R.V.I. Guar. Co. v. Comm'r

R.V.I. GUARANTY CO., LTD. AND SUBSIDIARIES, PETITIONER

v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 27319–12. Filed September 21, 2015.

P sold contracts for which the company’s name is an

acronym—‘‘residual value insurance.’’ The parties insured

under these contracts included leasing companies, manufac-

turers, and financial institutions. The assets insured included

passenger vehicles, commercial real estate, and commercial

equipment. The insured parties were the lessors of these

assets or provided financing for such leases. When pricing a

lease, a lessor must estimate what residual value the asset

will have when it is returned to him at the end of the lease.

P insured against the risk that the actual value of the asset

upon termination of the lease would be significantly lower

than the expected value. R concluded that P’s policies do not

constitute insurance for Federal income tax purposes. This

conclusion was based chiefly on a determination that the les-

sors were purchasing protection against an investment risk,

not an insurance risk.

1. Held: The risks insured by the policies P sold cover an

insurance risk.

2. Held, further, the policies P sold constitute contracts of

‘‘insurance’’ for Federal income tax purposes.

Dennis L. Allen, M. Kristan Rizzolo, and Daniel H.

Schlueter, for petitioner.

Laurie A. Nasky and John Anthony Guarnieri, for

respondent.

LAUBER, Judge: During 2006 petitioner R.V.I. Guaranty

Co., Ltd., & Subsidiaries (RVI or petitioner) sold contracts for

which the company’s name is an acronym—‘‘residual value

insurance.’’ The parties insured under these contracts

included leasing companies, manufacturers, and financial

institutions. The assets insured included passenger vehicles,

commercial real estate, and commercial equipment. The

insured parties were the lessors of these assets or provided

financing for such leases.

209

210 145 UNITED STATES TAX COURT REPORTS (209)

When pricing a lease, a lessor must estimate what residual

value the asset will have when it is returned to him at the

end of the lease. RVI insured against the risk that the actual

value of the asset upon termination of the lease would be

significantly lower than the expected value. Typically, the

insured value was set slightly below the expected residual

value; if the asset’s actual value at the end of the lease was

lower than the insured value, RVI would pay the difference.

On audit, the Internal Revenue Service (IRS or

respondent) concluded that the policies RVI offers do not con-

stitute ‘‘insurance’’ for Federal income tax purposes. This

conclusion was based chiefly on a determination that the les-

sors were purchasing protection against an investment risk,

not an insurance risk. Concluding that petitioner was there-

fore not an ‘‘insurance company’’ entitled to compute its tax-

able income using the insurance accounting rules set forth in

section 832, the IRS determined a deficiency of $55,197,620

for the 2006 taxable year. 1

Petitioner timely petitioned for redetermination of this

deficiency. After concessions, 2 the sole issue for decision is

whether the RVI policies constitute contracts of ‘‘insurance’’

for Federal income tax purposes. We hold that they do.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulations of facts and the attached exhibits are incor-

porated by this reference. At the time petitioner filed its peti-

tion, its principal place of business was in Connecticut.

R.V.I. Guaranty Co. Ltd. (RVIG) is incorporated in Ber-

muda. At all times since its incorporation, it has been reg-

istered and regulated as an insurance company in compliance

with the requirements of the Bermuda Insurance Act of

1978. RVIG is the common parent of an affiliated group of

corporations that includes R.V.I. America Insurance Com-

1 Allstatutory references are to the Internal Revenue Code as in effect

for the tax year at issue. All Rule references are to the Tax Court Rules

of Practice and Procedure. We round all dollar amounts to the nearest dol-

lar.

2 The parties have filed a stipulation of settled issues resolving the other

two allegations of error set forth in the petition, namely, the ‘‘alternative

insurance adjustments’’ issue described in paragraph 4.b and the ‘‘imputed

interest’’ issue described in paragraph 4.c.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 211

pany (RVIA). RVIA was incorporated in 1994 as a property

and casualty (P&C) insurance company. It began business in

1995 and is domiciled in Connecticut.

During 2006 RVIA engaged exclusively in the business of

issuing policies of residual value insurance. RVIA reinsured

with RVIG almost all of the risk represented by these poli-

cies. Bermuda law requires insurance companies to meet

specified requirements governing solvency, liquidity, min-

imum capital, and surplus. RVIG met or exceeded all of these

requirements during 2006.

In 1999 RVIG elected under section 953(d) to be treated as

a domestic corporation for Federal income tax purposes. That

election was in effect during 2006 and has not been revoked.

RVI filed a consolidated Federal income tax return for 2006

on Form 1120–PC, U.S. Property and Casualty Insurance

Company Income Tax Return, using a calendar fiscal year.

The Policies

Petitioner issued residual value insurance policies to unre-

lated insureds engaged in the business of leasing assets or

financing asset leases. At the inception of any lease, the

lessor anticipates that the leased property will depreciate

during the lease term to a probable ‘‘residual value’’ due to

normal wear and tear. Numerous factors, however, can cause

property to decline in value more precipitously than

expected. These factors may include excess wear and tear, as

well as macro-economic events like recession, high interest

rates, or price deflation. The residual value of an asset may

also be adversely affected by risks to which that particular

property is subject. For example, commercial real estate

might drop in value because of urban blight in a particular

neighborhood or the bursting of a national real estate bubble.

Industrial equipment might drop in value because of techno-

logical change or local factory closings. Passenger vehicles

might drop in value because of high oil prices or a shift in

consumer preferences toward battery-powered cars.

To protect against such risks, the lessor or finance com-

pany could purchase a policy of residual value insurance. In

recent years, such policies have been issued by numerous

well-established insurance companies, including American

International Group (AIG), Chubb Group of Insurance

212 145 UNITED STATES TAX COURT REPORTS (209)

Companies, Royal Insurance Company of America, ACE

Group, QBE Group, and Great American Insurance Group.

During the tax period in issue, RVIA was a leading issuer of

residual value insurance policies (RVI policy or policies).

Each RVI policy indemnified the insured against loss in

the event that assets insured under the policy had an actual

value at lease termination lower than the insured value that

the policy specified for those assets. Typically, the insured

value was slightly below the expected residual value. The

insured thus retained the risk for the initial layer of loss

(between the expected residual value and the insured value),

and RVIA indemnified the insured against the remaining

risk of loss (between the insured value and a lower actual

residual value).

A simple example may illustrate the mechanics of a typical

RVI policy. Assume that an automobile with an initial pur-

chase price of $20,000 is leased for three years and that its

expected residual value upon lease termination is $10,000.

RVIA 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 condi-

tions of coverage. The lessor would bear the $1,000 initial

layer of loss.

RVI policies typically called for a single premium payable

at inception of the contract. The premiums charged depended

on how much risk RVIA assumed, i.e., on the magnitude of

the gap between the expected residual value and the insured

value. Generally speaking, petitioner expected losses on its

policies to be quite low, and it priced the insurance accord-

ingly. The policy premium rarely exceeded $4 for each $100

of insurance protection provided and (depending on the type

of property) could be as low as 50 cents for each $100 of cov-

erage.

The RVI policies included standard terminology and policy

provisions typical of insurance policies generally, including

the requirement of an ‘‘insurable interest’’ and provisions

governing claims, exclusions, payment of losses, and condi-

tions to coverage. For RVIA to have liability under a con-

tract, the insured had to meet various conditions precedent,

e.g., paying the premium, having an ownership interest in

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 213

the covered property, providing written notice of a claim, and

complying with the terms of endorsements regarding return

conditions. Upon payment of a loss RVIA was subrogated to

any rights of recovery the insured might have against third

parties concerning that property.

RVIA sometimes included in its policies other limitations

on loss, such as a policy deductible. By accepting terms that

limited RVIA’s risk of loss, an insured could often reduce its

premium. For example, the insured might elect to exclude

from coverage assets of volatile value, or might accept strict

‘‘return conditions’’ requiring the covered property to be in

excellent condition at lease termination.

Certain RVI policies provided for ‘‘pooling.’’ Under

‘‘pooling,’’ a single policy would cover multiple assets under

leases terminating within a specific period (say one year). A

‘‘loss’’ would be deemed to occur if the aggregate residual

value of those assets was less than their aggregate insured

value.

RVIA wrote three basic types of policies—‘‘FASB,’’ ‘‘pri-

mary,’’ and ‘‘hybrid.’’ 3 An FASB policy was one under which

the insured value of the covered property was set at a level

to provide the lessor with enough insurance coverage to

enable it to use ‘‘direct financing lease’’ accounting. See

Statement of Financial Accounting Standards No. 13 (a lease

may be classified as a ‘‘financing lease’’ if the present value

of the lease payments and any guaranteed portion of the

residual value exceeds 90% of the value of the asset). Under

a ‘‘financing lease’’ the lessor can accelerate income into the

lease’s earlier years for financial accounting purposes. A pri-

mary policy was one under which the insured value was not

set at a level tied to ‘‘financing lease’’ accounting. A hybrid

policy was one under which each insured asset was subject

to both primary and FASB coverage.

RVIG’s business in 2006 consisted principally of reinsuring

the risks represented by RVIA’s policies of residual value

insurance. As measured by net unearned premiums, 97.5% of

RVIG’s business at year end 2006 was attributable to RVIA

risks. RVIG also reinsured risks under residual value policies

3 FASB refers to the Financial Accounting Standards Board, the organi-

zation responsible for establishing Generally Accepted Accounting Prin-

ciples (GAAP) in the United States.

214 145 UNITED STATES TAX COURT REPORTS (209)

issued by other insurance companies. Reinsurance of risks

arising under other types of contracts represented less than

1% of RVIG’s business.

RVIA grouped its policies into three business segments:

passenger vehicles, commercial real estate, and commercial

equipment. ‘‘Commercial equipment’’ included aircraft, indus-

trial equipment, and rail cars. At year end 2006 RVIA had

951 policies in force insuring 714 unrelated insureds. The

assets covered by these policies included 754,532 passenger

vehicles, 2,097 real estate properties, and 1,387,281 pieces of

commercial equipment. Within each business segment, RVIA

insured a wide variety of assets, i.e., many different makes

and models of automobile, various kinds of buildings in

diverse geographical locations, and many different types of

industrial equipment. The passenger vehicles comprised 20

different types of automobile (including pickup trucks,

sedans, SUVs, and sports cars) and approximately 50 dif-

ferent vehicle models. The commercial real estate comprised

15 different types of properties (including retail stores, ware-

houses, industrial buildings, office buildings, and motels) in

seven different geographic regions. And the commercial

equipment comprised 30 different types of equipment,

including aircraft, rail cars, construction equipment, and

shipping containers.

