After poking around this arrangement, the IRS issued a notice of deficiency to Reserve Mechanical Corporation in 2016. The IRS explains its concerns with captive insurance companies such as the Reserve Mechanical Corporation as follows:[vi]
[Income tax] abuse can occur where one or more affiliated insureds pay (often excessive) premiums to a captive insurer for insurance that they do not really need. On the insureds’ side, this generates large deductions and thereby decreases their current taxable income. On the captive’s side, income is exempt from tax as long as gross receipts for the taxable year do not exceed $600,000 and more than 50 percent of such gross receipts consist of premiums. Because the insureds and the insurer are under common control, the insureds (or their owners) never really lose control of the funds. And although the insurer may nominally provide insurance to unrelated parties, abusive arrangements are structured so that there is little or no risk that the insurer will have to pay any significant loss suffered by such parties.
The IRS successfully argued before the U.S. Tax Court that the policies issued to Peak by its captive insurer did not (a) involve an adequate shifting of the risk of loss; or (b) amount to insurance within the commonly accepted meaning of the term.
While the Tax Court and the briefs submitted to the 10th Circuit focus primarily on the first point, the second point holds the potential to radically expand or drastically restrict the U.S. insurance landscape.
A close look at the single claim made against a policy issued by the Reserve Mechanical Corporation illustrates the potential implications of the 10th Circuit’s decision in this case. The Loss of Major Customer policy pays out when a customer representing at least 10% of Peak’s annual sales reduces its use of Peak’s services in an “unusual” or “irregular” manner.[vii]
Reserve Mechanical Corporation accepted Peak’s claim of such circumstances and paid $339,820.[viii]
The questions before the 10th Circuit include whether a contract covering an unexpected decrease in sales volume is really “insurance”. An affirmative answer could be transformative as the insurance industry battles for turf with other financial services sectors. A negative answer could box insurers into traditional 20th century risks as the modern digital economy speeds ahead.
The lawyers representing Reserve Mechanical Corporation seem to grasp the ramifications of this case at least with respect to the potential role of insurance in managing risks in the 2020’s:[ix]
[H]ad the pandemic occurred in 2009, Reserve’s regulatory-changes policy would have covered losses from government-mandated shutdowns; Reserve’s loss-of-services policy would have covered losses of key employees due to sickness; and Reserve’s loss-of-major-customer policy would have covered losses of orders from major customers as a result of business slowdown. During the current crisis, while commercial carriers are denying pandemic-related claims, the broad coverages written by captives have allowed many businesses to remain viable. The current crisis is a case study for why captive insurance is necessary and should exist right alongside commercial insurance.
Maybe those are really insurance contracts, or maybe they are not. The 10th Circuit may very well decide in the next few months.
Given the potential stakes of this case, the Centers for Better Insurance plans to publish a series of articles with the Reserve Mechanical Corporation appeal as a platform from which to ask:
- If these contracts are not insurance, what are they?
- What has the IRS and U.S. Tax Court already decided about the boundaries of insurance – and should we have been paying more attention?
- Is the Anguillan Financial Services Commission really the only relevant regulator here or should the Idaho Department of Insurance (or NAIC) have some role to play?
- Can the concept of insurance mean one thing for policies issued by captives and another for policies issued by traditional insurers?
- What happens if insurance means different things for the purposes of tax, accounting, and financial services regulation?
[ii]Reserve Mechanical Corp. v. Commissioner of the IRS
, T.C. Memo 2018-96 (June 18, 2018), page 6-7.
[iii]Reserve Mechanical Corp. v. Commissioner of the IRS
, T.C. Memo 2018-96 (June 18, 2018), page 17.
[iv]Reserve Mechanical Corp. v. Commissioner of the IRS
, T.C. Memo 2018-96 (June 18, 2018), page 3.
[v]Reserve Mechanical Corp. v. Commissioner of the IRS
, T.C. Memo 2018-96 (June 18, 2018), page 8.
[vi]Reserve Mechanical Corp. v. Commissioner of the IRS
, Brief for the Appellee (July 6, 2020), page 5-6 (citations omitted).
[vii]Reserve Mechanical Corp. v. Commissioner of the IRS
, Brief for the Appellee (July 6, 2020), page 51-52.
[viii]Reserve Mechanical Corp. v. Commissioner of the IRS
, Brief for the Appellant (Feb. 21, 2020), page 25.
Reserve Mechanical Corp. v. Commissioner of the IRS, Rely Brief for the Appellant (Sept. 25, 2020), page 14-15 (citations omitted).