Commodity Price Risk for Captives?

With ILM201802014 the Internal Revenue Service seem to have extended the extent to which speculative risks may constitute insurable risks. This is based, in part, on the determination in RVI Guaranty Co Ltd and others vs Commissioner.

In RVI the court found that residual value insurance, whilst being a speculative risk, also constituted an insurable risk in line with the commonly accepted sense of insurance. This was supported by the fact that established commercial insurance companies including Chubb and AIG provided residual value insurance and certain states had legislation on their books that included residual value policies as insurance.

With the ILM the Service seem to have gone further than RVI by recognizing that exchange rate risks may be insurable even though this is not widely offed by commercial insurance companies and no statute exists to accept this as an insurance risk. The inference is that commodity pricing issues may also be insurable.

Whilst on the face of it this may seem to provide opportunity for captive insurers to increase the scope of coverage offered to their parents, there are still certain issues to consider. Firstly, I don´t think that the ILM provides carte blanche to insure all commodity pricing or exchange rate issues. The specific risks and the policy wording applicable are prime concerns. Secondly, there remains a need for there to be sufficient risk distribution within the captive.

As to which risks may be insured I would suggest caution. My view is that if there is an investment and you want to insure the downturn on the investment that that is not insurance and it remains a pure investment risk. However, if the risk is directly linked to the business as a whole (rather than a specific investment) then it may reasonable to expect that certain commodity pricing issues can be accommodated. For insurable risk you may need to be able to demonstrate a clear and direct link between the commodity pricing and the business performance. An indirect link may not be sufficient.

The captive will have to carefully draft policy wordings to respond to the specific risks that are considered insurable. The policy will need to define the claim settlement process because there are likely to be fluctuations over the policy period which may be in the insured parties favor at times as well as against them.

Risk distribution, if solely relating to the exchange rate or commodity pricing, will look at the independence of the risks being insured. Under the RVI case it was found that there was sufficient risk distribution because of the policies were spread among several thousand unrelated parties, its policies were in separate risk segments (vehicles, real estate and commercial equipment), by asset types within the risk segment, across many states and for different lease durations (1 to 5 years starting on different dates). Trying to get that type of independent risk distribution for commodity pricing or exchange rates may prove challenging.

Finally, whilst the IRS provides some guidance on what is insurance, there will continue to be potential issues with accounting for such speculative risks. Before your captive writes any speculative type risk make sure to speak with your accountant.

If you would like to discuss this opportunity for your business or your captive insurance company in line with the new guidance from the IRS under this ILM please contact us.

Greg Taylor

CEO

Albion Risk Consulting, S.A.

Not Legal Advice

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