basic taxation of p&c insurance companies anita minassian – aig greg domareki – deloitte...

Basic Taxation of P&C Insurance Companies

Anita Minassian – AIG

Greg Domareki – Deloitte

November 2011

Copyright © 2011 Deloitte Tax, LLP. All rights reserved.2

GOALS/OBJECTIVES:

•To provide participants with a background and understanding of the basic principles of property and casualty insurance taxation.


TAX TRAINING TOPICS:

• P&C Taxation Overview• Premiums Earned• Premium Acquisition Expenses• Overview of Investment Income• Losses Incurred

Overview of Taxationfor Insurance Companies


What is an insurance company?• An insurance company is a company whose primary and predominant business

activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies (1)

• Primary and predominant means “more than half of that business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.” (2)

• Classification of Insurance Companies

(a) Life ‒ Engaged in a business of issuing life insurance, annuity, and noncancellable A&H contracts

‒ Life insurance reserves plus unearned premiums and unpaid losses on noncancellable A&H is greater than 50% of total reserves

‒ Files a blue blank/blue pages

(a) Property & Casualty “P&C”‒ If an insurance company does not qualify as a “life”, it is taxed as a P&C company.

‒ Files a yellow blank/yellow pages

Source: (1) Treasury Regulation 1.831(a) and 1.801-3(a) (2) Section 816(a)


• Section 501(c)(15)

An P&C company is exempt from tax if the greater of the net written premiums or direct written premiums are less than or equal to $350,000.

Determination is made on a controlled group basis – 50% ownership.

P&C companies exempt from tax must file Form 990.

TAXATION OF P&C COMPANIESGROSS INCOME (≤$350,000)


TAXATION OF P&C COMPANIES GROSS INCOME (>$350,000)

Gross Income Sec. 832(b)(1)

Investment Income Sec. 832(b)(2)

Derivatives

Realized Gain(Loss)

Ordinary

Interest Income Dividends Income

Rent

Underwriting Income Sec. 832(b)(3)

Premiums

Earned Sec. 832(b)(4)

Less: Losses & Expenses IncurredSec. 832(b)(5)

Gain on Sale/Disposition of PropertySec. 832(b)(1)(B)

All Other IncomeSubchapter B (Sec 61) – Section 832(b)(1)(C)


• Deductions allowed by Section 832(c), generally are treated like regular corporations with additional insurance specific deductions such as:

Losses incurredAs defined by Section 832(b)(5), “the term ‘losses incurred’ means losses incurred during the

taxable year on insurance contracts” (i.e., claim adjustment services, commissions &

brokerage fees, salaries, legal expenses related to policy claims, etc…)

Policyholder dividends paid or declared“Dividends and similar distributions paid or declared to policyholders” including “amounts

returned or credited to policyholders on cancellation or expiration of policies.” (3)

Special deductions for mortgage insurersSection 832(e) allows a company which writes mortgage guaranty insurance an additional

deduction relating to bonds purchased under Section (e)(2), “The deduction shall be allowed to

the extent that tax and loss bonds are purchased in an amount equal to the tax benefit

attributable to such deduction…”

• Section 832(d), “double deductions” prohibits expenses deducted under Section 832(c) to be deducted more than once.

TAXATION OF P&C COMPANIESDEDUCTIONS

Source: (3) Section 832(c)(11)

Overview of the Annual Statement


• Gross income includes investment and underwriting income “…computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners…”(3)

• “The underwriting and investment exhibit is presumed to reflect the true net income of the company, and insofar as it is not inconsistent with the provisions of the Code will be recognized and used as a basis for that purpose. All items of the exhibit, however, do not reflect an insurance company’s income as defined in the Code”(3)

• Under Section 832(b)(6), allowable deductions includes “all expenses shown on the annual statement approved by the National Association of Insurance Commissioners…”

Source: (3) Treasury Regulation 1.832-4(a)(2)

IMPORTANCE OF ANNUAL STATEMENT


• The meaning of these provisions is sometimes unclear. The Service typically

argues that the annual statement is only a guide for determining taxable income,

but has argued both ways.Home Insurance Group v. Commissioner, 89-1 USTC 9329

United State Tax Court determined deficiencies on taxes paid by the insurer on the ground that the insurer was not entitled to deduct expenses in the year the

insurance contracts were issued since the events that establishes liability have yet to occur.

