IRS Rules that Retroactive Reinsurance is not Reinsurance for Tax Purposes

(Co-authored with Peter H. Winslow and Lori J. Jones)

In PLR 200711017 (Dec. 14, 2006), the IRS National Office ruled that loss portfolio reinsurance (which is generally accounted for as retroactive reinsurance under SSAP 62) between two related insurance companies does not qualify as insurance for tax purposes, even though the reinsurance satisfied the criteria for risk transfer under SSAP 62 for property and casualty reinsurance and even though the state insurance department confirmed that reinsurance accounting treatment is correct. Because the agreement between the companies covered only loss reserves related to insured events that already had occurred, the ruling notes that “the element of fortuity is absent” and concludes that the agreement transfers only a timing and investment risk. Noting that the taxpayer could not procure an arrangement with similar terms in the commercial reinsurance market because, in part, if the companies were unrelated, the same statutory accounting treatment would not be available, the ruling also concludes that the reinsurance agreement is not insurance in the commonly accepted sense “as envisioned by the caselaw.”

The ruling considers an agreement between a reinsurance company and its parent (another reinsurance company) under which the subsidiary company transferred or ceded its liability for losses (including loss adjustment expenses and incurred-but-not-reported losses) to its parent company, for losses occurring no later than a specific year that was several years before the agreement. The ceding company paid an amount equal to the statutory reserves being transferred, and such amount was placed in a notional account to which a set rate of interest would be credited. The assuming company is obligated to pay any losses covered by the agreement up to an aggregate limit. If at any time the amount of claims exceeds the balance in the notional account, the assuming company must pay the excess up to the aggregate limit; if the balance in the notional account exceeds the claims paid at the end of the contract, the positive balance will be remitted to the assuming company. The facts note that, but for the companies being related, SSAP 62 would require the agreement to be accounted for as retroactive reinsurance. Because the companies are related and because the agreement meets SSAP’s criteria for risk transfer, the companies are allowed to account for the agreement as prospective reinsurance.