4.42.5  Miscellaneous  (05-29-2002)

  1. This chapter covers miscellaneous topics related to the insurance industry.  (05-29-2002)
Segregated Asset Accounts (Separate Accounts)

  1. Background of annuities:

    1. Annuity — The regular annuity policies issued by insurance companies provide for periodic payments to beneficiaries in a fixed dollar amount determined at the time the policies are issued. Because of the drastic effect of post-World War II inflation on the purchasing power of fixed payments, the standard life annuity became insufficient to provide for living expenses of policyholders. As a result, financial institutions, such as banks, savings and loan associations, and mutual funds, started to issue products which provided better returns for their customers. To complete with these new products, the life insurance companies developed a variable annuity.

    2. The variable annuity offers benefits that vary with the investment experience of assets that fund the variable annuity contract. In other words, the insurance company does not guarantee a fixed dollar amount of payment in a variable contract. The benefits payable under a variable annuity contract vary with the insurance company’s investment experience with respect to such contracts. The premiums of the variable contracts are invested according to the wishes of the policyholders in the mutual funds with various investment strategies. Some of the investment portfolios include money market; intermediate government securities; high yield; balanced ; growth and income; equity index; common stock; and global progressive stock. There are many other types of portfolios in addition to the few mentioned above. The policy values increase or decrease with the values of the underlying assets in the portfolio. Prospectuses are published for each variable annuity in which detailed information is given about the annuities the insurance company is offering. For state insurance regulatory purposes, a life insurance company that issues variable annuity and qualified pension plan contracts must account separately for various items of income, exclusions, deductions, assets, reserves and liabilities attributable to those contracts in a special Annual Statement called the "Green Book" . State laws provide that assets in the separate accounts may be invested without regard to the usual restrictions that are placed on the general accounts. Under the 1959 Act, special treatment is applied to variable annuities and to qualified pension contracts which are includible in the separate accounts. The 1984 Act retained this special treatment and extended it to variable life insurance contracts. Under the 1984 Act, the separate accounts are taxed under the provisions of IRC section 817 and the regulations issued under the 1959 Act to the extent that they are still applicable.

  2. Accounting — In the life insurance business there are two main functions, insurance and investment, with many subfunctions. Selling of contracts, underwriting and contract administration, premium collection and payment of premium taxes, claims, and benefits are the insurance functions.

    1. All the insurance functions of separate accounts are channeled through the general accounts Annual Statement called the "Blue Book." The summary of operations, page 4, of the Blue Book includes all the insurance functions applicable to the separate Accounts. These functions are netted out on line 24A, (Net transfers to (+) or from (–) Separate Accounts) page 4 of the Blue Book.

    2. The separate accounts Annual Statement, (Green Book) reflects all the investment transactions applicable to the assets of the separate accounts. The summary of operations, page 4, of the Green Book combines all the functions performed by the general accounts for the separate accounts and the investment activities of the separate accounts.

  3. In examining the separate accounts, you should do the following:

    1. Familiarize yourself with the separate accounts

    2. Trace the amounts in the summary of operations in the Green Book to the exhibits in the Green Book—gross investment income (Exhibit 2); capital gains and losses on investments (Exhibit 3) or net investment income or capital gains and losses [Exhibit 5, Investment Taxes, Licenses and Fees (Excluding Federal Income Taxes)]; and increase in aggregate reserve for policies and contracts.

    3. Request a copy of the prospectus for each group of variable contracts included in the Green Book. Reading of the prospectus will give the examiner a better understanding of the taxpayer’s variable contract.

    4. Request from the taxpayer a reconciliation of line 24a, page 4, summary of operations in the Blue Book to the insurance functions in the summary of operations, page 4, of the Green Book. (Request components of line 24a of the Blue Book. See Figure 5–2, column 2.)

  4. Figure 5–2 of this handbook shows the elimination of the separate accounts amount from the general accounts. The amounts from the general accounts (the insurance functions plus the investment functions) and the capital gains from the Green Book are combined in the summary of operations, page 4 of the Green Book (see Figure 5–3 of this handbook). Some separate accounts invest in real estate and are claiming depreciation and other investment expenses included in capital gains and losses to arrive at net investment income reported in the summary of operations instead of gross investment income shown on line 3 and capital gains and losses on line 4 as shown in the illustration (Figure 5–3 of this handbook).

  5. Depreciation, if claimed, is offset by the realized/unrealized gain that results from the decrease in the basis of the real estate. The amount of depreciation claimed does not affect profit or loss because it is offset by unrealized gains and changes in policyholder reserves. Therefore, depreciation would not be allowed if the basis of the underlying asset was not reduced for the computation of realized and unrealized capital gains or losses in the exhibits of the Green Book. See the following Figure–1.

    Figure 4.42.5-1

    Verification of Net Transfer to Separate Accounts Shown in General Accounts Blue Book (Schedule 1, L. 24A)
    Summary of Operations — Total Income (Sch. 2, L.5) 389,526
    Less: Gross Investment Income (40,000)
    Capital Gains (Losses) 9,474
    Net income Transferred from General Accounts 359,000
    Summary of Operations — Total Deductions (Sch. 2, L.5) 378,500
    Less: Increase in Reserves (242,000)
    Net Deductions Transferred from General Accounts 136,500
    Net Transfer from General Accounts (359,000 – 136,500) 222,500
    General Account, Line 24A, Net Transfer to Separate Acct 240,000
    Balance — Loss Transferred to Separate Account (17,500)

    The above formula verified the correctness of the amount of the net transfer from the general account to the separate account. This formula can be used to eliminate duplications of income or deductions for tax purposes. Generally, a separate Form 1120–L is prepared for the general account and for each Segregated asset account and the bottom line is aggregated for tax purposes.

  6. Since some insurance companies issue different kinds of variable contracts, the preparation of Form 1120–L for each separate asset account can be voluminous; therefore, taxpayers usually prepare one schedule which includes two or more variable contracts with similar characteristics and make line by line consolidation with the general account to arrive at the gain or loss from operations. When there are a substantial number of different types of variable contracts, they are grouped in supporting schedules as group pool, group single, and individual, and the grand total is consolidated with the general account to arrive at gain or loss from operations.

