Market Insurance versus Self Insurance: The Tax-Differential Treatment and Its Social Cost

Abstract

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,

Captive insurance tax policy: resolving a global problem.

“…One established tax doctrine requires that the legal separateness among affiliated corporate entities, including a parent corporation and its captive insurer, be respected for 10 See M. Moshe Porat, et al, 1991, "Market Insurance Versus Self-Insurance: The Tax-Differential Treatment and Its Social Cost," The Journal of Risk and Insurance,58,4,[657][658][659][660][661][662][663][664][665][666][667][668][669] 11 While the Service does not audit every business transaction to insure its economic efficiency, certain classes of transactions that can be clearly identified as inefficient or potentially inefficient are not permitted full tax-deductibility. For example, corporate entertainment expenses are only partially tax-deductible.…”

Captive Insurance Tax Policy: Resolving a Global Problem

“…One established tax doctrine requires that the legal separateness among affiliated corporate entities, including a parent corporation and its captive insurer, be respected for See George L. Head and M. Moshe Porat, 1990, "Tax Treatment of Pre-Loss Risk Financing CostA Public Policy Perspective," Journal of Insurance Regulation,8,4,[394][395][396][397][398][399][400][401][402][403][404][405][406][407] 10 See M. Moshe Porat, et al, 1991, "Market Insurance Versus Self-Insurance: The TaxDifferential Treatment and Its Social Cost," The Journal of Risk and Insurance,58,4,[657][658][659][660][661][662][663][664][665][666][667][668][669] 11 While the Service does not audit every business transaction to insure its economic efficiency, certain classes of transactions that can be clearly identified as inefficient or potentially inefficient are not permitted full tax-deductibility. For example, corporate entertainment expenses are only partially tax-deductible.…”