PLR 1030014: Reinsurance pool arrangement qualifies as insurance for tax purposes

Plain-English summary

The IRS ruled on a foreign-country insurance company that elected to be taxed as a domestic corporation and insured risks of a related sole proprietorship. The company ceded all of its direct consideration and associated risks to a pool of unrelated participants, then received a quota share of the pool's consideration and risks. The IRS concluded that the arrangement had sufficient risk shifting and risk distribution, so the contracts constituted insurance for federal income tax purposes. The consideration paid by the sole proprietorship was therefore an insurance premium, and the company would qualify under subchapter L for the relevant year if it were a domestic corporation. The ruling did not address the pool's entity classification, other participants, premium calculations, or other requirements under section 162.

Ruling snapshot

• Question: Did the company's pooled direct insurance and reinsurance arrangement qualify as insurance for federal income tax purposes?
• Outcome: Approved
• Key authorities: IRC §§ 162, 816, 831, 845, 953, and 6110

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201030014 Third Party Communication: None
Release Date: 7/30/2010 Date of Communication: Not Applicable
Person To Contact:
Index Numbers: 831.03-00; 162.04-03 ---------------------, ID No. -------------
Telephone Number:
--------------------
----------------------- Refer Reply To:
------------------- CC:FIP:4
------------------------------------ PLR-122742-08
------------------------------------------ Date:
-------------------------------------------- April 16, 2010

In Re: --------------------------------------

Legend

Company = ------------------------------------------------------------------------

Lead Company = --------------------------------------------------------

Foreign Country M = --------------------

2 = ---------

Individual A = -----------------------------------------------------------

Individual B = ---------------------------------------------------

Sole Proprietorship = ---------------------------------------------

                                          ------------------------------------------------------------------------
                                          ------------------------------------------------------

Trust = -----------------------------------------------------------

Date A = --------------------------
PLR-122742-08 2

Y = ----------------

Year C = -------
Number a = ---

Number b = --

Number c = --

Number d = ---

Number e = ---

Number f = ---------

Independent Insurer 1 = ---------------------------------------------

Independent Insurer 2 = ----------------------------------------

Independent Insurer 3 = -------------------------------------------------

Independent Insurer 4 = ----------------------

Independent Insurer 5 = --------------------------------------------

Dear -----------------

This is in response to the letter submitted by Company dated May 12, 2008, primarily
requesting a ruling under § 831 relating to Company’s status as an insurance company
for federal income tax purposes.

FACTS

Company was incorporated in Foreign Country M on Date A. Company has been
licensed by the Insurance Regulators of Foreign County M as a Class 2 Association
Insurance Company effective for Year C. Also effective for Year C, Company has made
an election under § 953(d) to be taxed as a domestic corporation. All of the stock of
PLR-122742-08 3

Company is owned by Trust; in turn, Individual A and Individual B are each Number a %
beneficial owners of Trust. Individual B is the spouse of Individual A.

Sole Proprietorship is the Y professional practice of Individual A, the income and
expenses of which are reported on the joint federal income tax return of Individual A and
B.

Company issues to Sole Proprietorship contracts which cover insurance risks: (1)
capital asset (output) coverage,1 (2) employment related practices liability coverage, (3)
executive liability coverage, and (4) commercial crime coverage. Company is
responsible for the issuance of contracts, billing premiums and claims processing with
respect to its insured.

Company participates in a pool operated by Lead Company, incorporated and licensed
as an insurance company in Foreign Country M. The pool consists of Number b
independent entities in addition to Company. All participants in the pool issue contracts
by which for consideration they provide coverage for certain insurance risks.
They use recognized actuarial techniques, based, in part, on commercial rates for
similar coverage, to determine the consideration to be charged.2 The aggregate
number of other entities which are covered by the participants on a per line of business
basis is at least Number d and as many a Number e. Each participant conducts no
business other than the issuing and administering the contracts described herein.

