Court-approved restructuring of an insolvent long-term-care insurer's policies is tax-neutral to policyholders

Plain-English summary

Two affiliated life insurance companies that sold long-term care policies became insolvent and were placed into court-supervised liquidation, and a state court approved a plan to restructure their policies (reducing unfunded benefits, splitting each policy into "covered" and "uncovered" pieces, and shifting coverage to state guaranty associations and a reinsurer). The insurers asked the IRS how this restructuring affects both the policyholders and the insurers under the tax code. For policyholders, the IRS ruled the restructuring is essentially tax-neutral: it does not change a policy's issue date for the long-term-care rules of § 7702B, is not a taxable exchange or disposition under § 1001, produces no taxable income under § 104(a)(3), and leaves the owner's tax basis in the policy unchanged. For the insurers, the IRS spelled out the specific reserve and premium income and deduction consequences under the life-insurance company rules of Subchapter L (§§ 803, 805, 807) at each restructuring step. The IRS declined to rule on whether the insurers can exclude cancellation-of-debt income under the insolvency exception of § 108. The ruling matters because it lets a troubled long-term-care insurer be wound down without hitting its policyholders with surprise tax bills on benefits they may never fully receive.

Ruling snapshot

• Question: What are the tax consequences to policyholders and to the insurers of a court-approved restructuring of long-term-care policies in an insurance liquidation?
• Outcome: Approved (six favorable holdings; IRS declined to rule on the § 108 insolvency-discharge question)
• Key authorities: IRC §§ 104(a)(3), 7702B, 1001, 1011, 803, 805, 807; Treas. Reg. § 1.1001-1(a); Rev. Proc. 92-57

Full text (IRS public release)

Internal Revenue Service                          Department of the Treasury
                                                  Washington, DC 20224

Number: 201845020                     Third Party Communication: None
Release Date: 11/9/2018               Date of Communication: Not Applicable
Index Number: 104.00-00, 803.00-00,
              805.00-00, 807.01-00,   Person To Contact:
              1001.00-00, 1011.00-00, ------------------------, ID No. ------------------
              7702B.00-00             ----------------------------------------------------
                                      Telephone Number:
----------------------------          ----------------------
------------------------------------------------              Refer Reply To:
----------------------------------------                      CC:FIP:B04
 ----------------------------------                           PLR-107228-17
                                      Date:
                                      August 15, 2018


Insurer A      =     -----------------------------------------------------------------------------------------------
                     ----------------------------------
Insurer B      =     -----------------------------------------------------------------------------------------------
                     ---------------------------
Parent         =     -----------------------------------------------------------------------------------------------
                     ----------------------------
State          =     -------------------
Court          =     ----------------------------------------------------
X              =     ----
Date 1         =     -------------------
Date 2         =     ----------------------
Date 3         =     --------------------
Date 4         =     --------------------


Dear ------------------:

      This letter is in response to the letter and supplemental correspondence
submitted by your authorized representative that requested rulings on the application of
§§ 104, 803, 805, 807, 1001, 1011, and 7702B of the Internal Revenue Code (the
"Code") to the liquidation of Insurer A and Insurer B (each, an "Insurer").

FACTS

Corporate Structure and Insurance Business of Insurers

       Parent is a holding company that is the common parent of a life/non-life
consolidated group that includes the Insurers. Parent owns all of the stock of Insurer A.
Insurer A, in turn, owns all of the stock of lnsurer B. Both Insurers are State-domiciled
stock insurance companies and are life insurance companies under § 816.

       The Insurers have issued primarily long-term care policies and certain other
accident and health insurance policies (each, a "Policy"). None of the Policies has any
cash value. Many of the long-term care policies are tax-qualified under § 7702B, but
others are not. Neither Insurer has written any new business since Date 1, but both
Insurers have been required to renew their existing business, pursuant to and subject to
the terms of the Policies and applicable law.

