Captive Insurance Tax Policy: Resolving a Global Problem

Over the past three decades, the global captive insurance movement has established itself as a significant alternative to traditional insurance. During this period, the controversy surrounding the tax-deductibility of both premiums paid to captives and reserves held by captives has never abated. In the United States, the controversy derives from a fundamental conflict within a federal tax policy that attempts to respect the legal separate-ness of corporate entities, while at the same time questioning the economic substance of transactions between affiliated entities. Because many nations' tax authorities follow the lead of the U.S. Internal Revenue Service on this issue, a resolution of the controversy is of global interest.In this article, the fundamental principles underlying the tax-deductibility of both insurance premiums (for the insured) and insurance reserves (for the insurer), are examined from both theoretical and practical perspectives. The authors then propose a heuristic method for justifying the tax-deductibility of premiums based upon an index that measures: (1) the extent to which the captive is constrained by market forces to engage in the “business of insurance,” and (2) the efficiency of risk transfers. The deductibility of reserves is addressed by a special case of the index.This approach provides a unified resolution to issues of tax policy for captive insurers that allows for partial solutions in the spectrum from no tax-deductibility to full tax-deductibility, and provides consistent solutions to all arrangements involving captives, including variations in the ownership structure and in the types of business written. The authors argue that the approach is both theoretically sound and intuitively appealing; that it is consistent with the U.S. government's established policy of favoring traditional insurers over alternative risk management techniques; and that it is fair and reasonable to all parties, reducing incentives for abuse, litigation, and distortions of economic activity.