Reinsurance FAQ
What is Reinsurance? Reinsurance is the transfer of insurance risk (and associated insurance premiums) from one insurance company to another insurance company. The company that receives (or "assumes") the insurance risk (and associated reinsurance premiums) is called the "Reinsurance Company" and the company that transfers (or "cedes") the risk (and associated premium) is called the "ceding company".
How much risk does the Reinsurance Company have? This depends upon the agreement between the Insurance Company and the Reinsurance Company. And even though it might seem like the Reinsurance Company should take as little risk as possible, this would mean that they (i.e. the Reinsurance Company) would get as little of the associated premiums as possible.
If the Reinsurance Company has determined that the business is (or should be) profitable, then it would be in the Reinsurance Company's best interest to "assume" as much risk and associated premiums as possible at the least cost (or "Ceding Fee").
What is the cost of Reinsurance? The cost of reinsurance varies greatly, and it is based upon industry standards and the product and or products being reinsured. The cost of Reinsurance is described as a "Ceding Fee" or "Ceding Allowance", and consists of the payment from the Reinsurance Company to the Insurance Company as compensation for "assuming" the risk (and associated premiums).
What are the types of Reinsurance Treaties? A Reinsurance "Treaty" is simply a contract (or agreement) between two insurance companies that set forth the terms of the Reinsurance Agreement. There are basically two types of reinsurance treaties involved in our various programs. They are: (1) Excess of Loss and (2) Quota Share and each type of Reinsurance Treaty has its' own unique characteristics.
Excess of Loss is the type of reinsurance where the Reinsurance Company assumes the claims liability above a set claims amount (or level). There is usually less risk transferred (and also less premium) in this type of agreement because the Insurance Company (or ceding company) keeps the initial (or underlying or working) layer of risk. This type of reinsurance is normally utilized when the ceding insurance company wants to keep as much risk as possible and only wants to protect against catastrophic claims.
Quota Share is the type of reinsurance where the Reinsurance Company assumes a certain percentage of all premiums generated. This usually means that the Reinsurance Company receives more of the risk (and associated premiums) of the business written.
The Quota Share amount is normally quoted in percentage terms (i.e. 50% quota share, 75% quota share, 100% quota share, etc.). In a 100% quota share agreement, the Reinsurance Company will receive all the premiums less the associated ceding fees.
What are the methods of ceding business? For single premium products, which are the primary types of insurance policy involved in our programs, the business can be ceded on either a Written Basis or an Earned Basis.
Does a Reinsurance Treaty normally have a "termination" clause? This is not a frequently asked question, but it should be. All reinsurance agreements have termination clauses, but when entering into a Reinsurance Agreement, the Reinsurance Company should be very careful in making sure that there are no hidden penalties in the "termination clause" of the agreement. These appear more often in "Earned" reinsurance agreements because the unearned assets are held on the Ceding Companies books, not the Reinsurance Company's books, and this creates the potential for the Reinsurance Company to forfeit the unearned business.
TAX QUESTIONS
What is my tax rate and how are my taxes calculated? As stated earlier, the typical Reinsurance Company in our program elects to be taxed as a U.S. Insurance Company; therefore the Reinsurance Company is subject to the tax rate imposed by the U.S. Internal Revenue Code (IRC). The tax rate can vary based upon the size and type of Reinsurance Company. If the Reinsurance Company can qualify as a "Small Insurance Company", there are potential tax benefits.
What is the "Small Insurance Company" category? This is also not a direct answer. It depends on two sets of circumstances (or tests).
The first test is what the type of Insurance Company is. For tax purposes, the insurance company can be either a "Life" insurance company or a "Non-Life (or Casualty)" insurance company. Most of our automobile dealer client's companies will qualify as "casualty insurance companies" because of the type of business they write and the method of ceding business. The second test refers to the "annual net premiums" that the insurance company receives. If the casualty insurance company writes less than $350,000 of premium per year it has the opportunity under fairly strict guidelines to qualify as a "tax-exempt" insurance company under Section 501(c)(15) of the IRC.
If the insurance company receives between $350,000 and $1,200,000 of premiums on an annual basis, it can then "elect" to be taxed only on "investment income". This is an irrevocable election, but it means that there is no tax on the "underwriting profits" of the insurance business.
This company is taxed under Section 831(b) (2) of the IRC. If the casualty insurance company writes more than $1,200,000 of premiums in a given year, then the company is taxed at the full corporate tax rate on all profits. The premium test is done annually and starts over each year.
Are there any other tax considerations? As stated earlier, the ownership of the Reinsurance Company should be structured to avoid any potential "self-insurance" issues. However, once this hurdle is overcome (normally by establishing a brother/sister relationship and/or insuring "unrelated risk"), there are potential qualitative considerations in structuring the ownership of the Reinsurance Company. We mentioned some of these earlier, such as (1) key employee deferred compensation benefits, (2) estate planning and (3) establishing the most effective underwriting and tax structure.
Why is deductibility of premiums such an important issue? Deductibility of premiums is such an important issue because if you can't get past this hurdle it doesn't matter how or where your Reinsurance Company is (1) located, (2) capitalized, (3) regulated or (4) run, which are secondary issues to the "deductibility" issue. And why this is important is because if a non-insurance company (such as an automobile dealer) pays a premium that ultimately ends up being insured or reinsured by an affiliated company and the automobile dealer can't deduct the premium payment, then this is obviously a bad result. In other words, if the premium payor can't deduct the premiums, then the premium payor would end up paying tax on all the associated income without any deductions allowed against the income.
What is a brother/sister relationship and why is it important? I will answer this in reverse order. A brother/sister relationship is important because the tax courts (and now the Internal Revenue Service itself, has begun to allow the deductibility of premiums if paid by a "brother" to a "sister").
As to what creates a brother/sister relationship, this occurs when two (or more) organizations have a common "parent". An example would be an automobile dealer (the parent), an automobile dealership owned by the automobile dealer (the brother) and a Reinsurance Company also owned by the automobile "dealer", which would be the sister.
If the automobile dealership, not the dealer, owned the Reinsurance Company, then there would exist a "parent/child" relationship, and then the premiums paid by the parent would be nondeductible (given no other circumstances).
What is "distribution of risk" and why is it important? I will answer this in reverse order also. "Distribution of risk" is important for the same reason as "brother/sister", because both are a means to create "deductibility" of premiums paid by an affiliated company to another affiliated insurance (or Reinsurance) company.
The complete answer to this question would require a treatise on the subject (really both question and answer). Basically, this concerns the relationship between the premium payor and the ultimate recipient of the premiums. If a parent company pays a premium to a subsidiary insurance company for coverage on itself (i.e. the parent company), then this is considered to be "inside risk" and the premiums paid by the parent would not be deductible. A perfect example of this type of business would be Dealer Obligor service contracts if there were an affiliated Reinsurance Company relationship.
How much risk does the Reinsurance Company have? This depends upon the agreement between the Insurance Company and the Reinsurance Company. And even though it might seem like the Reinsurance Company should take as little risk as possible, this would mean that they (i.e. the Reinsurance Company) would get as little of the associated premiums as possible.
If the Reinsurance Company has determined that the business is (or should be) profitable, then it would be in the Reinsurance Company's best interest to "assume" as much risk and associated premiums as possible at the least cost (or "Ceding Fee").
What is the cost of Reinsurance? The cost of reinsurance varies greatly, and it is based upon industry standards and the product and or products being reinsured. The cost of Reinsurance is described as a "Ceding Fee" or "Ceding Allowance", and consists of the payment from the Reinsurance Company to the Insurance Company as compensation for "assuming" the risk (and associated premiums).
What are the types of Reinsurance Treaties? A Reinsurance "Treaty" is simply a contract (or agreement) between two insurance companies that set forth the terms of the Reinsurance Agreement. There are basically two types of reinsurance treaties involved in our various programs. They are: (1) Excess of Loss and (2) Quota Share and each type of Reinsurance Treaty has its' own unique characteristics.
Excess of Loss is the type of reinsurance where the Reinsurance Company assumes the claims liability above a set claims amount (or level). There is usually less risk transferred (and also less premium) in this type of agreement because the Insurance Company (or ceding company) keeps the initial (or underlying or working) layer of risk. This type of reinsurance is normally utilized when the ceding insurance company wants to keep as much risk as possible and only wants to protect against catastrophic claims.
Quota Share is the type of reinsurance where the Reinsurance Company assumes a certain percentage of all premiums generated. This usually means that the Reinsurance Company receives more of the risk (and associated premiums) of the business written.
The Quota Share amount is normally quoted in percentage terms (i.e. 50% quota share, 75% quota share, 100% quota share, etc.). In a 100% quota share agreement, the Reinsurance Company will receive all the premiums less the associated ceding fees.
What are the methods of ceding business? For single premium products, which are the primary types of insurance policy involved in our programs, the business can be ceded on either a Written Basis or an Earned Basis.
- Written Basis — This means that the premiums are ceded to the Reinsurance Company as they are produced (i.e. immediately). This obviously transfers the assets (and liabilities) to the Reinsurance Company in the quickest manner.