Overview of Liquidation Proceedings and Liquidator's Authority

        On Date 2, under approval by the Court, the State Insurance Commissioner (the
"Commissioner") ordered the Insurers into rehabilitation. Due to the Insurers'
deteriorating financial conditions and other relevant considerations, the Commissioner
requested that the Court convert the Insurers' rehabilitation to a liquidation. On Date 3
(the "Effective Date"), the Court entered orders of liquidation for the Insurers (the
"Liquidation Orders"). The Court appointed the Commissioner as the statutory liquidator
(the "Liquidator"). As of, or soon after, the Effective Date, state insurance guaranty
associations ("GAs") were required to provide coverage to the Insurers' policyholders for
Covered Benefits. Covered Benefits are the amount of a Policy's benefits that are
within the limits, conditions, and scope of coverage of the responsible GA, taking into
account the residence and other attributes of the policyholder as determined by the
responsible GA in accordance with applicable law. Uncovered Benefits are the amount
of a Policy's benefits that exceed Covered Benefits.

Planned Restructuring

       As part of the liquidation, the estimated liabilities under the Policies will be
restructured as provided in a restructuring statement filed with and approved by the
Court (the "Restructuring Statement"). Each Policy's provisions shall be subject to
certain modification provisions as described in the Restructuring Statement. To
determine the extent of restructuring, a determination will be made as to what portion of
each Insurer's assets will be required for costs of administration and contingencies, and
the rest of its assets (the "Allocated Assets") will be notionally allocated to each Policy in
proportion to the estimated liability associated with each Policy, as determined by each
Policy's gross premium reserve before any restructuring or modification of the Policy
following the Liquidation Orders.

         Each Insurer has estimated liabilities with respect to its Policies ("Policy
Liabilities") that vastly exceed its assets, and therefore, are not fully funded by that
Insurer. The amount of a Policy's liabilities before the restructuring is referred to as the
Unmodified Policy Value. The amount of the Unmodified Policy Value that an Insurer
can reasonably expect to fund based on future premiums and Allocated Assets is the
Initial Funded Restructured Policy Value. The amount of the Unmodified Policy Value
that exceeds the Initial Funded Restructured Policy Value is the Unfunded Benefit
Liability.

       As of the Effective Date, each Policy's Unmodified Policy Value will be
restructured into a Covered Benefits component (a "Covered Benefits Component") and
an Uncovered Benefits component (an "Uncovered Benefits Component"). Each
Policy's Covered Benefits Component and Uncovered Benefits Component will be
further divided into an Initial Funded Restructured Policy Value subcomponent and an
Unfunded Benefit Liability subcomponent. This will allow the Insurers to have separate
Policy components timely assumed or guaranteed as appropriate by the GAs and by
another insurance company ("Reinsurer"), which could provide coverage for Uncovered
Benefits. This is intended to prevent any Policy coverages from being unnecessarily
terminated.

        Also as of the Effective Date, a Policy's Uncovered Benefits Component will be
restructured by reducing the Uncovered Benefits Component to its Initial Funded
Restructured Policy Value subcomponent in return for an amount of indebtedness from
the Insurer to the Policy's owner (the "Owner") that is equal to the Unfunded Benefit
Liability by which the Uncovered Benefits Component is reduced. Within X days after
this restructuring, the Initial Funded Restructured Policy Value subcomponent of the
Uncovered Benefits Component will be transferred to and reinsured by Reinsurer, which
will have a liability only to the extent that Reinsurer will have obtained sufficient funding
from the Policy's Insurer.

      As of the Final Restructuring Date, which is Date 4 unless a different date is
approved by the Court, a Policy's Covered Benefits Component will be restructured by
reducing the Covered Benefits Component to its Initial Funded Restructured Policy
Value subcomponent in return for an amount of indebtedness from the Insurer to the
Owner that is equal to the Unfunded Benefit Liability by which the Covered Benefits
Component is reduced.

       The GAs and Reinsurer will separately continue, reinsure, assume, or guarantee
the respective Covered Benefits and Uncovered Benefits and receive transfers of
Allocated Assets to fund these benefits through their rights of subrogation, in
accordance with their agreements with the Liquidator. The transfer of Policy Liabilities
to a GA or Reinsurer will be effected by a Court-approved transaction described by the
Restructuring Statement that will extinguish the Insurer's liability with respect to such
Policy. Generally, such a termination of the Insurer's liability will occur when Allocated
Assets are transferred to (or for the benefit of) the transferee to fund the payment of
such a liability. The Liquidator will seek an order from the Court discharging the
Insurers for any remaining Unfunded Benefit Liability debt to the Owners and the GAs
pursuant to and at the time of the final discharge order (as defined in the Restructuring
Statement) following completion of all of the other steps in the liquidation.

