The definition of insurance and why it matters for captives

By Matthew Queen

The IRS continues its war on captive insurance through its annual announcement that microcaptive insurance companies remain on the Dirty Dozen list. Yet, the IRS declines to adhere to a coherent definition of insurance and leverages byzantine case law against taxpayers in an arbitrary and capricious manner.

The IRS adheres to a definition of insurance created for life insurance companies. The test provides there must be an arrangement with an insurable interest, there must be risk shifting and distribution, and there must be insurance in its commonly accepted sense.

The four elements of this test are vague with contradictory interpretations in U.S. Tax Court. This poses a threat to small businesses making the 831(b) election, as well as larger, mid-market firms that do not.

The origins of the IRS’s four-part insurance test are a 1940s case known as Helvering v. Le Gierse, in which the Supreme Court resolved a tax shelter involving life insurance policies.

This led to the court’s opinion that risk shifting and distribution were critical to insurance, as well as the creation of “insurance in its commonly accepted sense” as a vague test to which to hold captive insurance companies.

Each prong has either been undermined by later court rulings, applied inconsistently or is no longer relevant to today’s insurance market.

The holding in Helvering v. LeGierse was never intended to be a holistic definition of insurance. The discordant case law flowing from the case proves this point.

First, there is no consensus on risk shifting. Risk shifting makes sense for life insurance where 100% of the risk is shifted to the carrier. It makes less sense in property/casualty insurance where large deductibles and self-insured retentions are commonplace.

The tax court presumes that captives achieve “risk shifting” when they are adequately collateralized under the requirements of their domicile. Consequently, any captive insurance company with a license passes this test. Risk shifting is a meaningless standard.

The second flawed prong of the IRS’s test is risk distribution. Case law dissecting risk distribution is contradictory and the only thing actuaries agree on is that the standard is complicated. The IRS takes the position that anything less than an absurd number of risks fails risk shifting whereas actuaries routinely argue that risk shifting may occur with as few as several dozen points of risk.

Risk distribution’s inherently uncertain standard arms the IRS to challenge any captive insurance transaction. If the IRS pursues this line of argument against larger captives, it will one day cut all but the biggest captives in the world out of the market. Small and mid-market companies simply cannot achieve the number of points of risk the IRS seems to believe are necessary. This is another ridiculous criterion for something to be insurance, as other policies covering risks without thousands of data points already exist, and yet insurers seem to have no issue generating proper rates for them.

The IRS also leans heavily on the “insurance in the commonly accepted sense” prong. This evolving test exists as a generic sniff test inquiring as to whether a captive more or less acts like a commercial insurance carrier. There is no objective standard. It is not a meaningful test since there is no bright-line rule to be followed.

As an alternative, I propose the following as a more appropriate framework:

If captive insurance companies pay claims, then there should be a rebuttable presumption that the transaction is insurance.
If the captive insurance company has no claims, then appropriate factors to consider include:
- The insured possesses an interest in the insured thing.
- The insured is subject to a risk of loss by losing the thing or an impairment of interest in the thing.
- The insurer assumes at least some risk of the loss.
- The insurer’s financials indicate the ability to pay that loss.
- In consideration for this service of assuming the risk of loss, the insurer accepts premiums.
- Insurance for the risk of loss is the primary motivation for the transaction.
- This type of transaction constitutes something that should be regulated for the benefit of the public interest.

This would be a more reasonable, objective method to determine what insurance is and can be applied to a wide variety of situations, meaning it would not need to be revisited for many years. I hope the IRS is listening.

Matthew Queen is the owner of The Queen Firm. Contact him at [email protected].