Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 1
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`FILED
`PUBLISH
`United States Court of Appeals
`
`Tenth Circuit
`UNITED STATES COURT OF APPEALS
`
`
`May 13, 2022
`FOR THE TENTH CIRCUIT
`
`_________________________________
`Christopher M. Wolpert
`Clerk of Court
`
`
`
`
`
`
`No. 18-9011
`
`
`RESERVE MECHANICAL CORP., f/k/a
`Reserve Casualty Corp.,
`
` Petitioner - Appellant,
`
`v.
`
`COMMISSIONER OF INTERNAL
`REVENUE,
`
` Respondent - Appellee.
`
`--------------------------------
`
`ALABAMA CAPTIVE INSURANCE
`ASSOCIATION, INC.; ARIZONA
`CAPTIVE INSURANCE ASSOCIATON,
`INC.; DELAWARE CAPTIVE
`INSURANCE ASSOCIATION INC.;
`GEORGIA CAPTIVE INSURANCE
`ASSOCIATION, INC.; HAWAII
`CAPTIVES INSURANCE COUNCIL;
`KENTUCKY CAPTIVE ASSOCIATION,
`INC.; MISSOURI CAPTIVE
`INSURANCE ASSOCIATION;
`MONTANA CAPTIVE INSURANCE
`ASSOCIATION, INC.; NORTH
`CAROLINA CAPTIVE INSURANCE
`ASSOCIATION,; UTAH CAPTIVE
`INSURANCE ASSOCIATION; SELF
`INSURANCE INSTITUTE OF
`AMERICA,
`
` Amici Curiae.
`
`
`_________________________________
`
`
`
`1
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 2
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`Appeal from the Commissioner of Internal Revenue
`(CIR No. 014545-16)
`_________________________________
`
`Val J. Albright, Foley & Lardner, LLP, Dallas, Texas (Michelle Y. Ku, Foley & Lardner,
`LLP, Dallas, Texas, E. John Gorman, Logan R. Gremillion, and Coby M. Hyman, The
`Feldman Law Firm LLP, Houston, Texas, with him on the briefs) for the Petitioner-
`Appellee.
`
`Geoffrey J. Klimas, Attorney, Tax Division (Richard E. Zuckerman, Principal Deputy
`Assistant Attorney General, Joshua Wu, Deputy Assistant Attorney General, Francesca
`Ugolini, Attorney, Arthur T. Catterall, Attorney, Tax Division, with him on the brief),
`Department of Justice, Washington, D.C., for Respondent-Appellee.
`
`Elizabeth J. Bondurant (Jonathan Reid Reich, with her on the brief), Womble Bond
`Dickinson (US) LLP, Atlanta, Georgia, filed a brief for Amici Curiae The Alabama
`Captive Insurance Association, Inc., Arizona Captive Insurance Association, Inc.,
`Delaware Captive Insurance Association Inc., Georgia Captive Insurance Association,
`Inc., Hawaii Captives Insurance Council, Kentucky Captive Association, Inc., Missouri
`Captive Insurance Association, Montana Captive Insurance Association, Inc., North
`Carolina Captive Insurance Association, Utah Captive Insurance Association, and Self
`Insurance Institute of America.
`_________________________________
`
`Before HARTZ, HOLMES, and PHILLIPS, Circuit Judges.
`_________________________________
`
`HARTZ, Circuit Judge.
`_________________________________
`
`
`
`Reserve Mechanical Corp. appeals the decision of the Tax Court affirming the
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`decision of the Commissioner of Internal Revenue that it did not qualify for an exemption
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`from income tax as a small insurance company and that the purported insurance
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`premiums it received must therefore be taxed at a 30% rate under I.R.C. § 881(a). We
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`hold that the record supports the Tax Court’s decision that the company was not engaged
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`in the business of insurance. The court had two grounds for deciding that Reserve was not
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`an insurance company. First, it determined that Reserve had not adequately distributed
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 3
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`risk among a large number of independent insureds—a hallmark of any true insurance
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`company. Virtually all the insured risk was that of one insured, a company that had the
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`same ownership as Reserve itself. To appear to distribute risk, Reserve entered into an
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`insurance pool with other purported insurance companies, each owned by an affiliate of
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`its insured, but the arrangement lacked substance and the pool itself did not distribute
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`risk. Second, the Tax Court determined that the policies issued by Reserve were not
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`insurance in the commonly accepted sense. For example, the premiums were not the
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`result of arm’s-length transactions and were not reasonable, and Reserve was not
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`operated in the way legitimate insurance companies operate. In addition, Reserve argues
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`that if it was not an insurance company, the premiums it received must be treated as
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`nontaxable capital contributions. We also reject that argument.
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`I.
`
`OVERVIEW
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`From 2008 to 2010, when Reserve Mechanical Corp. was known as Reserve
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`Casualty Corp., it issued a number of insurance policies to Peak Mechanical Corp. Two
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`men, Norman Zumbaum and Cory Weikel, owned both Reserve (through Reserve’s
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`parent corporation, Peak Casualty) and Peak. Before these policies were issued, Peak had
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`limited its insurance coverage to commercial policies that cost about $100,000 a year.
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`Peak maintained those policies but also paid Reserve more than $400,000 a year for the
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`supplemental insurance obtained through the new policies. The relationship between
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`Reserve and Peak is often termed “captive” insurance. See 3 Steven Plitt et al., Couch on
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`Insurance § 39:2 (3d ed. 2021) (“A captive insurer is a corporation organized for the
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 4
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`purpose of insuring the liabilities of its shareholders or their affiliates.” (internal
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`quotation marks omitted)).
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`Peak did not appear to get much in return for its $400,000 annual payment to
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`Reserve. The appellate record indicates that Peak recovered on only one loss, receiving a
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`payment of slightly less than $340,000; and even then, as we shall see, the bona fides of
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`the claim were questionable and the handling of the claim was highly irregular. The high
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`premiums on the policies could, however, be a significant financial benefit to Zumbaum
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`and Weikel even if—indeed, especially if—Peak never suffered a loss covered by the
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`policies issued by Reserve. The benefit arises from the tax treatment of small insurance
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`companies, which has special consequences when the small insurer is a captive insurer,
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`sometimes referred to as a “micro-captive.” As the Supreme Court recently explained:
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`A micro-captive transaction is typically an insurance agreement between a
`parent company and a “captive” insurer under its control. The [Internal
`Revenue] Code provides the parties to such an agreement with tax
`advantages. The insured party can deduct its premium payments as business
`expenses. And the insurer can exclude . . . those premiums from its own
`taxable income, under a tax break for small insurance companies. The result
`is that the money does not get taxed at all.
`
`CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1587 (2021) (citations omitted). Thus, Peak
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`could treat the $400,000 in annual premiums it paid to Reserve as a deductible business
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`expense on its federal income-tax returns, while Reserve would be exempt from income
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`taxation so long as it qualified as an insurance company under the tax laws. (Reserve
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`relied on I.R.C. § 501(c)(15), which exempts insurance companies from income taxation
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`under § 501(a) if they receive no more than $600,000 a year in premiums.) The $400,000
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`moved from one entity owned by Zumbaum and Weikel to another entity they owned; so,
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 5
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`pre-tax, they had the same wealth despite the transfer. But their businesses paid
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`significantly less tax. In particular, the more paid in premiums on the insurance policies,
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`the greater the tax deduction, so there would be a strong financial incentive for those who
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`owned both the business and its captive to set the premiums as high as possible, unlike
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`the usual incentive for a business to reduce its expenses. Such tax benefits and incentives
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`have led micro-captive transactions to come under scrutiny because of “their potential for
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`tax evasion.” CIC Servs., 141 S. Ct. at 1587.
