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Foreign Financial LLC Suggests Expanding Proposed PFIC Regs

APR. 14, 2021

Foreign Financial LLC Suggests Expanding Proposed PFIC Regs

DATED APR. 14, 2021
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April 14, 2021

Internal Revenue Service
CC:PA:LPD:PR (REG-111950-20)
1111 Constitution Avenue, N.W.
Washington, DC 20044

Re: Comments to PFIC Regulations Concerning Their Impact to Insurance Companies

The purpose of this letter is to provide comments on Proposed Regulations1 (the “Regulations”) issued on January 15, 2021 by the United States (“US”) Department of Treasury and the Internal Revenue Service (collectively, “Treasury”) under sections 1291, 1297, and 1298 of the Internal Revenue Code's passive foreign investment company (“PFIC”) rules.2 The comments in this letter concern certain guidance in the Regulations applicable to insurance companies.

I. Background

The Global Atlantic Financial Group LLC is a foreign corporation with a shareholder base substantially comprised of US persons. Through our subsidiaries, we are an insurance and reinsurance company that is a leading provider of retirement and life insurance products in the US market and reinsurance solutions. We are grateful for the responsiveness Treasury has shown to comment letters regarding the 2019 Proposed Regulations3 and their impact to the insurance industry. We believe that the Regulations are more aligned with the intent of the PFIC regime and its application to insurance companies, and we appreciate the opportunity to submit comments on the Regulations.

II. Comments

All capitalized terms used here that are not otherwise defined have the same meaning as in the Regulations.

1. Scope of activities constituting a QIC's core functions

a. Background

The Proposed Active Conduct Requirements are focused on a QIC's core functions, which are defined generally as the QIC's underwriting, investment, contract and claims management, and sales activities.4 For a reinsurance company, contract and claims management activities are not considered a core function with respect to indemnity reinsurance contracts to the extent that the ceding company has agreed to retain contract and claims management activities under a reinsurance contract.5

Each core function is further defined —

  • The term underwriting activities “means the performance of activities related to a QIC's decision to assume an insurance risk (for example, the decision to enter into an insurance or reinsurance contract, setting underwriting policy, risk classification and selection, designing or tailoring insurance or reinsurance products to meet market or customer requirements, performing actuarial analysis with respect to insurance products, and performing analysis for purposes of setting premium rates or calculating reserves, and risk retention).”6

  • The term "investment activities” means “investment in equity and debt instruments and related hedging transactions and other assets of a kind typically held for investment, for the purpose of producing income to meet obligations under the insurance, annuity, or reinsurance contracts.”7

  • The term “contract and claims management activities” means “performing the following activities with respect to an insurance or annuity contract: Monitoring a contract (or group of contracts) over its life cycle (that is, maintaining the information on contractual developments, insured risk and occurrences, and maintaining accounts on premiums, claims reserves, and commissions); performing loss and claim reporting (establishing and maintaining loss reporting systems, developing reliable claims statistics, defining and adjusting claims provisions and introducing measures to protect and reduce claims in future); and all the activities related to a policyholder's claim, including processing the claims report, examining coverage, handling the claim (working out the level of the claim, clarifying causes, claims reduction measures, legal analysis) and seeking recovery of funds due to the QIC.”8

  • The term “sales activities” means “sales, marketing, and customer relations with respect to insurance or reinsurance policies.”9

b. Comments

We generally agree with the approach taken in the Proposed Active Conduct Requirements to focus on a QIC's activities that are fundamental for the active conduct of its insurance business. However, we believe that the core functions as defined in the Proposed Active Conduct Requirements exclude certain activities that are essential for a QIC's active conduct of its insurance business.

For an insurer or reinsurer, its capital management and risk management activities are essential to the active conduct of its insurance business, and would not appear to cleanly fall within the definition of underwriting, investment, contract and claims management, or sales activities. Insurance is a highly regulated industry across much of the globe, and as such, insurers and reinsurers are subject to strict capital requirements by their regulators, which vary according to the types of insurance or reinsurance business undertaken by the company, the mix of the company's investment portfolio, and many other factors. Accordingly, insurers and reinsurers must actively monitor and manage their capital requirements with respect to local regulatory laws. In the United States, all states have fixed minimum capital and surplus requirements, as well as Risk-Based Capital requirements. In Europe, Solvency II requires insurers and reinsurers to calculate and monitor their Minimum Capital Requirement and Solvency Capital Requirement. Similarly, Bermuda-based insurers and reinsurers are required to calculate and monitor their capital adequacy with respect to the Bermuda Solvency Capital Requirement. Adhering to and maintaining compliance with a jurisdiction's regulatory requirements, which are often complex, is an essential component of an insurers and reinsurers' business. Insurers and reinsurers must also obtain ratings from rating agencies to instill confidence in policyholders and counterparties to do business with the company. The rating determination is dependent on the underwriting, investment, and capital profile of the company.

