Bermuda’s Re/Insurance Model to Be Tested Following U.S. Tax Reforms: Fitch

February 5, 2018 by

The Bermuda re/insurance model will be tested following U.S. tax reforms and the continuing challenges of competitive market conditions, according to a report by Fitch Ratings.

The cut in the U.S. corporate tax rate to 21 percent from 35 percent, along with the new base erosion and anti-abuse tax (BEAT), will “significantly reduce the long-standing Bermuda tax advantage over the U.S.,” said the report, “Bermuda 2018 Market Update – U.S. Tax Reforms Cut into Bermuda’s Advantage as Market Remains Competitive.”

“U.S. tax reforms will shrink the profitability gap between Bermuda and U.S. companies that has already been narrowing over the last several years as competitive market conditions have reduced Bermuda’s historical ROAE [return on average equity] advantage,” said the report.

The report emphasized, however, that the overall benefit of Bermuda as a domicile will likely endure, although at a decreased level. Fitch has not planned any immediate rating actions in response to the U.S. tax changes.

BEAT to Alter Ceded Strategy

One major aspect of the tax changes — BEAT — will affect the tax benefit that Bermuda re/insurers have previously derived from quota share treaties when U.S. business is transferred to Bermuda and other offshore affiliates through intercompany reinsurance, Fitch said. Companies traditionally paid a U.S. excise tax of 4 percent on direct premiums and 1 percent on reinsurance premiums.

“Following various unsuccessful attempts in the U.S. Congress since 2000 to discourage these offshore reinsurance transactions by limiting the deductibility of reinsurance premiums paid by insurers to their foreign affiliates, the recent tax reforms included meaningful changes in the related excise tax,” Fitch said.

“The added BEAT increases the excise tax on a step-up basis to 5 percent in 2018, 10 percent in 2019 and 12.5 percent in 2026 and substantially reduces the economic incentive to internally cede business from the U.S. to Bermuda.”

Fitch said most of these reinsurance arrangements will be eliminated or significantly altered, with Bermuda re/insurers “retaining more business and capital in their U.S. subsidiaries, taxed at U.S. rates.” This shift in capital to the U.S. will also reduce Bermuda re/insurers’ dividend flexibility.

Hedge Fund Re/Insurers Receive Clarity

In the new tax law, the U.S. government was addressing concerns that hedge funds had set up re/insurance companies primarily to avoid taxes by getting an exemption from passive foreign investment (PFIC) rules, Fitch indicated. “The new tax law amends the PFIC exception for qualifying insurance companies by adding a ‘bright-line’ test that should help to remove uncertainty and add needed clarity to the industry.”

Fitch noted that the test may force some hedge fund reinsurers to make strategic changes to avoid being deemed a PFIC, which would have adverse tax implications for their U.S. shareholders.

“The new test requires applicable insurance liabilities — excluding unearned premium reserves — to constitute more than 25 percent of assets to be considered a legitimate insurance company,” Fitch said.

There also is an alternative, qualitative test for some established, traditional short-tail re/insurers that might not pass the bright-line test. If these companies can show they are predominantly engaged in insurance, they can still qualify as insurance entities, “provided insurance liabilities make up at least 10 percent of assets,” the report said.

Pricing Short-Lived

Fitch predicted that improved pricing would be short-lived given the abundance of alternative capital that competes directly with traditional capital. It remains to be seen, said Fitch, whether additional rate increases will be attained during the mid-year renewals.