Income tax: taxation implications of arrangements known as financial insurance and financial reinsurance

This Ruling sets out the ATO's views on the taxation implications of payments made under any of the wide range of arrangements commonly known as 'financial insurance' and 'financial reinsurance'.

This Ruling applies to a taxpayer who is either engaged in the business of insurance or who is involved in reinsurance activities of insurance business. References in this Ruling to 'financial reinsurance' are equally applicable to 'financial insurance' as if references to reinsurance included insurance. This Ruling will apply to all insurance arrangements other than those involving permanent policies of life insurance.

The rulings contained herein will give guidance as to the circumstances in which arrangements will be acceptable for taxation purposes as insurance and reinsurance arrangements.

A glossary of terms is contained at Attachment F .

The need for the Ruling arises from the identification by the ATO of a number of arrangements known as 'financial reinsurance' but which, in the opinion of the ATO, are solely or predominantly financing arrangements. It is understood that the use of financial reinsurance in many other countries is on the increase, and the indications are that Australia may be following that trend.

A premium paid in respect of reinsurance coverage is deductible only where the contract provides for the transfer of the risk of loss from the occurrence of contingent insured events through the indemnity to the reinsured in respect of losses which it suffers as a result of its carrying on a business of insurance.

Where, however, the arrangement does not transfer the risk of loss to an insured the premiums paid to an insurer are not deductible as an insurance expense of an insured.

An arrangement will not be accepted as a reinsurance arrangement for taxation purposes where: (a) it is not possible for the reinsurer to incur a significant loss under the arrangement; and (b) the reinsurer does not assume a significant insurance risk under the arrangement.

Where a reinsurance arrangement is considered to be a financial reinsurance arrangement for taxation purposes it is not accepted that premiums paid constitute allowable income tax deductions. Rather, the payments of 'premiums' under the arrangement will be treated as loans while 'claims' and 'commissions' paid under the arrangement, to the extent that those payments equal 'premium' payments, will be treated as the repayment of those loans (see paragraphs 57-68 for an explanation of financial reinsurance).

Where a financial reinsurance arrangement is not accepted as a reinsurance arrangement for taxation purposes, the amounts paid to the reinsurer under the arrangement are not assessable income. Consequently, they are not to be taken into account in calculating a reinsurer's unearned premium provision or as giving rise to liabilities that form part of the calculation of a reinsurer's outstanding claims provision.

Income derived by a reinsurer from the investment of amounts received by the reinsurer from the reinsured are assessable income of a reinsurer under subsection 25(1) of the ITAA. Amounts payable to the reinsured by the reinsurer which represent a return on the amount paid by the reinsured under the agreement, will be deductible to a reinsurer under subsection 51(1) of the ITAA when the liability to make those payments is incurred and assessable to a reinsured under subsection 25(1) of the ITAA as income derived in the course of carrying on the business of reinsurance. The taxation treatment of financial reinsurance will follow that of banking and financing arrangements.

Amounts paid by a reinsured as financial reinsurance 'premiums' to a reinsurer will not be allowable under subsection 51(1) of the ITAA as deductions to a reinsured. They are not to be taken into account in the calculation of the reinsured's unearned premium provision.

This Ruling applies to years commencing both before and after its date of issue. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20). The application of public Rulings where a taxpayer has a private ruling is considered at paragraph 19 of Taxation Ruling TR 92/20 and also in Taxation Determination TD 93/34.

The considerations for determining whether the payment of premiums under a reinsurance arrangement are deductible are similar to those for determining whether direct insurance premiums are deductible. In a reinsurance arrangement, there must be a transfer of insurance risk and the subsequent exposure of the reinsurer to a significant loss . This is a fundamental reason for the existence of insurance and reinsurance, to pass the risk of loss from the insured to an insurer or from the reinsured to the reinsurer.

