Distinguishing Risk: The Disparate Tax Treatment of Insurance and Financial Contracts in a Converging Marketplace
David S. Miller
Proskauer; Proskauer Rose LLP
May 2, 2002
Tax Lawyer, No. 2, Winter 2002
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.
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.
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 in vestment 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.
Number of Pages in PDF File: 104
Date posted: May 15, 2002 ; Last revised: January 4, 2011