  7. As you may have already noticed by analyzing the Green Book, the basis of each asset in a segregated asset account is increased by any appreciation and decreased by any depreciation, IRC section 817(a) and (b), and the appreciation and depreciation are reflected in the computation of the investment income and the reserves. For tax purposes, adjustments have to be made to eliminate the capital gains or losses attributable to variable contracts because the capital gains are not taxable and losses are not deductible. IRC section 817(a) and (b). The rationale of this adjustment is that the realized gains or losses are not included in income for tax purposes (See Figure 5–4 of this handbook) and unrealized gains or losses are never included in income for tax purposes.

  8. Capital gains or losses attributable to "seed money" and surplus are subject to general tax law treatment. This will be illustrated and explained later.

  9. The deduction for death benefits should be reduced to the extent that it was increased in the taxable year for appreciation, if not adjusted in the reserve above.

  10. There are instances where an insurance company will transfer cash to the separate accounts which will be held for many years. Capital gains and losses applicable to seed money and surplus should be part of the general account for tax purposes.

  11. Figure 5–4 of this handbook illustrates how the increase in reserves in the Green Book was adjusted to exclude a portion of realized and unrealized losses applicable to seed money and surplus. The allocation in this illustration was made on the ratio of mean surplus of $26,000 divided by the mean assets of $615,000 = 4.2242 percent and applied to realized/unrealized loss of $9,474 to arrive at realized and unrealized loss applicable to seed money and surplus of $400 (see Figure 5–4 of this handbook).

    1. The adjusted end of the year reserve of $654,000 plus decrease in value of statement assets of $9,874 less the beginning reserve of $412,000 determines the reserve increase for tax purposes of $251,874.

    2. Here it should be noted that the beginning reserve for the computation of the increase/decrease in reserves should be the unadjusted reserve shown in the Green Book. In accordance with Treas. Reg. 801–8(f)(2) issued under the 1959 Act to the extent that it still applies.

  12. The amounts in column 3 of Figure 5–2 of this handbook after required tax adjustments to premiums, reserves and other needed adjustments are aggregated with the amounts in Figure 5–4 of this handbook to arrive at tentative LICTI before dividend-received deduction.

  13. Other pertinent information for the examination of separate accounts includes:

    1. Separate accounts usually show a net gain from operations due to loading in premiums, risk charges, mortality gains, withdrawal charges, surrender charges and investment charges.

    2. The allocation of the market value changes to surplus (seed money and surplus) could be obtained from the insurance company’s records. The formula in Figure 5–4 of this handbook can be used in the absence of such information or to test the reasonableness of the taxpayer’s data.

    3. Premium income should be adjusted for deferred and uncollected amounts, just as it is done in the general account if the policyholders receive premium reminder notices based on "planned" periodic premiums (see the prospectus).

    4. The reserves as they are shown in the Green Book exhibit titled Analysis of Increases in Reserve during the Year should be recomputed for tax purposes only if they include deferred and uncollected premiums and surrender charges. See the following Figures–2 through Figure–4.

    Figure 4.42.5-2

    Sample Page 1
    Life Insurance Company
    Summary of Operations
        Col. 1
    A/S P.4
    Col. 2
    Col. 3
    Net G.A.
    1 Premium and annuity considerations 1,657,000 310,000 1,347,000
    1A Annuity and other fund deposits 278,000 49,000 229,000
    2 Considerations for suppl. cont. w.l.c. 9,000 9,000
    3 Considerations for suppl. cont. w.o.l.c. 30,000 30,000
    4 Net investment income 448,000 448,000
    5 Commissions and expense all. on rein. 103,000 103,000
    5A Reserve adjustments on rein. ceded (83,000) (83,000)
    6 Aggregate write-ins for misc. income 10,000 10,000
    7 Totals (Items 1 to 6) 2,452,000 359,000 2,093,000
    8 Death benefits 74,000 40,000 34,000
    9 Annuity benefits 130,000 2,000 128,000
    10 Surrender benefits 140,000 85,000 55,000
    11 Interest on policy or contract funds 3,300 3,300
    12 Payments on policy contr. with life cont. 3,700 3,700
    16 Payments on policy contr. w/out l. cont. 112,000 112,000
    17 Increase in aggregate res. for l. c. 1,290,000 1,290,000
    20 Commission on prem. & ann. cont. 170,000 170,000
    22 General insurance expenses 280,000 9,500 270,500
    23 Insurance taxes and licenses 5,000 5,000
    24A Net transfer to separate account 240,000 240,000
    25 Sundry disbursements 69,000 69,000
    26 Totals (Items 9 to 25) 2,517,000 376,500 2,140,500
    27 Net gain from oper. before div. ded. (65,000) (17,500) (47,500)

    Figure 4.42.5-3

    Sample Page 2
    Life Insurance Company
    Separate Account
    Summary of Operations
    1 Transfers from the general account of net premiums  
    2 Other transfers from the general account 49,000
    3 Gross investment income (Exhibit 2) 40,000
    4 Capital gains and losses (Exhibit 3) (9,474)
    5 Total (Items 1 to 4) 389,526
    6 Transfer on account of death benefits 42,000
    7 Transfer on account of terminations 41,000
    8 Transfer on account of policy loans 44,000
    9 Increase in aggregate reserve for policies and contracts 242,000
    10 Charge for investment management and mortality & exp. quar. 9,500
    11 Totals (Items 6 to 10) 378,500
    12 Net gains from operations (including 240,000 net operating transfers from the general account) (Item 5 minus Item 11) 11,026

    Figure 4.42.5-3

    Exhibit 2 — Gross Investment Income
        1 2 3 4
        Collected During Year Due Current Year Due Previous Year Earned During Year
    1 Common Stocks 38,900 38,900
    2 Preferred Stocks 1,000 100 90 1,010
    3 Totals 39,990 100 90 40,000

    Figure 4.42.5-3

    Exhibit 3 — Capital Gains and Losses on Investments (Unrealized)
    Capital Gains (or Losses)
        1 2 3 4 5
        Beginning of Year End of Year Increase (Decrease) Net Realized Capital Gain or Losses During Year Net Gain or Losses
    1 Common Stocks 28,000 (46,000) (75,000) 64,526 9,474
    2 Preferred
    3 Totals 28,000 (46,000) (75,000) 64,526 (9,474)

