Trans City Life Insurance Company, an Arizona Corporation v. Commissioner

106 T.C. No. 15

UNITED STATES TAX COURT

TRANS CITY LIFE INSURANCE COMPANY,
AN ARIZONA CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 23678-93, 16934-94. Filed April 30, 1996.

P is an insurance company authorized to sell
disability and life insurance within the State of
Arizona. P’s primary and predominant business activity
is writing credit life and disability insurance
policies. During the subject years, P and G, an
unrelated entity, entered into two retrocession
(reinsurance) agreements for valid and substantial
business reasons. Under the terms of each agreement, G
retroceded its position on reinsurance to P, and P
agreed to pay G a $1 million ceding commission. The
agreements helped P qualify as a life insurance company
under sec. 816, I.R.C., which, in turn, allowed P to
claim the small life insurance company deduction under
sec. 806, I.R.C. Relying on sec. 845(b), I.R.C., R
disregarded both of these agreements because, she
alleged, the agreements did not transfer to P risks
proportionate to the benefits that P derived from the
small life insurance company deductions under sec. 806,
I.R.C.
Held: R may rely on sec. 845(b), I.R.C., prior to
the issuance of regulations. Held, further: R
committed an abuse of discretion in determining that
the agreements had “a significant tax avoidance effect”
 - 2 -

under sec. 845(b), I.R.C., with respect to P. Held,
further: P may amortize each ceding commission over
the life of the underlying agreement.

James E. Brophy III and Mark V. Scheehle, for petitioner.1

Avery Cousins III, Susan E. Seabrook, Lana Eckhardt, and

Nancy S. Vozar, for respondent.

CONTENTS

Findings of Fact

1. General Facts..................................... 6
a. Petitioner................................... 6
b. Notices of Deficiency........................ 7

2. Reinsurance in General............................ 8
a. Overview..................................... 8
b. Experience Refund Provisions.................11
c. Risk Transfer and Risk Charges...............12
d. Termination..................................14

3. The 1988 and 1989 Retrocession Agreements.........15
a. Overview.....................................15
b. Purpose of the Agreements....................19

4. 1988 Agreement....................................21
a. Original Agreement...........................21
b. First Amendment/Trust Account................22
c. Underlying Business..........................24
d. Ceding Commission and Risk Charge............25
e. Right To Withhold............................26
f. Recapture....................................27
g. Termination..................................28

5. 1989 Agreement....................................28
a. In General...................................28
b. Amendments...................................29
c. Underlying Business..........................31
d. Ceding Commission and Risk Charge............31
e. Right To Withhold............................34

1
Brief amicus curiae was filed by John W. Holt and
Susan J. Hotine as counsel for the American Council of Life
Insurance.
 - 3 -

f. Recapture....................................35
g. Termination..................................35

Opinion

1. Overview..........................................37
2. Lack of Regulations under Sec. 845(b).............39
3. Significant Tax Avoidance Effect..................41
4. Amortization of Ceding Commissions................56

LARO, Judge: Trans City Life Insurance Company, an Arizona

corporation, petitioned the Court to redetermine respondent's

determinations for its 1989 through 1992 taxable years.

Respondent determined deficiencies of $603,356, $510,716,

$382,508, and $297,928 in petitioner’s 1989, 1990, 1991, and 1992

Federal income taxes, respectively. Respondent's determination

for 1989 was reflected in a notice of deficiency issued to

petitioner on September 15, 1993 (the 1993 Notice). Respondent's

determinations for 1990, 1991, and 1992 were reflected in a

second notice of deficiency issued to petitioner on September 12,

1994 (the 1994 Notice).

In her amendments to answers (Amendments), respondent

asserted that petitioner was not entitled to amortize ceding

commissions payable under two reinsurance agreements with The

Guardian Life Insurance Company of America (Guardian).

Respondent asserted in her Amendments that the 1989 through 1992

deficiencies were $672,210, $553,533, $437,584, and $354,246,

respectively.

We must decide:

1. Whether respondent may rely upon section 845(b), prior

to the issuance of regulations. We hold she may.
 - 4 -

2. Whether the two reinsurance agreements at issue had

“significant tax avoidance [effects]” under section 845(b), with

respect to petitioner. We hold they did not.2

3. Whether petitioner may amortize the ceding commissions

payable under the reinsurance agreements over the life of the

agreements. We hold it may.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the taxable years in issue.

Rule references are to the Tax Court Rules of Practice and

Procedure. Dollar amounts are rounded to the nearest dollar.

The 50-percent ratio described in section 816(a) is referred to

as the Life Ratio.3

2
This holding moots another issue before us; namely,
whether petitioner's disability insurance policies are
“noncancellable” under sec. 816(a)(2).
3
Sec. 816 provides in part:

SEC. 816. LIFE INSURANCE COMPANY DEFINED.

(a) Life Insurance Company Defined.--For purposes
of this subtitle, the term "life insurance company"
means an insurance company which is engaged in the
business of issuing life insurance and annuity
contracts (either separately or combined with accident
and health insurance), or noncancellable contracts of
accident and health insurance, if--

(1) its life insurance reserves (as
defined in subsection (b)), plus

(2) unearned premiums, and unpaid losses
(whether or not ascertained), on
noncancellable life, accident or health
policies not included in life insurance
reserves,

comprise more than 50 percent of its total reserves (as
(continued...)
 - 5 -

(...continued)
defined in subsection (c)). For purposes of the
preceding sentence, the term “insurance company” means
any company more than half of the business of which
during the taxable year is the issuing of insurance or
annuity contracts or the reinsuring of risks
underwritten by insurance companies.

(b) Life Insurance Reserves Defined.--

(1) In general.--For purposes of this
part, the term “life insurance reserves”
means amounts--

(A) which are computed or
estimated on the basis of
recognized mortality or morbidity
tables and assumed rates of
interest, and

(B) which are set aside to
mature or liquidate, either by
payment or reinsurance, future
unaccrued claims arising from life
insurance, annuity, and
noncancellable accident and health
insurance contracts (including life
insurance or annuity contracts
combined with noncancellable
accident and health insurance)
involving, at the time with respect
to which the reserve is computed,
life, accident, or health
contingencies.

(2) Reserves must be required by law.--
Except--

(A) in the case of policies
covering life, accident, and health
insurance combined in one policy
issued on the weekly premium
payment plan, continuing for life
and not subject to cancellation,
* * *

* * * * * * *

in addition to the requirements set
(continued...)
 - 6 -

FINDINGS OF FACT4

1. General Facts
a. Petitioner

At all relevant times, petitioner was an Arizona corporation

with its principal offices located in Scottsdale, Arizona. It

was an “insurance company” for purposes of section 816(a), and it

was authorized by the State of Arizona Department of Insurance to

sell disability and life insurance within the State of Arizona.

(...continued)
forth in paragraph (1), life
insurance reserves must be required
by law.

* * * * * * *

(4) Amount of reserves.--For purposes
of this subsection, subsection (a), and
subsection (c), the amount of any reserve (or
portion thereof) for any taxable year shall
be the mean of such reserve (or portion
thereof) at the beginning and end of the
taxable year.
(c) Total Reserves Defined.--For purposes of
subsection (a), the term “total reserves” means--

(1) life insurance reserves,

(2) unearned premiums, and unpaid losses
(whether or not ascertained), not included in
life insurance reserves, and

(3) all other insurance reserves
required by law.
4
Some of the facts have been stipulated and are so found.
The stipulations and attached exhibits are incorporated herein by
this reference.
 - 7 -

Its primary and predominant business activity was writing credit

life and disability insurance policies covering individuals who

financed vehicles purchased from automobile dealers. During the

subject years, it wrote direct credit policies that generated the

following amounts of premiums from life and disability insurance:

Year Life insurance Disability insurance

1989 $3,227,739 $2,570,868
1990 2,626,873 1,971,888
1991 2,590,894 1,807,293
1992 3,189,966 2,079,715

b. Notices of Deficiency

Petitioner’s 1989 through 1992 Forms 1120L, U.S. Life

Insurance Company Income Tax Return, reported small life

insurance company deductions (see section 806) of $1,770,350,

$1,792,007, $1,361,574 and $1,109,638, respectively. Respondent

disallowed these deductions. According to the 1993 Notice:

Your reinsurance agreement with Guardian Life Insurance
Company of America has a significant tax avoidance
effect with respect to the Trans City Life Insurance
Company. Pursuant to Internal Revenue Code section 845
an adjustment is made to reserves to eliminate the
avoidance effect by treating the reinsurance agreement
as terminated on December 31, 1989 and reinstating the
agreement on January 1, 1990.

By eliminating the avoidance effect of this agreement
you do not meet the requirements of a life insurance
company as specified in Internal Revenue Code section
816 because the reserves necessary to meet the
definition of a life insurance company do not comprise
more than 50 percent of your total reserves.

Therefore, it is determined that the amount of
$1,770,350.00, claimed on your return as a small life
insurance company deduction for the taxable year ended
December 31, 1989, is not allowed.

Accordingly, income is increased in the amount of
$1,770,350.00 for the taxable year ended December 31, 1989.
 - 8 -

The 1994 Notice is virtually identical to the 1993 Notice,

and it states the same reason for respondent’s adjustments to the

years referenced therein. Neither the 1993 Notice nor the 1994

Notice disregarded the income that petitioner earned under the

reinsurance agreements.

