Opinion ID: 6340618
Heading Depth: 2
Heading Rank: 2

Heading: Reserve’s Direct Policies

Text: Reserve issued 13 policies to Peak (RocQuest and ZW were also named insureds, but we will generally refer only to Peak) on December 4, 2008: 1) Excess Directors & Officers Liability (for liability for wrongful acts committed by directors and officers acting in such capacity) 2) Special Risk – Loss of Major Customer (for reduction in net income caused by loss of major customer) 3) Special Risk – Expense Reimbursement (for expenses to mitigate adverse publicity arising from incidents such as a liability incident, product recall, labor dispute, or bankruptcy; and civil-liability defense costs if there was no underlying insurer or all defense expenses have been exhausted) 4) Special Risk – Loss of Services (for loss of services of employees to be specifically named) 5) Special Risk – Weather Related Business Interruption (for losses from interruption of business caused by weather) 6) Excess Pollution Liability (for cost of cleaning up on-site pollution and liability for creating pollution) 7) Special Risk – Tax Liability (if tax liability exceeds 115% of filed tax liability) 8) Excess Intellectual Property Package (for liability for wrongful acts by Peak and for damage to Peak’s intellectual property caused by wrongful acts of others) 9) Special Risk – Regulatory Changes (for damages to business from changes in the law) 10) Special Risk – Punitive Wrap Liability (for punitive damages that would be paid by one of the other Reserve policies to Peak except that a law or judicial ruling precludes insuring punitive damages) 11) Excess Employment Practices Liability (for liability for wrongful discharge, workplace harassment, retaliation for exercising employmentrelated legal rights, breach of employment contract, etc.) 12) Excess Cyber Risk (for liability and for business and property loss caused by others) 13) Special Risk – Product Recall (for expenses of recall of products manufactured or sold by Peak) For each policy the policy period was less than a month, extending from December 4, 2008, to January 1, 2009, and the liability limit was $1 million. The total premium was $412,089.02. The policies were claims-made policies: The claim must have been based 14 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 15 on acts, errors, or omissions after the policy inception date or, if applicable, after the earlier retroactive date set forth in the policy. And the claim must have been made and reported to Reserve after the policy inception date and during the policy period or, if applicable, during the extended reporting period set forth in the policy. Policy # 7—the tax-liability policy—had special provisions on retroactivity and reporting, apparently intending to cover tax returns due before 2009 if covered losses were reported within four years of the due date. Six policies (1, 6, 8, 10, 11, 12) had a retroactive date of January 1, 2005 (so the act or omission giving rise to the claim could have predated the policy by as much as four years) and an extended reporting period of three or four years (so the claim could have been made and reported to Peak as late as December 2012). The remaining policies had no retroactive date but extended reporting periods of one year or, in one case (policy #13), four years. Each policy contained an other-insurance clause, which provided, “The limits and deductibles stated herein only apply after coverage is exhausted from any and all other valid insurance policies issued by any other insurer,” Reserve Mech. Corp. v. Comm’r, T.C. Memo. 2018-86 at 14, 115 T.C.M. (CCH) 1475 (T.C. 2018) (Reserve) (capitalization omitted); 3 so if Peak suffered a loss that could be covered by both a Reserve policy and one of its commercial policies, Reserve would pay For simplicity and uniformity we refer to the pagination of the Tax Court’s 3 memorandum opinion throughout this opinion. 15 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 16 nothing unless the claim exhausted the benefits under the commercial policy. Several of these policies were executed with singular carelessness. For example, two of the policies erroneously listed Pacific Arts Entertainment, LLC and Pacific Arts Presents, LLC as the insureds, rather than Peak, RocQuest, and ZW. And although the directors-and-officers policy stated that it covered the specific officers and directors listed in Schedule 1-A, an attachment to the policy, Schedule 1-A did not list a single insured person, so the policy—for which Peak paid $17,122—would provide no coverage. Also, in the apparent rush to issue the policies (and pay premiums that would be deductible in 2008), Peak paid for three policies—employment-practices liability, weather-related business disruption, and cyber risk—that apparently were deemed unnecessary after a little further consideration, as they were dropped in 2009, after being in place for less than one month. 4 (Notably, the later-issued feasibility study described one of the discontinued coverages—employment-practices liability—as a “major liability concern[]” for Peak. Aplt. App., Vol. 7 at 2062.)