    Figure 4.42.5-4

    Sample Page 3
    Life Insurance Company
    Asset 12/31/92 475,000
        12/31/93 756,000
        Mean 615,500
    Surplus and Seed Money 12/31/92 27,000
        12/31/93 25,000
        Mean 26,000
    Allocation of Realized/Unrealized Appreciation (Depreciation)
    A Total Realized/Unrealized   (9,474)
    B Mean Surplus over Mean Assets (26,000 / 615,500)   4,2242%
    C Surplus Portion of Realized/Unrealized Loss (A x B)   (400)
    D Decrease in Value of Separate Account Assets (A – C)   (9,074)
    Increase (Decrease) in Reserves
      Life Insurance Reserves — End   654,000
      Decrease/(Subtract Increase) in Value of S.A. Assets   9,074
      Subtotal   663,074
      Less: Reserves — Beginning   412,000
      Increase (Decrease) in Reserves   251,074
    Allocation of Required Policy Interest
    E Investment Yield 95% of Gross Investment (40,000 x 95%)   38,000
    F Surplus Portion of Investment Yield (E x B)   1,605
    G Required Policy interest (E – F)   36,595
    Allocation of Surplus Portion of Realized Capital Gains
    H Total Realized Capital Gain   64,526
    I Surplus portion of Realized Capital Gains (H x B)   2,726

    Note: The amount of 2,726 will be reported in Schedule D of the general account.

    Figure 4.42.5-4

    Sample Page 4
    Life Insurance Company
    Separate Account — Taxable Income
    1 Gross Premiums 359,000
    2 Investment Income 40,000
      Total Gross Income 399,000
    3 Death Benefits 42,000
    4 Transfer on account of termination 41,000
    5 Transfer on account of Policy Loans 44,000
    6 Increase in reserves (Adjusted) 251,074
    7 Other deductions 9,500
      Total Deductions 387,574
      Gain or (Loss) from Operations before Dividend — Received  
      Deduction 11,426  (05-29-2002)

  1. Reinsurance is a transaction where an insurance company (the ceding company) transfers (cedes) a portion or all of the risks it has underwritten to another insurance company (the reinsurer or assuming company). Reinsurance is used by insurance companies for several reasons, including the following:

    1. Expand capacity.

    2. Reduce net exposure.

    3. Sustain and survive catastrophic loss.

    4. Achieve statistically predictable loss behavior.

    5. Alter the mix of business or withdraw from a line of business or a geographical area.

  2. The two basic types of reinsurance are assumption and indemnity.

    1. In assumption reinsurance transactions, the reinsurer becomes solely liable to the policyholders, and the policies are transferred from the ceding company to the books of the reinsurer. Basically, assumption reinsurance is the means used to transfer ownership of insurance policies.

    2. In indemnity reinsurance transactions, the ceding company remains liable to the policyholders. It may pass all or only a portion of the risk to the reinsurer. Three of the basic types of indemnity reinsurance are Yearly Renewable Term (YRT), coinsurance, and modified coinsurance (modco). YRT reinsurance is the purchase of one-year term insurance by a life insurance company from another company to cover the net amount at risk of the policies reinsured. The net amount at risk is the excess of the face amount of a policy over the reserve. Coinsurance is a type of reinsurance arrangement where the reinsured is indemnified on all or a portion of its risks for certain policies by another company. The coverage is proportional for the percentage reinsured, so the reinsurer is liable to the ceding company on its agreed portion of all the obligations of the reinsured policies. The ceding company pays the reinsurer a proportional part of the premiums collected on the policies. In return, the reinsurer reimburses the ceding company for the proportional part of the death claim payments as well as other benefits and expenses such as cash surrender values, policy loans, commissions, and premium taxes. The reinsurer must also establish the required reserves for the portion of the policies it has assumed. Modco is a variation of coinsurance where the reserves for the original policies are maintained by the ceding company. The ceding company also retains ownership of the assets supporting the reinsured reserves. The assuming company transfers to the ceding company, on a periodic basis, the increase in reserves less an amount of interest that the reinsurer would have earned if it held the assets.

  3. Reinsurance Arrangements—Reinsurance agreements can be on a facultative or automatic basis.

    1. A facultative plan is one in which an individual risk offered for reinsurance by an insurer can be accepted or rejected by the reinsurer. With proportional facultative reinsurance, the reinsurer assumes a proportional share of premiums and losses. With nonproportional facultative reinsurance, the insurer transfers the part of the risk that is in excess of its own retention limits.

    2. Automatic plans of reinsurance can also be either proportional or nonproportional. However, on the agreed upon policy types or excess retention limits, the insurer must cede and the reinsurer must accept the risks. By agreeing to accept all business automatically ceded to it, the reinsurer is relying on the underwriting judgement of the ceding company.

  4. Accounting for Reinsurance:

    1. YRT — Under the provisions of IRC section 803(a)(1) and 803(b)(1), the reinsurance premiums paid by the ceding company are treated as reductions to its premium income. The assuming company includes the amount as part of its premium income. Under the provisions of IRC section 805(a)(1), the assuming company deducts as death benefits the payments it makes to the ceding company for death claims and the ceding company reduces its death benefit deduction for the reimbursement.

    2. The reserves on reinsured policies will be initially computed by the ceding company without regard to the reinsurance. Therefore, the reserves must be reduced by the ceding company and a reserve must be established by the assuming company for the risk transferred.

    3. Coinsurance — Since under a coinsurance arrangement the assuming company has a proportionate part of all the obligations of the policies, the income and deduction classifications are generally the same for the ceding and assuming companies. For example, premium income from the policies is included in premium income of the assuming company and reduces the premium income of the ceding company while death benefits reimbursed by the assuming company are included in the death benefit deduction of the assuming company and reduce the death benefit deduction of the ceding company. Experience refunds adjust premiums under IRC section 803(b)(1) and policyholder dividends reimbursed are deducted by the assuming company as dividends and included in premium income by the ceding company.

    4. If an existing block of business is reinsured, the ceding company transfers assets it holds to support the reserves to the assuming company. The asset transfer reduces premium income for the ceding company and increases premium income for the assuming company per IRC section 803(a)(1) and 803(b)(1). The asset transfer is treated as a sale or exchange of asset and gain or loss will be recognized if the fair market value differs from the tax basis. The accounting entries for the termination of a reinsurance contract covering existing business are the reverse of those for the initial accounting.

