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Sec. 848 capitalization of insurance acquisition costs.

On Nov. 15, 1991, the IRS released its long-awaited proposed regulations on the capitalization of deferred acquisition costs (DACs). The IRS regulations cover the following. * In a liberal approach to the requirements for group life insurance contracts, such contracts are allowed to be underwritten considering risks such as sex, smoker/nonsmoker and age, without jeopardizing their group classification. * Items in a reinsurance agreement must be treated consistently by both the ceding company and the assuming company. * A ceding company may reduce its DACs only if (1) the assuming company is required to capitalize DACs, (2) neither party to the reinsurance contract is the direct writer and (3) the assuming company has general deductions that are less than the DACs it would otherwise be required to capitalize under a reinsurance agreement. The companies may make an election, however, requiring the assuming company to capitalize DACs without regard to the general deduction limitation, in which case the ceding company may reduce its own DACs to be capitalized to the full extent of the "net negative consideration" under the contract. * Interim rules for reinsurance contracts entered into before Dec. 31, 1991 for the 1991 tax year. Contracts entered into on or after 1992 will be subject to the new rules.

Sec. 848 applies to "specified insurance contracts," which are defined as any life insurance contracts, annuity contracts, noncancelable and guaranteed renewable accident and health contracts, and combination contracts. Under Sec. 848(c), the capitalization rates are 1.75% for annuity contracts, 2.05% for group life contracts and 7.70% for all other specified insurance contracts.

Pension plan contracts (as defined in Sec. 818(a)), flight insurance and qualified foreign contracts (as defined in Sec. 807(e)(4)) are exempt from the DAC capitalization requirements (Sec. 848(c)). However, the exemption f or qualified foreign contracts does not extend to the assumption of such contracts through reinsurance agreements.

The definitions in the proposed regulations for life insurance contracts, annuity contracts and noncancelable and guaranteed renewable accident and health contracts do not vary from their general definitions. Life contracts issued after Dec. 31, 1984 must meet the requirements of Sec. 7702. Annuity contracts must be subject to the rules of Sec. 72, or constitute a qualified funding asset under Sec. 130(d) (i.e., a structured settlement). Noncancelable and guaranteed renewable accident and health contracts are the same as those referred to in Sec. 816.

In the case of a combination contract, the entire premium is subject to the highest capitalization rate applicable to any of the coverages provided. A combination contract is any contract that provides two or more types of coverage that, if provided separately, would be subject to Sec. 848. There is an exception to this rule for combination contracts offering group life coverage with annuity coverage. In these cases, the entire premium is treated as an "other" life contract and as such is subject to the highest DAC capitalization rate (i.e., 7.70%). Prop. Regs. Sec. 1.848-1(h)(1) provides guidance for the definition of group contracts. To be classified as a group life contract: * The contract must be a group life insurance contract under applicable law. * The coverage must be provided under a master contract issued to the group policyholder. * The premiums on the contract must be reported as group life insurance premiums on the insurance company's annual statement. * Premiums must be determined on a group basis. * The proceeds must not be payable to the insured's employer or an organization to which the insured belongs. * A contract must cover an eligible group.

An eligible group includes employee groups, debtor groups, labor union groups, association groups, credit union groups and combination or multiple groups. A group may be determined by using any reasonable characteristic other than individual members' health (Prop. Regs. Sec. 1.848-1 (h)(2)).

In addition, there are requirements as to individual member eligibility and premium charges. Generally, the eligibility requirements are met if the insurance company cannot deny or limit coverage to any member of a qualified group. Insurers using the results of medical examinations, responses to questions on medical history, or other evidence as to the member's insurability in deciding to deny or limit coverage before Jan. 1, 1993 (as a result of grand-fathering in the proposed regulations) will not disqualify such premiums. However, after Jan. 1, 1993 such use of this information will forfeit group status.

The only exception to this rule lies in group term life coverage without cash surrender value (Prop. Regs. Sec. 1.848-1 (h)(3)(ii)(B)). For these contracts the insurance company can limit or deny coverage based on answers to questions about the applicant's medical history, or that of family members.

