rr-09-26.pdf

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Part I

Section 831.--Tax on Insurance Companies other than Life Insurance Companies

Rev. Rul. 2009-26

ISSUE
In the situations described below, is Z
's agreement with IC Y treated as
"reinsuring risks" underwritten by insurance companies for purposes of determining
whether Z
is an insurance company within the meaning of § 831(c)?
FACTS
Situation 1. IC Y and Z are stock corporations that are licensed and regulated as
insurance companies in all jurisdictions in which they do business. IC Y
is an insurance
company for federal income tax purposes, subject to tax under § 831(a).
For valid, non-tax business purposes, IC Y
entered into a contract, or treaty, with
Z at the beginning of Year 1. Under the contract, IC Y agreed to pay to Z 90 percent of
all the premiums received with regard to all the insurance contracts issued by IC Y in
the commercial multiple peril line of business in a 10-state region. In exchange, Z

agreed to indemnify IC Y
for 90 percent of all the losses under those contracts. IC Y

2

remained directly liable to its policyholders. A contract of this type is sometimes
referred to as indemnity reinsurance.
During Year 1, insurance contracts that IC Y
entered into with 10,000 unrelated
policyholders were subject to the contract between IC Y

and Z. Z possessed adequate
capital to fulfill its obligations under the contract, and in all respects operated at arms-
length in its transaction with IC Y and in accordance with the applicable requirements
state law. The contract with IC Y
of
was Z’s only business during Year 1.
Situation 2
. The facts are the same as in Situation 1, except that the contrac
between IC Y
t
and Z covered only the risks of X, a policyholder of IC Y unrelated to Z.
In addition, Z

assumed risks of policyholders unrelated to X but in the same line of
business through contracts with other insurance companies. The contracts with IC Y
and with other insurance companies were Z
’s only business during Year 1. Had Z
assumed these risks by entering into contracts with each of the original policyholders
(including X
) directly, those contracts would have qualified as insurance contracts for
federal income tax purposes, and Z would have qualified as an insurance company for
l income tax purposes. Seefedera
, e.g., Rev. Ruls. 2005-40, 2005-2 C.B. 4; 2002-91,
2002-2
for purposes of § 831, the term "insurance company" has the meaning given to such
C.B. 991; 2002-90, 2002-2 C.B. 985; and 2002-89, 2002-2 C.B. 984.
LAW
Section 831(a) of the Internal Revenue Code provides that taxes, computed as
provided in § 11, are imposed for each taxable year on the taxable income of each
insurance company other than a life insurance company. Section 831(c) provides that,

3

e
or ann

term by § 816(a). Under § 816(a), the term "insurance company" means "any company
more than half the business of which during the taxable year is the issuing of insuranc
uity contracts or the reinsuring of risks underwritten by insurance companies."
Neither the Code nor the regulations define the terms “insurance” or “insurance
contract.” The Supreme Court of the United States has explained that in order for an
arrangement to constitute insurance for federal income tax purposes, both risk shifting
and risk distribution must be present. Helvering v. Le Gierse
, 312 U.S. 531 (1941). Th
risk transferred must be risk of economic loss. Allied Fidelity Corp. v. Commiss
e
ioner
,
572 F.2d 1190, 1193 (7
th
Cir. 1978). The risk must contemplate the fortuitous
occurrence of a stated contingency, Commissioner v. Treganowan, 183 F.2d 288, 290
91 (2d Cir. 1950), and must not be merely an investment or business risk. Rev. Rul.
2007-47, 2007-2 C.B. 127. In addition, the arrangement must constitute insurance in
the commonly accepted sense. See
-
, e.g., Ocean Drilling & Exploration Co. v. U.S., 98
F.2d 1135, 1
8
153 (Fed. Cir. 1993); AMERCO, Inc. v. Commissioner
, 979 F.2d 162 (9
th

