"Life is risk," or so says King Benny in the movie Sleepers in response to Dustin Hoffman's character's attempt to avoid becoming involved in an underworld conspiracy. The point may be a cliché, but it's true. Risk cannot be avoided. Nonetheless, ever since Renaissance merchants created insurance to mitigate the damage of lost cargo on voyages to the Far East, business has relied on indemnification from insurance to prevent financial ruin should a risky event occur.
Like most common-law concepts, it has taken many individual cases and many decades—in some cases, centuries—to develop a settled view of the necessary elements for a valid insurance policy. These elements are a definable risk, a fortuitous event, an insurable interest, risk shifting, and risk distribution. In addition, there is a very important legal difference between a reserve and an insurance company.
Because the law of contracts is used to interpret an insurance policy, the basic elements of contract (offer, acceptance, and consideration) must be present for a court to uphold an insurance agreement. The insurer offers indemnification, or "compensation for a past loss," as its part of the bargained-for exchange. But this is only offered in the event that a specifically enumerated and clearly defined risk occurs.
Defining Risk
The risk can be broadly or narrowly defined; the only definitional limiting factors are statute and public policy. As an example, the standard property policy provides coverage in the event of 11 specifically named perils: fire, lightning, explosion, windstorm or hail, smoke, aircraft or vehicles, riot or civil commotion, vandalism, sprinkler leakage, sinkhole collapse, and volcanic action. All other insurance policies contain similar language for their respective underlying coverage. The occurrence of the risk is a condition to the insurer's performance, and, therefore, must be clearly evident from a plain reading of the policy or contract.
But the risk's occurrence must have an additional component: fortuity. Indemnification from insurance only occurs if the happening of the loss cannot be predicted because foreseeable risks can either be planned for to mitigate damages or avoided altogether, thereby eliminating the need for insurance.
Fortuity
The unknown or unforeseen element of the fortuity definition is best explained by the three primary fortuity-related defenses offered by insurers to deny a claim. The first of these is the "known loss" defense where an insurer will argue that the loss had either already occurred or the insured should have known the loss would occur when he or she purchased the policy. The assumption in the latter case is that the insured should have taken appropriate steps to mitigate the foreseeable damage.
In the second defense, the insurer will assert some type of advance preparation was warranted because the possibility of loss was so high as to make the event unavoidable.
In the third case, the insurer will aver the loss was ongoing when the insured purchased insurance. The one common element to all of these defenses is the assumption that the insured knew or should have known that a loss had either occurred or was so likely to occur as to warrant some type of preventative action.
Insurable Interest
A third insurance element is a relationship between the insured and the property insured must be such that property damage will negatively impact the insured's finances. This relationship is also referred to as insurable interest, an element of insurance that developed over a considerable period of time. During the Renaissance, individuals who had no ownership interest in either the boat or cargo would nonetheless buy an insurance policy on a specific vessel or its contents—a practice that encouraged obvious illegal activities. And, despite having no familial relationship, individuals in the 1800s purchased life insurance on celebrities' lives as a way to profit from their death. Courts eventually concluded that allowing this practice promoted economic waste and potentially encouraged illegal activities. As such, the insured would eventually have to demonstrate a strong-enough relationship with the subject of the insurance such that property damage would directly hurt the insured.
And finally, and by far most importantly, is the legal difference between a reserve and an insurance company. A reserve is an accounting entry, where a company will set aside money for a particular contingency. 1 As an example, suppose you have to pay a friend $100 by the end of the year. In anticipation of making a future payment, you put the money in an envelope and place it in a drawer. A business setting up a reserve conceptually performs the exact same actions: they identify a potential contingency ("we'll have to pay $1,000 to John Smith") and then escrow money for its payment ("here is the $1,000 we will pay to John Smith by a specific date"). They account for the practice by setting up a reserve in their general ledger, which is then placed on its balance sheet as a liability. But, most importantly, the person or company establishing the reserve uses his/her/its own monies to extinguish the reserve and pay the claim for which the fund is established.
Risk Shifting and Risk Distribution
In contrast, an insurance transaction must contain risk shifting and risk distribution, both of which were first stated as requirements in the case Helvering v. LeGierse, 312 U.S. 531, 61 S. Ct. 646 (1941). Risk shifting is a straightforward concept: the insured must transfer the financial burden of loss to the insurer. This element is accomplished via contract, is rarely in dispute, and is proven by the insurer's paying a claim to the insured—a process often referred to as "indemnification" or "making the insured whole."
Risk distribution requires a more in-depth explanation. Begin with the risk born by a single home owner who does not have property insurance. It is highly unlikely he will have sufficient financial resources to replace his home in the event that it is destroyed by a fortuitous event. But if that individual pools his or her risk with other similarly situated home owners who live across a geographically diverse area, a key development occurs: The possibility that the insured's funds will return to him as part of the indemnification payment decrease. It is this pooling of premiums in the insurance company that allows it to avoid being called a reserve fund for tax purposes and is the key difference between a reserve and insurance company. In effect, the insured has shifted his or her risk of loss not only to a separate company but to other parties.
The distinction between a reserve and an insurance company carries with it very important tax ramifications: insurance premiums are deductible; reserve payments are not. The nondeductibility of reserves comes from a series of cases tried by the Bureau of Tax Appeals in the early 20th century. In all these cases, the court ruled against the taxpayers, citing a variety of the following legal theories.
- The tax code allowed a deduction for business expenses but not for amounts paid into an internally held reserve. This is supported by a strict reading of the statute. 2
- Moving funds internally—from cash to a reserve or from one corporate "pocket" to another—does not shift the risk as required by insurance.
- Preventing the manipulation of gross income through the use of "reserves" and "contingency funds" as outlined in Spring Canyon Coal Co. v. Commissioner of Int. Rev., 43 F.2d 78 (10th Cir. 1930). 3
- Both accrual and cash accounting methods require the taxpayer to deduct specific "realized" amounts. A taxpayer cannot deduct a speculative amount. 4
Finally, there is an interrelationship between risk shifting and risk distribution such that they are the "flip sides of the same coin." 5 They are rarely discussed except in tandem, and the terms are often used interchangeably in the captive case law.
All five of these elements must be present in all insurance transactions. If even one is absent, insurance does not exist.
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Footnotes
John Downes and Jordan Elliott Goodman, Finance and Investment Handbook, pg. 446, third edition, 1990.
2 See also Appeal of William J. Ostheimer, 1.B.T.A. 18, 21 ("The statute specifies what deductions are allowable and, except in the case of in insurance companies, no provision is made in the 1918 Act for the deduction of a reserve as such.").
3 See also Appeal of Consolidated Asphalt, 1 B.T.A. 79, 81 ("When estimating the reserve to set aside for a construction contract, the appellant's accountant doubled the amount set aside for the years in question.").
4 See Gen. Couns. Mem. 35340, (May 15, 1973) ("However, because anticipated casualty losses are contingent in nature, it is a firmly established principle of tax accounting that even as accrual basis taxpayer may not deduct amounts it adds to a reserve for insuring its own risks.").
See Priv. Ltr. Rul. 200724036 (March 20, 2007), Priv. Ltr. Rul. 8844001 (Feb. 26 1988), Priv. Ltr. Rul. 8111087 (Dec. 18 1980), Priv. Ltr. Rul. 200950017 (Sept. 8 2009), and Priv. Ltr. Rul 200644047 (April 7, 2006).
