Ten-year captive excess-loss policies were not insurance

Plain-English summary

Related healthcare businesses bought ten-year excess-loss policies from a captive insurer owned by the same individual. The policies were priced before the parties set the attachment points, those points apparently were established at least four years into the policy period, and the liability caps were set where claims were expected to reach them. The IRS concluded that the arrangement shifted no meaningful insurance risk and instead resembled prefunding through guaranteed investment contracts. It also found that the premiums were not actuarially determined and that the arrangement was not insurance in the commonly accepted sense. The captive therefore had to accrue premium income when due or paid, whichever came first. It could not accrue claim liabilities until payment because economic performance for those noninsurance liabilities occurred only when the claims were paid.

Ruling snapshot

• Question: Did seven related-party ten-year excess-loss policies qualify as insurance for federal income tax purposes?
• Outcome: Advice given: no, and premium income and claim liabilities must be accounted for under the ordinary accrual rules
• Key authorities: IRC §§ 451, 461, 832; Treas. Reg. §§ 1.451-1, 1.461-1, 1.461-4; Helvering v. Le Gierse, 312 U.S. 531 (1941)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201533011
       Release Date: 8/14/2015
       CC:FIP:B04
       POSTF-146000-13

UILC: 832.00-00, 162.04-03

date: May 06, 2015

 to:   Gwen Schoen
       Attorney (CC:LB&I:CTM:LA:1)
       (Large Business & International )

from: Sarah E. Lashley
Assistant to the Branch Chief, Branch 4
(Financial Institutions & Products )

subject: -------------------------------------------------------------------------------

       Legend

       Taxpayer            =   ---------------------------------------------------
       Individual          =   --------------------------
       Entity 1            =   ----------------------------------------------------
       Entity 2            =   -------------------------------------
       Entity 3            =   -----------------------------------------------------------
       Entity 4            =   ---------------------------------------------
       Entity 5            =   ------------------------------------
       Entity 6            =   --------------------------------------
       Administrator       =   -------------------------------------------
       State               =   -----------
       Year 1              =   -------
       Year 2              =   -------
       Year 3              =   -------
       Year 4              =   -------
       Year 5              =   -------
       A                   =   -----------------
       B                   =   -----------------
       C                   =   -----------------

       This is in response to your request for legal analysis in the cited case.

POSTF-146000-13 2

Issue

Whether the seven 10-year excess loss policies1 qualify as insurance for Federal
income tax purposes.

Summary of Arrangement

Entities 1-6 and Administrator (the “Group Entities”) entered into 10-year excess loss
policies with Taxpayer in Year 2.2 The policies are identical apart from the insured
Group Entity, policy numbers, and premiums. Entities 1-6 are S-corporations for
Federal income tax purposes. Individual owns all the stock of Entities 1-6.

Entities 1-6 provide healthcare services to members of unrelated health maintenance
organizations (“HMOs”). HMOs do not purchase these services directly from Entities 1-

6. HMOs contract with Administrator to have Entities 1-6 provide healthcare services to
   the HMOs’ members.

Individual also owns all the stock of Administrator. Administrator is a C-corporation.
Administrator does not provide healthcare services directly to patients. The HMOs pay
Administrator on a capitated, pre-paid monthly basis. The capitation fees cover primary
healthcare, hospital, and specialized healthcare services. Administrator pays Entities 1-
6 sub-capitation fees. The amount of the sub-capitation fee paid to each of Entities 1-6
depends primarily on the number of HMO members who receive primary healthcare
services from each entity. Administrator also contracts with hospitals to provide hospital
services to the HMO members, and contracts with specialists to provide specialized
healthcare services to the HMOs’ members.

Individual owns all of Taxpayer’s stock. Taxpayer is a C-corporation. In December of
Year 1, Taxpayer incorporated in State. Taxpayer is licensed with the State Division of
Insurance (“State DOI”) to operate as a pure captive insurance company. In general,
under the State captive statute, a pure captive insurer only insures the risks of its parent
and affiliated entities or controlled unaffiliated entities.

