Presentation by Michael-Paul James on The Tax Deductibility of Premiums Paid to Captive Insurers: A Risk Reduction Approach Li-Ming Han, and Gene C. Lai

1. The Tax Deductibility of
Premiums Paid to Captive
Insurers: A Risk Reduction
Approach
Li-Ming Han, and Gene C. Lai
Presentation by Michael-Paul James

2. TABLE OF CONTENTS
All content in this presentation is quoted or paraphrased directly from paper.
01
Introduction
The question, the
context, the issues
02
Risk Shifting
Risk reduction or
shifting?
03
Parent Contribution
Negotiating the
differences in opinions
04
Resolutions
A new theory and its
application
2

3. Introduction
The question, the context, the
issues
01

4. Research Question
Should premiums to captive insurers enjoy the same
tax benefits as those awarded to independent
insurers?
● Note: Captive insurers are insurances subsidiaries of a noninsurance
firm (parent) who own the insurer.
4
01

5. 33%
of Fortune 500
Formed Captive Insurers
1991
By 1998, 80% of Fortune 500 companies owned captives
By 2021, 90% of Fortune 500 companies owned captives
Why?
1. Provide non-conventional coverage not available in market.
2. Save premium costs
3. Stabilize parents’ earnings.
4. Tax and distribution advantages
5. Asset protection from creditors
6. Access to lower cost reinsurance market
5
01

6. Paper’s Purpose
1. Clarify the concept of risk shifting.
2. Maintain the concept of the proportionate
contribution of the parent’s specific risk to the
parent’s total risk as a relevant measure for tax
deductibility of premiums paid to the captive.
3. Develop a theory to resolve the difference opinions
among the Tax Court, the IRS, and the companies
involved in the tax deductibility issue.
4. Develop a method to determine the degree of tax
deductibility of premiums paid to captives.
6
01

7. Ruling Conflict
● IRS Ruling 88-72
○ No level of outside risk results in risk shifting
○ Premiums paid to captives writing outside risks are not tax
deductible
● Two conflicting decisions with IRS 88-72
○ Tax Court on 1987 Gulf Oil Decision
○ IRS General Counsel Memorandums (GCM) 35483 & 38136
■ Both ruled that premiums are tax deductible if captives
underwrote substantial external risks.
■ Court indicated that risk was passed to unrelated policy
holders.
7
01

8. Risk Shifting
Risk reduction or shifting?
02

9. Risk Shifting
● To measure the effect of risk shifting
○ The ratio of the parent’s total risk with and without outside risks.
■ Smith (1986) concludes total risk increases by underwriting
outside risks, supports IRS 88-72
○ Expected income and variance of net income variability
■ Hofflander and Nye (1984) propose if the variables do not
change under different strategies, neither should the tax
code.
○ Focus: whether relationship between captive and parent reduce
risks, not whether it should be shifted to outside insureds.
■ Outside risk not considered in tax effects for non-captives.
○ A parent company cannot shift risk to outside policyholders
through the captive.
9
02

10. Risk Measures
● Variance and Standard Deviation
○ Accepted by the court system regarding captives
○ Parent-Specific Risk
■ Firm is the parent of a captive
○ Captive Risk
■ Risk of the captive
■ Captive Total Risk = Parent-Specific Risk + Outside Risks
○ If Parent wholly owns captive:
■ Captive Total Risk = Parent-Specific Risk
■ Otherwise, Captive Total Risk ≠ Parent-Specific Risk
10
02

11. Risk of Wholly Owned Captives
Figure 1: The relationship of the parent total risk, captive total risk, and parent specific risk of the wholly owned captive insurer.
11
02
Parent
Total Risk
Captive
Total Risk
Parent
Specific Risk
Outside
Risk

12. Shifting Motives
● IRS historically rejected tax deductibility of
premiums to wholly owned captives.
● Economic Family Doctrine (pre 1977)
○ Those who bear the ultimate economic burden of loss are the
same persons who suffer the loss
● Substance over form criterion (1977)
○ Transactions recorded in the financial statements and
accompanying disclosures of a company must reflect their
economic substance rather than their legal form.
● Risk Shifting Theory (1986)
○ 88-72: Parent’s loss exposure increases with outside risk
underwritten by captive.
12
02

13. Risk Shifting Theory
● Risks are not shifted to policyholders except in the
case of insurer bankruptcy.
● Risk Shifting Theory: A pure risk transferred from
the insured to the insurer, who is generally in a
stronger financial position.
● Policyholders shift risk to captive and ultimately to
parent.
● Risk Shifting is a special case of risk reduction
● Risk Reduction can be achieved through
diversification (Law of Large Numbers)
13
02

