Reserve Mechanical and the war on small captives

Once upon a time humans looked up at the gods and saw comfort and decadence. They wielded fire, which provided warmth and energy. Prometheus looked down on the poor humans with pity. Struck with righteousness, he stole fire and delivered it to humankind. People took fire and developed new tools. Some created new means of delivering water, and shed light in the darkness, and ushered prosperity on levels never before imagined. Others took fire and developed weapons, conquered their neighbours, and visited misery upon existence. Such is humanity.

The 831(b) tax election delivers captive insurance to the middle market. After decades of large market companies scoring a string of victories against the Internal Revenue Service (IRS) to legitimise captive insurance, the middle market now has a cost-effective avenue to participate in alternative risk financing.

Captive insurance is a capital-intensive process. Through the 831(b) tax election, the captive’s profits are not considered taxable income. This tax feature creates an additional cushion to absorb the considerable costs of operating an insurance company.

Some captive managers and promoters have used the 831(b) election to provide a competitive edge for companies that need leverage to compete against their larger peers. Others used the 831(b) election to turn insurance into a tax shelter. Such is humanity.

Pain for the taxpayer

In June 2018 the US Tax Court issued its decision in the latest 831(b) risk pool captive insurance case. What a disaster for the taxpayer. The case of Reserve Mechanical v Commissioner is the latest case addressing the viability of 831(b) risk pools. After Reserve Mechanical, the captive industry possesses two clear data points through which to analyse the court’s treatment of risk pools for captive insurance. From these cases we see a clear trend: risk-free risk pools will not be upheld by the Tax Court.

In the 2017 case of Avrahami v Commissioner the Tax Court wrestled with a matter of first impression: whether a particular risk pool provided sufficient risk distribution for an 831(b) captive. Experts debate the general applicability of Avrahami as the case provides sparse guidance as to what a proper risk pool looks like. Instead, the court focused on “back office” issues previously overlooked in captive cases. The court focused on the slack actuarial science used to justify the premiums charged by the 831(b) captives to cover various exotic risks. Based on the evidence, it appeared that the captive was reverse-engineered to arrive at premiums just low enough to qualify for the 831(b) election.

Due to captive case law, the Avrahami captive needed to insure a certain amount of third party risk to qualify as a legitimate insurance company. The Avrahami captive attempted to comply with third party risk requirements via participation in the captive manager’s risk pool. Premiums were ceded to the risk pool in exchange for reinsurance, and then the risk pool retroceded risk back to the captive.

At the end of the day, the transaction occurred only on the books as there were virtually no claims to insure in the risk pool. Through an accounting sleight of hand, the pool laundered risk for the captive owners.

The Tax Court declined to directly assess the quality of the risk pool, and rightly so. The reality is that the Tax Court is unqualified to opine as to what constitutes a properly constructed risk pool. Risk pooling has been around for 400 years and is in practice all over the insurance industry. State-assigned risk pools, the national terrorism risk pool, and the nuclear energy risk pool are a few examples.

Risk pooling hinges on providing insurance for insurance companies. Risks are pooled frequently operated via quota share reinsurance treaties or other risk-shifting transactions to spread uninsurable risks across a greater pool to insurers. Risk pools reflect one of the central precepts of insurance: all of us are stronger than some of us.

However, risk pools must have risk. The Avrahami captive was struck down for a number of reasons. Chief among them was the fact that the risk laundering programme used by the captive manager’s risk pool was a sham designed to circumvent IRS issues and create a favourable tax vehicle for the owner of the captive.

A clearer vision

Although Avrahami failed to provide a clear rule governing the validity of a risk pool, the vision of the Tax Court is clarified when the case is paired alongside Reserve Mechanical. In Reserve, the Tax Court considered a captive situation in a similar economic arrangement.

The Reserve captive had lackadaisical actuarial studies, virtually no losses, and participated in a risk-free risk pool, although the Reserve captive was stronger than the Avrahami one. The risk pool itself assumed a small amount of third party risk by reinsuring another pool of vehicle contracts. The specifics of the pooling arrangement were complicated, but ultimately meaningless.

The Tax Court barely analysed whether the risk pool constituted a legitimate insurance arrangement. Instead, the analysis focused on whether the whole transaction was one that a bona fide insurance company would conduct.

As is par for course, the Tax Court assessed all four elements of a captive insurance company: 1) whether there is an insurable risk; 2) whether there is insurance in the commonly accepted sense; 3) whether there is risk shifting; and 4) whether there is risk distribution.

Scant case law directly opines as to whether a transaction consists of insurance in the commonly accepted sense, but the Tax Court’s opinion leveraged this underutilised element of captive insurance while evaluating the transaction.

The Tax Court analysed “insurance in the commonly accepted sense” through the prism of a bona fide insurance company. In other words, is the transaction at issue in Reserve the kind of transaction that a normal insurance company would conduct?

No. It was a sham. End of discussion.

Again, much like Avrahami, the Tax Court focused on the back office of the captive manager. The feasibility study was incomplete. The actuarial reports for reserves and rates were insufficient. The risk pool had virtually no risk. The whole operation appeared reverse-engineered to arrive at a specific premium. This is not how insurance works. Insurance underwriters assess risks, work with actuaries to set rates and reserves, and pay claims on risks. Basically, none of that occurred in Reserve and the Tax Court rendered the captive invalid.

To be fair, the captive manager’s risk pool was more sophisticated than the manager in Avrahami. Further, the manager secured scores of determination letters from the IRS blessing similar transactions. Yet, all the hard work was for naught. Section 831(b) transactions remain a Transaction of Interest for the IRS. The service announced that it was bringing the heat against deficient captive insurance companies and they meant it.

Missing the point

Losses are not the definition of insurance. The fact that the IRS focuses so much on claims and losses represents a fundamental misunderstanding of insurance. Yet, it needs a place to start. Honest captive practitioners know that a significant number of captives provide little more than a sophisticated tax dodge for their clients.

The IRS has the executive mandate to hunt down tax shelters for the benefit of the public good. Political leanings aside, it is literally the job of the IRS to ferret out tax shelters. Since captives have been abused by promoters, the IRS will hound small captives for time to come.

So, through Reserve we see Avrahami in better light. Risk pools will survive if they look like real insurance. If a risk pool has a circular flow of funds with virtually the same amount of premium going in as coming out, then the risk pool is less likely to be upheld. If the captive is insuring exotic risks with no honest exposures to the insureds, then the captive is less likely to be upheld. In short, the Tax Court is employing a sniff test with regard to 831(b) captives. If it looks like insurance, and acts like insurance, then it is insurance.

Nobody likes nebulous standards. Honest captive practitioners should review their captives for compliance issues. Many 831(b) captives are perfectly legitimate. There is nothing dishonest about running a small insurance company. In fact, the biggest advantage the 831(b) election provides is that it opens the market of captive insurance to the middle market. But for the 831(b) election, the costs of a captive may be way too much for middle market companies to afford. Consequently, the large market companies retain their competitive advantages. So, the 831(b) captive is not a bad business practice.

Perhaps the great tragedy of the war on 831(b) captives is that innocent captive managers will get sucked into needless lawsuits against the IRS. The service is ill-equipped to evaluate what constitutes insurance. Yet, the IRS is the principal body governing the essence of insurance.

This means that mistakes will be made. Further, the Tax Court’s warpath against 831(b) companies creates the possibility that the Tax Court will overstep its bounds and issue a needlessly complex opinion that harms the legitimate wing of the small captive industry.

Matthew Queen is job title at Venture Captive Management. He can be contacted at:  mqueen@venturecaptive.com