PwC Addresses Active Insurance Exception in PFIC Regs

April 14, 2021

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

Re: REG-111950-20 — Comments on the Proposed Regulations regarding Qualifying Insurance Corporation exception to status as a Passive Foreign investment Company

Dear Sir or Madam:

PricewaterhouseCoopers LLP respectfully submits this letter on behalf of a client in response to the proposed (REG-111950-20) (“Proposed Regulations”) and final (T.D. 9936) regulations (“Final Regulations”) under section 1297, published in the Federal Register on January 15, 2021, that provide general rules for determining whether a foreign corporation qualifies as a passive foreign investment company (“PFIC”), as well as specific rules applicable to foreign insurance companies.¹ For purposes of determining whether a foreign corporation is a PFIC, section 1297(b)(2)(B) excepts from “passive income” income which is derived in the “active conduct of an insurance business” by a qualifying insurance corporation (“QIC”). The Proposed and Final Regulations refer to this exception as the “Active Insurance Exception.”

We submit the following three comments for your consideration with respect to the Active Insurance Exception:

Our comments are discussed in detail below.

1. The proposed Factual Requirements Test that a QIC must meet to be considered engaged in the “active conduct” of an insurance business should account for activities of a reinsurer that enters into a relatively small number of reinsurance treaties representing a large number of underlying policies

a. Factual Requirements Test was added to provide additional flexibility

Section 1297(b)(2)(B) provides an exclusion from the definition of passive income for income derived in the active conduct of an insurance business by a QIC. The statute is silent, however, on how the determination of the QIC's active conduct of an insurance business (“Active Conduct Test”) should be made. In proposed regulations issued in 2019, the IRS and Treasury provided an active conduct percentage test, which was computed by taking the internal costs incurred to actively conduct the insurance business over all such costs incurred, as the exclusive means to determine if a QIC met the Active Conduct Test. In response to several comments which were critical of the test, the IRS and Treasury amended the test to provide more flexibility. Prop. Treas. Reg. § 1.1297-5 provides a new “factual requirements test” which may be satisfied to meet the Active Conduct Test, as an alternative to the active conduct percentage test (which has also been revised) (the “Factual Requirements Test”). The Preamble to the Proposed Regulations requests comments on the test. The Factual Requirements Test contains very detailed requirements with respect to functions of the insurance business, considered core functions by the Proposed Regulations.

Under Prop. Treas. Reg. § 1.1297-5(c), the Factual Requirements Test is met if:

b. Application of the Factual Requirements Test disadvantages some reinsurers

The detailed requirements of the Factual Requirements Test put some reinsurance companies at a disadvantage. The business model of some reinsurance companies is to assume a large “block” of insurance business (generally with life/annuity risks) through reinsurance, acquiring such large blocks of business only from time to time. Such a reinsurance company remains vigilant about market opportunities, but the market for such business can be highly competitive, requiring expensive due diligence and underwriting. In some cases, it is not worthwhile to pursue a block of business that is highly sought after by several companies, because the reinsurer may form a view that it would be outpriced by the competition. In addition, the insurance regulators limit a reinsurance company's capacity to reinsure by its capital or surplus. The reinsured blocks of business tend to require a significant amount of capital commitment, such that one or more blocks may completely deploy the capital available in the reinsurance company. Once a reinsurer's capital is fully deployed, no further reinsurance contracts may be issued until additional capital is available from the investors, creation of surplus through operation of the business, or through retrocession contracts that free up surplus. As a result of these factors, the underwriting function of the reinsurer is more sporadic and opportunistic, where the underwriting and assumption of a new reinsurance contract may not occur every year. Such a company nevertheless is “active” by any measure.

The Proposed Regulations state that underwriting is a core function, and core functions must be carried out on a regular and continuous basis. In addition, the officers and employees must perform virtually all of the active decision-making functions relevant to the underwriting function on a contract by contract basis, without outsourcing them to independent contractors. As each block of insurance risk assumed is a single contract, the underwriting function may be met on a contract by contract basis. However, “regular and continuous” underwriting in the case of the reinsurers described should be interpreted in line with the common practice of such reinsurers, to allow for the inherent irregularity of the underwriting that is typical to the business.