    5. It should be noted that there will be tax effects from the transaction due to any difference between the statutory and tax computation of the reserves. Another item that affects initial net income or loss is the ceding commission which is discussed below.

    6. For many years there has been considerable controversy about whether ceding commissions were currently deductible or must be capitalized and amortized. Ceding commissions are amounts paid by an assuming company to acquire business under a coinsurance contract. They are incurred at the onset of the reinsurance contract and do not include the periodic commission payments. Regulations in the past held that the payments must be capitalized and could be amortized over the reasonably estimated life of the contracts reinsured for assumption reinsurance agreements.

    7. The Supreme Court held in Colonial American Life Insurance Company v. Commissioner, 89–1 USTC 9377, 63 AFTR 2d 89–1461, that ceding commissions paid pursuant to an indemnity reinsurance agreement must be capitalized and amortized over the estimated life of the reinsurance contract.

    8. IRC section 848 enacted by the Revenue Reconciliation Act of 1990 superseded the regulations and Colonial American for reinsurance of those contracts that are "specified insurance contracts" (see Deferred Acquisition Costs in Chapter 4, text 4.10) and allows a current year deduction in the year the expense is incurred.

    9. Ceding commissions incurred before September 30, 1990 or which are incurred with respect to policies that are not "specified insurance contracts" under IRC section 848 are capitalized and amortized under the rules described in b.4 and b.5. above. Ceding commissions on reinsurance contracts incurred before November 15, 1991, are subject to the interim rules of Treas. Reg. 1.848–3 for tax years beginning before January 1,1995. Reinsurance agreements entered into on or after November 14, 1991, are subject to the interim rules for 1991.

    10. The interim rules hold that the reinsurer must treat ceding commissions as a general deduction. The ceding company must treat ceding commissions as non-premium related income under IRC section 803(a)(3). The ceding company may not reduce its general deductions by the amount of the ceding commissions. The amount of the ceding commission is deemed to equal the excess of the increase in the reinsurer’s tax reserves resulting from the reinsurance agreement over the gross consideration incurred by the ceding company for the reinsurance agreement, less any amount incurred by the reinsurer as part of the reinsurance agreement.

    11. If the reinsurance contract is of a type in which the general rules of IRC section 848 apply, the ceding commission is included in net premiums as defined in IRC section 848(d).

    12. Modified Coinsurance — The accounting for modco agreements is primarily the same as a coinsurance agreement except for reserve accounting. Since the ceding company retains control of the assets, no reserve adjustment is made. The payments on reserve increases, investment income on assets held with respect to reserves, and any income tax reimbursement are accounted for by adjusting premiums under IRC section 803(a)(1).

    13. For deferred acquisition cost purposes, the general interim rules for determining gross amount of premiums as contained in Treas. Reg. 1.848–3(b) do not apply. The parties must determine their net premiums on a net consideration basis as described in Treas. Reg. 1.848–2(f)(5).

  5. Surplus relief reinsurance (indemnity reinsurance)

    1. When an insurance company initially sells a policy it incurs a number of expenses such as commissions to the agent selling the policy, medical exams, and establishing a policy file. In addition, it is required to establish a full reserve on its accounting records. As a general rule, these expenses and the reserve will exceed the premium income received on the policy. This excess must be absorbed in the surplus account.

    2. The burden on a company’s surplus is particularly heavy in times of business expansion. Indemnity reinsurance is a major tool in relieving the strain on the surplus account. By ceding a portion of its risks, the company is able to expand its capacity to write new business. This relief is usually provided in the form of a ceding commission that reimburses a company for its up-front expenses. The commission may also be an estimate of the value of expected future profits on the policies.

    3. Some surplus relief agreements, however, are primarily financing arrangements entered into by ceding companies to produce increased surplus, often on a temporary basis, which provide little or no indemnification of policy benefits. It is these types of financing arrangements that will require additional investigation because of the lack of transfer of insurance risk to the assuming company.

    4. Elements of a reinsurance agreement that indicate it might be a financing arrangement include the ultimate result is determinable in advance structured or pre-determined reimbursement schedules and side agreements and financial guarantees.

  6. IRC section 845. The Deficit Reduction Act of 1984 provided the Treasury authority to recharacterize or reallocate items of income and deduction of reinsurance agreements between both related and unrelated parties.

    1. For related parties (entities owned or controlled directly or indirectly by the same interests), the recharacterization or reallocation can be made when necessary to reflect the proper source and character of the various items. This provision is effective for contracts entered into after September 27, 1983.

    2. The authority to adjust or recharacterize reinsurance agreements between unrelated parties is dependent on the transaction having a significant tax avoidance effect. This provision is effective for contracts entered into after December 31, 1984. The Conference Report accompanying the enactment of IRC section 845 provides the following examples of when a tax avoidance effect may arise. The reinsurance contract artificially reduces a company’s equity. The transaction changes the source or character of any item. The agreement defers taxation of income items or eliminates the "SRLY taint" of a previous net operating loss. The contract artificially transfers tax benefits between taxpayers in different tax brackets. The transaction effectively extends a carryover period.

    3. A tax avoidance effect is deemed to be significant if the transaction is designed so that the tax benefits enjoyed by one or both parties to the contract are disproportionate to the risk transferred between the parties. The Conference Report also provides guidance in the factors that may be considered in determining the existence of a significant tax avoidance effect—age of business reinsured; character of the business reinsured; structure for determining potential profits; duration of the agreement; termination provisions; tax positions of the parties; and financial situation of the parties.

  7. Suggested audit steps:

    1. Review the schedule of the reinsurance agreements in effect at the end of the calendar year which is located in Schedule S of the Annual Statement. The schedule includes the premiums and reserves (on a statutory basis) for all assumed and ceded contracts. Schedule S can be used to identify contracts that would have a material effect on the tax return.

    2. Review financial statements. Statement of Financial Accounting Standards No. 113, Accounting and Reporting for Reinsurance of Short Duration and Long Duration Contracts requires all insurance enterprises to disclose, "The nature, purpose, and effect of ceded reinsurance transactions on the insurance enterprises’s operations..." To meet the conditions for reinsurance accounting a contract must indemnify the ceding company against loss or liability.

