What is Insurance? · PDF fileWhat is Insurance? annuity. The insurance policy and annuity...

�

Chapter 2

What is Insurance?

This chapter addresses:

• ThedefinitionofinsuranceundertheFederalincometaxlaw,in-cludingtheimpactoftherisk-shifting,risk-distribution,andotherrequirementsofinsurance;

• Theapplicationoftheseandotherrequirementsofinsuranceinvariouscontextsincludingcaptiveinsurancearrangements;and

• Commercial-typeinsuranceundersection501(m).

Part I: Introduction

(a) Background

Whether a contract issued by an insurance company qualifies asinsurance fundamentally influences the tax treatment of the insurer,policyholders,andbeneficiaries.Thedefinitionofinsurancecompany,forexample,dependsdirectlyonthestatusofthecontractsthatacompanyissuesbecausean insurancecompany is a “companymore thanhalf ofthebusinessofwhichduringthetaxableyearistheissuingofinsuranceorannuitycontractsorthereinsuringofrisksunderwrittenbyinsurancecompanies.”1Atradeorbusinesscannotdeductapaymentforcoverageasaninsurancepremiumundersection162(a)unlessthepaymentrelatestoaninsurancetransaction.2Abeneficiaryofalifeinsurancepolicycanex-cludeproceedsofthepolicyifthecontractqualifiesaslifeinsuranceand

1 Section816(a)(flushlanguage).Thedefinitionofinsurancecompanyundersection816(a)isaddressedonpages67-68.

2 Treas.reg.section1.162-1(a).

� Federal Income Taxation of Insurance Companies

thepaymentsaremadebyreasonofthedeathoftheinsured.�Althoughitgenerallyisclearwhetheragiventransactionqualifiesasinsurance,thestatusofatransactionisunclearorsubjecttodisputebetweentaxpayersandthegovernmentincertaincontexts.�

(b) Helvering v. Le Gierse

The Internal Revenue Code does not define “insurance.”5 The TaxCourtstatedthat“[i]nsuranceriskisinvolvedwhenaninsuredfacessomeloss-producing hazard (not an investment risk), and an insurer acceptsapayment, calledapremium,asconsideration foragreeing toperformsomeactifandwhenthathazardoccurs.”6TheSupremeCourtstatedinHelvering v. Le Gierse,7thelandmarkcaseinvolvingthedefinitionofinsur-ance, that “[h]istorically and commonly insurance involves risk-shiftingandrisk-distributing.”8

LeGierse, thebeneficiaryofhermother’s insurancepolicy,wasanexecutorofhermother’sestateandattemptedtoexcludetheproceedsoftheinsurancepolicyfromFederalestatetax.LeGierse’smotheracquiredasinglepremiumlifeinsurancepolicywithadeathbenefitof$25,000,for$22,9�6,atage80.Hermotherdidnothavetotakeaphysicalexaminationoranswerquestionsthatawomanapplicantforlifeinsurancegenerallyhadtoanswer.Hermotheralsoacquiredanannuitythatwouldmakeperiodicpaymentsforaslongshelivedforconsiderationof$�,179.Theacquisitionof the insurance policy and annuity were linked because the insurancecompanywouldnotissuetheinsurancecontractwithoutalsoissuingan

� Section101(a).Abeneficiarycanexcludeonlytheportionoftheproceedsdeterminedundersection7702(g)(2)ifthecontractqualifiesasalifeinsurancecon-tractunderapplicablelawbutdoesnotqualifyasalifeinsurancecontractforFederalincometaxpurposesundersection7702.

� Compare section7702,whichdetermineswhetheracontractthatqualifiesasalifeinsurancecontractunderapplicablelawisalifeinsurancecontractforFederaltaxpurposes.Lifeinsurancecontractsincludequalifiedaccelerateddeathbenefitriders,otherthanridersthatarelong-termcareinsurancecontractsundersection7702B,undersection818(g).

5 See Sears, Roebuck & Co. v. Comr.,972F.2d858at861(7thCir.1992).

6 Black Hills Corp. v. Comr.,101T.C.at182,revised on reconsideration,102T.C.505(199�),aff ’d. 7�F.�d799(8thCir.1996).

7 �12U.S.5�1(19�1).

8 Id.at5�9.

What is Insurance? �

annuity.Theinsurancepolicyandannuityweretreatedasseparatecon-tractsinallotherformalrespects.Theinsurancepolicyincorporatedtheusualcharacteristicsofthattypeofcontract.

TheCourtconcludedthatthetwocontractsmustbeconsideredto-gether.The life insuranceandannuitycontracts involvedoppositerisksand,incombination,offseteachother.Thearrangementthereforedidnotinvolveinsurance.9

(c) Economics of insurance coverage

The risk-shifting and distribution requirements highlighted in Le Gierse (andaddressedbelow)reflect theeconomicsof insurancecover-age.Insurancepremiumsforoneyearofcoverage,forexample,exceedtheexpectedcostofcoverage(whichequalsthecostofaclaimtimestheprobabilitythatavalidclaimwillbemade)becausethepremiumshavetocoverthecostofclaimspaidandothercosts,includingadministrativecostsincurredbytheinsurer.Insuredsarewillingtopaythisamounttotransfertheriskofincurringasizablefinanciallossthatwouldariseifthecoveredcontingencyinfactoccurs.

Theinsurerbenefitsbypoolingagivenriskwithnumerousotheras-sumedrisks.Theexpectedvalueofthelossesincurredbytheinsurer,perdollarofpremiumincome,remainsunchangedasalifeinsurerprovideslifeinsurancecoveragetoanincreasingnumberof(equallysituated)in-sureds.Theactuallossesassumedbytheinsurermaydifferfromexpectedlossessothataninsurer’stotallossesmayexceeditsexpectations.10Thespreadoftheriskofloss(orpossibilitythattheinsurerwillincuraverylargeloss)perpremiumdollardecreases,however,asmoreinsuredsarecovered,asaresultofthestatisticallawoflargenumbers.Consequently,thelossincurredperpremiumdollargetsincreasinglymorepredictableas the insurercoversa largernumberof insureds.TheSeventhCircuitdescribedthelawoflargenumbersasfollows,11

9 Id. at5�0-5�2.

10 Insuredsalsoassumetheriskthatinvestmentyieldsonamountsheldwillbetoolow.(Thisfactorisespeciallyimportantifinsurersholdsignificantamountstocoverlong-termrisks,suchasforwholelifeinsurance,becausethecumulativeeffectofanincorrectestimateofanassumedinterestratecanbesignificantforalong-termcontract).Inaddition,insurersassumetheriskthatexpenses,otherthanclaims,willexceedexpectations.

11 See Sears, Roebuck & Co. v. Com’r.,972F.2d858at862-86�(7thCir.1992).

10 Federal Income Taxation of Insurance Companies

Onethousandpersonsatage�0pay$�50eachforaone-yearpolicywithadeathbenefitof$200,000.Inanormalyeartwoofthesepersonswilldie,sotheinsurerexpectsto receive $�50,000 and disperse $�00,000. Of course,moremaydieinagivenyearthantheactuarialtablespre-dict.Butasthesizeofthepoolincreasesthelawoflargenumberstakesover,andtheratioofactualtoexpectedlossconvergesonone.Theabsolutesizeoftheexpectedvariance[spread]increases,buttheratiodecreases.

Insurersdeterminetheexpectedvalueoflossesperpremiumdollar(�00/�50 in the Seventh Circuit’s example) and the spread (riskiness)ofactual/expected losses incurredusingactuarialprinciples. Insurancecoverage involvingmore thanoneperiodalso involvesrisk-shiftinganddistribution although the analysis is more complex than that examinedabove.

(d) Risk shifting and distribution and other factors

TheprimaryfactorsthattheServiceandcourtsexaminetodeterminewhetheratransactionisinsurancearewhetherthepolicyholdertransfersinsuranceriskstoaseparateentity(risk-shifting)andwhethersuchentityspreadstheriskswithriskstransferredbyothers(risk-distribution).TheServiceandcourtsalsoattempttodeterminewhetherthetransactionhasother characteristics traditionally associated with insurance. Whether agiven factor is present or required for a given transaction to qualify asinsurancefortaxpurposesisnotalwaysdefinitivelyclearandasourceofconsiderablecontentionbetweeninsurersandthegovernmentincertaincontexts.

Risk-shifting—Risk-shifting involves one party “shifting its risk oflosstoanother.”12TheJointCommitteeonTaxationstated1�thatthe,

12 Black Hills Corp. v. Com’r.,101T.C.17�,182(199�),revised on reconsideration102T.C.505(199�),aff ’d.7�F.�d799(8thCir.1996).

1� JointCommitteeonTaxation,Tax Reform Proposals: Taxation of Insurance Products and Companies(JCS-�1-85),(Sept.20,1985)at60.[HereinaftercitedasTax Reform Proposals].

What is Insurance? 11

conceptofrisk-shiftingreferstothefactthatariskoflossisshiftedfromtheindividualinsuredtotheinsurer(andtheinsurancepoolmanagedbytheinsurer).Forexam-ple,underafire insurancepolicy, thepropertyowner’sriskoflossfromafire(andtheresultingdamagecosts)is shifted from theowner to the insurancecompany totheextentthattheinsuranceproceedsfromthecontractwillreimbursetheownerforthatloss.

Risk distribution—Risk distribution (or sharing), “involves thepartyontowhomriskisshifteddistributingaportionofthatriskamongothers.”1�TheJointCommitteeonTaxationstated15thatthe,

conceptofrisk-distribution...reliesonthelawoflargenumbers. That is, within a group of a large number ofindividual insureds who share a similar type of risk ofloss,onlyacertainnumberwillactuallysuffer the losswithin any defined period of time. When a loss is suf-fered by any insured, each individual insured makes acontribution through thepaymentofpremiums towardindemnifyingthelosssuffered.

Theunderlying facts andcircumstances influencewhether there issufficient risk distribution in a given transaction. In Technical AdviceMemorandum200�2�026,16aparentcompanyandoperatingsubsidiariesmadepaymentstoarelatedforeigncaptiveforpollutionliabilitycoverage.Approximately two thirds of the coverage was for one of the operatingsubsidiaries,which“operatedasmallnumberofplants,mostofwhichen-gagedinthesameoperationsandusedandstoredthesamechemicals.”17TheServiceconcludedthat“onlylimited”riskdistributionwaspresent.ItdistinguishedtheTaxCourt’sholdinginThe Harper Group v. Commis

1� Black Hills Corp. v. Com’r.,101T.C.at182,revised on reconsideration102T.C.505(199�),aff ’d.7�F.�d799(8thCir.1996).

15 SeeTax Reform Proposals,note1�at60-61.

16 Feb.7,200�.Thistechnicaladviceisaddressedatnotes98-10�andaccom-panyingtext.

17 Id.at9.


sioner,18inwhichpaymentstoaninsurancecaptivequalifiedasdeductibleinsurancepremiumsalthoughasmuchas71percentof thepremiumswereforrelatedpartyrisks.InThe Harper Groupthe71percentcoveredmorethanonerelatedpolicyholderandthecoverageinvolved“anexten-sivevarietyofcargoshipmentsthroughouttheworldbyavarietyofmeansandvessels.”19Incontrast,“twothirdsofthepremiumsinthepresentcaserepresentthepollutionliabilityofasingleinsuredwithsimilaroperationsinahandfuloflocations.”20

Is risk shifting a requirement of insurance?—TheServiceandcourtsgenerallyrequirethattoqualifyasinsuranceanarrangementmustshiftanddistributecoveredrisksandsatisfycertainotherrequirements.The Seventh Circuit stated in Sears, Roebuck & Co. v. Commissioner,21however,thatriskshiftinganddistributionarenotrequiredbystatuteandthatitisa“blunder”totreataphraseinanopinionasifitwerestatutorylanguage.22Itquestionedtheneedtoshiftriskforcorporatecoveragetoqualifyasinsurancefortaxpurposes.2�

Other factors—Riskshiftinganddistributionarenottheonlyfactorsthatcourtsexaminetodeterminewhetheratransactionorcontractquali-fiesasinsurance.Inaseriesofcasesinvolvingwhollyownedinsurancecompanies, theTaxCourtexaminedwhethera transaction involves thepresence of an insurance risk, and whether it involves “commonly ac-ceptednotionsofinsurance,”inadditiontowhethertheinsurancerisk,ifpresent,isshiftedanddistributed.2�

Impact of nontraditional factors—TheU.S.SupremeCourtstatedthatitisnotnecessaryforinsurancecoveragetoincorporatetraditional

18 96T.C.�5(1991).

19 TAM200�2�026(Feb.7,200�)at9.

20 Id.

21 972F.2d858(7thCir.1992).

22 Id.at861.

2� Id.at862-86�.Theseissuesareaddressedatnotes1��-1�8andaccompany-ingtext.

2� See Sears, Roebuck & Co. v. Com’r.,96T.C.61,101(1991),aff ’d. on this issue, rev’d. in part972F.2d858(7thCir.1992),whichisaddressedatnotes1�6-1�9andaccompanyingtext.


characteristics of an insurance contract for the coverage to qualify asinsurancefortaxpurposes.ItheldinHaynes v. United States25thatcov-erage provided by a telephone company qualified as health insurancealthoughthe“employeespaidnofixedperiodicpremiums,therewasnodefinitefundcreatedtoassurepaymentofthedisabilitybenefits,andtheamountanddurationofthebenefitsvariedwiththelengthofservice.”26TheCourtstatedthatpaymentoffixedpremiumsatregularintervalsandthepresenceofadefinite fundarenot required forcoverage toqualifyasinsurance.TheCourtconcludedthatthereisnothinginthestatuteorlegislativehistorythatlimitshealthinsurancetothecharacteristicsofanormalinsurancecontract.27

Part II: Self-Insurance and Captive Insurers

(a) Background

Acompanymaynotbeable toacquireneededcoveragefromcom-mercialinsurers,ormayonlybeabletoacquireitatgreatcost.Thecom-pany(orgroupofcompanies)mayrespondbysettingamountsasideand“self-insuring”tocovertheserisks.Paymentsforsuchcoveragearenotdeductibleasinsurancepremiums.Asanalternative,acompanyorgroupof companies may establish a “captive” insurance company to addresstheirinsurancegoals.Whethercoveragefromacaptiveisinsurancehasbeenanespeciallycontentiousissue.TheService’sviewofthetaxtreat-ment,however,hasbeenevolvingtowardstandardsthatreflectmuchofthecaselaw.

(b) Self-insurance

Tax treatment of self-insurance “premiums”—Amountssetasideasreservesforself-insurancecoveragearenotdeductible.ThetaxpayerinRevenueRuling69-51228self-insuredtocoverfirelossesbecauseitoth-erwisewasunabletoobtainneededcoverage.TheServiceruled(with-

25 �5�U.S.81(1956).

