dissenting: I believe that the majority has incorrectly decided both of the issues in this case. First, the majority’s treatment of “unpaid losses,” a component of the “losses incurred” of a property and casualty insurance company, as defined by section 832(b)(5), is a radical departure from the annual statement method of accounting, which section 832 and its predecessors have required property and casualty insurance companies to use in reporting underwriting and investment income for Federal income tax purposes since 1921.
Second, in my view, the holding that the payments made by Sears to its wholly owned subsidiary, Allstate, constitute “insurance premiums” disregards the requirement that a transaction must involve risk shifting in order to constitute “insurance.” The same is true for the two other so-called “captive” insurance cases released today, AMERCO & Subsidiaries v. Commissioner, 96 T.C. 18 (1991), and Harper Group & Subsidiaries v. Commissioner, 96 T.C. 45 (1991). I address both issues in turn below.
Unpaid Loss Reserves of Mortgage Guaranty Insurance Subsidiaries
I disagree with the majority’s holding that a mortgage guaranty insurance company cannot take a delinquent loan into account in estimating “unpaid losses,” until the time the lender acquires title to the mortgaged property. I also disagree with the underlying premise that the liability of a property and casualty insurance company does not become fixed, and the insurance company does not realize a “loss,” until an event takes place which makes it certain that a payment will be made in a particular case.
At the outset, I note the majority’s finding that the PMI companies maintained their books and records in accordance with the State insurance regulatory requirements applicable to mortgage guaranty insurance companies and computed their gross income on the basis of the Underwriting and Investment Exhibit of the Annual Statement approved by the National Association of Insurance Commissioners (NAIC), referred to heréin as the annual statement. Majority op. at 73. I further note the finding that, for Federal income tax purposes, the PMI companies also computed their underwriting income, including their deduction for losses incurred, in accordance with the annual statement method of accounting. Majority op. at 79.
For both State regulatory and Federal income tax purposes, the PMI companies computed unpaid losses, in accordance with the annual statement, by taking into account not only loans under which a borrower’s default had resulted in conveyance of the property to the lender but also loans which had been in default for 4 or more months and loans which were in the process of foreclosure. The majority opinion makes the following finding:
In 1982, the PMI companies determined their ending reserves for unpaid losses on the case basis method pursuant to State law. Under that method, the companies determined estimates for reported losses on:
(i) insured loans which have resulted in the conveyance of property which remains unsold;
(ii) insured loans in the process of foreclosure; and
(iii) insured loans in default for 4 or more months.
In addition, also pursuant to State law, the PMI companies estimated the amount of losses that had been incurred but not reported to them by the end of that year. [Majority op. at 79-80.]
The effect of the majority’s holding is to limit the PMI companies and, presumably, all mortgage guaranty insurance companies to the first of the above three categories of loans in estimating unpaid losses for Federal income tax purposes.
As the basis for this holding, the majority advances the general proposition that an insurance company’s liability must have become fixed during the taxable year before the company will be deemed to have incurred a loss for purposes of section 832(b)(5). Short of that time, the majority says, an “insured event” has not taken place during the taxable year and the insurance company is merely estimating “potential losses,” rather than “actual unpaid losses,” contrary to section 1.832-4(a)(5) and (a)(5) and (b), (b), Income Tax Regs.
I agree with the general proposition advanced by the majority but I disagree with the manner in which the majority applies it in this case. Specifically, I disagree with the majority about what “fixes” an insurance company’s liability for purposes of estimating unpaid losses.
The majority adopts the view that an insurance company’s liability does not become fixed in a particular case until the occurrence of an event which makes it certain that the company will be required to make a payment in the case. Based upon that view, the majority redefines the “insured event” under a mortgage guaranty insurance policy in terms of the lender’s acquisition of “good and merchantable title to the mortgaged property.” The majority reasons that it is not until then that “the PMI companies were obligated to pay the insured lender.” Majority op. at 109. The majority also reasons that a borrower’s initial default, the insured event used for annual statement purposes, cannot be the “insured event” because, at that point, the insurance company will not necessarily be required to pay a claim. For example, the majority opinion states, “Even after a default, the insurer might not and probably would not ever pay anything,” majority op. at 109 (emphasis supplied), and the opinion notes, “The policies did not require the insurer either to take over the monthly payments of a delinquent borrower or otherwise to make a payment to the lender if a borrower missed one or more mortgage payments.” Majority op. at 109.
