PLR 1219010: Pooled reinsurance for related insureds qualifies as insurance for federal tax purposes

Plain-English summary

A company asked whether its contracts with related insureds qualified as insurance for federal income tax purposes. The company directly insured a partnership and a corporation, ceded premiums and risks to a pool of unrelated insurers, and then assumed a quota share from that pool. The IRS concluded that the arrangement provided adequate risk shifting and risk distribution, so the contracts constituted insurance and the consideration paid by the insureds could qualify as insurance premiums under the regulations. The IRS also concluded that the company would qualify under subchapter L for the taxable year if it were a domestic corporation, subject to the stated facts and conditions.

Ruling snapshot

• Question: Does the described direct insurance and pooled reinsurance arrangement qualify as insurance for federal income tax purposes?
• Outcome: approved
• Key authorities: IRC §§ 831, 816, 953(d), 162(a), and 845; Treas. Reg. § 1.162-1(a); Helvering v. LeGierse; Rev. Ruls. 2002-89, 2002-90, 2002-91, 2005-40, 2007-47, and 2009-26

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201219010 Third Party Communication: None
Release Date: 5/11/2012 Date of Communication: Not Applicable
Index Numbers: 831.03-00; 162.04-03
Person To Contact:
------------------- ---------------------, ID. # -----------------
------------- Telephone Number:
----------------------------- ---------------------
--------------------------------------- Refer Reply To:
-------------------------- CC:FIP:4
PLR-138611-11
In re: -----------------------------. Date:
February 3, 2012

Legend

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

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

2 = --

Date A = ----------------

Year B = -------

Partnership A = ----------------------------

Grantor Trust A = -------------------------------------------

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

B = ---------

Insured Partnership C = -----------------------------------

Insured Corporation D = -----------------------------

State E = ---------
PLR-138611-11 2

S = -----------------------------

Number T = --

Number U = ----

Number V = ----

Number W = ----

Number X = ----------

Number Y = ---

Number Z = ---

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

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

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

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

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

Independent Insurer 6 = -----------------------------------------

Independent Insurer 7 = -------------------------------------------------

Independent Insurer 8 = ------------------------------

Independent Insurer 9 = ----------------------

PLR-138611-11 3

Independent Insurer 10 = ----------------------

Independent Insurer 11 = ------------------

Independent Insurer 12 = ---------------------------------------------

Independent Insurer 13 = ----------------------------------------------------

Independent Insurer 14 = ------------------------------------------------------------------------

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

This is in response to the letter submitted by Company dated September 12, 2011,
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 and started insurance operations on
Date A. Company has been issued a Class 2 Association License by the Insurance
Regulator of Foreign County M effective for Year B. Also effective for Year B, Company
has made an election under § 953(d) to be taxed as a domestic corporation. All of the
stock of Company is owned by Partnership A. Partnership A has Grantor Trust A as its
Number T percent general partner. Grantor Trust A is also its Number U percent limited
partner. The B Family Irrevocable Trust is the remaining Number T percent limited
partner of Partnership A. The grantor of Grantor Trust A is Individual A.

Insured Partnership C was created in late Year B to own and operate a substantial
number (Number V) of multiunit residential rental real estate properties previously
owned and operated by Individual A as a sole proprietorship. Individual A is the
Number W percent general partner and Grantor Trust A is the other Number W percent
general partner of Insured Partnership C.

Insured Corporation D is a State E corporation which is engaged in business as a
general contractor providing construction contracting services exclusively to Insured
Partnership C. Insured Corporation D operates out of the same main office in which it
and the Insured Partnership C both use to manage the real estate properties. All of the
stock of Insured Corporation D is owned by Individual A.
PLR-138611-11 4

Company offers the Insured Partnership C and Insured Corporation D insurance
coverage which comprise the following four types of contracts: (1) S policy, (2)
employment related practices liability policy, (3) executive liability policy, and (4)
commercial crime policy.

The most significant policy is the S policy. This policy is a package policy that contains
coverage for buildings, business personal property, business income and extra
expense, legal defense and other business related coverages. The employment-related
practices liability policy provides coverage for liability arising out of claims for injury to
an employee because of an employment-related offence, as well as a duty to defend.
The executive liability coverage policy provides two coverages: one applies to liability
arising out of claims for wrongful acts or interrelated wrongful acts committed by the
named company’s directors or officers, the other is corporate reimbursement coverage
that applies to claims for which the named company is legally obligated to indemnify its
directors or officers when such claims involve wrongful acts or interrelated wrongful acts
committed by them. The commercial crime policy covers business losses due to
employee theft of money, securities, other property of the insured, including client’s
property on the client’s premises.

