Active conduct of an insurance business
(a) Scope.— This section provides rules pertaining to the exception from passive income under section 1297(b)(2)(B) for income derived in the active conduct of an insurance business. Paragraph (b) of this section sets forth the options for a qualifying insurance company (QIC) to qualify as engaged in the active conduct of an insurance business and describes circumstances under which a QIC will not be engaged in the active conduct of an insurance business. Paragraph (c) of this section describes the factual requirements that are sufficient to show that a QIC is engaged in the active conduct of an insurance business for purposes of section 1297(b)(2)(B). Paragraph (d) of this section describes an alternative active conduct percentage test, pursuant to which a QIC may be deemed to be engaged in the active conduct of an insurance business for purposes of section 1297(b)(2)(B). Paragraph (e) of this section describes the circumstances under which officers and employees of certain entities related to a QIC may be treated as if they were employees of the QIC. Paragraph (f) of this section provides definitions applicable to this section. Paragraph (g) of this section provides the applicability date of this section.
(b) Active conduct of an insurance business.—
(1) In general. —A QIC is engaged in the active conduct of an insurance business only if it satisfies—
(i) the factual requirements test in paragraph (c) of this section; or
(ii) the active conduct percentage test in paragraph (d) of this section.
(2) Exceptions.— Notwithstanding paragraph (b)(1) of this section, a QIC is not engaged in the active conduct of an insurance business if either of the following circumstances apply—
(i) It has no employees or only a nominal number of employees and relies exclusively or almost exclusively upon independent contractors (disregarding for this purpose any related entity that has entered into a contract designating its status as an independent contractor with respect to the QIC) to perform its core functions;
(ii) It is a vehicle that has the effect of securitizing or collateralizing insurance risks underwritten by other insurance or reinsurance companies or is an insurance linked securities fund that invests in securitization vehicles, and its stock (or a financial instrument, note, or security that is treated as equity for U.S. tax purposes) is designed to provide an investment return that is tied to the occurrence of a fixed or predetermined portfolio of insured risks, events, or indices related to insured risks.
(c) Factual Requirements Test.—
(1) In general.— A QIC satisfies the factual requirements test of paragraph (b)(1)(i) of this section if all the following are met—
(i) The officers and employees of the QIC carry out substantial managerial and operational activities on a regular and continuous basis with respect to its core functions as described in paragraph (c)(2) of this section; and
(ii) The officers and employees of the QIC perform virtually all of the active decision-making functions relevant to underwriting functions as described in paragraph (c)(3) of this section.
(2) Substantial managerial and operational activities with respect to core functions.—
(i) Substantial managerial and operational activities.— Substantial managerial and operational activities with respect to a QIC’s core functions requires all of the following—
(A) Establishing the strategic, overall parameters with respect to each core function;
(B) Establishing, or reviewing and approving, detailed plans to implement the strategic, overall parameters for each of the QIC’s core functions;
(C) Managing, controlling and supervising the execution of the detailed plans to carry out each of the QIC’s core functions;
(D) Establishing criteria for the hiring of employees or independent contractors to execute the detailed plans to carry out each of the QIC’s core functions, and if independent contractors are hired, prescribing the goals and objectives of the engagement, the scope of work, evaluation criteria for contractor eligibility and for submissions by prospective contractors, and criteria and budget for the work to be performed;
(E) Reviewing the conduct of the work performed by employees or independent contractors to ensure that it meets the goals, standards, criteria, timeline, and budget specified by the QIC, and taking appropriate action if it does not; and
(F) Conducting each of the requirements above by officers or senior employees of the QIC, which officers or employees are experienced in the conduct of those activities and devote all or virtually all of their work to those activities and similar activities for related entities.
