The Legal Definition of Insurance, Part II


Risk Shifting and Risk Distribution


Risk shifting and risk distribution, were both stated as requirements by the Supreme Court in Helvering v. LeGierse.[1]  Risk shifting is a straightforward concept: the insured must transfer some or all of the financial burden of loss to the insurer.  This element is accomplished via contract and is rarely in dispute, as attested to by the dearth of case law on point.

Risk distribution requires a more in-depth explanation.  Begin with the risk borne by a single homeowner who does not have property insurance.  It is highly unlikely he will have sufficient financial resources to replace his home in the event it is destroyed by a fortuitous event.  But if that individual pools his risk with other similarly situated homeowners 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, since all of the insureds are unlikely to suffer a simultaneous loss; while it becomes more likely that one insured’s funds (and any earnings thereon while held by  the insurer) will ultimately support a payment to another insured who has indeed lost his home.  It is this pooling of premiums in the insurance company, resulting in a distribution of the risk of loss (and potential for indemnification) across the entire pool of insured persons, that prevents insurance from being merely a reserve fund for tax purposes:  this is the key difference between a reserve and an insurance company.  In effect, the insured has shifted his risk of loss not only to a separate company but to other parties.


The Difference Between A Reserve and An Insurance Company


A reserve is an accounting entry, whereby a company will designate an amount of its funds in anticipation a particular contingency emerging.[2]  For example, a business anticipates it will have to pay $1,000 for a potential loss.  To account for this, the business establishes a reserve account in its general ledger which is then placed on its balance sheet as a liability.  But most importantly, the person or company establishing the reserve ultimately uses his/its own monies to extinguish the reserve and pay the claim.

The distinction between a reserve and an insurance company carries with it important tax ramifications: insurance premiums are deductible;[3] reserve payments are not.  The non-deductibility of reserves developed over a series of cases before the Bureau of Tax Appeals in the early 20th century.  In all these cases, the Bureau held against the taxpayers, citing a variety of legal theories:

  • The tax code allows 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.[4]
  • Moving funds internally – from cash to a reserve or from one corporate “pocket” to another – does not shift the risk as required by insurance.[5]
  • Preventing the manipulation of gross income through the use of “reserves” and “contingency funds” is an important tax principle.[6]
  • Both accrual and cash accounting methods require the taxpayer to deduct specific “realized” amounts. A taxpayer cannot deduct a speculative amount.[7]


[1] Helvering v. LeGierse, 312 U.S. 531 (1941) (An insured purchased both an annuity and a life insurance policy very close to her death.  After she died, the estate filed an estate tax return and did not include the proceeds of life insurance in the estate. In analyzing the transaction, the court noted: “That life insurance is desirable from an economic and social standpoint as a device to shift and distribute risk of loss from premature death is unquestionable. That these elements of risk-shifting and risk-distributing are essential to a life insurance contract is agreed by courts and commentators.”  The court simply used the two terms within the same sentence.  Subsequent cases over the next 40-50 years would provide guidance as to the exact definition of each term.).

[2] Downes at 446 (a reserve is a “segregation of retained earnings to provide for such payouts as dividends, contingencies, improvements or retirement of preferred stock.)

[3] 26 U.S.C. 162(a); Treas. Reg. 1.162-1(a)(“ … together with insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business,”)

[4] 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.”).

[5] Pan-American Hide Co. v. Commissioner, 1 B.T.A. 1249 (B.T.A. 1925) (“The taxpayer’s contention in effect is that it may take from its income in one pocket an amount equal to what it would have to pay as fidelity insurance premiums and put this in another pocket as a reserve and deduct it from gross income as an ordinary and necessary expense incurred in its business.”)

[6] Spring Canyon Coal Co. v. Comm’r of Internal Revenue, 43 F.2d 78 (10th Cir. 1930). 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.”).

[7] 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 an accrual basis taxpayer may not deduct amounts it adds to a reserve for insuring its own risks.”).

About F. Hale Stewart JD, LL.M

F. Hale Stewart, Esq. is a partner at The Hale Stewart Law Firm.