Additionally, to meet the Factual Requirements Test, substantial managerial and operational activities with respect to core functions must be carried out by officers or senior employees of the QIC, who are experienced in the conduct of those activities and devote all or virtually all of their work to those activities and similar activities for related entities. This requires each insurance company to have employees who only perform certain functions for all related entities on a full-time basis. The reinsurance companies described above may not require full time employees to actively operate their business. For this reason, it is not uncommon for officers and employees of such companies to wear “dual hats” where they perform other functions for related or even unrelated entities as employees. It is unclear why an employee or an officer may not carry out dissimilar activities for related entities, or even for unrelated entities, if their activities with respect to the tested foreign reinsurance company are enough to meet its business needs and otherwise meet the Factual Requirements Test.

The Factual Requirements Test in the Proposed Regulations inadvertently favors larger insurance companies, while disfavoring smaller insurance and reinsurance companies.² Although the active conduct percentage test remains an alternative means to meet the Active Conduct Test, it would be unfair to prevent reinsurance companies that are actively engaged in a reinsurance business from meeting the Factual Requirements Test, solely because they enter into reinsurance contracts to acquire that business infrequently. The infrequency of the reinsurance transactions should not be taken to mean that the reinsurance business is inactive. Instead, recognition should be given to the fact that the infrequency is due to constraints imposed by size, competition and capital that are inherent in the nature of the business. The reinsurance business is an active business that requires the reinsurer to continually look for reinsurance business opportunities in the market within its constraints and should qualify a company as “engaged in the active conduct of an insurance business” within the meaning of section 1297(b)(2)(B).

c. IRS and Treasury should modify the Factual Requirements Test to treat reinsurers more appropriately

The Factual Requirements Test is not part of the Code and was not described in the legislative history to the TCJA. Rather, the IRS and Treasury created the test to provide flexibility for income of genuinely active insurance companies to qualify for the Active Insurance Exception of section 1297(b)(2)(B). In line with that objective, specifically two modifications are warranted:

• First, the elements of the definition of “substantial managerial and operational activities” in Prop. Treas. Reg. § 1.1297-5(c)(2)(i) should be modified so that it does not require officers or senior employees of the QIC, who are experienced in the conduct of those activities, to devote all or virtually all of their work to those activities and similar activities for related entities.

• Second, the “regular and continuous basis” requirement in Prop. Treas. Reg. § 1.1297-5(c)(2)(ii) should be modified to remove any implication that a reinsurer fails to meet the requirement solely because it assumes large blocks of business less frequently than annually. In particular, this requires giving recognition to reinsurers who are continually searching for opportunities for reinsurance business but may actually underwrite reinsurance contracts only as permitted within the constraints imposed by size, competition and capital that are inherent in the nature of the business as described above.

2. AIL for business assumed by a QIC from unrelated parties on a modco basis should follow its AFS

a. Section 1297(f) addresses the priority of AFSs and application of the capping rule

Section 1297(f) generally provides that a QIC is a foreign corporation that (1) would be subject to tax under subchapter L if it were a domestic corporation, and (2) has AIL constituting more than 25 percent of its total assets on its AFS (“the 25-percent test”).

Section 1297(f)(3)(B) provides that the AIL shall not exceed the lesser of such amount (the “capping rule”):

Section 1297(f)(4)(A) provides that the term AFS means a statement for financial reporting purposes (the “AFS priority rule”) which:

The term “applicable insurance regulatory body” means, with respect to any insurance business, the entity established by law to license, authorize, or regulate such business and to which the statement described in section 1297(f)(4)(A) is provided.³

b. Reinsurers assuming risks through modco from unrelated parties should follow the statutory framework to determine AIL reported on the AFS under the AFS priority rule; regulations should not change the result through a capping rule

Some offshore reinsurance companies reinsure risks of unrelated domestic insurance companies through modco, which is described in the Preamble to the Proposed Regulations as a reinsurance arrangement that permits a ceding company to continue to hold the reserves and assets required to support the insurance liabilities for the reinsured contracts during the policy term. The underlying contracts may be annuity and life insurance contracts with mortality and morbidity risks that the domestic insurance company issues to the general public in the United States. The offshore reinsurance company may prepare its only stand-alone financial statements based on IFRS which is required to be filed with the local regulatory body. Under IFRS, the offshore reinsurance company shows the gross assets and insurance reserves related to the reinsurance contract.