2. Reinsurance in General

a. Overview

Reinsurance is an agreement between an initial insurer (the

ceding company) and a second insurer (the reinsurer), under which

the ceding company passes to the reinsurer some or all of the

risks that the ceding company assumes through the direct

underwriting of insurance policies. Generally, the ceding

company and the reinsurer share profits from the reinsured

policies, and the reinsurer agrees to reimburse the ceding

company for some of the claims that the ceding company pays on

those policies. A reinsurer may pass on (retrocede) its position

on reinsurance to a third insurer. This type of agreement is

called a retrocession agreement, and the third insurer is called

a retrocessionaire.

Virtually all life insurance companies purchase reinsurance,

and the probability of loss on any reinsurance agreement tends to

be low. Reinsurance is commonly purchased to protect against

single claims in excess of the level prudently borne by an

insurer’s financial capacity. For example, a ceding company may

choose to reinsure all life insurance policies over $250,000

because it decides that $250,000 is the maximum risk that it can
 - 9 -

assume. Reinsurance is also commonly purchased as a financial

tool for providing surplus relief or financing an investment in

new business growth. An insurer’s statutory surplus will usually

decrease under statutory accounting principles when it issues new

policies.5 Although an insurer's assets increase by the amount

of the premiums received on the policy, its liabilities and

expenses increase by a greater amount, due, primarily, to the

insurer’s payment of commissions to its agents on their issuance

of the policy. Reinsurance agreements are commonly used in the

insurance industry to provide the surplus relief for this

depletion.

In the financial setting, the reinsurer generally transfers

up-front capital (a ceding commission) to the ceding company to

cover part or all of the ceding company’s acquisition expense for

the reinsured policies, in addition to reimbursing the ceding

company for some or all of the claims that the ceding company

pays under the policies. The ceding commission is generally the

amount of the surplus relief. Reinsurance is called conventional

reinsurance when the ceding commission equals the ceding

company's acquisition expense plus some profit on the block of

policies insured, and the reinsurer has the right to all future

profits. Reinsurance is called surplus relief reinsurance when

the ceding commission is less then the amount paid under

conventional reinsurance, and the ceding company shares the

5
Statutory surplus equals the insurer's assets minus its
liabilities.
 - 10 -

future profits with the reinsurer. In the case of surplus relief

reinsurance, the ceding company usually receives profits after

the reinsurer has recovered its ceding commission plus the

stipulated profit margin.

A ceding company may accept either a known current return on

reinsured policies through conventional reinsurance or a share of

the policies’ future profits through surplus relief reinsurance.

A reinsurer pays a smaller ceding commission for surplus relief

reinsurance than for conventional reinsurance because it has a

right to less than all of the reinsured business’ future profits.

In the case of either conventional reinsurance or surplus relief

reinsurance, risk is transferred if the reinsurer must reimburse

the ceding company for future claims, and the reinsurer receives

revenues generated by the reinsured policies regardless of

experience.

State regulations usually require that an insurance company

file annual statements with the insurance department of the State

in which it is domiciled. These reports must contain financial

statements that show the insurer’s operations as of December 31.

These financial statements must show a minimum amount of surplus.

Insurance companies typically enter into surplus relief

reinsurance agreements at the end of the year to increase their

surplus under statutory accounting principles, in order to meet

these minimum surplus requirements.6 Although insurance

6
A surplus relief reinsurance agreement usually increases
the ceding company's surplus under statutory accounting
(continued...)
 - 11 -

companies commonly enter into reinsurance agreements at the end

of the year, some reinsurance agreements are consummated at other

than yearend.

b. Experience Refund Provisions

The parties to a surplus relief reinsurance agreement

usually have a provision (the experience refund provision) that

controls the allocation of future profits between them. The

experience refund provision usually caps the amount of profits

that the reinsurer may retain from the reinsured business, which,

in turn, allows the ceding company to participate in favorable

experience.7 Experience refund provisions do not eliminate or

reduce the transfer of risk because, in part, the reinsurer is

liable for any loss on the reinsured policies. An experience

refund provision increases the risk to the reinsurer because a

refund is a return of profits to the ceding company, which, in

turn, lessens the reinsurer’s cushion for absorbing future

losses.

An experience account (EA) is used to account for the

reinsurer’s share of profits. The EA is a notional account that

tracks the profits or losses of the reinsured business. The EA

balance is referred to as the EAB.

(...continued)
principles. When the surplus is increased in this manner, the
reinsurer usually realizes a corresponding decrease.
7
In other words, the reinsurance agreement may require that
some of the profits must be paid (refunded) to the ceding
company, after the reinsurer has recovered its ceding commission
plus the stipulated profit margin.
 - 12 -

c. Risk Transfer and Risk Charges

Reinsurance agreements are structured to transfer risks that

are inherent in the underlying policies. Risks commonly found in

policies sold by life insurers include mortality, lapse, and

investment.

Mortality is: (1) The risk that policyholders will die and

death benefits will be paid sooner than expected, in the case of

life insurance, or (2) the risk that policyholders will continue

to live and collect benefits longer than expected, in the case of

annuity insurance. When a life policy is reinsured, the

reinsurer usually agrees with the ceding company to reimburse it

for the full death benefits. In the case of annuity contracts,

the reinsurance agreement may transfer two types of mortality

risk. First, reinsurers usually realize a loss when a

policyholder dies in the early years of his or her policy,

because the death benefit tends to be higher than the cash value.

Second, reinsurers usually suffer a loss when the annuitization

benefits which are payable according to the settlement terms of a

policy are greater than anticipated due to better than expected

annuitant longevity (i.e., the policyholder lives longer than

predicted by standard mortality tables).

Surrender, which is also known as lapse, is the risk that a

policy holder will voluntarily terminate his or her policy prior

to the time that the insurer recoups its costs of selling and

issuing the policy. A reinsurer will realize a loss on the

reinsurance agreement when: (1) It receives an initial
 - 13 -

consideration that is less than the policy’s cash surrender value

and (2) the policyholder terminates the policy before the initial

consideration plus renewal profits exceed the cash value.

The risk of investment is threefold; namely, the risks of

credit quality, reinvestment, and disintermediation. Credit

quality is the risk that invested assets supporting the reinsured

business will decrease in value, which, in turn, may lead to a

default or a decrease in earning power. Reinvestment is the risk

that invested funds will earn less than expected due to a decline

in interest rates. Disintermediation is the risk that interest

rates will rise, and that assets will have to be sold at a loss

in order to provide for withdrawals on account of surrender or

maturing contracts.

Investment risk may or may not be transferred to the

reinsurer. Investment risk is fully transferred if the reinsurer

receives the funds backing the block of policies to invest for

its own account. If the ceding company holds the assets backing

the reinsured block, the terms of the reinsurance agreement

dictate whether the investment risk is borne by the ceding

company or the reinsurer.

There is generally no single accepted method of quantifying

the risk of mortality or surrender, and there is no recognized

Federal standard. Risk may be quantified based on: (1) The

amount of the reserve for the reinsured policies; i.e.,

the present value of future benefits less the present value of

future premiums determined on a statutory basis, (2) the face
 - 14 -

amount of the reinsured policies; i.e., the reinsurer’s total

contractual liability, and (3) the amount for which the reinsurer

is at risk; i.e., the difference between the face amount of the

policies and the reserves.

Provisions for risk charges are commonplace in reinsurance

agreements to set the profit margin that a reinsurer expects to

earn on the agreement. A reinsurance agreement may state, for

example, that any renewal profits on the reinsured business will

first accrue to the reinsurer to the extent of the risk charge,

then be used to repay the reinsurer's ceding commission, and

then, to the extent of any excess, returned to the ceding company

through the experience refund provision. Risk transfer is not

eliminated through the use of a risk charge because a reinsurer

earns its charge only from actual renewal profits, if any. When

claims exceed revenues, the reinsurer suffers the loss.

Actual risk transfer is a fundamental principle of

reinsurance. When a purported reinsurance agreement transfers

little or no insurance risk, the agreement is not reinsurance,

but is the equivalent of a loan or some other type of financing

arrangement.

d. Termination

Reinsurance agreements usually give the ceding company the

unbridled discretion to terminate the agreement, either

immediately or after a stipulated number of years. In order to

exercise its right of termination, the ceding company must

usually pay the reinsurer its outstanding loss (if any) at the
 - 15 -

time of recapture. Such a provision is intended to give

reinsurers the ability to recover their investments in the case

of early recaptures by a ceding company. Risk transfer is not

eliminated by a right of termination provision because losses

remain with the reinsurer if the ceding company does not

terminate the reinsurance.

It is common for a surplus relief reinsurance agreement to

terminate when it no longer provides surplus relief.

3. The 1988 and 1989 Retrocession Agreements

a. Overview

This litigation focuses on two retrocession agreements (the

Agreements) entered into between petitioner (as the

retrocessionaire) and an unrelated entity, Guardian (as the

reinsurer).8 The Agreements were mainly surplus relief

reinsurance agreements, and petitioner’s costs connected to the

Agreements were minimal. The form of the Agreements was (and

still is) common in the insurance industry.

