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How to Start a Trade War

Rep. Neal's terrible plan to tax offshore reinsurance companies.

3:30 PM, Jun 19, 2009 • By ELI LEHRER
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For much of the last decade, Massachusetts Democrat Richard Neal has banged away at proposals for vast tax increases on "offshore affiliated reinsurance"--coverage that insurance companies purchase from their own non-U.S. subsidiaries. As arcane as the issue sounds, the tax hike Neal wants could have vast negative consequences for the U.S. economy. If the proposal--introduced in the last Congress and likely to be reintroduced shortly--were to become law, it would create chaos in American insurance markets, stick consumers with over $10 billion in insurance rate hikes, create demand for massive new government property insurance programs, and start a trade war with the European Union.

Explaining how a narrowly targeted tax could have such major consequences requires some background on how reinsurance works. To begin with, all sizeable primary insurers--companies like State Farm and Allstate that sell products directly to consumers as well as companies like CNA and ACE that deal in commercial insurance--buy coverage of their own, reinsurance, to cover expenses after major catastrophes and diversify the types of risks they face. Reinsurance typically comes into play following expensive contingencies like hurricanes and billion-dollar liability payouts. Primary insurers almost always buy "affiliated" reinsurance, from a parent or sister company they can trust with information about their greatest liabilities and that won't abandon them after a major loss.

Most reinsurance comes from companies that have "domiciles" (official headquarters locations) outside of the United States. International transactions play a major role in making all types of insurance work as advertised: Insurance prices fall when insurers manage risks across a broader pool of similar risks unlikely to happen at the same time. International markets do this, for example, when they let insurers pool the risk of a cyclone hitting Indonesia with the risk of a hurricane in Florida. (The seasons are different so the events never happen simultaneously.)

Today, offshore companies pay federal excise taxes roughly equivalent to the corporate income tax, and although all reinsurers engage in strategies to minimize tax liabilities, nobody has a permanent tax advantage. Neal's proposal, a protectionist tariff for all intents and purposes, would give U.S.-domiciled companies a big upper hand by imposing an enormous, burdensome tax on supposedly excessive offshore affiliated reinsurance transactions. If it became law, hardly anybody would use offshore affiliated reinsurance. Although U.S.-based reinsurers would sell more reinsurance much reinsurance would simply vanish. Primary insurers would have to raise rates and reduce coverage in order to rebuild the financial cushion they now get from affiliated offshore reinsurance.

The Brattle Group, an economic research and consulting firm, has estimated that under Neal's proposal, insurers would have to raise premiums by an estimated $10 to $12 billion to replace the coverage they would lose. Total reinsurance capacity would also fall by about a fifth. The pain, however, would fall very heavily on certain industries and types of people: Brattle estimates that coastal homeowners, airlines, and businesses that need complex liability insurance would get hit the hardest.

Politics, however, could dictate a different outcome than Brattle's economic analysis. Rather than letting prices rise, many states--particularly those with high windstorm and earthquake risk--might try to prohibit primary insurers from passing higher costs to consumers and set up public programs to compete with the private market. That's what Florida did after brutal 2004 and 2005 hurricane seasons sent reinsurance costs soaring. Today, a fifth of Florida's home-owners depend on a state-run entity to cover their homes, and taxpayers are on the hook for at least $25 billion in unfunded insurance liabilities. Although companies would still write them--states rarely try to control commercial insurance prices--some types of commercial policies might well get so costly that businesses would come running to governments for help. And states would probably find little choice but to set up publicly backed insurance for everything from crop to medical malpractice coverage.