15 October 1997 Internal T.I. 9638486 - MODIFIED CO-INSURANCE

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

The comparison of traditional co-insurance and modco reinsurance arrangements and the determination of the amount of the reserve that the ceding company is entitled to pursuant to sections 1401 of the Regulations taking into account section 1402 of the Regulations under each arrangement.

Position:

The differences between the two arrangements should not affect the amount of the reserve computed pursuant to section 1401 of the Regulations and taking into account section 1402 of the Regulations.

Reasons:

When dealing with a reinsurance arrangement there has to be a transfer of risk. Consequently, the ceding insurer must compute its policy reserves net of the reinsurance ceded as required pursuant to section 1402 of the Regulations.

								October 15, 1997

	MEMORANDUM TO FILE				963848

MODIFIED CO-INSURANCE ("modco")

Position

While there are differences between traditional co-insurance and modco reinsurance arrangements in our view these differences should not affect the amount of the reserve that the ceding company is entitled to pursuant to sections 1400 and 1401 of the Income Tax Regulations ("Regulations") after giving effect to section 1402 of the Regulations.

DISCUSSION

In simple terms under a traditional co-insurance arrangement a portion of the risk (eg 90%) with regard to specified policies is ceded to a reinsurer and in consideration therefor a reinsurance premium is paid to the reinsurer. The reinsurer uses this premium to support the reserves for the liabilities assumed and has the investment risk with regard to the investment of the premium. If unregistered the reinsurer would leave sufficient assets in a trust to cover its reserves with regard to the liabilities it has reinsured. Otherwise the ceding company would be required by the Office of the Superintendent of Financial Institutions ("OSFI") to maintain sufficient assets to support the liabilities reinsured.

As in the case of a co-insurance arrangement, under a modco arrangement a portion of the risk (eg 90%) with regard to specified policies is ceded to the reinsurer in consideration for a reinsurance premium. However the reinsurance premium is either not paid to the reinsurer or, if paid, is returned by the reinsurer to the ceding company. The reinsurance premium retained by, or returned to, the ceding company (the "Retained Reinsurance Premium") provides it with the assets to support the reserves in respect of the risks that have been ceded to the reinsurer. It is our understanding that in most cases the reinsurance premium is retained by the ceding company.

Therefore while the ceding company maintains the full reserve on its books and reports the full amount of the reserve to OSFI a portion of this reserve is funded by the Retained Reinsurance Premium that relates to risks that have been reinsured. We understand that modco reinsurance is being used primarily with unregistered non-resident reinsurers and/or in non-arm's length situations.

It is our understanding that the ceding company will maintain what we will refer to as the modco adjustment account (it could also be referred to as the modco reporting document, as an example) wherein it will keep a summary of all the individual elements which are to be taken into account in the modco reinsurance contract.

The modco reinsurance contract also establishes and in some cases fixes the risk of the reinsurer with regard to the interest or investment risk. While it has been suggested that this shifts the investment risk to the ceding company with regard to business reinsured this, in our view, is not accurate. The reinsurer would no longer be directly responsible for investment risk per se but only because it has provided for or hedged the investment risk by provision in the modco reinsurance contract. This is evidenced by the fact that there is provision in the contract for crediting interest, through the modco adjustment account, to the reinsurer in respect of the Retained Reinsurance Premium. The agreed upon rate may be more or less than what the reinsurer would have been able to earn had it retained and invested the Retained Reinsurance Premium elsewhere. Where such assets are insufficient to support the liabilities reinsured with the reinsurer the reinsurer would pay or credit interest to the ceding company through the modco adjustment account in respect of the shortfall.

Accordingly in our view, apart from the fact that the ceding company holds the assets in support of the reinsurer's reserve requirements (as opposed to the reinsurer placing such assets in a trust, for example) and the implications with respect to the investment risk discussed above, modco reinsurance is no different than co-insurance although it is accounted for differently.

