Captive currency-fluctuation contracts are not insurance

Plain-English summary

A corporate group used a captive insurance subsidiary to issue contracts covering adverse movements in specified foreign currencies. Chief Counsel concluded that currency fluctuation can create an insurable economic risk and that the contracts appeared to shift risk, although risk distribution remained unclear. The arrangement nevertheless failed the commonly accepted sense of insurance. The coverage limit was undefined and inconsistently applied, premiums were based on twice a market option price rather than demonstrated arm's-length insurance pricing, and contract payouts did not track participants' actual currency losses. Monthly overlapping contracts also could produce multiple recoveries, so Chief Counsel advised that neither contract qualified as insurance for federal income tax purposes.

Ruling snapshot

• Question: Do captive contracts covering affiliated companies against specified foreign-currency movements constitute insurance for federal income tax purposes?
• Outcome: advice given, the contracts do not constitute insurance
• Key authorities: R.V.I. Guaranty Co. v. Commissioner; Avrahami v. Commissioner; Rent-A-Center, Inc. v. Commissioner; Helvering v. Le Gierse

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           memorandum
           Number: 201802014
           Release Date: 1/12/2018
           CC:FIP:B04:JEGlover                            Third Party Communication: None
           POSTU-141476-15                                Date of Communication: Not Applicable

 UILC:     831.00-00

  date:    October 06, 2017

     to:   Richard E. Trogolo
           Associate Area Counsel (Cincinnati, Group 1)
           (Large Business & International)
           Attn: Marc Shapiro, Senior Attorney
                 CC:LB&I:HMT:CIN1:CLE

  from:    Rebecca L. Baxter
           Senior Technician Reviewer, Branch 4
           (Financial Institutions & Products)


subject:   Coverage of Foreign Currency Fluctuation by Captive

           This memorandum addresses coverage of foreign currency fluctuation by a captive
           insurance company. This memorandum should not be used or cited as precedent.

           LEGEND

           Taxpayer           =      ------------------------------------------------------------------------------------
                                     ----------------------------------------------------------
           Captive            =      -----------------------------------------
           State              =      ------------
           Month A            =      ------
           Year 2             =      -------
           Contract 1         =      ------------------------------------------------------------------------------------
                                     ----------------------------------------------------------------------
           Contract 2         =      ------------------------------------------------------------------------------------
                                     ------------------------------------------------------------------------------
           Number A           =      ----
           Number B           =      ----
           Number C           =      ----
           Number D           =      ----
           Year 1             =      -------
POSTU-141476-15                                  2

Date A              =    -----------
Date B              =    -----------
Year 3              =    -------
Outside Actuary     =    -------
Actuarial Review    =    ------------------------------------------------------------------------------------
                         ------------------------------------------------------------------------------------
                         ------------------------
Number E            =    ----
Number F            =    -----
Number G            =    ----
Number H            =    ----
Number I            =    4
Number J            =    ----
Number K            =    ----
Number L            =    ----
Number M            =    8
Number N            =    1
Number O            =    2
Number P            =    7

ISSUE

Whether an arrangement between affiliated operating entities and a captive insurance
affiliate concerning the fluctuation in the value of specified foreign currencies is
insurance for federal income tax purposes.

CONCLUSION

While economic risk of loss arising from the fluctuation in the value of specified foreign
currencies can be an insurable risk, certain terms of this arrangement do not comport
with the commonly accepted sense of insurance. Thus, this arrangement does not
constitute insurance for federal income tax purposes.

FACTS

Taxpayer is the parent of a group of business entities (hereinafter, Taxpayer and its
subsidiaries are referred to as “Taxpayer Group”). Taxpayer Group designs,
manufactures, and markets professional, medical, industrial, and commercial products
and services.

Taxpayer Group includes a captive insurance company (“Captive”), which is regulated
as a pure captive insurance company under State law. As a pure captive, Captive may
not insure any risks other than those of its parent and affiliated companies. Captive
provides coverage to U.S. members of Taxpayer Group for automobile liability, products
liability, general liability, workers’ compensation, product warranty, credit guarantee
POSTU-141476-15                                     3

insurance, earthquake damage coverage, retiree medical cost coverage, and
guaranteed renewable accident and health insurance.1
The U.S. members of Taxpayer Group for which Captive provides insurance are
subsidiaries of Taxpayer. Captive is also a subsidiary of Taxpayer.

