Uncollectible insurance deductibles treated as bad debts after claim payment

Plain-English summary

Chief Counsel analyzed an insurer's treatment of unreimbursed deductible amounts under high-deductible liability policies. Because the insurer did not include the deductible layer in gross premiums written, it could not include that reimbursable layer in losses incurred under section 832(b)(5). Before the insurer paid a claim, it had no enforceable right to reimbursement and therefore no bona fide debt under section 166. Once it paid the claim, the contractual reimbursement right became a debt, and any amount later determined to be wholly or partly worthless could qualify for a bad-debt deduction through section 832(c)(10). Section 832(d) prevents a second deduction if the same deductible amount already was included in both gross premiums and losses incurred.

Ruling snapshot

• Question: Could an insurer deduct uncollectible high-deductible reimbursements as insurance losses or bad debts?
• Outcome: Advice given. The current method did not produce a section 832(b)(5) loss, but a section 166 bad-debt deduction could arise after claim payment.
• Key authorities: IRC §§ 166, 831, and 832; Treas. Reg. §§ 1.166-1, 1.166-2, and 1.832-4.

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201642034
       Release Date: 10/14/2016
       CC:FIP:B04: JEGlover                           Third Party Communication: None
       PREF-112116-15                                 Date of Communication: Not Applicable

UILC: 832.06-00, 166.03-00

date: July 01, 2016

 to:   J. Paul Knap
       Attorney
       (CC:LB&I:RFTH:CH2M)

from: Alexis A. MacIvor
Branch Chief, Branch 4
(Financial Institutions & Products)

subject: Treatment of Reimbursements on High Deductible Policies under § 832

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       LEGEND

       Taxpayer   = -------------------------------------------------
       Tax Period = -------

       ISSUES

       1. Is Taxpayer entitled to a loss incurred under § 832(b)(5) for uncollectible deductibles?

       2. Is Taxpayer entitled to a deduction under § 832(c)(10) for a bad debt within the scope
       of § 166 for uncollectible deductibles?

       CONCLUSIONS

       1. Under § 832(b)(5), as constrained by § 1.832-4(a)(4), Taxpayer is not entitled to a
       loss incurred for uncollectible deductibles using its current methodology.

       2. Under § 832(c)(10), Taxpayer is entitled to a deduction for a bad debt within the
       scope of § 166 for an uncollectible deductible, to the extent consistent with § 832(d).

PREF-112116-15 2

FACTS

Taxpayer writes high deductible policies covering workers’ compensation, automobile,
and general liability. These policies are implemented through a base policy with a high
deductible endorsement and an accompanying negotiated security agreement. State
law requires an insurer providing workers’ compensation or automobile liability coverage
to pay claimants on a first-dollar basis without regard to any applicable deductibles that
might apply. This requirement is imposed even if the insurer does not expect the
insured to reimburse the deductible or the insured is insolvent or bankrupt. Accordingly,
the base policy provides that Taxpayer will pay the full amount of all claims on behalf of
the insured, just as it would if the policy did not have any deductible.

The endorsement sets forth the amount and terms of the deductible and provides that
the insured will reimburse Taxpayer for claims that Taxpayer pays that are within the
deductible limit. The portion of claims for which the insured agrees to reimburse
Taxpayer is referred to as the “deductible layer.” The separately negotiated security
agreement addresses the amount and type of collateral Taxpayer requires.

For purposes of annual statement reporting, unpaid loss reserves for high deductible
plans shall be determined in accordance with the National Association of Insurance
Commissioners’ (NAIC) Statement of Statutory Accounting Principles (SSAP) 55.
Reserves for claims arising under high deductible plans shall be established net of the
deductible; however, no reserve credit shall be permitted for any claim where any
amount due from the insured has been determined to be uncollectible. SSAP 65 ¶ 35.

Taxpayer complies with this statutory accounting guidance. Taxpayer monitors
bankruptcy filings, delinquent premium payments, and other legal notices as well as
information provided by underwriters, brokers, agents, and others to determine if the
insured is unlikely to be able to fulfill its obligations to reimburse Taxpayer for the
deductible layer amount. If Taxpayer is of the opinion that any portion of a deductible
layer reimbursement recoverable has become uncollectible, Taxpayer establishes a
“supplemental reserve” for the amount of the uncollectible reimbursement to reverse the
reserve credit as required by SSAP 65 ¶ 35. The supplemental reserve only includes
deductible layer amounts that relate to claims for which unpaid loss reserves have been
established and are deemed uncollectible; it does not include amounts that are an
actuarial estimate of deductible amounts that may be uncollectible in the future. When
the unpaid loss reserve and supplemental reserve are combined, Taxpayer reports an
appropriate level of reserves in compliance with SSAP 65 ¶ 35 on its annual statement.

