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.

What is Insurance?

What is Insurance?

Background

Whether a contract issued by an insurance company qualifies as insurance fundamentally influences the tax treatment of the insurer, policyholders, and beneficiaries. The definition of insurance company, for example, depends directly on the status of the contracts that a company issues because an insurance company is a “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.” 

A trade or business cannot deduct a payment for coverage as an insurance premium under section 162(a) unless the payment relates to an insurance transaction. A beneficiary of a life insurance policy can exclude proceeds of the policy if the contract qualifies as life insurance and the payments are made by reason of the death of the insured. Although it generally is clear whether a given transaction qualifies as insurance, the status of a transaction is unclear or subject to dispute between taxpayers and the government in certain contexts.

(b) Helvering v. Le Gierse

The Internal Revenue Code does not define “insurance.” The Tax Court stated that “insurance risk is involved when an insured faces some loss-producing hazard (not an investment risk), and an insurer accepts a payment, called a premium, as consideration for agreeing to perform some act if and when that hazard occurs.” The Supreme Court stated in Helvering v. Le Gierse, the landmark case involving the definition of insurance, that “historically and commonly insurance involves risk-shifting and risk-distributing.”

Le Gierse, the beneficiary of her mother’s insurance policy, was an executor of her mother’s estate and attempted to exclude the proceeds of the insurance policy from Federal estate tax. Le Gierse’s mother acquired a single premium life insurance policy with a death benefit of $25,000, for $22,946, at age 80. Her mother did not have to take a physical examination or answer questions that a woman applicant for life insurance generally had to answer. 

Her mother also acquired an annuity that would make periodic payments for as long she lived for  consideration of $4,179. The acquisition of the insurance policy and annuity were linked because the insurance company would not issue the insurance contract without also issuing an annuity. The insurance policy and annuity were treated as separate contracts in all other formal respects. The insurance policy incorporated the usual characteristics of that type of contract.

The Court concluded that the two contracts must be considered together. The life insurance and annuity contracts involved opposite risks and, in combination, offset each other. The arrangement therefore did not involve insurance.

9 Ways to lower your Insurance Cost (Part 2)

4) Reduce Coverage on Older Cars

Consider dropping collision and/or comprehensive coverages on older cars. If your car is worth less than 10 times the premium, purchasing the coverage may not be cost effective. Auto dealers and banks can tell you the worth of cars. Or you can look it up online at Kelley’s Blue Book (http://www.kbb.com). Review your coverage at renewal time to make sure your insurance needs
haven’t changed.

5) Buy your Homeowners and Auto Coverage from the Same Insurer

 
Many insurers will give you a break if you buy two or more types of insurance from them. You may also get a reduction if you have more than one vehicle insured with the same company. Some insurers reduce rates for long- time customers. But it still makes sense to shop around! You may save money buying from different insurance companies, compared with a multipolicy discount.

6) Maintain a Good Credit Record

Establishing a solid credit history can cut your insurance costs. Insurers are increasingly using credit information to price auto insurance policies. Research shows that those who effectively manage their credit also are more
responsible drivers. To protect your credit standing, pay your bills on time, don't obtain more credit than you need and keep your credit balances as low as possible. Check your credit record on a regular basis and have any
errors corrected promptly so that your record remains accurate.

9 Ways to lower your Insurance Cost (Part 1)

One of the best ways to keep your auto insurance costs down is to have a good driving record. Listed below are other things you can do to lower your insurance costs.

1) Shop Around

Prices vary from company to company, so it pays to shop around. Get at least three price quotes. You can call companies directly or access information on the Internet. Your state insurance department may also provide comparisons of prices charged by major insurers. (State insurance department phone numbers and Web sites can be found on the back cover.)

You buy insurance to protect you financially and provide peace of mind. It's important to pick a company that is financially stable. Check the financial health of insurance companies with rating companies such as A.M. Best (http://www.ambest.com) and Standard & Poor’s  (http://www.standardandpoors.com/ratings) and consult consumer magazines. Get quotes from different types of insurance companies. 

Some sell through their own agents. These agencies have the same name as the insurance company. Some sell through independent agents who offer policies from several insurance companies. Others do not use agents. They sell directly to consumers over the phone or via the Internet.

Don't shop price alone. Ask friends and relatives for their recommendations. Contact your state insurance department to find out whether they provide information on consumer complaints by company. Pick an agent or company representative that takes the time to answer your questions. You can use the checklist on the back of this brochure to help you compare quotes from insurers.

