Is Homogeneity Required to Qualify as Insurance?

Since the income tax was enacted, the IRS and tax practitioners have struggled with the fundamental question: what is insurance? The term is not defined in the Internal Revenue Code except indirectly in I.R.C. § 7702 which defines a life insurance contract. Instead, Congress has deferred to the courts to develop the criteria to determine whether an arrangement will be treated as insurance for tax purposes.

In the context of captive insurance companies, the Tax Court has developed a three-pronged framework for a facts-and-circumstances analysis in determining whether an arrangement is insurance for tax purposes: (1) an insurance transaction must involve “insurance risk”; (2) “insurance” is to be defined in its commonly accepted sense; and (3) insurance involves risk shifting and risk distribution. The courts have characterized the elements of this framework not as independent or exclusive, but as informing each other and, to the extent not fully con- sistent, confining each other’s potential excesses.

Under the Tax Court’s test, the existence of “insurance risk” is a threshold requirement in determining whether insurance exists for tax purposes. Generally, insurance risk is present if an insured faces some hazard, and an insurer accepts a premium and agrees to perform some act if or when the loss event relating to the hazard occurs. The focus is on the nature of the losses covered by the policies and the designated responsibility for payment of those losses. In general, this part of the test probably will be met if: (1) the types of risk insured are risks for which commercial insurance companies typically issue insurance policies; and (2) the terms of the pol- icy do not convert the coverage to a mere investment risk, a loan, a mere claims-servicing arrangement, or some other arrangement that does not involve insurance risk.