Residual Value Insurance

Residual Value Insurance

November 12, 2015 | By Keith Martin in Washington, DC

Residual value insurance was at issue in a case before the US Tax Court in late September.

This is insurance that an asset will be worth at least the insured value at the end of a lease term or some other period of time. The court included some interesting data about such insurance in its opinion.

The case involved a Bermuda-based insurer and looked at how the company reported its premium income on its 2006 tax return. Residual value insurance accounted for more than 97% of the company’s business that year. The company accounted for the premiums it collected like an insurance company. Insurance companies are allowed by section 832 of the US tax code to spread out the premium income over the years that claims are expected to be paid. The IRS said the company is not an insurance company because residual value insurance is not “insurance” for US tax purposes.

The US Tax Court disagreed with the IRS in a decision in a case called R.V.I. Guaranty Co., Ltd. v. Commissioner. Even though RVI is based in Bermuda, the company elected under section 953(d) of the US tax code to be taxed like a US company. Its income was from US sources.

The US tax code does not define “insurance.” The US Supreme Court said in a 1941 decision that “[h]istorically and commonly insurance involves risk shifting and risk distributing.” Courts have also considered whether a transaction involves insurance “in its commonly-accepted sense” and whether the risk transferred is an “insurance risk.”

The IRS analogized the residual value policies to “puts” that an investor might enter into to protect his downside case and said the policies were downside protection for customers against an investment loss rather than true insurance. Another strike against them, the IRS said, is the policies paid on a particular date — for example, the end of an equipment lease — rather than after some unpredictable occurrence, like a car crash.

The court disagreed.

It found the following important. RVI is regulated as an insurance company in every state in which it operates. The insurance regulators in the states view these policies as insurance. This is insurance in its most classic form in the sense that risk is being distributed among all the policyholders by collecting premiums from a wide pool of customers. There is a significant risk of loss to the insurance company.

The court recited a number of interesting facts about the residual value insurance business.

During 2006, RVI had 951 policies in force covering 754,532 autos, 2,097 buildings and 1,387,281 commercial equipment assets.

The policies covered $16.2 billion in insured value.

RVI had a cumulative loss ratio through 2006, the tax year at issue, of 27.7% and through 2013, when the case went to trial, or 34%. The cumulative loss ratio is the share of premiums that had to be paid in claims. RVI paid more than $150 million in claims through 2013.

Premiums were low: the premiums rarely exceeded $4 per $100 of coverage and could be as low as 50¢ per $100.

The policyholder took the first loss. For example, if a residual value policy was written for a lessor of an auto that was expected to be worth $10,000 at the end of the lease term, and the insured value was $9,000, then the lessor suffered the first $1,000 in loss. The policy paid to the extent the residual value at the end of the lease term was less than $9,000.