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Seventh Circuit opens door for captive insurance.

The past few years have witnessed an increasing erosion of the IRS's anticaptive insurance position. The latest loss for the Service comes in the Seventh Circuit's affirmation of a Tax Court ruling that Sears, Roebuck and Co.'s payment of premiums to its wholly owned subsidiary, Allstate Insurance, was a deductible payment of insurance premiums. Although most observers felt that the IRS was bound to lose in litigation on the Sears-Allstate arrangement, the Seventh Circuit decision is notable for its departure from the course set in prior captive insurance litigation.

Pre-1989 case law

and Humana

Starting with Rev. Rul. 77-316, the Service took the position that, when members of the same affiliated group attempted to create insurance between them, they failed to do so; it was not possible to accomplish a shifting and a distribution of insurance risk, as required by the definition of insurance articulated in Helvering v. Le Gierse, 312 US 531 (1941). The essence of the IRS position was that risk shifting and risk distribution could not, as a matter of law, occur within the same economic family.

Taxpayers argued that, under Moline Properties, 319 US 436 (1943), the separate corporate entities within a group of related corporations had to be respected.

Before 1989, the courts almost uniformly agreed with the substance of the IRS's position while explicitly rejecting the economic family argument. Instead, the courts relied on the Le Gierse test and found that insurance by a parent with its subsidiary failed to create the requisite risk shift (from the parent) and risk distribution (with other insureds).

The extent to which the Service was winning its battle against captive insurance arrangements could be seen in the Ninth Circuit's decision in Clougherty Packing Co., 811 F2d 1297 (9th Cir. 1987). In that case, the court squarely addressed the Moline Properties argument and held that, even respecting the separate nature of the entities, the purported insured had not effectuated a transfer of its risk when it insured with a subsidiary because its assets (either directly or in the form of its investment in the subsidiary) remained at risk for any loss.

See, also, for example, the almost perfunctory manner in which the Third Circuit affirmed the Tax Court in Gulf Oil, 914 F2d 396 (3d Cir. 1990), aff'g 89 TC 1010 (1987), by citing Le Gierse and Clougherty Packing along with a number of other cases treating transactions between parents and subsidiaries as not creating insurance for the parent.

Two 1987 Tax Court decisions (Gulf Oil and Humana, 88 TC 197 (1987)), however, contained the seeds of later defeats on the captive insurance issue. In Gulf Oil, the IRS challenged a classic captive insurance arrangement and prevailed. The taxpayer, however, argued that the presence of insured third-party risks allowed the arrangement to satisfy the Le Gierse test.

The court rejected the taxpayer's argument, because for the years at issue premiums from third parties were de minimis (22% of total premiums). However, the court added the following footnote:

Without expert testimony, we decline to determine what portion of unrelated premiums would be sufficient for the affiliated group's premiums to be considered payments for insurance. However, if at least 50 percent are unrelated, we cannot believe that sufficient risk transfer would not be present. This anticipated sharing of premiums paid by unrelated insureds is similar in concept to a mutual insurance arrangement.

Thus, the Tax Court opened the door for captive insurance arrangements in which significant third-party risks were assumed by the insurance entity.

In Humana, 88 TC 197 (1987), rev'd, 881 F2d 247 (6th Cir. 1989), the Tax Court extended its parent-subsidiary holdings to a captive arrangement between brother-sister corporations. On appeal, the Sixth Circuit reversed the Tax Court on the brother-sister transaction while holding that the parent-subsidiary transaction did not create insurance. The court reached its decision by fully embracing the Moline Properties doctrine and then looking to the effect of the transactions on the balance sheet of the purported insured.

The Service declined to appeal Humana and chose instead to look for a better captive insurance case to take to the Supreme Court. Thus, the Sixth Circuit has opened the door for brother-sister captives.

The Tax Court

in Sears, etc.

Against this background came the litigation of three parent-subsidiary cases in which significant third-party risks were also underwritten by the insurance company. In each case, the taxpayer prevailed. In AMERCO, 96 TC 18 (1991), Harper Group, 96 TC 45 (1991), and Sears, Roebuck and Co., 96 TC 61 (1991), the Tax Court articulated a three-pronged test to determine whether claimed insurance deductions for payments from a parent or affiliate to a captive insurance company were proper: 1. Whether the arrangement involved the existence of an "insurance risk." 2. Whether there was both risk shifting and risk distribution. 3. Whether the arrangement was for "insurance" in the commonly accepted sense.

