Analyzing the Tax Deductibility of Premiums Paid to Captive Insurers

Abstract

This paper analyzes the issue of the tax deductibility of insurance premiums paid to captive insurers. The Internal Revenue Service has obstensibly taken a very hard line in restricting tax deductibility of premiums, as evidenced by such highly publicized court cases as the Carnation case. Documents now public under the Freedom of Information Act show that this approach is not always followed in individually negotiated cases that are not litigated and therefore unpublicized. A review and summary of these documents is presented. In the second half of the paper, the first attempt at quantitative analysis of the tax deductibility issue is shown. An analysis of how and when risk shifting occurs when the captive insurer writes insurance on unrelated risks is shown. The paper examines why the pooling of unrelated risks may lead to positive or negative financial results. Since the middle part of the seventies the use of captive insurers has become common among the nation's largest corporations. Many have been formed out of necessity during the time when products liability insurance and medical malpractice liability coverage were unavailable in the market to many busi- nesses. Others have been formed as a reaction to significant price increases put into effect during the 1976-79 period. The growth exhibited by the captive insurance industry during the seventies and early eighties has slowed considerably. For example, in each of the past two years the number of new captives registered in Bermuda has equalled 89, down from 118 in 1981, 119 in 1980, and 117 in 1979 [8, 12]. In addition, 26 captives have been liquidated in 1983 compared to 22 liquidations in 1982, and at this time it is believed that 1983 premium volume held steady with the 1982 volume [8]. Barry D. Smith is an Assistant Professor of Insurance at the Wharton School, University of Pennsylvania. He earned his Ph.D. as a Huebner Fellow at that institution. Dr. Smith also holds the CPCU, CLU, and FLMI designations. He is the author of How Insurance Works: An Introduction to Property and Liability Insurance and a co-author of Risk Classification in Life Insurance. He has published articles in this Journal and the CPCU Journal. The author acknowledges the support he received from the Wharton School's Junior Faculty Summer Fellowship Program and thanks Robert Liles of the Silverstein and Mullens law firm for his help and support. This content downloaded from 157.55.39.110 on Sun, 04 Dec 2016 04:52:59 UTC All use subject to http://about.jstor.org/terms 86 The Journal of Risk and Insurance While certain segments of the industry, such as association captives, joint venture captives, rent-a-captives, and the trading of controlled business among captives have grown, two primary reasons the overall growth has slowed are as follows [9, 10, 11, 131. First the foremost is the continuation of the soft market for commercial insurance. With insurance prices at rock bottom levels, a major incentive for using a captive insurer, cost savings, is