Risk Distribution: Unrelated Insurance
In Rev.Ruling 2002-89, set forth in whole below, the IRS essentially created what is called a "safe harbor" for captives to meet risk distribution, if the captive has earned 50% or more of its total premiums in a given year from unrelated third-party insureds.
The problem is that a captive insurance company has a restricted insurance license, which usually limits the captive's ability to write insurance to only:
It is because of this 50% third-party insurance requirement that captive managers have created so-called "risk pools" for their captive clients who cannot meet the "multiple-insured" safe harbor (treated elsewhere in this website).
IRS Revenue Ruling 2002-89
Revenue Ruling 2002-89, 2002-52 I.R.B. 984 (12/30/2002)
Section 162. - Trade or Business Expenses
26 CFR 1.162-1: Business Expenses.
(Also sections 801, 831)
Captive insurance. This ruling considers circumstances under which arrangements between a domestic parent corporation and its wholly owned insurance subsidiary constitute insurance for federal income tax purposes.
Rev. Rul. 2002-89
Are the amounts paid by a domestic parent corporation to its wholly owned insurance subsidiary deductible as "insurance premiums" under section 162 of the Internal Revenue Code?
Situation 1. P , a domestic corporation, enters into an annual arrangement with its wholly owned domestic subsidiary S whereby S "insures" the professional liability risks of P either directly or as a reinsurer of these risks. S is regulated as an insurance company in each state where S does business.
The amounts P pays to S under the arrangement 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.
In implementing the arrangement, S may perform all necessary administrative tasks, or it may outsource those tasks at prevailing commercial market rates. P does not provide any guarantee of S 's performance, and all funds and business records of P and S are separately maintained. S does not loan any funds to P.
In addition to the arrangement with P, S enters into insurance contracts whereby S serves as a direct insurer or a reinsurer of the professional liability risks of entities unrelated to P or S. The risks of unrelated entities and those of P are homogeneous. The amounts S receives from these unrelated entities under these insurance contracts likewise are established according to customary industry rating formulas.
The premiums S earns from the arrangement with P constitute 90% of S 's total premiums earned during the taxable year on both a gross and net basis. The liability coverage S provides to P accounts for 90% of the total risks borne by S.
Situation 2. Situation 2 is the same as Situation 1 except that the premiums S earns from the arrangement with P constitute less than 50% of S's total premiums earned during the taxable year on both a gross and net basis. The liability coverage S provides to P accounts for less than 50% of the total risks borne by S.
LAW AND ANALYSIS
Section 162(a) of the Code provides, in part, that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
Section 1.162-1(a) of the Income Tax Regulations provides, in part, that among the items included in business expenses are insurance premiums against fire, storms, theft, accident, or other similar losses in the case of a business.
Neither the Code nor the regulations define the terms "insurance" or "insurance contract." The United States Supreme Court, however, has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. LeGierse, 312 U.S. 531 (1941).
Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by the insurance payment. Risk distribution incorporates the statistical phenomenon known as the law of large numbers. Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums. Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987). Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. See Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989).
No court has held that a transaction between a parent and its wholly-owned subsidiary satisfies the requirements of risk shifting and risk distribution if only the risks of the parent are "insured." See Stearns-Roger Corp. v. United States, 774 F.2d 414 (10th Cir. 1985); Carnation Co. v. Commissioner, 640 F.2d 1010 (9th Cir. 1981), cert. denied 454 U.S. 965 (1981). However, courts have held that an arrangement between a parent and its subsidiary can constitute insurance because the parent's premiums are pooled with those of unrelated parties if (i) insurance risk is present, (ii) risk is shifted and distributed, and (iii) the transaction is of the type that is insurance in the commonly accepted sense. See, e.g. , Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135 (Fed. Cir. 1993); AMERCO, Inc. v. Commissioner, 979 F.2d 162 (9th Cir. 1992).
S is regulated as an insurance company in each state in which it transacts business, and the arrangements between P and S and between S and entities unrelated to P or S are established and conducted consistently with the standards applicable to an insurance arrangement. P does not guarantee S's performance and S does not make any loans to P; P's and S's funds and records are separately maintained. The narrow question presented in Situation 1 and Situation 2 is whether S underwrites sufficient risks of unrelated parties that the arrangement between P and S constitutes insurance for federal income tax purposes.
In Situation 1, the premiums that S earns from its arrangement with P constitute 90% of its total premiums earned during the taxable year on both a gross and a net basis. The liability coverage S provides to P accounts for 90% of the total risks borne by S. No court has treated such an arrangement between a parent and its wholly-owned subsidiary as insurance. To the contrary, the arrangement lacks the requisite risk shifting and risk distribution to constitute insurance for federal income tax purposes.
