Group Seeks Changes to Proposed Hedge Fund Reinsurance Regs

RAA welcomes the opportunity to comment on the proposed regulation defining a foreign insurance company for purposes of the Passive Foreign Investment Company ("PFIC") rules under Code § 1297(b)(2)(B). If a foreign insurance company is deemed to be a PFIC, its U.S. shareholders will be liable for additional U.S. tax.

In general, a PFIC is a foreign corporation (that is not a controlled foreign corporation) if more than 75 percent of its gross income is passive income or at least 50 percent of its assets are held for the production of passive income. Because insurance companies primarily hold passive assets while engaging in an active business, the statute provides an exclusion from "passive income" for income derived in the active conduct of an insurance business, except as provided in the regulations. This exception requires that the corporation be predominantly engaged in the insurance business and would be taxable under subchapter L if it were a domestic corporation. The proposed regulations would establish criteria for qualification as an insurance company by defining the terms "active conduct" and "insurance business."

To address the concern about overcapitalization that underlies the PFIC provisions, the Preamble to the proposed regulation requests comments on "how to determine the portion of a foreign insurance company's assets that are held to meet obligations under insurance contracts issued or reinsured by the company." The Preamble provides one example, which would determine maximum capitalization as assets that do not exceed a specified percentage of the corporation's total insurance liabilities for the year, but also asks if other methods would be more appropriate.

EXECUTIVE SUMMARY:

Code § 1297(b)(2)(B) provides requirements that a foreign corporation must meet in order to qualify for the insurance company exception: The company must (1) be engaged in the active conduct (2) of an insurance business, (3) be predominantly engaged in the insurance business, and (4) be taxable under Subchapter L if it were a domestic company. The proposed regulation sets forth requirements to determine whether the "predominantly engaged" and "Subchapter L" tests are satisfied by reference to existing law and regulations, but expressly defines "active conduct" and "insurance business."

Taxable under Subchapter L Requirement

The proposed regulation relies upon the definition of an "insurance company" taxable under Subchapter L in Code § 816(a) and § 831(c),¹ which require that more than half the company's business during the year must be the issuing of insurance or annuity contracts or reinsuring risks underwritten by insurance companies. This reference brings into consideration a broad range of facts and circumstances, based upon a comprehensive examination of each company's operations, business model, product lines, and regulatory capital requirements. A similar "facts and circumstances" approach was adopted in Rev. Proc. 2003-34, 2003-23 IRB 1, which considered all relevant factors, including, but not limited to "the size of its staff, whether [the company] engages in other trades or businesses, and its sources of income." RAA believes that a facts and circumstances test is the best method to determine whether an entity is an insurance company. Use of affiliated entities or independent contractors to perform insurance, investment and administrative services should have no bearing on whether a company is considered to be an insurance company. The determining factor should be whether a company assumes insurance risk, not how it accomplishes that end.

The Business of Insurance Requirement

The proposed regulation defines an "insurance business" as "issuing insurance and annuity contracts and the reinsuring of risks . . . together with investment activities and administrative services that are required to support or are substantially related to insurance contracts issued or insured by the foreign insurance company." While the broader definition is accurate, RAA believes the single most important function is the assumption of insurance risk.²

The IRS recognized that assumption of true insurance risk was crucial in Notice 2003-34,³ which cited numerous cases in which companies failed to qualify as insurance companies because they had not assumed true insurance risk or had assumed only nominal amounts of risk.⁴

If the regulation adopted the facts and circumstances approach of IRS Notice 2003-34, it would provide better guidance to taxpayers and their advisors, and the IRS. Notice 2003-34 recognized that the company's status as an insurance company turns on whether its primary and predominant business activity is issuing insurance or reinsurance contracts, and took a broad view of all of the relevant facts to be considered, including "the size of its staff, whether it engages in other trades or businesses, and its sources of income." It also cited numerous cases regarding insurance company status, thereby making it clear that an insurer must "use its capital and efforts primarily in earning income from the issuance of contracts of insurance."⁷ Quite simply, the assumption of insurance risk should be the principal factor in the "business of insurance" test.

