By Sean King, JD, CPA, MAcc
Principal, CIC Services, LLC
This is part two of our series on the recent Reserve Mechanical tax court opinion that gave the IRS a much-needed win.
In part one of this series we discussed the impact of the Reserve Mechanical decision on risk distribution arrangements in general and on risk pools in particular. We distinguished our views on that subject from those of alarmist commentators, instead placing ourselves firmly among the majority of industry experts who believe that the decision only adversely impacts pools where the transfer of risk is not priced or is mispriced. If anything, the logic used by the judge to invalidate Reserve Mechanical’s risk pool reaffirms the legitimacy of many dissimilarly structured and properly priced pools.
THE ALTERNATIVE BASIS FOR THE JUDGE’S RULING
However, the Reserve Mechanical judge also ruled for the IRS on an alternative basis. Effectively, the judge ruled that even if real risk distribution had been present (that is, if the risk pool had worked), the arrangement still didn’t qualify as insurance “in its commonly accepted sense,” and so the captive wasn’t eligible for favorable tax treatment under Internal Revenue Code Section 501 (c) 15 regardless.
This second part of the opinion is, respectfully, poorly written in relation to the first. A good legal opinion will recite the facts, note the relevant laws, explain HOW the law applies to the specific facts, DISTINGUISH any seemingly contradictory prior precedent, and finally reach a legal conclusion. However, in this case, the judge basically just recites the facts and the law without explaining exactly how the law applies to the facts and without distinguishing prior precedent. This leaves readers guessing as to exactly why the judge decided the way she did.
Some commentators have suggested that each fact mentioned by the judge as a basis for her conclusion is individually significant. In other words, if your captive has any identical fact, then…you’re sunk because the presence of any such fact is enough to taint the entire structure. But, that’s not what the judge actually said, and interpreting the case that way both makes a fool of the judge and overturns years of prior precedent (recent cases where identical facts were specifically deemed by the court to be acceptable).
As a general rule of legal interpretation, it’s improper to just infer that a newer case overturns an older one. Rather, overturning prior precedent generally must be done explicitly. Insightful readers of the Reserve Mechanical decision will therefore make every effort to harmonize the present ruling with prior precedent rather than reading them antagonistically. When that’s done (as we do below), the decision is not quite as radical or controversial as some have suggested.
For the most part, all that’s needed to harmonize the Reserve Mechanical case with precedent is to understand that the facts mentioned by the court as relevant to its conclusion are not individually significant but only cumulatively so.
THE RELEVANT FACTORS
To determine whether the arrangement qualified as insurance in the ordinary sense, the judge weighed and balanced a number of factors (all taken from prior precedent):
“To determine whether an arrangement constitutes insurance in its commonly accepted sense we look at a number of factors, including whether the company was organized, operated, and regulated as an insurance company; whether it was adequately capitalized; whether the policies were valid and binding; whether the premiums were reasonable and the result of an arm’s-length transaction; and whether claims were paid. R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. at 231; Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 24-25; Harper Grp. v. Commissioner, 96 T.C. at 60.”
Below we discuss the court’s analysis of these factors and interpret it in light of prior precedent.
ORGANIZATION, OPERATION AND REGULATION
After finding that Reserve Mechanical, the captive insurance company (“CIC”) in question, was organized and regulated like an insurance company, the court concluded that it nonetheless was not OPERATED like one. In reaching this conclusion, the court cited a number of important facts, some that make perfect sense and others that – at least at first blush – seem to demonstrate either an ignorance of, or complete disregard for the insurance industry, business norms and recent court precedent.
Among the latter is the court’s emphasis on the fact that the CIC had no operational employees and outsourced its management to a third party captive insurance manager.
However, rather than these things being evidence that the CIC wasn’t operated like a real insurance company, they are in fact completely consistent with insurance industry norms and have been for decades. For instance, a significant percentage of all licensed and regulated insurance companies in the world have no paid operational employees. And, the CICs in the precedent-setting Humana, Securitas and Rent-a-Center tax court cases (in which the taxpayers all won!) likewise had zero paid operational employees. In Rent-a-Center, the court’s majority specifically criticized a dissenting judge for clinging to the CIC’s lack of employees as evidencing something nefarious or unusual. Said the Rent-a-Center court:
“In the real world of large corporations, these practices are commonplace. For ease of operations, including running payroll, companies create a staff leasing subsidiary and lease employees companywide. Or they hire outside consultants to handle the operations of a specialty business such as a captive insurer. [This CIC], like Humana, hired an outside management company to handle its business operations. Compare op. Ct. note 6 ([this CIC] engaged Aon to provide management services) with Humana Inc. & Subs. v. Commissioner, 88 T.C. at 205 (Humana engaged Marsh & McLennan to provide management services).”
