Colonial American Life Ins. Co. v. C.I.R.

Decision Date26 April 1988
Docket NumberNo. 87-4492,87-4492
Citation843 F.2d 201
Parties-1143, 88-1 USTC P 9307 COLONIAL AMERICAN LIFE INSURANCE COMPANY, Petitioner-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
CourtU.S. Court of Appeals — Fifth Circuit

Nancy G. Morgan, Michael C. Durney, Acting Asst. Atty. Gen., Tax Div., Michael L. Paup, Chief, Gary R. Allen, William S. Rose, Jr., Acting Asst. Atty. Gen., Appellate Section, Dept. of Justice, William F. Nelson, Chief Counsel, I.R.S., Washington, D.C., for respondent-appellant.

Thomas G. Nash, Jr., Dallas, Tex., for petitioner-appellee.

Jack H. Blaine, Wm. T. Gibb, Carolyn P. Chiechi, Margaret Milner Richardson, Washington, D.C., for amicus curiae (ACLI).

W. Roy Woodall, Jr., Washington, D.C., for amicus curiae (NALC).

Appeal from the Decision of the United States Tax Court.

Before GARZA, REAVLEY and DAVIS, Circuit Judges.

GARZA, Circuit Judge.

I

Colonial American Life Insurance Company is a life insurance company that sells life, accident and health insurance. This action was brought by Colonial after the Commissioner of Internal Revenue disallowed Colonial's deductions of "ceding commissions" incurred in 1975 and 1976. 1 The Tax Court rejected the Commissioner's disallowance of Colonial's deductions, holding that amounts paid by a reinsuring company (Colonial) to an initial insurer (Transport) under a contract for indemnity reinsurance may be deducted in the year incurred and not amortized over the anticipated useful life of the policies. We are reversing the Tax Court.

Before considering the narrow tax question involved in this case, it is necessary to first understand the nature of an indemnity reinsurance contract and its relationship to other forms of reinsurance transactions. Reinsurance is an arrangement whereby an insurance company transfers some or all of the risks it has underwritten to another insurance company. 2 The company purchasing the reinsurance is known as the initial insurer, the reinsured, or the ceding company; the company acquiring the risk is known as the reinsurer or the reinsuring company.

There are basically two types of reinsurance--assumption reinsurance and indemnity reinsurance. In assumption reinsurance, the reinsuring company takes over for the initial insurer and becomes directly liable to the policyholders. The initial insurer is relieved of all liability, including the maintenance of the required reserves. The reinsuring company has the duty of establishing and maintaining the required reserves. In addition, the reinsuring company is entitled to all premiums paid and must pay all future claims and expenses with respect to the policies.

With respect to indemnity reinsurance, two variations are relevant here: conventional coinsurance and modified coinsurance. In an indemnity reinsurance contract the initial insurer and the reinsuring company share the benefits and obligations arising out of the reinsured policy or contract. Furthermore, the initial insurer will transfer to the reinsuring company all or part of its liability on the policies being reinsured. The initial insurer remains directly liable to the policyholders and continues to collect premiums and to pay claims and expenses. The reinsuring company will then reimburse the initial insurer for the claims and expenses attributable to the risks it has reinsured.

Conventional and modified coinsurance significantly differ in their effect on the reserves of the insurance companies involved. Essentially, reserves are liability accounts representing the present value of the company's net liabilities under the policies in force. Life insurance companies are required to maintain reserves in an amount equal to the excess of the present value of future benefits payable under the policies over the present value of future net premiums. Such liability must be backed by cash or other assets of the insurance company. In a conventional transaction, the initial insurer reduces its reserves by the amount attributable to the ceded liability. The reinsuring company will then establish reserves to cover that liability acquired. In a modified coinsurance transaction the initial insurer maintains the required reserves and merely collects and pays over to the reinsurer the investment income derived from the assets supporting the reserves.

In conventional and modified coinsurance two exchanges take place: (1) the initial insurer pays the reinsuring company full consideration for the reserve liability assumed, and (2) the reinsuring company pays the initial insurer a "ceding commission" or an "initial allowance" for the business acquired. Insurance companies typically net these transactions, with only the excess amount changing hands. Thus, the reinsuring company has income equal to the reserve liability actually assumed even though such liability exceeds the consideration actually received. This appeal centers primarily over the proper characterization of ceding commissions for the purposes of the Internal Revenue Code. In this case, the ceding company, Transport entered into both conventional and modified coinsurance agreements with the reinsuring company, Colonial.

Under the conventional agreement, Colonial agreed to reinsure three percent of Transport's liabilities on a block of whole life insurance policies in return for a three percent of future premium income from those policies. The agreement called for an initial consideration (ceding commission) in the amount of $60,000 payable to Transport for the right to receive the future income generated by the reinsured policies, and for an additional consideration (reinsurance premium) in the amount of $675,762 3 payable by Transport to Colonial for assuming a share of Transport's reserve liability with respect to the reinsured policies.

Under the modified agreement, Colonial reinsured an additional 31 percent share of the same block of life insurance policies, and agreed to pay Transport an additional ceding commission of $620,000 as consideration for the right to a proportionate share of Transport's future income of the policies. Unlike the conventional agreement, the modified agreement did not call for an initial reinsurance premium to cover a proportionate share of the reserves on the reinsured policies since no portion of those reserves was shifted to Colonial under this agreement. After netting the amounts payable to each party, $4,238 (without interest) was paid by Colonial to Transport on December 29, 1985. Colonial also paid a finder's fee of $13,600.

On July 1, 1976, a second pair of conventional and modified coinsurance agreements were made with Transport by Colonial as reinsurer. The conventional agreement covered an additional 3.6 percent share of the block of policies. It provided for a ceding commission of $72,000 payable to Transport by Colonial in return for a proportionate share of the future premium income from the block of policies, and a reinsurance premium of $851,398 4 was paid by Transport to Colonial for assuming Transport's liability for the reserves attributable to the 3.6 percent share of the reinsured policies.

Under the modified agreement, Colonial acquired an additional 39 percent share of the block of policies and agreed to pay consideration of $780,000 as a ceding commission to Transport for the right to a 39 percent of Transport's future premium income. No reserves were shifted to Colonial, therefore no initial reinsurance premium was required. After netting the amounts payable to each party, $602 (without interest) was paid by Colonial to Transport on October 5, 1976.

Transport retained all the records regarding the block of policies and continued to process and pay all claims. Transport was to pay Colonial its percentage of the income from the reinsured policies under the new insurance agreements and Colonial was to then reimburse Transport for that portion of the expenses and benefit payments attributable to Colonial's share of those policies. Transport was also to have the right to regain the business on a scheduled basis.

In both the 1975 and 1976 modified coinsurance agreements, Colonial and Transport consented to the application of the rules for the optional tax treatment of policies reinsured as provided by section 820 of the Internal Revenue Code of 1954 (26 U.S.C.) and Section 1.820-2 of the Treasury Regulations on Income Tax (26 C.F.R.). 5 As a result, Transport's retention of the reserves applicable to taxpayer's share of the reinsured policies was treated...

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