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COLONIAL AMERICAN LIFE INSURANCE CO. v. COMMISSIONER INTERNAL REVENUE

decided: June 15, 1989.

COLONIAL AMERICAN LIFE INSURANCE CO
v.
COMMISSIONER OF INTERNAL REVENUE



CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT.

Kennedy, J., delivered the opinion of the Court, in which Rehnquist, C. J., and Brennan, White, Marshall, and Scalia, JJ., joined. Stevens, J., filed a dissenting opinion, in which Blackmun and O'Connor, JJ., joined, post, p. 260.

Author: Kennedy

[ 491 U.S. Page 246]

 JUSTICE KENNEDY delivered the opinion of the Court.

The arcane but financially important question before us is whether ceding commissions paid by a reinsurance company to a direct insurer under a contract for indemnity reinsurance are fully deductible in the year tendered or instead must be amortized over the anticipated life of the reinsurance agreements.

I

This case involves the workings of the reinsurance industry. In order to spread the risks on policies they have written or to reduce required reserves, insurance companies commonly enter into reinsurance agreements. Under these agreements, the reinsurer pays the primary insurer, or "ceding company," a negotiated amount and agrees to assume the

[ 491 U.S. Page 247]

     ceding company's liabilities on the reinsured policies. In return, the reinsurer receives the future income generated from the policies and their associated reserve accounts.

Reinsurance comes in two basic types, assumption reinsurance and indemnity reinsurance. In the case of assumption reinsurance, the reinsurer steps into the shoes of the ceding company with respect to the reinsured policy, assuming all its liabilities and its responsibility to maintain required reserves against potential claims. The assumption reinsurer thereafter receives all premiums directly and becomes directly liable to the holders of the policies it has reinsured.

In indemnity reinsurance, which is at issue in this case, it is the ceding company that remains directly liable to its policy-holders, and that continues to pay claims and collect premiums. The indemnity reinsurer assumes no direct liability to the policyholders. Instead, it agrees to indemnify, or reimburse, the ceding company for a specified percentage of the claims and expenses attributable to the risks that have been reinsured, and the ceding company turns over to it a like percentage of the premiums generated by the insurance of those risks.

Both the assumption and the indemnity reinsurer ordinarily pay an up-front fee, known as a "ceding commission," to the ceding company.*fn1 The issue in this case is whether ceding commissions for indemnity reinsurance may be deducted by the reinsurer in the year in which they are paid, or whether they must be capitalized over the estimated life of the underlying policies. Petitioner writes and reinsures life, accident, and health insurance. In 1975 and 1976, petitioner entered into four indemnity reinsurance agreements to reinsure

[ 491 U.S. Page 248]

     blocks of life insurance policies written by Transport Life Insurance Company, the ceding company. The agreements required petitioner to indemnify Transport for 76.6% of Transport's liabilities under the block of reinsured policies.*fn2 Petitioner also contracted to pay ceding commissions of $680,000 for the 1975 pair of agreements and $852,000 for the 1976 pair of agreements. In addition, petitioner paid Transport a "finder's fee" of $13,600 in 1975, which the parties agree is subject to the same tax treatment as the ceding commissions.

On its federal income tax returns for 1975 and 1976, petitioner claimed deductions for the full amount of the ceding

[ 491 U.S. Page 249]

     commissions and the finder's fee. The Commissioner disallowed the deductions, concluding that the ceding commissions and finder's fee had to be capitalized and amortized over the useful life of the reinsurance agreements, a period later stipulated to be seven years. Petitioner then filed for review in the Tax Court, which agreed with petitioner that the ceding commissions could be deducted in full in the year of payment.

The Court of Appeals for the Fifth Circuit reversed, holding that ceding commissions are not currently deductible. 843 F.2d 201 (1988). The Court of Appeals reasoned that ceding commissions represent payments to acquire an asset with an income producing life that extends substantially beyond one year, and that under fundamental principles of taxation law, such payments must be amortized over the estimated life of the asset.

To resolve a conflict in the Courts of Appeals,*fn3 we granted certiorari. 488 U.S. 980 (1988).

II

This case is initially a battle of analogies. The tax treatment of life insurance companies is prescribed in Part I of Subchapter L of the Internal Revenue Code of 1954, 26 U. S. C. §§ 801-820 (1970 ed. and Supp. V). Given that these provisions do not specify in explicit terms whether ceding commissions for indemnity reinsurance may be taken as current deductions, the parties each argue that the tax treatment of allegedly analogous payments should be controlling. Petitioner analogizes to the tax treatment of "agents' commissions and other expenses incurred by a life insurance company in issuing directly-written insurance." Brief for Petitioner 21. Such expenses of primary insurers are currently deductible under § 809(d)(12) of the Code, which incorporates

[ 491 U.S. Page 250]

     the allowance for "ordinary and necessary" business expenses under § 162(a).*fn4 Petitioner argues that indemnity reinsurance is in effect a direct insurance agreement between the reinsurer and the ceding company. Parties to an indemnity reinsurance agreement, petitioner points out, stand in the same relation to one another as do the parties to a conventional insurance policy: in return for a premium, the reinsurer agrees to reimburse the ceding company in the event the company becomes liable for certain designated risks. Petitioner reasons that just as a direct insurer may currently deduct the commissions it pays to acquire policies, so should an indemnity reinsurer be able to deduct currently the ceding commissions it expends to acquire business.

Respondent counters with an analogy to assumption reinsurance, the ceding commissions for which, it is well established, must be capitalized and amortized. See 26 CFR § 1.817-4(d) (1988). "[T]here is essentially no economic difference," respondent argues, "between a ceding commission paid in an assumption reinsurance transaction and one paid in an indemnity reinsurance transaction." Brief for Respondent 19-20. In both cases, according to respondent's analysis, the ceding ...


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