Annuity-risk retrocession contract qualifies as reinsurance for federal tax purposes

Plain-English summary

A reinsurance company had assumed mortality, longevity, lapse, credit, reinvestment, and related risks under modified coinsurance agreements covering annuity contracts. It entered into a contract under which an affiliated foreign retrocessionaire would absorb losses above specified aggregate limits, with quarterly payments determined by an actuarial and transfer-pricing formula. The IRS found insurance risk because the underlying risks were typical of annuity contracts, risk shifting because the retrocessionaire would offset covered losses, and risk distribution because the contract pooled risks across more than a redacted number of annuity contracts. The arrangement also had the features of insurance in its commonly accepted sense, including a regulated and adequately capitalized insurer, a binding contract, actual payments, and a legitimate business purpose. The IRS ruled that the contract was reinsurance for federal income tax purposes but did not decide the taxpayer's insurance-company status, the underlying contracts' annuity status, or whether the pricing was arm's length.

Ruling snapshot

• Question: Is the contract transferring excess annuity-related risks to the affiliated retrocessionaire reinsurance for federal income tax purposes?
• Outcome: Approved
• Key authorities: IRC §§ 72 and 816; Helvering v. Le Gierse; Rev. Rul. 2005-40; Rev. Rul. 2009-26

Full text (IRS public release)

 Internal Revenue Service                                      Department of the Treasury
                                                               Washington, DC 20224

 Number: 202109005                                             Third Party Communication: None
 Release Date: 3/5/2021                                        Date of Communication: Not Applicable
 Index Number: 831.00-00
                                                               Person To Contact:
 ----------------                                              --------------------, ID No. ---------------
 ------------------------------                                Telephone Number:
 -------------------------------                               --------------------
 ------------------------------------------------              Refer Reply To:
 -------------------------------------                         CC:FIP:B04
 ------------------------------                                PLR-123686-19
                                                               Date:
                                                               December 10, 2020




 Taxpayer                   = ------------------------------------------------------
 Parent                     = ---------------------------------------------------------
 Retrocessionaire           = -------------------------------------------------
 Holding Company            = --------------------------------------------------
 Domicile                   = ------------
 Contract                   = -----------------------------------------------------------------------------------
                              --------------------------------------
 Number A                   = ------
 Number B                   = ---------------
 Date                       = ---------------------
 Year 1                     = -------
 Year 2                     = -------


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

This letter responds to Taxpayer’s request for a letter ruling that the Contract between
Taxpayer and Retrocessionaire is reinsurance for Federal income tax purposes.

                                                    FACTS

Taxpayer represents the following facts:

Taxpayer is domiciled in Domicile, where it is regulated as an insurance company.
Taxpayer has determined that it would qualify under § 816 of the Internal Revenue
Code (“Code”) as an insurance company other than a life insurance company.
Taxpayer has elected under § 953(d) to be treated as a domestic corporation and
computes its U.S. Federal income tax under § 831(a). Taxpayer is a subsidiary of
Parent and is included in Parent’s consolidated Federal income tax return. Parent is in
turn a subsidiary of Retrocessionaire, which is also domiciled in Domicile, where it is
regulated as an insurance company. Retrocessionaire has not elected under § 953(d)
to be treated as a domestic corporation. Retrocessionaire reinsures both affiliates and
PLR-123686-19                                2

third parties and is well capitalized to support its substantial business with unrelated
third parties. Retrocessionaire is directly owned by Holding Company, a publicly traded
insurance holding company domiciled in Domicile. Retrocessionaire and Taxpayer are
part of the Holding Company Group, made up of Holding Company’s direct and indirect
subsidiaries.

Taxpayer is a reinsurance company. As part of its reinsurance business, Taxpayer
through various modified co-insurance agreements (“Modco Agreements”) assumes
risks under deferred and immediate annuity contracts issued by, or in a few instances
reinsured by, affiliates of Taxpayer (the “Annuity Contracts”). Taxpayer represents that
the Annuity Contracts are issued by life insurance companies and satisfy the criteria for
treatment as annuity contracts under § 72. The risks assumed by Taxpayer under the
Modco Agreements (the “Reinsured Risks”) with respect to some Annuity Contracts
(specifically, deferred annuities that contain permanent purchase rate guarantees)
include mortality, longevity, lapse, credit quality, reinvestment, and disintermediation
risks and with respect to other Annuity Contracts (specifically, immediate annuities)
include mortality, longevity, credit quality, and reinvestment risk.

