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Risk distribution
in captives
Byron Crawford looks at Internal Revenue Service rulings on risk distribution and how they can affect a captive’s tax position.
April 2006
On June 17, 2005, the Internal Revenue Service (IRS) issued Revenue Ruling 2005-401. This ruling focused on the requirement of risk distribution based on the framework first set forth under previously issued Revenue Rulings 2002-89, 2002-90 and 2002-912.
Interestingly, the current IRS position on risk distribution, as collectively gleaned from these rulings, has evolved into a dual requisite criteria of (1) the statistical phenomenon known as the “law of large numbers” (including the elements of mass, homogeneity and independence) and (2) one that “entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks”3 . In earlier years, by contrast, the IRS seemed to focus solely on the statistical requirement as constituting the element of risk distribution.
You can see the statistical focus as expressed in this commentary from the now obsolete Rev. Rul. 89-61. This commentary was intended to clarify and explain the element of risk distribution that had been raised in the earlier Rev. Rul. 88-72.
When additional statistically independent risk exposure units are insured, an insurance company’s potential total loss increases, as does the uncertainty of the amount of that loss. As the uncertainty regarding the company’s total loss increases, however, there is an increase in the predictability of the insurance company’s average loss (total loss divided by the number of exposure units). That is, by insuring a large number of statistically independent risk exposure units, a company takes advantage of the statistical phenomenon known as the law of large numbers. (When the sample number increases, the probability density function of the average loss tends to become more concentrated around the mean.) Due to this increase in predictability, there is a downward trend in the amount of capital that the company needs per risk unit to remain at a given level of solvency. In this sense, the additional insureds may make a company more efficient in the way its capital provides security, and thus may “help protect the company’s solvency”. Without an increase in capital, however, the increase in the predictability of the average loss is at the cost of an upward trend in the company’s risk of ruin (the probability that total losses may exceed total premiums and capital).
To isolate the issue of risk distribution in Rev. Rul. 2005-40, the IRS presents four fact patterns involving unrelated parties. By using unrelated parties, the IRS could identify the characteristics needed for adequate risk distribution unencumbered by the element of risk shifting.
In Situation 1, a domestic corporation, X, operated a large fleet of automotive vehicles representing a significant volume of independent, homogeneous risks, and insured these risks with Y, an unrelated domestic corporation. X was the only insured of Y. The Service stated that while this situation may constitute the shifting of risks from X to Y, the risks were not in turn distributed among other insureds; therefore, the arrangement did not constitute insurance for Federal income tax purposes.
In Situation 2, the facts were the same as in Situation 1, except Y also insured the risks of Z, a domestic corporation unrelated to Y or X. Z constituted 10 percent of the risk insured by Y, and X constituted 90 percent of the risks insured by Y. Again, the Service found that while risk shifting may exist in Situation 2, the requisite risk distribution did not exist to constitute insurance. The Service stated that even with two unrelated insureds, there was an insufficient pool of other premiums to distribute the risk among.
In Situation 3, a domestic corporation, X, conducted business through 12 limited liability companies, of which it was the single owner. The LLCs were disregarded as entities for Federal income tax purposes. The LLCs entered into insurance arrangements with Y, an unrelated party. None of the LLCs accounted for less than 5 percent or more than 15 percent of the total risk assumed by Y under the agreements. The Service stated that if an entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner. Therefore, applying that rule to Situation 3, Y had entered into an insurance arrangement only with X. As a result, the arrangement between X and Y did not constitute insurance for Federal income tax purposes.
In Situation 4, the facts are the same as in Situation 3, except that each of the 12 LLCs elected to be classified as an association for Federal income tax purposes. The arrangement between Y and each LLC then constituted the shifting of a risk of loss from each LLC to Y. The risks of the LLCs were distributed among various other LLCs. Therefore, the arrangement constituted insurance for federal income tax purposes. Additionally, because the arrangement with the 12 LLCs represented Y’s only business, and those arrangements were insurance contracts for Federal income tax purposes, Y was an insurance company within the meaning of IRC §831(c) and §816(a), and the 12 LLCs were entitled to deduct the amounts paid as insurance premiums under IRC §162.
When you consider the three Captive Rulings issued in 2002 and Revenue Ruling 2005-40 together, you can summarise several bright line observations regarding the “multiple insured entities” requisite element for the presence or absence of risk distribution.
1. Revenue Ruling 2002-89 and 2005-40 both tells us that when there is a 90 percent concentration of risk in one insured, there is insufficient risk distribution to merit insurance treatment.
2. However, Revenue Ruling 2002-89 also tells us that if a single insured’s (i.e., the parent’s) premium percentage were reduced below 50 percent and the unrelated entities premium percentage were increased above 50 percent, risk shifting and risk distribution would be present.
3. Revenue Rulings 2002-90, 2002-91 and 2005-40 were consistent in presenting a favourable fact pattern where risk distribution was held to exist when the risk from each insured did not account for more than 15 percent of the total risk assumed by the insurer under all the agreements.
4. Finally, Revenue Ruling 2005-40 confirms that form prevails over substance, when it refused to recognise risk distribution when the entities were disregarded for tax purposes, but accepted the presence of risk distribution when those same entities were taxed as separate entities.
But as listed below, the rulings raise questions and can lead taxpayers to make logical inferences from what the Rulings do not tell us.
1. Can risk distribution be present when there is a concentration of risk in one insured that is 49.9 percent or less and the other entitie(s) constitute at least 50.1 percent of the risk as measured by earned premiums? Does it matter that the other entities were unrelated for the purpose of risk distribution? RR 2002-89.
2. Risk distribution is present when there are as few seven (100 percent divided by 15 percent) insured entities and a relatively even distribution of risk. RR 2002-91.
3. Can risk distribution be present when there are only three insureds and no single insured’s risk exceeds 50 percent? Note RR 2002-89 did not specify a number of unrelated insureds but used the plural “entities” to describe the unrelated insureds. Would there be sufficient risk distribution with three equal insureds and no single insured is in significant part paying for its own risks? 4. Can choosing an alternative entity status serve to create risk distribution, i.e., use of dual member LLCs (taxed as a partnership entities) versus choosing single member LLCs (disregarded as entities)? Does a partnership “entity” merit the same respect as an association? RR 2005-40
5. Finally, in Notice 2005-49, the IRS has sought comments with regard to the relevance of homogeneity in determining whether risks are adequately distributed for an arrangement to qualify as insurance. Can the addition of additional insured entities contributing non-homogeneous risk exposures to the pool of risks create sufficient risk distribution?
Most taxpayers do not fit the precise fact patterns to be able to rely on the 2002 captive rulings. We expect that the IRS will have opportunities to address some of these questions in private letter rulings.
1 2005-27 I.R.B. 4.
2 Rev. Rulings 2002-89, 90 and 91 are commonly known to provide safe harbour fact patterns for certain captive insurance arrangements and include fact patterns to help taxpayers understand the concepts of risk shifting and risk distribution.
3 Each of the 2002 rulings cites Clougherty Packing Co. v. Commissioner,
811 F.2d 1297, 1300 (9th Cir. 1987) and Humana Inc. v. Commissioner,
881 F.2d 247, 257 (6th Cir. 1989).
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