What Is a Reciprocal Insurance Company and How Is It Taxed?

A reciprocal is an arrangement through which mutual promises of the participants ("subscribers") are exchanged with respect to their insurance risks. It is not a separately incorporated company. Nevertheless, for federal tax purposes it is characterized as an insurance company. The business of the reciprocal insurance company is conducted through two separate entities—this unincorporated insurance facility that pays insurance losses and an "attorney-in-fact" that is designated by contract to administer the reciprocal.

Each subscriber is insured by all of the other subscribers and, in turn, insures each of the other subscribers, generally up to a designated amount. Under the specific provisions of certain state insurance laws, reciprocals may issue nonassessable policies, in which case loss payments are limited to the available assets of the reciprocal. In those cases in which the policies of a reciprocal are assessable, the assessment generally is subject to a cap that often is based on a percentage of the member's annual premium. Of course, any capital accumulated by the reciprocal from premiums and investment income also would generally be available to pay losses.

The subscribers of a reciprocal are represented by the attorney-in-fact, which generally has full power to manage the day-to-day affairs of the reciprocal, subject only to any express contractual limitations imposed by the subscribers. Thus, the attorney-in-fact may be authorized to issue policies on behalf of the reciprocal, administer claims, manage investments, and perform other day-to-day management functions.

A reciprocal may qualify as a captive insurance company under the captive insurance laws of a state. The benefits of the lower capital requirements of those laws may be relevant to a reciprocal, depending on the particular capital requirements applicable to the reciprocal in its state of domicile. There also may be other benefits under the captive laws of some states—such as reduced premium taxes, exemptions from state guaranty funds, and reduced state regulation of policy forms.

In almost all respects, a reciprocal is subject to the same US federal income tax rules that apply to traditional insurance companies. There are, however, a couple of special rules under subchapter L of the Internal Revenue Code that apply only to reciprocals.  Section 835 allows a reciprocal to take account of the fact that its business is conducted through two separate entities. A reciprocal may elect a method of accounting for tax purposes that effectively results in the aggregation of items of income and deduction of the unincorporated insurance facility and its attorney-in-fact for purposes of determining the reciprocal's federal income tax liability.

In addition, section 832(f) permits a current tax deduction for "savings" ¹ credited to subscriber accounts even if the credits are not distributed to subscribers. As a result, reciprocals enjoy (in certain limited circumstances) tax efficiencies otherwise unavailable under the US tax laws. For tax-exempt entities, such as hospitals, subscriber credits that are received are generally not characterized as unrelated business income, unlike subpart F insurance income inclusions from controlled foreign corporations, which are characterized as unrelated business income.

The Treasury regulations provide that a reciprocal may claim the deduction for subscriber account credits only to the extent the subscriber has a legally enforceable right to receive the subscriber account balance upon withdrawal from the reciprocal and only if such amounts actually are paid from the reciprocal to terminating subscribers.  The requisite legal obligation will not be considered absent merely because credits to a subscriber's account remain subject to future losses incurred by the reciprocal. In no event may the aggregate subscriber account credits for a taxable year exceed the total amount of "savings to the subscribers" for the year. The regulations do not define what is meant by the phrase "savings to the subscribers."

In PLR 9836023, the Internal Revenue Service (IRS) was asked to consider how the limitation on subscriber account credits is to be computed. The IRS concluded:

the term "savings to subscribers for the taxable year" refers to statutory income as reported on [the reciprocal's] NAIC annual statement, including net underwriting gain or loss, net investment gain or loss, other income, dividends to policyholders, and federal and state taxes.

Because of differences between the ways in which taxable income and statutory income are computed, subscriber account credits may not be sufficient to completely eliminate a reciprocal's taxable income for a year, under the IRS's interpretation.

In order to secure a tax deduction for amounts credited to subscriber accounts, a reciprocal must notify each subscriber of the amount credited to its subscriber account before the 16th day of the 3rd month following the taxable year for which the amount is credited (i.e., by March 15 in the case of a calendar year taxpayer). While the Treasury regulations prescribe what information must be provided to subscribers when amounts are credited to subscriber accounts, the regulations do not indicate that the required notice must be made on any particular IRS form.

A subscriber of a reciprocal insurance company must treat amounts representing savings credited to the subscriber's account as a dividend for purposes of computing taxable income, without regard to whether the amounts credited actually are distributed.  To the extent insurance premiums paid by the subscriber were deductible, the subscriber's taxable income for the taxable year in respect of which the credit was posted by the insurer will be increased by the amount credited to the subscriber's account, thereby reducing the potential tax benefits associated with a reciprocal form of organization. (This, of course, would only be of concern to subscribers that are subject to federal income tax.) If such amounts subsequently are used to absorb losses of the reciprocal, the subscriber will be entitled to an additional deduction for insurance expense in the year in which such amounts are absorbed.

1. The amount of a reciprocal's "savings" in a year is equal to the amount of reciprocal's income without regard to any amount credited to subscriber accounts.