(j) Significant unrelated risks

Historic Background—In Revenue Ruling 88-72, a wholly owned subsidiary of the taxpayer insured risks of unrelated parties as well as risks of its parent and other affiliates. The coverage of the related risks represented a small fraction of its total insurance business. The Service ruled that the coverage of its parent’s and other affiliates’ risks did not qualify as insurance because the economic risk of loss had not shifted.

The risk of loss did not shift because the parent continued to have an economic stake in whether it or the subsidiary incurred a loss. The parent and its subsidiaries therefore could not deduct premiums paid to their life insurance affiliate. The Service declared Revenue Ruling 88-72 obsolete in Revenue Ruling 2001-31, in which the Service disavowed its “economic family theory.” The Service’s position—The Service addresses two situations in which a wholly-owned subsidiary “insured” the professional liability risks of its parent, either directly or through reinsurance, as well as “homogeneous” similar risks of unrelated parties, in Revenue Ruling 2002-89. In each situation, the amounts that the parent pays its subsidiary “are established according to customary industry rating formulas.

In all respects, the parties conduct themselves consistently with the standards applicable to an insurance arrangement between unrelated parties.” The subsidiary “may perform all necessary administrative tasks, or it may outsource those tasks at prevailing commercial market rates.” In addition, the parent does not provide any guarantee regarding the subsidiary’s performance, the subsidiary does not make a loan to its parent, and all funds and records of the parent and subsidiary are maintained separately.

In situation 1, the premiums and risks assumed from the parent were 90 percent of the subsidiary’s total risks for its taxable year. The Service concluded that the arrangement in this situation was not insurance for Federal income tax purposes. The requisite risk shifting and distribution were not present because such a large portion of the premiums and risks were from the parent. The parent’s payments to its subsidiary therefore were not deductible as “insurance premiums” under section 162.

In situation 2, the premiums and risks assumed from the parent were less than 50 percent of the subsidiary’s total risks assumed for its taxable year. The Service concluded that the arrangement was insurance so that the parent’s payments to its subsidiary were deductible as insurance premiums under section 162. Court pronouncements—The Tax Court concluded (in dicta) in Gulf Oil that coverage of a company’s risks is insurance if an “insurance subsidiary” covers a sufficient amount of unrelated risks. It stated that premiums of an affiliated group, will no longer cover anticipated losses of all of the insureds [if a sufficient proportion of premiums are paid by unrelated parties because] the members of the affiliated group must necessarily anticipate relying on the premiums of the unrelated

insureds in the event that they are ‘the unfortunate few’ and suffer more than their proportionate share of anticipated losses.

Only two percent of the premiums paid to the insurance subsidiary in the years before the court in Gulf Oil were from unrelated insureds, which the Tax Court considered de minimis. The Tax Court “declined” to indicate the amount of premiums for unrelated risks that would be sufficient for affiliated group premiums to qualify as insurance premiums. It stated, however, that “if at least 50 percent are unrelated, we cannot believe that sufficient risk would not be present.”

The Tax Court rejected the “economic family” theory espoused by the Service in Revenue Ruling 77-316. Although the economic family approach would have reached the same result that the Tax Court reached in the case before it, the Service’s approach “would have foreclosed a wholly owned captive from ever being considered a separate insurance company.”

The court stated that “we specifically reserved any discussion of the tax consequences of payments to captives with unrelated owners and/ or unrelated insureds.” Courts have respected arrangements in which the unrelated risks covered by captive insurers involved 52 to 74 percent of the written insurance covered in AMERCO v. Commissioner, 29 to 33 percent in The Harper Group v. Commissioner, and 44 to 66 percent in Ocean Drilling & Exploration Co. v. United States.

(i) Coverage by an unrelated company

An arrangement in which an unrelated company assumes risks from only one company does not qualify as insurance. In Revenue Ruling 2005- 40, situation 1, a courier transport company that owned and operated a fleet of vehicles paid a premium to an unrelated company to assume the risks of loss arising from the use of the vehicles in its business. The premium was an arms-length amount determined “according to customary insurance industry rating formulas” and the assuming company held enough capital to fulfill its obligations under the agreement.

