8175 / What are the risk shifting and distribution requirements that allow a captive insurance contract to qualify for favorable tax treatment?

Risk shifting is traditionally found to be present in an insurance contract because the insured party shifts the risk of loss to the insurance company. Risk distribution occurs when the insurance company that assumes the risk of loss distributes this risk among a pool of insured entities.³

The problem captive insurance companies often face in meeting these requirements is that both the insured and the insurer are usually owned within the same corporate group, so the risk never leaves that group. The IRS has ruled that the insurance premiums paid by a parent company to its subsidiary captive entity were not deductible.⁴ In Revenue Ruling 77-316, the IRS introduced the concept of the “economic family” and found that because the parent entity and wholly-owned captive insurance company were a part of the same economic family, no risk shifting was present because the risk remained within the corporate “family.”⁵ Further, risk distribution was not present because the captive did not distribute its risk among a group of insured entities, since it insured only entities within its own economic family.⁶

Though the IRS abandoned this rigid approach to captive insurance transactions in Revenue Ruling 2001-31, where it announced that it would examine these transactions on a case-by-case basis, the basic analysis is still important because risk shifting and risk distribution remain required elements of the insurance contract.⁷

Risk shifting and risk distribution have been found to exist in several captive insurance arrangements. In Revenue Ruling 78-338, the IRS found risk shifting and risk distribution existed where the captive was owned by 31 unrelated shareholders, none of whom owned a controlling stake in the captive.⁸ In Revenue Ruling 2002-91, the taxpayer-company and a small group of companies in the same industry formed a group captive (see Q 8172) where an insurance contract was found to exist.⁹ The captive provided insurance only to the group of owners, none of whom controlled more than a 15 percent interest in the captive. The IRS allowed the deduction, finding that an insurance contract existed because:

1. an insurance risk was present;


2. the risk was shifted and distributed; and


3. the transaction was of a type that is insurance in the commonly accepted sense.¹⁰

The IRS noted that there was a very real possibility that any member of the group could sustain losses in excess of the premiums that it paid to the captive. By paying premiums to the captive, risk was shifted to, and distributed among, the unrelated group.

The IRS has privately ruled that an insurance contract existed in a “brother-sister” captive arrangement where the parent entity formed a captive subsidiary to provide insurance to its “sibling” subsidiaries.¹¹ The IRS found that an insurance relationship was present and listed several factors that were important in its determination:

1. Neither the parent entity nor any related entities guaranteed the subsidiary’s performance;


2. The captive subsidiary was adequately capitalized;


3. There was a legitimate insurance-related reason for forming the captive (in this case, recent disruptions in the market for workers’ compensation insurance);


4. The captive was fully regulated for most of the year as a U.S. insurance company;


5. The captive assumed the workers’ compensation risks of several of its sibling subsidiaries, distributing the risk of loss among this pool of insureds.

---

Planning Point: These factors, among others, are those typically relied upon by the IRS in the facts-and-circumstances inquiry employed to determine whether a valid insurance contract exists.¹²

---