Primer: Property-Casualty Reinsurance

1. 42nd Annual Insurance Tax Conference Primer:  Property-Casualty Reinsurance Maria Jones, Miller & Chevalier Bruce Cohen, Berkshire Hathaway Inc. Brenda Viehe-Naess, Washington Advocates Group November 3, 2017

2. Agenda • What is Reinsurance • Definition and Basic Mechanics • Purposes of Reinsurance • Types of Reinsurance • Overview of Reinsurance Transactions • Taxation of Reinsurance • Reinsurance Transaction Examples • Reinsurance in M&A • Significant Tax Issues • Qualification as Insurance • IRC §845 • Federal Excise Tax on Foreign Insurance • FATCA

3. What is Reinsurance? Reinsurance is an agreement between an initial insurer (the ceding company) and a second insurer (the reinsurer), under which the ceding company passes to the reinsurer some or all of the risks that the ceding company assumes through the direct underwriting of insurance policies. Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 278 (1996)

4. Definition • Contract between insurance company and reinsurer • No privity of contract between insurer’s policyholders and reinsurer • Risk spreading through reinsurance is essential to protect the financial solvency of all insurance companies, both primary companies and reinsurance companies

5. Purposes of Reinsurance • Limit liability • Allows insurer to limit loss exposure to level appropriate for its surplus & underwriting parameters without turning away producers • Stabilization • Reduces the wide swings in profits and losses inherent in the P&C business • Catastrophe protection • Protection against losses from single event and in the aggregate • Risk spreading through reinsurance is essential to protect the financial solvency of all insurance companies, both primary companies and reinsurance companies. • Increased capacity • Allows insurer to transfer costs of new business and continue to expand

6. Types of Reinsurance – Quota Share • Proportional or “Quota Share” • A reinsurance contract written on a proportional basis that prorates all premiums, losses and expenses between the insurer and the reinsurer on a pre-arranged basis. 

7. Types of Reinsurance - XL • Excess of Loss (XL) • The reinsurer agrees to cover losses within a band, from an agreed amount or attachment point up to an agreed maximum. • Excess of loss coverage may provide for payments in excess of an aggregate amount, or above a specified amount on a per occurrence basis. • Typically, a company’s reinsurance plan involves a combination of both pro rata and excess of loss reinsurance, with overarching excess of loss coverage to prevent catastrophic losses.

8. Types of Reinsurance • Missing piece of cake = quota share/proportional reinsurance • Each layer of cake = non-proportional reinsurance, includingexcess layers

9. Types of Reinsurance • Treaty • A reinsurance contract under which the reinsured company agrees to cede and the reinsurer agrees to assume a portfolio of risks of a particular class or classes of business. • Facultative • Reinsurance of individual risks by offer and acceptance wherein the reinsurer retains the ability to accept or reject and individually price each risk offered by the ceding company.

10. Ceding Commission • An amount paid by the reinsurer to compensate a ceding company for its acquisition and other overhead costs, including premium taxes. • It is often deducted from the reinsurance premium paid. • Ceding commission payment may also include a profit factor, called a ceding allowance.

11. Overview of Reinsurance Transactions Premiums and Risks Premiums and Risks Reinsurer Assuming Co. Insurer CedingCo. Ceding Commission Reinsurance Recoverables Familiar Tax Terms Equivalent Industry Terms Seller transfers assets & liabilities to Buyer Insurer transfers insurance risk to Reinsurer. Buyer pays Seller purchase price for net assets purchased Reinsurer pays Insurer a ceding commission Value in excess of tangible assets = godwill Value in excess of tangible net assets = Value of business in force

12. Flows of a Reinsurance Transaction Reinsurer Ceding Insurer Retrocessionaire Retrocession of Risks Reinsurance of Risks Subsequent reinsurance transfers of risk ─ retrocessions of risk ─ provide reinsurers with the same ability as insurers to manage their capital and risk levels