After thus redefining the “insured event” under a mortgage guaranty policy, the remainder of the opinion is merely an application of the general proposition to which I referred above. The majority merely declares that any estimate of “loss” made on the basis of an event which takes place prior to the insured event, i.e., the lender’s acquisition of title, is improper because it involves only an estimate of potential losses, rather than actual losses. Since the majority defines “insured event” in terms which make payment in a particular case a certainty, the effect of the majority opinion is to substantially delay the time at which the PMI companies, and presumably all mortgage guaranty insurance companies, are permitted to recognize losses for tax purposes.
My principal objection to the majority opinion is that it summarily disregards the different timing rules under the annual statement. Moreover, in my view, there is no authority for the majority’s premise that payment must be certain before a “loss” is incurred. In fact, the insured event formulated by the majority based upon that premise, i.e., the lender’s acquisition of title to the mortgaged property, not only deviates from the annual statement method of accounting which is applicable to property and casualty insurance companies, but also deviates from the “all events” test which is applicable to commercial enterprises on the accrual method of accounting. Finally, I am not willing to disregard the fact that “Default is the loss event recognized by the mortgage insurance industry, state regulatory requirements, * * * the Federal Home Loan Mortgage Corporation, and the Federal Housing Administration.” Majority op. at 103, quoting from petitioner’s opening brief.
The use of the annual statement method of accounting is mandatory for Federal income tax purposes. Section 832(b)(1)(A) directs that the gross income of property and casualty insurance companies, consisting of investment income and underwriting income, is to be “computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners.” Unpaid losses, including both claims reported and unpaid and claims incurred but not reported (IBNR), form a part of “losses incurred,” as defined by section 832(b)(5), and are taken into account in computing underwriting income which is defined by section 832(b)(3) to mean “the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred.” Similarly, section 832(b)(6) defines the term “expenses incurred” for property and casualty insurance companies to mean “all expenses shown on the annual statement approved by the National Association of Insurance Commissioners.”
The requirement that property and casualty insurance companies compute gross income and expenses in accordance with the annual statement is unqualified. It differs from the accounting rules prescribed for life insurance companies which specifically direct that computations shall be made principally “under an accrual method of accounting.” Sec. 811(a). The annual statement method governs in the case of life insurance companies only “to the extent not inconsistent with” the accrual method of accounting used by the company “or any other provisions of this part” (i.e., part 1 of subchapter L of the Code). Sec. 811(a). The Code provisions dealing, with property and casualty insurance companies, on the other hand, do not refer to the accrual method of accounting or any method of accounting, other that the annual statement method.
The majority opinion quotes extensively from the Court’s analysis in Bituminous Casualty Corp. v. Commissioner, 57 T.C. 58 (1971). Majority op. at 86-87. The issue in that case involved the Commissioner’s attempt to “disallow” for income tax purposes certain reserves which had been reported on the basis required by the annual statement. In that case, the Court specifically considered the “controlling effect” of the annual statement for Federal income tax purposes and, after reviewing the cases which had addressed that issue, the Court concluded as follows;
Two things are clear from these lines of cases. First, none of the cases stands for the proposition that general provisions appearing elsewhere in the Internal Revenue Code may be used to modify the annual statement method of computing underwriting income. On the contrary, the New Hampshire Fire Insurance [2 T.C. 708 (1943), affd. 146. F.2d 697 (1st Cir. 1945)] line of cases holds that Congress intended to follow the annual statement form precisely in respect of the items specified in section 832(b)(3) through (6), while the General Reinsurance Corp. [190 F.2d 148 (2d Cir. 1951)] line of cases holds that Congress intended that the annual statement be followed except to the extent inconsistent with the ordinary meaning of the language in section 832(b)(3) through (6). [Bituminous Casualty Corp. v. Commissioner, supra at 80-81.1
The Court found it unnecessary to choose between the two lines of cases described above because the result would be the same under either line: Either the reserves at issue were correct because the annual statement form must be followed precisely, or they were correct because they were not inconsistent with the ordinary meaning of the language in section 832(b)(3) through (6).
The same is true in this case. The majority opinion advances nothing to suggest that there is an inconsistency between the annual statement and the language in section 832(b)(3) through (6). Cf. Western Casualty & Surety Co. v. Commissioner, 65 T.C. 897 (1976), affd. 571 F.2d 514 (10th Cir. 1978). Therefore, I submit, the annual statement must be followed in this case and the majority errs in selecting a different timing rule under which mortgage guaranty insurance companies are required to take delinquent loans into account in estimating unpaid losses.
