Retroactive insurance

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A casualty insurance company provided $30x coverage to an insured in Revenue Ruling 89-96.181 The insured incurred a liability of an unascertained amount as a result of a catastrophe in June 1987 although the underlying facts indicated that the total liability would exceed $130x. The insured subsequently paid $50x to obtain $100x of additional insurance, increasing the coverage for the catastrophe to $130x. The insurer increased its unpaid losses by $100x and deducted the (discounted) present value of the $100x increase in coverage as losses incurred.

The Service ruled that the retroactive arrangement did not qualify as insurance. Risk-shifting was lacking because the catastrophe covered by the contract already occurred. The Service stated that establishing a loss for $100x indicated that the insurer expected to have to pay the additional $100x of coverage. The taxpayer incurred the risk that payments on the contract would be made earlier than expected and that the investment yield for the period from the date that the premium was received until the date the claim was paid would be less than expected, which are investment risks

Reciprocal flood insurance exchange arrangements (Cont)

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Net earnings (determined after a fee to an attorney-in-fact), if any, were credited to subscribers' individual surplus accounts. A subscriber could elect to apply the unencumbered balance of its account to an annual premium deposit or withdraw it. Subscribers' risks were divided into classes or grouped in accordance with the nature of the business's flood hazard, location, and flood district. A subscriber's catastrophe loss account was decreased by a pro-rata share of the adjusted losses incurred by similarly classified subscribers.

The Service concluded that risk shifting was not present in the reciprocal flood insurance arrangement. A major flood would probably affect all properties in a particular flood basin so that there was little likelihood that the subscribers would share any risk.177 Proceeds received in the event of
flood damage would, in effect, be a return of the subscriber's own money because each subscriber was substantially underinsured.

The non-withdrawable one percent of the premium deposit that was credited to the general reserve fund was for a fixed liability, which was deductible as an insurance expense.178 The Service ruled that an annual premium deposit to the exchange was a nondeductible contingent deposit to the extent that it was withdrawable by the company.179 Earnings from the investment of the funds were taxable when they were credited to an annual premium deposit or became withdrawable.

Finding a Good Value in Life Insurance

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After you have decided which kind of life insurance is best for you, compare similar policies from different companies to find which one is likely to give you the best value for your money. A simple
comparison of the premiums is not enough. There are other things to consider. For example:

• Do premiums or benefits vary from year to year?
• How much do the benefits build up in the policy?
• What part of the premiums or benefits is not guaranteed?
• What is the effect of interest on money paid and received at different times on the policy?

Once you have decided which type of policy to buy, you can use a cost comparison index to help you compare similar policies. Life insurance agents or companies can give you information about several different kinds of indexes that each work a little differently. One type helps you compare the costs between two policies if you give up the policy and take out the cash value. Another helps you compare your costs if you don't give up your policy before its coverage ends. Some help you decide what kind of questions to ask the agent about the numbers used in an illustration.

Each index is useful in some ways, but they all have shortcomings. Ask your agent which will be most helpful to you. Regardless of which index you use, compare index numbers only for similar policies-those that offer basically the same benefits, with premiums payable for the same length of time.

Remember that no one company offers the lowest cost at all ages for all kinds and amounts of insurance. You should also consider other factors:

• How quickly does the cash value grow? Some policies have low cash values in the early years
that build quickly later on. Other policies have a more level cash value build-up. A year-byyear
display of values and benefits can be very helpful. (The agent or company will give you a
policy summary or an illustration that will show benefits and premiums for selected years.)
• Are there special policy features that particularly suit your needs?
• How are nonguaranteed values calculated?

For example, interest rates are important in determining policy returns. In some companies increases reflect the average interest earnings on all of that company's policies regardless of when issued. In others, the return for policies issued in a recent year, or a group of years, reflects the interest earnings on that group of policies; in this case, amounts paid are likely to change more rapidly when interest rates change.

Reciprocal flood insurance exchange arrangements

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A contract carrier corporation that hauled automobiles from an automobile assembly plant leased land on which it stored the autos and other equipment in Revenue Ruling 60-275. The land was bound by a river and therefore exposed stored property and leasehold improvements to flood damage. Under an agreement with a "reciprocal flood insurance exchange," the company and others subject to flood risk made annual payments for a specified period for flood insurance coverage. The company acquired $150x of coverage underwritten over a ten-year period, of which $15x (ten percent) became effective when the policy was issued and delivered. The company's property subject to flood loss equaled $500x.

The exchange credited one percent of the initial premium to its general reserve fund, which was used to cover certain administrative expenses and losses exceeding the catastrophe loss account. The remainder was allocated to the catastrophe loss account. This account was charged with a pro-rata share of losses occurring during the year and for incurred reinsurance costs, for each subscriber. The company could withdraw amounts credited to its catastrophe loss account after the end of the current policy year, but could not withdraw amounts credited to the general reserve fund (although subscribers shared in the net balance of the general reserve fund, if any, if the exchange terminated).

Ruling requests

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In Revenue Procedure 2002-75, the Service indicated that,

we will now consider ruling requests regarding the proper tax treatment of a captive insurance company.

However, some questions are arising in the context of a captive ruling request are so inherently factual (within the meaning of section 4 .02(1) of Rev. Proc. 2002-3) that contact should be made with the appropriate Service function prior to the preparation of such request to determine whether the Service will issue the requested ruling.

Inquiries regarding whether the Service considers a proposed captive transaction so inherently
factual that it cannot rule, should be directed to Chief, Branch 4 , Office of the Associate Chief Counsel (Financial Institutions & Products) at (202) 622-3970 (not a toll-free call).

Further guidance requested

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The Service indicated in Notice 2005-49 that further guidance is needed, and requested comments, with respect to “the standards for determining whether an arrangement constitutes insurance” for Federal income tax purposes. It stated

The Bank Job 7

The Bank Job 7

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Life Insurance Illustrations

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Life Insurance

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Life insurance is a contract between the policy owner and the insurer, where the insurer agrees to reimburse the occurrence of the insured individual's death or other event such as terminal illness or critical illness. The insured agrees to pay the cost in terms of insurance premium for the service. Specific exclusions are often written in the contract to limit the liability of the insurer, for example claims related to suicide, fraud, war, riot and civil commotion is not covered.

Purpose

People take out life insurance policies for a number of reasons. Such insurance provides security to family members upon the loss of a loved one. For instance, if the primary wage earner dies in his or her prime, the death benefit received from the policy will assist the surviving family members in overcoming the burden of the tragic loss. The proceeds can also help pay for funeral costs when the death is unexpected.

Life insurance can be purchased by individuals, but is also offered as a perk by many employers. Often times, large employers and government employers offer group life insurance at no cost to the employee. Should the employee wish to obtain additional coverage from the employer's insurance company, they can usually do so at reduced rates. In most circumstances, the insurance becomes once the employee no longer works for the company.

What is leasing?