In the assessment of premiums, all members covered must be charged the same premium for the contract to qualify as group coverage. Differences in premium charges are allowed only to the extent they arise from variations in gender, smoking habits or actual age of each member (Prop. Regs. Sec. 1.848-1(h)(3)(iii)). For contracts with flexible premiums, the mortality and expense charges imposed must meet this "identical premium" requirement.

If a group contract fails to meet the eligibility and/or identical premium requirements for any member, all premiums received under the group contract are treated as other life insurance premiums subject to the 7.70% capitalization rate.

Prop. Regs. Sec. 1.848-1(h) has special rules for supplemental life insurance contracts and payments of proceeds on contracts issued to well are benefit funds and on credit life insurance contracts. In the case of group life contracts that provide for supplemental life coverage, the primary coverage and the supplemental coverage are treated as two separate contracts (Prop. Regs. Sec. 1.848-1(h)(4)). Each contract must separately meet the eligibility and identical premium requirements and the group affiliation requirement. For the group affiliation requirement, a member's spouse and dependent children are treated as members of the group if they are eligible for coverage.

For contracts issued to welfare benefit funds, payment of proceeds to the fund will not jeopardize the contracts' group classifications, provided the proceeds are paid as a death benefit (Prop. Regs. Sec. 1.848-1(h)(5)). Similarly, if the proceeds of a credit life insurance contract are paid to the insured's creditor in satisfaction of the insured's debt, the status of the contract as a group contract will not be jeopardized.

These provisions are effective for tax years beginning after Nov. 15, 1991.

The amount of policy acquisition costs to be capitalized and amortized will be computed by multiplying net premiums of specified insurance contracts by the percentage in Sec. 848(c)(1) for each type of insurance contract.

Prop. Regs. Sec. 1.848-2(a) defines net premiums as equal to gross premiums less return premiums and the net negative consideration for any reinsurance contracts. This calculation is done for each category of specified insurance contracts (i.e., life contracts, group life contracts and annuity contracts).

Gross premiums are defined by Prop. Regs. Sec. 1.848-2(b)(2) to include --advance premiums; --certain amounts in premium deposit fund accounts; --fees; --assessments; --self-charged premiums for employee benefits (including those for employees defined in Sec. 7701(a)(20)); --dividends accrued on life insurance contracts used to provide additional insurance benefits (as defined in Sec. 7702(f)(5)); and --the net positive consideration for any reinsurance contracts.

For premium deposit fund accounts, these amounts will be recognized as a component of gross premiums at the time the amount is applied or irrevocably committed to the payment of a premium. An amount is considered irrevocably committed if neither the amount nor any earnings on the amount may be returned to the policyholder or used by the policyholder to fund another contract. Note that premiums received by an insurance company under a retired lives reserve arrangement are to be treated as amounts irrevocably committed to the payment of premiums on a specified insurance contract (Prop. Regs. Sec. 1.848-3).

Also to be included in gross premiums is the fair market value of a specified insurance contract issued in exchange for an existing contract within the meaning of Sec. 1001. This inclusion may be waived by the IRS if the exchange of contracts is the result of the rehabilitation or liquidation of an insolvent insurer (Prop. Regs. Sec. 1.848-4).

Together with rules governing which amounts are to be included in the computation of gross premiums, Prop. Regs. Sec. 1.848-5 (c)(1) lists the amounts not included in gross premiums. * Deferred and uncollected premiums. * Policyholder dividends paid to the policyholder and immediately returned to the insurance company as a premium on the same contract that generated the dividend, including: --a policyholder dividend applied to pay a premium on the contract that generated the dividend; --excess interest accumulated within the contract; --a policyholder dividend applied to purchase a paid-up addition on the contract that generated the dividend; --a policyholder dividend applied to reduce premiums otherwise payable on the contract that generated the dividend; --an experience-rated refund applied to pay a premium on the group contract that generated the refund; and --an experience-rated refund applied to a premium stabilization reserve held with respect to the group contract that generated the refund. * Premiums waived as a result of a policyholder becoming disabled. * Premiums considered to be paid on a contract as the result of the surrender of a paid-up addition previously issued for the same contract. * Amounts considered to be premiums on an election by a policyholder or beneficiary to receive death benefits other than in a lump sum.

