IRS determination 1121029: exemption denied to an insurance company

Plain-English summary

The IRS issued a final adverse determination that an insurance company did not qualify for exemption under IRC § 501(c)(15). The company provided commercial casualty and property insurance-type services and entered into direct-writing and reinsurance arrangements. The IRS concluded that too few insureds supported an adequate premium pool and that the company's risks were too heavily concentrated in one insured, so the arrangements did not provide sufficient risk distribution. The company was instructed to file federal income tax returns within 30 days and was given a right to protest the determination.

Ruling snapshot

• Question: Did the insurance company qualify for exemption under IRC § 501(c)(15) when most of its premium income came from one related group of insureds?
• Outcome: Revocation.
• Key authorities: IRC §§ 501(a), 501(c)(15), 953(d), and 6110; Rev. Ruls. 2002-89, 2002-90, and 2005-40.

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Release Number: 201121029 Contact Person:
Release Date: 5/27/2011

Date: March 02, 2011 Identification Number:

XXXXXX

XXXXXX Contact Number:

XXXXXX

UIL Code: 501.15-00 Employer Identification Number:

XXXXXX

Form Required To Be Filed:
Tax Years:

Dear

This is our final determination that you do not qualify for exemption from Federal income tax
under Internal Revenue Code section 501(a) as an organization described in Code section
501(c)(15).

We made this determination for the following reason(s):

There are an insufficient number of insureds to provide for an adequate premium-pooling base.

In addition, your risk is too heavily concentrated in one insured. As a result, your business lacks
one of the principle elements of insurance, risk distribution. Thus, because you do not qualify as
an insurance company, you do not meet the statutory requirement for exemption under section
501(c)(15) of the Code.

You must file Federal income tax returns on the form and for the years listed above within 30
days of this letter, unless you request an extension of time to file. File the returns in accordance
with their instructions, and do not send them to this office. Failure to file the returns timely may
result in a penalty.

We will make this letter and our proposed adverse determination letter available for public
inspection under Code section 6110, after deleting certain identifying information. Please read
the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the
instructions in Notice 437. If you agree with our deletions, you do not need to take any further
action.

If you have any questions about this letter, please contact the person whose name and
telephone number are shown in the heading of this letter. If you have any questions about your
Federal income tax status and responsibilities, please contact IRS Customer Service at
1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933. The IRS
Customer Service number for people with hearing impairments is 1-800-829-4059.

XXXXXX 2

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Enclosure
Notice 437
Redacted Proposed Adverse Determination Letter
Redacted Final Adverse Determination Letter

INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

Date: August 20, 2010 Contact Person:
Identification Number:

XXXXXX

XXXXXX Contact Number:

XXXXXX
FAX Number:
Employer Identification Number:

XXXXXX

LEGEND:

Place = XXXXXX

A = XXXXXX

B = XXXXXX

C = XXXXXX

D = XXXXXX

E = XXXXXX

F = XXXXXX

Date 1 = XXXXXX

Year 1 = XXXXXX

m = XXXXXX

n = XXXXXX

o = XXXXXX

p = XXXXXX

q = XXXXXX

r = XXXXXX

s = XXXXXX

t = XXXXXX

u = XXXXXX

v = XXXXXX

w = XXXXXX

x = XXXXXX

y = XXXXXX

Dear

We have considered your application for recognition of exemption from Federal income tax
under Internal Revenue Code section 501(a). Based on the information provided, we have
concluded that you do not qualify for exemption under Code section 501(c)(15). The basis for
our conclusion is set forth below.

XXXXXX

FACTS

You were incorporated on Date 1 in Place. You are in the business of providing certain
commercial casualty and property insurance-type services. You also “reinsure” certain
contracts as described below. You filed an election under section 953(d) of the Internal
Revenue Code, which allows an election by a foreign insurance company to be treated as a
domestic corporation.

