Strike Two – Another Loss for Captive Insurance

In yet another captive insurance case, the United States Tax Court has ruled in favor of the Internal Revenue Service. The opinion on the case of Reserve Mechanical Corp, f/k/a Reserve Casualty Corporation v. Commissioner of Internal Revenue was released on June 18, 2018. While many may have been surprised that the taxpayer’s experts were unable to persuade the Court, the conclusion is no surprise when compared to the logic and precedent of continuing legal guidance in the captive insurance arena.

The Tax Court has always focused on four criteria in deciding whether an arrangement constitutes insurance: that it involves insurable risk, that risk shifting and risk distribution are sufficiently present, and that the arrangement is insurance in the commonly accepted sense. Using these criteria and some select facts noted below, we can begin to see how the Reserve opinion was put together.

Issue Identification

The shareholders of Peak Mechanical & Components, Inc. (“Peak”) sought expertise on captive insurance and through the feasibility study, it was determined that additional coverage could be necessary. As a result, Reserve Mechanical Corporation was incorporated in 2008 and issued various policies to Peak covering excess exposures beyond the policy limits of the existing commercial policies. Reserve then reinsured those risks with PoolRe Insurance Corporation (“PoolRe”) in an attempt to increase risk distribution.

The quota share agreement with PoolRe was intended to pool risks from unrelated parties and redistribute that risk among the pool participants. The agreement provided that “[t]he same amount that Peak …[was] obligated to pay PoolRe for the stop loss coverage was to be paid to Reserve pursuant to the quota share arrangement.” Evidence was never provided, however, to explain, “how all [participants] in the quota share arrangement would be able to transfer a particular set of risks and assume in exchange a blended portion of completely different risks for exactly the same premium price.”

As it did in the Avrahami1 decision less than a year ago, the Tax Court focused its opinion on the insurance status of the pooling arrangement. Seeing the aforementioned flow of funds as more than a coincidental circular flow was just one of the strikes that the Court chalked up. Beyond that, there was no evidence to support that the reinsurance premiums were actuarially determined.

Additionally, during the tax years in question, Peak had incurred only one documented loss for which it made an insurance claim against its commercial policy. The amount of that loss was valued at either $2,000 or $25,000 depending on whether you asked the insurance company or Peak. Regardless, the policy limit was $1,000,000 and therefore a far cry from either value.

Because of the loss history of Peak, it was decided that there could not possibly be any insurable risk for PoolRe to have assumed because there was no evidence that significant losses had or would ever occur that would surpass commercial coverage limits and those of the direct policy limits of Reserve such that PoolRe might ever have to realize a claim. Ultimately, the Tax Court said that the quota share arrangement was not valid insurance for federal tax purposes; therefore, it could not provide risk distribution to the overall Reserve program.

Furthermore, Reserve itself was not able to sufficiently distribute risk without reliance on PoolRe, mainly due to the fact that the majority of premiums related to one named insured – Peak. Even when the number of Peak exposures was taken into consideration a la the Securitas2 decision, there were not enough to overcome the distribution requirement. This was not the only criteria for insurance that Reserve failed to support. For example, cookie cutter policies were often used to issue to the direct policies to Peak and the two other related party insureds. However, the policies never indicated how much premium was attributable to any one insured, and thus the policies appeared to cover risks that were irrelevant to the two other related parties. This and other facts led the Tax Court to opine that Reserve was not operating as insurance company in the commonly accepted sense, and because other parts of the four criteria for insurance qualification were absent, Reserve could not be considered an insurance company for tax purposes.

What’s a Captive to Do?

The Reserve case is reminiscent of the Avrahami case from the fall of 20173. Both scenarios offered weak fact patterns in support of the four insurance criteria that the Tax Court would ultimately look to as it developed its opinion. Both scenarios also indicate a shift in historical guidance toward a sufficiency of both the number of insureds as well as the number of risk exposures. Will your captive be able to establish risk distribution by the aggregation of facts and circumstances, or would it strike out, too?

If you have not heard it before: Now is the time to revisit your operating plan, compare your initial feasibility study to current operations, re-assess your commercial vs captive insurance needs and have regular conversations with your tax advisors. It was noted in at least ten places in the Tax Court’s opinion of Reserve Mechanical Corporation that “no evidence” was provided to support various taxpayer positions. Do not let this be the legacy of your captive. Consistent, ongoing documentation is critical.

If you need a partner for your captive insurance program, please contact us.

1Avrahami v. Commissioner 149 T.C. 7 (August 21, 2017)
2Securitas Holdings, Inc. v. Commissioner, T.C. Memo. 2014-225 at *27 (October 29, 2014)
3See also: Stubbs, S. (September 2017) Breaking Down the Avrahami Decision

Sarah Stubbs
Sarah Stubbs | Principal