Tax count conclusions

Alan Fine of Brown Smith Wallace discusses the questions he feels are raised by the Reserve Mechanical case and the takeaways for captive insurers

In June 2018, the US Tax Court issued another decision in a micro captive insurance case, ‘Reserve Mechanical v. Commissioner of Internal Revenue’. In this case, the court determined that the risk sharing pool being used, PoolRe Insurance, did not qualify as a ‘bona fide’ insurance company. Therefore, the arrangements involving the pool lacked the requisite risk shifting, resulting in the taxpayer’s deductions for premiums paid to the captive being denied.

Case background

Reserve Mechanical was created by the owners of Peak Mechanical and Components. Peak’s business operations involved the distribution, servicing, repairing and manufacturing of equipment used for underground mining and construction. Reserve issued policies to Peak and two affiliated entities with little activities, covering a variety of enterprise risks such as loss of major customer, excess pollution liability, excess cyber risk, weather-related business interruption and regulatory changes. The policies in question were excess policies that took effect only after the insureds’ commercial coverages were exhausted. Premium amounts were calculated only for the three insureds together without any breakout of the premiums per insured. Seven of the 13 policies issued in the captive’s first year contained retroactive dates.

During the years in question, there was a single claim under the direct policies, for loss of a major customer. Reserve paid a total of $175,000 in connection with the covered loss.

Peak then entered into a stop-loss arrangement where PoolRe agreed to pay claims paid by Reserve if certain claims thresholds were exceeded. Between 51 and 56 other parties entered into similar arrangements with PoolRe. PoolRe also entered into quota-share policies to redistribute risks among the other PoolRe participants. Reserve also assumed risks from PoolRe related to vehicle service contracts.

Reserve, which had been formed and domiciled in Anguilla, elected to be treated as a domestic insurance company for all purposes of the Internal Revenue Code. It filed as a tax-exempt insurance company under Section 501(c) (15), as its premiums were less than $600,000 per year, and more than half of its income came from insurance operations.

The court’s decision

The court determined that Reserve did not insure sufficient related parties nor statistically independent risks from these parties to satisfy the requirement of risk distribution. The court then turned its analysis to the pooled reinsurance arrangements with PoolRe.

The US Tax Court took exception to the circular course of cash flows between Reserve and PoolRe; for example, Reserve would receive payments from PoolRe exactly equal to that paid by Reserve to PoolRe. There were also concerns that the underlying risks assumed by Reserve were not comparable in scale to those risks ceded by Reserve, and that PoolRe did not enter into the arrangements with Reserve for the purpose of distributing risks. For these reasons, the court determined that PoolRe was not a ‘bona fide’ insurance company.

The US Tax Court then turned its attention to whether the policies issued by Reserve constituted insurance in the commonly accepted sense. In particular, the court seemed to focus most on the lack of a non-tax business purpose for creating the captive and paying premiums. The court pointed to the fact that there were no changes to the coverages purchased in the commercial marketplace nor was the taxpayer able to demonstrate the need for these additional coverages. The feasibility study did not document the need for the additional coverages, the probability of a loss event that would be covered by the new policies or how the new policies would supplement the existing commercial policies.

It is worth noting, however, that the court did acknowledge that these items were discussed at various points leading up to the feasibility study, including during the visit of the Peak facilities and operational sites.

The court also took exception to the pricing of the policies issued by the captive, noting in one instance where more premium dollars were spent for one month of coverage from the captive than was spent for an entire year’s coverage in the commercial marketplace.

Court’s decision sparks questions about future conclusions

There are a few areas of the court’s rationale that are unsettling. First, the court had a problem with the fact that the taxpayer and its owners failed to conduct an independent due diligence of the risk pool. The court did not explain whether this standard applies to all insurance arrangements or just to captive insurance, and appears to impose the requirement that anyone involved in a captive insurance arrangement become an expert in reinsurance. How far would this rationale extend? For example, do investors in an oil and gas partnership need to become experts in the various aspects of drilling?

Second, the court also found the ‘cookie cutter policies’ issued by Reserve (created by the captive manager and affiliated law firm) problematic. This issue seems to be a ‘heads we win, tails you lose’ argument for the IRS, and ignores the fact that there tend to be incredible similarity in policies issued by commercial carriers for the same lines of coverage. Does this mean that a person’s homeowners policy isn’t a valid insurance arrangement because it has exactly the same language as the policy received by a neighbour?

Third, as previously discussed, the court had issues with the lack of support in the feasibility study demonstrating the need for the additional insurance coverages. It focused heavily on lack of evidence that Peak ever had costs resulting from excess pollution liability, determining that there was a lack of a non-tax business purpose for the purchases from Reserve. Is a prior claim now required to justify the purchase of a new line of coverage? If a doctor has never had a malpractice claim or event, does that mean the physician has no non-tax business purpose behind the purchase of malpractice insurance? The opinion could certainly be read that way.

Finally, in determining whether an insurance arrangement constitutes insurance, opinion requires the consideration of more than ‘whether the premiums chosen can be arrived at by actuarial means’. This is particularly confusing. Wouldn’t the certification of premiums by a licensed actuary be demonstration of the arm’s length nature of the premium determinations?

Takeaways for captive insurance companies

Here are two key points captives should take away from the Reserve Mechanical decision: