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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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