The majority does not address the controlling effect of the annual statement or discuss the two lines of cases analyzed by the Court in Bituminous Casualty Corp. v. Commissioner, supra. The majority justifies its disregard of the timing requirements under the annual statement on the ground that “State insurance regulators are concerned with the solvency of the insurer,” whereas “Federal tax statutes are concerned with the determination of taxable income on an annual basis.” Majority op. at 110. While I agree with that observation, I submit that it does not permit us to disregard the specific requirement of the Code that the underwriting income of property and casualty companies is to be “computed on the basis of” the annual statement. See sec. 832(b)(1)(A).
Moreover, the legislative history of the predecessor of section 832 shows that Congress was specifically advised that the annual statements submitted by property and casualty insurance companies are prepared to safeguard the interests of the public but it chose to rely on the annual statement for income tax purposes. The testimony of a representative of the Treasury Department, Dr. T.S. Adams, who was instrumented in formulating the present scheme for taxing property and casualty insurance companies when it was first adopted in 1921, includes the following:
Dr. Adams. Let me take up fire and miscellaneous insurance companies.
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In the plan presented here the income and deductions are expressed in their own technical terms. All these insurance companies, as you know, have to make reports every year. Those are uniform reports. They are carefully worked out, and the interests of the public are properly safeguarded. In the proposed amendment the terms used in this report are employed. It starts out in this way: The ordinary insurance company has a possibility of making two kinds of profits: that is, it collects premiums from policyholders and on these it may make an underwriting income. Then they invest these funds, and have an investment income, and there is a possibility of a net income from that source. This plan starts out by saying that insurance companies shall be taxed upon their net underwriting income plus their net investment income, if any. Then the whole scheme of computing net income has, as is necessary in the case of insurance companies, to be on the accrued or incurred basis instead of on the actual cash basis. That is the basis of this uniform report, and it is adopted here. [Testimony of Dr. T.S. Adams, Treasury Representative, Hearings before the Committee on Finance on H.R. 8245, U.S. Senate, 67th Cong., 1st Sess., 394 (1921); emphasis supplied.]
As mentioned above, I disagree with the premise underlying the majority opinion that the liability of an insurance company cannot become fixed for purpose of section 832(b)(5) prior to the occurrence of an event which makes it certain that a payment ultimately will be required. I submit that the majority confuses an insurance company’s liability to make a payment when and if one becomes necessary with the payment itself. An insurance company’s liability to pay must be fixed but the payment itself need not be. Otherwise, property and casualty insurance companies would not be entitled to treat, as “losses,” cases in which the insurance company denies liability, Rev. Rui. 70-643, 1970-2 C.B. 141, and cases in which the obligation to make a payment is contingent, Modem Home Life Ins. Co. v. Commissioner, 54 T.C. 935 (1970). In all of those cases, there is no certainty that a payment will be required, until the contingency is removed or until the insurance company is found liable or ceases to contest liability. For purposes of both the annual statement and Federal income tax, a property and casualty insurance company is entitled to recognize the “loss” nevertheless.
Modern Home Life Ins. Co. v. Commissioner, supra, one of the cases cited by the majority, is contrary to the majority’s premise that a “loss” cannot take place until an event which makes payment certain. That case involved an insurance company’s deduction for losses incurred under a group disability insurance policy. The insurance company agreed, under the policy, to make mortgage payments on behalf of an insured mortgagor in the event that “injury or sickness wholly and continuously disabled an Insured Mortgagor” from making the payments. The Commissioner disallowed the deduction to the extent it included an estimate of future payments on behalf of claimants who were sick or disabled on the last day of the taxable year. The Commissioner argued that such amounts were not deductible because they were contingent upon future events and, in effect, were estimates of “future losses.” Modern Home Life Ins. Co. v. Commissioner, supra at 938.
After noting that the terms “losses incurred” and “unpaid losses” are “predicated on insurance concepts” and that they must be construed to include “estimated liability for losses” which could not otherwise be deducted in the year in which the event occurs, the Court held as follows:
Thus, if we regard the initial sickness or illness or disability as the occurrence of the event insured against, the petitioner’s liability to pay “something” became fixed on or before December 31 of the year in which the insured first became sick or disabled. The amount which the petitioner would be called upon to pay was dependent on the duration of that illness or disability but that condition went to a determination of the amount of the liability, if any, rather than to the fact of liability. [Modern Home Life Ins. Co. v. Commissioner, supra at 940; emphasis supplied.]
