Two men enter, one man leaves

October 04, 2012 at 08:00 PM

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It is ironic that 2013 marks the 100th anniversary of the income tax, because insurance industry officials are making it clear that it will be a critical one for the insurance industry.

That means that the election November 6 for the presidency, the entire House and one-third of the Senate could perhaps impact the attractiveness of the tax-advantaged products that are the lynch pin of the insurance industry for, perhaps, another century.

"In an ironic twist of historical symmetry, in 2013 the National Association of Insurance and Financial Advisors (NAIFA) will be fighting again to protect our products from a very polemically charged Washington, looking to pay down its debt," said Robert Miller, outgoing president at the trade group's annual meeting in Las Vegas last month. "And it's a big one."

Miller noted that in 1913, NAIFA's predecessor association, the National Association of Life Underwriters, helped to carve out the tax benefits of life insurance products during the Woodrow Wilson administration. Those tax advantages are now at serious risk, Miller said.

"No matter which party members in this room belong to, there is one bandwagon you better get on today: the insurance party," Miller said. "We are one signature from extinction—just one."

The tax advantages Miller warned about were those that apply to a number of life insurance products and features, including inside buildup of value, corporate-owned life insurance, bank-owned life insurance, the estate tax, general federal tax rates, non-qualified deferred compensation plans and the dividend-received deductions on variable annuity contracts. All of these enjoy some kind of preferential tax treatment…for now. That could all change as the country heads toward a so-called "fiscal cliff" in January 2013, when the terms of the Budget Control Act of 2011 would kick in. This would include the expiration of Bush-era tax breaks, a larger overall tax burden for many, and deep, automatic government spending cuts in both defense and Medicare. Based on the Obama administration's proposed 2013 budget, other provisions on the table include generation-skipping transfer taxes and grantor-retained annuity trusts.

In comments at a financial and investment roundtable in March, American Council of Life Insurers President and CEO Dirk Kempthorne added that regardless of who wins the presidential election and which party controls the House and Senate, tax expenditures would resurface in 2013 in connection with tax reform. Almost everything will be on the table, he said.

"It will be up to the industry to show that the current tax treatment of life insurance and retirement savings products that has been in place for the last 100 years should remain intact for another 100 years, " Kempthorne said. "We must show Congress and the administration that tampering with our companies and our products is not just bad public policy, but undermines efforts to help people maintain their financial security, dignity and independence throughout their entire lives."

In an interview with National Underwriter, Chris Morton, vice president, legislative affairs for the Association of Advanced Life Underwriters (AALU) said much the same as Kempthorne, noting that regardless of who won the White House in November, threats to the tax treatment of life insurance would persist. On both sides of the aisle, he said, there is a push to lower tax rates and broaden the tax base to simplify the tax code in a way that many feel will stimulate economic growth and provide certainty. "These are goals that everyone shares," Morton said.

To pay for the lowering of rates, Morton explains, politicians on both sides advocate dipping into "the so-called bucket of tax expenditures." This puts the inside build-up/cash value of life insurance policies on what the government considers to be a short list of lost revenue opportunities. The AALU, however, feels that life insurance should not be considered a tax expenditure since such products are purchased with after-tax dollars.

Morton explained that from a tax policy perspective, a tax is not imposed until there is cash to pay the tax. Just as the government would not impose a tax on the appreciation of one's home or stock, any gain that comes from the surrender or sale of a life insurance policy should be taxed at ordinary income, and not at a preferential rate.

Underlying the concern, NAIFA has already scheduled a lobbying conference for April 2013, out of concern that Congress will be getting an early start on tax and expenditure reform.

The total impact of the so-called "fiscal cliff" was delayed for six months when the Senate, on September 22 passed legislation that extended the current budget for the 2013 fiscal year for six months.

However, the so-called "extender" only dealt with discretionary federal appropriations and $1.2 trillion in automatic spending cuts over 10 years are still due to take effect on January 1.

This would impact both entitlement and defense spending, and would likely result in a cut of government expenditures and tax hikes totaling $600 billion in 2013.

A key Republican senator has been quoted as saying that if President Obama is re-elected Republicans would have to bend to give him some tax increases in order to fend off a huge cut in defense spending. As of late September, Obama maintained as much as a seven-point lead over his opponent, Massachusetts Governor Mitt Romney.

"We might as well cut a deal," Sen. James DeMint, R-SC. said of an Obama win. "If Republicans want to maintain the defense, we're going to have to give tax increases to Obama."

"When Jim DeMint is suddenly open to revenues, you know the tide is turning," a grinning Sen. Charles Schumer, D-N.Y., responded.

The thinking is also that if Romney wins, Republicans will offer Obama a deal whereby severe cuts in Medicare and other entitlement programs will be averted in exchange for a one-year, across-the-board extension of the Bush tax cuts.

