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Perspective: In parametric terms, it is important to define whether a contract is insurance or exchange



These days, parametric insurance, excuse the expression, is a hot topic among those considering the impact of climate change. From homeowners to businesses to state and local authorities to nation states, the idea of ​​risk transfer agreements that resolve and pay losses is much faster than losses covered by customary property insurance contracts. And the positive impact on resilience is undeniable because loss payments in parametric transactions are meant to be made shortly after events occur, which is exactly when everyone affected by an event needs cash to finance repairs, pay for losses not covered by standard property insurance and accelerate recovery efforts.

However, for some U.S. purchasers of parametric insurance, the promise that ordinary loss adjustment activity can be significantly reduced or completely avoided should be considered in the context of federal securities law and tax issues. The challenge begins with calling all such risk transfer products "parametric insurance". When such products are truly insurance, the good news is that federal securities and commodities laws should not apply, saving issuers from regulation as traders.

For commercial purchasers, the cost of such insurance cover would usually be deductible as a normal and necessary business expense and claims for damages would generally not be included in taxable income. For private individuals, of course, insurance premiums are generally not deductible, but whether parametric insurance losses must be included in taxable income ̵

1; either as short- or long-term capital gains – definitely matters.

Insurance or exchange?

Following the approval of the landmark Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, the US Securities and Exchange Commission and the Commodity Futures Trading Commission conducted a joint exercise on swaps which ended in late 2012 with the publication of 600 pages of updated rules that extensively regulate a corner of the financial markets that until 2010 had been largely unregulated.

What is a swap? The Commodity Exchange Act defines swap to include, in part, all agreements, contracts or transactions “that provide for the purchase, sale, payment or delivery (other than dividends on own securities) that depend on the occurrence, non-existence or extent of the event or event in in connection with a potential economic, economic or commercial consequence. Sounds a bit like an insurance contract, right?

The commissions recognized the possibility of confusion and uncertainty and at the beginning of the common rule they noted that they "did not interpret this clause so that products historically treated as insurance products would be included in the swap or security-based swap definitions. The commissions are not aware of anything in Title VII [in Dodd-Frank] which indicates that Congress intended traditional insurance products to be regulated as swaps or security-based swaps. "

How do state insurance laws define insurance contracts? New York defines an insurance contract as" any agreement or other transaction in which a party … is obliged to give another party a benefit of economic value … due to the fact that an event in which the insured has occurred … has or is expected to have at the time of such an event, a material interest that will be adversely affected by the event . Not surprisingly, the definitions of insurance in the state insurance laws vary. California's definition, for example, is probably narrower, because it is a "contract in which you undertake to compensate another for loss, damage or liability arising from a contingent or unknown event."

In the common rules, commissions explained in detail how they distinguished between state-regulated insurance products taken out by traditional insurers and swap transactions that were to be regulated by commissions. The four-part analysis of the commissions tests the products themselves and the suppliers of the products, considers "traditional insurance products" and includes a grandfather provision.

In short, the insurance product test under the common rules excludes the definition of exchange all contracts that do not:

thus, the risk of loss with respect to this interest is borne continuously throughout the term of the agreement, contract or transaction; and requires … that the loss occurs and be proven, and that any payment or compensation is therefore limited to the value of the insurable interest.

The supplier test has four tips, which requires that the debtor / insurer is essentially either a regulated insurer who takes out a regulated product, a government entity, a reinsurer – with certain restrictions – or a non-approved insurer listed by NAIC: international insurance department.

The list of listed products lists many traditional insurance products, including property / accident insurance and reinsurance. The commissions warned that an "agreement, contract or transaction marked as" reinsurance "or" retrocession "in relation to reinsurance, but performed as a swap or security-based swap or otherwise designed to circumvent Title VII of (Dodd- Frank), would not satisfy Insurance Safe Harbor and would be a swap or security-based swap.

So, what factors should both suppliers and buyers consider in determining whether a particular product is a replacement or insurance? First, that the contract is in fact an insurance product – including that the buyer has an insurable interest in a property to be protected and that the buyer must "prove" the loss and the size of the loss, the payment of which must not exceed the value of the insurable interest. Secondly, that an insurer is the counterparty that bears the risk in the transaction. Thirdly, that the product fits into one of the listed types of insurance contracts in the common rules – including property / accident insurance.

Tax Considerations

Obviously for those who do not pay federal income tax, such as state or local authorities or tax-exempt organizations, neither the deduction of the cost of parametric insurance nor including parametric insurance loss payments in taxable income should matter. But taxpayers and certain individuals, such as owners of coastal wind / flood homes looking for an alternative or complement to increasingly expensive overinsurance, should carefully consider the facts and circumstances of a proposed transaction. Is the parametric insurance product in fact offered insurance, in which case traditional insurance-related tax rules apply? or is it a swap – which is a regulated investment product – in which case the "premium" would not be deductible, as a normal and necessary operating cost and loss payment may not be excluded from income as damages in connection with accident insurance would be. [19659002]

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