Vehicle-service-contract reinsurance qualifies as insurance

Plain-English summary

A foreign corporation planned to elect treatment as a U.S. insurance company and assume, through a chain of reinsurance agreements, all risk under vehicle service contracts sold to consumers. The contracts covered unexpected mechanical breakdown and related repair costs rather than routine maintenance or prepaid services. The IRS concluded that the contracts shifted consumers' economic risk and distributed it across a substantial number of consumers and vehicles, with the reinsurance chain passing those risks to the taxpayer. It ruled that the taxpayer's agreement with the initial reinsurer was an insurance contract for federal tax purposes. The taxpayer would qualify as an insurance company under section 831 for any year in which reinsuring those risks constituted more than half of its business.

Ruling snapshot

• Question: Does the taxpayer's assumption of vehicle-service-contract risks constitute insurance, and can the taxpayer qualify as an insurance company under section 831?
• Outcome: approved, if more than half of the taxpayer's business for the year is reinsuring those risks
• Key authorities: IRC §§ 816(a) and 831; Rev. Rul. 2009-26; Helvering v. Le Gierse

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201802004                                             Third Party Communication: None
Release Date: 1/12/2018                                       Date of Communication: Not Applicable
Index Number: 831.00-00
                                                              Person To Contact:
----------------------------------                            ----------------------, ID No. ------------------
-------------------------------------------------------       Telephone Number:
--------------------------------                              --------------------
------------------------------------------------------        Refer Reply To:
-----------------------------------------                     CC:FIP:B04
                                                              PLR-112892-17

                                                              Date:
                                                              October 16, 2017




Taxpayer                      =   ----------------------------------------------------------------------------------
Obligor                       =   -----------------------------------------
Insurer                       =   ---------------------------------------------------
Guarantor                     =   -----------------------------------------
Initial Reinsurer             =   -------------------------------------------
Claims Administrator          =   -----------------------------------------
State W                       =   ----------
State X                       =   ---------
Country 1                     =   --------------------------------
Country 2                     =   -----------------------------------
Agreement 1                   =   ---------------------------------------------------------
Agreement 2                   =   -----------------------------------------
Agreement 3                   =   ----------------------------------



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

This letter is in response to the request, submitted by your authorized representative, for
rulings on the federal income tax treatment of certain contracts under Part II of
Subchapter L of the Internal Revenue Code.

FACTS

Taxpayer is a Country 1 corporation. It is not licensed or recognized as an insurance
company under Country 1 law or the law of any state in the United States. Pursuant to
Agreement 1, Taxpayer will acquire the risk under Vehicle Service Contracts (“VSCs”)
but will not sell VSCs nor sell, repair, or manufacture vehicles. Taxpayer will make a
PLR-112892-17                                         2


§ 953(d) election to be treated as a U.S. insurance company for federal income tax
purposes and will report its underwriting and investment income on a Form 1120-PC.

Motor vehicle dealers (“Dealers”) sell VSCs to eligible motor vehicle purchasers
(“Consumers”). Purchasing a VSC is optional and the cost is not included in the
purchase price of the vehicle. The VSCs provide coverage for a pre-determined period
of time or for a pre-determined number of miles driven, whichever comes first. The
VSCs provide Consumers with financial protection against economic loss for certain
repair costs by covering the cost of repairs or by reimbursing Consumers for the cost of
parts and labor to repair or replace covered parts. The VSCs also cover a portion of
towing costs, incidental extra expenses related to trip disruption, and costs for a rental
replacement automobile. Consumers obtain VSC covered services from Dealers or
another service provider. The VSCs are not prepaid service contracts, and they do not
cover routine preventive maintenance. The VSCs also do not cover repairs covered by
a manufacturer’s warranty and, except as stated above, do not cover incidental or
consequential damages such as property damage, personal injury, inconvenience, or
loss of vehicle use.

If the consumer purchases a VSC, the risk of the unexpected equipment failure
transfers to Obligor, the other party to the VSCs. When there is a breakdown on a
vehicle covered by a VSC, Obligor is responsible for the economic loss that otherwise
would have been borne by the Consumer.

