T.C. Memo. 1997-482
UNITED STATES TAX COURT
HOSPITAL CORPORATION OF AMERICA AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 10663-91, 13074-91 Filed October 27, 1997.
28588-91, 6351-92
N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,
Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,
Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,
and John W. Bonds, Jr., for petitioners in docket No. 10663-91.
N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,
Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,
Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,
John W. Bonds, Jr., and Daniel R. McKeithen, for petitioners in
docket No. 13074-91.
- 2 -
N. Jerold Cohen, Walter H. Wingfield, Stephen F. Gertzman,
Amanda B. Scott, Reginald J. Clark, Randolph W. Thrower, Walter
T. Henderson, Jr., and John W. Bonds, Jr., for petitioners in
docket No. 28588-91.
N. Jerold Cohen, Reginald J. Clark, Randolph W. Thrower,
Walter T. Henderson, Jr., and John W. Bonds, Jr., for petitioners
in docket No. 6351-92.
Robert J. Shilliday, Jr., Vallie C. Brooks, and William B.
McCarthy, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Chief Judge: These cases were consolidated for
purposes of trial, briefing, and opinion and will hereinafter be
referred to as the instant case.1 Respondent determined
deficiencies in petitioners' consolidated corporate Federal
income tax as follows:
1
The instant case involves many issues, most of which have
been settled or decided already. Separate briefs of the parties
were filed for each of the distinct categories of issues involved
in the instant case. We decided tax accounting issues in
Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-105;
Hospital Corp. of Am. v. Commissioner, 107 T.C. 73 (1996); and
Hospital Corp. of Am. v. Commissioner, 107 T.C. 116 (1996). We
decided an issue related to the sale of the stock of certain
subsidiaries to HealthTrust, Inc.--The Hospital Company in
Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-559. We
decided a depreciation issue in Hospital Corp. of Am. v.
Commissioner, 109 T.C. 21 (1997). The instant opinion involves
the last remaining issues for decision, which issues the parties
have denominated the captive insurance or Parthenon Insurance Co.
issues.
- 3 -
TYE Deficiency
1978 $2,187,079.00
1980 388,006.58
1981 94,605,958.92
1982 29,691,505.11
1983 43,738,703.50
1984 53,831,713.90
1985 85,613,533.00
1986 69,331,412.00
1987 294,571,908.00
1988 25,317,840.00
Unless otherwise indicated, all section references are to the
Internal Revenue Code in effect for the years in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
The issues to be decided are:
(1) Whether Parthenon Insurance Co. (Parthenon), a wholly
owned subsidiary of petitioner Hospital Corporation of America
(HCA), is an insurance company within the meaning of the Internal
Revenue Code; and
(2) if Parthenon is an insurance company, what portion of
its unpaid loss reserves and expenses are deductible pursuant to
section 832(c).2
2
In accordance with the holding of the Court of Appeals for
the Sixth Circuit in Humana Inc. v. Commissioner, 881 F.2d 247
(6th Cir. 1989), affg. in part and revg. in part 88 T.C. 197
(1987), petitioners seek deductions only for reserve additions
attributable to reserves for claims against Parthenon's sister
subsidiaries, and not for reserve additions attributable to
reserves for claims against HCA itself. Absent stipulation of
the parties to the contrary, our decision in the instant case is
appealable to the Sixth Circuit.
- 4 -
FINDINGS OF FACT
Some of the facts have been stipulated for trial pursuant to
Rule 91. The parties' stipulations of fact are incorporated
herein by reference and are found as facts in the instant case.
In General
Petitioners are members of an affiliated group of
corporations of which HCA is the common parent. HCA was
incorporated during 1960 under the laws of the State of Tennessee
as Park View Hospital, Inc. During 1968, Park View Hospital,
Inc. joined with 11 other hospitals to form HCA. After that
date, and through the years in issue, HCA's stock was publicly
held and traded on the New York Stock Exchange.3
HCA maintained its principal offices in Nashville,
Tennessee, on the date the petitions were filed. For each of the
years involved in the instant case, HCA and its domestic
subsidiaries filed a consolidated Federal corporate income tax
3
On Mar. 17, 1989, a group consisting of HCA key management
and certain outside investors acquired control of HCA and caused
it to purchase all of the stock held by the public shareholders,
and they then transformed HCA from a publicly held corporation to
a privately held corporation. On Mar. 4, 1992, HCA again went
public and changed its name to HCA-Hospital Corporation of
America. On Feb. 10, 1994, HCA was merged with and into Galen
Healthcare, Inc., a subsidiary of Columbia Healthcare Corp. of
Louisville, Kentucky, and the subsidiary changed its name to HCA-
Hospital Corp. of America. On that same date, the parent changed
its name to Columbia/HCA Healthcare Corporation.
- 5 -
return (consolidated return) on Form 1120 with the Director of
the Internal Revenue Service Center at Memphis, Tennessee.
Petitioners' primary business is the ownership, operation,
and management of hospitals. Petitioners' hospitals provide
health care customarily provided by hospitals. Most of
petitioners' hospitals are acute care hospitals providing a
facility, personnel, equipment, and medical supplies and
pharmaceuticals needed to perform medical and surgical procedures
to treat sick or injured persons with various physical disorders.
Some of petitioners' facilities are psychiatric hospitals
providing medical treatment to persons with mental or emotional
disorders and drug and alcohol dependency problems.
Additionally, certain petitioners operate a variety of medically-
related businesses ancillary to petitioners' primary business.4
A fundamental component of petitioners' business philosophy is
the use of their combined purchasing power to obtain goods and
services at the lowest possible cost whenever practical to do so.
At the outset of its organization, HCA generally placed all
newly constructed or acquired hospitals in separate corporations.
In later years, in some cases, HCA placed all newly acquired or
newly constructed hospitals located in a particular State in a
4
See Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-
105, for a detailed description of petitioners' hospital
operations. We incorporate herein our findings of fact contained
in that Memorandum Opinion.
- 6 -
separate corporation rather than having a separate corporation
for each hospital in that State. In a few instances, HCA
acquired a group of hospitals that, for various business reasons,
were placed in a single corporation or were allowed to remain in
the acquired corporation.
During the years ended 1981 through 1988, as of yearend HCA
owned the following number of subsidiaries and hospitals, and had
the following number of patient beds:
Number of Hospitals Patient
Year Subsidiaries Owned Beds
1981 124 188 29,298
1982 124 186 29,720
1983 126 196 31,393
1984 123 200 32,515
1985 135 230 37,423
1986 122 227 37,490
1 1 1
1987 74 132 24,087
1988 74 131 23,849
1
During 1987, pursuant to a plan of reorganization, petitioners divested 104
hospitals from the HCA organization by selling the stock of the subsidiaries
owning those hospitals to HealthTrust, Inc.--The Hospital Co. See Hospital
Corp. of Am. v. Commissioner, T.C. Memo. 1996-559, for a detailed description
of that transaction.
Prior to calendar year 1977, petitioners purchased general
and professional liability insurance from Continental Insurance
Co. (Continental). The hospitals owned by petitioners were not
permitted to purchase insurance individually from other sources.
Every State regulates the insurance companies licensed to do
business within its borders. Insurance companies that are fully
licensed in a particular jurisdiction often are referred to as
- 7 -
admitted companies. Admitted insurance companies can insure any
insurable risk. Other insurance companies may be licensed to
write only on a surplus lines basis; i.e., they are allowed to
underwrite only risks that admitted companies in the State do not
or will not cover. Admitted insurance companies are required to
file annual reports on a calendar year basis with the appropriate
State insurance department in a form specified by the National
Association of Insurance Commissioners (NAIC).
A line of business refers to a group of insurance policies
involving similar risks. Some lines of business, such as
workers' compensation, can be written only by admitted carriers.
Marketing is the process of selling policies to insureds.
Underwriting is the selection and pricing of risks to be insured.
The pricing portion of the underwriting function is the process
of setting premiums in amounts that are expected to be sufficient
to cover insured losses and the expenses of adjusting claims, and
the costs of operating the company and any planned underwriting
profit. State regulatory agencies limit the premiums that may be
written by insurance companies to amounts that are prudent in
light of the companies' capitalization. Premiums are usually set
by trained underwriters or actuaries, who may be employees or
outside consultants. For certain lines of insurance, such as
workers' compensation, rates are set by law on the basis of
statistical information compiled by rating bureaus, with only
- 8 -
specified modifications permitted to take into account the loss
experience of the particular employer.