Under 26 U.S.C.S. § 446(b), “taxable income was to be computed under the accounting method regularly used by a taxpayer for keeping his books unless

the method used did not clearly reflect income. Further, the court held that where the Commissioner determined that a taxpayer’s accounting method did not clearly

reflect income, the Commissioner’s determination was to be upheld unless clearly unlawful.”Sears-Allstate, 92-2 USTC 50,426

“…the lower court held that the insurer could not incur a loss until the insured had suffered the defined economic loss.”(4)

IMPORTANCE OF ANNUAL STATEMENT (cont’d)

Source: (4) Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858 (7th Cir. 1992)

http://www.lexis.com/research/xlink?app=00075&view=full&searchtype=get&search=972+F.2d+858


• Annual statement often conflicts with basic tax principles:

Claim of right doctrine – receipts should be included in the income in the actual year of collection, rather than as “earned”.

All events test – “Generally under an accrual method, income is to be included for the taxable year when all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Under such a method, a liability is incurred, and generally is taken into account for federal income tax purposes in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance (4) has occurred with respect to the liability.” (5)

Source: ((5) Treasury Regulation 1.446-1(c)(1)(ii)

IMPORTANCE OF ANNUAL STATEMENTSTATUTORY vs. TAX ACCOUNTING

Losses Incurred and Loss Reserve Discounting


Losses Incurred, Section 832(b)(5)

The term “losses incurred” means losses incurred during the taxable year on insurance contracts computed as follows:

(i) To losses paid during the taxable year, deduct salvage and reinsurance recovered during the taxable year.

(ii) To the result so obtained, add all unpaid losses on life insurance contracts plus all discounted unpaid losses (as defined in Section 846) outstanding at the end of the taxable year and deduct all unpaid losses on life insurance contracts plus all discounted unpaid losses outstanding at the end of the proceeding taxable year.

(iii) To the results so obtained, add estimated salvage and reinsurance recoverable as of the end of the preceding taxable year and deduct estimated salvage and reinsurance recoverable as of the end of the taxable year.

“The term ‘expenses unpaid’ shall not included any unpaid loss adjustment expenses shown on the annual statement, but such unpaid loss adjustment expenses shall be included in unpaid losses.” (6)

TAXATION OF P&C COMPANIESLOSSES INCURRED

Source:(6) Section 832(b)(6)


Property Lines (“short-tail” lines)

Losses are reported and settled quickly

Liability Lines (“long-tail” lines)

Losses are reported more slowly and settlement is delayed; may involve litigation. More difficult to estimate because the amounts are more uncertain , liability exposures are higher,

and the time between occurrence and settlement of the loss is longer.

Multiple peril Involves both property and liability risk (i.e. homeowners, commercial multiple-peril).

Case Reserves Incurred loss has occurred and been reported to the company, but amount of loss may be uncertain.

Incurred but not reported (“IBNR”) Loss has occurred but has not been reported to the company and the amount of the loss remains

uncertain.

TAXATION OF P&C COMPANIES LOSS RESERVES – DEFINITIONS


Unpaid losses Estimate of direct future costs of incurred losses.

Unpaid loss adjustment expenses (i.e. legal costs, claims adjuster expenses)

Estimate of future costs for determining and settling incurred losses Loss adjustment expenses (“LAE”) may be allocated to specific claims or unallocated.

Undiscounted Unpaid LossesUnpaid losses shown in the annual statement filed by the taxpayer for the year ending

with or within the taxable year of the taxpayer. (7)

Deficient reserves Reserves are insufficient to fund incurred losses.

Redundant reserves Reserves are greater than necessary to fund incurred losses.

Source: (7) Section 846(b)(1)

TAXATION OF P&C COMPANIES LOSS RESERVES – DEFINITIONS cont’d.


Discounting of loss reserves was enacted in the Tax Reform Act of 1986 to avoid understatement of income.