In the Sears case, the subject matter of the insurance was personal injury liability. The Tax Court found that the presence of an insurance risk was "indisputable." The risk shifting and risk distribution test was satisfied by the substantial business purposes underlying the formation of Allstate and by the pooling of risk with other Allstate insureds. Finally, the court found that the Sears-Allstate transaction was consistent with common notions of insurance.

The Seventh Circuit

in Sears

The Seventh Circuit rejected both Le Gierse and the Tax Court's three-pronged test. The risk shifting and risk distribution criterion that other courts have drawn from Le Gierse was dismissed as merely a "mention." The court then stated that "it is a blunder to treat a phrase in an opinion as if it were statutory language." But having rejected the three-pronged test and Le Gierse, the court returned, at least in part, to the substance of that analysis.

For the Seventh Circuit, the Le Gierse decision dealt with whether there was, in substance, an insurance risk. Since Mrs. Le Gierse had expected to die soon and the insurance company had expected to return her money to her heirs, no insurance risk existed. By contrast, the Sears-Allstate transaction was one of substance. The court pointed to the fact that the same transaction entered into with an unrelated insurance company would clearly have been "genuine insurance." Thus, the court in effect gave an affirmative answer on the first of the Tax Court criteria.

In a discussion of the reasons that a corporate taxpayer might have for purchasing insurance, the court implicitly returned to the Le Gierse formulation. The court rejected risk shifting as a motivation but embraced risk distribution. It recognized that one purpose of insurance could be to receive reimbursement for a loss from a third party. But the court went on to find that corporations do not insure to protect their wealth or future income, but rather to spread the cost of casualties over time. In addition to the time shifting of expenses, the court found that companies purchase insurance for the administration of the insurance program.

In dealing explicitly with risk shifting, the court found that an insurance company does not so much accept risk as cause it to disappear. That is, the pooling of risks causes the risks to diminish. This pooling aspect (risk distribution in traditional jargon) is, according to the Seventh Circuit, "an important aspect of insurance." The court characterized this pooling aspect as a function that captive insurance does not perform.

The court noted a variety of additional factors that demonstrated that the Sears-Allstate arrangement was genuine insurance, that is, insurance in the commonly understood sense. These included hedging and administration, maintenance of reserves, payment of taxes, and participation in risk pools. The court noted that the states treated these arrangements as insurance and that Sears could not withdraw at a whim.

Finally, the court restated the issue as not "What is insurance?" but as "Is there adequate reason to recharacterize the transaction?" From this perspective, the issue becomes a question of whether the transaction possessed substance independent of the form of the corporate structure. The Tax Court could, and did, decide this factual question in favor of the taxpayer.

Ramifications of the

Sears decision

The Seventh Circuit decision breaks new ground in three important ways. 1. The court has elevated the importance of whether an arrangement is understood to be insurance in the common sense of the term. 2. The court has effectively abandoned the requirement for risk shifting in the context of captives with substantial outside risks. 3. The court has placed new emphasis on the concept of risk distribution.

Each of these aspects, if sustained by other courts, could have important ramifications for the treatment of many types of purported insurance transactions. Captives: The most obvious point is that the IRS has suffered a major defeat in its continuing battle against captive insurance. Previously, the only adverse circuit court decision on captive insurance had been the Humana decision on brother-sister arrangements. The Sears decision is the first appellate decision to approve the insurance of a parent's risk through a subsidiary. In that regard, it is likely to feed interest in captive structures and to encourage more aggressive tax filing positions. Two caveats are appropriate, however. First, the Sears court was not asked to address the treatment of purported insurance with a subsidiary that dealt only with related parties. Indeed, the court noted that it was not surprised by the fact that the Tax Court would accept the Service's position on pure captives while rejecting its arguments in transactions with insurance affiliates that have substantial outside insurance business.

