Section of Taxation Publications
  VOL. 55
NO. 2
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 Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
 Distinguishing Risk: The Disparate Tax Treatment of Insurance and Financial Contracts in a Converging Marketplace
David S. Miller

Partner, Cadwalader, Wickersham & Taft, New York, New York. University of Pennsylvania, B.A. 1986; Columbia University, J.D. 1989; New York University, LL.M. 1994. This article was originally presented to the Tax Forum on October 1, 2001.


The distinction between an insurance contract and a financial instrument was once well understood. Insurance contracts transferred primarily insurance risk-the risk of loss upon the occurrence of an insurable hazard, such as a natural disaster, death, or theft-and were issued only by regulated insurance companies and only to a holder with an insurable interest. Financial instruments, on the other hand, provided an investment return or reflected primarily financial risk-the risk of changes in the value of a business, a commodity or other property, or a financial index-and could be issued by unregulated entities and to a broad spectrum of investors.

However, investor sophistication, capital markets liquidity, and financial innovation have blurred these nice distinctions. The credit protection traditionally available only through bond insurance is now offered by counterparties of financial instruments, such as credit linked notes, credit default swaps, and credit options. For instance, the risk of a natural disaster, which historically was borne by only insurance companies, is now assumed by the holders of catastrophe and weather bonds and derivatives. Conversely, the investment returns historically available only through conventional stocks, bonds, mutual funds, and other financial instruments are now available through whole-life and variable life insurance products, residual value, finite, retroactive, and retrospectively-rated insurance policies.

Although the capital and insurance markets have evolved and converged, the tax laws that apply to these instruments have not, and the characterization of a particular instrument as an insurance contract (or its issuer as an insurance company) gives rise to consequences that are radically different from those that would result if the instrument were treated as a financial contract. This static bipolar tax treatment of instruments in a converging marketplace at once places a premium on the characterization of a contract as insurance or, alternatively, as a financial instrument, and permits tax arbitrage. The arbitrage potential, in turn, invites a reexamination of the tax policies underlying each regime, the continuing justification for their disparate tax treatments, and the prospects for rationalization.

Part II of this Article explores the differences in tax treatment between an insurance contract and an economically similar non-insurance financial instrument that offers asset or liability protection. These differences affect both the purchasers and issuers of the protection in different ways. For example, periodic insurance (and guarantee) premiums generally give rise to current ordinary deductions, but periodic option premiums give rise only to a capital loss, and only upon lapse. In addition, life insurance proceeds are generally exempt from all income taxes and offer favorable basis recovery rules and tax-free access to appreciation.

Companies that issue insurance contracts as their principal business are deemed to be corporations for federal income tax purposes, while companies that issue economically equivalent options or other non-insurance financial instruments may qualify as partnerships. Tax-exempt organizations issuing insurance generally are subject to tax on their insurance income; tax-exempt organizations entering into non-insurance financial instruments generally are not. On the other hand, insurance companies benefit from Subchapter L, which offers them exceptions from generally-applicable principles of realization-based taxation that are not available to taxable companies entering into non-insurance financial instruments.

Other distinctions apply to foreigners issuing protection. An excise tax is imposed on certain insurance premiums paid by U.S. taxpayers to foreigners, but no withholding or excise taxes are generally imposed on option premiums or notional principal contract payments. Finally, U.S. shareholders of foreign insurance companies may escape the anti-deferral regimes that would apply if the foreign corporations had issued non-insurance financial instruments.

Part III of this Article discusses the definition of insurance for federal tax purposes. Formulated by the Supreme Court in 1941, the definition involves four separate elements: (i) the form and local law regulatory treatment of the contract, (ii) the predominance of "insurance risk," (iii) a net transfer of that risk, and (iv) a "pooling" of that risk with other risks. Part III explains that the test, which was originally crafted to exclude the proceeds of a combination insurance and annuity contract from a long-since-repealed estate tax exemption, is less reflective of the broader tax policies surrounding the distinction between insurance and other financial instruments, and has been applied unevenly in the past 60 years. Part III argues that the transfer of insurance risk only-and not pooling-should be necessary for an insured to achieve the tax consequences associated with insurance, that the scope of insurance risk should be interpreted broadly, and that pooling should be relevant only to determine the insurer's taxation, whether as a domestic insurance company eligible for taxation under Subchapter L, or as a foreign insurer or reinsurer subject to the excise tax on premiums.

To demonstrate the limitations of the existing definition, Part IV applies the current definition of insurance both to insurance products with investment features and financial instruments with insurance features.

Finally, Part V discusses the tax policies surrounding the treatment of taxpayers that transfer and assume risk generally, and insurance in particular, touching upon five different topics: (i) the proper timing and character for taxpayers that buy asset and liability risk protection, (ii) the proper scope of Subchapter L and the proper timing of income and losses for taxpayers subject to it, (iii) the proper tax treatment of tax-exempt and foreign risk protectors, (iv) the proper tax treatment of U.S. shareholders of foreign risk protectors and, finally, (v) the appropriate scope and breadth of the existing tax subsidy for life insurance.

Part V makes eight salient (and somewhat sweeping) observations and suggestions. First, to rationalize the current law regarding captive insurance companies, Congress should either permit current deductions for a portion of a taxpayer's actuarially-determined reserves and self-insurance or, alternatively, deny deductions for insurance (and other risk-management) premium payments made to related insurance companies that do not insure unrelated risks. Second, to better measure taxpayers' economic losses and eliminate the current tax preference for liability insurance, Congress or the Service should allow current deductions for nonrefundable payments made for past-act liability protection, regardless of whether the protection qualifies as insurance under current law.

Third, to avoid timing and character mismatches for taxpayers that manage their asset risk contractually, Congress or the Service should develop an enhanced integration regime that would apply regardless of the tax characterization of the asset protection. Fourth, to eliminate the disparate tax treatment that currently exists between non-insurance securities dealers and insurance companies offering bond default protection, and to better measure economic income, all such businesses should be subject to mark-to-market taxation.

Fifth, to reduce the existing tax preferences available under Subchapter L, Congress should reevaluate the timing of income and deductions under Subchapter L for insurance companies and consider rules that better measure their economic income and loss regardless of statutory accounting conventions. Sixth, to rationalize the disparate tax treatment of foreigners providing risk protection to U.S. taxpayers, Congress should develop a comprehensive regime for cross-border risk protection, which would apply regardless of the form of the protection as insurance or otherwise.

Seventh, to avoid unjustified deferral by U.S. shareholders seeking primarily investment fund returns, Congress or the Service should define narrowly the exclusion from the passive foreign investment company rules for insurance companies. And, finally, Congress should continue its periodic reevaluation of the scope and breadth of the tax subsidy provided for life insurance products.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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