Active Conduct Requirement

Prop. Reg. § 1.1297-4(b)(1) defines "active conduct" by reference to Treas. Reg. § 1.367(a)-2T(b)(3), which provides that the determination of "active conduct" is a facts and circumstances test, which is satisfied "only if the officers and employees of the corporation carry out substantial managerial and operational activities." Unlike Treas. Reg. § 1.367(a)-2T(b)(3), however, the proposed regulation prohibits an entity from counting officers and employees of related entities in making that determination. This prohibition conflicts with established industry practices, as well as regulatory restrictions in the U.K. and elsewhere. If continued without change, it would result in PFIC treatment of numerous, long established reinsurers and their affiliates, as well as various alternate risk transfer mechanisms, such as catastrophe bond structures and sidecars.

After reviewing the PFIC statute's legislative history, eighteen years ago commentators concluded that incorporating the Section 367(a) active trade or business standard into the PFIC insurance company exception would be contrary to legislative intent.⁸ Based upon a Treasury submission by representatives of companies using captive management companies that led to the amendment of the PFIC exception, the commentators concluded:

Shared/Leased Employees: A common alternative to the "services model" is the use of shared or leased employees by two or more companies, with one reimbursing the other for the cost of the employees' services. The proposed regulation could be interpreted as disqualifying entities using such employees, an unreasonable result given this widespread industry practice.

Independent Contractors: The regulation should not disqualify the many legitimate insurance companies that outsource substantial underwriting, investment, accounting, or claims functions to independent contractors. In both the U.S. and abroad, marketing of reinsurance is commonly conducted through independent brokers, and some, acting as Managing General Agents (MGAs), have the power to bind reinsurance contracts. Alternate risk mechanisms such as catastrophe bonds and sidecars, established for a limited purpose and limited time period, outsource numerous functions, but should not be disqualified as insurance companies under Code § 1297(b)(2)(B) because they assume insurance risk.

In short, the definition of an insurance business should be focused on the assumption of insurance risk, and not the exact means by which insurance risk is assumed. Outsourcing elements of the business (underwriting, administration, investment, claims handling) that may be considered in a broad facts and circumstances test should not preclude companies that would qualify as an insurance company under Subchapter L from qualifying for the insurance company exception in the PFIC rules, so long as company employees are responsible for oversight of independent contractors.

PART TWO: ASSETS HELD TO MEET THE REASONABLE NEEDS OF THE INSURANCE BUSINESS

The PFIC rule's central concern is that foreign companies may maintain "financial reserves [i.e., "surplus"] in excess of the reasonable needs of their insurance business."¹¹ The Preamble defines the term "insurance business" as the activity of issuing insurance contracts and the reinsuring of risks underwritten by insurance companies, "together with investment activities and administrative services that are required to support or are substantially related to insurance contracts issued or reinsured by the foreign insurance company." Investment activities would be treated as related "to the extent that income from the activities is earned from assets held by the foreign corporation to meet obligations under the contracts."

This definition is too narrow. Property-casualty reserves represent only losses that have actually been incurred. But P&C insurers and reinsurers have potential losses from unexpired contracts, and must hold capital to meet losses that may occur in the future. The proposed regulation's definition fails to recognize that reinsurance companies must have assets beyond reserves to cover future losses and unusually severe losses, and that such additional capital is required by regulators, rating agencies and prospective buyers. In addition, rating agencies typically require newer companies to operate with higher capital ratios. In practice, it is exceedingly difficult for a reinsurer to be competitive without a high rating from a recognized rating agency, and the greater its capital, the more likely a ceding company is to select that reinsurer. Quite simply, additional capital or "surplus" is an indication that a reinsurer can withstand low frequency/ high severity losses (hurricanes, earthquakes, terrorism, product liability, and environmental losses) and pay claims in timely fashion.

The financial profiles of insurance and reinsurance companies vary widely depending upon the lines of business that they write and the capital requirements imposed by regulators, rating agencies, and the marketplace, but, in all cases, reinsurance companies need to maintain capital in excess of reserves to meet severe but infrequent losses. The amount of capital required varies according to the types of risk underwritten, the volume of risk, the diversification of risk, and regulatory standards. Equally important in setting capital levels are rating agency requirements. Ceding insurers and their brokers often look for capital beyond regulatory capital as evidence of greater financial strength, and reinsurers ordinarily maintain higher levels to encourage placements.