13. Indemnity Reinsurance Policy- holders Premiums Risk Insurer(Ceding Co.) Reinsurer (Assuming Co.) Recoverables Ceding Commission Reinsurer has no liability to insurer’s policyholders; Reinsurer’s only liability for claims is to Insurer In event of Reinsurer’s default or insolvency, Ceding Insurer must pay all policyholder claims Relationship with Policyholder – Ceding Insurer handles all customer transactions Ceding commission reflects costs of acquiring business (agent’s commission, advertising + profits)

14. Assumption Reinsurance Policy- holders Block of Business Customer Relationships Seller (Ceding Co.) Buyer (Assuming Co.) Purchase Price Ceding Commission • Assets & Liabilities of Business to be transferred including customer relationships • Relationship with Policyholder – Ceding Co. is no longer involved • Assuming company steps in shoes of ceding insurer • In U.S., commonly found in an insolvency context

15. Types of Reinsurance Indemnity • Reinsurer assumes liabilities of specified policy risks of the Insurer – but customer relationship remains with the Insurer (i.e., name of insurer on policyholder insurance card doesn’t change) • The contractual relationship is between the ceding and assuming company – not between the assuming company and the policyholder • Insurer remains liable for credit risk on policies transferred – if Reinsurer goes insolvent – Insurer must still pay claims to policyholder • Because policyholders are not affected, policyholder approval is not required Assumption • Insurer sells all aspects of the business to the Reinsurer – including the customer interface (name of insurer on policyholder insurance card changes to Reinsurer from Insurer) • Insurer is no longer liable at any level for risks of policies transferred • Because policyholders are affected, policyholder approval of the transfer is required of ALL policyholders

16. TAXATION OF REINSURANCE

17. Taxation of Reinsurance • Ceding Insurer • Deducts premium paid to reinsurer • Recognizes ordinary income • Ceding commission • Reinsurance recoveries received are included in “losses incurred” calculation • Any release of reserves • Assuming Reinsurer • Recognizes ordinary income for premium received • Deducts • Ceding commission • Reinsurance intermediary fee • Reserves established for losses incurred • Unearned premium reserve for any coverage extending beyond taxable year

18. Reinsurance Transaction Example: Ceding Insurer

19. Reinsurance Transaction Example: Assuming Reinsurer

20. Reinsurance in M&A • An insurance company acquisition can be structured as either a stock purchase or as indemnity reinsurance • If taxable stock purchase, a §338 election recharacterizes the transaction as a deemed asset acquisition • Target corporation is deemed to sell all of its assets to “new target” which also assumes liabilities • The deemed sale of insurance policies is treated as an assumption reinsurance transaction

21. Reinsurance in M&A • Assumption reinsurance is treated as the sale of the policies being insured. Distinguish between: • “Mere reinsurance,” and • “Specified asset acquisition” —The acquisition of significant business assets, in addition to insurance contracts, to which goodwill and going concern value could attach. See Treas. Reg. §1.1060-1(b)(9). • What is assumption reinsurance for this purpose? – See CCA 201642032

22. Reinsurance in M&A • Section 1060 utilizes a residual method of allocation for the purchase price in specified asset acquisitions, including section 338 elections. • Seven asset classes. • Applies to value ceding commission and other intangibles. • Section 197 applies to assumption reinsurance transactions. §197(d)(2). Ceding commission in assumption reinsurance is amortized over 15 years. • In contrast, ceding commission in indemnity reinsurance must be amortized over term of acquired contracts.

23. Taxation of Reinsurance • Section 1060 - Applies to "applicable asset acquisitions“ • Any transfer, whether direct or indirect, of a group of assets if the assets transferred constitute a trade or business in the hands of either the seller or the purchaser. • A group of assets constitutes a trade or business if— • The use of such assets would constitute an active trade or business under section 355; or • Its character is such that goodwill or going concern value could under any circumstances attach to such group. Treas. Reg. § 1.1060-1(b). • Application to insurance transaction • Does not apply to "mere reinsurance.“ • Applies if the purchaser acquires significant business assets, in addition to insurance contracts, to which goodwill and going concern value could attach. Treas. Reg. §1.1060-1(b)(9).

