IRS may separately examine reinsurance recoverable estimate

Plain-English summary

A property and casualty insurer argued that the IRS could not separately challenge its estimate of uncollectible reinsurance because its combined unpaid-loss and reinsurance amounts were reasonable in the aggregate. Chief Counsel rejected that position. Reinsurance recoverable is a distinct component of losses incurred under section 832(b)(5)(A), and the IRS may demand information and test its reasonableness even when it does not examine the unpaid-loss reserve. Reinsurance unlikely to be collected because of a reinsurer's impairment or insolvency should not reduce the insurer's actual unpaid losses. The same reasonable-likelihood-of-recovery standard should apply to reinsurance on paid and unpaid losses.

Ruling snapshot

• Question: May the IRS challenge estimated reinsurance recoverable without also challenging the insurer's unpaid-loss reserves?
• Outcome: Advice given: yes.
• Key authorities: IRC § 832(b)(5); Treas. Reg. § 1.832-4; Blue Cross and Blue Shield of Texas, Inc. v. Commissioner, 328 F.3d 772 (2003).

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201515017
       Release Date: 4/10/2015
       CC:FIP:B04:RLBaxter                            Third Party Communication: None
       POSTF-120081-14                                Date of Communication: Not Applicable

UILC: 832.00-00, 832.06-01

date: December 22, 2014

 to:   Reid M. Huey
       Associate Area Counsel (St. Paul)
       (Large Business & International)
       Attn: Teri Jackson

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

subject: Reinsurance Recoverable

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       LEGEND

       Insurance Company      =   ---------------------------------
       Date 1                 =   ---------------------------
       $X                     =   -----------------
       $Y                     =   -----------------

       ISSUES

       Whether the Service may challenge a taxpayer’s estimate for reinsurance recoverable
       under Internal Revenue Code § 832(b)(5)(A)(iii) separately from a determination
       regarding the reasonableness of the taxpayer’s unpaid loss reserves under
       § 832(b)(5)(A)(ii).

       CONCLUSIONS

       The Service may challenge a taxpayer’s estimate for reinsurance recoverable under
       § 832(b)(5)(A)(iii) separately from a determination regarding the reasonableness of the
       taxpayer’s unpaid loss reserves under § 832(b)(5)(A)(ii).

POSTF-120081-14 2

FACTS

Insurance Company (the “Taxpayer”), a property and casualty insurer, reported an
allowance for uncollectible reinsurance recoverable at Date 1 of $X. Taxpayer’s
consolidated unpaid loss reserves at Date 1 was $Y. In the current audit cycle, the
Service has chosen not to examine whether Taxpayer’s reserves for unpaid losses
under § 832(b)(5)(A)(ii) are a fair and reasonable estimate of the amount the taxpayer
will be required to pay. The Service, however, is challenging the amount reported as
uncollectible reinsurance used to determine the estimated reinsurance recoverable
under § 832(b)(5)(A)(iii).

LAW AND ANALYSIS

Insurance companies subject to tax under § 831 are required to determine gross
income under § 832(b)(1). Section 832(b)(1)(A) provides that one of the items taken
into account in gross income is the combined gross amount earned during the taxable
year from investment income and from underwriting income computed on the basis of
the underwriting and investment exhibit of the annual statement approved by the
National Association of Insurance Commissioners. The term “underwriting income” is
defined in § 832(b)(3) as “the premiums earned on insurance contracts during the
taxable year less losses incurred and expenses incurred.”

Section 832(b)(5) provides, in part as follows:

   (A) In general. The term “losses incurred” means losses incurred during the
       taxable year on insurance contracts computed as follows:
       (i) To losses paid during the taxable year, deduct salvage and reinsurance
             recovered during the taxable year.
       (ii) To the result so obtained, add all unpaid losses on life insurance contracts
             plus all discounted unpaid losses (as defined in section 846) outstanding
             at the end of the taxable year and deduct all unpaid losses on life
             insurance contracts plus all discounted unpaid losses outstanding at the
             end of the preceding taxable year.
       (iii) To the results so obtained, add estimated salvage and reinsurance
             recoverable as of the end of the preceding taxable year and deduct
             estimated salvage and reinsurance recoverable as of the end of the
             taxable year.
   The amount of estimated salvage recoverable shall be determined on a
   discounted basis in accordance with procedures established by the Secretary.