The insurance laws of some States provide for a category of
limited purpose insurance companies, popularly called captive
insurance companies or captive insurers. Captive insurance
company statutes generally apply to companies that insure on a
direct basis only the risks of companies related by ownership to
the insurer. Because pure captive insurance companies typically
are formed for the purpose of insuring the risks of related
companies, the function of risk selection, in essence, is
attained at the onset.
The State of Colorado's Captive Insurance Company Act
(Colorado captive insurance statute) allows the formation of pure
captive insurance companies whose authority to write direct
insurance business is limited to insuring the risks of related
corporations. The Colorado captive insurance statute requires a
pure captive insurance company licensed in that State to maintain
and to deposit with the commissioner of insurance minimum actual
capital of $300,000 and accumulated surplus of $200,000, which
deposit may be in the form of an irrevocable letter of credit.
The State of Tennessee's Captive Insurance Company Act
(Tennessee captive insurance statute) requires a pure captive
insurance company licensed in that State to maintain minimum
capital and surplus of $750,000, with the surplus to be at least
- 9 -
$350,000. For captive insurance companies, the Tennessee
Department of Commerce and Insurance, Division of Insurance
(Department of Insurance), requires the ratio of net written
premiums to policyholders' surplus (i.e., the net worth of an
insurance company) to be no greater than 3 to 1. Captive
insurance company rates may not be excessive, inadequate, or
unfairly discriminatory. The Tennessee captive insurance statute
does not require pure captive companies to use the NAIC format.
Tennessee insurance company regulatory provisions require
less startup capital for "pure captive" insurers than for
companies licensed to sell insurance to the general public,
impose lower premium taxes in comparison to commercial companies,
and provide an exemption from participation in State involuntary
risk plans, such as assigned risk pools and guaranty funds. The
business functions and operations of captive insurance companies
in Tennessee are subject to examination by the Department of
Insurance at least once in a 5-year period, or when the
Commissioner deems it prudent to conduct an examination.
Business functions include underwriting, marketing, investing,
claims adjusting, loss reserving, and financial reporting.
Prior to the mid-1970's, the availability and price of
coverage for medical malpractice risks were not significant
concerns for an organization the size of HCA. During the mid-
1970's, however, increases in the size and frequency of medical
- 10 -
malpractice awards led to a crisis in both the price and the
availability of medical malpractice insurance. Some physicians
and hospitals formed mutual insurance associations or pools
because the insurance industry was unwilling or unable to provide
malpractice coverage at a price that the physicians and hospitals
considered reasonable.
During 1976, in response to the uncertain availability and
high cost of medical malpractice insurance, petitioners
considered alternative methods to provide professional and
general liability coverage to hospitals which were owned directly
by petitioners at a lower cost than commercial insurance
available from various third party insurance companies.
Alternatives contemplated included self-insuring, joining with
competing hospital companies in the formation of a malpractice
insurance company, or forming a wholly owned captive insurance
company whose principal business would be to provide insurance
for the liability risks of petitioners' hospitals. During the
time that petitioners were considering those alternatives,
approximately 40 to 45 percent of the revenues of petitioners'
hospitals came from reimbursement of costs for patient care by
the Federal Medicare program. Consequently, the reimbursability
of premium costs by the Medicare program was a significant
consideration in evaluating the alternatives.
- 11 -
At all relevant times, the Healthcare Financing
Administration (HCFA) of the U.S. Department of Health, Education
and Welfare (or its predecessor agencies) administered the
Medicare system of reimbursement. During the mid-1970's,
existing Medicare regulations did not address reimbursement of
premiums payable to captive insurance companies. Medical industry
efforts, however, eventually resulted in the promulgation of
specific regulations during 1979 which allowed reimbursement of
liability premiums charged related entities by limited purpose or
captive insurance companies, provided that appropriate regulatory
standards were met. The Medicare standards ultimately adopted
included requirements that the captive insurer be recognized as
an insurance company by an appropriate Government and be operated
in accordance with the jurisdiction's laws, that premiums be
determined according to actuarial standards, that only reasonable
premium costs be reimbursable, and that the arrangement represent
a prudent business decision. Compliance with those requirements
was monitored through comprehensive annual audits.
From 1981 through 1983, Medicare reimbursement to hospitals
for providing covered treatment was made on the basis of the
hospitals' direct costs and allocated indirect costs, including
premiums paid for qualifying general and professional liability
insurance (malpractice insurance). Beginning in 1983, and over a
4-year transition period, a significant part of Medicare
- 12 -
reimbursement was made on the basis of diagnostic related
groupings, in which specific treatments or procedures are
reimbursed at set rates, although reimbursement of certain
outpatient and psychiatric procedures continued to be based on
cost. Throughout the years at issue, petitioners wanted their
premium payments for general and professional liability insurance
to qualify as reimbursable costs for Medicare purposes, though
the direct financial benefit of such qualification was
comparatively less after 1983 than before.
The determination as to whether liability insurance premiums
charged by limited purpose insurance companies would qualify for
Medicare reimbursement was reviewed by intermediaries employed
for that purpose by HCFA. The intermediaries conducted annual
audits of captive insurance companies to determine whether the
premiums charged to insureds met HCFA standards. Throughout the
years here in issue, Blue Cross/Blue Shield of Tennessee, Inc.
(Blue Cross) was the intermediary charged with auditing limited
purpose insurance companies formed in Tennessee to determine
whether the liability premiums that they charged their insureds
would qualify for Medicare reimbursement.
Another consideration on the part of HCA management in
evaluating alternatives to commercial malpractice insurance was
- 13 -
the prospect of Federal income tax deductions for the reserves5
that would be maintained against insured labilities of the
operating companies. HCA management believed that setting up a
legitimate U.S. insurance company managed by insurance
professionals would offer the best chance of obtaining that
deduction, though they realized that favorable tax treatment was
not assured.
The Formation of Parthenon
During 1976, HCA formed Parthenon as a wholly owned
subsidiary under the Colorado captive insurance statute, Colorado
Rev. Stat. secs. 72-36-1 to 72-36-30 (1963), now codified at
secs. 10-6-101 to 10-6-130 (1991). HCA management expected that
5
In Western Natl. Mut. Ins. Co. v. Commissioner, 102 T.C.
338, 350-351 (1994), affd. 65 F.3d 90 (8th Cir. 1995), we defined
the term "reserve" as follows:
In the insurance industry a policy reserve represents a
liability; i.e., it represents an obligation to the
policyholders. Historically, reserves have been described
in PC [property and casualty] insurance literature as
estimated liabilities for losses and loss adjustment
expenses. To some extent, loss reserves are estimates
extrapolated from past trends, patterns, averages, and
inferences and predictions as to the future. Accordingly,
"The reserve simply operates as a charge on so much of an
insurance company's assets as must be maintained in order
for the company to be able to meet its future commitments
under the policies it has issued." The general concept for
reserves is the same for life and PC insurance companies.
[Fn. ref. omitted; citations omitted.]
- 14 -
an appropriate portion of the premiums would be reimbursable to
the hospitals under the then-applicable Medicare regulations and
deductible under the Federal income tax laws. Petitioners
incorporated Parthenon in the State of Colorado because HCA's
chief financial officer, who also was the executive responsible
for petitioners' insurance programs, believed that the goal of
building a legitimate insurance company would be advanced by
having a State-regulated captive insurer, rather than an offshore
company, and because at that time the State of Colorado was the
only State that had adopted a captive insurance statute. In
accordance with Colorado law, the initial capitalization of
Parthenon was $1,500,000, $1 million of which was represented by
an unconditional standby letter of credit in favor of the
Insurance Commissioner of Colorado, and the remainder of which
was in cash.
Parthenon commenced business during January 1977. At all
relevant times, HCA owned all of Parthenon's common stock.
Parthenon did not own stock in any of HCA's other subsidiaries.
Parthenon's Operations During Its Early Years
Parthenon submitted the policy form to be used for general
and hospital professional liability insurance to the Colorado
Insurance Department for approval. The initial policy form
issued by Parthenon to petitioners provided coverage limits of
$250,000 per occurrence and was a claims-made policy form. A
- 15 -
claims-made policy covers only losses from occurrences within the
policy period that are reported during the period, as opposed to
an occurrence-basis policy, which covers losses whenever
reported. Other things being equal, premiums on an occurrence
basis are generally greater than premiums under a claims-made
policy form.