Company receives consideration for the coverage it provides to Sole Proprietorship.
Under “Coinsurance Agreement A” (an automatic pro rata indemnity reinsurance treaty)
it contributes all of this consideration on each line it insures to the pool. Further, using
“Coinsurance Agreement B” (another automatic pro rata indemnity reinsurance
agreement) Company will then receive a quota share of the aggregate consideration
contributed to the pool which is equivalent in dollar terms to Number f % of the amount it
contributed to the pool for each line of coverage. Under Coinsurance Agreement B,
Company (in its role as a reinsurer) is liable for its pro rata share of the claims which are
incurred and reported during the accounting period.3

1
This contract is a package policy that contains coverage for buildings, business personal property,
business income and extra expense, legal defense and other business related coverage. Further, the
capital asset (output) policy issued to Sole Proprietorship contained a number of additional endorsements
including professional liability business interruption and excess professional liability legal claim expenses.
2
More specifically, the pricing of the contracts is based on an actuarial model that is published by the
Insurance Services Office and the results of that model are compared with available market based pricing
from other insurance companies.
3
Incurred Claims means (a) paid claims, plus, (b) ceded outstanding claim reserves and (including
present value reserves on continuing, unreported and reported but unpaid claims, and a claim liability for
claims in course of settlement and for incurred but not reported claims), less (c) ceded outstanding claims
and liabilities as of the end of the previous accounting period.
PLR-122742-08 4

No entity covered by a participant has any obligation to pay any additional consideration
if that entity’s actual losses during any period of coverage exceed the consideration
paid. Consideration paid by any covered entity may be used to satisfy claims of the
other covered entities. No entity that terminates its coverage is required to make
additional contributions to a participant to cover losses in excess of the consideration
paid. Company, Lead Company, or any of the other participants in the pool are not
related.

As a result of Company’s participation in the pool, the net consideration received by
Company will, generally, have the following characteristics on each line of coverage it
provides: (1) through the other participants, Company will, thus, assume (in total) risks
from no less than Number d and as many as Number f independent entities in any line
of coverage, and (2) through operation of the pool, all of the covered entities, including
Sole Proprietorship, will account for no more than 15% of the total risks assumed by
Company. Also, it is represented that there are no guarantees of Company’s
obligations by Trust, Individuals A or B, or any other related person. In addition,
Company represents that that it is well capitalized and does not provide any
shareholder loans.

LAW AND ANALYSIS

Section 831(a) of the Internal Revenue Code provides that taxes, computed as provided
in § 11, are imposed for each taxable year on the taxable income of each insurance
company other than a life insurance company. Section 831(c) provides that, for
purposes of § 831, the term “insurance company” has the meaning given to such term
by § 816(a). Under § 816(a), the term “insurance company” means “any company more
than half of 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.”

Neither the Code nor the regulations define the terms “insurance” or “insurance
contract” in the context of property and casualty insurance. The Supreme Court of the
United States has explained that in order for an arrangement to constitute insurance for
federal income tax purposes, both risk shifting and risk distribution must be present.
Helvering v. Le Gierse, 312 U.S. 531 (1941). The risk transferred must be risk of
economic loss. Allied Fidelity Corp. v. Commissioner, 572 F.2d 1190, 1193 (7th Cir.
1978). The risk must contemplate the fortuitous occurrence of a stated contingency,
Commissioner v. Treganowan, 183 F.2d 288, 290-291 (2d Cir. 1950), and must not be
merely an investment or business risk. Rev. Rul. 2007-47, 2007-2 C.B. 127. In
addition, the arrangement must constitute insurance in the commonly accepted sense.
See, e.g., Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 (Fed.
Cir. 1993); AMERCO, Inc. v. Commissioner, 979 F.2d 162 (9th Cir. 1992).

Risk shifting occurs if a person facing the possibility of an economic loss transfers some
or all of the financial consequences of the potential loss to the insurer, such that a loss
PLR-122742-08 5

by the insured does not affect the insured because the loss is offset by a payment from
the insurer. 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 premiums and set aside for the
payment of such a claim. By assuming numerous relatively small, independent risks
that occur randomly over time, the insurer smooths out losses to match more closely its
receipt of premiums. Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300
(9th Cir. 1987).

Courts have recognized that risk distribution necessarily entails a pooling of premiums,
so that a potential insured is not in significant part paying for its own risks. Humana,
Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989). See also Ocean Drilling and
Exploration Co., 988 F.2d at 1153 (“Risk distribution involves spreading the risk of loss
among policyholders.”); Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th
Cir. 1986) (“[R]isk distributing means that the party assuming the risk distributes his
potential liability, in part, among others.”) On the other hand, a purported insurance
arrangement where an issuer who contracts with only one policyholder and retains the
risk under such contract does not qualify as an insurance contract for federal income tax
purposes. See Rev. Rul. 2005-40, 2005-2 C.B. 4.

Rev. Rul. 2002-89, 2002-2 C.B. 984, set forth circumstances under which arrangements
between a domestic parent corporation and its wholly owned subsidiary constitute
insurance and explained that a parent/wholly owned subsidiary arrangement does not
constitute insurance if the parent accounts for 90% of the risk, but does if other insureds
constitute more than 50% of the risk.

