Revenue Offset Understanding

Owarnock

Is the following the correct understanding of revenue offset? Sorry if this seems redundant but it helps to put it in my own words and write out how I think about it.

Acquisition costs are not deferred and instead are incurred at the onset of the policy, which in the text example is a $20 loss. Since this is a loss, typically a company could claim a tax credit on the loss. Instead what is done is 20% of UEP is moved to Earned Premium and that 20% is not taxed. So while the loss itself doesn’t receive a tax credit, this is made up for in moving 20% of UEP directly to EP untaxed.

Is this correct?

graham

I'm not sure what you wrote is exactly right.

The way I understand it is that the revenue-offset is a substitute for deferring acquisition costs. The effect of the revenue-offset may not quite equal the effect of deferring acquisition costs but it's considered close enough. Deferring acquisition costs makes sense because it matches revenue and expenses. When they can't be deferred, revenue and expenses are no longer matched so the revenue-offset procedure tries to "correct" this mismatch.

• If the $20 acquisition cost could be deferred until the associated premium is earned then this $20 acquisition cost is "paid for" by the EP and since it's an expense, this corresponding $20 of EP isn't taxed. Nice and simple.
• The problem arises because the $20 acquisition cost cannot be deferred under SAP so the insurer has to "pay it" before they are allowed to recognize the associated EP. But because this $20 is an expense, they are entitled to reduce their taxable income by that amount and they end up getting a tax refund later. Then when the corresponding $20 of UEP is finally earned, that counts as income and the insurer has to pay taxes.
• So instead of the insurer first taking the $20 loss and then getting a tax refund for it later, the revenue-offset permits the insurer to move $20 of UEP to EP immediately. This increases (taxable) income by $20 but pays the acquisition costs so that revenue and losses are now matched.
• When the insurer pays taxes at the end of that year, they can reduce their taxable income by the acquisition costs of $20 to cancel out the increase in taxable income due to "recognizing" EP a little early. Everything works out as it should without the extra 2 steps of the insurer first taking a loss and then getting a refund later to compensate for taking a loss on something that should have counted as expense.

Owarnock

This helps a lot, thank you!

zporiri

Agreed, that was a very helpful explanation!

ychen612

I was able to follow everything up to the last bullet point as my head was stuck with the TBI formula presented in the wiki that equals to TBEP + InvInc - TBIL and wondering where the heck is reducing taxable income by acquisition costs comes into play here to offset the early recognition of it in EP.

Then I finally got my head around it that the above formula is just based on past exam problems and the real-life TBI calculation would also include the deduction of U/W expense, where acquisition costs belong to. So in the end, this increase in taxable income would be cancelled out.

Am I understanding this correctly now?

Staff - AC

Yes, correct.

arch1892

If insurers recognize acquisition cost immediately which reduces their taxable income, why would they get a tax refund only later?

Staff - AC

Tax refunds are not related to tax-based income calculation. Where do you find it said that they get a tax refund only later?