US tax court rules against captive’s stop-loss insurance transactions, citing Avrahami

The US tax court has ruled that a risk pool operating as a stop-loss insurer was not operated as a bona fide insurance company and the transactions between it and its captive insureds were not insurance transactions, citing the Avrahami ruling. However, the decision has been described by Capstone Associated Services, a captive services firm based in Houston, and the manager of the stop-loss insurer, as doing “a disservice to the captive insurance industry”. The case, Reserve Mechanical Corp. v. Commissioner of Internal Revenue, involved a captive, Reserve Mechanical Corp, domiciled in Anguilla. The tax court concluded that Reserve’s quota share policies with Capstone’s risk pool, Pool Re, also domiciled in Anguilla, were not bona fide insurance agreements. The court said: “The quota share arrangement involved a circular flow of funds. The premiums were not negotiated at arm's length. All the insureds of the participants in the quota share arrangement were obligated to pay the same percentage of premiums to Pool Re. There is no evidence that the premiums [that] Peak and the other insureds were obligated to pay Pool Re, and the premiums that PoolRe was obligated to pay Reserve, were actuarially determined. Pool Re's activities as they relate to those policies were not those of a bona fide insurance company.” The court concluded that the coinsurance contracts were not bona fide reinsurance agreements, and that Pool Re was not a bona fide insurance company. It said the purported reinsurance agreements between it and Reserve did not allow Reserve to effectively distribute risk. “Risk distribution is a necessary component of insurance, and its absence in this case is sufficient for us to conclude that Reserve's transactions during the tax years in issue were not insurance transactions. The absence of risk distribution is enough to conclude that the transactions between Reserve and its insureds were not insurance transactions. An alternative ground for this holding is that they did not constitute insurance in the commonly-accepted sense.” It pointed to the recent ruling of Avrahami v. Commissioner to support its ruling. It stated: “Reserve was organised and regulated as an insurance company, and it satisfied the regulatory requirements of its domicile jurisdiction. It also paid a claim filed under one of its policies. However, it was not operated as a bona fide insurance company, and there was no legitimate business purpose for the policies that Reserve issued for the insureds.” Capstone, which has offices in Anguilla, said it “respectfully disagreed with the court’s opinion and in particular the court’s reliance in deciding this case on the Avrahami opinion”, adding: “Reserve had no loans, participated in a diversified pool, assumed unaffiliated, third-party reinsurance, reported and paid substantial losses, and had policies that were designed to meet the needs of the underground mining business that it insured.” It went on: “Oddly, the court rejected the professionally-administered pooling arrangement which involved hundreds of third-party insureds and hundreds of policies as being ‘circular’, evidencing an unexpected rejection of a fundamental industry standard risk-sharing mechanism dating back more than a century.” According to Capstone, the court rejected Reserve’s third-party reinsurance programme “which was fully in evidence, because the more than 100,000 underlying direct written policies from a recognised admitted carrier were not put into evidence but were only the subject of (unchallenged) testimony”. Capstone said the court gave no weight to the fact that the IRS had issued 39 favourable rulings involving similar captive insurance arrangements and the same reinsurance arrangements. “Of even greater surprise, the court called out for evidence that an insured had experienced a loss before a company could buy insurance covering such event,” it said. Capstone concluded: “The court’s opinion does a disservice to the captive insurance industry and the bona fide captive insurance companies like Reserve.”

US tax court rules against captive’s stop-loss insurance transactions, citing Avrahami

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