Opinion ID: 6340618
Heading Depth: 3
Heading Rank: 1

Heading: Stop-Loss and Quota-Share Agreements

Text: The first arrangement involved stop-loss coverage provided by PoolRe to Peak. Through endorsements on all of Reserve’s direct policies with Peak, PoolRe received 18.5% of the premiums paid by Peak on each policy in 2008 and 2009, and 19.9% of the premiums in 2010. See Figure 3 (showing the 2008 and 2009 arrangements). In return, PoolRe assumed (through an endorsement on the policy) some of Reserve’s exposure on each policy. A financial backstop for Reserve was ostensibly important because it could 27 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 28 face liabilities exceeding $8 million per year on the policies issued to Peak; at least for the first few years of its operation, such liabilities could not be covered by the combination of Reserve’s $100,000 initial capitalization and the additional capital acquired from annual premium payments. But PoolRe did not provide much of a backstop. The amount that PoolRe could be required to pay each year on the stop-loss coverage was strictly limited, and the requirements for it to make any payment at all were intricate, restrictive, and highly unlikely to materialize. Figure 3 – Reserve’s Reinsurance Relationship We describe in some detail the limits with respect to the 2009 policies to illustrate the general issues. First, PoolRe incurred no liability under the stop-loss coverage until 28 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 29 Reserve received claims from Peak in excess of the total premiums paid by Peak (18.5% of which went to PoolRe). Thus Peak needed to submit claims to Reserve in excess of $448,127.03 to trigger the stop-loss coverage. If that condition was satisfied, PoolRe would then pay amounts exceeding the total premiums, but only up to a maximum of 150% of those premiums. PoolRe could therefore not be required to pay more than about $672,000 in stop-loss coverage on the 2009 policies, even though the liability of Reserve to Peak could have been as high as $8 million on those policies. The amount that PoolRe would have to pay on Reserve’s policies was also restricted by an additional requirement that had little to do with Reserve. PoolRe’s total liability on all its stop-loss coverage for the captive insurers was limited to 125% of the total yearly premiums paid for stop-loss coverage by all the captive insurers. In 2009 PoolRe received just under $83,000 in premiums on the Reserve policies; from all the captive insurers together, it received about $6 million. If a number of the other captive insurers suffered large losses in the same year, the amount that Reserve could recoup from PoolRe for that year could be further reduced. Another feature of the PoolRe coverage, however, made the above limitations more theoretical than real. The limitations were unlikely to ever come into play because PoolRe would incur liability only if what the policy called an “Attachment Point” were satisfied. Aplt. App., Vol. 12 at 3411. There were four possible attachment points, each requiring at least two significant losses. Thus, a single catastrophic loss on one of the Reserve policies would not trigger any payments by PoolRe. The first attachment point was that Peak suffer at least two losses where (1) each loss was caused by a separate 29 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 30 event and (2) each loss cost Peak at least $100,000. A second attachment point would be triggered only when Peak experienced three losses, each caused by a separate event, that caused the loss of at least $60,000. The third required four separate losses of $36,000 or more; and the fourth required five separate losses of $20,000 or more. 9 Even then, PoolRe would pay no more than the amount that exceeded the attachment point on the claim where the attachment point was first satisfied (and for all later claims). For example, if the first claim was for $1 million, and the second was for $125,000, PoolRe would pay only $25,000, the amount by which the second claim exceeded the $100,000 threshold. The other captive insurers in the program had similar arrangements with PoolRe, which made no payments under the stop-loss coverages to any of the 50-odd captive insurers (on their 400-plus policies) for at least the period at issue in this case. Because it was so unlikely that any money would ever be paid under the stop-loss coverage provided by PoolRe, one might infer that it was of very little financial utility to Peak or Reserve. But PoolRe was an essential part of the mechanism that created the appearance that Reserve had substantially diversified its risks beyond those faced by its affiliate Peak. What created that appearance was Reserve’s reinsurance of liabilities of PoolRe. Not only did PoolRe provide stop-loss coverage for the insureds of Reserve and 9 In 2010 the conditions for payment under the stop-loss coverage were revised. For that year the stop-loss insurance from PoolRe would have been triggered if the total claims submitted from Peak to Reserve reached 35% of the total, aggregate premiums for all of Reserve’s direct policies. Above that threshold, PoolRe would pay 50% of the claims, though it would not pay more than the total premiums themselves. There were no longer any separate Attachment Points that needed to be satisfied. 