When a claim is paid, Taxpayer releases the unpaid loss reserve and supplemental
reserve attributable to the paid loss. The deductible layer amount is then reported as a
receivable and, if uncollectible in whole or part, a bad debt, in which case the
uncollectible deductible layer amount is reported as an uncollectible receivable.

Taxpayer provided the following example illustrating the methodology:
PREF-112116-15 3

Assume a policy with a $5 million limit and a $300,000 reimbursable deductible layer.
Loss events occur that Taxpayer values at $400,000. Taxpayer initially adds $400,000
to unpaid losses,1 and nets the reimbursable deductible layer amount of $300,000,
producing a final unpaid loss of $100,000.

Assume the insured posted $200,000 of collateral, and Taxpayer learns the insured is in
bankruptcy and the estimated bankruptcy recoverable is $50,000. Accordingly, the
actual deductible layer amount reimbursement will be $250,000 rather than the
contractually mandated $300,000. Accordingly, Taxpayer increases the supplemental
reserve by $50,000 which is then added to unpaid losses, producing aggregate unpaid
losses of $150,000.

When Taxpayer pays the claim, it reduces unpaid losses by $150,000. Taxpayer posts
a receivable of $300,000 (the nominal reimbursement) and applies the collateral of
$200,000, for a net receivable of $100,000. Taxpayer also reports a contra asset of
$50,000 to reflect the portion of the receivable that it does not expect to recover.

Although the specific terms of each contract may vary, common to each specimen
submitted to our office is that Taxpayer is not entitled to reimbursement until Taxpayer
has actually paid the claim.2

The issues presented, as with most issues arising under the application of subchapter
L, is not whether an item is includible in or deductible from gross income, but the time of
recognizing the item and the analytical reason for that recognition and timing.

LAW AND ANALYSIS

Issue 1

Section 831(a) imposes tax computed as provided in § 11 for each taxable year on the
taxable income of every insurance company other than a life insurance company.

Section 832(a) defines taxable income for a company subject to § 831 to be the gross
income defined in § 832(b)(1) less the deductions allowed by § 832(c).

Section 832(b)(1)(A) defines gross income to include the combined gross amount
earned during the taxable year, from investment income and from underwriting income,

1
For purposes of illustration, discounting required by § 846 is ignored.
2
For example, one endorsement specimen provides “[Taxpayer] will pay part of all of any Deductible
Amounts or ‘allocated loss adjustment expense’ to effect settlement of any claim and, upon notification of
the action taken, [the insured] will reimburse us for such part of any Deductible Amounts or ‘allocated loss
adjustment expenses’ as shown on the billing from us.” Another provides “[the insured] will be billed
[periodically] following the effective date of [the contract] for the following: paid losses within the
deductible amounts plus applicable paid ALAE paid during [the period].”
PREF-112116-15 4

computed on the basis of the underwriting and investment exhibit of the annual
statement approved by the NAIC.

Section 832(b)(3) defines underwriting income to be premiums earned on insurance
contracts during the taxable year less losses incurred and expenses incurred. See also,
§ 832(c)(4) (allowing a deduction for losses incurred, as defined in § 832(b)(5)).

Section 1.832-4(a)(2) of the Income Tax Regulations provides that the Underwriting and
Investment Exhibit of the Annual Statement is presumed to reflect the true net income of
the company and, insofar as it is not inconsistent with the provisions of the Code, will be
recognized and used as a basis for that purpose. All items of the exhibit, however, do
not reflect an insurance company’s income as defined in the Code.

Section 832(b)(4) defines premiums earned as gross premiums written on insurance
contracts during the taxable year, reduced by return premiums and premiums paid for
reinsurance, plus 80 percent of unearned premiums on outstanding business at the end
of the preceding taxable year and reduced by 80 percent of the unearned premiums on
outstanding business at the end of the taxable year.

