PLR 200843026: Vehicle service contracts were insurance and indemnity was reinsurance

Plain-English summary

A subsidiary issued vehicle service contracts covering economic loss from mechanical breakdowns and related rental, towing, and road-service costs. It did not perform repairs, and an unrelated insurer agreed to indemnify it for all claims under the contracts. The IRS found insurance risk because covered breakdowns were fortuitous economic losses, risk shifting because the issuer reimbursed covered claims, and risk distribution because it assumed many independent contracts. The arrangements were not prepaid maintenance because routine service was excluded and the issuer provided reimbursement rather than repair work. The IRS ruled that the service contracts were insurance contracts, that the issuer qualified under § 831(c) in years when issuing them constituted more than half its business, and that the indemnity agreement was reinsurance.

Ruling snapshot

• Question: Were the vehicle service contracts insurance, did their issuer qualify as an insurance company, and was its indemnity agreement reinsurance?
• Outcome: Approved. The contracts were insurance, the issuer qualified when they exceeded half its business, and the indemnity agreement was reinsurance.
• Key authorities: IRC §§ 816(a), 831(c)

Full text (IRS public release)

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Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200843026 Third Party Communication: None
Release Date: 10/24/2008 Date of Communication: Not Applicable
Person To Contact:
Index Number: 831.00-00 --------------------, ID No. -------------
Telephone Number:
---------------------
------------------------------- Refer Reply To:
---------------------------------------- CC:FIP:B04
------------------------ PLR-122271-08
---------------------------------- Date:
July 21, 2008

Taxpayer = ------------------------------------------------------
Parent= = ---------------------------------------------------------------------------
Date A = -------------------
Contracts = ------------------------------------------------------------------------------------------

Year B = -------
Number C = --------
Number D = ---------
Agreement: = -----------------------------------------------------------------------------------------

Company E = --------------------------------------------------------------------
Number F = ----
Number G = --

Dear ----------------:

   This responds to your representative’s letter of May 7, 2008, requesting rulings

under part I of subchapter L of the Internal Revenue Code.

                                                   Facts

      Taxpayer represents as follows:

    Taxpayer is a wholly owned subsidiary of Parent. Parent operates as a third

party administrator providing various services related to the administration of “vehicle
service contracts” (also known as “extended warranty contracts”) issued by unrelated
insurance companies.

    Beginning around Date A, Taxpayer began issuing vehicle service contracts

(“Contract(s)”). The Contracts provide the holder with protection against economic loss
PLR-122271-08 2

for certain expenses related to vehicle repair not covered by the manufacturer’s
warranty. The Contracts also cover a portion of the replacement vehicle rental expense
and towing and road service expense incurred as a result of a covered breakdown. The
Contracts do no cover any preventative or routine maintenance, such as engine tune-
up, suspension alignment, filters, or fluids. The Contracts do not cover incidental or
consequential damages. Taxpayer does not perform any repair services but rather only
reimburses repair facilities or the holder of the Contract. The Contracts’ coverage
period is the first occurring of a stated time or miles driven. In the event a holder
cancels the Contract prior to its expiration, Taxpayer is obligated to refund to the holder
the unearned premium in an amount determined under the formula specified in the
Contracts.

  The Contracts are sold by retail automobile dealers. Upon the sale of a Contract,

the dealer collects the full premium charge and remits a predetermined portion to
Taxpayer with the balance being the dealer’s commission. As of the end of Year B,
Taxpayer had in force approximately Number C Contracts and anticipates issuing in
excess of Number D Contracts per year.

   Taxpayer has entered into an agreement (“Agreement”) with unrelated Company

E whereby Company E agrees to indemnify Taxpayer for 100% of claims made under
the Contracts. The Agreement is in accordance with the applicable state law
requirements and is treated as an insurance contract for such purposes.

  Taxpayer has entered into an arrangement with Parent whereby Parent will

perform services for Taxpayer related to the administration of the Contracts.

  In addition to the Contracts, Taxpayer administers certain other products; the

percentage of Taxpayer’s revenue derived from the Contracts exceeds Number F %
and that derived from the other administrative services is less than Number G %.

                                Law and Analysis

Requested Ruling #1

    Neither the Code nor the Regulations thereunder define the terms “insurance” or

“insurance contract”. The accepted definition of “insurance” for federal income tax
purposes relates back to Helvering v. LeGierse, 312 U.S. 531, 539 (1941), in which the
Court stated that “[h]istorically and commonly insurance involves risk-shifting and risk-
distributing.” Case law has defined “insurance” as “involve[ing] a contract, whereby, for
an adequate consideration, one party undertakes to indemnify another against loss
arising from certain specified contingencies or perils…It is contractual security against
possible anticipated loss.” Epmeier v. United States, 199 F.2d 508, 509-10 (7th Cir.
1952).
PLR-122271-08 3

   Cases analyzing “captive insurance” arrangements have distilled the concept of

“insurance” for federal income tax purposes to three elements, applied consistently with
principles of federal income taxation:1 1) involvement of an insurance risk; 2) shifting
and distribution of that risk; and 3) insurance in its commonly accepted sense. See,
e.g., AMERCO, Inc. v. Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992), aff’g 96
T.C. 18 (1991).

