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.
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.
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.
