The Bermuda insurance/reinsurance model will be tested following U.S. tax forms 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 titled “Bermuda 2018 Market Update – U.S. Tax Reforms Cut into Bermuda’s Advantage as Market Remains Competitive.” (The Fitch report can be downloaded from its website.)

“The U.S. tax reforms will shrink the profitability gap between Bermda 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. As a result, Fitch plans no immediate rating actions in response to the U.S. tax changes.

Base Erosion and Anti-Abuse Tax (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, said Fitch, noting that 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,” said Fitch.

“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.

As a result, the ratings agency 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 Insurers, Reinsurers Receive Clarity

In the new tax law, the U.S. government was addressing concerns that hedge funds had set up insurance and reinsurance companies primarily to avoid taxes by getting an exemption from passive foreign investment (PFIC) rules, indicated Fitch.

“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,” said the report.

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 explained.

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

Market Remains Competitive

Fitch also pointed to the ongoing competitive market as another challenge affecting Bermuda – and of course last year’s record catastrophes, which totaled a record $135 billion.

“Large re/insurers with operations in Bermuda will report an underwriting loss for full-year 2017,” said Fitch. “The 2017 GAAP combined raio for the group of 10 re/insurers Fitch actively follows will approximate 108 percent-109 percent, with catastrophe losses adding over 20 points to the combined ratio.” This is a deterioration from 91.8 percent in 2016, which included 5.3 points from catastrophes.

Pricing Finally Bottomed

While reinsurance pricing finally bottomed out and turned slightly upward following last year’s catastrophe events, Fitch said, the increases “were not as sizable or as widespread as many market participants had anticipated” after such record-breaking losses.

“The only areas that experienced significant rate increases were non-marine retrocession, with rates up 10 percent-30 percent for catastrophe loss bit business and up to 15 percent for loss-free accounts, and the Caribbean with 20 percent-40 percent increases on catastrophe loss hit accounts and up to 20 percent on loss free programs.”

During the January 2018 renewals, U.S. property rates were up 5 percent to 10 percent for loss-affected accounts and flat to up to 7.5 percent for loss-free business, Fitch said. At the same time, European property catastrophe loss-free premiums were flat to up to 5 percent.

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.

“The June 2018 reinsurance renewals will be particularly telling as they primarily relate to Florida property catastrophe risk, which was significantly affected by Hurricane Irma,” added the report. However, the absence of an even costlier event, such as a direct hurricane landfall in Miami, “might serve to temper Florida property reinsurance rate increases.”

*This story ran previously in our sister publication Insurance Journal