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.