SOURCE: Foreign Insurance Excise Tax - Audit Technique Guide, April 2008, as found at http://www.irs.gov/businesses/small/art ... 63,00.html NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Chapter 10 - Insurance Company Reinsurance
As discussed in Chapter 6, insurance in the generally accepted sense is a contract to transfer the risk of loss from one party to another for payment of consideration. In order for insurance to exist, there must be risk-shift and risk-distribution. There also must be a pure risk of loss (loss or no loss) as opposed to a speculative risk (gain, loss or no loss). Business risk, investment risk, and asset risk are subcategories of speculative risk.
Reinsurance is a transaction between two insurance companies to transfer risks insured. Reinsurance in this sense is essentially insurance for an insurance company.
Insurance Companies in General
Insurance can generally be classified into two categories: property and casualty insurance, and life insurance. The term “insurance company” means a company whose primary and predominant business activity during the taxable year is the issuance of insurance or annuity contracts. The term also includes a company engaged in the reinsuring of risk underwritten by insurance companies. It is the character of the business, which determines whether a company is taxable as an insurance company under the Internal Revenue Code. Cite: G.C.M. 39146.
Types of Insurance Companies
Insurance is provided by a number of different organizations. The most common types of insurance organizations include stock companies, mutual companies, reciprocal exchanges, Lloyd’s, federal and state governments, and captive insurers.
Stock Company - A company owned by shareholders whose ownership is evidenced by shares of stock. The shareholders participate in any surplus remaining from premium and investment income after insurance losses and the costs of doing business have been paid. Stock companies are prevalent in the life insurance industry.
Mutual Company - A company without stockholders or capital stock. All risks and all profits are the property of the policyholders. Mutual companies are prevalent in the property and casualty insurance industry.
Reciprocal exchange - A group of individuals, corporations, or other organizations, referred to as subscribers, who are exposed to similar insurable risks and wish to share these risks among themselves. For example, a number of independent hospitals that have exposure to professional liability suits may form a reciprocal exchange in order to share these risks. Each subscriber is liable for its proportionate share of the total liability should a claim be presented.
Lloyd’s Association - A kind of organization for underwriting insurance or reinsurance in which a collection of individuals assume policy liabilities as the individual obligations of each. When spelled with an apostrophe, the term refers to Lloyd’s of London, the formal name of which is “Underwriters at Lloyd’s, London.”
Federal and state governments - Provide insurance protection for certain risks that are beyond the ability or resources of most private insurers to assume. Examples of federal insurance are: the Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC). At the State level, the most common type of insurance protection provided is workers’ compensation. These state programs are administered by a state agency under the direction of a state supervisory board.
Captive insurers - Wholly owned corporate subsidiaries that insure the risks of the parent corporation and other entities within the affiliated group. Captives are discussed in depth in Chapter 6.
Discussion of Reinsurance Terms
In order to better understand reinsurance and the terms included in this section, refer to the diagram of the flow of transactions below:
A is the initial insured. B is the insurance Company and C is the Reinsurance Company.
Note: References (example: (B) made in this section are to the entities above.
Reinsurance - A transaction between two insurance companies to transfer risks. The direct or primary insurance company (B) is called the ceding company or reinsured. The ceding company may transfer (cede) some or all or its risk to a reinsurer (C) which is the assuming company. When a company reinsures, it may cede its risks to authorized companies or to unauthorized companies.
Authorized reinsurance - Insurance placed with a reinsurer who is either licensed or otherwise recognized by a particular state insurance department. On the other hand,unauthorized reinsurance is insurance placed with a reinsurer who is not licensed or recognized by a particular state insurance department.
The reinsurer (C) may also transfer or retrocede all or a part of the risk it assumes from an insurer (B) to another third party insurer called a retrocessionare. This type of agreement is called a retrocession agreement. The risk transferred between insurance companies may be transferred several more times, or retroceded.
