Captive insurance arrangements more common

Most protected cell companies involve a commercial insurer that sponsors a captive insurance company. That captive has several segregated cells which are funded by business insureds to cover their own risks. These arrangements are often used by small- to mid-sized businesses that do not have the expertise or resources to establish their own captive insurance company.

The IRS has published a new Revenue Ruling (2008-8), which provides guidance with respect to tax issues pertaining to protected cell companies. Protected cell companies are insurance companies, often formed offshore, which have multiple separate cells, each of which are insulated from the credit risks of the other cells. In effect, they have multiple companies operating within a single corporate entity.

CONSISTENT VIEW

The IRS has taken a consistent view over the years that more than one insured must be involved in order for the elements of risk shifting and risk distribution to be present. For example, a captive insurance company owned by, and insuring the risks of, a single parent does not satisfy the risk shifting and distribution requirements. The new Revenue Ruling continues to follow this position, but has not answered the key question of how many insureds are enough.

In following its prior precedent, the IRS concluded that an arrangement whereby the cell provided liability coverage to its sole shareholder, and no others, did not involve risk-shifting and distribution. Thus, the arrangement did not constitute an insurance contract, and the sole shareholder was not allowed to deduct the premiums it paid to the cell.

On the other hand, if a cell is used to insure the risks of multiple affiliated entities, then the premiums paid by the affiliates would be considered insurance premiums and would be tax-deductible. The IRS concluded in that situation that risk-shifting had occurred among the affiliated entities.

The Revenue Ruling settles the question of whether the mere existence of multiple cells within the protected cell company changes the historical analysis of whether an insurance contract exists. It does not-risk shifting and distribution must still be present. While the Revenue Ruling is important in that it provides clarification on this point, it should not come as a surprise to most corporate taxpayers.

This column is written for informational purposes only and should not be construed as legal advice.

Barry Senterfitt is a partner in the insurance industry practice of Akin Gump Strauss Hauer & Feld LLP in the firm's Austin, Texas, office.