An Open Letter to State Insurance Commissioners: States of America, Unite!
By: Sean G. King, JD, CPA, MAcc
Your authority and ability to regulate the business of insurance within your state is currently under direct attack by the Internal Revenue Service. Unless states unite to defend their legal authority to regulate insurance, the IRS will become the de facto regulator for some types of insurance in the United States.
For the last several decades, state insurance departments have largely remained silent as the IRS indiscriminately attacked the legitimacy of many of the insurance companies they regulate. This silence has been predicated upon three key assumptions: (1) That it is the job of the states only to regulate insurance and the federal tax consequences of a given transaction are irrelevant to that effort, (2) that IRS attacks on insurance companies hinge upon narrow questions of federal tax law and therefore do not threaten the exclusive authority or ability of states to regulate insurance arrangements, and (3) that such attacks are limited to a subset of the insurance market, namely captive insurance arrangements. These assumptions are simply no longer valid.
Ryan Work, Vice President of Government Relations with the Self Insurance Institute of America (SIIA), recently confirmed in a talk given at the Tennessee Captive Insurance Association annual conference something that I’ve been arguing for several years now: The IRS is explicitly seeking to “usurp” (his word) the power of states to regulate insurance via a nationally-coordinated audit enforcement program targeting insurance companies. The IRS has in fact admitted this: In a recent May meeting with representatives of SIAA, the IRS asserted explicitly that the states were not “doing their job” in regulating the business of insurance and that its recent targeting of insurance companies results from a conscious attempt to take up the resulting regulatory slack.
The outcomes of these audits is determined most often not by the specific fact pattern of the case at hand or by application of esoteric federal tax law provisions but rather by the IRS’s predetermined and completely discredited notion that these insurance companies do not insure real “insurance” risks (in the commonly accepted sense of the word).
Let’s be explicitly clear what the IRS is asserting here: The Service now openly contends that the states are knowingly licensing and regulating bogus “insurance” companies that don’t actually sell any “insurance” (in the commonly accepted sense of the word). If the IRS is to be believed, your insurance department, by licensing “sham” insurance companies, is knowingly aiding and abetting businesses in committing fraud. Why? Simply because doing so brings business and revenue to your state, or so the IRS contends.
The IRS’s self-serving slander of state insurance regulators provides as a useful pretext justifying its intervention in regulating the insurance markets through its audit enforcement efforts. Nonetheless, such intervention presents multiple problems. First and foremost, as noted in the AMERCO case, 96 T.C at 42 (citing McCarran-Ferguson Act), “Congress has delegated to the states exclusive authority (subject to exception) to regulate the business of insurance” [Emphasis added]. Inherent in the grant of exclusive authority to regulate something is the authority of the regulator to decide and define the extent of any required regulation. Given this, the IRS has absolutely no authority to review the work of state regulators or conclude that they are not “doing their job”. The IRS’s attempts to intervene by systematically auditing insurance companies in your state, and alleging that they are insurance “shams”, is an explicit effort by the IRS to redefine your job, to redefine “insurance”, and to replace its regulatory judgement for yours, thereby subverting your exclusive authority of states to regulate insurance.
Recent IRS attacks on the insurance companies you regulate hinge in large part upon whether the risks being insured are properly characterized as “insurance risks” versus merely “business risks” or “investment risks.” In arguing that the risks insured are not properly the subject of “insurance” (in the ordinary sense of that word), the Service consistently relies on legal analysis that, as we shall see below, the courts have repeatedly and soundly rejected.
Note that the IRS is not using these discredited legal arguments to allege that the risks in question are simply “uninsurable” under some esoteric and narrow interpretation of federal tax law. Federal tax law doesn’t even define the term “insurance,” after all. Rather, the Service is arguing that these risks are not the proper subject of “insurance” in the ordinary sense of the word in the first place, and that your department is wrong to have concluded otherwise.
Such attempts by the IRS to very narrowly define “insurance in the ordinary sense” should greatly concern state insurance regulators for at least two reasons. First, inherent in the “exclusive authority” to regulate something is the ability to define it, and without this ability, the authority to regulate is largely meaningless. States have the authority to define what is and is not the proper subject of “insurance in the ordinary sense,” not the IRS.
And, importantly, federal courts agree: In RVI Guaranty (RVI) (which was not a case involving the limited issue of captive insurance arrangements), the court noted, “We have repeatedly emphasized the significance of State insurance regulation in determining whether an entity should be recognized as an “insurance company.” See Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61, 101 (1991), aff’d in part, rev’d in part, 972 F.2d 858 (7th Cir. 1992); Harper Group, 96 T.C. at 60; AMERCO, 96 T.C. at 42; Securitas Holdings, T.C. Memo. 2014-225, at *5-6.” [Emphasis added]
So, when the IRS attacks taxpayer residents of your state for operating properly-licensed and regulated insurance companies on the grounds that such companies don not provide real “insurance in the ordinary sense,” it is explicitly attacking and undermining both your authority to define and regulate insurance and insurance companies.
Second, the IRS’s self-serving attempts to limit the definition of “insurance” to something narrow, and to usurp your regulatory authority by doing so, contradict both Congressional statute and case law. Last year’s RVI Guaranty (RVI) case confirms as much.