Arrangements that do not involve a transfer of risk of insurance loss (generically referred to as financial insurance/reinsurance) are not accepted as insurance/reinsurance for income tax purposes in the following circumstances: (a) the insurer/reinsurer does not assume a significant insurance risk under the arrangement; and (b) it is not reasonably possible for the insurer to incur a significant loss under the arrangement.

Insurance risk can be defined as the risk arising from uncertainties about both: • the ultimate amount of net cash flows from premiums, commissions, claims and claim settlement expenses paid or incurred under a contract ( underwriting risk ); and • the timing of the receipt or payment of those cash flows ( timing risk ).

The acceptance or otherwise for taxation purposes of a reinsurance arrangement can be explained using the flow chart on the following page:

The possibility of incurring a significant loss as referred to in paragraphs 8, 15 and 17 requires that for an arrangement to be acceptable as reinsurance for taxation purposes the possibility of a significant insurance loss must exist.

A reinsured may utilise financial reinsurance to achieve one or more financial goals, rather than obtaining indemnity from insurance risk as its primary purpose. It is common for financial reinsurance to have a lower amount of total insurance risk transfer than has been historically utilised in other reinsurance arrangements. Consequently, the arrangement may not expose the reinsurer to a significant loss and may not provide for the reinsurer to assume significant insurance risk. (Refer to Attachments D and E for examples of financial reinsurance arrangements that contain no insurance risks.)

If it is not possible for the reinsurer to incur a significant loss under the arrangement that arrangement cannot be held to constitute a reinsurance arrangement for income tax purposes.

The term 'reasonably possible' (see paragraphs 15(b) and 17) indicates a situation where the chance of the future insured event or events occurring is more than remote but less than likely.

A contract will not have transferred insurance risk if the probability of a significant variation in the amount and timing of the payments by the reinsurer is remote.

The evaluation of the possibility of a significant loss is to be based on the present value of all estimated cash flows between the reinsurer and the reinsured under reasonably possible outcomes. This includes cash flows from premiums, commissions, claims adjustable features etc, regardless of their characterisation in the contract. The reinsurer will need to demonstrate that the present value of estimated cash flows will result in the possibility of a significant loss. The calculation excludes however, third party expenses incurred as a result of the contract. The interest rate used in the present value calculations of each reasonably possible outcome tested should be the same.

In other words, whether a loss is significant or not will initially be determined by comparing the present value of the payments to be made to the reinsurer by the reinsured with a reasonably possible loss to the reinsurer. A loss would arise where the present value of the cash flows from the reinsured would be exceeded by the potential payments under reasonably possible outcomes by the reinsurer to the reinsured.

The significance of possible losses under different scenarios should be evaluated by comparing the various calculations of the present value of all cash flows with the present value of the amounts paid or payable to the reinsurer under the contract. The different scenarios to be evaluated may include, for example, "Best", "Most Likely" and "Worst" case scenarios. If the present value of the possible outcomes is not significantly different from the present value of the amounts payable to the reinsurer the arrangement will not expose the reinsurer to a significant loss. Consequently, the arrangement will not be treated as a reinsurance arrangement for taxation purposes.

If a contract is likely to be terminated under any reasonably possible scenario, the effect of the termination on cash flows between the reinsured and the reinsurer must also be considered when determining if it is reasonably possible for the reinsurer to incur a significant loss under the arrangement.

If, for example, where upon cancellation or expiry of a contract the reinsured is required to reimburse the reinsurer for any losses incurred by the reinsurer under the arrangement, then the reinsurer's exposure to a significant loss would be eliminated. Consequently, the arrangement would fail the first test in paragraph 8.

In circumstances where the arrangement contractually provides a facility for the reinsured to reimburse the reinsurer where claims exceed premiums and investment income or where claims reduce the reinsurer's return on capital, a contingent liability may be created which may require supporting capital from the reinsured. The effect of this facility needs to be taken into account when considering if it is reasonably possible for the reinsurer to incur a significant loss. In the event of an unexpectedly large claim the facility may result in an actual liability being created which may stand in line with, or even rank ahead of, policyholder claims. It is the potential for the creation of this liability which distinguishes some financing arrangements from reinsurance. In these circumstances where the reinsurer is reimbursed for losses, it cannot be said that it is reasonably possible for the reinsurer to incur a significant loss under the arrangement.

