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.