Taxpayer’s initial business plan, filed with the State DOI, stated that Taxpayer would
issue workers’ compensation and professional liability coverage to the Group Entities.
Taxpayer revised its initial business plan, filing a second business plan with the State
DOI. The second business plan stated that Taxpayer would issue one-year excess loss
policies to the Group Entities. The new policies were in addition to the existing workers’
compensation and professional liability coverage described in the initial business plan.

1
The use of terms such as policies, insureds, insurer, and premiums are for convenience only and do not
imply that there is a genuine insurance arrangement for Federal income tax purposes.
2
Entities 2 and 3 merged in Year 3.
POSTF-146000-13 3

Taxpayer then revised its business plan again, filing a third business plan with the State
DOI. The third business plan stated that Taxpayer would cancel the one-year excess
loss policies and issue 10-year excess loss policies to the Group Entities. The plan
stated that, “premiums for the policies for all the entities will total A, payable evenly over
the 10-year period. The limit of liability for the policies will total B. . . . The expected
losses under the policies will total C, which on a discounted [basis] equals the premiums
to be paid.” C is less than B and greater than A.

The excess loss policies Taxpayer issued to each of the seven Group Entities covered a
portion of the Group Entities’ costs of providing healthcare services (the “Costs”) to the
HMO members over 10 years. The 10-year term started in December 31, Year 2, and
went through December 31, Year 5. Premiums were due in 10 equal annual
installments. Each policy covered one of Group Entity’s Costs to the extent they
exceeded a specified amount (the attachment point). A Group Entity’s Costs that
exceeded the attachment point could trigger claims by that Group Entity to Taxpayer.3
At the time of its execution, each of the policies provided that the attachment point was
“$To Be Determined.” Therefore, even though the business plan filed with the State
DOI stated that the total premiums would equal the discounted amount of expected
losses, the premiums for the policies were priced and the policies were executed before
Taxpayer and the Group Entities established the attachment point. It is not clear when
the attachment point was established, but circumstantial evidence indicates that it
happened no earlier than four years into the 10-year policy period.

Taxpayer’s potential liability to each Group Entity was also capped under each policy
(the “Policy Cap”). The policies limited Taxpayer’s liability to each Group Entity to 150
percent of the premiums that each Group Entity paid. There is evidence that when the
attachment point was established, the parties fully expected Group Entities’ claims to
exceed the Policy Cap. Taxpayer later raised the Policy Cap to 170 percent of
premiums in an undated policy endorsement. Each Group Entity did not pay additional
premiums for the increased Policy Cap. Additionally, there is evidence that the parties
expected Group Entities’ claims to exceed the newly raised Policy Cap when the Policy
Cap was raised. Claims were payable at the end of the 10-year policy term. No claims
were made under the policy from its inception through Year 4.4

In the aggregate, the Group Entities paid A in premiums over the 10-year policy term.
Each Group Entity claimed a deduction for each taxable year under section 162 for
premiums paid to Taxpayer.

3
There is no indication that Costs covered by the policies represented actual losses to the Group Entities.
Furthermore, there is no evidence that claims under the policies were for Costs that exceeded the
capitated payments that Group Entities received, whether directly or indirectly, from the HMOs. For
purposes of this memorandum, we will assume that claims under the policies represented actual losses to
the Group Entities.
4
Subsequent years have not yet been audited by the Service.
POSTF-146000-13 4

Law

Insurance

Neither the Internal Revenue Code nor the Income Tax Regulations define the terms
“insurance” or “insurance contract” for Federal income tax purposes. In Helvering v. Le
Gierse, 312 U.S. 531, 539 (1941), the Supreme Court held that “[h]istorically and
commonly insurance involves risk shifting and risk distributing.” Cases analyzing
captive insurance arrangements have described insurance as having the following three
elements: (1) 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, 164-165 (9th Cir. 1992), aff’g 96 T.C. 18 (1991).

