Sec. 848 capitalization of insurance acquisition costs.

• Author: Cuddy, Michael J.

On Nov. 15, 1991, the IRS released its long-awaited proposed regulations on the capitalization of deferred acquisition costs (DACs). The IRS regulations cover the following. * In a liberal approach to the requirements for group life insurance contracts, such contracts are allowed to be underwritten considering risks such as sex, smoker/nonsmoker and age, without jeopardizing their group classification. * Items in a reinsurance agreement must be treated consistently by both the ceding company and the assuming company. * A ceding company may reduce its DACs only if (1) the assuming company is required to capitalize DACs, (2) neither party to the reinsurance contract is the direct writer and (3) the assuming company has general deductions that are less than the DACs it would otherwise be required to capitalize under a reinsurance agreement. The companies may make an election, however, requiring the assuming company to capitalize DACs without regard to the general deduction limitation, in which case the ceding company may reduce its own DACs to be capitalized to the full extent of the "net negative consideration" under the contract. * Interim rules for reinsurance contracts entered into before Dec. 31, 1991 for the 1991 tax year. Contracts entered into on or after 1992 will be subject to the new rules.

Sec. 848 applies to "specified insurance contracts," which are defined as any life insurance contracts, annuity contracts, noncancelable and guaranteed renewable accident and health contracts, and combination contracts. Under Sec. 848(c), the capitalization rates are 1.75% for annuity contracts, 2.05% for group life contracts and 7.70% for all other specified insurance contracts.

Pension plan contracts (as defined in Sec. 818(a)), flight insurance and qualified foreign contracts (as defined in Sec. 807(e)(4)) are exempt from the DAC capitalization requirements (Sec. 848(c)). However, the exemption f or qualified foreign contracts does not extend to the assumption of such contracts through reinsurance agreements.

The definitions in the proposed regulations for life insurance contracts, annuity contracts and noncancelable and guaranteed renewable accident and health contracts do not vary from their general definitions. Life contracts issued after Dec. 31, 1984 must meet the requirements of Sec. 7702. Annuity contracts must be subject to the rules of Sec. 72, or constitute a qualified funding asset under Sec. 130(d) (i.e., a structured settlement). Noncancelable and guaranteed renewable accident and health contracts are the same as those referred to in Sec. 816.

In the case of a combination contract, the entire premium is subject to the highest capitalization rate applicable to any of the coverages provided. A combination contract is any contract that provides two or more types of coverage that, if provided separately, would be subject to Sec. 848. There is an exception to this rule for combination contracts offering group life coverage with annuity coverage. In these cases, the entire premium is treated as an "other" life contract and as such is subject to the highest DAC capitalization rate (i.e., 7.70%). Prop. Regs. Sec. 1.848-1(h)(1) provides guidance for the definition of group contracts. To be classified as a group life contract: * The contract must be a group life insurance contract under applicable law. * The coverage must be provided under a master contract issued to the group policyholder. * The premiums on the contract must be reported as group life insurance premiums on the insurance company's annual statement. * Premiums must be determined on a group basis. * The proceeds must not be payable to the insured's employer or an organization to which the insured belongs. * A contract must cover an eligible group.

An eligible group includes employee groups, debtor groups, labor union groups, association groups, credit union groups and combination or multiple groups. A group may be determined by using any reasonable characteristic other than individual members' health (Prop. Regs. Sec. 1.848-1 (h)(2)).

In addition, there are requirements as to individual member eligibility and premium charges. Generally, the eligibility requirements are met if the insurance company cannot deny or limit coverage to any...