The Court rejected respondent’s attempt to redefine the “insured event” to one which made payment certain, as would be required for an accrual method taxpayer.
In this case, the majority redefines the insured event prescribed under the annual statement method, a borrower’s initial default, because of its view that the payment of a claim was not sufficiently fixed at that time. In choosing a different “insured event,” the majority asserts that it does not mean to apply the “all events” test applicable to taxpayers on the accrual method of accounting. Majority op. at 112-113. The “all events” test requires the taxpayer’s liability to be firmly established. During the years at issue in this case, it set forth a two-pronged test under which deductions were allowable for the taxable year in which all of the events have occurred which established the fact of the liability giving rise to such deduction and the amount thereof could be determined with reasonable accuracy. Sec. 1.446-l(c)(ii), Income Tax Regs. In 1984, Congress enacted section 461(h) and added to the “all events” test the requirement that “economic performance” must have occurred during the taxable year. Sec. 91(a), Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 598.
The majority opinion explains that its view differs from the “all events” test because “Even if the lender has acquired title, the amount of the loss will not necessarily be known” and it further notes that the insurance company would be entitled to deduct IBNR losses. Majority op. at 113. The majority opinion says that petitioner is, therefore, “not prohibited from using estimated amounts that would be improper under general accounting in computing its ‘losses incurred.’ ” Majority op. at 113. I note that, under the “all events” test as applicable in this case, the company’s liability would not become fixed until the lender files a claim with the company, rather than at the time the lender acquires title to the mortgaged property. See United States v. General Dynamics Corp., 481 U.S. 239 (1987).
To summarize, following a borrower’s initial default, a number of other events may take place, including notice of the default to the insurance company, initiation of foreclosure proceedings, the borrower’s transfer of title to the mortgaged property to the lender, and the lender’s submission of a claim to the insurance company. These “events” are reactions to, and take place as consequence of, the borrower’s default. The majority rejects the insured event under the annual statement, a borrower’s initial default, because the insurance company’s liability for payment of the claim was not sufficiently certain at that time. On the other hand, it rejects the insured event under the “all events” test, the lender’s submission of a claim, because the company’s liability was too firmly established at that time, in view of the nature of a property and casualty insurance company which makes it inappropriate to apply general tax accounting principles.
I submit that, in rejecting both the annual statement method of accounting and the “all events” test, the majority has devised its own system. I also submit that the majority’s view about what is necessary to fix an insurance company’s liability and its definition of the insured event in conformity with that view is nothing more than selecting a different “link in the chain of events creating liability for purposes of” estimating losses incurred, pursuant to section 832(b)(5), to borrow a phrase from the Supreme Court’s opinion in United States v. General Dynamics Corp., supra at 244.
Moreover, the majority’s view is similar to an argument rejected by the Court in the Bituminous Casualty Corp. v. Commissioner, supra at 82. In that case the Commissioner argued that, for purposes of the issues in that case, the word “liability” does not have the same meaning as when used in the “all events” test but refers to “an existing liability” in the sense that “all occurrences, i.e., injuries, accidents, or other covered events, have taken place, on the basis of which the retrospective premium will ultimately be determined.” Bituminous Casualty Corp. v. Commissioner, supra at 82-83. The Court rejected the Commissioner’s argument on the ground that there was no authority to justify giving the term a meaning different from that in the insurance industry. The same is true here.
The majority formulates its approach in this case on the basis of a “recurring theme” which it perceives to arise from three cases, State of Maryland Deposit Ins. Fund Corp. v. Commissioner, 88 T.C. 1050 (1987); Maryland Savings-Share Ins. Corp. v. United States, 226 Ct. Cl. 487, 644 F.2d 16 (1981); and Modern Home Life Ins. Co. v. Commissioner, 54 T.C. 935 (1970). Majority op. at 105-109. The majority acknowledges that all three cases are “distinguishable from each other and from the present case.” Majority op. at 108.