    3. Review state insurance department examination report. The report should indicate whether or not state regulators have accepted a company’s reinsurance agreements and may include comments regarding whether or not material insurance risk has been transferred.

    4. Review tax workpapers to verify that tax reserves rather than statutory reserves have been used to report reinsurance transactions. Verify, also, that reinsurance transactions are treated consistently for statutory, financial, and tax purposes.

    5. Review the reinsurance contracts. Elements indicating that a contract may not be a normal reinsurance transaction are provisions for complicated premiums, commissions, experience ratings, or settlement. To be accounted for as reinsurance, a contract must have insurance risk. Insurance risk does not include investment yield risk, credit risk, or expense risk. For tax purposes, the critical factors in qualifying as insurance have historically been the presence in a binding arrangement, of risk-shifting and risk distribution. Helvering v. LeGierse, 312 U.S. 531, 539 (1941). The contract will indicate the business being reinsured and the frequency and timing in which the settlements will be made.

    6. Review the periodic accounting settlements. Verify that elements such as commission payments and experience rated refunds are calculated and settled as set out in the contract. If there is a deviation from the terms, there may be amendments to the contract or side agreements negating terms of the agreement.  (05-29-2002)
Policyholder Dividends – IRC section 808

  1. Line 1 of Schedule E of Form 1120–L amount paid or accrued — The 1984 Act provides that the deduction for policyholder dividends is the amount paid or accrued during the taxable year. Policyholders dividends include any amount paid or credited where the amount is not fixed in the contract but depends upon the experience of the company or the discretion of management. Policyholders dividends are defined in section 808(e)(1) and (2) as any amount which increases the cash surrender value of the contract or other benefits payable under the contract, or reduces the premium otherwise required to be paid. These policyholder dividends shall be treated as paid to the policyholder and returned by the policyholder to the company as a premium. The source for Schedule E, line 1 1120–L is taken from the Annual Statement Exhibit 7, line 9, columns 1 and 2 plus the amount due and unpaid in Exhibit 7, line 10, columns 1 and 2.

  2. Line 2 of Schedule E excess interest — Is any amount in the nature of interest in excess of the prevailing State assumed rate for such contract.

  3. Line 3 of Schedule E premium adjustments — Means any reduction in the premium under an insurance or annuity contract which for such reduction would have been required to be paid under the contract. If no premium amount is fixed in the contract, variations in premiums paid during the course of the contract are not considered premium adjustments. Further, a change in the amount of a premium that is attributable to the insurability of the insured is not considered a premium adjustment.

  4. Line 4 of Schedule E experience-rated refunds — Means any refund or credit based on the experience of the contract or group involved. Thus, for example, if a company sells a group policy to an employer covering the lives of its employees and the premium received exceeds the sum of the claims paid and other expenses, any refund of such excess is an experience-rated refund. The Act also adopts the general rule that any policyholder dividend that increases any of the benefits payable under the contract (including the cash surrender value) or reduces the premium otherwise required, is treated as paid to the policyholder and returned by the policyholder to the company as a premium.  (05-29-2002)
Differential Earnings Amount – IRC section 809

  1. Line 1 Schedule C of the Form 1120–L Annual statement surplus and capital — This entry should match the amount on page 3, line 37 of the NAIC Annual Statement.

  2. Line 2 Schedule C nonadmitted financial assets — Nonadmitted financial assets are financial assets that are not permitted to be included as part of the corporation’s financial condition for state regulatory purposes.

    1. This includes the sum of lines 1 through 10, column 3, Exhibit 13, from the Annual Statement. This also includes, at their fair market value, financial assets shown on Schedule X of the Annual Statement.

    2. Some mutual insurance companies have classified their nonadmitted financial assets as a reduction to ledger assets in the Annual Statement. Agents should be on the alert, if there are no nonadmitted assets reflected in column 3. Any nonadmitted assets that are included in ledger assets should be adjusted.

  3. Line 3 Schedule C excess of statutory reserves over tax reserves on IRC section 807(c) items — Statutory reserves is the aggregate amount of IRC section 807(c) reserves after the deduction of deficiency reserves, due and deferred premium amounts and other adjustments.

    1. Statutory reserves are reflected in Exhibits 8, 9, and 10 of the Annual Statement and also page 3, lines 1, 2, 3, 4.1, 5, 9, 10, 11, and 27, and possibly other write-in lines. Examples of reserves that may appear on a write-in line are excess interest guarantee reserves; and reserves for Guaranteed Investment Contracts (GIC) which have purchase rate guarantees.

    2. Separate accounts reserves meeting the definition of IRC section 807(c) reserves should be included in both the statutory reserves and tax reserves.

    3. Both statutory reserves and tax reserves are net of reinsurance.

  4. Line 4 deficiency reserves — A deficiency reserve is that portion of the reserve on a particular contract by which the present value of the future net premiums required for such contract exceeds the present value of the future actual premiums. Deficiency reserves are contained in Exhibit 8, Part G (Miscellaneous), of the Annual Statement. These reserves, even though required by state law, cannot be included in life insurance reserves for tax purposes. Accordingly, deficiency reserves are to be excluded from both statutory and tax reserves when computing line 3 above and are to be added back on this line.

  5. Line 5a Schedule C asset valuation reserve — This entry should match the amount on page 3, line 24.1 of the NAIC Annual Statement.

  6. Line 5b Schedule C interest maintenance reserve — This entry should match the amount on page 3, line 11.4 of the NAIC Annual Statement.

  7. Line 6 Schedule C other voluntary reserves — Request a schedule showing the nature and amount of:

    1. Each voluntary reserve.

    2. Any Annual Statement reserve that is not an item listed in IRC section 807(c)—not part of the policyholder dividend reserve; not a deficiency reserve included on line 4; and not included on lines 5a and 5b.

    3. A voluntary reserve may be a group life contingency reserve, a mortality fluctuation reserve, a special reserve for unforeseen contingencies, or any provision for policyholder dividends payable after the close of the following year.

    4. A reserve for Federal taxes may be in whole or in part a voluntary reserve. If the reserve is for a Federal income tax liability that might arise in the future if certain items are identified on audit such a reserve will be treated as a voluntary reserve because liability for those amounts is contingent on detection of the tax issue, assertion of a deficiency, and resolution of the issue. If the reserve is for taxes accrued and payable on the due date of the return for the year, it will not constitute a voluntary reserve.

