IRS's captive appeals fall on deaf ears; mortgage issue is lost as well.

The Seventh Circuit (in Sears Roebuck, 972 F2d 858 (1992), aff'g 96 TC 61 (1991)) and the Ninth Circuit (in AMERCO, 979 F2d 162 (1992), aff'g 96 TC 18 (1991), and Harper, 979 F2d 1341 (1992), aff'g 96 TC 45 (1991)) have affirmed the validity of an insurance arrangement between a parent corporation and its wholly owned subsidiary insurer.

In these three cases, the Tax Court had ruled that when a captive had insured both related and unrelated risks, all risks qualified as insurance. The U.S. Claims Court reached the same conclusion in Ocean Drilling, 24 Cl. Ct. 714 (1991).

The amount of unrelated risks in each of the Tax Court cases varied significantly. Unrelated risk in Sears exceeded 99% of its subsidiary's (Allstate) total business, while the unrelated risks in AMERCO ranged from 52% to 74%, and in Harper from 29% to 33%. Clearly the high level of unrelated risks in Sears helped prove that the combined risk pool of related and unrelated risks was sufficient to distribute the risk that Sears was placing, thus lowering its overall risk of loss. However, even with significantly lower levels in AMERCO and Harper, the Ninth Circuit concluded that the combined risk pool was sufficient to produce the necessary elements of risk shifting and risk distribution, thus affirming the existence of insurance. In addition, the Ninth Circuit's acceptance of the Tax Court's three-part definition of insurance as (1) the presence of insurance risk, (2) risk shifting and risk distribution and (3) insurance in its commonly accepted sense appears to have opened the door for captives to qualify even when unrelated risks are under 50%.

In each of the cases, a great deal of emphasis was placed on the definition of insurance. Based on the 1941 Supreme Court decision in LeGierse, 312 US 531, the Tax Court had determined that an insurance arrangement must include elements of both risk shifting and risk distribution in order to be treated as insurance for tax purposes.

The Seventh Circuit took a different approach. Calling any attempt to define insurance for tax purposes a "tricky definitional" problem the court noted that "it is a blunder to treat a phrase in an opinion [in LeGierse] as if it were statutory language."

The Seventh Circuit (and by agreement, the Ninth Circuit) went on to state that perhaps the provision of risk shifting and risk distribution was of lesser consequence than the form of the transaction and the form of the corporate structure. The court pointed out that the tax law was generally more concerned with a transaction's true form, rather than whether or not the transaction had substance independent of the tax consequences. (The latter is most often an issue of fact that is somewhat easier to determine.) On this basis, both the Seventh and Ninth Circuits found that nothing of substance would have differed in the present cases if the parent companies had purchased insurance from wholly unrelated insurers. The courts found that the captives provided the parent companies with insurance, performing all of the functions of insurance companies. This represents a significant departure from the concept that risk shifting and risk distribution are the sole indicia of insurance, as established in LeGierse and followed in many subsequent cases. The Service's request for a rehearing by the Ninth Circuit has been denied and its apparent attempt to create a split in the circuits has failed, at least for now.

In the second issue decided by the Seventh Circuit in Sears, PMI Company (a subsidiary of Allstate) wrote mortgage insurance, insuring lenders against the risk that borrowers would default on their payments.

Mortgage insurers generally insist that lenders try to collect from borrowers, and often require a lender to foreclose on the property before paying the loss. PMI established reserves for losses when property was conveyed to the lender but not yet sold, when the property was in the process of foreclosure, or when the loan had been in default for at least four months. In addition, PMI established a reserve based on an estimate of loans for which one of these criteria was met, but had not yet been reported.

The IRS had challenged the timing of the deductions. The Tax Court had agreed with the Service, ruling that an "insurer cannot incur, a loss until the insured has suffered the defined economic loss, to wit, after the lender takes title to the mortgaged property and submits a claim for loss."

The Appeals Court found that in setting reserves, PMI used actual cases in its estimates of losses to be incurred and complied with both industry requirements and Treasury regulations in establishing such reserves. The court pointed out that regulations dealt with "actual unpaid losses," but did not require such losses to be qualified and immediately payable." In reversing the decision, the Appeals Court stated that the Tax Court confused quantification of the loss," which does not occur until the lender takes title, with "the occurrence of the covered loss."