PARENT CORPORATION MAY NOT DEDUCT INSURANCE PREMIUMS PAID TO CAPTIVE SUBSIDIARY EVEN THOUGH CAPTIVE INSURED UNRELATED PARTIES.

Rev. Rul. 88-72

ISSUE

If a wholly owned insurance subsidiary insures risks of unrelated parties and "insures" certain business risks of its parent corporation (or the parent's subsidiaries), are the "insurance premiums" paid by the parent corporation (or the parent corporation's subsidiaries) deductible as ordinary and necessary business expenses under section 162 of the Internal Revenue Code?

FACTS

X and its domestic subsidiaries entered into annual insurance policies with X's wholly owned domestic insurance subsidiary, S1, to "insure" against potential losses from property damage, personal injury, pollution, and certain related risks. S1 is engaged in the trade or business of issuing insurance contracts to the general public. S1 is regulated as an insurance company by the states where it does business and is taxed as an insurance company under subchapter L of chapter 1 of the Code. The "insurance policies" issued to X and its subsidiaries were a small fraction of S1's total insurance business. The contractual terms including the premium rates for X (and its subsidiaries) were customary in the industry. The policies between S1 and X or its subsidiaries would qualify as insurance for federal tax purposes but for X's ownership of S1.

LAW AND ANALYSIS

Section 162(a) of the Code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 1.162-1(a) of the Income Tax Regulations provides that among the items included in business expenses are insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business.

Rev. Rul. 77-316, 1977-2 C.B. 53, presents three situations dealing with payments made by a parent corporation and its domestic subsidiaries to the parent's wholly owned foreign insurance company (the captive). The captive did not accept risks from parties other than the parent and its subsidiaries. The parent and its subsidiaries claimed that the payments were deductible insurance premiums. In each of these situations, Rev. Rul. 77-316 holds that amounts paid by the parent or its subsidiaries were not deductible under section 162 of the Code. The ruling explains as follows:

[T]he insuring parent corporation and its domestic subsidiaries, and the wholly owned "insurance" subsidiary, though separate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss. . . .

* * * Because . . . [the premiums] remain within the economic family and under the practical control of the respective parent in each situation, there has been no amount "paid or incurred."

* * * [N]othing has occurred other than a movement of an asset (cash) within each family of related corporations. . . . [S]uch amounts will be considered contributions of capital. . . .

1977-2 C.B. at 54-55.

Subsequent court decisions involving facts similar to the situations in Rev. Rul. 77-316 have held that payments made by a parent corporation or its subsidiaries to a wholly owned insurance captive are not deductible under section 162 of the Code because risk of economic loss is not shifted away from the parent (or its subsidiaries). See, e.g., Clougherty Packing Co. v. Commissioner, 811 F.2d 1297 (9th Cir. 1987); Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. 1986); Stearns-Roger Corp. v. United States, 774 F.2d 414 (10th Cir. 1985); Mobil Oil Corp. v. United States, 8 Cl.Ct. 555 (1985). Cf. Carnation Co. v. Commissioner, 640 F.2d 1010 (9th Cir. 1981), cert. denied, 454 U.S. 965 (1981).

Insurance under the Code cannot exist without the shifting of an economic risk of loss from the insured to the insurer. Helvering v. LeGierse, 312 U.S. 521 (1941), 1941-1 C.B. 430. If the insured has shifted its risk to the insurer, then a loss by the insured does not affect the insured because the loss is offset by the proceeds of an insurance payment. In situations where a purported insurance arrangement does not shift risk of loss, the courts have consistently characterized the contract-holders' "premium" payments as items that are not deductible under section 162 of the Code. See e.g., Mobil Oil Corp. 8 Cl.Ct. at 567; Humana v. Commissioner, 88 T.C. 197, 207 (1987); Clougherty Packing Co. v. Commissioner, 84 T.C. 948, 960 (1985), aff'd 811 F.2d 1297 (9th Cir 1987).

