Attorney-at-Law

THE RESIDUUM

In Uncategorized on 09/22/2015 at 03:15

Not the Heavy Dragoon, as compounded by Sir W. S. Gilbert’s Patience, rather this is another of IRS’ failed attempts at dealing with insurance. This insurer (and Judge Lauber says it is an insurer) deals with residual value insurance.

And that’s its name, R.V.I. Guaranty Co., Ltd. & Subsidiaries, 145 T. C. 9, filed 9/21/15.

The question: is residual value insurance truly insurance? Or is it a hedge against an investment risk?

Judge Lauber: “A simple example may illustrate the mechanics of a typical RVI policy. Assume that an automobile with an initial purchase price of $20,000 is leased for three years and that its expected residual value upon lease termination is $10,000. RVIA [the US sub] might insure that automobile for 90% of the expected residual value, yielding an insured value of $9,000. If, at lease termination, the automobile had an actual residual value of $8,500, the RVI policy would indemnify the lessor for $500, assuming the lessor satisfied all terms and conditions of coverage. The lessor would bear the $1,000 initial layer of loss.” 145 T. C. 9, at p. 6.

In short, if the lessor guesses wrong about the residual value, the sum of rental payments plus residual value won’t cover its acquisition, administrative and financing costs. So it will lose.

R.V.I., domiciled in (where else?) Bermuda, insures lessors and lenders against bad guesses of the value of the property at lease expiry. But one of its subs is a US on-shore, and they report consolidated.

IRS claims R.V.I. covers an investment risk, not an insurance risk, so R.V.I. can’t use the Section 832 accounting rules that real insurers use.

The difference? $55 million deficiency.

R.V.I.’s policies read like real insurance. States regulated R.V. I. like an insurer, and R.V.I. reported to the regulators like an insurer. And Fitch, Moody’s and S&P rated R.V.I. like an insurer.

IRS didn’t care, and said R.V.I. had to use Sections 451 and 461 to compute income, not Section 832, because R.V.I. flunks the Section 832(c) test. And IRS buttressed its position with T.A.M. 201149021 (Aug. 30, 2011).

R.V.I. proffers expert testimony that it insures against “low frequency/high severity” risks, like earthquakes or floods. That there may be systemic risk does not negate pooling of risk. Mortgage guaranty insurers got killed in the subprime meltdown, but that didn’t mean they weren’t writing insurance.

IRS’ expert says the policies weren’t policies, because risk was illusory. In the year at issue, R.V.I. lost little or nothing.

But many of the insured leases had years to run at that point. Judge Lauber let in evidence of what happened later, over IRS’ objections.

“Respondent objected to 2013 as post-dating the tax year in issue and ‘irrelevant for that reason.’ The Court overruled this objection. A loss under an RVI policy is payable only at the end of a lease, and many of the insured assets were subject to very long leases. By definition, therefore, many RVI policies in existence in 2006 could not have come to a payout resolution, and could not possibly have had a loss, as of year end 2006. Yet many of these policies could (and did) experience significant losses upon lease termination. In order to display accurately RVIA’s loss experience under the policies it held during 2006, it is necessary to consider the complete terms of these contracts.” 145 T. C. 9, at p. 12, footnote 6.

IRS’ expert says there is no timing risk, because the loss occurs, not at random like an earthquake or flood, but on a fixed date, the lease expiry date. But this is like mortgage guaranty insurance, covering a lender where the borrower hasn’t sufficient cash in the deal, so that the lender has to lend more than its usual loan-to-value ratio would warrant.

True, ripostes R.V.I., the risk of borrower default is random, but the underlying issue is diminution of the value of the collateral security.

An IRS expert claims that, since the insured can make a profit if R.V.I. pays off, it isn’t risk insurance but a speculative hedge. But Judge Lauber isn’t convinced, since holders of institutional investment portfolios and municipal bonds can buy insurance against loss.

The magic formulas are risk-shifting and risk-distribution, the classic standard going back to seventeenth-century England; “the losse falleth lightlie upon the many, rather than heavilie upon the fewe”. All the R.V.I. insureds shift some of the risk to the insurer, and the risk of any great loss is covered by the premiums paid by all.

First, R.V.I. covers a real risk of loss, and the State regulators so determined.

Second, the fact that a loss is unlikely to occur doesn’t mean that there is no risk. Earthquakes are (thankfully) uncommon, but they do occur.

Third, taking only the year at issue as the sole test whether there was real risk is itself unrealistic. Loss only occurs at lease expiry, and some insured leases had 25-year terms, a classic case of “it ain’t over till the fat lady sings”.

Fourth, R.V.I. insured a lot of stuff for a lot of different persons. That’s risk distribution.

But IRS shows that never-say-die quality. “Undeterred, respondent contends that the RVI policies do not sufficiently distribute risk because some systemic risks, like major recessions, could cause insured assets to decline in value simultaneously. Like most insurers, RVIA did face certain systemic risks, but many of the risks against which it insured were uncorrelated. Examples of risks that affected different insured assets differently include regional economic downturns, rising fuel prices, over-supply of particular assets, technological improvements, vehicle recalls, regional industrial migration, acts of terrorism, high interest rates, decreased availability of financing, and regulatory changes like restrictive building codes. Indeed, even systemic risks like major recessions were mitigated by the temporal distribution of RVIA’s risks over lease terms as long as 28 years.” 145 T. C. 9, at pp. 34-35.

There need not be complete independence of risk, only meaningful distribution of risk.

IRS claimed that R.V.I. deferred some premium payments, but that doesn’t negate coverage, as the undeferred premiums were paid, and the deferred premiums were a tiny part of R.V.I.’s book.

State regulation is a key. The Federal courts have historically deferred to the States when it comes to insurance, and R.V.I. has been treated as an insurer in every State where it does business.

IRS’ hair-splitting over “speculative risk” versus “pure risk” is metaphysics.

“The insureds purchase insurance from RVIA to protect against the risk that unexpected events will wreak havoc with these lease-pricing formulas and generate an ordinary business loss instead of a profit. This is not an investment risk; it is a risk at the very heart of the lessor’s business model. In comparison with typical stock investors, therefore, the insureds under the RVI policies are at the opposite end of the bell curve.” 145 T. C. 9, at p. 58.

Ultimately, it’s the duck test. If it swims, waddles and quacks, it ain’t a kangaroo. And here the policies look like insurance. And R.V.I. will be taxed accordingly.

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