The following arrangements are in place, or will be entered into, with respect to the
VSCs:

    1) Obligor's duties under the VSCs are guaranteed by an insurance policy Obligor
       enters with Guarantor, a State W corporation, which is unrelated to Obligor.1

    2) Obligor will enter into Agreement 2 with Insurer, a State X captive insurance
       company, to transfer 100 percent of its risk under the VSCs. Obligor and insurer
       are wholly owned by a common parent.

    3) Insurer will enter into Agreement 3 with Initial Reinsurer, a Country 2 insurance
       company, to transfer 100 percent of its risk under the VSCs.

    4) Under Agreement 1, Initial Reinsurer will transfer 100 percent of its risk under the
       VSCs to Taxpayer.



1
 In the event Obligor ceases to operate, is bankrupt or otherwise financially impaired, or a claim or
contract cancellation refund is not paid within sixty days after proof of loss has been filed, the Consumer
may file a direct claim with Guarantor.
PLR-112892-17                                 3


Pursuant to Agreement 1, Initial Reinsurer will remit to Taxpayer a predetermined arms-
length amount for each VSC. Neither Obligor, Insurer, Initial Reinsurer, nor Taxpayer
will provide repair services under the VSCs.

Claims Administrator will investigate and process all claims for covered repair made
under the VSCs. As claims are made and approved, Insurer will reimburse Obligor. In
turn, Initial Reinsurer will reimburse Insurer the amount it paid to Obligor and, in
accordance with Agreement 1, Taxpayer will reimburse that amount to Initial Reinsurer.

Insurer and Initial Reinsurer are brother-sister entities of the same control group.
Taxpayer is unrelated to the Dealers and is not in the same controlled group as Insurer
and Initial Reinsurer. However, the individual who owns Taxpayer is a minority owner of
the holding company that owns Insurer and Initial Reinsurer.

Taxpayer represents that:

   1) More than half its business during the taxable year will be reinsuring Initial
      Reinsurer’s risk under the VSCs; and

   2) For federal income tax purposes, it will account for the VSC premiums it
      receives, the related unearned premiums, the related unpaid losses, and other
      items of income and deductions in accordance with § 832.

LAW AND ANALYSIS

Section 831(a) provides that taxes, computed as provided in § 11, are imposed for each
taxable year on the taxable income of every insurance company other than a life
insurance company. Section 831(c) defines the term “insurance company” for purposes
of § 831 as having the same meaning as that term is given under § 816(a). Section
816(a) provides that 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 Internal Revenue Code, nor Treasury regulation, define “insurance” or
“insurance contract” for federal income tax purposes. In the seminal case addressing
this subject, the United States Supreme Court reasoned that in order for a transaction to
qualify as insurance

      the amounts must be received as a result of a transaction which involved
      an actual ‘insurance risk’ at the time the transaction was executed.
      Historically and commonly insurance involves risk-shifting and risk-
      distributing . . . That these elements of risk-shifting and risk-distributing are
      essential to a life insurance contract is agreed by courts and
      commentators.
PLR-112892-17                                  4


Helvering v. Le Gierse, 312 U.S. 531, 539 (1941). Subsequent cases, in analyzing
whether premiums paid to captive insurance companies are deductible, have
considered whether the transaction constitutes insurance in its “commonly accepted
sense” and whether the risk transferred is an “insurance risk” to establish a framework
for determining whether an arrangement will be respected as insurance for federal tax
purposes. R.V.I. Guaranty Co., LTD v. Commissioner, 145 T.C. 209, 224-25 (2015).
See also, Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1, 13-14 (2014).

The risk transferred must be risk of economic loss. Allied Fidelity Corp. v.
Commissioner, 572 F.2d 1190, 1193 (7th Cir. 1978). Courts consider “all of the facts
and circumstances to determine whether an arrangement qualifies as insurance.” Rent-
A-Center, 142 T.C. at 22 (citing Harper Group v. Commissioner, 96 T.C. 45 at 57
(1991)).

