Magazine article Risk Management

New Thoughts on the Tax Rules concerning Risk Retention

Magazine article Risk Management

New Thoughts on the Tax Rules concerning Risk Retention

Article excerpt

The Internal Revenue Service allows businesses to take income tax deductions for ordinary and necessary expenses. Any premium a firm pays for property or liability insurance is considered such an expense. However, money reserved for future property or liability losses, held either by the firm or a non-traditional commercial insurer, is not, according to the IRS, an ordinary and necessary business expense.

The IRS contends that insurance transfers risk, but other risk financing transactions do not. Therefore, no other risk financing transactions except insurance qualify for a pre-loss tax deduction. The key to deductibility, according to the IRS, is risk transfer. Pre-loss retention costs, such as additions to an organization's internal loss reserves or premiums paid to a captive insurer, are not tax deductible.

This IRS response refers to a 1941 U.S. Supreme Court ruling, Helvering v. LeGierse, that recognized insurance premiums as a deductible business expense but never said other pre-loss risk financing costs were not deductible. That's because in 1941 full-premium-in-advance insurance with no experience-sensitive adjustments was the only pre-loss risk financing technique in general use. However, just as risk financing has changed since then, so should the tax treatment of risk financing.

An Ignored Objective?

The IRS has advanced, and the federal tax courts have tended to endorse, interesting arguments for the government's position. These arguments contain terms that have been incorporated into the jargon of the risk financing community: "risk shifting," "risk distribution," "economic family doctrine," "unrelated risks" and "all events test." This language has spawned major insurance and other risk financing trends such as the movement of captives offshore and then back onshore as well as the development of association captives and rent-acaptive arrangements. In fact, it was largely in response to the IRS and tax court rulings that many captives turned in the late 1970s and early 1980s to writing unrelated business. Several ventures resulted in major financial failures because they were imprudent attempts at risk financing measures designed to meet complex rules for tax-favored risk transfers.

The confusion stemming from the transfer/retention criterion for tax deductibility of pre-loss risk financing costs should be replaced by "back-to-basics" public policy objectives as foundations for the tax treatment of risk financing plans. The real question is whether the differing tax treatment of commercial insurance and various risk retention plans serve the public interest in such fundamental areas as economic growth, stability, protecting lives and property and increased productivity

Rules Subsidize Insurance

The thrust of this change must be to eliminate the distinction between transfer and retention as the basis for granting or denying tax deductibility to pre-loss costs of risk financing. This criterion effectively grants favored tax treatment to insurance and builds tax barriers to risk retention plans. The Internal Revenue Code subsidizes insurance despite the fact that no one has ever shown that it is economically or socially preferable to retention for risk financing.

This insurance preference is strengthened by tax advantages. Even if the true costs of retention and insurance are equal, the tax deductibility of commercial insurance premiums makes insurance less costly than retention in after-tax dollars. This artificially low after-tax cost of insurance stimulates the excessive production and purchase of insurance. Consequently, the economy's resources for risk financing are inefficiently allocated, with too much dependence on commercial insurance and not enough reliance on retention-both of which are contrary to the goal of maximizing productive resources within an entire economy.

Rejecting the transfer/retention criterion for tax deductibility creates opportunities for using tax laws to promote the public interest by granting favorable tax treatment to risk financing techniques that foster economic growth and stability, the preservation of lives and property and increased productivity. …

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