Each business segment accounted for roughly one-third of

RVIA’s business as measured by remaining unearned pre-

miums at year end 2006. 4 The terms of the leases to which

the covered assets were subject varied considerably within

business segments and from one segment to another. The

lease terms for vehicles were typically one to five years; the

4 As measured by remaining unearned premiums, the passenger vehicle

segment accounted for 31.9%, the commercial real estate segment for

34.6%, and the commercial equipment segment for 33.5% of RVIA’s busi-

ness. Total unearned premiums for these three segments at year end 2006

were $47.5 million, $51.6 million, and $50 million, respectively. As meas-

ured by premiums earned during 2006, the passenger vehicle segment ac-

counted for 58.8%, the commercial real estate segment for 12.6%, and the

commercial equipment segment for 28.6% of RVIA’s business. The percent-

ages for the latter two segments were smaller as measured by earned pre-

miums because the insured assets were leased for longer terms, with the

result that the premium was ‘‘earned’’ more slowly. Total earned premiums

for the three segments during 2006 were $27.6 million, $5.9 million, and

$13.4 million, respectively.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 215

lease terms for real estate were much longer, often 28 years;

the lease terms for commercial equipment varied greatly.

Even where assets (such as vehicles) were subject to the

same lease term (such as three years), the policies insuring

them could end in different years because initiated at dif-

ferent times.

The events that could cause losses under RVI policies

varied considerably. Certain macro-economic events, such as

recessions, high unemployment, or unexpectedly high

interest rates, could affect various insured assets similarly.

But many events that could cause loss were uncorrelated.

For example, technological obsolescence of a type of commer-

cial aircraft probably would not affect the value of an office

building. And risks within a given business segment were

often uncorrelated. For example, the loss of a major tenant

in a Chicago office building likely would not affect the value

of a building leased to a restaurant in New York. 5

At year end 2006 the total insured value of RVIA-insured

property was roughly $9.1 billion in the passenger vehicle

segment, $2.1 billion in the commercial real estate segment,

and $4.9 billion in the commercial equipment segment.

Divided by type of policy, the total insured value of property

covered under FASB policies was about $5.0 billion, under

primary policies was about $3.7 billion, and under hybrid

policies was about $7.4 billion. (All amounts ignore reinsur-

ance).

Petitioner paid significant claims under the RVI policies

and incurred significant insurance losses. On an absolute

dollar basis, RVIA paid more than $150 million in claims

through 2013, which included more than $28 million in

claims on FASB policies. 6 An insurance company’s ratio of

5 In 2007 RVIA sustained a substantial loss on a policy covering an office

building in El Paso, Texas, after the building’s lead tenant, El Paso Nat-

ural Gas, moved to Houston. The risk causing this loss was uncorrelated

with risks that could affect the value of buildings that RVIA insured in

other locations, much less the value of motels and convenience stores com-

ing off lease 15 years later.

6 Respondent objected to the admissibility of financial information for

2007–2013 as post-dating the tax year in issue and ‘‘irrelevant for that rea-

son.’’ The Court overruled this objection. A loss under an RVI policy is pay-

able only at the end of a lease, and many of the insured assets were sub-

ject to very long leases. By definition, therefore, many RVI policies in ex-

Continued

216 145 UNITED STATES TAX COURT REPORTS (209)

paid losses (including related loss adjustment expenses) to

earned premiums is generally called its ‘‘loss ratio.’’ From

RVIA’s inception through 2006, its cumulative loss ratio was

27.7%. From RVIA’s inception through the end of 2013, its

cumulative loss ratio increased to about 34%. Its annual loss

ratios from 2000 through 2013 were as follows:

Year Loss ratio

2000 ................................................................... 1.0%

2001 ................................................................... 0.9%

2002 ................................................................... 0.3%

2003 ................................................................... 1.3%

2004 ................................................................... 64.2%

2005 ................................................................... 48.6%

2006 ................................................................... 33.2%

2007 ................................................................... 20.4%

2008 ................................................................... 97.9%

2009 ................................................................... 11.5%

2010 ................................................................... 27.1%

2011 ................................................................... 18.1%

2012 ................................................................... 0.2%

2013 ................................................................... 30.7%

Regulation of Petitioner

The residual value policies were treated as ‘‘insurance’’ for

insurance regulatory purposes during 2006 by all States in

which RVIA sold products, including Connecticut, New York,

Pennsylvania, Ohio, Texas, Illinois, and Georgia. RVIA was

required to be (and was) licensed to sell insurance in each

State in which it issued policies. It was required to pay to

those States insurance premium taxes, which totaled

$639,764 for 2006. It was required to file with the insurance

department of each State quarterly or annual ‘‘statutory

financial statements.’’ These statements were required to be

prepared in accordance with ‘‘statutory accounting principles’’

(SAP) prescribed by the National Association of Insurance

Commissioners (NAIC). RVIA was additionally required by

Connecticut, its State of domicile, to meet minimum capital

and surplus requirements, which it met for 2006.

istence 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.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 217

Under the SAP, an insurer may not treat a contract as

‘‘insurance’’ in its statutory financial statements unless it

assumes a significant insurance risk under the contract and

faces a reasonable possibility of incurring a significant loss.

See Statement of Standard Accounting Practice 62R. 7 RVIA

determined that it was required to account for its policies as

insurance—and it did in fact account for those policies as

insurance—in its statutory financial statements, including

those it prepared for 2006. RVIA’s independent auditor, BDO

Seidman LLP (BDO), examined its 2006 statutory financial

statements and issued an unqualified opinion that they were

fairly stated in accordance with SAP.

The Connecticut Insurance Department examined RVIA’s

2006 statutory financial statements for compliance with SAP.

During this examination, an actuary from the department

met with an actuary appointed by RVIA to review its annual

actuarial report prepared by PricewaterhouseCoopers LLP

(PwC). Following this review, the department raised no ques-

tions concerning RVIA’s accounting for its residual value

policies as ‘‘insurance.’’ 8

RVIG was licensed to sell insurance and reinsurance in

Bermuda. It likewise accounted for the residual value policies

as ‘‘insurance’’ in its statutory filings. RVIG’s independent

auditor, Arthur Morris & Co., examined its 2006 statutory

7 The Statements of Standard Accounting Practice (SSAP) provide guid-

ance for the completion of an insurer’s statutory financial statements. The

SSAP are issued by NAIC and published in its Accounting Practices and

Procedures Manual. SSAP 62R, cited in the text, was originally drafted to

establish rules of accounting for reinsurance. However, the evidence at

trial established that practitioners regularly apply its principles to direct

insurance as well.

8 RVIA was required by Connecticut, and by each other State in which

it was licensed, to secure an annual actuarial report addressing the rea-

sonableness of its reserves for unpaid losses, loss adjustment expenses,

and unearned premiums. The PwC actuarial report opined that RVIA’s re-

serves complied with Connecticut insurance law and with accepted actu-

arial standards. Petitioner’s expert, Michael E. Angelina, explained that,

if underwriting risk had not been present, ‘‘I would expect the various re-

ports to have highlighted this issue. This has been my past experience

with the large accounting firms and regulatory agencies.’’ Kent E. Barrett,

one of respondent’s experts, testified that if BDO or PwC had believed that

the RVI policies did not constitute ‘‘insurance’’ for SAP purposes, they

would have had an obligation to say so. Neither BDO nor PwC raised any

question on this point.

218 145 UNITED STATES TAX COURT REPORTS (209)

financial statements and issued an unqualified opinion that

they were fairly stated in accordance with Bermuda insur-

ance law. An independent actuary reviewed its reserves for

unpaid losses and loss adjustment expenses and opined that

those reserves complied with Bermuda law and accepted

insurance practice.

Petitioner received ‘‘insurance strength ratings’’ in 2006

from the major insurance rating agencies. Fitch Ratings gave

petitioner an A+ strength rating. Moody’s Investors Services

gave it an A3 rating. Standard & Poor’s Insurer Credit

Report gave it an A rating.

Tax Return and Notice of Deficiency

On its 2006 consolidated return, petitioner reported its

income and expenses consistently with the requirements of

section 832 governing computation of ‘‘insurance company

taxable income.’’ The IRS issued a notice of deficiency dis-

allowing petitioner’s use of insurance company accounting. It

determined that:

residual value insurance policies that insure against market decline are

not insurance contracts for Federal income tax purposes. It is further

determined that [petitioner must] calculate its annual taxable income

using IRC sections 451 and 461 instead of IRC section 832; this

accounting method change is required since [petitioner] no longer quali-

fies as an insurance company since [it] does not meet the requirements

of IRC section 831(c).[9]

Expert Testimony

Both parties offered extensive expert testimony at trial.

This testimony addressed various characteristics of ‘‘insur-

ance’’ as applied to petitioner’s residual value policies. These

characteristics include risk shifting, risk distribution, com-

monly accepted notions of insurance, and the presence of

insurance risk.

Risk Shifting and Risk Distribution

Petitioner offered, and the Court recognized, Michael E.

Angelina, executive director of the Academy of Risk Manage-

ment and Insurance at St. Joseph’s University, as an expert

9 During the examination, the IRS issued Technical Advice Memo-

randum 201149021 (Aug. 30, 2011) outlining its position concerning these

issues.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 219

on the topics of insurance, risk management, and actuarial

science. Professor Angelina opined that ‘‘insurance at its root

has two fundamental attributes: risk shifting and risk dis-

tribution.’’ He characterized the risks against which peti-

tioner insured as ‘‘low-frequency/high severity risks,’’ analo-

gizing them to earthquakes, major hurricanes, and other

‘‘catastrophic risks.’’ He explained that petitioner distributed

these risks in the same way that other P&C companies dis-

tribute catastrophic risk, e.g., by ‘‘underwriting its risks to

avoid over-concentration in any one segment (passenger

vehicle, commercial real estate, and commercial equipment)

or geographic area.’’ He explained that petitioner also

engaged in ‘‘temporal distribution’’ of its risks by insuring

different forms of property, with lease terms of varying

length, under policies terminating in different years. This

‘‘enabled RVI to avoid a ‘run on the bank’ scenario in

extreme economic downturns.’’ 10

Petitioner offered, and the Court recognized, Robert S.