Also, many US states and foreign jurisdictions that license and regulate captive insurance companies actually require that the CIC appoint an approved third party captive insurance manager and that such manger assume most management responsibility for the CIC. As the Tennessee Department of Insurance has told us (an approved manager in Tennessee) on several occasions, “we ultimately look to you guys to help ensure compliance with the domicile’s rules.” Hiring a third party manager to oversee the CIC isn’t just common, it’s often required!
So, did the court just get that issue wrong? Or, is the court instead saying something more nuanced and fact-dependent? Clearly the latter.
The court’s real issue doesn’t seem to be with the CIC’s lack of employees or use of a third party manager per se, but rather upon the fact that nobody seemed to be looking out for the interests of the CIC, not even its owner, Zumbaum:
“Zumbaum, Reserve’s 50% owner, president, and chief executive officer, knew virtually nothing about its operations. At trial he showed very little knowledge of provisions in the policies that [the primary insured] and his other entities held with [the CIC]. Zumbaum did not know how claims were made or handled, and he did not know where or how [the CIC’s] records were kept. [The CIC’s] operations were managed at [the third party manager’s] direction. It maintained an address in Anguilla, but there is no evidence that any activities were ever performed there.”
According to the court, there was also a lack of due diligence around policy issuance:
“Other than the feasibility study that [the third party manager] produced, there is no evidence that any due diligence was performed for the policies that [the CIC] issued. The feasibility study gave an overview of [the primary insured’s] operations, and some background documents relating to [its] operations were attached to the feasibility study. However, many of the background documents covered periods after [the CIC’s] incorporation. The feasibility study was not complete when [the CIC] issued the direct written policies for 2008 or 2009. The feasibility study did not provide details about the other [two direct] insureds…and they were parties under every policy that [the CIC] issued. These two entities were named as insureds on policies that did not seem to apply to their limited activities.”
The opinion also noted:
“There is no evidence that [the CIC] performed any due diligence with respect to the reinsurance agreements that it executed with [the risk distribution pool]. With respect to the quota share arrangement it agreed to assume risks relating to a number of different businesses and a number of different lines of insurance. Nothing in the record indicates that [the CIC] or anyone performing activities on [the CIC’s] behalf evaluated these risks before executing the quota share policies.”
Remember, as we discussed last week in detail (HERE), the risk distribution pool in the Reserve Mechanical case did not transfer a fixed percentage of the first-dollar-to-last-dollar risks on the underlying direct policies to the CIC. So, actuarially speaking, the transfer of risk from the risk distribution pool required separate actuarial pricing, pricing that did not exist in this case. The result was that the CIC assumed risks of the pool while (if the court is right) having done no diligence to ensure that it was adequately compensated for doing so. This is, of course, not something that an ordinary self-interested insurance company would do.
Another factor indicating that nobody was looking out for the interests of the CIC was its claims procedures (or lack thereof):
“Only one claim was filed under [the CIC’s] direct written policies. A claim notice was generated for the Stillwater loss, but no supporting documentation accompanied the claim notice. [The insured] did not submit and [the CIC] did not insist on obtaining any documents to substantiate the occurrence or the amount of the claimed loss. The first payment for the Stillwater loss was made out of [the CIC’s] bank account more than a month before [the CIC] and [the insured] executed the settlement and release agreement. [The insured] received another large payment out of [the CIC’s] bank account several months after the execution of the settlement and release agreement. [The CIC] did not execute an addendum to the settlement and release agreement reflecting this payment until years after the tax years in issue. All payments for the Stillwater loss were made by checks that Howard, an employee [of the insured], signed.”
Obviously, any real self-interested insurance company would require evidence to support the legitimacy of any claims and would demand a complete release upon payment. That Reserve Mechanical didn’t suggested to the court that it wasn’t operated at “arm’s length” like a real insurance company.
Note the last sentence from two quotes above. The court states that it should generally be sufficient for independent parties “acting on [the CIC’s] behalf” (that is, an agent) to look after its interests. Phew! After all, wasn’t that the third party captive manager’s and attorney’s job?
Usually, the answer would be “yes.” But in this case the captive manger and captive attorney were related to each other and provided most all relevant services—captive formation, risk assessment, policy underwriting, direct policy pricing, reinsurance policy pricing, pool management, etc.—under one roof (or at least two related roofs), and for multiple similarly-situated clients. The omnipresence of a single, obviously conflicted captive manager/attorney combined with its lack of a financial interest in the profits of the captive suggested to the court that it wasn’t sufficiently looking after the interests of the captive.