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. 2005-40, 2005 C.B. 4, 7. 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 occurs when an insurer pools a large enough collection of unrelated
risks (those unaffected by the same event) and distributes the risks among the
policyholders. Rent-A-Center, 142 T.C. at 24; Avrahami v. Commissioner, 149 T.C.
No. 7, at 60. A captive may achieve adequate risk distribution by insuring only
subsidiaries within its affiliated group. Id. But see Rev. Rul. 2005-40, 2005-4 C.B. 4
(holding that where only one entity participates as the insured, the arrangement lacks
sufficient risk distribution). In analyzing risk distribution, there must be both a sufficient
number of insured companies as well as a sufficient number of independent risk
exposures. Avrahami, 149 T.C. No. 7 at 63-64.

In Situation 1 of Rev. Rul. 2009-26, 2009-2 C.B. 366, the Service considered a ninety
percent quota share arrangement between a ceding company with 10,000 policyholders
and a reinsurer that had no other business. The Service concluded that the reinsurance
contract between the ceding company and the reinsurer shifted risk to the reinsurer and
distributed risk among the 10,000 policyholders the ceding company insured.
Accordingly, the reinsurer qualified as an insurance company because it reinsured risks
underwritten by an insurance company and assuming these risks constituted more than
half of its business for the year.

To determine whether an arrangement constitutes insurance in its commonly accepted
sense, factors to consider are: (1) whether the insurer is organized, operated, and
regulated as an insurance company by the states or jurisdictions in which it does
business; (2) whether the insurer is adequately capitalized; (3) whether the insurance
PLR-112892-17                                  5


policies are valid and binding; (4) whether the premiums are reasonable in relation to
the risk of loss; and (5) whether premiums are duly paid and loss claims are duly
satisfied. R.V. I. Guaranty Co., Ltd, 145 T.C. at 231; Rent-A-Center, 142 T.C. at 24-25.

We conclude that, for federal tax purposes, Taxpayer’s agreement, Agreement 1, with
Initial Reinsurer is an insurance contract for federal income tax purposes. Pursuant to
Agreement 1, Taxpayer acquires risks under the VSCs. Obligor does not provide repair
services under the VSCs and the VSCs are not prepaid service contracts. Under the
VSCs, for a fixed price, Obligor is obligated to indemnify the Consumer for economic
loss not covered by the manufacturer’s or other warranty arising from the mechanical
breakdown of, and repair expense to, a purchased or leased motor vehicle. The VSCs
shift the Consumers’ risks of loss due to mechanical failure to Obligor. Obligor is the
obligor under the VSCs issued to a substantial number of individual Consumers. The
VSCs cover a substantial number of motor vehicles. Therefore, the risks will be
distributed across a large number of insureds and risk exposures. Obligor transfers
these risks to Insurer. Insurer transfers these risks to Initial Reinsurer, and Initial
Reinsurer will transfer these risks to Taxpayer. These reinsurance transactions are
similar to the one described in Situation 1 of Rev. Rul. 2009- 26 because, by “looking
through” the reinsurance arrangements to the original Consumers, the risks ultimately
assumed by Taxpayer will be distributed among a large number of insured.

In addition to having insurance risk, risk shifting, and risk distribution, based on the facts
described above, the arrangement constitutes insurance in its commonly accepted
sense.

HOLDINGS

Based on the information submitted and Taxpayer’s representations:

   1) Taxpayer’s agreement, Agreement 1, with Initial Reinsurer is an insurance
      contract for federal income tax purposes.

   2) Provided that at the end of each taxable year more than half of Taxpayer’s
      business is reinsuring the VSCs, Taxpayer will qualify as insurance company
      for that taxable year for purposes of § 831.

Except as expressly provided herein, no opinion is expressed concerning the tax
consequences of any aspect of any transaction or item discussed or referenced in this
letter. The rulings contained in this letter are based upon information and
representations submitted by Taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. This office has not verified any of the
material submitted in support of the request for rulings, and it is subject to verification
on examination. This ruling is directed only to the taxpayer who requested it. Section
6110(k)(3) provides that it may not be used or cited as precedent.
PLR-112892-17                                 6


In accordance with the Power of Attorney on file with this office, a copy of this letter
is being sent to your authorized representatives.

                                       Sincerely,



                                       Rebecca L. Baxter
                                       Senior Technician Reviewer, Branch 4
                                       (Financial Institutions & Products)