26 Id.at8�-8�.

27 Id.

28 1969-2C.B.2�.


out detailed elaboration) that the amounts set aside as a self-insurancereserves were not ordinary and necessary expenses deductible undersection162.29

Self-insurancepremiumsarenotdeductibleiftheyarepaidtoasepa-ratefundoranirrevocabletrust.InSpring Canyon Coal Co. v. Commissioner�0acoalminingandtwoothercompaniesestablishedaself-insur-ancefundandpaidpremiumsequaltotheamountthatwouldbepaidtoastateinsurancefund.Anindependentagentadministeredthefundforthethreecompaniesbutdidnotcommingletheirfunds.Thefundcoveredcompensation,medical,andotherbenefitsunderthestate’sWorkmen’sCompensationActaswellasincidentaladministrationcosts.

TheTenthCircuitconcludedthattheamountssetasidewerereservesforcontingentlossesakintoreservessetasidebyinsurancecompanies.Itheldthatamountssetasidetocovercontingentliabilitiesbycompaniesotherthaninsurancecompanieswerenotdeductible,however.�1Thecom-panycoulddeductincurredexpenseswhenitpaidinjuredworkmenbutitwas“notentitledtodeductasanexpenseasumofmoneywhichitmighthaveexpendedforinsurancepremiums,butdidnot.”�2

InSteere Tank Lines, Inc. v. United States��atransporterofpetroleumproductswasrequiredto“showevidenceoffinancialresponsibility” forthepaymentofaccidentclaims.Itenteredintoanagreementwithanin-surance company, Tri-State, which provided Steere Tank Lines with anevidence of financial responsibility bond. Steere Tank Lines agreed toindemnifytheinsurerforallclaimsthatithadtocoverandmadetwopre-miumpaymentseachyear.Onepremium,whichcompensatedTri-Stateforprovidingtheevidenceoffinancialresponsibility,wasnon-refundable.Theotherpremiumwasallocatedtoacontractpremiumaccount.Tri-Statereturnedtheexcessoftheamountspaidintothefundovertheamountsitpaid forclaimsandadministrationaftersixyears(themaximumstat-uteof limitationsperiodfor tortclaims).TheFifthCircuitheldthat theamountspaidintothecontractpremiumaccountwerenotdeductibleuntila covered liability became fixed, concluding that the arrangement with

29 Id.

�0 ��F.2d78(10thCir.19�0),cert. denied28�U.S.65�(19�1).

�1 Id. at80.

�2 Id.

�� 577F.2d279(5thCir.1978),cert. denied��0U.S.9�6(1979).


Tri-State was not insurance. There was no risk-shifting because SteereTankLines“wasobligatedtopayallrisks.”��

In Anesthesia Service Medical Group, Inc. v. Commissioner�5 a pro-fessionalcorporationmadecontributionstoanirrevocabletrustcreatedto cover medical malpractice claims against its employees. The TaxCourtandNinthCircuitheldthatthecontributionswerenotdeductiblepremiumpayments.TheNinthCircuitreasonedthatthepayments“cre-atedacapital asset inuring to itscontinuedbenefit.”�6Thecourtswerenotpersuadedbythemedicalgroup’scontentionthatliabilitywasshiftedfromtheemployees,notthecorporation.TheNinthCircuitnotedthatthemedicalgroupwasliableforthetortiousactsofitsemployeesthatwerecommitted within the scope of their employment under the doctrine ofrespondeat superior.�7

The accrual of benefit obligations—TheSupremeCourtaddressedthetimingofthedeductionofmedicalpaymentsofanaccrualbasisnon-insurerthatself-insuredcertainmedicalcarecoverageinUnited States v. General Dynamics Corp.�8GeneralDynamicspaidmedicalclaimsoutofitsownfundsbutemployedprivatecarrierstoadministertheplan,insteadofcontinuingitspurchaseofinsurancefromothers.Itsetupareservetocoveritsliabilityformedicalcarereceivedbyemployees.

GeneralDynamicsargued that it coulddeduct certain amounts setaside as reserves as accrued expenses. The Court of Claims held thattheamountsetasidesatisfiedthealleventstestbecausethemedicalser-viceswererenderedandtheamountofliabilitycouldbeestablishedwithreasonableaccuracy.�9TheSupremeCourtheld,however, thatGeneral

�� Id.at280.

�5 85T.C.10�1(1985),aff ’d.825F.2d2�1(9thCir.1987).

�6 Id.at2��.

�7 Id. at2�2.But compare,Rev.Rul.92-9�,1992-2C.B.�5,inwhichgroup-termlifecoverageobtainedbyacompanyforitsemployeesfromitsinsurancesubsidiaryqualifiedaslifeinsurance.Thisrulingisaddressedatnotes158-161andaccompany-ingtext.

�8 �81U.S.2�9(1987).

�9 77�F.2d122�,125-1226(Ct.Cl.1985).


Dynamicswasliabletopayforcoveredmedicalservicesonlyifproperlydocumentedclaimswerefiled.�0

TheCourtconcludedthatalthoughGeneralDynamicscouldmakeareasonableestimateoftheamountofliabilityforclaimsthatwouldbefiledformedicalcarereceivedduringtheapplicableperiod,estimatedclaimswerenotintendedtofallwithinthealleventstest.Otherwise,Congresswould not have needed to provide an explicit provision that insurancecompaniescoulddeductreservesforincurredbutunreportedclaims.�1

(c) Captive insurers: historic background

Whether coverage of risks of affiliated companies qualifies as “in-surance” forFederal income taxpurposeshasbeenasourceofconsid-erable contention between the Service and taxpayers. Before it issuedRevenueRuling2001-�1,�2theService’spositionwasthatcoverageofanaffiliate’srisksisnotinsurance.Itappliedan“economicfamilytheory”inRevenueRuling77-�16,��whichprovidedthat,��

the insuring parent corporation and its domesticsubsidiaries,and thewhollyowned“insurance”subsid-iary, though separate corporate entities, represent oneeconomicfamilywiththeresultthatthosewhobeartheultimateeconomicburdenoflossarethesamepersonswhosuffertheloss.

In Revenue Ruling 77-�16, the Service applied its economic familytheoryinthefollowingthreesituations,

1. A foreignwhollyownedcaptive insurerprovidedfireandothercasualtyinsurancecoverageforitsparentanditsparent’sdomes-

�0 �81U.S.at2��.

�1 Id.at2�5-2�7.

�2 2001-1C.B.1��8,amplified in Rev.Ruls.2002-89and2002-90.Rev.Rul2001-�1isaddressedatnotes�8-50andaccompanyingtext.

�� 1977-2C.B.5�,clarified and amplified inRev.Rul.88-72,1988-2C.B.�1,declared obsoleteinRev.Rul2001-�1.Rev.Rul.2001-�1,2001-1C.B.1��8,amplified inRev.Ruls.2002-89and2002-90,isaddressedatnotes�8-50andaccompanyingtext.

�� 1977-2C.B.at5�.

What is Insurance? 1�

ticsubsidiaries.Theparentanditssubsidiariespaidpremiumsatcommercialratestothecaptiveforthecoverage.

2. A parent and its domestic subsidiaries paid casualty insurancepremiums to an unrelated domestic insurance company, whichimmediately reinsured 95 percent of the risks to a foreign “in-surance” subsidiary that was wholly owned by the parent. Theunrelatedinsurerremainedtheprimaryinsurerandtherewerenocollateralagreementsbetweentheunrelatedinsurerandtheparentcompanyortheothersubsidiaries.

�. A parent and its domestic subsidiaries paid casualty insurancepremiumsto theparent’swhollyowned“insurance”subsidiary,whichreinsured90percentofthecoverageoftheriskstoanun-relatedinsurancecompany.

TheServiceruledthatthepremiumspaidineachsituationwerenotdeductible (but for amounts addressed below) because “there was noeconomicshiftingordistributingofrisksoflosswithrespecttotheriskscarriedorretained”bythe“insurance”subsidiary.Itconcludedineachcasethatthe“insuranceagreement”was“designedtoobtainadeductionbyindirectmeansthatwouldbedeniedifsoughtdirectly.”�5

TheServiceallowedtheparentandits(non-insurance)subsidiariestodeductonlypremiumspaidforrisksthatwereultimatelybornebyanunrelatedinsurer.Consequently,theparentandsubsidiariescoulddeductnopremiuminsituationone.Theycoulddeductpremiumsonlyforfivepercentoftherisksretainedbytheunrelatedinsurerinsituationtwo,andthe90percentcededtotheunrelatedinsurerinsituationthree.

TheServicerecognizedthateachparentanditssubsidiaries,includingthewhollyowned“insurance”subsidiaries,wereseparatecorporateenti-ties,reflectingtheSupremeCourt’sholdinginMoline Properties, Inc. v. Commissioner.�6Itapplieditseconomicfamilytheory,however,andcon-cluded that “those who bear the ultimate economic burden of loss arethesamepersonswhosuffer the loss.”�7Theparentretained“practicalcontrol”ineachsituation.

�5 1977-2C.B.at55.

�6 �19U.S.��6(19��).

�7 1977-2C.B.at5�.

1� Federal Income Taxation of Insurance Companies

(d) The Service no longer follows the economic family theory

TheServiceconcludedinRevenueRuling2001-�1�8thatit“willnolon-gerinvoketheeconomicfamilytheorywithrespecttocaptiveinsurancetransactions.”�9 It reasoned that no court addressing captive insurancetransactionshasfullyacceptedtheeconomicfamilytheory50asprovidedinRevenueRuling77-�16.

Whetheratransactionqualifiesasinsurancedependsontheunderly-ingfactsandcircumstances.Relevantfactorsincludetheamountofrelated(and unrelated) party risks, the capitalization of a captive and whetherrelatedpartiesprovideguarantiesorotherfinancialenhancements.Theimpactofsalientfactorsisaddressedbelow.

(e) No unrelated risks transferred in parent-subsidiary arrangements

In general—TheServiceandcourtsholdthatcoveragebyacaptivesubsidiaryof itsparent’srisks isnot insurance if itonlycoversrisksofrelated parties. Humana, Inc. and a wholly owned Netherlands AntillescompanyestablishedHealthCareIndemnity,Inc.(HCI)tocoverrisksofHumanaandotherHCIsubsidiaries(“sistercorporations”),inHumana, Inc. v. Commissioner.51TheSixthCircuitexaminedtheimpactofthe“in-surance” transactions on the insured’s assets in both parent-subsidiaryandbrother-sisterarrangements.Itconcludedthatrisk-shiftingwaslack-ingintheparent-subsidiarytransactionsbecausetheriskoflossneverlefttheparent.Itreasonedthatacaptive’sstockisanassetofitsparentsothatalosssufferedbythecaptivedecreasesthevalueoftheparent’sassets.52

Indirect arrangements—TheNinthCircuitheldthatthetaxpayerscouldnotdeduct“insurancepremiums”attributabletocoverageprovidedby unrelated insurers that was reinsured with the taxpayers’ insurance

�8 2001-1C.B.1��8,amplified inRev.Ruls.2002-89and2002-90.

�9 Id.

50 Id.

51 88T.C.197(1987),aff ’d. in part rev’d. in part881F.2d2�7(6thCir.1989).

52 Id.at25�. Thetaxtreatmentofbrother-sistertransactionsisaddressedatnotes71-80andaccompanyingtext.


subsidiaries inCarnation v. Commissioner5�andClougherty Packing Co. v. Commissioner.5�Thecaptivesonlycoveredrelated-partyrisks ineachcase.

InCarnation,aprocessorandsellerof foodsandgroceryproductsincorporated Three Flowers Assurance Co., Ltd., a wholly owned (Ber-muda) subsidiary, to insure and reinsure multiple-line risks. Carnationacquired insurance coverage from American Home Assurance Co., anunrelatedinsurancecompany,whichagreedtoreinsure90percentoftheriskswithThreeFlowers.ThreeFlowerscoveredonlyCarnationanditssubsidiaries.AmericanHomepaid90percentofCarnation’spremiumstoThreeFlowers,whichpaidAmericanHomeafivepercentcommissiononnetpremiumsceded,andreimburseditspremiumtaxes.

American Home was concerned that Three Flower’s would notbe able to cover the reinsured losses so Carnation agreed to capitalizeThreeFlowerswithupto$�millionatits(Carnation’s)electionorThreeFlowers’srequest.55TheServiceallowedadeductiononlyfortenpercentofthepremium,whichrelatedtothecoveragethatwasnotcededtoThreeFlowers.TheCommissionerarguedthatthereinsurancewasanindirectform of self-insurance and that such payments were within Carnation’spracticalcontrol.56

TheTaxCourtheldthat90percentofthepremiumspaidbyCarna-tiontoAmericanHomewasnotdeductible.CitingLe Gierse,thecourtcon-cludedthataninsuranceriskwasnotpresentbecausethecapitalizationofThreeFlowerswithupto$�million“ondemand”neutralizedtherisksthatAmericanHomereinsuredwithThreeFlowers.57TheNinthCircuitconcludedthattheagreementsamongthepartieswereinterdependent.That American Home refused to enter into a reinsurance arrangementunlessCarnationagreedtocapitalizeThreeFlowerswasthekeyfactor.Thecourtalso indicated that theService’ssecondsituation inRevenueRuling77-�16,inwhich“aninsurancesubsidiary”reinsuredaportionofitsparent’srisks,supported itsconclusion that theagreementsneutral-

5� 71T.C.�00(1978),aff ’d. 6�0F.2d1010(9thCir.1981),cert. denied�5�U.S.965(1981).

5� 8�T.C.9�8(1985),aff ’d.811F.2d1297(9thCir.1987).

55 71T.C.�0�;811F.2dat101�.

56 Id.at�05.

57 Id.at�09.Le Gierseisaddressedatnotes5-9.Theimpactofguaranteesandvariousfinancialenhancementsisaddressedatnotes81-97andaccompanyingtext.


izedtherisk-shiftingfromCarnationtotheextentthatriskwasreinsuredbyThreeFlowers.58

InClougherty Packing,aslaughteringandmeatprocessingcompanyself-insured a portion of its workers’ compensation risks and obtainedexcess liability insurance for the remaining coverage from 1971-1977.It subsequently terminated its self-insurance arrangement and createdLombardyInsuranceCorporation,acaptiveinsurancecompany,whichitcapitalizedfor$1million.

Clougherty purchased workers compensation coverage from Fre-montIndemnityCo.,anunrelatedinsurancecompany.Fremontreinsuredthefirst$100,000ofeachclaimwithLombardyandceded92percentofClougherty’spremiums.FremontchargedCloughertyanadditionalfivepercentofitspremiumsasafeeforprovidingacaptiveinsurerprogram.FremontremainedliableifLombardybecameinsolventorotherwisede-faulted.Lombardy’sonlybusinesswasreinsuringClougherty.59

Clougherty distinguished its transaction from that in Carnation. ItarguedthatCarnation’sagreementtocapitalizeitsreinsurancesubsidiarywith$�,000,000ondemandneutralized“anyriskshiftinginCarnationandtheabsenceofanysuchagreementrequires[thecourtto]reachanop-positeresultinthiscase.”60TheNinthCircuit,however,denied92percentof the deduction for Clougherty’s premium payments. It reasoned thatClougherty’snetworthdecreasedwhenLombardypaidaclaimbecauseitdecreasedthevalueofClougherty’sstock.ThecourtstatedthataclaimdecreasedClougherty’sassetstothesameextentthatitwouldif itself-insuredinthe“ordinarysense.”61

CloughertyarguedthatRevenueRuling77-�16wasinconsistentwiththe Supreme Court’s conclusion in Moline Properties62 that one mustrecognizeaffiliatedcompaniesasseparatecompanies.TheNinthCircuitrespondedthatMoline PropertiesdoesnotrequiretheCommissionerto

58 6�0F.2dat101�.Rev.Rul77-�16isaddressedatnote�5andaccompanyingtext.Rev.Rul.77-�16,however,wasdeclaredobsoletebyRev.Rul.2001-�1,2001-1C.B.1��8.Seenotes�8-50andaccompanyingtext.

59 811F.2d.at1299.

60 Id. at1�0�.

61 Id.at1�05.

62 �19U.S.��6(19��).


ignoretheimpactofalossonitsassets“merelybecausetheassethappenstobestockinasubsidiary.”6�

(f) Brother-sister transactions

Humana—In Humana, Inc. v. Commissioner,6� the Sixth Circuitconcludedthatrisk-shiftingwaspresentinthebrother-sistertransactionsbecausetheinsureddidnotownstockoftheinsurancesubsidiarysothata losscoveredbytheinsurerdidnot influencetheinsured’snetworth.Thecourtalsoconcluded,withoutdetailedelaboration,thatrisk-distribu-tionwaspresent.Itstated,“weseenoreasonwhytherewouldnotberiskdistributionintheinstantcasewherethecaptiveinsuresseveralseparatecorporationswithinanaffiliatedgroupandlossescanbespreadamongtheseveraldistinctcorporateentities.”65

HCA and Kidde Industries—The Tax Court, in Hospital Corporation of America et. al. v. Commissioner,66(HCA),andtheCourtofFed-eralClaims,inKidde Industries, Inc. v. United States,67(Kidde),appliedthe“balancesheet”approachtodeterminewhetherrisk-shiftingwaspresentinthetaxpayers’captiveinsurancearrangements.

HCA involvedthetaxtreatmentofacaptiveinsurancearrangementwhosefacts,“withafewsignificantdifferences,...[were]strikinglysimi-lartothefactspresentedinHumana[.]”68HCAcreatedawhollyowned(captive) subsidiary, Parthenon, which provided a wide range of insur-ancecoveragesforit’sparent,HCA,anditssistercorporations.TheTaxCourt used the balance sheet approach applied by the Sixth Circuit inHumanatodeterminewhetherHCAanditsaffiliatesshiftedtheirriskstoParthenon.ItconcludedthatHCAdidnotshiftitsriskstoParthenonbutthatthesisteraffiliatesdid(butforcertainworkerscompensationcover-

6� 811F.2dat1�07.

6� 88T.C.197(1987),aff ’d. in part rev’d. in part 881F.2d2�7(6thCir.1989).

65 Id. at257.

66 7�T.C.M.1020(1997),aff ’d. on another issue��8F.�d1�6(6thCir.200�),cert. denied subnom.HCA & Subsidiaries v. Comr.5��U.S.81�(200�).

67 �0Fed.Cl.�2(1997).

68 7�T.C.M.at10�8(1997),aff ’d. on another issue��8F.�d1�6(6thCir.200�),cert. denied subnom.HCA & Subsidiaries v. Comr.5��U.S.81�(200�).


agesubject toan indemnificationagreement,which isaddressed in theanalysisoftheimpactofguarantees).69

Kiddewasa“broad-based,decentralizedconglomeratewith15sepa-ratedivisionsand100whollyownedsubsidiaries”in1977-1978,theyearsbeforethecourt.Before1977,Travelersprovidedworkerscompensation,automobile and general liability (including products liability) coverage.TravelerswouldnotrenewKidde’sproducts liabilitycoverage for1977.Kiddecouldonlyobtainsuchcoverageatextremelyhighrates.Itestab-lishedKiddeInsuranceCompanyLimited(KIC),aBermudacaptive,onDecember22, 1976, toprovideworkerscompensation, automobile, andgeneralliability(includingproductsliability)coverageforKidde’sdivisionsandoperatingsubsidiaries.Kiddeanditsoperatingsubsidiariesobtainedinsurancecoveragefromanunrelatedprimaryinsurerthat“transferred”specifiedportionsoftherisktoKIC.

TheU.S.CourtofFederalClaimsdeniedthedeductionofpremiumsattributabletothecoverageforKIC’sparent(thatis,Kidde’sdivisions).Applyingthebalancesheetapproach,thecourtconcludedthatKiddedidnotshiftitsriskoflosstoitscaptivewhenthecaptivepaidaloss.Payingthelossdecreasedthevalueoftheparent’sholdingsofthecaptive’sstocksotheparentrealizedtheeconomicimpactoftheloss.

ThecourtallowedKiddetodeductpremiumsattributabletocoverageof itssubsidiariesafterMay�1,1978.Alosspaidbythecaptivedidnotdecrease thevalueofasubsidiary’sassetsso that thesubsidiarycouldtransfertheriskoflosstothecaptive.ThecourtconcludedthatriskwasnottransferredbeforeJune1,1978asaresultoftheimpactofanindem-nityagreementbetweenKiddeandtheprimaryinsurer.70

The Service’s position on brother-sister arrangements—Priorto issuing Revenue Ruling 2001-�171 the Service held that coverage inbrother-sisterarrangementswasnotinsuranceunderitseconomicfamilytheory.72 InFieldServiceAdvice200125005,7�andFieldServiceAdvice

69 Seenotes92-95andaccompanyingtext.

70 �0Fed.Cl.at�8-50.

71 2001-1C.B.1��8,amplified inRev.Ruls.2002-89and2002-90.Rev.Rul.2001-�1isaddressedatnotes�8-50andaccompanyingtext.

72 Theeconomicfamilytheory,articulatedinRev.Rul.77-�16,1977-2C.B.5�,isaddressedatnotes��-��andaccompanyingtext.

7� Jan.25,2001.


200125009,7� however, the Service’s National office recommended thatthe Service concede the deduction of premiums paid by an operatingsubsidiarytoasisterinsurancecaptive.ItconcludedinFieldServiceAd-vice200125005 thatcontesting thedeductionof thesepremiumsraisedsubstantiallitigationhazards,notingthattheServicelostonthe“brother/sister”issueinHumanaandKidde Industries.Factors“suchas‘holdharm-less’agreementstounrelatedinsurersoranyoneelse”werenotpresent.TheServiceconcededthat“[n]ocourt,inaddressingacaptiveinsurancetransaction, has fully accepted the economic family theory set forth inRev.Rul.77-�16.”75Inaddition,thetaxpayerprovidedsomesupportthatithadavalidbusinessreasonforcreatingthecaptive.76

InRevenueRuling2002-90,77adomesticholdingcompanycreatedawholly-ownedsubsidiarytoprovideinsurancecoveragefor12domesticoperatingsubsidiariesthatprovidedprofessionalservices.Theoperatingsubsidiariesprovidedthesame“generalcategoriesofprofessionalservic-es.”Eachsubsidiaryoperatedonadecentralizedbasisinaseparatestate.Noneoftheoperatingsubsidiarieshadcoverageforlessthan5percentnormorethan15percentofthetotalriskscoveredbytheinsurancesub-sidiary.Intotalthesubsidiarieshad“asignificantvolumeofindependent,homogeneousrisks.”78

The insurance subsidiary was licensed in each of the 12 states inwhichtheoperatingsubsidiariesdidbusiness.Theholdingcompanypro-

7� March12,2001.

75 Id.at�.

76 Id.at5.Cf.TAM2001�900�(Aug.6,2001)inwhichaparentcompanycre-atedaninsurancesubsidiarytohelpmeettheworkers’compensationneedsofcertainoperatingsubsidiarieswhentheworkers’compensationmarketbecamevolatile,theavailabilityofcoverageunpredictable,andpremiumcostsinconsistent.TheServiceconcludedthattheinsurancesubsidiaryqualifiedasaninsurancecompany,reasoningthattheinsurancesubsidiaryassumedanddistributeda“largenumberofhomoge-neousindependent[workers’compensation]risksamongitsinsureds.”Id.at7.Itwascreated,“atleastinpart,[inresponseto]significantdisruptionsinthepricetobepaidtounrelatedinsurersforworkers’compensationcoverage”initsstate.Id.Itissuedaseparatepolicytoeachoftheoperatingsubsidiaries.Furthermore,itwasadequatelycapitalizedandits“premiumtosurplusratiowasstrong.”Id.Inaddition,“therewerenoparentalorrelatedpartyguarantees(inanyform)proppingup”theinsurancesubsidiary.Id.

77 2002-2C.B.985,amplifyingRev.Rul.2001-�1,2001-1C.B.1��8.Rev.Rul2001-�1isaddressedatnotes�8-50andaccompanyingtext.

78 Id.


videdadequatecapitaltoitsinsurancesubsidiarybuttherewasnoparen-talguaranteeandtherewerenorelatedpartyguarantees.Theinsurancesubsidiaryloanednofundstoitsparentortheoperatingsubsidiaries.

The Service concluded that the insurance subsidiary provided in-surance to the operating subsidiaries. It reasoned that the operatingsubsidiaries’professionalliabilityriskswereshiftedtotheinsurancesub-sidiary.Thepremiumspaidwerearms-lengthandwere“pooledsuchthata loss by one operating subsidiary [was] borne, in substantial part, bythepremiumspaidbyothers.”79Inaddition,theinsuranceandoperatingsubsidiaries“conduct[ed]themselvesinallrespectsaswouldunrelatedpartiestoatraditionalinsurancerelationship,and[theinsurancesubsid-iary]wasregulatedasaninsurancecompanyineachstatewhereitdidbusiness.”80

(g) Impact of undercapitalizations, guarantees and other financial enhancements

In general—Thecapitalizationofacaptiveortheuseofaguaranteeorotherfinancial enhancements can influencewhether a transaction isinsurance. The Tax Court’s conclusion in Carnation81 that the transac-tionbetweenCarnationanditscaptive,ThreeFlowers,wasnotinsurancewasinfluencedbyAmericanHome’srefusaltoenterintothetransactionwithoutCarnation’sagreementtocapitalizeThreeFlowerswithupto$�million.82

InHumana, theSixthCircuit indicated that theundercapitalizationof the foreign captive combined with the capitalization agreement run-ningtothecaptiveinCarnation,theindemnificationagreementinStearnsRoger,8�andtheundercapitalizationofthecaptiveinBeech Aircraft,8�

79 Id. at986.

80 Id. at986.

81 71T.C.�00(1978),aff ’d. 6�0F.2d1010(9thCir.1981),cert. denied�5�U.S.965(1981).

82 71T.C.at�09.Seenotes55-56.

8� 577F.Supp.8��(D.Colo.198�), aff ’d.77�F.2d�1�(10thCir.1985).

8� 797F.2d920(10thCir.1986).


weresufficient factors tofinda lackofrisk-shifting.85TheSixthCircuitalsoaddressedtheimpactofanundercapitalizationand/oreconomicen-hancementsonthecharacterizationofacaptiveinsurancearrangementinMalone & Hyde v. Commissioner.86

Malone & Hyde—Malone & Hyde, a company in the wholesalefoodbusiness,obtainedautomobile,worker’scompensation,andgeneralliabilitycoverageforitsdivisionsandsubsidiariesfromNorthwesternNa-tional InsuranceCompany,anunrelatedcasualty insurer.Northwesternreinsured specified amounts of this coverage with Eastland Insurance,Ltd., a Bermuda captive, and a wholly owned subsidiary of Malone &Hyde.EastlandprovidedNorthwesternwithanirrevocableletterofcreditof $250,000 (later increased to $600,000) to cover any unpaid amountsunderthereinsuranceagreement.Eastlanddidnotreinsureanyrisksofunrelatedpartiesduringtheyearsatissue.Malone&Hydealsoenteredintoahold-harmlessagreementwithNorthwestern,whichprovidedthatNorthwesternwouldbeheldharmlessanddefendedwithregardtoanythird-partyclaimthatmightariseifEastlanddefaultedonitsobligationsasreinsurer.

Malone&Hydearguedthatpremiumspaidtocoverriskstransferredfromsister corporationsweredeductibleunderprinciples addressed inHumana. The Commissioner argued that the facts of Malone & Hydeweredistinguishable from thoseofHumanabecause the transaction inMalone & Hydeincludedhold-harmlessagreementsandlettersofcredit.The Tax Court concluded that the agreements reflected “reasonable,cautious business practices in dealing with a new customer and a newreinsurer”andthatEastlandwasavalidinsurancecompany.Eastlandwasadequately capitalized under Bermuda law. The insurance agreementswithNorthwesternandthereinsuranceagreementwithEastlandresultedfrom arms-length negotiations and were evidenced by written policiesandendorsements.Inaddition,“Eastlandoperatedasaseparateandvi-ableentity,financiallycapableofmeetingitsobligations.Insum,thear-rangementsamongMalone&Hyde,itssubsidiaries,Northwestern,andEastlandconstitutedinsuranceinthecommonlyacceptedsense.”87The

85 881F.2dat25�nt.2(6thCir.1989).See alsotheSixthCircuit’sopinioninMalone & Hydeat62F.�dat8�1-8�2.

86 66T.C.M.1551(199�),rev’d.62F.�d8�5(6thCir.1995).

