.6Insurance Premium and Excise Taxes 10.7Regulatory Effects on Loss Financing Compulsory Insurance Restrictions on the Choice of Insurance 10.8Financial Accounting Influences on Loss Financing Financial Accounting for Insurance Premiums and Uninsured Losses Cash Flow Impacts of Financial Accounting Numbers 10.9Summary AppendixTax Benefits when Insurers Overstate Loss Reserves

Tax Benefits Defined Definition of a tax benefit – A transaction provides a tax benefit if the _______ _________ of expected tax payments of the parties involved is lowered. Expected tax payments vs. ex post tax payments Present values Nominal recipient versus actual incidence Tax minimization does not always ______ shareholder wealth maximization

Tax Effects of Loss Financing Decisions – Main tax benefits from insurance arise for four reasons: ___________ in tax rates (also applies to hedging) ___________ tax treatment of insurers and non-insurance firms Tax treatment of depreciated property Risk reduction allows for greater use of debt, which creates additional tax shields (also applies to hedging)

Progessivity in Tax Rates – Intuitive explanation of the effect of hedging Oil producer subject to oil price risk: –In years when oil prices are high ==> high taxable income ==> tax rate is high –In years when oil prices are low ==> low taxable income ==> tax rate is low –Effect of hedging: Lower taxable income when oil prices are _____ (and tax rate is high) and _______ taxable income when oil prices are low (and tax rate is low) Essentially, hedging transfers ________ to years when it is taxed at a _______rate

Example of the Effect of Progressive Tax Rates ProbabilityBefore-tax incomeAfter-tax income _____ $10m $7.2m _____5 $2m $1.8m Expected Value $6m $4.5m Eliminate uncertainty at no cost ==> before-tax income = $6m & after-tax income = $_____ $2m $6m$10m After-tax income Before-tax income

Different Tax Treatment of Insurers – Description Insurers can deduct incurred losses = paid losses + ________in PV of estimated unpaid losses (change in PV of loss reserve) Non-insurance firms can deduct ______ losses – Implication: Insurers can move tax deductions for losses _______ in time relative to non-insurance firms

Example of Different Tax Treatment of Insurers – Example: Due to events in year 1, Crocker expects loss payments:End of Year 1Year 2__ Loss payments _____ $2m Assume opportunity cost of capital = 8%, tax rate=34% Without insurance, PV of tax shields = (.34*$2M) + (.34*$2M) = $1.212, (1.08)^2

Example of Different Tax Treatment of Insurers

– PV of tax shield for insurer = $______*(0.34)/ $0.148(0.34)/ = $1.256m – Difference between insurer and non-insurer = $1.256m - $______ = $0.043m = $43,184 – Important insight: Difference arises because the insurer implicitly does not pay tax on ______ ________ on funds set aside to pay future losses

Example of Different Tax Treatment of Insurers – Calculate the tax savings on implicit interest Amount of money at end of time 1 needed to pay future losses = $_______ Interest earned on these funds = $1.852 (.08) = $148,148 Tax that would be paid on the interest = 0.34($_______) = $50,370 PV of the tax saving = $50,370/ = $43,184

Insuring Depreciated Property Intuitive Explanation: Assume that (1) the value of existing property has been depreciated to zero (book value =0) (2) that future depreciation expenses resulting from replacement of damaged property are _____ ______ whether the firm is insured or uninsured (3) that the premium loading is zero (4)income tax rate > capital gains rate

Insuring Depreciated Property Tax effects of purchasing property insurance: (1) the firm is able to deduct the insurance premium when calculating taxable earnings, regardless of whether a _____ occurs. (2) if a loss occurs the firm will have to recognize a capital gain equal to the insurance indemnity payment. The first effect > _______ _______ of the second effect when the income tax rate exceeds the capital gains rate That is, the income tax savings from deducting the premium ______ the expected capital gains tax payment.

Interest Tax Shields on Debt Optimal amount of debt is determined by the advantages and disadvantages of debt financing – Advantages Interest tax shields Reduce ________ problem between managers and shareholders – Disadvantages Expected bankruptcy costs Expected ______ due to –underinvestment problem –overinvestment in risky projects (asset substitution)

Interest Tax Shields on Debt Disadvantages of debt increase as _________ of financial distress increases Decrease risk ==> decrease probability of financial distress ==> borrow _____ ==> gain additional interest tax shields

Other Tax Issues State premium taxes – generally, 2% – some variation across states Federal excise taxes – 1% on reinsurance – 4% on _______ insurance

Regulatory Effects Compulsory Insurance – _____ Restrictions on the choice of insurers – Admitted insurers – Excess & surplus lines market – Fronting

Financial Accounting Effects Riskier cash flows ==> – more ______ reported income – more ______ balance sheet numbers – Who cares? Contracts depend on ________ numbers –managerial contracts –debt contracts Less volatility makes assessing managers easier