There were no guarantees nor loans of premiums back to the courier transport company. The courier transport company was not obligated to pay additional premiums if the actual risks exceeded the premiums paid and it was not entitled to a refund if the actual losses were less than the premiums paid in any period. The parties conducted themselves in a manner that was “consistent with the standards applicable to an insurance arrangement between unrelated parties,” except that the recipient of the premiums assumed risks only from the courier transport company.

The Service concluded that the arrangement did not qualify as insurance reasoning that although the “arrangement may shift the risks of [the courier transport company], the risks [were] not distributed among other insureds or policyholders.” The facts were the same in situation 2, except that in addition to assuming the risks of the courier transport company the unrelated company assumed risks from another fleet owner that conducted a courier transport business. The second fleet owner was unrelated to the first. The amounts earned and risks transferred from the second fleet owner constituted 10 percent of the total earnings of and risks borne by the assuming company.

The Service concluded that the arrangement between the original courier transport company and the assuming company did not qualify as insurance because there was an “insufficient pool of other premiums to distribute [the courier original transport company’s] risk.” In situation 3 the courier transport business was conducted through 12 wholly owned limited liability companies (LLCs). Each LLC transfers risks and pays a specified premium to an unrelated company. The premium paid by each LLC was an arms length amount determined “according to customary insurance industry rating formulas” and the assuming company held enough capital to fulfill its obligations under the agreement. There were no guarantees nor loans of premiums back to a given LLC.

The LLC would not be obligated to pay additional premiums if the actual risks exceeded the premiums paid and it was not entitled to a refund if the actual losses were less than the premiums paid in any period. The parties conducted themselves in a manner that was “consistent with the standards applicable to an insurance arrangement between unrelated parties,” except that the recipient of the premiums only assumed risks from the LLCs.

Each of the LLCs was a “disregarded entity” under regulation section 301.7701-3, and therefore treated as branches or divisions of the LLCs’ owner. The Service concluded that the arrangements did not qualify as insurance because it covered the risks of only one entity, the LLCs’ owner.

In situation 4 , each LLC elected to be treated as an association. The Service concluded that the arrangement between each LLC and the unrelated assuming company was insurance, because each LLC transferred risks to the assuming company and distributed the risks with those of the other LLCs.

(h) Coverage of other “related” entities

An individual, Fred Lennon, wholly owned Crawford Fitting, a manufacturer of valves and fittings, in Crawford Fitting Company v. United States. He also owned at least 50 percent of four regional warehouses and held varying interests in other companies that provided services and/or parts to the manufacturers. Crawford, other manufacturers of valves and fittings, various companies that provided parts and services for the manufacturers and the regional warehouses obtained coverage from Constance, which was created under the Colorado Captive Insurance Company Act. Constance retained a specified portion of the covered risk and reinsured the remaining coverage with an unrelated reinsurer.

The warehouses owned 80 percent of Constance. Crawford employees and lawyers owned the remaining 20 percent. Members of Lennon’s family held the interests in the warehouses that Lennon did not directly hold. Consequently, Lennon had a significant economic stake in both Crawford

Fitting and Constance. 

The government argued that the portion of Crawford’s premium that was attributable to the retained coverage was a “reserve for self-insurance.”  It asserted that the risk of loss remained in Crawford’s economic group. The District Court for the Northern District of Ohio, however, held that Crawford’s premiums were deductible reasoning that Constance was “legitimately organized to enable Crawford to secure insurance at a reasonable price, without substantial limitations on the types and amounts of risk  in return for the payment of legitimate premiums.” Constance was adequately capitalized.

Further, Crawford did not own stock in Constance or any of the warehouses that owned stock in Constance. The premiums were “actuarially based” and proportional to the risks covered. Risk distribution was present because the insureds included numerous entities that were not affiliated with Crawford. Crawford therefore shifted the risk of loss from its economic family to Constance and Constance distributed the risks of the insureds. 

