TAM 1117027: A managed-care HMO was taxable as an insurance company

Plain-English summary

The IRS considered whether a managed-care HMO was subject to the insurance-company tax rules in Part II of Subchapter L. The HMO arranged health care through provider networks, received fixed premiums from subscriber groups, and remained responsible for providing covered care. The IRS concluded that the arrangements involved insurance risk, risk shifting, and risk distribution, and that the HMO was therefore taxable as an insurance company for federal income tax purposes. The result was based on the majority of the HMO's business being its comprehensive hospital and medical line of business.

Ruling snapshot

• Question: Was the managed-care HMO an insurance company subject to Part II of Subchapter L for the years at issue?
• Outcome: Advice given.
• Key authorities: IRC §§ 816(a), 831(c); Helvering v. LeGierse, 312 U.S. 531 (1941); Rush Prudential HMO, Inc. v. Moran, 536 U.S. 355 (2002); AMERCO, Inc. v. Commissioner, 979 F.2d 162 (9th Cir. 1992); Cardinal Life Insurance Co. v. United States, 300 F. Supp. 387 (N.D. Tex. 1968), aff'd, 425 F.2d 1328 (5th Cir. 1970).

Full text (IRS public release)

                      INTERNAL REVENUE SERVICE
            NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                     December 03, 2010

                                             Third Party Communication: None
                                             Date of Communication: Not Applicable

Number: 201117027
Release Date: 4/29/2011
Index (UIL) No.: 831.00-00
CASE-MIS No.: TAM-129839-10

Acting Director, Field Operations

     Taxpayer's Name:                        --------------------------------------------
     Taxpayer's Address:                     ----------------------
                                             -------------
                                             --------------------------------------
     Taxpayer's Identification No            ----------------
     Year(s) Involved:                       --------------------
     Date of Conference:                     -----------------------

LEGEND:

Taxpayer = --------------------------------------------

State A = -----------

Year 1 = -------

Year 2 = -------

Year 3 = -------

This memorandum responds to your request for technical advice dated July 21, 2010.

ISSUE:

Whether for the taxable years Year 2 and Year 3, Taxpayer is subject to the provisions
of Part II of Subchapter L of the Internal Revenue Code and thereby taxable as an
insurance company for federal income tax purposes.

TAM-129839-10 2

CONCLUSION(S):

For the years at issue, Taxpayer is subject to the provisions of Part II of Subchapter L of
the Internal Revenue Code and thereby taxable as an insurance company for federal
income tax purposes.

FACTS:

Taxpayer is a managed health care organization that began operations in May of Year

1. Taxpayer is owned by four health care associations. Taxpayer is licensed in State A
   as a Health Maintenance Organization (“HMO”) and is considered a “Network-Model”
   HMO. Taxpayer is regulated by State A pursuant to the relevant State A statutory
   provisions and files an Annual Statement as required by the National Association of
   Insurance Commissioners (NAIC). The Taxpayer is also subject to periodic
   examination of its operations by State A’s Department of Insurance.

Taxpayer does not directly provide health care to its subscriber members, rather
Taxpayer contracts with networks that in turn arrange for the provision of health care
services through participating health care providers. Taxpayer’s subscribers are both
small and large employers, including primary care physicians from a broad network of
Physician Hospital Organizations.

Taxpayer has three lines of business and maintains a variety of managed care options
among the three lines. The majority of Taxpayer’s premium income is derived from its
comprehensive hospital and medical line of business. The remaining premium income
consists of other unrelated coverage.

Taxpayer offers both HMO benefit and point-of-service benefit plans to its subscriber
members. Taxpayer’s HMO benefit plan is the most popular health insurance option.
The HMO benefit plan allows members and their dependents to choose their own
primary care physician, pay a predictable copayment or coinsurance for in-network
services, seek in-network specialists without a primary care referral, enroll in certain
wellness programs, and benefit from disease and complex case management at no
additional cost. In addition, primary care physicians are available to assist members in
navigating the health care system. Employers are also able to actively participate in
plan design under the Taxpayer’s HMO benefit plan.

The Taxpayer’s point-of-service benefit plan offers employers and their employees the
flexibility of a traditional insurance plan, but with the cost containment feature of a
managed care plan. Taxpayer’s benefit plan allows members to choose primary care
physicians, receive full in-network benefits, including in-network benefits for copayment
and coinsurance, and seek in-network primary care physician’s assistance in navigating
the health care system. Members can see most in-network specialists without a primary

TAM-129839-10 3

care physician’s referral. Members are allowed to access out-of-network providers
without a referral, but must pay higher out-of-pocket expenses.

Taxpayer also offers an alternative to their classic HMO and point-of-service plans that
includes features of both. Under the alternative plan, members can select either the
higher premium preferred provider program or at no additional cost, the HMO network.
Members can see most in-network specialists without a primary care physician referral,
enroll in certain wellness programs, receive assistance in navigating the healthcare
system and receive disease management and complex case management. Health plan
benefits under the alternative plan are the same regardless of which network option is
chosen. Members and their dependents must select the same network. Employers can
actively engage in benefit plan design.