Petitioner and Guardian agreed that the first agreement (the

1988 Agreement), executed on December 29, 1988, was effective

October 1, 1988. Petitioner and Guardian agreed that the second

agreement (the 1989 Agreement), executed on December 28, 1989,

was effective June 30, 1989. The effective date of the 1989

Agreement coincided with the last day of the second quarter in

which the 1988 Agreement was terminated, and it reflected the

efforts of petitioner and Guardian to continue their relationship

8
Guardian is a mutual company domiciled in New York.
 - 16 -

following that termination. The effective date of the 1989

Agreement marked an anniversary of the June 30, 1987, effective

date of the underlying reinsurance agreement.

The Agreements provided that petitioner would reimburse

Guardian for benefits paid to policyholders under life insurance

and annuity plans of insurance. Benefits included amounts

payable on the death of any insured, cash values payable when

withdrawn by policyholders or upon cancellation of the policies,

and annuity benefits payable upon policyholder annuitization.

Petitioner agreed to pay Guardian a ceding commission of $1

million on each of the Agreements, which represented the value

that petitioner was willing to pay in exchange for receiving its

share of future profits on the reinsured policies. If the

reinsured policies were profitable, petitioner would receive all

of the profits until it recovered its $1 million ceding

commission, plus a quarterly risk charge of .3 percent of the

unrecovered balance.9 Afterwards, petitioner would receive 10

percent of the profits, and Guardian would receive the remaining

90 percent by way of an experience refund. If the reinsured

policies were not profitable enough to allow petitioner to

receive its ceding commissions and risk charges, petitioner would

suffer the loss.

Petitioner could not compel Guardian to terminate the

Agreements under any circumstance. Before January 2, 1990, and

9
Prior to its amendment, the 1989 Agreement provided that
the quarterly risk fee would equal .25 percent of the unrecovered
balance.
 - 17 -

January 2, 1991, Guardian could not recapture any of the policies

underlying the 1988 Agreement and the 1989 Agreement,

respectively. Beginning with each of those dates, Guardian had

discretion to recapture policies under the related Agreement.

If Guardian exercised this right before January 2, 1992, it had

to pay an early recapture fee equal to the absolute value of any

negative EAB.10 If Guardian exercised this right after January

1, 1992, or chose to leave the reinsurance in place after that

date, Guardian did not have to pay a recapture fee, and

petitioner had no recourse to recover its loss. Neither Guardian

nor any of its representatives promised petitioner that Guardian

would make petitioner whole if it recaptured either of the

Agreements after January 1, 1992, and Guardian undertook no

obligation to make petitioner whole.

The Agreements were structured so that Guardian had an

economic incentive to terminate the Agreements when the surplus

relief, as measured by the EAB, was zero. If business was

profitable, Guardian could have terminated the Agreements.

Guardian also could have left the Agreements in place, when the

EAB was equal to or greater than zero, if the underlying

businesses generated a loss or if Guardian did not want to assume

the risk of recapture. Business could have been so volatile, for

example, that Guardian could have wanted to leave the Agreements

in place because the cost of reinsurance would have been less

10
This type of early recapture fee arrangement was common
in the industry.
 - 18 -

than the risk of future adverse experience. If the reinsured

business was volatile or losses developed, and Guardian did leave

the reinsurance in place, the risk of loss would have remained

with petitioner. Guardian’s unilateral right to terminate the

Agreements increased rather than decreased petitioner’s risk.

Throughout the duration of the Agreements, a negative EAB

represented the remaining surplus relief generated for Guardian

by the underlying agreement. The amount of the negative EAB also

represented petitioner's outstanding liability for the ceding

commission payable under the related Agreement. The moment that

the EAB was zero was important because Guardian would have had to

start paying petitioner profits from the reinsured business,

rather than crediting the EAB, if the agreement continued after

that time. Petitioner had no meaningful control over the

operation of the EAB.

Each of the Agreements had a “funds withheld” provision that

was common in the insurance industry. Such a provision

eliminates unnecessary cash-flow and does not affect the economic

substance of the agreement or the risk that is transferred. The

“funds withheld” provision in the Agreements avoided the need for

petitioner to transfer to Guardian funds equal to the ceding

commission, only to have Guardian transfer funds back to

petitioner for the reinsurance profits. As petitioner earned and

reported renewal profits from Guardian, petitioner simply reduced

its liability to Guardian by the amount of the cash that would

otherwise have been transferred to it by Guardian. The “funds

withheld” provision provided additional security to Guardian, and
 - 19 -

it did not limit the risk transferred from Guardian to

petitioner.

The insurance industry is heavily regulated. Petitioner was

obligated under statutory accounting principles to establish

reserves for the liabilities it incurred under each of the

Agreements. Guardian would not have legitimately obtained the

surplus relief it sought under the Agreements if the National

Association of Insurance Commissioners (NAIC) and New York State

requirements for risk transfer had not been met.11 Guardian

would also have violated its own rules and policies, as well as

State law, if it reported a statutory credit for ceding to

petitioner liabilities associated with the Agreements, absent an

actual transfer of risk to petitioner. The Agreements passed to

petitioner almost 100 percent of the risk held by Guardian for

mortality, surrender, and investment.

b. Purpose of the Agreements
The relationship between Guardian and petitioner was

arm’s-length, and each had differing interests. Both petitioner

and Guardian derived valid and substantial benefits from the

Agreements, without regard to taxes. Guardian entered into each

11
The NAIC is an organization of insurance commissioners
from various States who are responsible for the regulation of
insurance. The NAIC accredits State insurance departments, and
it issues model regulations (which are not law unless and until
they are adopted by a State) to promote uniform insurance regulation
throughout the nation. The financial statement form prescribed by
the NAIC is known in the life insurance industry as the “annual
statement” (annual statement), and the annual statement must be
filed annually in each State in which the life insurance company
does business.
 - 20 -

of the Agreements to obtain risk coverage and to get surplus

relief of $1 million. Guardian would not have entered into

either Agreement had the Agreement not increased its surplus by

$1 million. Guardian earned a spread on the difference between

the risk fees it paid petitioner under the Agreements and the

risk fees it received from the underlying agreements.

Petitioner entered into the Agreements to: (1) Retain its

profitable credit disability business, (2) retain the credit

disability business’ assets, on which it was earning investment

income, and (3) maintain its life insurance status by obtaining

enough life reserves (on a coinsurance basis) to satisfy the Life

Ratio. The Agreements also gave petitioner the ability to

withhold the ceding commissions, while earning 1.2 percent on the

risk charge and continuing to earn approximately 8 percent on the

amount of the commission.

Petitioner wanted to be a life insurance company for Federal

income tax purposes, and petitioner would not have qualified as a

life insurance company during any of the subject years if the

reserves associated with the Agreements were not included in the

calculation of the Life Ratio (ignoring petitioner's alternative

argument that its disability policies were noncancellable); the

Life Ratio would have been less than 50 percent in each year.

Petitioner’s Life Ratio for 1989 through 1992 was greater than

50 percent when the reserves associated with the Agreements are

included in the calculation of the Life Ratio.

Qualification as a life insurance company was petitioner's
 - 21 -

primary business objective because it enabled petitioner to earn

more money for its shareholders (irrespective of tax

consequences) than any other alternative. Instead of entering

into the Agreements, petitioner could have ceded away its credit

disability insurance business in order to maintain its

qualification as a life insurance company. Petitioner employed

this technique both before and after the subject years. If

petitioner had ceded away its credit disability business, it

would have paid less tax than it did by entering into the

Agreements.

4. 1988 Agreement

a. Original Agreement

The 1988 Agreement was drafted by Guardian. Under the

agreement, petitioner assumed 95 percent of Guardian’s interest

in Guardian’s: (1) January 1, 1984, reinsurance agreement with

Business Men’s Assurance (BMA) and (2) January 1, 1985,

reinsurance agreement with United Pacific Life Insurance Company

(UPL). Guardian retained an experience refund equal to 90

percent of the positive net cash-flow from the reinsured

policies. The experience refund provision was part of the 1988

Agreement because Guardian was unwilling to sell to petitioner

the profits on business with reserves in excess of $180 million

for $1 million. The parties agreed to the 90-percent figure

because the block of business was expected to be sufficiently

profitable that petitioner's 10 percent of the profits would

exceed the ceding commission.
 - 22 -

James H. Gordon has been petitioner's independent actuary

since its incorporation in 1967, except for 1979 to 1982.

Mr. Gordon negotiated the 1988 Agreement on behalf of petitioner,

and he dealt only with Jeremy Starr of Guardian. Mr. Gordon

attempted to obtain for petitioner a risk fee between 1.5 and 1.8

percent. Guardian refused to pay that amount.

The effect of the 1988 Agreement on Guardian was to increase

its taxable income by the $1 million ceding commission, in

addition to a tax on equity that resulted from Guardian’s status

as a mutual insurer, and decrease its liabilities related to its

coinsurance reserves. Petitioner was able to retain assets from

its credit life and disability business (and the related

investment income) that it would have otherwise had to cede away,

and it was able to retain the underwriting profit on that

business.

The 1988 Agreement did not extend any loss carryover period

for petitioner. It did not eliminate for petitioner any separate

return limitation year (SRLY) taint from any previous operating

loss. It did not change the character of any item of income or

deduction for petitioner from ordinary to capital or capital to

ordinary. It did not change the source of any item of income or

deduction for petitioner from foreign to domestic or domestic to

foreign.

b. First Amendment/Trust Account

The first amendment to the 1988 Agreement was completed on

January 28, 1989. It required that: (1) A trust (the Trust) be
 - 23 -

established with First Interstate Bank of Arizona, N.A. (FIB),

(2) petitioner and Guardian each pay 50 percent of the cost of

maintaining the Trust, and (3) securities be deposited into the

Trust to secure petitioner’s performance under the 1988

Agreement. The Trust was a security device for Guardian to

secure payment of petitioner's obligations, and it was structured

to allow Guardian to receive credit on its annual statements for

the additional capital surplus it sought to obtain.