The ultimate decision as to whether an arrangement, as a whole, exposes the reinsurer to the possibility of incurring a significant loss will depend on an objective assessment of the component parts of the arrangement, together with any ancillary arrangements, whether written or otherwise, and other relevant factors. Ancillary arrangements include arrangements associated with the reinsurance arrangement and need to be included in the assessment of the arrangement as a whole.

We are aware of arrangements which attempt 'to cloak reality' or 'to disguise' the real situation through the inclusion of some degree of transfer of insurance risk and the creation of a composite arrangement. Where there is uncertainty as to whether significant insurance risk has been transferred we consider that the whole arrangement is to be treated as a financial arrangement and not insurance/reinsurance for taxation purposes.

A contract will not be accepted as a reinsurance contract for taxation purposes if the contract, or other associated contracts or agreements, either directly or indirectly compensate the reinsurer for the reinsurer's losses under the arrangement. Thus, ancillary arrangements need to be examined in conjunction with a purported reinsurance contract to ascertain if a significant amount of insurance risk has been transferred under the arrangement as a whole.

Listed below are some known features that limit the amount of insurance risk transferred to the reinsurer. Each of the features are indicative only, and the list is not intended to be exhaustive. Some of these features may also be present in acceptable reinsurance arrangements and it is for this reason that the arrangement must be considered in its entirety. • Experience Account Balance (EAB). This balance is potentially available to be paid out to the reinsured upon termination. It usually comprises the following: • premiums paid. • Add a credit for a portion of the investment income earned by the reinsurer. • Less claims paid by the reinsurer and the reinsurer's margin. (Refer to Attachments D and E for examples of the operation and effect of an EAB). • Cancellation and recapture clauses (commutation clauses). These clauses operate to return a portion of the EAB if it is positive and to require the reinsured to reimburse the reinsurer if the EAB is negative. • Delays in the timely payment of amounts due under the terms of the contract. If the ultimate timing of payments by the reinsurer is known or the contract provides for other than timely reimbursement of the reinsured (eg, until the end of the second or third year ), then risk has not been transferred. Contractually stipulated payment schedules, accumulating retentions, floating retentions and other adjustable features generally prevent timely reimbursement. • Adjustments to premiums based on the experience of the arrangement. This may occur where, for example, no claims have been made, and consequently, future premiums may be reduced. Conversely, the cover provided may be increased whilst premiums remain stable. • Renewal clauses . These clauses provide for the automatic renewal of the contract if the EAB is in a deficit or if the deficit exceeds a specified amount. In some circumstances coverage may be cancelled but still leave the reinsured with the obligation to pay the remaining premiums.

The transfer of insurance risk in financial reinsurance arrangements, if any, is minimal and the transaction is not, in substance, in the nature of the reinsurance of insurance risks. It is considered that the substance of financial reinsurance is more akin to a 'banking', 'financing' or 'funding' arrangement than the historical concept of reinsurance and the transfer of insurance risk. Given that the substance of financial reinsurance is more akin to banking or financing arrangements the taxation treatment of financial reinsurance will follow that of banking and financing arrangements. This may also involve the application of Division 16E of the ITAA. Specifically, Division 16E may apply to scenario 1 in Attachments D and E as the arrangement could be a 'qualifying security' with an 'eligible return'.

In order that the rulings contained herein may be better understood, the concepts of insurance, reinsurance, financial insurance/reinsurance and the terminologies used in the industry, as they are understood by the ATO, are explained in this Ruling. The explanations are provided solely with the view of assisting in the understanding of the extent to which this Ruling is intended to apply.

When considering the concept of insurance we need to look at the reasons individuals and companies take out insurance. Why do people insure their homes, cars, boats etc?