Miccolis as an expert on insurance and actuarial science,

particularly in the field of mortgage guaranty insurance. Mr.

Miccolis is an actuary with Deloitte Consulting LLP and

president-elect of the Casualty Actuarial Society. He opined

that, for approximately 98% of the RVI policies, it was

‘‘reasonably self-evident’’ that risk was transferred from the

insured to RVIA.

Petitioner offered, and the Court recognized, Nancy L.

Litwinski, a certified public accountant (C.P.A.), as an expert

in insurance accounting and the application of statutory

accounting principles by insurance companies and state regu-

lators. Ms. Litwinski testified that RVIA’s policies were

consistently treated as insurance for SAP purposes by RVIA,

by its independent auditors, and by the Connecticut Insur-

ance Department. This treatment, she testified, was based on

the determination that the residual value policies constituted

‘‘insurance’’ under SAP.

10 Professor Angelina noted that ‘‘the presence of systemic risk does not

mean an insurer has failed to pool risk. * * * [T]he ability to diversify risk

at the more expected levels may have adverse consequences in tail sce-

narios where there is no ability to diversify. This was clearly evident in

2008 during the mortgage crisis as some mortgage guarantee insurers

were not able to recover from their systemic failure.’’

220 145 UNITED STATES TAX COURT REPORTS (209)

Respondent offered, and the Court recognized, Charles

Cook, a managing director of MBA Actuaries LLC, as an

expert in insurance and actuarial science. Mr. Cook com-

pared petitioner’s policies to ‘‘property catastrophe coverages

such as windstorm or flood.’’ He opined that no meaningful

risk of loss was transferred from the policyholder because

RVIA ‘‘did not appear to be exposed to significant loss.’’ He

opined that petitioner’s risk of loss, especially under the

FASB policies, was ‘‘remote.’’ Mr. Cook agreed that petitioner

did distribute risk geographically, temporally, and among

diverse business segments. But he concluded that its risk

distribution and diversification were less beneficial to it than

is typical for insurers because the risks it assumed were

more highly correlated.

In analyzing risk transfer, Mr. Cook limited his review to

losses that had occurred as of year end 2006. In opining that

petitioner’s risk of loss was ‘‘remote,’’ he relied on the fact

that many policies had experienced no losses as of that date.

On cross-examination, it was pointed out that many of these

policies could not possibly have experienced a loss as of year

end 2006 because losses were payable only upon lease termi-

nation and many policies still had multiple years to run.

Upon review of petitioner’s post-2006 experience, Mr. Cook

acknowledged that many policies for which he had computed

a loss ratio of ‘‘zero’’ actually experienced significant losses. 11

Mr. Cook ultimately conceded these errors, acknowledging

that his method of computing loss ratios systematically

understated the true extent of petitioner’s losses.

Respondent offered, and the Court recognized, Kent E.

Barrett, a C.P.A. at Veris Consulting, as an expert with

respect to International Financial Reporting Standards

(IFRS), GAAP, and SAP. Mr. Barrett opined that petitioner’s

FASB policies had only a remote chance of loss and did not

transfer significant underwriting risk. In making this assess-

ment, Mr. Barrett relied on the fact that most of the policies

11 For example, for the policy that RVIA issued to U.S. Bank in 2005,

for which Mr. Cook computed a loss ratio of ‘‘zero,’’ RVIA ultimately paid

more than $12 million in claims after receiving only $8 million in pre-

miums, producing a loss ratio in excess of 150% for the first declaration

period alone. Moreover, of this $12 million in losses, $8 million was attrib-

utable to the policy’s FASB coverage. This contradicted Mr. Cook’s asser-

tion that RVI’s risk of loss under its FASB policies was ‘‘remote.’’

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 221

on RVIA’s books during 2006 ‘‘had experienced no claim pay-

ments of significance as of the end of 2006.’’

Commonly Accepted Notions of Insurance

Professor Angelina testified that the RVI policies have all

the indicia of standard insurance policies and are treated as

‘‘insurance’’ by State regulators and other participants in the

insurance marketplace. In formal respects, the policies ‘‘have

standard sections encompassing declarations, insuring agree-

ments, definitions, exclusions, conditions, and miscellaneous

provisions.’’ The policies have standard provisions that

‘‘define the duties of an insured after loss, how losses are to

be settled, and if any remediating elements need to be

reflected in the final loss settlement.’’ RVIA maintained

actuarially sound insurance reserves for its policies and

accounted for all transactions using proper insurance

accounting.

Mr. Barrett did not dispute these points. But he opined

that the RVI policies differ from typical insurance policies in

certain ways. The risk against which petitioner insures is not

a fortuitous ‘‘insured event,’’ like a car accident, a hurricane,

or a fire. Rather, petitioner insures against a greater-than-

anticipated decline in the economic value of property over

time. As a corollary of this observation, Mr. Barrett noted

that RVIA does not face what he called ‘‘timing risk,’’

namely, the uncertainty that arises under most insurance

policies as to when a covered loss will occur. Under the RVI

policies, a ‘‘loss’’ will occur (if at all) only on the last day of

the policy term, a date that is known in advance. Finally,

Mr. Barrett characterized as nontraditional certain contract

terms that RVIA offered to its policyholders.

Insurance Risk

Professor Angelina opined that the RVI policies cover an

insurance risk and not simply an investment risk. He noted

that losses on RVI policies can vary from zero to the full

insured value. The premium RVIA charged was typically no

more than 4% of the insured value and (for certain contracts)

ranged as low as 0.5% of the insured value. Professor

Angelina opined that RVIA was thus subject to underwriting

risk, namely, the risk that the premiums received (and

income earned thereon) will be insufficient to cover claims

222 145 UNITED STATES TAX COURT REPORTS (209)

made under the policy. This can arise from an inaccurate

assessment of future risks, from an overconcentration of

risks in a particular loss-exposed area, or from macro-eco-

nomic or industry-specific factors wholly outside the under-

writer’s control.

Mr. Miccolis opined that the risks assumed by petitioner

resemble the risks assumed under policies of mortgage guar-

anty insurance, which are generally regarded as involving

‘‘insurance risk.’’ In both cases, the insurer assumes a signifi-

cant risk of loss ‘‘arising out of a financial transaction which

is caused by an unexpected decline in the value of property

after coverage begins.’’ In both cases, the loss suffered by the

insurer can be caused by local conditions in specific markets

or by ‘‘macro-economic conditions, such as general unemploy-

ment, interest rates, and the state of the credit markets.’’

The insured under a mortgage guaranty contract seeks

protection against a possible investment loss—namely,

diminution in the value of its loan asset—but that fact does

not negate the existence of ‘‘insurance risk’’ under such poli-

cies. Mr. Miccolis opined that the same conclusion should fol-

low for residual value insurance.

On cross-examination, Mr. Miccolis agreed that mortgage

guaranty insurance differs from residual value insurance in

one respect. Under the former, the insurer’s payment obliga-

tion is triggered by the homeowner’s default, a fortuitous

event; under the latter, the insurer’s payment obligation

arises because property has declined in value as of a par-

ticular time. But despite this distinction, Mr. Miccolis testi-

fied that the two types of insurance are essentially similar:

in both cases, what truly drives the insurer’s loss is an

underlying decline in the economic value of the insured’s

property or collateral.

Respondent offered, and the Court recognized, Etti

Baranoff, an associate professor of finance and insurance at

Virginia Commonwealth University, as an expert in risk

management, insurance, and financial economics. She opined

that the RVI policies are not contracts of insurance because

they cover ‘‘speculative risk’’ as opposed to ‘‘insurance risk.’’

According to Dr. Baranoff, the ‘‘foundation of insurance is

that it is a product responding to the management of pure

risk only.’’ A transaction involves ‘‘pure risk,’’ she testified, if

the only possible outcomes, from the insured’s point of view,

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 223

are ‘‘loss’’ or ‘‘no loss.’’ A homeowner considering the pur-

chase of fire insurance, for example, faces the possibility of

a fire (resulting in a loss) or the possibility of no fire

(resulting in no loss). The homeowner cannot enjoy a gain

with respect to the risk insured against.

A lessor considering the purchase of an RVI policy, by con-

trast, faces three possible outcomes: ‘‘loss,’’ ‘‘neutral,’’ or

‘‘gain.’’ The covered assets could depreciate below the

expected residual value (resulting in a loss); they could

depreciate to the expected residual value (yielding a neutral

outcome); or they could depreciate less than expected or actu-

ally appreciate (resulting in a gain). Because the uncertain-

ties to which the insured property is subject might generate

either a loss or a gain, Dr. Baranoff characterized RVI’s poli-

cies as involving ‘‘speculative risk,’’ like a stock investment,

as opposed to ‘‘pure risk.’’ She analogized the insured under

an RVI policy to an investor who, desiring to hedge his bets,

purchases an option allowing him to ‘‘put’’ his stock to

another investor if the stock declines to a specified price by

a specified date.

Dr. Baranoff relied in her report on textbooks that note the

distinction between ‘‘pure risk’’ and ‘‘speculative risk.’’

During cross-examination, petitioner’s counsel pointed out

that certain of the texts she cited state that speculative risks

can be insured. See, e.g., George E. Rejda & Michael J.

McNamara, Principles of Risk Management and Insurance 5

(12th ed. 2014) (‘‘Some insurers will insure institutional port-

folio investments and municipal bonds against loss.’’). In

response, Dr. Baranoff reiterated her position that ‘‘pure

risk’’ is the only possible subject of insurance, dismissing

Professor Rejda’s statement to the contrary as ‘‘an

uncarefully written sentence.’’ On balance, we found her

testimony argumentative and unpersuasive.

Disagreeing with Dr. Baranoff, Professor Angelina opined

that insurance can cover certain speculative risks. ‘‘[T]here

are many financial risks,’’ he testified, ‘‘that now are com-

monly insured, such as trade credit insurance, mortgage

guaranty insurance, and municipal bond insurance to name

a few.’’ The Court regarded Professor Angelina as a credible

witness and found his testimony helpful.

