SERVICE PIERCES PURPORTED INSURANCE CONTRACT TO DISALLOW PREARRANGED LOSS DEDUCTIONS.

Rev. Rul. 89-96

ISSUE

With respect to the retroactive agreement described below, is a casualty insurance company entitled to claim a deductjion under section 832(b)(5) of the Internal Revenue Code for "losses incurred" during the taxable year on insurance contracts?

FACTS

As a result of a catastrophe during June 1987, Y incurred a liability to injured persons the exact amount of which could not be ascertained, but was expected to be substantially in excess of $130x. At the time the catastrophe ocurred, Y's liability insurance coverage totaled $30x. In July 1987, for a premium of $50x, Y obtained from taxpayer Z additional "liability insurance" coverage in the amount of $100x. Z is a commercial insurance company unrelated either to Y or to Y's primary liability carrier. Under this contract, Z promised to pay on behalf of Y (subject to the contract's limit of $100x) those sums in excess of $30x for which Y would thereafter become legally liable to pay as damages as a result of the June catastrophe. Y fully disclosed all the facts concerning the catastrophe to Z on the application for additional coverage. On its annual statement for state regulatory purposes, Z included the $50x "premium" from Y in earned premiums and included $100x in unpaid losses.

Z is a calendar year taxpayer. On its 1987 federal income tax return, in computing its gross income under section 832 of the Code, Z treated the gross "premium" of $50x as fully earned. Z's expenses ("loading") allocable to the contract were deminimis relative to the $50x. As part of its losses incurred on insurance contracts, Z included the unpaid loss of $100x and deducted an appropriately discounted amount. The net effect of entering into the contract with Y was to reduce Z's underwriting income for 1987 by the excess of the discounted $100x loss over the $50x "premium". From the economic terms of the contract it was reasonable to expect that the amount of net "premium" received from Y (gross premium less loading), the amount of its tax savings resulting from the increased deduction for "losses incurred," and the investment income earned on those amounts would probably exceed its maximum anticipated liability, $100x, under its contract with Y.

LAW AND ANALYSIS

Section 832(b)(1) of the Code provides that, in the case of an insurance company subject to the tax imposed by section 831, "gross income" includes the combined gross amount earned during the taxable year, from investment income and from underwriting income, computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners.

Section 832(b)(3) of the Code provides that the term "underwriting income" means the premiums earned on insurance contracts during the taxable year losses incurred and expenses incurred.

Section 832(b)(5) of the Code provides that the term "losses incurred" means losses incurred during the taxable year on insurance contracts, computed as follows: (i) to losses paid during the taxable year, add salvage and reinsurance recoverable outstanding at the end of the preceding taxable year and deduct salvage and reinsurance recoverable outstanding at the end of the taxable year, (ii) to the result so obtained, add all unpaid losses on life insurance contracts plus all discounted unpaid losses (as defined in section 846) outstanding at the end of the taxable year and deduct unpaid losses on life insurance contracts plus all discounted unpaid losses outstanding at the end of the preceding taxable year.

Section 846 of the Code provides for the discounting of unpaid loss reserves to take into account the time value of money. Except for losses already discounted on the annual statement, section 846(b) provides that, for purposes of section 846, the unpaid losses reflected on the insurance company's annual statement. Rev. Rul. 87- 34, 1987-1 C.B. 168, provides loss payment patterns and discount factors used for discounting unpaid losses for calendar year 1987.

Section 1.832-4(b) of the regulations provides that every insurance company must be prepared to establish to the satisfaction of the district director that the part of the deduction for losses incurred that represents unpaid losses at the close of the taxable year comprises only actual unpaid losses stated in amounts that, based on the facts in each case and the company's experience with similar cases, can be said to present a fair and reasonable estimate of the amount the company will be required to pay. Amounts included in, or added to, the estimates of such losses that, in the opinion of the district director, are in excess of the actual liability will be disallowed as a deduction.

For purposes of the federal tax law, risk shifting is an indispensible characteristic of insurance. Helvering v. LeGierse, 312 U.S. 531 (1941), 1941-1 C.B. 430. A similar standard has been used both for exemption from federal antitrust laws, see Group health Life Insurance Co. v. Royal Drug Co., 440 U.S. 205, 211 (1979) ("The primary elements of an insurance contract are the spreading and underwriting of a policyholder's risk."), and for federal securities laws, see Securities and Exchange Commission v. United Benefit Life Insurance Co., 387 U.S. 202 (1967); Securities and Exchange Commission v. Variable Annuity life Insurance Co., 359 U.S. 65 (1959). Moreover, the opinions in United Benefits Life, 387 U.S. at 211, and in LeGierse, 312 U.S. at 542, indicate that the transfer of an investment risk cannot by itself create insurance.

The present arrangement does not involve the requisite risk shifing necessary for insurance. The catastrophe has already occurred, and the economic terms of the contract demonstrate the absence of any transfer of risk apart from an investment risk. Z charges a "premium" of $50x to assume Y's unaccrued liability (subject to the contract's limit of $100x) because from an economic perspective it was reasonable to expect that the amount of net "premium" received from Y, the amount of the tax saving resulting from the increased deduction for "losses incurred," and the investment income earned on these amounts, would exceed its maximum anticipated liability of $100x. Although the contract created certain risks for Z, those risks are investment risks and not insurance risks. Specifically, the only risks borne by Z in this situation are (1) that it will be required to make payments with respect to a known loss earlier than expected and (2) that the available investment yield between the time of payment of the premiums and the time of payment of the claims will be lower than expected. When tested against the federal tax definition of insurance, therefore, the retroactive arrangement in the present situation fails to create an insurance contract. Z's assumption of investment risks cannot create an insurance agreement for federal income tax purposes.

Furthermore, under the stated facts, Z's establishment of a reserve for a loss of $100x, on the basis of facts known at the time the arrangement was entered into, indicated that Z anticipated that it would be required to pay on behalf of Y the $100x maximum amount that could be paid under the policy. This fact additionally supports the conclusion that Y did not transfer to Z any insurance risk.

HOLDING

Z cannot include the loss in the retroactive agreement in "losses incurred" on insurance contracts under section 832(b)(5) of the Code.

DRAFTING INFORMATION

The principal author of this revenue ruling is William T. Sullivan of the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Sullivan on (202) 566-3458 (not a toll- free call).