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Insurance pools and “group captives” (Cond-2)

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The Service concluded that the contracts issued by the group captive
to each of the members, including the taxpayer, were insurance
contracts because,
• each member faced true insurable hazards and was required to
maintain general liability coverage to operate in its industry;
• each member was unable to obtain affordable insurance coverage
from commercial insurers “due to the occurrence of unusually
severe loss events;”
• there was a real possibility that a member could realize losses
that exceeded the premiums that it paid and no member was reimbursed
for premiums that exceeded its losses; and,
• the taxpayer and other members were unrelated.

Federal Income Taxation of Insurance Companies
A professional corporation that employed 10 physicians and 15
registered nurses made non-assessable premium payments to a mutual
exchange, in Revenue Ruling 80-120.170 The exchange was formed and
qualified under state law to provide medical professional liability
coverage to all physicians and medical professional corporations that
were licensed to practice in the state and maintained at least 50
percent of their practice in the state. It insured more than 5000
physicians and several professional corporations. The Service ruled
that the payments were deductible as premiums under section 162
because the company covered a sufficient number of policyholders, no
one policyholder owned a controlling interest in the exchange, and the
policies were non-assessable.

Insurance pools and “group captives” (Cond)

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The Service concluded, in effect, that the coverage can qualify as
insurance and the premiums paid to the insurer may be deductible as insurance
premiums, although the insurer had no owners other than the 3 6
funds. More funds transferred risks under the arrangement than the 3 1
corporations that transferred their risks in Revenue Ruling
78-338.
In Revenue Ruling 2002-91,169 a group of unrelated businesses in an
industry that faced significant liability hazards and were required by regulators
to maintain adequate liability coverage could not obtain affordable
insurance from commercial insurers as a result of significant losses from
unusually severe loss events. The taxpayer and a significant number of
other businesses in the industry formed a group captive to provide insurance
liability coverage for certain
risks.
The group captive provided coverage only for the taxpayer and other
members. No member owned more than 15 percent of the group captive
and no member held more than 15 percent of any corporate governance
issue. The group captive was adequately capitalized and its operations
were independent of the operations of each of its members.
The premiums that the group captive charged were determined using
actuarial techniques and were based, in part, on commercial rates for
similar coverage. The group captive pooled premiums from its members
and no member had to pay additional premiums if its losses in any period
exceeded the premiums that it paid. No member received a refund if its
losses were lower than its premiums.

(n) Insurance pools and “group captives”

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Risk shifting and distribution may be present if an insurance company is owned by numerous unrelated companies and the insurer only covers members of that group. Indeed, in the extreme, a mutual insurer can be viewed as a group captive because the insurer provides
coverage only for its owners. In Revenue Ruling 78-338, the Service concluded that a
foreign insurance company owned by 31 unrelated (shareholder) corporations
qualified as an insurance company. 

No shareholder had a controlling interest in the company and no shareholder’s individual coverage exceeded five percent of the total insured risks. The arrangement satisfied the risk
shifting and distribution requirements because the shareholder-insureds were unrelated and the economic risk of loss could be distributed among the shareholders that comprised the insured group.

The Service applied the principles of Revenue Ruling 78-338 in Letter Ruling 9642028, in which an assessable mutual insurance company was owned by 34 mutual funds and two foreign companies that operated in a “manner intended to qualify as a regulated investment company [under the Internal Revenue Code].” Each fund was a money market fund that
invested in short-term securities. Although each of the 3 6 funds was a “Name X” mutual fund, none of the funds was controlled by the parent company of the Name X consolidated group. No single investor directly or indirectly beneficially owned as much as one percent of the aggregate value of the stock of all of the funds.

The funds proposed to establish a mutual assessable insurance company to insure against default risks on the assets held by each of the funds. The insurer would cover losses on insurable assets arising from the nonpayment f principal or interest, and other specified financial  risks.

(m) Premiums paid to cover others’ risks

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A company may pay premiums to a related insurer to cover other persons’ risks. In Revenue Ruling 92-93, a manufacturer paid premiums to a subsidiary insurance company for group-term life insurance coverage for its employees. The Service concluded that the arrangement was not self-insurance because the manufacturer did not incur the underlying economic risk of loss.

 

The economic benefit was enjoyed by the employees, not the employer, which could not be the beneficiary under the contract. The arrangement, in effect, was a form of compensation for the taxpayer’s employees, who benefited from the life insurance coverage.

The Service ruled that similar principles would apply to the acquisition of accident and health insurance, including waiver of premium coverage upon disability that was provided by an employer for its employees. The Service applied similar principles in Revenue Ruling 92-94 to a nonlife insurance company that “charges itself an amount representing premiums for its liability to pay insurance or annuity benefits for its employees.”

It held that the arrangement was not self-insurance because it shifted employees’ risks to an insurance company. The amount that the insurer charged itself represented additional gross premiums written.

(l) Economic substance and arms length income allocations

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In United Parcel Service of America, Inc. v. Commissioner,150 the Tax Court concluded that a captive arrangement that UPS created to cover damage or loss to packages it collected and shipped for its customers was a sham. In the transaction, UPS was liable for the first $100 of loss from damage or loss to packages it collected and shipped for its customers.

A customer could purchase additional coverage from UPS by paying 25 cents per $100 of additional liability.

UPS created and capitalized OPL, a Bermuda based captive, late in 1983. On December 3 1, 1983, UPS distributed shares of OPL to its shareholders, which were current and former employees as well as families, trusts and estates of former employees. The distributions were taxable dividends to the shareholders. UPS retained a small portion of the OPL shares.

UPS restructured its excess value charge program beginning 1984. It transferred excess value amounts, less claims paid in excess of $100, each month to NUF, a wholly owned subsidiary of AIG and a domestic insurance company. NUF reinsured the EVC coverage with OPL. NUF retained a $1 million fronting service fee for agreeing to reinsure the coverage to OPL.

UPS continued the functions and activities related to the EVC coverage and remained liable for the damage or loss of packages up to the lesser of $100 or their declared value. UPS did not charge NUF or OPL for the extensive services that it provided with respect to the EVCs.

UPS argued that it restructured the EVC arrangement for bona fide non-tax business considerations. UPS indicated that in 1983 it was concerned that continuing to receive the EVC income could be illegal under the insurance law of various states. The Tax Court, however, concluded that if UPS believed that it had to divest itself of a highly profitable business because of concerns that it was pursuing illegal activities it would have scrutinized the merit of its concerns more carefully than it did.

The Tax Court examined the amount that UPS paid to transfer the coverage in the reinsurance because the lack of an arms length price is an indicator that an arrangement is a sham, according to the court. The court concluded that UPS did not pay an arms length amount because it could have obtained the coverage elsewhere for considerably less than it paid. 

It held that UPS earned the excess value charges it received from its customers for the excess value coverage and denied the deduction under section 162 for amounts paid to NUF. In addition, the court added interest, and imposed severe penalties.

