Tax Treatment of Reinsurance

Study guide: Exam 6U

The Tax Treatment of Reinsurance is how cessions, recoveries and commutations flow into a U.S. P&C insurer's federal taxable income. Because the tax computation starts from the annual statement (Insurance Income Tax), reinsurance generally follows its statutory treatment — ceded premium reduces premium, recoveries reduce losses incurred — but unpaid losses enter at their discounted tax value, so the tax result of a reinsurance transaction, a commutation above all, can differ sharply from its statutory result.

$\Delta\text{Taxable income}_{\text{cedant}} = \text{Price} - d_c \times \text{Recoverable}$

$\Delta\text{Taxable income}_{\text{reinsurer}} = d_r \times \text{Reserve} - \text{Price}$

These are the effects of a commutation at a given price, where $d_c$ and $d_r$ are each party's §846 discount factors on the commuted reserves (Loss Reserve Discounting). The statutory result uses the same formulas with $d = 1$ , so a commutation priced near present value produces a statutory loss for the cedant and gain for the reinsurer far larger than their taxable counterparts.
Statutory accounting of the commutation (SSAP No. 62R): the cedant eliminates the recoverable and records the cash received as a negative paid loss; the reinsurer eliminates a reserve carried at ultimate for a payment made at present value; both book the difference in underwriting income. Commuted balances are written off through the schedules where they were recorded, which distorts both parties' Schedule P triangles.
Why the two factors differ. IRS discount factors vary by line and accident year. A cedant carries ceded excess-of-loss reserves under the underlying line, while the reinsurer reports them as non-proportional assumed reinsurance, which has its own payment pattern — so even an agreed price gives asymmetric tax results. Since the 2017 TCJA both parties must use the IRS patterns.
Current versus deferred. Total tax expense (current plus deferred) equals the tax rate times the book gain or loss; discounting decides only how much is current and how much is a change in the deferred tax asset on the reserve discount. Under SAP the deferred part goes directly to surplus and must pass the admissibility test.
Other rules to recognise: ceded unearned premium reduces the net UPR on which the $20\%$ revenue offset is computed; a $1\%$ federal excise tax applies to reinsurance premiums paid to foreign reinsurers unless an exemption applies; §845 lets the IRS reallocate items under reinsurance between related parties, or under any contract with a significant tax avoidance effect; and for large groups the base erosion and anti-abuse tax (BEAT) can reach reinsurance premiums ceded to foreign affiliates.

Tax Effect of a Commutation A cedant carries a $\$500$ recoverable (undiscounted) on the commuted business; the reinsurer carries a $\$550$ reserve for the same claims. They commute for $\$400$ . The cedant's §846 discount factor on these reserves is $0.875$ ; the reinsurer's, on its non-proportional assumed line, is $0.85$ . Both pay tax at $21\%$ .

Compute each party's statutory and taxable result, and split its tax effect into current and deferred.
Answer Statutory (undiscounted):
 $\begin{align*} \text{Cedant} &= 400 - 500 \\ &= -100 \\ \text{Reinsurer} &= 550 - 400 \\ &= 150 \end{align*}$ 
Taxable (discounted):
 $\begin{align*} \text{Cedant} &= 400 - 0.875(500) \\ &= -37.5 \\ \text{Reinsurer} &= 0.85(550) - 400 \\ &= 67.5 \end{align*}$ 
Cedant: current tax falls by $0.21 \times 37.5 = 7.875$ . Its net reserves rise by the $\$500$ it takes back, of which the tax basis recognises $\$437.5$ , so its deferred tax asset rises by $0.21 \times 62.5 = 13.125$ . Total benefit $7.875 + 13.125 = 21.0 = 0.21 \times 100$ .

Reinsurer: current tax rises by $0.21 \times 67.5 = 14.175$ , and the deferred tax asset on its $\$82.5$ discount reverses by $0.21 \times 82.5 = 17.325$ . Total $14.175 + 17.325 = 31.5 = 0.21 \times 150$ .

Each side should negotiate on an after-tax basis: the cedant's cash tax saving is small next to its book loss, and part of its benefit is a deferred tax asset it may not be able to admit in full.

Ceding to an Offshore Affiliate A U.S. insurer proposes a $50\%$ quota share of its book to a Bermuda affiliate that is not engaged in a U.S. trade or business, with a ceding commission well above the insurer's acquisition costs. Identify the tax and statutory issues.

Answer

Excise tax: $1\%$ of the ceded premium, unless an exemption applies.

BEAT: if the group is large enough, the premiums are base erosion payments to a foreign related party.

§845(a): the parties are related, so the IRS may reallocate income and deductions if the premium and commission do not reflect the risk actually transferred.

Statutory: the commission in excess of anticipated acquisition cost must be set up as a liability and amortised over the contract, not taken into surplus at once (SSAP No. 62R). Unless the affiliate is authorised, certified or a reciprocal-jurisdiction reinsurer, credit for the cession depends on collateral, and any unsecured amount drives the provision for reinsurance in Schedule F. And the contract must pass risk transfer like any other.

A structure that looks efficient before tax can lose its appeal once excise tax, BEAT and the statutory deferral of the excess commission are priced in.