Whose Risk and How Is It Spread An update on risk shifting and risk distribution

Paul Philips EY Partner Hugh Tollack 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 and

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 (9 th 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 (9 th 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 (6 th 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 (6 th 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, (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 – 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 (9 th 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 (6 th 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 – 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 – 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

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 and Rev. Rul e.g., the Service follows Rev. Rul and the employees are seen and the insureds and Rev. Rul is modified.

Questions? Q & A Contacts: Paul H. Phillips IIIHugh L. Tollack II, CPA Partner,Director of Tax Audits, Research and Financial Services, TaxPlanning EY LLPRent-A-Center, Inc. (312) (972)