(ii) Regular and continuous basis.— Carrying out managerial and operational activities on a regular and continuous basis requires that the parameters and plans described in paragraphs (c)(2)(i)(A) and (B) of this section are regularly reviewed and updated and that the activities described in paragraphs (c)(2)(i)(C) and (E) of this section are carried out on a daily or other frequent basis as part of the ordinary course of the QIC’s operations.
(3) Performance of virtually all of the active decision-making functions relevant to a QIC’s underwriting activities.—
(i) Active decision-making functions.— Active decision-making functions are the underwriting activities that are most important to decisions of the QIC relating to the assumption of specific insurance risks.
(ii) Performance requirements.— Performance of virtually all of the active decision-making functions relating to underwriting activities requires all of the following—
(A) Carrying out virtually all of the activities related to a QIC’s decision to assume an insurance risk, as set forth in the definition of underwriting activities, by employees and not by independent contractors; and
(B) Evaluating, analyzing, and conducting virtually all of the decision-making with respect to executing an insurance contract on a contract-by-contract basis, including determining whether the contract meets the QIC’s criteria with respect to the risks to be undertaken and pricing and is otherwise sound and appropriate.
(iii) Exclusions.— The following activities are not active decision-making functions relevant to a QIC’s core functions—
(A) Development of underwriting policies or parameters that are changed infrequently without further ongoing, active involvement in the day-to-day decision-making related to these functions; and
(B) Clerical or ministerial functions with respect to underwriting that do not involve the exercise of discretion or business judgment.
(4) Number of officers and employees.— The number of officers and employees actively engaged in each core function is a relevant factor in determining whether the factual requirements in paragraph (c)(1) of this section have been satisfied.
(d) Active conduct percentage test.— A QIC satisfies the active conduct percentage test of paragraph (b)(1)(ii) and will be deemed to be engaged in an active insurance business for the applicable reporting period only if it satisfies the percentage requirement in paragraph (d)(1) of this section and, to the extent core functions are outsourced, the oversight requirement in paragraph (d)(2) of this section.
(1) Percentage test.— For the applicable reporting period covered by the applicable financial statement, total costs incurred by the QIC with respect to the QIC’s officers and employees for services rendered with respect to its core functions (other than investment activities) equals or exceeds 50 percent of total costs incurred by the QIC with respect to the QIC’s officers and employees and any other person or entities for services rendered with respect to its core functions (other than investment activities).
(2) Outsourcing.— To the extent the QIC outsources any part of its core functions to unrelated entities, officers and employees of the QIC with experience and relevant expertise must select and supervise the person that performs the outsourced functions, establish objectives for performance of the outsourced functions, and prescribe rigorous guidelines relating to the outsourced functions which are routinely evaluated and updated.
(e) Related officers and employees.— For purposes of this section, a QIC’s officers and employees are considered to include the officers and employees of a related entity if the requirements of this paragraph (e) are satisfied. In determining whether an activity is carried out by employees, the activities of persons that are independent contractors and that are not related entities are disregarded. An entity may be a related entity regardless of whether it has entered into a contract designating its status as an independent contractor with respect to the QIC. An entity is treated as a related entity only if the requirements of this paragraph (e) are satisfied.
(1) Modified qualified affiliate requirement.— The entity is a qualified affiliate of the QIC within the meaning of §1.1297-2(e)(2) (determined by treating the QIC as the tested foreign corporation) except that, for purposes of this section, section 1504(a)(2)(A) (with “more than 50 percent” substituted for “at least 80 percent”) also applies for purposes of determining qualified affiliate status.
(2) Oversight and supervision requirement.— The QIC exercises regular oversight and supervision over the services performed by the related entity’s officers and employees for the QIC.
(3) Compensation requirement.— The QIC either—
(i) Pays directly all the compensation costs of the related entity’s officers and employees attributable to core functions performed by those officers and employees on behalf of the QIC;
(ii) Reimburses the related entity for the portion of its expenses, including compensation costs and related expenses (determined in accordance with section 482 and taking into account all expenses that would be included in the total services costs under §1.482-9(j) and §1.482-9(k)(2)) for the performance by its officers and employees of core functions on behalf of the QIC; or
(iii) Otherwise pays arm’s length compensation in accordance with section 482 on a fee-related basis to the related entity for services related to core functions.