Inadequate capitalization

The “insurance” subsidiary of the foreign parent of a domestic holding company covered pollution liabilities with respect to (1) manufacturing by five operating subsidiaries of the holding company and (2) certain real estate owned by the holding company and used by two of the holding company’s operating subsidiaries in Technical Advice Memorandum 200323026. The foreign parent, incorporated in Country R, created the insurance subsidiary under the laws of another foreign country, Country S.

The insurance subsidiary was capitalized with $500x, although an independent consultant performed a feasibility study and recommended that the initial capitalization should be $10,000x. Premiums for the first year totaled $1000x, including $620x from one of the subsidiaries. By June 30 of “Year 4 ” the shareholder’s equity grew to $2,822x. The insurance subsidiary issued six policies, each of which covered liability of up to $10,000x per pollution incident and an aggregate of up to $10,000x. The amount of premiums varied considerably among the insureds. For the period July 1 of Year 3 to June 3 0 of Year 4 , more than two thirds of the premiums were paid by Operating Subsidiary 3.

The Service concluded that insurance was not present because the captive was not adequately capitalized. The capitalization was only onetwentieth of the amount recommended in a feasibility study and liability on a single incident that equaled the $10,000x per incident limit would far exceed the captive’s equity, premium and investment income combined.

That the capitalization was sufficient to obtain a charter in Country S and to satisfy a “specific tax rule” of Country R were not sufficient to  demonstrate that it was adequately capitalized for United States Federal income tax purposes. In contrast, the Service noted that although one potential insurance loss could substantially exceed the capitalization, many states “limit the amount of loss to which an insurer may be exposed on any one risk to ten percent of the insurer’s surplus.” The Service also concluded that sufficient risk distribution was lacking.

In addition, the Service concluded that the insurance arrangement among the parties was too informal. The policies for “Year 2” and “Year 3,” for example, were not formally executed until “Year 4 .” The taxpayers “assert[ed] that there were oral contracts in the meantime.”

(g) Impact of undercapitalizations, guarantees and other financial enhancements

In general—The capitalization of a captive or the use of a guarantee or other financial enhancements can influence whether a transaction is insurance. The Tax Court’s conclusion in Carnation that the transaction between Carnation and its captive, Three Flowers, was not insurance was influenced by American Home’s refusal to enter into the transaction without Carnation’s agreement to capitalize Three Flowers with up to $3 million.

In Humana, the Sixth Circuit indicated that the undercapitalization of the foreign captive combined with the capitalization agreement running to the captive in Carnation, the indemnification agreement in Stearns- Roger, and the  undercapitalization of the captive in Beech Aircraft, were sufficient factors to find a lack of risk-shifting.85 The Sixth Circuit also addressed the impact of an undercapitalization and/or economic enhancements on the characterization
of a captive insurance arrangement in Malone & Hyde v. Commissioner.

 

Malone & Hyde—Malone & Hyde, a company in the wholesale food business, obtained automobile, worker’s compensation, and general liability coverage for its divisions and subsidiaries from Northwestern National Insurance Company, an unrelated casualty insurer. Northwestern reinsured specified amounts of this coverage with Eastland Insurance, Ltd., a Bermuda captive, and a wholly owned subsidiary of Malone & Hyde. Eastland provided Northwestern with an irrevocable letter of credit of $250,000 (later increased to $600,000) to cover any unpaid amounts under the reinsurance agreement. Eastland did not reinsure any risks of
unrelated parties during the years at issue. Malone & Hyde also entered into a hold-harmless agreement with Northwestern, which provided that Northwestern would be held harmless and defended with regard to any third-party claim that might arise if Eastland defaulted on its obligations as reinsurer.

Malone & Hyde argued that premiums paid to cover risks transferred from sister corporations were deductible under principles addressed in Humana. The Commissioner argued that the facts of Malone & Hyde were distinguishable from those of Humana because the transaction in Malone & Hyde included  hold-harmless agreements and letters of credit. 

