relative contribution of the parent's own risks to the parent's total risks, including the
He maintains that the effect of risk shifting due to the captive underwriting outside risks should be gauged by the ratio of the parent's total risk with and without outside risks.
The two cited studies follow a similar approach: using the parent's total risk as a criterion to compare various risk management strategies such as insurance through a conventional insurer, insurance through a captive and self-insurance, and draw conclusions therefrom.
It should be emphasized that the effect of the captive underwriting outside risks to the parent's total risk is an important concern as well, as discussed in Hofflander and Nye (1984) and Smith (1986).
The purposes of this article are (1) to clarify the concept of risk shifting; (2) to establish the concept of the proportionate contribution of the parent's specific risk to the parent's total risk as a relevant measure for tax deductibility of premiums paid to the captive; (3) to develop a theory to resolve the different opinions among the Tax Court, the IRS, and the companies involved in the tax deductibility issue; and (4) to develop a method to determine the degree of tax deductibility of premiums paid to captives.
The concept of the proportionate contribution of the parent's specific risk to the parent's total risk is established and a method to determine the degree of tax deductibility of premiums paid to captives is developed.
Current tax law allows the deduction of premiums paid to an unrelated insurer, regardless of the size of its total risk being increased or decreased by the outside risks underwritten by its captive.
The above discussion leads to the belief that it is the size of the proportionate contribution of a parent's specific risk to its total risk rather than the size of the parent-total risk itself that should be used in determining the tax deductibility.
In his study, the captive total risk is written as(10) [Mathematical Expression Omitted] where [Mathematical Expression Omitted]: variance of the captive distribution,
Second, although the above equation itself is correct if the variance is measured by a relative unit, the variance so derived represents captive total risk. As discussed in the previous section, it is maintained here that the proportionate contribution to total risk instead of captive total risk should be the relevant risk measure regarding the issue of tax deductibility.
The proportionate contribution of Firm A's insured specific risk to its total risk after insurance is reduced to zero through the conventional insurance transaction.(15) Therefore the insurance premiums are fully deductible in this case.
The current study maintains that the total risk of the firm after "insurance arrangements" is irrelevant.