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`Capstone Associated Services, Ltd., which consulted for and managed a number of
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`captive insurance companies besides Reserve, advised Zumbaum and Weikel in creating
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`Reserve and handled the technical and management issues, such as preparing policies and
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`recommending premiums. It believed that for Reserve to be a qualified insurance
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`company it would have to receive at least 30% of its premiums from companies not
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`affiliated with it, a threshold we can assume to be correct for purposes of this appeal.
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`In the Background section of this opinion we will describe in some detail how
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`Reserve purported to obtain this diversification of risks. But it may be useful to orient the
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`reader by sketching the key aspects of the arrangement now. Capstone ostensibly created
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`diversification of risks in two ways, which together accounted for about 30% of the
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`“premiums” received by Reserve. First, it arranged for 50-some captives under its
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`management to, in essence, be liable on reinsurance policies issued to each other. In a
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`reinsurance relationship one insurance company, the reinsurer, acts as an insurer of
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`another insurance company; typically, the reinsured insurance company pays a premium
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`to the reinsurer and the reinsurer assumes a portion of the liabilities of the reinsured
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 6
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`company on the insurance policies issued by the reinsured company—that is, the
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`reinsured company “cedes” some of its liability to the reinsurer. See Black’s Law
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`Dictionary 1539 (11th ed. 2019) (defining reinsurance as “[i]nsurance of all or part of
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`one insurer’s risk by a second insurer, who accepts the risk in exchange for a percentage
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`of the original premium”); 13A John Alan Appleman & Jean Appleman, Insurance Law
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`and Practice § 7681, at 480 (1976) (“Reinsurance, to an insurance lawyer, means one
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`thing only—the ceding by one insurance company to another of all or a portion of its
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`risks for a stipulated portion of the premium, in which the liability of the reinsurer is
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`solely to the reinsured, which is the ceding company, and in which contract the ceding
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`company retains all contact with the original insured, and handles all matters prior to and
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`subsequent to loss.”); but cf. Colonial Am. Life Ins. Co. v. Comm’r, 491 U.S. 244, 247
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`(1989) (adopting a more expansive notion of reinsurance). For example, a company that
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`issues homeowners insurance may pay a premium to a reinsurer to protect the
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`homeowner-insurance company from unsustainable losses if a major fire destroys too
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`many homes insured by the company.
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`The reinsurance arranged by Capstone was accomplished through PoolRe
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`Insurance Corp., another company managed by Capstone. Through PoolRe each of the
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`captive insurers in effect reinsured, and was reinsured by, each of the other captives, with
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`PoolRe acting as the intermediary. See Figure 1.
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 7
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`
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`Figure 1 – Capstone’s Role
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`
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`The process involved two steps. To begin with, on each policy issued by Reserve and the
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`other captives, PoolRe provided what was termed stop-loss coverage (purportedly to
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`protect the captive insurers from excess losses) through an endorsement on the policy that
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`required PoolRe to assume a portion of the liability incurred by the captive insurer on the
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`policy covering the insured (such as Peak). The restrictions on payment under the stop-
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`loss coverage, which will be explored later, were sufficiently intricate and demanding
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`that it appears they were never satisfied during the years in question (either on the stop-
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`loss coverage for Reserve policies or the stop-loss coverage provided for the other
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`captives), so there were no payouts on the coverage. For this stop-loss coverage, PoolRe
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`received a fixed percentage (18.5% the first year) of the premiums paid on the policies
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`issued by the captives.1 As the second step, the captives in turn reinsured all of PoolRe’s
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`1 Strictly speaking this was not a reinsurance agreement since PoolRe was directly
`liable to the insured (such as Peak) under an endorsement on the policy from the captive
`insurer (such as Reserve) to the insured.
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 8
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`stop-loss coverage, with each captive receiving a premium from PoolRe equal to the
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`premium its insured paid to PoolRe. See Figure 2.
