SERVICE CLARIFIES POSITION ON PARENT COMPANY'S INSURANCE PREMIUMS PAID TO WHOLLY OWNED SUBSIDIARY.

Rev. Rul. 89-61

This revenue ruling clarifies the LAW AND ANALYSIS portion of Rev. Rul. 88-72, 1988-36 I.R.B. 26. In its discussion of the economics of insurance, Rev. Rul. 88-72 states that the increase in average loss predictability resulting from the acceptance of additional risks "helps protect the [insurance] company's solvency." This statement could cause confusion. The improved average loss predictability indeed may allow the insurance company to use its capital more efficiently in protecting its solvency. However, in the absence of some additional capital, the improved predictability is normally accompanied by a reduced probability of the insurance company's solvency.

When additional statistically independent risk exposure units are insured, an insurance company's potential total loss increases, as does the uncertainty of the amount of that loss. As the uncertainty regarding the company's total loss increases, however, there is an increase in the predictability of the insurance company's average loss (total loss divided by the number of exposure units). That is, by insuring a large number of statistically independent risk exposure units, a company takes advantage of the statistical phenomenon known as the law of large numbers. (When the sample number increases, the probability density function of the AVERAGE loss tends to become more concentrated around the mean.) Due to this increase in predictability, there is a downward trend in the amount of capital that the company needs PER RISK UNIT to remain at a given level of solvency. In this sense, the additional insureds may make a company more efficient in the way its capital provides security, and thus may "help protect the company's solvency." Without an increase in capital, however, the increase in the predictability of the average loss is at the cost of an upward trend in the company's risk of ruin (the probability that total losses may exceed total premiums and capital).

In the absence of an addition to the insurance company's aggregate capital, insuring additional risk exposure units at competitive rates normally increases the company's risk of ruin. To avoid such an increase, when an insurance company expands its business, there is an addition to the amount of capital that state insurance regulators require the company to hold. The greater need for capital when risks are added demonstrates that the new insureds do not take on any risks previously assumed by the company. If some of the company's risks were transferred to the new insureds, the company would not need more capital to keep its risk of ruin from increasing.

Accordingly, the LAW AND ANALYSIS portion of Rev. Rul. 88-72 is clarified by deleting from the sixth paragraph the sentence "This increase in predictability helps protect the company's solvency."

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 88-72 is clarified. This clarification of Rev. Rul. 88- 72 will appear in that revenue ruling when it is republished in 1988- 2 C.B.