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 the loss
does not affect the insured because the insurance payment offsets the loss. Rev. Rul.
2002-89, 2002-2 C.B. 984; Rev. Rul. 2002-90, 2002-2 C.B. 985; Rev. Rul. 2002-91,
2002-2 C.B. 991; Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th
Cir. 1987), aff’g 84 T.C. 948 (1985); Allied Fidelity Corp. v. Commissioner, 572 F.2d
1190, 1193 (7th Cir. 1978), aff’g 66 T.C. 1068 (1976); Cuesta Title Guaranty Co. v.
Commissioner, 71 T.C. 278, 286 (1978). For risk shifting to be present, the party that
bears the ultimate financial loss must not be the same party that suffers the loss. “If
parties structure an apparent insurance transaction so as to effectively eliminate the
effect of insurance risk therein, insurance cannot be present.” AMERCO, Inc., 96 T.C.
at 39.

The risk transferred pursuant to an insurance contract must be a risk of economic loss.
Allied Fidelity Corp., 572 F.2d at 1193. Losses that exist at the time of the insurance
agreement, or that are so probable or imminent that there is insufficient risk being
transferred between the insured and insurer, are not proper subjects of insurance. 1
Couch on Insurance 3d, ¶ 102:8.

For risk to shift, the insurer must be a “viable entity, financially capable of meeting its
obligations.” AMERCO, Inc., 96 T.C. at 40; Gulf Oil Corp. v. Commissioner, 89 T.C.
1010, 1024 (1987); The Harper Group v. Commissioner, 96 T.C. 45, 59 (1991), aff’d,
979 F.2d 1341 (9th Cir. 1992) (discussing the insurer’s financial capacity to pay the
insured’s claims as part of its risk shifting analysis). In captive cases, the courts have
scrutinized the capitalization of the captive for purposes of determining if there was risk
shifting. Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835, 839-840 (6th Cir. 1995);
Humana, Inc. v. Commissioner, 881 F.2d 247, 253 (6th Cir. 1989); Stearns-Roger Corp.
v. United States, 774 F.2d 414, 415 (10th Cir. 1985); Carnation Co. v. Commissioner,
640 F.2d 1010, 1013 (9th Cir. 1981).

In addition, an arrangement must resemble insurance in its commonly accepted sense
POSTF-146000-13 5

to qualify as insurance for Federal income tax purposes. See e.g., AMERCO, Inc. v.
Commissioner, 979 F.2d at 165. The determination of whether an arrangement
resembles insurance in its commonly accepted sense encompasses a number of
factors, including state regulators’ definitions of insurance companies and insurance
transactions. AMERCO, Inc., 96 T.C. at 42; The Harper Group, 96 T.C. at 60.
However, state law definitions are not dispositive for Federal income tax purposes.
AMERCO, Inc., 96 T.C. at 42. The capitalization of the insurer, whether premiums were
charged as the result of an arm’s-length transaction, whether premiums were actuarially
determined, and whether the policies were valid and binding are also relevant for
purposes of determining whether there is insurance in its commonly accepted sense.
See Rev. Rul. 2002-91, 2002-2 C.B. 991; Malone & Hyde, Inc., 62 F.3d at 836; The
Harper Group, 96 T.C. at 60; Gulf Oil Corp., 89 T.C. at 1028 n. 15.

Income Tax Accounting

Section 451 provides that the amount of any item of gross income shall be included in
gross income for the taxable year in which received by the taxpayer unless such
amount is to be properly included in a different period.

Treas. Reg. § 1.451-1(a) provides in part that under an accrual method of accounting,
income is includible in gross income when all the events have occurred which fix the
right to receive such income and the amount thereof can be determined with reasonable
accuracy. All the events that fix the right to receive income occur when the required
performance takes place, payment is due, or payment is made, whichever happens first.
See Schlude v. Commissioner, 372 U.S. 128 (1963); Rev. Rul. 80-308, 1980-2 C.B.
162.