Subscriber groups are most commonly employers and consist of an organization, firm or
governmental entity that has contracted with Taxpayer to arrange health care services
for its employees, retirees, their spouses and dependents. Subscriber members are
most commonly employees and consist of an individual who meets the eligibility
requirements for membership in one of Taxpayer’s health care plans.

Taxpayer and each employer or subscriber group enter into a subscriber group service
contract agreement. This agreement between Taxpayer and the respective employer or
subscriber group expresses the agreed upon contractual rights and obligations of all
parties involved and describes the costs, procedures, conditions, eligibility, enrollment,
covered services, limitations, exclusions and other obligations to which subscriber
members are subject under Taxpayer’s plans. In exchange for health care services
provided under the selected managed care options, Taxpayer received premium income
from the subscriber group as provided for by the group service contract agreement.
The premium is calculated based upon factors such as the type of benefit plan selected,
the age of the member and the number of members enrolled in the plan.

Networks consist of licensed physicians and other healthcare professionals, hospitals,
skilled nursing facilities, home health care agencies and other providers of health care
services. The networks enter into written agreements with Taxpayer to provide health
care services to members of subscriber groups. Taxpayer publishes a “provider
directory” containing the names, addresses and phone numbers of all participating
providers. Taxpayer does not contract directly with the participating providers. Under
these agreements, sometimes referred to as physician network agreements, Taxpayer
compensates the network on a monthly basis for the provision of health care services to
its members by its health care professionals on a or per person rate. Generally, this is a
fixed fee arrangement provided for in the agreement between Taxpayer and the
network.

TAM-129839-10 4

LAW AND ANALYSIS:

I.R.C. § 831(c) provides that the term “insurance company” has the same meaning
given to such term by I.R.C. § 816(a). Under I.R.C. § 816(a), the term “insurance
company” means “any company more than half of the business of which during the
taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks
underwritten by insurance companies.” The determination of whether an arrangement
constitutes insurance is made on a yearly basis and thus, each year must be
considered independently. See I.R.C. § 816(a); Cardinal Life Insurance Co. v. United
States, 300 F.Supp 387, 392 (N.D. Tex. 1968), rev’d on other grounds, 425 F.2d 1328
(5th Cir. 1970).

Neither the Code nor the regulations define the terms “insurance” or “insurance
contract.” The standard for evaluating whether an arrangement constitutes insurance is
set forth in Helvering v. LeGierse, 312 U.S. 531, 539 (1941), in which the Court stated
that “historically and commonly insurance involves risk-shifting and risk-distributing” in a
transaction “which involve[s] an actual ‘insurance risk’ at the time the transaction was
executed.” Insurance has been described as “involv[ing] a contract, whereby, for
adequate consideration, one party agrees to indemnify another against loss arising from
certain specified contingencies or perils.” Epmeir v. United States, 199 F.2d 508, 509-
10 (7th Cir. 1952). Insurance is contractual security against possible anticipated loss.
Id. Cases analyzing “captive insurance” arrangements have distilled the concept of
“insurance” for federal income tax purposes to three elements, applied consistently with
principles of federal income taxation: (1) involvement of an insurance risk; (2) shifting
and distribution of that risk; and (3) insurance in its commonly accepted sense. See,
e.g., AMERCO, Inc. v. Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992), aff’g 96
T.C. 18 (1991).

The risk transferred must be risk of economic loss. Allied Fidelity Corp. v.
Commissioner, 572 F.2d 1190, 1193 (7th Cir. 1978). The risk must contemplate the
fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F.2d
288, 290-91 (2d Cir. 1950), and must not be merely an investment or business risk.
LeGierse, 312 U.S. at 542; Rev. Rul. 89-96, 1989-2 C.B. 114.

Risk shifting occurs if a person facing the possibility of an economic loss transfers some
or all of the financial consequences of the potential loss to the insurer, such that a loss
by the insured does not affect the insured because the loss is offset by a payment from
the insurer. See Rev. Rul. 60-275, 1960-2 C.B. 43 (concluding risk shifting not present
where subscribers, all subject to the same flood risk, agreed to coverage under a
reciprocal flood insurance exchange); see also Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987) (holding risk shifting not present
where captive covered only related-party risk).

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Risk distribution incorporates the statistical phenomenon known as the law of large
numbers. The concept of risk distribution “emphasizes the pooling aspect of insurance:
that it is the nature of an insurance contract to be part of a larger collection of
coverages, combined to distribute risks between insureds.” AMERCO and Subsidiaries
v. Commissioner, 96 T.C. 18, 41 (1991), aff’d 979 F.2d 162 (9th Cir. 1992). In
Treganowan, the court explained that “[b]y diffusing the risks through a mass of
separate risk shifting contracts, the insurer casts his lot with the law of averages. The
process of risk distribution, therefore, is the very essence of insurance.” Treganowan,
183 F.2d at 291 (quoting Note, The New York Stock Exchange Gratuity Fund: Insurance
That Isn’t Insurance, 59 Yale L.J. 780, 784 (1950)); see also Beech Aircraft Corp. v.
United States, 797 F.2d 920, 922 (10th Cir. 1986), (stating risk distribution “means that
the party assuming the risk distributes his potential liability, in part, among others”);
Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993)
(stating “[r]isk distribution involves spreading the risk of loss among policyholders”).