Parthenon retained the Wyatt Co. (Wyatt), an international
actuarial and insurance consulting firm, to recommend the initial
premium amount to be charged by Parthenon to petitioners. The
recommended premium amount for policy year 1977 was $4,500,000.
That amount compared to a quotation of $5,232,000 from
Continental for a policy providing the same limits to the same
insureds but on an occurrence basis.
During a portion of its first year of existence, Parthenon's
day-to-day operations were managed by Frank B. Hall and Company
of Colorado, an independent consulting firm. Senior HCA
management, however, decided that Parthenon should be operated by
its own employed management and staff, based in part on a
recommendation of an insurance industry consultant to the effect
that a properly staffed and operated company could produce a
savings for petitioners of more than $1 million per year in
premiums.
Parthenon's first president was the late John A. Hill (Mr.
Hill), then the Chairman of HCA. Formerly, Mr. Hill had served
- 16 -
as a president of the Aetna Insurance Co. He was Parthenon's
president until mid-1977, at which time he became Chairman of
Parthenon's Board of Directors. Mr. Hill served in that capacity
until October 1985.
On August 16, 1977, Parthenon hired Robert A. Reeves (Mr.
Reeves) as its president. He also served as HCA's vice president
of insurance. Prior to being retained by Parthenon, Mr. Reeves
had been employed as president of Ashland Oil Company's two
captive insurance company subsidiaries. He continued as
Parthenon's president until October 1, 1985.
After becoming president of Parthenon, Mr. Reeves hired
experienced insurance executives to fill key managerial
positions, including Robert E. Pierson (Mr. Pierson), Maurice J.
Castille (Mr. Castille), and Charles Anderson (Mr. Anderson).
Mr. Pierson, a Chartered Property and Casualty Underwriter, had
been employed as a claims manager for the St. Paul Insurance
Companies. Mr. Pierson was hired initially to serve as
Parthenon's claims manager. He also was a vice president of
Parthenon from 1978 until October 1985, when he became president.
Mr. Pierson continued as president of Parthenon until February
20, 1987.6
6
William W. McInnes became president of Parthenon as of June
8, 1987. He served in that position throughout the remainder of
the years in issue.
- 17 -
Mr. Castille, who had been the risk manager of Humana Inc.,
a competing hospital chain, was hired to head Parthenon's loss
prevention and quality assurance operation. Mr. Anderson, a
former controller of an insurance brokerage firm in the State of
Kentucky, became head of Parthenon's financial operations.
On October 28, 1977, HCA contributed an additional $1
million to Parthenon as paid-in capital.
During March 1978, HCA management learned that Continental,
which had been providing workers' compensation insurance to
petitioners, was not interested in renewing coverage under any
type of insurance plan. As a captive insurer, Parthenon could
not insure workers' compensation risks directly, but it could
reinsure7 the risks of an admitted company, if the admitted
company agreed to "front" the business; i.e., to insure the risks
and then reinsure them with Parthenon. In that event, the States
would look to the admitted company for payment of the losses, and
the admitted company would look to Parthenon for reimbursement.
Accordingly, during March 1978, HCA, Ideal Mutual Insurance Co.
(Ideal Mutual), and Parthenon negotiated an arrangement whereby
Ideal Mutual agreed to provide workers' compensation insurance to
petitioners and Parthenon agreed to reinsure Ideal Mutual on that
7
Reinsurance is a contract with a second insurer in which the
second insurer agrees to provide coverage of risks that the first
insurer has already assumed under an insurance contract with
another party. 1 Couch on Insurance 3d, sec. 1:4, at 1-8 to 1-9
(1995).
- 18 -
insurance. As a condition to Ideal Mutual's willingness to
complete the transaction, HCA executed a May 18, 1978 "comfort
letter". That letter provided as follows:
In consideration of the issuance of the Workers'
Compensation and Employers Liability Policies by Ideal
Mutual Insurance Company ("Ideal") to Hospital Corporation
of America ("HCA"), its affiliated and subsidiary companies
and certain of its managed hospitals and the reinsuring of
said policies with Parthenon Insurance Company
("Parthenon"), HCA agrees that in the event, refusal or
inability of Parthenon to provide or maintain the required
Letter of Credit or to pay Ideal the cash advance against
reinsurance losses recoverable under the Reinsurance
Agreement, HCA will pay itself on behalf of Parthenon or
cause Parthenon to pay all the reinsured losses recoverable
by Ideal from Parthenon in accordance with the terms of the
Reinsurance Agreement until all such claims have been
settled or otherwise disposed of.
The general and hospital professional liability policy form
used by Parthenon for policy years 1978 through 1985 was
substantially unchanged and covered all losses arising out of
occurrences during the policy period. For each of those years
Parthenon issued one policy of general and hospital professional
liability insurance to "Hospital Corporation of America, or its
owned hospitals, corporations, and other subsidiaries".
Premiums for the liability insurance coverage provided by
Parthenon to petitioners were based on actuarial analyses of the
projected loss and loss expense adjustment, using industry loss
experience (and, subsequently, using the hospitals' loss
experience supplemented by industry experience), to which was
added Parthenon's operating expenses and the reinsurance costs.
- 19 -
The rate making process involved first estimating the total
covered losses that would be experienced by the hospitals and
then making an actuarial determination of premium rates, adjusted
on the basis of geographical differences in loss costs, that
could be multiplied by the number of exposure units (e.g.,
occupied beds, outpatient visits, and emergency room visits) of
each insured hospital to reach a premium sufficient, in the
aggregate, to cover the estimated losses of the entire group.
Each insured hospital would pay only the geographically adjusted
average loss represented by the applicable rate times its units
of loss exposure.
Parthenon's Reincorporation in the State of Tennessee
The Colorado Insurance Commissioner objected to Parthenon's
decision to base its full-time staff and operations in Nashville,
Tennessee. Consequently, during 1978, after the enactment of the
Tennessee captive insurance statute, which statute is
substantially identical to the Colorado captive insurance
statute, HCA decided to reincorporate Parthenon in the State of
Tennessee. Accordingly, Parthenon Insurance Co. of Tennessee was
incorporated under the laws of that State on December 13, 1978,
and on that date applied for a Certificate of Authority to
transact insurance business under the Tennessee captive insurance
statute. On December 18, 1978, Parthenon Insurance Co.
(Colorado) was merged into Parthenon Insurance Co. of Tennessee
- 20 -
(hereinafter also referred to as Parthenon), which latter company
became the surviving corporation. During December 1978,
Parthenon submitted to the Department of Insurance for review and
approval the form of general and hospital liability policy to be
issued to petitioners in 1979, and an Actuarial Review.
Effective January 1, 1979, Parthenon was licensed by the State of
Tennessee as a captive insurance company.
As a licensed captive insurance company under Tennessee law,
Parthenon was subject to the regulatory supervision of the
Department of Insurance. During August 1979, Parthenon adopted
procedures and guidelines to govern the investment of its reserve
and surplus funds, including an incorporation of the Tennessee
regulations governing insurance company investments.
During December 1979, Mr. Reeves, as president of Parthenon,
requested that HCA contribute an additional $1 million to
Parthenon's capital.
Parthenon's Operations During the Years in Question
HCA management required that the hospitals owned by
petitioners acquire their liability insurance from Parthenon.
Parthenon did not market liability insurance coverage to
hospitals owned by petitioners because they were automatically
covered by the Parthenon policy. For each of the years in issue,
Parthenon issued one liability insurance policy which covered
HCA, its owned hospitals, corporations, and other subsidiaries.
- 21 -
Parthenon had no planned underwriting profit. It was a pure
captive insurance company but nonetheless submitted annual
reports using the NAIC format for all years in issue except 1982
and 1983. Its premium charges for liability and workers'
compensation coverages were made using rates applied to occupied
beds and patient visits for liability coverage and payroll
amounts for workers' compensation coverage. Those amounts were
charged on a hospital by hospital basis.
Hospitals not owned but managed by petitioners (managed
hospitals) could elect to be insured by Parthenon. Only a small
percentage of the managed hospitals were insured by Parthenon.
