Mortgage Insurance Group Seeks 2 Changes to PFIC Regs

April 13, 2021

CC:PA:LPD:PR (REG-111950-20)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

RE: Letter on Proposed Treasury Regulations Issued December 4, 2020 Under Sections 1297 & 1298 (IRS REG-111950-20)

Dear Sir or Madam:

Essent Group Ltd. (“Essent Group," "EGL," or the "Company") appreciates the opportunity to comment on the Proposed Regulations (REG-111950-20) published in the Federal Register on January 15,2021, under sections 1297 and 1298,¹ governing the passive foreign investment company ("PFIC") rules (the "Proposed Regulations").

I. REQUEST FOR MODIFICATION

The Proposed Regulations provide guidance under the PFIC rules of sections 1297 and 1298, including the application of the PFIC rules to insurance companies. Although the Proposed Regulations provide welcome guidance on a number of issues, they do not address certain of the unique characteristics of mortgage insurance companies like those operated by Essent Group ("the Company"). As discussed below, and as recently recognized in the final PFIC regulations published in the Federal Register on January 15, 2021 [Final Reg. §1.1297-4(d)(3)J, the mortgage insurance industry has unique characteristics inherent to the long-tailed risks of a 30-year fixed rate mortgage. A more detailed analysis of the risks and background of the industry can be found in our letter to Treasury dated September 9, 2019, which was our written response to the 2019 proposed PFIC regulations.

We submit the following two comments for your consideration.

First, we request that Treasury and the IRS consider a tailored modification to the current Proposed Regulations. The requested modification pertains to the qualified domestic insurance company ("QDIC") limitation rule proposed under Prop. Reg. §1.1297-6(e)(2)(i) through (iv). We request that the "QDIC Limitation Rule", which limits non-passive assets of a non-life insurance company to 400% of total insurance liabilities, be modified to also include the additional reserves required by State law or regulation for mortgage insurance companies which are recognized and defined under IRC Section 832(e).

Second, we request that a rule be provided that allows tested foreign corporations to electively apply the QDIC rule, notwithstanding that section 1298(b)(7) applies.

II. CONTINGENCY RESERVES OF A DOMESTIC MORTGAGE INSURANCE COMPANY

The standard mortgage guaranty insurance policy issued in the U.S. is a multi-year contract that is generally non-cancellable by the insurer except for non-payment of premium. Furthermore, the typical insured mortgage carries a 30-year term. Accordingly, mortgage insurance is inherently a long-tailed risk.

Domestic mortgage insurance companies are regulated by state regulators and operate as monoline² insurers; that is, by law they may not write any other kind of insurance business. The state regulators require that the mortgage insurance companies prepare financial statements ("annual statements") under the National Association of Insurance Commissioners ("NAIC") statutory accounting, and file them with the state regulator. Statutory accounting rules are developed and promulgated by the NAIC, to address certain unique issues of regulated insurance companies, and differ from GAAP with respect to certain practices and transactions.

The underwriting and investment exhibits in the annual statement form the basis of the determination of a mortgage insurer's taxable income under section 832(a). A copy of the annual statement³ has to be submitted by the taxpayer with its income tax return for the year covered by such return (or made available to the IRS on demand if the taxpayer is an electronic filer).

Under both U.S. GAAP and the statutory accounting rules prescribed by the NAIC, a reserve for losses (including "incurred losses") is not recognized in the financial statements of a mortgage insurer until a borrower has missed two consecutive monthly mortgage payments and remains at least two payments in arrears. This accounting model does not take into account a significant increase in defaults that could arise in future periods from an adverse nationwide economic downturn. Instead, the state regulators, through rules promulgated by the NAIC Model Act, require mortgage guaranty insurers to record special reserves on a statutory accounting basis known as "contingency reserves." Also, the Model Act requires that mortgage guaranty insurers refrain from transacting business within other classes of insurance (i.e. "monoline" requirement).

Contingency reserves under the statutory accounting rules are calculated as a flat 50% of all earned premiums from mortgage guaranty insurance or reinsurance, are recorded as a liability with a charge to policyholders' surplus on the statutory financial statements, and are held for a period of ten years. Contingency reserves reduce surplus, and thus effectively act to limit dividends from the regulated insurance company and, accordingly, serve to protect policyholders by preserving capital to pay claims in adverse economic cycles. Contingency reserves are not recognized for GAAP accounting purposes; thus, there is a discrepancy between insurance liabilities as booked on a GAAP versus statutory basis of accounting. The Code recognizes the unique nature of the risks inherent to the mortgage guaranty industry and refers to the contingency reserves in the annual statement as "the amount required by State law or regulation to be set aside in a reserve for mortgage guaranty insurance losses resulting from adverse economic cycles" in section 832(e)(1)(A). Section 832(e) provides that the contingency reserves may be deducted on the Company's tax return provided that tax and loss bonds are properly purchased in an amount equal to the tax benefit derived from such deductions.