Guardian and petitioner executed an agreement with FIB,

effective December 30, 1988, establishing the Trust. The

agreement was drafted by Guardian. Based on discussions with

Mr. Starr, Mr. Gordon estimated that petitioner’s required

deposit to the Trust as of December 31, 1988, was approximately

$850,000. Based on this estimate, petitioner transferred

securities totaling $850,397 into the Trust in early February

1989.

During the entire period that the Trust was in existence,

petitioner had a right to receive, and received on a monthly

basis, all investment income (including interest and dividends)

from the Trust’s assets.12 Petitioner also had a reversionary

interest in the Trust’s assets, and it reported these assets on

its financial statements filed with the Arizona Department of

Insurance. Guardian had the sole discretion to make withdrawals

12
From 1989 through 1992, petitioner received investment
income totaling $252,588.
 - 24 -

from the Trust at any time, without any further act or notice or

satisfaction of any condition or qualification.

c. Underlying Business

The 1988 Agreement was indemnity reinsurance on a

combination coinsurance, modified coinsurance plan. The business

retroceded to petitioner under the 1988 Agreement consisted of

two blocks of single premium deferred annuity (SPDA) policies.

The first block was insurance written by UPL during 1984,

reinsured by BMA in 1984, retroceded to Guardian in 1984, and

retroceded to petitioner under the 1988 Agreement. The first

block consisted of a 52.6316-percent quota share of the block of

SPDA policies underlying the reinsurance agreement between UPL

and BMA. The second block was insurance written during 1985 by a

subsidiary of UPL, reinsured by UPL in 1985, retroceded to

Guardian in 1985 under an agreement referred to as the New York

Retro, and retroceded to petitioner under the 1989 Agreement.

Petitioner had no right to terminate or in any way shift or

avoid losses that might occur under the 1988 Agreement, and the

1988 Agreement did not limit petitioner’s obligation to pay

losses if they occurred. Petitioner was liable on each contract

underlying the Agreement to pay the amount of the benefit that

corresponded to the portion of the contract reinsured

(95 percent). Petitioner was also liable: (1) To pay a

surrender benefit equal to the surrender and matured endowment

benefits paid by Guardian on the portion of the contracts

reinsured and (2) to pay those benefits in the same manner as
 - 25 -

provided in the reinsured contracts.

Petitioner did not pay claims, make refunds directly to the

insured, otherwise contact the insured, or perform administrative

functions with respect to the policies underlying the 1988

Agreement.

d. Ceding Commission and Risk Charge

The ceding commission was recorded as a negative $1 million

in the EAB as of October 1, 1988, and represented the pretax

surplus relief generated for Guardian and the pretax statutory

cost to petitioner as of that date. Petitioner deducted the

$1 million ceding commission on its 1988 Form 1120L.

The NAIC regulations applicable to the 1988 Agreement

required that a reinsurer such as petitioner participate

significantly in the risk of mortality, surrender, or investment.

In the case of the reinsured business, the 1988 Agreement

transferred to petitioner the risk of investment, surrender,

excess mortality, and annuitization. If losses were incurred and

profits were insufficient to recoup the losses, petitioner

maintained the burden of the losses. The 1988 Agreement passed

to petitioner the risk of paying 100 percent of the benefits on

the portion of the underlying policies that it assumed.

During the period that the agreement was in effect, Guardian

paid petitioner risk fees totaling $4,676. Three thousand

dollars of this amount was paid in 1988, and the remaining $1,666

was paid in 1995. Guardian paid petitioner the $1,666 amount

after petitioner discovered that the amount had not been paid as
 - 26 -

required.

e. Right To Withhold

The 1988 Agreement provided that Guardian would pay

petitioner reinsurance premiums and an initial consideration

equal to the total reserves on the reinsurance policies in force

at the start of the agreement. The 1988 Agreement permitted

Guardian to elect to withhold funds equal to the coinsurance

reserves on the reinsured policies. The 1988 Agreement permitted

petitioner to elect to withhold funds equal to the ceding

commission. Guardian had to pay petitioner interest on the funds

that it withheld, and petitioner had to pay Guardian interest on

the funds that it withheld.

The 1988 Agreement provided that all moneys due either

Guardian or petitioner would be netted against each other. The

1988 Agreement provided that negative experience refunds could

offset positive experience refunds within the same calendar year.

The 1988 Agreement allowed petitioner to carry forward negative

net refunds for a calendar year to future calendar years.

Although the 1988 Agreement allowed each party to withhold funds

equal to the amount specified in the agreement, the parties could

not withhold funds in excess of the amount specified. Within 45

days after the end of each calendar quarter, Guardian was

obligated to pay petitioner, and petitioner was obligated to pay

Guardian, the amounts due under the 1988 Agreement, subject to

each party’s right to withhold funds up to the maximum amount.
 - 27 -

Because petitioner could not withhold funds in excess of the $1

million ceding commission, petitioner had to pay Guardian losses

in excess of the amounts it was entitled to withhold if the

absolute value of the negative EAB exceeded $1 million. In the

event of Guardian’s insolvency, petitioner was obligated to

continue to fulfill its contractual liabilities under the 1988

Agreement without increase or diminution.

When Guardian and petitioner signed the 1988 Agreement, each

elected to exercise its right to withhold funds. No cash changed

hands at that time.

f. Recapture

The 1988 Agreement provided that Guardian would

automatically recapture a contract (but not all contracts) if the

ceding company elected to recapture. Subject to termination upon

recapture by the ceding company, the term of the 1988 Agreement

was unlimited and could not be terminated unilaterally by

petitioner. The 1988 Agreement provided that petitioner's

liability with respect to a contract would terminate on the date

of recapture.

g. Termination
Termination dates for reinsurance agreements, including

retroactive termination dates, are subject to negotiation, but a

termination date cannot be made retroactive to a prior calendar

year. The termination date of the 1988 Agreement was negotiated

between the parties.

On or about February 8, 1989, UPL notified Guardian that UPL
 - 28 -

would be effecting a recapture of the business underlying its

reinsurance agreement with Guardian due to NAIC compliance

issues. Guardian did not notify Mr. Gordon or petitioner of this

fact until some time in the fall of 1989.

The 1988 Agreement was terminated on December 28, 1989,

effective as of April 1, 1989. The effective date was the first

day of the second quarter, and it was the day after the

termination of the New York Retro, the earliest of the underlying

agreements to terminate. By the written terms of the 1988

Agreement, Guardian had to recapture the N.Y. Retro SPDA policies

from petitioner, effective March 30, 1989, as a result of the

recapture of those policies by the ceding company.

5. 1989 Agreement

a. In General

Following the termination of the 1988 Agreement, Guardian

and petitioner negotiated and entered into the 1989 Agreement.

The 1989 Agreement was very similar to the 1988 Agreement.

The 1989 Agreement was negotiated by Mr. Gordon (for petitioner)

and Mr. Starr (for Guardian), and it was drafted by Guardian.

Although the 1989 Agreement did not provide for the continuation

of the Trust, petitioner and Guardian continued to maintain the

Trust to secure petitioner’s performance under the 1989 Agreement

and to allow Guardian to receive credit on its annual statements

for statutory accounting purposes.13 Petitioner continued to

13
Petitioner continued to maintain the Trust with Guardian
as its beneficiary until the Trust was terminated in 1994.
 - 29 -

deposit into the Trust securities in the amount approximately

equal to the negative EAB.

The 1989 Agreement did not extend a carryover period for tax

purposes. It did not eliminate the SRLY taint of a previous net

operating loss for petitioner. It did not change the character

of an item of income or deduction for petitioner from ordinary to

capital or capital to ordinary. It did not change the source of

an item of income or deduction for petitioner from domestic to

foreign or foreign to domestic. It did not artificially reduce

petitioner's equity or result in any deferral of income to

Guardian.

Petitioner’s Federal marginal income tax rate for its 1989

taxable year was approximately 16 percent. Petitioner’s Federal

marginal income tax rate for the taxable years 1990 through 1992

was approximately 18 percent. During each of these years,

Guardian was taxed at the full corporate income tax rate,

including a significant equity tax under section 809.

b. Amendments

The 1989 Agreement was amended three times. The first

amendment, completed on July 17, 1990, to be effective as of

June 30, 1989, eliminated the experience refund provision, and

increased the risk fee from .25 percent per quarter to .3 percent

per quarter of the absolute value of the EAB. The amount of the

risk fee was within the range of risk fees normally payable by

reinsurers to retrocessionaires such as petitioner. The 1989

Agreement originally contained an experience refund provision,

pursuant to which petitioner agreed to refund to Guardian
 - 30 -

90 percent of the net cash-flow of the retroceded insurance.

Petitioner’s portion of the total reserves on the business

reinsured under the 1989 Agreement was approximately $7.4

million, and an experience refund provision of 90 percent would

have meant that the reinsured business would have had to earn

$10 million in profits on assets attributable to reserves of

$7.4 million, in order for petitioner to recover its $1 million

ceding commission. Mr. Starr recognized the error and advised

petitioner of the error shortly after the 1989 Agreement was

executed. Mr. Starr found the error when he was reviewing the

agreement in connection with signing his actuarial opinion.