Parthenon performed the risk selection element of underwriting
with respect to its coverage of managed hospitals. Parthenon
engaged in marketing of insurance to the managed hospitals.
Separate liability insurance policies were issued to each managed
hospital that elected to be insured by Parthenon. Respondent has
not adjusted the insurance transactions of managed hospitals
reported by petitioners on their consolidated tax returns and its
insurance of managed hospitals is not in issue in the instant
case.
During 1981, Parthenon had 16 employees. By 1986, Parthenon
had 47 employees. During January 1987, all of the HCA companies
underwent a reduction in force, and accordingly Parthenon's staff
was reduced by 12 employees.
- 22 -
Parthenon did not utilize HCA's centralized cash management
program, but maintained its own separate banking arrangements and
cash management system. It also maintained its own accounting
records, computerized information management system, and
personnel files. Parthenon's employees were issued monthly
checks by HCA's payroll department, which furnished payroll
services to Parthenon, but Parthenon reimbursed HCA for the wage,
salary, and benefit amounts paid to or on behalf of Parthenon's
employees each month.
From 1981 through July 1985, Parthenon occupied quarters in
a building owned by HCA. From July 1985 to February 1988, the
offices of Parthenon were in a building leased by HCA. During
the period 1981 through February 1988, Parthenon had either a
separate written lease or sublease agreement with HCA or occupied
the premises without a written lease, for which it was charged a
monthly amount as rent. From February 1988 through the end of
that year, Parthenon occupied quarters in a building owned by
HCA, but HCA charged Parthenon no rent and there was no formal
lease agreement between the parties.
Parthenon's investments were the responsibility of an
investment committee appointed by its Board of Directors, subject
to policies and procedures which included a requirement of
compliance with the investment mandates and restrictions of the
Tennessee Insurance Code. Parthenon employed outside investment
- 23 -
advisers to manage the company's investments under the
supervision of its investment committee. Additionally,
Parthenon's investment committee received informal investment
advice and counsel from HCA's corporate investment staff, under
the direction of William McInnes, HCA's vice president for
finance. Parthenon's investment portfolio complied with the
requirements of the Tennessee statute and was typical of the
portfolios maintained by property and casualty insurance
companies generally.
For the years 1981 through 1986, Parthenon issued to
petitioners annual policies providing $10 million in primary
comprehensive hospital liability, comprehensive personal injury
liability, comprehensive property damage liability, and
advertising liability coverages. For the years through 1985, the
coverage offered by Parthenon was on an "occurrence" basis, which
meant that Parthenon indemnified the insureds against all covered
liabilities arising out of any occurrence that caused injury
during the policy period, no matter when the claim arising out of
that injury was reported. For 1986 and subsequent years,
Parthenon provided liability insurance to petitioners on a
"claims made" basis, which meant that coverage was extended only
for claims actually made against an insured during the policy
period arising out of events subsequent to a designated
- 24 -
"Retroactive Date", which in the instant case was January 1,
1986.
During 1981 through 1984, Parthenon assumed reinsurance of
workers' compensation risks written for petitioners by Ideal
Mutual. Under the reinsurance arrangement, Ideal Mutual ceded
premiums (with associated liabilities) to Parthenon, less a
ceding commission designed to cover Ideal Mutual's costs and an
element of profit.
Ideal Mutual became insolvent and was placed into
liquidation by the New York Insurance Department effective
December 26, 1984. Following that development, HCA entered into
an agreement with Continental and the New York Insurance
Department whereby Continental agreed to assume the direct
workers' compensation risks that Ideal Mutual had insured prior
to its insolvency. As a condition of agreeing to substitute its
own policies for those of Ideal Mutual, Continental required, and
HCA provided, an agreement indemnifying Continental against
liabilities, other than Continental's obligations under its
policies, that might result from the agreement to cede insurance
obligations entered into as of September 6, 1985, between HCA and
the Superintendent of Insurance of the State of New York as
Rehabilitator of Ideal Mutual. After 1984, Parthenon reinsured
the workers' compensation risks assumed by Continental, receiving
the premium less a ceding commission designed to cover
- 25 -
Continental's expenses and an element of profit. The reinsurance
contracts covering workers' compensation risks required Parthenon
to post a letter of credit to secure its reinsurance obligations.
When the New York Insurance Department placed Ideal Mutual
in liquidation during 1984, the receiver placed a freeze on the
payment of any claims for workers' compensation against
petitioners' hospitals made under policies with Ideal. At that
time, HCA operated 26 hospitals in the State of Florida that were
subject to a Florida law which would tie up the bank accounts of
those hospitals unless the claims of nurses and others on
disability under the workers' compensation law were paid. In
order to prevent the tie-up of those bank accounts, HCA, or the
applicable subsidiaries, paid those workers' compensation claims.
Through 1986, HCA paid premiums to Ideal Mutual or
Continental for workers' compensation insurance and charged the
applicable hospitals on the same basis that total premiums were
set by the insurer; i.e., by the application of statutorily-set
rates per dollar of payroll. Commencing policy year 1987, the
underlying workers' compensation policies were rated
retrospectively; i.e., premiums were adjusted after the policy
year to reflect the actual losses from that year, subject to
minimum and maximum premium limits.
In addition to workers' compensation reinsurance, Parthenon
during the years in question also assumed other reinsurance from
- 26 -
unrelated insurance companies that had written direct insurance
covering petitioners--for example, Arkwright-Boston, which wrote
direct property coverage for petitioners. The amounts involved
are less than 1 percent of total reserves at December 31, 1986,
and Parthenon is not claiming a deduction for an addition to its
reserves for those liabilities.
During policy years 1981 through 1986, Parthenon negotiated
reinsurance agreements with a number of professional reinsurance
companies in the United States and England covering portions of
the risks of petitioners and of the managed hospitals that
Parthenon had insured. During policy year 1981, Parthenon ceded
all potential liabilities in excess of $350,000 per occurrence to
reinsurers. Liabilities in the layer $650,000 excess of $350,000
were ceded to General Reinsurance Corp. (General Re), the largest
reinsurance company in the United States. Liabilities in the
layer $4 million excess of $1 million were ceded 80 percent to
General Re and 20 percent to various syndicates at Lloyds of
London. The remaining liabilities were ceded 20 percent to
General Re, 40 percent to INA Reinsurance Co., and 40 percent to
a consortium of Lloyds syndicates and British reinsurance
companies. General Re, Parthenon's principal reinsurer, reviewed
Parthenon's claims and other operations on an ongoing basis to
ensure that the reinsured business was conducted in accordance
with appropriate standards.
- 27 -
During policy years after 1981, General Re and Parthenon
entered into an agreement rescinding the reinsurance formerly
provided by General Re in the layer $650,000 excess of $350,000,
with the result that Parthenon thereafter effectively retained $1
million in liability exposure for its own account until 1986,
when the retention was increased to $2 million. Through policy
year 1986, Parthenon reinsured its excess exposures in a manner
similar to the reinsurance arrangements described above for
policy year 1981. Respondent does not dispute deductions for the
reinsurance premiums.
Formation of Parthenon Casualty Insurance Company
During 1984, HCA's management decided to form a company to
enter into the business of marketing professional liability
insurance to physicians who practiced at petitioners' hospitals.
Under applicable State law, that insurance could be provided only
by an insurance company licensed on an admitted or surplus lines
basis in each relevant jurisdiction. That company could not at
the same time qualify as a captive insurance company under the
Tennessee captive insurance statute. In order to meet the
requirements of relevant States that the carriers they admit have
a prescribed period of operating history in their domiciliary
jurisdiction, HCA decided to use Parthenon (Old Parthenon) as the
corporate entity that would qualify as a new surplus lines
- 28 -
company, and to form a new corporation (New Parthenon) to
continue to fulfill Parthenon's former captive insurance role.
Accordingly, HCA incorporated New Parthenon during 1984
under the Tennessee captive insurance statute to continue
providing captive insurance to petitioners. New Parthenon
originally was named Parthenon Casualty Insurance Company, but
subsequently changed its name to Parthenon Insurance Company upon
beginning operations. During 1985 and subsequent years, New
Parthenon issued policies and reinsurance contracts covering the
general and professional liability risks of petitioners on the
same basis as the old insurance company of the same name and
using basically the same staff of employees.
During March 1985, Old Parthenon changed its name to
Parthenon Casualty Insurance Company (PCIC), qualified as a
licensed surplus lines insurance company in a number of States,
and ceased its former role of a pure captive insurance company.