The Eleventh Circuit reversed and remanded the Tax Court’s decision. The appellate court concluded that the EVC transfer had both economic effect and a business purpose. The arrangement had economic effect because there was a genuine insurance policy between UPS and National Union. The court stated that although “the odds of losing money on the policy were slim, National Union had assumed liability for the losses of UPS’s excess-value shipper’s, again a genuine obligation.”154 The reinsurance did not “completely foreclose the risk of loss because reinsurance treaties, like all agreements, are susceptible to default.”

The court concluded that “altering the form of an existing, bona fide business” to do the job in a more tax effective way is a genuine business purpose. A business purpose is present if a taxpayer chooses among alternative ways to acquire capital and applies the most tax-effective manner, for example. In UPS, there was a “real business that served the genuine need for customers to enjoy loss coverage and for UPS to lower its liability exposure.”

The Eleventh Circuit remanded the case to the Tax Court to address the Service’s alternative argument that section 482 or 845 should apply to reallocate the amount of income (or other items) transferred to National Union to reflect an arms length transaction.

The Seventh Circuit (Contd)

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Individuals and corporations pay premiums to insurers for different purposes, in the court’s view. Individuals acquire insurance coverage to protect their wealth and future income or to provide income replacement or a substitute for bequests to their heirs. Corporations, such as Sears,
acquire insurance to spread the cost of casualties more evenly over time and to benefit from an insurance company’s expertise and ability to provide highly specialized insurance-related services. Corporations buy “loss-evaluation and loss-administration services, at which insurers have a
comparative advantage, more than they buy loss distribution.”

The court was satisfied that the transaction had sufficient characteristics of insurance to preclude a recharacterization. It increased Allstate’s insurance pool, which reduced Allstate’s ratio of expected to actual losses. It allocated the administrative work on claims to Allstate employees, who had a “comparative advantage” at those tasks. The court stated that the transaction placed, Sears’s risks in a larger pool, performing one of the standard insurance functions in a way that a captive does not.
More: Allstate furnishes Sears with the same hedging and administration services it furnishes to all other customers.

It establishes reserves, pays state taxes, participates in state risk-sharing pools (for insolvent insurers), and so on, just as it would if Sears were an unrelated company. Although Sears could deduct its premiums paid to Allstate because the underlying transaction qualified as insurance, the deduction was offset on Sears’s consolidated return as premium income of Allstate. Significantly,
however, Allstate could deduct reserves established when Sears incurred a covered loss because the coverage qualified as insurance. This tax treatment reflects the underlying economics because Allstate could deduct reserve increases that it had to establish when Sears incurred a loss covered by Allstate.

The Seventh Circuit

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The Seventh Circuit affirmed the Tax Court’s holding that the transaction between Sears and Allstate qualified as insurance. However, instead of asking “ ‘[w]hat is the definition of insurance?[,]’
” the court examined whether “there [was] adequate reason to recharacterize the transaction[.]” The appellate court indicated that the Internal Revenue Code does not define insurance and that in Le Gierse the Supreme Court “mentions the combination of risk shifting and risk distribution.” The court added, however, that it would be a “blunder to treat “a phrase in an opinion as if it were statutory language[.]”

The Supreme Court “was not writing a definition for all seasons and had no reason to, as the holding of Le Gierse is only that paying the ‘underwriter’ more than it promises to return in the
event of a casualty is not insurance by any standard.”The Seventh Circuit recognized that a loss incurred by Sears and covered by Allstate would have less financial impact on Sears than a loss incurred Sears but covered by an independent insurer. However, the court questioned whether risk-shifting is necessarily a requisite of insurance. It reasoned, in part,

[i]f retrospectively rated policies, called ‘insurance’ by both issuers and regulators, are insurance for tax purpose and the Commissioner’s lawyer conceded for purposes of this case that they are—then it is impossible to see how risk shifting can be a sine qua non of ‘insurance.’

(k) Sears

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Background—The Service argued in Sears, Roebuck & Co. v. Commissioner, that the coverage of Sears’s risks by Allstate, a wholly owned subsidiary, did not qualify as insurance. This coverage represented less than one-percent of Allstate’s total business and the business was conducted in an arm’s length manner.

The Tax Court—The Tax Court indicated that whether a transaction qualifies as insurance depends on the underlying facts and circumstances.

After applying the following three sets of factors the court concluded that Allstate’s coverage of Sears’s risks constituted insurance,

(1) Allstate covered claims that arose from insurance risks. The court contrasted the coverage with arrangements involving investment risks. It focused on the “nature of the losses covered by the policies and the designated responsibility for payment of those losses.” The impact on Sears’s “ultimate profit or loss
from Allstate’s operations [was] not significant to the analysis of whether the contractual arrangements deal with insurance risks;”

(2) The policies shifted and distributed the risks. The risks were shifted to Allstate, which “was a separate, viable entity, financially capable of meeting its obligations.”139 In addition, Allstate was not formed or operated to self-insure Sears. The policies were sold under the same terms, and in the same context as sales to unrelated third parties. The court stated that risk distribution is the “spreading of loss among the participants in an insurance program.” Such spreading arises from the pooling of risks among unrelated insureds, which “increases the reliability in establishing premiums and estimating appropriate reserves;” and,

(3) The transactions reflected commonly accepted notions of insurance. The court concluded that the arrangement was characterized as insurance with regards to all non-tax purposes

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(j) Significant unrelated risks

Historic Background—In Revenue Ruling 88-72, a wholly owned subsidiary of the taxpayer insured risks of unrelated parties as well as risks of its parent and other affiliates. The coverage of the related risks represented a small fraction of its total insurance business. The Service ruled that the coverage of its parent’s and other affiliates’ risks did not qualify as insurance because the economic risk of loss had not shifted.

The risk of loss did not shift because the parent continued to have an economic stake in whether it or the subsidiary incurred a loss. The parent and its subsidiaries therefore could not deduct premiums paid to their life insurance affiliate. The Service declared Revenue Ruling 88-72 obsolete in Revenue Ruling 2001-31, in which the Service disavowed its “economic family theory.” The Service’s position—The Service addresses two situations in which a wholly-owned subsidiary “insured” the professional liability risks of its parent, either directly or through reinsurance, as well as “homogeneous” similar risks of unrelated parties, in Revenue Ruling 2002-89. In each situation, the amounts that the parent pays its subsidiary “are established according to customary industry rating formulas.

In all respects, the parties conduct themselves consistently with the standards applicable to an insurance arrangement between unrelated parties.” The subsidiary “may perform all necessary administrative tasks, or it may outsource those tasks at prevailing commercial market rates.” In addition, the parent does not provide any guarantee regarding the subsidiary’s performance, the subsidiary does not make a loan to its parent, and all funds and records of the parent and subsidiary are maintained separately.

In situation 1, the premiums and risks assumed from the parent were 90 percent of the subsidiary’s total risks for its taxable year. The Service concluded that the arrangement in this situation was not insurance for Federal income tax purposes. The requisite risk shifting and distribution were not present because such a large portion of the premiums and risks were from the parent. The parent’s payments to its subsidiary therefore were not deductible as “insurance premiums” under section 162.