The second amendment, effective December 31, 1991, changed

the agreement from indemnity reinsurance on a combined

coinsurance, modified coinsurance plan to indemnity reinsurance

on a coinsurance, funds withheld plan basis. Guardian asked for

this amendment because California had changed its regulations

concerning modified coinsurance, and Guardian wanted to assure

itself that the 1989 Agreement complied with the new regulations.

Petitioner agreed to the second amendment because it had the

potential to decrease petitioner’s exposure under the 1989

Agreement, and petitioner’s actuary was concerned that the

business was not as profitable as expected.

The third amendment, completed on December 28, 1993,

terminated the 1989 Agreement effective as of 12 a.m. on

October 1, 1993.
 - 31 -

c. Underlying Business

The insurance business underlying the 1989 Agreement was

volatile and risky. UPL and Guardian entered into a reinsurance

agreement on November 25, 1987, under which Guardian reinsured a

portion of a block of single premium deferred annuity (SPDA)

policies written from January 1 through December 31, 1987, and a

portion of a block of single premium whole life (SPWL) policies

written from January 1 through December 31, 1987. Pursuant to

the 1989 Agreement, petitioner assumed 30 percent of Guardian’s

interest in the individual life portion of the reinsurance

agreement between UPL and Guardian. The 1989 Agreement did not

reinsure with petitioner any deficiency or excess interest

reserves. The reserves for the business underlying the 1989

Agreement were smaller than the reserves associated with the 1988

Agreement.

Petitioner did not pay claims, make refunds directly to the

insured, or otherwise contact the insured or perform

administrative functions with respect to the policies underlying

the 1989 Agreement.

d. Ceding Commission and Risk Charge

The ceding commission for the 1989 Agreement was recorded as

a negative $1 million in the EAB as of June 30, 1989, and

represented the pretax surplus relief generated for Guardian and

the pretax statutory loss to petitioner as of that date. The

$1 million ceding commission was approximately 13 percent of the

reserves attributable to petitioner under the 1989 Agreement
 - 32 -

(i.e., $1 million ceding commission/$7.8 million of reserves.14

The $1 million ceding commission resulted in taxable income to

Guardian and an increase in Guardian’s equity tax. Petitioner

did not deduct the net loss attributable to the 1989 Agreement,

but capitalized it (to be amortized) under the principles of

Colonial Am. Life Ins. Co. v. Commissioner, 491 U.S. 244 (1989).

On its 1990 through 1992 Forms 1120L, petitioner claimed

deductions of $125,719, $161,613 and $165,605, respectively, for

the amortization of the loss associated with the 1989 Agreement.

Guardian paid petitioner $36,768 for risk charges on the

1989 Agreement. The market place, through competition, limits

the upside that a reinsurer can earn on a risk charge, but does

not limit a reinsurer’s downside risk. The risk charges did not

limit petitioner’s downside risk because of its obligation to pay

benefits under the Agreements. The risk charges that a

retrocessionaire like petitioner will earn are generally less

than the risk charges that a ceding reinsurer such as Guardian

would earn. If the experience under the reinsured policies was

bad, both Guardian and petitioner could be adversely affected.

The 1989 Agreement met the risk transfer regulations then in

effect under the laws of the State of New York. The 1989

Agreement also met the risk transfer requirements under the 1985

NAIC model regulation concerning risk transfer. The risks

involved with SPWL policies include: (1) Investment, (2) excess

14
Guardian also paid UPL an allowance under the reinsurance
agreement between them. This allowance was approximately
10 percent of the reserves attributable to Guardian under the
agreement.
 - 33 -

surrender, and (3) excess mortality. The 1989 Agreement involved

the transfer of significant risks from excess mortality, excess

surrender, and investment. With respect to the risk of

surrender, this risk increased as the underlying policies aged.

The insurance policies underlying the 1989 Agreement contained

surrender provisions that increased the likelihood of surrender

as the policies aged.

The 1989 Agreement obligated petitioner to pay Guardian a

death benefit equal to the death benefit paid by Guardian on the

portion of the contract reinsured so long as the 1989 Agreement

was in effect. The 1989 Agreement also provided that petitioner

would pay Guardian a surrender benefit equal to the surrender and

matured endowment benefits paid by Guardian on that portion of

the contract reinsured, so long as the 1989 Agreement was in

effect. The 1989 Agreement provided no way for petitioner to

escape from actual losses in the event of Guardian’s insolvency.

The primary method petitioner had to recover the $1 million

ceding commission in the 1989 Agreement was through the profits

of the business. No provision in the 1989 Agreement guaranteed

that the reinsured business would be profitable or that

petitioner would in fact recover its ceding commission.

Petitioner had the risk under the 1989 Agreement of losing more

than its $1 million ceding commission. Petitioner had 100

percent of the risk of claims exceeding revenue. Petitioner

could lose money if either the mortality of the insureds or the

rate of surrender under the reinsured policies turned out to be

higher than predicted. If enough policies terminated through
 - 34 -

death or surrender so that the losses associated with these

policies exceeded the investment income due petitioner,

petitioner would lose money.

e. Right To Withhold

The 1989 Agreement provided that Guardian would pay

petitioner an initial consideration equal to the total reserves

on policies in force at the start of the agreement. Petitioner

was obligated to pay Guardian cash if the EAB was negative by

more than $1 million. Petitioner could offset negative

experience refunds against positive experience refunds within the

same calendar year.

The 1989 Agreement allowed both Guardian and petitioner to

withhold certain funds from each other. The 1989 Agreement

permitted Guardian to withhold funds equal to the coinsurance

reserves on the reinsured policies. The 1989 Agreement permitted

petitioner to elect to withhold funds equal to the ceding

commission. When petitioner and Guardian signed the 1989

Agreement, each elected to exercise its right to withhold funds

and made no cash payments.

All moneys due either Guardian or petitioner were to be

netted against each other, and interest was required to be paid

on the funds withheld. Cash settlements were required when the

netted amounts exceeded the right of either party to withhold

funds.
 - 35 -

f. Recapture

The 1989 Agreement had an unlimited duration, and petitioner

could not unilaterally terminate it. Although Guardian could

recapture the underlying business after January 1, 1992, without

paying a recapture fee, the option to do so was solely

Guardian's. At various times after January 2, 1992, Guardian

could have elected to terminate the 1989 Agreement and recapture

the underlying business, leaving petitioner with a significant

loss. For example, if on January 3, 1992, Guardian had elected

to terminate the agreement, petitioner would have owed Guardian

approximately $945,000; i.e, the amount of the negative EAB.

If the 1989 Agreement had been terminated as of June 30, 1992,

petitioner would have owed Guardian approximately $606,159, for

the then-negative EAB.

g. Termination

The third amendment, which terminated the 1989 Agreement,

was drafted by Guardian. The third amendment provided that each

party to the 1989 Agreement waived any rights it had, that the

termination was conclusive for all purposes without exception,

and that neither party to the agreement would owe the other any

further obligations after the termination date. Guardian agreed

to the termination because it believed that the EAB had become

positive, and that it would have otherwise had to begin paying

petitioner profits from the underlying business. Petitioner

agreed to the termination because the Commissioner had challenged

the 1989 Agreement, and Mr. Gordon was concerned about how her
 - 36 -

challenge might affect the agreement. Mr. Gordon also expected

that Guardian would want to recapture the underlying policies.

When the third amendment was executed, Mr. Gordon believed

that all settlements for amounts due petitioner had been made.

In fact, settlement had not been made. As a result of this

error, petitioner did not receive from Guardian moneys it was

entitled to receive. The third amendment would not have been

executed if Mr. Gordon had realized the error. The provision in

the third amendment pursuant to which each party waived its

rights also appears in the terminating amendments to the

reinsurance agreement between UPL and Guardian.

When the 1989 Agreement was terminated, neither party had

accurate information as to the actual status of the EAB. The

accounting information provided by Guardian showed a positive EAB

of $140,663. The EAB was actually negative by approximately

$260,181. Although the EAB was negative, petitioner made no

payment to Guardian, because neither party realized that it was

negative. Neither petitioner nor Guardian would have made the

decisions each did, if it had had accurate information.

OPINION

1. Overview

This case takes the Court inside the complex and esoteric

world of insurance law, taking into account the technical jargon

and standards utilized therein. In making our findings, we have

examined volumes of filings, reams of trial testimony, boxes of

exhibits, and assorted expert reports. Many of the critical

facts were disputed by the parties, and each party introduced
 - 37 -

testimony, exhibits, and/or other evidence to support her or its

proposed findings of fact. As the trier of fact, we have found

the facts herein by evaluating and weighing the evidence before

us, giving proper regard to our perception of each witness

derived from seeing and hearing him or her testify on the stand.

We have been guided by petitioner’s expert, Diane B. Wallace,

whom, as discussed below, we find to be very knowledgeable on the

reinsurance industry. We have also been guided by our

understanding of the insurance and reinsurance industries in

general, as well as by our knowledge of the applicable statutory

scheme as it relates to these industries.