The accounting records and account balances for the previously
written captive business remained with PCIC, even though its
principal activity was to underwrite the professional liability
risks of third-party physicians. Additionally, during March
1985, PCIC declared and paid to HCA a dividend in the amount of
$2,250,000. HCA contributed that dividend to New Parthenon as
paid-in surplus.
- 29 -
During 1985 and subsequent years, PCIC issued policies to
individual physicians. The employees of New Parthenon and PCIC
during 1985 were basically the same and they continued to service
the pre-1985 captive block of insurance, which had continued on
PCIC's books after the name change and new underwriting
direction. PCIC and New Parthenon entered into an intercompany
pooling agreement during 1985 whereby each ceded to and assumed
reinsurance from the other, with the end result that risks
written by the entities combined were shared on an 85/15 basis.
New Parthenon and PCIC executed a portfolio transfer
reinsurance agreement during 1986, to realign each company's
portfolio of business to correspond more nearly to the primary
business purpose of each company. The net result sought by the
portfolio transfer was to place the captive insurance business
from the beginning with New Parthenon and the physicians'
insurance business from the beginning with PCIC. Effective April
15, 1988, HCA sold all of its shares of PCIC to an unrelated
purchaser under an agreement whereby, by executing a reinsurance
contract, New Parthenon acquired PCIC's pre-sale physicians'
insurance business.
The combined capital and surplus for both New Parthenon and
PCIC, where appropriate, for the years 1977 through 1988, is as
follows:
- 30 -
Year Total Capital and Surplus
1977 $2,587,916
1978 2,956,429
1979 5,611,805
1980 7,814,415
1981 10,788,729
1982 23,013,556
1983 29,504,345
1984 38,905,712
1985 47,607,864
1986 60,006,224
1987 85,853,294
1988 102,949,055
Hereinafter, we use the term "Parthenon" to refer to the HCA
subsidiary providing insurance and reinsurance for petitioners.
During the years in issue, Parthenon did not declare any
formal dividends to HCA, other than the $2,250,000 dividend paid
to HCA during 1985.
Premium Setting
During the years at issue, Parthenon set the premiums
charged by Parthenon for insurance coverage of petitioners from
information provided by Parthenon's actuary. Up to and including
a portion of policy year 1986, actuarial services regarding
premium rates were provided by Wyatt, principally through Eldon
Klaassen (Mr. Klaassen), a consulting actuary. For a portion of
policy year 1986 and thereafter, actuarial services were provided
by Terry J. Biscoglia (Mr. Biscoglia), first as a consulting
actuary with Coopers & Lybrand, an international public
accounting and consulting firm, and then in the same capacity
with Wakely & Associates, a national firm of consulting
- 31 -
actuaries.8 For exposures above Parthenon's retained limits, the
reinsurers set their own premium requirements.
Premium rates for liability coverages were designed to be
applied to an exposure base consisting of licensed beds (after
1981, average occupied beds), emergency room patient visits (for
those hospitals choosing emergency room physicians' coverage),
and (after 1981) outpatient visits. The rates to be applied to
the exposure base were adjusted to reflect relative risk exposure
by geographical area, on the basis of loss information available
to the consulting actuary. Parthenon's rate manuals also
contained schedules allowing for the application of debits or
credits against the published rates to reflect specific
conditions affecting the risk of any particular hospital.
On a quarterly basis, Parthenon's accounting personnel
applied the determined rates to the corresponding exposure units
from the latest available census of patient information from each
hospital and billed HCA for the total premium amount thus
determined, and also the premiums attributable to the reinsurance
8
The parties stipulated that Wyatt Co. (Wyatt) provided
actuarial services to Parthenon through policy year 1986 and that
Mr. Biscoglia provided actuarial services for policy years after
1986. Both Mr. Klaassen and Mr. Biscoglia, however, testified
that Wyatt was replaced during 1986 and other evidence in the
record clearly supports a finding that Mr. Biscoglia provided
some actuarial services for Parthenon for a portion of that year.
Although we do not lightly disregard the stipulations of the
parties, when appropriate, we may do so where the stipulated
facts are clearly contrary to facts disclosed by the record.
Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976).
- 32 -
coverages of risks above Parthenon's retained limits of
liability. Final adjustments were made at the end of each year
to recalculate the ultimate premium reflected by the actual
number of appropriate exposure units.
After receiving bills from Parthenon, HCA generally paid the
premium amounts in a timely fashion by check or wire transfer
and, using the schedules provided by Parthenon's accounting
department described above, charged each hospital its individual
premium, determined by application of rates to that hospital's
exposure base and adding the hospital's share of the reinsurance
premium.
During early 1985, Mr. Klaassen concluded that Parthenon's
losses were developing more adversely than originally had been
anticipated. Additionally, Parthenon made certain procedural
changes to improve its claims reporting process that had the
effect of making actuarial predictions temporarily more
difficult.
Accordingly, on four occasions during 1985 through 1987,
Parthenon's consulting actuary advised Parthenon that its
reserves were no longer adequate. Consequently, HCA paid
Parthenon payments classified by HCA as additional premiums to
fund reserve deficiencies. In each case, the additional amount
- 33 -
(reserve strengthening payment)9 was collected by Parthenon from
HCA, which in turn used schedules prepared by Parthenon's
accounting department to charge each of the hospitals a pro rata
share of the total additional amount. A breakdown of the reserve
strengthening payments petitioners paid to Parthenon is as
follows:
Reserves Strengthened and Amounts Paid
Date Professional Workers'
Paid and General Compensation Other Total
1
7/29/85 $11,977,587 $6,098,709 - $18,076,296
12/9/85 12,438,804 342,662 $5,338 12,786,804
2
4/24/86 42,487,000 - - 42,487,000
3/31/87 13,000,000 - - 13,000,000
1
Allocated to reserves for years ended 1977 through 1984.
2
Allocated to reserves for years ended 1982 through 1985.
As of yearend 1985 and 1986, Parthenon recorded additional
amounts of $42.5 million and $13 million, respectively, as
9
Use of the term "reserve strengthening" is for convenience
only and should not be construed as a finding that the additional
payments constitute a reserve strengthening within the meaning of
sec. 1023(e)(3)(B) of the Tax Reform Act of 1986 (TRA-1986), Pub.
L. 99-514, 100 Stat. 2404, or within a technical meaning commonly
understood by the insurance industry. See, e.g., Western Natl.
Mut. Ins. Co. v. Commissioner, supra; Atlantic Mut. Ins. Co. v.
Commissioner, T.C. Memo. 1996-75, revd. 111 F.3d 1056 (3d Cir.
1997); sec. 1.846-3(c), Income Tax Regs. The parties have
reached an agreement on the computation of the "fresh start"
provisions of sec. 1023(e)(3) of TRA-1986. Accordingly, we do
not address the conflicting opinions of the Court of Appeals for
the Eighth Circuit in Western Natl. Mut. Ins. Co. v.
Commissioner, supra (rejecting respondent's definition of
"reserve strengthening" as promulgated in sec. 1.846-3, Income
Tax Regs., and accepting our definition), and the Court of
Appeals for the Third Circuit in Atlantic Mut. Ins. Co. v.
Commissioner, supra (upholding the regulatory definition).
- 34 -
premiums receivable for statutory accounting and financial
reporting purposes, and recorded corresponding yearend additions
to reserves. Mr. Klaassen considered Parthenon's allocation
method to be reasonable from an actuarial standpoint. Blue Cross
found the additional premiums to be reasonable and necessary and
allowable for Medicare reimbursement purposes. The Department of
Insurance concluded that the additional amounts collected should
be treated as premiums for the business that had been in force
and charged Parthenon premium taxes on them accordingly.
During late 1985, Roger E. Mick (Mr. Mick) was appointed
senior vice-president and chief financial officer of HCA. He
thought that petitioners' loss experience did not justify the
amounts of premiums that Parthenon's consulting actuaries
projected were needed to fund its loss reserve requirements. He
believed that petitioners' actual professional liability losses
would be much less than the actuaries were predicting. He
thought that the funds petitioners were paying to Parthenon could
be used more effectively in other areas of petitioners' core
hospital business.
