Tax Deductions for Catastrophic Risk Insurance Reserves: Explanation and Economic Analysis

Publication Date: September 2005

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Business

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Abstract:

In the wake of Hurricane Katrina that struck several states along the Gulf of Mexico on August 29, 2005, the attention of policymakers in Congress and elsewhere has turned to the subject of insurance for large catastrophic risks, including natural disasters such as hurricanes and earthquakes. The generally perceived increase in the incidence of major catastrophes and their increasingly costly nature has prompted some analysts to question whether the economy's market for catastrophe insurance is sufficient to meet the burdens of major catastrophes: does the market provide a sufficient amount of insurance against major catastrophes, or is there a shortage? And, to the extent that catastrophe insurance exists, are the insuring firms sufficiently capitalized so that widespread insolvencies would not occur? Some have suggested that federal action is advisable to make sure that insurance industry resources are adequate to ensure the availability and affordability of disaster insurance and payment of claims when disasters occur.

One widely-discussed proposal would change the tax treatment of catastrophic risk insurance by permitting insurance companies to establish tax-deductible reserve funds for catastrophes. A version of the proposal was developed by a working group of the National Association of Insurance Commissioners, and a similar plan was introduced as legislation in the 108th Congress (H.R. 4186; Representative Foley) and again in the 109th Congress (H.R. 2668). The proposals' supporters argue that they would enhance the ability of insurance firms to meet the requirements of major disasters without risking insolvency and would increase the availability of catastrophe insurance.

Economic analysis suggests that provision of a tax-deductible insurance reserve for catastrophes would constitute a preferential tax benefit in the form of a deferral or postponement of taxes: tax rules for most other types of activities permit the deduction of losses only when losses actually occur, not when reserves for losses are established. According to theory, tax benefits that favor one type of activity over another ordinarily hamper economic efficiency and reduce economic welfare by diverting resources from their most productive use. In some cases, however, markets may fail and government intervention through taxes or other policies may improve efficiency. The question economic analysis asks of the tax-deferred reserve deduction is thus whether market failures exist in the case of catastrophe insurance. While some economic analysts have identified a number of market failures that might reduce the volume of catastrophe insurance, others are skeptical.

This report will be updated as legislative developments occur.