IRS Finds Risk Distribution in Two Reinsurance Arrangements

A recent Internal Revenue Service (IRS) revenue ruling confirms, for the first time in formal guidance, assumptions long-held by taxpayers about the proper analysis of risk distribution in the context of reinsurance. Revenue Ruling 2009-26 (2009 38 I.R.B. 366) analyzes risk shifting and risk distribution in the context of property casualty reinsurance, but its principles would apply equally to other types of arrangements, such as reinsurance of XXX life reserves, where a special purpose reinsurance company is used to assume risks from a single direct writer.

Revenue Ruling 2009-26 considers two fact patterns involving Insurance Company Y (“Insurance Co.”) and Reinsurer Z and whether Reinsurer should be treated as an insurance company under I.R.C. § 831(c). In Situation 1, Insurance Co. entered into a 90 percent quota share reinsurance contract with the Reinsurer that covered 10,000 insurance policies issued by Insurance Co. in the commercial multiple peril line of business. This was the Reinsurer’s only business during the year. The ruling found that the policies issued by Insurance Co. involved insurance risks, transferred those risks from 10,000 unrelated policyholders to Insurance Co., distributed those risks (in that a loss by one policyholder was not borne in substantial part by that policyholder’s premiums), and were insurance in the commonly accepted sense. The ruling also found that the reinsurance contract between Insurance Co. and Reinsurer likewise transferred the risks to Reinsurer and constituted reinsurance in the commonly accepted sense. With respect to risk distribution, the ruling concluded that the reinsurance contract did nothing to disturb the distribution of the risks of the 10,000 policyholders that had been achieved by their policies with Insurance Co. Accordingly, the Reinsurer qualified as an insurance company for tax purposes. This analysis likewise suggests that reinsurance of the XXX life reserves of a single ceding company would meet the risk distribution requirement for tax purposes even if that reinsurance constituted the entirety of the reinsurer’s business.

In Situation 2 of the ruling, the facts were the same, except that the reinsurance contract with Insurance Co. covered the risks of only one policyholder (X, unrelated to Reinsurer), and Reinsurer also entered into reinsurance contracts with other insurance companies to assume additional policies in the same line of business. In this situation, although the risks of the single policyholder (X) assumed from Insurance Co. may not have been “distributed” when viewed in isolation, risk distribution was achieved by Reinsurer’s assumption of similar risks of unrelated policyholders from other insurance companies, so that the risks of each original policyholder (including X) were distributed in that a loss by one policyholder was not borne in substantial part by that policyholder’s premiums. Therefore, the ruling concluded, Reinsurer was treated as an insurance company under I.R.C. § 831(c) in Situation 2 as well.