I. QDIC Limitation Rule

Final Reg. §1.1297-6(b)(2) and (c)(2) provide that income and assets, respectively, of a QDIC are nonpassive for purposes of determining whether a non-U.S. corporation is treated as a PFIC (the "QDIC Rule"). Final Reg. §1.1297-6(e)(l) defines a QDIC as a domestic corporation that is subject to tax as an insurance company under subchapter L, is subject to Federal income tax on its net income, and is a look-through subsidiary of a tested foreign corporation.

The Preamble to the Proposed Regulations states that the QDIC Rule is intended to address situations where a tested foreign corporation owns a 25 percent or greater interest in a domestic insurance corporation through a structure to which section 1298(b)(7) does not apply, such that the income and assets of the QDIC are taken into account in determining whether the tested foreign corporation is a PFIC.

The Preamble goes on to say that the Treasury Department and IRS believe that limits on the amount of a QDIC's assets and income that are treated as non-passive may be appropriate in cases where a QDIC holds substantially more passive assets than necessary to support its insurance and annuity obligations. Accordingly, Prop. Reg. §1.1297-6(e)(2) provides that the amount of a QDIC's otherwise passive income and assets that may be treated as non-passive is subject to a maximum based on an applicable percentage of the QDIC's total insurance liabilities ("QDIC Limitation Rule").

The Treasury and the IRS recently acknowledged the unique nature of the mortgage guarantee industry in the final regulations issued on December 4, 2020 in response to comments received with respect to its 2019 proposed regulations. These regulations effectively allow for a foreign mortgage insurance company to qualify for the "ratings agency exception", which allows it to meet the definition of qualified insurance company ("QIC") if its applicable insurance liabilities ("AIL") constitute at least 10% of its assets (a 25% test is otherwise required). In this connection the Preamble to the Final Regulations acknowledges that with respect to mortgage insurers, the Federal Housing Finance Agency, in its role as regulator of Fannie Mae and Freddie Mac (government-sponsored entities or GSEs who purchase or guarantee a majority of U.S. home mortgage loans), also prescribes capital requirements that must be satisfied by private mortgage insurers to be eligible to provide mortgage insurance on loans owned or guaranteed by Fannie Mae or Freddie Mac. These guidelines, known as the Private Mortgage Insurer Eligibility Requirements ("PMIERs"), were set after the 2007-2008 financial crisis and are designed to ensure that mortgage guaranty insurers maintain sufficient capital to cover obligations in times of financial distress, when defaults and foreclosures increase. Rating agencies evaluate satisfaction of the PMIERs guidelines when rating mortgage guaranty insurers. The PMIERs and rating agency capital standards geared to ensuring capital adequacy in times of crisis may result in a mortgage guaranty insurer being required to hold an amount of capital that causes its current insurance liabilities to be less than 25 percent of its assets in low loss years when the economy is strong.

The Treasury Department and IRS favorably considered the comments made with respect to its 2019 proposed regulations, and the circumstances under which an insurance company would need assets in excess of 400 percent of its insurance liabilities in order to obtain a specific credit rating or meet the counterparty capital requirements of the PMIERs needed to write new business. The Preamble to the Final Regulations further notes that companies that may require a higher level of capital as compared to insurance liabilities are companies that include monoline companies providing mortgage or financial guaranty insurance that experience significant losses on a low frequency but high severity basis. In low loss years, these types of companies may have less than 25 percent insurance liabilities to assets, but the additional assets maybe viewed as necessary by rating agencies or the GSE's and FHFA for the mortgage guaranty insurance companies to meet insurance obligations in high loss years.

We appreciate the IRS and Treasury's approach of providing a broader definition of total insurance liabilities that includes unearned premium reserve ("UPR”) in the proposed regulations, which is only applicable for the QDIC Limitation Rule, in contrast to the statutory definition of AIL for QIC determination purposes. However, due to the unique character of the mortgage insurance industry, the proposed definition of total insurance liabilities does not go far enough.