There are also remarkable errors in pricing the premiums on two policies. McNeel, Capstone’s director of the insurance operation, prepared a rating worksheet for each of 4 Besides dropping the three policies in 2009, Peak replaced the expensereimbursement policy by two policies covering the same risks—one to mitigate adverse publicity and one to provide for civil-liability defense costs. Also, on six policies the liability limit was reduced from $1 million to $500,000, so the total limit of liability dropped from $13 to 8 million. Peak paid premiums of $448,127.03 on the 11 policies in 2009. Peak kept the same 11 policies and paid $445,314.01 in 2010. 16 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 17 the policies. On the 2008 worksheet, for example, one column set the annual premium for each policy, and an adjacent column contained a pro rata percentage to account for how premiums calculated on an annual basis should be adjusted for retroactive and partialyear coverage. For those policies with retroactive coverage the pro rata percentage was usually 95%. For four of the policies (loss of major customer, loss of services, productrecall reimbursement, and weather-related business interruption) with no retroactive coverage (so the occurrence had to be during December 2008) the pro rata percentage was 10% (presumably reflecting that the coverage was for occurrences during less than 10% of a full year). But for Special Risk – Regulatory Changes, which also had no retroactive coverage, the pro rata percentage was 95%. When asked about this at oral argument, counsel for Reserve responded, “It certainly strikes me as an error.” Oral Arg. at 37:30. 5 A similar error was made with respect to the policy for Special Risk – Expense Reimbursement. 5 In a letter to the court sent a few days after oral argument, counsel for Reserve retracted this statement, stating that there was no proration error. The letter asserts that the proration factor on the worksheet reflected McNeel’s “judgment of the percentage of risk of the policy remaining,” and notes that the premium was comparable to that on a document provided by Mid-Continent General Agency, Inc., which purportedly was produced independently and provided premiums that “were pro-rated for short term policies.” Appellant Reserve Mechanical Corp.’s Suppl. Letter Br., at 2. What is absent from the retraction, however, is any plausible explanation of why the regulatory-changes premium for one month of coverage was essentially the same as the premium for a year’s coverage, particularly when the premiums for the other non-retroactive policies were treated so differently. The loss-of-major-customer premium jumped from $7,268 (for a policy limit of $1 million) for the one-month coverage in 2008 to $50,625 (for a $500,000 limit) for the year-long coverage in 2009; the loss-of-services premium jumped from $4,874 ($1 million policy limit) in 2008 to $62,791 ($1 million limit) in 2009; and the product-recall-reimbursement premium jumped from $5,087 to $35,438 even though 17 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 18 Perhaps more important, the manner of arriving at the premium prices on McNeel’s rating worksheet was questionable. The core task in setting premiums for an insurance policy is predicting risk: the size and frequency of losses covered by the policy. See Owens v. Aetna Life & Cas. Co., 654 F.2d 218, 240 (3d Cir. 1981) (“The [insurance] company must set its premiums based on its prediction of two cost variables: the probability of a particular risk of loss occurring and the magnitude of the loss if it occurs.”). But the record is devoid of evidence of the necessary risk assessment by Reserve. Peak had no history of any losses that would be covered by the Reserve policies, so the premiums could not be based on Peak’s actual experience. The feasibility study briefly described the risks that would be covered by the policies, but it contained no discussion of the probability or size of the risks. For example, when the feasibility study discussed Peak’s need for employment-practices liability coverage, it merely stated that this liability “has become a hot topic over the past several years as complaints and legal action nationwide have skyrocketed for wrongful termination, discrimination, harassment, and other employment-related practices.” Aplt. App., Vol. 7 at 2056. (Again, Peak dropped its excess-employment-practices-liability coverage after one month, before the feasibility study was issued.) the policy limit dropped from $1 million to $500,000. (The weather-related-businessinterruption policy was not continued in 2009.) In contrast, for the regulatory-changes coverage, the one-month premium in 2008 of $64,899 (for a $1 million policy limit) dropped to $47,588 for annual coverage in 2009 (with a $500,000 policy limit). In examining whether the Tax Court properly determined that Reserve did not satisfy its burden of establishing that it was providing insurance, we are not inclined to give any weight to an ipse dixit by counsel. 