(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.”