To illustrate our concerns, we have attached industry data (APPENDIX A) showing the results of applying a 400% limit to loss reserves and UPR to the gross assets of a domestic mortgage insurance company versus the inclusion of400% of contingency reserves in such calculation. We would like to bring to your attention that in every case the proposed QDIC Limitation Rule would create material amount of passive assets, which would not be the case if the contingency reserves were included in the definition of total insurance liabilities to which the 400% rule is applied.

The Treasury and the IRS have already recognized, albeit in the context of the QIC rules as stated in the above extract from the Preamble to the Final Regulations, that mortgage insurers have unique businesses that require them to hold assets that are more than 400% of their insurance liabilities. We request that a similar recognition of the industry be made with respect to the QDIC Limitation Rule as was made on the QIC rules in the final regulations, by allowing them to include contingency reserves as part of total insurance liabilities, which is multiplied by 400% to determine the QDIC Limitation. We recommend that final regulations modify the definition of total insurance liabilities provided in Prop. Reg. §1.1297-6(e)(2)(iv)(B) to say:

(B) Companies taxable under Part II of Subchapter L. In the case of a company taxable under part II of Subchapter L, the term total insurance liabilities means the sum of unearned premiums (determined under §1.832-4(a)(8)), unpaid losses., and the amount required by State law or regulation to be set aside in a reserve for mortgage guaranty insurance losses resulting from adverse economic cycles [as described under section 832(e)(1)(A)].

We believe that such a modification would allow for parallel construction of rulemaking between the concept of a QIC and QDIC for purposes of the mortgage insurance industry. Adopting such a rule would be consistent with the legislative history of section 832(e), where Congress recognized the unique nature of the mortgage guaranty industry as noted above. By restricting the additional amount of reserves to be included in the definition of total liabilities to those that are described in Section 832(e), the rule would only allow those companies that operate a mortgage guaranty insurance business, and that are required to establish the reserve under State law or regulations, to avail of the rule. As the contingency reserve is an amount that is reflected on the annual statement⁴ every year which is submitted with the U.S. federal income tax return of the mortgage insurance company, it is also an amount that is objectively verifiable and readily available.

II. Expanding the QDIC Rule to taxpayers who are subject to section 1298(b)(7)

Additionally, we believe that the application of the QDIC Rule should not be limited to those structures to which section 1298(b)(7) does not apply. We appreciate that the QDIC Rule is meant to address a situation where no relief is provided by the PFIC statutory framework to a tested foreign corporation that owns a domestic insurance company through a structure in which section 1297(c) applies. Under Final Reg. §1.1297-2(b)(2)(iii), if section 1298(b)(7) and section 1297(c) both apply, section 1298(b)(7) takes priority. However, the two provide dissimilar results in the context of a domestic insurance company because whether or not insurance liabilities are taken into account can make a material difference. Specifically, under section 1298(b)(7), the qualified stock held by the domestic corporation is treated as an asset which does not produce passive income (and is not held for the production of passive income) and any amount included in gross income with respect to such stock is not treated as passive income. The value of the stock of a domestic insurance company takes into account the net value of the company, that is, its gross assets reduced by its insurance liabilities, which could be a material amount. However, under the QDIC rule, subject to the QDIC limitation rule, the gross assets (not reduced by insurance liabilities) and income of the QDIC are considered nonpassive. Therefore, a tested foreign company that owns a domestic insurance company may have materially different amounts of non-passive assets and income depending on whether section 1298(b)(7) or section 1297(c) applies. We believe that tested foreign corporations that own domestic insurance companies should be treated similarly, regardless of their ownership structure, as a matter of sound tax policy. Accordingly, we recommend that a rule be provided that allows tested foreign corporations to apply the QDIC rule by an election, notwithstanding that section 1298(b)(7) otherwise could apply. In general, the application of the QDIC rule, as opposed to the section 1298(b)(7) rule would provide a more equitable result in the insurance context, as the asset and income tests for PFIC purposes are done on a gross basis.

Once again, thank you for the opportunity to provide these comments, and thank you also for attending the virtual meeting on March 29. If you have any questions or require additional information, please feel free to contact Lawrence McAlee at 610-230-0293 and Joe Wenger at 610-230-0565.

Sincerely,

Lawrence E. McAlee
Senior Vice President and CFO

Joseph E. Wenger
Vice President — Tax

Essent Group Ltd.

Copies to:
Ms. Angela Walitt
Ms. Je Y. Baik
Ms. Josephine Firehock
Mr. David Brazell