The primary issue before us is one of first impression;

namely, whether it was an abuse of discretion for the

Commissioner to determine that each of the Agreements had “a

significant tax avoidance effect” within the meaning of section

845(b). The tax avoidance effect identified by the Commissioner

is that the Agreements allowed petitioner to claim and benefit

from the small life insurance company deduction of section 806.15

15
Sec. 806 provides in part:

(a) Small Life Insurance Company Deduction.--

(1) In general.--* * * the small life insurance
company deduction for any taxable year is 60 percent of
so much of the tentative LICTI for such taxable year as
does not exceed $3,000,000.

(2) Phaseout between $3,000,000 and $15,000,000.--
The amount of the small life insurance company
deduction determined under paragraph (1) for any
taxable year shall be reduced (but not below zero) by
15 percent of so much of the tentative LICTI for such
(continued...)
 - 38 -

Given the fact that there are no regulations under section 845,

the Commissioner relies primarily on legislative history and her

experts’ opinions on industry standards to support her

determination that the Agreements had a “significant tax

avoidance effect” under section 845(b). In forming our opinion,

we look first to the law as written by the legislators, and we

consult the legislative history primarily to resolve ambiguities

in the words used in the statutory text.16 Landgraf v. USI Film

Prods, 511 U.S. , 114 S.Ct 1483 (1994); Consumer Prod. Safety

Commn. v. GTE Sylvania, Inc., 447 U.S. 102, 108 (1980).

(...continued)
taxable year as exceeds $3,000,000.

(3) Small life insurance company deduction not
allowable to company with assets of $500,000,000 or
more.---

(A) In general.--The small life
insurance company deduction shall not be
allowed for any taxable year to any life
insurance company which, at the close of such
taxable year, has assets equal to or greater
than $500,000,000.

* * * * * * *

(b) Tentative LICTI.--For purposes of this part--

(1) In general.--The term “tentative LICTI” means
life insurance company taxable income determined
without regard to the small life insurance company
deduction.
16
In Western Natl. Mut. Ins. Co. v. Commissioner, 102 T.C.
338, 355 (1994), affd. 65 F.3d 90 (8th Cir. 1995), we stated that
the language used in subchapter L generally had the meaning
attributed thereto by experts in the field because Subchapter L
was drafted by the Congress in language peculiar to the insurance
industry. We do not interpret the term "significant tax
avoidance effect" according to an industry meaning, because we do
not find that the term has a specific meaning in the industry.
 - 39 -

Section 845, which was enacted as section 212(a) of the

Deficit Reduction Act of 1984 (DEFRA), Pub. L. 98-369, 98 Stat.

494, 757, provides:

SEC. 845. CERTAIN REINSURANCE AGREEMENTS.

(a) Allocation in Case of Reinsurance Agreement
Involving Tax Avoidance or Evasion.--In the case of 2
or more related persons (within the meaning of section
482) who are parties to a reinsurance agreement (or
where one of the parties to a reinsurance agreement is,
with respect to any contract covered by the agreement,
in effect an agent of another party to such agreement
or a conduit between related persons), the Secretary
may--

(1) allocate between or among such
persons income (whether investment income,
premium, or otherwise), deductions, assets,
reserves, credits, and other items related to
such agreement,

(2) recharacterize any such items, or

(3) make any other adjustment,

if he determines that such allocation,
recharacterization, or adjustment is necessary to
reflect the proper source and character of the taxable
income (or any item described in paragraph (1) relating
to such taxable income) of each such person.

(b) Reinsurance Contract Having Significant Tax
Avoidance Effect.--If the Secretary determines that any
reinsurance contract has a significant tax avoidance
effect on any party to such contract, the Secretary may
make proper adjustments with respect to such party to
eliminate such tax avoidance effect (including treating
such contract with respect to such party as terminated
on December 31 of each year and reinstated on January 1
of the next year).

2. Lack of Regulations Under Section 845(b)

Petitioner argues that respondent may not rely on section

845(b) because she has not prescribed regulations thereunder.

Petitioner argues that section 845(b), without regulations,
 - 40 -

violates the Due Process Clause of the Fifth Amendment to the

U.S. Constitution because it does not set forth an ascertainable

standard sufficient to alert taxpayers as to the section’s reach.

Petitioner points to the term "significant tax avoidance effect",

and argues that the term is too vague to be interpreted without

regulations.

We disagree with petitioner's claim that section 845(b),

without regulations, is unconstitutionally vague. The

Constitution does not require that the Commissioner prescribe

regulations for section 845(b). See SEC v. Chenery Corp.,

332 U.S. 194, 201-203 (1947); Columbia Broadcasting Sys. v.

United States, 316 U.S. 407, 425 (1942). In the absence of

regulations, the statutory text may be interpreted in light of

all the pertinent evidence, textual and contextual, of its

meaning. See Commissioner v. Soliman, 506 U.S. 168, 173 (1993);

Crane v. Commissioner, 331 U.S. 1, 6 (1947); Old Colony R. Co. v.

Commissioner, 284 U.S. 552, 560 (1932). Although it is true,

as petitioner points out, that the Congress anticipated that

regulations would be issued under section 845(b), see

H. Conf. Rept. 98-861, at 1064-1065 (1984), 1984-3 C.B.

(Vol. 2) 1, 318-319, it is not true, as petitioner would have us

hold, that section 845(b) requires regulations in order to be

effective. We find nothing in the statutory text, or in its

legislative history, that conditions the section's effectiveness

on the issuance of regulations. See Estate of Neumann v.
Commissioner, 106 T.C. (1996); H. Enters. Intl., Inc.,
 - 41 -

v. Commissioner, 105 T.C. 71, 81-85 (1995).

We are mindful that a vital component of due process is that

a statute be "reasonably clear". See Smith v. Goguen, 415 U.S.

566, 572 (1974); Grayned v. City of Rockford, 408 U.S. 104,

108-109 (1972); Retired Teachers Legal Defense Fund, Inc. v.

Commissioner, 78 T.C. 280, 284-285 (1982). We conclude that

section 845(b) passes that test. As will be reflected in the

following discussion, the term "significant tax avoidance effect"

has a discernible meaning taking into account the relevant

legislative history and other aids to its interpretation.

3. Significant Tax Avoidance Effect

Respondent determined that the Agreements had a significant

tax avoidance effect with respect to petitioner. Respondent

argues that the Agreements did not transfer life insurance risk

to petitioner that was proportionate to the benefit it derived

from the small life insurance company deduction. Respondent

relies primarily upon the testimony of her three experts,

Ralph J. Sayre, Jack M. Turnquist, and Charles M. Beardsley.

Mr. Sayre is a consulting actuary for Actuarial Resources of

Georgia, and he is a member of various actuarial societies.

Mr. Turnquist is a member of various actuarial organizations, and

he has been self-employed since 1987, providing consulting

services on actuarial and technical communications relative to

the operation of life insurance companies. Mr. Beardsley is an

actuary, and he is an expert on the annual statement reporting

for insurance companies.
 - 42 -

Petitioner argues that respondent’s determination is wrong

because the benefit of the small life insurance company deduction

is not a tax avoidance effect under section 845(b). Petitioner

also argues that the Agreements did not have a significant tax

avoidance effect with respect to petitioner because the

Agreements transferred the risk of loss from Guardian to

petitioner. Petitioner relies mainly on the testimony of

Ms. Wallace, who has been the president of the D.B. Wallace Co.

from 1990 to present. The D.B. Wallace Co. specializes in

reinsurance agreements and regulatory compliance with respect

thereto. Ms. Wallace is also the NAIC’s primary lecturer in its

nationwide educational programs, which are offered to the staff

of insurance regulators on the topics of accounting and

regulatory compliance for reinsurance transactions.

We agree with petitioner that the Agreements did not have a

significant tax avoidance effect within the meaning of section

845(b). Before explaining our reasons for that conclusion, we

summarize our impressions of the experts. We have broad

discretion to evaluate the cogency of an expert's analysis.

Sammons v. Commissioner, 838 F.2d 330, 333-334 (9th Cir. 1988),

affg. in part and revg. in part on another issue T.C. Memo.

1986-318; Ebben v. Commissioner, 783 F.2d 906, 909 (9th Cir.

1986), affg. in part and revg. in part on another issue T.C.

Memo. 1983-200. We evaluate and weigh an expert’s opinion in

light of his or her qualifications and with regard to all other

evidence in the record. Estate of Christ v. Commissioner,
 - 43 -

480 F.2d 171, 174 (9th Cir. 1973), affg. 54 T.C. 493 (1970);

IT&S of Iowa, Inc. v. Commissioner, 97 T.C. 496, 508 (1991);

Parker v. Commissioner, 86 T.C. 547, 561 (1986). We are not

bound by an expert’s opinion, especially when it is contrary to

our own judgment. Orth v. Commissioner, 813 F.2d 837, 842

(7th Cir. 1987), affg. Lio v. Commissioner, 85 T.C. 56 (1985);

Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976),

affg. T.C. Memo. 1974-285; Estate of Kreis v. Commissioner,

227 F.2d 753, 755 (6th Cir. 1955), affg. T.C. Memo. 1954-139.

If we believe it is appropriate to do so, we may adopt an

expert’s opinion in its entirety, or we may reject it in its

entirety. Helvering v. National Grocery Co., 304 U.S. 282,

294-295 (1938); see Buffalo Tool & Die Manufacturing Co. v.

Commissioner, 74 T.C. 441, 452 (1980). We may also choose to

adopt only parts of an expert’s opinion. Parker v. Commissioner,

supra at 562.

We find the opinion of Ms. Wallace to be most helpful in

resolving the issues presented herein, and we rely heavily on it

in making our findings and reaching our conclusions. Ms.