Rev. Rul. 2002-90, 2002-2 C.B. 985, holds that an arrangement between a licensed
insurance subsidiary of parent, and each of 12 of parent’s operating subsidiaries where,
inter alia, no one subsidiary accounts for less than 5% nor more than 15% of the total
risk insured by the insurance subsidiary constitutes insurance.

Rev. Rul. 2002-91, 2002-2 C.B. 991, holds that an arrangement involving a group of
unrelated businesses of which, inter alia, none accounted for more than 15% of the total
insured risk constitutes insurance.

Rev. Rul. 2005-40, applies the principles of Rev. Ruls. 2002-89 and 2002-90 to
situations involving corporations and single-member limited liability companies.

As pointed out in the law background of Rev. Rul. 2009-26, 2009-38 I.R.B. 366, the
Internal Revenue Code of 1986 and administrative guidance treat reinsurance in a
manner similar to direct insurance for many purposes; for example, both direct
PLR-122742-08 6

insurance and reinsurance business may qualify a taxpayer as an insurance company
under section 816(a) or 831(c), as applicable.4

In Alinco Life Insurance Co. v. United States, 373 F.2d 336 (Ct Cl. 1967), a large
finance company formed a wholly-owned subsidiary corporation (Alinco), which qualified
as a life insurance company under the laws of Indiana. Customers of the finance
company (borrowers) purchased credit life insurance from an unrelated insurance
company, which in turn reinsured a fixed proportion of those contracts with Alinco.
Even through Alinco reinsured risks underwritten by only one insurance company, those
risks aggregated nearly one billion dollars of business, with a large number of
customers, for which Alinco was required by the state insurance department to maintain
reserves. Interpreting regulatory language that was identical to what now appears in
§ 816(a), the court concluded that Alinco was in the business of “reinsuring risks”
underwritten by insurance companies.

Section 162(a) of the Code provides, in part, that there shall be allowed as a deduction
all of the ordinary and necessary expenses paid or incurred during the taxable year in
carrying on a trade or business.

Section 1.162-1(a) of the Income Tax Regulations provides, in part, that among the
items included in business expenses are insurance premiums against fire, storms, theft,
accident, or other similar losses in the case of a business.

In the present situation, under Coinsurance Agreement A Company contributes all of its
direct consideration and associated risks to the pool and, under Coinsurance
Agreement B, Company receives a quota share of the consideration and associated
risks from the pool equal in dollar terms to Number f % of the amount Company ceded
to the pool on each line of coverage. The result is that there are a sufficient number of
unrelated covered entities such that none is paying for a significant portion of its own
risks. Accordingly, given that insurance risks are covered, the arrangement achieves
adequate risk shifting and risk distribution such that the contracts issued by Company
constitute insurance for federal income tax purposes. For the year for which the
predicate facts were represented, this appears to be more than half of Company’s
business.

CONCLUSION

Based solely on the information submitted and the representations made, and provided
that Company is adequately capitalized and continues to operate as a participant in the
pool (in the manner described above), we conclude that the arrangement between the
Sole Proprietorship and Company constitutes insurance for federal income tax
4
On the other hand, section 845 which grants to the Secretary explicit authority to reallocate,
recharacterize, or make other adjustments with respect to certain reinsurance arrangements does not
refer to direct insurance.
PLR-122742-08 7

purposes, such that consideration paid by Sole Proprietorship to Company is an
insurance premium under § 1.162-1(a) of the Income Tax Regulations, and Company
would qualify under part II of subchapter L for the taxable year if it were a domestic
corporation.

Except as expressly provided herein, no opinion is expressed in this letter ruling under
the provisions of any other section of the Code or Regulation. No opinion is expressed
as to whether or not the amount of premiums charged by Company has been calculated
correctly or whether other requirements under § 162 have been met. See e.g. , Rev.
Rul. 2007-3, 2007-1 C.B. 350. Further, no opinion has been requested and none has
been expressed as to whether the pool is an entity for federal income tax purposes, or
as to the classification of any other participant or the treatment of any arrangement
involving any other participant. This ruling letter is directed only to the taxpayer who
requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited
as precedent.

A copy of this letter should be attached to any Federal income tax return to which it is
relevant.

In accordance with the power of attorney on file in this office, we are sending a copy of
this letter to your authorized representative.

                                             Sincerely yours,

                                                    /S/

                                             JOHN E. GLOVER
                                             Senior Counsel, Branch 4
                                             Office of the Associate Chief Counsel
                                             (Financial Institutions & Products)