1986 Tax Ct. Memo LEXIS 384 | Tax Ct. | 1986
MEMORANDUM FINDINGS OF FACT AND OPINION
WRIGHT,
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. For purposes of clarity, the general principles concerning reinsurance are incorporated in the findings of fact.
Petitioner, Colonial American Life Insurance Company (Colonial), was incorporated in 1924 in the State of Louisiana. Its principal place of business at all relevant times was in New Orleans, Louisiana. Petitioner timely filed Federal income tax returns for the calendar years 1975 and 1976.
At all relevant times petitioner was authorized to and did engage in the insurance business in Louisiana and in numerous other states, writing various forms of life, accident, and health insurance. Petitioner's principal insurance risks during the years in controversy consisted of life contingencies originally written by it or written by other companies and reinsured by petitioner.
Reinsurance is1986 Tax Ct. Memo LEXIS 384">*386 an arrangement whereby an insurance company transfers some or all of the risks it has underwritten to another insurance company. 1 The company purchasing the reinsurance is known as the initial insurer, the reinsured, or the ceding company; the company acquiring the risk is known as the reinsurer or the reinsuring company.
There are basically two types of reinsurance -- assumption reinsurance and indemnity reinsurance. In assumption reinsurance, the reinsuring company takes over for the initial insurer and becomes directly liable to the policyholders.The initial insurer is relieved of all liability, including the maintenance of the required reserves. The reinsuring company has the duty of establishing and maintaining1986 Tax Ct. Memo LEXIS 384">*387 the required reserves. In addition, the reinsuring company is entitled to all premiums paid and must pay all future claims and expenses with respect to the policies.
With respect to indemnity reinsurance, two variations are relevant here: conventional coinsurance (hereinafter "coinsurance") and modified coinsurance (hereinafter "modified coinsurance"). In contrast to assumption reinsurance, under coinsurance and modified coinsurance, the initial insurer and the reinsuring company share the benefits and obligations arising out of the reinsured policy or contract. The initial insurer transfers to the reinsuring company all or part of its liability on the policies being reinsured, but it remains directly liable to the policyholders and continues to collect premiums and to pay claims and expenses. The reinsuring company must reimburse the initial insurer for the claims and expenses which are paid by the initial insurer and which are attributable to the risks it has reinsured.
Coinsurance and modified coinsurance differ, however, in their effect on the reserves of the insurance companies involved. Essentially, reserves are liability accounts representing the present value of the1986 Tax Ct. Memo LEXIS 384">*388 company's net liabilities under the policies in force. Life insurance companies are required to maintain reserves in an amount equal to the excess of the present value of future benefits payable under the policies over the present value of future net premiums. Such liability must be backed by cash or other assets of the insurance company. In a coinsurance transaction, the initial insurer reduces its reserves attributable to the ceded liability and the reinsuring company must establish reserves to cover the liability acquired. In a modified coinsurance transaction, however, the initial insurer maintains the required reserves and merely collects and pays over to the reinsurer the investment income derived from the assets supporting the reserves. Although the initial insurer does not release the reserves and underlying assets, upon the parties' consent to treatment under section 820, 2 the retention of assets and maintenance of reserves by the initial insurer are treated as custodial on behalf of the reinsuring company. Thus, for Federal tax purposes, in both coinsurance and modified coinsurance transactions, the same shift of reserves from the initial insurer to the reinsuring1986 Tax Ct. Memo LEXIS 384">*389 company takes place.
In coinsurance and modified coinsurance two exchanges take place: (1) the initial insurer pays the reinsuring company full consideration for the reserve liability assumed, and (2) the reinsuring company pays the initial insurer a "ceding commission" or an "initial allowance" for the business acquired. Insurance companies typically net these transactions, with only the excess amount changing hands. Thus, the reinsuring company has income equal to the reserve liability actually assumed even though such liability exceeds the consideration actually received.
In 1975, petitioner entered into two reinsurance transactions, one on a coinsurance basis and the other on a modified coinsurance basis, with respect to policies of life insurance originally written by Transport Life Insurance Company (Transport), with petitioner as the reinsuring company and Transport as the initial insurer or ceding company. Petitioner and Transport consented, with1986 Tax Ct. Memo LEXIS 384">*390 respect to the modified coinsurance transaction, to application of the rules for the optional treatment of policies reinsured therein provided by section 820 and the regulations thereunder.
