(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.