June 27, 2018 - Commentary by Capstone Associated Services, Ltd.
Does Captive Insurance Exist After the Reserve Decision?
Reserve Mechanical Corp. f.k.a. Reserve Casualty Corp. v. Commissioner of Internal Revenue (“Reserve”) was decided by the United States Tax Court in an opinion issued by Judge Kathleen Kerrigan (the “Opinion”) on June 18, 2018. https://www.reserve-casualty-corp.com/
Given that insurance is a specialized area of the law, the tax court took testimony from multiple experts and fact witnesses consisting of 10 from Reserve’s side (7 of which were recognized by the court as experts, with the rest being fact witnesses) and only one substantive witness, which was an expert witness from the government’s side. Despite such, the court appears to have based its decision on its own understanding of the insurance industry, without fully discussing the evidence presented, and appears to have rejected established norms, introducing newly articulated concepts that formed the basis for what the court considers insurance for federal income tax purposes. Capstone offers this as the first in a series of commentaries on the tax court’s decision in Reserve.
As a preliminary matter, any analysis of the Opinion must be done with reference to the trial record. Because a court’s written opinion sometimes – as we believe is the case here – may not fully reflect the evidence before it, it is important to review the record when performing a proper review of a court decision. The trial transcript in the Reserve case can be found at https://www.reserve-casualty-corp.com/
This first commentary deals with coverages and losses. By way of background, the insureds’ main business was distributing, servicing, maintaining and rehabbing/manufacturing underground mining equipment providing ventilation for miners and water removal to prevent flooding in underground mines. Many of these products are part of the life support systems for miners operating in mines generally 5,000 – 8,000 feet below ground in Idaho and Nevada.
Court’s View of Actual Losses Being Necessary for Coverage
The court appeared to conclude that, if a business had not experienced an actual loss in an area of coverage, then no non-tax reason exists for acquiring insurance.1 That is, in the court’s view, a business apparently must have experienced an uninsured loss before it can later be covered by insurance. In the case of Reserve’s insureds, whose facilities were located within one of the country’s largest Superfund sites, the court appears to have viewed the absence of a prior pollution claim as negating the ability of the insureds to deduct prospective pollution coverage. Further, because there was no proof that any of the insurance policies covered losses previously experienced, the court concluded that no non-tax reason existed for the insurance. By extension, broad-based business interruption coverage and employment practices liability insurance – both provided through Reserve – would not in the court’s view be insurance given that there was no history of prior losses.
That an insured must have experienced losses before it can legitimately obtain coverage would appear to be fundamentally inconsistent with longstanding practices. The court’s analysis appears to suggest that unless a business has been flooded, flood coverage is not insurance for federal income tax purposes. The same goes for fire insurance. Does this extend as well to key man life insurance or theft coverage? The court’s apparent requirement for an insured to show prior losses has no basis in the business community or the insurance industry. What is being insured against is the fortuitous risk of future losses, not the fear of a reoccurrence.
Court’s Characterization of Coverages as “Excess Insurance”
The court appears to have concluded that the captive policies, which did not duplicate any commercial coverages, were not obtained for non-tax reasons because the insured had never exhausted the commercial policies in any year, despite the commercial policies covering distinct and separate risks from the policies issued by the captive.2 As the court appears to have viewed the landscape, because an insured’s fire policy and workmen’s compensation policy were not exhausted, policies covering product recall, punitive wrap or regulatory changes were not insurance for federal income tax purposes.
Additionally, the court erroneously concluded that the captive coverages (again which were distinct from and did not duplicate any commercial coverages) which were stated as “excess” over any other scheduled policies, if any, were improperly designed because they were “excess.”3 The court’s repeated focus on this “excess” issue – in rejecting Reserve’s policies as valid insurance – was misplaced given the fact that each and every one of the direct policies issued by Reserve covered insurance risks for which the insureds had no underlying coverage. Each of the direct policies issued by Reserve represented the primary (first layer) coverage and did not provide coverage that was “excess” over any other commercial or captive insurance. The court concluded that this “excess” language, even in the absence of a duplicative underlying commercial policy, was fatal to a finding of insurance for federal income tax purposes.4
Interestingly, the direct written policies issued by Reserve to the named insureds expressly contained the following provision, which the court did not mention:
THIS EXCESS POLICY DOES NOT REQUIRE THE INSURED TO MAINTAIN ANY SPECIFIC UNDERLYING PRIMARY INSURANCE POLICIES UNLESS SPECIFIED BY ENDORSEMENT TO THIS POLICY. THE COVERAGES AFFORDED HEREIN WILL DROP DOWN AND PROVIDE COVERAGE ONLY IF THERE ARE NO OTHER VALID AND COLLECTIBLE INSURANCE POLICIES IN FORCE TO WHICH A CLAIM WOULD APPLY, SUBJECT TO THIS POLICY’S TERMS AND CONDITIONS. (emphasis added)
The court made the incorrect conclusions described above on issues that were not even presented at trial. To be sure, the government’s sole substantive witness agreed that most of Reserve’s contracts were policies of insurance. At least seven expert and fact witnesses testified that Reserve’s policies were insurance policies as commonly understood for insurance purposes, with the testimony of these witnesses being uncontested at trial with respect to at least 11 of the 14 policies. The court rejected all of this in favor of her own analysis but did not cite to the government’s otherwise discredited expert, Mr. Riggin, anywhere in the Opinion.
Court’s Emphasis on “Cookie Cutter” Policies
Another surprising view adopted by the court was its imposition of an apparent requirement that the policies be individually drafted and not be based on “forms” to be valid insurance.5 The court viewed the policies as “cookie cutter” rather than, apparently, being individually manucripted and negotiated one at a time. This stands in contrast with form policies and endorsements issued and copyrighted by the Insurance Services Organization (ISO). To be sure, just as in the financial and real estate industries, which are rife with “form” documents (e.g., deeds of trust, security agreements, financing statements, among others), “forms” are standard and have widespread acceptance and understanding throughout the insurance industry.
Despite it being ubiquitous in the insurance industry for policy contracts to be based on forms, the court apparently viewed this as being yet another “fatal factor” in her analysis in rejecting the contracts as insurance. Also, the court took issue with the fact that the policies were copyrighted. The court did not address how it is possible to pool or share risk among unaffiliated insureds using a hodgepodge of individually negotiated contractual coverages.
Form policies, of course, are common in the insurance industry and exist to facilitate the pooling and sharing of risks with respect to unaffiliated insureds under similarly contracted for coverages and to achieve certainty on the scope of coverage. The court appeared to call for an unrealistic approach in requiring that policies be individually manuscripted and negotiated for each insured. In these regards, the court has a wholly different understanding of how a business should conduct itself regarding insurance issues.
This article has focused on specific insurance coverage issues discussed in Reserve. Additional commentaries will address other distinct holdings of this case, with the next commentary focusing on policy pricing concepts discussed in the court’s Opinion.
1 At page 57 of the Opinion, the court states: “Reserve contends that Peak was on a Superfund site and could have been exposed to pollution liability, for which no third-party coverage [could be purchased in the marketplace]. Peak itself did not engage in mining practices that spread pollutants, and it already had systems in place to control the fluid runoff when it cleaned equipment used in polluted mines. In 2008 Peak had operated in Osburn continuously for over 10 years. Reserve provided no evidence that Peak had ever incurred costs during that time for excess pollution liability.”
2 Consistent with industry practice, the policies expressly resolved whether the Reserve contracts were excess or primary in the instance of any other insurance. The Reserve contracts stated that they were excess if there were underlying or other policies, which was not the case. The court discussed this factor along with other factors such as Peak’s lack of significant loss history and the fact that Peak filed and received payment of “only” one claim from Reserve totaling $339,820 during the three tax years in issue. In doing so, the court found that “Taking into consideration all the surrounding facts and circumstances, we conclude that no unrelated party would reasonably agree to pay Reserve the premiums that Peak and the other insureds did for the coverage provided by the direct written policies.” The court did not discuss the uncontested testimony of two actuarial experts who testified for Reserve that the premiums charged by Reserve were reasonable in amount.
3 At page 14 of the Opinion, the court placed significant emphasis on the fact that all of the direct written insurance policies issued to the name insureds contained the following provision: “THE COVERAGES AFFORDED BY THIS POLICY ARE EXCESS OVER ANY OTHER VALID AND COLLECTIBLE INSURANCE POLICY ISSUED BY ANY OTHER INSURER * * *. THE LIMITS AND DEDUCTIBLES STATED HEREIN ONLY APPLY AFTER COVERAGE IS EXHAUSTED FROM ANY AND ALL OTHER VALID INSURANCE POLICIES ISSUED BY ANY OTHER INSURER.” As explained above, the court omitted from its citation language setting-out that if there were no underlying policies, Reserve’s policies would drop down to primary coverage. And the court did not acknowledge that the coverages issued by Reserve did not duplicate coverage with the insured’s commercial policies.
4 The court cited this “excess policy” concept repeatedly as a factor in reaching its conclusion at page 43 of the Opinion that “PoolRe was removed far from any actual risk associated with the business or operations of Reserve’s insureds.”
5 At page 54 of the Opinion, the court states: “Generally, Reserve's direct written policies contained the necessary terms to make them valid and binding insurance, and they were signed by representatives of Reserve and the insureds. We agree with respondent, however, that the direct written policies were “cookie cutter” policies. The policies on their face indicate that they were the copyrighted material of Capstone, and Capstone employees testified at trial that they administered many of the same policies for all of their clients.”