Amounts applied from a dividend accumulation account to any premiums on a specified insurance contract are not treated as paid to and immediately refunded by the policyholder.

Returned premiums are defined as amounts returned or credited to the policyholder. They do not include amounts returned to another insurance company pursuant to a reinsurance agreement (Prop. Regs. Sec. 1.848-2(d)).

For ceding companies, net consideration for a reinsurance contract is the excess of claim and benefit reimbursements, commissions and adjustments received, over premiums and commissions paid to the assuming company (Prop. Regs. Sec. 1.848-2(e)(2)). For assuming companies, the calculation is reversed, i.e., it is the excess of premiums and commissions received, over reimbursements for claims and benefits, commissions and adjustments paid. To the extent this calculation for either party results in an amount less than zero, that party has net negative consideration. The effect of this new rule is to compute premiums with respect to reinsurance transactions on a "cash" basis (Prop. Regs. Sec. 1.848-2(e)(2)).

Subject to limitations, the amount of net negative consideration computed by a company reduces the net premiums subject to DAC capitalization. Conversely, net positive consideration ultimately increases the amount of net premiums subject to DAC capitalization, also subject to general deduction limitations.

Prop. Regs. Sec. 1.848-2(e)(1) provides for consistency in the calculation of net consideration on reinsurance contracts, i.e., one company's net negative must equal the other company's net positive. To provide for consistency in the timing of the recognition of any income and expense item related to reinsurance contracts, Prop. Regs. Sec. 1.848-2 (e)(4) stipulates that such items must be taken into account in the first tax year for which the item must be taken into account by either party.

Under Prop. Regs. Sec. 1.848-2 (f), the amount of total DACs required to be capitalized in a given year is limited to the greater of the computed DACs amount or a company's total general deductions. This general rule is applied to reinsurance agreements; however, when neither party to the reinsurance agreement is the direct writer, the use of negative consideration with respect to any reinsurance agreement is limited to the amount of net positive consideration actually recorded as a result of the same reinsurance transaction. The "required capitalization amount" for a reinsurance contract (positive or negative) is determined by multiplying the net positive or net negative consideration for the contract by the applicable percentage for the category of contract being reinsured (i.e., group life, annuity, other life). Thus, if the company with the net positive consideration did not capitalize all computed DAC due to the general deduction limitation (i.e., had a "capitalization shortfall"), a corresponding reduction in the use of the net negative consideration of the other party is required. If this treatment is not verified, net negative consideration should not be taken into account in determining the capitalizable amount for such contract. For purposes of the consistency requirement, each retrocession is treated as a separate reinsurance contract (Prop. Regs. Sec. 1.848-2(e)(6)).

To determine general deductions allocable to reinsurance contracts, the company must compare its total general deductions to the total amount of DAC to be capitalized, computed without regard to reinsurance contracts (Prop. Regs. Sec. 1.848-2 (f)(5)). The company must then compute its capitalization amount for its reinsurance contracts. if the total required capitalization amount for all reinsurance contracts (including contracts with either net negative or net positive consideration) exceeds the general deductions allocable to reinsurance contracts, there is a capitalization amount, based on the percentage of each contract's positive required capitalization to total positive capitalization from all reinsurance contracts.

Once the shortfall by contract is determined, the company must compute the reduction in net negative consideration that the other company must take into account in determining its required capitalization amount. This is determined by dividing the allocable capitalization shortfall of each contract by the percentage (as set forth in Sec. 848(c)(1)) that correlates to the type of contract being reinsured (Prop. Regs. Sec. 1.848-2 (f)(6)). A company with net negative consideration cannot reduce premiums by this net negative amount in computing DAC capitalization without verification of treatment by the other party. (See the examples in Prop. Regs. Sec. 1.848-2(i).)

