An unexpected issue faced by property & casualty insurers during the COVID-19 pandemic has been premium refunds to policyholders – especially on personal auto policies.
The refunds and rebates are justified by substantial reductions in auto claims and losses because of less driving as people have sheltered at home and as stores and restaurants have remained closed or with restricted operations.
Beginning in late March, shortly after stay-at-home orders were widely imposed nationwide, many insurers began voluntarily paying partial premium refunds to personal auto policyholders. In addition, some state insurance commissioners have mandated auto premium refunds because of the reduction in miles driven: California was the first state to require premium refunds not just for personal auto but also for other lines of business, by order of the insurance commissioner on April 13. New Jersey recently followed suit. Aside from mandates, a number of states have encouraged insurers to consider granting premium refunds. In addition, where permitted, some companies have begun offering discounts on renewal premiums to reflect the current better-than-expected loss experience, instead of or in addition to refunds on current policies.
Actuarial Considerations for Premium Refunds
Theoretically, the amount of premium returned to policyholders should be commensurate with the expected reduction in costs to the insurer, as insurance rates should provide for all costs associated with the transfer of risk. In practice, this amount can be difficult to quantify without relevant prior data from which to make inferences. It can also be difficult because there are several components of the overall change in cost that insurers need to consider.
Most importantly, insurers need to estimate the decrease in claim frequency. For personal auto, because claims are reported quickly, insurers would likely have seen meaningful changes in the number of reported claims early as stay-at-home mandates were issued.1 This impact would be more difficult to estimate in other lines of business where claims may take longer to report from the initial date of the accident and where the change in exposure is difficult to quantify.
While the number of claims reported to insurers lowers the expected costs of providing coverage, several factors offset this reduction. First, insurers need to estimate the expected change to the average cost per claim. For personal auto, the average cost per claim could potentially increase if cars are driving faster on average due to reduced traffic, resulting in more severe accidents. Second, insurers need to quantify changes in their expenses. Costs to support employees working in a remote environment may have been unanticipated in insurers’ rates. Finally, insurers need to quantify changes to their anticipated investment income due to recent economic events, because anticipated investment income is considered by actuaries when setting rates.
The amount and timing of premium refunds may also become more complicated for insurers from an implementation perspective going forward. Some insurers have implemented premium refunds or renewal discounts on a countrywide basis, adhering to state-specific requirements as needed. In the future, however, insurance companies may need to monitor states individually—or otherwise consider the risk presented by diverse policyholders— when deciding if and when additional premium refunds or discounts may be warranted given the diversity in decision-making of state and local municipalities with regards to reopening.
Federal Income Tax Treatment of Premium Refunds
Tax treatment from the insurance company’s perspective
Rebates and refunds of auto policy premiums are treated as “return premiums” under section 832(b)(4)(A) of the Internal Revenue Code. That means they are simply deducted from gross premium income in computing a company’s underwriting income for tax purposes. Thus, premium rebates and refunds operate to reduce taxable income in the year the rebate or refund is paid to the policyholder – in other words, a good tax result from the insurance company’s perspective.2
IRS regulations state that “return premiums” for tax purposes “include amounts which were previously paid [by the policyholder] and become refundable due to … decreases in risk exposure during the effective period of an insurance contract.” The decrease in auto insurance “risk exposure” is exactly what has happened during COVID 19, as insureds drive less and have fewer accidents. Thus, these auto premium rebates and refunds qualify as “return premiums” under the IRS definition, and the result is to reduce an insurance company’s taxable income. (The same result would obtain if the rebates and refunds were treated as deductible policyholder dividends).
Tax treatment from the personal lines policyholder’s perspective
Premium rebates and refunds on personal auto policies are not taxable income to the policyholder. Consumer rebates and refunds are generally treated as a reduction in the purchase price of the goods or services involved. Thus, a premium rebate check received by an individual policyholder is not taxable income, any more than the individual would have $100 taxable income if he or she paid a sale price of $300 rather than the list price of $400 for some consumer good.
That favorable tax treatment holds true as long as the personal auto premium was not deducted in the first place by the policyholder. For personal auto and home insurance, that will almost always be the case because the premiums represent non-deductible personal expenses. However, if the policyholder, for whatever reason, deducted the premium as a business expense in the first place, then the policyholder would have to treat the rebate as taxable income in order to avoid gaining a double tax benefit. However, that would be a rare situation for typical personal home and auto insurance.3 In general, insurance companies will not be required to issue Form 1099 to their policyholders reporting the rebate as taxable income.
Tax treatment from the commercial lines policyholder’s perspective
Premium refunds for commercial policies have been offered by multiple carriers, although the frequency and size of refunds has been less than for personal lines. Many large trucking enterprises self-insure their commercial auto exposure, and mid-range enterprises often purchase policies where premium is adjusted at the end of the policy period based on number of vehicles and miles driven. And premiums paid by commercial entities would typically have been deducted from taxable income.
Hence whether labeled as stemming from the coronavirus or as a previously agreed-upon adjustment based on miles driven, premium refunds for commercial policies would typically be additions to taxable income. However, for many struggling businesses, this addition to taxable income may be moot if they are unable to survive the pandemic.
The initial California bulletin mandating premium refunds covered decreased exposure in March and April. California has since issued a subsequent bulletin extending its mandate to May. Perhaps sensing uncertainty, New Jersey set certain deadlines in its bulletin but left the coverage period for refunds undefined.
As we write, a mixture of stay-at-home orders remains in place across states and counties. Even without these orders, health concerns will keep many at home for an extended period. Should a prolonged first wave or later second wave result in the extension of government orders, premium refunds or discounts will likely continue.
As insurers weigh premium refunds against reduced renewal premium (or perhaps consider both), both actuarial and tax considerations will be at hand. Estimating the impact of a second wave may prove just as uncertain as under the first. While little can be done to reduce uncertainty, actuarial and tax considerations will guide appropriate treatment of any premium adjustments.
1 The decrease in personal auto claim frequency to insurers may not be as great as for personal autos overall. Some states have ordered auto insurers to cover claims occurring while using a personal vehicle to deliver food. Use of a personal vehicle for commercial purposes such as this would typically be excluded from coverage under a personal auto policy. Hence the overall decline in personal auto accidents would be offset by additional coverage provided.
2 However, given the expected reduction in losses, the overall taxable income may not be less in the current environment.
3 One situation in which individuals might try to deduct personal auto premiums as a business expense, and thus might need to treat premium refunds as taxable income, is if they use their car for ride-sharing, food delivery or other commercial activity. Many personal auto policies exclude commercial ride-sharing and food delivery from coverage, but some states are challenging that exclusion during COVID-19.