1.S3.1 Evolution of the Obligor-KB...2019/10/01 · 10/22/2019 6 © GPW AND ASSOCIATES, INCIRS Technical Advice Memorandum 9218004 (1992) IRS makes three conclusions: 1. Dealer is

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© GPW AND ASSOCIATES, INC

F&I Reinsurance and Product Conferenceby

Kirk BorchardtExecutive Vice President & Chief Legal Counsel

Dealers Assurance Company

October 28, 2019


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What is an obligor?• Someone who has an obligation.

• In an ordinary contract, usually both parties have obligations called for by the contract and they are both obligors to some degree.

• In a vehicle service contract or other aftermarket contract, once the consumer pays the purchase price, the “maker” or “issuer” of the contract carries the obligation to provide the benefits called for by the contract.

• NAIC Model Service Contract Act: “Service contracts shall identify any administrator, the provider obligated to perform the service under the contract, the service contract seller, and the service contract holder . . . .” Section 5(D).

• “This is an agreement between you and ABC Warranty Corp.”


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Common law throughout the US…

• Persons or entities in the chain of distribution of the covered product may issue warranties covering the product or enter into pre-paid repair agreements without being deemed engaged in the business of insurance.

• Who’s in the chain of distribution? The manufacturer, distributor, dealer, or seller.

• What if I’m not in the chain of distribution and I issue a service contract anyway?


You are an insurance company!

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Court Case ExampleGuaranteed Warranty Corp, Inc., v. Arizona ex rel. Humphrey

23 Ariz. App. 327, 533 P.2d 87 (1975).

• An insurable interest• A risk of loss• An assumption of the risk by the insurer• A general scheme to distribute the loss over larger group of persons • The payment of premium for the assumption of the risk

“We believe that under the facts of this case, a true warranty does not exist. Guaranteed Warranty is neither the manufacturer nor the seller of the television sets or the picture tubes.”


Tax Effect of Factory vs. Dealer Obligor to the Dealer - (Pre - 1992)

Factory Obligor Program

Retail price $2,000

Dealer remit 800

Dealer commission 1,200

Taxable income 1,200

Dealer Obligor Program

Sales revenue $2,000

Insurance expense 800

Net sales income 1,200

Taxable income 1,200

Net tax effect was the same, but the route to get there was different:

• Factory program – commission income; no insurance expense to consider

• Dealer program – sales revenue less business expense deduction for insuring the service contract; the deductibility of the insurance expense is very relevant!

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Two Mutant States – Florida and Wyoming

The business structure for nationwide service contract providers pre-1992:

• Dealer obligor was implemented in every state, except Florida and Wyoming

• A separate company issued contracts directly to the consumers in Florida and Wyoming

Ch. 634 Program

Sales revenue $2,000

Insurance expense 800


Taxable income 0 (to the Ch. 634 company)

Into the insurance accounting pipeline

1978 Florida adopts Chapter 634 requiring all service contracts to be issued by licensed service agreement companies

1987 Wyoming decides to follow Florida and enact a similar law


Fateful Restructuring of the ESP Service Contract Program

TO BE THE OBLIGOR

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IRS Technical Advice Memorandum 9218004(1992)

IRS makes three conclusions:

1. Dealer is the principal of the service contract, not a selling agent

2. Dealer must include the total payments received in its gross income

3. Dealer must amortize the insurance expense over the duration of the service contract

A sea of change in the service contract industry is brought about by a simple amortization ruling.


Dealer Program Y1 Y2 Y3 Y4 Y5

Sales Revenue 2,000 0 0 0 0

Insurance Expense 800 0 0 0 0

Expense Deduction (160) (160) (160) (160) (160)

Taxable Income 1,840 (160) (160) (160) (160)

Factory Program

Retail price $2,000

Dealer remit 800


Taxable income

1,200

Tax Effect of Factory vs. Dealer Obligor after the 1992 TAM

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SWIM(ming) to the Rescue

IRS Revenue Procedure 92-98 (replaced by Rev. Proc. 97-38), creating the Service Warranty Income Method of Accounting for service contract revenue

• Available only for manufacturers, wholesalers and retailers of motor vehicles and other durable consumer goods.

• Allows the “qualified advance payment amount,” i.e., secret IRS code for insurance premium payments made by the taxpayer to insure the service contract, to be included in taxable income ratably over the duration of the service contract rather than in the year of receipt.