I believe that each of the three cases was properly decided and I agree with the following “recurring theme” which the majority derives from those cases:
In Modem Home Life Ins. Co., we allowed a deduction for the “unpaid losses” portion of “losses incurred” where the event insured against, the disability of the insured, had occurred prior to the end of the year, even though the amount of the loss was not fixed at that time. In both of the Maryland cases, the event insured against had not occurred and, in State of Maryland Deposit Ins., we concluded that the insurance company taxpayer was not entitled to deduct a loss until the occurrence of the event that fixed the liability under the insurer’s bylaws. In all three cases, however, the conclusion turned on whether or not the event insured against, under the terms of the polices or contracts at issue, had occurred. In both Modern Home Life Ins. Co. and State of Maryland Deposit Ins., we concluded that an insurer is not entitled to a deduction for unpaid losses until the time that the insuirer’s liability was fixed under the relevant contractual terms. [Majority op. at 108-109.]
As the majority points out above, all three cases set forth the requirement that an insured event which fixes the liability of the insurance company must occur during the taxable period before an insurance company incurs a “loss.” As discussed above, however, the majority opinion goes beyond that requirement. It also holds, in effect, that the incurred event must make it certain that the insurance company will make a payment in each case. I submit that none of the three cases stands for that proposition. In fact, as discussed above, Modem Home Life Ins. Co. v. Commissioner, supra, stands for the opposite proposition. It holds that once an insured event takes place, a property and casualty insurance company can incur a loss for tax purposes, even though there is no certainty that a payment will be required.
None of the above three cases relied upon by the majority provides authority to disregard the annual statement method of accounting or to disregard the insured event taken into account under that method. Indeed, in Modem Home Life Ins. Co. v. Commissioner, supra, the Court rejected the Commissioner’s attempt to apply “the strict terms of accrual” to the taxpayer and, in effect, to redefine the “insured event” from the initial sickness or illness of the insured mortgagor to a later event, compatible with the “all events” test, which would firmly establish the taxpayer’s obligation to make the mortgage payments in the future based upon the insured mortgagor’s continued sickness or disability.
The Maryland cases both involve the Maryland Deposit Insurance Fund Corporation (MDIFC), a State chartered corporation, formed to guarantee the accounts of depositors'in savings and loan associations which were not Federally insured. The MDIFC was not a traditional insurance company. It reported income and expenses on the cash receipts and disbursements method of accounting until 1971 when it received permission to change to the accrual method. Maryland Savings-Share Ins. Corp. v. United States, supra at 18. Its Federal income tax returns for 1974 through 1982, the years at issue in the second Maryland case, were filed on the accrual method of accounting. State of Maryland Deposit Ins. Fund Corp. v. Commissioner, supra at 1056. There is no suggestion in either opinion that MDIFC conformed itself to State insurance regulations or filed annual statements.
In each of the two Maryland cases, the taxpayer attempted to redefine the “insured event” from the event established under MDlFC’s bylaws, i.e. the bankruptcy of a member institution or the appointment of a conservator or receiver for such institution. The taxpayer sought to include as loss events certain acts which were not covered under the bylaws, consisting of a “course of conduct that typically precedes a failure,” including acts of mismanagement, issuance of bad loans, and embezzlement. In the Maryland cases, the Courts refused to permit the taxpayer to redefine the event of default, and they applied the general rule that an insurance company does not incur a loss until an insured event takes place.
Unlike the Maryland cases, the “insured event” under the annual statement in this case, a borrower’s default, is an integral part of the insurance coverage under the subject mortgage guaranty insurance policies. It is evident from the facts found by the majority that every loss covered under the subject policies started with and was attributable to a “default by a borrower.” The majority found that, under the policies, “the insured lender was required to notify the insurer when a borrower under an insured mortgage loan was ‘in default,’ i.e., the borrower failed to make a required payment of principal and interest on a timely basis.” Majority op. at 75. The length of default was not a condition to recovery under the policies but clearly a default was.
Admittedly, the occurrence of a default did not ultimately lead to a payment by the insurance company in every case. The fact of the matter is that a borrower could cure a default at any time and stop the foreclosure process. It is also possible, although it probably did not happen as often, that the value of the real estate held as collateral turned out to be sufficiently high to offset the balance of the mortgage and the lender’s costs, so that no additional payment from the insurance company was required.
It is clear, however, that the PMI companies treated themselves as liable once the initial default occurred during the policy period, even though later events leading up to payment of the loss, such as notice of default, foreclosure, acquisition of title and claim by the insured, all took place after the policy was canceled or expired. The majority found the following:
As interpreted by the PMI companies, the policies generally in effect during the years in issue provided coverage for losses resulting from delinquencies within the policy period. A claim would be allowed as long as the policy was in effect during the period in which the initial delinquency occurred. The policy did not have to be in effect at the time the NOD was received, foreclosure proceedings were instituted, or title was transferred from the borrower.