Second, the costs of operating a captive may outweigh the tax benefits available. The net benefit derived from a captive is the ability to deduct discounted unpaid losses in the year of the loss rather than deducting undiscounted losses when paid. If economic interest rates and the adjusted Federal rate (AFR) used for discounting loss reserves are identical, the net effect is to eliminate any tax on investment income. When tax interest rates exceed economic interest rates, as may be occurring currently because of the five-year base period used in determining the AFR, the rules tend to produce a prepayment of tax that is recovered as losses are paid. Retrospectively rated plans and reinsurance: Although interest in captives may be limited by costs and the current level of investment returns, the Seventh Circuit's decision may be of interest in other areas. Dicta in the court's opinion and the fundamental logic of the court's holding substantially undercut positions that the IRS has sought to develop in areas other than captive insurance. For example, the Service has felt that insurance contracts (such as workers' compensation contracts) with heavy retrospective rating adjustments may not constitute insurance. Similarly, health insurance contracts that are either administrative service contracts or administrative service only contracts may, in the IRS's view, not present sufficient risk shifting and risk distribution to create insurance. The view of the Seventh Circuit that earnings smoothing and administrative service are essential ingredients of insurance would argue for classifying such contracts as insurance.

Similarly, the Service has wanted to attack some retrospectively rated and similar transactions on the theory that no risk shifting or risk distribution has occurred. If a transaction is structured so that risk of loss and potential for profit stay with the purported insured, the IRS will argue that no insurance exists and the "premium payment" must have been a loan or something else (presumably nondeductible). See IRS Letter Ruling (TAM) 9029002, in which a portfolio reinsurance transaction was treated as a financing because the "premium" would adjust directly with actual experience. Note that the subject matter of that transaction was losses on reported claims and that the transaction was treated as a financing for book purposes. See also Rev. Rul. 89-96, holding that retroactive insurance of a known loss was not insurance.

On the other hand, at least two published rulings treat contracts with retrospective premium adjustments as bona fide insurance. See Rev. Rul. 77-453 (initial and additional premiums due on a rolling adjustment under a reinsurance contract were deductible when paid, even though implicitly subject to refund at the next adjustment) and Rev. Rul. 78-338 (premium with potential retrospective adjustment paid to a group captive is deductible). See also IRS Letter Ruling 8433029 (contract that provided for a formula-based refund to the ceding company when loss development did not exceed the first layer of multilayer coverage was treated as reinsurance).


Sec. 845 gives the Service authority to adjust the tax consequences of reinsurance transactions between unrelated parties if it finds a "significant tax avoidance effect" to the transaction. The IRS has yet to fully test this authority. The legislative history of Sec. 845 relied heavily on a comparison of the risk shifted in a transaction to the resultant tax benefits. Given its treatment of risk in the Sears decision, the Seventh Circuit might well find that reinsurance transactions are inherently low risk transactions. From this perspective, Sec. 845's legislative history would be of little help, and the court might well be persuaded by factors such as regulatory treatment and business purpose.

In its treatment of the captive issue, the Seventh Circuit relied on the fact that the transaction was regarded as insurance in the course of commerce and by state regulators. With respect to the other issue litigated in the case, the deductibility of reserves on private mortgage insurance, the court was even more direct in its reliance on state regulatory concepts to define Federal tax rules: "State insurance commissioners' preferences about reserves thus are not some intrusion on federal tax policy; using their annual statement IS federal tax law."

While many accepted the view that a contract cannot constitute insurance for tax purposes if it is not so respected by the regulators, the Seventh Circuit might well hold that if a transaction is treated as insurance by the regulators it must be so respected by the tax authorities. This would bring a new urgency to the debates that surround FASB and NAIC deliberations over accounting for financial reinsurance.

Perhaps the FASB's refusal to clarify what it means by risk transfer has left the door open for adoption of the Seventh Circuit's notion that risk transfer really means risk distribution and that reinsurance (as with insurance) is a mechanism for earnings smoothing, not permanent earnings protection.

In any event, the deference that the Seventh Circuit showed to industry accounting practices in both the captive and private mortgage insurance portions of its decision underscores the importance that the current debates in the NAIC and FASB may have for both ceding and assuming companies.
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Author:Brown, Thomas M.
Publication:The Tax Adviser
Date:Mar 1, 1993
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