Cir. 19

d
92).
Risk shifting occurs if a person facing the possibility of an economic loss
transfers some or all of the financial consequences of the potential loss to the insurer,
such that a loss by the insured does not affect the insured because the loss is offset by
a payment from the insurer. Risk distribution incorporates the statistical phenomenon
known as the law of large numbers. Distributing risk allows the insurer to reduce the
possibility that a single costly claim will exceed the amount taken in as premiums an
set aside for the payment of such a claim. By assuming numerous relatively small,

4

iums. Clougherty Packing Co. v. Commissioner
independent risks that occur randomly over time, the insurer smooths out losses to
match more closely its receipt of prem,
811 F.

2d 1297, 1300 (9th Cir. 1987).
Courts have recognized that risk distribution necessarily entails a pooling of
premiums, so that a potential insured is not in significant part paying for its own risks.
Humana, Inc. v. Commissioner
, 881 F.2d 247, 257 (6th Cir. 1989). See also Ocean
Drilling & Exploration Co., 988 F.2d at 1153 ("Risk distribution involves spreading the
risk of loss among policyholders."); Beech Aircraft Corp. v. U.S.

, 797 F.2d 920, 922
(10th Cir. 1986) ("'[R]isk distributing means that the party assuming the risk distributes
his potential liability, in part, among others.") Thus, purported insurance arrange
that involve an issuer who contracts with only one policyholder do not qua
ments
lify as
insuran

pany.
s

ce contracts for federal income tax purposes. Rev. Rul. 2005-40.
The Code and administrative guidance treat reinsurance in a manner similar to
insurance for many purposes. For example, gross premiums of both life and non-life
insurance companies include not only premiums on direct business, but also gross
premiums in respect of assumed liabilities under contracts issued by another com
Section 803(b)(1)(E); Rev. Rul. 77-453, 1977-2 C.B. 236. Consistently, both life
insurance reserves under § 807 and discounted unpaid losses under § 846 include not
only reserves and losses on direct business, but also reserves and losses on liabilitie
assumed under contracts issued by another company. Furthermore, a contract that
reinsures another contract is treated in the same manner as the reinsured contract
under § 848(e)(5) for purposes of computing the amount of specified policy acquisition

5

expenses that must be capitalized and amortized as deferred acquisition costs (DAC)
under § 848. Most importantly, both direct insurance and reinsurance business may
qualify a taxpayer as an insurance company under § 816(a) or § 831(c), as applicable.
But see § 845 (granting the Secretary explicit authority to reallocate, recharacterize
make other adjustments with r
, or
espect to certain reinsurance arrangements, but not
referring to direct insurance).
Courts have generally analogized reinsurance to insurance, as well. For
example, in Ocean Drilling & Exploration Co.
, 988 F.2d at 1153 n25, the court noted that
“[d]irect insurance and reinsurance are both considered insurance,” and in Cologne Life
Reinsurance Co. v. Commissioner, 80 T.C. 859, 862 (1983), acq, 1985-2 C.B. v
court noted that “[u]nder [part I of subchapter L], the issuance of indemnity life
reinsurance is treated
iii, the
generally as the issuance of life insurance”, except where
specified otherwise.
In Alinco Life Insurance Co. v. United States
, 373 F.2d 336 (Ct.Cl. 1967), a large
finance company formed a wholly-owed subsidiary corporation (Alinco), which qua
as a life insurance company under the laws of Indiana. Customers of the finance
company (borrowers) purchased credit life insurance from an unrelated insurance
company, which in turn reinsured a fixed proportion of those contracts with Alinco.
Even though Alinco reinsured risks underwritten by only one insurance compan
risks aggregated nearly one billion dollars of business, with a large number of
customers, for which Alinco was required by the state insurance department to mainta
lified
y, those
in
reserves. Interpreting regulatory language that was identical to what now appears in