18 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 19 One source of information would have been insurance-industry data. Yet even though one of Reserve’s expert witnesses testified that commercial insurance policies were available as an alternative to several of the Reserve policies, there is no evidence that anyone compared the rates on such policies or otherwise considered industry standards. Instead, the record suggests that McNeel based the rates on the premiums charged by other captive insurers managed by Capstone. For the most part those premiums were apparently based solely on the annual projected sales revenue of the insured—for example, regardless of the particulars of the business (nature of the business, location, etc.) the premium for the coverage depended only on the projected sales revenue. The only exception was employment-practices-liability coverage, the premiums for which were based on the number of employees. McNeel prepared a document that summarized the premium rates per $250,000 of coverage on all the different policies issued by Capstone entities. The document, in the words of the Tax Court, “provided both an average and a range of rates from which [McNeel] could choose for each type of policy.” Reserve, at 15. But McNeel’s testimony contained no suggestion that he looked at the businesses insured under the other policies to see if they would be likely to have risks comparable to those of Peak. On the contrary, he acknowledged that he was unaware whether the other captives were in a business similar to Peak, or were similar in other respects to Peak. Nor was there any evidence showing that the premiums charged by the other Capstone entities (who likely had the same tax incentive as Reserve to charge as high a premium as possible) were themselves reasonable. 19 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 20 Reserve claims that McNeel’s proposed premiums were supported by the independent work of Mid-Continent General Agency, Inc., “a managing general underwriter,” which provided what are called “pricing indication[s],” Aplt. App., Vol. 5 at 1209, 1242, that closely correlated with McNeel’s suggested premiums. But how these indications were generated was left unexplained. McNeel testified that someone from Mid-Continent visited Capstone’s office for about 10 days and looked at its files, but what files in particular are not specified. No representative from Mid-Continent testified at trial. And the only documentation offered to show how Mid-Continent arrived at these prices was a letter from Mid-Continent to McNeel that purported to “comment on the methodology [Mid-Continent] use[s] to assist in developing premium quotations.” Aplt. App., Vol. 12 at 3560. The letter, however, stated merely that Mid-Continent’s methods “involve[] the evaluation of exposures for a given line of insurance, examination of historic loss date [sic], if any, the consideration of increased limits factors[6] . . . , and acknowledgement of market rate adjustments.” Id. at 3560–61. The letter did not provide further details, and it did not mention Peak or Reserve’s policies. We recognize that Reserve called two experts as witnesses to defend the pricing of the Peak policies, Esperanza Mead and Michael Solomon. Although Mead testified that 6 Limit factors are used to compute what the premium should be for a particular liability limit based on the premium already determined for a different liability limit. Because the likelihood of a large loss is generally significantly less than the likelihood of a smaller loss, the premium is not proportional to the liability limit. For example, if the proper premium for $250,000 of coverage is $1,000, one could calculate the proper premium for $1 million coverage by multiplying $1,000 by the appropriate limit factor (3.4 in McNeel’s calculations) to arrive at a premium of $3,400. 20 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 21 the Reserve premiums were reasonable, her conclusions rested on questionable assumptions. Reserve had no loss data for her to use nor did she use any risk information from general industry sources. And to the extent that she relied on the premise that the premiums for the policies issued by the other Capstone captive insurers were reasonable, that premise was not supported by loss data from those insurers. Mead’s report does tabulate the claims payments by Capstone captives for a five-year period; but she assessed this information as having “low credibility” for actuarial purposes because so few claims were paid, and the information had no material effect on her conclusions. Aplt. App., Vol. 5 at 1256. She instead reached her conclusion that the premiums charged by Reserve and the other Capstone captives were reasonable only by making the assumption, unsupported by any data, that the captives would ultimately pay claims equal to about 75% of the premiums. She employed that figure solely because it is standard in the insurance industry (which means merely that 25% of insurance premiums ordinarily go to overhead, administrative expenses, and profit). Under this assumption one would expect Peak, a business with almost no history of insurance losses and only general concerns about the future, to average over $300,000 