- Earned Basis —This means that the premiums are ceded to the Reinsurance Company as they "earn" over the life of the policy. This normally transfers the assets (and associated liabilities) to the Reinsurance Company in the slowest manner.
Does a Reinsurance Treaty normally have a "termination" clause? This is not a frequently asked question, but it should be. All reinsurance agreements have termination clauses, but when entering into a Reinsurance Agreement, the Reinsurance Company should be very careful in making sure that there are no hidden penalties in the "termination clause" of the agreement. These appear more often in "Earned" reinsurance agreements because the unearned assets are held on the Ceding Companies books, not the Reinsurance Company's books, and this creates the potential for the Reinsurance Company to forfeit the unearned business.
TAX QUESTIONS
What is my tax rate and how are my taxes calculated? As stated earlier, the typical Reinsurance Company in our program elects to be taxed as a U.S. Insurance Company; therefore the Reinsurance Company is subject to the tax rate imposed by the U.S. Internal Revenue Code (IRC). The tax rate can vary based upon the size and type of Reinsurance Company. If the Reinsurance Company can qualify as a "Small Insurance Company", there are potential tax benefits.
What is the "Small Insurance Company" category? This is also not a direct answer. It depends on two sets of circumstances (or tests).
The first test is what the type of Insurance Company is. For tax purposes, the insurance company can be either a "Life" insurance company or a "Non-Life (or Casualty)" insurance company. Most of our automobile dealer client's companies will qualify as "casualty insurance companies" because of the type of business they write and the method of ceding business. The second test refers to the "annual net premiums" that the insurance company receives. If the casualty insurance company writes less than $350,000 of premium per year it has the opportunity under fairly strict guidelines to qualify as a "tax-exempt" insurance company under Section 501(c)(15) of the IRC.
If the insurance company receives between $350,000 and $1,200,000 of premiums on an annual basis, it can then "elect" to be taxed only on "investment income". This is an irrevocable election, but it means that there is no tax on the "underwriting profits" of the insurance business.
This company is taxed under Section 831(b) (2) of the IRC. If the casualty insurance company writes more than $1,200,000 of premiums in a given year, then the company is taxed at the full corporate tax rate on all profits. The premium test is done annually and starts over each year.
Are there any other tax considerations? As stated earlier, the ownership of the Reinsurance Company should be structured to avoid any potential "self-insurance" issues. However, once this hurdle is overcome (normally by establishing a brother/sister relationship and/or insuring "unrelated risk"), there are potential qualitative considerations in structuring the ownership of the Reinsurance Company. We mentioned some of these earlier, such as (1) key employee deferred compensation benefits, (2) estate planning and (3) establishing the most effective underwriting and tax structure.
Why is deductibility of premiums such an important issue? Deductibility of premiums is such an important issue because if you can't get past this hurdle it doesn't matter how or where your Reinsurance Company is (1) located, (2) capitalized, (3) regulated or (4) run, which are secondary issues to the "deductibility" issue. And why this is important is because if a non-insurance company (such as an automobile dealer) pays a premium that ultimately ends up being insured or reinsured by an affiliated company and the automobile dealer can't deduct the premium payment, then this is obviously a bad result. In other words, if the premium payor can't deduct the premiums, then the premium payor would end up paying tax on all the associated income without any deductions allowed against the income.
What is a brother/sister relationship and why is it important? I will answer this in reverse order. A brother/sister relationship is important because the tax courts (and now the Internal Revenue Service itself, has begun to allow the deductibility of premiums if paid by a "brother" to a "sister").
As to what creates a brother/sister relationship, this occurs when two (or more) organizations have a common "parent". An example would be an automobile dealer (the parent), an automobile dealership owned by the automobile dealer (the brother) and a Reinsurance Company also owned by the automobile "dealer", which would be the sister.
If the automobile dealership, not the dealer, owned the Reinsurance Company, then there would exist a "parent/child" relationship, and then the premiums paid by the parent would be nondeductible (given no other circumstances).
What is "distribution of risk" and why is it important? I will answer this in reverse order also. "Distribution of risk" is important for the same reason as "brother/sister", because both are a means to create "deductibility" of premiums paid by an affiliated company to another affiliated insurance (or Reinsurance) company.
The complete answer to this question would require a treatise on the subject (really both question and answer). Basically, this concerns the relationship between the premium payor and the ultimate recipient of the premiums. If a parent company pays a premium to a subsidiary insurance company for coverage on itself (i.e. the parent company), then this is considered to be "inside risk" and the premiums paid by the parent would not be deductible. A perfect example of this type of business would be Dealer Obligor service contracts if there were an affiliated Reinsurance Company relationship.