6

§ 816(a), the court concluded that Alinco was in the business of "reinsuring risks"
underwritten by insurance companies.
In the context of captive insurance, courts have likewise looked through a
fronting arrangement to analyze whether the requirements of risk shifting and risk
distribution were met. See, e.g., Carnation Co. v. Commissioner, 71 T.C. 400 (1978),
aff'd 640 F.2d 1010 (9th Cir. 1981) (concluding that premiums paid by taxpayer to an
unrelated insurer were not deductible to the extent risks under the contract were in turn
reinsured with taxpayer's wholly-owned subsidiary); Kidde Industries, Inc. v. United
States, 40 Fed. Cl. 42 (1997).
ANALYSIS
Situation 1
In Situation 1, the contracts issued by IC Y
to 10,000 unrelated policyholders
involved commercial multiple peril risks, which are insurance risks. The contracts
shifted those insurance risks from those policyholders to IC Y
, and distributed those
risks such that a loss by one policyholder was not borne, in substantial part, by the
premiums paid by that policyholder. The contracts were insurance in the commonly
accepted sense. The contracts thus were insurance contracts for federal income tax
purposes.
The contract, or treaty, between IC Y
and Z in turn shifted 90 percent of the risks
under those insurance contracts from IC Y, an insurance company, to Z. As in Alinco
Life, the transaction shifted insurance risks which were funded by reserves and
constituted reinsurance in the commonly accepted sense. As to Z
, the risks of each

7

original policyholder were still distributed such that a loss by one such policyholder was
not borne, in substantial part, by the premiums paid by that policyholder. Hence, by
entering into its arrangement with IC Y
, Z was "reinsuring risks" within the meaning of
§§ 816(a) and 831(c).
Because, under the arrangement with IC Y
, Z was treated as "reinsuring risks"
underwritten by an insurance company, and the arrangement represented more than
half the business of Z for Year 1, Z qualified as an insurance company within the
meaning of § 831(c), even though the contract with IC Y
was Z's only business for the
year.
Situation 2
In Situation 2, the facts are the same as in Situation 1, except that the
arrangement between IC Y
and Z shifted to Z only the risks of X, a policyholder of IC Y
unrelated to Z. Z assumed additional risks of the same line under contracts with other
insurance companies in the same line of business.
The risks assumed by Z
under the arrangements with IC Y and with other
insurance companies were insurance risks. Those risks were shifted from the original
policyholders (including X
) to the primary insurers (including IC Y), and in turn to Z. As
to Z
, the risks of each original policyholder (including X) were distributed such that a
loss by one policyholder was not borne, in substantial part, by the premiums paid by
that policyholder. Hence, by entering into its arrangements with the primary insurers
(including IC Y), Z was "reinsuring risks" underwritten by insurance companies within
the meaning of §§ 816(a) and 831(c).

8
Because under the arrangements with the primary insurers (including IC Y
) Z is
treated as "reinsuring risks" underwritten by insurance companies, and those
arrangements represented more than half the business of Z
for Year 1, Z qualified as an
insurance company within the meaning of § 831(c).
HOLDINGS
In Situation 1, Z
's agreement with IC Y is treated as "reinsuring risks"
underwritten by an insurance company because, even though the agreement was Z's
only business during Year 1, the requirement of risk distribution was still met from the
standpoint of Z
as to each original policyholder. Accordingly, Z was an insurance
company within the meaning of § 831(c).
In Situation 2, Z's agreement with IC Y is treated as" reinsuring risks"
underwritten by insurance companies because, even though the agreement covered
only the risks of a single policyholder, Z
assumed sufficient risks under agreements with
other insurance companies in Year 1 such that requirement of risk distribution was met
from the standpoint of Z
as to each original policyholder. Accordingly, Z was an
insurance company within the meaning of § 831(c).
DRAFTING INFORMATION
The principal author of this revenue ruling is John E. Glover of the Office of
Associate Chief Counsel (Financial Institutions & Products). For further information
regarding this revenue ruling, contact Mr. Glover at (202) 622-3970 (not a toll-free call).