The main issue for the parent company and the captive insurance company is whether the captive is a valid insurance entity. This determination has an effect on the tax deduction for the premiums paid from the parent and/or related entities to the captive.
In order for the captive to be treated as a true insurance entity for income tax purposes, the elements of risk-shifting and risk-distribution must be present.
This has been established in several cases in the tax courts.
Risk-shifting – is defined as the transfer of the impact of a potential loss from the insured to the insurer. If the insured has truly shifted the risk, then a loss incurred on the risk does not affect the insured. Instead, the insurer bears the loss in its payment of proceeds to the insured.
Risk-distribution – is the spread of the risk of loss to others beyond the insured. Therefore, if the insured suffers a loss, the cost of the loss is distributed to all parties who have paid a premium to the insurer. The more parties which insure their risks and pay insurance premiums to the insurer, the more distribution of risk.
How can risk-distribution and risk-shifting be established?
There are two ways to ensure that some degree of risk-shifting and risk-distribution applies. They are reinsurance and unrelated party insurance. Reinsurance is only effective for the portion of the risks being insured. The introduction of unrelated insurance can, however, provide both risk-shifting and risk-distribution for the captive as a whole, provided that it meets certain requirements.
Source: Tax Issues – Thought # 1