In Situation 2, the premiums that S earns from its arrangement with P constitute less than 50% of the total premiums S earned during the taxable year on both a gross and a net basis. The liability coverage S provides to P accounts for less than 50% of the total risks borne by S. The premiums and risks of P are thus pooled with those of the unrelated insureds. The requisite risk shifting and risk distribution to constitute insurance for federal income tax purposes are present. The arrangement is insurance in the commonly accepted sense.
In Situation 1, the arrangement between P and S does not constitute insurance for federal income tax purposes, and amounts paid by P to S pursuant to that arrangement are not deductible as "insurance premiums" under section 162.
In Situation 2, the arrangement between P and S constitutes insurance for federal income tax purposes, and the amounts paid by P to S pursuant to that arrangement are deductible as "insurance premiums" under section 162.
EFFECT ON OTHER DOCUMENTS
Reve. Rul. 2001-31, 2001-1 C.B. 1348, is amplified.
The principal author of this revenue ruling is John E. Glover of the Office of the Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling contact Mr. Glover at (202) 622-3970 (not a toll-free call).
Follow Adkisson's Captive Insurance Companies on social media:
Articles On Captives
An archive of articles by Jay Adkisson on captive insurance companies. Click here for more
Discusses the unique characteristics and problems of captive insurance companies that qualify for the IRC section 831(b) election. Click here for more
An overview of captive taxation, including the IRS's abandonment of its "Economic Family Theory". Click here for more
Tax: Protected Cell Companies
Considers the unique tax issues that involve protected cell companies (a/k/a SBUs). Click here for more
Tax: Risk Distribution: Multiple Insureds
Considers the IRS safe harbor for multiple insureds and risk distribution through many "points of insurance" generally. Click here for more
Tax: Risk Distribution: Unrelated Insurance
Describes the IRS "50% unrelated third-party insurance" safe harbor and related issues. Click here for more
Tax: Risk Distribution: Risk Pools
Introduces the concept of risk pools which are sometimes used by captive managers to assist their clients in obtaining 50% third-party insurance, and which are currently under heavy scrutiny by the IRS. Click here for more
Tax: Risk Shifting
Considers the tax law requirement that an insurance arrangement have a true shifting of risk between the insured and the insurer. Click here for more
Jay Adkisson has been an expert witness and is available for consultation as an expert regarding captive insurance company matters. Click here for more
Jay Adkisson has been involved with the formation of well over 100 captive insurance companies since 1998, and now assist prospective captive owners in evaluating their suitability for a captive, and in forming the captive and obtaining its insurance license. Click here for more
Jay Adkisson is regularly involved with the remediation of defective captive arrangements, and with consulting and second-opinion reviews of existing captives. Click here for more
Jay Adkisson frequently serves as counsel in disputes involving insurance companies. Click here for more
More Websites By Jay Adkisson
About Jay Adkisson
Jay's personal webpage with his background, lists of his books and articles, and past and future speaking appearances, are found at jayadkisson.com
Avoidable Transactions a/k/a Fraudulent Transfers
An examination, with Jay's commentary, about the Uniform Voidable Transactions Act a/k/a 2014 Revisions to the Uniform Fraudulent Transfers Act, for which Jay was an American Bar Association Adviser to the Drafting Committee of the Uniform Law Commission, is found at voidabletransactions.com
An examination, with Jay's commentary, about the so-called Harmonized Acts (the Uniform Partnership Act, the Uniform Limited Partnership Act, and the Uniform Limited Liability Company Act) as they relate to charging orders, and a collection of Jay's articles on the subject, is found at chargingorder.com
Jay's award-winning and frequently cited website regarding various tax schemes and financial scams, with a popular comment board for those scams, is found at quatloos.com
Riser Adkisson LLP
For the website of Jay's law firm, Riser Adkisson LLP, and information about his legal services, see risad.com
Adkisson's Captive Insurance Companies (2006) available at Amazon.com
Contact Jay at by e-mail to jay [at] risad.com or to 702-953-9617
(c) 2017 Jay D. Adkisson. All Rights Reserved. No claim to original government works. The information contained in this website is for general educational purposes only, does not constitute any legal advice or opinion, and should not be relied upon in relation to particular cases. Use this information at your own peril; it is no substitute for the legal advice or opinion of an attorney licensed to practice law in the appropriate jurisdiction. This site is http://www.captiveinsurancecompanies.com