Taxpayer Group conducts business throughout the world. Sales and purchases in
currencies other than the U.S. dollar expose Taxpayer Group to fluctuations in foreign
currencies relative to the U.S. dollar and may adversely affect Taxpayer Group’s
operations and financial condition. Therefore, in Month A, Year 2, Taxpayer entered
into two categories of contracts with Captive on behalf of U.S. members of Taxpayer
Group (“Participants”) to cover the risk arising from fluctuations in the rate of exchange
between the U.S. dollar and specified foreign currencies. Contract 1 is intended to
cover the Participants’ currency risks with respect to receipts from the manufacturing
and selling of products to foreign customers while Contract 2 is intended to cover the
Participants’ currency risks with respect to amounts owed to related foreign entities in
their respective currencies. Taxpayer explained that a Participant is exposed to the
effects of foreign currency valuations on the price of the Participant’s products, the
volume of its sales, the receipt of invoices priced in foreign currency, and the cost of
materials and services purchased when translated to U.S. dollars for reporting
purposes.

Under Contract 1, Captive agrees to:

        indemnify [Participant] for the amount of Loss of Earnings [Participant]
        sustain[s] due to decrease in the value of Specified Foreign Currency
        relative to the U.S. dollar. The covered amount of Loss of Earnings will be
        measured in U.S. dollars as the percentage increase in the Rate of
        Exchange of the U.S. dollar against the Specified Foreign Currency
        between the effective date and the expiration date as specified within the
        declarations endorsements, multiplied by the Coverage Limit.

Contract 1 includes the following definitions:

        Coverage Limit means the lesser of (1) the Specified Loss Limit (for each
        [Participant]) as listed within the declarations endorsements or (2) such
        [Participant]’s sales revenue received or accrued in the Specified Foreign
        Currency during the Policy Period (as defined in the declarations) as
        measured by translation into U.S. dollars at foreign currency exchange
        rates that are reflected in such [Participant]’s financial statements.

        Loss of Earnings means the percentage increase in the Rate of Exchange
        of the U.S. dollar against the Specified Foreign Currency between the
1
  We offer no opinion whether these risks are insurable risks or whether the structure of the arrangement
between the members of Taxpayer Group and Captive with respect to these risks is insurance for federal
income tax purposes.
POSTU-141476-15                                   4

       effective date and expiration date as stated within the declarations
       endorsements, multiplied by the Coverage Limit.

       The Rate of Exchange of the U.S. dollar against the Specified Foreign
       Currency means the spot price as quoted by Bloomberg LP at 10:00 a.m.
       EST on the effective day of each declarations endorsement.

       Premium means the Rate of Premium multiplied by the Coverage Limit.

       The Rate of Premium per dollar of coverage means two times the amount
       of premium as quoted by Bloomberg LP at 10:00 EST on the effective day
       of each declarations endorsement, as a percentage of notional for a 12-
       month call option contract for the purchase of U.S. dollars against
       Specified Foreign Currency.

Contract 1 also provides for a retrospective premium adjustment as follows: “The
Premium shown in each of the declarations endorsements is a deposit Premium only
and is the maximum [the Participant] will pay. The actual Premium will be subject to
adjustment after the expiration date of each declaration endorsement, based on [the
Participant]’s actual loss experience.”

Under Contract 1, the retrospective premium adjustment is calculated as “[Number A]%
of the deposit Premium, minus paid losses in excess of [Number B]% of the deposit
Premium.”2 The effect of the adjustment “in no case shall … result in a final premium
that exceeds the deposit Premium” and “if the retrospectively adjusted premium is less
than the deposit Premium, [Captive] will refund the difference to [Participant] within
[Number D] days of the end of the term outlined in the applicable declaration
endorsement.”

Under Contract 2, Captive agrees to:

       indemnify [Participant] for the amount of Loss of Earnings [Participant]
       sustain[s] due to an increase in the value of Specified Foreign Currency
       relative to the U.S. dollar. The covered amount of Loss of Earnings will be
       measured in U.S. dollars as the percentage decrease in the Rate of
       Exchange of the U.S. dollar against the Specified Foreign Currency
       between the effective date and expiration date as specified within the
       declarations endorsements, multiplied by the Coverage Limit.