Section 1.832-4(a)(4)(i) defines gross premiums written as amounts payable for
insurance coverage. The label placed on a payment in a contract does not determine
whether an amount is a gross premium written. Gross premiums written do not include
other items of income (for example, charges for providing loss adjustment or claims
processing services under administrative or cost-plus arrangements). Gross premiums
written on an insurance contract include all amounts payable for the effective period of
the insurance contract.

Section 832(b)(5) defines losses incurred to be losses incurred during the taxable year
on insurance contracts, computed by taking losses paid during the taxable year,
reduced by salvage and reinsurance recovered during the taxable year, adding all
unpaid losses on life insurance contracts plus all discounted unpaid losses outstanding
at the end of the taxable year, deducting unpaid losses on life insurance contracts plus
all discounted unpaid losses outstanding at the end of the preceding taxable year, and
adding estimated salvage and reinsurance recoverable at the end of the preceding year
and deducing estimated salvage and reinsurance recoverable as of the end of the
taxable year.

Section 1.832-4(a)(4)(i) provides that to the extent that amounts paid or payable with
respect to an arrangement are not gross premiums written, the insurance company may
not treat amounts payable to customers under the applicable portion of such
arrangements as losses incurred described in § 832(b)(5).3

3
In general, a taxpayer is not allowed to deduct an otherwise deductible amount if the taxpayer is entitled
to reimbursement, unless the reimbursement is included in gross income, is worthless, or is unlikely to be
collected. Glendinning, McLeish & Co. v. Commissioner, 61 F.2d 950, 952 (2d Cir. 1932), aff’g 24 B.T.A
518 (1931); Addressograph-Multigraph Corp. v. Commissioner, 4 T.C.M. 147, 177 (1945); Findley v U.S.,
PREF-112116-15 5

F.W. Services, Inc. v. Commissioner, T.C. Memo. 2010-128, aff’d, 459 Fed. Appx. 389
(5th Cir. 2012) (unpublished opinion), involved funding of the deductible layer of a
workers’ compensation policy and an employer’s liability policy with a “reserve fund”
contract entered into with an affiliate of the insurers. The court upheld disallowance of a
deduction for amounts paid into the reserve fund in excess of the actual claims and
expenses paid during the year, holding that the payments to the reserve fund provided
only assurance that the deductible amounts would be paid and did not alter the risk
inherent in the true insurance; “a reserve arrangement does not morph into insurance
just because there is an insurance policy next to it.”

Taxpayer did not include the deductible layer amount in gross premiums written.
Therefore, section 1.832-4(a)(4)(i) prohibits Taxpayer from including the reimbursable
deductible layer amount as a component of § 832(b)(5) losses incurred. If Taxpayer
had included the reimbursable deductible in gross premiums, Taxpayer could have
included the reimbursable deductible component of losses as losses incurred.

Issue 2

Under § 832(a) the taxable income of an insurance company taxable under § 831 is the
gross income as defined in § 832(b)(1) less the deductions allowed by § 832(c).

Section 832(c)(10) allows deductions (other than those specified in § 832(c)) as
provided in §§ 161 – 199 and in §§ 401 – 420.

Section 1.832-4(a)(2) provides that the underwriting and investment exhibit of the
annual statement is presumed to reflect the true net income of the company, and insofar
as it is not inconsistent with the provisions of the Code will be recognized and used as a
basis for that purpose. Accordingly, Taxpayer is generally subject to the accrual
method of accounting. Sections 448(a); 446. See also, e.g., Western Casualty & Surety
Co. v. Commissioner, 65 T.C. 897, 903 (1976) (“We note that petitioner, in accordance
with the instructions on filling out the income statements of the underwriting and
investment exhibit on the annual statement form, is required to use the accrual method
of accounting.”), aff’d in part, 571 F.2d 514 (10th Cir. 1978); City Investing Co. v.
Commissioner, T.C. Memo. 1987-36, aff’d sub nom., 875 F.2d 377 (2nd Cir. 1989), cert.
den. sub nom., 493 U.S. 1069 (1990);

Section 166(a)(1) allows as a deduction any debt which becomes worthless within the
taxable year while § 166(a)(2) provides that when satisfied that a debt is recoverable
only in part, the Secretary may allow such debt, in an amount not in excess of the part
charged off within the taxable year, as a deduction. Section 166(b) provides that for
purposes of § 166(a), the basis for determining the amount of the deduction for any bad

28 F.Supp. 715, 719 (W.D. La. 1939); Standard Oil Co. of N.J. v. Commissioner, 11 T.C. 843, 848-49
(1948), supplementing 7 T.C. 1310 (1946); Pittsburgh Indus. Eng’g Co. v. Commissioner, 9 T.C.M. 1132,
1140 (1950). See Weihrauch v. Commissioner, 37 T.C.M. 28, 32 (1978); Rev. Rul. 75-46, 1975-1 C.B.
55.
PREF-112116-15 6

debt shall be the adjusted basis provided in § 1011 for determining the loss from the
sale or other disposition of property.

