Case Law

The captive insurance industry has long been captivated by IRS attention to captive insurance arrangements, particularly with respect to the "economic family" doctrine. The Service frequently revisited its position with respect to what constitutes an insurance company for federal income tax purposes. The following case law, Revenue Rulings and Field Service Advice, serve to define the rules and view of the Service, as it stands currently, September of 2009.

Humana Inc. v. Commissioner

One of the most important early captive insurance cases was Humana Inc. v. Commissioner [(6th Cir. 1989) 881 F.2d 247] In Humana, the Sixth Circuit Court of Appeals directly addressed the issue of a brother-sister captive arrangement and held that amounts paid by subsidiaries of the parent to a captive insurance company were deductible insurance premiums. Humana, Inc. ("Humana") and its several subsidiaries operated hospitals. Humana created a Colorado captive insurance company to provide coverage to Humana and its subsidiaries. The court found that premiums paid by Humana to the captive were not deductible as insurance, stating that, under the principals of Cougherty Packing Co. v. Commissioner [(1979) 84 T.C. 948 afft. (9th Cir 1987) 811 F.2d 1297] and Carnation Company v. Commissioner [(1978) 71 T.C. 400, affd. (9th Cir 1981) 640 F.2d 1010, cert. denied (1981) 454 U.S. 965], premiums paid by a parent to its subsidiary captive are not deductible as insurance because the risk of loss did not leave the parent corporation.

However, with respect to the payment of premiums by Humana's subsidiaries to the captive, the court looked to the basic principles of Le Gierse [Helvering v. Le Gierse, supra. 312 U.S. 531] and asked whether there was risk shifting and risk distribution. The court stated that "we must treat Humana Inc., its subsidiaries and Health Care Indemnity [the captive] as separate corporate entities under Moline Properties. When considered as separate entities, the first prong of Le Gierse is clearly met. Risk shifting exists between the subsidiaries and the insurance company." In finding that there was valid risk shifting, the court held that the arrangement between the Humana subsidiaries and the insurance company was not a sham; the insurance contracts were bona fide arms-length contracts entered into with legitimate business purpose. There was economic reality in the transaction between when a loss occurred, it would be paid by the insurance company and would not affect the balance sheets of Humana or its subsidiaries. The court, therefore, rejected any substance over form argument by the IRS and state that "the test to determine whether a transaction under the Internal Revenue Code section 162(a) (1954) is legitimate or illegitimate is not a vague and broad 'economic reality' test. The test is whether there is risk distribution and risk shifting. Only if the transaction fails to meet the above two-pronged test can the court justifiably reclassify the transaction as something other than insurance." [Humana Inc. v. Commissioner, supra 881 F.2d at p. 255]

Finally, the Humana court held that risk distribution was present on the brother-sister arrangement, satisfying the second prong of the test: "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." [Humana Inc. v. Commissioner, supra 881 F.2d at p. 257]

Cases Subsequent to Humana

Several subsequent cases involved facts and analysis similar to Humana. As a result of these cases, in Rev. Rul. 2001-31 [2001-26 C.B. 1348] the IRS states that the "economic family" doctrine would no longer be applied to captive insurance arrangements. However, the Service indicted that it would continue to challenge captive insurance arrangements based on the "facts and circumstances of each case."

State Captive Divisions & Associations

Case Law

Humana Inc. v. Commissioner

Cases Subsequent to Humana