By Steven Miller, former IRS Acting Commissioner and alliantgroup National Director of Tax
On August 14, 2015, the IRS Office of Chief Counsel released Chief Counsel Advice Memorandum 201533011, addressing whether certain policies issued by a captive insurance company would qualify as insurance for federal income tax purposes. The taxpayer in the memorandum is a captive insurance company that issues workers’ compensation, professional liability coverage and excess loss policies to seven different related entities. The overall validity of the captive insurance company or the validity of the workers’ compensation and the professional liability coverage are not addressed in the memorandum.
The insured entities provide healthcare services to individual members of health maintenance organizations (HMOs). The HMOs pay a capitated amount to the insured dependent on the number of HMO members who receive healthcare services from each insured. The taxpayer issued a 10-year excess loss policy to each of the ensured entities, which were based on the cost of the healthcare services provided to HMO members. The claims for these policies were payable at the end of the 10-year policy term.
The amount of loss covered by each excess layer policy is a portion of the costs of healthcare services provided to HMO members over the 10-year policy period. A loss is defined as the costs in excess of the “attachment point.” The attachment point is a pre-determined dollar amount provided in the policy. In this particular case, it appears that the taxpayer did not determine the attachment point until four years after the policy was executed. In the view of the IRS, the delayed determination of the attachment point allowed the taxpayer to know the exact amount of the claims for the years that the attachment point was not set.
Premiums were determined by the taxpayer at the time of the initial execution of the policies and were paid in annual installments during the policy period. Policy liability limits were originally set as 150 percent of the premiums, and then, at a later date, increased to 170 percent of the premiums. Losses for each year exceeded the policy limits.
In disallowing the deduction, the IRS stated that the policies did not shift risk because losses were expected to exceed the policy cap and, therefore, the taxpayer could expect to pay 170 percent of the premiums. The IRS argument states that there is no risk because “losses were certain to occur.” Additionally, because the attachment point was not set until year four of the 10-year policy period, some of the losses had already been incurred. When the attachment point was determined, the IRS reasoned that it was set where the losses would reasonably be expected to exceed the policy cap. Thus, the policy premiums were more of a pre-payment than an insurance premium.
The IRS compared this situation to those in Rev. Rul. 89-96 and Rev. Rul. 2007-47 in making its determination. In comparing this arrangement to Rev. Rul. 89-96, the IRS stated 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.” The IRS also explained that the policies were effectively “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.” When comparing to Rev. Rul. 207-47, the IRS said that “economically, it was merely the corporation’s prefunding” of its future expenses. Additionally, the IRS stated that “the overall risk taxpayer assumed under the policy is an investment risk.”
The IRS also argued that the premiums were not actuarially determined. The IRS made two points in support of this position. Their first point was that, since the premiums were determined before the attachment point, they could not have been actuarially determined. Additionally, the taxpayer increased the policy cap without changing the premiums. The IRS stated that in this situation it looks like the taxpayer determined the “potential losses to provide a specific return on investment” for the insured. Therefore, the policies are not insurance in the commonly accepted sense.
In conclusion, the IRS found that the 10-year excess layer policy did not shift the risk of the insured and was not insurance in the commonly accepted sense. Because it is not truly insurance, the IRS also determined that the payments made as premiums to the insurance company should be recognized as income in the year it is received, but the deduction for payments made for claims should not be taken into account until the claim is paid in year 10, not when the loss occurs.
There is much that we do not know about this CCA. It is odd in several regards. The most obviously interesting aspect is that not only is there no deduction due to the premium being a pre-payment, but that the pre-payment is income to the captive. This result seems simplistic and really quite harsh. In addition, this CCA represents a continued hardening of the IRS position on what risks are insurable and what constitutes insurance in the commonly accepted sense.
Even as the IRS sharpens its views, it has yet to succeed in convincing the courts of the correctness of those views. There are several pending examinations and court cases that will further this story in coming months. Stay tuned.
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