Contract 2 includes the following definitions:



2
 Upon an early termination, the determination of retrospective adjusted premium differs to achieve a
proration between the duration of coverage and the period not to be covered; in such case the adjusted
premium will not be less than Number C% of the deposit Premium regardless of the duration of coverage.
POSTU-141476-15                             5

      Coverage Limit means the Specified Loss Limit (for each [Participant]) as
      listed within the declarations endorsements.

      Loss of Earnings means the percentage decrease in the Rate of
      Exchange of the U.S. dollar against the Specified Foreign Currency
      between the effective date and expiration date as stated within the
      declarations endorsements, multiplied by the Coverage Limit.

Contract 2 uses the same definitions for Rate of Exchange, Premium, and Rate of
Premium as in Contract 1. Contract 2 also uses the same retrospective premium
adjustment mechanism as in Contract 1.

Taxpayer explains that the Bloomberg option was chosen as the benchmark for
determining the Premium for both Contracts because although the Contracts differ from
the referenced option, the risks are comparable. Taxpayer offered that the purpose of
this premium methodology, under which the Rate of Premium and maximum premium
payable are double the market rate for an option providing similar risk protection, is to
bolster the financial capacity of Captive so that Captive would have an additional source
of funding for losses. Taxpayer previously offered that this methodology would be used
initially but as the program gathered experience the pricing would use sound actuarial
principles based on the experience of the Participants. However, although the
Contracts have been in place since Year 1, it appears the Contracts continue to be
implemented using the original, options-based, pricing methodology.

Notably, neither Contract describes the term “Specified Loss Limit.” However,
representatives of Taxpayer indicated to the Service that Contract 1 generally has been
implemented as if Specified Loss Limit was equal to the Participant’s export sales for
the prior year, though apparently the limit was modified on an interim basis (the reason
and extent of modification are not clear). Representatives of Taxpayer indicated that
Contract 2 has been implemented as if the Specified Loss Limit was equal to the
amount of each Participant’s outstanding loans at the endorsement effective date.

The Contracts each cover a policy period of one year with monthly endorsements
extending the coverage of both Contracts. That is, the Contracts were initially issued for
the period of Date A, Year 2, through Date B, Year 3, but beginning with the month after
Date A, Year 2, an endorsement was added to provide coverage for the following year
from that date. For example, if a Contract was issued on January 1, an endorsement
would be added effective February 1 expiring January 31 of the following year. In
effect, for each calendar year Taxpayer has 12 separate contracts, one becoming
effective each month and one expiring each month. Taxpayer asserts that by
staggering the purchase of foreign currency exchange risk coverage in this manner,
each Participant obtains protection against the trend of a strengthening or weakening
dollar (whichever side the coverage responds to).
POSTU-141476-15                              6

Outside Actuary performed Actuarial Review, noting that the coverage limits for the
Contracts are “derived as a function of the prior year production for each [Participant],
separately.” With respect to the premium structure:

       The final premiums are a function of both the currency options market 1
       year call premium and the actual loss experience as adjusted by the retro
       premium feature. The deposit premium rates are determined as twice the
       1 year call option rate for each currency pair, separately.

       The retro premium adjustment is a risk sharing mechanism that recasts
       the final loss ratios most notably where actual losses are between
       [Number E]% and [Number F]% of the deposit premium amounts.

With regard to Contract 1, for Year 1, Number G entities participated, covering a total of
Number H currencies; the average number of currencies covered per Participant was
Number I. For Year 2, Number B entities participated, covering at total of Number J
currencies; the average number of currencies covered per Participant was Number I.
For Year 3, Number K entities participated, covering a total of Number L currencies; the
average number of currencies covered per Participant was Number M.

With regard to Contract 2, for Year 1, Number N entities participated, covering a total of
Number O currencies; the average number of currencies covered per Participant was
Number O. For Year 2, Number P entities participated, covering a total of Number O
currencies; the average number of currencies covered per Participant was Number N.
For Year 3, Number M entities participated, covering a total of Number O currencies;
the average number of currencies covered per Participant was Number N.

The Contracts have features commonly found in insurance policies, such as the format
and language, the payment of consideration, and the administration of claims of
covered loss. In addition, the Contracts exclude any loss which is covered under
property insurance or business interruption insurance. The Contracts do not mention
any parental guarantee or premium loan back that could be inconsistent with a bona
fide insurance arrangement.

For Year 1, a previous taxable year, we concluded in CCA 201511021 that the
Contracts were not insurance because the Contracts lacked insurance risk and that the
Contracts were also not insurance in its commonly accepted sense. In light of R.V.I.
Guaranty Co., v. Commissioner, 145 T.C. 209, 245 n22 (2015), we have reconsidered
our analysis.

LAW AND ANALYSIS

Neither the Internal Revenue Code nor Treasury regulations define “insurance” for
federal income tax purposes. R.V.I. Guaranty Co., 145 T.C. at 224-25. Courts have
held that a captive insurance arrangement among affiliates can constitute insurance for
POSTU-141476-15                              7

federal income tax purposes where the arrangement satisfies the following elements:
(1) the arrangement must involve insurable risks; (2) the arrangement must shift the risk
of loss to the insurer and distribute the risks among the policyholders; and (3) the
arrangement must be insurance in its commonly accepted sense. Rent-A-Center, Inc.
v. Commissioner, 142 T.C. 1, 21 (2014); Sears, Roebuck & Co. v. Commissioner, 96
T.C. 61, 101 (1991), aff’d in part and rev’d in part, 972 F.2d 858 (7th Cir. 1992);
AMERCO, Inc. & Subs. v. Commissioner, 96 T.C. 18, 38 (1991), aff’d, 979 F.2d 162 (9th
Cir. 1992); Harper Group v. Commissioner, 96 T.C. 45, 58 (1991), aff’d, 979 F.2d 1341
(9th Cir. 1992). Courts consider “all of the facts and circumstances to determine
whether an arrangement qualifies as insurance.” Rent-A-Center, 142 T.C. at 22 (citing
Harper Group, 96 T.C. at 57).

Whether a risk is an “insurable risk” is examined from the perspective of both the
insured and insurer. R.V.I. Guaranty Co., 145 T.C. at 225 (citing Harper Group, 96 T.C.
at 57). Not all risks faced by a business are insurable. The Tax Court has observed
that “[i]nsurance risk is involved when an insured faces some loss-producing hazard
(not an investment risk), and an insurer accepts a payment, called a premium, as
consideration for agreeing to perform some act if and when that hazard occurs.” R.V I.
Guaranty Co., 145 T.C. at 235 (quoting Black Hills Corp. v. Commissioner, 101 T.C.
173, 182 (1993), aff’d, 73 F.3d 799 (8th Cir. 1996)). Typically, the loss produced by the
occurrence of the hazard must be an economic loss. Allied Fidelity Corp. v.
Commissioner, 66 T.C. 1068 (1976), aff’d, 572 F.2d 1190, 1193 (7th Cir. 1978), cert.
den., 439 U.S. 835 (1978).

Central to the notion of insurance risk is the concept of a “fortuitous event.” AMERCO,
979 F.2d at 167. A fortuitous event is “[a] happening that, because it occurs only by
chance or accident, the parties could not reasonably have foreseen.” Black’s Law
Dictionary 725 (9th ed. 2009). In order for an arrangement to constitute insurance, the
arrangement must involve the fortuitous occurrence of a stated contingency,
Commissioner v. Treganowan, 183 F.2d 288, 290-91 (2nd Cir. 1950), cert. den., 340
U.S. 853 (1950), and must not merely involve an investment or business risk. Helvering
v. Le Gierse, 312 U.S. 531, 542 (1941); Rev. Rul. 2007-47, 2007-2 C.B. 127; Rev. Rul.
89-96, 1989-2 C.B. 114. That the risk may be mitigated through a mechanism other
than insurance does not mean the risk is not an insurance risk. R.V.I. Guaranty, 145
T.C. at 245. Moreover, nontax regulatory treatment of the risk and the arrangement to
mitigate the risk as insurance is highly probative. Id. at 237-38, 245-46.