224 145 UNITED STATES TAX COURT REPORTS (209)

OPINION

I. Burden of Proof

The Commissioner’s determinations in a notice of defi-

ciency are generally presumed correct, and the taxpayer

bears the burden of proving those determinations erroneous.

Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioner does not contend that the burden of proof shifts to

respondent under section 7491(a) as to any issue of fact.

II. Petitioner’s Status as an ‘‘Insurance Company’’

Insurance companies are subject to the corporate income

tax imposed by section 11. See secs. 801(a)(1) (life insurance

companies), 831(a) (other insurance companies). The taxable

income of insurance companies, however, is computed under

special rules. For P&C companies, those rules are set forth

in section 832, captioned ‘‘Insurance Company Taxable

Income.’’ In order to match income with anticipated loss

expenses, section 832 provides (among other things) that pre-

miums are generally taken into income not as received but

only as ‘‘earned.’’ See Bituminous Cas. Corp. v. Commis-

sioner, 57 T.C. 58, 77 (1971) (observing that if ‘‘premiums

were to be taxed as received and the deductions allowed only

as they later became fixed, the result would be to tax very

large sums of money as income when in fact those amounts

will never really become income because they will have to be

paid out to policyholders’’).

To compute its taxable income under this special regime,

the taxpayer must be an ‘‘insurance company.’’ For this pur-

pose, ‘‘the term ‘insurance company’ means any company

more than half of the business of which during the taxable

year is the issuing of insurance or annuity contracts or the

reinsuring of risks underwritten by insurance companies.’’

Sec. 816(a) (life insurance companies, cross-referenced in sec-

tion 831(c), other insurance companies); see sec. 1.801–3(a),

Income Tax Regs. (‘‘[I]t is the character of the business actu-

ally done in the taxable year which determines whether a

company is taxable as an insurance company[.]’’).

Neither the Internal Revenue Code nor the Treasury Regu-

lations define the term ‘‘insurance’’ or ‘‘insurance contract.’’

The meaning of these terms for Federal income tax purposes

has thus been developed chiefly through a process of

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 225

common-law adjudication. In the seminal case addressing

this subject, the United States Supreme Court noted that

‘‘[h]istorically and commonly insurance involves risk-shifting

and risk-distributing.’’ Helvering v. Le Gierse, 312 U.S. 531,

539 (1941). In addition to requiring risk transfer and risk

distribution, the courts have considered whether the trans-

action constitutes insurance ‘‘in its commonly accepted sense’’

and whether the risk transferred is an ‘‘insurance risk.’’ E.g.,

Black Hills Corp. v. Commissioner, 101 T.C. 173, 182 (1993),

aff ’d, 73 F.3d 799 (8th Cir. 1996). These factors establish a

framework for determining ‘‘the existence of insurance for

Federal tax purposes.’’ AMERCO & Subs. v. Commissioner,

96 T.C. 18, 38 (1991), aff ’d, 979 F.2d 162 (9th Cir. 1992). We

conclude that the RVI policies met all of these requirements

during 2006 and that petitioner was therefore taxable as an

‘‘insurance company.’’

A. Risk Shifting

Insurance is an arrangement that must be examined from

the perspective of both the insurer and the insured. Harper

Grp. v. Commissioner, 96 T.C. 45, 57 (1991), aff ’d, 979 F.2d

1341 (9th Cir. 1992). From the insured’s perspective, insur-

ance is a risk transfer device, that is, a mechanism by which

the insured obtains protection from financial loss by paying

the insurer a premium. Ibid.; Black Hills Corp., 101 T.C. at

182–183. By paying a premium, the insured externalizes his

risk of loss by shifting that risk to the insurer.

We have no difficulty concluding that the lessors and

finance companies that purchased the RVI policies trans-

ferred to petitioner a meaningful risk of loss. As Professor

Angelina explained, these companies faced a significant busi-

ness risk: if the values of the leased assets declined more

precipitously than expected by the end of the lease term,

their lease pricing formula could generate a substantial eco-

nomic loss. Absent the RVI policy, the insured would bear

the entire risk associated with loss-causing events. By pur-

chasing the policy, the insured transferred to RVIA that risk

of loss, to the extent of the assets’ insured values. RVIA was

indisputably a well-capitalized company fully capable of

paying claims and absorbing the risks transferred to it. See

Harper Grp., 96 T.C. at 59 (finding risk transfer where the

insurer ‘‘not only was financially capable of satisfying claims

226 145 UNITED STATES TAX COURT REPORTS (209)

made against it, but it in fact paid such claims’’). The RVI

policies thus transferred the ‘‘impact of a potential loss’’ to

the insurer from the insured. See Gulf Oil Corp. v. Commis-

sioner, 89 T.C. 1010, 1036 (1987), aff ’d, 914 F.2d 396 (3d Cir.

1990).

RVIA accounted for its policies under SAP. These rules

forbid an insurer in its statutory financial statements to

treat a contract as ‘‘insurance’’ unless the insurer assumes a

significant risk under the contract and faces a reasonable

possibility of incurring a significant loss. See SSAP 62R. By

issuing an unqualified opinion that RVIA’s statutory finan-

cial statements were fairly stated under SAP, its external

auditor agreed that it bore a significant insurance risk.

Citing insurance accounting standards, Mr. Miccolis found it

‘‘reasonably self-evident’’ that risk was transferred under

98% of RVIA’s policies. See FASB 113; SSAP 62R; Reinsur-

ance Attestation Supplement 20–1, Risk Transfer Testing

Practice Note. 12 The PwC actuarial report opined that

RVIA’s reserves complied with Connecticut insurance law

and with accepted actuarial standards, and the Connecticut

Insurance Department agreed with this assessment.

Respondent’s experts conceded that the RVI policies did

shift some risk of loss. After being recalled, Mr. Cook

informed the Court of his conclusion that RVIA’s real estate

segment, which accounted for 34.6% of its business during

2006, did transfer sufficient risk of loss. And Mr. Barrett

acknowledged that the FASB policies, which respondent

views most skeptically, transferred to RVIA ‘‘some amount of

risk.’’ As he explained, this was necessarily the case because

lessors purchased FASB policies in order to obtain direct

financing lease accounting, which requires the lessor to shift

to the insurer a sufficient level of risk with respect to the

12 The Risk Transfer Testing Practice Note, cited in the text, was origi-

nally issued in the reinsurance context. However, the evidence at trial es-

tablished that practitioners regularly apply its principles to direct insur-

ance as well. Under this principles-based standard, risk transfer is charac-

terized as ‘‘reasonably self-evident’’ when: (i) potential loss under the

agreement is much greater than the premium, (ii) the agreement contains

standardized terms and conditions typical for the type of coverage, and (iii)

the agreement does not include impermissible provisions regarding rein-

surance.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 227

guaranteed portion of the residual value. See Statement of

Financial Accounting Standards No. 13.

The thrust of respondent’s position is that the RVI policies

did not transfer enough risk of loss because losses were rel-

atively unlikely to occur. This argument is unpersuasive on

both theoretical and evidentiary grounds. Both parties’

experts analogized the RVI policies to ‘‘catastrophic’’ insur-

ance coverage, which insures against earthquakes, major

hurricanes, and other low-frequency, high-severity risks. An

insurer may go many years without paying an earthquake

claim; this does not mean that the insurer is failing to pro-

vide ‘‘insurance.’’ Mr. Barrett acknowledged that, under

many catastrophic coverages, the odds of a loss occurring

may be quite low. He was aware of no instance in which an

insurance regulator had determined that the risk of loss on

a policy of direct insurance was too ‘‘remote’’ for the product

to be treated as ‘‘insurance.’’ And respondent offers no plau-

sible metric by which a court could make this assessment.

In opining that insufficient risk of loss was transferred to

RVIA, respondent’s experts relied on the fact that, as of year

end 2006, many of RVIA’s policies had experienced no losses.

But in computing a ‘‘loss ratio’’ of zero for these policies,

respondent’s experts committed a methodological error.

Whereas RVIA received all premiums at policy inception, a

loss could occur only upon lease termination; many of its

policies in force at year end 2006 had 3, 5, or 25 years to run.

By definition, no loss could possibly have occurred under

such policies as of year end 2006, but major losses could (and

did) occur subsequently. The absence of losses prior to 2007,

therefore, was not a logical basis upon which to ground an

opinion that petitioner had assumed no meaningful risk of

loss under these policies. Mr. Cook ultimately conceded this

error, acknowledging that his method of computing loss

ratios systematically understated the true extent of peti-

tioner’s losses.

RVIA’s actual loss experience demonstrates that it bore a

significant risk of loss. From inception through 2006, RVIA’s

cumulative loss ratio was about 28%; from inception through

2013, its cumulative loss ratio was about 34%. As one would

expect with catastrophic-type coverage, RVIA’s loss ratio in

some years was extremely low. But in other years it was as

high as 49%, 64%, and (during the 2008 financial crisis) 98%.

228 145 UNITED STATES TAX COURT REPORTS (209)

On an absolute dollar basis, RVIA paid more than $150 mil-

lion in claims through 2013. Even if we consider only the

FASB policies, the segment on which respondent’s experts

focus, RVIA paid more than $28 million in claims through

2013. All in all, we conclude that the level of risk transferred

to RVIA under these policies was more than sufficient to

treat them as ‘‘insurance contracts’’ for Federal income tax

purposes.

B. Risk Distribution

From the insurer’s perspective, insurance is a risk-distribu-

tion device, that is, a mechanism by which the insurer pools

multiple risks of multiple insureds in order to take advan-

tage of ‘‘the law of large numbers.’’ This statistical phe-

nomenon is reflected in the financial world by the diversifica-

tion of investment portfolios. It is embodied in the day-to-day

world by the adage, ‘‘Don’t put all your eggs in one basket.’’

Clougherty Packing Co. v. Commissioner, 811 F.2d 1297,

1300 (9th Cir. 1987), aff ’g 84 T.C. 948 (1985).

Many insureds who pay premiums will not incur losses.

Insuring many independent risks in return for numerous

premiums thus serves to distribute risk, in effect spreading

a portion of the insurer’s potential liability among his

insureds. See Black Hills Corp., 101 T.C. at 183; Harper

Grp., 96 T.C. at 59; AMERCO, 96 T.C. at 40–41. Distributing

risk allows the insurer to reduce the possibility that a single

costly claim will exceed the amount taken in as a premium

and set aside for the payment of that claim.