A lender could cancel a policy during a delinquency period and receive a premium refund and still be entitled to file a claim for loss as long as the initial delinquency occurred within the policy period. If the delinquency was cured, there was no coverage for any subsequent delinquencies that occurred after the cancellation. It was not uncommon for lenders to allow policies to lapse.
[Majority op. at 78.]
Moreover, a borrower’s initial default is treated as the insured event not only by the PMI companies and the State insurance regulators, but also by the Federal Home Loan Mortgage Corporation which imposes reserve requirements, similar to those under the annual statement, on eligible insurers, majority op. at 79, and by the Federal Housing Administration, which adopted accounting practices and reporting policies similar to those followed by private mortgage guaranty insurers under the annual statement. Majority op. at 80.
The fact that every default did not result in the payment of a claim does not mean that no default did. Indeed, as the majority notes, for many lines of insurance, the percentage of insured events which does not result in ultimate loss payment can run from 5 percent to 90 percent, depending on the nature of the coverage. Majority op. at 112. I see no more justification for redefining the insured event in connection with those lines of insurance than I do in the case of mortgage guaranty insurance.
In computing their unpaid losses, the mortgage guaranty insurance companies in this case started with all cases in which a borrower had defaulted during the year and, based upon their experience with such cases, they determined which cases would ultimately require a payment and which of them would be cured or, ultimately, would require no payment. The process followed by the PMI companies, as described by the majority, including the use of a so-called “loss frequency factor” and “loss severity rate,” in my view, follows estimating techniques which are common in the insurance industry. See majority op. at 81-83, 111. The companies’ estimates are based upon actual loss events, i.e., defaults, which occurred during the year and which are covered under a policy in force. They are not merely predictions of losses which may take place in the future. After a borrower’s initial default, the PMI companies are liable to make whatever loss payments are eventually required. Modern Home Life Ins. Co. v. Commissioner, supra.
The estimates made by the PMI companies are not insulated from review and adjustment by the Commissioner merely because they are set forth on the annual statement. In the words of the regulations, the insurance company “must be prepared to establish to the satisfaction of the district director that the part of the deduction for * * * unpaid losses * * * based upon the facts in each case and the company’s experience with similar cases, * * * represent a fair and reasonable estimate of the amount the company will be required to pay.” Sec. 1.832-4(b), Income Tax Regs. The adjustments approved by the majority in this case, however, go far beyond the adjustments contemplated by the regulations. They represent a complete revision of the accounting and reporting method required under the annual statement for Federal income tax purposes and, in my view, are contrary to requirement contained in section 832(b)(1)(A) that underwriting income is to be “computed on the basis of” the annual statement.
I find it impossible to reconcile the majority’s view about what is necessary to fix the liability of an insurance company with its recognition of the fundamental difference between property and casualty insurance companies, which use the annual statement method of accounting, and other commercial entities and its further recognition of the inappropriateness of applying general tax accounting principles to property and casualty insurance companies. See majority op. at 112-113.
Payments to Insurance Company Subsidiary
The opinions released today in the Sears, AMERCO, and Harper cases constitute another installment in the continuing saga over the treatment of payments to so-called “captive” insurance companies. When we last addressed this issue in Gulf Oil Corp. v. Commissioner, 89 T.C. 1010, 1023 (1987), affd. on this issue 914 F.2d 396 (3d Cir. 1990), the Court was faced for the first time “with a wholly owned captive that insurefd] unrelated third-party risks as well as those of its affiliated group.” In each of the Court’s three prior opinions on this issue, Carnation Co. v. Commissioner, 71 T.C. 400 (1978), affd. 640 F.2d 1010 (9th Cir. 1981), cert. denied 454 U.S. 965 (1981); Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985), affd. 811 F.2d 1297 (9th Cir. 1987); and Humana, Inc. v. Commissioner, 88 T.C. 197 (1987), affd. in part and revd. in part 881 F.2d 247 (6th Cir. 1989), the facts were “identical” to those in Gulf, except “the captive insured risks only within the affiliated group.” Gulf Oil Corp. v. Commissioner, supra at 1023.
In Gulf, the majority of the Court opined that the addition to the captive’s premium pool of “a sufficient proportion of premiums paid by unrelated parties” should allow the premiums paid by the affiliated group to be deductible as insurance premiums, rather than to be treated as payments to a reserve from which to pay losses. To be sufficient, the premiums from unrelated parties had to be high enough to cause “the aggregate premiums paid by the captive’s affiliated group [to be] insufficient in a substantial amount to pay the aggregate anticipated losses of the entire group, the affiliates and unrelated entities.” Gulf Oil Corp. v. Commissioner, supra at 1027. In that situation, the Court said, “Risk distribution and risk transfer would be present, and the arrangement [would] no longer in substance [be] equated with self-insurance.” Gulf Oil Corp. v. Commissioner, supra at 1027.
In Gulf Oil Corp., the captive’s net premium income from the insurance of third-party risks was only 2 percent of the captive’s total net premium income, an amount insufficient to satisfy the Court that “risk transfer had occurred.” 89 T.C. at 1027. Accordingly, the Court held that its prior decisions, Carnation Co. v. Commissioner, supra, Clougherty Packing Co. v. Commissioner, supra, and Humana, Inc. v. Commissioner, supra, were applicable and that the amounts paid by Gulf and its affiliates to the captive were not deductible as insurance premiums. Gulf Oil Corp. v. Commissioner, supra at 1027.
The facts in the Sears, AMERCO, and Harper cases are similar to those in Gulf, except that the percentage of each captive’s premium income derived from the insurance of outside risks exceeds the level found to be de minimus in the Gulf case. In Sears, the majority found that “the total premiums for Allstate’s policies with unrelated policy holders represented approximately 99.75 percent of Allstate’s total premiums earned during the years in issue.” Majority op. at 64. In AMERCO & Subsidiaries, the majority found that “outside insurance constituted over 50 percent of Republic Western’s gross written premiums for each of the years at issue.” Amerco v. Commissioner, 96 T.C. 18, 36-37 (1991). (Fn. ref. omitted.] Lastly, in Harper, the majority found that “the unrelated insureds comprise approximately 30 percent of Rampart’s business.” Harper Group & Subsidiaries v. Commissioner, 96 T.C. 45, 60 (1991). In light of the discussion by the majority in Gulf about the effect of insuring unrelated risks, the result reached by the Court in the Sears, AMERCO, and Harper cases is not surprising.
The majority in each case outlines a “framework” for addressing questions of the existence of insurance for Federal tax purposes which is comprised of the following three principles: First, the transaction must involve an actual insurance risk; second, it must involve both risk shifting and risk distribution; and, third, it must involve commonly accepted notions of insurance. Majority op. at 100-101; AMERCO & Subsidiaries v. Commissioner, supra at 38-42; Harper Group v. Commissioner, supra at 57. In each of the subject cases, the majority lists risk shifting as one of the principles to take into account in determining whether “insurance” exists. However, I submit that the effect of the opinions in the subject cases is to completely dispense with the test of risk shifting, if premiums earned by the captive from unrelated insureds amount to 30 percent of the total premiums during the year, see Harper Group & Subsidiaries v. Commissioner, supra at 58-60, or qualify as “substantial,” an “opaque” term which the majority does not define, see AMERCO & Subsidiaries v. Commissioner, supra at 37.
The majority concludes that there was “technical risk shifting” by briefly recounting the fact that the subject transactions followed the form of “insurance” contracts under which premiums were transferred, and losses paid and the fact that the captive was “a separate, viable entity, financially capable of meeting its obligations.” Majority op. at 100; AMERCO & Subsidiaries v. Commissioner, supra at 40; see Harper Group & Subsidiaries v. Commissioner, supra at 60. The majority finds that “risk shifting was also present in substance” but its explanation of the basis for the finding differs in each opinion. In Sears, the majority explains that the captive, Allstate, was neither formed nor operated for the purpose of providing “self-insurance” to Sears but sold policies to Sears on the same basis as it sold policies to unrelated third parties. Majority op. at 100. In AMERCO, the majority’s explanation goes beyond the fact that the captive was not the equivalent of a reserve for losses of its parent and includes the fact that the captive “wrote substantial other business during each of the years at issue, see Gulf Oil Corp. v. Commissioner, supra at 1027.” AMERCO & Subsidiaries v. Commissioner, supra at 41. Thus, in AMERCO, the majority makes specific reference to the theory advanced by the majority in Gulf that the addition of unrelated insurance premiums into the insurance pool establishes risk transfer. Lastly, in Harper Group & Subsidiaries, the majority notes that the captive was not a sham but conducted a bona fide business and was regulated as an insurance company under the laws of Hong Kong and that the premiums paid by its affiliates were negotiated at arm’s length. Harper Group & Subsidiaries v. Commissioner, supra at 59. In Harper & Subsidiaries v. Commissioner, supra, the majority also states as follows (at 59):
In our opinion, in the captive insurance company arena, given a sufficient number of unrelated insureds, risk can be transferred from an owner-insured to the captive insurer.