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`
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`Figure 2 – How the Reinsurance Pool Worked
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`The net result of this arrangement was that each captive insurer received the full
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`premium paid by its insureds—the 81.5 % paid directly to the captive by the insured plus
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`the 18.5% paid to PoolRe, which in turn later paid that amount to the captive. Through
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`this arrangement, all the captive insurers shared the entire risk of the stop-loss coverage
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`provided by PoolRe. If one of the captives incurred liability that triggered the stop-loss
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`coverage, PoolRe would pay its share of the loss but would be fully reimbursed through
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`the reinsurance it obtained from the captives as a whole, with each captive paying its
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`proportionate share. As previously mentioned, however, this risk apparently never
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`materialized. At least during the period relevant to this appeal, PoolRe did not need to
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 9
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`pay on any stop-loss coverage, so the payments to and from PoolRe were a wash. But
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`Reserve could argue that 18.5% of the premiums paid by Peak came to Reserve from
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`PoolRe, rather than from its affiliate (Peak), and that it thereby distributed risk beyond its
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`affiliates.
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`The second way in which Capstone arranged for the captives to ostensibly
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`diversify risks was by purportedly arranging for each captive to reinsure a small
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`percentage of risk that PoolRe assumed from coinsuring thousands of vehicle-service
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`contracts with another insurance company. See Black’s Law Dictionary 954 (11th ed.
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`2019) (providing one definition of coinsurance as “[i]nsurance provided jointly by two or
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`more insurers”). Reserve claimed to have received about 15% of its premiums through
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`this arrangement. In each year for which we have a record, Reserve reported that it
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`incurred liability from this reinsurance approximately equal to the amount it was owed in
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`premiums. Taken together, the premiums from both these plans constituted more than
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`30% of the premiums Reserve received from Peak and PoolRe.
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`Questioning the bona fides of Reserve’s various arrangements, the IRS rejected
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`Reserve’s claim to be a qualified insurance company and assessed it for back taxes.
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`Reserve challenged the assessment in the United States Tax Court but lost. Reserve has
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`appealed to this court. Exercising jurisdiction under 26 U.S.C. § 7482(a), we affirm.2 In
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`the Tax Court proceedings Reserve had the burden of proving that the IRS’s assessment
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`2 Reserve appealed to this circuit, perhaps because it filed its tax return in Utah.
`See 26 U.S.C. § 7482(b)(1)(B). The Commissioner has not challenged venue.
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 10
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`was incorrect. On the record before it, the court could properly find that Reserve had not
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`satisfied its burden—in particular, Reserve had not proved that its purported insurance
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`transactions were truly arrangements for insurance. We also reject Reserve’s challenge to
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`the Tax Court’s refusal to accept Reserve’s claim that its receipts from Peak were, if not
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`insurance, nontaxable capital contributions.
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`Our discussion will proceed as follows: First, we describe at length the facts
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`relevant to the issues before us. Second, we review the applicable law and the decision of
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`the Tax Court holding that Reserve was not an insurance company. Third, we explain
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`why we affirm that holding. Fourth, we reject Reserve’s argument that it owes no taxes
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`even if it was not an insurance company because the “premium” payments from Peak
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`must then be deemed nontaxable contributions of capital.
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`II.
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`BACKGROUND
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`In this section we will discuss the formation of Reserve, the policies it issued to
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`Peak, the reinsurance arrangements it made with PoolRe that ostensibly allowed it to
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`distribute risk to entities not affiliated with Peak, and the tax claim instituted against
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`Reserve.