RVIA insured a vast array of different risk exposures.

During 2006 it had 951 policies in force covering 714 dif-

ferent insured parties. Besides being spread among

numerous unrelated insureds, its risks were distributed in at

least four ways: across business segments (passenger vehicle,

commercial equipment, and real estate), across asset types

within each segment, across geographic locations (for real

estate), and across lease duration.

RVIA’s policies during 2006 covered 754,532 passenger

vehicles, 2,097 individual real estate properties, and

1,387,281 commercial equipment assets. The passenger

vehicles comprised 20 different types of automobile (including

pickup trucks, sedans, SUVs, and sports cars) and approxi-

mately 50 different vehicle models. The commercial real

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 229

estate comprised 15 different types of properties (including

retail stores, warehouses, industrial buildings, office

buildings, and motels) in seven different geographic regions.

And the commercial equipment comprised 30 different types

of equipment, including aircraft, rail cars, construction equip-

ment, and shipping containers.

Petitioner’s insured assets were also distributed across

lease terms. The policies in effect during 2006 covered assets

with lease terms ranging from 1 to 28 years. Even within the

same business segment, an event (like a real estate crash)

could cause losses for some insureds yet have no adverse

impact on RVIA with respect to leases terminating many

years later. This temporal distribution reduced petitioner’s

risk because it meant that the assets it insured would be

exposed to different loss-causing events occurring at different

times. 13

Respondent’s expert Mr. Cook acknowledged that peti-

tioner achieved pooling, diversification, and distribution of

risk. His report made a very limited claim, namely, that the

risk-distribution benefits petitioner enjoyed were ‘‘less than

is usual for an insurer.’’ By the end of his testimony, how-

ever, he expressly acknowledged that he was not raising the

absence of risk distribution as a reason why RVIA’s policies

fail to qualify as ‘‘insurance.’’

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 cer-

tain 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

13 Respondent’s expert Mr. Cook explained: ‘‘[T]he passage of time has a

significant effect on depreciation rates and market effects, and the periods

of time are even longer on commercial equipment and real estate. The time

spread is a valuable part of the diversification. * * * It’s one of the

reason[s] we didn’t find the diversification to be so inferior as to not be in-

surance. * * * [T]he temporal distribution was one of the good things we

saw.’’

230 145 UNITED STATES TAX COURT REPORTS (209)

like restrictive building codes. Indeed, even systemic risks

like major recessions were mitigated by the temporal dis-

tribution of RVIA’s risks over lease terms as long as 28

years.

Many insurers face systemic risks. Mortgage guaranty

insurance, municipal bond insurance, and financial guaranty

insurance all provide coverage against risk of loss attrib-

utable to adverse macro-economic conditions, such as reces-

sions, high unemployment, high interest rates, or seizing up

of credit markets. As Professor Angelina noted, some mort-

gage guaranty insurers during 2008–2009 ‘‘were not able to

recover from their systemic failure,’’ yet respondent concedes

that the product these companies offer is ‘‘insurance.’’ RVIA

adequately distributed systemic risks, as other providers of

catastrophic coverage do, by spreading its risks temporally,

geographically, and across asset classes.

The legal requirement for ‘‘insurance’’ is that there be

meaningful risk distribution; perfect independence of risks is

not required. See Rent-A-Center, Inc. & Subs. v. Commis-

sioner, 142 T.C. 1, 24 (2014) (‘‘Risk distribution occurs when

an insurer pools a large enough collection of unrelated risks

(i.e., risks that are generally unaffected by the same event or

circumstance’’).); Harper Grp., 96 T.C. at 55, 59–60 (finding

sufficient risk distribution where insurer insured numerous

unrelated insureds even though the risks ‘‘were not statis-

tically independent * * *, but rather were highly cor-

related’’); Gulf Oil Corp., 89 T.C. at 1025 n.9 (stating that

sufficient risk distribution may exist if risks are independent

‘‘to some minimum extent’’). We have no difficulty con-

cluding, as respondent’s expert Mr. Cook ultimately did, that

the RVI policies accomplish sufficient risk distribution to be

classified as ‘‘insurance’’ for Federal tax purposes. 14

14 Respondent errs in contending that the ‘‘pooling’’ provisions of certain

RVI policies negate risk distribution. These pooling provisions simply ag-

gregate covered exposures; they do not negate risk distribution among the

covered insureds. Equally erroneous is respondent’s contention that RVIA’s

‘‘deferred premium’’ provisions negate risk distribution. The deferred por-

tion of the premium acted like a deductible; RVIA still collected the bal-

ance of the premium, which could be used to pay claims of other insureds.

In any event, as Mr. Cook noted, fewer than 24 of RVIA’s 951 policies in

force during 2006 provided for deferred premiums.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 231

C. Commonly Accepted Notions of Insurance

As the Supreme Court has observed, the absence of a

statutory definition of ‘‘insurance’’ from the Internal Revenue

Code ‘‘strengthens the assumption that Congress used the

word ‘insurance’ in its commonly accepted sense.’’ Le Gierse,

312 U.S. at 540; see AMERCO, 96 T.C. at 38. To determine

whether an arrangement constitutes insurance in its com-

monly accepted sense, we have considered such factors as: (1)

whether the insurer is organized, operated, and regulated as

an insurance company by the States in which it does busi-

ness; (2) whether the insurer is adequately capitalized; (3)

whether the insurance policies are valid and binding; (4)

whether the premiums are reasonable in relation to the risk

of loss; and (5) whether premiums are duly paid and loss

claims are duly satisfied. See Harper Grp., 96 T.C. at 60;

Securitas Holdings, Inc. v. Commissioner, T.C. Memo. 2014–

225, at *27.

The first factor has particular significance because ‘‘Con-

gress has delegated to the states the exclusive authority

(subject to exception) to regulate the business of insurance.’’

AMERCO, 96 T.C. at 42 (citing the McCarran-Ferguson Act,

59 Stat. 33, as amended, 15 U.S.C. secs. 1011–1015 (1998)).

We have repeatedly emphasized the significance of State

insurance regulation in determining whether an entity

should be recognized as an ‘‘insurance company.’’ See Sears,

Roebuck & Co. v. Commissioner, 96 T.C. 61, 101 (1991), aff ’d

in part, rev’d in part, 972 F.2d 858 (7th Cir. 1992); Harper

Grp., 96 T.C. at 60; AMERCO, 96 T.C. at 42; Securitas

Holdings, T.C. Memo. 2014–225, at *5–*6. It is undisputed

that RVIA was organized, operated, and regulated as an

‘‘insurance company’’ by every State in which it did business,

and that RVIG was organized, operated, and regulated as an

‘‘insurance company’’ by its country of domicile, Bermuda.

The RVI policies likewise satisfy the other factors we have

deemed relevant. RVIA and RVIG met the minimum capital

requirements of their respective regulators, and both were

adequately capitalized. The RVI policies were valid and

binding: when covered losses occurred, the insureds filed

claims and RVIA paid those claims, amounting to $150 mil-

lion through 2013. The premiums charged were negotiated at

arm’s length between RVIA and its various insureds, none of

232 145 UNITED STATES TAX COURT REPORTS (209)

which was related to petitioner by ownership. The RVI poli-

cies took the form of insurance and contained standard provi-

sions typical of insurance policies generally, including the

requirement of an ‘‘insurable interest.’’ See Allied Fid. Corp.

v. Commissioner, 572 F.2d 1190, 1193 (7th Cir. 1978)

(requiring the insured to have an ‘‘insurable interest’’ in the

covered assets), aff ’g 66 T.C. 1068 (1976).

Respondent does not seriously challenge any of these

points. Rather, he argues that the RVI policies do not qualify

as insurance because they differ in certain respects from

insurance policies with which most people are familiar. First,

he notes that RVI policies do not pay immediately upon the

happening of a ‘‘fortuitous event,’’ like a car crash, but upon

a contract’s reaching its termination date. But the fact that

a loss must persist to the end of a lease term does not make

the events that cause the loss—recessions, interest rate

spikes, or bank failures—any less random or fortuitous. The

payment terms of the RVI policies are dictated by the under-

lying business transaction: RVIA is insuring against loss

under a lease, and whether a loss has occurred cannot be

known until the lease ends. This feature of the RVI policies,

while perhaps atypical, does not impugn their status as

‘‘insurance.’’ See Commissioner v. Treganowan, 183 F.2d 288,

291 (2d Cir. 1950) (contract may qualify as ‘‘life insurance’’

even though it lacks standard features of many life insurance

policies), rev’g 13 T.C. 159 (1949); G.C.M. 39,154 (September

20, 1983) (‘‘[D]espite the fact that the surety bonds written

by the taxpayer possess certain unique characteristics not

shared by many other types of insurance contracts, they

nevertheless, constitute ‘insurance contracts’ for purposes of

subchapter L[.]’’).

Respondent’s insistence that ‘‘[f]ortuity is essential for

* * * risk pooling and the law of large numbers’’ 15 betrays

the narrow and esoteric sense in which he employs the term

‘‘fortuity.’’ As we have explained previously, losses under RVI

policies are caused by fortuitous events outside of its control.

15 Respondent appears to base this argument, not on the testimony of his

expert witnesses, but on a passage in a scholarly article published in 2003.

See Edward D. Kleinbard, ‘‘Competitive Convergence in the Financial

Services Markets,’’ 81 Taxes 225, 238 (2003). We do not read Professor

Kleinbard as using the term ‘‘fortuity’’ in the narrow sense urged by re-

spondent.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 233

And its policies clearly do pool risks to take advantage of the

law of large numbers. Indeed, as Professor Angelina

explained, the fact that losses under RVI policies occur only

upon lease termination actually enhances risk pooling by

‘‘enabl[ing] RVI to avoid a ‘run on the bank’ scenario in

extreme economic downturns.’’ Reduced to its essentials,

respondent’s argument is that a loss is ‘‘fortuitous’’ only if

payment occurs immediately or shortly after the loss-causing

event occurs. Respondent cites no authority for the propo-

sition that this feature is an essential ingredient of ‘‘insur-

ance’’ for State regulatory purposes or for Federal income tax

purposes.