In order to reimburse the ceding insurer (B) for its expenses, the reinsurer (C) will pay the ceding company (B) a ceding commission. Ceding commissions may include agent commissions, premium taxes, license and other fees, and administrative and overhead expenses, which are incurred by the reinsured (B) in underwriting the contract. The ceding commission will also include a profit factor for the ceding insurance company (B).
Reinsurance is created via a reinsurance contract between the two insurance companies. There are a number of different types of reinsurance contracts which will be discussed later in this lesson.
Why Insurance Companies Reinsure
An insurer purchases reinsurance for different reasons. The major reasons are to accomplish the following:
Reduce exposure on a particular risk or class of risk.
Protect the insurance company against a large accumulation of losses caused by a major catastrophe.
Obtain an ability to accept risks and policies involving insurance amounts which are larger than they could accept without the reinsurance.
Stabilize operating results.
Reduce premium volume and total liabilities to levels appropriate to capital accounts, and
Obtain assistance with new insurance products and lines of insurance.
Basic Types of Reinsurance
Reinsurance can generally be classified into two broad categories, assumption reinsurance and indemnity reinsurance.
Assumption reinsurance is “an arrangement whereby another person (the reinsurer) becomes solely liable to the policyholders on the contracts transferred by the [ceding company]”. Cite: Treas. Reg. § 1.809-5(a)(7)(ii).
Under an assumption reinsurance agreement, the reinsurer steps into the ceding company’s shoes, becoming directly liable to the policyholders. The reinsurer also receives all premiums directly.
Example: Company A purchases a policy of casualty insurance from Insurer B. Insurer B cedes the risk to Insurer C under an assumption reinsurance contract. Should a loss occur to the risks insured, Insurer C will be responsible for payment on the loss. Also, once the assumption reinsurance agreement is signed, Company A will be aware of the reinsurance agreement, and Company A will pay premiums directly to Insurer C.
Indemnity reinsurance is “an arrangement whereby the [ceding company] remains solely liable to the policyholder, whether all or only a portion of the risk has been transferred to the reinsurer.” Cite: Treas. Reg. § 1.809-4(a)(1)(iii)).
Under an indemnity reinsurance agreement, the reinsuring company agrees to accept and to indemnify the issuing (ceding) company for all or a part of the risk of loss under the policies specified in the agreement. Both insurers are co-insurers.
Example: Company A purchases a policy of insurance from Insurer B. Insurer B then transfers the risks insured to Insurer C under an indemnity reinsurance agreement. (After the agreement between Insurer B and Insurer C is executed, Company A will still pay premiums to Insurer B only. Company A may not know of the agreement between Insurer B and Insurer C.) Should a loss occur, Insurer B would be responsible for payment on the loss to Company A. Insurer B would then turn to Insurer C for payment under the terms of the indemnity reinsurance agreement.
With an indemnity reinsurance arrangement, it is not uncommon for the ceding company to establish a “funds held account,” sometimes referred to as a “funds withheld,” which holds the unearned premium reserve or the outstanding loss reserve. The net balance of the funds withheld increases with additional premiums received or decreases as claims are paid. As profits emerge, the ceding company pays the reinsurer its share. Conversely, the reinsurer reimburses the ceding company for any losses that occur after the funds withheld balance reaches a certain specified amount.Indemnity reinsurance can take two forms, pro-rata reinsurance, (often referred to as co-insurance in the life insurance industry) and excess of loss reinsurance. These terms are discussed below.
Pro-Rata Reinsurance / Co-insurance In pro-rata reinsurance, the reinsurer’s participation is predetermined and is proportional. Therefore, the reinsurer is responsible for loss reimbursement based upon the proportions set forth in the contract. In the life insurance industry, this type of reinsurance is typically referred to as coinsurance and if a funds held account is utilized, it is referred to as modified co-insurance. Pro-rata reinsurance contracts can be written as quota share or surplus share arrangements.