You are wholly owned by A. You have only one class of stock—m of no par value shares. Out
of these m shares, you issued n shares in equal amounts to individuals D and E. The total
consideration paid for the shares was $o paid in cash. D and E also serve as your only
corporate officers and directors. D serves as your director, corporate executive officer (CEO),
president, treasurer, and assistant secretary. E serves as your director, vice president,
secretary, and assistant treasurer. Neither D nor E holds financial interests in any other
insurance companies. Moreover, neither D nor E has any agreement or relationship with any of
the shareholders of the insurance companies with which you conduct business. The documents
indicate that you are wholly owned by A, which is wholly owned by D and E in equal parts.

You have employed company F as your resident manager for an annual compensation
estimated to be less than $p.

In addition to the q direct-written “insurance” contracts that you issued to B, you and entity C
entered into an agreement titled “Joint Underwriting Stop Loss Endorsement.” C is not related
to you, A, B, D or E. You represent that C is a regulated insurer. It appears that under this
agreement, you are responsible for payment of claims up to certain specified thresholds. If the
thresholds are met, then C becomes liable for payment of claims up to certain specified limits. If
the specified limits for C’s payment of claims are exceeded, then you again become liable. It
also appears that for each of the above-referenced contracts, you receive 81.5% of the total
premiums. C receives 18.5% of the total premiums. It is unclear whether B pays you and C
directly or whether B pays you and you remit 18.5% to C.

During Year 1, you entered into two types of reinsurance arrangements. In the first
arrangement, you assumed reinsurance contracts from C. The primary issuers on these
contracts are unaffiliated insurance companies that underwrite credit-type policies (credit
property, credit disability, and/or credit life) and policies for vehicle service contracts. For Year
1, you received $r in “premium” income from this arrangement.

You refer to the second arrangement as a “reinsurance risk pooling program.” In this
arrangement, you participate in a “reinsurance risk pool” with several other unrelated insurance
companies (“pool participants”). The risk pool is operated by C. Each pool participant has one
or more affiliated operating entities for which it underwrites insurance coverage (generally
casualty type coverage). B insures a portion of the direct insurance underwritten by the pool
participants using a so-called “stop loss” endorsement. You currently participate in over s
insurance policies with more than t insureds. You blend together your direct-written insurance
and then reinsure the entire book on a quota-share basis with each of the pool participants.
During Year 1, you received $u in “premiums” with respect to this second arrangement.

2)
4

XXXXXX

Your gross income totaled $v for Year 1 which consists of $w in direct written premiums and $x
in reinsurance assumed and pooled premiums.

Of your total premium income for Year 1, 69.5% is from B, 14.7% is from the first reinsurance
arrangement, and 15.8% is from the “reinsurance risk pooling program.”

For Year 1, your assets totaled $y and total capital equaled $o.

LAW AND ANALYSIS

Neither the Code nor the regulations define the terms “insurance” or “insurance contract.” The
standard for evaluating whether an arrangement constitutes insurance is Helvering v. LeGierse,
312 U.S. 531 (1941), in which the Court stated that “historically and commonly insurance
involves risk-shifting and risk-distributing in a transaction which involve[s] an actual ‘insurance
risk’ at the time the transaction was executed.” Insurance has been described as “involv[ing] a
contract, whereby, for adequate consideration, one party agrees to indemnify another against
loss arising from certain specified contingencies or perils. Epmeier v. United States, 199 F.2d
508, 509-10 (7th Cir. 1952). Insurance is contractual security against possible anticipated loss.
Id. Cases analyzing “captive insurance” arrangements have distilled the concept of “insurance”
for federal income tax purposes to three elements, applied consistently with principles of federal
income taxation: (1) involvement of an insurance risk; (2) shifting and distribution of that risk;
and (3) insurance in its commonly accepted sense. See e.g., AMERCO, Inc. v. Commissioner,
979 F.2d 162, 164-65 (9th Cir. 1992), aff'g. 96 T.C. 18 (1991).

The risk transferred must be risk of economic loss. Allied Fidelity Corp. v. Commissioner, 572
F.2d 1190, 1193 (7th Cir. 1978). The risk must contemplate the fortuitous occurrence of a
stated contingency, Commissioner v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950), and
must not be merely an investment or business risk. LeGierse, 312 U.S. at 542; Rev. Rul. 89-96,
1989-2 C.B. 114.

