Bail and surety bonds

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The Tax Court and Seventh Circuit held that bail bonds are not insurance contracts in Allied Fidelity Corp. v. Commissioner. The Tax Court stated,

[i]n common understanding, an insurance contract is an agreement to protect the insured (or a third-party beneficiary) against a direct or indirect economic loss arising from a defined contingency. The insurer undertakes no present duty of performance but stands ready to assume the financial burden of any covered loss. In contrast, the principal obligation of the bail surety is to produce the
defendant at trial.

The Service concluded in Revenue Ruling 68-101, that bail bonds are not insurance contracts because they do not involve a monetary loss shifted and assumed by an accused or court. Surety bonds, however, can qualify as insurance contracts. "A surety is one who has agreed (in writing) to answer for the debt, default, or miscarriage of another." Surety bonds involve three parties. "The bond is the joint and several obligation of the principal and the surety in favor of the obligee named in the bond."

The Service concluded that the surety bonds at issue in General Counsel Memorandum 3 9,154202 qualified as insurance because the taxpayer, a surety, agreed to protect the obligee from the economic risk of loss arising from a default by the principal. The Service concluded that a risk of loss was present although the surety has a right of indemnity against a defaulting principal.

The Service distinguished the characterization of the surety bonds from that of the bail bonds in Allied Fidelity. It stated that the surety did not assume a duty to perform, but "stands ready to assume the financial burden of any covered loss." A bail bond, however, involves the duty to produce a defendant at trial so that it resembles a contract to perform a service.

Retrospective insurance (cont)

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The retrospective premiums were determined six months after the coverage period and annually thereafter until all claims were satisfied or until the taxpayer and the insurance company agreed to a final retrospective premium.One of the factors that influenced the retrospective premium after the first determination date was the actual loss payments made by the insurer.

The Service bifurcated the taxpayer's premium payments into a deductible insurance component and a non-deductible "reserve for losses" component. It indicated that, "no risk of loss [was] shifted or distributed by the taxpayer to the extent that the amount payable by taxpayer to the insurance company is based on the actual losses of taxpayer during the period covered by the arrangement" so that the taxpayer could not deduct the component of premium payments based on such losses.

The Service distinguished the retrospective rated contracts from retrospectively rated contracts addressed in Revenue Ruling 83-66,189 in which a medical malpractice insurance policy provided a retrospective rate credit refund if the insurer's overall loss experience was not as great as it projected.190 The retrospective credits in the 1983 ruling were based on the insurance company's experience whereas the amounts ultimately payable by the manufacturer in the technical advice were based, in part, on its own loss experience for its policy year.

Retrospective insurance

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Many insurance policies provide for retrospective premium adjustments at the end of the coverage period. The Tax Court stated in Sears, the premium under a retrospectively rated policy is set using the loss data generated over the year in which the policy is in force. The retrospectively rated insured typically pays a deposit at the beginning of the year. At the end of the year, the insured receives a refund if loss experience has been favorable and may have to pay an additional premium if loss experience is unfavorable. There are usually limits on the amount of the additional premium that must be paid.