In situation 2, the premiums and risks assumed from the parent were less than 50 percent of the subsidiary’s total risks assumed for its taxable year. The Service concluded that the arrangement was insurance so that the parent’s payments to its subsidiary were deductible as insurance premiums under section 162. Court pronouncements—The Tax Court concluded (in dicta) in Gulf Oil that coverage of a company’s risks is insurance if an “insurance subsidiary” covers a sufficient amount of unrelated risks. It stated that premiums of an affiliated group, will no longer cover anticipated losses of all of the insureds [if a sufficient proportion of premiums are paid by unrelated parties because] the members of the affiliated group must necessarily anticipate relying on the premiums of the unrelated

insureds in the event that they are ‘the unfortunate few’ and suffer more than their proportionate share of anticipated losses.

Only two percent of the premiums paid to the insurance subsidiary in the years before the court in Gulf Oil were from unrelated insureds, which the Tax Court considered de minimis. The Tax Court “declined” to indicate the amount of premiums for unrelated risks that would be sufficient for affiliated group premiums to qualify as insurance premiums. It stated, however, that “if at least 50 percent are unrelated, we cannot believe that sufficient risk would not be present.”

The Tax Court rejected the “economic family” theory espoused by the Service in Revenue Ruling 77-316. Although the economic family approach would have reached the same result that the Tax Court reached in the case before it, the Service’s approach “would have foreclosed a wholly owned captive from ever being considered a separate insurance company.”

The court stated that “we specifically reserved any discussion of the tax consequences of payments to captives with unrelated owners and/ or unrelated insureds.” Courts have respected arrangements in which the unrelated risks covered by captive insurers involved 52 to 74 percent of the written insurance covered in AMERCO v. Commissioner, 29 to 33 percent in The Harper Group v. Commissioner, and 44 to 66 percent in Ocean Drilling & Exploration Co. v. United States.

(i) Coverage by an unrelated company

An arrangement in which an unrelated company assumes risks from only one company does not qualify as insurance. In Revenue Ruling 2005- 40, situation 1, a courier transport company that owned and operated a fleet of vehicles paid a premium to an unrelated company to assume the risks of loss arising from the use of the vehicles in its business. The premium was an arms-length amount determined “according to customary insurance industry rating formulas” and the assuming company held enough capital to fulfill its obligations under the agreement.

There were no guarantees nor loans of premiums back to the courier transport company. The courier transport company was not obligated to pay additional premiums if the actual risks exceeded the premiums paid and it was not entitled to a refund if the actual losses were less than the premiums paid in any period. The parties conducted themselves in a manner that was “consistent with the standards applicable to an insurance arrangement between unrelated parties,” except that the recipient of the premiums assumed risks only from the courier transport company.

The Service concluded that the arrangement did not qualify as insurance reasoning that although the “arrangement may shift the risks of [the courier transport company], the risks [were] not distributed among other insureds or policyholders.” The facts were the same in situation 2, except that in addition to assuming the risks of the courier transport company the unrelated company assumed risks from another fleet owner that conducted a courier transport business. The second fleet owner was unrelated to the first. The amounts earned and risks transferred from the second fleet owner constituted 10 percent of the total earnings of and risks borne by the assuming company.

The Service concluded that the arrangement between the original courier transport company and the assuming company did not qualify as insurance because there was an “insufficient pool of other premiums to distribute [the courier original transport company’s] risk.” In situation 3 the courier transport business was conducted through 12 wholly owned limited liability companies (LLCs). Each LLC transfers risks and pays a specified premium to an unrelated company. The premium paid by each LLC was an arms length amount determined “according to customary insurance industry rating formulas” and the assuming company held enough capital to fulfill its obligations under the agreement. There were no guarantees nor loans of premiums back to a given LLC.

The LLC would not be obligated to pay additional premiums if the actual risks exceeded the premiums paid and it was not entitled to a refund if the actual losses were less than the premiums paid in any period. The parties conducted themselves in a manner that was “consistent with the standards applicable to an insurance arrangement between unrelated parties,” except that the recipient of the premiums only assumed risks from the LLCs.

Each of the LLCs was a “disregarded entity” under regulation section 301.7701-3, and therefore treated as branches or divisions of the LLCs’ owner. The Service concluded that the arrangements did not qualify as insurance because it covered the risks of only one entity, the LLCs’ owner.

In situation 4 , each LLC elected to be treated as an association. The Service concluded that the arrangement between each LLC and the unrelated assuming company was insurance, because each LLC transferred risks to the assuming company and distributed the risks with those of the other LLCs.

(h) Coverage of other “related” entities

An individual, Fred Lennon, wholly owned Crawford Fitting, a manufacturer of valves and fittings, in Crawford Fitting Company v. United States. He also owned at least 50 percent of four regional warehouses and held varying interests in other companies that provided services and/or parts to the manufacturers. Crawford, other manufacturers of valves and fittings, various companies that provided parts and services for the manufacturers and the regional warehouses obtained coverage from Constance, which was created under the Colorado Captive Insurance Company Act. Constance retained a specified portion of the covered risk and reinsured the remaining coverage with an unrelated reinsurer.

The warehouses owned 80 percent of Constance. Crawford employees and lawyers owned the remaining 20 percent. Members of Lennon’s family held the interests in the warehouses that Lennon did not directly hold. Consequently, Lennon had a significant economic stake in both Crawford

Fitting and Constance. 

The government argued that the portion of Crawford’s premium that was attributable to the retained coverage was a “reserve for self-insurance.”  It asserted that the risk of loss remained in Crawford’s economic group. The District Court for the Northern District of Ohio, however, held that Crawford’s premiums were deductible reasoning that Constance was “legitimately organized to enable Crawford to secure insurance at a reasonable price, without substantial limitations on the types and amounts of risk  in return for the payment of legitimate premiums.” Constance was adequately capitalized.

Further, Crawford did not own stock in Constance or any of the warehouses that owned stock in Constance. The premiums were “actuarially based” and proportional to the risks covered. Risk distribution was present because the insureds included numerous entities that were not affiliated with Crawford. Crawford therefore shifted the risk of loss from its economic family to Constance and Constance distributed the risks of the insureds. 

Inadequate capitalization

The “insurance” subsidiary of the foreign parent of a domestic holding company covered pollution liabilities with respect to (1) manufacturing by five operating subsidiaries of the holding company and (2) certain real estate owned by the holding company and used by two of the holding company’s operating subsidiaries in Technical Advice Memorandum 200323026. The foreign parent, incorporated in Country R, created the insurance subsidiary under the laws of another foreign country, Country S.

The insurance subsidiary was capitalized with $500x, although an independent consultant performed a feasibility study and recommended that the initial capitalization should be $10,000x. Premiums for the first year totaled $1000x, including $620x from one of the subsidiaries. By June 30 of “Year 4 ” the shareholder’s equity grew to $2,822x. The insurance subsidiary issued six policies, each of which covered liability of up to $10,000x per pollution incident and an aggregate of up to $10,000x. The amount of premiums varied considerably among the insureds. For the period July 1 of Year 3 to June 3 0 of Year 4 , more than two thirds of the premiums were paid by Operating Subsidiary 3.

The Service concluded that insurance was not present because the captive was not adequately capitalized. The capitalization was only onetwentieth of the amount recommended in a feasibility study and liability on a single incident that equaled the $10,000x per incident limit would far exceed the captive’s equity, premium and investment income combined.

That the capitalization was sufficient to obtain a charter in Country S and to satisfy a “specific tax rule” of Country R were not sufficient to  demonstrate that it was adequately capitalized for United States Federal income tax purposes. In contrast, the Service noted that although one potential insurance loss could substantially exceed the capitalization, many states “limit the amount of loss to which an insurer may be exposed on any one risk to ten percent of the insurer’s surplus.” The Service also concluded that sufficient risk distribution was lacking.

In addition, the Service concluded that the insurance arrangement among the parties was too informal. The policies for “Year 2” and “Year 3,” for example, were not formally executed until “Year 4 .” The taxpayers “assert[ed] that there were oral contracts in the meantime.”

(g) Impact of undercapitalizations, guarantees and other financial enhancements

In general—The capitalization of a captive or the use of a guarantee or other financial enhancements can influence whether a transaction is insurance. The Tax Court’s conclusion in Carnation that the transaction between Carnation and its captive, Three Flowers, was not insurance was influenced by American Home’s refusal to enter into the transaction without Carnation’s agreement to capitalize Three Flowers with up to $3 million.

In Humana, the Sixth Circuit indicated that the undercapitalization of the foreign captive combined with the capitalization agreement running to the captive in Carnation, the indemnification agreement in Stearns- Roger, and the  undercapitalization of the captive in Beech Aircraft, were sufficient factors to find a lack of risk-shifting.85 The Sixth Circuit also addressed the impact of an undercapitalization and/or economic enhancements on the characterization
of a captive insurance arrangement in Malone & Hyde v. Commissioner.

 

Malone & Hyde—Malone & Hyde, a company in the wholesale food business, obtained automobile, worker’s compensation, and general liability coverage for its divisions and subsidiaries from Northwestern National Insurance Company, an unrelated casualty insurer. Northwestern reinsured specified amounts of this coverage with Eastland Insurance, Ltd., a Bermuda captive, and a wholly owned subsidiary of Malone & Hyde. Eastland provided Northwestern with an irrevocable letter of credit of $250,000 (later increased to $600,000) to cover any unpaid amounts under the reinsurance agreement. Eastland did not reinsure any risks of
unrelated parties during the years at issue. Malone & Hyde also entered into a hold-harmless agreement with Northwestern, which provided that Northwestern would be held harmless and defended with regard to any third-party claim that might arise if Eastland defaulted on its obligations as reinsurer.

Malone & Hyde argued that premiums paid to cover risks transferred from sister corporations were deductible under principles addressed in Humana. The Commissioner argued that the facts of Malone & Hyde were distinguishable from those of Humana because the transaction in Malone & Hyde included  hold-harmless agreements and letters of credit. 

The Tax Court concluded that the agreements reflected “reasonable, cautious business practices in dealing with a new customer and a new reinsurer” and that Eastland was a valid insurance company. Eastland was adequately capitalized under Bermuda law. The insurance agreements with Northwestern and the reinsurance agreement with Eastland resulted from arms-length negotiations
and were evidenced by written policies and endorsements. In addition, “Eastland operated as a separate and viable entity, financially capable of meeting its obligations. In sum, the arrangements among Malone & Hyde, its subsidiaries, Northwestern, and Eastland constituted insurance in the commonly accepted sense.” The Tax Court distinguished its holdings in Carnation and Clougherty stating that “we found in Carnation, and further articulated in Clougherty, that
the capitalization agreement was not a critical factor in the outcome of the case, but only one of several factors to be considered in determining whether or not the requisite risk shifting was present.”

The Sixth Circuit reversed the Tax Court’s decision, concluding that insurance was lacking because the ultimate risk remained with Malone & Hyde under the hold-harmless agreements.89 It distinguished Humana, stating that Humana established the captive to address the loss of insurance coverage, a legitimate business concern, and its captive was not a sham. The captive was fully capitalized, domestically incorporated, established without any guarantees from its parent, and acted in a straightforward manner. The court stated, when the entire scheme involves either undercapitalization or indemnification of the primary insurer by the taxpayer claiming the deduction, or both, these facts alone disqualify the premium payments from being treated as ordinary and necessary business expenses to the extent such payments are ceded by the primary insurer to the
captive insurance subsidiary.

In HCA,92 the Tax Court applied the principles of Malone & Hyde and concluded that risk shifting was absent with respect to workers compensation obligations covered by the captive as a reinsurer to the “extent and during the time” that HCA agreed to indemnify the primary insurer against nonperformance of the captive. However, the impact of the indemnification agreement was not sufficient for the court to conclude that the transactions between the captive and its sister corporations were not bona-fide. The court reasoned, in part, that the agreement only applied to one type of coverage, which was not the primary coverage provided by the captive.

In Kidde, the Court of Federal Claims concluded that risk was not transferred to the captive before June 1, 1978 under a captive insurance arrangement (described in the section above). Kidde remained ultimately responsible for the underlying losses as a result of the impact of an indemnity agreement with the primary insurer, which was in effect while the parties worked out the details of the captive insurance agreement. 

The court concluded that the indemnity agreement was not meant to be a long-term commitment because retaining the ultimate responsibility for the covered losses would be fundamentally inconsistent with the existence of a true insurance relationship. The court found that the agreement terminated as of May 3 1, 1978 because by that date the captive’s assets and a letter of credit from a major U.S. bank were sufficient to ensure that the captive would be able to protect the primary insurer’s interests.

The Service's position on brother-sister arrangements

Prior to issuing Revenue Ruling 2001-31 the Service held that coverage in brother-sister arrangements was not insurance under its economic family theory. In Field Service Advice 200125005, and Field Service Advice 200125009, however, the Service's National office recommended that the Service concede the deduction of premiums paid by an operating subsidiary to a sister insurance captive. It concluded in Field Service Advice 200125005 that contesting the deduction of these premiums raised substantial litigation hazards, noting that the Service lost on the "brother/sister" issue in Humana and Kidde Industries. Factors "such as 'hold harmless' agreements to unrelated insurers or anyone else" were not resent.

The Service conceded that "no court, in addressing a captive insurance transaction, has fully accepted the economic family theory set forth in Rev. Rul. 77-316." 

In addition, the taxpayer provided some support that it had a valid business reason for creating the captive. In Revenue Ruling 2002-90, a domestic holding company created a wholly-owned subsidiary to provide insurance coverage for 12 domestic operating subsidiaries that provided professional services. The operating subsidiaries provided the same "general categories of professional services." Each subsidiary operated on a decentralized basis in a separate state.

None of the operating subsidiaries had coverage for less than 5 percent nor more than 15 percent of the total risks covered by the insurance subsidiary. In total the subsidiaries had "a significant volume of independent, homogeneous risks."

The insurance subsidiary was licensed in each of the 12 states in which the operating subsidiaries did business. The holding company provided adequate capital to its insurance subsidiary but there was no parental guarantee and there were no related party guarantees. The insurance subsidiary loaned no funds to its parent or the operating subsidiaries. 
 

The Service concluded that the insurance subsidiary provided insurance to the operating subsidiaries. It reasoned that the operating subsidiaries' professional liability risks were shifted to the insurance subsidiary. The premiums paid were arms-length and were "pooled such that a loss by one operating subsidiary was borne, in substantial part, by the premiums paid by others." 

In addition, the insurance and operating subsidiaries conducted themselves in all respects as would unrelated parties to a traditional insurance relationship, and [the insurance subsidiary]was regulated as an insurance company in each state where it did business."

(f) Brother-sister transactions

Humana—In Humana, Inc. v. Commissioner,64 the Sixth Circuit concluded that risk-shifting was present in the brother-sister transactions because the insured did not own stock of the insurance subsidiary so that a loss covered by the insurer did not influence the insured’s net worth. The court also concluded, without detailed elaboration, that risk-distribution was present. It stated, “we see no reason why there would not be risk distribution in the instant case where the captive insures several separate corporations within an affiliated group and losses can be spread among the several distinct corporate entities.”

HCA and Kidde Industries—The Tax Court, in Hospital Corporation of America et. al. v.  Commissioner, (HCA), and the Court of Federal Claims, in Kidde Industries, Inc. v. United States, (Kidde), applied the “balance sheet” approach to determine whether risk-shifting was present in the taxpayers’ captive insurance arrangements.

HCA involved the tax treatment of a captive insurance arrangement whose facts, “with a few significant differences, . . . [were] strikingly similar to the facts presented in Humana[.]” HCA created a wholly owned (captive) subsidiary, Parthenon, which provided a wide range of insurance coverages for it’s parent, HCA, and its sister corporations. The Tax Court used the balance sheet approach applied by the Sixth Circuit in Humana to determine whether HCA and its affiliates shifted their risks to Parthenon. It concluded that HCA did not shift its risks to Parthenon but that the sister affiliates did (but for certain workers compensation cover- age subject to an indemnification agreement, which is addressed in the analysis of the impact of guarantees).

Kidde was a “broad-based, decentralized conglomerate with 15 separate divisions and 100 wholly owned subsidiaries” in 1977-1978, the years before the court. Before 1977, Travelers provided workers compensation, automobile and general liability (including products liability) coverage. Travelers would not renew Kidde’s products liability coverage for 1977.

Kidde could only obtain such coverage at extremely high rates. It established Kidde Insurance Company Limited (KIC), a Bermuda captive, on December 22, 1976, to provide workers compensation, automobile, and general liability (including products liability) coverage for Kidde’s divisions and operating subsidiaries. Kidde and its operating subsidiaries obtained insurance coverage from an unrelated primary insurer that “transferred”  specified portions of the risk to KIC.

The U.S. Court of Federal Claims denied the deduction of premiums attributable to the coverage for KIC’s parent (that is, Kidde’s divisions). Applying the balance sheet approach, the court concluded that Kidde did not shift its risk of loss to its captive when the captive paid a loss. Paying the loss decreased the value of the parent’s holdings of the captive’s stock so the parent realized the economic impact of the loss. The court allowed Kidde to deduct premiums attributable to coverage of its subsidiaries after May 3 1, 1978. A loss paid by the captive did not decrease the value of a  subsidiary’s assets so that the subsidiary could transfer the risk of loss to the captive. The court concluded that risk was not transferred before June 1, 1978 as a result of the impact of an indemnity
agreement between Kidde and the primary insurer.

(e) No unrelated risks transferred in parent-subsidiary arrangements

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In general—The Service and courts hold that coverage by a captive subsidiary of its parent’s risks is not insurance if it only covers risks of related parties. Humana, Inc. and a wholly owned Netherlands Antilles company established Health Care Indemnity, Inc. (HCI) to cover risks of Humana and other HCI subsidiaries (“sister corporations”), in Humana, Inc. v. Commissioner.51 The Sixth Circuit examined the impact of the “insurance” transactions on the insured’s assets in both parent-subsidiary and brother-sister arrangements. It concluded that risk-shifting was lacking in the parent-subsidiary transactions because the risk of loss never left the parent. It reasoned that a captive’s stock is an asset of its parent so that a loss suffered by the captive decreases the value of the parent’s assets.

Indirect arrangements—The Ninth Circuit held that the taxpayers could not deduct “insurance premiums” attributable to coverage provided by unrelated insurers that was reinsured with the taxpayers’ insurance subsidiaries in Carnation v. Commissioner53 and Clougherty Packing Co. v. Commissioner. The captives only covered related-party risks in each case.

In Carnation, a processor and seller of foods and grocery products incorporated Three Flowers Assurance Co., Ltd., a wholly owned (Bermuda) subsidiary, to insure and reinsure multiple-line risks. Carnation acquired insurance coverage from American Home Assurance Co., an unrelated insurance company, which agreed to reinsure 90 percent of the risks with Three Flowers. Three Flowers overed only Carnation and its subsidiaries. American Home paid 90 percent of Carnation’s premiums to Three Flowers, which paid American Home a five percent commission on net premiums ceded, and reimbursed its premium taxes.

American Home was concerned that Three Flower’s would not be able to cover the reinsured losses so Carnation agreed to capitalize Three Flowers with up to $3 million at its (Carnation’s) election or Three Flowers’s request.55 The Service allowed a deduction only for ten percent of the premium, which related to the coverage that was not ceded to Three Flowers. The Commissioner argued that the reinsurance was an indirect form of self-insurance and that such payments were within Carnation’s practical control.

The Tax Court held that 90 percent of the premiums paid by Carnation to American Home was not deductible. Citing Le Gierse, the court concluded that an insurance risk was not present because the capitalization of Three Flowers with up to $3 million “on demand” neutralized the risks that American Home reinsured with Three Flowers.57 The Ninth Circuit concluded that the agreements among the parties were interdependent. 

That American Home refused to enter into a reinsurance arrangement unless Carnation agreed to capitalize Three Flowers was the key factor. The court also indicated that the Service’s second situation in Revenue Ruling 77-316, in which “an insurance subsidiary” reinsured a portion of its parent’s risks, supported its conclusion that the agreements neutralized the risk-shifting from Carnation to the extent that risk was reinsured by Three Flowers.

In Clougherty Packing, a slaughtering and meat processing company self-insured a portion of its workers’ compensation risks and obtained excess liability insurance for the remaining coverage from 1971-1977. It subsequently terminated its self-insurance arrangement and created Lombardy Insurance Corporation, a captive insurance company, which it capitalized for $1 million.