The RVI case hinged largely upon whether the insurance company in question sold legitimate “insurance” (in the ordinary sense). In alleging that it did not, the IRS argued that the arrangement insured merely an “investment risk,” lacked the necessary element of fortuity, insured losses that result from indeterminable causes, didn’t insure a “pure risk,” insured only “speculative” risks, etc. The court rejected each of these arguments rather dismissively. Regarding the Service’s contention that the policies in question insured mere “investment risk,” the court concluded:
[W]e reject respondent’s contention that the RVI policies involve an uninsurable “investment risk.” These policies were designed and marketed as insurance products. Similar products were sold in the insurance market by other major insurance companies. These policies were undergirded by insurance strength ratings from the major insurance rating agencies. For more than 80 years the courts have recognized that contracts insuring against the risk that property will decline in value can involve “insurance risk.” The types of events that cause losses under these policies closely resemble the events that cause losses under policies of mortgage guaranty and municipal bond insurance. Most importantly, every State in which petitioner does business recognizes these policies as involving insurance risk and regulates them as “insurance.” [Emphasis added]
Notice that the court’s “most important” consideration in concluding that the risks were properly insurable was your characterization of the arrangement as the proper regulator and definer of “insurance” (per the McCarran-Ferguson Act). The court rightly recognized that your authority to regulate insurance would be meaningless without the commensurate authority to define it.
Regarding the IRS’s position that the RVI policies lacked the necessary element of fortuity, the court concluded:
Respondent’s insistence that “[f]ortuity is essential for risk pooling and the law of large numbers” betrays the narrow and esoteric sense in which he employs the term “fortuity.” As we have explained previously, losses under RVI policies are caused by fortuitous events outside of its control. And its policies clearly do pool risks to take advantage of the law of large numbers. [Emphasis added]
Regarding the IRS’s contention that the precise causes of loss under the policy were indeterminable and therefore such losses were uninsurable, the court concluded:
Respondent’s efforts to split hairs by disentangling the causes of “loss” are philosophically interesting. But we do not think they carry much weight in determining whether the RVI policies constitute “insurance” for Federal income tax purposes. [Emphasis added]
Regarding the Service’s contention that the arrangement was invalid because the risks insured were not “pure risks”, the court said:
Against this consensus of insurance regulators, insurance auditors, and the insurance marketplace, respondent offers Dr. Baranoff’s opinion that the RVI policies are not “insurance” because they do not cover a “pure risk”.
We find respondent’s attempt to distinguish between a “pure risk” and a “speculative risk” in this setting as essentially metaphysical in nature. [Emphasis added]
And finally, regarding the Service’s contention that the risks insured were too “speculative” to be properly insured, the court concluded:
The thrust of respondent’s position is that the RVI policies did not transfer enough risk of loss because losses were relatively unlikely to occur. This argument is on unpersuasive on both theoretical and evidentiary grounds. Both parties’ experts analogized the RVI policies to “catastrophic” insurance coverage, which insures against earthquakes, major hurricanes, and other low-frequency, high- severity risks. An insurer may go many years without paying an earthquake claim; this does not mean that the insurer is failing to provide “insurance.” Mr. Barrett acknowledged that, under many catastrophic coverages, the odds of a loss occurring may be quite low. He was aware of no instance in which an insurance regulator had determined that the risk of loss on a policy of direct insurance was too “remote” for the product to be treated as “insurance.” And respondent offers no plausible metric by which a court could make this assessment. [Emphasis Added]
In short, we can now add the RVI Guaranty case to a long list of cases, spanning nearly forty years, in which the IRS has offered up “narrow,” “esoteric,” hair-splitting, “metaphysical,” and “unpersuasive” arguments in a misguided attempt to undermine the legitimacy of very common insurance arrangements. For a couple of additional recent cases, see Securitas or Rent-a-Center.
Against a consensus of state insurance regulators, insurance company auditors, actuaries, the insurance marketplace, and even the courts and Congress, the IRS stands alone in its continued claims that a great many of the insurance companies that you regulate do not issue real “insurance” policies (in the ordinary sense of the word). Given its absolutely shameful record of unsuccessfully defending its positions in court, why does the IRS persist in making these fallacious arguments against the insurance companies you regulate? Why does it continue to target insurance companies for audit on an industrial scale? Because, via its campaign of audit terror, the IRS can effectively become the de facto regulator of insurance even without Congressional sanction and in contravention of court precedent. As a practical matter, most taxpayers simply can’t afford to defend themselves against IRS attack in court, and there is currently no other mechanism for taxpayers to hold the IRS accountable for its abusive overreach and conscious disregard of the law. Without cost-effective access to the courts, taxpayers are forced to bend to the IRS’s will, and the IRS’s discredited legal positions become the de facto law of the land.
In short, the audit harassment of your resident taxpayers and the companies you regulate isn’t intended to merely enforce tax law, for the courts have spoken on that subject already. Rather the terror campaign represents a unilateral effort of the executive branch of the federal government to extend federal regulatory authority over the insurance markets under the guise of a federal tax law enforcement effort, much like ObamaCare extended federal authority over health insurance in part by enforcing “tax penalties” against individuals who refuse to purchase health insurance. ObamaCare was at least enacted by Congress. By contrast the audit terror campaign against insurance companies proceeds in contravention of Congressional will and despite court rulings overturning the legal arguments upon which these audit enforcement actions hinge.
The only solution to protect both your residents and your authority is a political one. Unless political action is taken to prevent it, the IRS will increasingly become the de facto regulator of insurance in the United States. Effective political action will require the states to speak with a unified voice.
Unless states are prepared to give up regulatory authority, they must actively resist IRS attempts to become the de facto regulator of insurance.