Business Risks v Insurance Risks

Though the Internal Revenue Code defines what an insurer is, it is silent with regard to what is an insurance contact. Over the years, in various advisories or memoranda, the Internal Revenue Service (IRS) has consistently asserted the position that a contract is not an insurance contract if it covers only what the service defines as “business risk.” In the context of whether there is insurance for federal income taxation purposes, best practices in policy drafting would thus generally dictate that those writing policy contracts for captives should be mindful of how the service defines insurance versus business risk. The answer to the question of what the service thinks is a “business risk” preliminarily starts with how to define “insurance risk.”

What is an insurance risk?

An insurance transaction must involve the insurance risk of the insured that is transferred to the insurance company. For example, in AMERCO v Commissioner of IRS, 979 F.2d 162 (1992) and Helvering v LeGierse, 61 S.Ct. 646 (1941).

Caselaw consistently defines insurance risk as “contractual security against possible anticipated loss”, as referenced in Epmeier v US, 199 F.2d 508, 509-510 (7th Circuit 1952). But, the risk transferred must be of an economic loss, as shown in Allied Fidelity Corporation v Commissioner, 572 F.2d 1190, 1193 (7th Circuit 1978).

In determining whether a risk is an insurable one, courts have long held that the risk must be fortuitous—see Commissioner v Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950). Fortuity, used as a noun, means a chance happening or event.

There is generally a three-prong test for what constitutes insurance for federal tax purposes. Under this test, to qualify as an insurance transaction, there must be an insurance risk; risk shifting and risk distribution; and insurance in its commonly accepted sense. AMERCO, supra. This article first focuses on defining the concept the service refers to as “business” risk and then discusses insurance in its commonly accepted sense in the context of how to write insurance policy contracts that cover insurance, and not business, risk.

The service’s general position on business risk

Below is a brief highlight reel of certain positions taken by the service. This is not meant to be all inclusive, but rather, just focuses on a few cases or decisions with interesting fact patterns or conclusions.

In determining whether a risk is insurable or whether it is an uninsurable business or investment risk, the service has consistently taken the position that insurance contracts must protect against economic loss only. In other words, the service believes that certain types of risk are not insurable because they don’t involve economic loss. In this regard, the service has attempted to define certain contract risks as business or investment risks and in so doing, has held that the contract transaction at issue was not an insurance transaction and thus the contract wasn’t an insurance policy and the company issuing the disputed contract wasn’t an insurance company for federal income taxation purposes. For example, an overbroad application of Helvering v LeGierse, supra has been used by the service time and again to stand for the proposition that investment or business risks of an insured can never be insurance risks. Since Helvering was decided, the service has continued to whittle away at the concept of insurance risk, in an effort to further define its view of what is an uninsurable business risk.

Besides investment risk, another area where the service has found there is not insurance risk is in contracts that have a service component. In this context, if the service component to a contract governs over the contract’s offering of protection against economic loss, the service has found that this kind of contract is to be treated as a “services,” and not “insurance,” contract. In Revenue Ruling 68-27, 1968 WL 15297, the service held that when the taxpayer provided preventative medical care services “to various groups and individuals who prepay the contract price at fixed monthly rates,” that this was “predominately a normal business risk of an organisation engaged in furnishing medical services on a fixed-price basis” and thus there wasn’t an insurance risk. One can understand the service’s viewpoint here given that there were fixed costs and such expected and finite costs might well set the cost of the risk so clearly that one could argue fortuity has been compromised.

In general counsel memorandum 39146, chief counsel opined on the tax treatment for a taxpayer that wanted to enter into certain warranty agreements. 1984 WL 264895. In exchange for a fee, the taxpayer planned to enter into “a master warranty agreement with builders of frame buildings agreeing to assume a portion of their warranty liability exposure for inherent defects.” Ultimately then, the taxpayer would issue a five year joint warranty in the name of the purchaser and the builder. In the event of loss due to a covered event, like damage from wind, snow, sleet or ice, the taxpayer/warrantor would pay the builder its out of pocket expenses incurred in repairing the damage, or if the insured builder was no longer in business, the taxpayer/warrantor would repair or replace the covered property. The chief counsel held that the warranty contracts at issue covered only business and not insurance risk because the warranty only protected against defects in the manufacturing process, which the builder controlled and thus there was no “outside peril” or fortuitous type loss.

