Tax Reform's Impact on Insurance Industry Stock Returns

Abstract

This article analyzes the market response of insurers' stock returns to the formulation debate, and enactment of the Tax Reform Act of 1986. Provisions of the Tax Reform Act portended increases in the effective tax rates of insurers despite the proposed lowering of marginal rates. The stock prices of insurers reacted negatively in the formulation, debate, and Committee mark-up phases of the legislative process. Significant abnormal returns were not evidenced in the enactment phase. Several provisions of the Tax Reform Act of 1986 (hereafter referred to as TRA '86) boded unfavorable consequences for insurers. The repeal of the 20 percent special life insurers' deduction, limitations of loss reserves to the present value of unpaid losses, reduction n the deductibility of unearned premiums, taxation of a portion of certain dividends (those subject to the intercorporate exclusion) and previously tax-exempt securities, and the potential tax on inside buildup, were aimed directly at the operations of insurers.(1) Stockholders' expectations could have been adversely impacted by the announcement of any one or combination of these provisions as they progressed through the legislative process. The purpose of this article is to analyze the market response of insurers' stock returns to the formulation, debate, and enactment of TRA '86. Data and Methodology The sample analyzed in this study consists of 19 large, publicly-traded insurers.(2) Each company in the final sample successfully completed the following screening process. First, a sample participant had to have an uninterrupted return series for the entire analysis period. Second, the shares of a sample company had to be actively traded so that non-synchronous price data were not an important problem. Third, a sample participant could have no major firm-specific announcements during the estimation and event intervals. The screening for firm-specific announcements entailed a search of the Wall Street Journal Index beginning six months prior to an event date and extending through the analysis period. When a relevant firm-specific event occurred, the company was eliminated as a sample observation. The well-known Fama, Fisher, Jensen, and Roll methodology is used to estimate the market's reaction to new information about TRA '86.(3) The Fama, et.al. approach facilitates the construction of statistical tests that can reveal significant departures of actual returns from those predicted by the single-index return generating model. Once a sample has been screened for return variations due to specific firm effects, the remaining residual (abnormal) returns are attributable to the event being studied. The event interval analyzed in this article extends from 60 days prior to a particular event date (ED-60) to 60 days after the event date (ED+60). Furthermore, each of the four event windows (EWs) was separated into several sub-phases around its specific event date. The reasoning behind this approach is as follows. The content of pending tax legislation begins to leak to the public prior to the scheduling of hearings and other official proclamations. Hence, adjustments of returns may begin to occur in the pre-announcement and pre-enactment phases of the event period. As investors come to anticipate specific changes in the tax code, they act on their expectations and returns begin to adjust before the event's official announcement. Return adjustments following the announcement and passage of TRA '86 were evaluated in terms of the significance of cumulative residuals over the period ED+1 to ED+60. The event windows considered in this article are listed in Table 1. The announcement of President Reagan's tax reform proposal and Chairman Rostenkowski's agreement to work with the Administration to draft a tax package are the main focuses of EW-1. Both Treasury I and II included modifications to the tax code that had important implications for insurers. …