Several domestic insurance companies, spearheaded by Chubb Corp. and Hartford Financial Services Group, Inc., are seeking changes in the U.S. Tax Code that could result in adverse economic impacts for risk retention groups and group captives. Proposed legislation contained in H.R. 4192 seeks to eliminate the competitive advantage that certain foreign companies with domestic affiliates have over U.S. companies.

This advantage arises because such foreign companies write business through a U.S. licensed affiliate and reinsure a portion of such business with a foreign reinsurance affiliate in countries that have a lower effective tax rate than the United States. As a result of this concern, these domestic insurers have sought to have legislation enacted which would, in their view "level the playing field." This has been countered by a number of offshore insurers and domestic purchasers of insurance who have argued that, among other things, the proposal: (i) is intended to gain a competitive advantage for those complaining domestic insurers, as the federal excise tax on reinsurance is designed to tax cessions of premium covering U.S. risk to foreign insurers; (ii) seeks to target reinsurers domiciled in offshore jurisdictions; and (iii) could adversely affect capacity and pricing.

Initially, a proposal was made to increase the federal excise tax on reinsurance ceded from a U.S. licensed insurance company to a foreign reinsurer provided that the U.S. licensed company was at least 25 percent owned by the same foreign corporate group that controlled the reinsurer. That proposal, however, has apparently been abandoned and a new one developed which seeks to impute income back to the U.S. ceding company based on the reserves it maintains with regard to the ceded business. The proposal would apply if that business is ceded to a reinsurer under common control with the U.S. licensed company. Alternatively, the ceding company can elect to include in its income the taxable income of foreign reinsurer to which it cedes business.

The new proposed provisions would be contained in proposed Section 845(c) of the Internal Revenue Code. The following comments relate to these provisions:

First, the rules are relatively clear that they are intended to apply only to U.S. risks, i.e., risks relating to property in the U.S., a liability arising out of activity in the U.S., or in connection with the lives or health of U.S. persons. If enacted, it may be advisable for insurers that are writing policies providing world-wide coverages for a single insured to provide separate policies for U.S. and non-U.S. coverages. Similar advice is also often provided currently as a way of minimizing the Federal insurance premiums excise tax.

Second, the provision relates to a domestic person that directly or indirectly reinsures with a related foreign reinsurer. Thus, the statute intends to cover situations in which one or more intermediate reinsurers are involved. Given the language of the statute, however, and its intent, the "imputation" of investment income would presumably only apply to that portion of the reserve on the U.S. company's books that related to the risk ultimately assumed by the related foreign insurer. For practical purposes, however, this provision may in some circumstances be difficult to monitor. Thus, for example, where a foreign insurer participates in a treaty in which another reinsurer has written business of a U.S. affiliate, the U.S. person may not know or be able to determine that a portion of the business is being ceded indirectly to its foreign affiliate. Any attempts by IRS to audit cessions in and out of intermediate companies that have no other U.S. connection may not be met with favor by the home jurisdiction.

Third, no federal excise tax is due on the portion of the premium ceded to the related party. This is an interesting provision in certain limited circumstances. Thus, for example, if a domestic company writes a larger than anticipated book of property or other short-tail business early in the year and wants to cede it to its foreign affiliate, the provision may in fact create a benefit. Since the imputation of investment income is based on the NAIC statement, and reserves on the above-described book of business will likely be low at the end of the year, the cession can be made without the burden of a 1% federal excise tax. Also, domestic ceding companies with net operating loss (NOL) carry-forwards may not be put off by the income imputation.

Fourth, the new version of the proposal includes several logical exceptions. Thus, if the foreign reinsurer makes a domestic election under Section 953(d) of the Internal Revenue Code of 1986, as amended, the provisions do not apply. The Subpart F exception is intended to provide that if the income is taxed to U.S. shareholders under the Subpart F provisions, the provisions of the section will not apply. One would have expected the provision to read: "... include under subpart F [all of] the income attributable to reinsurance of the United States risks ceded to the related foreign reinsurer." It is curious that the words "all of" are not included in the statute, giving rise to questions as to whether the exception applies if, for example, a foreign person owns more than 50% of the U.S. ceding company and 40% of the foreign entity, but a U.S. company owns 60% of the foreign reinsurer and none of the ceding company.

The statute applies to a reinsured and reinsurer that are commonly controlled by applying the principles of section 482. The regulations interpreting that provision describe "controlled" as follows:

Thus, the "control" test is very broad and could well be extended to include entities in which the common owner has less than a 50% interest. In the example above the question arises whether the exception would apply because a U.S. person includes in income a part of but not all of "the income attributable to the reinsurance of the United States risks ceded to the foreign reinsurer..." That is, can the income imputation be "washed away" by the presence of an unrelated "U.S. shareholder?" The final exception applies if the domestic cedant agrees to pay tax on all reinsurance ceded — not only that ceded to the related party.

Fifth, the definition of foreign insurer applies the new provision to any foreign person assuming U.S. risks, unless it is established to the satisfaction of the Secretary of Treasury that it is subject to an effective income tax rate greater than 20% of the maximum rate applicable to domestic corporations — i.e., 7%. The calculation of the tax rate must be done using U.S. tax principles. Thus, it would appear, as argued by a number of offshore entities, that the draftsperson was attempting to target those offshore jurisdictions which impose no local income tax on exempt insurers and reinsurers.

Finally, the statute is to become effective for all tax years ending after the date of enactment. Thus, for example, enactment in December makes the provision applicable to all of the year's cessions as all domestic ceding companies report on a calendar year. This provision also may make for some difficulty in making the allowed election if it is to be retroactive.

The question arises as to how this proposal might apply to a risk retention group. Although most RRGs are either directly owned by their members or by a domestic holding company owned by their members, structures have developed that do not seem to be affected by these proposals.

Thus, if a group captive domiciled in an offshore jurisdiction formed an insurance subsidiary in the United States to write only U.S. liability risks, and with respect to which the owners of the group captive were all insureds of the insurance subsidiary and all insureds of the insurance subsidiary were owners of the group captive — the insurance subsidiary would qualify as an RRG which could then register and solicit member/insureds. Such a company could cede business to the group captive which could provide reinsurance support.

In most cases, the group captive would be a controlled foreign corporation by virtue of the related person insurance income rules under Subpart F of the Internal Revenue Code of 1986, as amended, because more than 20 percent of the income would be derived from shareholder insureds (see Section 953(c)(3)(A) of the Code). Accordingly, the income derived from reinsurance placed with the group captive from the RRG would be taxable to the U.S. shareholders of the group captive and the Subpart F exception to the new proposed legislation would likely apply. Similarly, group captives which had made the section 953(d) election to be taxed as a domestic corporation also would fall within a legislative exception. However, to the extent that the proposal increases the cost of reinsurance, it could boost rates or decrease reinsurance capacity available to RRGs and group captives.