    5. Agents should be on the alert for any aggregate write-ins for liabilities which can be found in the Annual Statement on page 3, line 25. Some of these items may constitute a voluntary reserve.

  8. Line 7 Schedule E 50 percent of the amount of any provision for policyholder dividends payable in the next tax year — Include 50 percent of the total Annual Statement provision for policyholder dividends to be paid in the following year, whether accrued or unaccrued for tax purposes at the end of the tax year. Policyholder dividends include excess interest, premium adjustments, and experience-rated refunds. Any Annual Statement provision for policyholder dividends payable after the close of the following tax year is treated as a voluntary reserve. This item should represent 50 percent of the sum of Annual Statement page 3, lines 7.1, 7.2, 8, 11.2 and all or a portion of certain other lines up to the extent that these amounts relate to dividends payable in the 12 month period following the close of the taxable year.

  9. Line 8b of Schedule C adjustment for equity allocable to noncontiguous Western Hemisphere countries and other adjustments — The statements below normally apply to mutual life insurance companies. Any equity adjustment made on this line will require a corresponding reserve adjustment on line 3. This line should include:

    1. Equity allocable to noncontiguous Western Hemisphere countries. The allocable equity is to be based on the relative magnitudes of tax reserves, and only if the ratio in IRC section 809(g)(5) exceeds 5 percent.

    2. Equity allocable to a contiguous country branch if an IRC section 814 election has been made. This election requires that a separate account has been made.

    3. Reduction in equity base for a mutual successor of a fraternal benefit society.

  10. Line 13 differential earnings amount (line 12 times the differential earnings rate). Enter here and on Schedule E, line 6. The differential earnings rate for Schedule C and the recomputed differential earnings rate for page 1 of the 1120–L are determined by the Secretary on the basis of information submitted by the 50 largest domestic stock life insurance companies and all mutual life insurance companies through the filing of IRS information return Form 8390. When the data supplied produces a negative rate then the rate must be limited to zero. See Treas. Reg. 1.809–9 (c). The U.S. Court of Appeals reversed the District Court’s decision in the American Mutual case. American Mutual Life Insurance Co. V. United States, 43 F.3d 1172 (8th Cir. 1994), cert. denied, 116 S.Ct. 335 (1995). The Court of Appeals concluded that Congress did not intend to give mutual life insurance companies so-called dividend deductions greater than their dividends in any given year. Thus, the recomputed DER can never be less than "0."  (05-29-2002)
Short Taxable Years IRC section 811(e)

  1. If any return of a corporation made under IRC section 811(e) is for a period of less than the entire calendar year (referred as a "short period" ) then IRC section 443 shall not apply in respect to such period, but life insurance company taxable income shall be determined, under Treas. Reg. 1.818–5(c) on an annual basis by a ratable daily projection of the appropriate figures for the short period.  (05-29-2002)
Payroll Taxes

  1. In connection with withholding and FICA taxes, verification should be made to ensure that amounts awarded as prizes in sales contests have been added to the successful salesman’s income.

  2. A life insurance company may or may not be liable for any one or all of the payroll taxes (FIT, FICA, and FUTA) on earnings of its insurance agents, depending on the facts in each case. Various rulings have been issued on the subject. Contracts with agents should be examined to determine if withholding responsibilities are being met.

  3. Any expenditures for conventions should be examined to ascertain if the costs are directly related to bona fide business meetings or should be added to the income of the agent.  (05-29-2002)
Tax on Policies Issued By Foreign Insurers

  1. IRC section 4371 imposes a tax on premiums paid to a foreign insurer or reinsurer.

  2. Quarterly returns on Form 720 (Quarterly Federal Excise Tax Return) must be filed by the person who pays the premiums.

  3. Particular attention should be given to companies ceding policies to foreign reinsurers to ensure compliance with this section of the Code.

  4. It should be noted the tax is assessed on gross premiums and not on the net remittance—premiums less ceding commissions—to the foreign insurer.  (05-29-2002)
General Business Credit

  1. Life insurance companies qualify for general business credit in the same manner and to the same extent as corporations in general. The business credit is a combination of the following credits:

    1. Investment credit such as for energy property, rehabilitation expenditures, and reforestation expenses.

    2. Targeted jobs credit.

    3. Alcohol fuels credit.

    4. Research credit.

    5. Low-income housing credit for buildings placed in service after 1986.

    6. Enhanced oil recovery credit.

    7. Disabled access credit.

    8. Renewable electricity production credit—for tax years ending after December 31, 1992.

  2. Special attention should be given to the recapture of credit claimed due to failure to continue meeting the requirements for a qualified low-income building in the case of low-income housing credit or early disposition of investment credit property.

  3. It should be noted that for purposes of the research credit, the costs of developing computer software for the taxpayer’s own use in general, administrative, or consulting services generally will not be eligible for the credit.  (05-29-2002)
Foreign Tax Credit

  1. Life insurance companies qualify for the deduction or credit for taxes imposed by foreign countries to the same extent as corporations in general.

  2. Special attention should be given to the computations of the limitation on the amount of credit in any year in which the limitation provided in IRC section 904(a) is applicable. Both the numerator and denominator of the limitation fraction should be determined in the same manner.

  3. An insurance company generally falls within the definition of a financial services entity and insurance income from that company will be sourced as financial services income. Under the look-through rules of IRC section 904(d)(3) and Treas. Reg. 1.904–5(c)(1), an amount included in gross income of the U.S. parent from the foreign insurance company will maintain its character as financial services income. Thus, the Subpart F inclusion should be placed in the parent’s financial services income basket.

  4. Review the taxpayer’s sourcing schedules in the tax workpapers. The financial services Subpart F income could be characterized as general limitation income. The effect of doing this is to combine high-taxed general limitation income with low-taxed financial services income.


    Many foreign insurance companies operate in countries which impose little or no tax.

