Does the Tax Law Require That Statutory Reserves Be Backed By Assets?

In Aug. 29, 2014, the Internal Revenue Service (IRS) released Private Letter Ruling 201435011 (May 16, 2014), which addresses the computation of “losses incurred” under Section 832(b)(5) and the statutory cap on discounted unpaid losses under Section 846(a) (3). Although the letter ruling involves a nonlife insurance company in rehabilitation, life insurers may find it useful in determining the statutory reserve cap under Section 807(d). In particular, the letter ruling supports the position that the computation of an insurer’s statutory reserve cap does not depend on the nature or quality of assets, or even whether there are assets, supporting reserves accepted by a life insurer’s regulator on the annual statement.

Stated Facts

The taxpayer in the letter ruling wrote insurance policies with respect to a particular business and ultimately incurred significant losses on certain of those policies. After those losses were incurred, the taxpayer voluntarily stopped writing new policies. The taxpayer’s regulator then issued an order suspending further payment on any policy claims and prohibiting the taxpayer from writing any new policies.

The taxpayer’s parent commenced a bankruptcy proceeding. The bankruptcy court ordered the appointment of a rehabilitator for the taxpayer and began a court-supervised rehabilitation proceeding. A rehabilitation plan was ultimately approved that provided that when a policyholder makes a valid claim under a policy, the claim will be divided into a portion that will be paid currently and a portion that may be paid in the future. More specifically, the taxpayer will pay promptly a portion of the claim in cash based on the cash payment percentage in effect at the time; the remaining portion of the claim will be deferred, and may become payable in the future depending on the taxpayer’s financial performance and condition. In accordance with the rehabilitation plan and the regulator’s guidelines under that plan, the taxpayer will adjust its statutory accounting treatment of the restructured policies to establish and maintain a “minimum surplus amount” that will be reflected on its annual statement. The letter ruling does not describe the reason for the maintenance of this amount, but presumably the taxpayer lacked sufficient assets to cover all of its losses and the regulator wanted to ensure it maintained a certain level of surplus. In any case, the reporting of the minimum surplus amount ultimately decreases the amount of undiscounted unpaid losses reported on the taxpayer’s annual statement.

Relevant Law

Taxable income for nonlife insurance companies includes “the combined gross amount earned during the taxable year, from investment income and from underwriting income ... computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners.” Underwriting income equals the premiums earned on insurance contracts during the taxable year less losses and expenses incurred. Losses incurred include the increase or decrease during the year in discounted unpaid losses (as defined in Section 846), which are determined by discounting the unpaid losses shown on the insurer’s annual statement. Innoevent, however, may the amount of discounted unpaid losses exceed the amount of unpaid losses included on the annual statement (i.e., the statutory cap on discounted unpaid losses).