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

44 Pages Posted: 12 Sep 2000

See all articles by Scott E. Harrington

Scott E. Harrington

University of Pennsylvania - Wharton School

Greg Niehaus

University of South Carolina - Darla Moore School of Business

Date Written: July 2000

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.

Suggested Citation

Harrington, Scott E. and Niehaus, Greg, On the Tax Costs of Equity Finance: The Case of Catastrophe Insurance (July 2000). Available at SSRN: https://ssrn.com/abstract=241843 or http://dx.doi.org/10.2139/ssrn.241843

Scott E. Harrington (Contact Author)

University of Pennsylvania - Wharton School ( email )

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Greg Niehaus

University of South Carolina - Darla Moore School of Business ( email )

College of Business Administration
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Columbia, SC 29208
United States
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803-777-6876 (Fax)

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