The Clarity in New Loss Discounting Rules
Insurance companies received good news recently with the release of two new revenue procedures addressing the new loss discounting rules for property and casualty companies, as enacted by the Tax Cuts and Jobs Act (the “TCJA”). Most taxpayers will find that the new guidance simplifies the administrative burden in adopting the new rules and provides a favorable tax result as compared to the original proposal.
The Internal Revenue Service (“IRS”) and Treasury published final regulations, along with Rev. Proc. 2019-30 and 2019-31, which provide guidance on how to apply the final regulations enacted by the TCJA and the factors needed to compute loss discounting for federal tax purposes. The TCJA significantly changed the way insurance companies discount their unpaid loss and estimated salvage recoverable under the Internal Revenue Code  (“IRC”). The new legislation altered the method used for computing the discount factors, from the applicable federal mid-term interest rate to the corporate bond yield curve, eliminated the use of company specific factors and removed the use of different payout patterns for certain lines of business.
Proposed regulations issued at the end of 2018 under the TCJA, and Rev. Proc. 2019-06 published in early 2019, contained initial guidance on the new basis for calculating the discount, how to account for the change, as well as estimated factors for 2017 and 2018. This was important as it allowed taxpayers to calculate the required adjustments in their year-end tax provisions and extensions, which were generally significant to most taxpayers. Taxpayers were required to account for these in 2018 by recalculating the tax reserves for 2017 and amortize this difference over an 8-year period, which directly affects both, the current and deferred taxes as recorded for book purposes.
The proposed regulations prescribed the use of the average monthly spot interest rates with a maturity range between 0.5 and 17.5 years. This resulted in an applicable interest rate of 3.12 percent, compounded semi-annually as the basis for determining the estimated factors included in Rev. Proc. 2019-06. Further, the proposed regulations discontinued the use of the composite method that was used by many taxpayers to discount loss reserves for accident years 10 and older.
A New Way Forward
The final guidance issued on July 22, 2019 addresses several critical areas and includes revisions in response to industry comments on the proposed regulations and Rev. Proc. 2019-06. The final regulations require a single rate approach for determining the discount factors for a particular tax year, which is consistent with the proposed regulations. However, the final regulations outline that the annual rate for any calendar year is the average of the corporate bond yield curve’s monthly spot rate, with maturities ranging from 4.5 to 10 years. The final maturity range is favorable to taxpayers and was the result of many commenters expressing concern over the wide maturity range. This resulted in the applicable interest rate dropping from the proposed 3.12 percent to 2.94 percent for 2017 and 2018, which changed all the discount factors for the 2017 and 2018 tax years.
The final regulations also reinstated the use of the composite method for determining the discount for reserves held on accident years 10 and older, which simplifies things for many taxpayers. Commenters to the proposed regulations highlighted difficulties expected with compiling the data required for accident years that are not separately reported on the National Association of Insurance Commissioners (“NAIC”) annual statement.
The final regulations also require companies to discount unpaid losses independently of their estimated salvage recoverable. Although the factors are the same for both, the change in discounting unpaid losses for the 2017 re-measurement is recognized ratably over an 8-year period, where the change in discounting salvage recoverable is recognized differently. Taxpayers will recognize the entire change for discounting the 2017 salvage recoverable in year one if favorable; otherwise, the change would be recognized over a 4-year period, which is consistent with general method change procedures under IRC section 481(a).
Rev. Proc. 2019-30 also eases the administrative burden for taxpayers by treating the change as an automatic method change, waiving the requirement to get formal IRS approval or the need to file Form 3115, Application for Change in Method of Accounting.
Due to the timing when the final regulations and the revenue procedures were published, certain relief is provided for taxpayers who have already filed their 2018 tax returns. Taxpayers with a tax year ending before June 17, 2019 have options for how to account for the changes, as long as the taxpayer used the proposed factors and is consistent for both the 2018 discounting and the re-measurement of 2017, for all lines and accident years. These options are as follows:
- File an amended tax return for 2018 to reflect the final discount factors and related transition adjustment;
- File a 2018 tax return using the proposed factors for 2018 and 2017, adjusting for the difference between factors prospectively, starting with the 2019 tax return. The difference between the proposed and final factors associated with the revaluation of 2017 and prior reserves will be amortized over the remaining 7 years, starting in 2019. The difference between the proposed and final factors associated with the 2018 reserves can be recognized in full in the 2019 tax year; or
- The same as option 2, but instead the taxpayer could choose to amortize the difference between proposed and final factors for the 2018 reserves ratably over the remaining 7 year spread, starting in 2019.
Ultimately, the final regulations and subsequent revenue procedures should come as good news for most taxpayers as the revisions are mostly favorable. This is an example where the process for implementing new regulations actually worked as intended, where the IRS asked and listened to industry feedback when finalizing these regulations. In addition, Rev. Proc. 2019-31 also provides the discount factors for the 2019 accident year, which historically has not been available so early in the tax year.
 Sections 832, 846; 1.832-4 and 1.846-1