• In addition to the qualified advance payment amount, the taxpayer must include in taxable income an imputed income charge to compensate the government for the time-value loss of tax revenue.


Dealer Program Y1 Y2 Y3 Y4 Y5

Sales Revenue 2,000 0 0 0 0

Insurance Expense (QAPA)

800 0 0 0 0

Excess Revenue (1) 1,200 0 0 0 0

Annual QAPA (2) 160 160 160 160 160

Imputed Income (3) 19 19 19 19 19

Expense Deduction (4) (160) (160) (160) (160) (160)

Taxable Income(1)+(2)+(3)-(4)

1,219 19 19 19 19

Effect of SWIM

1992 Applicable Federal Rate – 6.0%; created $19.00/yr. or $95.00 over 5 years

2019 AFR – 2.0%; $6.00 per year or $30.00 over 5 years

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SWIM is Good, but not Perfect• It sounds complicated and dealers did not know how to work through it

• The imputed income charge causes slight increase in tax

Meanwhile, out in the field . . .• Dealers were moving to factory programs in lieu of learning how to SWIM

• Some administrators offered to prepare the SWIM calculations for the dealer and even absorb the SWIM imputed income charge

• Other administrators just started offering administrator-obligor programs, state-law be damned

• State law was a roadblock in many states


Quest for the Administrator-Obligor• Florida and Wyoming are looking pretty good now – accounting same as a factory

program

• Some state regulators accepted the A-O structure

• Most states considered A-O service contract to be a form of insurance that could only be issued by an authorized insurance company

• Lobby efforts nationally to take A-O service contracts outside of the scope of insurance regulation

• National Association of Insurance Commissioners (NAIC) convenes a task force to work up model legislation, resulting in the adoption of the NAIC Service Contracts Model Act in 1995

• Service Contract Industry Council formed and becomes real active in promoting the Model Act or some variant of it

• Battle of the lists

• California, one of the last big states, goes A-O in 1997

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A-O’s cannot SWIM• SWIM is available only to manufacturers, wholesalers and retailers of the motor

vehicles or other durable consumer goods

• A-Os do not sell motor vehicles


Insurance Company Tax Treatment for Obligors

• Evolving IRS positions on analogous situations

HMO’s can be taxed like insurance companies – TAM 9412002

Home protection companies can be insurance companies – TAM 9416001

• TAM 9601001 permits an obligor, who has more than 50% of its revenues derived from the sale of service contracts, to be taxed a like a property and casualty insurance company

Premiums paid for contractual liability insurance treated as reinsurance premiums and are fully deductible in the first year

• Analyzing TAM 9601001

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Benefits of Insurance Company Tax Treatment

• Provides optimal tax environment for the A-O

Virtually every service contract provider, including manufacturer affiliates, has migrated to insurance company tax treatment

• Provides tax parity with factory programs

• New insurance structures could be created – Failure to Pay and Aggregate Excess of Loss policies, in which the A-O retains legal title to reserve assets

• New business structures possible – DOWC

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What is a DOWC?• A DOWC is an obligor owned by an automobile dealer

• How is it different from a regular obligor – it is not different in any way

• For large dealer groups with more than $2.3 million in premium

• The company is not a foreign insurance company; the following are not applicable:

Section 953(d) election Section 831(b) election Forms 8886 (micro captives) and 8938 (foreign financial assets)


How does it work operationally?Initial Incorporation

• Dealer forms a general business corporation under state law; it will be taking C corporation tax treatment

• Can use his own corporate lawyers

• There is nothing special about the formation process – there is no specific process for organizing a DOWC

• Forms a board of directors, adopts organizational minutes, issues corporate stock, and observes other corporate formalities

• There are no specific capital requirements required by law

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How does it work operationally?Regulatory Compliance

• The DOWC is subject to all service contract provider laws and regulations in states where it intends to conduct business

Applies for and obtains service contract provider license

Satisfies financial responsibility requirement by purchasing acceptable contractual liability insurance

Files service contract forms with state regulators if required by law

Changes to VSC forms must be filed with regulators if applicable


How does it work operationally?Product Implementation

• Most dealers will not have the infrastructure and industry relationships to implement a complete program

• Assuming the Dealer does not have his own full-fledged administration facility, the Dealer will partner with an administrator for the following:

