Practitioners looking for guidance regarding the formal definition of an insurance company will universally cite the three prongs of the test devised in Harper Group v. Commissioner, 96 T.C. 45 (1991), known as the Harper test: the existence of insurance risk, risk shifting and risk distribution, and insurance in its commonly accepted sense.
Risk shifting was the subject of the first few captive cases.1 While courts have not formally defined risk distribution, it has been thoroughly discussed in numerous decisions. Insurance in its commonly accepted sense has been analyzed in a perfunctory manner. Insurance risk, however, was never dealt with until R.V.I. Guar. Co. v. Commissioner, 145 T.C. 209 (2015), which thankfully provided clear factors.
R.V.I. Guar. Co. v. Commissioner
In this case, RVI Guaranty2 sold residual value insurance, which indemnified the insured if a property it leased or collateralized dropped below a projected value. The following example from the case illustrates how this insurance works.
Assume that an automobile with an initial purchase price of $20,000 is leased for three years and that its expected residual value upon lease termination is $10,000. RVIA might insure that automobile for 90% of the expected residual value, yielding an insured value of $9,000. If, at lease termination, the automobile had an actual residual value of $8,500, the RVI policy would indemnify the lessor for $500, assuming the lessor satisfied all terms and conditions of coverage.- R.V.I. Guar. Co. Ltd. and Subsidiaries v. Comm'r, 145 T.C. 209, 212 (2015)
This coverage has tremendous financial utility. A key calculation for a lessor is the value of assets at the end of longer-term leases. To continue with the preceding example, a lessor would calculate that in 3 years it could sell the auto for X. If the market declined below that value, it could file a claim on this insurance, strengthening the company's financial performance.
The preferred position of the Internal Revenue Service (IRS) regarding what can be insured has been that insurers can only underwrite pure risk.3 Because property value can increase over time, the argument was that RVI's insurance wasn't insurance, assessing the insurer with a $55.1 million deficiency.
The court sided with the taxpayer. Key to its decision is that "Congress has delegated to the states the exclusive authority (subject to exception) to regulate the business of insurance." R.V.I. at 231. The decision noted it was referencing the McCarran-Ferguson Act, 15 U.S.C. 1011-1015, a key federal law. The court then noted that RVI was "organized, operated, and regulated as an 'insurance company' by every state in which it did business." RVI at 231.
State Regulation Is Not Lacking
This is an incredibly important—and too often overlooked—factor in other captive cases. The United States has a 50-state tapestry of state-level insurance regulation governing every aspect of the insurance business. All states take insurance regulation very seriously because of its economic importance. No regulator wants the negative publicity of a bankrupt insurer, even one that only insures one company.
The court noted that state regulators not only analyzed the policy when RVI filed its application to become a Connecticut insurer but also when the company filed its annual reports with the state. State regulators never stated any concern with the policies.
The decision also noted that every year outside auditors opine on the insurer's financial condition. As part of that process, accountants and actuaries must be confident that the insurer "assumes a significant risk under the contract and faces a reasonable possibility of incurring a significant loss." Id. at 238. None stated any concern with the policies in any report.
Finally, one of the insurer's experts observed that RVI faced a real underwriting risk—the possibility that the premium was insufficient for the potential claim. Here, it's important to remember the standard premium equation: losses + allocated expenses + unallocated expenses + profit = premium.
Assuming the insurer correctly projects expected losses, it will be fine. But there is always the possibility that the insurer's projections will be imperfect, meaning it will pay more in claims than it receives in premium. This is a key component of the insurance transaction. However, RVI charged an exceptionally low premium (typically, no more than 4 percent of the insured value), exposing the company to a very high underwriting risk.
The most important aspect of the R.V.I. case is the court's clear recognition of and deferral to the state regulatory regime.4 McCarran-Ferguson was codified in 1945 and states, "The business of insurance, and every person engaged therein, shall be subject to the laws of the several States which relate to the regulation or taxation of such business." As any insurance professional will tell you, state regulators are knowledgeable about insurance and take their jobs very seriously; it is refreshing to see a court recognize this fact.
As a corollary, the court also trusts the state-level regulator process set up to regularly inspect and analyze insurers. The annual auditing and accounting processes that apply to insurers are in-depth and difficult. Actuaries and accountants engaged in the process are typically well-qualified individuals who take their jobs very seriously as well.
Finally, the R.V.I. decision allows the insurance industry to evolve. If a new risk is insured, the state regulators will vet it to determine if it's an appropriate topic of insurance. If they give a green light, so should the tax court.
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1See Carnation Co. v. Commissioner, 71 T.C. 400 (1978); Stearns Rogers Corp. Inc., v. U.S., 577 F. Supp. 833 (D. Col. 1984); Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985); Beech Aircraft Corp. v. U.S., 1984 WL 988 (1984). (In these cases, the IRS based its argument on the economic family doctrine, which treated an entire corporate group as a unified entity. Hence, there was no risk shifting.) In later cases, risk shifting was based on the existence of a valid insurance policy. See Humana Inc. v. C.I.R., 881 F.2d 247, 251 (1989). ("Risk shifting involves the shifting of an identifiable risk of the insured to the insurer. The focus is on the individual contract between the insured and the insurer.")
2 R.V.I. America Insurance Company (RVIA) issued the residual value insurance policies, and R.V.I. Guaranty Co., Ltd. (RVIG), reinsured those policies. For simplicity's sake, both companies are referred to collectively as RVI.
3 Harvey W. Rubin, Ph.D., CLU, CPCU, Dictionary of Insurance Terms, Fifth Edition, Baron's Educational Services, 1987, p. 411 ("Situation involving a change of loss or no loss, but no chance of gain").
4 This issue has yet to be included in a micro-captive decision. It's also likely to be a hotly contested legal issue in the upcoming captive cases.