The Internal Revenue Service has released a complicated regulation that could affect the profitability of some insurance company asset acquisitions. The IRS published the final rule, Application of Section 338 to Insurance Companies, in the Federal Register on April 10.

The final rule, based on a draft published in March 2002, affects insurance business acquisitions and other deals involving assumption reinsurance and indemnity reinsurance.

The final rule also includes a temporary regulation affecting a controversial point in the proposed regulation, which involves accounting for increases in reserves for acquired policies made after the acquisition date.

In many cases, the proposed rule would have required “reinsurers,” or “new targets,” to capitalize many increases in reserves for the acquired contracts that exceeded 2% per year.

The proposed rule would not have required capitalization of reserve increases if the business were under state receivership or if the deduction for the increases in reserves were spread over 10 taxable years, officials write.

“Many commentators objected,” IRS officials write in a preamble to the new final regulation.

The critics say the IRS should not treat the reserve liabilities as contingent liabilities, but IRS officials say the new rule blends elements of the asset purchase accounting model, which applies to most deals, and the services model, which typically applies to insurance companies.

“Treating increases in reserves for acquired contracts similarly to contingent liabilities under the asset purchase model is just one aspect of that amalgam,” the officials write.

“Without requiring capitalization of at least some increases in reserves, there is an incentive for sellers to defer increases in reserves,” the officials write.

But the IRS has responded by issuing the temporary regulation and using the temporary regulation for a proposed permanent rule.

The temporary regulation will require capitalization of reserves for policies acquired under the new rule “only for increases in reserves that clearly reflect a so-called ‘bargain purchase,’” officials write.

A copy of the final rule is on the Web at Document Link.

A copy of the proposed rule is at Document Link.