Though the court does not explicitly say so, a captive insurance arrangement where legal services, risk assessment services, policy underwriting, actuarial pricing, captive management services, and other services are provided by separate, unrelated professionals, each contracting directly with the CIC and each owing it a separate and independent duty of loyalty, shouldn’t be subject to the same criticism.
Because the court mentioned a lack of claims in passing, some commentators have seized upon this to suggest that any captive with a low claims rate won’t withstand scrutiny. But this court never said that, and such a conclusion is completely inconsistent with prior precedent. For instance, in the RVI case the court said:
“An insurer [against earthquakes] may go many years without paying an earthquake claim; this does not mean that the insurer is failing to provide “insurance.” [The IRS’s expert] 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.”
In short, the Reserve Mechanical court’s issue with how the CIC was operated seems clearly to be that nobody was looking after its interests. This conclusion wasn’t based upon any one of the several facts cited but rather on the combination of the facts that: (1) the CIC had no employees who understood the insurance business, the risks assumed or the claims process, and (2) the third party CIC manager/attorney who assumed these insurance responsibilities was omnipresent, conflicted and had no financial interest in the CIC’s results.
VALID AND BINDING POLICIES
After holding that the CIC was adequately capitalized (having satisfied the minimum capital requirements of its domicile), the court turned to the question of whether the company issued “valid and binding policies.”
Although the court concluded that the evidence was mixed, and that this factor was “neutral” (neither supporting the IRS’ or the taxpayer’s position), the court was oddly critical of some particulars:
“Generally, [the CIC’s] direct written policies contained the necessary terms to make them valid and binding insurance, and they were signed by representatives of [the CIC] and the insureds. We agree with [the IRS], however, that the direct written policies were “cookie cutter” policies. The policies on their face indicate that they were the copyrighted material of [the third party captive manager], and [manager’s] employees testified at trial that they administered many of the same policies for all of their clients. In many instances the policies were not reasonably suited to the needs of the insureds, particularly Rocquest and ZW, both of which had extremely limited operations.”
At first this seems like a strange criticism because (1) virtually all commercial insurance policies are “cookie cutter” even when mainline commercial carriers issue them, (2) even mainline commercial carriers administer essentially identical policies for “all their clients,” (3) virtually all states require insurance sold to the general public be on pre-approved “policy forms”—forms filed with and approved by the State Department of Insurance, and (4) in some prior cases (such as the RVI case) the IRS has made exactly the opposite argument—that is, that unique and customized policy language is evidence that the arrangement wasn’t real insurance.
Additionally, insurance policies are increasingly being copyrighted. In a 2005 court case involving American Family Life Assurance Co. (Aflac), a federal court specifically ruled that insurance policy language may be copyrighted, and using copyrighted policies is by no means an unusual practice within the insurance industry today. Nor is it unusual to license copyrighted policies to other unrelated companies for their use.
So, unless the Reserve Mechanical judge is simply ignorant, neither boilerplate policy language nor customized language nor copyright are necessarily evidence of anything unusual. Should we simply assume the judge to be ignorant about such matters, or is she once again saying something a little more nuanced? Obviously… the latter.
From the last quote above, it’s clear that the judge’s issue wasn’t with the policy language itself but rather with the omnipresent captive manger/attorney who drafted the policies without regard to the interests of the CIC itself. Had there been some evidence that some person looking out for the CIC’s interests had at least reviewed the policy forms and found them acceptable for use by the CIC, then I doubt the court would have been concerned. Regardless, it’s important to remember that the taxpayer didn’t lose on this issue, the court simply found it to be a “neutral” factor.
REASONABLENESS OF PREMIUMS
Unfortunately for the taxpayer, the court didn’t focus on whether or not the amount of the premiums for the direct insurance was reasonable. The evidence on that point was essentially uncontroverted and favored the taxpayer. Multiple competent and recognized experts testified that the premiums charged by the CIC for its directly written policies were reasonable in amount. By contrast, the only expert offered by the IRS declined to offer an opinion regarding the actuarial reasonableness of specific policy premiums.