Clougherty purchased workers compensation coverage from Fremont Indemnity Co., an unrelated insurance company. Fremont reinsured the first $100,000 of each claim with Lombardy and ceded 92 percent of Clougherty’s premiums. Fremont charged Clougherty an additional five percent of its premiums as a fee for providing a captive insurer program.

Fremont remained liable if Lombardy became insolvent or otherwise defaulted. Lombardy’s only business was reinsuring Clougherty. Clougherty distinguished its transaction from that in Carnation. It argued that Carnation’s agreement to capitalize its reinsurance subsidiary with $3,000,000 on demand neutralized “any risk shifting in Carnation and the absence of any such agreement requires [the court to] reach an opposite result in this case.”60 The Ninth Circuit, however, denied 92 percent of the deduction for Clougherty’s premium payments. It reasoned that Clougherty’s net worth decreased when Lombardy paid a claim because it decreased the value of Clougherty’s stock. The court stated that a claim decreased Clougherty’s assets to the same extent that it would if it selfinsured in the “ordinary sense.”

Clougherty argued that Revenue Ruling 77-316 was inconsistent with the Supreme Court’s conclusion in Moline Properties62 that one must recognize affiliated companies as separate companies. The Ninth Circuit responded that Moline Properties does not require the Commissioner to ignore the impact of a loss on its assets “merely because the asset happens to be stock in a subsidiary.”

(d) The Service no longer follows the economic family theory

The Service concluded in Revenue Ruling 2001-3148 that it “will no longer invoke the economic family theory with respect to captive insurance transactions.” It reasoned that no court addressing captive insurance transactions has fully accepted the economic family theory as provided in Revenue Ruling 77-316.

Whether a transaction qualifies as insurance depends on the underlying facts and circumstances. Relevant factors include the amount of related (and unrelated) party risks, the capitalization of a captive and whether related parties provide guaranties or other financial enhancements. The impact of salient factors is addressed below.

(c) Captive insurers: historic background

Whether coverage of risks of affiliated companies qualifies as "insurance" for Federal income tax purposes has been a source of considerable contention between the Service and taxpayers. Before it issued Revenue Ruling 2001-31,

the Service's position was that coverage of an affiliate's risks is not insurance. It applied an economic family theory" in Revenue Ruling 77-316, which provided that, the insuring parent corporation and its domestic subsidiaries, and the wholly owned insurance" subsidiary, though separate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss.

 

 

In Revenue Ruling 77-316, the Service applied its economic family theory in the following three situations,

1. A foreign wholly owned captive insurer provided fire and other casualty insurance coverage for its parent and its parent's domestic subsidiaries. The parent and its subsidiaries paid premiums at  commercial rates to the captive for the coverage.

2. A parent and its domestic subsidiaries paid casualty insurance premiums to an unrelated domestic insurance company, which immediately reinsured 95 percent of the risks to a foreign "insurance" subsidiary that was wholly owned by the parent. The unrelated insurer remained the primary insurer and there were no collateral agreements between the unrelated insurer and the parent company or the other subsidiaries.

3. A parent and its domestic subsidiaries paid casualty insurance premiums to the parent's wholly owned "insurance" subsidiary, which reinsured 90 percent of the coverage of the risks to an unrelated insurance company.

The Service ruled that the premiums paid in each situation were not deductible (but for amounts addressed below) because "there was no economic shifting or distributing of risks of loss with respect to the risks carried or retained" by the "insurance" subsidiary. It concluded in each case that the "insurance agreement" was "designed to obtain a deduction by indirect means that would be denied if sought directly."

The Service allowed the parent and its (non-insurance) subsidiaries to deduct only premiums paid for risks that were ultimately borne by an unrelated insurer. Consequently, the parent and subsidiaries could deduct no premium in situation one. They could deduct premiums only for five percent of the risks retained by the unrelated insurer in situation two, and the 90 percent ceded to the unrelated insurer in situation three.

The Service recognized that each parent and its subsidiaries, including the wholly owned "insurance" subsidiaries, were separate corporate entities, reflecting the Supreme Court's holding in 

Moline Properties, Inc. v. Commissioner.46 It applied its economic family theory,  however, and concluded that "those who bear the ultimate economic burden of loss are the same persons who suffer the loss." The parent retained "practical control" in each situation.

The accrual of benefit obligations

The Supreme Court addressed the timing of the deduction of medical payments of an accrual basis noninsurer that self-insured certain medical care coverage in United States v. General Dynamics Corp.

General Dynamics paid medical claims out of its own funds but employed private carriers to administer the plan, instead of continuing its purchase of insurance from others. It set up a reserve to cover its liability for medical care received by employees. 

 General Dynamics argued that it could deduct certain amounts set aside as reserves as accrued expenses. The Court of Claims held that the amount set side satisfied the all events test because the medical services were rendered and the amount of liability could be established with reasonable accuracy.

The Supreme Court held, however, that General  Dynamics was liable to pay for covered medical services only if properly documented claims were filed.

 

The Court concluded that although General Dynamics could make a reasonable estimate of the amount of liability for claims that would be filed for medical care received during the applicable period, estimated claims were not intended to fall within the all events test. Otherwise, Congress would not have needed to provide an explicit provision that insurance companies could deduct reserves for incurred but unreported claims.

Part II: Self-Insurance and Captive Insurers

(a) Background

A company may not be able to acquire needed coverage from commercial insurers, or may only be able to acquire it at great cost. The company (or group of companies) may respond by setting amounts aside and "self-insuring" to cover these risks. Payments for such coverage are not deductible as insurance premiums. As an alternative, a company or group of companies may establish a "captive" insurance company to address their insurance goals. Whether coverage from a captive is insurance has been an especially contentious issue. The Service's view of the tax treatment, however, has been evolving toward standards that reflect much of the case law.

(b) Self-insurance

Tax treatment of self-insurance "premiums"

—Amounts set aside as reserves for self-insurance coverage are not deductible. The taxpayer in Revenue Ruling 69-51228 self-insured to cover fire losses because it otherwise was unable to obtain needed coverage. The Service ruled (with- out detailed elaboration) that the amounts set aside as a self-insurance reserves were not ordinary and necessary expenses deductible under section 162.

Self-insurance premiums are not deductible if they are paid to a separate fund or an irrevocable trust. In Spring Canyon Coal Co. v. Commissioner a coal mining and two other companies established a self-insurance fund and paid premiums equal to the amount that would be paid to a state insurance fund. An independent agent administered the fund for the three companies but did not commingle their funds. The fund covered compensation, medical, and other benefits under the state's Workmen's Compensation Act as well as incidental administration costs. The Tenth Circuit concluded that the amounts set aside were reserves for contingent losses akin to reserves set aside by insurance companies.

