When Does a ‘Protected Cell’ Fail the IRS Test?

Protected cell companies don't always past muster as an insurance captive.


This is the first in a series of regular tax columns by Robert Willens, founder and principle of Robert Willens LLC, a tax publishing and advisory service.

When so-called protected cell companies (PCC) were first introduced to the global market in the late 1990s, they were viewed as an alternative to captive insurers. The new structure allowed companies that were too small to form captives to reap some of benefits of owning an insurance company — such as cost control, stable pricing, direct access to reinsurers, and customized risk management.

In time, PCCs were also used as to ring-fence structured finance arrangements. To be sure, a cell’s income, expense, assets, liabilities and capital are accounted for separately from the PCC and from any other cell. Moreover, the assets of each cell are protected from the creditors of other cells and the PCC.

Currently, several states have enacted statutes that provide for the creation of PCCs. As a result, many U.S.-based PCCs have entered into arrangements with clients which may or may not rise to the level of insurance for tax purposes. Indeed, if the arrangement is characterized by the Internal Revenue Service as insurance, the client receives a benefit, in that “premiums” paid are a deductible expense under Sec. 162(a) of the tax code.

Difference of Opinion

But the IRS has offered two views of PCCs, and in Revenue Ruling 2008-8, the agency analyzed two common scenarios and reached different conclusions regarding the insurance status of each of these arrangements. The difference is tied to the concepts of risk shifting and risk distribution.

The ruling, citing Helvering v. LeGierse, 312 US 531 (1941), says that for an arrangement to constitute insurance two indispensable characteristics, known as risk shifting and risk distribution, must be present. Risk shifting occurs when a person facing the prospect of an economic loss transfers some or all of the financial consequences to an insurer. Risk distribution, as the name implies, occurs when the party assuming the risk distributes its potential liability among others, at least in part.

A transaction between a parent and its wholly-owned subsidiary will not satisfy these requirements if only the risks of the parent are insured (see Carnation Co. v. Commissioner, 640 F.2d 1010 (9th Cir. 1981). On the other hand, an arrangement between an “insurance subsidiary” and other subsidiaries of the same parent may well qualify as insurance.

That is the case even if there are no insured policyholders outside of the affiliated group, so long as the requisite risk shifting and risk distribution are present. (See Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989). In addition, the qualification of an arrangement as an insurance contract is not, in any way, dependent upon or influenced by the regulatory status of the issuer.

Testing the Pool

The first IRS scenario involves a PCC, which was formed by a sponsor under the laws of jurisdiction A. The PCC has established multiple accounts or “cells” each of which has its own name and, more importantly, is identified with a specific participant. For the purposes of this article, the PCC will be called Alpha PCC and the sponsor ABC Inc.

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