   Insurance risk involves risk of economic loss. Allied Fidelity Corp. v.

Commissioner, 572 F.2d 1190, 1193 (7th Cir.), cert. denied, 439 U.S. 835 (1978). The
risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner
v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950), and must not be merely an
investment or business risk. LeGierse, 312 U.S. at 542; see also Rev. Rul. 2007-47.

    Risk shifting occurs when a person facing the possibility of an economic loss

transfers some or all of the financial consequences of the potential loss to the insurer.
See Rev. Rul. 92-93, 1992-2 C.B. 45 (while parent corporation purchased a group-term
life insurance policy from its wholly owned insurance subsidiary, the arrangement was
not held to be “self-insurance” because the economic risk of loss was not that of the
parent) modified on other grounds, Rev. Rul. 2001-31, 2001-1 C.B. 1348. If the insured
has shifted its risk to the insurer, then a loss by the insured does not affect the insured
because the loss is offset by the insurance payment. See Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987).

   Risk distribution incorporates the statistical phenomenon known as the law of

large numbers. Distributing risk allows the insurer to reduce the possibility that a single
costly claim will exceed the amount taken in as a premium and set aside for the
payment of such a claim. Insuring many independent risks in return for numerous
premiums serves to distribute risk. By assuming numerous relatively small,
independent risks that occur randomly over time, the insurer smoothes out losses to
match more closely its receipt of premiums. See Clougherty Packing Co., 811 F.2d at
1300; Rev. Rul. 2005-40, 2005-2 C.B. 4.

     The “commonly accepted sense” of insurance derives from all of the facts

surrounding each case, with emphasis on comparing the implementation of the
arrangement with that of known insurance. Court opinions identify several nonexclusive
factors bearing on this, such as the treatment of an arrangement under the applicable
state law, AMERCO, Inc., 96 T.C. at 41; the adequacy of the insurer’s capitalization and
utilization of premiums priced at arm’s length, The Harper Group v. Commissioner, 96
T.C. 45, 55 (1991), aff’d 979 F.2d 1341 (9th Cir. 1992); separately maintained funds to
pay claims, Ocean Drilling & Exploration Co. v. United States, 24 Cl. Ct. 714, 728
(1991), aff’d per curiam, 988 F.2d 1135 (Fed. Cir. 1993); and the language of the

1
These principles include respecting the separateness of corporate entities, the substance of the
transaction(s), and the relationship between the parties. Sears, Roebuck and Co. v. Commissioner, 96
th
T.C. 61, 101-02 (1991), aff’d, 972 F.2d 858 (7 Cir, 1992).
PLR-122271-08 4

operative agreements and the method of resolving claims, Kidde Indus. Inc. v.
Commissioner, 49 Fed. Cl. 42, 51-52 (1997).

   The Contracts are aleatory contracts under which Taxpayer, for a fixed price, is

obligated to indemnify the holder for economic loss not covered by the manufacturer’s
warranty, arising from the mechanical breakdown of, and repair expense to, a vehicle.
The plans are not prepaid service contracts because Taxpayer does not perform any
repair services. By accepting a large number of risks, Taxpayer has distributed the risk
of loss under the Contracts.

   Accordingly, we conclude that the Contracts constitute insurance contracts for

federal income tax purposes.

Requested Ruling #2

   Under § 831(c), the term “insurance company” has the meaning given to such

term by § 816(a). Section 816(a) provides that the term “insurance company” means
any company more than half the business of which during the taxable year is the issuing
of insurance or annuity contracts or the reinsuring of risks underwritten by insurance
companies.

  Based on the representations concerning its business activities, we conclude that

Taxpayer will qualify as an insurance company under § 831(c) for any taxable year in
which more than half of its business is the issuing of the Contracts.

Requested Ruling #3

  Reinsurance is commonly thought of as

         a contract whereby one insurer transfers or ‘cedes’ to
         another insurer all or part of the risk it has assumed under a
         separate or distinct policy or group of policies in exchange
         for a portion of the premium. In essence, reinsurance is
         insurance for insurance companies.

COUCH ON INSURANCE § 9:1 (2008). And this view of reinsurance has been shared
in the context of litigation concerning federal income taxes. See, e.g., Colonial Am. Life
Ins. Co. v. Commissioner, 491 U.S. 244, 246-47 (1989).

   Here, the Agreement has all the hallmarks of a reinsurance treaty and as such

constitutes reinsurance for federal income tax purposes and should be accounted for
under part II of subchapter L accordingly.

                                     Rulings

PLR-122271-08 5

   We rule that:

  1. that the Contracts constitute insurance contracts for federal income tax

purposes;
2. that Taxpayer qualifies as an insurance company under § 831(c); and
3. that the Agreement constitutes a reinsurance contract for federal income tax
purposes.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of
the material submitted in support of the request for rulings, it is subject to verification on
examination.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

                                    Sincerely,

                                       /S/

                                    Donald J. Drees, Jr.
                                    Senior Technician Reviewer, Branch 4
                                    (Financial Institutions & Products)

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