Section 848: Capitalizing Policy Acquisition Expenses
Tax law requires insurers to defer deducting policy acquisition costs, capitalizing a proxy amount based on premiums and amortizing it over several years.
Federal tax law requires certain business expenditures that provide a long-term benefit to be capitalized, meaning the cost is spread out over several years rather than deducted at once. The insurance industry has specific regulations for handling the costs of acquiring new business, such as commissions and underwriting expenses.
Because these costs are linked to policies that produce premium income for many years, tax law mandates a specific method for capitalizing them. This approach aligns the deduction for acquiring a policy with the income stream from that policy.
Determining Specified Policy Acquisition Costs
The rules for capitalizing insurance policy acquisition costs are in Section 848 of the Internal Revenue Code. This section establishes a proxy system instead of requiring companies to track actual acquisition expenses. A portion of an insurer’s general deductions are designated as “specified policy acquisition costs” (SPACs) and must be capitalized.
Section 848 applies to insurance companies and only to certain types of long-duration contracts. The three main categories are life insurance contracts, annuity contracts, and noncancellable or guaranteed renewable accident and health insurance contracts. Any reinsurance agreement that covers the risks of these specified contracts is treated in the same manner as the original contract it reinsures.
A distinction is made for accident and health (A&H) policies, as only those that are “noncancellable” or “guaranteed renewable” are subject to Section 848 capitalization. A noncancellable policy is one that an insurer must renew and cannot cancel, nor can it change the premium rates stated in the contract. A guaranteed renewable policy also requires the insurer to renew the coverage, but it may permit the insurer to change the premium rates for an entire class of policyholders.
Calculating the Capitalization Amount
The amount of specified policy acquisition costs an insurer must capitalize is not based on actual spending but is determined by a formula. This formula applies a set percentage to the “net premiums” received for the year for each category of specified insurance contract. This proxy calculation simplifies compliance by avoiding the complexity of tracing specific expenses to specific policies.
To perform the calculation, an insurer must first determine its net premiums for each contract category. Under Section 848, “net premiums” are defined as the gross amount of premiums and other consideration received on contracts, reduced by return premiums and by premiums paid for reinsurance.
Once net premiums are calculated, specific capitalization percentages are applied. The amount to be capitalized is 2.09% of net premiums for annuity contracts, 2.45% for group life insurance contracts, and 9.2% for all other specified insurance contracts. This last category includes individual life insurance and noncancellable or guaranteed renewable accident and health policies.
It is possible for the calculation to result in a negative number, a situation known as “negative capitalization.” This occurs if an insurer’s reinsurance premiums paid out exceed its gross premiums received in a category for the year. When this happens, the negative amount can be used to reduce the unamortized balance of SPACs from prior years. Any remaining negative amount after this reduction may be deducted in the current taxable year.
The calculation of the capitalization amount is also affected by reinsurance transactions involving ceding commissions. When an insurer cedes policies to a reinsurer, the reinsurer often pays a ceding commission to the original insurer. Section 848 specifies that these ceding commissions reduce the amount that the reinsurer must capitalize by reducing the reinsurer’s net premiums.
Amortization and Deduction Rules
The general rule under Section 848 requires the capitalized amount to be amortized, or deducted, on a straight-line basis over a 180-month period, which is equivalent to 15 years. This extended amortization period reflects the long-term income stream generated by the underlying insurance policies.
The 180-month period starts on the first day of the first month of the second half of the taxable year in which the expenses were incurred. For a company using the calendar year for its tax filings, amortization for a given year’s capitalized expenses begins on July 1st. In the first year, the company can deduct six months’ worth of the total amortized amount.
An exception to the 180-month rule exists for smaller insurance companies. This provision allows for a shorter, 60-month (5-year) amortization period for the first $5 million of specified policy acquisition expenses capitalized during a taxable year. This relief is phased out for companies with larger amounts of SPACs; if a company’s total SPACs for the year exceed $10 million, the $5 million eligible for the shorter amortization period is reduced dollar-for-dollar by the excess.