Captive strategic reviews

Importance of Actuaries in IRS Audit of 831(b) Captives

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The article below being republished explains the weight placed on actuarial testimony by the tax court in the recent RVI case. It confirms the importance of the associated best practice standards we as a firm have been promoting for years now. Our strategic review service will help you address any deficiencies your program may have had in prior years.

Here is the republished artucle by and experienced actuarial firm’s view of the RVI case:

The recent decision of the U.S. Tax Court in RVI Guaranty Co. Ltd. & Subsidiaries v. Commissioner of Internal Revenue (RVI v. IRS) is not only the latest in a string of victories for the insurance industry, it is also yet another case where the expert testimony of actuaries holding credentials from the Casualty Actuarial Society (CAS) were pivotal in the decision of the court.

Briefly stated, the RVI v. IRS case was focused on a determination of whether residual value insurance constituted insurance for federal income tax purposes. In supporting RVI’s contention that residual value insurance was in fact insurance for tax purposes, the court had several key findings that appear to have applicability in other insurance and particularly captive insurance coverages. The Court:

  • had no difficulty finding that from the insured’s perspective they were paying premium to transfer meaningful risk of loss.
  • rejected the contention that coverages with low frequency and high severity do not provide risk transfer solely due to the absence of claims. The Court recognized that residual value insurance was analogous to hurricane and earthquake insurance in that an insurer may go many years without paying a claim. In the words of the Court, “this does not mean that the insurer is failing to provide ‘insurance.’”
  • went on to note that “(m)any insureds who pay premiums will not incur losses.”
  • reinforced that “perfect independence of risks is not required” for risk distribution.
  • gave credence to both the state insurance regulatory treatment and the Statutory Accounting Principles as they were applied to residual value insurance at RVI by their regulators and auditors, respectively. In regard to the regulatory aspects of this issue, they specifically cited that “Congress has delegated to the states the exclusive authority (subject to exception) to regulate the business of insurance” in deferring to the opinion of state insurance regulators.
  • gave weight to how “commonly accepted notions of insurance” applied to residual value insurance. In particular, the facts that state insurance departments treat this coverage as insurance and that many well-established insurance companies provide similar coverage and treat it as insurance were considered in the opinion. This is a bit of a departure from prior decisions.
  • found that “speculative risk” in some cases can still be insured.
  • found that “(f)or more than 80 years, the States have regulated as ’insurance’ contracts that provide coverage against decline in market values of particular assets.”

As interesting as the key elements of the decision are, the importance of the expert testimony of actuaries from the CAS cannot be overlooked. This continues a trend of the Court placing significant importance on the testimony and credibility of actuaries in other cases such as ACUITY, A Mutual Ins. Co. v. Commissioner of Internal Revenue. In the RVI case, two leading members of the CAS played instrumental roles. Current CAS President, Bob Miccolis, of Deloitte Consulting, and former American Academy of Actuaries Casualty Practice Council Vice President, Mike Angelina, who currently serves as executive director of the Academy of Risk Management and Insurance at Saint Joseph’s University, were essential to the success of RVI’s case. On the essential issues of risk transfer/shifting, risk distribution, commonly accepted notions of insurance, and the definition of insurance risk, their testimony was critical and was often specifically cited in the opinion. The Court went out of its way in discussing the issue of insurance risk to state, “The Court regarded Professor Angelina as a credible witness and found his testimony helpful.”

The IRS’ experts did not fare as well. During the same insurance risk discussion the Court in evaluating one of the IRS’ experts (an academic and non-actuary) stated “we found her testimony argumentative and unpersuasive.” Another expert upon cross examination “ultimately conceded … errors, acknowledging that his method of computing loss ratios systematically understated the true extent of petitioner’s losses.” The error in question demonstrated a lack of understanding of the coverage provided by residual value insurance and undermined the credibility of the expert.

In RVI v. IRS, the U.S. Tax Court continues to provide the insurance industry with meaningful and favorable clarification of fundamental concepts such as risk distribution, risk transfer, and the definition of insurance. They also continue to place a great deal of importance on the credible testimony of actuarial expert witnesses.

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Why all 831(b) Micro-Captives Need a Strategic Review

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Feasibility studies are common in the captive industry as part of the formation process. “Refeasibility study” is a newly coined term meaning taking a fresh look to see if you would make the same decisions now. Frankly “refeasibility” is a silly term. Well managed captives following best practices do a “refeasibility” study at least annually anyway, as part of the “renewal” procedure we recommend and feel should be part of all base management fees. Annual renewals, done correctly, almost invariably lead to business plan changes resulting in modifications to lines of cover and policy rating.


Strategic reviews go beyond feasibility, refeasibility or annual renewal procedure studies. For one they should be conducted by a fresh pair of eyes. And they should have a scope beyond an actuarial peer review.

Strategic reviews should look at all existing documentation, including processes and procedures, financial condition, reports (financial, regulatory and tax), contractual relationships, everything available relating to the captive since inception, and identifies all weaknesses and areas needing improvement. A strategic review’s main objective is to identify any potential problem areas that might arise during a regulatory or tax examination of the captive.

The reason strategic reviews are not common is captive managers guard their processes and procedures and documentation very closely. They do so out of competitive spirit as well as insecurity.

Owners of captives should be the one making a decision to hire someone to do a voluntary strategic review, and demand the manager cooperate and provide all needed documentation if not already in the owner’s possession (as it should be via shared secure dedicated server or a cloud storage service facility).


The slowest time of year for most captive managers seems to be the June through August time period. This would be a good time to conduct a strategic review. This would also seem allow sufficient time to address any findings of concern by year end.


Every strategic review engagement is uniquely customized. The exact scope should be articulated in the engagement agreement.

We have done general “clean up” testing strategic reviews for captive managers which merely involved reviewing client databases to see if core documentation connected to formations was properly stored and easily retrieved in client files. Deficiencies are not uncommon from the early years as a manager since many managers in their early years lacked staff depth and expertise compared to today. Earlier year client project files are often not documented to the same degree of quality and scope as more recent captive project may be. This type of strategic review helps bring older client captive documentation standards up to current practice standards if possible. Many management firms have grown fast and are busy; full time internal staff often simply lack time, or expertise, to do this type of special project work.

We recommend every strategic review initiated by an owner (verses by the management firm to get a second and outside opinion on the quality of their program and staff work product) consider having part of its scope be development of a RFQ (Request For Quote) component if the owner is considering either changing managers (possibly creating a new captive and winding down an old one no longer deemed adequate for any of many reasons that may surface during a strategic review) or looking for engagement renewal negotiation strength.

For information on best practice standards today in the micro-captive industry, read this article.

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