LAW AND ANALYSIS

        Section 104(a)(3) provides that except in the case of amounts attributable to (and
not in excess of) deductions allowed under § 213 for any prior taxable year, gross
income does not include amounts received through accident or health insurance (or
through an arrangement having the effect of accident or health insurance) for personal
injuries or sickness (other than amounts received by an employee, to the extent such
amounts (A) are attributable to contributions by the employer which were not includible
in the gross income of the employee, or (B) are paid by the employer).

      Under § 213(d), premiums paid under a qualified long-term care insurance
contract are generally treated as payments for insurance for purposes of the deduction
allowed under § 213 for expenses paid for medical care.

       Under § 7702B(a), a qualified long-term care insurance contract is treated as an
accident and health insurance contract and amounts received as benefits under such a
contract generally are treated as amounts received for personal injuries and sickness
and as reimbursement for expenses actually incurred for medical care. Section
7702B(b) defines a qualified long-term care insurance contract as an insurance contract
that (a) provides protection only for coverage of qualified long-term care services; (b)
does not pay or reimburse expenses incurred for certain services or items reimbursable
under Title XVIII of the Social Security Act; (c) is guaranteed renewable; (d) does not
provide for a cash surrender value; (e) permits premium refunds or policyholder
dividends to be applied only as a reduction in future premiums or an increase in future
benefits; and (f) meets the consumer protection requirements of § 7702B(g).

       In Rev. Proc. 92-57, 1992-2 C.B. 410, the Service recognized that "[i]nsurance
companies that issue or assume (through reinsurance) annuity, life insurance, or
endowment contracts can become financially troubled and subject to rehabilitation,
conservatorship, insolvency, or similar state proceedings" and that the "[o]rderly
rehabilitation of these insurance companies may require modification or restructuring of
these annuity, life insurance, or endowment contracts." Rev. Proc. 92-57 provides
administrative relief with respect to the these contracts by treating the modification or
restructuring of certain contracts as not resulting in a loss of "grandfathered" status for
purposes of §§ 72, 101(f), 264, 7702, and 7702A, and as not requiring retesting or the
beginning of a new test period under §§ 264([d])(1), 7702(f)(7)(B)-(E), and 7702A(c).

       To qualify for this administrative relief, the modification or restructuring of an
affected contract must satisfy the following conditions:

   1) The modification or restructuring (by endorsement or otherwise) of the affected
      contract must occur as an integral part of the rehabilitation, conservatorship,
      insolvency, or similar state proceeding. Modification or restructuring may
      include, but is not limited to, reductions in benefits, adjustments to mortality or
      other expense charges, reductions in the rate of interest credited to the contract,
      and restrictions on the policyholder's ability to receive benefits under the affected
      contract.

   2) The modification or restructuring of an affected contract must be approved by the
      state court, the state insurance commissioner, or any other responsible state
      official with authority to act in a rehabilitation, conservatorship, insolvency, or
      similar state proceeding.

Rev. Proc. 92-57, Sec. 2.02.

      The proposed modifications and restructuring of the Policies pursuant to the
Restructuring Statement are within the scope of the relief provided by Rev. Proc. 92-57
because these modifications and restructuring are "an integral part of the rehabilitation,
conservatorship, insolvency, or similar state proceeding" and will be approved by the
appropriate state authorities as part of such proceedings.

       Under § 1001(a), the gain from the sale or other disposition of property shall be
the excess of the amount realized therefrom over the adjusted basis provided in § 1011
for determining gain, and the loss shall be the excess of the adjusted basis provided in
such section for determining loss over the amount realized.

       Section 1.1001-1(a) of the Income Tax Regulations provides that "the gain or
loss realized from the conversion of property into cash, or from the exchange of
property for other property differing materially either in kind or in extent, is treated as
income or as loss sustained."

       Section 1011(a) provides the general rule that the adjusted basis for determining
the gain or loss from the sale or other disposition of property, whenever acquired, shall
be the basis (determined under § 1012 or other applicable sections of this subchapter
and subchapters C (relating to corporate distributions and adjustments), K (relating to
partners and partnerships), and P (relating to capital gains and losses)), adjusted as
provided in § 1016.

       Under § 803(a), gross income of a life insurance company includes (1) the gross
amount of premiums and other consideration on insurance and annuity contracts, (2)
the net decrease in reserves which is required by § 807(a), and (3) all other amounts
not included under (1) or (2) which are includible in gross income.

