Business Risk v. Insurance Risk. Current IRS Targets. Captive Insurance Taxation- Brief

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1 Business Risk v. Insurance Risk Current IRS Targets BG1 Pooling Arrangements Nominal risk shifting. Business owner reimburses the pool for significant losses Dubious Risks Widget shop in Nebraska obtaining tsunami risk Pricing of policies for terrorism and cyber risk. Captive Insurance Taxation- Brief Insurance premiums paid to an unrelated insurance company are deductible under Reg (a). Self-insurance occurs when a company transfers money to an account in order to pay its claims. Self-insurance is not deductible. What happens when premium payments are made to a wholly-owned insurance company? Are these premiums deductible third-party insurance or nondeductible selfinsurance?

2 Slide 2 BG1 recent seminar discussing IRS targets IRS has been playing catch up Ben Glenn, 12/3/2013

3 Captive Insurance Taxation- Brief (Cont.) There is no definition of insurance in the IRC or Regulations. No indication in IRC or Regulations of the proper treatment of payments by parent corporations to captive insurance companies IRS applied the economic family theory to captive insurance companies. After several court cases (Ocean Drilling & Exploration Co., Malone & Hyde, Inc. & AMERCO, Inc.) the Service issued Rev. Rul abandoning the economic family theory. Basic Requirements for Taxation as Insurance Three Prong Test 1. The arrangement involves the existence of an insurance risk 2. There is both risk transfer and risk distribution 3. The arrangement is for insurance in its commonly accepted sense. Insurance Risk vs. Business Risk Traditional coveragessuch as general liability, medical malpractice, and product liability are more obviously identified as insurance risks. More exotic coveragesmay not be insurance risks. Availability in the open market is not determinative in this regard. An insurance risk cannot be a business risk, but there is no bright line test to determine one from the other.

4 Legal Standards IRS View of Insurance Risk (IRS Litigation Guideline Memorandum 1990) PURE RISKS Only a "pure risk" is an insurance risk Hazards that expose a business to adverse but uncertain financial consequences A "pure risk" can only have bad or neutral result A speculative or investment risk can have a good, bad or neutral result e.g., risk of a profit or loss from a business taking a position on a foreign currency Edyth LeGiers e (80 years old) Helvering v. LeGierse a) Annuity Contract $4,179 $ per year for life b) Life Insurance Contract $22,946 $25,000 to beneficiary upon death Connecticu t General Life TOTAL PREMIUM = $27,125 TOTAL PAYMENT = $25,000 + annuity Mrs. LeGierse died one month after signing contracts. payment

5 Helvering v. LeGierse Court concluded insurance policy would not have been issued without annuity contract Contracts had to be considered together Annuity and insurance are opposites and neutralize the risk in the other Total payments by Mrs. LeGierseexceeded face value of the insurance policy Any risk the prepayment would earn less than amount paid under annuity was an investment risk similar to the type risk assumed by a bank Commissioner v. Treganowan FORTUITOUSNESS Insurance risk requires uncertainty as to whether the risk will materialize Fortuitousness must exist during the term of the insurance contract Fortuitousness does not exist if the loss is reasonably certain or expected to occur during the policy period TAM Facts and circumstances analysis as to whether an arrangement is insurance for federal tax purposes Policies in question provided insurance to protect the residual value of leased assets at the end of the lease term TAM concludes policies protect against an investment risk due to market forces To be an insurance risk the decline in value must be result of a casualty event TAM also concludes where market forces depress asset values the risks are interdependent and there is no risk distribution

6 Rev. Rul medical service contract to provide medical service through the organization's employed physicians and staff was predominentlythe furnishing of medical services on a fixed price basis rather than an insurance risk Rev. Rul and Rev. Rul contract to retroactively cover losses from catastrophe lacked fortunity and was an investment risk Allied Fidelity Corp. v. Commissionerrisk transferred must be of economic loss. Business Risk v. Insurance Risk Discussion Business Risk A risk for loss so closely tied to an insured s way of doing business that is not considered to be an appropriate subject of insurance coverage. Such risks are typically addressed as overhead (i.e. the cost of the loss is included in the price of the business s products or services) or as a subject for loss control. The cost of replacing a defective product or redoing defective work is a classic business risk and is therefore excluded from most liability polices

7 Insurable Risk For a risk to be insurable, several things need to be true. Must able to charge a premium high enough to cover not only claims expenses, but also to cover the insurers expenses i.e. the risk cannot be catastrophic, or so large that no insurer could hope to pay for the loss. The nature of the loss must be definite and financially measurable. The loss should be random in nature, else the insured may engage in adverse selection Speculative Risk Uncertain prospect of financial gain or loss. A business investment that could either return a profit or sustain a loss, such as the purchase of a common stock, is an example of a speculative risk. In most instances, speculative risks are not insurable Gambling Investing Starting a business Relationships Buying a Home Captive Policy Examples Extended Warranties Property Buy downs Deductible Buy downs Medical Stop Loss Reputational Risk SEC Investigation Cyber risk DIC Loss of Key Customer Terrorism BI Tax Audit Defense