That gives Congress some breathing room to forestall the deep cuts in expenditures for the 2013 fiscal year mandated by the legislation that some feared would throw the country immediately into a deep recession.

However, the Bush tax cuts, the so-called Economic Growth and Tax Relief Reconciliation Act of 2001 (EGGTRA), expires December 31. If Congress fails to act, the tax rates in effect at the beginning of 2001 take effect. That, combined with fixing the the Alternative Minimum Tax (AMT), and dealing with tax extenders, amounts to about a $4 trillion tax increase.

By year-end, Congress will also have to decide whether to extend federal, supplemental unemployment benefits, and the current two-point cut in employees' share of Social Security taxes.

Additionally, doctors who treat Medicare patients will take almost a 30 percent cut in the rate by which Medicare reimburses them if Congress doesn't enact the so-called doc fix. Add another $1 trillion to the total from these issues.

And, the estate tax returns to a $1 million personal exemption and a 55 percent top tax rate.

Almost 15 million U.S. households (12.5 percent) would have a potential tax liability if Congress fails to act and the estate tax law reverts back to $1 million and 55 percent maximum tax, according to a study recently released by LIMRA, LOMA and LL Global.

"The uncertainty that has surrounded our estate tax laws has made it impossible for Americans to plan for a reasonable transition of their assets to the ones they love and to charity for the greater good," according to Robert Kerzner, president and CEO of LIMRA, LOMA and LL Global. "Today, there are three likely possibilities that Congress could adopt—if they address this issue before the end of the year—which would impact many American families and businesses."

Approaching the fiscal cliff

As Danea Kehoe, an outside counsel with DBK Consulting in Washington, D.C. noted at the recent NAIFA meeting, some of this could be positive. A higher tax rate on income, for example, could make the inside build-up of life insurance and annuities look more attractive. But the impact on estate tax rates, and higher tax rates on mutual funds and other financial investment options remain serious negatives.

EGTRRA made significant changes in several areas of the tax code, including income tax rates, estate and gift tax exclusions, the capital gains tax, and qualified and retirement plan rules. In general, the act lowered tax rates and simplified retirement and qualified plan rules such as for individual retirement accounts, 401(k) plans, 403(b) plans and pension plans.

The pension plan changes were made permanent in the 2006 Pension Modernization Act, and the law was extended for two years in December 2010. In that extension, estate tax provisions were extended and enlarged.

Under the legislation, the 39.6 percent bracket was gradually lowered to 35 percent by 2006 and the capital gains tax reduced from 20 percent to 15 percent.

The bill phased out the estate tax for 2010 after gradually lowering it to a per-person $3.5 million exemption and a 45 percent maximum tax rate for 2009.

Under the extension, which expires December 31, the per-person exemption is $5 million and the maximum tax rate is 35 percent. It also amended the 2001 law by providing "portability"—eliminating the complex estate planning documentation necessary to ensure that beneficiaries of estate get the benefits of a couple's exemption. (Under the current policy, an executor of a deceased spouse's estate is able to transfer any unused exemption to the surviving spouse without such planning.) It also restored the reunification of estate and gift taxes eliminated under the 2001 bill.

Prior to EGTRRA, the estate and gift taxes were unified, creating a single graduated rate schedule for both. That single lifetime exemption could be used for gifts and/or bequests. The EGTRRA decoupled these systems. The 2010 extension reunified the estate and gift taxes for 2011 and 2012 and indexed it for inflation effective in 2012.

It is entirely possible, given that the deadline for the "fiscal cliff" crisis has already been kicked to March 27, 2013, that Congress will punt and extend EGGTRA as is for perhaps one or two years while comprehensive tax reform is worked out in the incoming Congress.

Work has already started on that issue. The Senate Finance Committee and the House Ways and Means Committee, the key tax-writing panels in Congress, have already held joint hearings on important tax issues.

Analysts at Washington Analysis in Washington, D.C., which advises institutional investors and hedge funds, note that Congress will need to extend the current debt limit in the first quarter of 2013, if not sooner.

Washington Analysis analysts say that a GOP sweep means a near crisis like last year's debate on the debt issue is much less probable. "If Obama wins, however, we would expect two to four debt limit fights in 2013 that could end up looking a lot like the fight in August 2011," the analysts said.

What if Obama Wins?

What if Romney Wins?

Given that recent polls indicate that the previously predicted Republican sweep of Congress is much less likely, and that Democrats in the House could narrow the current 25-seat Republican majority in the House, an extension of the status quo ante for one or two years while Congress works on a bipartisan solution to the burgeoning debt issue is growing more likely.