Under a quota share arrangement, a fixed percentage of the insurance policies written by the insurer is automatically ceded to the reinsurer. Usually the percentage of the reinsurer’s share of the risk is the same as the percentage of the written premium it receives.
Example: Company B has issued policies with premiums totaling $10,000,000. According to the terms of the quota share treaty, Company B will cede 60% of its premiums to Company C.
Multiplied by Quota Share % .60
Equals Premiums Ceded 6,000,000
Under a surplus share arrangement, the assuming insurance company must accept the amount of risk above the net retention of the ceding company. The amount of net retention (the amount retained) of risk by the ceding company is specified in the treaty, and the percent of participation is based on the type of risk insured. The amount of risk insured in the original policy in excess of the amount of retention is called the surplus.
Example: Company B issues a policy for $500,000 with an insurance premium of $5,000. The reinsurance contract specifies a $100,000 retention level. Company B retains $100,000 and cedes the remaining $400,000 of the risk to Company C.
Original Policy $500,000
Less Ceding Company’s Retention (100,000)
Equals Surplus Ceded to Company C $400,000Reinsurance Premium Ceded:
Policy premium times [surplus divided by original risk]
$5,000 times (400,000 divided by 500,000)
Excess of loss reinsurance - Does not provide a sharing of all the risk. Under this arrangement, the reinsurer’s participation depends on the size of the loss and/or time involved. The reinsurance becomes effective only when losses reach a stipulated amount or retention level, and then only to limits set forth in the contract. Types of excess of loss reinsurance include per risk reinsurance, catastrophe reinsurance, and stop loss reinsurance.
Example: Company B reinsures with Company C. In its excess of loss treaty, Company B must retain the first $100,000 loss on a certain type of negotiated risk. Company C will cover losses up to $500,000.
Total Loss $700,000
Less Company B Retention 100,000
Less Company C Payment 500,000
Equals Balance Paid by Co. B $100,000
Per risk reinsurance or per claim excess reinsurance provides coverage for losses in excess of a predetermined amount on a per risk basis. For example, a building is insured under a policy of casualty insurance and a reinsurance contract is secured under per risk coverage of $100,000. In the case of damages to the building, should the damages exceed the preset amount of $100,000, the reinsurer is responsible for the amount of loss over the $100,000.
Catastrophe reinsurance or per occurrence reinsurance provides coverage for losses in excess of a predetermined amount resulting from a specific catastrophic event or series of events. For example, claims for damages due to hurricanes are reinsured to the extent the accumulated losses due to hurricanes within the coverage period exceed the predetermined amount.
Stop loss reinsurance or aggregate excess of loss reinsurance provides coverage for accumulated losses incurred by the ceding company in excess of a predetermined amount during a specified period. For example the ceding company would absorb all losses in their entirety until the aggregate losses reach a specific dollar amount or maximum loss ratio. The reinsurer then would reimburse the ceding company to bring the dollar amount of losses or loss ratio down to a specified maximum level.
Types of Reinsurance Contracts
Reinsurance is transacted through a contract or agreement between insurance companies whereby risk is distributed. Reinsurance contracts are generally categorized as facultative reinsurance or treaty reinsurance.
Facultative reinsurance gives the reinsurer the option to accept or refuse each risk offered by the ceding company. Usually a binder is prepared by the insurance company and is signed by the reinsurer. The reinsurer subsequently issues a reinsurance certificate.
Treaty reinsurance is reinsurance that is not facultative reinsurance. Treaty reinsurance is usually a detailed contract that defines, among other provisions, the type of business reinsured, the exclusions, and the amount covered. Treaty reinsurance automatically reinsures a defined type of business. The reinsurer does not have the right to accept or reject each individual risk within a policy. Treaty reinsurance is the more common type of reinsurance.
Key Elements of a Reinsurance Contract
The reinsurance contract is a detailed agreement that defines the entire reinsurance agreement. Among other things, the reinsurance contract defines the type of business reinsured, the excluded business, ceding commissions, offsets, and premium amounts. It prescribes for the manner in which reports and remittances are to be made. It also provides for redress based on insolvency, errors, and omissions.
