Insurers Seek Changes to Proposed Loss Limitation Regs

November 12, 2019

Internal Revenue Service
Room 5203
PO Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Application of the Proposed Section 382(h) Regulations to Insurance Companies

Ladies and Gentlemen:

We are writing today on behalf of the American Property Casualty Insurance Association (“APCIA”), the National Association of Mutual Insurance Companies, and the Reinsurance Association of America (the “Trades”). We are providing comments on the recent Notice of Proposed Rulemaking published on September 10, 2019 providing guidance on section 382(h), (the “Proposed Regulations”).¹ The Trades appreciate the opportunity to comment on the Proposed Regulations. The Trades collectively represent the great majority of insurance companies issuing property and casualty (non-life) insurance throughout the United States.

The Proposed Regulations address items that are included in the calculation of built-in gains and losses under section 382 of the Code. Prior to the issuance of the Proposed Regulations, Notice 2003-65 had allowed two safe harbors for determining whether income and deduction items were treated as built-in for purposes of section 382(h); these were termed the “1374 approach” and the “338 approach.” The Proposed Regulations generally adopt the 1374 approach. However, the Proposed Regulations modify the 1374 approach to include the amount of any deductible contingent liability that is paid or accrued during the recognition period as a built-in loss.

The Proposed Regulations do not address the application of the proposed rules to insurance companies. Thus, it seems that the drafters of the Proposed Regulations intend the provisions of the Proposed Regulations to apply in the same manner to insurance companies as they do to corporations that are not insurance companies. Unfortunately, as described below, application of these rules without modification to accommodate the special rules applicable to insurance companies leads to results that are inequitable or impossible to apply.

As discussed below, subchapter L of the Code contains provisions applicable only to insurance companies and reflects the differences between insurance companies and other corporations. However, the provisions of subchapter C, including section 382, also apply to insurance companies because they are corporations under section 7701(a)(3). This overlap of subchapters has historically resulted in conflicting rules. In those cases, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) have found it necessary to adopt special coordination provisions when the rules of these subchapters overlap.²

We understand that applying section 382(h) to a loss corporation that is an insurance company raises complex and arcane issues similar to other issues that arise from the interplay between subchapter L and other areas of the Code. As such, we would be happy to work with Treasury and the IRS in developing fair and appropriate regulations that would apply the section 382(h) rules to insurance companies. The purpose of this letter is to provide a start to this effort, by providing our preliminary views of the basic conceptual framework that would offer coherent and equitable results in determining an insurance company's built-in items of gain and deduction for section 382(h) purposes.

I. Summary of Recommendations

• The final regulations should provide that an insurance company's tax reserve is the appropriate estimate of liabilities for tax purposes.

• The final regulations should provide that when valuing the assets of an insurance company for purposes of section 382, the company's liabilities, specifically its tax reserves, should be taken into account.

II. Section 382(h) Issues Specific to Insurance Companies

A. Treatment of Liabilities

1. Background

The legislative history to section 382 states that the purpose of the section is to “distinguish between normal changes in the ownership of a going business, where tax attributes such as a net operating loss carryover are incidental, and an acquisition chiefly for the sake of loss carryovers themselves” due to concerns that without such rules, there could be “a free traffic of loss carryovers.”³ Additionally, with respect to built-in losses, there was concern that “taxpayers could reduce or eliminate the impact of the general rules [of section 382] by causing a loss corporation (following an ownership change) to recognize its built-in losses free of the special limitations (and then to invest the proceeds in assets similar to the assets sold).”⁴ The concern extended to liabilities that would give rise to deductions after the ownership change date and resulted in the enactment of section 382(h)(6).

The treatment of liabilities necessarily is sui generis for an insurance company because while other businesses take on risks of loss as a collateral aspect of doing business, taking on insurance liabilities is the essential purpose of an insurance company. Put another way, an insurance company exists for the purpose of allowing many policyholders to share the risk of loss that in reality will only be incurred by a few of those policyholders. At its most basic level, a doctor might be able to determine the value of his or her practice by assuming his patient will not file a claim against him for negligent care. However, an insurance company that writes medical malpractice insurance for thousands of doctors can never make such an assumption, because the insurance company knows based upon the law of large numbers that at least some doctors it insures will have claims filed against them, which will cause the insurance company to pay some amount of claims. Thus, an insurance company, unlike another type of business, cannot rationally assume it will owe no liabilities and determine its value on that basis. To the contrary, any valuation of an insurance company's value begins and ends with the business it has written and the claims it expects to pay in the future.

It is for this reason that insurance companies are taxed differently from other companies. When certain loss events occur that may create an obligation for a property and casualty insurance company to pay a claim under an insurance contract, the insurance company establishes a reserve to cover the amount of the potential claim (its “loss reserve”). The amount of the loss reserves is determined based on estimates of losses arising from reported events and losses arising from unreported events (the latter of these are commonly known as incurred but not reported losses).