However, while it’s true that an insured may have control over a process or the insured may even expect a loss or loss related expense of some form, the fact of the loss happening can nonetheless be fortuitous when that insured does not know the exact timing, place or cost of any risk that actually manifests in a loss. Even a controlled process can still present risk. Things can always happen that are unexpected and outside of the control of a person or entity who is charged with evaluating or managing a risk. And it’s also possible that an insured might be expecting some risk to ultimately manifest in loss, but that doesn’t necessarily mean that the insured has any control over when the loss will happen or what is the order of magnitude it might reach. Moreover, many commercial insurance policies cover claims stemming from risk or loss within the insured’s control, including product recall, professional liability, and auto liability, to name a few.

In fact, the service has consistently suggested that proving insurance risk can be done by comparison to what the commercial market will insure. Logically, this position should include coverages presently available from admitted, surplus lines, and specialty carriers worldwide, as well as coverages previously made available but from which the commercial market has withdrawn. The commercial market has considered certain contingencies, perils and classes of damages to be insurance risks, but has nonetheless declined to cover them through the use of narrow insuring clauses, certain definitions, and exclusions contained in their policies. The point here is that if the commercial market would cover something as an insurance risk or decline to cover something as an insurance risk, then a captive should be able to cover those risks as well.

Holding in a similar manner, chief counsel also issued advice in the form of determining that a proposed group captive design to cover decommission costs for nuclear power plants presented contractual coverage for business, and not insurance, risk and thus the contracts proposed did not amount to insurance for federal income taxation purposes. See IRS CCA 200629028. In this case, it was stipulated that the nuclear power plants would have to be decommissioned in the future, there were estimates as to the decommission dates, and there were projected costs for decommissioning. Chief counsel opined that “when a nuclear power plant is placed in operation, it is inevitable that the licensee will incur the cost of decommissioning the plant when operation ceases. The obligation to decommission has attached therefore no hazard or fortuity as to the occurrence of decommissioning… The licensee does not bear the risk of whether decommissioning will occur—that is inevitable.”

So, again, the service held that because the taxpayer had some semblance of knowledge relative to a risk and some idea that the risk was indeed going to manifest in some way down the line, that these facts meant there was no fortuity and thus no insurance risk.

In a 2015 chief counsel advisory, counsel held that when a group of taxpayers entered into a contract with an affiliated insurance company where the taxpayer/insureds would receive payments under the contract if their earnings suffered because of currency fluctuations, this arrangement did not constitute insurance for federal income taxation purposes. See IRS CCA 20151102.

But, currency fluctuations are absolutely not within the control of the insured and the insured has no way of knowing exactly what they will be, when they will happen, or how any such fluctuations will impact the business.

While it’s true that the taxpayer group here was indeed expecting some form of currency fluctuation to impact its business at some point, that doesn’t mean that the group knew the exact extent of any such fluctuation’s impact on its business or how much loss it would cause.

Fortuitous loss caused by currency fluctuations outside of the control of the insured is an economic loss to the insured. Moreover, diminished value, or loss caused by diminished value, is insurable in many contexts, including but not limited to the context presented by the more recent decision in R.V.I. Guaranty Company, Ltd. v Commissioner of Internal Revenue, 145 T.C. No. 9 (September 15, 2015).

R.V.I. was an important decision to the captive industry (even though it did not involve a captive) in that it holds that certain residual value contracts were insurance for federal income tax purposes. R.V.I. issued contracts to insureds that leased assets or financed leases, where the insureds were leasing companies, manufacturers, and financial institutions. The insured assets were vehicles, commercial real estate, and commercial equipment. The residual value contracts insured against the risk that the insured assets would decline more rapidly in value than expected so that the asset value at lease termination would be much less than originally contemplated at the time of leasing. The way these contracts worked is that if the asset’s actual value was less at the end of the lease than the insured value, R.V.I. would pay the difference under the policy. So, the loss compensated under the policy was the difference between actual value and insured value.