Risk shifting occurs if a person facing the possibility of an economic loss transfers some
or all of the financial consequences to an insurer, such that a loss does not affect the
insured because the loss is offset by a payment from the insurer. Rev. Rul. 2005-40,
2005-2 C.B. 4. The arrangement addressed in this memorandum is described as a
“brother-sister arrangement” because it involves an arrangement between affiliated
subsidiaries of Taxpayer (here, the Participants) and another subsidiary of Taxpayer
that is the insurer (here, the Captive). See, e.g., Rent-A-Center, 142 T.C. at 16
(considering the deductibility of premiums paid by affiliated subsidiaries to a captive in a
POSTU-141476-15                                        8

brother-sister arrangement). Such an arrangement can shift risk from the affiliated
subsidiaries to the captive even if the aggregate net worth of all of the affiliated
subsidiaries of a parent corporation is not affected by an incurred loss. Id. at 20-21.
However, among the conditions predicate for risk shifting is that the entity assuming the
risk, the captive, be “financially capable of meeting its obligations”. Id. at 31; see also
Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835, 842-43 (6th Cir. 1995) (either
undercapitalization or indemnification of the insurer by the taxpayer claiming the
deduction, or both, precludes risk shifting to the insurer).

Risk distribution occurs when an insurer pools a large enough collection of unrelated
risks (those unaffected by the same event) and distributes the risks among the
policyholders. Rent-A-Center, 142 T.C. at 24; Avrahami v. Commissioner, 149 T.C. No.
7, at 60. A captive may achieve adequate risk distribution by insuring only subsidiaries
within its affiliated group. Id. But see Rev. Rul. 2005-40, 2005-4 C.B. 4 (holding that
where only one entity participates as the insured, the arrangement lacks sufficient risk
distribution). In analyzing risk distribution, there must be both a sufficient number of
insured companies as well as a sufficient number of independent risk exposures.
Avrahami, 149 T.C. No. 7 at 63-64. In Avrahami, the court held that since the captive
insured only 3 or 4 insured entities, the captive failed to adequately distribute risk. Id.
In addition, the captive did not cover a sufficient number of risk exposures to achieve
risk distribution merely through its affiliated entities (issuing 7 types of direct policies).
By contrast, the court found sufficient risk distribution in R.V.I., which used 951 policies
covering 714 different insured entities with more than 750,000 vehicles, 2,000 parcels of
real estate, and 1.3 million equipment assets. The court also found sufficient risk
distribution in Rent-A-Center, 142 T.C. 1, where the arrangement covered
approximately 15 affiliated subsidiaries,3 more than 14,000 employees, 7,100 vehicles,
and 2,600 stores in all 50 States. See also, Securitas Holdings, Inc. v. Commissioner,
T.C. Memo. 2014-255. Here, the number of Participants in, and the currencies covered
by Contract 1, varied each year; the number of Participants in Contract 2 varied each
year. Whether these Contracts involved a sufficient number of insured companies as
well as a sufficient number of independent risk exposures to achieve risk distribution is
not clear.

The determination of whether an arrangement fits within the “commonly accepted
sense” of insurance is made by weighing certain nonexclusive factors. These
nonexclusive factors include whether (1) the insurer is organized, operated, and
regulated as an insurance company by the States in which it does business; (2) the
insurer is adequately capitalized; (3) the insurance policies are valid and binding; (4) the
premiums are reasonable in relation to the risk of loss; and (5) the premiums are duly
paid and loss claims are duly satisfied. See, e.g., R.V.I. Guaranty, 145 T.C. at 231
(citing Harper Group, 96 T.C. at 60; Securitas Holdings, T.C. Memo. 2014-225). An
insurer may be considered adequately capitalized if it meets the minimum capital
requirements of its regulator. See Avrahami, 149 T.C. No. 7, at 70, 76 (however, the

3
    The opinion does not provide additional detail regarding the number of entities.
POSTU-141476-15                                     9

court concluded that Pan American was not a bona fide insurance company, even
though it met the Island of Nevis’ “loosely regulated [ ] low capitalization requirements”).

In this case, the adverse movement of foreign currency valuations presents the
possibility of an economic loss. The movement of the foreign currency valuation could
be a fortuitous event.4 Accordingly, given the role of currency fluctuation in the
Participants’ business, we conclude that foreign currency risk can be an “insurance
risk,” though this arrangement bears resemblance to a notional principal contract or
other type of a § 988 transaction.