Develop product terms and rates, contract forms, and marketing brochures Secure lender approvals – yes, that means F&I Sentinel Establish a reporting interface Perform all front-end and back-end administration Provide statistical reporting and assist in tax return preparation

• It is essentially a private label program operated by an administrator, except that the obligor is owned by the Dealer

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Insurance Requirements• The insurance requirements are the same as for any service contract obligor

• State law does have relaxed standard for DOWCs

• Reserve and trust requirements are governed by the CLIP insurer and each insurer will have its own terms and conditions

• Contrary to popular belief, there is nothing intrinsic about a DOWC that enables the Dealer to retain full control of reserve assets or exercise unlimited investment discretion

• Most CLIP insurers are relatively agnostic on favoring a DOWC program versus a CFC program; if the carrier is known to provide advances of future profits, it will do so under either program


What’s the secret sauce?• The DOWC attraction stems from the manner in which it is permitted to prepare its

financial statements and federal income tax returns

• As an insurance company (see TAM 9601001 and subsequent rulings), a DOWC is entitled to follow statutory insurance accounting principles (“SAP”) in preparing its financial statements, from which its federal income tax returns are derived

• Like every insurance company, its gross revenues from the sale of its insurance policies (i.e., VSCs) is a function of the retail price set forth in the VSC declarations

• MOST IMPORTANTLY, under SAP the DOWC is required to expense the commissions paid to the dealerships in the year of payment, which is in contrast to the GAAP requirement of establishing an asset account for deferred acquisition costs

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SAP accounting creates surplus strain and net operating losses?

• The immediate deduction of deferred acquisition expenses leads to the creation of a net operating loss for tax purposes

Just like the surplus strain created by commission expenses in the credit life and disability business

• May shield income from tax for 7-10 years or more

• Works best when VSCs are of a longer duration and sales volume is in a growth mode

• Its only a timing difference – Taxes will become due in the future as the business earns out


Dealer Owned Warranty CompanyPro Forma Income Statement Assumptions

Assumptions New Used

Retail Sale Price $2,000 $2,200

Dealer Commission $1,250 $1,350

Dealer Remittance $ 750 $ 850

Admin Fees (includes insurance) $ 150 $150

Loss Reserve Component $ 600 $700

Loss Ratio 80% 80%

Contract Term 60 months 48 months

Earnings Pattern Reverse Rule

of 78’sPro rata

Production Amount 10,000/year 3,500/year

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One New Vehicle Service Contract

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Net Written Premium 2,000 0 0 0 0 0

Beginning UPR 0 1,980 1,823 1,508 1,036 407

Ending UPR 1,980 1,823 1,508 1,036 407 0

Earned Premium 20 157 315 472 630 407

Acquisition Expense 1,400 0 0 0 0 0

Losses Incurred 5 38 76 113 151 98

Change in UPR 1,980 (157) (315) (472) (630) (407)

Stat. Underwriting Gain (1,385) 120 239 359 478 309

Investment Income 6 12 11 9 7 4

Pre Tax Statutory Income (1,379) 131 250 368 485 313

20% Tax Adjustment 396 (31) (63) (94) (126) (81)

Fed Taxable Income (983) 100 187 273 359 232

Fed. Inc. Tax Provision 0 0 0 0 0 1

NOL Carryforward 0 983 883 696 423 64

Net Stat Gain After Tax (1,379) 131 250 368 485 312

Change in Def. Acq. Costs 1,386 (110) (220) (330) (441) (285)

Pre Tax GAAP Income 7 21 30 37 44 28

One Used Vehicle Service Contract

Year 1 Year 2 Year 3 Year 4 Year 5

Net Written Premium 2,200 0 0 0 0

Beginning UPR 0 1,902 1,352 802 252

Ending UPR 1,902 1,352 802 252 0

Earned Premium 298 550 550 550 252

Acquisition Expense 1,500 0 0 0 0

Losses Incurred 76 140 140 140 64

Change in UPR 1,902 (550) (550) (550) (252)

Stat. Underwriting Gain (1,278) 410 410 410 188

Investment Income 6 11 9 6 4

Pre Tax Statutory Income (1,272) 421 419 416 192

20% Tax Adjustment 380 (110) (110) (110) (50)

