Whose Risk and How Is
It Spread
An update on risk
shifting and risk
distribution
Paul Philips
Hugh Tollack
EY
Partner
Rent A Center, Inc.
Director of Tax Audits,
Research and Planning
AGENDA
• Historical view of risk shifting & risk distribution
• Stepping through the updates
– Risk Shifting
• Parental Guaranty
• Circular cash flows
• Netting
– Risk Distribution
• The Law of Large Numbers
• Impact to Rev. Rul. 2002-90 and 2005-40
Risk Shifting and Risk Distribution
• The seminal case for defining an insurance contract is
Helvering v. Le Gierse, 312 U.S. 531 (1941), where the courts
established that a contract of insurance must involve
Risk Shifting and Risk Distribution
• Le Gierse involved a life insurance policy (single risk) and
annuity equal to the face value of the life policy
• Although the Le Gierse court did not define these terms
specifically, subsequent courts have provided guidance as to
their meaning
Risk Shifting
• Risk shifting is viewed from the perspective of the insured
• In order for risk shifting to exist, the insured must transfer its
risk of economic loss due to some hazard to an insurance
company that has adequate capital to accept the risk
• Risk shifting as provided under accounting principles such as
GAAP have proven to be instructive, but not determinative
(i.e., a 10% chance of a 10% loss)
• The “balance sheet” test is frequently used by the courts to
determine whether an insured has shifted its risks to the
insurer (under this test, a sole shareholder generally cannot
shift its risks to its wholly-owned captive subsidiary)
Risk Shifting
• Carnation Co. v. Commissioner, 71T.C. 400(1978), aff’d, 640
F.2d 1010 (9th Cir 1981) – parent-sub relationship including
capital support agreement, payable upon demand, from the
Parent to the captive as compelled by a third party.
• Clougherty Packing Co. v. Commissioner, 84 T.C. 948, 957
(1985), aff’d 811 F.2d 1297 (9th Cir. 1987) – parent-sub
relationship in which the balance sheet and net worth analysis
negated risk shifting.
• Humana Inc. & Subs. v. Commissioner, 881 F.2d 247, 248 (6th
Cir. 1989) – parent-sub arrangement disallowed as insurance,
but brother/sister risk upheld upon appeal under the balance
sheet and net worth analysis.
Risk Shifting
• Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835, 841 (6th
Cir. 1995) – holding that a reinsurance arrangement was not
bona fide because the captive was undercapitalized and the
parent guaranteed the captive’s obligations to an unrelated
insurer.
• Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42, 49-50
(1997) – holding that a reinsurance arrangement lacked risk
shifting because the parent indemnified the captive’s
obligation to pay an unrelated primary insurer.
• Hospital Corp. of Am. v. Commissioner, T.C. Memo 1997-482
– holding that risk shifting did not occur due to parent’s
agreement to indemnify third party / unrelated insurer.
Risk Distribution
• Risk distribution is viewed from the insurance company’s
perspective
• Based on the actuarial principle of “the law of large numbers,”
risk distribution entails spreading risks among a large group
allowing the insurer to reduce the possibility that one claim will
exceed the premiums collected
• While the courts have addressed the concept of risk
distribution, no single case defines what constitutes adequate
risk distribution in a captive arrangement (e.g. number of
underlying insureds, number of entities). Nevertheless, while
a specific quantity of risks has not been defined by the courts,
the Tax Court has articulated principles that are useful.
Risk Distribution
• Clougherty Packing Co. v. Commissioner, 84 T.C. 948, 957
(1985), aff’d 811 F.2d 1297 (9th Cir. 1987) – “Distributing risk
allows the insurer to reduce the possibility that a single costly
claim will exceed the amount taken in as a premium . . . by
assuming numerous relatively small, independent risks that
occur randomly over time, the insurer smoothes out losses to
match more closely its receipt of premiums”
• Humana Inc. & Subs. v. Commissioner, 881 F.2d 247, 248 (6th
Cir. 1989) – Risk distribution occurs when an insurer pools a
large enough collection of unrelated risk (i.e. risks that are
generally unaffected by the same event or circumstance).
Risk Distribution
• Harper Grp. v. Commissioner, 96 T.C. at 57 – risk distribution
also allows the insurer to more accurately predict expected
future losses. In analyzing risk distribution, we look at the
action of the insurer because it is the insurer’s, not the
insured’s, risk that is reduced by risk distribution.