Treas. Reg. §1.832-4(a)(14) provides in computing losses incurred the determination of
unpaid losses at the close of each year must represent actual unpaid losses as nearly
as it is possible to ascertain them.
POSTF-120081-14 3

Treas. Reg. §1.832-4(b) provides:

(b) Losses incurred.—Every insurance company to which this section applies must
be prepared to establish to the satisfaction of the district director that the part of
the deduction for “losses incurred” which represents unpaid losses at the close of
the taxable year comprises only actual unpaid losses…These losses must be
stated in amounts which, based upon the facts in each case and the company’s
experience with similar cases, represent a fair and reasonable estimate of the
amount the company will be required to pay. Amounts included in, or added to,
the estimates of unpaid losses which, in the opinion of the district director, are in
excess of a fair and reasonable estimate will be disallowed as a deduction. The
district director may require any insurance company to submit such detailed
information with respect to its actual experience as deemed necessary to
establish the reasonableness of the deduction for “losses incurred.”

Treas. Reg. §1.832-4(c) provides that under § 832(b)(5)(A), losses incurred are
computed by taking into account losses paid reduced by salvage and reinsurance
recovered, the change in discounted unpaid losses, and the change in estimated
salvage and reinsurance recoverable. For purposes of § 832(b)(5)(A) (iii), estimated
salvage recoverable include all anticipated recoveries on account of salvage. Estimates
of salvage recoverable must be based on the facts of each case and the company’s
experience with similar cases.

Taxpayer argues that the Service may not challenge the amount reported as
uncollectible reinsurance because Taxpayer’s net amount calculated under
§ 832(b)(5)(A)(ii) and (iii) are in the aggregate fair and reasonable. It is anomalous to
hold that the Service can only challenge the reasonableness of the entire amount of
losses incurred but not any portion that makes up the whole amount.

Although the Code and regulations do not expressly define reinsurance recoverable,
§ 832(b)(5)(A) and Treas. Reg. §1.832-4(b) and (c) provide that reinsurance
recoverable is included in the calculation of losses incurred. Therefore, the scope of the
term “reinsurance recoverable” must be interpreted in accordance with the rules
applicable to losses incurred. See Blue Cross and Blue Shield of Texas, Inc. v.
Commissioner, 328 F.3d 772 (2003) (same argument for salvage recoverable).

Treas. Reg. §1.832-4(b) provides, in part, that the district director may require any
insurance company to submit such detailed information with respect to its actual
experience as deemed necessary to establish the reasonableness of the deduction for
losses incurred. Since reinsurance recoverable is part of losses incurred, reinsurance
recoverable must not only be reasonable but is subject to examination by the Service.
Accordingly, the Service may challenge a taxpayer’s estimate for reinsurance
recoverable under § 832(b)(5)(A)(iii) separately from a determination regarding the
reasonableness of the taxpayer’s unpaid loss reserves under § 832(b)(5)(A)(ii).
POSTF-120081-14 4

In addition, reinsurance recoverable in § 832(b)(5)(A)(iii) includes balances due from
reinsurance companies for paid and unpaid losses and loss expenses that will be
recovered from reinsurance based on the contractual arrangement between the
taxpayer and the reinsurer.

Treas. Reg. §1.832-4(b) states “that the part of the deduction for ‘losses incurred’ which
represents unpaid losses at the close of the taxable year comprises only actual unpaid
losses…stated in amounts which, based upon the facts in each case and the company’s
experience with similar cases, represent a fair and reasonable estimate of the amount
the company will be required to pay.” Therefore, if collection of reinsurance is or
becomes reasonably doubtful, because of the impairment or insolvency of the reinsurer,
the regulations—at least in the case of an unpaid claim—require such reinsurance to be
eliminated in the computation of losses incurred. Because the unpaid loss must be
stated in the “actual” amount that “the company will be required to pay,” it should not be
reduced for reinsurance that is unlikely to be collected.

The same standard of reasonableness should apply to paid losses as it does to unpaid
losses. The application of different standards for reinsurance on paid and unpaid losses
would necessitate senseless income adjustments at the point at which the standard
changes i.e., when the loss is paid, even if the original loss and reinsurance estimates
ultimately prove correct. It would also be anomalous to require a higher standard for
excluding uncollectible reinsurance after a loss is paid than before the loss is paid;
reinsurance recoverable with respect to the reasonable likelihood of recovery should be
the relevant measuring rod in either case.

Finally, Taxpayer’s argument that the Service may not challenge the amount reported
as uncollectible reinsurance because Taxpayer’s net amount calculated under
§ 832(b)(5)(A)(ii) and (iii) are in the aggregate fair and reasonable ignores Treas. Reg.
§1.832-4(c). If, as Taxpayer argues, the estimate of salvage and reinsurance
recoverable is rolled into the general “fair and reasonable standard” of Treas. Reg.
§1.832-4(b), then there would be no reason to have a discrete standard for estimated
salvage recoverable in Treas. Reg. §1.832-4(c).

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-4435 if you have any further questions.

cc: Internal Revenue Service
Attn: Industry Director, (LB&I:RFTH)
Retailers, Food, Transportation & Healthcare
1901 Butterfield Road, Suite 310
Downers Grove, IL 60515