Opinion ID: 3014809
Heading Depth: 2
Heading Rank: 1

Heading: The Reinsurance Model

Text: The Tax Court’s most significant criticism of Capital’s valuation concerned the “reinsurance model” used by Daniel McCarthy, Capital’s actuarial valuation expert, see supra n.2.
McCarthy valued the contracts at issue at their “highest and best use.” He concluded that this use could be determined using a “reinsurance model,” whereby he asked how much the 376 contracts cancelled in 1994 would have been worth if they had been sold together in a reinsurance transaction in 1987. McCarthy argued that this is the highest and best use of the contracts, and that they would be worth more sold together in a reinsurance transaction than they would be if they were sold separately. In fact, it seems unlikely that any such contracts could be sold separately. See Trigon, 215 F. Supp. 2d at 706 (“It is an undisputed fact that there are no known sales of single group health insurance contracts between insurance carriers either before January 1, 1987, or after.”). Blocks of contracts can, however, be sold, and McCarthy represented that the 376 contracts lost in 1994 would have constituted a “credible” block that could have been sold between insurers. See 122 T.C. at 250. The Trigon court reasoned that these contracts are properly valued under a willing-buyer model that assumes a buyer with facilities comparable to those of Capital: [Group] contracts must be valued on the theory that they would be sold to a hypothetical willing buyer having facilities comparable to those of the seller. Attempting to value the contracts on a stand-alone basis (which the government appears to advocate), rather than as part of a going concern, results in an improper determination of “liquidation value,” rather than fair market value. 215 F. Supp. 2d at 708-09 (citation omitted). We find this analysis persuasive. We reject the government’s argument that a one-at-a-time 22 sale model is required. The government cites cases holding that minority shares of stock must be valued according to their own value, without taking into account a control premium that might inhere in a larger block of stock. See Ahmanson Found. v. United States, 674 F.2d 761, 772 (9th Cir. 1981); Rev. Rul. 93-12, 1993-1 C.B. 202. But such cases are inapposite: the control premium for a majority stock holding has a separate value over and above the value of each individual share, while McCarthy’s use of the reinsurance model is designed not to capture additional value but to account for the transaction costs involved in selling a single contract.4 Capital need not value its contracts only at their liquidation value, rather it may use the reinsurance model to determine its basis.
The Tax Court nonetheless took the reinsurance model as evidence that Capital’s contracts could not be valued individually. It found that, at most, McCarthy had proven the value of the 376contract block sold by Capital, but it had not proven the value of each individual contract: [A]s it must, petitioner does not claim a single loss deduction in 1994 upon the termination of the 376 group contracts. Rather, petitioner claims 376 separate loss deductions relating to the termination of each of the 376 separate group contracts. What is required to support petitioner’s claimed loss deductions under section 165 are valuations of the group contracts that reflect a value for each contract as a separate and discrete contract. . . . [A]ll 4 A fairer analogy might be to odd-lot sales of stock. A shareholder who sells stock in even lots—traditionally, of 100 shares—will usually get a better price and/or pay a lower commission than one who sells “odd lots” of, say, one or six or twenty-three shares. As far as we are aware, shareholders may always value their stock on the assumption that it would be sold in normal market transactions, not in inefficient odd-lot transactions. McCarthy’s method is no more objectionable than this. 23 petitioner has done is establish that the group contracts are capable of being valued in blocks. Petitioner has not, however, established that the group contracts are capable of being valued separately and independently as individual assets. 122 T.C. at 250-51; see also Trigon, 215 F. Supp. 2d at 709 (“[T]he issue is not whether the highest and best use of Trigon’s contracts is as part of an ongoing health insurance company. . . . The issue, instead, is whether specific contracts can be valued separately from the block of contracts to which they belong.”). Capital argues that the contracts can be valued separately, and that McCarthy did in fact value each contract separately. McCarthy testified to this effect, noting that his valuation methodology in this case was consistent with his practice in appraising insurance contracts when advising insurers that are demutualizing: It was consistent, in that it took into account the characteristics of each contract being valued. It was consistent, in that it took into account as the standard of that to be discounted of the emerging stream of expected statutory earnings, and it was consistent, in that they were discounted to present value. He referred to this as a “seriatim or one-at-a-time valuation.” He readily admitted, however, that he calculated the contracts’ value based on an assumption that they would be sold in batches. We think that the Tax Court, and the Commissioner, misunderstood the requirements of separate valuation. As noted above, Newark Morning Ledger, 507 U.S. at 566, requires that a taxpayer wishing to deduct his losses of intangible assets must show that those assets are susceptible of separate valuation. In many cases, this will be impossible, simply because the taxpayer really possesses a single indivisible asset whose whole is incommensurable with the sum of its parts, a single mass “composed of constantly fluctuating components.” Id. at 567. Thus, for instance, a company may not depreciate its “assembled work force,” because new employees are constantly being trained to replace old ones, and because there is no meaningful way to assign 24 distinct values to each member of this workforce. Id. at 560. The value inheres in the “assembly” of the workforce, not in any one individual. Insurance contracts are different. They are valued all the time; indeed, Daniel McCarthy, Capital’s expert, has