Contrast to:
• Rev. Rul. 2002-90 – risk distribution exist when twelve brother/sister
entities pay premiums into the captive with each entity representing
no less than 5% or greater than 15% of the premium paid.
• Rev. Rul. 2005-40 – Clarified that the brother/sister subsidiaries
need to be legal entities not disregarded for federal income tax
purposes
Recent Updates
• Rent-A-Center, Inc. v. Commissioner, 142 T.C. No. 1
• Securitas Holdings, Inc. and Subsidiaries v. Commissioner,
T.C. Memo 2014-225
Update – Risk Shifting
• Rent-A-Center, Inc. v. Commissioner
– The balance sheet and net worth analysis provides the proper
analytical framework to determine risk shifting in a brother-sister
arrangement. Concluding that the policies at issue shifted risk from
RAC’s insured subsidiaries to Legacy (the Captive).
– The parental guarantee did not affect the balance sheet or net worth of
the subsidiaries, was limited or did not shift away the ultimate risk of
loss back from the captive, did not involve an undercapitalized captive
and was not requested by an unrelated insurer. Concluding that the
parental guaranty did not negate risk shifting.
– Netting, or the use of journal entries to account for intercompany funds
on a net basis, was deemed acceptable provided complete and
accurate records are maintained.
Update – Risk Shifting
• Securitas Holdings, Inc. and Subsidiaries v. Commissioner
– Cited Rent-A-Center in stating that the Tax Court previously held that
the existence of a parental guaranty by itself is not enough to justify
disregarding the captive insurance arrangement. Also found that the
captive was adequately capitalized and stated no payments were made
with respect to the guaranty.
– Also addressed netting, restating that it is unrealistic for members of a
consolidated group to cut checks to each other and using journal
entries to keep track of the flow of funds is commonplace. Accordingly,
held the captive arrangement as a whole adequately shifted risk.
Update - Risk Distribution
• Rent-A-Center, Inc. v. Commissioner
– Legacy insured three types of risk: workers’ compensation, automobile
and general liability. RAC’s subsidiaries owned between 2,623 and
3,081 stores; had between 14,300 and 19,740 employees; and
operated between 7,143 and 8,027 insured vehicles. RAC’s
subsidiaries operated stores in all 50 States, D.C., Puerto Rico and
Canada. RAC’s subsidiaries had a sufficient number of statistically
independent risks. Thus, by insuring RAC’s subsidiaries, Legacy
achieved adequate risk distribution.
Update – Risk Distribution
• Securitas Holdings, Inc. and Subsidiaries v. Commissioner
– Protectors, and ultimately SGRL, insured five types of risk: workers’
compensation, automobile, employment practice, general and fidelity
liabilities. Securitas AB Group employed over 200,000 people in 20
countries, and the SHI Group, alone, employed approximately 100,000
people each year and operated over 2,250 vehicles.
– Risk distribution is viewed from the insurer’s perspective. As a result of
the large number of employees, offices, vehicles, and services provided
by the U.S. and non U.S. operating subsidiaries, SGRL was exposed to
a large pool of statistically independent risk exposures. This does not
change merely because multiple companies merged into one. The risk
associated with those companies did not vanish once they all fell under
the same umbrella… Court held that by insuring the various risk of U.S.
and non U.S. subsidiaries, the captive achieved risk distribution.
Update – Risk Distribution
• The query is whether the opinions in Rent-A-Center and
Securitas will provide the final nails in the coffin that is the
Service’s position on risk distribution that there needs to be a
certain number of legal entities insured by the captive in order
to achieve risk distribution as set forth in Rev. Rul. 2002-90
and 2005-40.
• Rev. Rul. 2014-15 - e.g., the Service follows Rev. Rul. 92-93
and the employees are seen and the insureds and Rev. Rul.
2005-40 is modified.
Questions?
Q&A
Contacts:
Paul H. Phillips III
Partner,
Financial Services, Tax
EY LLP
(312) 879-2898
Paul.Phillips@ey.com
Hugh L. Tollack II, CPA
Director of Tax Audits, Research and
Planning
Rent-A-Center, Inc.
(972) 801-1331
hugh.tollack@rentacenter.com