Fortuity

The concept of “unknown”

 So what is this mystical concept that so many insurance market participants are wrestling
with? In most basic terms, “fortuity” carries the meaning of occurring by chance, being lucky
If there was ever a broad or fortunate. In the practical sense, being lucky or fortunate is more likely to be associated
concept for an industry with an unexpected gain or advantage, such as a profit windfall from an event or circumstance.
to wrestle with within the Within insurance, fortuity takes on a slightly different meaning — the insured event is either
insurance law, it is the uncertain to occur or, in case of life insurance, certain to occur but at an uncertain time. One
concept of fortuity. Over the may think that an arrangement that involves “risk,” by definition, should have fortuity, as risk
involves having an uncertainty about the future outcome and a potential for such outcome to
last couple of decades, the
be unfavorable (i.e., causing an insurable event to occur). As we will explore below, this area
taxpayers, underwriters, does not have a clear demarcation line.
regulators, tax authorities
and the courts all took
a bite out of the fortuity
Risk unknown?
“apple,” putting their own When talking about fortuity, perhaps the most notable initial piece of guidance that the
insurance industry has is Rev. Rul. 89-96, commonly referred to as the MGM Grand ruling
stamp on what the concept
(issue at hand — obtaining insurance for an event that has already occurred and whether such
encompasses and what an arrangement constitutes insurance risk). In its analysis, the Internal Revenue Service (the
should be considered Service) did not focus on the narrative defining the coverage within the contract, but rather
a fortuitous event. It is zeroed in on the economics of the arrangement. In this particular instance, the contract was
noteworthy that, just like drafted in such a manner that the only true risk appeared to be investment risk, and the
the definition of insurance Service concluded that the assumption of an investment risk, by itself, cannot serve as the
sole basis of an insurance contract for federal income tax purposes.
risk, the breadth of fortuity
and what it truly means for It is important to point out that the Service did not argue the fact that the covered risk under
an event to be fortuitous this MGM insurance arrangement was not appropriate as a subject matter of an insurance
contract. The Service focused on the notion that there can be a difference between the
has also expanded in recent
covered risk that is the subject matter of an insurance contract — in this case, claims resulting
years through business, from a catastrophe — and the type of risk assumed by the insurance company. Focusing on the
environment, regulatory and economics, the Service effectively concluded that the insurance company did not assume the
judicial efforts. covered risk, or better stated, the only risk that was transferred to the insurance company was
an investment risk, as the contract lacked underwriting risk. One may ask — why would not, at
least part of this contract, be an underwriting risk? After all, we all know that there are policies
out there that insure past events. The answer is — lack of fortuity! In the case of MGM’s policy,
the coverage provided by the insurance company covered a catastrophe that occurred before
the contract was entered into and the policyholder had already incurred the liabilities, which
were projected to be in excess of the policy limits. Under the contract, the insurance company
established reserves in the amount equal to the maximum exposure (maximum amount that
could be paid under the issued policy), based on the known facts and estimates at the time
of the contract’s execution. Based on the Service’s calculations, taking into account the total
of the premiums paid under the contract, plus the tax savings to the insurance company
on its related loss reserve deduction, plus the investment earnings on the premiums paid,
it appeared that the only true variable was the investment yield the company may earn, as
the ratio of expected to actual losses automatically defaulted to 1, as all the exposures were
known prior to execution of the contract.

Fortuity The concept of “unknown”

The fortuity of it all …
Taking the lesson from the MGM ruling, the industry started looking Not until the Tax Court’s (the Court) decision in the RVI Guaranty Co.
harder into some of the arrangements that were being structured. Ltd. v. Commissioner 145 T.C. 9 case (RVI) (a case where the Court’s
In fact, the market started considering what other “knowns” within an broad and pragmatic views helped the insurance market far beyond
insurance arrangement may put an insurance contract in the Service’s addressing fortuity), did the industry get additional insight into fortuity
crosshairs due to the awakening of their new friend — fortuity. and the Court’s reluctance to accept the Service’s narrow views on
it. In a striking contrast to the Service’s overall view on fortuity and
One of the concerns became policies that covered an event(s) that
its decisions in Rev. Ruls. 89-96 and 2017-47, the Court concluded
everyone knew would occur; however, no one knew when and/
in RVI that an insurance contract can involve speculative risk and an
or the magnitude of the exposure. In the post-MGM ruling era, the
investment element. Citing a specific situation in RVI, the Court noted
question remained — does this policy fall within what the Service
that the fact that the lease contracts matured on different dates and
would see as a fortuitous event? The industry got its refresher of
covered a multitude of independent risks, albeit similar in nature,
the Service’s line of thinking on the issue in Rev. Rul. 2007-47. The
did not preclude the contract from being treated as insurance. That
ruling involved an event with a virtual certainty of occurrence, but
singular discussion is a key counterpoint to Rev. Rul. 2007-47 (the
no certainty on the timing or the exposure. Taking into consideration
impact of the RVI decision on Rev. Rul. 89-96 is not as profound,
the apparent fortuity of the event, at least from the timing and
although it does bring into question some of the Service’s reasoning).
exposure perspectives, most would consider this policy to have a valid
underwriting risk and the insurance policy to qualify as insurance for In RVI, the Court noted that the concept of fortuity should be viewed
federal income tax purposes, ceteris paribus. The Service disagreed. broadly, noting that the Respondent’s (i.e., the Service’s) insistence
that “… the [f]ortuity is essential for … risk pooling and the law of
Noting in its ruling that part of the conclusion relies on Rev. Rul. 89-96,
large numbers to qualify an arrangement” betrays the narrow and
the Service did not attempt to reconcile how it achieved a similar result
esoteric sense in which (the Service) employs the term fortuity. The
in both cases, given the fundamental factual differences. In Rev. Rul.
Court recognized the broad lens one should look through in seeking to
2007-47, the ultimate payment/exposure was dependent on a number
identify the presence of fortuity in an arrangement, especially when an
of contingencies, making it impossible to know the potential exposure
arrangement, outside of consideration of fortuity, appears to possess
beyond reasonable estimate, an estimate that utilized sound insurance
and utilize sound insurance and actuarial practices in estimation,
and actuarial principles. It therefore becomes rather clear that the policy
shifting and distribution of underlying risk of a policy under review.
limit in this case is not simply set at the level of calculated ultimate
exposure, as it was in MGM, but rather based on a projected exposure,
with a potential for payments being well above such projection.