       Under § 805(a), a life insurance company is entitled to a deduction for (1) all
claims and benefits accrued, and all losses incurred (whether or not ascertained),
during the taxable year on insurance and annuity contracts, and (2) a net increase in
reserves required by § 807(b) to be taken into account. Section 807(b) permits an
increase in the amount of life insurance reserves, as calculated under § 807(d), for the
taxable year to be deducted under § 805(a)(2).

HOLDINGS

    1. Any Court-approved Policy restructuring or modification described in the
      Restructuring Statement will not affect the Policy's issue date for purposes of
      § 7702B.

    2. Any Court-approved Policy restructuring or modification described in the
      Restructuring Statement will not be treated as a material change of the Policy or
      an exchange of property for other property differing materially either in kind or in
      extent, and thus will not result in a taxable disposition of any interest in such
      Policy by its Owner under § 1001.

    3. Any Court-approved Policy restructuring or modification described in the
      Restructuring Statement will not result in any amount includible in gross income
      by its Owner under § 104(a)(3).

    4. The Owner's adjusted basis under § 1011 in any Policy will remain the same
      immediately after any Court-approved restructuring, modification, guarantee,
      assumption, continuation, reinsurance, or enhancement of any of the Policy's
      provisions or benefit liabilities as such adjusted basis was immediately before
      such transaction.

    5. When any Policy is initially restructured as of the Effective Date to reduce the
      Policy's unfunded liabilities, for purposes of Subchapter L of Chapter 1 of the
      Code, as of the Effective Date:

            a. The restructuring Insurer will include in income under § 803(a)(2) the
               total amount of the existing tax reserves under § 807(d) attributable to
               the Policy's Unmodified Policy Value;

            b. The restructuring Insurer will be able to deduct under § 805(a)(1) as
               accrued benefits an amount equal to the Policy's Unmodified Policy
               Value;

            c. The restructuring Insurer will include in premium income under § 803(a)
               the sum of the restructured Policy's Covered Benefits Component and
               Initial Funded Restructured Policy Value subcomponent of the
               Uncovered Benefits Component; and

            d. The restructuring Insurer will be able to deduct under § 805(a)(2) the
               increase in tax reserves under § 807(d) attributable to the sum of the
               restructured Policy's Covered Benefits Component and Initial Funded
               Restructured Policy Value subcomponent of the Uncovered Benefits
               Component.

    6. When any Policy is finally restructured as of the Final Restructuring Date to
      reduce its unfunded liabilities, for purposes of Subchapter L of Chapter 1 of the
      Code, as of the Final Restructuring Date:

            a. The restructuring Insurer will include in income under § 803(a)(2) the
               total amount of the existing tax reserves under § 807(d) attributable to
               the then current Covered Benefits Component of the Policy;

            b. The restructuring Insurer will be able to deduct under § 805(a)(1) as
               accrued benefits an amount equal to the then current Covered Benefits
               Component of the Policy;

            c. The restructuring Insurer will include in premium income under § 803(a)
               the restructured Policy's then current Initial Funded Restructured Policy
               Value subcomponent of the Covered Benefits Component; and

            d. The restructuring Insurer will be able to deduct under § 805(a)(2) the
               increase in tax reserves under § 807(d) attributable to the Policy's then
               current Initial Funded Restructured Policy Value subcomponent of the
               Covered Benefits Component.

        Except as expressly provided herein, no opinion is expressed concerning the tax
consequences of any aspect of any transaction or item discussed or referenced in this
letter.

       We decline to rule on whether the restructuring Insurer excludes from gross
income under § 108(a)(1)(B) any income from the discharge of indebtedness to
policyholders or the GAs by court order resulting from the restructuring or modification
of the Policies pursuant to the Restructuring Statement (the Unfunded Benefit Liability)
to the extent that the restructuring Insurer is insolvent at the time of the discharge. See
Rev. Proc. 2018-1, Sec. 6.11.

      The rulings contained in this letter are based upon information and
representations submitted by the Insurers and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the request for rulings, it is subject to verification on
examination. This ruling is directed only to the taxpayer who requested it. A copy of
this ruling must be attached to any tax return to which it is relevant. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.

                                       Sincerely,



                                       Rebecca L. Baxter
                                       Senior Technician Reviewer, Branch 4
                                       (Financial Institutions & Products)



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