The Self Insurance Institute of America and 10 state captive associations Friday urged a federal appeals court to reverse a tax court ruling unfavorable for microcaptives.

In a friend of the court brief filed with the 10th U.S. Circuit Court of Appeals in Denver, the captive trade associations argue that U.S. Tax Court Judge Kathleen Kerrigan erred in ruling in Reserve Mechanical Corp. v. Commissioner of Internal Revenue that a microcaptive owned by an Osburn, Idaho-based mining services company was not operated as a legitimate insurer.

The Reserve Mechanical case is one of several recent victories by the IRS against so-called 831(b) captives, which are microcaptives electing Section 831(b) of the Internal Revenue Code and are taxed only on their investment income, not their underwriting income.

In the court filing, the trade associations argue Judge Kerrigan erroneously: failed to consider the concept of fortuitous loss and instead held that a history of losses was required to justify a classification of insurance; criticized the use of standardized or “cookie-cutter policies”; and ruled that risk pools failed to achieve risk distribution.

The risk pooling element of the captive structure was a key focus of the lower court ruling. The Reserve captive, which was owned by Peak Mechanical & Components Inc., was covered under a stop-loss policy through PoolRe Insurance Corp., an Anguilla-based insurer. Reserve and other captives also had a quota-share reinsurance agreement with PoolRe. Over three years Reserve bore no losses under the quota share and the reinsurance premium it received matched the premium it paid for stop-loss coverage.

The judge ruled that the arrangement constituted a “circular flow of funds” created for tax purposes.

In the amicus brief, the trade associations argue that pooling is a routine transaction that is common in the insurance industry.

 “A pooling transaction is one that materially changes its participants’ economic positions by mixing the risks they insure,” the filing states.

Commercial insurers regularly pool risks among affiliated companies, the trade associations argue.

In addition to the SIIA, state captive associations from Alabama, Arizona, Delaware, Georgia, Hawaii, Kentucky, Missouri, Montana, North Carolina and Utah joined the amicus brief.