Instead, the court chose to focus on the reasonableness of the insured’s decision to pay the premiums—that is… to buy the insurance at all. Again, the court focused on the business purpose of the captive arrangement (or lack thereof). On that point, the court concluded that the taxpayer had offered insufficient evidence to carry its burden of proof:
“In cases involving brother-sister captive arrangements in which we determined that the premiums charged were reasonable, we have also found that the arrangement under scrutiny was undertaken principally to achieve a business purpose. See, e.g., Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 3-5 (the principal objective of the arrangement was to reduce costs, improve efficiency, obtain otherwise unavailable coverage, and provide accountability and transparency); Securitas Holdings v. Commissioner, at *7-*8 (finding the captive insurance arrangement at issue provided more cost-effective insurance coverage than would have otherwise been available). Generally, we conclude that premiums are reasonable when it can be shown that the amounts agreed upon by the parties were the result of arm’s-length negotiations. See R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. at 231-232; Harper Grp. v. Commissioner, 96 T.C. at 60. In determining whether an arrangement constitutes insurance in the commonly accepted sense we consider more than whether the premiums chosen can be arrived at by actuarial means. We consider whether the facts demonstrate that the terms of the arrangement were driven by arm’s-length considerations. See R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. at 234-235 (finding the subject policies constituted insurance in the commonly accepted sense because the policies’ terms “correspond to, and are driven by, the characteristics and business needs of the underlying * * * transactions).”
The facts do not reflect that [the primary insured] had a genuine need for acquiring additional insurance during the tax years in issue. There was no significant history of losses that would justify such a drastic increase, and [the business owner’s] testimony that he was concerned about increased risks beginning in 2008 did not support a significant increase in insurance coverage. All the direct written policies included a provision that the coverage afforded by the policy would be valid only after insurance coverage from other insurers was exhausted. Peak had never come close to exhausting the policy limits of its third-party commercial insurance coverage.
With respect to premiums, the facts and circumstances of this case demonstrate that the direct written policies were not the result of arm’s-length negotiations. Taking into consideration all the surrounding facts and circumstances, we conclude that no unrelated party would reasonably agree to pay Reserve the premiums that Peak and the other insureds did for the coverage provided by the direct written policies. Although Capstone calculated Reserve’s premiums using objective criteria and what appear to be actuarial methods, the absence of a real business purpose for Reserve’s policies leads us to conclude that the premiums paid for the polices were not reasonable and not negotiated at arm’s length.” [emphasis added]
To arrive at this conclusion, the court emphasized several pieces of evidence (or in some cases a lack of evidence).
First, the court noted again that the conflicted captive manager (rather than an independent actuary) developed the Reserve Mechanical pricing. And, rather than relying on well-established actuarial tables, industry loss ratios, or mainline commercial rates filed with the states to develop the premiums, the court insisted that it instead relied only – or at least primarily – upon the premiums charged by other captive insurance clients managed by the same manager (whose pricing was developed in the same manner). If the court’s presentation of the facts is accurate, the result was a kind of circular logic—pricing of client one’s policies were influenced by the pricing of client two through ten’s policies… which were each then influenced by each other, and seemingly without any reality checks. Why would an arms-length insured agree to such an unusual policy pricing methodology, the court implicitly asks? In the absence of any evidence as to why, the court suggested that the insured was motivated by something other than a need or desire for insurance (e.g., a tax deduction?).
The takeaway? Make certain that final policy pricing is determined by a competent, disinterested actuary who – as much as possible – develops rates by reference to widely-used pricing tables or other independent benchmarks rather than focusing only on the premiums and experience of the pool members. Perhaps also choose a domicile where the regulators review and approve policy pricing.
The court also highlighted that the insured’s total annual insurance spend increased from a pre-CIC amount of $100,000 to a post-CIC amount of $400,000 plus. Yet, the insured had never suffered any losses for many of the risks covered by the additional premiums. The insured also retained essentially all of the third party commercial coverage even after the CIC was formed. The taxpayer/insured failed (in the court’s mind) to offer a sufficient business rationale for accepting such substantial premium increases in light of its favorable loss history and retention of outside insurance. The absence of a documented business purpose for these decisions again suggested to the court that the insured was motivated to pay premiums by something other than genuine insurance considerations.
Some alarmist commentators have suggested that the court ruled that it’s improper to insure against losses never before sustained. However, that’s not what the court said at all. The court simply noted that such large premium increases look suspicious, especially when combined with a favorable loss history and retention of third party insurance, and that this particular taxpayer/insured failed to introduce sufficient evidence to overcome that suspicion.
