Theoretical Considerations of the Effect of Federal Income Taxes on Investment Income in Property-Liability Ratemaking

Although the use of investment income in ratemaking for property-liability insurance has received much theoretical discussion since the mid-1970s, little attention has been paid to the role of federal income taxes in ratemaking. The pricing models of Fairley (1979), Hill and Modigliani (1987), and Myers and Cohn (1987) all incorporate federal income taxes as an accounting item, a necessary cost of doing business. The present research establishes a theoretical foundation for the proper handling of taxes through the Myers-Cohn pricing model and the Myers Theorem. Explicit derivations of the capital asset pricing model betas for both the tax and the after-tax returns in terms of the asset portfolio beta are included. In particular, it is shown that the after-tax beta is not equal to one minus the tax rate times the investment return beta. Estimation problems for the appropriate effective tax rate on investment income are discussed.