Sources of Information for Reinsurance Premiums Ceded
Several sources of information are useful in reconciling foreign insurance premiums ceded:
Form 720 and supporting workpapers.
Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return.
Form 1120-L, U.S. Life Insurance Company Income Tax Return.
NAIC Annual Statement.
Form 720 and Supporting Workpapers
Along with copies of the Forms 720 filed for all entities, the supporting workpapers used to prepare the returns are to be requested. Depending upon the detail provided in the workpapers, names of “taxable insurers” and the amount of “taxable premiums” will be listed. Subsequent Information Document Requests can be prepared to verify or clarify this information.
A review of comparative financials will give a historical overview of the company’s insurance activities; premium income and expense; information concerning parent subsidiaries, and affiliates; and acquisitions and legal proceedings.
Provide information on ceded premiums, assumed reinsurance, commissions, expenses, and excise tax deposits. Detail on ceded premiums can be reconciled with Forms 720, settlement statements, and the NAIC schedules reporting reinsurance premiums ceded.
Every domestic non-life insurance company and every foreign corporation that would qualify as a non-life insurance company subject to taxation under I.R.C. § 831 as if it were a U.S. corporation, must file Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return. Form 1120-PC, Schedules E and I provide information on net premiums written, the method of accounting, and foreign and domestic affiliates.
Note: An exemption is provided for non-life insurance companies exempt under I.R.C. § 501(c)(15). These companies are required to file Form 990, Return of an Organization Exempt from Income Tax.
A life insurance company (LIC) is an insurance company in the business of issuing life insurance and annuity contracts, either separately or combined with health and accident insurance, or non-cancelable contracts of health and accident insurance, that meet the reserves test in I.R.C. § 816(a).
Every domestic LIC and every foreign corporation that would qualify as a LIC if it were a U.S. corporation must file Form 1120-L, U.S. Life Insurance Company Income Tax Return. Form 1120-L, Schedules G and M provide information on gross premiums, return premiums, premiums and other consideration incurred for reinsurance, the method of accounting, and foreign and domestic affiliates.
NAIC Annual Statement
The National Association of Insurance Commissioners (NAIC) is an association of the various state insurance commissioners formed for the purpose of uniformity of regulatory practices and information reporting among the states. While the NAIC has no official power to enforce compliance with any of its recommendations, the NAIC’s recommendations and forms are generally adopted and widely accepted by the states.
Treasury Regulation § 1.6012-2(c) requires that the NAIC Annual Statement be filed with Form 1120-L and Form 1120-PC. A schedule which reconciles the NAIC Annual Statement to the tax return is required to be attached to the return. A penalty may be imposed if the annual statement is not included when the income tax return is filed.
Various schedules, not limited to the following, in the NAIC Property/Casualty Annual Statement provide data and background information on reinsurance activities:
Underwriting and Investment Exhibit - Part 2B, Premiums WrittenSchedule F - Part 1, Assumed Reinsurance
Schedule F - Part 2, Premiums Portfolio Reinsurance Effected or (Cancelled) during Current Year
Schedule F - Part 3, Ceded Reinsurance
Supplemental Exhibits and Schedules Interrogatories
Notes to Financial Statement
Schedule Y, Information Concerning Activities of Insurer Members of a Holding Group
Part 1, Organization Chart
Part 2, Summary of Insurer’s Transactions with Any Affiliates
The bordereau (singular) or bordereaux (plural) is a periodic report or settlement statement that accounts for the reinsurance premiums paid from the initial insurer to the reinsurer. It is usually prepared by the ceding company (initial insurer) and is provided at interim periods to the reinsurer. A bordereau reflects the following items:
Losses and loss adjustment expenses (LAE’s).
Incurred but not reported (IBNR) losses.
Amounts due to/from reinsurer.