Wallace’s testimony and reasoning were more clear, coherent, and

persuasive than those of her counterparts; namely, Messrs. Sayre,

Turnquist, and Beardsley. We are unpersuaded by, and generally

do not rely on, the opinions of Messrs. Sayre, Turnquist, and

Beardsley in making our findings or in reaching our conclusions.

We find the opinions of Messrs. Sayre and Turnquist to be

inconsistent and problematic, and we generally find that their
 - 44 -

opinions are unhelpful to us.17 For example, Mr. Sayre stated

that petitioner and Guardian dealt at arm’s length, but that each

would ignore the express terms of the Agreements and change its

conduct whenever it chose to do so. We find that the record does

not support the latter part of this statement. Mr. Sayre further

stated that he did not believe that the Agreements transferred

any meaningful risk. Under questioning by the Court, however,

Mr. Sayre conceded that petitioner could suffer a loss under both

of the Agreements. Ms. Wallace, Mr. Starr, and Mr. Gordon were

all unable to understand or reproduce many of the material

results reached by Mr. Sayre. Neither Mr. Sayre nor

Mr. Turnquist adequately analyzed what would have happened under

the Agreements if significant losses were to have arisen.

We turn to the substance of this case. The applicability of

section 845(b) hinges on whether a reinsurance agreement has a

“significant tax avoidance effect” on any party to the agreement.

Respondent argues that the Agreements had a significant tax

avoidance effect because they allowed petitioner to benefit from

the small life insurance company deduction of section 806.

Respondent claims that the only reason petitioner entered into

the Agreements was to qualify as a life insurance company in

order to benefit from the small life insurance company deduction.

Respondent claims that the Agreements were not designed to

17
We also find that the opinion of Mr. Beardsley is of
little benefit to the Court. From our point of view, the salient
parts of his testimony focused on issues that were conceded by
petitioner at or before trial.
 - 45 -

generate for petitioner anything more than nominal profits, apart

from tax savings. Petitioner replies that the benefit of the

small life insurance company deduction is not a tax avoidance

effect under section 845(b). Petitioner claims that it entered

into the Agreements for valid and substantial business reasons

that went beyond qualifying as a life insurance company.

A tax avoidance effect must be significant to one or both of

the parties to a reinsurance agreement in order for the

Commissioner to exercise her authority to make adjustments under

section 845(b). The conference report on DEFRA states that a tax

avoidance effect is significant “if the transaction is designed

so that the tax benefits enjoyed by one or both parties to the

contract are disproportionate to the risk transferred between the

parties.” H. Conf. Rept. 98-861, supra at 1063; 1984-3 C.B.

(Vol. 2) at 317. This test focuses on the economic substance of

the agreement, and the conference report sets forth seven factors

that help determine an agreement’s economic substance. These

factors, which are nonexclusive and none of which is

determinative by itself, are: (1) The duration or age of the

business reinsured; (2) the character of the business reinsured;

(3) the structure for determining the potential profits of each

of the parties and any experience rating; (4) the duration of the

reinsurance agreement between the parties; (5) the parties’ right

to terminate the reinsurance agreement and the consequences of a

termination; (6) the relative tax positions of the parties; and

(7) the general financial situations of the parties. Id.
 - 46 -

We turn to these factors and analyze them one at a time.

We also analyze and discuss other factors that we find to be

relevant to our determination. In analyzing all of the factors,

we apply a deferential standard of review because the text of

section 845(b) confers broad discretion on the Commissioner

similar to that of section 482 and like provisions. We shall

sustain the Commissioner’s determination as within her discretion

unless the determination is arbitrary, capricious or without

sound basis in fact. Capitol Fed. Sav. & Loan Association v.

Commissioner, 96 T.C. 204, 213 (1991); Procter & Gamble Co. v.

Commissioner, 95 T.C. 323, 332 (1990), affd. 961 F.2d 1255 (6th

Cir. 1992).

i. Duration or Age of Business Reinsured

The duration or age of the business reinsured bears directly

on the transfer of significant economic risk between the parties.

The reinsurance of new business may carry a greater risk of

lapse, and thus of potential loss to the reinsurer, than the

reinsurance of old business. H. Conf. Rept. 98-861, supra at

1063, 1984-3 C.B. (Vol. 2) at 317.

The two blocks of SPDA policies underlying the 1988

Agreement and the block of SPDA policies underlying the 1989

Agreement were several years old. Respondent argues that the

history of these policies allowed petitioner to predict the

policies’ potential profits, which, in turn, allowed petitioner

to minimize its risk through the negotiation of a ceding

commissions that would be recouped out of those profits. We
 - 47 -

disagree. The reinsurance of older policies under the facts

herein resulted in a greater risk transfer than if the policies

had been new. In contrast to what commonly happens, the risk of

surrender increased as these policies aged. This was because the

policies carried surrender charges, which decreased over time,

creating an incentive to defer the surrender of the policies.

As Ms. Wallace testified, the surrender rates on policies of this

kind tend to be higher after surrender charges have been reduced.

Mr. Starr’s credible testimony also established that petitioner’s

risk of loss increased over time because the decreasing surrender

charges reduced a source of profit for petitioner.

This factor favors petitioner.

ii. Character of Business Reinsured

Coinsurance of yearly renewable term life insurance (YRTLI),

as contrasted to ordinary life insurance, generally does not have

a significant tax avoidance effect because coinsurance of YRTLI

does not involve the transfer of long-term reserves. Id. at

1063, 1984-3 (Vol. 2) at 317. In a typical reinsurance agreement

involving YRTLI, the parties negotiate each year's risk premium

that will be paid to the ceding company to cover the risk that is

transferred for that year. Because the reinsurer receives a

premium each year to cover the risk for that year, the reinsurer

does not establish long-term reserves.

The SPDA and SPWL policies at issue required one-time, lump-

sum payments of premiums on an up-front basis, and as a

consequence the policies were backed by relatively long-term
 - 48 -

reserves. Respondent argues that these long-term reserves led to

tax avoidance, and that the coinsurance-modco structure did not

change the Agreements into the equivalent of YRTLI or otherwise

minimize their tax avoidance effect. We disagree. Ms. Wallace

testified (and we believed) that the use of the coinsurance-modco

structure minimized the transfer of reserves to petitioner.

Under this structure, she testified, many of the reserves stayed

with Guardian instead of being transferred to petitioner. This

structure was similar to the reinsurance of YRTLI.

This factor favors petitioner.

iii. Determining Potential Profits and Experience Rating

An experience rating formula that results in the reinsurer’s

assuming a risk of loss beyond the annual mortality risk, as well

as enjoying a share of profits commensurate with its loss

exposure, may indicate that the tax benefits resulting from the

assumption of reserve liabilities by the reinsurer are not

disproportionate to the risk transferred between the parties.

When the experience rating formula for a reinsurance agreement

results in the reinsurer’s receiving only an annual risk premium,

plus a fixed fee, the agreement may be economically equivalent to

YRTLI combined with a financing arrangement. H. Conf. Rept.

98-861, supra at 1063, 1984-3 C.B. (Vol. 2) at 317.
Respondent argues that the fee structure of the Agreements

was a financing arrangement. Respondent claims that the

Agreements were structured to terminate when the EAB equaled

zero. Respondent concludes that petitioner rented its surplus to
 - 49 -

Guardian in exchange for an annual fee of 1.2 percent of the

outstanding surplus relief.

We do not find that the record supports respondent’s

argument, claim, or conclusion. As is typical with most

reinsurance agreements, petitioner’s profit or loss on the

Agreements was only ascertainable upon the Agreements’

termination. Because petitioner could not terminate the

Agreements, they would continue (and petitioner would remain at

risk) for as long as Guardian left the Agreements intact.

Petitioner faced mortality, surrender, and annuitization risks

for the duration of the Agreements. If cumulative benefit costs

exceeded revenues, petitioner could be left with the losses

permanently at Guardian’s option. Petitioner also was to receive

future profits from the blocks of policies, at a set profit

margin. As Ms. Wallace testified, this method of computing the

profit margin is a very common feature in reinsurance agreements.

She also testified that the 1.2-percent risk charge and the

10-percent profit sharing feature were within the range of common

charges for this type of agreement.

This factor favors petitioner.

iv. Duration of Agreement

A long-standing agreement for automatic reinsurance of

certain types of policies tends to indicate that there is no

significant tax avoidance effect when a coincidental tax benefit

is enjoyed by a ceding company because income arising from the

reinsurance transaction offsets an expiring loss carryover.
 - 50 -

A longstanding policy may be ignored if the experience rating

formula in effect allows the parties to tailor income, expense,

and profit allocation on an individual contract basis. Id.

Respondent notes that the Agreements arose from a new

relationship, and that the duration of the 1988 Agreement was

approximately 6 months. According to respondent, these facts

demonstrate tax avoidance effect. We disagree. Although the

Agreements arose from a new relationship, the Agreements were

unlimited in duration, and petitioner could not unilaterally

terminate them. Although the Agreements proved to be of a

relatively short duration, this was due to Guardian’s decision to

recapture the underlying insurance, a decision over which

petitioner had no control. The Agreements also contained no

experience rating provision that allowed the parties to tailor

results on an individual contract basis.