Often, the parent of the offshore reinsurance company is a non-insurance holding company that owns other insurance and reinsurance companies. The parent and its subsidiaries together may file a consolidated financial statement on either a GAAP or IFRS basis.

In applying section 1297(f)(4), the foreign reinsurance company determines that the IFRS-based financial statements are its AFS. As it is the only financial statement it prepares on a stand-alone basis, the AFS priority rule does not change the result. The insurance reserves, as they relate to life insurance and annuity contracts that have mortality and morbidity risks are AILs, that are reported on its AFS.

Under the Final Regulations, a foreign corporation's AIL may not exceed the lesser of (1) the amount shown on any financial statement filed (or required to be filed) with the applicable insurance regulatory body for the same reporting period covered by the AFS; (2) the amount determined on the basis of the most recent AFS, if the AFS is prepared on the basis of GAAP or IFRS, regardless of whether the AFS is filed with the applicable insurance regulatory body; or (3) the amount required by the applicable law or regulation of the jurisdiction of the applicable regulatory body (or a lower amount allowed as a permitted practice). If one of the limitation amounts is not applicable (for example, if the AFS is not prepared on the basis of GAAP or IFRS), the limitation is equal to the lesser of the other amounts described.

Although the limitation under section 1297(f)(3) refers to the amount reported to the applicable insurance regulatory body in the AFS, the Final Regulations clarify that an AFS prepared under GAAP or IFRS is taken into account⁴ regardless of whether it is filed with the local regulator. This rule is intended to prevent foreign corporations that choose not to file GAAP or IFRS statements with the local regulator from relying on statutory accounting standards that define liabilities more broadly than GAAP or IFRS. A financial statement prepared on a consolidated basis that takes into account affiliates that are not owned by the tested foreign corporation (for example, sister companies) is not treated as the AFS unless it is the only financial statement of the tested foreign corporation and is provided to an insurance regulator. Because the consolidated financial statement of the parent described above includes non-insurance companies, it is not treated as the AFS of the reinsurance company under this rule.

The Preamble to the Proposed Regulations, in discussing modco, explains as follows:

It has been held that life insurance reserves on policies reinsured under a modco arrangement are attributed to the ceding company, and not the assuming company. See Rev. Rul. 70-508, 1970-2 C.B. 136 (1970). See generally Colonial Am. Life Ins. v. United States, 491 U.S. 244, 248, n.2 (1989); Anchor National Life Ins. v. Commissioner, 93 T.C. 382, 423 (1989). Proposed § 1.1297-4(f)(2)(i)(D)(3) is not intended to apply to modco arrangements where the ceding company retains the assets supporting the insured risks (because they do not create an amount recoverable from another party), but the Treasury Department and IRS request comments as to whether the rule appropriately addresses modco arrangements and whether additional rules may be necessary in the final regulations. The Treasury Department and IRS also request comments as to whether to more specifically define amounts recoverable from another party through reinsurance and whether there are other special circumstances in which modification of the definition of AIL is appropriate.⁵

The Preamble thus acknowledges the effect of a modco arrangement when the tested foreign insurance company cedes risks; however, the points raised apply equally when it assumes business through modco. In the case of the reinsurance company in question, notwithstanding that the risks are assumed through modco, the statutory framework provides the determination of its AIL and AFS. The fact that the risks are assumed through modco should not change the result. Although the capping rule has a provision for the IRS and Treasury to cap the amount of the AIL to a lower amount than the amount reported on the AFS, no such rule should be promulgated in the case of modco between unrelated parties.

c. The IRS and Treasury could address any concerns of double counting of AIL by applying a “no double counting rule” to modco arrangements between related parties, but not by imposing an extra-statutory consistency requirement to arrangements between unrelated parties

We appreciate that the IRS and Treasury may be concerned that because different accounting systems treat modco differently, in certain cases both the ceding and the assuming company may show the full amount of reserves and assets on their respective AFSs. This may be an issue if both the ceding and the assuming company are in the same financial group — such that their assets and liabilities affect the same tested foreign corporation. Any concerns that the reserves may be counted twice by the same tested foreign corporation may be already addressed by the rules of Treas. Reg. § 1.1297-4(f)(2)(i)(D)(1) and (2), which provide that no item may be taken into account more than once and that AIL include only the liabilities of the foreign corporation whose QIC status is being tested, and not liabilities of other entities within a consolidated group, or may be addressed by a similar rule.