This result is not altered if the wholly owned insurance company insures unrelated third parties. By accepting a large number of independent risks, an insurance company takes advantage of the statistical phenomenon known as the law of large numbers. As additional independent risks are shifted to the company, the company's potential loss exposure increases. Although the potential loss exposure increases, there is an increase in the predictability of the average loss that will be incurred by the company on each risk that it has undertaken. This increase in predictability helps protect the company's solvency. (Because this assumption of additional risks reduces the percentage of the total risk undertaken by the company that is derived from each risk exposure unit, it is conventionally referred to as "risk distribution.") Acceptance of additional risks, however, does not reallocate the risks that the company previously assumed nor effect a transfer of risks that were not otherwise shifted to the company.

For these reasons, risk shifting between X (or its subsidiaries) and S1 is not created by the existence of what is called "risk distribution." Even though unrelated third parties have successfully shifted their risks to S1 and thus disposed of their economic stakes in whether their losses occur, X continues to have an economic stake in whether its own loss or its subsidiaries' losses occur. By operating an insurance business in which it insures unrelated parties, S1 may increase the predictability of the average loss incurred on each risk and may attract additional resources that can be used to pay the loss claims of X or its subsidiaries. The increased predictability of average loss incurred and the availability of these extra resources, however, does not alter the fact that, unlike the case where there is true insurance, X is made poorer if either X or its subsidiaries experience losses. This is because the loss reduces the net worth of S1, and the net worth of X reflects the reduction in the value of S1. Thus, the risk of those losses has not been shifted to S1.

In Mobil Oil Corp., one of the captive insurance subsidiaries (Bishopsgate Insurance Co.) insured risks of unrelated third parties as well as risks of its parent's affiliates. ¹ Mobil claimed, essentially without objection by the government, that for most of the years at issue third party insurance represented the majority of Bishopsgate's business in terms of total net earned premiums. Nonetheless, the court disallowed the deduction under section 162 of the Code for the "premiums" paid to Bishopsgate. In doing so, the court found that "[i]nsurance through a wholly-owned insurance affiliate is essentially the same as setting up reserve accounts," and it concluded, "[T]here was no transfer of the risk of loss." Mobil Oil. Corp., 8 Cl. Ct. at 567, 568. See also Stearns-Roger Corp. v. United States, 577 F. Supp. 833, 834 (D. Colo 1984), aff'd, 774 F.2d 414 (10th Cir. 1985).

Thus, the presence of third party insureds is immaterial to whether risk shifting exists. But see Gulf Oil Corp. v. Commissioner, 89 T.C. 1010, 1072 (1987) (dictum). The Service will not follow this dictum in Gulf Oil to the extent that it rejects the economic family concept of Rev. Rul. 77-316 and suggests that the presence of third party insureds might under certain circumstances produce the requisite risk shifting.

HOLDING

X and its subsidiaries cannot deduct under section 162 of the Code amounts paid to S1 as "insurance premiums," notwithstanding S1's acceptance of insurance risks from unrelated parties. This holding would be the same if the insurance subsidiary were a foreign corporation.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 77-316 is amplified and clarified.

DRAFTING INFORMATION

The principal author of this revenue ruling is William T. Sullivan of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Sullivan on (202) 566-4197 (not a toll-free call).

¹ Although not explicitly discussed in the opinion, the presence and magnitude of the third party insurance were among the uncontested facts found by the court. See Mobil Oil Corp., 8 Cl. Ct. at 556 n.1; Plaintiff's Post-Trial Brief at 47; Plaintiff's Requested Findings of Fact at Nos. 152 and 155; Defendant's Objections to Plaintiff's Requested Findings of Fact at Nos. 152 and 155. The absence from the opinion of any discussion of the third party risks further indicates that the court viewed those risks to be immaterial to the issue of the premiums' deductibility under section 162 of the Code.