Court-ordered restructuring of long-term care policies in an insurer rehabilitation is not a taxable event for policyholders

Plain-English summary

A state-domiciled life insurance company that sold guaranteed-renewable long-term care policies was placed into rehabilitation by a state court because its projected liabilities far exceeded its assets. Under the court-approved rehabilitation plan, the policies will be restructured: underfunded policies are split into a funded portion and an unfunded portion, policyholders elect among options that raise premiums or cut benefits, and the unfunded piece becomes a general debt the insurer may or may not repay. The insurer asked the IRS how this restructuring affects taxes. The IRS ruled favorably on five points: the restructuring does not change a policy's issue date for section 7702B, is not a material change or taxable disposition under section 1001, does not turn otherwise-excludable health benefits into taxable income under section 104(a)(3), and does not change the policyholder's basis; it also confirmed how the insurer accounts for the reserve and premium changes under the life-insurance-company rules in subchapter L. The IRS declined to rule on whether the insurer has cancellation-of-debt income under section 108. This matters because it assures policyholders that a distressed insurer's court-supervised policy changes will not trigger tax on them.

Ruling snapshot

• Question: What are the federal tax consequences, for policyholders and the insurer, of restructuring long-term care policies as part of a state-court insurer rehabilitation?
• Outcome: Approved (five favorable rulings; IRS declined to rule on the section 108 discharge-of-indebtedness question)
• Key authorities: IRC §§ 104(a)(3), 7702B, 1001, 1011, 803, 805, 807(d); Rev. Proc. 92-57, 1992-2 C.B. 410

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202235004                                              Third Party Communication: None
 Release Date: 9/2/2022                                         Date of Communication: Not Applicable
 Index Number: 1001.00-00, 1011.00-00,
               104.00-00, 7702B.00-00,                          Person To Contact:
               803.00-00, 805.00-00,                            ---------------------, ID No. -----------------
               807.00-00, 807.01-00                             Telephone Number:
                                                                --------------------
                                                                Refer Reply To:
 -----------------------                                        CC:FIP:B04
 --------------------------------------                         PLR-124736-21
 ------------------------------------------------------------   Date:
 ------------------                                             May 31, 2022
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Legend

 Insurer                      = --------------------------------------------------------------------------------
                                ---------------------------------------------
 Parent                       = ------------------------------------------------------------------------
 Court                        = ---------------------------------------------------
 Plan                         -   --------------------------------------------------
 Restructuring                = --------------------------------------------------------------------------------
 Statement                      ----------------------------------------------------
 State                        = ------------------
 Date 1                       = -------
 Date 2                       = -----------------------
 Date 3                       = ----------------------
 Date 4                       = --------------------------
 Effective Date               = --------------------------------------------------------------------------------
                                ------------------


Dear ---------------:
PLR-124736-21                                 2

This letter is in response to the letter submitted by your authorized representative that
requested rulings on the application of §§ 104, 108, 803, 805, 807, 1001, 1011, and
7702B of the Internal Revenue Code (the “Code”) to the rehabilitation of Insurer. The
material information submitted in that letter and subsequent correspondence is
summarized below.

                                          FACTS

Parent is the common parent of a consolidated group that includes Insurer. Parent
owns all of the stock of Insurer. Insurer is a State-domiciled stock insurance company
and a life insurance company under § 816.

Insurer has issued or assumed and novated guaranteed renewable long-term care
insurance policies (the “Policies”). None of the Policies has any cash value. Some of
the Policies are qualified long-term care insurance contracts under §7702B. Insurer has
not written any new business since Date 1 but has been required to renew its existing
Policies pursuant to and subject to the terms of the Policies and applicable law.

On Date 2, under approval by the Court, the State Insurance Commissioner (the
“Commissioner”) ordered Insurer into rehabilitation because Insurer’s projected liabilities
significantly exceeded its projected assets. The Court appointed the Commissioner as
the statutory rehabilitator (the “Rehabilitator”). On Date 3, the Court approved the Plan,
which is a plan for the rehabilitation of Insurer. The Plan requires the restructuring of
certain insurance liabilities under the Policies (the “Policy Liabilities”) and the adoption
of certain policy modifications (the “Restructuring”), which will occur pursuant to the
Restructuring Statement. On Date 4, the Court approved the Restructuring Statement
as part of the Plan. The State guaranty association (the “GA”) is not required to provide
coverage to Insurer’s policyholders for Policy benefits as a result of the rehabilitation or
the Plan. However, the GA’s obligations could be triggered if Insurer is placed in
liquidation as a result of a separate Court order.

The Plan contemplates that the rehabilitation will occur in three phases.

In Phase One, the Rehabilitator will determine for which of the Policies Insurer is
projected to have insufficient assets to fund Policy Liabilities because the Policies are
underpriced. A Policy will be considered underpriced if the premium for the Policy is
below the “If Knew Premium”. The “If Knew Premium” is generally the premium Insurer
would have charged from inception of the Policy had it known what it knows now. To
address the underfunding of the Policies, the Policy Liabilities of each Policy as of the
Effective Date and prior to any Restructuring (the “Unmodified Policy Value”, which is
equal to such Policy’s gross premium reserve) will be notionally allocated between (1)
an amount Insurer is projected to have sufficient assets to fund (the “Initial Funded
Restructured Policy Value”) and (2) an amount Insurer is projected to be unable to fund
(the “Unfunded Benefit Liability”).
PLR-124736-21                                 3

To determine the Initial Funded Restructured Policy Value, liquid invested assets of
Insurer will first be notionally set aside to pay administrative costs, unpaid claims, and
certain other debts. The balance of such assets will be notionally allocated among the
Policies based on the accumulated premiums for each Policy. Each Policy’s Initial
Funded Restructured Policy Value will be determined based upon such Policy’s
notionally allocated assets and its expected premiums. Each Policy’s Unfunded Benefit
Liability will be the excess of such Policy’s Unmodified Policy Value over its Initial
Funded Restructured Policy Value. The notional allocation of the assets among the
Policies will be made separately for (1) Policies issued in states in which the senior
insurance regulatory official of that state elects to “opt-out” of certain provisions of the
Plan (“Opt-Out States”) and (2) Policies issued in all other states (“Opt-In States”).