As for the candidates, President Obama has proposed raising the tax on long-term capital gains from 15 percent to 20 percent. He would maintain the current rates of 0 percent and 15 percent on qualified dividends and long-term capital gain for couples earning less than $250,000.

He would maintain the 3.8 percent Medicare tax on long-term capital gains that is scheduled to take effect in 2013.

Romney proposes maintaining the 0 percent and 15 percent rates on qualified dividend and long-term capital gains. He would eliminate taxes on capital gains, dividend and interest for taxpayers with adjusted gross income below $200,000. Romney would eliminate the 3.8 percent Medicare tax on capital gains.

On income taxes, Obama proposes that couples earning more than $250,000 a year would see their rate move back to 39.6 percent after the expiration this December 31 of the Bush-era tax cuts that lowered it to 35 percent.

Romney calls for setting the highest tax rate at 25 percent and the lowest at 8 percent, down two percentage points from the current level. The plan proposed by vice presidential candidate Paul Ryan proposes a simpler plan. He calls for creating two tax rates, 10 percent and 25 percent, to replace the six that currently exist.

On tax preferences, Republicans would pay for lowering ordinary tax rates by eliminating certain deductions and credits. However, they have not said which of these would be targeted.

Democrats call for a cap of 28 percent on itemized deductions as well as on health insurance provided by employers, municipal interest, retirement plan contributions and student loan deductions and expenses for higher education.

On estate taxes, President Obama calls for raising the current estate and gift tax rates to 45 percent, with a $3.5 million per-person exemption, the 2009 level. Democrats on the House sought to hold up the December 2010 deal that was much sweeter than the 2009 levels, but, given that their ranks were decimated by the 2010 elections, finally decided to surrender and go home.

Under the Republican plan, the estate and gift taxes would be eliminated.

The current corporate tax rate is 35 percent. Candidates for both parties advocate reducing it, although the details differ greatly.

Obama wants to trim the rate to 28 percent, while adding a minimum tax on profits. The president advocates a tax break for businesses that shift work to the U.S., while deductions for moving work out of the country would be scuttled. Obama also would seek higher taxes on oil and gas companies, while easing taxes on manufacturers.

Romney wants to lower that even further than does Obama, to 25 percent. Romney would also lower taxes on overseas profits.

Another key issue is the AMT, which has been problematic for Congress for many years. The AMT came into existence in 1969 because Congress wanted to ensure that wealthy taxpayers hand over a minimum sum of their total income to the government. But the formula used to determine it, which has changed over the years, now affects middle-class families because the amount was never adjusted for inflation.

Congress has acted many times to prevent it from eating into the income of middle-class wage earners. The problem is that by 2008, the AMT was yielding $26 billion in annual revenue, and Congress has been unable to come up with a politically-viable alternative source of funds.

Now, Obama proposes that households with earnings of $1 million or more to pay at least 30 percent of their income in taxes. Romney, on the other hand, has called for eliminating the AMT.

What about PPACA and Dodd-Frank?

As to health care, Romney reiterated in late September his plan to repeal the health care law. According to analysts at Washington Analysis, if Romney is elected, the Patient Protection and Affordable Care Act (PPACA) would be repealed; its design, taxes/fees, and insurance market reforms would be eliminated.

However, the analysts said, it would be unlikely for this to take place in a single legislative package since Republicans under no circumstances would have a filibuster-proof margin in the Senate.

The analysts say this would result in a "less heavy-handed regulatory environment, and any coverage expansion would encourage use of private insurers."

The medical loss ratio (MLR) law requiring at least 80 percent of every healthcare premium dollar to go to the costs of actual medical care would obviously be a casualty of any Romney election win. The MLR has been a particular sore point for insurance agents, who have established creating an exemption of agent commissions from the MLR as their top legislative priority.

Another likelihood is that PPACA's cutback of funding for the Medicare Advantage program would be "scaled back, if not reversed," according to Washington Analysis analysts.

If Obama wins, according to an investor's note prepared by Washington Analysis, there will still likely be efforts to water down some healthcare reform policies like the MLR or exchange plan requirements. "Congress would likely push for greater use of health savings accounts and catastrophic plans, purchase of insurance across state lines, creation of association health plans, and medical malpractice insurance reform," the analysts said.

The industry is also confronting a host of regulatory issues stemming from reforms enacted through the Dodd-Frank financial services reform law (or Dodd-Frank).

For example, the Dodd-Frank mandated filing of a report by the Department of Treasury on reforming and modernizing state insurance regulation was due in January, but still has not been filed.

When it will be filed, and which of its recommendations will be implemented depends on who is president.

A President Romney will likely move to dismantle the Dodd-Frank if elected, or, in the alternative, to move slowly, if at all, in promulgating the thousands of regulations sill needed to implement it.