The Tax Court concluded that the agreements reflected “reasonable, cautious business practices in dealing with a new customer and a new reinsurer” and that Eastland was a valid insurance company. Eastland was adequately capitalized under Bermuda law. The insurance agreements with Northwestern and the reinsurance agreement with Eastland resulted from arms-length negotiations
and were evidenced by written policies and endorsements. In addition, “Eastland operated as a separate and viable entity, financially capable of meeting its obligations. In sum, the arrangements among Malone & Hyde, its subsidiaries, Northwestern, and Eastland constituted insurance in the commonly accepted sense.” The Tax Court distinguished its holdings in Carnation and Clougherty stating that “we found in Carnation, and further articulated in Clougherty, that
the capitalization agreement was not a critical factor in the outcome of the case, but only one of several factors to be considered in determining whether or not the requisite risk shifting was present.”

The Sixth Circuit reversed the Tax Court’s decision, concluding that insurance was lacking because the ultimate risk remained with Malone & Hyde under the hold-harmless agreements.89 It distinguished Humana, stating that Humana established the captive to address the loss of insurance coverage, a legitimate business concern, and its captive was not a sham. The captive was fully capitalized, domestically incorporated, established without any guarantees from its parent, and acted in a straightforward manner. The court stated, when the entire scheme involves either undercapitalization or indemnification of the primary insurer by the taxpayer claiming the deduction, or both, these facts alone disqualify the premium payments from being treated as ordinary and necessary business expenses to the extent such payments are ceded by the primary insurer to the
captive insurance subsidiary.

In HCA,92 the Tax Court applied the principles of Malone & Hyde and concluded that risk shifting was absent with respect to workers compensation obligations covered by the captive as a reinsurer to the “extent and during the time” that HCA agreed to indemnify the primary insurer against nonperformance of the captive. However, the impact of the indemnification agreement was not sufficient for the court to conclude that the transactions between the captive and its sister corporations were not bona-fide. The court reasoned, in part, that the agreement only applied to one type of coverage, which was not the primary coverage provided by the captive.

In Kidde, the Court of Federal Claims concluded that risk was not transferred to the captive before June 1, 1978 under a captive insurance arrangement (described in the section above). Kidde remained ultimately responsible for the underlying losses as a result of the impact of an indemnity agreement with the primary insurer, which was in effect while the parties worked out the details of the captive insurance agreement. 

The court concluded that the indemnity agreement was not meant to be a long-term commitment because retaining the ultimate responsibility for the covered losses would be fundamentally inconsistent with the existence of a true insurance relationship. The court found that the agreement terminated as of May 3 1, 1978 because by that date the captive’s assets and a letter of credit from a major U.S. bank were sufficient to ensure that the captive would be able to protect the primary insurer’s interests.

The Service's position on brother-sister arrangements

Prior to issuing Revenue Ruling 2001-31 the Service held that coverage in brother-sister arrangements was not insurance under its economic family theory. In Field Service Advice 200125005, and Field Service Advice 200125009, however, the Service's National office recommended that the Service concede the deduction of premiums paid by an operating subsidiary to a sister insurance captive. It concluded in Field Service Advice 200125005 that contesting the deduction of these premiums raised substantial litigation hazards, noting that the Service lost on the "brother/sister" issue in Humana and Kidde Industries. Factors "such as 'hold harmless' agreements to unrelated insurers or anyone else" were not resent.

The Service conceded that "no court, in addressing a captive insurance transaction, has fully accepted the economic family theory set forth in Rev. Rul. 77-316." 

In addition, the taxpayer provided some support that it had a valid business reason for creating the captive. In Revenue Ruling 2002-90, a domestic holding company created a wholly-owned subsidiary to provide insurance coverage for 12 domestic operating subsidiaries that provided professional services. The operating subsidiaries provided the same "general categories of professional services." Each subsidiary operated on a decentralized basis in a separate state.

None of the operating subsidiaries had coverage for less than 5 percent nor more than 15 percent of the total risks covered by the insurance subsidiary. In total the subsidiaries had "a significant volume of independent, homogeneous risks."