Despite not being able to reconcile the latest ruling to its predecessor, Conclusion
the Service, in the analysis section of the ruling, stated that the Although no one expects the Service or other authorities
arrangement was merely a pre-funding of the policyholder’s future to forget the concept, it is reasonable to say that with the
obligations, and that the overall risk assumed by the insurance changing insurance market environment, innovative products,
company was whether the estimated present value of the cost of and the Court’s broader view on what may constitute fortuity,
performing the remediation procedures, which was the premium the market participants will see a more reserved approach
amount paid by the policyholder, would accrue to the greater of the from the Service in its challenge of fortuity. The ambiguity of
amount of claims under the insurance contract or the policy limit. It the concept is not going away; however, all parties need to
then stated that this risk is similar to the timing and investment risks look beyond the mere appearance of a policy and dive into
that Rev. Rul. 89-96 already concluded not to be insurance risks. individual details to ascertain whether a policy lacks notions
Considering the views posed by the Service in Rev. Ruls. 89-96 of insurance and aims to mitigate an exposure that should not
and 2007-47, one begins to wonder what, if any, deviation can an be considered a valid insurance (i.e., pure investment risk).
insurance policy have from a traditional, run of the mill homeowners’- As always, a sound feasibility study, coupled with professional
type policy in order for the Service to consider it a qualifying policy actuarial and tax opinions, will help the insureds and captives
for tax purposes? Although both rulings were drastically different, secure peace of mind with respect to broadening advanced
the Service found one niche item, indicating a much broader (and pools of risk that are being currently discussed and/or insured
someone confusing) connection in order to equate the situations and in the market.
render both arrangements not qualified insurance for tax purposes.

Fortuity The concept of “unknown”

The views expressed are those of the authors and do not necessarily EY | Assurance | Tax | Transactions | Advisory
reflect the views of Ernst & Young LLP or any other member firm of
the global EY organization. About EY
EY is a global leader in assurance, tax, transaction and advisory services.
The insights and quality services we deliver help build trust and confidence
in the capital markets and in economies the world over. We develop
outstanding leaders who team to deliver on our promises to all of our
stakeholders. In so doing, we play a critical role in building a better working
world for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one or more, of

the member firms of Ernst & Young Global Limited, each of which is a
separate legal entity. Ernst & Young Global Limited, a UK company limited
Contacts: by guarantee, does not provide services to clients. For more information
about our organization, please visit ey.com.
Mikhail Raybshteyn is a Tax senior manager
in Ernst & Young LLP’s Financial Services Ernst & Young LLP is a client-serving member firm of Ernst & Young Global
Organization Insurance Sector, a member of the Limited operating in the US.
EY Global Captive Network and is the EY Captive
Insurance Services deputy leader, focused on © 2018 Ernst & Young LLP.
US federal, state and international tax matters. All Rights Reserved.
Mikhail has more than 13 years of experience
serving the insurance market in a tax advisor SCORE No. 01769-181US
role and serves as a tax technical resource on CSG No. 1803-2623874
a number of captive insurance and general ED None
insurance tax matters. Mikhail can be reached at
+1 516 336 0255 or [email protected]. This material has been prepared for general informational purposes only and is not intended to be relied
upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.
Paul H. Phillips III is a Tax partner in Ernst & Young
LLP’s Financial Services Organization, focused ey.com
on US federal income tax matters. Paul has more
than 25 years of experience serving the captive
insurance market as a business tax advisor. Paul is
a co-founder and co-leader of EY Captive Insurance
Services and co-leads EY’s Global Captive Network.
Paul can be reached at +1 214 754 3232 or
[email protected].