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Bush Tax Plan Will Impact P-C Insurers

By Robert P. Hartwig

Last month, President George W. Bush unveiled an ambitious economic plan to resuscitate the ailing American economy. The plan calls for a staggering $674 billion in tax cuts for individual taxpayers, small businesses and investors.

The signature feature of the plan is a proposal to eliminate the so-called “double taxation” of dividends, which is expected to save investors $364 billion over the next 10 years. The administration hopes the elimination of the dividend tax, combined with an acceleration in tax cuts now slated for 2004-to-2006, will boost spending, increase corporate profits, stimulate economic growth and give stocks a much needed lift.

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

Nevertheless, the potential economic impact of the plans essential elements on the property-casualty insurance industry are significant, and include implications for investment performance and investment strategy, exposure growth and pricing.

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

It is important to keep in mind that none of the Bush plans proposals affect insurers directly. There are no tax breaks for big corporations and no special provisions designed to help insurers or financial services firms. The immediate impact on p-c insurers will come primarily through incentive effects associated with the purchase and issuance of dividend-paying stocks over other securities.

In the intermediate term, a successful stimulus plan will spur economic growth, leading to increased business investment and employment, as well as growth opportunities for insurers. Longer term, and potentially more serious, is the effect of a rising federal deficit on interest rates. Most economists agree that soaring government spending, despite the Bush administrations assertions to the contrary, lead to higher interest rates.

The dividend profile of the p-c industry is not attractive (see accompanying chart). Of the 95 publicly traded p-c and multiline insurers tracked by SNL Securities, only 52 (55 percent) pay a dividend, while 43 companies pay no dividend at all. In contrast, 71.9 percent of S&P 500 companies paid dividends at the end of 2002.

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

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

The large difference between the simple average dividend yield and the median and market capitalization weighted yields is attributable to the fact that the most generous payouts are by small companies, while several of the largest p-c and multiline companies pay little or no dividend.

In fact, nearly 75 percent of the industrys market cap is represented by companies that pay a dividend yield of less than 1 percent. Only 24 percent of the industrys market capitalization is represented by insurers with dividends exceeding the S&P 500.

The Bush proposal to eliminate the dividend tax clearly favors stocks that pay dividends. All else equal, investors will pay more for a stock with a higher dividend yield. The upshot for p-c insurers is that dividend yields will have to be competitive to attract and retain equity capital should the elimination of the dividend tax become a reality.

Cash-rich insurers that pay little or no dividend may find it necessary 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 Bush plan became public.

Elimination of the dividend tax makes stocks relatively more attractive than other securities such as bonds, cash and real estate. As of year-end 2001, insurers held 66 percent of their invested assets in the form of bonds, but just 17 percent in the form of stock, suggesting that elimination of the tax will provide only a modest boost to return on investment.

In terms of dollars, elimination of the dividend tax could lower insurer tax bills by $800 million based on current dividend yields, tax rates and stock holdings. While this sum is considerable, the net impact on the industrys estimated 2002 return on equity is just 0.4 points (see accompanying chart).

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

The combined impact of higher dividend yields and elimination of the dividend tax would add about $1.5 billion to the industrys 2002 estimated net income and raise ROE by 0.7 points. Assuming dividend yields rise to 2.75 percent, the industrys ROE increases by 0.9 points to 5.3 percent–nearly one full percentage point above the 4.4 percent ROE estimated for 2002.

For insurers to realize still greater benefits from the elimination of the dividend tax would require reallocating a greater proportion of invested assets in stocks while investing less in bonds. This strategy is fraught with risk, however. Stocks remain in the grip of a prolonged bear market, so even a modest drop in equity prices could swamp any benefits from higher dividend yields and lower taxes.

The biggest single criticism of the Bush stimulus package is its heavy reliance on deficit spending. Under the proposal, as of estimates on Jan. 27, the federal deficit will soar from $159 billion recorded in fiscal year 2002 to an estimated $220 billion or more this year. (As recently as 2001, the government ran a surplus of $127 billion.)

The $350 billion net swing from surplus to deficit means that the government will siphon hundreds of billions of dollars annually from credit markets. Despite the Bush administrations assertions to the contrary, most economists believe that deficit spending, all else 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 and are replaced by higher-yielding securities, leading to higher investment income.

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

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

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

On the other hand, elimination of the dividend tax could provide a modest boost to investment returns, as long as those gains are not offset by plunging bond prices associated with higher interest rates from the soaring federal budget deficit.

Robert Hartwig, Ph.D., CPCU, is senior vice president and chief economist at the Insurance Information Institute in New York. He can be reached at bobh@iii.org.

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