The coinsurance agreement provided for the payment by petitioner to Transport of an initial consideration or ceding commission in the amount of $60,000, and a payment by Transport to petitioner of an amount equal to the mean reserves attributable to the risks reinsured. The modified coinsurance agreement provided for the payment by petitioner to Transport of an initial consideration in the amount of $620,000. The accounting between the two companies with respect to the foregoing transactions (excluding interest) was as follows:
Modified | ||
Coinsurance | Coinsurance | |
Reserves Transferred | $675,762 | |
Ceding Commission | 60,000 | 620,000 |
Amount Due Transport | ($615,762) | $620,000 |
In 1976, petitioner as reinsurer and Transport as ceding company entered simultaneously into two further reinsurance transactions with respect to the same policies, which policies belonged to the same groups or blocks of policies affected by the 1975 reinsurance transactions described above. 1986 Tax Ct. Memo LEXIS 384">*391 The 1976 coinsurance agreement provided for the payment of an initial consideration by petitioner to Transport of $72,000, and a payment by Transport to petitioner of an amount equal to the mean reserves attributable to the risks reinsured. The 1976 modified coinsurance agreement provided for the payment by petitioner to Transport of an initial consideration in the amount of approximately $780,000. The accounting between the companies with respect to the foregoing transactions (excluding interest) was as follows:
Modified | ||
Coinsurance | Coinsurance | |
Reserves Transferred | $851,398 | |
Ceding Commission | 72,000 | 780,000 |
Amount due Transport | ($779,398) | $780,000 |
During 1975, petitioner paid a "finders fee" of $13,600 with respect to its reinsurance transactions with Transport, and deducted this sum as an expense.
In his statutory notice of deficiency, respondent determined that the excess amounts of the required reserves over the cash received by petitioner 3 were attributable to the acquisition of an intangible asset with an indeterminate useful life and were not deductible. Alternatively, respondent determined that such excess amounts were attributable1986 Tax Ct. Memo LEXIS 384">*392 to the cost of acquiring assets and must be amortized over their estimated life. He capitalized such amounts and restored them to petitioner's income, but allowed no amortization because the reasonable estimated life of those assets had not been established. He also included those amounts in the computation of petitioner's assets for the taxable years 1975 and 1976, respectively.
Respondent disallowed the deduction for the $13,600 finders fee paid by petitioner in 1975, and restored that amount as an income item and asset for said year. The basis of respondent's action was his determination that such expense was a part of the cost of the 1975 reinsurance transactions with Transport.
OPINION
The first issue is whether amounts paid by a reinsuring company to an initial insurer under a contract for indemnity reinsurance may be deducted currently1986 Tax Ct. Memo LEXIS 384">*393 or must be amortized over the anticipated useful life of the policies.
This Court addressed this question in
(ii) The term "return premiums" means amounts returned or credited which are fixed by contract and do not depend on the experience of the company or the discretion of the management. Thus, such term includes amounts refunded due to policy cancellations or erroneously computed premiums. Furthermore, amounts of premiums or other consideration returned to another life insurance company in respect of reinsurance ceded shall be included in return premiums. * * *
Respondent argues generally that the cost to petitioner of its reinsurance transactions constitutes an investment in the nature of a capital expenditure or a deferred expenses, which must be amortized over the reasonably anticipated life of each respective transaction. In
Although a reinsuring company does acquire an asset in a broad sense in the form of potential future profit, such is also true when an insurance company issues a single policy to an individual. Yet, the expenses relating to that policy are currently deductible. While respondent's argument is appealing, it does not comport with how life insurance companies are taxed with respect to insurance they issue. In essence, respondent argues indemnity reinsurance should be taxed as is assumption reinsurance; yet, the Code treats one as the issuance of insurance and one as acquisition of an asset. That makes all the1986 Tax Ct. Memo LEXIS 384">*397 difference.
In support of his position that the amounts in question must be amortized respondent relies upon
We disagree with respondent's initial assertion for the reasons set forth in support of our holding in
Respondent next contends that
We disagree with respondent's reading of
Second, by1986 Tax Ct. Memo LEXIS 384">*401 using the phrase "consideration in respect of assuming liabilities under contracts not issued by the taxpayer," the first clause of
Respondent next argues that petitioner cannot rely on the first clause of the second sentence of
Return premiums are defined in the regulations as amounts returned or credited which are fixed by contract and do not depend on the experience of the company or the discretion of the management.
Finally, respondent conceded on brief that resolution of the principal issue herein would be determinative of the treatment to be accorded the finders fee of $13,600. Thus, petitioner is allowed a deduction for such amount in the year in which it was paid.
To reflect concessions of the parties and the foregoing,
Footnotes
1. An insurance company may want to reinsure its risks for a number of reasons including the diversification of its business, the acquisition of another insurance company indirectly through the acquisition of its business, the avoidance of a concentration of risk in one geographic area or line of business, and relief from the surplus drain that may occur as a result of the heavy expenses and the necessity of establishing reserves connected with newly written policies.↩
2. All section references and reference to the "Code" are to the Internal Revenue Code of 1954, as amended and in effect during her year in issue. All Rule references are to the Tax Court Rules of Practice and Procedure.↩
3. These amounts were determined as follows:
↩ 1975 Coinsurance Modified Coinsurance Total Reserves required $675,762 $620,000 Recd. by Petitioner 615,762 Excess $ 60,000 $620,000 $680,000 1976 Reserves required $851,398 $780,000 Recd. by Petitioner 779,398 Excess $ 72,000 $780,000 $852,000 4. We recently reached the same conclusion on similar facts in
, andIndividual Life Assurance Co. v. Commissioner, T.C. Memo. 1986-201 .Modern Security Life Insurance Co. v. Commissioner, T.C. Memo. 1985-629↩