What Is Insurance? Where Are the Rules?

October 2005

Much has been written and discussed of late on what constitutes insurance especially for the purpose of claiming a tax deduction for premiums paid. This issue is also at the heart of many captive programs. As usual, the Internal Revenue Service has issued its thoughts, and many of us should pay attention and analyze them thoroughly.

by Michael R. Mead
M.R. Mead & Company, LLC

Captives should not be established merely for tax benefits, but certainly prudent business persons will always want to consider all of the benefits and challenges of owning a captive. One benefit may be tax deductibility. The accrual of funds to pay future losses through self-insurance is not deductible until the loss is paid. If the accrual becomes premiums paid to an insurer, then it is deductible as an ordinary business expense (Treas. Reg. § 1.162-1(a)). If the premium is paid to a captive, then we have a more interesting discussion. Is it really a premium?

The issue for deductibility currently rests on three main positions: risk shifting, risk distribution, and homogeneity. Before going further into each of these we must step back and take a clear look at insurance.

Insurance is not defined in any U.S. or state laws as such. This is usually a surprise to those who don’t spend a lot of time on insurance trivia. There are a few exceptions, but the court rulings have been pretty much along the lines of "Insurance is insurance. We all know it when we see it."

Risk Shifting and Distribution

The landmark case still widely cited is Helvering v. LeGierse, 312 U.S. 531, 539 (1941). It is surprising to many that a 60-year-old case is still the best that we have to work from, but that is the situation. So, there is no rulebook. There is precedent, interpretation, advice and counsel, and thorough preparation.

The LeGierse case said that for a transaction to be considered insurance, it must transfer the risk of loss from one party to another, among other points. That is risk shifting. How risk shifting is defined by law, courts, and the IRS is the subject of much time and money. Captives have been at the center of this issue. If you own a captive, and insure the risks of your business, have you shifted the risk? How much is needed to qualify (5, 10, 50 percent)? What about reinsurance? Who owns the captive?

Risk distribution refers to the expectation that risk of loss will be spread mathematically, usually with the law of large numbers protecting the party who accepts risk from taking on too much risk of the same sort, for too little premium. This is often seen in property insurance using geographic exposures to avoid concentration of risk in one dangerous place. Risk distribution issues occupy the actuary in determining reasonable assumptions and applying those assumptions to rates and loss forecasts.

Another surprise perhaps is that while premiums paid are deductible as business expenses, the IRS does not make the laws; Congress makes the laws, and they often do not contain specific language for application by the relevant government agency. The agencies make the rules which may or may not have the force of law, and they can be wrong. The IRS works very hard for the best interests of all of us, but it is a difficult task given the multitudes of risks being insured, the complex needs of American commerce today, and the shifting status of the traditional market.

From time to time, it publishes decisions or rulings that apply to a limited situation, but give clarity to consultants, attorneys, and tax advisers. This clarity will not apply to every case, however. If your case is unique, the precedents may need further clarity or challenge. You may have to determine your tolerance to what is known as a tax posture, i.e., aggressive, passive, or somewhere in between. Your advisers’ counsel is worth what you pay for it. But it also can be wrong, or not stand the challenge. This is why you must choose your advisers carefully, and get to understand the issues. Talk with the actuaries and tax accountants.

Homogeneity

This is the case with the homogeneity issue. Homogeneity refers to the so-called mix of business. Some cases and rules would say that in order to merit a tax deduction, to be called insurance, the risks assumed should be of sufficient variety as to their nature as to be diverse and give the possibility of smoothing exposure.

To be clear, if a transaction, i.e., a deduction or policy issuance, is deemed to NOT be insurance, it is likely to be deemed a personal investment transaction. This opens up a large door to a room of many pitfalls, hazards, fines, and penalties. You don’t want to open that door.

When the IRS, for example, issues an opinion or private letter ruling, it almost always applies to the facts and circumstances of the issue at hand. Your case may be different. Many advisers and consultants prefer to follow the exact pronouncements of the IRS with no deviation. That may or may not be the correct approach for your individual facts and circumstances.

You will hear, or read, that the IRS says this, or the IRS doesn’t like that. These items must be considered in the light of the reality that the rulebook is not cast in stone. Just because a bureaucrat does not like an application of existing law, does not make it illegal. The rules change, advisers view things differently, and society changes the light in which some transactions are viewed. For instance, insuring balance sheet losses to manage financial results would seem in the best interests of shareholders, and is done by insurers through reinsurance. But managing balance sheets has taken on a negative aura in many places today. To say that the IRS is cracking down on something does not mean that Congress is cracking down.

In yet another circumstance, the captive owner must be keenly aware of the issues and, in the end, exercise best judgment. Many old saws apply here, such as "If it sounds too good to be true, it probably is." and "If it walks like a duck and quacks like a duck, it is a duck." As you learn more about deductibility issues, be ever mindful that no advice will keep you completely safe, and that common sense prevails with both captives and IRS interpretations ... in most cases.

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