Treas. Reg. § 1.461-1(a)(2) provides in part that under an accrual method of
accounting, a liability is incurred, and is generally taken into account for Federal income
tax purposes, in the taxable year in which: (1) all the events have occurred that
establish the fact of the liability, (2) the amount of the liability can be determined with
reasonable accuracy, and (3) economic performance has occurred with respect to the
liability. Uncertainty as to the amount of the liability does not prevent a taxpayer from
taking into account that portion of the amount of the liability which can be computed with
reasonable accuracy.

Treas. Reg. § 1.461-4(g)(7) provides that, in the case of taxpayer’s liability for which
economic performance rules are not provided elsewhere, economic performance occurs
as the taxpayer makes payments in satisfaction of the liability to the person to whom the
liability is owed.
POSTF-146000-13 6

Analysis

As explained below, we conclude that the seven 10-year excess loss policies do not
qualify as insurance for Federal income tax purposes. The policies do not shift any risk
from the Group Entities to Taxpayer and the arrangement is not insurance in its
commonly accepted sense. As a result, Taxpayer accrues income from premiums
when they are due or paid, whichever happens first, but does not accrue liabilities from
claims until those claims are paid.

Insurance

The economic risk under each policy is that at the end of that 10-year policy period each
Group Entity will make claims up to the Policy Cap (i.e., 170 percent of premiums) if the
cost of healthcare services it provided over the 10-year period exceeded the attachment
point. See Allied Fidelity Corp., 572 F. 2d at 1193. Accordingly, the policies purportedly
transferred this risk of economic loss from the Group Entities to Taxpayer. However,
the policies effectively shifted no risk because Taxpayer could expect to pay 170
percent of the premiums because the Costs incurred by each Group Entity were clearly
expected to exceed the Policy Cap. The effect was to eliminate the transfer of an
insurance risk from the Group Entities to Taxpayer because the losses were certain to
occur and, in fact, had already been partially incurred at the time the terms of the
policies were finalized (i.e.: when the Policy Cap was increased and when the
attachment point was set). The attachment point under each policy was not established
until at least four years into the 10-year policy period. When the parties finally set the
attachment point, they set it at a level where they would have reasonably expected the
Costs of each Group Entity to exceed the Policy Cap. See AMERCO, 96 T.C. at 39; 1
Couch on Insurance 3d, ¶ 102:8.

The arrangement between Taxpayer and the Group Entities resembles the situation that
the Service considered in Rev. Rul. 89-96, 1989-2 C.B. 114. The Service held that a
property and casualty insurance company could not claim a deduction under
section 832(b)(5) for “losses incurred” when the casualty event had taken place before
the parties entered into the purported insurance contract. The expected amount of
losses incurred as a result of the casualty event greatly exceeded the amount covered
under the contract. The Service found that the “premium” received, plus the tax benefits
to the insurer, plus the expected investment income on those amounts “would exceed
its anticipated liability.” The Service concluded that because the amount of the casualty
loss the insurer could expect to pay was known at the contract’s inception, the
arrangement lacked the requisite shifting of an insurance risk.

As in Rev. Rul. 89-86, the only risk that Taxpayer assumes is the risk “that the available
investment yield between the time of payment of the premiums and the time of payment
of the claims will be lower than expected.” Rev. Rul. 89-96. The policies were drafted
so that the maximum amount recoverable under the contracts (B), which was 150
percent of premiums, would certainly be reached. Therefore, the policies were
POSTF-146000-13 7

effectively designed as guaranteed investment contracts, payable in 10 years, with 1/10
of the principal deposited each year, and with a fixed annual interest rate of 7.25
percent (which is the rate necessary to grow 100 units, deposited in equal installments
over 10 years, into 150 units at the end of those 10 years). The Policy Cap was later
raised to 170 percent, increasing the Group Entities’ potential return on investment.
Moreover, if the tax savings of treating the transaction as insurance for Federal income
tax purposes were taken into account, the effective promised annual rate of return
would be even higher.