As of the Effective Date, the Unfunded Benefit Liability will be eliminated from each
Policy and its Policy Liabilities and treated as creating an equal amount of separate
indebtedness of Insurer to the Policy’s owner (a “Policy Owner”). Such indebtedness
(the “Debt”) will be a non-insurance, general creditor indebtedness and will not
constitute a separate contractual obligation covered by the applicable GA if Insurer were
to be liquidated. It is possible, but not guaranteed or projected, that Insurer will make
partial payments on the Debt before the end of the rehabilitation.

As part of the Restructuring, Policy Owners of underfunded Policies will be required to
elect one of four options added to the Policy for Phase One to increase the Policy’s
premiums or reduce its benefits, so that the premiums of such Policies will be adequate
on an If Knew Premium basis. There is a default option for Policy Owners that do not
make an election. The elections will generally be implemented as of the Effective Date
after the Policy Liabilities have been restructured into their separate IFRPV and UBL
components. The Plan has special provisions for Policies issued in Opt-Out States.
Generally, the benefits of Policies issued in Opt-Out States will be reduced to
correspond to the premiums approved in that state.

In Phase Two, the results of Phase One will be evaluated. If necessary, certain Policy
Owners may be required to make additional elections (similar to those in Phase One)
under options added to the Policy for Phase Two as part of its Restructuring as of the
Effective Date that would further increase premiums or reduce benefits of their Policies.
The Plan has special provisions applicable to Phase Two for the Policies issued in Opt-
Out States.

In Phase Three, the Rehabilitator will complete the run-off of the Policies. If there are
sufficient funds, the Rehabilitator may make payments under the Debt and pay other
creditors on account of any amounts owed to them apart from Policy Liabilities. The
Rehabilitator will request that any Debt that remains unsatisfied at the conclusion of the
rehabilitation will be discharged by the Court at the time of the final discharge order.

                                  LAW AND ANALYSIS
PLR-124736-21                                  4

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 (1)
are attributable to contributions by the employer which were not includible in the gross
income of the employee or (2) 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 (1) provides protection only for coverage of qualified long-term care services; (2)
does not pay or reimburse expenses incurred for certain services or items reimbursable
under Title XVIII of the Social Security Act; (3) is guaranteed renewable; (4) does not
provide for a cash surrender value; (5) permits premium refunds or policyholder
dividends to be applied only as a reduction in future premiums or an increase in future
benefits; and (6) 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 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.
PLR-124736-21                                 5

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.

Under § 1001(a), the gain from the sale or other disposition of property is the excess of
the amount realized therefrom over the adjusted basis provided in § 1011 for
determining gain, and the loss is 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, is the
basis (determined under § 1012 or other applicable sections of subchapter O,
subchapter C (relating to corporate distributions and adjustments), subchapter K
(relating to partners and partnerships), and subchapter 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, less
return premiums and premiums and other consideration arising out of indemnity
reinsurance and (2) the net decrease in reserves which is required by § 807(a).

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) the net increase in reserves
which is required by § 807(b).

Section 807(d) provides the method of computing the amount of life insurance reserves
for purposes of part I of subchapter L (other than § 816).

                                         RULINGS

    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.
PLR-124736-21                                6

    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 the Policy Owner under § 1001.

    3. Any Court-approved Policy restructuring or modification described in the
      Restructuring Statement will not cause any amount otherwise excludible from
      gross income under § 104(a)(3) to become includible in gross income by the
      Policy Owner.

    4. The Policy Owner’s adjusted basis under § 1011 in any Policy will remain the
      same immediately after any Court-approved restructuring or modification
      described in the Restructuring Statement as such adjusted basis was
      immediately before such transaction.

    5. When any Policy’s Unmodified Policy Value is 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. 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. Insurer will be able to deduct under § 805(a)(1) as accrued benefits an
             amount equal to the Policy’s Unmodified Policy Value;
          c. Insurer will include in premium income under § 803(a) the restructured
             Policy’s Initial Funded Restructured Policy Value; and
          d. Insurer will be able to deduct under § 805(a)(2) the increase in tax
             reserves under § 807(d) attributable to the restructured Policy’s Initial
             Funded Restructured Policy Value coverage.

We decline to rule on whether Insurer excludes from gross income under § 108(a)(1)(B)
any income from the discharge of indebtedness to the Policy Owner to the extent that
Insurer is insolvent at the time of the discharge. See Rev. Proc. 2021-1, Sec. 6.11.

                                        CAVEATS

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer, accompanied by penalty of perjury statements executed by
PLR-124736-21                                           7

an appropriate party. This office has not verified any of the material submitted in
support of the ruling request, and it is subject to verification on examination.

Except as specifically set forth above, no opinion is expressed or implied concerning the
federal tax consequences of the rehabilitation of Insurer under any other provision of the
Code or federal tax regulations.

This ruling letter is directed only to the taxpayer who requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

A copy of this letter should be attached to any federal tax return to which it is relevant.

Pursuant to a power of attorney on file in this office, a copy of this ruling is being
furnished to your authorized representative.



                                                        Sincerely,


                                                        ________________________
                                                        Daniel P. Phillips
                                                        Senior Counsel, Branch 4
                                                        Office of Associate Chief Counsel
                                                        (Financial Institutions & Products)




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