Fed Taxable Income (891) 311 309 306 142

Fed. Inc. Tax Provision 0 0 0 1 1

NOL Carryforward 0 891 580 271 0

Change in Def. Acq. Costs 1,297 (375) (375) (375) (172)

Pre Tax GAAP Income 25 46 44 40 19

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(Thousands) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Net Written Premium 27,700 27,700 27,700 27,700 27,700 27,700 27,700 27,700 27,700 27,700

Beginning UPR 0 26,462 49,425 67,316 78,560 82,627 82,627 82,627 82,627 82,627

Ending UPR 26,462 49,425 67,316 78,560 82,627 82,627 82,627 82,627 82,627 82,627

Earned Premium 1,238 4,737 9,809 16,456 23,633 27,700 27,700 27,700 27,700 27,700

Acquisition Expense 19,250 19,250 19,250 19,250 19,250 19,250 19,250 19,250 19,250 19,250

Losses Incurred 312 1,180 2,425 4,049 5,784 6,760 6,760 6,760 6,760 6,760

Change in UPR 26,462 22,963 17,891 11,244 4,067 0 0 0 0 0

Stat. Underwriting Gain -18,324 -15,693 -11,866 -6,843 -1,401 1,690 1,690 1,690 1,690 1,690

Investment Income 81 237 375 486 566 621 667 714 762 811

General Expenses 9 5 5 5 5 5 5 5 5 5

Pre Tax Statutory Income -18,251 -15,461 -11,496 -6,362 -839 2,306 2,352 2,399 2,447 2,496

20% Tax Adjustment 5,292 4,593 3,578 2,249 813 0 0 0 0 0

Fed Taxable Income -12,959 -10,869 -7,918 -4,113 -26 2,306 2,352 2,399 2,447 2,496

Fed. Inc. Tax Provision 0 0 0 0 0 0 0 0 0 0

NOL Carryforward 0 12,959 23,828 31,746 35,859 35,885 33,578 31,226 28,827 26,379

Change in Def. Acq. Costs 18,402 15,988 12,472 7,855 2,847 0 0 0 0 0

Pre Tax GAAP Income 151 527 976 1,493 2,007 2,306 2,352 2,399 2,447 2,496


Dealer Owned Warranty Company Ten Year Pro-Forma Income Statement (Summary Data)

Years 10-15 Total

Earned Premium 110,326,981 277,000,000

Acquisition Expense 19,250,000 192,500,000

Losses Incurred 26,809,809 67,600,000

Stat. Underwriting Gain 64,267,172 16,900,000

Investment Income 3,875,047 8,386,217

General Expenses 30,000 78,500

Pre Tax Statutory Income 68,112,219 25,207,717

Fed Taxable Income 51,586,823 25,207,717

Fed. Inc. Tax Provision 479,576 479,576

Pre Tax GAAP Income 10,067,923 24,728,141

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Nothing lasts forever…• A DOWC is a fully taxable entity – no 831(b) elections

• Eventually, the NOLs will be exhausted as time passes and premiums become earned

• In the absence of other structural changes or solution, all of the underwriting gains will eventually be taxed to the DOWC at ordinary income rates (currently 21%)

• Leading solution recommended by DOWC promoters – (i) put existing DOWC into runoff and have it elect Section 831(b) treatment to be taxed only on investment income, and (ii) form a new DOWC for business going forward


Control Group Issues

• At the outset of the program – what happens with any 831(b) reinsurers owned by the principal?

• When the taxation period begins – Can it really make the 831(b) election?

• If the DOWC is part of a controlled group, any insurer in that group will likely lose its ability to make or continue making an 831(b) election

• The fact that an insurer is in runoff and has no new premium of its own does not mean it can be part of a controlled group that has premium in excess of $2.3 million and still make the 831(b) election

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Examples:


Examples:

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Examples:


Examples:

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Examples:


True or False

A Dealer Owned Warranty Company is licensed as an insurance company within the state it operates.

A. True

B. False

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Kirk BorchardtExecutive Vice President & Chief Legal Counsel

Dealers Assurance Company2040 Alameda Padre Serra, Suite 102

Santa Barbara, CA 93103805.963.2983

[email protected]

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Documents

1.S3.1 Evolution of the Obligor-KB...2019/10/01 · 10/22/2019 6 © GPW AND ASSOCIATES, INCIRS Technical Advice Memorandum 9218004 (1992) IRS makes three conclusions: 1. Dealer is