30 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 31 the 50 other captive insurers, but Reserve and the other captives in turn reinsured PoolRe’s stop-loss coverage for all the captives’ insureds (such as Peak), thereby assuming all the liability of PoolRe for the stop-loss coverage. In other words, PoolRe was essentially only an intermediary. The liability for paying for stop-loss claims incurred by a captive insurer ultimately rested on all the captive insurers as a group. This risk-pooling reinsurance arrangement, which was called a quota-share agreement, gave the appearance that each captive insurer (such as Reserve) was spreading its risk beyond its affiliated companies (such as Peak) by incurring liability on the stop-loss coverage provided for the benefit of the other captive insurers. For participating in the reinsurance pool, each captive received from PoolRe a premium equal to the amount that PoolRe itself had received from that captive’s insureds for the stop-loss coverage, so that, in effect, the captive insurer (such as Reserve) ultimately received all the premiums paid by its insured (such as Peak). For example, in 2009 Peak paid 18.5% of its premiums (about $83,000) directly to PoolRe for the stoploss coverage, but PoolRe then paid Reserve that same amount ($83,000) for its reinsurance of stop-loss coverage, so Reserve ended up receiving 100% of what Peak paid for insurance. See Figure 3 above. In return for receiving this premium from PoolRe, the captive insurer was liable for a corresponding percentage of the liability incurred on the reinsurance provided to PoolRe by the captive insurers as a group. If the captive insurer received 3% of the total premiums paid by PoolRe for reinsurance, it was liable for 3% of what PoolRe had to pay on its stop-loss coverage. 31 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 32 The nature of the arrangement can be illustrated by a simplified example. Say, the PoolRe risk pool had three captives, A, B, and C, which respectively reinsure 50%, 30%, and 20% of the total stop-loss risk, because A’s insureds pay 50% of the premiums to PoolRe for the stop-loss coverage, B’s pay 30%, and C’s pay 20%. If Captive B’s insured has a covered claim that requires PoolRe to pay it $100, then Captive A must pay PoolRe $50, Captive B must pay $30, and Captive C must pay $20. B ends up reducing its potential $100 loss to $30, while the other pool members are out $50 and $20. No matter which captive insurer incurs the loss, the loss is ultimately borne in the same 5:3:2 proportions by the three captives. In the actual PoolRe arrangement for 2009, the percentage of the total reinsurance paid by a captive ranged from 0.0984% (for a captive whose insureds paid $5,550 in stop-loss premiums) to 3.3235% (for a captive whose insureds paid $187,434 in premiums). Reserve’s percentage was about 1.47%, based on Peak’s paying PoolRe $82,904 in premiums for the stop-loss coverage on Peak’s policies with Reserve. PoolRe then paid Reserve the identical sum as the premium for reinsurance. Although Reserve ultimately received premiums precisely matching the combined total that Peak paid to Reserve and PoolRe, the reinsurance arrangement gave the appearance that Reserve was receiving only 81.5% of the premiums paid by Peak and a substantial premium paid by PoolRe (equal to 18.5% of the premiums paid by Peak) for reinsurance of stop-loss coverage for about 400 businesses (the insureds of the other captives) who were not affiliated with Reserve. (Recall that Capstone believed that for Reserve to be qualified as an insurer under the tax laws, Reserve needed to receive at 32 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 33 least 30% of its premiums from its insurance of unaffiliated insureds, and the quota-share arrangement purportedly provided about half of that amount.) We recognize that a legitimate pool with a similar arrangement might properly distribute risk among insurers, even captive insurers. Here, however, the question was whether the stop-loss coverage was a legitimate risk. As previously noted, no claims under that coverage were made during the years in question by any of the 400 or so companies insured by the captive insurers participating in the PoolRe pool. In addition, even assuming that the stop-loss coverage provided by PoolRe was not illusory, the only support in the record for the pricing of this coverage for the 2008 and 2009 policies is a 2005 letter signed by Robert Snyder, the director of risk consulting for the firm Myron Steves, who later served as one of the authors of Reserve’s 2009 feasibility study, and eventually as a director of PoolRe itself. The letter was in response to a request from PoolRe to comment on the reasonableness of its Stop-Loss/Reinsurance premium structure, under which PoolRe would receive 18.5% of the premium paid by the insured. The letter concluded that “both the quota share premium retained by PoolRe and the quota share reinsurance premium(s) ceded to the captives via the pooling mechanism are reasonable.” Aplt. App., Vol. 12 at 3568. The letter explains, however, that its “analysis and observations are limited to