Syzygy Insurance Co. v. Commissioner: What You Should Know

from the Spring Consulting Group Team

The courts ruled that Syzygy Insurance Company, a microcaptive created by Highland Tank & Manufacturing Co. and its associates (HT&A) did not qualify as an 831(b) microcaptive entity between the years of 2009 and 2011. Federal courts have been especially assertive outlining bad fact patterns for certain captives, as seen in similar case results such as Avrahami v. Commissioner and Reserve Mechanical Corp v. Commissioner.

In handling these cases, the court has consistently outlined the following parameters in determining what constitutes an insurance arrangement.

1. Must involve insurable risks
2. Must shift risk of loss to the insurer
3. Must distribute the risk among its policyholders
4. Must qualify as insurance in the commonly accepted sense

Understanding the criteria and results of these court rulings is imperative to ensure that your clients' captives, or even your own, are appropriately managed and operated.

The Petitioner

In 2008, HT&A established its subsidiary Syzygy as a Delaware-domiciled microcaptive insurance company. The microcaptive was managed by Alta Holdings, LLC, a California-based captive service provider. During the years in questions, 2009–2011, Syzygy utilized two fronting insurers: U.S. Risk Associates Insurance Co. (SPD) Ltd and Newport Re, Inc. Alta's typical operations did not involve the promotion of direct policy purchases, so, instead, participants would purchase their policies from fronting insurers like U.S. Risk and Newport Re that were related to Alta.

In the Syzygy arrangement, 100 percent of the fronted risk was ceded, and a reinsurance arrangement was set up such that 49 percent of these premiums (net of fronting fees) were ceded to Syzygy for assuming the first $250,000 of a claim (layer 1). Claims between $250,000 and $1 million (layer 2) were retained by a pool that held a quota share agreement between each of the 40 to 50 Alta pool participants, including Syzygy. The remaining 51 percent of the premiums went to Syzygy for assuming their quota share piece of the total portfolio's layer 2 risk. The original feasibility study suggested that Syzygy's overall loss and loss adjustment expense ratio was expected to be 56 percent, although the actual ratio was only 1.5 percent. This low ratio was driven by the minimal claim activity in layer 2 from pool insureds and HT&A not filing claims even though they could have.

Similar loss and loss adjustment expense ratio comparisons can be made with other unsuccessful recent captive cases such as Avrahami and Reserve.

The Ruling

The court raised four issues to which Syzygy had to answer regarding its operations.

1. Whether payments through a microcaptive insurance arrangement from HT&A to Syzygy and its fronting insurers are deductible as insurance premiums
2. Whether Syzygy's section 831(b) election was invalid for the years 2009, 2010, and 2011
3. Whether, if the court was unable to find the arrangement as qualified insurance, the purported premium payments would be included in the captive's income
4. Whether the petitioners were liable for the accuracy-related penalties for the aforementioned years at issue

The US Tax Court's opinion focused on two main points of contention in this case: risk distribution and qualification as an insurance arrangement in "the commonly accepted sense." Before determining whether Syzygy distributed risk through the agreement with U.S. Risk and Newport Re, the court had to evaluate whether these two fronting insurers were actually bona fide insurance companies. Like with Avrahami and Reserve, the court was looking to answer yes to each of the following criteria. 

• Is there no circularity to the flow of funds?
• Are the policies developed in an arm's length approach?
• Did the captive charge actuarially determined premiums?
• Does the captive face actual exposures and insurance versus business risk?
• Is the captive subject to regulatory control, and did it meet minimum statutory requirements?
• Was the captive created for a nontax business reason?
• Was a comparable coverage in the marketplace more expensive or even available?
• Was it adequately capitalized?
• Were claims paid from a separately maintained account?

The court noted there was interaction between many of these criteria, but focused specifically on the first three.

1. The court observed that the previously described flow of funds in the arrangement was "suspiciously" close to circular, though this was not enough to determine invalidity of the insurance arrangement.
2. Additionally, the arrangement produced unusually high premiums, especially in comparison to what the commercial market was offering at the time. The court also found that Syzygy only actually paid one single claim during the years of issue, yet there was no investigation into claim coverage being valid according to the policy terms.
3. In addition, during the years in issue, there were no timely policies that were issued to HT&A by Syzygy nor the fronting insurers.

These highly dubious interactions essentially negate the few insurance-like qualities the arrangement may have had. The court concluded that the two fronting insurers were not bona fide insurers. They did not issue policies, and, therefore, Syzygy did not accomplish sufficient risk distribution through its reinsurance of those policies. It was claimed that the program was set up in this way to achieve "safe harbor," with the premiums being arbitrarily attributed to the two layers, and this was not acceptable.

Despite what appears to be already extremely unfavorable evidence against Syzygy, the court still determined whether or not the arrangement qualified as "insurance in the commonly accepted sense" using the following.

• Was the insurance company organized, operated, and regulated as an insurance company?
• Was it adequately capitalized?
• Were the policies valid and binding?
• Were the premiums reasonable and a result of an arm's length transaction?
• Were any claims paid?

Syzygy had the appearance of a legitimate insurance company because it was operated like an insurance company and ensured that it met its domicile's minimum capitalization requirements. However, Judge Ruwe, who was assigned to the case, stated, "[A]lthough Syzygy was organized and regulated as an insurance company, met Delaware's minimum capitalization requirements, and paid a claim, these insurance-like traits do not overcome the arrangement's other failings. Syzygy was not operated like an insurance company. The fronting carriers charged unreasonable premiums and late-issued policies with conflicting and ambiguous terms."

Further detail of the court's scrutiny from the case is summarized below.