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`We recite the evidence of record in some detail. The amicus brief submitted to this
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`court, as well as the briefs of Reserve itself, suggest that the decision of the Tax Court
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`undermines perfectly proper practices in the creation and operation of captive insurance
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`companies. But the specific evidence presented can make all the difference. Two
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`transactions that appear similar in form may be treated quite differently under the law
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`because of differences in the underlying substance. We do not hold that the forms of the
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 11
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`transactions involving Reserve are improper (for example, insurance pools such as
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`PoolRe may be perfectly legitimate in other circumstances); we hold only that the Tax
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`Court could properly conclude that they were not insurance transactions in substance.
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`A.
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`Formation of Reserve
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`Zumbaum and Weikel formed Peak in the mid-nineties to operate near deep
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`underground mines in Idaho’s Silver Valley. Peak continues to do business in Idaho,
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`primarily on the Bunker Hill Superfund Site, but also in other locations in Idaho and
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`Nevada. It manufactures and sells equipment that supports underground mining
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`operations. This equipment includes ventilation fans that control the temperature of the
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`mines, submersible pumps that remove the groundwater from the mines, and vehicles that
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`transport workers, explosives, and fuel to, from, and within the mines. Peak also repairs
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`and cleans mining equipment that is often contaminated with hazardous waste like lead or
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`zinc. Because the cleaning operations risk creating hazardous-waste runoff, Peak employs
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`various measures, such as the use of cleaning bays, sumps, and containment areas, to
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`prevent spreading the contaminants.
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` In 2008 and 2009 Peak had 17 employees, including two shop managers, ten shop
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`staff, and two outside salespersons. By 2010 it was down to 13 employees. Zumbaum and
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`Weikel also owned two other business entities: RocQuest holds the real estate that Peak
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`leases for its operations, and ZW was created by Zumbaum and Weikel to lend money to
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`Zumbaum’s secretary when she wanted to buy a bar in Silver Valley. At trial Zumbaum
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`described the operations of RocQuest and ZW as insignificant.
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 12
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`Before obtaining insurance from Reserve, Peak relied on several commercial
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`policies for its insurance needs: Most recently it had paid premiums of $95,828 for 2007,
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`and $57,300 for the first half of 2008. The coverage limits for the policies ranged from
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`$5,000 to $2 million. Peak filed few claims under these policies—some claims under its
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`auto-insurance policies and a claim under its commercial-property policy for snowstorm
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`damage to the roof of one of Peak’s buildings (Peak spent $25,000 to replace the roof but
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`recovered only $2,000 from the insurer). Although Peak claimed that it was unhappy with
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`its insurers’ handling of these claims, Peak continued its policies with them, even after
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`procuring the additional coverage from Reserve.
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`Zumbaum and Weikel reached out to Capstone after a mentor recommended
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`taking a look at forming a captive insurance company. Stuart Feldman, chief executive
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`officer of Capstone’s general partner, Capstone Holdings Corp., and Lance McNeel,
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`Capstone’s director of insurance operation, conducted an on-site visit of Peak in August
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`2008. Before the visit Peak provided Capstone with background documents on Peak’s
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`finances, taxes, and current insurance. The visit lasted six to eight hours. McNeel and
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`Feldman toured Peak’s facilities and discussed Peak’s business operations and insurance
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`risks.
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`After the visit Capstone began preparing a “Captive Insurance Company
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`Feasibility Study” to “evaluate[] Peak’s desire to explore the option of forming a captive
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`insurer for the purpose of writing coverages that are generally unavailable or impractical
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`to obtain in the conventional insurance marketplace.” Aplt. App., Vol. 7 at 2027, 2030
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`(emphasis added). For reasons not explained in the record, Capstone did not produce the
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 13
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`final version of the study until August 2009. The study outlined advantages of captives,
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`such as “lower risk costs,” investment income, tailored policies, coverage prices that
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`“track closely with the risks inherent in an insured’s own exposures,” access to
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`reinsurance, and “complete control over the operation of [the] captive[].” Id. at 2040–42.
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`It said that “[c]overage lines that address reasonably predictable, non-catastrophic
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`exposures are good candidates for coverage by a captive,” and that other “unpredictable
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`exposures may also be good candidates,” but that those exposures would likely require
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`“pooling or reinsurance.” Id. at 2040.
