Self-insured? There may be a better option: most major U.S. corporations use self-insurance, but 'tax insurance' may offer a better answer for risk avoidance and improve both balance sheet and income statement ratios.

The vast majority of Fortune 2000 firms use some form of self-insurance, accruing a reserve of funds for potential physical, financial, property or employee losses on lieu of purchasing a policy from companies in the business of insuring these types of losses.

However, there are instances where self-insurance strategies might actually be harming companies--such as setting up of a reserve and accruing for tax liabilities when the company has taken an aggressive position in claiming certain tax deductions or tax credits, and is unsure its tax position will be upheld.

Fortunately, in these days of the Public Company Accounting Oversight Board (PCAOB), the Securities and Exchange Commission (SEC) and Internal Revenue Service (IRS) all peering over the shoulders of tax directors and CFOs, a new management tool has emerged to help ease the pain of reserving for taxes and immediately improve financial results: tax insurance.

This insurance can eliminate accounting accruals for contingent tax liabilities by insuring the contingent tax liability itself. Extinguishing the contingent tax liability allows the corporation to enjoy the immediate benefit of profit improvement by eliminating the contingent reserve on the income statement. Thus, this type of market insurance has several advantages over self-insurance, among them: significant risk reduction, low cost, known timing and tax minimization strategies that serve to maximize the firm's value.

The Tax Insurance Strategy

Tax insurance is a relatively new risk-financing technique that a number of companies are implementing. Tax insurance can be defined as a transfer by a ceding enterprise (a corporation) to an assuming enterprise (a major insurance company) of the liability for potential taxes due in a transaction in which the primary element of risk is financial rather than strategic. An important feature of such an arrangement is that it represents an unconditional financial commitment by the assuming enterprise to pay a sum certain in amount: the face value of the insurance policy.

In practice, the need for this type of contract occurs when there are concerns about previous or future tax positions taken, or the IRS either will not issue a private letter ruling or there is insufficient time to obtain one. Some other examples of previous or future tax positions taken that can be insured include issues arising as a result of concerns about:

* Availability of corporate net operating loss (NOL) carry-forwards as a result of change in ownership.

* Whether a current transaction might jeopardize the tax treatment of a prior tax-free spin-off.

* Whether a lease transaction might be treated as a sale for tax purposes.

* Whether debt might be treated as equity.

* Protection against a tax liability arising from potential loss of S corporation qualification.

* Whether basis should be stepped up or carried over as a result of a potential transaction.

* Tax-free spin-offs, tax-free mergers, like-kind exchanges, tax-free corporate reorganizations, using NOLs to avoid capital gains tax, escrows, contestability issues and other similar situations, including tax appeals, where the company is uncertain about its aggressive position.

On the income statement, the company records the premium paid as a current expense. If the policy covers more than one accounting period, the expense should be amortized over the remaining life of the policy. The reserve accrual for contingent tax liability is eliminated, since it is extinguished by the contract.

On the balance sheet, the company records the prepaid insurance premium as an asset, and amortizes it over the remaining contract period. The potential insurance proceeds are recorded as other receivables-insurance. The offsetting liability is shown as deferred income taxes-insurance. Both should be amortized over the remaining life of the policy. Additionally, the major terms and conditions of any insurance policy should be disclosed in the footnotes, if material.

Thus, a CFO can strengthen the company's financial statements by avoiding unnecessary accruals, reduce risk by guaranteeing the tax position and increase shareholder wealth by boosting earnings.

So Why Not Self-Insure?

Many large corporations and some Fortune 2000 companies are not in the habit of purchasing this type of market insurance because they are "self-insured." Some CFOs assume that because they are self-insured, there is little or no advantage to tax insurance. However, there are many scenarios where there are considerable advantages to market insurance, as described by Moshe Porat in his 1991 study, "Market Insurance vs. Self-Insurance: The Tax Differential."

Porat states that modern financial theory explains why market insurance is consistent with value maximization of the firm: because it provides the tax advantage of taking present deductions, while self-insurers can only deduct actual losses when incurred. A second tax advantage concerns the replacement of impaired assets, since an asset can be replaced using insurance proceeds for which the insured is not taxed.

