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

The concepts of risk shifting and risk distribution are two issues that are especially important for the pure captive insurance company (see Q 8172). In order to be treated as an insurance contract, both risk shifting and risk distribution must be present.¹ If the captive transaction is not treated as an insurance contract, the tax deduction for insurance premiums may be unavailable.²Risk 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