Rev. Rul. 69-375

Advice has been requested whether the consideration paid by a life insurance company in acquiring a block of cancellable accident and health policies under an assumption reinsurance agreement may be treated as a deferred expense under section 1.817-4(d) of the Income Tax Regulations that may be amortized over the reasonably estimated life of such contracts.

Under an assumption reinsurance agreement effective December 31, 1967, X life insurance company ceded to Y life insurance company all of its cancellable accident and health policies in force. Pursuant to such agreement, Y became solely liable to the policyholders on the policies assumed, and the relationship between X (the original insurer) and the policyholders was terminated. On the policies transferred to Y there were unearned premiums of 20x dollars at December 31, 1967. The purchase price (consideration) paid by Y to X was three times the unearned premiums. Both X and Y are taxable as life insurance companies for Federal income taxes under Part I of Subchapter L of the Internal Revenue Code of 1954.

Generally, cancellable health and accident contracts are issued for a period of 12 months or less. Moreover, the insurer is not under an obligation to renew or continue the policy at specified premiums as is the case with long term life insurance or noncancellable health and accident insurance contracts or as in the case of guaranteed renewable health and accident insurance contracts where the premium may be adjusted but only by classes. Unlike life insurance, noncancellable health and accident, or guaranteed renewable health and accident insurance, cancellable contracts give the insurer the right, in its uncontrolled discretion, to raise the premium rates on individual policies, to alter the scope of the coverage, or to cancel the contract. Thus, not being long term contracts, nothing more than unearned premiums were maintained by X with respect to the contracts reinsured.

Section 1.817-4(d) of the Income Tax Regulations provides in pertinent part that:

"(1) For any taxable year beginning after December 31, 1958, the reinsurance of all or a part of the insurance contracts of a particular type by a life insurance company * * *, whereby the reinsuring company or companies assume all liabilities under such contracts, shall not be treated as the sale or exchange of a capital asset but shall be subject to the provisions of sections 806(a) and 809 and the regulations thereunder. * * *

"(2) * * *

"(ii) In connection with assumption reinsurance * * *, a reinsurer shall in any taxable year beginning after December 31, 1957--

* * * * *

"(b) Treat any amount paid to the reinsured, to the extent such amount meets the requirements of section 162, as a deferred expense under section 809(d)(12) and amortize such amount over the reasonably estimated life * * * of the contracts reinsured * * *.

"(iii) For purposes of this subparagraph, the term 'reasonably estimated life' means the period during which the contract remains in force. Such period shall be based on the facts in each case (such as age, health, and sex of the insured, type of contract reinsured, etc.) and the assuming company's experience (such as mortality, lapse rate, etc.) with similar risks."

The above regulations are applicable in the situation of the acquisition of long term contracts. The particular types of contracts referred to are those which necessitate the maintenance of life insurance reserves for which adjustment must be made, together with adjustment of the assets, under section 806(a) of the Code. Such contracts can be subject to a "reasonably estimated life" as defined because they have a life longer than one year and the acquiring company's experience with regard to mortality, lapse rates, etc. is meaningful. That is not the case, however, in the assumption of cancellable health and accident where the acquiring insurance company "* * * could cancel high risk policies, which would cause a high termination rate in early years followed by a low termination rate in later years. In addition, changes in the rate structure and coverage, if atypical of action by the insurance industry generally, would have a substantial impact on lapse rates. * * * reflects perhaps an inherent obstacle to the amortization of cancellable health and accident policies." International Life Insurance Co., 51 T.C. 765, 774. See also Rev. Rul. 65-175, C.B. 1965-2, 41.

In considering the particular type of contract subject to assumption reinsurance, there is no reason why there would be any different result simply because cancellable health and accident contracts are acquired by a life insurance company subject to tax imposed by section 802 of the Code rather than by an insurance company subject to tax imposed by section 831 of the Code.

Accordingly, it is held that the consideration paid by Y to acquire cancellable acident and health contracts may not be treated as a deferred expense under section 1.817-4(d) of the regulations that may be amortized over the reasonably estimated life of such contracts. Such expenditure represents the cost of acquiring an intangible asset having an indeterminate useful life.