Companies looking to establish insurance coverage, especially in situations involving a captive type of arrangement, will, as always, need to focus on the qualification of the coverage as insurance for U.S. federal income tax purposes. While this traditionally involves an analysis of the risk shifting and risk distribution aspects of the arrangement, an often overlooked factor relevant to the analysis requires a determination of whether the coverage involves an “insurance risk” for these same purposes, or some other excluded type of coverage (for example, coverage for an investment risk). A recent example demonstrating the need to consider this factor surfaced this past week when the Internal Revenue Service (IRS) released a Chief Counsel Advice (CCA 201511021, March 13, 2015) determining in relevant part that a covered product was not insurance for tax purposes because it provided protection for what was determined to be investment rather than insurance risk. In the ruling, an affiliated group of corporations, through its parent, entered into a contract with their affiliated captive insurance company to address certain risks arising from fluctuations in the rate of exchange between the U.S. dollar (USD) and particular foreign currencies. The contracts protected against “loss of earnings” resulting from fluctuations in the value of each specified foreign currency against the USD up to a stated coverage limit for a one-year period. Such “loss of earnings” represented an approximation of the actual loss suffered by the insured corporations, not the actual loss suffered as a result of the change in exchange rate. 

As the IRS noted in its evaluation, the determination of whether an arrangement constitutes insurance for federal income tax purposes is an inexact science, requiring an examination of the underlying facts and circumstances. After considering the substance of the subject contracts, however, the IRS determined that protecting against foreign currency fluctuations did not qualify as insurance because the arrangements lacked “insurance risk.” An insurance risk involves the risk of economic loss resulting from a fortuitous event or hazard; in contrast, an investment risk involves the general risk of business success. The arrangement merely approximated losses arising from changes in currency valuation over a period of time, not an actual loss from a specific damaging incident. Accordingly, the IRS determined that the contracts protected against an investment risk, not an insurance risk, and therefore did not qualify as insurance for federal income tax purposes.

As illustrated in the CCA, one must keep in mind the question as to whether or not the protected-against risk represents a permissible insurance risk or an investment risk in conducting an analysis of a proposed insurance product. Companies should consult with experienced tax advisors regarding such a determination or for answers to any questions with respect to the elements of insurance for federal income tax purposes.