As an alternative to the computation and allocation of the capitalization shortfall, the company with the net positive consideration may elect to include all such consideration in its capitalizable amount, without regard to the general deduction limitation (Prop. Regs. Sec. 1.848-2(f)(7)). This election allows the company with net negative consideration to reduce its net premiums subject to DAC capitalization, without verification that the company with net positive consideration was limited by its general deductions. This greatly reduces the burden on the company with net negative consideration. As a result of this election, a company with net positive consideration may be required to report negative general deductions.

To make this election, both parties must include as a statement in the reinsurance contract, or as an addendum to the reinsurance contract, their election to waive the general deduction limitation for DAC capitalization. In addition, both companies must include an election statement in their first tax return filed after the effective date of the election. Under Prop. Regs. Sec. 1.848-2(f)(7), the election statement must --provide that the party with the net positive consideration will capitalize specified policy acquisition costs relating to such reinsurance contract without regard to the general deduction limitation; --set forth the agreement of both parties to exchange information pertaining to the net consideration computed for such reinsurance contract each year for which it is in effect; --specify the effective date of election; and --be signed by both parties. This election may not be revoked without prior IRS consent.

The essence of this election is to force companies to waive the general deduction limitation. Without this election, a company would have to make its estimated tax payments without knowing the extent to which it will ultimately be able to use any net negative consideration in determining the amount of DAC capitalization. For a company to compute its capitalization shortfall it must have determined its taxable income including general deductions for the year. A company with net negative consideration cannot compute its taxable income until the other party finalizes information about the capitalization shortfall.

Since this determination may not be made until late in the tax return preparation process, timely compliance may be impossible. In addition, a mutual life company must include in general deductions any increase in the Sec. 809 tax. A determination of capitalization shortfall cannot be made until the differential earnings rate is released, which occurs shortly before the return is due. If the parties originally reported a capitalization shortfall and this shortfall is later changed, the proposed rules do not provide guidance as to whether this change must be reported to the other parties to the reinsurance agreement. The election to waive the general deduction limitation removes the dependency of one party's taxable income to the other party.

Notwithstanding the election to waive the general deduction limitation, the proposed regulations essentially force both companies to coordinate their respective treatment of all items related to a given reinsurance contract. Note that this will most likely result in reporting problems for the parties to the reinsurance agreement (due to variations in financial accounting methods, reporting cutoff dates and the timing of data collection). A company that enters into multiple reinsurance agreements must provide information to and receive information from all of the parties to its reinsurance agreements, making compliance with this provision impractical.

The proposed regulations contain a variety of other special rules on the computation of net consideration. * For modified coinsurance or funds-withheld reinsurance, the amount of any reserve transferred on either the inception or termination of the contract is not taken into account in determining net consideration for the year Prop Regs. Sec. 1.848-2(e)(5)). any intervening reserve adjustments and investment income credited are to be included in determining net consideration. * A retrocession is considered a separate reinsurance agreement (Prop. Regs. Sec. 1.848-2(e)(6)). The party relieved of the liability under the contract is considered the ceding company. * The recapture or termination of a reinsurance contract is not treated as a separate contract (Prop. Regs. Sec. 1.848-2(e)(6)). * If a reinsurance agreement includes more than one category of specified insurance contract, both parties to the contract must determine net consideration separately for each category of specified insurance covered by the contract (Prop. Regs. Sec. 1.848-2 (e)(7)).

With regard to the reduction in net premiums for net negative consideration, no such reduction is allowed if the other party to the reinsurance agreement (for federal tax purposes) is neither an insurance company subject to U.S. tax on its underwriting income nor a controlled foreign corporation.

The reduction of net negative consideration and general limitation provisions are effective for all amounts arising under any reinsurance agreement executed on or after Nov. 15, 1991, and all amounts arising under any reinsurance agreement for tax years beginning after Dec. 31, 1991, without regard to when the reinsurance agreement was entered into. The net consideration provisions are effective for amounts arising under a reinsurance agreement for tax years beginning after Dec. 31, 1991.
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Author:Meyer, Charles R.
Publication:The Tax Adviser
Date:Apr 1, 1992
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