Taxpayer has entered into the Contract with Retrocessionaire with regard to the
obligations assumed by Taxpayer under specified Modco Agreements (the “Covered
Modco Agreements”). The Contract is for a stated term of one year, beginning Date,
and automatically renews annually for Number A years, unless Taxpayer provides
timely written notice of non-renewal to Retrocessionaire. During that term, the Contract
must be renewed if the total amount paid or payable by Retrocessionaire under the
Contract from Date through the date Contract would be terminated exceeds the total
amount paid or payable by Taxpayer under the Contract from Date through the date
Contract would be terminated. Under the Contract, Retrocessionaire agreed to
indemnify Taxpayer against loss from the Reinsured Risks under the Covered Modco
Agreements (the “Covered Reinsured Risks”) in excess of certain aggregate specified
limits. The Covered Reinsured Risks relate to over Number B Annuity Contracts.
Taxpayer entered the Contract to reduce or eliminate its exposure to such excess
losses and to align Taxpayer’s exposure to the Reinsured Risks with Taxpayer’s
available capital and the capital of the Holding Company Group.

The payments under the Contract are computed quarterly. For each quarter, a payment
is computed taking into account the aggregate year-to-date business activity of
Taxpayer related to the Covered Modco Agreements. If the result for the quarter is
negative, indicating that losses under the Covered Modco Agreements exceeded the
aggregate specified limits, an amount is owed by Retrocessionaire to Taxpayer,
indemnifying Taxpayer for the adverse experience under the Covered Modco
Agreements. If the result for the quarter is positive, a formula specified in the Contract
is applied to different tranches of risk to determine the amount Taxpayer owes
Retrocessionaire. Taxpayer has represented that the formula and risk tranches were
determined by both an actuarial analysis and a third-party transfer pricing analysis.
Taxpayer has also represented that there is a reasonable probability of a loss requiring
PLR-123686-19                                3

payment by Retrocessionaire occurring, and this probability was one of the factors
considered in determining the formula and risk tranches. Each quarterly settlement
payment takes into account the other quarterly settlement payments made during the
calendar year. Hereinafter, if the quarterly payments made by Taxpayer to
Retrocessionaire exceed those made by Retrocessionaire to Taxpayer in a taxable
year, the net amount of the quarterly payments for the taxable year is referred to as the
“Taxpayer Payment;” if the quarterly payments made by Retrocessionaire to Taxpayer
exceed those made by Taxpayer to Retrocessionaire, the net amount of the quarterly
payments is referred to as the “Retrocessionaire Payment.” Taxpayer made Taxpayer
Payments to Retrocessionaire for Year 1 and Year 2. Retrocessionaire has made a
quarterly payment under the Contract, but there has been no Retrocessionaire Payment
to date.

                                 REQUESTED RULING

The Contract is reinsurance for Federal income tax purposes.

                                  LAW AND ANALYSIS

Law

Neither the Code nor the Income Tax Regulations defines the terms “insurance” or
“insurance contract” for Federal income tax purposes. In the seminal case addressing
this subject, the United States Supreme Court described “insurance” as an arrangement
that is insurance “in its commonly accepted sense,” involving “insurance risk,” “risk-
shifting,” and “risk-distributing.” Helvering v. Le Gierse, 312 U.S. 531, 539 (1941).
Subsequent cases have also considered whether an arrangement involves insurance
risk, risk shifting, and risk distribution and have considered additional factors in
determining whether an arrangement is insurance “in its commonly accepted sense.”
See, e.g., AMERCO, Inc. v. Commissioner, 979 F.2d 162, 165 (9th Cir. 1992), aff’g 96
T.C. 18 (1991); Avrahami v. Commissioner, 149 T.C. 144, 177 (2017).