14. Parent Contribution
Negotiating the differences in
opinions
03

15. Proportionate Contribution
● Parent-total risk or parent-specific risk?
● Larger capital and surplus lowers insolvency risks.
● Increase of parent-total risk should be irrelevant to
tax deductibility of premiums.
○ Risk has never been a factor in tax deductibility.
● Theory: If the proportionate contribution of the
parent-specific risk to the parent total risk is
reduced as a result of diversification, then the
parent should be rewarded for the diversification
with partial tax deductibility.
15
03

16. Degree of Tax Deductibility
● Varcm
= m Vard
without outside risks
● Varcn
= n Vard
with outside risks
● n > m, therefore Varcn
> Varcm
● Captive risks increase with added outside risks
○ Vard
: Variance of one unit of exposure in terms
of dollars
16
03

17. Smith’s error
● Captive total risks
● σc
2
= p2
σp
2
+ (1-p)2
σo
2
σc
: variance of captive loss distribution
σp
: variance of parent loss distribution (written by captive)
σo
: variance of outside risks loss distribution (written by captive)
p: risk proportion of parent premiums (written by captive)
Wrong:
1. Variance with total dollars lost increases with more outside risks.
2. If relative unit, represents the captive total risks not parent total risk
17
03

18. A Relative Risk Measure
18
03
Recognizes the additional premiums received by the captive when
writing outside risks.

19. Variance Decreasing in n
19
03
By the law of large numbers (LLN), captive underwriting risks decrease as
n increases.

20. Parent-specific contribution
20
03
Each term represents effects of one unit of risk to parent-total risk.
m terms are associated with contribution of parent-specific risk.
Note from equation 7: Fama, “Foundations of Finance” 1976

21. Parent proportionate contribution
21
03
Parent’s percentage contribution decreases as additional outside risks
are written. The impact of the covariance term σij
increases with
additional outside risks (n-m)

22. 2 Assumptions
22
03
● IID Risks
○ Variance: π = 1 - m/n
○ Standard Deviation: π = 1 - (√m)/(√n)
○ Variance leads to higher tax deductibility.
● Equal Covariances Across Pairs of Risks
○ Holds above equations

23. Resolutions
A new theory and its
application
04

24. Applications
24
04
● Case I- Conventional Insurance
○ Firm’s contribution of specific risk to total risk is zero (m = 0)
○ Insurance premiums are fully deductible (π = 1)
● Case II- Self Insurance
○ Firm’s does not reduce nor shift any risk (m = n).
○ Insurance premiums are not tax deductible (π = 0)
● Case III- Single Parent Captive, No Outside Risks
○ Firm’s does not reduce nor shift any risk (m = n).
○ Insurance premiums are not tax deductible (π = 0)
● Two methods (Reminder)
○ Variance: π = 1 - m/n
○ Standard Deviation: π = 1 - (√m)/(√n)

25. Applications
25
04
Table 1: An illustration of the degrees of tax deductibility using variance and standard deviation as risk measures (100 total risks, m parent risks)
m 0 10 20 30 40 50 60 70 80 90 100
VAR* π 1.000 0.900 0.800 0.700 0.600 0.500 0.400 0.300 0.200 0.100 0.000
SD π 1.000 0.684 0.553 0.452 0.368 0.293 0.225 0.163 0.106 0.051 0.000
*VAR and SD Identifies that the degrees of tax deductibility are obtained by using the variance and standard deviation as risk measures
● Case IV- Single Parent Captive with Outside Risks
○ Firm’s reduces or shifts risk by the variance or standard
deviation method.
○ Insurance premiums are partially tax deductible (π ≠ 0,1)

26. The Gulf Oil Case
26
04
Table 2: Gulf Oil: Captive Risk Breakdown
Year % of Unrelated Risk
1975 2
1976 7
1977 16
1978 51
1979 54
1980 53
1981 54
1982 48
1983 62
The data are quoted from Duer (1989)
● Court refused deductions before 1975 due to lack of unrelated risks
● Case footnotes suggest full deductibility after 1978 (> 50%).
● Court’s all or nothing approach to be replaced with paper’s method.

27. Application
27
04
● Case V- Group Captive with Outside Risks
○ Firm reduces risk through partial ownership and outside
diversification.
○ Insurance premiums are partially tax deductible.
○ α: parent’s proportional ownership of the captive.
○ Partial ownerships has no impact on deductibility because the
partial ownership is offset by partial retention of captive risk

28. Application
28
04
● Case VI- Carnation Case (Reinsurance)
○ Firm uses commercial insurer, the commercial insurer reinsures
partially with the Firm’s captive.
○ Use same method as IV.
○ Substance over Form Criterion

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