The insurance subsidiary was licensed in each of the 12 states in which the operating subsidiaries did business. The holding company provided adequate capital to its insurance subsidiary but there was no parental guarantee and there were no related party guarantees. The insurance subsidiary loaned no funds to its parent or the operating subsidiaries. 
 

The Service concluded that the insurance subsidiary provided insurance to the operating subsidiaries. It reasoned that the operating subsidiaries' professional liability risks were shifted to the insurance subsidiary. The premiums paid were arms-length and were "pooled such that a loss by one operating subsidiary was borne, in substantial part, by the premiums paid by others." 

In addition, the insurance and operating subsidiaries conducted themselves in all respects as would unrelated parties to a traditional insurance relationship, and [the insurance subsidiary]was regulated as an insurance company in each state where it did business."

(f) Brother-sister transactions

Humana—In Humana, Inc. v. Commissioner,64 the Sixth Circuit concluded that risk-shifting was present in the brother-sister transactions because the insured did not own stock of the insurance subsidiary so that a loss covered by the insurer did not influence the insured’s net worth. The court also concluded, without detailed elaboration, that risk-distribution was present. It stated, “we see no reason why there would not be risk distribution in the instant case where the captive insures several separate corporations within an affiliated group and losses can be spread among the several distinct corporate entities.”

HCA and Kidde Industries—The Tax Court, in Hospital Corporation of America et. al. v.  Commissioner, (HCA), and the Court of Federal Claims, in Kidde Industries, Inc. v. United States, (Kidde), applied the “balance sheet” approach to determine whether risk-shifting was present in the taxpayers’ captive insurance arrangements.

HCA involved the tax treatment of a captive insurance arrangement whose facts, “with a few significant differences, . . . [were] strikingly similar to the facts presented in Humana[.]” HCA created a wholly owned (captive) subsidiary, Parthenon, which provided a wide range of insurance coverages for it’s parent, HCA, and its sister corporations. The Tax Court used the balance sheet approach applied by the Sixth Circuit in Humana to determine whether HCA and its affiliates shifted their risks to Parthenon. It concluded that HCA did not shift its risks to Parthenon but that the sister affiliates did (but for certain workers compensation cover- age subject to an indemnification agreement, which is addressed in the analysis of the impact of guarantees).

Kidde was a “broad-based, decentralized conglomerate with 15 separate divisions and 100 wholly owned subsidiaries” in 1977-1978, the years before the court. Before 1977, Travelers provided workers compensation, automobile and general liability (including products liability) coverage. Travelers would not renew Kidde’s products liability coverage for 1977.

Kidde could only obtain such coverage at extremely high rates. It established Kidde Insurance Company Limited (KIC), a Bermuda captive, on December 22, 1976, to provide workers compensation, automobile, and general liability (including products liability) coverage for Kidde’s divisions and operating subsidiaries. Kidde and its operating subsidiaries obtained insurance coverage from an unrelated primary insurer that “transferred”  specified portions of the risk to KIC.

The U.S. Court of Federal Claims denied the deduction of premiums attributable to the coverage for KIC’s parent (that is, Kidde’s divisions). Applying the balance sheet approach, the court concluded that Kidde did not shift its risk of loss to its captive when the captive paid a loss. Paying the loss decreased the value of the parent’s holdings of the captive’s stock so the parent realized the economic impact of the loss. The court allowed Kidde to deduct premiums attributable to coverage of its subsidiaries after May 3 1, 1978. A loss paid by the captive did not decrease the value of a  subsidiary’s assets so that the subsidiary could transfer the risk of loss to the captive. The court concluded that risk was not transferred before June 1, 1978 as a result of the impact of an indemnity
agreement between Kidde and the primary insurer.

(e) No unrelated risks transferred in parent-subsidiary arrangements

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In general—The Service and courts hold that coverage by a captive subsidiary of its parent’s risks is not insurance if it only covers risks of related parties. Humana, Inc. and a wholly owned Netherlands Antilles company established Health Care Indemnity, Inc. (HCI) to cover risks of Humana and other HCI subsidiaries (“sister corporations”), in Humana, Inc. v. Commissioner.51 The Sixth Circuit examined the impact of the “insurance” transactions on the insured’s assets in both parent-subsidiary and brother-sister arrangements. It concluded that risk-shifting was lacking in the parent-subsidiary transactions because the risk of loss never left the parent. It reasoned that a captive’s stock is an asset of its parent so that a loss suffered by the captive decreases the value of the parent’s assets.

Indirect arrangements—The Ninth Circuit held that the taxpayers could not deduct “insurance premiums” attributable to coverage provided by unrelated insurers that was reinsured with the taxpayers’ insurance subsidiaries in Carnation v. Commissioner53 and Clougherty Packing Co. v. Commissioner. The captives only covered related-party risks in each case.

In Carnation, a processor and seller of foods and grocery products incorporated Three Flowers Assurance Co., Ltd., a wholly owned (Bermuda) subsidiary, to insure and reinsure multiple-line risks. Carnation acquired insurance coverage from American Home Assurance Co., an unrelated insurance company, which agreed to reinsure 90 percent of the risks with Three Flowers. Three Flowers overed only Carnation and its subsidiaries. American Home paid 90 percent of Carnation’s premiums to Three Flowers, which paid American Home a five percent commission on net premiums ceded, and reimbursed its premium taxes.

American Home was concerned that Three Flower’s would not be able to cover the reinsured losses so Carnation agreed to capitalize Three Flowers with up to $3 million at its (Carnation’s) election or Three Flowers’s request.55 The Service allowed a deduction only for ten percent of the premium, which related to the coverage that was not ceded to Three Flowers. The Commissioner argued that the reinsurance was an indirect form of self-insurance and that such payments were within Carnation’s practical control.

The Tax Court held that 90 percent of the premiums paid by Carnation to American Home was not deductible. Citing Le Gierse, the court concluded that an insurance risk was not present because the capitalization of Three Flowers with up to $3 million “on demand” neutralized the risks that American Home reinsured with Three Flowers.57 The Ninth Circuit concluded that the agreements among the parties were interdependent. 

That American Home refused to enter into a reinsurance arrangement unless Carnation agreed to capitalize Three Flowers was the key factor. The court also indicated that the Service’s second situation in Revenue Ruling 77-316, in which “an insurance subsidiary” reinsured a portion of its parent’s risks, supported its conclusion that the agreements neutralized the risk-shifting from Carnation to the extent that risk was reinsured by Three Flowers.

In Clougherty Packing, a slaughtering and meat processing company self-insured a portion of its workers’ compensation risks and obtained excess liability insurance for the remaining coverage from 1971-1977. It subsequently terminated its self-insurance arrangement and created Lombardy Insurance Corporation, a captive insurance company, which it capitalized for $1 million.

Clougherty purchased workers compensation coverage from Fremont Indemnity Co., an unrelated insurance company. Fremont reinsured the first $100,000 of each claim with Lombardy and ceded 92 percent of Clougherty’s premiums. Fremont charged Clougherty an additional five percent of its premiums as a fee for providing a captive insurer program.

Fremont remained liable if Lombardy became insolvent or otherwise defaulted. Lombardy’s only business was reinsuring Clougherty. Clougherty distinguished its transaction from that in Carnation. It argued that Carnation’s agreement to capitalize its reinsurance subsidiary with $3,000,000 on demand neutralized “any risk shifting in Carnation and the absence of any such agreement requires [the court to] reach an opposite result in this case.”60 The Ninth Circuit, however, denied 92 percent of the deduction for Clougherty’s premium payments. It reasoned that Clougherty’s net worth decreased when Lombardy paid a claim because it decreased the value of Clougherty’s stock. The court stated that a claim decreased Clougherty’s assets to the same extent that it would if it selfinsured in the “ordinary sense.”

Clougherty argued that Revenue Ruling 77-316 was inconsistent with the Supreme Court’s conclusion in Moline Properties62 that one must recognize affiliated companies as separate companies. The Ninth Circuit responded that Moline Properties does not require the Commissioner to ignore the impact of a loss on its assets “merely because the asset happens to be stock in a subsidiary.”