This factor favors petitioner.

v. Right To Terminate and Consequences of Termination

The existence of a payback provision that protects a

reinsurer from losses on early termination of the reinsurance

agreement following the payment of a large up-front ceding

commission, but before the reinsurer has been able to enjoy the

future profit stream, may be a reasonable business practice and

should not automatically be viewed as having a tax avoidance

effect. On the other hand, a payback provision which allows a

reinsurer to recover all of its losses in any case, through

adjustments in future premiums or specific termination
 - 51 -

provisions, indicates that the transaction is merely a financing

arrangement. H. Conf. Rept. 998-861, supra at 1063, 1984-3 C.B.

(Vol. 2) at 317.

Respondent concedes that the written terms of the

Agreements: (1) Prevented petitioner from unilaterally

terminating the Agreements and (2) obligated Guardian to pay

petitioner a recapture fee only if Guardian terminated the

Agreements in the initial period. Respondent claims, however,

that the parties’ understanding was to the contrary. According

to respondent, Guardian and petitioner understood that Guardian

would terminate the Agreements at petitioner’s request.

Respondent also claims that Guardian, upon terminating the

Agreements, intended to make petitioner whole for any losses

suffered.

The record does not support respondent’s assertion that

there was an unwritten understanding concerning the termination

or recapture of the Agreements. Under the terms of the

Agreements, recapture would occur solely at Guardian’s option.

Both Agreements contained an explicit early recapture provision,

of the kind reflecting “a business practice” as described in the

conference report. Neither Agreement had a payback provision of

the sort which the conference report finds indicative of a mere

financing arrangement.

This factor favors petitioner.

vi. Relative Tax Positions

The relative tax positions of the parties is a factor to be
 - 52 -

considered in determining tax avoidance effect because the

economic value of income and deductions depends on the tax

bracket of the insurer. Bracket shifting is possible, for

example, between small and large insurers, profit and loss

insurers, and life and nonlife insurers. Id.

It appears that Guardian was in a higher tax bracket than

petitioner, but we find this inconclusive. We draw no inference

from this factor. It is neutral.

vii. General Financial Situations

The general financial situation of the parties is another

factor to consider. The conference report states, for example,

that the fact a surplus relief reinsurance agreement is entered

into to protect a party from insolvency may indicate that the

transaction has no significant tax avoidance effect. Id.

Respondent argues that the general financial situation of

Guardian points toward a conclusion of a significant tax

avoidance effect because Guardian did not need the surplus relief

generated by the Agreements to protect itself from insolvency.

Unlike respondent, we do not draw from the example in the

conference report a negative inference that surplus relief

invariably has a significant tax avoidance effect unless its

object is to prevent an insolvency. Ms. Wallace testified that

it is common for an insurer with excess capital and surplus in

relation to liabilities to increase its return by putting that

capital and surplus to work, as petitioner did via the

Agreements.
 - 53 -

This factor favors petitioner.

viii. Risk Transferred Versus Tax Benefits Derived

The legislative history of section 845(b) refers to a

determination of the amount of: (1) The tax benefits enjoyed by

the parties to a reinsurance agreement, as well as (2) the risk

transferred between the two. H. Conf. Rept. 98-861, supra at

1063, 1984-2 C.B. (Vol. 2) at 317. Respondent generally argues:

(1) The risk fees received by petitioner under the Agreements are

the appropriate measure of the risk transferred to it by Guardian

and (2) the small life insurance company deduction is the tax

benefit that petitioner derived from the Agreements. Respondent

concludes that Guardian did not transfer risks to petitioner

which were commensurate with the latter’s benefit from the small

life insurance deduction. In respondent’s view, petitioner

assumed minimal risk, as reflected in the size of the risk fees,

while enjoying disproportionate tax benefits.

We reject respondent’s position on the proper measure of

risk. A more appropriate standard is to compare the tax benefits

(in this case, petitioner’s tax savings from the small life

insurance company deduction) to petitioner’s exposure to loss

under the Agreements, measuring the latter based on the

difference between the face amount of the reinsured policies and

the amount of reserves backing those policies. By that

reckoning, the insurance risk incurred by petitioner was not

disproportionate to the tax benefits. The risks associated with
 - 54 -

the policies reinsured under the Agreements became apparent in

1991 when, as a result of financial problems experienced by UPL,

significantly more of the policies were surrendered than had been

expected.

We find support for our standard in the regulations of the

NAIC. In 1985, the NAIC issued its Model Regulation on Life

Reinsurance Agreements (the 1985 Model Regulation). The 1985

Model Regulation states that a ceding company may not receive

credit for reinsurance if any of the following conditions exist,

in substance or in effect:

(1) the primary effect of the reinsurance
agreement is to transfer deficiency reserves
or excess interest reserves to the books of
the reinsurer for a "risk charge" and the
agreement does not provide for significant
participation by the reinsurer in one or more
of the following risks: mortality, morbidity,
investment or surrender benefit;

(2) the reserve credit taken by the ceding
insurer is not in compliance with the
Insurance Law (or Code), Rules or
Regulations, including actuarial
interpretations or standards adopted by the
Department;

(3) the reserve credit taken by the ceding
insurer is greater than the underlying
reserve of the ceding company supporting the
policy obligations transferred under the
reinsurance agreement;

(4) the ceding insurer is required to
reimburse the reinsurer for negative
experience under the reinsurance agreement,
except that neither offsetting experience
refunds against prior years' losses nor
payment by the ceding insurer of an amount
equal to prior years' losses upon voluntary
termination of in-force reinsurance by that
ceding insurer shall be considered such a
 - 55 -

reimbursement to the reinsurer for negative
experience;

(5) the ceding insurer can be deprived of
surplus at the reinsurer's option or
automatically upon the occurrence of some
event, such as the insolvency of the ceding
insurer, except that termination of the
reinsurance agreement by the reinsurer for
non-payment of reinsurance premiums shall not
be considered to be such a deprivation of
surplus;

(6) the ceding insurer must, at specific
points in time scheduled in the agreement,
terminate or automatically recapture all or
part of the reinsurance ceded;

(7) no cash payment is due from the
reinsurer, throughout the lifetime of the
reinsurance agreement, with all settlements
prior to the termination date of the
agreement made only in a "reinsurance
account," and no funds in such account are
available for the payment of benefits; or

(8) the reinsurance agreement involves the
possible payment by the ceding insurer to the
reinsurer of amounts other than from income
reasonably expected from the reinsured
policies.[18]

The NAIC issued the 1985 Model Regulation primarily to

distinguish reinsurance agreements that legitimately transferred

risk, from those that did not. The NAIC was concerned that

affording reinsurance treatment for regulatory purposes absent a

meaningful transfer of risk did not fairly represent the

financial condition of the parties to the reinsurance agreement.

The 1985 Model Regulation sets forth rules for a ceding company's

18
In 1992, the NAIC issued another regulation that
generally updated the Model Regulation. As of August 16, 1993,
42 States had adopted a version of the Model Regulation or its
successor, or had legislation pending.
 - 56 -

transfer of its reserves to a reinsurer. These rules have

similarities to the factors identified by the Congress in the

conference report on DEFRA, with the notable exception of the

factor involving the relative tax positions of the parties (with

which the NAIC would not be concerned).

This factor favors petitioner.

ix. State Determinations

The 1989 Agreement was examined for risk transfer by the

Arizona Department of Insurance and found to have transferred

risk.

This factor favors petitioner.

x. Conclusion

We have analyzed the factors mentioned above. Most of these

factors favor petitioner. None of these factors favors

respondent’s determination. We conclude that the factors show

that the Agreements did not have a significant tax avoidance

effect within the meaning of section 845(b). We conclude that

respondent’s determination to the contrary amounted to an abuse

of discretion. We hold for petitioner on this issue. We have

considered all arguments made by respondent for a contrary

holding and, to the extent not discussed above, find them to be

without merit.

4. Amortization of Ceding Commissions
We turn to the final issue. Respondent asserted in her

Amendments that petitioner was not entitled to deduct or

amortize any part of the ceding commissions. Respondent alleges
 - 57 -

that these commissions were not paid to acquire income-producing

capital assets, unlike the ceding commissions in Colonial

American Life Ins. Co. v. Commissioner, 491 U.S. 244 (1989).

In Colonial American, the Supreme Court stated that a ceding

commission is "an up-front, one-time payment to secure a share

in a future income stream." Id. at 260. According to

respondent, the ceding commissions were not paid by petitioner

for the right to realize income from the reinsured policies

because the Agreements were designed to return to petitioner

income approximately equal to the amount of the commissions.

Respondent bears the burden of proof on this issue. Rule 142(a);

Estate of Bowers v. Commissioner, 94 T.C. 582, 595 (1990).

We find respondent's argument unpersuasive. The short

answer to this question is that the ceding commissions were paid

to allow petitioner to share in the future income stream from the

reinsured policies. Petitioner entered into the Agreements and

incurred the related commissions for valid and substantial

business reasons. The ceding commissions were incurred in arm's-

length transactions between unrelated parties. We find that

these ceding commissions were “part of the purchase price to

acquire the right to a share of future profits”, Colonial
American Life Ins. Co. v. Commissioner, supra at 251, and, as

such, were capital expenditures that must be amortized over the

life of the Agreements, id. at 252-253. Respondent has not

proven otherwise.

We have considered all arguments made by respondent for a
 - 58 -

contrary holding and, to the extent not discussed above, find

them to be without merit.

To reflect the foregoing,

Decision will be entered

for petitioner.