general commentary regarding stop loss insurance and the reinsurance pooling concept, and specifically, our assessment of the proposed premium structure.” Id. at 3567. It does not indicate that Snyder had undertaken any specific assessment of the risks arising from the underlying insurance policies of the PoolRe captives or examined how any particular provisions of the stop-loss coverage, 33 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 34 such as the highly restrictive attachment points, affected the insurer’s risks. It noted that a review of the premiums was “necessarily subjective,” id., and stated that the premiums employed by PoolRe are reasonable, “recognizing that in our judgment stop loss coverage in general might fairly be priced at anywhere from 2.5% to 30% of written premium.” Id. at 3568. Talk about going out on a limb. There is no evidence Capstone performed any further risk analysis before settling on 18.5% as the price paid by all captive insureds in 2008 and 2009. 10 The premium for stop-loss coverage should depend on both the likelihood of losses covered by the Reserve policy and the likelihood that the losses during the year would satisfy the attachmentpoint and other conditions of the stop-loss coverage, which depends both on the amount of the loss and the frequency of losses. Not only does nothing in the record provide reason to believe that 18.5% of the total premium is the appropriate premium for the stoploss coverage for any particular captive insured, but Reserve has also failed to explain why it should be the same percentage for every captive insured. Reserve has provided no reason to believe, for instance, that for every (properly priced) insurance policy with a $1 million coverage limit, the probability of incurring two losses exceeding $100,000 in the same year is identical. And there is no indication in the record that the owners of Reserve 10 In 2010, in addition to the previously discussed changes in stop-loss coverage, Capstone changed the premium percentage received by PoolRe to 19.9%. Reserve submitted a letter from Glicksman Consulting, LLC in support of this number. But that letter did not assess any risk. Rather, it presented a range of options based on a number of (unsubstantiated) risk assumptions provided by PoolRe and said that it was beyond “the scope of th[e] review to recommend a specific change” to the stop-loss premium rate. Aplt. App., Vol. 12 at 3564. 34 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 35 or anyone else on its behalf exercised any diligence or investigated the risks it was assuming from participation in the PoolRe pool. One would think that pool members would want to make sure that the premium prices, and therefore their quota-share percentages, accurately reflected the risks involved because if one of the captives’ stoploss endorsements triggered a disproportionate number of claims, then that captive would receive a greater benefit than the rest of the pool members. 11 In the absence of due diligence in assessing the risks of the other captives in the PoolRe pool, the willingness of the captives, including Reserve, to join the pool can perhaps be explained by the unusual, if not unique, fact that both PoolRe and all the captives were managed by Capstone. (One of Reserve’s experts testified that he had never seen a risk pool where all the participants and the pool were managed by the same 11 Say the amount of premiums paid by Peak for its insurance was identical to the amount paid by the insureds of captive insurer A in the pool, but Peak was only 1% as likely as the insureds of A to incur a loss covered by the stop-loss coverage provided by PoolRe. Reserve and A each would forgo the same amount in premiums (18.5% of the total premiums in 2009) to PoolRe and each would be paid that same amount from PoolRe for reinsurance premiums. So Reserve and A would each effectively receive all premiums paid by its insureds. The problem would arise from the discrepancy between the liability each insurer would incur for reinsuring PoolRe’s stop-loss liability and the benefit each would receive from that coverage. Since each had to forgo (at least in form) the same amount in premiums to PoolRe, each would be liable for the same percentage of losses incurred by PoolRe when it had to pay on claims under the stop-loss coverage to any of the captive insurers in the pool. This would be highly unfair to Reserve under our assumption that Reserve would expect to receive only 1% as much benefit as A would receive from the stop-loss coverage. Reserve would be shelling out a lot more to reinsure A’s losses than it would be getting in return from A. If the stop-loss risks to the other captive insurers in the pool were more like the risks to A than the risks to Reserve, it would be foolish for Reserve to join the PoolRe pool. 35 Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 36 entity.) Zumbaum, for his part, testified that he completely relied on Capstone. Also, the captives may have determined, or been advised by consultants, that they would almost surely incur no liability under the stop-loss reinsurance policies, so the premiums for that coverage (which would come back to the captives via the reinsurance of PoolRe) was of no import.