Rev. Rul. 2007-47, 2007-30 I.R.B. 127, provides that an arrangement that provides for the
reimbursement of inevitable future costs does not involve the requisite insurance risk for
purposes of determining (1) whether the amount paid for the arrangement is deductible as an
insurance premium and (2) whether the assuming entity may account for the arrangement as an
“insurance contract” for purposes of subchapter L of the Code. In Rev. Rul. 2007-47, a
domestic corporation engaged in a business process that was inherently harmful to people and
property. Applicable government regulations require the corporation to take action to remediate
the harm and, therefore, the domestic corporation will incur future cost to restore its business
location. There is no uncertainty that future costs will be incurred. The domestic corporation
entered into a contract with a domestic insurance company to be reimbursed for its future costs.
The arrangement had no limits on its duration. Citing and amplifying Rev. Rul. 89-96, 1989-2
C.B. 114, Rev. Rul. 2007-47 holds that this was not an insurance arrangement. Arrangements
that are entered into to manage losses that are at least substantially certain to occur, or that are
not the result of fortuitous events, do not constitute insurance. The fortuity principle is central to
the notion of what constitutes insurance. Rev. Rul. 2007-47 holds that an arrangement that
purports to be an insurance contract that lacks the requisite insurance risk, or fortuity, may
instead be characterized as a deposit arrangement, a loan or a contribution to capital, an option
or indemnity contract based on the substance of the arrangement between the parties.

3

XXXXXX

Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of
the financial consequences of the potential loss to the insurer, such that a loss by the insured
does not affect the insured because the loss is offset by a payment from the insurer. See Rev.
Rul. 60-275, 1960-2 C.B. 43 (risk shifting not present where subscribers, all subject to the same
flood risk, agreed to coverage under a reciprocal flood insurance exchange).

Risk distribution incorporates the statistical phenomenon known as the law of large numbers.
The concept of risk distribution “emphasizes the pooling aspect of insurance: that it is the nature
of an insurance contract to be part of a larger collection of coverages, combined to distribute
risks between insureds.” AMERCO and Subsidiaries v. Commissioner, 96 T.C. 18, 41 (1991),
aff'd, 979 F.2d 162 (9th Cir. 1992). In Treganowan, 183 F.2d at 291, the court quoting Note,
The New York Stock Exchange Gratuity Fund: Insurance That Isn’t Insurance, 59 Yale L.J. 780,
784 (1950), explained that “[b]y diffusing the risks through a mass of separate risk shifting
contracts, the insurer casts his lot with the law of averages. The process of risk distribution,
therefore, is the very essence of insurance.” See also Beech Aircraft Corp. v. United States,
797 F.2d 920, 922 (10th Cir. 1986), (risk distribution “means that the party assuming the risk
distributes his potential liability, in part, among others”); Ocean Drilling & Exploration Co. v.
United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993) (“[r]isk distribution involves spreading the
risk of loss among policyholders”).

Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed
the amount taken in as premiums and set aside for the payment of such a claim. By assuming
numerous relatively small, independent risks that occur over time, the insurer smoothes out
losses to match more closely its receipt of premiums. Clougherty Packing Co. v. Commissioner,
811 F.2d 1297, 1300 (9th Cir. 1987). Risk distribution necessarily entails a pooling of
premiums, so that a potential insured is not in significant part paying for its own risks. See
Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989).

In Situation 1 of Rev. Rul. 2002-89, 2002-2 C.B. 984, S, a wholly owned subsidiary of P, a
domestic parent corporation, entered into an annual arrangement with P whereby S provided
coverage for P’s professional liability risks. The liability coverage S provided to P accounted for
90% of the total risks borne by S. Under the facts of Situation 1 the Service concluded that
insurance did not exist for federal income tax purposes. On the other hand, in Situation 2 of
Rev. Rul. 2002-89, the premiums that S received from the arrangement with P constituted less
than 50% of S's total premiums for the year. Under the facts of Situation 2, the Service
reasoned that the premiums and risks of P were pooled with those of unrelated insureds and
thus the requisite risk shifting and risk distribution were present. Accordingly, under Situation 2,
the arrangement between P and S constituted insurance for federal income tax purposes.