The reason for insurance is because both individuals and companies have limited resources. If, for example, a person's home was damaged or destroyed the person would not generally have the resources to repair or replace the home.

Insurance of any kind is about the spreading of risk based on the law of large numbers - the many paying for the few. A statute of Queen Elizabeth dated 1601 contained in its preamble a classic definition of insurance. The definition is as follows: "By means of a Policy of insurance it cometh to pass that upon the loss or perishing of any ship there followeth, not the undoing of any man, but the loss lighteth rather easily upon many than heavily upon few." We understand that this is the first time that the subject of insurance is referred to in English Law Books, and these few simple words contain the fundamental principles of insurance. Insurance enables insurers to spread the potential loss of a few individuals over many other individuals. Insurance thus involves the transfer of the potential for a loss from an individual who may be subject to the loss as a result of the occurrence of a adverse event, to an insurance company.

Insurance companies also face the same limitation of financial resources and have the same need to protect their assets. The concept of insurance, as it related to insurance companies, was considered by Menhennett J. in R . A . C . V . Insurance Pty Ltd v. FC of T 74 ATC 4169; (1974) 4 ATR 610; who stated at p 4176: "The essence of insurance business is that, in respect of each class of risk insured against, the insurance company aims to satisfy its liabilities to the policy holders who actually experience the risk primarily out of the total of the premiums paid by all the policy holders, most of whom normally do not experience the risk."

Where an insurance company can not meet the claims made against it by those it has insured because it does not have sufficient premium income or reserve assets a spread of losses faced by policyholders has not been achieved. In order to avoid this situation an insurance company similarly takes out insurance to cover its inability to pay. This is called reinsurance. Similar policies taken out by reinsurance companies are called retrocessions.

Insurance may be described as a contact of indemnity between the insured and the insurer. "Under a contract of insurance one party, known as the insurer, promises that on the occurrence of an uncertain specified event he will either indemnify the other party, known as the insured or the policyholder, for any financial loss he may sustain, or pay to him a certain sum, and in return the insured agrees to pay the insurer an ascertainable amount known as a premium." (R.L. Carter, Reinsurance , Kluwer Publishing Limited, 1979, page 3)

The essence of insurance is to create a premium pool (from the premiums paid by the many) out of which claims (incurred by a few) and expenses are paid. In addition the providers of the capital required to establish and conduct the business (the insurers) also seek a return on their investment. This concept can be expressed in the following equation: P = L + E + C + S Where P = Policy premiums (the amounts paid by the many). L = Losses (incurred by a few). E = Expenses of running the insurance business. C = Commission costs of obtaining the premiums. S = Surplus or profit to the insurer of carrying on the business.

The main purposes of an insurance arrangement, therefore, is to transfer the risk of loss that may arise from the insured's interest in the subject matter of the insurance to the insurer. Individuals, taking out motor vehicle insurance, for example, transfer the risk of experiencing a loss were an accident to happen, to an insurance company through an insurance policy. Under the insurance policy the insurance company undertakes to indemnify the insured person against such a loss. The consideration for that indemnity is the premium paid by the insured to the insurance company. (See Attachment A for an example of the transfer and distribution of risk under a simple insurance arrangement.)

The transfer of the risk of loss from the insured to the insurer then exposes the insurer to the possibility of incurring a significant loss under a particular insurance contract. The concept of significant loss is discussed in detail at paragraphs 8 and 17-31. The loss will be significant compared to the premium paid on the particular policy, however, it may not be significant in terms of the insurer's total business. In the example at Attachment A the loss of 1 car @ $20,000 is significant when compared to the premium ($400) paid by the insured. The loss however, is not significant when compared to the total premiums ($40,000) received by the insurer on its motor vehicle business. But, if a second car is totally destroyed in addition to the two partially damaged, the insurer would be subject to an overall significant loss.