Recognizing these differences, Congress has permitted insurance companies to deduct estimated loss reserves for events that have already occurred, where ordinary accrual rules would not allow for such deductions. In computing the taxable income of an insurance company, a company's tax reserves, as discussed in more detail below, are generally deductible under section 832(b). The tax treatment of loss reserves is similar to the treatment of accrued liabilities of other companies under the Code.⁵ In other words, the deduction for the loss reserves is allowed even though economic performance has not occurred. If the loss reserve amounts later adjusted, an increase in the reserve is deductible and a decrease in reserve is treated as income. When a claim is ultimately paid, the reserve with respect to that claim reduces to zero, increasing the insurance company's income. However, the claim is deductible, so the payment of the claim would result in a “wash” for tax purposes assuming the company's estimated reserve was correct.

2. Tax Reserves Represent the Best Estimate of the Company's Liabilities

For a property and casualty insurance company, the “statutory” reserve, i.e., the reserve developed by the insurance company's actuaries, represents the actuarial estimate of the amount the insurance company expects to pay out for claims that have been incurred but not yet paid, as reduced by salvage and reinsurance. However, for tax purposes, the loss reserve generally is a lower number because it is discounted to reflect the time value of money.⁶ Specifically, Congress recognized that the insurance company would generally hold assets to support the ultimate payment of the liabilities as required under state insurance laws and those assets would continue to produce income during the period they were held.

Thus, it is fair to say that the tax reserve represents Congressional determination of the most appropriate estimate of liabilities for tax purposes. For this reason, it is logical that the IRS has in other projects that involve the interplay between subchapter L and subchapter C concluded that the discounted tax reserves are the appropriate measure of a property casualty insurance company's liabilities. For example, Treas. Reg. § 1.338-11 provides that the tax reserves are treated as fixed liabilities for purposes of applying sections 338 and 1060 to an insurance company.⁷

B. The Tax Reserves Should Also Determine the Value of the Insurance Company

Under section 382(h), if a loss corporation has a net unrealized built-in gain (“NUBIG”), its section 382 limitation is generally increased as the gain is realized.⁸ On the other hand, if a loss corporation has net unrealized built-in loss (“NUBIL”), any built-in losses that are recognized during the recognition period are generally subject to the section 382 limitation, as if such losses were a pre-change loss.⁹

Under the Proposed Regulations, whether a loss corporation has a NUBIG or NUBIL is determined in part by calculating the value of the corporation's assets as if the corporation had sold the assets to an unrelated party at fair market value, with the hypothetical buyer assuming no liabilities.¹⁰

As written, for the reason described above, this provision is simply not compatible with how insurance companies are valued. In carrying on an active insurance business, an insurance company can never be acquired without the assumption of liabilities, because taking on liabilities for insurance risk is the essence of carrying on of an active insurance business. Furthermore, it is simply impossible to value an insurance company independent of these liabilities, as required by the Proposed Regulations.

Moreover, we believe that tax reserves are the appropriate measure for determining the liability of an insurance company for the purpose of measuring its value for tax purposes. The Preamble to the Final Regulations under Treas. Reg. § 1.338-11 states:

The IRS and Treasury Department believe that using tax reserves as a basis for valuing the [insurance business] is consistent with other areas in which tax reserves, not GAAP or statutory reserves, are used to compute taxable income. See, e.g., section 807 (prescribing rules for taking life insurance reserves and certain other reserves into account for purposes of computing life insurance company taxable income); section 846 (prescribing a methodology for discounting unpaid loss reserves for purposes of computing insurance company taxable income); and Rev. Proc. 90-36¹¹ (computing upfront ceding commission paid by a reinsurer as the increase in the reinsurer's tax reserve liabilities reserving from the reinsurance transaction, minus the value of the net assets received, for purposes of capitalizing ceding commissions to comply with the Supreme Court decision in Colonial American Life Insurance Company v. Commissioner, 491 U.S. 244.

We see no reason why this reasoning should not apply with equal force here.

As we stated above, we are setting out our view of the fundamental issues when applying section 382(h) to an insurance company taxed under subchapter L, and we would be glad to work with you as you develop these regulations. If you have any questions, please feel free to contact David Pearce (david.pearce@apci.org or 202-828-7114), Jonathan Rodgers (jrodgers@namic.org or 317-876-4206), or Joseph Sieverling (sieverling@reinsurance.org or 202-783-8312).

Sincerely,

David F. Pearce Jr.
Vice President and Director of Tax Policy

Jonathan Rodgers
Director of Financial and Tax Policy

Joseph B. Sieverling
Senior Vice President and Director of Financial Services

American Property Casualty Insurance Association
National Association of Mutual Insurance Companies
Reinsurance Association of America