By P. Bruce Wright, M. Kristan Rizzolo, and Saren Goldner, Eversheds Sutherland (US) LLP

Generally, premiums paid for insurance are deductible for federal income tax purposes in the year paid if the policy is an annual policy and are amortized over the policy period for a multiyear policy. In addressing the question of when premiums paid to a captive insurance company are deductible for federal income tax purposes, the key determination is whether the coverage provided by the captive will be respected as insurance for federal income tax purposes. A number of factors need to be taken into account when making that determination. The basic requirements for insurance treatment are insurance risk, risk transfer, risk distribution, and a policy that embraces common notions of insurance.

Risk Transfer. This element addresses the fact that there must be a transfer of risk from the insured to the captive insurance company.

The Internal Revenue Service (IRS) has taken the position, and courts have agreed, that if a party owns a captive (“Parent”) and Parent insures its risk with its subsidiary, there is no risk transfer because economically Parent is in the same position as it was without the insurance (i.e., if the captive receives a premium or pays a loss, the Parent’s balance sheet is unaffected).

Alternatively, case law and the IRS have recognized that if a captive with Parent risk has sufficient “unrelated risk” the Parent risk will be shifted along with the unrelated risk. Another IRS safe harbor ruling quantifies sufficient unrelated risk at 50 percent, but a Ninth Circuit case, Harper, involved just under 30 percent unrelated risk. Thus, questions arise as to what constitutes unrelated risk as there is no specific definition. However, common risks that are generally considered unrelated risks include risks of customers of the captive’s corporate group, extended warranty risk, risk relating to employee benefits provided to employees of the corporate group of which the captive insurer is a part, and risks that are derived from a risk pool.

Also, although there is no legal authority on point, the general rule of thumb is that, in determining the percentage of unrelated risk, one should look to the net retained risk in the captive. Thus, for example, if one were to write a large premium relating to unrelated risk and reinsure it 100 percent to a third party, there would be no unrelated risk to take into account.