24. SIGNIFICANT TAX ISSUES

25. QUALIFICATION AS INSURANCE

26. Qualification as Insurance • Three part test for valid insurance • Presence of insurance risk, • Risk shifting and risk distribution, and • Whether the arrangement would be considered “insurance” in its commonly accepted sense. Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61 (1991), as modified, 96. T.C. 671 (1991); The Harper Group v. Commissioner, 96 T.C. 45 (1991); AMERCO v. Commissioner, 96 T.C. 18 (1991), see alsoHelvering v. Le Gierse, 312 U.S. 531, 539-540 (1941). • “Insurance risk” is required; investment risk is insufficient. R.V.I. Guaranty Co. v. Comm'r, 145 T.C. 209, 224-225 (2015). • If parties structure an apparent insurance transaction so as to effectively eliminate the effect of insurance risk therein, insurance cannot be present. AMERCO, 96 T.C. at 38-39.

27. Qualification as Insurance • SSAP No.62/ SFAS 113 require significant risk transfer for qualification & parallel tax criteria • Section 12: Indemnification of the ceding entity against loss or liability relating to insurance risk in reinsurance requires both of the following: • a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance agreements; and • b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.

28. Qualification as Insurance • SSAP 62/ FAS 113 also requires review of factors such as side agreements, commutation clauses, and retrocessions that could limit the reinsurer’s risk, so that features not easily evaluated on the face of the contract would be considered. • Transaction that fails to qualify as insurance is treated as a deposit. • Structured reinsurance/finite risk reinsurance developed in 1980’s to make reinsurance available/affordable in “hard” markets

29. Categories of Reinsurance Prospective Retroactive Covers reserves for losses incurred that have already been established Commonly called “Loss Portfolio Transfers” IRS often questions retroactive reinsurance, based on Rev. Rul. 1989-96, 1989-2 C.B. 114, and its companion Rev. Rul. 2007-47 Industry view: losses may develop in excess of those projected and result in loss to reinsurer = true insurance risk. • Covers events occurring in a future year • Vast majority of reinsurance policies are written for one year, only • A small proportion of reinsurance is written for 3 year terms, especially in structure of Cat Bonds • Risk transfer key to qualification for insurance treatment for tax/ accounting purposes

30. Failure to Qualify as Insurance • Reinsurance transaction that fails to qualify is treated as deposit for both tax and accounting purposes • Ceding insurer • No deduction for premium • Reinsurance recoveries treated as return of capital + interest for tax purposes • Accounting treatment: recoveries amortized over period of coverage • Reinsurer • Premium treated as deposit for tax purposes --- income only to extent that there is an amount in excess of recoveries • No deductions for loss reserves or claims payments • Recoveries treated as return of capital (non deductible) + interest (deductible)

31. IRC §845

32. Power of the IRS to Modify CertainReinsurance Arguments – IRC 845 • Related Party Reinsurance • IRC §845(a) empowers the IRS to allocate, recharacterize or “make any other adjustment” to reflect the proper amount, source and character of the taxable income • Unrelated Party Reinsurance • IRC §845(b) empowers the IRS to make adjustments to eliminate a “significant tax avoidance effect” • Adjustments may be to only one party • May end the tax year

33. IRC §845 – Factors to Consider Age of business reinsured Financial position of the parties Character of business reinsured Factors to be considered: Tax position of the parties Structure for determining potential profits Termination provisions Duration of agreement

34. Power of the IRS to Modify CertainReinsurance Arguments – IRC §845 • Trans City Life Insurance Co. • IRS asserted agreements did not contain sufficient transfer of life insurance risk that was proportionate to the tax benefit derived. • Tax Court found agreements were entered into for valid business reasons and that the agreements satisfied six of the seven criteria contained in the Conference Committee Report • Tax Court considered the “possible” loss; not the “probable” loss • IRS abused its discretion in applying IRC §845(b)