Rebuttable Presumption: The wide variety of insurance company profiles illustrates the need for examination of individual companies on a case-by-case basis, using a facts and circumstances test. Nonetheless, RAA recognizes that the IRS has limited resources to examine reinsurance companies claiming the exception. In response to IRS's request, RAA has developed a rebuttable presumption using a simple "bright line" test based on a ratio of reserves-to-assets. This method allows a U.S. shareholder to readily determine whether a company qualifies for the insurance company exception. A company that does not satisfy the test may demonstrate that it qualifies as an insurance company using facts and circumstances. The alternative approach should include a list of factors that should be evaluated in determining whether any reinsurance company whose reserve level falls below the threshold nonetheless is truly engaged in the active conduct of an insurance business.

RAA believes that the key factor in determining qualification as an insurance company for purposes of § 1297(b)(2)(B) is the assumption of insurance risk. In addition, Treas. Reg. § 1.1297-4 should retain the requirements that Code § 816(a) and Treas. Reg. § 1.801-3(a) must be taken into account as if the foreign corporation were a domestic corporation subject to taxation under subchapter L. Modifications discussed above should be adopted in defining the "active conduct" of an "insurance business."

The regulation would provide a new rebuttable presumption using a reserve-to-asset ratio:

The reserves-to-assets ratios of comparable U.S. companies demonstrate that the 15 percent threshold is entirely fair and reasonable. Mainline, long established U.S. companies with ratios below 15 percent have never had their classification as insurance companies questioned (See Attachment 1, Exhibit 3). To impose a standard on foreign insurance companies which major U.S. insurance companies do not meet would be arbitrary and discriminatory.

The proposed 15 percent threshold best implements the policy underlying Code § 1297(b)(2)(B) because:

Reinsurance start-ups typically require five years to reach mature operation. The current regulations provide a two-year start-up period before a company must satisfy the PFIC tests, but this would be inadequate for reinsurance start-ups. We believe that any new regulation should provide at least a three-year start-up for reinsurance companies, i.e., a foreign corporation that is subject to the reserves-to-asset test and fails to satisfy the test on the last day of its first taxable year after the regulations are finalized will be considered to have satisfied the requirement for such taxable year and the following two taxable years if it satisfies the reserve-to-asset test at the end of its third taxable year following the taxable year in which the regulations become effective.

RAA recommends that there be a three-year transition rule to allow existing companies to bring their operations into compliance with the new reserves-to-asset test.

PART THREE: REQUEST FOR A HEARING

RAA requests a public hearing on the proposed regulation. Because RAA's witness Joseph Sieverling and many other industry officials will attend the Summer Meeting of the National Association of Insurance Commissioners (NAIC) meeting in Chicago from August 13 - 18, we ask that the hearing date be set for August 20 or later.

PART FOUR: REGULATIONS SHOULD BE ISSUED IN PROPOSED FORM

Because the regulations could have a substantial adverse effect on the ability of long established reinsurers to raise capital or even to be considered for new business, RAA asks that any future version be issued as a Proposed Regulation, with an opportunity for the industry to review and comment on their impact before the regulation takes effect

If you have questions about the RAA proposal or other aspects of this comment letter, please contact Joseph Sieverling (sieverling@reinsurance.org or 202-783-8312) or Brenda Viehe-Naess (bvns@att.net or 202-735-0060).

² The OECD recognized that underwriting/assumption of insurance risk was the "Key Entrepreneurial Risk Taking Function" (KERT) in Part IV, Insurance of "The Attribution of Profits to Permanent Establishments." While other elements such as product development, marketing, risk management, investment management and administration are included in their consideration, the critical factor was assumption of risk. See, p. 197, paragraph 168, July 17, 2008.

³ 2003-23 IRB 1.

⁴Inter-Am. Life ins. Co. v. Commissioner, 56 T.C. 497, 506-08 (1971), aff'd per curiam, 469 F.2d 697 (9^th Cir. 1971); Bowers v. Lawyers Mortgage Co., 300 F. Supp. 387 (1932).