The insurer, by accepting other policies which are not expected (on the basis of probabilities) to incur a loss, has effectively distributed the risk of loss amongst all the insured parties. The premiums from those parties that do not experience a loss are used to pay for the loss experience of the few. This is the basic concept of the 'law of large numbers' where the probability of insured events occurring is even among all insureds. The greater the number of insureds, the more the risk can be shared (given reasonable loss probabilities).

A transfer of risk will have occurred if one party has successfully transferred the risk of loss to another. This will happen when policies are written, premiums are paid by the insured to the insurer, and the insurer has the capacity to pay sums insured under policies in the event of claims being made.

In return for the acceptance of a risk, consideration in the form of money (known as a premium) must be paid by an insured to the insurer. The insurer must also be under an obligation to pay a sum of money, or its equivalent, upon the happening of the event insured. The insured must have a legal right to payment which cannot be at the insurer's discretion. ( Commercial Union Assurance Company of Australia Limited v. FC of T 77 ATC 4186; (1977) 7 ATR 435; Medical Defence Union Ltd v. Department of Trade (1979) 2 All ER 421; Oswald v. Bailey & Ors (1987) 4 ANZ Insurance Cases.)

The insurer will be exposed to a significant loss because it will have assumed a significant insurance risk under a particular contract. If the insured event occurs the insurer is liable for the insurance risk that the insurer has assumed under the contract of insurance. Insurance risk is discussed in more detail at paragraph 16.

Another factor in an insurance arrangement is that of risk distribution . This occurs when an insurer pools premiums from many customers to establish a pool of funds to enable the insurer to pay the losses suffered by a few customers. In three recent US Tax Court Cases the Court has held that risk distribution had occurred because a significant percentage of the insurer's business was with companies not related to it ( Amerco and Subsidiaries , and Republic Western Insurance Company v. Commissioner of Internal Revenue 96 T.C. No. 3; The Harper Group and Includible Subsidiaries v. Commissioner of Internal Revenue 96 T.C. No. 4 and Sears , Roebuck and Co . and Affiliated Corporations v. Commissioner of Internal Revenue 96 T.C. No. 5).

This distribution of risk is also a vital element of any contract of insurance. Refer to Attachment B for examples of risk transfer and risk distribution.

Generally speaking, reinsurance is the insuring of the risks undertaken by an insurer. Reinsurance is a form of insurance and the principles and practices applying to the conduct of insurance business generally apply equally to reinsurance. "A contract of reinsurance is a contract by which an insurer obtains insurance against loss or liability arising under its primary contract of insurance. Reinsurance of liability under a contract of reinsurance ('retrocession') is also possible." (David Kelly and Michael Ball, Principles of Insurance Law in Australia and New Zealand , Butterworths, 1991 page 15)

A contract of reinsurance has also been described as an independent contract of insurance. (Barker J. in Farmers Mutual Insurance Ltd v. QBE Insurance International Ltd ; American International Underwriters Ltd v. Farmers Mutual Insurance Ltd (1993) 7 ANZ Insurance Cases)

Historically, a reinsurance contract is described as a contract of indemnity. Under a contract of reinsurance one party known as the reinsurer, promises to indemnify the other party, known as the reinsured, for any financial losses sustained by the reinsured as a result of the occurrence of an uncertain event originally insured by the reinsured in its business of insurance. Reinsurance contracts, therefore, are concerned with providing for the insurance of risks under contracts of insurance.

Like insurance arrangements, a reinsurer would indemnify an entity which is subject to the risk that it will incur a loss on the occurrence of a specified event. In reinsurance arrangements the entity indemnified is the insurance company and the reinsurer indemnifies a portion of the risks originally assumed by the insurance company. Such portions may be in specific proportions to the amount of risk originally assumed or it may provide for protection over and above a specified amount or ratio of claims. Reinsurance thus involves the transfer of insurance risk from an insurer to a reinsurer and this transfer exposes a reinsurer to the possibility of incurring a significant loss under a reinsurance contract.

