On the Tax Costs of Equity Finance: The Case of Catastrophe Insurance

Abstract

We provide estimates of the tax costs of equity financing and the resulting effects on the prices of catastrophe insurance/reinsurance arrangements using a partial equilibrium model of insurance pricing and capitalization that incorporates specific loss distributions for nationwide catastrophe losses. After consideration of insurer investment in tax-exempt securities, the effect of loss carry-back/forward provisions on expected marginal tax rates, and personal taxes, our results imply that the tax costs of equity finance have a substantial effect on catastrophe insurance/reinsurance prices. The estimated tax costs generally exceed 100% of the present value of expected claim costs for high "layers" of catastrophe coverage, thus suggesting that U.S. corporate taxation plays a significant role in explaining both the limited scope of catastrophe insurance/reinsurance and the institutional responses that reduce tax costs. In particular, our results help explain growth in catastrophe reinsurance for U.S. risks with offshore (foreign) reinsurers in tax-favored jurisdictions and, at least in part, the innovation of catastrophe bonds, which reduce tax costs associated with equity financing while avoiding some of the expected costs of financial distress that accompany non-contingent subordinated debt financing.