In Rev. Rul. 2002-90, 2002-2 C.B. 985, S, a wholly owned insurance subsidiary of P, directly
insured the professional liability risks of 12 operating subsidiaries of its parent. S was
adequately capitalized and there were no related guarantees of any kind in favor of S. Most
importantly, S and the insured operating subsidiaries conducted themselves in a manner
consistent with the standards applicable to an insurance arrangement between unrelated
parties. Together, the 12 operating subsidiaries had a significant volume of independent,
homogeneous risks. Under the facts presented, the ruling concludes the arrangement between
S and each of the 12 operating subsidiaries of S's parent constitute insurance for federal
income tax purposes.

4

XXXXXX

Situation 1 of Rev. Rul. 2005-40, 2005-40 I.R.B. 4, describes a scenario where a domestic
corporation operated a large fleet of automotive vehicles in its courier transport business
covering a large portion of the United States. This represented a significant volume of
independent, homogeneous risks. For valid non-tax business purposes, the transport company
entered into an insurance arrangement with an unrelated domestic corporation, whereby in
exchange for an agreed amount of “premiums,” the domestic carrier “insured” the transport
company against the risk of loss arising out of the operation of its fleet in the conduct of its
courier business. The unrelated carrier received arm's length premiums, was adequately
capitalized, received no guarantees from the courier transport company and was not involved in
any loans of funds back to the transport company. The transport company was the carrier's
only “insured.” While the requisite risk-shifting was seemingly present, the risks assumed by the
carrier were not distributed among other insured’s or policyholders. Therefore, the arrangement
between the carrier and the transport company did not constitute insurance for federal income
tax purposes.

The facts in Situation 2 of Rev. Rul. 2005-40 mirror the facts of Situation 1 except that in
addition to its arrangement with the transport company, the carrier entered into a second
arrangement with another unrelated domestic company. In the second arrangement, the carrier
agreed that in exchange for “premiums,” it would “insure” the second company against its risk of
loss associated with the operation of its own transport fleet. The amount that the carrier
received from the second agreement constituted 10% of the total amounts it received during the
tax year on a gross and net basis. Thus, 90% of the carrier's business remained with one
insured. The revenue ruling concluded that the first arrangement still lacked the requisite risk
distribution to constitute insurance even though the scenario involved multiple insureds.

In Situation 4 of Rev. Rul. 2005-40, 12 LLCs elected classification as associations, each
contributing between five and 15% of the insurer’s total risks. The Service concluded that this
transaction constituted insurance for federal income tax purposes.

The principal concern with regard to your activities is whether there is sufficient risk distribution.
As discussed above, the idea of risk distribution involves some mathematical concepts. For
example, risk distribution is said to incorporate the statistical phenomenon known as the “law of
large numbers” whereby distributing risks allows the insurer to reduce the possibility that a
single costly claim will exceed the amount taken in as premiums. The concept hinges on the
assumption of “numerous relatively small” and “independent risks” that “occur randomly over
time.” Clougherty Packing Co., 811 F.2d 1297 at 1300.

As discussed, the Service in Rev. Rul. 2002-90, concluded that insurance existed where 12
insureds each contributed between five and 15% to the insured’s total risks. Similarly, in
Situation 4 of Rev. Rul. 2005-40, the Service concluded that insurance existed where 12 LLCs,
electing classification as associations, each contributed between five and 15% of the insurer's
total risks. Moreover, in Situation 2 of Rev. Rul. 2002-89, supra, the Service concluded that
insurance existed where a wholly owned subsidiary insured its parent, but the arrangement
represented less than 50% of the insurer’s total risk for the year.

The present facts are similar to those under Situation 1 of Rev. Rul. 2002-89, supra, and
Situation 2 of Rev. Rul. 2005-40, supra. In Situation 1 of Rev. Rul. 2002-89, supra, the liability
coverage provided to the parent corporation by its wholly owned subsidiary accounted for 90%

5

XXXXXX

of the total risks borne by the subsidiary. Similarly, in Situation 2 of Rev. Rul. 2005-40, supra, a
second insurer contributing 10% of the insured’s risks was added to the single-insured scenario
of Situation 1. The Service concluded in both of the above scenarios that insurance did not
exist because there lacked a sufficient number of insureds to provide for an adequate premium
pooling base. The Service’s published guidance does not address whether insurance exists
where the number of insureds varies between 1 and 12. Nor does such guidance deal with the
fact patterns involving a concentration of risk with a single insured of less than 90%.

