Determining “Premiums Paid” for Purposes of Applying the Premium Excise Tax to Funds Withheld Reinsurance

Since 1917, the federal tax law has included an insurance excise tax. Over the last century, various modifications and refinements have occurred, but the excise tax remains. In its current form, I.R.C. § 4371 imposes an excise tax on policies issued by foreign insurers or reinsurers covering U.S. risks. The rate of tax is 4 percent of each dollar of premium paid for property and casualty insurance and 1 percent of each dollar of premium paid for life, sickness, or accident insurance or for reinsurance. The beneficiary of the policy and any person who issues or sells the policy are jointly and severally liable for the tax, although the Internal Revenue Service (the “IRS”) generally looks to the person making the premium payments for the tax. Certain U.S. income tax treaties waive the excise tax if conditions specified in the treaty are satisfied.

The basic structure of the premium excise tax is simple, but its application to actual transactions can raise difficult questions. One particular area that raises issues is funds withheld reinsurance, a type of indemnity reinsurance. In a funds withheld reinsurance arrangement, the ceding company typically retains the initial premium due the reinsurer, usually in an amount equal to the statutory reserves attributable to the business identified in the reinsurance agreement. The ceding com- pany withholds the funds to permit statutory reserve credit for non-admitted reinsurance, to reduce the ceding company’s potential credit risk, or to retain control over investments. The ceding company and reinsurer establish accounting records that allow the parties to track increases and decreases in the net balance of the funds withheld. The ceding company uses the funds withheld to satisfy obligations of the reinsurer, such as expense reimbursement and the payment of claims. The net balance of the funds withheld increases or decreases over time as the reserves increase or decrease, surplus is repaid, and profit emerges. An investment adjustment is made each period to reflect the fact that the ceding company is holding the reinsurer’s assets.