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Merit Life Insurance Co. v. Commissioner of Internal Revenue

decided: August 11, 1988.


Appeal from the Decision of the United States Tax Court. No. 13441-78--Julian I. Jacobs, Judge.

Walter J. Cummings, Harlington Wood, Jr., Circuit Judges, and Hubert L. Will, Senior District Judge.*fn*

Author: Will

WILL, Senior District Judge.

This appeal involves the tax consequences of a general practice in the insurance industry called reinsurance. For any number of reasons, insurance companies transfer all or part of the risk of a block of policies, under which they are the original insurer, to another insurance company, the reinsurer, in exchange for, among other things, a commission. The original insurer is known as the reinsured or ceding company and commissions paid by the reinsurer (or retained by the reinsured) are called ceding commissions. There are two general types of reinsurance: indemnity and assumption. At issue is the tax treatment for ceding commissions in indemnity reinsurance transactions.

In indemnity reinsurance, the ceding company does not relinquish any of its contractual interest in the policies it issued and remains directly liable to the policy holders. No relationship, contractual or otherwise, exists between the reinsurer and the policy holders. The ceding company pays the reinsurer a percentage of the premiums it received, upon issuance of the policies, proportional to the risk assumed by the reinsurer, which may be part or all of the total risk. The ceding company continues to pay claims and expenses and collect premiums, and pays the reinsurer a percentage of the future premiums again based on the risk transferred. In exchange, the reinsuring company reimburses (indemnifies) the ceding company for its share of the claims and expenses attributable to the risk reinsured and pays (or the ceding company retains) a ceding commission.

State laws and regulations require that an insurance company maintain a reserve, in cash or other assets, reflected as a liability for accounting purposes, representing the excess of the present value of future benefits payable under the life insurance policy over the present value of future net premiums received. The amount of the reserve changes over the life of a policy and the reserve may not be used for other corporate purposes, such as distributing dividends to shareholders. However, the reserve may be invested to produce interest income. Indemnity reinsurance reduces the reserve required of the ceding company and increases the reserve required of the reinsurer, based on the proportion of the risk transferred to the reinsurer.*fn1

In contrast, assumption reinsurance involves the purchase of a block of insurance policies by the reinsurer from the original insurer at which point the reinsurer assumes all of the original insurer's risks and obligations and becomes directly liable to the policy holders. The original insurer is then relieved of all liability under the policies and the policy holders are informed that henceforth they are insured by the reinsuring company and all future premiums are to be paid and claims made to the reinsurer. The reinsurer pays all future claims, commissions, expenses and taxes. In addition, the reinsurer assumes the entire reserve liability, thereby reducing the ceding company's reserve liability. The purchase price is normally greater than but includes a commission to the selling company. The reinsurer simply purchases the policies and steps into the shoes of the ceding or selling company.

This case involves indemnity reinsurance. Merit Life Insurance Company ("Merit"), petitioner-appellee, an Indiana corporation, reinsured (agreed to indemnify) specified percentages, but not 100%, of five blocks of insurance policies, four of which were originally insured by American General Life Insurance Company of Delaware and one by American General Life Insurance Company of New York (both original insurers are hereinafter referred to as "American General"). American General paid "reinsurance premiums" to Merit, in an amount equal to the reserves Merit was required to carry on the policies less ceding commissions payable by Merit to American General.*fn2

In addition, under the terms of the contracts, American General agreed to transfer a specified percentage of the gross premiums thereafter received on the reinsured policies and Merit agreed to pay American General for its share of commissions, premium taxes and other expenses incurred by American General. Finally, each contract provided that American General could recapture the reinsured policies on specific dates.

During the tax years in question, 1973-75, Merit claimed a tax loss, under 26 U.S.C. § 809(b) (section 809(b) of "the Code"),*fn3 on each of the indemnity reinsurance contracts because the reserves required and expenses incurred with respect to each contract exceeded the reinsurance premiums Merit received from American General. Specifically, Merit recognized as gross income the consideration (reinsurance premiums) deemed received from American General for assuming reserve liabilities, pursuant to section 809(c)(1), and deducted the same amount as the reserve liability, pursuant to section 809(d)(2). Merit also deducted the ceding commissions paid to (or retained by) American General from its gross premiums (gross income), pursuant to section 809(c)(1).*fn4 Since these amounts exceeded the gross premiums, Merit reported a loss for the transactions which it used to offset gains from other operations during those years.