Section 1.166-1(c) provides that only a bona fide debt qualifies for purposes of § 166; a
bona fide debt is a debt which arises from a debtor-creditor relationship based upon a
valid and enforceable obligation to pay a fixed or determinable sum of money. A debt
arising out of the receivables of an accrual method taxpayer is deemed to be an
enforceable obligation for these purposes to the extent that the income such debt
represents has been included in the return of income for the year for which the
deduction as a bad debt is claimed or for a prior taxable year. That the bad debt is not
due at the time of deduction shall not itself prevent its allowance under this section.

Under § 1.166-2(a), in determining whether a debt is worthless in whole or part, the
Service will consider all pertinent evidence, including the value of the collateral, if any,
securing the debt and the financial condition of the debtor.

Section 1.166-3(a)(1) provides that a deduction under § 166(a)(2) on account of partially
worthless debts shall be allowed with respect to specific debts only.

Section 832(d) provides that nothing in § 832 shall permit the same item to be deducted
more than once.

For the uncollectible deductible layer reimbursement amount to be a debt within the
scope of § 166, it must be a bona fide debt. A debt is bona fide if Taxpayer’s
contractual rights to reimbursement are a valid and enforceable obligation to pay a fixed
or determinable sum of money. Section 1.166-1(c). Here, prior to Taxpayer’s payment
of a claim, Taxpayer does not have an enforceable claim to reimbursement; hence there
is no debt from the insured to the Taxpayer until Taxpayer’s payment of the claim.

The debt would be deemed an enforceable obligation for purposes of § 1.166-1(c) if the
income such debt represents has been included in the return of income for the year for
which the deduction is claimed or for a prior taxable year. Here, consistent with the
finding under Issue 1 that the deductible layer amount was not included in gross
premiums written, it does not appear that Taxpayer included the reimbursement in
income for the year for which the deduction is claimed or for a prior taxable year.

Once Taxpayer has paid the claim, Taxpayer has a contractual right to reimbursement
that is a bona fide debt for purposes of § 166. If all or part of the debt is later
determined to be worthless, Taxpayer may claim a full or partial deduction. Section
1.166-2.

If Taxpayer had included both the reimbursable deductible in gross premiums and the
reimbursable deductible component of losses as losses incurred, Taxpayer may not
also claim a deduction for the bad debt. Section 832(d).
PREF-112116-15 7

Accounting for Uncollectible Deductible Layer

The proper accounting for the uncollectible deductible layer reimbursement, given that it
was not included in gross premiums written, would be for Taxpayer to take a deduction
under §§ 832(c)(10) (as an allowable §166 deduction) at the time Taxpayer’s right to
reimbursement is determined to be worthless (i.e., uncollectible) under § 1.166-2.

This conclusion can be illustrated through the above example, involving a policy with a
$5 million limit and a $300,000 reimbursable deductible layer amount under which loss
events occur that Taxpayer values at $400,000. Taxpayer will be required to disburse
$400,000 and nominally should be reimbursed for $300,000, with the balance of
$100,000 borne by Taxpayer.

However, in addition to the posted collateral of $200,000, consistent with § 1.166-2,
Taxpayer has determined that it is able to recover only an additional $50,000, leaving a
$50,000 deficit in the amount reimbursed.

Taxpayer has a loss incurred under § 832(b)(5) of $100,0004 and an obligation to
disburse $400,000. As Taxpayer pays the claims, it should recognize losses paid under
§ 832(b)(5) of $100,000 and has a non-deductible disbursement of $300,000 for which it
has a nominal right of recovery, thus creating the bona fide debt of $300,000. Because
Taxpayer has determined consistent with § 1.166-2 that it is able to collect only
$250,000 of that debt, Taxpayer may claim a deduction under §§ 832(c)(10) (as an
allowable §166 deduction) for $50,000.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-6995 if you have any further questions.

4
For illustration purposes the discounting required by § 846 is ignored.