Reinsurance Regulation

Petitioner, a captive insurer domiciled in Anguilla, applied to be a tax-exempt small insurance company under IRC section 501(c)(15), and filed returns on this basis, making an election under IRC section 953(d). The Tax Court concluded this characterization was not appropriate, that Petitioner was not a bona fide insurance company, and that Petitioner should instead be treated as a foreign corporation.

The Tax Court found the reinsurance agreements did not allow Petitioner to effectively distribute risk, and in the absence of risk distribution, “a necessary component of insurance” Petitioner’s transactions were not insurance transactions.

Reserve Mechanical Corp. v. Commissioner of Internal Revenue, Docket No. 14545-16 (U.S. Tax Court June 18, 2018)

This post written by Nora A. Valenza-Frost.

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A tax court judge in New Jersey has handed Johnson & Johnson (J&J), and likely other New Jersey-based businesses that operate captive insurers, a significant loss in an opinion interpreting the federal Nonadmitted and Reinsurance Reform Act (NRRA) and related changes to New Jersey law regarding taxes on insurance premiums.

For the last 10 years, New Jersey has imposed what the court called a self-procurement tax on insurance premiums paid to captive insurers, and J&J, which has its headquarters in New Jersey and pays significant premiums to a captive insurer, pays such taxes. Initially, those taxes were based only on the premiums paid for risks located in New Jersey. After the passage of the NRRA and certain related changes to New Jersey law, the New Jersey Department of Banking and Insurance took the position that J&J must pay taxes to New Jersey on all the premiums it paid its captive insurer for U.S. risks. J&J filed a claim challenging this interpretation and seeking a refund of almost $56 million, alleging that both the NRRA and the changes to New Jersey law applied only to surplus lines business, and not to self-procured insurance.

The court disagreed. The NRRA provides that “no state other than the home state of an insured may require any premium tax payment for nonadmitted insurance.” This meant that New Jersey, which was previously able to tax premiums paid by out of state companies to nonadmitted insurers for risks located in New Jersey, could now only tax such premiums paid by businesses which New Jersey was their home state. The court rejected J&J’s argument, which was largely based on legislative history, that “nonadmitted insurance” as used in the NRRA does not include captive insurers. The court agreed with J&J, however, that the language of the changes to New Jersey law made it appear that only surplus lines insurance was covered by New Jersey’s adoption of the home state rule. And yet, after balancing what it called “the precise language” of the statute “against its true legislative intent,” the court found itself “convinced that the New Jersey Legislature intended to include self-procured insurance in the adoption of the Home State Rule because it intended to include all nonadmitted insurers, and not to limit it to only surplus lines.” This legislative intent thus trumped the “precise language,” and the court found that J&J must pay the tax on all premiums for risks located in the United States.

Johnson & Johnson v. Dir., Div. of Taxation & Comm’r, Docket No. 13502-2016 (June 15, 2018)

This post written by Jason Brost.

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Rhode Island has amended its laws related to voluntary restructuring of insurers and protected cell companies to allow for domestic insurance companies to enter into a voluntary restructuring, including the use of a protected cell, with the approval of the commissioner. The law now defines voluntary restructuring as “the act of reorganizing the legal ownership, operational, governance, or other structures of a solvent insurer, for the purpose of enhancing organization and maximizing efficiencies, and shall include the transfer of assets and liabilities to or from an insurer, or the protected cell of an insurer pursuant to an insurance business transfer plan. A voluntary restructuring under this chapter may be approved by the commissioner only if, in the commissioner’s opinion, it would have no material adverse impact on the insurer’s policyholders, reinsureds, or claimants of policies subject to the restructuring.” R.I. H8163A (eff. July 2, 2018).

This post written by Michael Wolgin.

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In this case, Reserve Mechanical Corp. (“Reserve”), a captive insurer incorporated under the laws of Anguilla, sued the Commissioner of Internal Revenue in the U.S. Tax Court regarding the Commissioner’s findings of $477,261 in deficiencies in Reserve’s federal income tax for the tax years 2008 through 2010. During those years, 100% of Reserve’s stock was owned by Peak Casualty Holdings LLC (“Peak”), a Nevada limited liability company.

The U.S. Tax Court held that Reserve failed to qualify as an insurance company for federal income tax purposes under the Internal Revenue Code section 501 (a), (c)(15), which provides for the tax-exempt treatment of income received by insurance companies that meet certain criteria. Because Reserve did not qualify as an insurer, the Court also determined that Reserve is not eligible to make an election under section 953 to be subject to U.S. federal income tax as a U.S. company.

In determining whether Reserve could be considered an “insurance company,” the U.S. Tax Court looked at risk distribution, focusing on the number of insureds and the number of risk exposures to determine whether Reserve distributed risks. For 2008, Reserve issued 13 direct written insurance policies with Peak and two other named insureds. For 2009, Reserve issued 11 policies and, for 2010, Reserve issued 11 policies involving the same parties. The policies covered between $8 and $13 million in potential losses. Each policy listed PoolRe Insurance Corp. as the stop loss insurer. For each of the years at issue, Reserve and PoolRe executed a joint underwriting stop loss endorsement, which by its terms applied to all of the policies Reserve issued. PoolRe executed reinsurance agreements designed to redistribute them to entities of Capstone Partners, a Texas limited partnership. For each of the tax years, the Court noted that Reserve and the Capstone entities each executed a quota share reinsurance policy with PoolRe, and Reserve also executed a credit insurance coinsurance contract with PoolRe, under which Reserve agreed to assume a small portion of risk that PoolRe had agreed to assume from an unrelated company, CreditRe Reassurance Corp. Ltd.

As for the direct policies, the Court found that ‘‘the number of insureds and the total number of independent exposures were too few to distribute the risk that Reserve assumed.’’ The Court held that it was not a bona fide insurance company and that there was no legitimate business purpose for the policies that Reserve issued for the insureds, noting: ‘‘[t]he direct written policies increased Peak’s insurance coverage and expenses for the tax years in issue, when it also continued to hold policies with third-party insurers. In the light of all the facts and circumstances the premiums charged for the policies were unreasonable.’’ Therefore, the Court ruled that Reserve’s transactions were not insurance transactions. The Court also found that Reserve’s quota share policies with PoolRe were not bona fide insurance agreements because the quota share arrangement involved ‘‘a circular flow of funds’’ and that the ‘‘premiums were not negotiated at arm’s length.’’ The Court noted that it found no evidence that the premiums the insureds paid PoolRe and the premiums that PoolRe paid Reserve ‘‘were actuarially determined.’’ Thus, the Court held that PoolRe’s activities as they relate to the policies were not those of a bona fide insurance company.

Therefore, as a result of its finding that Reserve did not qualify as an “insurance company”, the Court held that for the tax years at issue, Reserve is not eligible to make an election under section 953(d). Thus, the Court concluded that Reserve was subject to the 30 percent withholding tax on the premium it had received under section 881 (a) of the Internal Revenue Code and that Reserve did not provide proof to the court that these amounts should not be considered fixed, determinable, annual, periodical income. The Court rejected Reserve’s contention that the amounts it received during the tax years were capital contributions or nontaxable deposits. It also found that Reserve is not entitled to deductions, explaining that Reserve failed to establish that ‘‘it was engaged in or received income treated as income effectively connected with a trade or business within the United States.’’

Reserve Mechanical Corp. v. Commissioner of Internal Revenue, No. 14545-16 (U.S. Tax Ct. June 18, 2018).

This post written by Jeanne Kohler.

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