⁵ "A catastrophe bond ("cat bond") is a structured debt instrument that transfers risks associated with low frequency/high severity risks to investors. The insurance industry is increasingly employing catastrophe bonds as an alternative to traditional reinsurance and retrocession contracts." A.M. Best Methodology, Rating Natural Catastrophe Bonds, 1 (August 25, 2012). To create a cat bond, an insurer establishes a special purpose vehicle (SPV) that issues notes to investors, and the SPV is typically treated as a reinsurance company.

⁶ A "sidecar" is defined as a "temporary reinsurance vehicle that shares premiums and losses exclusively with an insurer primarily on a pro-rata basis, generally for business associated with catastrophe risk." The Breadth and Scope of the Global Reinsurance Market and the Critical Role Such Market Plays in Supporting Insurance in the United Slates, Federal Insurance Office, U.S. Department of the Treasury, December, 2014, p.39. The report notes, "A sidecar may be used to provide an additional source of reinsurance to an insurer when the reinsurance market has limited capital (e.g., following a natural disaster) and therefore allows an insurer to write more business during a time when rates are high. Id. P. 40.

⁷Indus. Life Ins. Co. v. United States, 344 F. Supp. 870, 877 (D. S.C. 1972), aff'd per curiam, 481 F.2d 609 (4^th Cir. 1973), cert. denied, 414 U.S. 1143 (1974).

⁸ "Restrictive Regs May Threaten Insurance Company Exception to PFIC Rules," Richard J. Safranek, Diana B. Chapman, 13 Ins. Tax Review 1147, July, 1997. "Congress very clearly did not intend for the phrase 'active conduct of an insurance business' in section 1296(b)(2)(B) to have the same meaning as 'active conduct of a trade or business' in section 367(a)(3). Rather, the phrase was intended to have the same meaning as 'active conduct of an . . . insurance . . . business' in the definition of 'financial services income' in section 904(d)(2)(c). A foreign insurance company need not have its own managerial and operational employees to generate financial services income, and it should not need such employees to qualify for the PFIC insurance company exception in section 1296(b)(2)(B)." (Italics and Code citations are original; Section 1296 was renumbered to section 1297P. L. 105-34, title XI, Sec. 1122(a), August 5, 1997) Id. At 1148.

⁹ In the UK, the Prudential Regulatory Authority prohibits an insurance company from sharing employees with another insurer. 01/04/2013 FCAPRA. To comply with this rule, UK reinsurers use a services company to provide underwriting, actuarial, accounting, and claims services to all the group's UK entities. Thus, the proposed regulation would treat all UK insurers as PFICs.

¹⁰ This is especially true for smaller insurance companies, which find that independent investment advisors offer them access to more sophisticated expertise, different types of investments, and cost savings than would be available if investment management were performed in house. See, e.g., National Association of Insurance Commissioners & The Center for Insurance Policy and Research, Capital Markets Special Report, Insurance Asset Management: Internal, External or Both? (Aug. 26, 2011), available at http://www.naic.org/capital_markets_archive/110826.htm; William Limburg, Outsourcing of General Account Investment: Changes in the Insurance Market Have [Led] to Rethinking Financial Strategy and Searching for New Ways to Ensure Profitability, THE ACTUARY MAGAZINE (Aug. 2007), available at https://www.soa.org/Library/Newsletters/The-Actuary-Magazine/2007/August/out2007aug.aspx; Eager, Davis & Holmes, LLC, Insurance Asset Outsourcing Exchange, Why Insurance Companies Outsource, available at http://www.eagerdavisholmes.com/pdf/insurance_outsource.pdf.

¹¹General Explanation of the Tax Reform Act of 1986, prepared by the Joint Committee on Taxation, May 4, 1987, p. 1025.

¹² The OECD, in its discussion of "The Attribution of Profits to a Permanent Establishment, Part IV, Insurance," comments, "There is no internationally agreed approach to determining particular ranges for the relative proportions of reserves and surplus making up the capital structure of insurance enterprises. For that reason, the question of the separate determination of reserves and surplus is regarded as one that is more appropriately left to the domestic law of the PE jurisdiction." Para. 77, Part IV, p.199.

¹³ For composite companies writing both life insurance and P&C contracts, UPR includes life insurance reserves.

¹⁴ However, this would also include composite companies writing both property casualty and life insurance.