SECTION 2. BACKGROUND

.01 An insurance company other than a life insurance company is subject to tax under § 831.

.02 Section 831(c) provides that for purposes of § 831, the term “insurance company” has the meaning given to such term by § 816(a). Section 816(a) provides the term “insurance company” means any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

.03 Section 832(a) provides that, for an insurance company subject to the tax imposed by § 831, the term “taxable income” means the company’s gross income as defined in § 832(b)(1) less the deductions authorized in § 832(c). Under § 832(b)(1), gross income includes underwriting income.

.04 Section 832(b)(3) defines underwriting income as the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred.

.05 Section 832(b)(4) defines the term “premiums earned on insurance contracts during the taxable year” as the gross premiums written on insurance contracts during the taxable year, less return premiums and premiums paid for reinsurance. The result so obtained is further adjusted by adding 80 percent of the unearned premiums on outstanding business at the end of the preceding taxable year and deducting 80 percent of the unearned premiums on outstanding business at the end of the taxable year.

.06 Section 833 provides special rules for existing Blue Cross or Blue Shield organizations and other organizations that meet the requirements of § 833(c)(3)—

(a) Section 833(a)(1) states that such an organization is subject to tax in the same manner as if it were a stock insurance company;

(b) Section 833(a)(2) allows a special deduction for such an organization, determined under § 833(b), which is the excess (if any) of (i) 25 percent of the sum of the

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taxpayers must use the definition of “reimbursement for clinical services provided to enrollees” that is set forth in HHS interim final regulations.

.03 For purposes of determining whether the 85-percent requirement of § 833(c)(5) is satisfied, the Service will not challenge the inclusion of “amounts expended for activities that improve health care quality” as defined in HHS interim final regulations.

Consequences of Nonapplication of § 833 by Reason of § 833(c)(5)

.04 Section 833(c)(5) provides that § 833 does not apply to an organization unless the organization’s percentage of total premium revenue expended on reimbursement for clinical services provided to enrollees is not less than 85 percent. Accordingly, the consequences for an organization for which this amount is less than 85 percent are as follows:

(a) The organization is not taxable as a stock insurance company by reason of § 833(a)(1) (but may be taxable as an insurance company if it otherwise meets the requirements of § 831(c));

(b) The organization is not allowed the special deduction set forth in § 833(b); and

(c) The organization takes into account 80 percent, rather than 100 percent, of its unearned premiums for purposes of computing premiums earned on insurance contracts during the taxable year under § 832(b)(4).

.05 Notwithstanding Section 3.04(a) of this notice and solely for the first taxable year beginning after December 31, 2009, the Service will not treat a taxpayer as losing its status as a stock insurance company by reason of § 833(c)(5) provided the following conditions are met—

(a) the taxpayer was described in § 833(c) in the immediately preceding taxable year;

(b) the taxpayer would have been taxed as a stock insurance company for the current taxable year but for the enactment of § 833(c)(5); and

(c) the taxpayer would have met the requirements of § 831(c) to be taxed as an insurance company for the current taxable year but for its activities in the administration, adjustment or settlement of claims under cost-plus or administrative services-only contracts.

claims incurred during the taxable year, liabilities incurred during the taxable year under cost-plus contracts, and expenses incurred during the taxable year in connection with the administration, adjustment, or settlement of claims or in connection with the administration of cost-plus contracts, over (ii) the adjusted surplus as of the beginning of the taxable year; and

(c) Section 833(a)(3) provides that the 20 percent reduction of unearned premiums set forth in § 832(b)(4) does not apply to such an organization.

.07 Section 9016 of the Affordable Care Act added § 833(c)(5) to the Code, effective for taxable years beginning after December 31, 2009. Section 833(c)(5) provides that § 833 does not apply to an otherwise-eligible organization unless the organization’s medical loss ratio, as defined, during the taxable year is not less than 85 percent. For this purpose, an organization’s medical loss ratio is equal to the amount expended on reimbursement for clinical services provided to enrollees under its policies during the taxable year (as reported under § 2718 of the Public Health Service Act) (“Section 833 MLR Numerator”) divided by the organization’s total premium revenue (“Section 833 MLR Denominator”).

.08 Section 2718 of the Public Health Service Act (the “PHS Act”) was added by § 1001 and amended by § 10101 of the Affordable Care Act, and was incorporated into the Code by § 9815(a)(1). Section 2718(a) of the PHS Act requires a health insurance issuer to submit an annual report to the Secretary of HHS concerning the ratio of the incurred loss (or incurred claims) plus the loss adjustment expenses (or change in contract reserves) to earned premiums. The report must include the percentage of total premium revenue, after accounting for collections or receipts for risk adjustment and risk corridors and payments of reinsurance, that the issuer expends (a) on reimbursement for clinical services provided to enrollees; (b) for activities that improve health care quality; and (c) on all other non-claims costs.

.09 Section 2718(b) of the PHS Act requires that a health insurance issuer, beginning not later than January 1, 2011, provide a rebate to each enrollee, on a pro rata basis, if the ratio of (a) the amount of premium revenue expended on reimbursement for clinical services and for activities

that improve health care quality to (b) the total amount of premium revenue (excluding Federal and State taxes and licensing or regulatory fees and after accounting for payments or receipts for risk adjustment, risk corridors and reinsurance) is less than a prescribed percentage.

.10 Section 2718(c) of the PHS Act directs the National Association of Insurance Commissioners (NAIC) to establish uniform definitions of the activities required to be reported to the Department of HHS under § 2718(a), and standardized methodologies for calculating measures of these activities, not later than December 31, 2010, and subject to the certification of the Secretary of HHS. On November 22, 2010, the Department of HHS filed with the Federal Register, for publication December 1, 2010, interim final regulations implementing § 2718. See http://www.ofr.gov/OFRUpload/OFR- Data/2010–29596_PI.pdf.