Insurance includes the issuing of annuity contracts. See § 816(a) (“‘[I]nsurance
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.”); S. Prt. 98-169 (Vol. 1) at 525-527 (1984); see
also Perano v. Commissioner, 130 T.C. 93, 101 (2008) (“The issuance of insurance, to
include annuities, requires risk shifting and risk distribution.”).

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, 2005-2 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).
PLR-123686-19                                4

Risk distribution occurs if the insurer pools a large enough collection of unrelated risks.
See, e.g., Avrahami, 149 T.C. at 181; see also Perano, 130 T.C. at 101-102 (the pooling
of possible annuity termination dates is risk distribution). Rev. Rul. 2009-26, 2009-38
I.R.B. 366, concludes that an entity, Z, the only business of which was to assume 90%
of the risk borne by IC Y under 10,000 insurance contracts, qualified as an insurance
company because, among other things, the risks Z assumed from IC Y remained
distributed.

The commonly accepted sense of insurance signifies, among other things, an
arrangement with an entity organized, operated, and regulated as an insurance
company. See Avrahami, 149 T.C. at 191; R.V.I. Guaranty Co., Ltd. v. Commissioner,
145 T.C. 209, 231 (2015). Other factors considered include whether the insurer was
adequately capitalized; whether the contracts were valid and binding; whether the
premiums were reasonable and the result of an arm’s length transaction; whether
claims were paid; whether the policies covered typical insurance risks; and whether
there was a legitimate business purpose for the transaction. See Avrahami, 149 T.C. at
191.

Analysis

The Covered Reinsured Risks are underwritten by the life insurance companies issuing
the Annuity Contracts and are risks commonly assumed in issuing annuity contracts.
The Covered Reinsured Risks are therefore considered insurance risks.

If Taxpayer’s experience with regard to the Covered Reinsured Risks under the
Covered Modco Contracts is negative, as expressed by the Contract’s formula, the
Retrocessionaire Payment has the effect of mitigating Taxpayer’s loss. The loss is
borne by Retrocessionaire, as evidenced by the Retrocessionaire Payment made to
Taxpayer. Accordingly, Taxpayer shifts a portion of the Covered Reinsured Risks to
Retrocessionaire under the Contract.

Retrocessionaire’s risk is distributed through the pooling of the Covered Reinsured
Risks, which relate to over Number B Annuity Contracts.

The Contract is insurance in the commonly accepted sense of insurance:
Retrocessionaire is organized, operated, and regulated as an insurance company and is
adequately capitalized; the Contract is valid and binding; the payment formula and risk
tranches used to calculate payments under the Contract were determined by both an
actuarial analysis and a third-party transfer pricing analysis; payments have been made
as provided in the Contract; the Annuity Contracts cover typical insurance risks of
annuity contracts; and there was a legitimate business purpose for acquiring insurance
from Retrocessionaire.
PLR-123686-19                                  5

                                          RULING

Based solely on the information submitted and the representations made, the Contract
is reinsurance for Federal income tax purposes.

                                         CAVEATS

The ruling contained in this letter is based upon information and representations
Taxpayer submitted, accompanied by penalty of perjury statements executed by
appropriate parties. This office has not verified any of the material submitted in support
of the ruling request, and it is subject to verification on examination.

No opinion is expressed as to the tax treatment of the transaction under the provisions
of any of the other sections of the Code and regulations that may also be applicable
thereto or to the tax treatment of any conditions existing at the time of, or effects
resulting from, the transaction that are not specifically covered by the above ruling.
Taxpayer has not requested any ruling, and no ruling is provided, regarding whether
Taxpayer is an insurance company for Federal income tax purposes, whether the
Annuity Contracts are annuity contracts within the meaning of § 72, or whether the
Contract is priced at arm’s length.

This ruling letter is directed only to the taxpayer who requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

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

Pursuant to a power of attorney on file in this office, a copy of this ruling is being
furnished to your authorized representatives.


                                        Sincerely,

                                        Kathryn J. Sneade
                                        Senior Technician Reviewer, Branch 4
                                        Associate Chief Counsel
                                        Financial Institutions and Products)



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