During 1986, Mr. Mick ordered a study be done to consider
alternatives to petitioners' purchasing their primary liability
insurance coverage from Parthenon. Petitioners delayed making
the quarterly premiums due Parthenon for the 1986 policy year.
Subsequently, Charles L. Kown, Associate General Counsel of HCA
- 35 -
and a board member and Secretary of Parthenon, wrote Parthenon's
president on September 11, 1986, and advised that, as an
insurance company subject to State regulation, it was critical
that Parthenon require premiums to be paid when due. Petitioners
paid the 1986 premiums during late 1986.
Workers' compensation premiums charged petitioners by Ideal
Mutual and, subsequently, by Continental, were set under State
law by rating bureaus, which are organizations that compile
statistical loss information to determine actuarially appropriate
premium rates. By statute in the relevant States, those rates
were subject to adjustment on the basis of the actual loss
experience of the individual insureds.
Reserve Setting
Hospital professional liability insurance, like other
medical malpractice coverages, is relatively "long tailed"; i.e.,
claims are often not reported until months or years after the
occurrence claimed to have resulted in liability. Because the
full extent of liabilities from reported claims may take a long
time to develop, reserves against future liabilities constitute
the bulk of total incurred losses during the first several years
following a policy year. Incurred but not reported (IBNR) losses
account for a significant portion of those reserves.
During the years in issue, Parthenon employed consulting
actuaries to assist in determining the appropriate reserves to
- 36 -
record for each of its "accident years"; i.e., calendar years
whose associated liabilities would be covered by the policies
issued for those years. The actuarial focus was on determining
appropriate IBNR reserves. Parthenon's claims personnel set the
amounts of case reserves on reported claims.
Typically, reserve adequacy studies would be made by the
actuary in the first or second quarter of a year, assessing the
adequacy of reserves posted by Parthenon as of December 31 of the
previous year. For 1986 and prior years, reserve studies were
made under the direction of Mr. Klaassen. For 1986 and later
years, reserve studies were made by Mr. Biscoglia.
During late 1984, Parthenon instituted a practice of
assigning statistically developed average reserve values to newly
opened claims' files pending actual investigation and evaluation
of the claim, in contrast to the previous practice of assigning a
nominal reserve amount for that interim period. During early
1985, Parthenon's claims department implemented new procedures
for increasing the efficiency of loss incident reporting. The
acceleration in timing and amount of reported losses caused by
those developments raised problems with the actuarial prediction
of IBNR losses.
Effective January 1, 1986, the policy issued by Parthenon
was a claims made policy, not an occurrence policy as had been
the case in prior years. Consequently, Parthenon went from
- 37 -
insuring all losses from occurrences in the policy year to
insuring only those losses that resulted in claims made during
the year.
During January 1987, Mr. Biscoglia estimated that the
general and professional liability reserves needed as of yearend
1986 were in a range between $218 million and $250 million, on an
undiscounted basis, and in a range between $176 million and $203
million, on a discounted basis. Subsequently, Mr. Klaassen was
asked to give a second opinion regarding the reserves for
professional liability losses and loss expenses evaluated as of
December 31, 1986, and he recommended reserves for Parthenon and
PCIC of approximately $221 million on an undiscounted basis and
$182 million on a discounted basis. Mr. Klaassen also suggested
an undiscounted value of $259.7 million, or $202.4 million on a
discounted basis, if Parthenon wanted an 80 percent probability
that the reserve would be adequate. Mr. Klaassen did not know
that Parthenon had adopted a claims-made policy for the 1986
policy year. Had he known, the portion of his estimate
attributable to the 1986 occurrences would have been reduced by
about 65 percent.
During February 1987, Parthenon requested and received
permission from the Department of Insurance to reduce the amount
of the 1986 reserves for losses and expense payments that it was
required to fund by discounting its professional liability
- 38 -
reserves. Parthenon requested permission to book total reserves
of $187,023,000. That request was supported by actuarial studies
prepared by Mr. Klaassen and Mr. Biscoglia, but it was above the
amount recommended by Mr. Klaassen and at the lower middle of the
range recommended by Mr. Biscoglia. In a letter addressed to the
Tennessee Commissioner of Insurance dated March 27, 1987, Mr.
Klaassen certified that the amounts carried on Parthenon balance
sheets on account of reserves for unpaid losses and loss
adjustment expense for yearend 1986 were computed in accordance
with accepted loss reserving standards and were fairly stated in
accordance with sound loss reserving principles, were based on
factors relevant to policy provisions, met the requirements of
the insurance laws of the State of Tennessee, and made good and
sufficient provision for all of Parthenon's unpaid loss and loss
expense obligations.
The amount of $187,023,000 represented the total of what
then already was booked as liability reserves on Parthenon's
books, and $13 million that HCA had previously booked as a
liability on the consolidated financial statements and agreed to
pay Parthenon as additional premium, and was in the range of
amounts recommended by its actuaries. For financial reporting
purposes, HCA recorded consolidated reserves for general and
hospital professional liabilities as of December 31, 1986, of
$120 million over and above the $187 million reserves for the
- 39 -
liabilities recorded as of that date by Parthenon. That amount
was equal to the difference between the low point of the range of
ultimate losses of petitioners predicted as of that time by Mr.
Biscoglia and the loss amounts recorded on the books of Parthenon
at that time. HCA management considered the $120 million
difference as an amount it was required to record for
consolidated financial reporting purposes under generally
accepted accounting principles, but which Parthenon did not have
to record because it represented liabilities that Parthenon did
not cover, and consisted of the amount of the discount for
investment income that Parthenon was permitted by the Department
of Insurance to remove from its reserves and the difference
between claims made and occurrence exposure for the 1986 policy
year.
Petitioners retained John A. Mackie (Mr. Mackie), a
certified public accountant (C.P.A.) who specializes, among other
fields, in insurance accounting, to assist petitioners to
determine Parthenon's undiscounted reserve amounts for use in
Parthenon's 1986 annual statement based on a $187 million
discounted general and professional liability reserve. Mr.
Mackie used discount factors to calculate that Parthenon would
need an undiscounted reserve of approximately $238 million for
unpaid losses and expenses relating to the general and
professional liability insurance that it had issued though 1986.
- 40 -
For 1987 and thereafter, the liability policy issued by
Parthenon to petitioners was modified to incorporate a $10
million deductible, causing petitioners to be substantially self-
insured for general and professional liability risks for policy
years after 1986. Parthenon continued to provide petitioners
risk management services and claims administration, and insured
high-level excess exposures, but no longer provided insurance for
any substantial portion of the day-to-day professional and
general liability risks faced by petitioners. Parthenon
continued to provide reinsurance of the workers' compensation
risks of petitioners on the same basis as before, with the
exceptions that a retrospectively rated feature was added in
1987, and charges to hospitals were made on the basis of
actuarial calculations of loss experience beginning in 1988.
As a result of the retrospectively rated premium plan for
workers' compensation insurance during policy years 1987 and
1988, Parthenon received a premium installment in the year the
policy was issued, followed by a payment in the second year
designed, within limits, to cover the losses plus expenses
actually incurred. Parthenon recorded annual statement
liabilities during the first year only to the extent that they
corresponded with the amount of that year's premium installment,
adjusting both premiums and liabilities in the second year to
reflect estimated total losses and corresponding premium amounts.
- 41 -
During 1987 and 1988, Parthenon recorded reserves for
general and professional liability losses that were higher than
the reserves suggested in Mr. Biscoglia's letter reports to
Parthenon, while its reserves for workers' compensation liability
were lower than the actuary's figures, which reflected his view
that all of the anticipated workers' compensation liabilities
should have been recorded in the first year. The undiscounted
reserve amounts Parthenon reported on its annual statement and
the actuary recommended for Parthenon and PCIC for policy years
1987 and 1988 are as follows:
1987
General and
Workers' Professional
Compensation Liability Total
Annual Statement $50,551,000 $192,397,000 $242,948,000
Actuary's
Recommendation 67,289,000 177,730,000 245,019,000
Difference (16,738,000) 14,667,000 (2,071,000)
1988
General and
Workers' Professional
Compensation Liability Total
Annual Statement $57,417,000 $172,789,000 $230,206,000
Actuary's
Recommendation 72,217,000 143,731,000 215,948,000
Difference (14,800,000) 29,058,000 14,258,000
- 42 -
For policy years 1987 and 1988, Mr. Biscoglia submitted formal
reports to HCA setting forth his professional and general
liability reserve recommendations for HCA and the sister
subsidiaries based on a range of values. Those reserve
recommendations included the professional and general liability
funded internally by HCA and the sister subsidiaries as well as
the professional and general liabilities transferred to Parthenon
and PCIC. In those reports, Mr. Biscoglia did not attempt to
allocate the reserve recommendations among the various entities.