87 Id.at1562.


TaxCourtdistinguisheditsholdingsinCarnation andCloughertystatingthat“[w]efoundinCarnation,andfurtherarticulatedinClougherty,thatthe capitalization agreement was not a critical factor in the outcome ofthecase,butonlyoneofseveralfactorstobeconsideredindeterminingwhetherornottherequisiteriskshiftingwaspresent.”88

TheSixthCircuitreversedtheTaxCourt’sdecision,concludingthatinsurancewaslackingbecausetheultimateriskremainedwithMalone&Hydeunder thehold-harmlessagreements.89 ItdistinguishedHumana,statingthatHumanaestablishedthecaptivetoaddressthelossofinsur-ancecoverage,a legitimatebusinessconcern,and itscaptivewasnotasham.Thecaptivewasfullycapitalized,domesticallyincorporated,estab-lishedwithoutanyguaranteesfromitsparent,andactedinastraightfor-wardmanner.90Thecourtstated,91

[w]hentheentireschemeinvolveseitherundercapitaliza-tionorindemnificationoftheprimaryinsurerbythetax-payerclaimingthededuction,orboth,thesefactsalonedisqualifythepremiumpaymentsfrombeingtreatedasordinaryandnecessarybusinessexpensestotheextentsuchpaymentsarecededbytheprimaryinsurertothecaptiveinsurancesubsidiary.

InHCA,92 theTaxCourtapplied theprinciplesofMalone & Hyde9�andconcludedthatriskshiftingwasabsentwithrespecttoworkerscom-pensationobligationscoveredbythecaptiveasareinsurertothe“extentandduringthetime”thatHCAagreedtoindemnifytheprimaryinsureragainstnonperformanceof thecaptive.9�However, the impactof the in-demnificationagreementwasnotsufficientforthecourttoconcludethatthetransactionsbetweenthecaptiveanditssistercorporationswerenot

88 Id. at1559.

89 62F.�dat8��.

90 Id. at8�2-8��.

91 Id. at8�2-8��.

92 7�T.C.M.1020(1997), aff ’d. on another issue��8F.�d1�6(6thCir.200�),cert. denied subnom. HCA & Subsidiaries v. Comr.5��U.S.81�(200�).

9� 66T.C.M.1551(199�),rev’d.62F.�d8�5(6thCir.1995).

9� 7�T.C.M.at10�9nt.1�(1997), aff ’d. on another issue��8F.�d1�6(6thCir.200�),cert. denied subnom.HCA & Subsidiaries v. Comr.5��U.S.81�(200�).


bona-fide.Thecourtreasoned, inpart, that theagreementonlyappliedtoonetypeofcoverage,whichwasnottheprimarycoverageprovidedbythecaptive.95

InKidde,96theCourtofFederalClaimsconcludedthatriskwasnottransferredtothecaptivebeforeJune1,1978underacaptiveinsurancearrangement(describedinthesectionabove).Kidderemainedultimatelyresponsiblefortheunderlyinglossesasaresultoftheimpactofanindem-nityagreementwith theprimary insurer,whichwas ineffectwhile thepartiesworkedoutthedetailsofthecaptiveinsuranceagreement.

Thecourtconcludedthattheindemnityagreementwasnotmeanttobealong-termcommitmentbecauseretainingtheultimateresponsibilityforthecoveredlosseswouldbefundamentallyinconsistentwiththeexis-tenceofatrueinsurancerelationship.ThecourtfoundthattheagreementterminatedasofMay�1,1978becausebythatdatethecaptive’sassetsandaletterofcreditfromamajorU.S.bankweresufficienttoensurethatthecaptivewouldbeabletoprotecttheprimaryinsurer’sinterests.97

Inadequate capitalization—The“insurance”subsidiaryof the for-eign parent of a domestic holding company covered pollution liabilitieswith respect to (1) manufacturing by five operating subsidiaries of theholdingcompanyand(2)certainrealestateownedbytheholdingcom-panyandusedbytwooftheholdingcompany’soperatingsubsidiariesinTechnicalAdviceMemorandum200�2�026.98The foreignparent, incor-poratedinCountryR,createdtheinsurancesubsidiaryunderthelawsofanotherforeigncountry,CountryS.

The insurance subsidiary was capitalized with $500x, although anindependentconsultantperformedafeasibilitystudyandrecommendedthat the initialcapitalizationshouldbe$10,000x.Premiums for thefirstyeartotaled$1000x,including$620xfromoneofthesubsidiaries.ByJune�0of“Year�”theshareholder’sequitygrewto$2,822x.99Theinsurancesubsidiary issued six policies, each of which covered liability of up to

95 Id. at10�9.

96 �0Fed.Cl.�2(1997).

97 Id.at58-59.Kidde,however,coulddeductpaymentscoveringrisksofitsoperatingsubsidiariestotheinsurancesubsidiaryfortheperiodafterMay�1,1978. Id.at67.

98 Feb.7,200�.

99 Id.at8.


$10,000xperpollutionincidentandanaggregateofupto$10,000x.Theamount of premiums varied considerably among the insureds. For theperiodJuly1ofYear�toJune�0ofYear�,morethantwothirdsofthepremiumswerepaidbyOperatingSubsidiary�.

TheServiceconcluded that insurancewasnotpresentbecause thecaptivewasnot adequately capitalized.Thecapitalizationwasonlyone-twentiethoftheamountrecommendedinafeasibilitystudyandliabilityon a single incident that equaled the $10,000x per incident limit wouldfar exceed the captive’s equity, premium and investment income com-bined.100

Thatthecapitalizationwassufficienttoobtainacharter inCountrySandtosatisfya“specifictaxrule”ofCountryRwerenotsufficienttodemonstratethatitwasadequatelycapitalizedforUnitedStatesFederalincometaxpurposes.Incontrast,theServicenotedthatalthoughonepo-tentialinsurancelosscouldsubstantiallyexceedthecapitalization,manystates“limittheamountof losstowhichaninsurermaybeexposedonanyonerisktotenpercentoftheinsurer’ssurplus.”101TheServicealsoconcludedthatsufficientriskdistributionwaslacking.102

In addition, the Service concluded that the insurance arrangementamongthepartieswastooinformal.Thepoliciesfor“Year2”and“Year�,”forexample,werenotformallyexecuteduntil“Year�.”Thetaxpayers“assert[ed]thattherewereoralcontractsinthemeantime.”10�

(h) Coverage of other “related” entities

Anindividual,FredLennon,whollyownedCrawfordFitting,amanu-facturer of valves and fittings, in Crawford Fitting Company v. United States.10�Healsoownedatleast50percentoffourregionalwarehousesandheldvaryinginterestsinothercompaniesthatprovidedservicesand/orparts to themanufacturers.Crawford,othermanufacturersofvalvesandfittings,variouscompaniesthatprovidedpartsandservicesforthemanufacturersandtheregionalwarehousesobtainedcoveragefromCon-

100 Id. at8.

101 Id.

102 TheService’sreasoningisaddressedatnotes16-20andaccompanyingtext.

10� Id.

10� 606F.Supp.1�6(N.D.Ohio1985).


stance,whichwascreatedunder theColoradoCaptive InsuranceCom-panyAct.Constanceretainedaspecifiedportionofthecoveredriskandreinsuredtheremainingcoveragewithanunrelatedreinsurer.

Thewarehousesowned80percentofConstance.Crawfordemployeesandlawyersownedtheremaining20percent.MembersofLennon’sfam-ilyheldtheinterestsinthewarehousesthatLennondidnotdirectlyhold.Consequently,LennonhadasignificanteconomicstakeinbothCrawfordFittingandConstance.

ThegovernmentarguedthattheportionofCrawford’spremiumthatwas attributable to the retained coverage was a “reserve for self-insur-ance.”105ItassertedthattheriskoflossremainedinCrawford’seconomicgroup.106

TheDistrictCourtfortheNorthernDistrictofOhio,however,heldthatCrawford’spremiumsweredeductiblereasoningthatConstancewas“legitimatelyorganizedtoenableCrawfordtosecureinsuranceatareason-ableprice,withoutsubstantiallimitationsonthetypesandamountsofrisk...inreturnforthepaymentoflegitimatepremiums.”107Constancewasadequatelycapitalized.Further,CrawforddidnotownstockinConstanceoranyofthewarehousesthatownedstockinConstance.Thepremiumswere “actuarially based” and proportional to the risks covered.108 RiskdistributionwaspresentbecausetheinsuredsincludednumerousentitiesthatwerenotaffiliatedwithCrawford.109CrawfordthereforeshiftedtheriskoflossfromitseconomicfamilytoConstanceandConstancedistrib-utedtherisksoftheinsureds.110

(i) Coverage by an unrelated company

Anarrangementinwhichanunrelatedcompanyassumesrisksfromonlyonecompanydoesnotqualifyasinsurance.InRevenueRuling2005-�0,111situation1,acouriertransportcompanythatownedandoperated

105 Id.at1�1.

106 Id.

107 Id.at1�5.

108 Id. at1�7.

109 Id.

110 Id.at1�8

111 2005-27I.R.B.�.


a fleet of vehicles paid a premium to an unrelated company to assumetherisksoflossarisingfromtheuseofthevehiclesinitsbusiness.Thepremiumwasanarms-lengthamountdetermined“accordingtocustom-aryinsuranceindustryratingformulas”andtheassumingcompanyheldenoughcapitaltofulfillitsobligationsundertheagreement.112

Therewerenoguaranteesnorloansofpremiumsbacktothecouriertransportcompany.Thecouriertransportcompanywasnotobligatedtopayadditionalpremiumsiftheactualrisksexceededthepremiumspaidanditwasnotentitledtoarefundiftheactuallosseswerelessthanthepremiumspaidinanyperiod.Thepartiesconductedthemselvesinaman-ner that was “consistent with the standards applicable to an insurancearrangementbetweenunrelatedparties,”11� except that the recipientofthepremiumsassumed risksonly from thecourier transport company.TheServiceconcludedthatthearrangementdidnotqualifyasinsurancereasoning that although the “arrangement may shift the risks of [thecouriertransportcompany],therisks[were]notdistributedamongotherinsuredsorpolicyholders.”11�

Thefactswerethesameinsituation2,exceptthatinadditiontoas-sumingtherisksofthecouriertransportcompanytheunrelatedcompanyassumedrisksfromanotherfleetownerthatconductedacouriertransportbusiness.Thesecondfleetownerwasunrelatedtothefirst.Theamountsearnedandriskstransferredfromthesecondfleetownerconstituted10percent of the total earnings of and risks borne by the assuming com-pany.TheServiceconcludedthatthearrangementbetweentheoriginalcouriertransportcompanyandtheassumingcompanydidnotqualifyasinsurancebecausetherewasan“insufficientpoolofotherpremiumstodistribute[thecourieroriginaltransportcompany’s]risk.”115

Insituation�thecouriertransportbusinesswasconductedthrough12whollyownedlimitedliabilitycompanies(LLCs).EachLLCtransfersrisks and pays a specified premium to an unrelated company. The pre-miumpaidbyeachLLCwasanarmslengthamountdetermined“accord-ingtocustomaryinsuranceindustryratingformulas”andtheassumingcompanyheldenoughcapitaltofulfillitsobligationsundertheagreement.

112 Id.

11� Id.

11� Id.at5.

115 Id.at5-6.


Therewerenoguaranteesnor loansofpremiumsbacktoagivenLLC.TheLLCwouldnotbeobligatedtopayadditionalpremiumsiftheactualrisksexceededthepremiumspaidand itwasnotentitledtoarefund ifthe actual losses were less than the premiums paid in any period. Thepartiesconductedthemselvesinamannerthatwas“consistentwiththestandardsapplicabletoaninsurancearrangementbetweenunrelatedpar-ties,”exceptthattherecipientofthepremiumsonlyassumedrisksfromtheLLCs.

EachoftheLLCswasa“disregardedentity”underregulationsection�01.7701-�, and therefore treated as branches or divisions of the LLCs’owner. The Service concluded that the arrangements did not qualifyas insurance because it covered the risks of only one entity, the LLCs’owner.116

Insituation�,eachLLCelectedtobetreatedasanassociation.TheServiceconcludedthatthearrangementbetweeneachLLCandtheun-relatedassumingcompanywasinsurance,becauseeachLLCtransferredriskstotheassumingcompanyanddistributedtheriskswiththoseoftheotherLLCs.117

(j) Significant unrelated risks

Historic Background—InRevenueRuling88-72,118awhollyownedsubsidiary of the taxpayer insured risks of unrelated parties as well asrisksof itsparentandotheraffiliates.Thecoverageoftherelatedrisksrepresentedasmallfractionofitstotal insurancebusiness.TheServiceruled that thecoverageof itsparent’sandotheraffiliates’ risksdidnotqualifyasinsurancebecausetheeconomicriskoflosshadnotshifted.119The risk of loss did not shift because the parent continued to have aneconomicstakeinwhetheritorthesubsidiaryincurredaloss.Theparentanditssubsidiariesthereforecouldnotdeductpremiumspaidtotheirlifeinsuranceaffiliate.TheServicedeclaredRevenueRuling88-72obsolete

116 Id. Cf. situation1oftherulinginwhichalloftheriskscoveredwerefromthecouriertransportcompany,whichisaddressedatnotes111-11�andaccompany-ingtext.

117 Id.at6.

118 1988-2C.B.�1,clarified inRev.Rul.89-61,1989-1C.B.75,declared obsolete inRev.Rul.2001-�1,2001-1C.B.1��8.

119 Id. at�2.


inRevenueRuling2001-�1,inwhichtheServicedisavowedits“economicfamilytheory.”120

The Service’s position—The Service addresses two situations inwhichawholly-ownedsubsidiary“insured”theprofessionalliabilityrisksofitsparent,eitherdirectlyorthroughreinsurance,aswellas“homoge-neous”similarrisksofunrelatedparties,inRevenueRuling2002-89.121Ineachsituation,theamountsthattheparentpaysitssubsidiary“areestab-lishedaccordingtocustomary industryratingformulas. Inallrespects,thepartiesconductthemselvesconsistentlywiththestandardsapplicabletoaninsurancearrangementbetweenunrelatedparties.”122Thesubsid-iary“mayperformallnecessaryadministrativetasks,oritmayoutsourcethose tasks at prevailing commercial market rates.”12� In addition, theparentdoesnotprovideanyguaranteeregardingthesubsidiary’sperfor-mance,thesubsidiarydoesnotmakealoantoitsparent,andallfundsandrecordsoftheparentandsubsidiaryaremaintainedseparately.

Insituation1,thepremiumsandrisksassumedfromtheparentwere90percentofthesubsidiary’stotalrisksforitstaxableyear.TheServiceconcluded that the arrangement in this situation was not insurance forFederalincometaxpurposes.Therequisiteriskshiftinganddistributionwerenotpresentbecausesuchalargeportionofthepremiumsandriskswerefromtheparent.Theparent’spaymentstoitssubsidiarythereforewerenotdeductibleas“insurancepremiums”undersection162.12�

Insituation2,thepremiumsandrisksassumedfromtheparentwerelessthan50percentofthesubsidiary’stotalrisksassumedforitstaxableyear.TheServiceconcludedthatthearrangementwasinsurancesothattheparent’spaymentstoitssubsidiaryweredeductibleasinsurancepre-miumsundersection162.125

120 2001-1C.B.1��8,amplified inRev.Ruls.2002-89and2002-90.Rev.Rul.2001-�1isaddressedatnotes�8-50andaccompanyingtext.

121 2002-2C.B.98�.

122 Id.

12� Id.

12� Id.at98�-985.

125 Id. at985.


Court pronouncements—The Tax Court concluded (in dicta) inGulf Oil126thatcoverageofacompany’srisksisinsuranceifan“insurancesubsidiary” covers a sufficient amount of unrelated risks. It stated thatpremiumsofanaffiliatedgroup,127

will no longer cover anticipated losses of all of the in-sureds[ifasufficientproportionofpremiumsarepaidbyunrelatedpartiesbecause]themembersoftheaffiliatedgroupmustnecessarilyanticipaterelyingonthepremi-umsoftheunrelatedinsuredsintheeventthattheyare‘theunfortunatefew’andsuffermorethantheirpropor-tionateshareofanticipatedlosses.

OnlytwopercentofthepremiumspaidtotheinsurancesubsidiaryintheyearsbeforethecourtinGulf Oilwerefromunrelatedinsureds,whichtheTaxCourtconsideredde minimis.128TheTaxCourt“declined”toindi-catetheamountofpremiumsforunrelatedrisksthatwouldbesufficientforaffiliatedgrouppremiumstoqualifyasinsurancepremiums.Itstated,however,that“ifatleast50percentareunrelated,wecannotbelievethatsufficientriskwouldnotbepresent.”129

TheTax Court rejected the “economic family” theoryespousedbytheServiceinRevenueRuling77-�16.Althoughtheeconomicfamilyap-proachwouldhavereachedthesameresultthattheTaxCourtreachedinthecasebeforeit,theService’sapproach“wouldhaveforeclosedawhollyownedcaptivefromeverbeingconsideredaseparate insurancecompa-ny.”1�0Thecourtstatedthat“[w]especificallyreservedanydiscussionofthetaxconsequencesofpaymentstocaptiveswithunrelatedownersand/orunrelatedinsureds.”1�1Courtshaverespectedarrangementsinwhichtheunrelatedriskscoveredbycaptiveinsurersinvolved52to7�percent

126 89T.C.1010(1987),aff ’d.91�F.2d�96(�rdCir.1990).

127 Id. at1027.

128 Id.at1027-1028.

129 Id.at1027nt.1�.

1�0 Id. at102�.TheServicestatedthatitwouldnotfollowtheGulfcourt’srejectionoftheeconomicfamilyconceptinRev.Rul.88-72,1988-2C.B.�1,clarified inRev.Rul.89-61,1989-1C.B.75.TheService,however,subsequentlydisavoweditseconomicfamilyconceptinRev.Rul.2001-�1,2001-1C.B.1��8.See notes�8-50andaccompanyingtext.

1�1 89T.C.at102�-1025.


ofthewritteninsurancecoveredinAMERCO v. Commissioner,1�229to��percentinThe Harper Group v. Commissioner,1��and��to66percentinOcean Drilling & Exploration Co. v. United States.1��

(k) Sears

Background—TheServicearguedinSears, Roebuck & Co. v. Commissioner,1�5thatthecoverageofSears’srisksbyAllstate,awhollyownedsubsidiary,didnotqualifyas insurance.Thiscoveragerepresentedlessthan one-percent of Allstate’s total business and the business was con-ductedinanarm’slengthmanner.1�6

The Tax Court—TheTaxCourtindicatedthatwhetheratransactionqualifiesasinsurancedependsontheunderlyingfactsandcircumstances.AfterapplyingthefollowingthreesetsoffactorsthecourtconcludedthatAllstate’scoverageofSears’srisksconstitutedinsurance,

(1) Allstate covered claims that arose from insurance risks.Thecourtcontrastedthecoveragewitharrangementsinvolvinginvestmentrisks.Itfocusedonthe“natureofthelossescoveredbythepoliciesandthedesignatedresponsibilityforpaymentofthose losses.”1�7 The impact on Sears’s “ultimate profit or lossfrom Allstate’s operations [was] not significant to the analysisof whether the contractual arrangements deal with insurancerisks;”1�8

(2) The policies shifted and distributed the risks.TheriskswereshiftedtoAllstate,which“wasaseparate,viableentity,financially

1�2 979F.2dat16�(9thCir.1992).

1�� 979F.2dat1��2(9thCir.1992).But compareTAM200�2�026(Feb.7,200�)inwhichriskdistributionwasconsideredtobelackingwheretwo-thirdsofthetotalcoveragewasforoneentity. Seenotes16-20andaccompanyingtext.

1�� 988F.2d11�5at1152-115�(Fed.Cir.199�).

1�5 96T.C.61(1991),aff ’d. on this issue rev’d. in part972F.2d858(7thCir.1992).

1�6 972F.2dat860.

1�7 96T.C.at100.

1�8 Id.


capable of meeting its obligations.”1�9 In addition, Allstate wasnot formed or operated to self-insure Sears. The policies weresoldunderthesameterms,andinthesamecontextassalestounrelatedthirdparties.Thecourtstatedthatriskdistributionisthe“spreadingoflossamongtheparticipantsinaninsurancepro-gram.”1�0Suchspreadingarisesfromthepoolingofrisksamongunrelatedinsureds,which“increasesthereliability inestablish-ingpremiumsandestimatingappropriatereserves;”1�1and,

(�) The transactions reflected commonly accepted notions of insurance.Thecourtconcludedthatthearrangementwaschar-acterizedasinsurancewithregardstoallnon-taxpurposes.1�2

The Seventh Circuit—TheSeventhCircuitaffirmedtheTaxCourt’sholding that the transaction between Sears and Allstate qualified as in-surance.However, insteadof asking “ ‘[w]hat is thedefinitionof insur-ance?[,]’”thecourtexaminedwhether“there[was]adequatereasontorecharacterizethetransaction[.]”1��

The appellate court indicated that the Internal Revenue Code doesnotdefineinsuranceandthatinLe GiersetheSupremeCourt“mentionsthecombinationofriskshiftingandriskdistribution.”1��Thecourtadded,however,thatitwouldbea“blundertotreat“aphraseinanopinionasifitwerestatutorylanguage[.]”1�5TheSupremeCourt“wasnotwritingadefinitionforallseasonsandhadnoreasonto,astheholdingofLe Gierse isonlythatpayingthe‘underwriter’morethanitpromisestoreturnintheeventofacasualtyisnotinsurancebyanystandard.”1�6

The Seventh Circuit recognized that a loss incurred by Sears andcoveredbyAllstatewouldhavelessfinancialimpactonSearsthanaloss

1�9 Id.

1�0 Id. at101.

1�1 Id.

1�2 Id.

1�� 972F.2dat86�

1�� Id. at861.

1�5 Id.

1�6 Id.


incurredSearsbutcoveredbyanindependentinsurer.However,thecourtquestionedwhetherrisk-shiftingisnecessarilyarequisiteofinsurance.Itreasoned,inpart,1�7

[i]f retrospectively rated policies, called ‘insurance’ byboth issuers and regulators, are insurance for tax pur-poses—and the Commissioner’s lawyer conceded forpurposesofthiscasethattheyare—thenitisimpossibletoseehowriskshiftingcanbeasine qua nonof‘insur-ance.’

Individualsandcorporationspaypremiumstoinsurersfordifferentpurposes, inthecourt’sview.Individualsacquire insurancecoveragetoprotecttheirwealthandfutureincomeortoprovideincomereplacementorasubstitute forbequests to theirheirs.Corporations, suchasSears,acquireinsurancetospreadthecostofcasualtiesmoreevenlyovertimeand to benefit from an insurance company’s expertise and ability toprovide highly specialized insurance-related services. Corporations buy“loss-evaluationandloss-administrationservices,atwhichinsurershaveacomparativeadvantage,morethantheybuylossdistribution.”1�8

The court was satisfied that the transaction had sufficient char-acteristics of insurance to preclude a recharacterization. It increasedAllstate’s insurance pool, which reduced Allstate’s ratio of expected toactual losses. It allocated the administrative work on claims to Allstateemployees,whohada“comparativeadvantage”atthosetasks.Thecourtstatedthatthetransactionplaced,1�9

Sears’srisksinalargerpool,performingoneofthestan-dardinsurancefunctionsinawaythatacaptivedoesnot.More:AllstatefurnishesSearswiththesamehedgingandadministrationservicesitfurnishestoallothercustom-ers.Itestablishesreserves,paysstatetaxes,participates

1�7 Id. at862.TheSeventhCircuit’simplicitviewthataretrospectivelyratedpolicycannotinvolverisk-shiftingisflawed.TheServiceconcludedthattheretrospec-tiveratedarrangementinRevenueRuling8�-66,198�-1C.B.��,involvedrisk-shifting,forexample.Seenotes189-191andaccompanyingtext.Notwithstandingthecourt’sviewregardingthesignificanceofrisk-shifting,AllstateclearlyassumedrisksthatSearstransferredintheunderlyingtransaction.

1�8 Id. at862.

1�9 Id.at86�.


instaterisk-sharingpools(forinsolventinsurers),andsoon,justasitwouldifSearswereanunrelatedcompany.

AlthoughSearscoulddeduct itspremiumspaid toAllstatebecausetheunderlyingtransactionqualifiedasinsurance,thedeductionwasoff-setonSears’sconsolidatedreturnaspremiumincomeofAllstate.Signifi-cantly,however,Allstate coulddeduct reservesestablishedwhenSearsincurredacoveredlossbecausethecoveragequalifiedasinsurance.Thistax treatment reflects the underlying economics because Allstate coulddeductreserveincreasesthat ithadtoestablishwhenSearsincurredalosscoveredbyAllstate.

(l) Economic substance and arms length income allocations

InUnited Parcel Service of America, Inc. v. Commissioner,150theTaxCourt concluded that a captive arrangement that UPS created to coverdamageorlosstopackagesitcollectedandshippedforitscustomerswasasham.Inthetransaction,UPSwasliableforthefirst$100oflossfromdamage or loss to packages it collected and shipped for its customers.AcustomercouldpurchaseadditionalcoveragefromUPSbypaying25centsper$100ofadditionalliability.

UPScreatedandcapitalizedOPL,aBermudabasedcaptive, late in198�.OnDecember�1,198�,UPSdistributedsharesofOPLtoitsshare-holders,whichwerecurrentand formeremployeesaswell as families,trusts and estates of former employees. The distributions were taxabledividendstotheshareholders.UPSretainedasmallportionoftheOPLshares.

UPSrestructureditsexcessvaluechargeprogrambeginning198�.Ittransferredexcessvalueamounts,lessclaimspaidinexcessof$100,eachmonthtoNUF,awhollyownedsubsidiaryofAIGandadomesticinsur-ancecompany.NUFreinsuredtheEVCcoveragewithOPL.NUFretaineda$1millionfrontingservicefeeforagreeingtoreinsurethecoveragetoOPL.

UPS continued the functions and activities related to the EVC cov-erageandremainedliableforthedamageorlossofpackagesuptothelesserof$100ortheirdeclaredvalue.UPSdidnotchargeNUForOPLfortheextensiveservicesthatitprovidedwithrespecttotheEVCs.

150 78T.C.M.262(1999),rev’d. and rem’d.25�F.�d101�(11thCir.2001).


UPSarguedthatitrestructuredtheEVCarrangementforbonafidenon-taxbusinessconsiderations.UPS indicated that in198� itwascon-cernedthatcontinuingtoreceivetheEVCincomecouldbeillegalundertheinsurancelawofvariousstates.TheTaxCourt,however,concludedthatifUPSbelievedthatithadtodivestitselfofahighlyprofitablebusi-nessbecauseofconcerns that itwaspursuing illegalactivities itwouldhavescrutinizedthemeritofitsconcernsmorecarefullythanitdid.151

TheTaxCourtexamined theamount thatUPSpaid to transfer thecoverageinthereinsurancebecausethelackofanarmslengthpriceisanindicatorthatanarrangementisasham,accordingtothecourt.ThecourtconcludedthatUPSdidnotpayanarmslengthamountbecauseitcouldhaveobtainedthecoverageelsewhereforconsiderablylessthanitpaid.ItheldthatUPSearnedtheexcessvaluechargesitreceivedfromitscustomersfortheexcessvaluecoverageanddeniedthedeductionundersection162foramountspaidtoNUF.Inaddition,thecourtaddedinterest,andimposedseverepenalties.152

The Eleventh Circuit reversed and remanded the Tax Court’s de-cision.15�TheappellatecourtconcludedthattheEVCtransferhadbotheconomiceffectandabusinesspurpose.ThearrangementhadeconomiceffectbecausetherewasagenuineinsurancepolicybetweenUPSandNa-tionalUnion.Thecourtstatedthatalthough“theoddsoflosingmoneyonthepolicywereslim,NationalUnionhadassumedliabilityforthelossesofUPS’sexcess-valueshipper’s,againagenuineobligation.”15�Thereinsur-ancedidnot“completely foreclose theriskof lossbecausereinsurancetreaties,likeallagreements,aresusceptibletodefault.”155

Thecourtconcludedthat“alteringtheformofanexisting,bonafidebusiness”todothejobinamoretaxeffectivewayisagenuinebusinesspurpose.Abusinesspurposeispresentifataxpayerchoosesamongalter-nativewaystoacquirecapitalandappliesthemosttax-effectivemanner,forexample.InUPS,therewasa“realbusinessthatservedthegenuine

151 Id.at28�.

152 Id. at29�,29�and295

15� 25�F.�d101�(11thCir.2001).

15� Id.at1018.

155 Id.


needforcustomerstoenjoylosscoverageandforUPStoloweritsliabilityexposure.”156

TheEleventhCircuitremandedthecasetotheTaxCourttoaddresstheService’salternativeargumentthatsection�82or8�5shouldapplytoreallocatetheamountofincome(orotheritems)transferredtoNationalUniontoreflectanarmslengthtransaction.157

(m) Premiums paid to cover others’ risks

A company may pay premiums to a related insurer to cover otherpersons’risks.InRevenueRuling92-9�,158amanufacturerpaidpremiumstoa subsidiary insurancecompany forgroup-term life insurancecover-ageforitsemployees.TheServiceconcludedthatthearrangementwasnotself-insurancebecausethemanufacturerdidnotincurtheunderlyingeconomicriskof loss.159Theeconomicbenefitwasenjoyedby theem-ployees,nottheemployer,whichcouldnotbethebeneficiaryunderthecontract.Thearrangement,ineffect,wasaformofcompensationforthetaxpayer’semployees,whobenefitedfromthelifeinsurancecoverage.160TheServiceruled thatsimilarprincipleswouldapply to theacquisitionofaccidentandhealthinsurance,includingwaiverofpremiumcoverageupondisabilitythatwasprovidedbyanemployerforitsemployees.161

TheServiceappliedsimilarprinciplesinRevenueRuling92-9�162toanonlifeinsurancecompanythat“chargesitselfanamountrepresentingpremiumsforitsliabilitytopayinsuranceorannuitybenefitsforitsem-ployees.”16�Itheldthatthearrangementwasnotself-insurancebecause

156 Id. at1020.

157 Id.

158 1992-2C.B.�5.

159 Id.

160 Id.at�6.Thedeductiondepended,inpart,onthereasonablenessoftheag-gregatecompensationprovidedtotheemployees.

161 Id. at�6.TheServiceindicatedthatitwouldnotfollowtheGulfdecisiontothe“extentthatitdeniesadeductionforamountsaparentcorporationpaystoshiftrisksofunrelatedemployeesandtheirbeneficiariestotheparent’swhollyownedinsurancesubsidiary.” Id.

162 1992-2C.B.1��.

16� Id.at1�5.


itshiftedemployees’riskstoaninsurancecompany.Theamountthattheinsurerchargeditselfrepresentedadditionalgrosspremiumswritten.16�

(n) Insurance pools and “group captives”

Riskshiftinganddistributionmaybepresentifaninsurancecompanyisownedbynumerousunrelatedcompaniesandtheinsureronlycoversmembersofthatgroup.Indeed,intheextreme,amutualinsurercanbeviewed as a group captive because the insurer provides coverage onlyforitsowners.InRevenueRuling78-��8,165theServiceconcludedthataforeigninsurancecompanyownedby�1unrelated(shareholder)corpora-tionsqualifiedasaninsurancecompany.Noshareholderhadacontrollinginterestinthecompanyandnoshareholder’sindividualcoverageexceededfivepercentofthetotalinsuredrisks.Thearrangementsatisfiedtheriskshiftinganddistributionrequirementsbecausetheshareholder-insuredswereunrelatedandtheeconomicriskoflosscouldbedistributedamongtheshareholdersthatcomprisedtheinsuredgroup.166

TheServiceappliedtheprinciplesofRevenueRuling78-��8inLetterRuling96�2028,167inwhichanassessablemutualinsurancecompanywasownedby��mutualfundsandtwoforeigncompaniesthatoperatedina“manner intendedtoqualifyasaregulated investmentcompany[undertheInternalRevenueCode].”168Eachfundwasamoneymarketfundthatinvested in short-term securities. Although each of the �6 funds was a“NameX”mutual fund,noneof the fundswascontrolledby theparentcompanyoftheNameXconsolidatedgroup.Nosingleinvestordirectlyorindirectlybeneficiallyownedasmuchasonepercentoftheaggregatevalueofthestockofallofthefunds.

Thefundsproposedtoestablishamutualassessableinsurancecom-panytoinsureagainstdefaultrisksontheassetsheldbyeachofthefunds.Theinsurerwouldcoverlossesoninsurableassetsarisingfromthenon-paymentofprincipalorinterest,andotherspecifiedfinancialrisks.

16� Id.Cf. Treas.reg.section1.809-�(a)(1)(i),whichprovidessimilartreatmentforlifeinsurers.

165 1978-2C.B.107.

166 Id.at108.Thestatusofinsurancepoolsasinsurersandrelatedtaxissuesareaddressedatpages68-70.

167 March20,1996.

168 Id.


The Service concluded, in effect, that the coverage can qualify asinsuranceandthepremiumspaidtotheinsurermaybedeductibleasin-surancepremiums,althoughtheinsurerhadnoownersotherthanthe�6funds.Morefundstransferredrisksunderthearrangementthanthe�1corporationsthattransferredtheirrisksinRevenueRuling78-��8.

InRevenueRuling2002-91,169agroupofunrelatedbusinessesinanindustrythatfacedsignificantliabilityhazardsandwererequiredbyregu-latorstomaintainadequateliabilitycoveragecouldnotobtainaffordableinsurancefromcommercialinsurersasaresultofsignificantlossesfromunusuallysevere lossevents.The taxpayerandasignificantnumberofotherbusinessesintheindustryformedagroupcaptivetoprovideinsur-anceliabilitycoverageforcertainrisks.

Thegroupcaptiveprovidedcoverageonlyforthetaxpayerandothermembers.Nomemberownedmorethan15percentofthegroupcaptiveandnomemberheldmorethan15percentofanycorporategovernanceissue. The group captive was adequately capitalized and its operationswereindependentoftheoperationsofeachofitsmembers.

Thepremiumsthatthegroupcaptivechargedweredeterminedus-ingactuarialtechniquesandwerebased,inpart,oncommercialratesforsimilarcoverage.Thegroupcaptivepooledpremiumsfromitsmembersandnomemberhadtopayadditionalpremiumsifitslossesinanyperiodexceededthepremiumsthatitpaid.Nomemberreceivedarefundifitslosseswerelowerthanitspremiums.

TheServiceconcludedthatthecontractsissuedbythegroupcaptivetoeachofthemembers,includingthetaxpayer,wereinsurancecontractsbecause,

• eachmemberfacedtrueinsurablehazardsandwasrequiredtomaintaingeneralliabilitycoveragetooperateinitsindustry;

• eachmemberwasunabletoobtainaffordableinsurancecoveragefrom commercial insurers “due to the occurrence of unusuallyseverelossevents;”

• there was a real possibility that a member could realize lossesthatexceededthepremiumsthatitpaidandnomemberwasre-imbursedforpremiumsthatexceededitslosses;and,

• thetaxpayerandothermemberswereunrelated.

169 2002-2C.B.991.


Aprofessionalcorporationthatemployed10physiciansand15regis-terednursesmadenon-assessablepremiumpaymentstoamutualinsur-anceexchange, inRevenueRuling80-120.170Theexchangewasformedandqualifiedunderstatelawtoprovidemedicalprofessionalliabilitycov-erage toallphysiciansandmedicalprofessional corporations thatwerelicensedtopracticeinthestateandmaintainedatleast50percentoftheirpractice in the state. It insured more than 5000 physicians and severalprofessionalcorporations.TheServiceruledthatthepaymentswerede-ductibleaspremiumsundersection162becausethecompanycoveredasufficientnumberofpolicyholders,noonepolicyholderownedacontrol-linginterestintheexchange,andthepolicieswerenon-assessable.171

(o) Further guidance requested

The Service indicated in Notice 2005-�9172 that further guidance isneeded, and requested comments, with respect to “the standards fordeterminingwhetheranarrangementconstitutesinsurance”forFederalincometaxpurposes.17�Itstated,17�

[t]he Service and the Treasury Department are awarethatfurtherguidanceisneededinthisareaandrequestcomments on issues that should be addressed. In par-ticular, comments are requested regarding (1) the fac-tors tobetaken intoaccount indeterminingwhetheracell captive arrangement constitutes insurance and, ifso,themechanicsofanyapplicablefederaltaxelections;(2)circumstancesunderwhichthequalificationofanar-rangementbetweenrelatedpartiesasinsurancemaybeaffectedbyaloanbackofamountspaidas“premiums;”(�)therelevanceofhomogeneityindeterminingwhetherrisks are adequately distributed for an arrangement toqualify as insurance, and (�) federal income tax issuesraisedbytransactionsinvolvingfiniterisk.

170 1980-1C.B.�1.

171 Id. at�2.

172 2005-2C.B.1�.

17� Id.

17� Id.


(p) Ruling requests

InRevenueProcedure2002-75,theServiceindicatedthat,175

[w]e will now consider ruling requests regarding theproper tax treatment of a captive insurance company.However,somequestionsarearisinginthecontextofacaptive ruling request are so inherently factual (withinthemeaningofsection�.02(1)ofRev.Proc.2002-�)thatcontact should be made with the appropriate Servicefunctionpriortothepreparationofsuchrequesttodeter-minewhethertheServicewillissuetherequestedruling....InquiriesregardingwhethertheServiceconsidersaproposedcaptivetransactionsoinherentlyfactualthatitcannotrule,shouldbedirectedtoChief,Branch�,OfficeoftheAssociateChiefCounsel(FinancialInstitutions&Products)at(202)622-�970(notatoll-freecall).

Part III: Characterization of Other Arrangements and Contracts

(a) Reciprocal flood insurance exchange arrangements

Acontractcarriercorporationthathauledautomobilesfromanauto-mobileassemblyplantleasedlandonwhichitstoredtheautosandotherequipment inRevenueRuling60-275.176The landwasboundbya riverand therefore exposed stored property and leasehold improvements toflood damage. Under an agreement with a “reciprocal flood insuranceexchange,”thecompanyandotherssubjecttofloodriskmadeannualpay-mentsforaspecifiedperiodforfloodinsurancecoverage.Thecompanyacquired$150xofcoverageunderwrittenoveraten-yearperiod,ofwhich$15x(tenpercent)becameeffectivewhenthepolicywasissuedanddeliv-ered.Thecompany’spropertysubjecttofloodlossequaled$500x.

Theexchangecreditedonepercentoftheinitialpremiumtoitsgener-alreservefund,whichwasusedtocovercertainadministrativeexpensesand lossesexceeding thecatastrophe lossaccount.The remainderwas

175 2002-2C.B.997.

176 1960-2C.B.��.


allocatedtothecatastrophelossaccount.Thisaccountwaschargedwithapro-ratashareoflossesoccurringduringtheyearandforincurredrein-surancecosts,foreachsubscriber.Thecompanycouldwithdrawamountscreditedtoitscatastrophelossaccountaftertheendofthecurrentpolicyyear,butcouldnotwithdrawamountscreditedtothegeneralreservefund(althoughsubscribersshared in thenetbalanceof thegeneral reservefund,ifany,iftheexchangeterminated).

Net earnings (determined after a fee to an attorney-in-fact), if any,were credited to subscribers’ individual surplus accounts. A subscribercouldelect toapply theunencumberedbalanceof itsaccount toanan-nual premium deposit or withdraw it. Subscribers’ risks were dividedintoclassesorgrouped inaccordancewiththenatureof thebusiness’sfloodhazard,location,andflooddistrict.Asubscriber’scatastrophelossaccountwasdecreasedbyapro-ratashareoftheadjustedlossesincurredbysimilarlyclassifiedsubscribers.

TheServiceconcludedthatriskshiftingwasnotpresentintherecip-rocalfloodinsurancearrangement.Amajorfloodwouldprobablyaffectallpropertiesinaparticularfloodbasinsothattherewaslittlelikelihoodthatthesubscriberswouldshareanyrisk.177Proceedsreceivedintheeventofflooddamagewould,ineffect,beareturnofthesubscriber’sownmoneybecauseeachsubscriberwassubstantiallyunderinsured.

Thenon-withdrawableonepercentofthepremiumdepositthatwascreditedto thegeneralreserve fundwasforafixed liability,whichwasdeductibleasaninsuranceexpense.178TheServiceruledthatanannualpremiumdeposittotheexchangewasanondeductiblecontingentdeposittotheextentthatitwaswithdrawablebythecompany.179Earningsfromtheinvestmentofthefundsweretaxablewhentheywerecreditedtoanannualpremiumdepositorbecamewithdrawable.180

177 Id. at�5-�6.

178 Id. at�6.

179 Id.

180 Id.


(b) Retroactive insurance

Acasualtyinsurancecompanyprovided$�0xcoveragetoaninsuredin Revenue Ruling 89-96.181 The insured incurred a liability of an unas-certainedamountasaresultofacatastropheinJune1987althoughtheunderlyingfactsindicatedthatthetotalliabilitywouldexceed$1�0x.Theinsuredsubsequentlypaid$50xtoobtain$100xofadditionalinsurance,in-creasingthecoverageforthecatastropheto$1�0x.Theinsurerincreaseditsunpaidlossesby$100xanddeductedthe(discounted)presentvalueofthe$100xincreaseincoverageaslossesincurred.

TheServiceruledthattheretroactivearrangementdidnotqualifyasinsurance.Risk-shiftingwaslackingbecausethecatastrophecoveredbythecontractalreadyoccurred.TheServicestatedthatestablishingalossfor$100xindicatedthattheinsurerexpectedtohavetopaytheadditional$100xofcoverage.Thetaxpayerincurredtheriskthatpaymentsonthecontract would be made earlier than expected and that the investmentyieldfortheperiodfromthedatethatthepremiumwasreceiveduntilthedate theclaimwaspaidwouldbe less thanexpected,whichare invest-mentrisks.182

(c) Retrospective insurance

Many insurance policies provide for retrospective premium ad-justments at the end of the coverage period. The Tax Court stated inSears,18�

[t]he premium under a retrospectively rated policy issetusingthelossdatageneratedovertheyearinwhichthepolicy is in force.Theretrospectivelyratedinsuredtypicallypaysadepositat thebeginningof theyear.Attheendoftheyear,theinsuredreceivesarefundiflossexperiencehasbeen favorableandmayhave topayanadditional premium if loss experience is unfavorable.

181 1989-2C.B.11�.

182 Id.at115.ComparetheriskinvolvedinLe Gierse,whichisaddressedatnotes7-9.

18� 96T.C.61,66-67(1991),aff ’d., in part, rev’d. in part972F.2d858(7thCir.1992).Searsisaddressedatnotes1�5-1�9andaccompanyingtext.


Thereareusuallylimitsontheamountoftheadditionalpremiumthatmustbepaid.

Retrospective rating isdesigned, inpart, toadjustafter the fact forerrorsmadeintheestimationofthepurepremium.Inaddition,largein-suredsneedinsuranceprotectionprimarilyforlargelosses,ratherthanforsmalldeviationsoflossesfromexpectedlosses.Inaretrospectiveratedplan,riskloadingcompensatestheinsurancecompanyforbearinglossesgreaterthantheupperlimitormaximumoftheplan.

Aretrospectivelyratedarrangementshouldqualifyas insurance,atleast in part, if it transfers a sufficient amount of insurance risk that isdistributed with risks of others and satisfies the other requirements ofinsurance. In Technical Advice Memorandum 86�700�,18� the Servicebifurcated retrospective arrangements between a manufacturer and anunrelated insurer into insurance and noninsurance components. Undera retrospective endorsement for certain contracts, premiums for thecontractsequaledthepremiumforinsurancethatwasnotretrospectivelyratedplusaretrospectivepremium.Thesizeofthepremiumswasdeter-minedbyacomplexsetofrules,basedonadministrativecosts,profitsaswellascertainrisksthattheinsurerassumed.