(d) The Service no longer follows the economic family theory

The Service concluded in Revenue Ruling 2001-3148 that it “will no longer invoke the economic family theory with respect to captive insurance transactions.” It reasoned that no court addressing captive insurance transactions has fully accepted the economic family theory as provided in Revenue Ruling 77-316.

Whether a transaction qualifies as insurance depends on the underlying facts and circumstances. Relevant factors include the amount of related (and unrelated) party risks, the capitalization of a captive and whether related parties provide guaranties or other financial enhancements. The impact of salient factors is addressed below.

(c) Captive insurers: historic background

Whether coverage of risks of affiliated companies qualifies as "insurance" for Federal income tax purposes has been a source of considerable contention between the Service and taxpayers. Before it issued Revenue Ruling 2001-31,

the Service's position was that coverage of an affiliate's risks is not insurance. It applied an economic family theory" in Revenue Ruling 77-316, which provided that, the insuring parent corporation and its domestic subsidiaries, and the wholly owned insurance" subsidiary, though separate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss.

 

 

In Revenue Ruling 77-316, the Service applied its economic family theory in the following three situations,

1. A foreign wholly owned captive insurer provided fire and other casualty insurance coverage for its parent and its parent's domestic subsidiaries. The parent and its subsidiaries paid premiums at  commercial rates to the captive for the coverage.

2. A parent and its domestic subsidiaries paid casualty insurance premiums to an unrelated domestic insurance company, which immediately reinsured 95 percent of the risks to a foreign "insurance" subsidiary that was wholly owned by the parent. The unrelated insurer remained the primary insurer and there were no collateral agreements between the unrelated insurer and the parent company or the other subsidiaries.

3. A parent and its domestic subsidiaries paid casualty insurance premiums to the parent's wholly owned "insurance" subsidiary, which reinsured 90 percent of the coverage of the risks to an unrelated insurance company.

The Service ruled that the premiums paid in each situation were not deductible (but for amounts addressed below) because "there was no economic shifting or distributing of risks of loss with respect to the risks carried or retained" by the "insurance" subsidiary. It concluded in each case that the "insurance agreement" was "designed to obtain a deduction by indirect means that would be denied if sought directly."

The Service allowed the parent and its (non-insurance) subsidiaries to deduct only premiums paid for risks that were ultimately borne by an unrelated insurer. Consequently, the parent and subsidiaries could deduct no premium in situation one. They could deduct premiums only for five percent of the risks retained by the unrelated insurer in situation two, and the 90 percent ceded to the unrelated insurer in situation three.

The Service recognized that each parent and its subsidiaries, including the wholly owned "insurance" subsidiaries, were separate corporate entities, reflecting the Supreme Court's holding in 

Moline Properties, Inc. v. Commissioner.46 It applied its economic family theory,  however, and concluded that "those who bear the ultimate economic burden of loss are the same persons who suffer the loss." The parent retained "practical control" in each situation.

The accrual of benefit obligations

The Supreme Court addressed the timing of the deduction of medical payments of an accrual basis noninsurer that self-insured certain medical care coverage in United States v. General Dynamics Corp.

General Dynamics paid medical claims out of its own funds but employed private carriers to administer the plan, instead of continuing its purchase of insurance from others. It set up a reserve to cover its liability for medical care received by employees. 

 General Dynamics argued that it could deduct certain amounts set aside as reserves as accrued expenses. The Court of Claims held that the amount set side satisfied the all events test because the medical services were rendered and the amount of liability could be established with reasonable accuracy.

The Supreme Court held, however, that General  Dynamics was liable to pay for covered medical services only if properly documented claims were filed.

 

The Court concluded that although General Dynamics could make a reasonable estimate of the amount of liability for claims that would be filed for medical care received during the applicable period, estimated claims were not intended to fall within the all events test. Otherwise, Congress would not have needed to provide an explicit provision that insurance companies could deduct reserves for incurred but unreported claims.