Bush Tax Plan Will Impact P-C Insurers

By Robert P. Hartwig

Last month, President George W. Bush unveiled an ambitiouseconomic plan to resuscitate the ailing American economy. The plancalls for a staggering $674 billion in tax cuts for individualtaxpayers, small businesses and investors.

The signature feature of the plan is a proposal to eliminate theso-called “double taxation” of dividends, which is expected to saveinvestors $364 billion over the next 10 years. The administrationhopes the elimination of the dividend tax, combined with anacceleration in tax cuts now slated for 2004-to-2006, will boostspending, increase corporate profits, stimulate economic growth andgive stocks a much needed lift.

The political battle lines over the Bushplan are being drawn, and whatever plan ultimately emerges fromWashington is likely to differ substantively from theadministrations current proposal.

Nevertheless, the potential economic impact of the plansessential elements on the property-casualty insurance industry aresignificant, and include implications for investment performanceand investment strategy, exposure growth and pricing.

Moreover, because the p-c industrys dividend ratio is well belowthat of most other industries (1.25 percent, compared with 1.75percent for the S&P 500), the ability of publicly tradedinsurers to raise equity capital might be diminished–unlessdividend yields are increased.

It is important to keep in mind that none of the Bush plansproposals affect insurers directly. There are no tax breaks for bigcorporations and no special provisions designed to help insurers orfinancial services firms. The immediate impact on p-c insurers willcome primarily through incentive effects associated with thepurchase and issuance of dividend-paying stocks over othersecurities.

In the intermediate term, a successful stimulus plan will spureconomic growth, leading to increased business investment andemployment, as well as growth opportunities for insurers. Longerterm, and potentially more serious, is the effect of a risingfederal deficit on interest rates. Most economists agree thatsoaring government spending, despite the Bush administrationsassertions to the contrary, lead to higher interest rates.

The dividend profile of the p-c industry isnot attractive (see accompanying chart). Of the 95 publicly tradedp-c and multiline insurers tracked by SNL Securities, only 52 (55percent) pay a dividend, while 43 companies pay no dividend at all.In contrast, 71.9 percent of S&P 500 companies paid dividendsat the end of 2002.

Secondly, the average dividend yield for the 95 insurers in thissample is 1.25 percent–a full half-percentage-point below the 1.75percent yield for the S&P 500 group. Sixty-four (67 percent) ofthe 95 insurers pay a dividend lower than the S&P 500, while 31pay a higher dividend.

The median (middle) dividend for insurers is just 0.59 percent.Weighted by market capitalization, the industrys average dividendyield stands at 0.78 percent.

The large difference between the simple average dividend yieldand the median and market capitalization weighted yields isattributable to the fact that the most generous payouts are bysmall companies, while several of the largest p-c and multilinecompanies pay little or no dividend.

In fact, nearly 75 percent of the industrys market cap isrepresented by companies that pay a dividend yield of less than 1percent. Only 24 percent of the industrys market capitalization isrepresented by insurers with dividends exceeding the S&P500.

The Bush proposal to eliminate the dividend tax clearly favorsstocks that pay dividends. All else equal, investors will pay morefor a stock with a higher dividend yield. The upshot for p-cinsurers is that dividend yields will have to be competitive toattract and retain equity capital should the elimination of thedividend tax become a reality.

Cash-rich insurers that pay little or no dividend may find itnecessary or desirable to increase or declare a dividend.Microsoft, one of the most successful tech companies in the world,declared its first-ever dividend in January shortly after the Bushplan became public.

Elimination of the dividend tax makes stocks relatively moreattractive than other securities such as bonds, cash and realestate. As of year-end 2001, insurers held 66 percent of theirinvested assets in the form of bonds, but just 17 percent in theform of stock, suggesting that elimination of the tax will provideonly a modest boost to return on investment.

In terms of dollars, elimination of the dividend tax could lowerinsurer tax bills by $800 million based on current dividend yields,tax rates and stock holdings. While this sum is considerable, thenet impact on the industrys estimated 2002 return on equity is just0.4 points (see accompanying chart).

If corporations choose to boost dividend yields (or declaredividends for the first time), the impact on p-c insurer return onequity could be more significant. For example, if the dividendyield on the S&P 500 group of stocks (which is not dissimilarto the industrys portfolio) were to rise to 2.25 percent from itscurrent 1.75 percent, then dividend income would rise by anestimated $660 million–all of it tax free.

The combined impact of higher dividend yields and elimination ofthe dividend tax would add about $1.5 billion to the industrys 2002estimated net income and raise ROE by 0.7 points. Assuming dividendyields rise to 2.75 percent, the industrys ROE increases by 0.9points to 5.3 percent–nearly one full percentage point above the4.4 percent ROE estimated for 2002.

For insurers to realize still greater benefits from theelimination of the dividend tax would require reallocating agreater proportion of invested assets in stocks while investingless in bonds. This strategy is fraught with risk, however. Stocksremain in the grip of a prolonged bear market, so even a modestdrop in equity prices could swamp any benefits from higher dividendyields and lower taxes.

The biggest single criticism of the Bush stimulus package is itsheavy reliance on deficit spending. Under the proposal, as ofestimates on Jan. 27, the federal deficit willsoar from $159 billion recorded in fiscal year 2002 to an estimated$220 billion or more this year. (As recently as2001, the government ran a surplus of $127 billion.)

The $350 billion net swing from surplus to deficit means thatthe government will siphon hundreds of billions of dollars annuallyfrom credit markets. Despite the Bush administrations assertions tothe contrary, most economists believe that deficit spending, allelse equal, leads to higher interest rates.

Higher interest rates have two effects on insurer performance.Over time, investment yields rise as low yielding bonds mature andare replaced by higher-yielding securities, leading to higherinvestment income.

However, rising interest rates would also produce instantaneouscapital losses in the industrys bond portfolio. This occurs becausethe price of older, low yielding bonds currently held by insurerswould fall in value as higher yielding securities are sold by thegovernment to raise fresh cash.

Because the decrease in bond prices is instantaneous, while theboost in investment income is only gradual, the impact of higherinterest rates represents a net negative for the p-c industry bycrimping an insurers ability to realize capital gains in their bondportfolios. Even a modest increase in interest rates of half apercentage point or so can produce billions in capital losses.

The Bush economic stimulus plan will affect the insuranceindustry in numerous ways. If the plan passes Congress (a bigif–Senate Minority Leader Tom Daschle has proclaimed it to be “deadon arrival” in its current form) then the relatively low dividendyield of the p-c insurance industry might be viewed by investors asa negative.

On the other hand, elimination of the dividend tax could providea modest boost to investment returns, as long as those gains arenot offset by plunging bond prices associated with higher interestrates from the soaring federal budget deficit.

Robert Hartwig, Ph.D., CPCU, is senior vice president andchief economist at the Insurance Information Institute in New York.He can be reached at [email protected].

Reproduced from National Underwriter Edition, February 3, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.