Again, the majority makes reference to the theory advanced in Gulf that sufficient distribution of risk among unrelated insureds, by itself, establishes risk transfer.
While AMERCO and Harper make reference to the theory advanced in Gulf, none of the three opinions analyzes whether the premiums paid by unrelated insureds are
sufficient to pay “the aggregate anticipated losses of the entire group, the affiliates and unrelated entities,” as would be required under the opinion of the majority in Gulf. Gulf Oil Corp. v. Commissioner, supra at 1027. Evidently, the majority’s view in the instant case as to what amount of premiums from unrelated insureds is sufficient to bring about risk shifting differs from the majority’s view in Gulf. Under the subject opinions, the amount of unrelated insurance need only be “substantial.” AMERCO & Subsidiaries v. Commissioner, supra at 41.
In any event, for the reasons set forth in Judge Goffe’s concurring opinion in the Gulf case, I disagree with the view that unrelated insurance establishes risk shifting. See Gulf Oil Corp. v. Commissioner, supra at 1032. It is not necessary to repeat Judge Goffe’s analysis here. Suffice it to say that, in my view, risk shifting and risk distribution are separate elements of “insurance” and both must be found. E.g., Helvering v. Le Gierse, 312 U.S. 531 (1941). “An arrangement without the elements of risk-shifting and risk-distributing lacks the fundamentals inherent in a true contract of insurance.” Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986). Moreover, the majority opinion in Sears notes that the experts who testified on both sides in that case “specifically addressed the theory of the majority in Gulf, but none of the experts fully adopted or supported that theory.” Majority op. at 99.
I also submit that the other facts identified by the majority as a basis for finding risk shifting are inappropriate for that purpose. For example, the majority concludes that the captive is not “operated for the purpose of providing ‘self-insurance’ ” to its parent corporation, majority op. at 100, or is “not the equivalent of a reserve for losses” of the parent, AMERCO & Subsidiaries v. Commissioner, supra at 41. This finding goes to the ultimate issue in the case, whether the payments are for “insurance” or are contributions to a reserve for losses, and makes it unnecessary to determine whether there is risk shifting. It is only necessary to determine whether there is risk shifting in order to answer the ultimate issue, not vice versa. See Clougherty Packing Co. v. Commissioner, 811 F.2d 1297 (9th Cir. 1987), affg. 84 T.C. 948 (1985). Similarly, the fact that the subject transactions are cast in the form of “insurance” transactions, is not determinative. The economic reality of the transactions, rather than their form, determine their tax consequences. Gregory v. Helvering. 293 U.S. 465 (1935).
Moreover, the fact that the captive is a separate entity and is financially capable of meeting its obligations does not determine whether risk shifting is present in a particular transaction. That depends upon whether the transaction has the effect of insulating the “insured” from the economic consequences of an insurance risk, it does not depend upon the captive’s financial capability. I agree with the Ninth Circuit’s formulation of what is required for risk shifting to exist in an insurance transaction:
we examine the economic consequences of the captive insurance arrangement to the “insured” party to see if that party has, in fact, shifted the risk. In doing so, we look only to the insured’s assets * * * to determine whether it has divested itself of the adverse economic consequences of a * * * claim. [Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305.]
The majority notes that Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943), requires the Court to respect the separateness of the two entities, absent some reason for disregarding that separateness, and finds no such reason is present in this case. Majority op. at 101. I agree. It does not follow, however, that there is risk shifting in these cases just because each of the captives is a separate corporation from its parent and other affiliated corporations, nor does it follow that we can not or should not take the economic relationship of the companies into account in evaluating whether risk shifting took place. Similarly, we can find that risk shifting did not take place, without disregarding the separate legal status of the entities. Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305; Beech Aircraft Corp. v. United States, supra.
Finally, the fact that the captive sells policies to unrelated insureds and the fact that affiliated corporations purchase policies from the captive on the same general terms as unrelated third parties, are facts which go to the question whether there has been risk distribution, not risk shifting.
For the foregoing reasons, I respectfully dissent.