The retrospectivepremiumsweredeterminedsixmonthsafter thecoverageperiodandannuallythereafteruntilallclaimsweresatisfiedoruntilthetaxpayerandtheinsurancecompanyagreedtoafinalretrospec-tivepremium.185Oneofthefactorsthatinfluencedtheretrospectivepre-miumafterthefirstdeterminationdatewastheactuallosspaymentsmadebytheinsurer.186

TheServicebifurcatedthetaxpayer’spremiumpayments intoade-ductibleinsurancecomponentandanon-deductible“reserveforlosses”component.Itindicatedthat,“noriskofloss[was]shiftedordistributedbythetaxpayertotheextentthattheamountpayablebytaxpayertotheinsurancecompanyisbasedontheactuallossesoftaxpayerduringthepe-riodcoveredbythearrangement”187sothatthetaxpayercouldnotdeductthecomponentofpremiumpaymentsbasedonsuchlosses.188

18� May2�,1986.

185 Id. at�.

186 Id.

187 Id.at8.

188 Id.at9.


The Service distinguished the retrospective rated contracts fromretrospectivelyratedcontractsaddressedinRevenueRuling8�-66,189 inwhich a medical malpractice insurance policy provided a retrospectiveratecreditrefundiftheinsurer’soveralllossexperiencewasnotasgreatasitprojected.190Theretrospectivecreditsinthe198�rulingwerebasedontheinsurancecompany’sexperiencewhereastheamountsultimatelypayablebythemanufacturerinthetechnicaladvicewerebased,inpart,onitsownlossexperienceforitspolicyyear.191

In Sears, the Seventh Circuit questioned whether risk shifting isnecessaryforatransactiontoqualifyas insurance, inpart,becauseret-rospectiveratedplansqualifyasinsurance.Thecourtstated,192

[i]fretrospectiveratedpolicies,calledinsurancebybothinsurersandregulators,areinsurancefortaxpurposes—andtheCommissioner’slawyerconcedesforpurposesofthiscasethattheyare—thenitisimpossibletoseehowriskshiftingcanbeasine qua nonofinsurance.

TheSeventhCircuit’simplicitpositionthataretrospectiveratedplannecessarily lacks risk-shifting is flawed. The Service concluded in Rev-enueRuling8�-6619�thattheretrospectiveratedplanaddressedintherul-inginvolvedrisk-shifting.TheService,however,mayscrutinizearrange-ments,includingretrospectiverateplans,thatdonotappeartosatisfytherequirementsofinsurance.19�TheServicemaybifurcateatransactionthat

189 198�-1C.B.��.

190 Thatthecontractsqualifiedasinsurancewasoneoftheunderlyingfactsoftheruling.Therulingaddressedwhetherapolicyholdercouldcurrentlydeducttheentirepremiumalthoughaportionmightberefunded.TheServiceruledthatitcould,inpart,becausethe“mereexpectancythatarefundmaybeforthcoming...didnotcreateanassetinthehandsofthe[policyholder}.”Id. at��-�5.

191 TAM86�700�(May2�,1986)at8.

192 972F.2d858at862(7thCir.1978).

19� 198�-1C.B.��.

19� Aretrospectiveratedplanmaybesuspectifitappearstoinvolvethetransferoflittleornoinsurancerisk.Cf.Notice2005-�9,2005-27I.R.B.1�,theServiceindi-catedthatmoreguidanceisneededintransactionsthatinvolvethetransferof“finiterisk.”Also comparethetaxtreatmentof“finitereinsurance”onpages120-121.


includesaninsurancecomponentandanon-insurancecomponentsuchasthetransactionaddressedinTechnicalAdviceMemorandum86�700�.195

(d) Bail and surety bonds

TheTaxCourtandSeventhCircuitheldthatbailbondsarenotinsur-ancecontractsinAllied Fidelity Corp. v. Commissioner.196TheTaxCourtstated,197

[i]ncommonunderstanding,aninsurancecontractisanagreementtoprotecttheinsured(orathird-partybenefi-ciary)againstadirectorindirecteconomiclossarisingfromadefinedcontingency.Theinsurerundertakesnopresentdutyofperformancebutstandsreadytoassumethefinancialburdenofanycoveredloss.Incontrast,theprincipalobligationof thebail surety is toproduce thedefendantattrial.

TheServiceconcludedinRevenueRuling68-101,198thatbailbondsarenotinsurancecontractsbecausetheydonotinvolveamonetarylossshiftedandassumedbyanaccusedorcourt.199

Suretybonds,however,canqualifyasinsurancecontracts.“Asuretyisonewhohasagreed(inwriting)toanswerforthedebt,default,ormis-carriageofanother.”200Suretybondsinvolvethreeparties.“Thebondisthejointandseveralobligationoftheprincipalandthesuretyinfavoroftheobligeenamedinthebond.”201TheServiceconcludedthatthesuretybonds at issue in General Counsel Memorandum �9,15�202 qualified asinsurancebecause the taxpayer, a surety, agreed toprotect theobligee

195 May2�,1986. TAM86�700�isaddressedatnotes18�-191andaccompany-ingtext.

196 66T.C.1068,107�(1976),aff ’d.572F.2d1190(7thCir.1978).

197 66T.C.at107�(citingCouch,Insurance 2d.,section1.2(1959)).

198 1968-1C.B.�19.

199 Id. at�21.

200 SeeS.Huebner,K.Black,Jr.,andB.Webb,Property and Liability Insurance (�thed.) (1996)pg.�08.

201 Id.

202 March1,198�.


fromtheeconomicriskoflossarisingfromadefaultbytheprincipal.TheServiceconcludedthatariskoflosswaspresentalthoughthesuretyhasarightofindemnityagainstadefaultingprincipal.

The Service distinguished the characterization of the surety bondsfromthatofthebailbondsinAllied Fidelity.Itstatedthatthesuretydidnotassumeadutytoperform,but“standsreadytoassumethefinancialburdenofanycoveredloss.”20�Abailbond,however,involvesthedutytoproduceadefendantattrialsothatitresemblesacontracttoperformaservice.20�

(e) Warranty & extended service contracts

TheServiceaddressedwhethercertainvehicleserviceagreements(VSAs)thatprovidedcoverageforthemechanicalbreakdownofcertainnewandusedmotorvehicleswereinsurancecontractsorprepaidservicecontractsinLetterRuling200509005.205Acompanyproposedtoissuecon-tractsthatwouldprovidecoveragethatexceededtheamountprovidedbyamanufactureroraguaranteeprovidedbyarepairer.Salesmenatmotorvehicledealerships,actingasagentsforthecompany,wouldsellthecon-tracts,retainaportionofthesalespriceasacommission,andremittheremaindertothecompany.

Thecompanypaidfeestoathirdpartyadministratorwithexpertiseinadjudicatingmechanicalbreakdownclaims,andtoalicensedinsurancecompanythatwould indemnifypurchasersof thevehicleserviceagree-ments if the company defaulted. The company allocated the remainingproceedstoacustodialaccountinitsnameasreserves,whichwereusedto pay claims under the vehicle service agreements. The company didnotmanufacture,sellorservicethemotorvehiclescoveredbytheagree-ments.

TheServiceconcludedthatthevehicleserviceagreementswerein-surancecontracts.Itstated,206

20� Id.

20� Id. TheTaxCourtquotedextensivelyfromAllied Fidelity,66T.C.at107�(1976),aff ’d.572F.2d1190(7thCir.1978).

205 Nov.17,200�.

206 Id. at�.TheServicealsoconcludedthatthecompanyqualifiedasaninsur-ancecompany.Seepages71-72.


[u]nlike prepaid service contracts, the VSAs are alea-torycontractsunderwhichCompany, forafixedprice,is obligated to indemnify the purchaser of the VSA foreconomiclossnotcoveredbywarrantiesprovidedbyamanufacturer, arising from the mechanical breakdownof, and repair expense to, a purchased motor vehicle.Thus, the VSAs are not prepaid service contracts be-causeCompany’sliabilityislimitedtoindemnifyingtheVSAcontractholderforlossesintheeventamechanicalbreakdownoccurs.Companydoesnotprovideanyrepairservices itself.Further,byacceptinga largenumberofrisks,CompanyhasdistributedtheriskoflossundertheVSAssoastomaketheaveragelossmorepredictable.

Acompanysoldhomewarrantycontractsunderwhich itagreedtomakespecifiedrepairsorreplacecoveredsystemsandappliancesforpur-chasersorsellersofpreviously-ownedhomes,inTechnicalAdviceMemo-randum 9�16001.207 The company, which was unrelated to any builderorrealestatecompany,didnotdirectlyrepairorreplaceafailedsystemorapplianceunderthehomewarrantycontracts.Repairsweremadebya network of independent contractors and technicians. Upon each visitfromacontractorortechnician,thecontractholderpaida“tradecallfee”andthetaxpayerpaidanyexcess.Thecontractswerenoncancellableandnonrefundable.

TheServiceconcludedthatthecontractsqualifiedasinsurance.Thecompanyassumedthecontractholder’sriskoflossfromthefailureofanycoveredsystemorapplianceduring thecontractperiodanddistributedthe risk by accepting a large number of risks. The contracts thereforesatisfiedtheriskshiftinganddistributionrequirementsofinsurance.

The Service distinguished its holding in Revenue Ruling 68-27,208inwhichitruledthatmedicalservicecontractsissuedbyahealthmain-tenanceorganizationthatprovidedservicesdirectlytosubscriberswerenot insurance contracts. The company in the technical advice did notprovideservicesperformedbyitssalariedemployeesbutcontractedwithindependentcontractorsandtechnicians.

207 June17,199�.

208 1968-1C.B.�15.Thisrulingisaddressedatpages70-71


In Letter Ruling 972701�209 the Service concluded that warrantysupplements that covered repairs to a product after the manufacturer’swarrantyexpiredqualifiedasinsurancecontracts.Thewarrantysupple-mentsgenerallycoveredrepairsmadenecessarybythefailureofmajorsystemsorcomponentsoftheproductarisingfromdefectsinmaterialsorworkmanshipbutnotfromaccidentsornormalwearandtear.

Customersof theproductcouldpurchase thewarrantysupplementcoverage from the taxpayer, which was the product’s exclusive UnitedStates distributor. The selling dealer was the taxpayer’s agent and theprimary provider of repairs. Participating dealers collected premiumschargedforthecoverageandtransmittedthem,lessacommission,tothetaxpayer.Thetaxpayerwasthesoleobligorunderthecontracts.

The taxpayerproposed thecreationofNewco1,whose soleorpre-dominantbusinesswouldbetoissueandadministerthewarrantysupple-mentprogram.ItalsoproposedtocreateNewco2,whichwouldprovideindemnificationcoverageforNewco1.

The Service concluded that the warranty supplements qualified asinsurance contracts. Risk shifting was present because Newco1 wouldbeobligatedtoindemnifyacontractholderfortheeconomiclossarisingfromafailureunderacoveredsystem.Inaddition,theriskwasdistributedbecauseNewco1wouldacceptnumerousrisks.

Incontrast,Serviceofficialsconcludedthat“expresslimitedwarran-ties”thatamanufacturerofconsumergoodsprovidedtoconsumersforitsproductsdidnotqualifyasinsuranceinILM200628018.210Underthistypeofwarrantya“manufacturer/sellerisobligatedtorepairorreplaceadefectiveproductifthedefectoccursduringaspecifiedperiodoftime.Theconsumersbearnoriskrelatedtoanydefectintheproductduringthewarrantyperiod.”211Manymanufacturersprovidesuchwarranties,atleast in part, to satisfy legal requirements to provide products that aremerchantableandfitforagivenpurpose.212

Themanufacturer“arguedthattheexpresslimitedwarrantiesitpro-videstoconsumersshouldbeconsideredinsurancecontractspurchased

209 April2,1997.

210 Feb.1�,2006.

211 Id.at�.

212 Id.


bytheconsumerswhentheybuy[themanufacturers’s]products.”21�TheServiceofficials,however,concludedthattheriskscoveredbythewar-ranties were business risks reflected in the price of its goods sold, notinsurancerisks.

“Thelimitedexpresswarrantycoversthegoodssoldfordefectsthatlikelyexistedinthegoodsatthetimeofsale.[Themanufacturer]doesnotseparatelysellthislimitedexpresswarranty—themanufacturer’slim-itedexpresswarrantycannotstandon itsown.”21�TheServiceofficialsreasonedinpartthat“[a]warrantythatcoversthegoodssoldfordefectsthatlikelyexistedinthegoodsatthetimeofsaleisnotinsuranceinthecommonlyacceptedsense.”215

Part IV: Commercial-Type Insurance: Section 501(m)

(a) Background

An organization described in section 501(c)(�) or 501(c)(�) can betax-exempt“onlyifnosubstantialpartofitsactivitiesconsistsofprovidingcommercial-typeinsurance,”undersection501(m).Whenitenactedsec-tion 501(m) as part of the Tax Reform Act of 1986, Congress was con-cernedthatcertaintax-exemptorganizationsthatprovidedtypesofinsur-ancecoveragethattaxableinsurancecompaniesalsoprovidedbenefitedfrom an unfair tax-based competitive advantage. The Ways and MeansCommitteeReportfortheTaxReformActof1986statedthatthecommit-teewas,216

concerned that exempt charitable and social welfareorganizationsthatengageininsuranceactivitiesareen-gagedinanactivitywhosenatureandscopeissoinher-entlycommercialthattax[-]exemptstatusisinappropri-ate.Thecommitteebelievesthatthetax-exemptstatusoforganizationsengagedininsuranceactivitiesprovidesanunfaircompetitiveadvantagetotheseorganizations.

21� Id.at2.

21� Id. at�.

215 Id.

216 H.R.Rep.No.�26,99thCong.1Sess.,pg.66�(Dec.7,1985).


InNotice200�-�1,217theServiceindicatedthatitintendstoissueproposedregulationsprovidingguidanceundersection501(m).

Acommercial-typeinsuranceactivityofanorganizationthatremainstax-exemptbecauseonlyan insubstantialpartof its activitiesconsistofprovidingcommercial-typeinsuranceistreatedasan“unrelatedtradeorbusiness”undersection501(m)(2)(A).Suchorganizationis“treatedasaninsurancecompanyforpurposesofapplyingsubchapterLwithrespecttosuchactivity.”218

Section501(m)(�)providescertainexclusionsfromcommercial-typeinsurance, including “incidental health insurance provided by a healthmaintenanceorganizationofakindcustomarilyprovidedbysuchorga-nizations,” under section 501(m)(�)(B). This exclusion has been verycontroversialandisaddressedindetailbelow.219

(b) Insurance pools

The Tax Court, in Florida Hospital Trust Fund, et. al. v. Commissioner220 and Paratransit Ins. Corp. v. Commissioner,221 and the UnitedStatesCourtofFederalClaims,inNonprofits’ Insurance Alliance of California v. United States,222 addressed whether insurance pools providedcommercial-type insurance, and therefore were not tax-exempt entitiesundersection501(m).Thecourtsexaminedwhetherthetypeofcoverageprovidedbythepoolswasprovidedbyfor-profitcommercialinsurers,andwhetherthepoolsweresubjecttooneoftheexceptionstosection501(m).Thecourtsconcludedthateachoftheinsurancepoolsprovidedcommer-cial-typeinsuranceandthereforewerenottax-exempt.22�

217 200�-1C.B.9�8.

