Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

elatively small. Through reinsurance, the insurance company becomes less vulnerable to the
adverse trend. The primary insurance company remains obligated to the consumer; the
reinsurer is obligated to the primary insurer. Thus, risk is diversified.
2. Expand client base
Policyholder surplus is the equity capital that may be invested by the insurance company
shareholders, plus unappropriated retained earnings. Surplus in an insurance company is
similar to shareholders equity in a corporation.
The surplus serves as a backup to the reserves in case losses are greater than anticipated.
Failure to maintain adequate surplus can inhibit future growth because there are insufficient
funds for future policies to be written. Generally, a specific amount of surplus must be
maintained for each insurance contract written.
Reinsurance is used by insurance companies to address a need for additional surplus to write
future policies by allowing the first insurer to shift liabilities off its balance sheet and onto the
reinsurers balance sheet. Reinsuring credit life and credit accident and health contracts, even
with related party reinsurers, is a common practice in the insurance industry.
One reason that can be argued by the reinsuring auto dealer, is the reinsurance arrangement
allows the dealer to increase the commission of the insurer. By funneling ceded contracts to
the reinsurance company, the dealer’s net commission is increased above state caps when the
contracts earn out and the dealer may have access to these reserves.
Applying traditional insurance standards to these arrangements may lead to the conclusion
that this is reinsurance in form, not substance. The arrangements do not achieve the usual
benefits associated with reinsurance, namely risk distribution and surplus relief. The only
recognized benefit that this arrangement produces is to increase commission income originally
capped by state statutes.
The Future
As we analyze the facets of dealer Aftersale Financial Products, we see that we have encountered
changes emerging that may establish a formula to apply to future analysis of true insurance
situations. We have seen the law evolve, from Humana, to the point where, as in the Ocean
Drilling case, outside risk and true insurance were determined to exist where 27 percent of sales
were to non-related parties. See Ocean Drilling, Inc. v. Commissioner, 24 Cl. Ct. 714 (1991).
Consider also the Malone & Hyde, Inc. decision discussed, above, in Chapter 12 of this Guide,
which distinguishes the Humana decision. See Malone & Hyde, Inc., 62 F.3d 835.
Will the dealer aftersale financial products issue go away now that Rev. Procs. 92-97 and 92-98
are in effect? In some cases this may be true. Remember, these revenue procedures only apply to
mechanical breakdown contracts for which the dealership purchases an insurance policy from an
unrelated third party to insure its obligations under the contract. As discussed throughout this
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