Rev. Rul. 82-69

ISSUE

May the amounts paid by the reinsurer to the primary insurer under an indemnity reinsurance agreement be deducted in full in the year accrued or must they be treated as a deferred expense and amortized?

FACTS

On January 1, 1982, X (the reinsurer), a life insurance company taxable under section 802 of the Internal Revenue Code, entered into an indemnity reinsurance agreement with Y (the reinsured), also a life insurance company taxable under section 802. Under the agreement, beginning on January 1, 1982, X agreed to reinsure 90 percent of Y's retained and future risks on a block of life insurance policies written by Y. Y agreed to pay to X 90 percent of all gross premiums received on the policies after January 1, 1982, less an annual commission that was intended to reimburse Y for a proportionate part of the administrative and service costs associated with the policies. In addition, upon execution of the agreement, X paid to Y an amount equal to 200 percent of the estimated gross premium receivable in 1982, on the risk reinsured. The indemnity reinsurance agreement labeled this payment by X a "ceding commission" and stated that its purpose was to reimburse Y for agents' commissions and other expenses associated with selling and maintaining the reinsured policies that were incurred by Y before the effective date of the reinsurance agreement. The agreement provides that after 20 years Y may terminate the reinsurance agreement.

LAW AND ANALYSIS

Section 1.809-4(a)(1)(iii) of the Income Tax Regulations defines the term "reinsurance ceded" as an arrangement whereby the reinsured remains solely liable to the policyholder, whether all or only a portion of the risk has been transferred to the reinsurer. This term includes indemnity reinsurance transactions.

Section 809(d)(11) of the Code provides that a life insurance company is allowed, as a deduction in computing gain or loss from operations, all other deductions allowed under Subtitle A for purposes of computing taxable income to the extent not allowed as deductions in computing investment yield.

Section 818(a) of the Code provides that all computations entering into the determination of taxes imposed by Chapter 1 of the Code relating to the taxation of life insurance companies must remain under the accrual method of accounting or, to the extent permitted by the regulations, under a combination of an accrual method of accounting with any other method permitted by Chapter 1 other than the cash receipts and disbursements method.

Section 461(a) of the Code provides the general rule that the amount of any deduction or credit allowed by Subtitle A must be taken for the tax year that is the proper tax year under the method of accounting used in computing taxable income. Section 1.461-1(a)(2) of the regulations provides that a taxpayer using an accrual method of accounting may deduct an expense in the tax year in which all the events have occurred that determine the fact of the liability and the amount of the liability can be determined with reasonable accuracy. However, any expenditure that results in the creation of an asset having a useful life that extends substantially beyond the close of the tax year may not be deductible or may be deductible only in part, for the tax year in which incurred.

Under the facts described, X makes two types of payments to Y, both of which may be generally called "ceding commissions" and both of which could be construed as expenses that create an asset with a useful life beyond the tax year. To place the indemnity reinsurance agreement on its books, X pays an "up-front ceding commission," which is similar to an agent's commission paid by a primary insurer. See discussion in Colonial Surety Company v. United States, 178 F. Supp. 600, 602 (Ct. Cl. 1959). However, unlike an agent's commission that is paid with respect to an individual policy that may be cancelled at an time, the "up-front ceding commission" is paid with respect to the acquisition of an agreement or contract with a readily determinable useful life--20 years.

Under the same indemnity reinsurance agreement X also pays an "annual ceding commission" that is netted annually from the allocable premiums paid by Y to X. Situations (1) of Rev. Rul. 79-138, 1979-1 C.B. 359, recognizes an annually paid ceding commission as such even though it is netted from the gross premiums paid by the primary insurer to the reinsurer. See also Rev. Rul. 70-552, 1970-2 C.B. 141, for another description of a reinsurance arrangement calling for an annual ceding commission. Unlike the "up-front ceding commission," the "annual ceding commission" is more closely associated with the individual risks reinsured and represents X's allocable share of the current expenses of the individual contracts issued by Y. Thus, the "annual ceding commissions" more closely parallel the primary insurer's expenses for individual policies, which when viewed separately have no readily determinable useful life.

HOLDING

The "up-front ceding commission" (200 percent of 1982 gross premiums) paid by X to Y represents an acquisition cost of a block of business, embodied in the indemnity reinsurance agreement, with a readily determinable useful life extending beyond the close of the tax year and thus must be amortized over the term of the agreement. A current deduction for the annual amount to be amortized is allowable under section 809(d)(11) of the Code.

Under Rev. Rul. 79-138, the amount annually netted from the gross premiums paid by Y to X is viewed as an "annual ceding commission." This amount, which represents reimbursement of current expenses relating to individual contracts, may be deducted by X in full as accrued.