Insurers and reinsurers must manage their capital requirements with respect to regulators, rating agencies, and the company's overall business plan, and determine if additional capital is necessary or how surplus capital should be deployed. Regulators and rating agencies do not simply assess capital as assets minus liabilities. Rather, there are complicated methodologies for calculating capital. Running these calculations and stress testing under various economic and business scenarios is a key part of an insurance business. Another component of ongoing capital management is the analysis and monitoring of the asset/liability mix of the company, to ensure that cash flows from investments and premiums align with expected cash outflows from losses, benefits, claims, or annuity payments. If additional capital is required, the company must determine how the additional capital can be raised (e.g., issuing additional equity, debt, performing a capital call, ceding business through reinsurance, selling a block of insurance business, etc.). If surplus capital exists, the company must determine how the additional capital can be redeployed (e.g., by expanding its underwriting activities into different lines of business, making distributions to shareholders, engaging in share repurchases, retiring debt, etc.). Throughout this process, insurers and reinsurers must monitor and report under various regulatory capital regimes, and engage with regulators, rating agencies, and other stakeholders to communicate information and respond to inquiries concerning the company's capital adequacy. Under the Proposed Active Conduct Requirements, the core functions, as defined, do not allow these essential activities to be taken into account. Yet, these capital management activities are ongoing throughout an insurer or reinsurer's life cycle, and are interrelated with the nature and extent of the company's underwriting, investment, contract and claims management, and sales activities.

The capital management function is a distinguishing feature of an active insurance company, and is separate and apart from general capital deployment considerations common to any corporate going concern. Furthermore, because of the nature of the activities comprising the capital management function, the capital management function cannot be viewed as part of an active insurance company's investment activities. Investment activities represent the activities of making investments in equity and debt instruments (and related hedging transactions). Capital management, as described above, comprises separate and distinct activities which in part affect, and are affected by, the nature and extent of investment activities.

With respect to risk management, the overall risk of an insurance company primarily includes insurance or underwriting risk, and investment or interest rate risk. Faced with increased regulatory and capital requirements, insurers have focused intently on establishing and improving strong risk management and governance programs. Many regulators such as the National Association of Insurance Commissioners, the Bermuda Monetary Authority and the Insurance Accounting & Systems Association have mandated that insurance companies adopt risk management frameworks, referred to as enterprise risk management (“ERM”) systems. ERM generally refers to a risk management strategy overseen by the board and managed by senior management that documents material risks and acceptable risk limits. The ERM system would generally include methods for identifying, assessing, monitoring, and reporting on risks. Most companies have dedicated risk officers and departments tasked with these responsibilities.

For the above reasons, the core functions for purposes of establishing that a QIC is engaged in the active conduct of an insurance business should include capital and risk management activities. Indeed, capital and risk management activities are perhaps the only activities among the other core functions that are consistently carried out across all active insurance companies, no matter what stage in their life cycle or nature of their business. Underwriting, investment, and sales activities will comprise a larger share of a QIC's core functions during a start-up phase and while the QIC is in a mature stage of operation, but taper off and eventually cease altogether when a QIC is in run-off. Contract and claims management activities likewise may constitute a smaller share of a QIC's core functions during its start-up phase, but increase over time such that it is the primary activity of a QIC in run-off. Capital and risk management activities, on the other hand, must be carried out over the entire course of the QIC's life cycle.

Recommendation: We respectfully request that final regulations expand the definition of “core functions” to include an additional core function for “capital and risk management activities.” Capital management activities should include the performance of the following activities: determining the level of capital of the QIC that is consistent with the QIC's business plan and regulatory, rating agency, and other requirements (including determining the appropriate asset/liability mix to support cash outflows due to losses, claims, benefits, and annuity payments); regular monitoring and reporting on capital under various required regulatory capital regimes (e.g., Solvency II); determining the appropriate actions to adjust the QIC's level of capital (such as issuing additional equity, issuing debt, performing a capital call, distributing a policyholder or shareholder dividend, repurchasing shares or retiring debt, entering into reinsurance contracts or selling off blocks of business); effectuating changes in the QIC's level of capital (such as engaging with regulators, rating agencies, financial institutions, reinsurers, or other persons or entities that are relevant to effectuating changes in the QIC's capital position); and engaging with regulators, rating agencies, and other stakeholders to communicate information and respond to inquiries concerning the company's capital adequacy. Risk management activities should include the establishment of an enterprise risk management framework, and the ongoing identification, assessment, monitoring, and reporting of risks within the purview of the company's risk management framework.