in submitted claims per year going forward. Neither Reserve nor its experts offered data, or even an explanation, to justify this assumption. As for Solomon, at least he looked at real-world data—for example, he assessed the risk of loss to Peak from recall of products it manufactured or sold by looking at the “annual economic impact of food safety outbreaks.” Aplt. App., Vol. 16 at 4724. But he opined on only six of the 13 policy coverages; and rather than assessing the 21 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 22 reasonableness of the premiums for each coverage, he said only that the total premium for the reviewed coverages was “reasonable in the aggregate.” Aplt. App., Vol. 13 at 3889. In any event, his report (and Mead’s as well) was prepared many years after issuance of the policies of concern on this appeal, and there is no evidence in the record that the premiums for those policies were based in any way on the data he used (much of which in fact postdated the policies). Neither expert examined what the real risks to Peak were. As summarized in the Commissioner’s brief: [N]either Solomon nor Mead compared taxpayer’s premiums to premiums charged by unrelated third-party insurers; therefore, neither had a basis to determine whether taxpayer’s premiums were commercially reasonable. Solomon merely opined that the aggregate premiums charged by taxpayer were reasonable when compared to Capstone’s internal pricing guidelines. Similarly, Mead merely opined that the aggregate premiums charged by taxpayer were reasonable when compared to rates charged by other Capstone-managed captives. Aplee. Br. at 60–61 (citations omitted). Reserve’s reply brief does not respond to, much less challenge, the quoted statement. Although the testimony of the two experts is quite technical, our understanding of the testimony supports what the Commissioner says. 2. Comparison to Commercially Available Policies Nor is there evidence of any effort to determine what other insurers might have charged Peak as premiums for similar policies. True, Capstone’s feasibility study stated that Peak wanted to create a captive insurer “for the purpose of writing coverages that are generally unavailable or impractical to obtain in the conventional insurance marketplace.” Aplt. App., Vol. 7 at 2030 (emphasis added). But the report of another of 22 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 23 Reserve’s experts, Robert Snyder, who in fact co-authored that feasibility study, said that at least six coverages provided to Peak by Reserve—pollution liability, intellectual property, “commercial property gap,” “punitive damages wrap,” cyber risk, and tax liability coverages—were available in the commercial market. Aplt. App., Vol. 12 at 3582–85 (capitalization omitted). Zumbaum and Weikel were apparently not particularly interested in Peak’s saving money on insurance premiums. Zumbaum admitted that he did not explore coverage on the commercial insurance market before creating Reserve. And although McNeel and Feldman both testified that Zumbaum and Weikel were the most significant people in determining the policies, pricing, and coverage, McNeel could not recall whether Zumbaum or Weikel questioned the premium numbers. Zumbaum testified that he did not review the Reserve policies in detail; instead, he testified that he “[p]robably scanned through them.” Aplt. App., Vol. 4 at 1134. Zumbaum also admitted that he relied on “Mr. McNeel, Mr. Feldman or other folks from Capstone” to tell him about the policies and that he would “believe[]” whatever they told him. Id. Aside from the premium calculations, there is also no evidence in the record that the choice of policies, or their specific contents, was based on an assessment of Peak’s particular needs. The feasibility study stressed that captive insurers are ideal for providing so-called “manuscript[]” policies, which it defined as policies with “coverage[] to address specific concerns.” Aplt. App., Vol. 7 at 2031. And Feldman testified that one advantage of captive insurers was that captives “design[] coverages not with a blunt instrument but with a scalpel”—effectively “tailoring coverages directly to the needs of 23 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 24 the business.” Aplt. App., Vol. 5 at 1372. But there is no evidence of such tailoring for the policies issued to Peak. McNeel acknowledged that Capstone “had policies that were common to a lot of different clients.” Id. at 1250. And the Tax Court described these as “‘cookie-cutter’” policies, noted testimony from Capstone employees that “they administered many of the same policies for all of their clients,” and observed that “[i]n many instances the [Peak] policies were not reasonably suited to the needs of the insureds, particularly Rocquest and ZW.” Reserve, at 54. (Of course, form policies have a very large, and quite proper, role in the insurance industry. In themselves, they do not suggest impropriety.) 