The Commissioner of Internal Revenue ("Commissioner"), respondent-appellant, found deficiencies in Merit's declared federal income taxes based on Merit's current deduction of all the ceding commissions in the tax years in which it issued the indemnity reinsurance.*fn5 The Commissioner determined that the ceding commissions must be amortized over the anticipated lives of the reinsurance contracts (between 57 and 64 months) because, according to the Commissioner, the reinsurance contracts are intangible assets with useful lives or more than one year.*fn6

Merit petitioned the United States Tax Court for a redetermination of the deficiencies. The case was submitted to the Tax Court without a trial and resolved based on the parties' stipulated facts and exhibits. The Tax Court, relying on its earlier opinion in Beneficial Life Insurance Co. v. Commissioner, 79 T.C. 627 (1982), reversed the Commissioner and held that in indemnity reinsurance arrangements the ceding commissions are deductible in full in the year in which the indemnity reinsurance is issued. Merit Life Insurance Company v. Commissioner of Internal Revenue, 1986 T.C. Memo 476, 52 T.C.M. (CCH) 638 (1987).

The Tax Court reaffirmed its view that an indemnity reinsurance transaction is not the purchase of an asset, but rather the sale of insurance by the reinsuring company to the ceding company. Accordingly, the Tax Court, as it had in Beneficial Life, viewed the ceding commissions paid by the reinsuring company (or retained by the reinsured) as analogous to currently deductible underwriting expenses such as agents' commissions paid by an original insurer on the issuance of a policy and reversed the Commissioner's disallowance of their deduction. The Commissioner appeals the Tax Court's ruling. We affirm.

Standard Of Review

As noted above, the Tax Court's decision was based on stipulated facts and exhibits. The court's holding that the ceding commissions in an indemnity reinsurance transaction are immediately deductible, based on uncontested facts, is a conclusion of law. Accordingly, we review the record de novo. United Fire Insurance Company v. Commissioner of Internal Revenue, 768 F.2d 164, 167 (7th Cir. 1985). See also Vukasovich, Inc. v. Commissioner of Internal Revenue, 790 F.2d 1409, 1413 (9th Cir. 1986) ("A general rule of special deference to the Tax Court is inappropriate although its judgments in its field of expertise are always accorded a presumption that they correctly apply the law."); 26 U.S.C. § 7482(a) (1982).


The Commissioner asked the Tax Court and now asks us to reconsider Beneficial Life. The Tax Court in Beneficial Life distinguished indemnity reinsurance from assumption reinsurance by deeming the former to be the "issuance of insurance," for which ceding commissions are immediately deductible, and the latter to be the "acquisition of an asset," for which ceding commissions must be amortized. 79 T.C. at 648. The Commissioner acknowledges that the distinction between assumption and indemnity reinsurance is significant to the policy holders and the ceding company but argues that it does not alter the reinsurer's position and should not create distinct tax consequences. According to the Commissioner, in both cases the reinsurer pays consideration (ceding commissions) for the right to receive future profits (reinsurance premiums) and, following the tax principle of matching expenses incurred (year by year) with income generated, see Commissioner v. Idaho Power Co., 418 U.S. 1, 12, 41 L. Ed. 2d 535, 94 S. Ct. 2757 (1974), the consideration must be amortized.

Merit argues that indemnity and assumption reinsurance are different and must be treated differently for tax purposes. It points out that the Code specifically treats both differently and the Tax Court recognized this in Beneficial Life. Although this distinction may not achieve a direct matching of income and expenses for tax purposes, the Code and treasury regulations provide for it. The same is true, it should be noted, as to the deduction of all commissions paid on the sale of insurance.

The court in, Beneficial Life specifically rejected the Commissioner's argument that ceding commissions in indemnity reinsurance transactions must be amortized:

Respondent [Commissioner] cites to us numerous cases which required capitalization and amortization of acquisition expenses. However, such cases apply when an asset is acquired, not when insurance is sold. Although a reinsuring company does acquire an asset in a broad sense in the form of potential future profit, such is also true when an insurance company issues a single policy to an individual. Yet, the expenses related to that policy are currently deductible. While respondent's argument is appealing, it does not comport with how life insurance companies are taxed with respect to insurance they issue. In essence, respondent argues indemnity ...

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