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.
