Feldblum Surplus

Question 1

Double-taxation overview

Answer 1

y = % yield on investment that an investor requires
Tc = corporate tax rate (21%)
Tp = personal tax rate (varies)

Avoid double-taxation by directly investing in stocks/bonds

tax on direct investment:
* (investment yield) x (personal tax rate) = y X Tp = 10% x 30% = 3%

tax on indirect investment:
* y x [Tc + (1 - Tc) x Tp] = 10% x [35% + (1 - 35%) x 30%] = 5.45%

cost of double-taxation:
* (tax on indirect investment) - (tax on direct investment) = 5.45% - 3% = 2.45%

Question 2

Implications of double-taxation

Answer 2

• investor must get a higher rate of return (through dividend payments) if investing indirectly through an insurer
• insurer must pay a higher rate of return than the investor could get through a direct investment
• policyholder must foot the cost of this higher return in the form of a margin added to their premium (specifically to offset the effect of double-taxation for the investor)

Question 3

Premium Margin Formula

Atkinson & Dallas Modification

Answer 3

cost of double-taxation = y x Tc (on before-personal-tax basis)
cost of capital = (cost of double-taxation) + (penalty regarding restrictions on investments)

cost of double-taxation = 35% x 8% = 2.8%
cost of capital = 2.8% + 2% = 4.8%

Margin = 4.8% / (1 - 35%) * (1 + 8%)^(-1/2) = 7.11%
= (yinsurer x Tc + yinvestor - yinsurer) / (1 - Tc) x (1 + y)^(-1/2)

Question 4

Liquidate or Continue Operations

Answer 4

Invested capital = S + (%acq x UEP) + (1 - %disc) x R - DTA
PV(future income) = (pre-tax income) x (1 - %tax) / (%CoC)

InvCap - CoL > PV(future income) > liquidate
InvCap - CoL < PV(future income) > continue operations
InvCap - CoL = PV(future income) > doesn’t matter