Circular Flow of Funds: The evidence provided showed that HT&A paid the fronting insurers $1.37 million of gross premiums during the years of issue, and, during that same timeframe, the fronting insurers ceded $1.31 million of reinsurance premiums to Syzygy. This caused the court to say, "[w]hile not quite a complete loop, this arrangement looks suspiciously like a circular flow of funds."

Arm's Length Contract: As ascertained by the Tax Court, "HT&A's captive program policy premiums had an average rate-on-line of approximately 6.08 to 6.2 percent, whereas the policies that were purchased outside of the captive program only had an average rate-on-line of 1.14 percent. Note this rate-on-line approach wasn't used in the actual pricing; it was only used to draw this comparison. Like the Reserve and Avrahami cases, the court is comparing the significantly higher captive premium levels with the competitively priced commercial market. The court's opinion summary pointed out, "In an arm's length negotiation, an insurance purchaser would want to negotiate lower premiums instead of higher premiums. Seemingly, the main advantage of paying higher premiums is to increase deductions."

Additionally, none of the captive policies provided a refund if the policy were to be canceled, and the captive policies required claims to be filed earlier than 30 days after the loss was incurred or 7 days after the policy expired. As explained by the expert witness, James Macdonald, and reiterated by HT&A's lack of justifiable evidence of the unusually high rates, the 7-day waiting period "would not be acceptable in an arm's length transaction because it simply does not allow enough time."

Actuarially Determined Premiums: The court helped define what "actuarially determined" means within this Syzygy opinion, which wasn't explicitly done in past case opinions. It states that "premiums charged by a captive insurance company were actuarially determined when the company relied on an outside consultant's reliable and professionally produced and competent actuarial studies." The court pointed out the two issues with respect to actuarially determined premiums was (1) the reasonableness of captive program premiums and (2) the 49 percent to 51 percent allocation of premium between the captive insured's retained layer and the reinsured layer.

The captive premiums were determined by Alta's chief underwriter, Greg Taylor, as was proven by an email from 2008 where Mr. Taylor identified the $500,000–$800,000 of premiums as a "guess." The court determined that there was no evidence to prove the existence of genuine calculations using an actuarial rating model to achieve reasonable premiums. Additionally, it was found that the actuary contracted by the captive domicile's regulator reviewed premiums in the context of Syzygy's solvency and not premium reasonableness. This is a common regulatory issue.

Evidence also showed that Alta didn't take the advice of a credentialed, outside actuary on his or her findings around the allocation of premiums between the retained layer and the pooled layer, where premium for the retained layer should be much larger than 49 percent to be commensurate with the risk. As in the Avrahami and Reserve cases, the court pointed out they are concerned about a one-size-fits-all approach and found the allocation of premiums to not be actuarially determined.

Payment of Claims: It was determined that $100,000 worth of claims under a deductible reimbursement policy were eligible for coverage but not submitted. Because HT&S had a claims processes for commercial policies that they did not implement for the captive program policy, this showed the structure was not insurance in the commonly accepted sense.

Valid and Binding Policies: Past case law is not entirely clear on what makes a policy "valid and binding." This court opinion for Syzygy did explicitly say, "We have held that policies were valid and binding when [e]ach insurance policy identified the insured, contained an effective period for the policy, specified what was covered by the policy, stated the premium amount, and was signed by an authorized representative of the company." The court opinion stated that Syzygy's policies' late issuances, ambiguous policy language, and conflicting terms in the context of a related-party transaction go against this notion.

Key Takeaways

In conclusion, the court determined the following answers for each of the original four issues.

1. Whether payments through a microcaptive insurance arrangement from HT&A to Syzygy and its fronting insurers are deductible as insurance premiums—No
2. Whether Syzygy's section 831(b) election was invalid for the years 2009, 2010, and 2011—Yes
3. Whether, if the court was unable to find the arrangement as qualified insurance, the purported premium payments would be included in the captive's income—Yes
4. Whether the petitioners were liable for the accuracy-related penalties for the aforementioned years at issue—No

Captive professionals should use this ruling as a lesson for future endeavors, or even to reevaluate their current arrangements.

The IRS takes great concern in assessing the legitimacy of all actuarial calculations relating to the formation of a captive. The competition in the commercial market, which ensure arm's length transactions, doesn't exist in the same fashion for captives. This is what has helped drive up captive premiums in many microcaptive pooling structures, as was the case with Syzygy's, to a level that is multiple times that of the insured commercial market premiums. The IRS has drawn this comparison in multiple cases now. The IRS's position on a captive transaction being just a circular flow of funds is difficult to defend when pool loss experience is well below expectations. This was certainly the situation in Syzygy's case.

Because of the lack of a competitive commercial market force naturally pushing down premiums to a reasonable level, it is the responsibility of the actuaries and other captive service providers to ensure that premiums are not only adequate from a solvency perspective but are also not excessive and show transfer of risk. By actuarial standards, excessive premiums will cause risk transfer tests to fail. Further, the pricing algorithm utilized for captives participating in any pooling structure should be vetted to ensure transfer of risk is theoretically sound and makes sense with actual program claim experience. It is imperative to maintain clear historical documentation of actuarial calculations.

Lastly, it is imperative to show evidence of covered claims when claims exist, and policy language should not be ambiguous.

Even if you believe your captive program arrangement is completely compliant, always keep thorough documentation to support the captive's structure, business plan, and overall legitimacy.

The above article is reproduced from a Spring Consulting Group whitepaper titled "Syzygy Insurance Co. v. Commissioner of Internal Revenue, What You Should Know," June 2019.