Self-insured? There may be a better option: most major U.S. corporations use self-insurance, but 'tax insurance' may offer a better answer for risk avoidance and improve both balance sheet and income statement ratios.

• Author: Perera, Nemo
• Position: Insurance

The vast majority of Fortune 2000 firms use some form of self-insurance, accruing a reserve of funds for potential physical, financial, property or employee losses on lieu of purchasing a policy from companies in the business of insuring these types of losses.

However, there are instances where self-insurance strategies might actually be harming companies--such as setting up of a reserve and accruing for tax liabilities when the company has taken an aggressive position in claiming certain tax deductions or tax credits, and is unsure its tax position will be upheld.

Fortunately, in these days of the Public Company Accounting Oversight Board (PCAOB), the Securities and Exchange Commission (SEC) and Internal Revenue Service (IRS) all peering over the shoulders of tax directors and CFOs, a new management tool has emerged to help ease the pain of reserving for taxes and immediately improve financial results: tax insurance.

This insurance can eliminate accounting accruals for contingent tax liabilities by insuring the contingent tax liability itself. Extinguishing the contingent tax liability allows the corporation to enjoy the immediate benefit of profit improvement by eliminating the contingent reserve on the income statement. Thus, this type of market insurance has several advantages over self-insurance, among them: significant risk reduction, low cost, known timing and tax minimization strategies that serve to maximize the firm's value.

The Tax Insurance Strategy

Tax insurance is a relatively new risk-financing technique that a number of companies are implementing. Tax insurance can be defined as a transfer by a ceding enterprise (a corporation) to an assuming enterprise (a major insurance company) of the liability for potential taxes due in a transaction in which the primary element of risk is financial rather than strategic. An important feature of such an arrangement is that it represents an unconditional financial commitment by the assuming enterprise to pay a sum certain in amount: the face value of the insurance policy.

In practice, the need for this type of contract occurs when there are concerns about previous or future tax positions taken, or the IRS either will not issue a private letter ruling or there is insufficient time to obtain one. Some other examples of previous or future tax positions taken that can be insured include issues arising as a result of concerns about:

* Availability of corporate net operating loss (NOL)...