Premium Deficiency Reserves Designated as Tier III Issue

On Sept. 12, 2008, the Internal Revenue Service (IRS) designated the deductibility of premium deficiency reserves as its first Tier III issue specifically related to the insurance industry. According to the IRS, Tier III issues present high compliance risks within an industry. They are not mandatory for IRS audit examination, but, when raised, trigger some degree of coordination between IRS auditors and IRS industry specialists. Although the IRS notice states that the issue applies to all types of insurance companies, it is really directed to property/casualty and health insurance companies. SSAP 53, paragraph 15 provides as follows for premium deficiency reserves:

When the anticipated losses, loss adjustment expenses, commissions and other acquisitions costs, and maintenance costs exceed the recorded unearned premium reserve, and any future installment premiums on existing policies, a premium deficiency reserve shall be recognized by recording an additional liability for the deficiency, with a corresponding charge to operations.

Paragraph 16 further requires disclosure of premium deficiency reserves on the annual statement.

It is surprising that premium deficiency reserves established under the National Association of Insurance Commissioners’ Statement of Statutory Accounting Principles (SSAP) 53 should be the first Tier III issue because, like their life insurance counterpart, their tax treatment is pretty clear. The regulations provide that unearned premiums do not include additional liabilities established on the annual statement to cover premium deficiencies. Moreover, premium deficiency reserves generally cannot be deducted as another type of insurance reserve. In general, an insurance company is required to use an accrual method of accounting for its deductions for commissions and other policy acquisition costs and for policy maintenance costs. Losses and loss adjustment expenses are deductible on a reserve basis under I.R.C. § 832(b)(5) and § 846(f)(2), but only as a fair and reasonable estimate of the amount relating to claims that already have been incurred. Premium deficiency reserves are not held for incurred claims. Rev. Proc. 2002-466 allows an insurance company to elect to use a reserve method of accounting for certain premium acquisition expenses. For this purpose, a premium acquisition expense is defined as “an expense that is primarily related to the production of gross premiums written on an insurance contract and directly varies with the amount of gross premiums written on the underlying contract.” It is possible that a portion of premium deficiency reserves may be deductible as premium acquisition expenses. But, if this special rule does not apply, it appears that there is very little controversy over the likely resolution of the IRS’ first Tier III issue.