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`As for Peak specifically, the study noted that Peak’s “current conventional policies
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`. . . offer broad and comprehensive coverage that is appropriately designed and priced,”
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`id. at 2047, and it acknowledged that Peak “had no losses of any significance” on its
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`current policies, id. at 2061. But it stated that a captive could insure against additional
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`risks, and it mentioned 13 categories of such risks, describing each in one to four
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`sentences. There was no discussion of the likelihood of any risk. The study did not
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`mention either ZW or RocQuest.
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`Zumbaum and Weikel did not wait for the final feasibility study before beginning
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`their insurance project. On December 3, 2008, about four months after the site visit, they
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`incorporated Reserve (as a subsidiary of their holding company named Peak Casualty) in
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`Anguilla, British West Indies, with an initial capital investment of $100,000. Reserve had
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`no employees and was managed by Capstone. Also in December, Reserve issued its first
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`set of policies.
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`B.
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`Reserve’s Direct Policies
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`Reserve issued 13 policies to Peak (RocQuest and ZW were also named insureds,
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`but we will generally refer only to Peak) on December 4, 2008:
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`1)
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`2)
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`3)
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`4)
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`5)
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`6)
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`7)
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`8)
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`Excess Directors & Officers Liability (for liability for wrongful acts
`committed by directors and officers acting in such capacity)
`Special Risk – Loss of Major Customer (for reduction in net income caused
`by loss of major customer)
`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)
`Special Risk – Loss of Services (for loss of services of employees to be
`specifically named)
`Special Risk – Weather Related Business Interruption (for losses from
`interruption of business caused by weather)
`Excess Pollution Liability (for cost of cleaning up on-site pollution and
`liability for creating pollution)
`Special Risk – Tax Liability (if tax liability exceeds 115% of filed tax
`liability)
`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)
`Special Risk – Regulatory Changes (for damages to business from changes
`in the law)
`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 employment-
`related legal rights, breach of employment contract, etc.)
`12) Excess Cyber Risk (for liability and for business and property loss caused
`by others)
`Special Risk – Product Recall (for expenses of recall of products
`manufactured or sold by Peak)
`
`9)
`
`10)
`
`13)
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`For each policy the policy period was less than a month, extending from December
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`4, 2008, to January 1, 2009, and the liability limit was $1 million. The total premium was
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`$412,089.02. The policies were claims-made policies: The claim must have been based
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`on acts, errors, or omissions after the policy inception date or, if applicable, after the
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`earlier retroactive date set forth in the policy. And the claim must have been made and
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`reported to Reserve after the policy inception date and during the policy period or, if
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`applicable, during the extended reporting period set forth in the policy. Policy # 7—the
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`tax-liability policy—had special provisions on retroactivity and reporting, apparently
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`intending to cover tax returns due before 2009 if covered losses were reported within four
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`years of the due date. Six policies (1, 6, 8, 10, 11, 12) had a retroactive date of January 1,
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`2005 (so the act or omission giving rise to the claim could have predated the policy by as
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`much as four years) and an extended reporting period of three or four years (so the claim
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`could have been made and reported to Peak as late as December 2012). The remaining
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`policies had no retroactive date but extended reporting periods of one year or, in one case
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`(policy #13), four years. Each policy contained an other-insurance clause, which
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`provided, “The limits and deductibles stated herein only apply after coverage is
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`exhausted from any and all other valid insurance policies issued by any other insurer,”
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`Reserve Mech. Corp. v. Comm’r, T.C. Memo. 2018-86 at 14, 115 T.C.M. (CCH) 1475
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`(T.C. 2018) (Reserve) (capitalization omitted);3 so if Peak suffered a loss that could be
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`covered by both a Reserve policy and one of its commercial policies, Reserve would pay
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`3 For simplicity and uniformity we refer to the pagination of the Tax Court’s
`memorandum opinion throughout this opinion.