These include regulation implementing the Volcker Rule, which limits private equity investments for their own accounts by financial institutions, as well as rules imposing strong regulation on trading of derivatives.

Whether a President Romney would move to repeal the provision of Dodd-Frank creating the Federal Insurance Office is unclear, but that is unlikely because of the key role the industry envisions for the agency in negotiating international trade agreements.

However, efforts are likely to be made to reduce data collection burdens on insurers imposed through creation of the Office of Financial Research (OFR).

At the recent NAIFA meeting, Scott Sinder, outside counsel to NAIFA and a partner at Steptoe and Johnson in Washington, said he expects the report to cover, among other things, "licensing reform."

He said NAIFA and most insurance industry officials support legislation that would recreate the National Association of Registered Agents and Brokers (NARAB) and true agent-licensing reciprocity across the country. NARAB would establish a voluntary federal licensure authority that would enable agents and brokers to get licensed from a Federal Licensure Authority rather than obtaining licenses separately by state. Being admitted as a NARAB member would automatically entitle one to be licensed in any other state.

Washington Analysis said in an investor's note that the Consumer Financial Protection Bureau (CFPB) "is likely to fade into the background for the next four years, issuing very few rules that are materially" if Romney is elected.

But, its impact on the insurance industry is limited because consumer protection on insurance products was reserved for the states under Dodd-Frank.

SIFI and the thrifts

At the same time, the FSOC is expected to designate at least three insurance companies as "systemically significant" by December through another provision of Dodd-Frank.

Whether these designations will be delayed through election of Romney as president is unclear.

However, if President Obama is re-elected, the FSOC is likely to proceed with designation of perhaps five non-banks, including at least three insurers, in December.

At the same time, insurance companies and trade groups—both property and casualty and life—are pulling out all the stops in an effort to thwart or delay the Federal Reserve Board's efforts to impose consolidated regulation of them through its new authority to oversee thrift holding companies.

For example, in a meeting with Federal Reserve Bank of Chicago officials recently, American Council of Life Insurance (ACLI) staffers asked the Fed not to impose new capital standards on thrift holding companies owned by insurers.

The ACLI argued, in comments at the meeting and in a statement submitted at a House hearing, that the Fed proposal inappropriately applies bank-centric standards and methodologies to insurance companies.

Comments on the proposal are due October 22, so it is unlikely that the Fed will likely issue final rules until sometime next year.

However, if the rules are promulgated as proposed, it would make the Fed the consolidated regulator of insurers with thrifts, establishing dual regulation of insurers.

Fighting a fiduciary standard

For agents, exemption from establishing of a uniform fiduciary standard for sale of investment products is a key priority.

NAIFA is also promoting designation of the Financial Industry Regulatory Authority a self-regulatory agency (SRO) for investment advisors, although there is opposition and a vote in the House Financial Services Committee has been postponed.

NAIFA testified in June that it preferred designation of FINRA as an SRO to other proposals, requiring investment advisors to pay the SEC a user fee to fund their exams or; establishing a new SRO for investment advisors.

Jill Hoffman, NAIFA's assistant vice president of federal government relations, said that "We believe that making FINRA the SRO is the best solution of all the options available," said Hoffman. "It will mean that you are subject to one master, and not multiple organizations examining you on an individual basis."

The agent industry was also successful in getting the Department of Labor (DOL) to withdraw and re-propose its fiduciary standard governing plan sponsors and service providers of 401(k)s and other self-directed retirement vehicles. But Hoffman cautioned that the issue remains a concern. This issue is likely to return if President Obama is re-elected.

"The DOL has already said that it intends, when it re-proposes the rule, to include individual retirement accounts," said Hoffman. "We don't believe they have any jurisdiction over IRAs".

NAIFA is also concerned about whether agents subject to the re-proposed standard and who receive a commission can still be a fiduciary under ERISA law. A separate issue is whether the DOL's standard potentially conflicts with that of the SEC.

As to the latter, NAIFA Vice President of Securities and State Government Relations Gary Sanders said the SEC's work towards releasing a harmonized fiduciary standard for broker-dealers and investment advisors has been "put on hold," in part because of concerns raised by NAIFA about a uniform standard.

He noted that NAIFA successfully advocated for safe harbors in the Dodd Frank Act for commission compensation and the sale of a limited basket of products.

A second NAIFA concern, he said, has also gained traction with the SEC: that a uniform fiduciary standard would negatively affect mid-market investors unable to afford the services of fee-based advisors subject to the higher standard.

Currently, supporters of a uniform fiduciary standard have initiated another effort to secure a uniform fiduciary standard regulation from the SEC, but acknowledged that the agency has put it on the back-burner.

SEC chairman Mary Schapiro is expected to step down even if President Obama is re-elected, so the future of this proposal remains unclear.

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