  5. Effective for years beginning after December 31, 1976, underwriting income will be sourced in the country where the risks are located. Prior to that date, the source was in the country where the contracts were negotiated and executed.  (05-29-2002)
Alternative Minimum Tax

  1. Life insurance companies are subject to alternative minimum tax much the same as corporations in general. Alternative minimum tax is the excess of the tentative minimum tax for the taxable year over the regular tax for the period. For corporations, tentative minimum tax is equal to 20 percent of the amount by which alternative taxable income exceeds an "exemption amount." Alternative minimum taxable income is calculated by adjusting the regular taxable income, before NOL, by specific "adjustments" and "tax preference items."

  2. One of the specific adjustments for insurance companies is the deduction determined under IRC section 833. This deduction, which is allowed to the Blue Cross/Blue Shield companies, must be added back.

  3. In general, the alternative minimum taxable income of any corporation for any taxable year beginning in 1987,1988, or 1989, shall be increased by 50 percent of the amount by which the adjusted net book income exceeds the alternative minimum taxable income for the taxable year (determined without regard to this adjustment or the alternative tax net operating loss adjustment). Subsequent taxable periods are subject to the adjusted current earnings adjustment discussed below.

  4. Corporate book income is the net income or loss reflected in the taxpayer’s applicable financial statements. The order of priority of financial statements for life insurance companies is:

    1. A statement filed with the Security and Exchange Commission.

    2. A certified audited financial statement that is used for credit purposes, for reporting to shareholders, or for any other substantial nontax purpose.

    3. A statement required to be provided to a federal or other governmental regulator (Annual Statement).

    4. Any other statements issued by an insurance company.

  5. Before its repeal, IRC section 56(f)(2)(H) provided rules for life insurance companies for the computation of the book income preference item. Mutual life insurance companies only reduce adjusted net book income for policyholders’ dividends to the extent that those dividends exceed the year’s differential earnings amount under IRC section 809.

  6. For taxable years beginning after 1989, the adjusted net book income adjustment was changed to the adjusted current earnings (ACE) adjustment.

  7. The computation for ACE begins with the pre-adjustment Alternative Minimum Taxable Income (AMTI). Some of the adjustments required to compute the ACE adjustment for life insurance companies include:

    1. Increases for income items taken into account in computing Earnings and Profits (E&P) but excluded from AMTI. For example, company share of tax-exempt interest; and income on life insurance contracts [as determined under IRC section 7702(g)] for the tax year less the portion of any premium that is attributable to insurance coverage, i.e., inside build-up on life insurance policies owned by the taxpayer.

    2. Generally, no deduction is allowed in computing ACE for items not included in computing E&P— the small life insurance company deduction; and dividend received deduction — but see paragraph (c) of this section.

    3. However, ACE is not adjusted for dividends that qualify for a 100 percent dividends received deduction or dividends received from a "20-percent owned corporation" to the extent such dividend is attributable to income of the paying corporation that is subject to Federal income tax.

    4. For tax years ending on or after September 30,1990, IRC section 848(i) contains a special rule for the treatment of acquisition expenses of qualified foreign contracts.  (05-29-2002)
Environmental Tax

  1. A corporation may be liable for the environmental tax if the modified AMT taxable income exceeds $2,000,000.

  2. The modified AMTI base for the tax is the AMTI computed without regard to net operating losses, the 1991 and 1992 energy preference deduction, and the income tax deduction for the environmental tax. The $2,000,000 exemption is aggregated for component members of controlled corporations. No credits are allowable against the tax. However, the tax is deductible from gross income for income tax purposes.

  3. The tax is computed on Form 4626 (Alternative Minimum Tax) in the tax return.  (05-29-2002)
Shareholders Surplus Account and Policyholders Surplus Account

  1. From January 1,1959 through January 1, 1984, stock life insurance companies were allowed to accumulate a portion of their earnings in a policyholders surplus account without having these earnings subject to current Federal income taxation. The remainder of their earnings were accumulated in the shareholders surplus account. Surplus accumulated prior to January 1, 1959 is treated as having been previously taxed and is referred to in IRC section 815 as "other accounts." Treas. Regs. section 1.815–5 detail all of the items which are included in other accounts.

  2. All stock life insurance companies, in existence prior to January 1,1984, are required to continue to maintain the two special surplus accounts for Federal income tax purposes. The purpose of these surplus accounts is to establish the proper income tax treatment to be afforded the life insurance company upon distribution to shareholders.

  3. The balance in the policyholders surplus account is "frozen" as of December 31,1983, meaning that no further additions may be made to policyholders surplus subsequent to that date, although reductions to the account balance are made. The balance in the shareholders surplus account is recalculated at the end of each taxable period.

  4. To the extent a distribution to shareholders is treated as being made out of the shareholders surplus account, no tax is imposed on the life insurance company with respect to such distribution. However, to the extent that a distribution to shareholders is treated as being made out of the policyholders surplus account, the amount subtracted from the policyholders surplus account by reason of such distribution must be taken into account in determining life insurance company total taxable income. The amount of distribution included in income is often referred to as "Phase III Income." By virtue of the operation of the three-phase tax system previously in effect for life insurance companies, life insurance company taxable income may not be less than zero for purposes of computing the Phase III income and tax. Therefore, Phase III income may not be reduced by a current loss from operations, an operations loss carryback or an operations loss carryover.

  5. IRC section 815 governs the ordering of distributions by a life insurance company to its shareholders, additions to and subtractions from the shareholders surplus account, and subtractions from the policyholders surplus account. IRC section 815(f), retained in current law, specifies the rules which were in effect prior to January 1,1984 for policyholders surplus account balances as of December 31, 1983.

  6. Under the general rule, distributions to shareholders are treated as first being made from the shareholders surplus account. Once this account has been reduced to zero, distributions are then considered to be made from the policyholders surplus account until this account is exhausted, and finally from other accounts.

  7. In the Annual Statements there is a "general surplus account" which appears at the lower part of page 4, Summary of Operations. The Annual Statement does not distinguish between shareholders surplus and policyholders surplus and follows statutory accounting as opposed to income tax accounting principles. This account should be examined, as an initial source, to verify distributions which should be subtracted from the shareholders surplus account in order to determine if an amount should be included in total taxable income as having been distributed out of the policyholders surplus account.

  8. It is important to verify the additions and subtractions from the shareholders surplus account since distributions to shareholders are considered to be made first from the available balance in the shareholders surplus account. It should also be noted that a capital loss carryback or an operations loss carryback will reduce the amount in the shareholders surplus account in the carryback year by the amount of the loss utilized, net of the tax refunded. A Phase Ill tax may be triggered in the carryback year if the distributions to shareholders plus the loss carryback exceeds the shareholders surplus account balance.

