Is Homogeneity Required to Qualify as Insurance?

Since the income tax was enacted, the IRS and tax practitioners have struggled with the fundamental question: what is insurance? The term is not defined in the Internal Revenue Code except indirectly in I.R.C. § 7702 which defines a life insurance contract. Instead, Congress has deferred to the courts to develop the criteria to determine whether an arrangement will be treated as insurance for tax purposes.

In the context of captive insurance companies, the Tax Court has developed a three-pronged framework for a facts-and-circumstances analysis in determining whether an arrangement is insurance for tax purposes: (1) an insurance transaction must involve “insurance risk”; (2) “insurance” is to be defined in its commonly accepted sense; and (3) insurance involves risk shifting and risk distribution. The courts have characterized the elements of this framework not as independent or exclusive, but as informing each other and, to the extent not fully consistent, confining each other’s potential excesses.