The arrangement between Taxpayer and the Group Entities is also similar to the
situation in Rev. Rul. 2007-47, 2007-2 C.B. 127, where a domestic corporation was
engaged in an inherently harmful activity and was required by law to incur certain
mitigation expenses upon the discontinuation of the activity. When the corporation
began the activity, it estimated that the present value of its future remediation costs was
$150x. It then entered into an arrangement with an insurance company under which it
paid the insurance company $150x in exchange for the promise to be reimbursed for its
future remediation costs up to a limit of $300x. The Service found that this arrangement
was not insurance because, economically, it was merely the corporation’s prefunding of
its future remediation expenses. The Service reasoned that “the overall risk assumed
by [the insurance company] was whether the estimated present value of the cost of
performing the measures ($150x) would accrue to exceed the greater of [the
corporation]'s costs to perform the required measures or the contract limit of $300x” and
that this “risk is akin to the timing and investment risks that Rev. Rul. 89-96 concludes
are not insurance risk.” As in the situation in Rev. Rul. 2007-47, the overall risk
Taxpayer assumed under the policy is an investment risk—namely, the risk that the
purported premiums that it received from the Group entities will grow over 10 years by
70 percent, which is all that it promised to pay to the Group entities. This purported
insurance risk is no more than the prefunding of future expenses.

Additionally, the premiums could not have been actuarially determined because they
were priced before the attachment point above which Taxpayer would provide coverage
to the Group Entities was established and the Policy Cap was raised without increasing
the premiums paid. It appears that, instead, the parties engineered Taxpayer’s potential
losses to provide a specific return on investment for Group Entities, which further
indicates a lack of insurance in its commonly accepted sense. See Rev. Rul. 2002-91,
2002-2 C.B. 991; Malone & Hyde, Inc., 62 F.3d at 836; The Harper Group, 96 T.C. at
60; Gulf Oil Corp., 89 T.C. at 1028 n. 15. Overall, there was not insurance in its
commonly accepted sense.

We conclude, based on all the facts and circumstances, that the policies do not qualify
as insurance contracts for Federal income tax purposes because there was a lack of
risk shifting and the contracts are not insurance in its commonly accepted sense.

Income Tax Accounting
POSTF-146000-13 8

Taxpayer receives premiums from the Group Entities in exchange for the promise to
pay, at the end of the policy period, the excess, if any, of each Group Entity’s costs over
the attachment point. Taxpayer’s right to receive income is fixed when the premiums
are due or are paid, whichever happens first. The amount of the premiums is fixed by
the contract, and therefore determinable with reasonable accuracy as of the start of the
policy period.

Taxpayer is liable for claims under each policy once each Group Entity’s costs exceed
the attachment point. The amount of that excess can be computed with reasonable
accuracy, and any uncertainty regarding the final amount of claims does not prevent
Taxpayer from taking into account the amount by which costs have already exceeded
the attachment point. Given that the policies at issue are not insurance for Federal
income tax purposes, the claims must be considered “other liabilities” under Treas. Reg.
§ 1.461-4(g)(7). Economic performance therefore occurs as Taxpayer makes payments
in satisfaction of the liabilities, which does not occur until the end of the policy periods.
Taxpayer’s liability for claims therefore does not satisfy all three prongs of the all events
test until the claims are paid.

Therefore, we conclude (1) that Taxpayer accrues income from premiums when they
are due or paid, whichever happens first, and (2) that Taxpayer does not accrue
liabilities from claims until those claims are paid.

Conclusion

For the reasons stated above, the seven 10-year excess loss policies do not qualify as
insurance for Federal income tax purposes. As a result, Taxpayer accrues income from
premiums when they are due or paid, whichever happens first, but does not accrue
liabilities from claims until those claims are paid.
POSTF-146000-13 9

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