35. Power of the IRS to Modify CertainReinsurance Arguments – IRC §845 • LAFA 20092101F – IRS disallowed a related-party reinsurance transaction under section 845(b). • PLR 9412005 – Clarified that additional correlative adjustments could be necessary under the facts set forth in PLR 9345006 (where the IRS had explicitly declined to opine on the applicability of section 845). • TAM 9346004 – Section 845(a) limited the taxpayer’s interest deductions where, as a result of related party reinsurance transactions, the source of the deductions changed from the nonlife to the life subgroup. The reinsurance transactions were held to have a substantial tax avoidance effect. • TAM 9339001 – Under section 845(b) unearned premium reserves on reinsured policies were attributable to the taxpayer for purposes of determining whether the taxpayer was a life insurance company under section 816.

36. Power of the IRS to Modify CertainReinsurance Arguments – IRC §845 • PLR 9335056 – Section 845 was not applicable to an assumption reinsurance agreement because the agreement did not have a significant tax avoidance effect as to the taxpayer. • TAM 9308003 – Disregarded reinsurance agreements under section 845 in determining whether the taxpayer qualified as a life insurance company under section 816. • TAM 9228003 – Noted that an examining agent had authority under section 845(b) to adjust an insurer’s computation of discounted unpaid losses to eliminate distortion in the insurer’s historical loss payment pattern. • PLR 8941032 – Did not opine on the applicability of section 845, but noted that section 845 “implicitly recognizes” that related party reinsurance agreements can be valid insurance transactions for other purposes of the Code.

37. Federal Excise Tax • Premiums received by non-U.S. domiciled insurer for insurance or reinsurance written on U.S. risks are subject to FET under Section 4371, unless exempted • 4% on direct written P&C, 1% on Reinsurance & Life • Several tax treaties have exemptions from the excise tax. • Foreign companies have entered into Closing Agreements confirming their FET exemption. List on IRS website https://www.irs.gov/businesses/international-businesses/exemption-from-section-4371-excise-tax • For Section 953(d) companies, premiums generating Effectively Connected Income (ECI) are exempt • Can be collected from ANYONE who touches the cash (brokers, insured, insurer, intermediary) • IRS/Treasury took position that cascading excise tax applies to each successive leg of reinsurance if ceded business is retroceded to a company not in a treaty country (See Rev. Rul. 2008-15 & TAM 9621001). • The government’s position was rejected in Validus Reinsurance Ltd. v. US, 786 F.3d 1039 (D.C. Cir. 2015). Rev. Rul. 2008-15 was revoked by Rev. Rul. 2016-3.

38. FATCA • The Foreign Account Tax Compliance Act (“FATCA”) imposes a 30% withholding tax on U.S. source insurance and reinsurance premiums paid to foreign, non-compliant “financial institutions.” • What is the source of reinsurance premiums? • Foreign P&C insurance and reinsurance companies are generally not “financial institutions” that have FATCA reporting obligations. • A foreign insurance company that has made a section 953(d) election is still considered foreign for FATCA purposes. • U.S. ceding insurer or broker must obtain FATCA documentation from reinsurer – Form W-8 BEN-E (foreign reinsurer) or Form W-9 (domestic reinsurer). • Foreign reinsurer must determine proper FATCA status to complete form. • Reinsurance contract will allow ceding insurer to withhold if FATCA documentation is not provided.

39. Questions/Comments?

40. Contact Information Brenda Viehe-Naess Washington Advocates Group 202-735-0060 bvns@att.net Maria O’Toole Jones Miller & Chevalier Chartered 202-626-6057 mjones@milchev.com Bruce Cohen Berkshire Hathaway Tax Group 203-328-6257 bruce.cohen@bhets.com