Budget analysts are predicting that the federal debt will increase to 75% of U.S. gross domestic product (GDP) by September 30, 2012, up from 62% of GDP just two years earlier.

President Obama sent out a Valentine’s Day budget proposal that came with no chocolates but did call for $46 trillion in federal spending from 2012 to 2021. In the proposal, the administration recommends a measure that could reduce a company’s ability to benefit from inside buildup, or the increase in cash value within a life insurance policy, on corporate-owned life insurance (COLI) for anyone other than individuals who own at least 20% of the company.

The proposal also would replace the current system for deciding how much of an insurance company’s dividend income consists of company’s share income that can receive a “dividends received deduction” (DRD) and how much consists of non-deductible policyholders’ share income.

“The general account DRD, tax-exempt interest, and increases in certain policy cash values of a life insurance company would instead be subject to a fixed 15% proration,” Treasury Department officials say in a discussion of the administration’s revenue proposals.

Together, officials say, the COLI proposal, the DRD change and a proposed change in reporting requirements for large life contracts could bring in $14 billion over 10 years – enough to cut federal spending by 0.03%.

The administration also would like to make insurers that own banks or thrifts join with banks in paying a “financial crisis responsibility fee” equal to 0.075% of deposits or other specified liabilities.

The Obama administration has presented those ideas before, without success, and securities analysts greeted them with much-disclaimered yawns.

Jeffrey Schuman, an analyst in the New York office of Keefe, Bruyette & Woods Inc., billed his comment on the proposal, “It’s February; It Must Be DRD/COLI Time.”

Analysts at Credit Suisse Securities (USA) L.L.C., New York, also expressed skepticism about the idea of the proposal becoming law.

Some have suggested that taking on an industry that can mobilize tens of thousands of citizen lobbyists who are active in their communities and trained to sell may not be the smartest move a budgeter could make.

Insurance groups such as the Association for Advanced Life Underwriting, the American Council of Life Insurers, GAMA International, the National Association of Insurance and Financial Advisors and NAILBA have teamed up to issue a statement opposing the COLI and DRD proposals.

“With our economy still recovering from the recent crisis, public policy should encourage families and businesses to responsibly plan for their financial futures,” the groups said. “The administration’s budget proposal would have the opposite effect.”

TIME TO PONY UP

The Obama administration is saying the federal debt could rise to a mind-boggling $19 trillion in 2021, up from about $10 trillion today.

Howard Mills, a former New York insurance superintendent who is now director of the insurance industry group at Deloitte L.L.P., New York, said the insurance industry is on guard.

“The federal government is obviously looking for revenue,” Mills said.

Leon Huffman, the co-chair of the government affairs committee at the National Association of Independent Life Brokerage Agencies, Fairfax, Va., warned attendees at NAILBA’s annual meeting in November 2010 that a Republican majority in the House would not necessarily mean two years of bliss for the life insurance industry.

“We have been put on notice that our products will be on the table when there are discussions about raising revenue,” Huffman said.

The Credit Suisse analysts said a COLI proposal that made it into law could cut some large insurers’ earnings by more than 1%, and they estimated the DRD change could cause a hit greater than 5% for some insurers. Schuman said the DRD change might cut earnings at some large insurers he follows by an average of less than 10 cents per share.

Doug Meyer, a managing director in the Chicago office of Fitch Ratings, said the COLI and DRD proposals would be material negatives for the life insurance industry…if they happen at all, that is. “We can’t predict what the final bill will look like,” Meyer said.

Neil Strauss, a senior credit officer at Moody’s Investors Service, has called the Obama administration budget proposals “credit negative for U.S. life insurers” adding that the COLI and DRD provisions “come at a tough time for life insurers.”

Revenue and net income are improving at life insurers but still have not recovered to pre-financial crisis levels, Strauss said.

Strauss noted that the introduction of the proposal was likely just the first step in a protracted debate.

“The ultimate resolution could run the gamut of enactment with retroactive provisions, which would be the most credit negative for the industry, to no change in the tax laws and the status quo maintained, which would be credit neutral,” Strauss said.

IT COULDN’T GET WORSE,
COULD IT?

Despite all this, there are possibilities far more extreme than the Obama budget proposal that give insurance lobbyists’ nightmares.

Obama’s deficit panel–the National Commission on Fiscal Responsibility and Reform–ended up considering a final proposal that made no mention of life insurance, and the commission was unable to endorse any proposals at all. But, in the early days, the commission considered the Zero Plan, which could have involved repealing all federal income tax exemptions, deductions and credits, including the exemptions and deductions that encourage use of life insurance.

During the last Congress, Sens. Ron Wyden, D-Ore., and Judd Gregg, R-N.H., tried to round up support for a draft of the Bipartisan Tax Fairness and Simplification Act of 2010. In one section of the draft, Wyden and Gregg propose eliminating the exclusion for group term life insurance purchased for employees.

When insurers lobby to protect their tax advantages, “it seems self-serving,” Mills said. “Nobody wants their taxes to go up.”

But life insurance really is different from other products, because it can help protect families from disaster and, in some cases, keep those families from having to turn to government safety net programs for help, Mills said.

“There really is a public policy component here,” Mills said. “That message frequently gets lost.”

U.S. life insurers have made that case many times during the past century.

Around the turn of the last century, many states had responded to 1905 investigations of life insurers by imposing new taxes on life insurers, or increasing existing taxes.

In January 1908, New York Life Insurance Company, New York, took out an ad in the publication now known as National Underwriter to protest the “false theory of statesmanship” that had led “nearly every state in the United States” to “impose an income tax on life insurance alone and not on any other business–thus raising trust funds, penalizing prudence and thrift, and unjustly discriminating against property dedicated to a sacred cause.”

No one knows what the future holds for taxation of life insurance and life insurers in the United States, but it seems as if the prospect of a $19 trillion debt could provide much inspiration for federal tax policy innovation.