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Insurance in the captive setting.

In 1991, the Tax Court released its opinions in three separate cases, each involving an insurance company that insured both related and unrelated insureds: Sears, Roebuck and Co., 96 TC 61; The Harper Group, 96 TC 45; and AMERCO, 96 TC 18. In each case the IRS had disallowed deductions for all premium payments made by a corporation to an affiliated insurance company, based on the theory that no transfer of insurance risk had taken place. The Tax Court disagreed with the Service and held in each case that risk shifting and risk distribution had been accomplished through the pooling of related and unrelated risks; therefore, the premiums paid by the corporations affiliated with the captive insurance company were deductible.

In analyzing captive insurance cases, the IRS, and now the Tax Court, have formulated a distinct theory based on the principle that an insurance relationship exists only if risk shifting and risk distribution are present. However, they have fundamentally different ideas about when risk shifting and risk distribution are present in a given case. Additionally, the Tax Court has indicated that two more requirements must be met; there must be an insurance risk present, and the transaction must constitute insurance in its commonly accepted sense.

Relying on LeGierse, 312 US 531 (1941), the Service has developed the "economic family" doctrine to analyze captive insurance cases. As first announced in Rev. Rul. 77-316, and later amplified and clarified in Rev. Rul. 88-71, a parent company can never shift risk to its wholly owned subsidiary. This theory, which has been the IRS's cornerstone argument in every captive case decided to date, was concisely summarized in Sears. The parent company can never shift risk, or obtain true insurance, from its wholly-owned subsidiary because all of the subsidiary's underwriting losses on the business of its affiliates will ultimately impact the common parent company's income statement and balance sheet assets on a dollar-for-dollar basis.

In a number of previous decisions the Tax Court rejected the economic family theory, but nevertheless found that risk shifting and risk distribution were not present when a captive provided insurance primarily to related parties. In determining whether a transaction was truly insurance, the Tax Court based its decision on the facts and circumstances of each case. The court made no attempt to formulate a single analysis to ascertain whether risk shifting and risk distribution were present in a particular case. In fact, the Tax Court (as well as other courts) often failed to distinguish these two elements.

In Sears, Harper and AMERCO, the Tax Court for the first time was confronted with fact patterns in which the wholly owned insurance company insured a substantial amount of unrelated risk. Rather than "dissect or reconsider" their prior opinions, the court chose to establish a three-prong test, each element of which must be satisfied in order for an insurance relationship to exist.

1. Presence of insurance risk: Basic to any insurance transaction is the agreement by an insurer, on payment of a premium, to compensate an insured if a loss event occurs. The risk must be associated with some form of identifiable hazard; an investment risk is insufficient. Moreover, an insurance risk is not present if risk is eliminated by other factors (as seen in LeGierse (annuity and life policy canceled out insurance risk) and Carnation, 71 TC 400 (1978), aff'd, 640 F2d 1010 (9th Cir. 1981) (indemnification agreement)). However, the parent's ownership of the insurance subsidiary does not necessarily eliminate the insurance risk.

2. Risk shifting and risk distribution: Although considered together as one prong of the test, each element must be present in order for insurance to exist. According to the court's analysis, risk shifting must be present in both form and substance. Insurance contracts must be written, premiums transferred and losses paid. In addition, the captive must be a separate, viable entity capable of meeting its financial obligations. In substance the transaction must not be a sham. The captive should have a bona fide business purpose and should function separately from its parent's business. Insuring unrelated parties on the same terms as related parties illustrates that the captive is a separate and distinct entity apart from its parent.

Risk distribution is accomplished by spreading the risk of loss among the participants in an insurance program. In the captive setting, the court held that risk distribution is present if a substantial amount of unrelated risk is insured by the captive.

3. Commonly accepted notions of insurance: The court believed that the transaction must be insurance as that term is defined in its commonly accepted sense. The Harper court listed the following factors in concluding that the transactions constituted insurance in the commonly accepted sense: the captive was organized, operated and fully regulated as an insurance company; the captive was adequately capitalized; the contracts were valid and legally binding; and the premiums charged were determined on an arm's-length basis. The Sears court stated that the transaction was "characterized as insurance for essentially all nontax purposes."

In what could be described as a fourth basic principle, the Tax Court noted in each case that the application of this analysis is consistent with the principles of federal income taxation. Specifically, the analysis gives due consideration to (1) the separate identity of each corporate entity; (2) both the form and the substance of the transaction; and (3) the relationship between the taxpayers. On this last point, the court noted in each case that the premiums paid to the captives from related parties were determined on an arm's-length basis.

Although the Tax Court's test consists of three prongs, many of the same factors are used in determining whether more than one particular prong is satisfied. For example, in Harper, the fact that the captive was regulated and operated as an insurance company and was adequately capitalized indicated that risk shifting was present and characterized the transaction as insurance in its commonly accepted sense. In AMERCO, the court stated that the presence of the technical indicia of risk shifting in combination with the substance of the transaction created insurance in the commonly accepted sense.

In previous decisions, many of the items identified in the first and third prong of the Tax Court's analysis were treated as factors to be included in the determination of whether risk shifting and risk distribution were present. By identifying these additional tests, and by listing several factors in determining whether a specific test is satisfied, it is difficult to determine whether any single factor is critical to the court's determination that an insurance relationship exists. For example, if the captive is not adequately capitalized, would this alone mean that the transaction is not insurance in its commonly accepted sense? If related parties were not charged an arm's-length premium, would an insurance relationship not exist or would the premiums merely need to be adjusted? These questions may remain unresolved for some time. However, to prevail in the Tax Court, taxpayers have now been instructed on how to structure their insurance captives.

The Tax Court's decisions in Sears, AMERCO and Harper probably represent the most important development affecting captive insurance companies in the last 15 years. These cases provide a new framework in which to analyze whether insurance exists in the captive insurance company setting.

The Tax Court's view of how risk shifting and risk distribution are accomplished is fundamentally at odds with the Service's approach. Under the Tax Court's "pooling" concept, an insurance relationship exists if the captive insures a substantial amount of unrelated risk and the transaction in both form and substance is insurance. Basically, the transaction must be treated as insurance for essentially all nontax purposes; the captive must be a separate, financially viable entity; and no countervailing agreements may exist that would negate the insurance risk.

As established in Harper, unrelated premiums equal to at least 30% of the captive's total gross premiums are considered "substantial." For purposes of determining unrelated risk, agreements and contracts must be closely scrutinized to determine whether any insurance charges built into the contract price or fee are properly allocable to an unrelated party. In this vein, a high degree of correlation between the related and unrelated risk may be irrelevant. The Tax Court also opened the possibility that insurance of a brother-sister corporation might be considered an unrelated risk.

These decisions represent only a chapter in the continuing saga of captive insurance companies. The Service has appealed these decisions (to the Seventh Circuit for Sears and the Ninth for AMERCO and Harper), so it will be interesting to see which theory the appellate courts will favor. The issue could conceivably reach the Supreme Court and might even be a subject for future legislation.
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Author:Shuster, Addison
Publication:The Tax Adviser
Date:Apr 1, 1992
Words:1449
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