The takeaway? If your insurance spend increases dramatically post CIC formation, make certain to document your business need for the insurance and why spending the additional premium dollars makes business sense. It’s not enough to simply know these things intuitively, rather they should be objectively and contemporaneously documented. Likewise, if you insure against losses that you’ve never before suffered, make sure that you document particularly well why the risk of such losses keep you up at night. And, if you’re going to retain all or most of your third party coverage, be sure to document the business purpose for that decision and note that the CIC coverage isn’t duplicative or merely excess.
The court further noted that many of the policies in question had retroactive effective dates in some years, so the insured was able to effectively purchase retroactive coverage. But, why would an insured agree to pay good money to retroactively insure risks of a loss that it knew (already) it hadn’t suffered? In the absence of a sufficient business explanation, the court concluded such payments were motivated by something other than a genuine business needs.
What is the takeaway? Avoid retroactive policy dates unless you can document their business purpose and necessity.
Next the court noted that premiums and coverage amounts for some lines changed significantly from year to year without explanation or sufficient business justification (it’s unclear whether no such justification existed, whether it existed but wasn’t offered into evidence or whether the court simply didn’t grasp the explanation). This unexplained variation in premiums and coverage amounts from year to year likewise implied to the court that the payment of premiums was motivated by something other than a genuine need for loss protection.
What is the takeaway? If rates or coverage amounts change significantly from year to year, be sure to contemporaneously document the underlying business purposes for such changes. And, make it a good one.
The most troubling parts of the court’s opinion on the issue of the reasonableness of the premium payments are its implications: (1) that no reasonable insured would pay to insure against risks of loss that it had not previously suffered, and (2) that no unrelated party would reasonably agree to pay to a CIC the premiums it charged in this case to insure against the same risks. If we read these statements in isolation, then such a proclamation from the court lacks any rational basis and conflicts with prior precedent.
These statements lack rational basis because virtually everyone who purchases insurance – at least initially – does so to insure against risks of loss that they’ve never suffered. For instance, the vast majority of people who insure against the risk of fire have never suffered a fire loss, and most of those will go to their grave never having filed a fire insurance claim. Can we say therefore that insuring against fire loss is unreasonable? Of course not.
Additionally, the whole purpose of tax subsidies, such as those offered by code Section 401(k), is to induce taxpayers to make decisions that they otherwise would not (for instance, to save more for retirement). In this case, the Section 501 (c) 15 [or 831(b) for other captives] tax subsidy available to small insurance companies exists for the very purpose of making it economically affordable for small businesses to insure against legitimate risks that otherwise wouldn’t be cost effective to insure. So, of course, nobody would ever purchase te same insurance for the same premium from an unrelated insurance company. But, that’s the whole point of a tax incentive/subsidy!
Can we interpret the court’s opinion more rationally? Yes. We need only recognize that the court did not hold that there’s never a reason to insure against risks for which the insured had never before suffered a loss. Nor did the court hold that purchasing insurance from a CIC that one would not purchase from an unrelated party is per se improper. Instead, the court simply held that, in light of all the suspicion as to the CIC’s legitimate business purpose (or lack thereof), this taxpayer failed to introduce sufficient evidence justifying the decision to purchase this insurance. As the court said, the facts offered into evidence “do not reflect…a genuine need for acquiring additional insurance during the tax years in issue.” Remember, the burden of proof is on the taxpayer in most of these cases, so an absence of evidence means the IRS wins.
What is the takeaway? Be prepared to offer evidence justifying the business purpose for any insurance purchased from a CIC.
PAYMENT OF CLAIMS
On this issue, the court’s opinion speaks for itself:
“[The CIC] paid the one claim that [the primary insured] filed during the tax years in issue. As we noted in connection with other factors, the circumstances surrounding the payment of that claim were unusual. Although this factor weighs slightly in [the CIC’s] favor, we do not regard the payments made in connection with the Stillwater loss as overwhelming evidence that [the CIC’s] direct written or reinsurance policies constituted insurance in the commonly accepted sense.”
Note that the CIC having paid just a SINGLE claim (albeit under unusual circumstances) “weighs slightly in [the CIC’s] favor.”
There’s no need or reason to read the court’s alternative finding in the Reserve Mechanical case as some alarmist commentators have. The finding is not the end of the captive insurance industry (or the end of small captives), nor does it demonstrate the court’s ignorance of the industry. Rather, when read as a whole, and when we consider that the factors noted by the court are cumulative evidence of the subjective intent of the CIC and its insureds and not individually significant, this case stands for the simple proposition that all CIC’s should be operated for their own self-interest (and not merely to advance the interests of its owners, primary insureds or third party advisors), and that each insured must have well-documented and legitimate non-tax reasons for purchasing the insurance in question.