A third advantage cited by Porat is that insurance premiums may be paid when the firm is profitable and subject to maximum tax rates, while the self-insured loss may occur when the firm is unprofitable and subject to lower tax rates (or no tax rate at all). Thus, Porat concludes that U.S. tax laws favor market insurance to stabilize or smooth earnings when the firm suffers large losses, especially in a single accounting period.

Consider the example of a major airline company that was self-insured. When several of its airplanes were destroyed, the company was unable to take maximum tax advantage of the write-offs due to chronic losses over a period of years. With tax insurance, on the other hand, earnings could have been smoothed, the tax benefit could have been immediate and the proceeds non-taxable.

Tax insurance is available to cover the potential tax liability itself, as well as penalties, interest, legal costs, escrows and gross-ups, if needed. It could even cover tax appeals to the tax courts. Premiums are very reasonable as well, ranging from 3-8 percent of the amount insured, and coverage is offered by some of the strongest insurance underwriting companies in the world.

How It Works

Here is an example of a typical transaction that can be covered with tax insurance:

Companies A and B agree to merge in a stock-for-stock, tax-free exchange. However there is some question about the pre- and post-stock ownership positions, thus placing the entire transaction at risk of being fully taxable to shareholders. The IRS will not issue a private letter ruling in a timely manner--or may not issue one at all. The value of the deal is $750 million, with $220 million of potential tax liability at risk for Company A.

Consequently, Company A prudently sets up a reserve for the full amount of the $220 million. Later, Company A enters into a tax insurance contract to insure the deal in exchange for a premium of $10 million, and arranges to have SwissRe underwrite the tax liability for the full amount of $220 million. Company A expects to merge with Company B within a year, meaning that this contract is considered short-term. With full confidence in its tax position and protection from federal, state and local taxes, fines, penalties, interest and appeals, the reserve for $220 million is extinguished, the merger proceeds smoothly, and shareholders are fully protected.

After the purchase of a tax insurance policy for $220 million face value, the insurance premium for $10 million is shown on the income statement as a current expense. The previous current tax accrual reserve for the $220 million is extinguished, thus releasing this amount to boost net income and earnings per share.

On the balance sheet, the $10 million insurance premium is recorded as a prepaid insurance asset that is amortized on a regular basis according to the terms of the contract. The insurance proceeds of $220 million are recorded as other receivables, since they are not a part of the normal business trade receivable operations. The offsetting liability is recorded as deferred income taxes-insurance. Both are shown under the current accounts, since the issue is expected to be resolved within one year. Had the issue been expected to occur over more than a year, a long-term receivable would have been set up with a corresponding long-term deferred income tax liability account shown.

However, the most favorable impact comes from examining the newly enhanced income statement and balance sheet financial ratios. All the liquidity and profitability ratios are enhanced in the range of 15 to 83 percent on a relative basis. Key among these enhancements is an improved debt leverage ratio, higher working capital amounts, profit margins and substantially higher earnings per share. This would have the effect of driving the company's stock price and valuation higher, all other things equal.

An indirect, but very positive side effect would be to lower the company's overall cost of capital and discount rate used for capital expenditure planning. The cost of capital would marginally improve due to the lower debt leverage and reduced cost of equity to shareholders from removing the uncertainty of tax risk. Self-insured companies cannot claim this advantage. Conversely, CFOs may wish to take on more debt as a result of the improved leverage ratio, and use the proceeds to profitability reinvest in other parts of the business.

There are many tax issues and scenarios similar to the foregoing for both corporations and wealthy individuals that can be protected by tax insurance. The increasing complexities of new tax rules and increasing disclosure burdens brought by The Sarbanes-Oxley Act, for example, can only serve to point out the major advantages of comforting CFOs by reducing risk to shareholders and guaranteeing a company's tax position by taking advantage of tax insurance.

Nemo Perera is Managing Partner of Risk Capital Partners (www.rcps.com), a boutique insurance brokerage and consultancy specializing in tax strategies for major corporations and high-net-worth individuals. Kenneth J. Purfey, a CEO and CFO for a number of major technology companies over a 30-year career, is a staff consultant at Risk Capital Partners.