1 July 2022Analysis

A Howey Test for insurance

The US Federal Trade Commission has reported that more than 46,000 people lost $1 billion in crypto scams since 2021. It is not surprising to read this—over that period, Bitcoin was down 50 percent, Ethereum 65 percent, and XRP 78 percent.

As insurance people, we know that the class action suits will soon follow. The trillion-dollar question will be: are cryptocurrencies securities? Lawyers, not coders, might determine the future of crypto.

The “Howey Test” is a framework established by the Supreme Court in 1946 to determine whether a transaction qualifies as a security. There are four parts to the Howey Test: 1) a party invests money; 2) in a common enterprise; 3) with the expectation of profit; and 4) based on the effort of a third party. Most crypto tokens involve the investment of money through token sales. Bitcoin was created by software developers.

In 2019, the Securities and Exchange Commission (SEC) ruled that Bitcoin failed the Howey Test. Bitcoin checks only the first box, which is the investment of money. There is no central company controlling Bitcoin, investors are not pooling funds into a joint enterprise, and the value of Bitcoin does not depend on a third party. This is not the case for Ethereum and XRP.

In 2020, the SEC sued Ripple Labs over its XRP token, claiming the token is an unregistered security. In most instances when SEC actions occur, companies settle and register their products. Ripple challenged the SEC and has requested that the agency unveil its process for conducting the Howey Test. To date, this case and clarity of definition remains unresolved.

Also unresolved is a reliable definition for insurance. What qualifies as insurance? Do your clients’ policies/captive insurance business qualify? What is the Howey Test for insurance?

Many look to the Internal Revenue Service (IRS) for guidance, but the agency has no formal definition of insurance either. We do know from several court cases that the IRS relies on a three-part test: 1) risk shifting; 2) risk distribution; and 3) a loss must be fortuitous.

Risk shifting and risk distribution are probably the most talked about. A fortuitous loss occurs at a time and in a way that the insured could not have anticipated. It is against public policy to insure a certainty as opposed to a risk.

What if your captive passes this three-part IRS test but fails the Rule of Indemnity? The Rule of Indemnity is back in the press again as Vermont is the latest domicile to approve the use of parametric coverage.

The Rule of Indemnity or the Indemnity Principle says an insurance policy should not confer a benefit greater in value than the loss suffered by the insured. Indemnities and insurance both guard against financial loss. The aim is to restore a party to the financial status they held before the event occurred, which makes sense for a property loss.


Even with replacement cost coverage, the goal is to make the insured whole. If you think about it though, there have always been exceptions to this rule.

A life insurance policy is of little value to the name listed on the policy. Life insurance policies benefit the living. Premiums paid have little to do with the perceived value or replacement of the person who dies—payouts reflect premiums paid and the dollar value of the policy. Yet life insurance certainly qualifies as insurance.

Parametric (index-based) insurance is another example of an indemnity rule breaker. Parametric covers have been around for 20 years. Select captive domiciles are now permitting the direct writing of parametric covers. Parametric covers do not indemnify pure loss. Set payments are made upon the occurrence of an objective triggering event such as an earthquake of a certain magnitude or a hurricane of a specific intensity.

Parametric triggers deliver insurance more efficiently. Parametics avoid lengthy claim investigations because when the index is triggered, the payout is made. No questions, no disputes. Independent triggers include hail meters/sensors, satellite images, and government data such as quake magnitude or wind speed.

What’s in the name?

Purchasers don’t care what the IRS or other governmental bodies think about the rule of indemnity. They just want protection and coverage triggers they understand.

Where does this leave us trying to define insurance?

Fortunately for me, early in my career, I worked with a corporate attorney who introduced me to the term “substantial authority”. Under IRS rules, the tax treatment of an item has “substantial authority only if the weight of published cases, rules, and other legal and administrative authorities is substantial in relation to the weight of opposing authorities”.

As it was explained to me, substantial authority doesn’t make you right, but it provides justification for the choices you made. In the case of the IRS, you may still pay the tax but hopefully without any penalty.

Don’t confuse substantial authority with the childhood phrase: “everyone else is doing it”. It didn’t work with your mother, and it’s probably not going to work with the regulators.

Certain microcaptives have been added to the IRS’s Dirty Dozen list. To make this list, the IRS has identified a large group of suspected rule-breakers. My advice is to trust your gut and the professionals you hire. If your captive serves a legitimate business purpose, that’s a good start.

What is my advice worth? Your mom also told you not to ride with strangers. I think about that every time I jump in an Uber or Lyft. Times change. Attitudes towards what constitutes insurance does too. I still think we need a test. Just don’t name it after me.

Greg Lang is the founder of Reinsurance and Insurance Network. He can be contacted at: