The IRS Definition of "Insurance"

What Constitutes "Insurance" for Tax Purposes

Insurance companies that are not life insurance companies are subject to special federal income tax provisions under Subchapter L of the Internal Revenue Code [See IRC 831-835].

These provisions define an "insurance company" as "any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies" [IRC 816(a)].  Regulations caution that:

though its name, charter powers, and subjection to state insurance laws are significant in determining the business which a company is authorized and intends to carry on, it is the character of the business actually done in the taxable year which determines whether a company is taxable as in insurance company under the Internal Revenue Code [Treas. Reg. 1.801-3(a)(1)].

The terms "insurance" and "insurance contract" are not defined in either the Code or Regulations.  However, the Supreme Court in Helvering v. Le Gierse, (1941) 312 U.S. 531 [61 S.Ct. 646, 85 L.Ed. 996] and subsequent courts, has regularly determined that a contract of insurance must involve: (a) risk shifting, and (b) risk distribution.

A. Risk Shifting and Risk Distrubution

In basic terms, the concept of risk shifting focuses on the insured--is the insured transferring its risk to another?  The concept of risk distribution focuses on the insurance company--does the insurance company distribute its risk among many insureds?  The IRS described these fundamental aspects of an insurance contract:

Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by the insurance payment.  Risk distribution incorporates the statistical phenomenon known as the law of large numbers.  Distributing risk allows the insurer to reduce the possibility that a single claim will exceed the amount taken in as premiums and set aside for the payment of such a claim.  By assuming numerous relatively small, independent risks that occur randomly over time, the insure smoothes out losses to match more closely its receipt of premiums.  [Rev. Rul. 2002-90, 2002-52 C.B. 985]

Many courts, including the Tenth Circuit Court of Appeals in Beech Aircraft Corp. v. United States, have denied an income tax deduction for premiums paid by a parent to its' wholly-owned subsidiary, since in a parent-subsidiary relationship, the risk does not really leave the taxpayer [(10th Cir 1986) 797 F.2d. 920].

A third test has been added by several courts to determine whether, under all the facts, the contract is "insurance" in its commonly accepted sense [Harper Group and Includible Subsidiaries v. Commissioner (1991) 96 T.C. 45, affd. (9th Cir 1992) 979 F.2d. 1341].  Among the factors considered by these courts is whether the company issuing the contract is properly organized and operated and has sufficient capitalization, and whether the policies it issues are commercially reasonable in their terms and premiums.

B. Economic Famliy Doctorine (Abandoned in 2001)

In many of the early captive insurance cases and rulings, the Internal Revenue Service attacked the structure by stating that the risk shifting prerequisite cannot exist for tax purposes when a corporation purchases insurance within the same "economic family."  For example, in Reve. Rul 77-316 [1977-2 C.B. 53, see also Rev. Rul. 88-72, 1988-2 C.B. 31], a parent corporation acquired insurance policies for itself and its subsidiaries through a foreign wholly-owned subsidiary.  The ruling concluded that "one economic family" existed among the parent and its subsidiaries for purposes of the risk shifting and risk distribution tests.  According to the IRS:

There is no economic shifting or distribution of risks of loss with respect to the risks carried or retained by the wholly owned foreign subsidiaries. . . . In each situation described, the insuring parent corporation and its domestic subsidiaries, and the wholly owned "insurance" subsidiary, through separate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss.  To the extent that the risks of loss are not retained in their entirety by (as in Situation 2) or reinsured with (as in Situation 3) insurance companies that are unrelated to the economic family of the insureds, there is no risk-shifting or risk-distribution, and no insurance, the premiums for which are deductible under section 162 of the Code.

Insurance did not exist for federal income tax purposes under these facts.  Following substantial litigation, many courts rejected the "economic family" doctrine and, in Rev. Rul 2001-31 [2001-26 C.B. 1348], the IRS abandoned this line of attack.