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Capstone: "Does Captive Insurance Exist after the 'Reserve' Decision?"

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June 28, 2018

Editor’s note:  In a June 21, 2018, article from Eversheds Sutherland, "Tax Court Issues Second Small Insurance Company Case," partners Bruce Wright and Saren Goldner summarized the latest small insurance company tax court case, Reserve Mech. Corp. v. Commissioner, 2018 Tax Ct. Memo LEXIS 87, (T.C. June 18, 2018), and identified the issues considered in the court's opinion.

Houston-based Capstone Associated Services, Ltd., (Capstone) who served as the captive manager for the arrangement, also issued an initial statement about the matter, which is available in the article "US Tax Court Finds Deficiencies in 'Reserve Mechanical' Captive Arrangement."

Capstone has subsequently provided its first commentary about the opinion, with reference to the full trial transcript, strongly stating that it believes the court made a number of incorrect conclusions surrounding coverages and losses. Read the full commentary below.

Disclaimer: The views, interpretations, opinions, findings, and conclusions expressed in the following commentary are those of the author, Capstone Associated Services, Ltd.,  and not those of  International Risk Management Institute, Inc. (IRMI) or

Does Captive Insurance Exist after the Reserve Decision?

Reserve Mech. Corp. f.k.a. Reserve Cas. Corp. v. Commissioner of Internal Revenue ("Reserve Mechanical") was decided by the US tax court in an opinion ("the Opinion") issued by Judge Kathleen Kerrigan on June 18, 2018. The Opinion is available to read at

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 Mechanical.

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 may not fully reflect the evidence before it—as we believe is the case here—it is important to review the record when performing a proper review of a court decision. The trial transcript in the Reserve Mechanical case is at

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, which provided 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 nontax 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 nontax 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 reoccurrance.

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 nontax reasons because the insured had neverexhausted the commercial policies in any year, despite the commercial policies covering distinctand separate risks from the policies issued by the captive.2 As the court appears to have viewedthe landscape, because an insured's fire policy and workmen's compensation policy were notexhausted, policies covering product recall, punitive wrap, or regulatory changes were notinsurance 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.


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 its own analysis, but did not cite to the government's otherwise discredited expert, Donald 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 being individually manuscripted and negotiated one at a time. This stands in contrast with form policies and endorsements issued and copyrighted by the Insurance Services Office, Inc. 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 its 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 Mechanical. Additional commentaries will address other distinct holdings of this case, with the next commentary focusing on policy pricing concepts discussed in the Opinion.

  1. On 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 3 tax years in issue. In doing so, the court found on page 61 of the Opinion 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. On 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. Also, 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 on page 44 of the Opinion that "PoolRe was removed far from any actual risk associated with the business or operations of Reserve's insureds."
  5. On 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."

This commentary is reproduced by with permission of Capstone Associated Services, Ltd.

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