In his second commentary on the Reserve Mechanical case, Sean King, principal at CIC Services, discusses the IRS’s much-needed victory and asks whether it was due to an ignorant court or a nuanced ruling
In part one, I discussed the impact of the Reserve Mechanical decision on risk distribution arrangements in general and on risk pools in particular. I distinguished my 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 Internal Revenue Service (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 favourable 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 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 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 just to 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 harmonise 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 harmonise 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 organised, operated, and regulated as an insurance company; whether it was adequately capitalised; whether the policies were valid and binding; whether the premiums were reasonable and the result of an arms-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 briefly discuss the court’s analysis of these factors and interpret it in light of prior precedent.
Organisation, operation and regulation
After finding that Reserve Mechanical, the captive insurance company in question, was organised 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 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 captive insurance company had no operational employees and outsourced its management to a third-party captive insurance manager.
However, rather than these things being evidence that the captive insurance company 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 captive insurance companies 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 criticised a dissenting judge for clinging to the captive insurance company’s lack of employees as evidencing something nefarious or unusual.
The Rent-a-Center court said: “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 company wide. Or they hire outside consultants to handle the operations of a speciality business such as a captive insurer.”
“[This captive insurance company], like Humana, hired an outside management company to handle its business operations. Compare op. Ct. note 6 ([this captive insurance company] 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).”
So, did the court 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 captive insurance company’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 captive insurance company, not even its owner, Zumbaum.
“Zumbaum, Reserve’s 50 percent owner, president and CEO, 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 captive insurance company]. Zumbaum did not know how claims were made or handled, and he did not know where or how [the captive insurance company’s] records were kept. [The captive insurance company’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 captive insurance company] 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 captive insurance company’s] incorporation.”
“The feasibility study was not complete when [the captive insurance company] 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 captive insurance company] 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 captive insurance company] performed any due diligence concerning 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 captive insurance company] or anyone performing activities on [the captive insurance company’s] behalf evaluated these risks before executing the quota share policies.”
As I discussed in previous commentary, 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 captive insurance company. 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 captive insurance company 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 captive insurance company was its claims procedures (or lack thereof): “Only one claim was filed under [the captive insurance company’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 captive insurance company] did not insist on obtaining any documents to substantiate the occurrence or the amount of the claimed loss.”
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 suggest 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 captive insurance company’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 manager 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, and so on—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 captive insurance company and each owing it a separate and independent duty of loyalty, shouldn’t be subject to the same criticism.
No need to be alarmist
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 captive insurance company and its insureds and not individually significant, this case stands for the simple proposition that all captive insurance companies 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.
