CAPTIVE INSURANCE won a round in court. The IRS is still deciding whether to appeal.

The IRS denied a company called Rent-A-Center deductions for premiums the company paid from 2002 through 2007 to an offshore subsidiary in Bermuda that the company formed to insure its other subsidiaries.

The US Tax Court said in January that the premiums were deductible.

The result would have been different if the subsidiary were insuring its parent company. This is the second time the US courts have upheld captive insurance arrangements between sister companies. The case is Rent-A-Center, Inc. v. Commissioner.  Rent-A-Center rents furniture and electronic appliances with a right to keep the furniture or appliances if the customer makes the full rent payments. It is about 35% of the US rent-to-own market based on store count. During 2002 through 2007, the company had roughly 3,000 stores in the United States, 19,000 employees and 8,000 vehicles. It operates in all 50 states, Canada, Puerto Rico and Mexico. 

It had been buying general liability, workers compensation and auto insurance from Travelers. It started exploring other options after receiving an invoice in 2001 for $3 million in claims handling fees. The company hired Aon Risk Consultants to advise it on options.

With Aon’s help, it bought insurance in 2002 from Discover Re, but Aon suggested it could save even more money by forming a captive insurance subsidiary, which it did in Bermuda in December 2002.

The captive wrote insurance for 15 Rent-A-Center subsidiaries. A third party was hired to administer claims. The policies had a cap on exposure. The company continued to buy excess coverage for losses above the cap from Discover Re.

Rent-A-Center was listed as the policyholder on the insurance, and it paid the annual premiums, but the subsidiaries reimbursed it for the premiums through monthly payments. The premiums were set based on loss forecasts by Aon. They were $3 million a year less than Discover Re quoted for the same coverage.

During 2002 through 2007, the captive earned net underwriting income of $28.8 million.

The Rent-A-Center parent company guaranteed the captive’s obligation to pay out on the policies, but only to the extent needed to satisfy a minimum solvency margin in Bermuda. The guarantee was cancelled once the captive reached the margin on its own.

The IRS called the arrangements a sham and denied the deductions the parent claimed for the insurance premiums. The deductions had the effect of shifting income from the US to Bermuda.

The US Tax Court disagreed. It said there was a real business motivation, the insurance contracts had arm’s-length terms, the premiums were actuarially determined, and the captive was subject to regulatory supervision by the Bermuda insurance commissioner, met Bermuda’s minimum statutory requirements and paid claims from a separately-managed account.

The court said to have real insurance, there must be both risk shifting and risk distribution.

A contract between a parent and subsidiary does not shift risk. However, two courts have now used a balance-sheet analysis to conclude that risk does shift when a captive insures a sister company drawing solely on the resources of the captive plus, in this case, a limited parent guarantee to pay claims. The other case was a decision by a US appeals court in Humana v. Commissioner in 1989. 

In order to have risk distribution, the insurer needs to insure a large enough pool of unrelated risks. The Tax Court said a captive may achieve adequate risk distribution by insuring only subsidiaries within its own affiliated group. There were a sufficient number of statistically independent risks in the Rent-A-Center case given the large number of stores, employees and vehicles.

The betting within the captives market is that the IRS will continue to deny deductions for premiums paid to captives, but will not appeal the Rent-A-Center decision, preferring to wait for other cases with better facts.