However, there should be no double counting concerns if the modco arrangement is between unrelated parties. Accordingly, we believe that although the capping rule has a provision for the IRS and Treasury to cap the amount of the AIL to a lower amount than the amount reported on the AFS, no such rule should be promulgated in the case of modco between unrelated parties. In fact, such a rule would go beyond the requirements of section 1297(f) itself. Reinsurance takes many forms, meeting different commercial objectives such as coinsurance, coinsurance with reinsurance trusts protecting the reinsured, coinsurance with funds withheld and modified coinsurance. Each such form of reinsurance is a valid reinsurance transaction. The statutory framework of section 1297 relies on the accounting treatment of each foreign company to determine its AIL, with priority rules and definitions. Any limitations on AILs should operate within the statutory framework provided in section 1297(f) whose priority ordering with respect to AFS is clear enough. Any additional limitations on AILs with respect to modco contracts would appear to disfavor certain reinsurance transactions notwithstanding that they are commercially motivated transactions undertaken for valid business reasons. However, a rule that denies the benefit of double counting to related taxpayers would be equitable and is in line with other areas of the regulations where a similar rule has been provided.

3. “Unearned premiums” for a mortgage insurer should, in appropriate cases, be included in AIL

Section 1297(f) defines a QIC as a foreign corporation (1) that would be subject to tax under Subchapter L if it were a domestic corporation, and (2) the AIL of which constitute more than 25 percent of total assets (i.e., the 25-percent test), determined on the basis of the assets and liabilities reported on the AFS for the last year ending with or within the tax able year. As noted above, AFS means a statement for financial reporting purposes that is made on the basis of GAAP, is made on the basis of IFRS, or is required to be filed with the applicable insurance regulatory body.

Under section 1297(f)(3) and Treas. Reg. § 1.1297-4(f)(2), AIL include loss and loss adjustment expenses, but exclude deficiency, contingency, or unearned premium reserves (“UPR”). Generally, this limitation ensures that the total assets an insurer holds are commensurate with its policy obligations, and that a foreign company is excluded from PFIC characterization only if it is not overly capitalized. For mortgage insurers, however, the unique business and regulatory requirements of mortgage insurance may produce anomalous results if AIL is determined based solely on the labels applied to its reserves. In this regard, amounts labeled “unearned premiums” of a mortgage insurer may, in some cases, bear a closer resemblance to losses (which are included in AIL) than to unearned revenue (which are excluded).

a. Labels should not control

The nature of a reserve, rather than its label, should determine whether it is included in the AIL of a mortgage insurer.

For life and health insurance business, section 1297(f)(3)(A)(ii) includes reserves “other than deficiency, contingency, or unearned premium reserves” in AIL. For other businesses, section 1297(f)(3)(A)(i) limits AIL to “loss and loss adjustment expenses.” Neither the Code nor the legislative history of section 1297(f) define “loss,” “unearned premiums,” or “contingency reserves.” The effect of the provision, however, is to include in AIL amounts that are determined with regard to losses that either have occurred or are expected to occur, and to exclude from AIL unearned revenue, or amounts set aside for unexpected claims or losses. In context, this makes sense of the provision's purpose, which is to determine that only an active insurance company, whose assets are commensurate with its policy obligations, is eligible for the Active Insurance Exception.

For certain mortgage insurers whose AFS is prepared on the basis of IFRS, however, these labels can be misleading because reserves established as “unearned premiums” reflect both unearned revenue and estimated losses on the insured loans. Thus, a mortgage insurer may be unfairly excluded from the protections of the Active Insurance Exception merely because a single label applies to two different components of its reserves, one of which clearly corresponds to the losses it may experience on underlying policies. To avoid this unfair result, the IRS and Treasury should interpret the term “unearned premium reserves” in a manner that looks through the label to the underlying economic reality of its various components.