2) Before You Buy a Car

Compare Insurance Costs Before you buy a new or used car, check into insurance costs. Car insurance premiums are based in part on the car’s sticker price, the cost to repair it, its overall safety record, and the likelihood of theft. Many insurers offer discounts for features that reduce the risk of injuries or theft. These include daytime running lights and antitheft devices. To help you decide what car to buy, you can get information from the Insurance Institute for Highway Safety (http://www.iihs.org).

3) Ask for Higher Deductibles

Deductibles are what you pay before your insurance policy kicks in. By requesting higher deductibles, you can lower your costs substantially. For example, increasing your deductible from $200 to $500 could reduce your collision and comprehensive coverage cost by 15 to 30 percent. Going to a $1,000 deductible can save you 40 percent or more. Before choosing a higher deductible, be sure you have enough money set aside to pay it if you have a claim.

Determining How Much You Can Afford for a Car

 Determining How Much You Can Afford


Before financing or leasing a vehicle, make sure you have enough income to cover your current monthly living expenses. Then, finance new purchases only when you can afford to take on a new monthly payment. The “Monthly Spending Plan” is a tool to help determine an affordable payment for you.

The only time to consider taking on additional debt is when you’re spending less each month than you take home. The additional debt load should not cut into the amount you’ve committed to saving for emergencies and other top prioritiesor life goals. Saving money for a down payment or trading in a vehicle can reduce the amount you need to finance. In some cases, your trade-in vehicle will take care of the down payment on your vehicle.

have left after taxes and other deductions have been made.you’ve made to expenses and credit obligations. Be sure to adjust any expenses, like vehicle maintenance and
insurance expenses, which might go up or down when you get a new vehicle.

Monthly Spending Plan

1.Complete Column 1 based on your current situation. Start with your monthly take-home pay. This is the amount you have left after taxes and other deductions have been made.

 

Subtract the amount you need for savings, monthly expenses and monthly creditor payments.

The remaining balance is the maximum amount you can afford to put toward the monthly payment for a vehicle and any new related expenses, like car insurance.

2.Complete Column 2 based on your new situation. This column will show your new vehicle payment and adjustments  you’ve made to expenses and credit obligations. Be sure to adjust any expenses, like vehicle maintenance and insurance expenses, which might go up or down when you get a new vehicle.

The remaining balance in Column 2 will indicate whether you can afford the new vehicle payment and change in expenses projected.

 

Shop for the Best Deal When Financing a Vehicle

Take the time to know and understand all of the terms, conditions and costs to finance a vehicle before you sign the contract. Review and compare the financing terms offered by more than one creditor.

Sample Comparison

This example will help you compare the difference in the monthly payment amount and the total payment amount for a 3-year and a 5-year credit transaction. Generally, longer terms mean lower monthly payments and higher finance charges. Make sure you have enough income available to make the monthly payment by reviewing your monthly spending plan. You’ll also need to factor in the cost of automobile insurance, which may vary depending upon the type of vehicle.

Should I Lease a Vehicle?

If you are considering leasing, there are several things to keep in mind. The monthly payments on a lease are usually lower than monthly finance payments on the same vehicle because you are paying for the vehicle’s expected depreciation during the lease term, plus a rent charge, taxes,  and fees. But at the end of a lease, you must return the vehicle unless the lease lets you buy it and you agree to the purchase costs and terms. To be sure the lease terms fit your situation: Consider the beginning, middle and end of lease costs. Compare different lease offers and terms, including mileage limits, and also consider how long you may want to keep the vehicle.

When you lease a vehicle, you have the right to use it for an agreed number of months and miles. At lease end, you may return the vehicle, pay any end-of-lease fees and charges, and “walk away.” You may buy the vehicle for the additional agreed-upon price if you have a purchase option, which is a typical provision in retail lease contracts. Keep in mind that in most cases, you will be responsible for an early termination charge if you end the lease early. That charge could be substantial. 

Another important consideration is the mileage limit – most standard leases are calculated basedon a specified number of miles you can drive,typically 15,000 or fewer per year. You can negotiate a higher mileage limit, but you will normally have an increased monthly payment since the vehicle’s depreciation will be greater during your lease term. If you exceed the mileage limit set in the lease agreement, you’ll probably have to pay additional charges when you return the vehicle.

When you lease, you are also responsible for excess wear and damage, and missing equipment. You must also service the vehicle in accordance with the manufacturer’s recommendations. Finally, you will have to maintain insurance that meets the leasing company’s standards. Be sure to find out the cost of this insurance.