Chapter 21 Tax, Regulatory, and Accounting Factors Affecting Corporate Risk Management

Chapter 21 Tax, Regulatory, and Accounting Factors Affecting Corporate Risk Management I. Multiple Choice 1. A tax benefit: a. b. c. always accrues to the party who receives the tax deduction. sometimes accrues to a party other than the one who receives the tax deduction. will always increase the wealth of the shareholders of the firm receiving the tax benefit. all of the above d. Answer: b Type: K 2. The tax benefits of insurance, as compared to retention, arise from several factors including: a. b. c. d. regressive tax rates hedging tax treatment of unpaid losses none of the above Answer: c Type: K 3. Premium taxes and excise taxes: a. b. c. d. increase the premium loading on insurance decrease the present value of expected losses cannot be passed on to insurance buyers in the form of higher premiums do not affect the choice between insurance and retention Answer: a Type: K 4. The tax treatment of uninsured losses: a. b. is the same as the financial reporting of uninsured losses. allows for a firm to choose when the loss will be deducted – either when the loss is incurred or when it is paid is the same for insurance companies and non-insurance companies. requires that the loss be deducted in the year it is paid. c. d. 186 Answer: d Type: K 5. The financial reporting requirements for uninsured losses require firms to recognize losses: a. b. c. d. when they occur when they are paid when they become probable and can be reasonably estimated. none of the above. Answer: a Type: K 6. A foreign insurer is: a. b. c. d. domiciled in the state. domiciled outside the U.S. domiciled in another state in the U.S. the same as an alien insurer. Answer: c Type: K 7. An admitted insurer in a particular state: a. b. c. d. can be domestic, foreign or alien. is always a domestic insurer. is not always licensed to sell insurance in the state. faces stricter regulation than non-admitted insurers. Answer: a Type: K 8. Which of the following statements is true regarding the relationship between a firm’s risk management decisions and its capital structure decisions? a. The risk management decisions should be made independently from the capital structure decisions. Risk management has no affect on a firm’s capital structure. Strategic decisions about a firm’s capital structure and risk management should not be made independently. None of the above. b. c. d. Answer: c 187 Type: K 9. Compulsory insurance rules: a. reduce the likelihood that firms will be unable to fulfill their legal obligations to others. are common for automobile liability risk. may include a self-insurance option that allows qualifying firms to retain the risk. all of the above. b. c. d. Answer: d Type: K 10. A tax benefit should be defined (or stated) in terms of a. b. c. d. actual tax payments actual tax deductions expected tax payments expected loss financing Answer: c Type: K 11. A firm will receive an expected tax benefit by reducing the variability of its income if a. b. c. d. tax rates are progressive tax rates are progressive and the probability of loss is low tax rates are regressive tax rates are regressive and the probability of loss is high Answer: a Type: K 12. Paying a fair premium that is equal to the firm’s expected loss has which of the following effects? (Assume there is no premium loading.) a. b. c. d. deducting the expected loss amount reducing expected tax payments increasing expected after-tax earnings all of the above Answer: d Type: K 188 13. US corporations can carry losses _____ years forward and _____ years backwards. a. b. c. d. 20 (forward), 3 (backwards) 25 (forward), 3 (backwards) 20 (forward), 2 (backwards) 22 (forward), 2 (backwards) Answer: c Type: K 14. This year’s deduction for incurred losses for CPT Insurance Company is equal to the a. b. c. d. present value of losses that were incurred this year value of losses that were paid this year value of losses that were paid this year plus any change in the discounted value of incurred losses that will be paid in the future dollar value of losses that incurred this year, no matter when they are expected to be paid, i.e. no discounting Answer: c Type: K 15. The principle advantage of using debt financing is/are a. b. c. d. interest tax shields cost of capital lower probability of financial distress a reduced variability of earnings Answer: a Type: K II. Fill-ins 1. When tax rates are progressive lower expected tax payments. 2. The tax treatment of losses on depreciated property provides a tax benefit to property insurance. 3. 4. Premium and , reducing the variability of cash flows will excise taxes increase the premium loading on insurance. Fronting refers to the practice of purchasing primary insurance from one insurer which immediately reinsures most of the exposure with another insurer. 189 5. The federal government excise tax on primary insurance transactions is percent. four III. Problems and Short Answer Questions 1. Explain why a tax benefit might not necessarily result in an increase in shareholder wealth for the firm receiving the benefit. Answer: If the product market is competitive, the firm that receives the tax break may be forced to pass on the benefit to their customers in the form of lower output prices. Type: K 2. Ellis Manufacturing, Inc. is considering whether to buy property insurance for their fully depreciated warehouse or to retain the risk. Explain how each of the following factors might make the insurance option more attractive than retention. a. b. progressive corporate income tax rates tax treatment of depreciated property. Answer: a. Tax payments with insurance will be based on certain level of income whereas without insurance, the firm will pay a higher tax rate when the loss does not occur than when it does occur. As a result of progressive tax rates, the reduction in after tax income in the years without a loss is less than the increase in after tax income in the years with a loss; b. Ellis be able to deduct the insurance premium whether or not a loss occurs. If a loss occurs, Ellis will have to recognize a capital gain equal to the insurance indemnity payment.. If the income tax rate exceeds the capital gains tax rate, the income tax savings from deducting the premium will exceed the capital gains tax payment. Type: A 3. Explain how less volatile financial accounting numbers due to the purchase of insurance can influence the magnitude or variability of cash flows. Answer: Purchase of insurance will cause less volatile earnings which will: a) allow investors to predict earnings and cash flows more accurately which may reduce the investor’s estimate of the riskiness of the firm (although this is non-systematic risk); b) reduces the likelihood of default on debt contracts; c) make it less costly for shareholders and other stakeholders to monitor management behavior. Type: K 190 4. Explain the tax treatment and financial accounting treatment for each of the following: a. b. insurance premiums uninsured losses Answer: a. premiums paid are a deductible expense in the year in which coverage is provided (both for taxes and financial accounting) b. uninsured losses are reported as an expense in the year in which they occur but are deducted for tax purposes in the year in which they are paid. Type: K 5. Explain the reasons for “fronting”. Answer: Fronting is used to comply with regulations that restrict the choice of insurers, to reduce excise taxes, and to satisfy third party demands that insurance be provided by a particular set of insurers. Type: K 191