The Preamble to the Final Regulations acknowledges differences in nomenclature among GAAP, IFRS, and local statutory accounting, and explains adjustments that may be required in order to determine the amount of a company's AIL:

It is anticipated that the starting point for determining the amount of AIL will be the AFS balance sheet. However, it may be necessary in some circumstances to disaggregate components of balance sheet liabilities to determine the amount of a company's insurance liabilities that meet the regulatory definition of AIL. . . . Some companies may have already adopted IFRS 17 for financial reporting purposes on an optional basis. IFRS 17 generally does not use the terms unpaid losses and LAE or unearned premium reserve on its balance sheet. Instead, those amounts are included in the overall insurance liabilities on the balance sheet and are required to be separately identified in the notes, as respectively, “liability for incurred claims” and “liability for remaining coverage.” While they bear a different name, they are intended to be substantially the same in concept to claims reserves and unearned premium reserves. Therefore, it is expected that a foreign corporation using IFRS 17 only include those amounts derived from the balance sheet that fall within the final regulation's definition of AIL. Similarly, a foreign corporation using IFRS 17 (or any other financial reporting standard) is expected to exclude contingency reserves and deficiency reserves (in addition to unearned premium reserves), as applicable, even when those categories do not separately appear on the balance sheet as a liability and are subsumed within another reported line item.⁶

For the same reasons, it is appropriate to disaggregate reserves determined under other systems for purposes of determining AIL if those reserves have characteristics of both losses and unearned premiums.

In recently finalized regulations,⁷ the Service explicitly instructed that labels are not determinative for purposes determining life insurance reserves under section 807(d). Under this provision, deductible life reserves of an insurance company generally are equal to 92.81 percent of the reserve determined using the tax reserve method. The reserve determined using the tax reserve method does not include asset adequacy reserves. Treas. Reg. § 1.807-1(b)(2) provides that “[i]n determining whether a reserve is a life insurance reserve, the label placed on such reserve is not determinative.”⁸ Likewise, for determining AIL of a mortgage insurer, the treatment of reserves as “losses” (included in AIL) or “unearned premiums” or “contingency reserves” (excluded from AIL) most appropriately depends on the nature of the reserves themselves and how they are determined.

b. Unearned Premiums generally refers to unearned revenue

Broadly, section 832(b)(4) relies on unearned premiums to ensure that gross premiums written on non-life insurance contracts are treated as “earned” over the period for which coverage is provided. Treas. Reg. § 1.832-4(a)(8) defines unearned premiums of a nonlife company as “the portion of the gross premium written that is attributable to future insurance coverage during the effective period of the insurance contract.” Treas. Reg. § 1.801-3(e) provides a different, but consistent, definition for purposes of the life insurance company qualification ratio of section 816.

Treas. Reg. § 1.832-4(a)(5)(v) recognizes the problem of accounting for UPR of a contract that spans several years and allows a contract to be accounted for as a series of 1-year contracts, rather than a contract spanning multiple years, provided premium acquisition expenses fall within a safe harbor amount.⁹ Whether gross premiums written and unearned premiums represent several years of coverage or a single year of coverage, the function of unearned premiums is to ensure unearned revenue is accounted for as it is earned. Under Treas. Reg. § 1.832-4(a)(9), the default method for determining premiums earned is ratably over the unexpired portion of the contract's effective period, provided risk of loss does not vary significantly over that period.

Section 832(e) recognizes the special nature of reserves that a mortgage insurer is required to set aside for losses that are anticipated to become due.¹⁰ The requirement to set amounts aside arises specifically because it is a certainty that some level of mortgage defaults will occur, particularly in adverse economic conditions.¹¹

c. UPR of a mortgage insurer are not solely unearned revenue, and are not contingency reserves either

Amounts that are labeled “unearned premiums” in the IFRS financial statements of a mortgage insurer should not be excluded automatically from AIL, because they are unlike “unearned premiums” for any other line of business. For example, in our client's case, amounts labeled “unearned premiums” of a mortgage insurer are determined based not on the term of coverage nor on the outstanding principal balance of the insured mortgages, but rather on an “expected loss emergence pattern,” updated periodically throughout the term of the policy. In this sense, “unearned premiums” are most sensitive to losses based on ongoing monitoring. Further, the amounts are required to be set aside in recognition of the fact that defaults on some mortgages in a pool are a virtual certainty. Under these circumstances, it is at best incomplete to think of “unearned premiums” as merely unearned revenue — they reflect the anticipated emergence of actual losses, updated on an ongoing basis.