It held that amounts set aside to cover contingent liabilities by companies other than insurance companies were not deductible, however. The company could deduct incurred expenses when it paid injured workmen but it was "not entitled to deduct as an expense a sum of money which it might have expended for insurance premiums, but did not." In Steere Tank Lines, Inc. v. United States a transporter of petroleum products was required to "show evidence of financial responsibility" for the payment of accident claims. It entered into an agreement with an insurance company, Tri-State, which provided Steere Tank Lines with an evidence of financial responsibility bond. Steere Tank Lines agreed to indemnify the insurer for all claims that it had to cover and made two premium payments each year. One premium, which compensated Tri-State for providing the evidence of financial responsibility, was non-refundable.

The other premium was allocated to a contract premium account. Tri-State returned the excess of the amounts paid into the fund over the amounts it paid for claims and administration after six years (the maximum statute of limitations period for tort claims). The Fifth Circuit held that the amounts paid into the contract premium account were not deductible until a covered liability became fixed, concluding that the arrangement with Tri-State was not insurance. 

There was no risk-shifting because Steere Tank Lines "was obligated to pay all risks." InAnesthesia Service Medical Group, Inc. v. Commissioner35 a professional corporation made contributions to an irrevocable trust created to cover medical malpractice claims against its employees. The Tax Court and Ninth Circuit held that the contributions were not deductible premium payments. The Ninth Circuit reasoned that the payments "created a capital asset inuring to its continued benefit." The courts were not persuaded by the medical group's contention that liability was shifted from the employees, not the corporation. The Ninth Circuit noted that the medical group was liable for the tortious acts of its employees that were committed within the scope of their employment under the doctrine of respondeat superior.

Is risk shifting a requirement of insurance?

The Service and courts generally require that to qualify as insurance an arrangement must shift and distribute covered risks and satisfy certain other requirements. The Seventh Circuit stated in Sears, Roebuck & Co. v. Commissioner, however, that risk shifting and distribution are not required by statute and that it is a “blunder” to treat a phrase in an opinion as if it were statutory language. It questioned the need to shift risk for corporate coverage to qualify as insurance for tax purposes.

Other factors—Risk shifting and distribution are not the only factors that courts examine to determine whether a transaction or contract qualifies as insurance. In a series of cases involving wholly owned insurance companies, the Tax Court examined whether a transaction involves the presence of an insurance risk, and whether it involves “commonly accepted notions of insurance,” in addition to whether the insurance risk, if present, is shifted and distributed.

Impact of nontraditional factors—The U.S. Supreme Court stated that it is not necessary for  insurance coverage to incorporate traditional characteristics of an insurance contract for the coverage to qualify as insurance for tax purposes. It held in Haynes v. United States25 that coverage provided by a telephone company qualified as health insurance although the “employees paid no fixed periodic premiums, there was no definite fund created to assure payment of the disability benefits, and the amount and duration of the benefits varied with the length of service.” The Court stated that payment of fixed premiums at regular intervals and the presence of a definite fund are not required for coverage to qualify as insurance. The Court concluded that there is nothing in the statute or legislative history that limits health insurance to the characteristics of a normal insurance contract.

Risk distribution

Risk distribution

Risk distribution (or sharing), "involves the party onto whom risk is shifted distributing a portion of that risk among others." The Joint Committee on Taxation stated that the, concept of risk-distribution . . . relies on the law of large numbers. That is, within a group of a large number of individual insureds who share a similar type of risk of loss, only a certain number will actually suffer the loss within any defined period of time. When a loss is suffered by any insured, each individual insured makes a contribution through the payment of premiums toward indemnifying the loss suffered. 

 

The underlying facts and circumstances influence whether there is sufficient risk distribution in a given transaction. In Technical Advice Memorandum 200323026,

a parent company and operating subsidiaries made payments to a related foreign captive for pollution liability coverage. Approximately two thirds of the coverage was for one of the operating subsidiaries, which "operated a small number of plants, most of which engaged in the same operations and used and stored the same chemicals."

 

The Service concluded that "only limited" risk distribution was present. It distinguished the Tax Court's holding in The Harper Group v. Commissioner, in which payments to an insurance captive qualified as deductible insurance premiums although as much as 71 per cent of the premiums were for related party risks. In The Harper Group the 71 per cent covered more than one related policyholder and the coverage involved "an extensive variety of cargo shipments throughout the world by a variety of means and vessels." In contrast, "two thirds of the premiums in the present case represent the pollution liability of a single insured with similar operations in a handful of locations."

Risk shifting and distribution and other factors

The primary factors that the Service and courts examine to determine whether a transaction is insurance are whether the policyholder transfers insurance risks to a separate entity (risk-shifting) and whether such entity spreads the risks with risks transferred by others (risk-distribution). The Service and courts also attempt to determine whether the transaction has other characteristics traditionally  associated with insurance.

Whether a given factor is present or required for a given transaction to qualify as
insurance for tax purposes is not always definitively clear and a source of considerable contention between insurers and the government in certain contexts.
Risk-shifting—Risk-shifting involves one party “shifting its risk of loss to another.”12 The Joint Committee on Taxation stated13 that the, concept of risk-shifting refers to the fact that a risk of loss is shifted from the individual insured to the insurer (and the insurance pool managed by the insurer). 

For example, under a fire insurance policy, the property owner’s risk of loss from a fire (and the resulting damage costs) is shifted from the owner to the insurance company to the extent that the insurance proceeds from the contract will reimburse the owner for that loss.

Economics of insurance coverage

The risk-shifting and distribution requirements highlighted in Le Gierse (and addressed below) reflect the economics of insurance coverage. Insurance premiums for one year of coverage, for example, exceed the expected cost of coverage (which equals the cost of a claim times the probability that a valid claim will be made) because the premiums have to cover the cost of claims paid and other costs, including administrative costs incurred by the insurer. Insureds are willing to pay this amount to transfer the risk of incurring a sizable financial
loss that would arise if the covered contingency in fact occurs.

The insurer benefits by pooling a given risk with numerous other assumed risks. The expected value of the losses incurred by the insurer, per dollar of premium income, remains unchanged as a life insurer provides life insurance coverage to an increasing number of (equally situated) insureds.

The actual losses assumed by the insurer may differ from expected losses so that an insurer’s total losses may exceed its expectations.10 The spread of the risk of loss (or possibility that the insurer will incur a very large loss) per premium dollar decreases, however, as more insureds are covered, as a result of the statistical
law of large numbers. Consequently, the loss incurred per premium dollar gets increasingly more predictable as the insurer covers a larger number of insureds. The Seventh Circuit described the law of large numbers as follows,

One thousand persons at age 30 pay $450 each for a one year policy with a death benefit of $200,000. In a normal year two of these persons will die, so the insurer expects to receive $450,000 and disperse $400,000. Of course, more may die in a given year than the actuarial tables predict. 

But as the size of the pool increases the law of large numbers takes over, and the ratio of actual to expected loss converges on one. The absolute size of the expected variance [spread] increases, but the ratio decreases. 

Insurers determine the expected value of losses per premium dollar (400/450 in the Seventh Circuit’s example) and the spread (riskiness) of actual/expected losses incurred using actuarial principles. Insurance coverage involving more than one period also involves risk-shifting and distribution although the analysis is more complex than that examined above.