On December 11, 2009, the Internal Revenue Service released two substantially identical Private Letter Rulings, PLRs 200950016 and 200950017, which approve the use of a captive reinsurance arrangement involving a fronting insurer. These rulings are significant in that they confirm and, in at least one respect, extend positions set forth by the IRS in revenue rulings issued in the past several years.
In the facts of each PLR, a group of individuals formed a domestic captive reinsurer (the Company) which ultimately reinsured certain risks of two groups of entities. One group of entities (the related entities) was owned by the shareholders of the Company; the other group of entities (the unrelated entities) was unrelated to the Company. The risks of each entity were insured by a fronting insurer; portions of the insured risk were reinsured by two intermediate reinsurers before being ultimately reinsured by the Company.
The PLRs held that the Company's captive reinsurance arrangement constituted insurance for tax purposes, applying the definition of insurance enunciated in the seminal 1941 Supreme Court case of Helvering v. LeGierse, 312 U.S. 531 (1941). The Court stated in LeGierse that, in order for an arrangement to constitute insurance for tax purposes, risk shifting and risk distribution must be present.
Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer such that a loss by the insured is offset by a payment from the insurer. The PLRs found risk shifting present in the initial insurance contracts between the fronting insurer and the insured entities.
Risk distribution incorporates the statistical phenomenon known as the law of large numbers. The PLRs state that "Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums." In this regard, the PLRs note that there were multiple insureds in the same industry with substantially identical policies, none of which controlled the Company, and that there were a "sufficient number" of unrelated insureds such that no one insured was paying for a significant portion of its own risks. As a result, the PLRs concluded that risk distribution was present.
The PLRs do not specify the total number of insured entities or the breakdown between the related entities and unrelated entities. In determining that the number of unrelated insureds was sufficient to result in risk distribution, the IRS presumably applied Revenue Ruling 2005-40. In that ruling, the IRS held that exposure to homogeneous risks of at least twelve unrelated insureds would be sufficient to establish risk distribution. On the right facts, however, it would seem that a sufficient number of related insureds would also create risk distribution, based on the IRS's conclusion in Revenue Ruling 2002-90. That ruling held that an arrangement similar to the one described in Rev. Rul. 2005-40, but among affiliated entities (a so-called brother-sister captive), constitutes insurance. It is possible that the IRS also could consider a combination of related and unrelated insureds to satisfy the risk distribution standard.
The PLRs held that risk distribution with respect to the ultimate insureds created risk distribution for the Company, even though the Company reinsured risk of only one entity, the second intermediate reinsurer. In so doing, the PLRs implicitly applied Revenue Ruling 2009-26. In Revenue Ruling 2009-26, the IRS held that a reinsurer could establish risk distribution where it reinsured risks of a single insurer, provided risk distribution existed with respect to the ultimate insureds.
The PLRs' discussion of risk shifting and risk distribution makes no mention of the various layers of reinsurance in the structure, apparently holding that the several cedings of insured risk did not affect the risk shifting or risk distribution analysis. In this regard, the PLRs extend the holding of Revenue Ruling 2009-26, in which the reinsurer had a direct relationship with the insurer.
Finally, the PLRs assess whether the Company is an insurance company taxable under section 831 of the Internal Revenue Code. For this purpose, an insurance company includes any company more than half of the business of which is the issuing of insurance contracts or the reinsuring of risks underwritten by insurance companies. The PLRs assumed that the fronting insurer and the intermediate reinsurers were insurance companies for this purpose, and the Company represented in the PLRs that its sole business was the reinsuring of risks pursuant to its reinsurance arrangement with the second intermediate reinsurer. As a result, the PLRs concluded that the Company was an insurance company for federal income tax purposes.
A private letter ruling such as the PLRs constitutes binding authority only for the taxpayer to whom it is issued. Nonetheless, such a ruling is viewed as expressing the current views of the IRS with respect to the subject matter of the ruling.