In order to achieve its overall risk distribution, Company participates in a reinsurance
pool consisting of Number Y independent insurers (Independent Insurers 1 through 14)
in addition to Company. These other insurers and their insureds are unrelated to
Company and Company’s insureds (Insured Partnership C and Insured Corporation D).
Thus, while Company, as a direct writer, receives premiums from its insureds under
Coinsurance Agreement A (a pro rata indemnity reinsurance treaty) it cedes Number X
percent of these directly written premiums on each line it insures to the reinsurance
pool. Further, using Coinsurance Agreement B (another pro rata indemnity reinsurance
agreement), Company will then assume a quota share of the premiums from the
reinsurance pool which is roughly equivalent in dollar terms to the amount it ceded on
each line of insurance.

The following applies to all of the insurers participating in the reinsurance pool:

All insurers issue insurance contracts and charge premiums for the insurance coverage
provided under their respective insurance contracts. All insureds use recognized
actuarial techniques, based, in part, on commercial rates for similar coverage, in order
to determine the premiums charged to an individual insured.

Each of the insurers pools all the premiums it receives in its general funds and pays
claims out of those funds. Each insurer investigates any claim made by an insured to
determine the validity of the claim prior to making payment on that claim. Each insurer
conducts no business other than the issuing and administering of insurance contracts.
PLR-138611-11 5

No insured has any obligation to pay any insurer additional premiums if that insured’s
actual losses during any period of coverage exceed the premiums paid by that insured.
Premiums paid by any insured may be used to satisfy claims of the other insureds. No
insured that terminates its insurance coverage is required to make additional premium
or capital payments to that insurer to cover losses in excess of its premiums paid.
There is a real possibility that an insurer will sustain a loss in excess of the premiums it
has received from its insureds. Finally, Company is not related to any other of the
Number Y insurers participating in the reinsurance pool, nor is Company related to any
of the Number Z independent insureds who are directly insured by any of the Number Y
other insurers participating in the reinsurance pool.

As a result of Company’s participation in the reinsurance pool, the written premiums of
Company will, generally, have the following characteristics on each line of coverage it
insures: (a) Company will assume (in total) risks from the more than 12 independent
policyholders with respect to insured businesses of these policyholders, and (b) no
single insured will account for more than 15 percent of the total risks assumed by
Company. Also, it is represented that there are no guarantees of Company’s
obligations by Individual A or any other related person or entity. In addition, Company
states that it is well capitalized.

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. LeGierse, 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.
PLR-138611-11 6

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
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 as 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 percent of the risk, but does if other
insureds constitute more than 50 percent 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 the 12 of parent’s operating subsidiaries
where, inter alia, no one subsidiary accounts for less than 5 percent nor more than 15
percent 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 percent 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.
PLR-138611-11 7

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
insurance and reinsurance business may qualify a taxpayer as an insurance company
under § 816(a) or 831(c), as applicable.1

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 though 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 Internal Revenue 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 any 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 a
substantial amount of its direct consideration (received from its insureds) and
associated risks to the pool, and under Coinsurance Agreement B, receives a quota
share of the consideration and associated risks from the pool roughly equal in dollar
terms to Number X percent of the amount Company ceded to the pool on each line of
coverage. The result is that there are a significant number of unrelated covered entities
such that none is paying for a significant portion of its own risk. Accordingly, given that
insurance risks are covered, the arrangement achieves adequate risk shifting and risk
distribution such that the contracts issued by Company to its insureds 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
1
On the other hand, § 845 which grants to the Secretary explicit authority to reallocate, recharacterize, or
make other adjustments to certain reinsurance arrangements does not refer to direct insurance.
PLR-138611-11 8

pool (in the manner described above), we conclude that the arrangement between the
insureds, Insured Partnership C (and its predecessor insured proprietorship operated by
Individual A), and Insured Corporation D, and Company constitutes insurance
for federal income tax purposes, such that the respective consideration paid
by the insureds to Company is eligible to meet the definition of insurance premiums
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.

CAVEATS

Except as expressly provided herein, no opinion is expressed in this letter ruling under
the provisions of any other section of the Code or Regulations. Further, no opinion is
expressed as to the federal income tax consequences of the transaction described
above if Company makes any loans to its affiliated insureds or parties related thereto.
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 reinsurance pool is an
entity for federal income tax purposes. Finally, no opinion has been requested and
none has been expressed as to the federal income tax consequences under
Subchapter K of the Internal Revenue Code of Individual A’s transfer to Insured
Partnership C of the rental real estate business previously owned and operated by
Individual A as a sole proprietorship. Specifically, no opinion is expressed or implied
regarding whether Insured Partnership C is a partnership for federal tax purposes or
whether § 721 applies to the transfer to Insured Partnership C.

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,


                                              SHERYL B. FLUM
                                              Chief, Branch 4,
                                              Office of the Associate Chief Counsel
                                              (Financial Institutions & Products)