7 3. Claim-Handling In addition, Reserve’s claims-handling operations were, to say the least, far from businesslike. Reserve handled only one claim during the years at issue—a claim from Peak under the special-risk policy for partial loss of a major customer. That policy, as the name suggests, reimbursed Peak for business losses “as a result of the loss of or reduction of services of a [m]ajor [c]ustomer.” Aplt. App., Vol. 12 at 3302. But the policy imposed significant restrictions on when coverage would be provided. For example, it would not cover the loss of a major customer if Peak “initiate[d] the termination,” or if Peak did 7 Altogether, Reserve did not provide the advantages touted by the feasibility study. Rather than Peak having “complete control” over Reserve, Aplt. App., Vol. 7 at 2042, Reserve was managed entirely by Capstone. Rather than Reserve providing “manuscript” coverage, id. at 2041, it issued boilerplate policies. And rather than providing insurance that is “generally unavailable or impractical to obtain in the conventional insurance marketplace,” id. at 2030, at least six of Peak’s policies were commercially available. 24 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 25 “not attempt or intend to replace” the customer, or if Peak caused the customer to leave by breaching the terms of its contract with the customer. Id. And the claim would not be paid under the policy if the insured had knowledge of the loss before the effective date of the policy. Peak filed its claim under the major-customer policy on April 6, 2009, about four months into the coverage period. Reserve’s initial notice of claim dated the loss as occurring during the first week of the policy period, on January 5, 2009. It described the claim as arising from a “[s]ignificant reduction of orders from Stillwater Mining Company, a customer representing 35% of sales.” Aplt. App., Vol. 19 at 5407. It said that “[t]he reduction in orders from Stillwater represents 16% of the insured’s sales for the period,” and said that its net income had dropped from $422,440 in the first quarter of 2008 to $232,620 in the first quarter of 2009, a drop of about 45%. Id. After subtracting the $25,000 deductible, the claim value for lost net income was $164,820. The underlying claim document that Peak allegedly submitted to Reserve to substantiate and explain these numbers is not in the record. In fact, the record contains no supporting documentation from Peak whatsoever. And Zumbaum gave conflicting testimony about whether Peak submitted the claim to Reserve or to Capstone. Moreover, there is no evidence that Reserve investigated the claim to determine if the loss was covered under the policy—did Peak know of the coming reduction in sales by January 1, 2009, the 25 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 26 effective date of the policy; 8 was the reduction caused by a breach of contract by Peak; etc.? Reserve paid $150,000 on the claim on April 21, 2009—about two weeks after Peak filed the claim. One month later, on May 27, Reserve and Peak executed a settlement agreement. The agreement (which misstates the coverage limit for the relevant policy as $1 million, rather than the actual $500,000) stated, among other things, that Reserve would pay Peak the full value of the claim—$164,820—and in return, Peak would “completely release[] and forever discharge[] [Reserve] from any and all past or present claims, demands, obligations, actions, causes of action, judgments, expenses and compensation . . . [that] may in any way grow out of the specified loss.” Aplt. App., Vol. 12 at 3553. Reserve then issued a second payment of $14,820 the same day as the agreement. Four months later, however, on September 10, 2009, Reserve issued a third check to Peak for $175,000. The sole possible explanation in the record is a line dated August 25, 2009, on the Notice of Claim form stating: “Re-open claim due to extended losses from lost customer.” Aplt. App., Vol. 19 at 5407. There is no supporting documentation for the $175,000 sum. All three checks from Reserve to Peak were signed 8 The December 2008 policy indemnified Peak “for any Business Interruption loss of up to twelve (12 months) suffered as a result of losing the services of a Major Customer.” Aplt. App., Vol. 11 at 3126 (emphasis added). The 2009 policy, which took effect five days before the “date of occurrence” stated on the Notice of Loss, changed the language to encompass “any Business Interruption loss . . . suffered as a result of the loss of or reduction of services of a Major Customer.” Aplt. App., Vol. 12 at 3302 (emphasis added). The loss on which Reserve paid Peak—which was not for the total loss of services but just a reduction of services—may not have been covered under the language of the December 2008 policy. 26 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 27 by a Peak employee. More than two years later, on January 30, 2012, the parties executed an addendum to the settlement agreement, which stated in full: “In consideration of the release set forth above, the Insurer agrees to pay the Insured the sum of Three Hundred Thirty Nine Thousand, Eight Hundred Twenty Dollars ($339,820.00). The foregoing sum [has] been paid by Insurer through two checks made payable to ‘Peak Mechanical & Components, Inc.’” Aplt. App., Vol. 12 at 3556.