Refunding Credit / Unearned Premium Reserve
For purpose of computing minimum unearned premium reserve, should a financial guaranty insurer include refunding credits in the written premiums for insurance policies on refunding bonds?
Financial guaranty insurers should include refunding credits in computing the unearned premium reserve for policies on refunding bonds.
A financial guaranty insurers provision of insurance for tax-exempt bonds enables the issuers to lower their financing costs because insured bonds are generally rated higher than uninsured bonds. In the event of a default by the obligor, the financial guaranty insurer is required to repay any outstanding interest and principal of the insured bond. Insurers are paid their entire premium at the time the insured bonds are issued. Tax-exempt bonds are typically issued for long periods of time, and often have terms of twenty (20) to thirty (30) years. In the event that interest rates in the economy decline sufficiently, a significant incentive exists for an issuer to refinance its debt. This is generally done by "calling" the original bonds and issuing refunding bonds.
Under most financial guaranty insurance policies, no cancellations are permitted and no refunds of premium are made. As a matter of business practice, however, insurers often credit the issuer with unused premium remaining from the original bonds if the issuer insured the refunding bonds through the same company. Thus, the insurance premium on the refunded bond would consist of two components; the credit from the original policy and the cash payment made when the policy for the refunding issue was purchased.
The IRS has questioned this practice, taking the view that financial guaranty insurers should take into income all amounts remaining in the unearned premium reserve attributable to the original issue at the time the original issue is called.
Financial guaranty insurers are governed by the New York Insurance Law in general and Article 69 thereof in particular. One of the requirements for financial guaranty insurers is the maintenance of an unearned premium reserve. This requirement is contained in N.Y. Ins. Law § 6903(c) (McKinney Supp. 2000), which provides as follows:
(c) Unearned premium reserve. An unearned premium reserve shall be established and maintained net of reinsurance with respect to all financial guaranty premiums. Where financial guaranty insurance premiums are paid on an installment basis, an unearned premium reserve shall be established and maintained, net of reinsurance, computed on a daily or monthly pro rata basis. All other financial guaranty insurance premiums written shall be earned in proportion with the expiration of exposure, or by such other method as may be prescribed by the superintendent.
The requirement that an unearned premium reserve be established stems in part from the recognition of the long term of exposure inherent in a financial guaranty policy. Typically, the term of an insured bond issue can run up to thirty (30) years. The premium, however, is paid up front. The unearned premium reserve provides a mechanism for matching the expiration of exposure and the earning of premium.
When an insured bond issue runs its entire term, the treatment of the amounts in the unearned premium reserve is clear the reserve is simply drawn down over the term of the bond issue. Similarly, in the event that a bond issue is called and not refunded, or, if the bond issue is refunded but not insured, any balance remaining in the unearned premium reserve for the policy covering the risk insured is properly deemed to be earned at such point. This is because, at such point, there exists no further risk outstanding, and all premium paid is earned.
If, however, the original bond issue is called and refunded, and the refunding issue is also insured, there has been some question on whether the unearned premium reserve was treated properly where all or part of the amounts remaining in the unearned premium reserve for the original bonds was credited to the premium for coverage on the refunding bonds. One view is that all premium should be deemed earned upon the redemption of the original bonds. This view is based upon policy language that states that no premium refunds are allowed, even in the event that the insured bonds are paid prior to maturity.
This view, however, ignores the economic reality of the transaction and more importantly, the statutory requirement for maintenance of an adequate reserve. In cases in which the issuers of refunding bonds are credited with part or all of the amounts remaining in the unearned premium reserve for the original bonds, such refunding credits are given only in conjunction with the continued provision of coverage for what is, from an underwriting view point, essentially the same risk.
Furthermore, to ignore the refunding credits when calculating the unearned premium reserve for the policy covering the refunding bonds improperly distorts the insurers income in that it would cause the insurer to recognize income which was not yet actually earned. More importantly, such a practice would cause an insurer to be under reserved. As indicated by § 6903(c), unearned premium reserves are required to be established and maintained with respect to all financial guaranty premiums. This requirement is not limited to only the cash portion of the premium. Therefore, financial guaranty insurers should include the refunding credits when establishing the unearned premium reserve for policies issued in connection with refunding bond.
For further information contact Senior Attorney Michael Campanelli of the Departments New York Office.