In supplemental addenda for policy years 1987 and 1988, Mr.
Biscoglia set forth discounted reserve recommendations for
Parthenon and PCIC based on fixed dollar values for the reserves.
Accounting
Parthenon's accounting department recorded and reported the
results of Parthenon's insurance operations. Parthenon
maintained its own separate accounting system from that of HCA,
including its own journals, general and subsidiary ledgers, and
other appropriate accounting records. Those records were kept in
accordance with HCA's Accounting Manual.
From its inception through November 1986, Parthenon's
accounting department prepared monthly financial statements and
reports referred to as "management reports." After 1986, no
management reports were prepared because the need for the reports
ceased.
- 43 -
The Department of Insurance permitted Parthenon to report
its results in management report format. For all years except
1982 and 1983, Parthenon and/or PCIC submitted to the Department
of Insurance annual statements in a form prescribed by the
National Association of Insurance Commissioners. The Department
of Insurance conducted examinations of the financial condition,
affairs, and management of Parthenon during 1979, 1984, and 1989.
Each examination report concluded that Parthenon had conducted
its operations in conformity with the requirements of the
Tennessee captive insurance statute. The examination report for
the period ending December 31, 1979, noted that Parthenon's
current policy forms and rates were filed and approved by the
Department of Insurance. From time to time Parthenon consulted
with and secured the approval of the Department of Insurance for
changes or developments in the conduct of its business, including
corporate restructuring to accommodate marketing to individual
physicians, additional premium collection to fund reserve
deficiencies, and discounting of professional liability reserves
for the time-value of money.
Auditing by Medicare Intermediary
During each of the years in issue, Parthenon was audited by
Blue Cross/Blue Shield of Tennessee (Blue Cross), as an
intermediary acting on behalf of HFCA (or its predecessor
agencies) for the purpose of determining whether premiums paid by
- 44 -
petitioners' hospitals qualified for reimbursement under the
Federal Medicare program. To make that determination, Blue Cross
was required to confirm that the premiums charged by Parthenon to
petitioners were reasonable in light of comparable commercial
rates, that both premiums and reserves were based on actuarial
determinations, that premiums did not reflect a profit factor,
that Parthenon was duly licensed and met appropriate criteria for
insurance companies set out by the State of Tennessee, that it
had adequate claims administration and adequate risk management,
and that there were no loans or transfers of funds from Parthenon
to any affiliated company other than payment of covered claims.
For each of the years in issue, Blue Cross found that Parthenon
met the required criteria. In audit reports issued for those
years, Blue Cross specifically confirmed the reasonableness,
prudence, and actuarial foundation of the premiums charged by
Parthenon, including the additional premiums charged to fund
deficiencies in the 1984-86 reserves.
Tax Treatment
Parthenon has been included in the consolidated returns
filed by petitioners since it began business during 1977.
Because of disagreement between petitioners and respondent as to
the proper tax treatment of premiums HCA and the sister
subsidiaries paid to Parthenon for earlier tax years petitioners
did not claim a deduction for the increase in insurance reserves
- 45 -
relating to premiums received by Parthenon from members of the
affiliated group on their consolidated returns for the years in
issue. In the petitions filed in the instant case, petitioners
claim that Parthenon is entitled to be treated as an insurance
company for the years in issue, that petitioners are entitled to
deduct premiums they paid to Parthenon for insurance coverage for
those years, and that Parthenon is entitled to deduct the
increase in its reserves associated with those premiums, in
amounts of premiums not less than the following:
Professional Reinsurance
and General of Workers'
Liability Compensation
Year Insurance Insurance Total
1981 $15,571,167 $3,404,406 $18,975,573
1982 21,742,220 4,514,782 26,257,002
1983 17,630,680 5,364,185 22,994,865
1984 12,016,909 2,598,288 14,615,197
1985 36,796,826
1986 80,247,632
1
1987
1
1988
1
Specific amounts were not stated in the petitions.
Petitioners claim that overpayments of tax with respect to
the transactions with Parthenon result in tax in issue for the
years in issue as follows:
TYE Increase (Decrease) in Tax
1981 ($8,703,732)
1982 (12,247,563)
1983 (11,520,738)
1984 (6,128,314)
1985 (22,228,950)
1986 (52,934,878)
- 46 -
1987 32,602,710
1988 306,593
Total (80,854,872)
OPINION
On a number of prior occasions, this Court has confronted
the issue of the deductibility of purported insurance premiums
paid to a wholly owned captive insurance company. E.g., Sears,
Roebuck & Co. and Affiliated Corps. v. Commissioner, 96 T.C. 61,
modified 96 T.C. 671 (1991), affd. on this issue, revd. in part
and remanded 972 F.2d 858 (7th Cir. 1992); Humana Inc. v.
Commissioner, 88 T.C. 197 (1987), affd. in part and revd. in part
881 F.2d 247 (6th Cir. 1989); Clougherty Packing Co. v.
Commissioner, 84 T.C. 948 (1985), affd. 811 F.2d 1297 (9th Cir.
1987); Carnation Co. v. Commissioner, 71 T.C. 400 (1978), affd.
640 F.2d 1010 (9th Cir. 1981); see also Malone & Hyde, Inc. v.
Commissioner, T.C. Memo. 1992-661, revd. and remanded 62 F.3d 835
(6th Cir. 1995). Our position has been to consider all of the
facts and circumstances when faced with the task of determining
whether a transaction nominally labeled "insurance" should be
recharacterized as "self-insurance" or as some other arrangement
that negates transfer of risk. Sears, Roebuck & Co. v.
Commissioner, 96 T.C. at 96; see also Amerco, Inc. v.
Commissioner, 979 F.2d 162, 165 (9th Cir. 1992) ("many
considerations can come into play when one attempts to decide
- 47 -
whether a deduction of a purported insurance premium will be
allowed"), affg. 96 T.C. 18 (1991). Additionally, we
consistently have rejected respondent's "economic family"
theory,10 expressed in Rev. Rul. 77-316, 1977-2 C.B. 53. E.g.,
Sears, Roebuck & Co. v. Commissioner, supra; Humana v.
Commissioner, 88 T.C. at 214. We have concluded, moreover, that
true insurance arrangements may exist between a captive insurance
company subsidiary and its parent, or among a captive insurance
company subsidiary and its sister subsidiaries, where the captive
insurer does substantial unrelated insurance business in addition
to the captive insurance business. See Sears, Roebuck & Co. v.
Commissioner, supra; Harper Group & Subs. v. Commissioner, 96
T.C. 45 (1991); Amerco, Inc. v. Commissioner, 96 T.C. 18 (1991).
The Court of Appeals for the Sixth Circuit, to which the
instant case would be appealable absent stipulation to the
10
Pursuant to the "economic family" theory, a parent cannot
shift risk of loss to a wholly owned subsidiary because the
parent and its subsidiaries, even though separate corporate
entities, represent one economic family. Consequently, the
ultimate economic risk of loss falls on the same persons and the
premiums remain within the economic family. Rev. Rul. 77-316,
1977-2 C.B. 53, 54; see also Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1301-1302 (9th Cir. 1987), affg. 84
T.C. 948 (1985. But see Rev. Rul. 92-93, 1992-2 C.B. 45 (parent
may deduct premiums paid to its wholly owned insurance subsidiary
for insurance on the life of an employee of the parent), which
distinguishes Rev. Rul 77-316. "The 'economic family' concept is
based on the theory that when a captive receives a dollar, its
net worth and its parent's net worth increases by that amount,
and that when the captive pays out a dollar the converse occurs."
Gulf Oil Corp. v. Commissioner, 89 T.C. 1010, 1024 n.7 (1987),
affd. 914 F.2d 396 (3d Cir. 1990)
- 48 -
contrary, has considered captive insurance company issues on two
occasions. See Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835
(6th Cir. 1995), revg. T.C. Memo. 1992-661; Humana Inc. v.
