Capital Structure, Solvency Regulation, and Federal Income Taxes for Property-Casualty Insurance Companies

The tax shields from debt financing reduce the cost of operations for firms with low cost of bankruptcy. State regulation prevents insurers from using long-term debt as statutory surplus, to ensure sufficient equity capital to meet policyholder obligations. Constraints on regulatory capital force policyholders to fund high tax costs on insurers and reduce the market forces that support solvency. Banks' risk-based capital (RBC) standards show how long-term subordinated debt can be used as secondary capital. Revisions in state regulation of capital structure may decrease premiums and give incentives to bondholders to monitor reserve adequacy. Moving to the banking RBC model benefits all parties: policyholders pay lower premiums, insurers have access to wider capital markets, and regulators gain market allies to ensure solvency.