Discount computed by line of business attributable to each accident year. (8)

“The amount of discounted unpaid losses at the end of any taxable year attributable to any accident year shall be the present value determine by using:

(a) the amount of undiscounted unpaid losses

(b) the applicable interest rate

(c) the applicable loss payment pattern.”(9)

Limitation: “In no event shall the amount of undiscounted unpaid losses with respect to any line of business attributable to any accident year exceed the aggregate amount of unpaid losses with respect to such line of business for such accident year included in the annual statement.” (10)

“Vintaging” Rule: “Once a taxpayer applies a series of discount factors to unpaid losses attributable to an accident year of a line of business, that series of discount factors must be applied to discount the unpaid losses for that accident for the line of business for all future taxable years. The discount factors cannot be changed to reflect a change in the taxpayer’s loss payment pattern during a subsequent year or to reflect a different interest rate.”(11)

Source: ( 8) Section 846(a)(1)( 9) Section 846(a)(2) (10) Section 846(a)(3)

(11) Treasury Regulation 1.846-1(a)

TAXATION OF P&C COMPANIES LOSS RESERVES DISCOUNTING


Company Payment Pattern “Company can elect to use its own experience in computing the loss payment pattern and calculate

discount factors based on that historical payment pattern rather than use the prescribed IRS/industry factors.”(12)

Election can be made for each determination year. Election applies to 5 accident years during the determination period (i.e. 2007-2011 A/Y’s)

Service can issue regulations preventing taxpayers from making the election unless they have “sufficient historical experience”.

Cannot be made for international or reinsurance lines of business.

Eligible Line of Business Eligible if, on the most recent annual statement filed before the beginning of the determination year

(2005 A/S for 2007 determination year), the taxpayer reported losses and loss expenses incurred for at least the number of accident years required to be separately reported on the A/S. (13)

Eligible if, taxpayer has at least five accident years of loss and loss expenses incurred for that line; and cumulative fraction of losses paid for in each of the last two accident years for which the taxpayer has experience equal or exceeds the cumulative fraction of loss and loss expense payments shown the earliest accident year (AY+9) on the IRS table. (14)

Source: (12) Section 846(e)(13) Treasury Regulation 1.846-2(b) (14) Revenue Procedure 92-76

TAXATION OF P&C COMPANIES LOSS RESERVES DISCOUNTING


TAXATION OF P&C COMPANIESCALCULATION OF TOTAL LOSSES INCURRED

LOSSES INCURRED PER BOOK Annual Stmt.

Gross Losses Paid, net of Salvage Recovered + AS Pg 9, Part 3, Col 4

Less:>> CY Salvage & Subrogation Recovered - AS Sch P, Col 23 (CY)

Plus:>> PY Salvage & Subrogation Recovered + AS Sch P, Col 23 (PY)

Plus:>> CY Unpaid Losses & LAE Reserves + AS Pg 3, Col 1, Line 1+3

Less:>> PY Unpaid Losses & LAE Reserves - AS Pg 3, Col 2, Line 1+3

Total Losses Incurred per Book = AS Pg 4, Line 2

• Loss reserves are established on the annual statement at the full dollar value of what losses will be settled at. Annual statement losses are generally not discounted, even though a long period of time may pass before the losses are actually paid (i.e., medical malpractice, workers compensation, environmental coverage’s).

• Certain states provide an exception for workers compensation and medical malpractice, which may be discounted using very conservative interest rates.


TAXATION OF P&C COMPANIES CALCULATION OF TOTAL LOSSES INCURRED, cont’d.

LOSSES INCURRED PER TAX 1120PC SCH FGross Losses Paid +

Plus: >> LAE Reclass* + Less: >> Salvage Recovered - Subtotal: >> Loss Paid during the tax year = Schedule F, Line 1Plus: >> CY Discounted Unpaid Losses & LAE + Schedule F, Line 2cLess: >> PY Discounted Unpaid Losses & LAE - Schedule F, Line 4cPlus: >> PY Discounted Salvage & Reinsurance Recoverable + Schedule F, Line 6Less: >> CY Discounted Salvage & Reinsurance Recoverable - Schedule F, Line 7Total: >> Total Losses Incurred per Tax Return = Schedule F, Line 8

* LAE are not taken into account on A/S in computing losses incurred.LAE are accounted for on A/S, Page 4, Line 4 and Part 4.Upon initial upload of an annual statement to an 1120PC, LAE paymentsare normally reported in Sch A of the return in the appropriate expense lines.A tax reclass from Sch A to Sch F of the 1120PC is required to report the correctamount of total losses incurred reported on Sch F.

About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

Copyright © 2011 Deloitte Tax, LLP. All rights reserved.Member of Deloitte Touche Tohmatsu Limited

http://www.deloitte.com/about

http://www.deloitte.com/us/about

basic taxation of p&c insurance companies anita minassian – aig greg domareki – deloitte...

Documents