Reinsurance in the past has generally followed the type of arrangement described in paragraphs 50-53 above. However in recent years this type of reinsurance has become increasingly difficult to obtain and more expensive. This reduction in availability of reinsurance is primarily a result of the huge increase in catastrophe losses faced by insurers and reinsurers over recent years.

The difficulty in obtaining reinsurance has had the following consequences: • a difficulty in obtaining reinsurance for some risks; • exclusion of some risks in certain locations; • the insured being required to hold an increased amount of the risk; • concerns about the viability of parties to the arrangements; and • a desire to limit exposure to risks whilst still selling a profitable product.

This difficulty in obtaining reinsurance has created a gap in an insurer's risk management techniques and a new tool was needed to enable insurers to manage the increased risks they are required to hold. Financial reinsurance appears to have evolved to become such a risk management tool.

Financial reinsurance has been described by many varying terms, some of which include: Bankers, Rollers, Portfolio Run-Offs, Time and Distance, Islands in the Sun, Accelerators or Redistributors of Income, Alternative Risk Transfers, Funded Covers, Retrospective Aggregates, Prospective Aggregates etc.

Financial reinsurance has existed for over twenty years and has its origins in techniques that rely on the time value of money, that is, the impact of interest to produce a benefit.

Financial reinsurance is a broad term encompassing a number of concepts and has been defined to include everything from a transaction embracing no risk of any type (which is tantamount to a loan) to transactions that include a number of different types of risk of loss ( timing risk , investment risk , credit risk and expense risk ) but seek to limit the insurance risk in the underlying risk being reinsured.

Timing risk is the risk of having to pay a loss before anticipated. Paying a loss earlier than anticipated does not allow for sufficient amounts of income to be generated and accumulated in order to pay the loss.

Investment risk is the risk that investment earnings will fall short of projected investment earnings. Investment risk is affected by timing risk as well as market fluctuations.

Credit risk includes: (a) the risk that the reinsured may not pay premiums when due, (b) subrogation rights that may not be enforceable, or (c) a retrocessionaire (the reinsurer's reinsurer) which may be unable to pay amounts due under a retrocession arrangement.

Expense risk is the risk that acquisition and operating expenses may exceed amounts expected when the reinsurance premium is calculated. Expense risk is primarily a problem of pricing the product.

Underwriting risk is the risk that there is a clear possibility that the insurer will pay more than premiums expected on any given policy.

We have become aware of arrangements that involve amounts being described as insurance premiums under an insurance arrangement that does not transfer any risk from the insured to the insurer. These arrangements are in reality no more than deposit arrangements in which claims are funded by the insured and appear to have the purpose or result of cloaking a non-deductible expense as an insurance arrangement to either create a deduction or to bring forward a deduction.

An example of this type of arrangement is illustrated in Attachment C . Although Attachment C is an illustration of financial insurance the same principles are involved in financial reinsurance. As can be seen from that example, the insured has not transferred any insurance risks to the insurer and it is the insured that actually funds the outgoings.

The arrangement illustrated in Attachment C is an attempt to bring forward a deduction for long service leave payments. This arrangement attempts to overcome the decision of the High Court in Nilsen Development Laboratories Pty . Ltd . & Ors v. FC of T 81 ATC 4031; (1981) 11 ATR 505, which held that provisions for long service were not deductible for income tax purposes and that a deduction is only available when the employer is finally obliged to make the payments. It has also been held in Ransburg Australia Pty Ltd v. FC of T 80 ATC 4114; (1980) 10 ATR 663, that payments by a taxpayer for indemnity against it's long service leave liabilities are not deductible. Further, this type of arrangement is an attempt to overcome the operation of subsection 51(3) of the ITAA. Such arrangements are not accepted as insurance arrangements for taxation purposes. These types of arrangements are no different from a deposit arrangement with a bank as there is minimal risk to either party. Consequently, the taxation treatment of this type of arrangement will follow that of banking and finance arrangements.

The only difference between financial insurance and financial reinsurance is that the former is an arrangement between a non-insurer and an insurer and the latter is between an insurer and a reinsurer.