Distributing risk allows the insurer to reduce the possibility that a single costly claim will
exceed the amount taken in as premiums and set aside for the payment of such a claim.
By assuming numerous relatively small, independent risks that occur over time, the
insurer smoothes out losses to match more closely its receipt of premiums. Clougherty
Packing Co. v. Commissioner, 811 F.2d at 1300. Risk distribution necessarily entails a
pooling of premiums, so that a potential insured is not in significant part paying for its
own risks. See Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989); see
also Steere Tank Lines, Inc. v. United States, 577 F. 2d 279 (5th Cir. 1978) (holding in
part that because Plaintiff paid all the “premiums,” there was no genuine pooling of
premiums). In Perano v. Commissioner, 130 T.C. 93 (2008), the court held that
there was no risk distribution among a broad number of individuals where the risk
was spread between two individuals.

In Rush Prudential HMO, Inc. v. Moran, the Supreme Court of the United States
ruled that the federal Employee Retirement Income Security Act (ERISA) did not
preempt an Illinois statute for medical review. 536 U.S. 355 (2002). In its discussion,
the Court concludes that HMOs are insurers that provide health care. Id. at 367.

“‘The defining feature of an HMO is receipt of a fixed fee for each patient enrolled under
the terms of a contract to provide specified health care if needed.’” Thus, the HMO
“‘assumes the financial risk of providing the benefits promised: if a participant never
gets sick, the HMO keeps the money regardless, and if a participant becomes
expensively ill, the HMO is responsible for the treatment….’” Id. The designs of HMOs
are far more broad than the “simple truism that all contracts are, in some sense,
insurance against future fluctuations in price” primarily because “HMOs actually
underwrite and spread risk among their participants[,]” a feature distinctive to insurance
and insurance companies. See id.; see also SEC v. Variable Annuity Life Ins. Co. of
America, 359 U.S. 65, 73 (1959).

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The Court points out that Congress in establishing and defining the phrase “Health
Maintenance Organization,” intended that HMOs should develop as a novel type of
health care delivery system – one that would “bear and manage risk.” Rush Prudential,
536 U.S. at 368. In fact, HMOs have taken over much of the business formerly
performed by traditional indemnity insurers and most every HMO is regulated as an
insurer under state law. See id. at 368-69, 372. As the Rush Prudential Court notes,
HMOs have “‘grown explosively in the past decade and [are] now the dominant form of
health plan coverage for privately insured individuals.’” Id. at 369 (citing GOLD &
HURLEY, THE ROLE OF MANAGED CARE “PRODUCTS” IN MANAGED CARE “PLANS,” IN
CONTEMPORARY MANAGED CARE 47 (M. Gold ed., Health Administration Press 1998).

An HMO does not cease to be an insurer when it arranges to limit its exposure, “as
when an HMO arranges for capitated contracts to compensate its affiliated physicians
with a set fee for each HMO patient regardless of the treatment provided.” Id. at 371.
Such capitation contracts “do not relieve the HMO of its obligations to the beneficiary” –
accordingly, the “HMO is still bound to provide medical care to its members, and this is
so regardless of the ability of physicians or third party insurers to honor their contracts
with the HMO.” Id. These capitation arrangements are comparable to reinsurance
contracts and as such do not take the primary insurer out of the insurance business. In
other words, an insurance company does not cease to be subject to risk when it
reinsures its business, unless the insured relieves the primary insurer of the risk under
an assumption reinsurance contract. It follows that, the elements of health care and
insurance inherent in an HMO are inextricably bound such that an HMO cannot
“checkmate common sense” by trying to submerge the insurance features beneath an
exclusive characterization of the HMO as a provider of health care services. See id. at
370.

The elements of risk shifting and risk distribution are present in the instant case. In
exchange for payment of premium, members of the various subscriber groups shift their
risk of economic loss to Taxpayer. The members are numerous such that risk
distribution is accomplished. The contracts at issue qualify as insurance under the
commonly accepted definition of insurance. The fact that Taxpayer pays its provider
network on a capitated basis does not shift the risk from Taxpayer to the provider
network. Absent a legitimate assumption reinsurance agreement, Taxpayer remains
the party responsible to the members of the subscriber group for the provision of health
care services in the form of insurance.

The majority of Taxpayer’s business is related to its comprehensive hospital and
medical line of business for which it contracts with the various network providers under
capitation agreements. We have concluded that these arrangements qualify as
arrangements of insurance for federal income tax purposes. Therefore, because the
majority of Taxpayer’s business is related to these arrangements, Taxpayer is subject to
the taxing provisions of Subchapter L of the Code and should file as an insurance

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company for federal income tax purposes. See I.R.C. §§ 831(c) and 816(a); see also
Cardinal Life Insurance Co., 300 F.Supp at 392.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.