A Unified Approach to Captive Insurance Tax Policy

Article excerpt

Over the past three decades, the captive insurance movement has established itself as a significant alternative to traditional insurance. Today, there are more than 3,000 captive insurers worldwide, accounting for approximately 6.5 percent of U.S. commercial property-liability insurance premiums. As captives proliferate, controversy surrounding the tax-deductibility of both premiums paid to captives and reserves established by captives continues unabated. The federal government, through law and Internal Revenue Service (IRS) regulations, remains steadfast in its determination to disallow tax deductions for risk-financing mechanisms other than traditional commercial insurance. While the federal courts have generally supported this basic policy, they have often disputed government rationales.

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A definitive resolution of tax policy issues for captive insurers is long overdue. To be workable, an approach to these complex issues must meet a number of criteria. First, it must be theoretically sound and intuitively appealing, as well as consistent with the government's established policy of favoring traditional insurers over alternative risk management techniques. In addition, it must be fair and reasonable to all parties, reducing incentives for abuse, litigation, and distortions of economic activity. Finally, it must provide room for partial solutions across the spectrum from no tax-deductibility to full tax-deductibility, and result in consistent solutions for all arrangements involving captives, including variations in the ownership structure and in the types of business written.

U.S. insurance tax policy has consistently favored transfers of risk to traditional insurers over alternative risk management techniques, most notably self-insurance. This bias goes back as far as the Tariff Act of 1909, and has persisted through subsequent laws up to and including the Tax Reform Act of 1986. The principal advantage given to traditional insurance over self-insurance is that traditional insurers can deduct reserve amounts established for unearned premiums and losses incurred but not yet paid (including losses incurred but not yet reported), whereas selfinsurers are afforded no such deductions. Furthermore, only insurance premiums paid to traditional insurers are tax-deductible as general business expenses.

Probably the best explanation for the government's unwillingness to grant self-insurers tax advantages similar to those of traditional insurers is the concern that self-insurance transactions are less likely to be allocatively efficient because they are not subject to the economic forces of the insurance marketplace. In other words, the government implicitly insists that, for a corporate business expense to be consistent with public policy, and therefore fully tax-deductible, the associated transaction must be allocatively efficient from the corporation's perspective.

From the government's perspective, loss reserves for self-insurance should not be taxdeductible because they involve transactions that are not subject to the economic forces of the insurance marketplace, and therefore potentially inefficient. Even if a self-insurer establishes reserves in an "arm's-length" manner (that is, by imitating the capital requirements and actuarial methodologies of traditional insurers), the potential for inefficiency remains. For example, a self-insurer may have economic incentives to manage the investment of reserves in a manner that is much different from (and possibly riskier than) that of a traditional insurer. As a practical matter, it is highly unlikely that Congress would consider granting improved tax treatment to self-insurers given the current political landscape regarding insurance issues, and concerns about the federal budget deficit. In fact, even traditional insurers have come under attack in recent years, losing some of their previous tax advantages.

The situation is complicated by the fact that two fundamental tax doctrines collide in the case of captive insurers. …