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Economic family doctrine isn’t really dead

Shared with captive.com by Johnson Lambert & Co.

The Internal Revenue Service in a surprising announcement last week revived, in a fashion, the economic family doctrine with regard to captive insurance companies. The IRS issued proposed regulations that provide guidance regarding the treatment of providing insurance coverage to other members of a consolidated group.

For many years the IRS had maintained that members of a consolidated group could not share insurance risk even though the Court system continually disagreed with that position. In 2001, the IRS issued Revenue Ruling 2001-31 which indicated it was no longer going to invoke the economic family theory cases involving a taxpayer who self-insures through its wholly-owned captive insurance subsidiary. This ruling was welcome news to many consolidated groups as they could now establish a wholly-owned insurance subsidiary. The IRS followed the 2001 ruling with 2002-90 which provided that a valid insurance arrangement could exist in a related party setting provided that there were at least twelve operating subsidiaries and the risk was fairly well distributed amongst all of the members. Numerous captive insurance companies have been formed since 2002 following the guidance contained in this ruling. On September 27, 2007, the IRS announced that the economic family theory has come back to life in a fashion by issuing proposed regulations that will essentially treat intercompany insurance transactions as self-insurance.

The new proposed regulations provide that, where a significant portion (defined as 5% or more) of the business of an insuring member arises from insuring the risks of other members, then the transaction should be treated on a “single” entity basis rather than as separate entities. The effect of this proposed regulation is to treat the insurance transaction in a manner comparable to self-insurance by a single corporation. Although, the insured will still take a current deduction for the premiums paid, the insurance company will not be able to establish loss reserves for incurred but not reported claims. The new regulation also provides that, where the significant insurance member assumes all or a portion of the risk on the insurance contract written on other members of the group by a nonmember, appropriate adjustments must be made to carry out the intent of these regulations.

In making the determination of whether an insuring member is a significant insurance member and therefore, subject to these rules, the regulations use an amount determined under Section 832(b)(4)(A), or gross premiums less reinsurance and return premiums.

These new regulations are effective for any intercompany insurance transaction that occur in consolidated return years beginning on or after the date these regulations are published as final.