  9. The taxpayer may elect to voluntarily transfer amounts from the policyholders surplus account to the shareholders surplus account effective as of the beginning of the subsequent taxable year. The amount added to the shareholders surplus account for the voluntary transfer is reduced by the amount of the tax on the transfer. Since this transfer is not effective for the current year, it cannot be utilized to provide additional shareholders surplus account amounts for current year distributions. A voluntary transfer is not subject to the "gross up" for income taxes as is computed for a direct distribution as explained in paragraph (12) below.

  10. The examiner must be alert to the potential for an involuntary distribution from policyholders surplus as a result of certain limitations being exceeded.

    1. If the policyholder surplus account at year end exceeds whichever of the following is the greatest, a subtraction is necessary: 15 percent of life insurance reserves at the end of the taxable year; 25 percent of the amount by which the life insurance reserves at the end of the taxable year exceed the life insurance reserves at the end of 1958; 50 percent of the net amount of the premiums and other consideration taken into account for the taxable year includible in income.

    2. IRC section 815(d)(4), of the law prior to January 1, 1934, requires the above subtractions. Therefore, references to reserves are also based on the reserving methods under the law in effect prior to January 1, 1984 including the provision of IRC section 818(c), net level revaluation.

    3. The subtractions from policyholders surplus for the amount in excess of the above limitations, less the tax imposed with respect to the subtraction, is added to the shareholders surplus account balance as of the first day of the subsequent taxable year.

    4. The subtractions required for exceeding the above limitations are not subject to the "gross up" for income taxes as is computed for a direct distribution as explained in paragraph (12) below.

    5. The examiner should always check the computation of the limitation amounts to determine whether a subtraction is required. Since the overall limitation is equal to the largest allowable balance determined under the three separate limitations, the examiner may conclude that no subtraction is necessary if the amount determined under any of the limitations is larger than the policyholder surplus account balance. It is relatively simple to compute the 50 percent of premiums limitation, therefore, it would normally be the first amount to verify. If the policyholder surplus account balance does not exceed this limitation, it is not necessary to compute the other two limitation amounts.

  11. Involuntary distributions from policyholders surplus may also result if the company does not qualify as a life insurance company or even as an insurance company. IRC section 815(d)(2), of the law prior to January 1,1984, requires the policyholder surplus account balance to be included as Phase Ill income if certain qualifications are not met.

    1. If for any taxable year the company is not an insurance company, the balance in the policyholders surplus account is includible in income for the prior taxable year, the last taxable year for which it was a life insurance company.

    2. If for any 2 successive taxable years the company does not qualify as a life insurance company under the provisions of IRC section 816(b), the balance in the policyholders surplus account is includible in income for the last taxable year for which it did qualify as a life insurance company.

    3. Subtractions from the policyholders surplus account due to loss of qualification as a life insurance company do not require any addition to the shareholders surplus account since the complete balance of the policyholders surplus account is eliminated thereby negating the need to differentiate between policyholders surplus and shareholders surplus.

  12. The final category of subtraction from the policyholders surplus account is direct or deemed distributions to shareholders which exceed the balance of the shareholders surplus account. The special consideration for this type of subtraction from the policyholders surplus account is that the amount distributed to the shareholders is the amount available after taxes. The distribution must be "grossed up" for tax purposes to determine the amount to be included in Phase Ill income.

    1. The amount subtracted from the policyholders surplus account, and included as Phase Ill income by the insurance company, is determined as shown in the following example for a $100,000 distribution to shareholders, in excess of the available shareholders surplus account balance, assuming a 35 percent tax rate.

    2. In the above example, $153,830 would be the amount included as Phase Ill income. At a 35 percent tax rate, the tax on $153,830 would be $53,830. The amount distributed to shareholders is then $153,830 less the $53,830 of tax imposed or $100,000.

    ____ X (1 – tax rate)
    ____ X (1 – .35)
    ____ X .65 = $153,830

  13. Policyholder surplus can also be reduced (but not included as Phase Ill income) under IRC section 815(d)(5), of the law prior to January 1, 1984, for amounts previously added to the account for claimed special deductions, allowed by prior law, in loss years where the operations loss sustained was not utilized in succeeding years and all or part of such loss expired. This means that the taxpayer did not receive a tax benefit for these additions to the policyholders surplus account and is therefore allowed to reduce the account balance by the unused amounts.

  14. The provisions of IRC section 845 provide the IRS with the authority to allocate, recharacterize or adjust items relating to reinsurance if that reinsurance involves tax avoidance or evasion, or the reinsurance contract has a significant tax avoidance effect. This concept would apply to the avoidance or evasion of Phase Ill tax through the use of reinsurance. Additional information concerning reinsurance topics can be found in text 5.2 above.

  15. Transactions between a group of related corporations may trigger a constructive distribution. Special consideration should be given to the potential of a policyholder surplus account distribution in the case of a stock redemption, a reorganization, a liquidation, or a distribution of company debt to shareholders. Such indirect distributions can result in substantial Phase Ill tax amounts.

  16. Subtractions from the policyholders surplus account may be overlooked by the taxpayer therefore the examiner should be diligent in this examination area. The tax consequences of distributions & policyholders surplus are potentially significant and involve numerous possibilities.  (05-29-2002)
Closing Discussions

  1. A closing interview will generally be held with members of the tax and legal departments to discuss items not finalized in previous meetings. If a large case is involved, the case manager, team coordinator, and other team members should be present.

  2. Insurance companies usually maintain a legal department headed by the General Counsel or Chief Counsel, who may carry the title of vice-president. In the case of a number of small companies, their legal affairs may be handled by a firm of practicing attorneys or consulting actuaries.

  3. In the closing interview, all points of law will generally be discussed with the designated officers and/or attorneys of the life insurance company. They will usually consider the principles of law pertaining to the issues involved and argue precedents with the examining agent. A decision as to whether the company will sign an agreement form or request an Appeals hearing should be indicated to the agent at this time.

  4. When a large case is involved, refer to the Case Managers Handbook for closing procedures and settlement practices.

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