Over the past 30 years, the tax treatment of insurance premiums paid to captive (i.e., subsidiary) insurance Companies has generated considerable controversy and litigation. In ihis article, we propose a new definition of insurance that is motivated by a careful analysis of the issues raised in the captive insurance tax controversy. Emphasizing the fundamental roles played by market forces and the efficiency of risk transfers, this new definition both broadens and refines traditional definitions of insurance.
This study proposes that the operation of single-parent captive insurers enhance the stature of managers and tests the hypothesis that corporations with heightened manager-owner conflicts of interest are more likely to operate a single-parent captive insurer. A time-series, cross-sectional sample of 4,212 observations is used. Corporate free cash flow and volatility of free cash flow are positively related to the likelihood of operating single-parent captive insurers while the availability of investment opportunities is inversely related to the likelihood of operating single-parent captive insurers. It appears, therefore, that corporations with heightened manager-owner conflicts of interest are more likely to operate captive insurers.
Much resources have been expended over the years debating the tax treatment of insurance versus self insurance. This article reviews and analyzes the principal concepts and inconsistencies that have evolved in dealing with the issue of premium tax deductibility. The Internal Revenue Service considers market insurance as the only visible means of risk shifting and therefore the only one worthy of tax deductibility. It is argued that other forms of risk reduction can be equally effective in reducing risk. The social cost associated with the present tax policy that favors market insurance over other forms of pre-loss risk financing are evaluated and depicted. The implicit objective of the article is to'shift the debate by refocusing on the question of an appropriate tax policy concerning risk financing, one that maximizes social welfare. On July 27, 1989, the U.S Court of Appeals of the Sixth Circuit Court rendered its decision in the case of Humana Inc. versus Commissioner (No. 88-1403), upholding the lower court's decision that premiums paid by a parent company to its captive insurance subsidiary shall not be deductible for income tax purposes. The same court reversed the decision with regard to premiums paid by an affiliated subsidiary to a captive, allowing their deductibility. The underlying principle is based on appearance rather than economic substance. Later dubbed "the balance sheet theory," the guiding principle is the effect of the premium on the insured's consolidated balance sheet figure. If the premium is paid to a captive, there is no direct effect on the consolidated balance sheet of the parent and the wholly owned captive, there is no risk shifting, and therefore the expense is not recognized. In contrast, if the premium is paid by a subsidiary, who may insure itself with the same captive,
Over the past three decades, the global captive insurance movement has established itself as a significant alternative to traditional insurance. During this period, the controversy surrounding the tax-deductibility of both premiums paid to captives and reserves held by captives has never abated. In the United States, the controversy derives from a fundamental conflict within a federal tax policy that attempts to respect the legal separateness of corporate entities, while at the same time questioning the economic substance of transactions between affiliated entities. Because many nations' tax authorities follow the lead of the U.S. Internal Revenue Service on this issue, a resolution of the controversy is of global interest.In this article, the fundamental principles underlying the tax-deductibility of both insurance premiums (for the insured) and insurance reserves (for the insurer), are examined from both theoretical and practical perspectives. The authors then propose a heuristic method for justifying the tax-deductibility of premiums based upon an index that measures: (1) the extent to which the captive is constrained by market forces to engage in the "business of insurance," and (2) the efficiency of risk transfers. The deductibility of reserves is addressed by a special case of the index.This approach provides a unified resolution to issues of tax policy for captive insurers that allows for partial solutions in the spectrum from no tax-deductibility to full tax-deduc-* Joseph E. Boettner Professor of Risk Management and Insurance and Chairman of the
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