spent much of his career valuing health and life insurance contracts in order to advise insurers and regulators on the fairness of demutualization transactions. While the Tax Court and the Commissioner have numerous quibbles with Capital’s valuation, they do not persuade us that these contracts do not each have an individual value. As Capital succinctly puts it, “the Tax Court erred because it confused (1) the question of whether an intangible has a value and useful life separate from goodwill . . . , with (2) the question of what the asset’s value is.” The Commissioner cites several pre-Newark Morning News cases for the proposition that taxpayers may not use average values to compute the value of specific accounts. Sunset Fuel, 519 F.2d at 785-86; Skilken v. Comm’r, 420 F.2d 266, 270 (6th Cir. 1969). But the averaging procedures in those cases were far cruder than McCarthy’s sophisticated statistical methods here. McCarthy represented that the 376 contracts lost in 1994 constituted a “fully credible” block of contracts, such that a willing-buyer reinsurer would expect high- and low-value contracts to cancel each other out, and would therefore purchase the community-rated contracts based on average rather than individual experience. Experiencerated contracts were, at all points, valued individually. The evidence is clear that McCarthy’s voluminous, thorough, and professional valuation was meant to determine a value for each individual insurance contract. As part of that individual valuation, McCarthy used various averaging procedures, sometimes to check his work, but sometimes as part of his initial calculations. The undisputed evidence appears to be that such averaging procedures were consistent with industry standards for valuing group insurance contracts for the purposes of reinsurance or demutualization. McCarthy’s use of industry-standard statistical methods does not render his appraisal invalid, or support the Tax Court’s conclusion that Capital’s contracts could not be valued individually. We thus hold that that conclusion was clearly erroneous. 25
The Tax Court also rejected McCarthy’s reinsurance model on the grounds that McCarthy made only “some type of vague expense adjustment” to account for intangibles such as goodwill that were associated with the 376 terminated contracts. 122 T.C. at 250-51. A larger adjustment for the intangibles, which the Commissioner believes is justified, would lead to a smaller tax deduction. McCarthy subtracted some $300 million from his total valuation of all of Capital’s contracts, to account for the value added by Capital’s name, reputation, and other goodwill factors, as well as by its workforce and provider network. These factors made up a part of the value of Capital’s contracts, but were not lost when those contracts were lost; therefore, Capital did not—and could not—claim them as part of its deduction. The dispute here is over the method of calculating this goodwill adjustment. McCarthy used a rental charge, whereby he valued these intangibles based on what it would cost Capital to rent them in a market transaction. The Commissioner argued, and the Tax Court agreed, that this was improper. Instead, the Tax Court found that McCarthy should have deducted a “capital charge” from the value of the contracts, based on a valuation of the intangible factors that takes into account the market rate of return on those factors. Although the Commissioner has not attempted to calculate what such a charge would look like, we assume that it would lead to a greater offset for these intangibles, and so to a smaller tax deduction. Capital argues, however, that McCarthy’s method, which used a rental charge rather than a capital charge, was proper and indeed standard. The Tax Court found that McCarthy’s explanation for not taking a capital charge for the related intangibles was “not credible.” Id. at 251. Capital claims that this contradicted the “undisputed testimony of all the experts,” which was that rental charges are normally used in insurance valuation, and that McCarthy’s use of them was proper. The Commissioner responds that McCarthy’s charge for the related intangibles was based on their cost to Capital rather than their market value, and that this method of deducting the other intangibles overstated the value of the lost contracts. Capital’s characterization of the record appears to be 26 mistaken. The Commissioner’s witnesses did not concede that McCarthy’s approach was correct, although neither did they claim that it was professionally untenable. They did argue for an alternative method, which presumably would have given a different, and greater, value to Capital’s goodwill. Given the dispute in the record between well-qualified experts, and the Tax Court’s greater familiarity with the issue, we cannot conclude that the Tax Court’s finding here was clearly erroneous. Indeed, this finding seem s conceptually correct—Capital’s goodwill factors should be subtracted at their value, not their cost—although Capital argues that McCarthy’s rental charge was meant to estimate value and not cost. We thus accept the Tax Court’s conclusion that McCarthy should have used a capital charge, rather than a rental charge, to extract goodwill from his valuation of the contracts. But, as explained above, see supra Part IV.B, Capital does not lose its entire deduction merely because the Commissioner has found some flaws in its method. On the remand that our other holdings require, the Commissioner will have the opportunity to explain what McCarthy should have done differently in this regard, relying on specific calculations of cash flows rather than on generic names like “capital charge” versus “rental charge.” The Commissioner will also be able to propose an alternate valuation for the $300 million goodwill adjustment. Capital, meanwhile, will have another opportunity to demonstrate to what extent McCarthy’s method captures the factors raised by the Commissioner. Ultimately, the Tax Court must determine what goodwill adjustment is appropriate, using either McCarthy’s rental charge, a capital charge proposed by the Commissioner on remand, or some other adjustment taking into account the arguments of both sides. In sum, the mere fact that McCarthy’s charge is flawed does not mean that the Tax Court may reject Capital’s entire valuation.