For each Contract the foreign currency risk is seemingly shifted from each Participant to
Captive. While Contract 1 and Contract 2 nominally cover opposite risks, it appears no
Participant was simultaneously covered by both Contracts with respect to the same
foreign currency risk; hence under no scenario would the risk be neutralized. Cf., Le
Gierse, 312 U.S. at 541 (combination of contracts neutralizing risk). However, whether
this risk was distributed, particularly with respect to Contract 2, is unclear. Further
development is necessary to evaluate whether the arrangement, in particular Contract
2, involves the pooling of a large enough collection of unrelated risks to utilize the
“statistical concept that theorizes that the average of a large number of independent
losses will be close to the expected loss.” Avrahami, 149 T.C. No. 7 at 60.

Captive is regulated by State as a pure captive insurance company. Premiums are also
duly paid and loss claims are duly satisfied. In addition, Taxpayer offered that the
purpose of the premium methodology, under which the Rate of Premium and maximum
premium payable are double the market rate for an option providing similar risk
protection, is to bolster the financial capacity of Captive so that Captive would have an
additional source of funding for losses, though Captive may meet the capital
requirements of State and may be adequately capitalized, cf., Avrahami, 145 T.C. No. 7
at 80.

Taxpayer, however, has not demonstrated that the arrangement constitutes insurance
in its commonly accepted sense, as understood in Avrahami, 149 T.C. No. 7 at 76;
R.V.I. Guaranty, 145 T.C. at 231, and other decisions. Though the Contracts follow a
policy form, an essential term of the agreement, the coverage limit, is on its face
ambiguous. The Contracts state that coverage is provided up to the Specified Loss
Limit, but that term is not defined in the Contracts. Whether the Specified Loss Limit
can be inferred from the conduct of the parties is unclear given that, at least in the case
of Contract 1, the conduct of the parties apparently has not been entirely consistent.
Specifically, the parties modifed the meaning of the term on an interim basis without
explanation. Cf., Restatement (Second) of Contracts, § 220 (agreement interpreted in
accordance with known relevant usage).


4
 The information provided does not suggest that the Participants have the legal or economic ability to
meaningfully influence any currency valuation.
POSTU-141476-15                             10

In addition, no documentation has been provided showing that the premiums are set at
arm’s length or priced using insurance experience. Captive’s premium methodology for
the Contracts, which steeply retrospectively rates a multiple of the commercially
available option price, may not be typical of commercial insurance practice.

Moreover, the Contracts’ coverage does not appear to match Participants’ risk of loss.
Here, the results under the Contracts do not tie to the actual exposure of Participants to
particular foreign currencies; Taxpayer and Captive acknowledge that the results under
each Contract are “determined independently of the actual value of loss.” Indeed, under
these Contracts it seems Participants may both have currency gains over the life of a
particular transaction (or group of covered transactions) and also be eligible for a benefit
under the Contracts (e.g., the currency could move favorably over the time of the
Participant’s exposure to the currency but also unfavorably when measured over the
one-year duration of a Contract), such that the risk involved may to some extent be
described as speculative. See e.g., 7 Couch on Ins. § 101:2 (wagering is not
insurance); 17 Couch on Ins. § 246:93 (insurance not for speculative purposes). In
addition, Participants may both have currency losses over the life of a particular
transaction (or group of covered transactions) and also not be eligible for a benefit
under the Contract.

Finally, the sequential laddering of the Contracts, each for the duration of a year, may
result in a Participant having multiple recoveries. The possibility of multiple recoveries
suggests that the insurable interest may not be substantial in relation to the amount of
insurance. See, e.g., 3 Couch on Ins. § 41:2 (stating that the extent of insurable interest
is typically not evaluated and it is immaterial that the interest of the insured is
overvalued as long as the actual interest is substantial in relation to the amount of the
insurance). In addition, this sequential laddering may be inconsistent with prevailing
commercial practice for insurance contracts.

Accordingly, we cannot conclude that the material provided by Taxpayer and Captive
demonstrates that either Contract 1 or Contract 2 satisfy each prong of the definitional
test of insurance for federal income tax purposes.


CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS
POSTU-141476-15                             11




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