218 Section501(m)(2)(B).Foranexampleofanactivitythat,intheService’sview,istaxedundersubchapterLasaresultofsection501(m)(2)seenotes2�7-2�8andaccompanyingtext.

219 Seenotes22�-252andaccompanyingtext.

220 10�T.C.1�0(199�),aff ’d.71F.�d808(11thCir.1996).

221 102T.C.7�5(199�)

222 �2Fed.Cl.277(199�).

22� ThesecasesareexaminedinE.Burstein,“InsurancePoolsProvideCom-mercial-TypeInsuranceinRecentCases,”9Insurance Tax Review�59(March1995).


(c) Incidental health insurance provided by an HMO

Background—AnindividualwhopaysafixedfeetoaHealthMainte-nanceOrganization(HMO)obtainshealthinsurancecoverageaswellasaccesstohealthcare.TheServicestatedinTechnicalAdviceMemoran-dum2000��0�6,22�

[w]henindividualsenrollinanHMOanddirectlyorin-directlypaytheHMOfixedpremiums,theHMOagreesthatitwill furnishhealthcareservicestotreattheirin-juries and illnesses.Under this arrangement, enrolleesprotectthemselvesagainsttheriskthattheywouldsuf-fereconomiclossfromhavingtopayforhealthcareser-vicesthatarenecessarybecauseofinjuriesandillnesses.By enrolling in an HMO, individuals shift their risk ofeconomiclosstotheHMO.

Commercial-type insurance does not include “incidental health in-suranceprovidedbyan[HMO]ofakindcustomarilyprovidedbysuchorganizations,” under section 501(m)(�)(B).225 That is, an HMO that isdescribedinsection501(c)(�)or501(c)(�)doesnot loseitstax-exemptstatusundersection501(m)ifprovidinghealthcareisitsprincipalactivityand the health insurance that it provides is incidental to suchprincipalactivity.

InNotice200�-�1,226theServiceindicatedthatitseekscommentsre-gardingtheexceptionforincidentalhealthinsuranceprovidedbyHMOsundersection501(m)(�)(B),specificallyrequesting,inter alia,commentson,227

whatfactorsorcriteriatheServiceshouldconsiderinde-terminingwhetherahealthmaintenanceorganization’s‘principalactivity’ isprovidinghealthcare[,]thefactorsor criteria the Service should consider in determiningwhether thehealth insuranceahealthmaintenanceor-ganization provides is ‘incidental to the organization’s

22� TAM2000��0�6(April27,2000)at5.

225 Section501(m)(�)(B).

226 200�-1C.B.9�8.

227 Id.


principalactivityofprovidinghealthcare’[and]howthisexceptionshouldbeappliedtoahealthmaintenanceor-ganizationthatdoesnotprovide‘healthcaretoitsmem-berspredominantlyatitsownfacilitythroughtheuseofhealth care professionals and other workers employedbytheorganization.’

When does an HMO provide incidental health insurance?—Whether an HMO is considered to provide incidental health insurancedependsontheunderlyingfactsandcircumstances.TheServicestatedthat toconclude that theHMOisproviding incidentalhealth insuranceit,228

mustbesatisfiedonthebasisofallthefactsandcircum-stances that any insurance element is a necessary andnormalconsequenceoftheHMO’sprincipalactivity[ofprovidinghealthcareservices]. Inmanycases, this in-quirywillbesubsumedwithintheanalysisofwhethertheinsuranceaspectsoftheHMO’sactivitiespredominate.

TheServiceaddressedtherelevantfactorsinGeneralCounselMem-orandum�9,829229andTechnicalAdviceMemorandum2000��0�6.2�0InGeneralCounselMemorandum�9,829,theServiceconcludedthatCon-gress applied the word “incidental” primarily in its qualitative sense,2�1indicatingthatlanguageinthelegislativehistoryoftheTaxReformActof1986supportsthisview.TheWaysandMeansCommitteeReportstatedthatcommercial-type insuranceexcludes“health insuranceprovidedbyahealthmaintenanceorganizationthat iscustomarilyprovidedbysuchorganization and is incidental to the organization’s principal activity ofprovidinghealthcare.”2�2

IntheService’sview, theprimaryfactor thatsupportsaconclusionthat an HMO qualifies for the incidental health insurance exception iswhethertheHMOtransfersallorasubstantialamountofitsfinancialrisk

228 Id. at2�.

229 August2�,1990.

2�0 April27,2000.

2�1 G.C.M.�9,829(Aug.2�,1990) at22.

2�2 H.R.Rep.�26,99thCong.1stSess.,pg.665(Dec.7,1985).


for“excessiveutilization”ofhealthcareservicestohealthcareproviders.The“bestexampleofanHMOprovidingonlyincidentalinsurancewouldbeonewhichhastransferredsubstantiallyalloftherisktoprovidersorthathasfixedthecostsinprovidingcare.”2��Consequently,HMOsthatqualifyundersection501(m)(�)(B)include,2��

an HMO operating under one of the common existingmodelsthat(1)compensatesprimarycarephysiciansex-clusivelyonasalary,capitation,orotherfixed-feebasis,and(2)shiftstothosephysicians(ortoHMO-affiliatedspecialists andhospitals) substantially all of the riskofexcessutilizationofspecialistsandhospitals,principallyprovideshealthcareandprovidesonlyincidentalhealthinsurance.

TheServicealsoconcludedthat,2�5

absentunusual facts[2�6],anHMOoperatingononeofthecommon,existingmodelsthatcompensatesprimarycare physicians exclusively on a salary, capitation orotherfixed-feebasisprincipallyprovideshealthcareandprovides only incidental health insurance, even thoughtheHMOpaysotherprovidersonafee-for-servicebasis.. . . Other HMOs must be evaluated against the abovestandardonthetotalityoftheirfactsandcircumstances.

OtherfactorscaninfluencewhetheranHMOqualifiesundersection501(m)(�)(B), such as the withholding of a significant portion of fees“otherwise payable” to providers. In Technical Advice Memorandum2000��0�62�7theServicestatedthat,2�8

2�� G.C.M.�9,829(Aug.2�,1990) at22.

2�� Id. at2�.

2�5 Id.at2�.

2�6 Unusualfactsincludecasesinwhich“providingorarrangingfortheprovi-sionofprimarycareisnotasignificantpartoftheHMO’sactivities,ortheHMOdoesnotuseagatekeeperapproach.” Id.at2�nt.2�.

2�7 April27,2000.

2�8 Id. at6.


anHMOthatpays itscontractedhealthcareprovidersalmostexclusivelyfees-for-serviceunderafeeschedulethat represents a meaningful discount from the physi-cians’usualandcustomarycharges(discountedfee-for-service)andwithholdsfromthesepaymentsasignificantpercentofthesefeesotherwisepayable,pendingcompli-ancewithperiodicbudgetorutilizationstandards,trans-ferstotheseproviders,ineffect,asubstantialportionofthefinancialriskassociatedwithitsobligationtofurnishhealthcaretoitsenrollees.

AnHMOdoesnot transferafinancial risk tohealthcareprovidersbypayingdiscountedfeesifthereisnowithhold,however.TheServicestatedthatacceptingdiscountedfeesinreturnforbeingassuredofhavingaflowpatientsisacommoncommercialpracticeforserviceproviders.2�9

Applying these standards—The Service concluded that an IPA-model HMO retained its tax-exempt status after the effective date ofsection 501(m) in General Counsel Memorandum �9,829.2�0 The HMOarrangedforthehealthcareofsubscribersbycontractingwithphysicianswhopracticedindependentlyandpaidthemonacapitatedbasis.Italsopaidabouthalfitsdirectcoststohospitalsonafee-for-servicebasis,whichresembled payments by a commercial insurer for hospitalization cover-age.

The Service reasoned that the HMO “was organized and operatedasa traditional IPA-modelHMOthatarrangedfor theprovisionofcareto its subscribers by contracting with selected physicians who practiceindependently.”2�1 It shifted its “riskassociatedwith thedemand forallphysicianservices...totheproviders.”Providingthehealthinsurance,includingthehospitalbenefitswas“qualitativelyincidental”totheHMO’sprincipalactivityofprovidingorarrangingfortheprovisionofservices,2�2althoughabouthalfofitspaymentswereforhospitalizationprovidedinamannerthatresembledhospitalizationprovidedbycommercialinsurance

2�9 Id.

2�0 August2�,1990.

2�1 Id.at2�.

2�2 Id.


companies.2��“[H]owanHMOpaysitsprimarycarephysiciansordinar-ilyisentitledtogreaterweightthanhowitpaysoutofarea(emergency)providers,referralspecialists,orhospitals.”2��

InTaxAdviceMemorandum2000��0�6,2�5an IPAmodelHMOde-scribedinsection501(c)(�)offeredtwomedicalplanstosubscribers.Un-derplanAsubscriberscoulduseonlyin-networkprimarycarephysiciansorphysiciansauthorizedbyanin-networkprimarycarephysician(exceptfor emergencies). Physicians were compensated on a capitated basis.TheServiceconcludedthatcommercial-type insurancewasnotpresentbecauseasubstantialamountofthefinancialriskwastransferredtotheprimarycarephysician.2�6

PlanBincludedapoint-of-serviceoption.Subscriberscoulduseanyphysicianincludinganout-of-networkphysician.TheServiceconcludedthatinsurancewaspresentunderplanBbecause“thephysiciansareonafee-for-servicebasiswhile[theHMO]retains[the]financialrisktofur-nishmedicalservices.”2�7PlanB,however,representedaninsubstantialpartof theHMO’stotalactivities.Consequently,althoughtheprovisionofservicesunderplanBwascommercial-typeinsurance,itwasaninsub-stantial part of the HMO’s activities so that it was subject to unrelatedbusinessincometax,whichwascalculatedundersubchapterL.2�8

Impact of Rush Prudential—TheServicemayhavetoreconsideritsviewsregardingtheimpactofatransferofsubstantialriskstoprovid-ersonthetaxtreatmentofHMOsundersection501(m)inresponsetheSupremeCourt’s2002decisioninRush Prudential HMO, Inc. v. Moran.2�9Rush, an HMO, denied Moran’s request to cover the cost of a medicalprocedurethatRushconsideredtobeunnecessary.Moranrespondedbymakingawrittendemandforanindependentmedicalreviewofherclaimunder the Illinois HMO Act. Rush refused the review, and argued that

2�� Id.at25.

2�� Id.

2�5 April27,2000.

2�6 Id.at7.

2�7 Id.

2�8 Section501(m)(2).

2�9 5�6U.S.�55(2002).


Moran’sstate lawsuit tocompelcompliancewith the IllinoisHMOActwaspreemptedbyERISA.

TheSupremeCourtaffirmedtheSeventhCircuit’sdecisionthattheIllinoisHMOlawwasnotpreemptedbyERISA.250WhileERISA“broadly”preempted state laws related to employee benefit plans, state laws that“regulat[e] insurance”arenotpreempted.TheCourtreasoned, inpart,thatHMOsareinsurersinadditiontoserviceproviders.ItdisagreedwithRush’sargumentthat“anHMOisnolongeraninsurerwhenitarrangestolimititsexposure,aswhenanHMOarrangesforcapitatedcontractstocompensateitsaffiliatedphysicianswithasetfeeforeachHMOpatientregardlessofthetreatmentprovided.”251

TheCourt,ineffect,viewedanHMOinthistypeofarrangementastheprimaryinsurerinareinsurancearrangementandindicatedthat“are-insurancecontractdoesnottaketheprimaryinsureroutoftheinsurancebusiness[.]”252RushdisavowsthedistinctionthattheServicestressesindetermining whether an HMO is providing incidental insurance undersection501(m)(�)(B)(althoughthedisputeinRushdoesnotinvolvethetreatmentofHMOsundersection501(m)).

(d) Other exceptions

Commercial-type insurance under section 501(m) does not includetheprovisionofinsuranceprovidedatsubstantiallybelowcosttoaclassof charitable recipients under section 501(m)(�)(A). Other exceptionsinclude,

• property/casualty coverage and/or retirement or welfare ben-efitsprovidedbyachurchorchurchassociationforsuchchurchorchurchassociation;25�

• charitablegiftannuities.25�

250 Id. at�87.

251 Id. at�71.

252 Id.

25� Sections501(m)(�)(C)and501(m)(�)(D).

25� Section501(m)(�)(E).


Congress narrowed the scope of section 501(m) by adding section501(n)aspartof theSmallBusinessJobProtectionActof1996.255Sec-tion501(m)doesnotapplytoqualifiedcharitableriskpoolsundersection501(n)(1)(A).Acharitableriskpoolmust,

• be organized and operated solely to pool insurable risks of itsmembers(otherthanrisksrelatedtomedicalmalpractice)andtoprovideinformationtoitsmembersregardingriskmanagementandcontrol;

• consistexclusivelyofmembersthataretax-exemptorganizationsdescribedinsection501(c)(�);

• beorganizedasanon-profitorganizationunderstatelawandex-emptfromstateincometax;

• obtain at least $1,000,000 in startup capital from non-membercharitableorganizations;

• becontrolledbyaboardofdirectorselectedbyitsmembersandprovideinorganizationaldocumentsthatmembersmustbetax-exemptandsatisfyotherrules.

Congressaddedsection501(n)becauseit“believedthatprovidingtax-exemptstatustonot-for-profitriskpoolswhosemembersareexclusivelytax-exemptcharitableorganizations,andwhichobtainsignificantcapitalfromnonmembercharitableorganizations,helpsmakeliabilityinsurancemoreaffordabletocharitableorganizations.”256

255 Pub.L.10�-188,section111�(a),110Stat.1755,1759-1760(Aug.20,1996).

256 JointCommitteeonTaxation,General Explanation of Tax Legislation Enacted in the 104th Congress,pg.69(JCS-12-6),Dec.18,1996.

What is Insurance? · PDF fileWhat is Insurance? annuity. The insurance policy and annuity...

Documents

Transcript of What is Insurance? · PDF fileWhat is Insurance? annuity. The insurance policy and annuity...