Respondent next argues that RVI policies fail to satisfy

what he calls ‘‘the timing risk requirement.’’ Under typical

casualty policies, respondent notes, ‘‘claims are triggered by

an insurable event that is uncertain as to if and when it may

occur.’’ By contrast, a loss under an RVI policy will occur (if

at all) at lease termination, a date that both parties know in

advance.

This argument is really a different way of phrasing

respondent’s previous argument, and it is unpersuasive for

the same reasons. RVIA is in fact subject to an array of

timing risks—e.g., whether a recession, oil price rise, or other

loss-causing event will occur before or after a particular lease

expires. It is uncertain under RVI’s policies, as under insur-

ance policies generally, whether or when these fortuitous

events will occur. The only uncertainty absent from RVI’s

policies is the date on which it will be determined whether

a loss has occurred. But as noted previously, this is simply

a function of the underlying business transaction.

Until lease termination, the lessee possesses the covered

asset and makes lease payments. It is not until the property

is returned to the lessor, with a value below the expected

residual value, that the lessor realizes a concrete economic

loss. As Mr. Miccolis explained at trial: ‘‘[T]he lessor doesn’t

have a loss, doesn’t have a financial impact until the prop-

erty is turned in at the end of the lease.’’ Because the eco-

nomic loss does not materialize until lease termination, it is

neither noteworthy nor odd that RVI defers payment of

claims until that time.

Municipal bond insurance operates similarly. The bond

issuer may seek bankruptcy protection long before the matu-

234 145 UNITED STATES TAX COURT REPORTS (209)

rity date of the covered bond, but the bond insurer does not

pay immediately upon the happening of that ‘‘fortuitous

event.’’ Rather, the insurer pays for loss of interest on the

covered bond only at the interest due date, and it pays for

loss of principal only at the bond’s scheduled maturity date.

See, e.g., Oppenheimer AMT-Free Muns. v. ACA Fin. Guar.

Corp., 971 N.Y.S.2d 95, 97–99 (App. Div. 2013). As under

RVI policies, therefore, a loss-causing event may occur at any

time during the policy term, yet the insurer is obligated to

pay loss claims only at specified dates that are known both

to insurer and insured in advance. Despite the absence of

what respondent would call ‘‘timing risk,’’ the Internal Rev-

enue Code provides that municipal bond insurance policies

can qualify as ‘‘insurance’’ for Federal income tax purposes.

See sec. 832(e)(6). We see no reason why residual value

insurance should be treated differently.

Finally, respondent notes that some RVI policies call for

nonrefundable premiums, a feature respondent regards as

atypical of insurance policies generally. But this feature, like

the payment terms discussed previously, is an outgrowth of

the underlying business transaction. An RVI policy will pay

out, if at all, only upon lease termination. In certain cir-

cumstances—for example, if inflation develops during a long-

term lease—the lessor may become confident that the

residual value of his leased asset will exceed its insured

value at lease termination. To prevent the insured from

taking a self-serving ‘‘wait and see’’ attitude in this setting,

RVIA may rationally choose to disallow premium refunds

upon mid-stream policy cancellations. This type of pricing

decision does not preclude the RVI policies from constituting

‘‘insurance’’ for Federal income tax purposes. 16

In sum, we find that the RVI policies give rise to insurance

‘‘in its commonly accepted sense.’’ Le Gierse, 312 U.S. at 540.

We agree with respondent that these policies have unique

features, but these features correspond to, and are driven by,

the characteristics and business needs of the underlying

leasing transactions. We do not see why an insurer’s tai-

loring its policy terms to the risks it undertakes to insure

16 The IRS has recognized that there are other types of insurance, such

as surety insurance, for which the policy may be made noncancellable and

for which the premium therefore is nonrefundable. See G.C.M. 39,154.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 235

should prevent its policies from qualifying as ‘‘insurance.’’

The arrangements between RVIA and its insureds ‘‘are

characterized as insurance for essentially all nontax purposes

* * * [and a] special rule for tax purposes is not justified by

either statute or case law.’’ Sears, Roebuck, 96 T.C. at 101.

D. Insurance Risk

Though we have often noted that insurance presupposes

‘‘insurance risk,’’ our precedents shed little light on the con-

tours of the latter term. We have said 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.’’ Black

Hills Corp., 101 T.C. at 182. Many of our prior cases involved

captive insurance arrangements in which the casualty risks

involved were indisputably ‘‘insurance risks.’’ Thus, while

reciting that ‘‘ ‘[i]nsurance risk’ is required’’ and ‘‘investment

risk is insufficient,’’ AMERCO, 96 T.C. at 39, our precedents

do not comprehensively explain how to distinguish the one

from the other.

In ascertaining whether the risk covered by the RVI poli-

cies is an ‘‘insurance risk,’’ we will examine the arrangement

‘‘from the perspective of both the insured and the insurer.’’

Harper Grp., 96 T.C. at 57. The Supreme Court undertook

the former inquiry in Le Gierse, where an 80-year-old woman

purchased an annuity contract bundled with a single pre-

mium life insurance policy. The insured died one month later

and her estate claimed that the life insurance proceeds were

exempt from estate tax under section 302 of the Revenue Act

of 1926, 44 Stat. at 70. The Court sustained the IRS’ chal-

lenge to that claim.

Noting that the term ‘‘insurance’’ was defined neither by

statute nor by regulation, the Court reasoned that ‘‘the

amounts must be received as the result of a transaction

which involved an actual ‘insurance risk’ at the time the

transaction was executed.’’ Le Gierse, 312 U.S. at 538–539.

Considering the annuity and life insurance contracts

together, the Court found that they ‘‘wholly fail to spell out

any element of insurance risk’’ because ‘‘annuity and insur-

ance are opposites; in this combination the one neutralizes

the risk customarily inherent in the other.’’ Id. at 541.

236 145 UNITED STATES TAX COURT REPORTS (209)

Because ‘‘the total consideration was prepaid and exceeded

the face value of the ‘insurance’ policy,’’ the only risk effec-

tively present from the company’s viewpoint ‘‘was an invest-

ment risk similar to the risk assumed by a bank.’’ Id. at

542. 17

In the instant case, the RVI policies clearly involved, from

the insurer’s perspective, an ‘‘insurance risk’’ rather than a

financial risk of the sort assumed by a bank. As Professor

Angelina explained, RVIA was at risk for ‘‘significant under-

writing losses that were not related to [its] investment

returns.’’ Depending upon the occurrence of fortuitous events,

RVIA’s loss under a contract could vary from zero to the full

insured value. Because the premium it charged was rarely

more than 4% of the insured value, it was clearly exposed to

underwriting risk, namely, the risk that the premiums

charged would not be enough to cover claims paid. In con-

trast to Le Gierse, petitioner’s business model depended not

simply on its investment returns, but on the ability of its

underwriters to price adequately the residual value risks

borne by its insureds in order to derive a sufficient pool of

premiums to cover the aggregate insured losses. This is the

same pricing risk assumed by insurance companies gen-

erally.

Respondent nevertheless contends that the RVI policies do

not involve ‘‘insurance risk’’ from the perspective of the

insured party. In respondent’s view, the lessors and finance

companies purchased the RVI policies to protect themselves

against investment losses, namely, greater-than-expected

decline in the market value of the assets they owned and

leased. Respondent analogizes this behavior to a stock inves-

tor’s purchase of a put option, which enables him to ‘‘put’’ the

stock to another investor if the stock falls below a specified

price before a specified date. From the insured’s standpoint,

therefore, respondent asserts that the RVI policies involve no

‘‘insurance risk,’’ but simply an ‘‘investment risk.’’ See Black

Hills Corp., 101 T.C. at 182.

17 In the companion case of Keller v. Commissioner, 312 U.S. 543, 545

(1941), the Court likewise found no ‘‘insurance risk’’ where the only risk

borne by the insurer was the risk of computational error or the ‘‘risk that

the funds might not earn enough to cover profitably the annuity payable

to the decedent.’’

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 237

We find this argument unpersuasive for several reasons.

For more than 80 years, the States have regulated as ‘‘insur-

ance’’ contracts that provide coverage against decline in the

market values of particular assets. In 1933 the Pennsylvania

Supreme Court held that an insurer’s indemnification

against loss from a decline in value of real estate involved an

insurance risk. See Commonwealth ex rel. Schnader v. Fid.

Land Value Assur. Co., 167 A. 300, 301 (Pa. 1933). The

insurance company there ‘‘insure[d] against a well-known

risk, to which all landowners are subject, depreciation from

the price paid.’’ Ibid. The company argued that it ‘‘makes

contracts merely to buy real estate, and that such contracts

are not insurance.’’ Id. at 302. The court rejected this argu-

ment, holding that the company ‘‘was clearly engaged in the

business of insurance’’ in providing its guaranty against

decline in the value of property. See id. at 303. ‘‘An insurer

guarantees against loss by an event that may or may not

happen. The event specifically contemplated here * * * is

depreciation in value of certain land below the price paid; the

loss to be indemnified is the amount of that depreciation.’’ Id.

at 302.

New York and Connecticut have by statute defined

residual value policies as a form of ‘‘insurance’’ since 1989.

See N.Y. Ins. Law secs. 1102, 1113(a)(22) (McKinney 2015);

Conn. Gen. Stat. Ann. sec. 38a–92a (West 2012). In 1991 the

Washington Supreme Court reached the same conclusion. See

Seattle-First Nat’l Bank v. Washington Ins. Guar. Ass’n, 804

P.2d 1263 (Wash. 1991). The State of Washington had estab-

lished an insurance guaranty fund to compensate policy-

holders in the event of insolvency of an insurance company

providing insurance coverage. The question was whether con-

tracts that ‘‘compensate[d] a lessor for a drop in the market

value of its leased vehicles’’ constituted ‘‘insurance,’’ thus

enabling policyholders to recover from this fund losses caused

by the insurer’s insolvency. Id. at 1269.

The court held that the residual value policies constituted

‘‘casualty insurance,’’ which the Washington statute defined

to include insurance ‘‘[a]gainst any other kind of loss * * *

properly the subject of insurance.’’ Id. at 1267–1269 (citing

Washington Revenue Code Annotated section 48.11.070). By

concluding that residual value policies cover a risk of loss

that is ‘‘properly the subject of insurance,’’ the Washington

238 145 UNITED STATES TAX COURT REPORTS (209)

Supreme Court necessarily determined that such policies

involve ‘‘insurance risk.’’ Accord Wells Fargo Credit Corp. v.

Arizona Prop. & Cas. Ins. Guar. Fund, 799 P.2d 908, 910

(Ariz. Ct. App. 1990) (concluding that policies ‘‘guarantee[ing]

that Wells Fargo would receive a fixed value for its leased

autos at the termination of the lease’’ constituted ‘‘casualty

insurance’’ under Arizona law).

Consistently with this State law precedent, petitioner’s

regulators and external auditors have uniformly concluded

that its policies involve ‘‘insurance risk.’’ RVIA was incor-

porated as an insurance company in Connecticut in 1994 and

has been continuously licensed to conduct the business of

insurance by its domicile and by all other States in which it

transacts business. Because RVIA sells ‘‘insurance,’’ it is

required to pay to these States insurance premium taxes

(which it has paid) and to meet minimum solvency require-

ments (which it has met).

During 2006 RVIA was required to file statutory financial

statements prepared in accordance with SAP. These rules

forbid an insurer in its statutory financial statements to

treat a contract as ‘‘insurance’’ unless the insurer assumes a

significant risk under the contract and faces a reasonable

possibility of incurring a significant loss. See SSAP 62R. By

issuing an unqualified opinion that RVIA’s statutory finan-

cial statements were fairly stated under SAP, its external

auditor agreed that it bore a significant ‘‘insurance risk.’’ The

Connecticut Insurance Department examined RVIA’s 2006

statutory financial statements for compliance with SAP and

agreed with this assessment. As Professor Angelina noted, if

there had been no underwriting or insurance risk, ‘‘I would

expect the various reports to have highlighted this issue.

This has been my past experience with the large accounting

firms and regulatory agencies.’’

As noted earlier, Congress generally has delegated to the

individual States the authority to regulate the business of

insurance. See McCarran-Ferguson Act, Pub. L. No. 79–15,

59 Stat. 33 (1945) (codified as amended at 15 U.S.C. secs.

1011–1015 (2006)); Barnett Bank of Marion Cty., N.A. v. Nel-

son, 517 U.S. 25, 40 (1996) (‘‘Congress ‘moved quickly,’

enacting the McCarran-Ferguson Act ‘to restore the

supremacy of the States in the realm of insurance regula-

tion.’ ’’ (quoting Dep’t of Treasury v. Fabe, 508 U.S. 491, 500

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 239

(1993))). State courts and State regulators have consistently

recognized as ‘‘insurance’’ residual value policies issued, not

only by RVIA, but also by AIG, Chubb Group, ACE Group,

Royal Insurance Company of America, and other well-estab-

lished insurance companies. The uniform conclusion of State

insurance regulators that the RVI policies involve ‘‘insurance

risk,’’ while ‘‘not dispositive of the issue before us, * * *

[does] inform our decision.’’ AMERCO, 96 T.C. at 42.

Against this consensus of insurance regulators, insurance

auditors, and the insurance marketplace, respondent offers

Dr. Baranoff’s opinion that the RVI policies are not ‘‘insur-

ance’’ because they do not cover a ‘‘pure risk.’’ According to

Dr. Baranoff, ‘‘pure risk’’ exists only in a binary situation

where the only possible outcomes are ‘‘loss’’ or ‘‘no loss.’’ A

lessor who buys an RVI policy, she notes, has the potential

to enjoy a gain on the underlying leasing transaction, e.g., if

the leased assets appreciate rather than depreciate in

value. 18 In her view, the RVI policies thus protect the

insured, not from an ‘‘insurance risk,’’ but from a ‘‘specula-

tive’’ or market risk. Respondent invites us to adopt this

‘‘pure risk’’ test as a bright-line rule to demarcate ‘‘insurance

risk’’ from ‘‘investment risk.’’

We decline this invitation. In support of her theory that

‘‘pure risk’’ is the only possible subject of ‘‘insurance,’’ Dr.

Baranoff relies, not on actual experience with the insurance

market, but on citations from textbooks designed for college

business students. While these authors note the distinction

between ‘‘pure risk’’ and other types of risk, they do not sup-

port her contention that ‘‘pure risk’’ is the only possible sub-

ject of ‘‘insurance.’’ Rather, they state (correctly) that insur-

ance is ‘‘generally’’ or ‘‘normally’’ targeted to pure risks. 19 In

18 While the covered assets could conceivably appreciate in value from

lease inception, RVIA would never pay a claim in that event. The RVI poli-

cies indemnified the insured against economic loss if the actual residual

value of the asset at lease expiration was less than its insured value. RVIA

did not insure against reduction in value attributable to normal wear and

tear and did not cover the initial layer of an insured’s loss. In short, RVIA

would pay a claim, as a fire insurance company would pay a claim, only

where the insured had suffered a sizable economic loss. This is important

because insurance generally acts only to indemnify the insured. See

Epmeier v. United States, 199 F.2d 508 (7th Cir. 1952).

19 See Mark S. Dorfman, Introduction to Risk Management and Insur-

Continued

240 145 UNITED STATES TAX COURT REPORTS (209)

a later edition of his text, which Dr. Baranoff does not cite,

Professor Rejda notes that while insurers ‘‘generally con-

centrate’’ on insuring pure risk, there are ‘‘certain excep-

tions.’’ ‘‘Some insurers,’’ he explains, ‘‘will insure institutional

portfolio investments and municipal bonds against loss.’’

Rejda & McNamara, supra, at 5. Other scholars describe the

difference between ‘‘pure risks’’ and ‘‘speculative risks’’ as

‘‘[t]o a large extent * * * semantic,’’ concluding that

‘‘[n]othing in the nature of speculative risk unequivocally

precludes the writing of insurance.’’ C. Arthur Williams, Jr.,

Michael L. Smith, & Peter C. Young, Risk Management and

Insurance 8, 384 (8th ed. 1998).

Confronted on cross-examination with the statements of

insurance scholars that insurance can cover speculative

risks, Dr. Baranoff insisted that those statements are actu-

ally consistent with her view that insurance covers ‘‘pure

risk’’ only. She dismissed Professor Rejda’s most recent state-

ment to the contrary as ‘‘an uncarefully written sentence.’’ In

the end, Dr. Baranoff was unable to explain how her view

lined up with those of the authors she cited, and we found

her testimony unpersuasive.

During trial and in post-trial briefs, the parties and their

experts extensively cited two standard treatises on insurance

law, 1 Couch on Insurance 3d (2015) and The New Appleman

on Insurance Law (2015). Neither of these treatises uses the

term ‘‘pure risk’’ when defining the meaning of ‘‘insurance’’

at common law. Judicial precedent likewise suggests no

limitation that would restrict ‘‘insurance’’ to the binary situa-

tion of ‘‘loss or no loss.’’ Most cases require only that the

insured shift to the insurer the risk from a ‘‘hazard,’’ a ‘‘spe-

ance 8 (8th ed. 2005) (‘‘Most speculative loss exposures are not subject to

insurance.’’ (Emphasis added.)); Scott E. Harrington & Gregory R.

Niehaus, Risk Management and Insurance 6–7 (1999) (‘‘Insurance con-

tracts generally are not used to * * * finance losses associated with price

risks.’’ (Emphasis added.)); George E. Rejda, Principles of Risk Manage-

ment and Insurance 6 (8th ed. 2003) (‘‘[P]rivate insurers generally insure

only pure risks * * * [and] speculative risks generally are not considered

insurable.’’ (Emphasis added.)); Emmett Vaughan & Therese Vaughan,

Fundamentals of Risk and Insurance 6–7 (11th ed. 2014) (‘‘The distinction

between pure risk and speculative risks is an important one because nor-

mally only pure risks are insurable.’’ (Emphasis added.)).

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 241

cific contingency,’’ or some ‘‘direct or indirect economic

loss.’’ 20

Respondent’s ‘‘pure risk’’ position lacks practical as well as

theoretical support, for if we accepted his submission several

familiar types of insurance would seem to be disqualified as

such. As early as 1932, the Supreme Court held that mort-

gage guaranty insurance constitutes ‘‘insurance’’ for Federal

income tax purposes. See United States v. Home Title. Ins.

Co., 285 U.S. 191, 195 (1932) (‘‘The guaranty of payment of

the principal and interest of mortgage loans constitutes

insurance.’’); Bowers v. Lawyers’ Mortg. Co., 285 U.S. 182,

189 (1932) (‘‘Undoubtedly the guaranties contained in the

policies and participation certificates were in legal effect con-

tracts of insurance.’’). The Internal Revenue Code explicitly

recognizes both ‘‘mortgage guaranty insurance’’ and ‘‘lease

guaranty insurance’’ as ‘‘insurance’’ for Federal income tax

purposes. See sec. 832(b)(1)(E), (c)(13), (e)(3) (specifying rules

for computation of ‘‘insurance company taxable income’’ by ‘‘a

company which writes mortgage guaranty insurance’’); sec.

20 See, e.g., Epmeier, 199 F.2d at 510 (noting that insurer indemnifies in-

sured ‘‘against loss arising from certain specified contingencies or perils’’);

Black Hills Corp., 101 T.C. at 182 (noting that insurer agrees ‘‘to perform

some act if and when * * * [a specified] hazard occurs’’); AMERCO, 96

T.C. at 38 (noting that insured ‘‘faces some hazard’’ and insurer agrees ‘‘to

perform some act if or when the loss event occurs’’); Allied Fidelity Corp.,

66 T.C. at 1074 (defining insurance as an agreement to protect insured

‘‘against a direct or indirect economic loss arising from a defined contin-

gency’’). A few of our cases have found as a fact that ‘‘pure risk’’ existed

in a particular case, or have summarized expert testimony noting that in-

surance typically covers ‘‘pure risk.’’ See Sears, Roebuck, 96 T.C. at 65, 92–

93; AMERCO, 96 T.C. at 33–34; Humana Inc. v. Commissioner, 88 T.C.

197, 209 (1987), aff ’d in part, rev’d in part, 881 F.2d 247 (6th Cir. 1989).