(f) Definitions.— The following definitions apply solely for purposes of this section.
(1) Applicable reporting period.— The term applicable reporting period has the meaning set forth in §1.1297-4(f)(4)
(2) Compensation costs.— The term compensation costs means all amounts incurred by the QIC during the applicable reporting period with respect to an officer and employee (including, for example, wages, salaries, deferred compensation, employee benefits, and employer payroll taxes).
(3) Contract and claims management activities.— The term contract and claims management activities means performing the following activities with respect to an insurance or annuity contract: Monitoring a contract (or group of contracts) over its life cycle (that is, maintaining the information on contractual developments, insured risk and occurrences, and maintaining accounts on premiums, claims reserves, and commissions); performing loss and claim reporting (establishing and maintaining loss reporting systems, developing reliable claims statistics, defining and adjusting claims provisions and introducing measures to protect and reduce claims in future); and all the activities related to a policyholder’s claim, including processing the claims report, examining coverage, handling the claim (working out the level of the claim, clarifying causes, claims reduction measures, legal analysis) and seeking recovery of funds due to the QIC.
(4) Core functions.— The term core functions means the QIC ‘s underwriting, investment, contract and claims management, and sales activities; however, contract and claims management activities will not be considered to be a core function of a reinsurance company with respect to indemnity reinsurance contracts to the extent that the ceding company has agreed to retain this core function under a reinsurance contract.
(5) Investment activities.— The term investment activities means investment in equity and debt instruments and related hedging transactions and other assets of a kind typically held for investment, for the purpose of producing income to meet obligations under the insurance, annuity, or reinsurance contracts.
(6) Qualifying insurance corporation or QIC.— The term qualifying insurance corporation or QIC has the meaning described in §1.1297-4(b).
(7) Sales activities.— The term sales activities means sales, marketing, and customer relations with respect to insurance or reinsurance policies.
(8) Total costs.— With respect to the QIC’s own officers and employees (and without regard to related officers and employees described in paragraph (e) of this section), the term total costs means the compensation costs of those officers and employees and related expenses (determined in accordance with section 482 and taking into account all expenses that would be included in the total services costs under §1.482-9(j) and §1.482-9(k)(2)) for services performed related to core functions. With respect to services performed by related officers and employees and unrelated persons or entities, the term total costs means the amount paid or accrued to the related or unrelated persons or entities for the services related to core functions. For purposes of this section, total costs, however, do not include any ceding commissions paid or accrued with respect to reinsurance contracts or commissions or fees paid or accrued to brokers or sales agents to procure reinsurance contracts.
(9) Underwriting activities.— The term underwriting activities means the performance of activities related to a QIC’s decision to assume an insurance risk (for example, the decision to enter into an insurance or reinsurance contract, setting underwriting policy, risk classification and selection, designing or tailoring insurance or reinsurance products to meet market or customer requirements, performing actuarial analysis with respect to insurance products, and performing analysis for purposes of setting premium rates or calculating reserves, and risk retention).
(10) Virtually all.— The term virtually all means all, other than a de minimis portion, measured on any reasonable basis.
(g) Applicability date.— This section applies to taxable years of shareholders beginning on or after [the date these regulations are filed as final regulations in the Federal Register]. A shareholder may choose to apply the rules of this section for any open taxable year beginning after December 31, 2017 and before [the date these regulations are filed as final regulations in the Federal Register], provided that, with respect to a tested foreign corporation, it consistently applies the rules of this section, §1.1297-4, and §1.1297-6 for such year and all subsequent years. [Prop. Reg. §1.1297-5.]
[Proposed 1-15-2021 (corrected 3-5-2021).]