In this regard the modco adjustment account effectively tracks the amount owing by the ceding company to the reinsurer in respect of the Retained Reinsurance Premium together with interest credited to the reinsurer on such Retained Reinsurance Premium plus or minus other adjustments. Therefore in our opinion the modco adjustment account reflects the liability of the ceding company to the reinsurer in respect of the Retained Reinsurance Premium in support of the future liabilities that the reinsurer has reinsured and will be required to satisfy. It does not represent income and expense of the ceding company per se although certain adjustments to this account would be reflected in the calculation of the ceding company's income for tax purposes (eg interest credited would be deductible and expenses charged would be included in income or a reduction of expense to the extent that they relate to deductible expenses of the ceding company).

As opposed to the modco adjustment account referred to above the modco reserve adjustment is comprised of reserve changes and interest income. The modco reserve adjustment has nothing to do with claims per se but claims are indirectly a component in determining what the modco reserve adjustment is as described below.

The reinsurer is ultimately responsible for 90% of the claims and will in fact be charged for 90% of the claims over the life of the contract. However, the charge for this participation is reflected with regard to the reserves which are adjusted annually through the modco adjustment account to take into account claims paid and interest or investment income earned. The modco reserve adjustment is therefore made up of the reserves reflected on the balance sheet (which take into account claims paid) and the amount of the investment income credited to the reinsurer through the modco adjustment account.

For example, in Year 1, we are assuming that the claims and the interest income are nil and that the reserves are $1,000,000. The modco reserve adjustment reflects $900,000 in favour of the ceding company which is 90% of the increase in reserve of $1,000,000. In Year 2, we are assuming that the claims are $263,798 and that the interest income is $100,000. The following reserve change would occur:

Opening reserves		1,000,000
Plus interest income	  100,000
Less claims			 (263,798)
Closing reserves		  836,202

Reserve change 1,000,000 - 836,202 = 163,798 (decrease)

Since the reinsurer is responsible for 90% of reserves, 90% of the decrease in reserves or $147,418 must be credited to the reinsurer. In addition, while the interest income is a component in the calculation of the reserve change amount, as described above, no credit has been given to the reinsurer per se and therefore the reinsurer must be credited with 90% of the interest income, $90,000, in our example, for a total adjustment of $237,418.

In this regard the reserve change is in respect of the $1,000,000 premium and not the total claims to be paid in the future or the interest income to be earned. In our examples, which are based on a perfect world, interest income will offset exactly the amount of the claims in excess of the $1,000,000 premium.

CONCLUSION

In summary and in general terms, even though we recognize that the terms of each arrangement will have to be reviewed, the appropriate treatment of a modco arrangement for income tax purposes would be as follows:

-the ceding company would include 100% of the premium received from the policyholders in income;

-the ceding company would be entitled to a deduction in respect of the reinsurance premium paid or payable to the reinsurer;

-where the ceding company owns 100% of the assets in support of the reserves relating to the policies it is indebted to the reinsurer in respect of the Retained Reinsurance Premium adjusted and evidenced by the modco adjustment account, notwithstanding that such indebtedness may not be expressly provided for in the contract as such. In this regard it is our view that neither the fact that the ceding company has title to the assets that support the reserves nor the accounting treatment utilized in the reporting of a modco arrangement changes or mitigates the fact that a portion of the risks has been reinsured. Accordingly section 1402 of the Regulations will apply to limit the reserves of the ceding company to the risks that are not the subject of the modco reinsurance contract;

-interest credited to the reinsurer through the modco adjustment account in respect of the Retained Reinsurance Premium in support of the liabilities reinsured by it will be deductible by the ceding company and may be subject to withholding tax where credited to a non-resident reinsurer;

-expenses charged to the reinsurer in respect of amounts deducted by the ceding company in computing its income will be included in the ceding company's income as a recovery of expenses;

-the reinsurer's share of claims which are charged to it through the modco adjustment account represent neither a deductible expense nor income or expense recovery of the ceding company. Such amount, as illustrated in the example to this memorandum, reduces the Retained Reinsurance Premium of the reinsurer and therefore the ceding company's indebtedness to the reinsurer;

-the modco adjustment account per se, subject to the comments above, represents neither income or expense of the ceding company. One must analyze the net result of the modco adjustment account which is normally reflected in the income statement of the ceding company to determine the income or expense elements included in this account.

The appendix sets out an example that compares the income tax implications in respect of a modco arrangement, as indicated above, to the accounting treatment provided in respect of a modco arrangement, a direct writing arrangement and a co-insurance arrangement.

F. Lee Workman