In none of these cases were we asked to decide whether ‘‘pure risk’’ is the

only possible subject of ‘‘insurance’’ for Federal income tax purposes or to

determine whether a particular contract failed to qualify as ‘‘insurance’’ be-

cause it provided coverage for something other than a ‘‘pure risk.’’ In

AMERCO, 979 F.2d at 167, the Court of Appeals for the Ninth Circuit re-

butted one of the IRS’ arguments by stating that insurance risk exists

where ‘‘[t]he only possible outcomes are loss or no loss.’’ That statement

was dictum because the existence of ‘‘insurance risk’’ was not at issue in

AMERCO. The Ninth Circuit affirmed our Court’s finding of fact that

‘‘there was an insurance risk involved’’ because ‘‘the AMERCO Group un-

doubtedly faced potential hazards from its operations which constituted in-

surable risks.’’ Id. at 165.

242 145 UNITED STATES TAX COURT REPORTS (209)

832(e)(6) (same, for ‘‘a company which writes lease guaranty

insurance’’).

Mortgage guaranty insurance protects a mortgage lender

from the risk that his collateral may decline in value and be

insufficient to cover the remaining loan balance in the event

of foreclosure. Residual value and mortgage guaranty insur-

ance thus cover substantially the same risk: unexpected

decline in the market value of the insured’s interest in prop-

erty. As Mr. Miccolis explained, both forms of insurance ‘‘pro-

vide protection against a contingent financial loss arising out

of a financial transaction which is caused by an unexpected

decline in the value of property after coverage begins.’’ The

two types of insurance, he noted, involve risks and risk

characteristics that ‘‘are comparable with respect to sub-

stance, causation, events, conditions, and financial impact.’’

In both cases, the value of the covered assets may be

adversely affected by fortuitous events specific to the par-

ticular property as well as by macro-economic conditions

such as interest rates, unemployment, inflation, deflation,

and unstable credit markets. These are the same risk expo-

sures that Dr. Baranoff cites in support of her position that

the RVI policies cover an uninsurable ‘‘speculative risk.’’

Municipal bond insurance, which gained prominence in the

United States during the 1970s, likewise provides coverage

against speculative risk. See generally 120 Cong. Rec. 28114,

28115 (1974). The Internal Revenue Code explicitly recog-

nizes municipal bond insurance as ‘‘insurance’’ for Federal

income tax purposes. See sec. 832(e)(6) (specifying rules for

computation of ‘‘insurance company taxable income’’ by ‘‘a

company which writes * * * insurance on obligations the

interest on which is excludable from gross income under sec-

tion 103’’). This form of insurance protects the bondholder

against loss of profit on his investment by guaranteeing that

he will receive payment of interest and repayment of prin-

cipal if the issuer fails to pay. As in the case of residual

value insurance, the insured does not face a binary situation

of ‘‘loss or no loss,’’ but has the possibility of gain or loss on

his bond investment. And losses under municipal bond poli-

cies, as under mortgage guaranty and residual value policies,

may be linked to macro-economic factors as well as factors

specific to the particular insured asset.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 243

Respondent insists that these two types of coverage differ

from residual value coverage in terms of the ‘‘triggering

event.’’ Under a mortgage guaranty policy, for example, the

insurer’s payment obligation is triggered by the homeowner’s

default, which respondent views as a random and ‘‘fortu-

itous’’ event. Because default is ‘‘an occurrence from which

the insured cannot profit,’’ respondent views mortgage guar-

anty coverage as involving ‘‘pure risk’’ even though the collat-

eral securing the loan (a home) represents an investment

that can rise or fall in value. Under a residual value policy,

by contrast, the event that triggers the insurer’s payment

obligation is simply a decline in the value of the insured

property as of a certain date, namely, lease expiration.

We think respondent is confusing the events that may

trigger a payment obligation with the events that actually

cause the loss. The homeowner’s default does not necessarily

cause a loss; if the homeowner defaults because he has

become unemployed, but the home is worth substantially

more than the outstanding mortgage balance, the mortgagee

upon foreclosure will experience no loss and will make no

claim on the insurer. Under mortgage guaranty insurance,

what actually causes the loss are the events responsible for

the decline in the value of the house that serves as collateral

for the loan. The same is true for residual value insurance.

In any event, we find respondent’s attempt to distinguish

between a ‘‘pure risk’’ and a ‘‘speculative risk’’ in this setting

essentially metaphysical in nature. The textbooks that Dr.

Baranoff cites describe municipal bond and mortgage guar-

anty insurance as covering ‘‘speculative risks,’’ even though

respondent insists that the triggering event is a ‘‘pure risk.’’

See, e.g., Rejda & McNamara, supra, at 5; S.S. Huebner, et

al., Property and Liability Insurance 366–367 (4th ed. 1996)

(describing municipal bond insurance as providing coverage

against speculative risk). Aristotle noted that there are at

least four distinct senses in which one thing may be said to

‘‘cause’’ another. Physics, bk. II, ch. 3. Respondent’s efforts to

split hairs by disentangling the causes of ‘‘loss’’ are philo-

sophically interesting. 21 But we do not think they carry

21 Onemight describe the homeowner’s default as the ‘‘but for’’ cause of

the mortgage guarantor’s loss, whereas the bursting of a national real es-

Continued

244 145 UNITED STATES TAX COURT REPORTS (209)

much weight in determining whether the RVI policies con-

stitute ‘‘insurance’’ for Federal income tax purposes.

Finally, respondent urges that we find the RVI policies to

entail mere ‘‘investment risk’’ by analogizing its policyholders

to investors who have purchased put options to protect their

stock. The problem with this argument is that the insureds

are not investors and the policies are not derivative products.

Investors invariably purchase stock in the hope that it will

appreciate in value, enabling them to sell the shares for a

capital gain. The assets petitioner insured are not invest-

ment assets; in the hands of the lessors or finance compa-

nies, they are ordinary business assets in the nature of

inventory or equipment. The insureds do not acquire these

assets expecting them to appreciate in value and be sold to

generate gain. To the contrary, the insureds typically expect

these assets to decline in value, but believe that they can

nevertheless be leased profitably if the lessor’s lease-pricing

formula works as expected.

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.

Analogizing the RVI policies to put options, moreover, is

little more than a simile. In the real world, put options are

typically settled for cash rather than by actual transfer of the

underlying shares. At a conceptual level, many insurance

products could be likened to put options. A mortgage guar-

anty policy, for example, could be said to give the policy-

holder the right to put the mortgage loan to the insurer

unless the insurer pays the insured the difference between

the remaining balance of the loan (the strike price) and its

value on the exercise date. Even a fire insurance policy could

be likened to a put on the fire-damaged house that is settled

by the insurer’s payment of the damage claim.

The parties agree that the RVI policies are not and cannot

be taxable for Federal income tax purposes as derivative

tate bubble might be the ‘‘efficient’’ cause.

(209) R.V.I. GUARANTY CO. & SUBS. v. COMMISSIONER 245

products. These policies were priced, sold, and regulated as

insurance products. For financial and securities regulatory

purposes, the policies cannot be treated as put options

because (among other reasons) they are regulated by the

States as ‘‘insurance.’’ See 17 C.F.R. sec. 1.3(xxx)(4)(i)(A)

(2014); id. sec. 240.3a69–1(a)(1).

The courts have long held that a product can be ‘‘insur-

ance’’ even though competing products exist in the financial

marketplace. In 1931 the Court of Appeals for the Second

Circuit rejected the argument that a mortgage guaranty con-

tract was not ‘‘insurance’’ because ‘‘banking corporations may

also sell mortgages with their guaranty.’’ Home Title Ins. Co.

v. United States, 50 F.2d 107, 111 (2d Cir. 1931) (concluding

that the State’s recognition and regulation of the issuer as an

insurance company ‘‘should turn the scales, if the question

hangs in doubt’’), aff ’d, 285 U.S. 191 (1932). And in 1933 the

Pennsylvania Supreme Court rejected the argument that a

contract guaranteeing the value of land could not be ‘‘insur-

ance’’ because it resembled ‘‘a real estate option.’’ See Fid.

Land Value Assur. Co., 167 A. at 302. When it comes to miti-

gating risk, there may be more than one way to skin the cat.

The existence of other strategies does not mean that the

strategy chosen is not ‘‘insurance’’ or that product purchased

involves no ‘‘insurance risk.’’ 22

For all these reasons, we reject respondent’s contention

that the RVI policies involve an uninsurable ‘‘investment

risk.’’ These policies were designed and marketed as insur-

ance products. Similar products were sold in the insurance

market by other major insurance companies. These policies

were undergirded by insurance strength ratings from the

major insurance rating agencies. For more than 80 years the

22 In Chief Counsel Advisory 201511021, 2015 WL 1094778 (Mar. 13,

2015), the IRS concluded that contracts under which a captive insurer in-

demnified its manufacturing affiliates against ‘‘loss of earnings’’ attrib-

utable to foreign currency swings did not constitute ‘‘insurance’’ for Federal

income tax purposes. The IRS noted, among other things, that the con-

tracts ‘‘provide[d] a reasonable approximation’’ of the loss suffered by the

affiliates, rather than ‘‘measur[ing] the actual loss suffered by the change

in exchange rate.’’ Cf. sec. 998 (providing for the tax treatment of certain

foreign currency transactions). We express no view on whether these con-

tracts would constitute ‘‘insurance’’ under the analysis set forth in this

Opinion.

246 145 UNITED STATES TAX COURT REPORTS (209)

courts have recognized that contracts insuring against the

risk that property will decline in value can involve ‘‘insur-

ance risk.’’ The types of events that cause losses under these

policies closely resemble the events that cause losses under

policies of mortgage guaranty and municipal bond insurance.

Most importantly, every State in which petitioner does busi-

ness recognizes these policies as involving insurance risk and

regulates them as ‘‘insurance.’’ Respondent is correct that

these policies have some features that are atypical of what

might be called ‘‘standard’’ insurance policies. But these dif-

ferences are driven by the economics of the underlying busi-

ness transaction and do not nullify the existence of ‘‘insur-

ance risk.’’

E. Conclusion

Our analysis of insurance risk, risk transfer, risk distribu-

tion, and the commonly accepted notions of insurance con-

vinces us that the RVI policies are ‘‘insurance contracts’’ for

Federal income tax purposes. Because more than half of peti-

tioner’s business during 2006 consisted of issuing ‘‘insurance

contracts,’’ petitioner was for that year an ‘‘insurance com-

pany’’ within the meaning of section 831(c) and was required

to compute its ‘‘insurance company taxable income’’ under

section 832.

To reflect the foregoing and the parties’ concessions,

Decision will be entered under Rule 155.

f