2. Companies excluded from being treated as engaged in the active conduct of an insurance business

a. Background

The 2020 Proposed Regulations set forth new guidance on determining whether a qualifying insurance corporation (“QIC”) is engaged in the active conduct of an Insurance Business (the “Proposed Active Conduct Requirements”).10 Satisfying the Proposed Active Conduct Requirements is a component part for a QIC to be eligible for the section 1297(b)(2)(B) “PFIC Insurance Exception.” Under the Proposed Active Conduct Requirements, a QIC is not treated as engaged in the active conduct of an Insurance Business if it is one of two types of entities (the “Active Conduct Exclusion”). As relevant here, a QIC is not treated as engaged in the active conduct of an insurance business under the Active Conduct Exclusion if —

“It has no employees or only a nominal number of employees and relies exclusively or almost exclusively upon independent contractors (disregarding for this purpose any related entity that has entered into a contract designating its status as an independent contractor with respect to the QIC) to perform its core functions”11

b. Comments

The Proposed Active Conduct Requirements do not provide guidance on what constitutes a “nominal number of employees." Because whether a QIC is subject to the Active Conduct Exclusion is a gating determination to qualify for the PFIC Insurance Exception, we believe more clarity is needed on what constitutes a “nominal number of employees.” To this end, what constitutes a “nominal number of employees” with respect to a QIC should not be based upon a fixed threshold that applies to all companies; rather, it should be based on all the facts and circumstances.

The scale and scope of a QIC's insurance business can vary widely from company to company and over time, and has corresponding variable implications concerning the headcount necessary and appropriate for a QIC to actively conduct its insurance business. For example, a QIC that is a direct underwriter will typically have a larger headcount than a reinsurer, because the direct underwriter typically performs more activities related to the selling, underwriting, ongoing customer relations, and claims handling functions with respect to any policy. Indeed, the Proposed Active Conduct Requirements acknowledge the differences in the scale of activities carried out between insurers and reinsurers by excluding from the definition of core functions of a reinsurer contract and claims Management Activities if the ceding company has agreed to retain these activities under a reinsurance contract.12 Differences in headcount can also arise depending on whether the QIC is in the early stages of its existence, is a mature company with a large portfolio of active policies and ongoing underwriting, or is in runoff. Over time, technological advancements that include more interactive, online-based ways of selling insurance, advancements in data science, and the integration of artificial intelligence in the insurance operating model will further change the scale and scope of the workforce needed to support an active insurance business. For all the above reasons, the necessary and appropriate headcount needed to support an active insurance business is dynamic both across companies and over time.

Recommendation: We respectfully request that final regulations provide that the determination of whether a QIC employs only a “nominal” number of employees for purposes of Prop. Treas. Reg. § 1.1297-5(b)(2)(i) is an annual determination based on all the facts and circumstances. The determination should be based on the character of the business actually conducted in the taxable year. Facts and circumstances to consider in determining whether a QIC employs only a nominal number of employees include (but are not limited to) (i) the extent to which the QIC is engaged in the business of issuing insurance and annuity contracts vs. reinsuring risks underwritten by insurance companies; and (ii) whether the QIC recently began operations or is in runoff.

We appreciate your consideration of our comments and recommendations discussed in this letter with respect to the PFIC Regulations. Please do not hesitate to reach out if you would like additional clarification or have additional questions.

Respectfully submitted,

Justin MacNeil
Email: justin.macneil@gafg.com
Managing Director, Tax
Global Atlantic Financial Group LLC
Hamilton, Bermuda

Copies to:

Chris Ocasal
Principal, International Tax and Transaction Services
Ernst & Young LLP
1101 New York Ave NW
Washington, DC 20005
Chris.ocasal@ev.com

John Owsley
Senior Manager, International Tax and Transaction Services
Ernst & Young LLP
1101 New York Ave NW
Washington, DC 20005
John.owslev@ev.com

FOOTNOTES

1REG-11950-20, 86 Fed. Reg. 4582 (January 15, 2021) (the “2020 Proposed Regulations”).

2All section references are to the Internal Revenue Code of 1986, as amended, (the “Code”) and to the regulations promulgated thereunder.

3REG-105474-18, 84 Fed. Reg. 33120 (July 11, 2019) (the “2019 Proposed Regulations").

4Prop. Treas. Reg. § 1.1297-5(f)(4).

5Id.

6Prop. Treas. Reg. § 1.1297-5(f)(9).

7Prop. Treas. Reg. § 1.1297-5(f)(5).

8Prop. Treas. Reg. § 1.1297-5(f)(3).

9Prop. Treas. Reg. § 1.1297-5(f)(7).

10See Prop. Treas. Reg. § 1.1297-5.

11Prop. Treas. Reg. § 1.1297-5(b)(2)(i).

12Prop. Treas. Reg. § 1.1297-5(f)(4).

END FOOTNOTES

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