19 June 2018Accounting & tax analysis

Small captives take another blow as US Tax Court favours IRS in Reserve Mechanical case

In a decision that may place small captive insurance companies under further scrutiny, the US Tax Court has ruled in favour of the IRS in the case of Reserve Mechanical Corp v Commissioner.

Following the case of Avrahami v Commissioner, this new case concerns an underground mining company Peak Mechanical & Components that set up a captive insurance company to insure a variety of enterprise risks.

In order to comply with the IRS’s various risk distribution requirements, the captive participated in a complex risk pooling arrangement in order to secure at least 30 percent third party premium in the captive. The risk pool, PoolRe Insurance, was operated by Capstone Associated Services.

On June 18, Judge Kerrigan determined that the captive was not a valid insurance arrangement based on language issues in its coverages, the fact there was only one single claim in the three years at issue, along with ineffective risk distribution.

Captive International spoke with Matthew Queen, general counsel and chief compliance officer at Venture Captive Management, who said that much like Avrahami, this case will be studied for years.

"The secret to a valid captive insurance program is to insure real risks and act like an insurance company," said Queen. "That is the big takeaway from the new holding issued by the US Tax Court in the matter of Reserve Mechanical Corp v Commissioner, T.C. Memo. 2018-86."

As Queen highlighted, each policy had contained language indicating that the coverages afford by the policy were excess over any other valid insurance policies. The insured maintained third party insurance contracts to provide 'real' insurance for the insured entities.

During the three years at issue, the policies only paid out a single claim.

"Said claim had no documentation, no investigation, and basically functioned as a reimbursement for the insured parties," said Queen.

The opinion also suggested that risk distribution had artificially been created through a risk-less risk-pool.

"While the premium mathematics complied with captive court precedent, the failure to operate in a manner befitting a standard insurance company indicated that the risk pool was really designed to assist with creating a tax shelter instead of a valid insurance arrangement," Queen commented.

Queen concluded: "Interestingly, the Tax Court spent a great deal of time analysing whether the arrangement constituted 'insurance in the commonly accepted sense.' This is one of the four prongs of the standard criteria for assessing whether an arrangement qualifies as insurance under the Internal Revenue Code. Case law exploring this prong is relatively sparse by comparison to questions relating to risk shifting and risk distribution. The biggest takeaway is that the Tax Court will look at a number of facts, including the organisation, operation, and regulation of the insurance company when assessing the validity of the captive arrangement."

Both Reserve and Capstone Associated have criticised the Court's opinion, and in particular the Court's reliance in deciding this on the Avrahami opinion.

They said the opinion does a "disservice" to the captive industry and the "bona fide captive insurance companies like Reserve".

In their statement, they said: “Reserve had no loans, participated in a diversified pool, assumed unaffiliated, third-party reinsurance, reported and paid substantial losses, and had policies that were designed to meet the needs of the underground mining business that it insured.

“Additionally, a series of recognised experts, including an insurance commissioner, two credentialed actuaries, an independent auditor, a nationally-renowned insurance economist and an underwriter, all testified on behalf of Reserve with scant testimony from the government’s witness whose testimony the government admitted was discredited on the stand.

“Oddly, the Court rejected the professionally-administered pooling arrangement which involved hundreds of third party insureds and hundreds of policies as being ‘circular’ evidencing an unexpected rejection of a fundamental industry standard risk sharing mechanism dating back more than a century. The Court rejected Reserve’s third- party reinsurance program which was fully in evidence because the more than one hundred thousand underlying direct written policies from a recognised admitted carrier, were not put into evidence but were only the subject of (unchallenged) testimony.”

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