But, in a Technical Advice Memorandum, the service concluded that residual value insurance policies weren’t insurance contracts because they managed losses that were substantially certain to occur. The service felt that the policies did not constitute insurance because in its view, the lessors were purchasing protection against market decline risk and this kind of risk is investment, and not insurance, risk. However, the court disagreed, finding that the policies covered an insurance risk because there was no expectation that the asset value at lease end could ever increase beyond the insured value, and while it’s true that the lessor’s business model is premised upon the fact that assets will decline in value (thus the lessor was expecting loss of some variety), the policies are nonetheless protecting against risk that undefined losses will interfere with the company’s business model.

The evaluation of insurance risk should be undertaken from a fortuity standpoint and not necessarily from the standpoint of determining an insured’s “control” over economic loss. After all, there is a pretty fine line between an economic loss and a business loss if control is going to be the differentiating factor. However, there is a very clear line between fortuitous and non-fortuitous risk or a foreseeable versus an unforeseeable event. If an insured knows of a loss at the time of contracting for insurance, it’s not covered. Intentional conduct that leads to losses can preclude coverage for a claim. A risk for which the insured has some semblance of control should be covered as long as that risk manifested with fortuity, and the insured had no way of knowing exactly how or when or what would be the cost of the risk, as it ultimately manifests in a claim circumstance.

Best practices in policy drafting: writing coverage for fortuitous, insurable risk

Policy contracts are written in a very specific way, using standard policy drafting conventions common to the insurance industry. Prolific use of over-generalised boilerplate policy language where the policy contract does not follow the flow of a traditional insurance policy format could be suggestive of a problematic policy contract. Captive best practices dictate that a captive insurer does not deviate too far from the traditional course when it comes to policy drafting.

In other words, captives should follow policy drafting rules and convention that applies to their traditional brethren.

In general, all insurance contracts contain the following:

  • The policy starts with a declarations page which identifies the policy number, named insured, the insurer, the type of policy, the policy limit, any applicable deductible or self insured retention, the period of the coverage, whether or not there is any retroactive date, and the premium.

  • A key component to any insurance policy is the insuring agreement. The provisions that make up a policy’s insuring agreement are used to describe the nature of the coverage and what is the covered peril, location or risk.

  • The definitions section of a policy provides definitions of key terms and phrases used throughout the policy. Defined terms are typically in bold or are highlighted in some other manner in the policy itself so that anyone reading the policy will know that the term has been defined in the coverage.

  • Exclusions to a policy reduce or eliminate coverage. They describe risk, locations, perils, property, or a type of claim, injury or damage that would not be covered under the policy.

  • Policy conditions are those terms and provisions that govern conduct. They detail the duties and obligations required of the insured in order to qualify for coverage. These provisions include notice provisions and cooperation provisions.

  • Endorsements are additional documents that are attached to a policy form that alter or modify the coverage provided in the form. They can delete or modify terms and provisions that exist in the form, and can expand or contract provisions in the policy form, or they can add new clauses to the policy altogether.

  • In evaluating captive insurance policies or programmes, the service routinely looks to the commercial market as a role model. The commercial insurance market considers certain contingencies, perils, and types of damages as insurance risks, but nonetheless will decline to cover those insurance risks through the use of narrow insuring clauses, definitions, and exclusions contained in their policies. Captives have been used to fill in these gaps left by the commercial market. If a commercial carrier would cover a risk, but declines to do so for its own reasons (it’s leaving the market for that risk, the risk of the particular insured would likely mean that the commercial carrier won’t make underwriting profit goals given the insured’s claim history and so on), why couldn’t a captive step in and cover that risk? If it’s an insurance risk to the commercial market, it would also be an insurance risk to the captive market.
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