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`nothing unless the claim exhausted the benefits under the commercial policy.
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`Several of these policies were executed with singular carelessness. For example,
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`two of the policies erroneously listed Pacific Arts Entertainment, LLC and Pacific Arts
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`Presents, LLC as the insureds, rather than Peak, RocQuest, and ZW. And although the
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`directors-and-officers policy stated that it covered the specific officers and directors listed
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`in Schedule 1-A, an attachment to the policy, Schedule 1-A did not list a single insured
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`person, so the policy—for which Peak paid $17,122—would provide no coverage. Also,
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`in the apparent rush to issue the policies (and pay premiums that would be deductible in
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`2008), Peak paid for three policies—employment-practices liability, weather-related
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`business disruption, and cyber risk—that apparently were deemed unnecessary after a
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`little further consideration, as they were dropped in 2009, after being in place for less
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`than one month.4 (Notably, the later-issued feasibility study described one of the
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`discontinued coverages—employment-practices liability—as a “major liability
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`concern[]” for Peak. Aplt. App., Vol. 7 at 2062.)
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`1.
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`Policy Premiums
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`There are also remarkable errors in pricing the premiums on two policies. McNeel,
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`Capstone’s director of the insurance operation, prepared a rating worksheet for each of
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`4 Besides dropping the three policies in 2009, Peak replaced the expense-
`reimbursement 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.
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 17
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`the policies. On the 2008 worksheet, for example, one column set the annual premium for
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`each policy, and an adjacent column contained a pro rata percentage to account for how
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`premiums calculated on an annual basis should be adjusted for retroactive and partial-
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`year coverage. For those policies with retroactive coverage the pro rata percentage was
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`usually 95%. For four of the policies (loss of major customer, loss of services, product-
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`recall reimbursement, and weather-related business interruption) with no retroactive
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`coverage (so the occurrence had to be during December 2008) the pro rata percentage
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`was 10% (presumably reflecting that the coverage was for occurrences during less than
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`10% of a full year). But for Special Risk – Regulatory Changes, which also had no
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`retroactive coverage, the pro rata percentage was 95%. When asked about this at oral
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`argument, counsel for Reserve responded, “It certainly strikes me as an error.” Oral Arg.
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`at 37:30.5 A similar error was made with respect to the policy for Special Risk – Expense
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`Reimbursement.
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`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
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`Appellate Case: 18-9011 Document: 010110683986 Date Filed: 05/13/2022 Page: 18
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`Perhaps more important, the manner of arriving at the premium prices on
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`McNeel’s rating worksheet was questionable. The core task in setting premiums for an
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`insurance policy is predicting risk: the size and frequency of losses covered by the policy.
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`See Owens v. Aetna Life & Cas. Co., 654 F.2d 218, 240 (3d Cir. 1981) (“The [insurance]
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`company must set its premiums based on its prediction of two cost variables: the
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`probability of a particular risk of loss occurring and the magnitude of the loss if it
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`occurs.”). But the record is devoid of evidence of the necessary risk assessment by
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`Reserve. Peak had no history of any losses that would be covered by the Reserve policies,
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`so the premiums could not be based on Peak’s actual experience. The feasibility study
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`briefly described the risks that would be covered by the policies, but it contained no
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`discussion of the probability or size of the risks. For example, when the feasibility study
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`discussed Peak’s need for employment-practices liability coverage, it merely stated that
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`this liability “has become a hot topic over the past several years as complaints and legal
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`action nationwide have skyrocketed for wrongful termination, discrimination,
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`harassment, and other employment-related practices.” Aplt. App., Vol. 7 at 2056. (Again,
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`Peak dropped its excess-employment-practices-liability coverage after one month, before
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`the feasibility study was issued.)
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`the policy limit dropped from $1 million to $500,000.