Assuming that all of your contracts do constitute insurable risks, over 69.5% of your total risks
for the Year 1 tax year are with the three entities that make-up B. In the present case, the fact
pattern for the year in question presents a heavy concentration of risks in just a few insureds.
In our view such concentration of risk does not allow the insurer to reduce the possibility that a
single costly claim will not exceed the amount of premiums taken in from such a limited number
of insureds. Therefore, there is not sufficient risk distribution to conclude that insurance exists.
Consequently, you do not qualify as an insurance company. You appear to rely on Harper
Group & Subsidiaries v. Commissioner, 96 T.C. 45 (1991) to support its argument that it
qualifies as an insurance company. You believe that the court in Harper Group holds that
where a single-insured paid 71% of the total premium, risk distribution was sufficient to qualify
the arrangement as insurance. Because less than 70% of your risk is from B, Applicant asserts
that the arrangement should qualify as insurance under Harper Group. This is a
misunderstanding of Harper Group. In Harper Group, 67% to 71% of the total premiums
received for the years at issue were not related to a single policyholder. Rather, the 67% to
71% were the total percentages received from all related policyholders, including brother sister
corporations (a total of 13 entities). The court’s analysis in Harper Group must be read in its
entirety and all the facts and circumstances must be considered, i.e. that there are 13 entities
making up the nearly two thirds risk concentration in all the years at issue. The Service took a
similar position in Rev. Rul. 2002-90, concluding that insurance existed in an arrangement
involving 12 insureds, each contributing between 5% and 15% of the insurer's total risks.
Moreover, in situation 4 of Rev. Rul. 2005-40, the Service concluded that insurance existed
where 12 LLCs, electing classification as associations, each contributed between 5% and 15%
of the insurer’s total risks. Also, in situation 2 of Rev. Rul. 2002-89, the Service concluded that
insurance existed where a wholly owned subsidiary insured its parent, but the arrangement
represented less than 50% of the insurer’s total risk for the year.

Section 501(c)(15) of the Code exempts certain insurance companies from federal income tax.
For the reasons stated above, you are not an insurance company within the meaning of section
501(c)(15). Therefore, you are not exempt from federal income tax under section 501(c)(15).

You have the right to file a protest if you believe this determination is incorrect. To protest, you
must submit a statement of your views and fully explain your reasoning. You must submit the
statement, signed by one of your officers, within 30 days from the date of this letter. We will
consider your statement and decide if the information affects our determination.

Your protest statement should be accompanied by the following declaration:

Under penalties of perjury, I declare that I have examined this protest statement, including
accompanying documents, and, to the best of my knowledge and belief, the statement
contains all the relevant facts, and such facts are true, correct, and complete.

6

XXXXXX

You also have a right to request a conference to discuss your protest. This request should be
made when you file your protest statement. An attorney, certified public accountant, or an
individual enrolled to practice before the Internal Revenue Service may represent you. If you
want representation during the conference procedures, you must file a proper power of attorney,
Form 2848, Power of Attorney and Declaration of Representative, if you have not already done
so. For more information about representation, see Publication 947, Practice before the IRS
and Power of Attorney. All forms and publications mentioned in this letter can be found at
www.irs.gov, Forms and Publications.

If you do not intend to protest this determination, you do not need to take any further action. If
we do not hear from you within 30 days, we will issue a final adverse determination letter. That
letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848 and any supporting documents to this address:

Internal Revenue Service
XXXXXX

XXXXXX

1111 Constitution Ave, N.W.
Washington, DC 20224

You may also fax your statement using the fax number shown in the heading of this letter. If
you fax your statement, please call the person identified in the heading of this letter to confirm
that he or she received your fax.

If you have any questions, please contact the person whose name and telephone number are
shown in the heading of this letter.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations