By Sean King, JD, CPA, MAcc
Principal, CIC Services, LLC
This is Part 2 of a series on the United States Tax Court’s recent Avrahami decision.
Introduction
Recently the United States Tax court issued the long-awaited opinion in the Avrahami captive insurance case. And after more than 30 years of losing most every captive insurance case of consequence, the IRS finally got a win.
In Part 1 of this series we discussed the court’s decision that the Avrahami captive insurance arrangement failed for lack of risk sufficient risk distribution. Unlike the captive insurance companies managed by us today, the Avrahami captive pooled only one type of risk, terrorism risk. Consequently, once the court determined that the terrorism policy was not a valid insurance contract, and that insuring only three or four related businesses was not enough, there was no other way for the Avrahamis to demonstrate risk distribution.
The court could have ended its decision right there. Without risk distribution there was no legitimate insurance arrangement. But, the court didn’t stop there. Rather it proceeded to consider whether the arrangement met another of the key criterion for valid insurance arrangements—that is, whether the arrangement was one of insurance in the “commonly accepted sense.” To make this determination the court considered a number of factors as follows:
Operated Like an Insurance Company?
The court first considered whether the Avrahami captive was operated like an insurance company. In ruling that it was not, the court emphasized several facts that are not indicative of the typical captive insurance arrangement.
First, the court noted that it had no established claims paying procedure and only dealt with claims on an ad hoc basis, having never received an actual claim until after being audited. By contrast, all captives that we manage have formalized claims paying procedures and pay actual claims each year.
The court also emphasized that the insurance company had invested nearly two-thirds of its assets in “long-term, illiquid and partially unsecured loans to related parties” and had failed to obtain advance approval from regulators for such loans. This too is highly atypical of the captives that we manage. A captive’s asset policy statement should always support its claims paying ability by emphasizing high liquidity, managed volatility, a reasonable return and tax efficiency. Sacrificing one or more of these to benefit insiders via large related-party loans is never advisable.
Next, the court noted that what claims were eventually paid by the captive were questionable. The court seemed to imply that claims were approved that otherwise should not have been, presumably just to assist the captive in defending itself in the audit. Whether this is true or not is debatable, but it is mostly irrelevant to our clients because our formalized risk management process requires that all claims of consequence be vetted and approved by an independent claims adjuster.
Based on these factors the court noted that the captive was not operated like an insurance company “in the commonly accepted sense.”
Capitalization
Next the court considered whether the captive was adequately capitalized to support its claims paying ability. Noting that the captive met the minimum capital required by regulators (St. Kitts regulators in this case), and citing prior precedent deferring to the determination of regulators, the court ruled the insurance company had adequate capital.
Valid and Binding Policies
The court next considered whether the policies were valid and binding. In suggesting that they were not due to contradictory terms, the court emphasized that it was unclear as to whether the policies were “claims-made” policies (which they purported to be) or “occurrence” policies (as the court interpreted their language to suggest):
By its plain terms the policy limits the coverage to legal expenses incurred and reported between December 2009 and December 2010, terms indicative of both a claims-made policy—the claim must be reported during the policy period—and of an occurrence policy—the claim must occur during the policy period.
On this point, the court basically misinterpreted the policy language. The policy language actually said that the insurer:
Agrees to pay to the Insured any legal expense incurred by the insured during the Policy Period, arising from or relating to the defense of any Insured Event as defined hereunder, which Insured event is instituted against the Insured during the Policy Period.
While I see how the judge interpreted the language the way he did, I respectfully suggest (as has every other insurance expert I’ve spoken with) that it’s not the best or even a reasonable interpretation. The interpretation hinges upon the definition of “Insured Event,” which the judge does not provide. Assuming (as with most all claims made policies) that “Insured Event” is defined to include events happening even prior to December 2010, then this is pretty standard “claims made” language and the judge simply erred.
Reasonableness of Premiums
Perhaps the most troubling part of the ruling was the court’s conclusion that the actuarial pricing of the policies issued by the captive was “utterly unreasonable.” In reaching this conclusion the court interpreted every fact in a light least favorable to the taxpayer, ignored contrary evidence offered by the taxpayer, and substituted its own judgement for that of a qualified and experienced actuary.
To its credit, the court did note a series of apparent deficiencies or oversights in the actuarial work. However, because the court presents only one side of the argument and fails to mention the taxpayer’s counterpoints, if any, it’s hard to know whether these apparent deficiencies are legitimate or, like the court’s criticism of the claims-made language discussed above, merely a function of the court’s unfamiliarity with the complexities of insurance and the actuarial sciences.
There is some reason to believe the latter. First, the court never cites the testimony of an opposing expert actuary critical of the Avrahami pricing because, presumably, the IRS never offered such testimony. Why didn’t it? If the pricing was “utterly unreasonable,” surely it would have been trivial for the IRS to find an actuary expert to testify to that, no?
However, to the contrary, multiple actuaries, some employed by state regulators, have reviewed the work of Avrahami’s actuary on multiple occasions. In the pending Wilson case before the same judge, which involved the same actuary and in some cases similar if not identical policies and coverages, renowned actuary Michael Angelina testified as an expert for the taxpayer (via a 54 page written analysis and opinion of the actuarial pricing) that “the actuarial work…is appropriate; the premium estimates developed…are reasonable; and are calculated in accordance with current actuarial standards.”
Mr. Angelina also testified that he had reviewed the Avrahami’s actuaries work in another situation involving a captive insurance company domiciled in Tennessee. Mr. Angelina testified that, in that case, another independent actuary employed by Tennessee captive insurance regulators, Mary Frances Miller, had also reviewed the work the work of the Avrahami actuary (albeit involving a different captive) and concluded:
I found the documentation to be complete. There was sufficient information provided in the business plan, pro formas and actuarial pricing recommendations for my review. The business plan contemplates ceded reinsurance risk to an offshore pool that is included on the State’s approved reinsurer list. I recommend approval of the application.
Even though there is some reason to believe that the Avrahami judge may have erred in his extensive criticism of the actuary and in his finding that the pricing was “utterly unreasonable,” we must nonetheless seek to learn what lessons we can from the ruling. It’s clear from the ruling that actuarial pricing should be informed by the unique policy provisions of each policy being priced and by the unique circumstances of each insured. Said another way, it’s critical that the actuary understand both the policy language in question and the unique circumstances of each insured when formulating pricing. This requires significant coordination between the attorney who drafts the policies, the insured, and the actuary.
Payment of Claims
The court found that the captive had, in fact, paid claims (once it came under audit by the IRS). While paying claims is a characteristic of legitimate insurance companies, it was not enough to save the Avrahami captive:
Although [the captive] was organized and regulated as an insurance company, paid the claims filed against it, and met the minimal capitalization requirements of St. Kitts, these insurance-like traits cannot overcome its other failings. It was not operated like an insurance company, it issued policies with unclear and contradictory terms, and it charged wholly unreasonable premiums.
Conclusion
Ultimately the judge concluded that, even if sufficient risk distribution had existed in this case, the whole arrangement still would have failed because the captive in question was not operated like an insurance company.
Key takeaways from this portion of the ruling are:
- Establish formal claims paying procedures
- If your captive has claims, file them well before the IRS arrives for an audit
- Participate in a well-structured risk pool or fronting arrangement that should result in claims as well
- Have claims reviewed by an independent claims adjuster
- Keep the insurance company’s assets sufficiently liquid
- Avoid insider loans of significant amounts
- Obtain regulator approval for any insider loans
- Ensure that policy terms are sufficiently clear
- Ensure that the actuary is intimately familiar with the specific policy terms and unique risk profile of each insured and that these factors inform price development
Fortunately, these takeaways are all standard operating procedure for captives managed by CIC Services.