A. General Principles
Section 162(a) allows the deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
Insurance premiums incurred by a business are generally deductible. See Treas. Reg. §1.162-1(a) (recognizing deductibility of “insurance premiums against . . . losses”).
Insurance companies are generally taxed on taxable income, including premium and investment income, in the same manner as other corporations.
Section 831(b), however, provides an alternative taxation regime for certain small insurance companies, commonly called “microcaptive” insurers.
An insurance company with annual written premiums of $1.2 million or less is subject to tax only on its investment income (and not its premium income), provided that it made a valid election under section 831(b).
To make a valid section 831(b) election, a captive entity must be an “insurance company.” An inherent requirement for a company to make a valid section 831(b) election is that it must transact in insurance.
The deductibility of insurance premiums in turn depends on whether the payments “were truly payments for insurance.”
Neither the Code nor the Treasury Regulations define “insurance.”
While insurance is deductible, amounts set aside in a loss reserve as a form of self-insurance are not. When the alleged insurer and insured are related — as will commonly be true in the case of microcaptive insurers — the line between insurance and self-insurance blurs.
Given the lack of a statutory definition, the meaning of insurance has thus been developed chiefly through a process of common-law adjudication.
The Supreme Court explained long ago that “[h]istorically and commonly insurance involves risk-shifting and risk-distributing.”
Building on this foundation, courts have looked to four nonexclusive but rarely supplemented criteria: [1] risk-shifting; [2] risk-distribution; [3] insurance risk; and [4] whether an arrangement looks like commonly accepted notions of insurance.
B. Risk Shifting
Whether a set of transactions gives rise to “insurance” must be examined from the perspective of both the insurer and the insured.
From the insured’s perspective, insurance is a risk transfer device, that is, a mechanism by which the insured obtains protection from financial loss by paying the insurer a premium.
By paying a premium, the insured externalizes his risk of loss by shifting that risk to the insurer.
For true risk shifting to occur, the insurer must be a well-capitalized company fully capable of paying claims and absorbing the risks transferred to it.
True risk transfer requires that the insured be reimbursed in all realistic loss scenarios, including those in which its claims exceed the premiums paid.
In a true reinsurance arrangement, the primary insurer remains liable if the reinsurer cannot pay, and risk transfer can arise in that way.
C. Risk Distribution
From the insurer’s perspective, insurance is a risk-distribution device, that is, a mechanism by which the insurer pools multiple risks of multiple insureds in order to take advantage of ‘the law of large numbers.’ This statistical phenomenon is reflected in the financial world by the diversification of investment portfolios.
Generally, risk distribution occurs when the insurer pools a sufficiently large collection of risks that are completely unrelated or are otherwise independent of each other. Risks are independent when the likelihood of a loss under one policy is independent of the likelihood of a loss under a separate policy.
The law of large numbers posits that the average of a large number of independent losses will be close to the expected loss. Thus, by assuming numerous relatively small, independent risks that occur randomly over time, the insurer smoothes out losses to match more closely its receipt of premiums. Distributing risk also allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as a premium.
D. Insurance in the Commonly Accepted Sense
Whether the arrangement constitutes insurance in the commonly accepted sense, courts will consider numerous factors, including whether the company was organized, operated, and regulated as an insurance company; whether the insurer was adequately capitalized; whether the policies were valid and binding; whether the premiums were reasonable and the result of an arm’s-length transaction; and whether claims were paid. Courts have also considered whether the premiums charged were actuarially deter-mined, whether comparable coverage was more expensive or even available, whether there was a circular flow of funds, and whether the putative insurance company was created for legitimate nontax reasons.