“Unearned premiums” of a mortgage insurer under IFRS bear no resemblance to contingency reserves, either. By definition, contingency reserves are not based upon expected losses, but upon unexpected losses, and are based on earned premium not unearned premium. For U.S. statutory accounting, for example, Statutory Issue Paper, No. 88, paragraph 14 provides as follows:

In addition to the unearned premium reserve, mortgage guaranty insurers shall maintain a liability referred to as a statutory contingency reserve. The purpose of this reserve is to protect policyholders against loss during periods of extreme economic contraction. The annual addition to the liability shall equal 50 percent of the earned premium from mortgage guaranty insurance contracts and shall be maintained for ten years regardless of the coverage period for which premiums were paid. (Emphasis added)

d. UPR of a mortgage insurer with AFS prepared on the basis of IFRS are most akin to unpaid losses

For all these reasons, in appropriate cases the UPR determined under IFRS for a mortgage insurer more closely resembles unpaid losses than unearned premiums: some level of losses in this line of business is certain to occur; the reserve is computed based on the expected emergence of losses rather than solely the unexpired coverage term or aggregate unpaid principal balance; and, it often is regulatorily required to be set aside so there are funds to satisfy claims.

We appreciate that the Final Regulations took into account comments on the special nature of the mortgage insurance line of business. We also appreciate that the regulations require that only reserves for “sustained” losses are includible in AIL. Nevertheless, we think it important that a mortgage insurer be permitted to consider the nature of reserves it holds, rather than the label, to determine whether those reserves are included in AIL. For a mortgage insurer, amounts that are required to be set aside, and that are computed based on anticipated emergence of actual losses, are most like “losses,” and are not like unearned revenue or contingency reserves. At a minimum, a mortgage insurer should be permitted to include in AIL that portion of UPR reported on its AFS that is determined by reference to future losses and that otherwise qualifies as AIL, as defined in the regulations.

e. IRS can address AIL of a mortgage insurer in a way that does not turn an active insurance company into a PFIC

In the absence of statutory definitions of “losses,” “unearned premiums,” and “contingency reserves” for purposes of section 1297(f), the IRS and Treasury should interpret these terms in a manner that takes into account the unique reserving methodologies within the mortgage insurance industry, and in particular recognizes that a mortgage insurer's UPR reported on its AFS prepared on the basis of IFRS is at least as much a function of anticipated losses as of unearned revenue.¹²

Either of two approaches would address the unique economics of mortgage insurance, while at the same time carrying out the intent and purpose of the definition of QIC and the ratio of AIL to total assets.

First, regulations could interpret UPR for a mortgage insurance company to exclude amounts labeled as UPR if the amount required to be set aside is based on estimated future losses, on the theory that these are more akin to unpaid losses than to unearned revenue relating to future coverage. This would be consistent with the reason amounts are required to be held, and consistent with the requirement that only reserves relating to losses, not reserves relating to unearned revenue, be reflected.

Second, regulations could interpret UPR for a mortgage insurance company to include only unearned amounts for the next 12 months and treat the remaining “UPR” as AIL. This would be consistent with the paradigm in Treas. Reg. § 1.832-4, where a multi-year contract may be treated as a series of one-year contracts, resulting in a much lower UPR amount for tax purposes.

Either interpretation would be more consistent with Subchapter L than treating “unearned premiums” of a mortgage insurer as unearned revenue under the circumstances described. Either interpretation would ensure that a mortgage insurer's AIL include its real, economic, required reserves that are set aside for future policy losses.

In summary

We appreciate this opportunity to comment on the Proposed Regulations. With the changes described above, we believe final regulations would more appropriately distinguish between insurers that are QICs engaged in the active conduct of an insurance business, and those that are not. If there are any questions, please call Surjya Mitra at (703) 855-9357, Mark Smith at (202) 412-2415, or Charles Markham at (202) 841-9355.

Very truly yours,

PricewaterhouseCoopers, LLP