Commissioner, 881 F.2d 247 (6th Cir. 1989), affg. in part and
revg. in part 88 T.C. 197 (1987). We must follow the rationale
of those cases to the extent that the facts presented in them are
squarely on point with the facts in the instant case. Golsen v.
Commissioner, 54 T.C. 742, 756-757 (1970), affd. 445 F.2d 985
(10th Cir. 1971).
In Humana, Inc. the taxpayer parent, together with various
of its subsidiaries, owned and operated between 62 hospitals
containing 8,586 beds and 92 hospitals containing 16,529 beds
during the years in issue. Humana Inc. v. Commissioner, 88 T.C.
at 199. During 1976, Humana incorporated Health Care Indemnity,
Inc. (HCI), a Colorado captive insurance company, with $1 million
in capitalization, to provide fire, general liability, medical
malpractice, and other casualty insurance for Humana and its
subsidiaries after Humana learned that it could no longer obtain
insurance coverage from a third-party insurer. Id. at 200-202.
Of the initial $1 million in capitalization, $750,000 was paid by
irrevocable letters of credit issued in favor of the Commissioner
of Insurance of the State of Colorado. Id. at 202. No
agreements existed between Humana or its subsidiaries and HCI
requiring the parent or sister subsidiaries to contribute
- 49 -
additional capital to HCI for the payment of any losses. Id.
During the last year in issue, however, Humana did contribute
$1,323,000 additional capital to HCI. Id. HCI was not included
in the consolidated returns filed by Humana and its subsidiaries.
Id. at 205. Relying on precedent, we held that the premiums paid
by Humana to HCI on its own behalf as well as the premiums paid
by Humana and then allocated and charged back to the sister
subsidiaries were not deductible but were equivalent to additions
to a reserve for losses. Id. at 206-207, 213-214.
The Court of Appeals for the Sixth Circuit affirmed our
decision that payments Humana had made to HCI for insurance on
behalf of its own hospitals were not deductible, but reversed our
similar decision as to those payments made on behalf of hospitals
owned by the sister subsidiaries. Humana Inc. v. Commissioner,
881 F.2d 247 (6th Cir. 1989). The court concluded that, pursuant
to the principles of Moline Properties, Inc. v. Commissioner, 319
U.S. 436 (1943), the sister subsidiaries must be treated as
separate corporations from the parent. In its analysis as to
whether risks had shifted to HCI, the Court of Appeals noted
that:
Health Care Indemnity met the State of Colorado's
statutory minimum requirements for an insurance company, was
recognized as an insurance company following an audit and
certification by the State of Colorado, and is currently a
valid insurance company subject to the strict regulatory
control of the Colorado Insurance Department. The State of
Colorado has either approved or established the premium rate
for insurance between the Humana affiliates and Health Care
- 50 -
Indemnity. As a valid insurance company under Colorado law,
Health Care Indemnity's assets cannot be reached by its
shareholders except in conformity with the statute.
Health Care Indemnity was fully capitalized and no
agreement ever existed under which the subsidiaries or
Humana Inc. would contribute additional capital to Health
Care Indemnity. The hospital subsidiaries and Humana Inc.
never contributed additional amounts to Health Care
Indemnity nor took any steps to insure Health Care
Indemnity's performance. It is also undisputed that the
policies purchased by the hospital subsidiaries and Humana
Inc. were insurance policies as commonly understood in the
industry. The hospital subsidiaries and Humana Inc. entered
into bona fide arms length contracts with Health Care
Indemnity. Health Care Indemnity was formed for legitimate
business purposes. Health Care Indemnity and the hospital
subsidiaries conduct legitimate businesses and are devoid of
sham. No suggestion has been made that the premiums were
overstated or understated. Health Care Indemnity did not
file its income tax returns on a consolidated basis with
Humana Inc. and its subsidiaries. Humana Inc.'s insured
subsidiaries own no stock in Health Care Indemnity, nor vice
versa. [Humana, Inc. v. Commissioner, 881 F.2d at 253;
citation omitted.]
The Court of Appeals specifically adopted the balance sheet
and net worth analysis described in Clougherty Packing Co. v.
Commissioner, 811 F.2d at 1305,11 to analyze whether risks had
11
In Clougherty Packing Co. v. Commissioner, 811 F.2d 1297
(9th Cir. 1987), affg. 84 T.C. 948 (1985), the taxpayer parent
incorporated a Colorado captive insurance company to reinsure a
portion of the workers' compensation risks primarily insured by a
third party insurance carrier. In affirming our decision that
risks had not shifted to the captive insurer, the Court of
Appeals for the Ninth Circuit neither adopted nor rejected
respondent's economic family concept, stating as follows:
In reaching our holding, we do not disturb the
separate legal status of the various corporate entities
involved, either by treating them as a single unit or
otherwise. Rather, we examine the economic
consequences of the captive insurance arrangement to
(continued...)
- 51 -
shifted from the sister subsidiaries to HCI. The court stated
that "If we look solely to the insured's assets, i.e., those of
the various affiliates of Humana Inc., and consider only the
effect of a claim on those assets, it is clear that the risk of
loss has shifted from the various affiliates to Health Care
Indemnity." Humana Inc. v. Commissioner, 881 F.2d at 252. The
court explained as follows:
The economic reality of insurance between a parent and a
captive insurance company is that the captive's stock is
shown as an asset on the parent's balance sheet. If the
parent suffers an insured loss which the captive has to pay,
the assets of the captive will be depleted by the amount of
the payment. This will reduce the value of the captive's
shares as an asset of the parent. In effect, the assets of
the parent bear the true economic impact of the loss. The
economic reality, however, of insurance between the Humana
subsidiaries and Health Care Indemnity, where the
subsidiaries own no stock in the captive and vice versa, is
that when a loss occurs and is paid by Health Care Indemnity
the net worth of the Humana affiliates is not reduced
accordingly. The subsidiaries' balance sheets and net worth
are not affected by the payment of an insured claim by
Health Care Indemnity. In reality, therefore, when the
Humana subsidiaries pay their own premiums under their own
insurance contracts, as the facts show, they shift their
risk to Health Care Indemnity. [Id. at 253.]
11
(...continued)
the "insured" party to see if that party has, in fact,
shifted the risk. In doing so, we look only to the
insured's assets, i.e., those of Clougherty, to
determine whether it has divested itself of the adverse
economic consequences of a covered workers'
compensation claim. Viewing only Clougherty's assets
and considering only the effect of a claim on those
assets, it is clear that the risk of loss has not been
shifted from Clougherty. [Id. at 1305; emphasis
added.]
- 52 -
Distinguishing the cases relied on by the Commissioner,12
the Court of Appeals stated further that the undercapitalization
of the captive insurer or the presence of an indemnification
agreement running from the parent to the captive insurer "alone
provided a sufficient basis from which to find no risk shifting
and to decide the cases in favor of the Commissioner." Humana v.
Commissioner, 881 F.2d at 254 n.2.
The Court of Appeals also stated:
In general, absent specific congressional intent to the
contrary, as is the situation in this case, a court cannot
disregard a transaction in the name of economic reality and
substance over form absent a finding of sham or lack of
business purpose under the relevant tax statute. [Id. at
255; citations omitted.]
The court noted that we had found that Humana had a valid
business purpose for incorporating the captive insurer. Id. The
court found both risk sharing and risk distribution involved in
the transactions between the Humana subsidiaries and HCI. Id.
Risk distribution was involved because losses were spread among a
number of Humana's subsidiaries. Id. at 257.
In Malone & Hyde, Inc. v. Commissioner, T.C. Memo. 1989-604,
supplemented by T.C. Memo. 1993-585, the taxpayer parent,
primarily a wholesale food distributor, together with
12
Those cases were: Beech Aircraft Corp. v. United States,
797 F.2d 920 (10th Cir. 1986); Stearns-Roger Corp. v. United
States, 774 F.2d 414 (10 Cir. 1985); Carnation Co. v.
Commissioner, 71 T.C. 400 (1978), affd. 640 F.2d 1010 (9th Cir.
1981).
- 53 -
approximately eight operating subsidiaries provided goods and
services required by their independent retail grocery store owner
customers. During 1977, Malone & Hyde incorporated Eastland
Insurance, Ltd. (Eastland) as a wholly owned Bermuda captive
insurance company to provide insurance for itself and its
subsidiaries at less cost than was available from third-party
insurers. Eastland was capitalized at $120,000, the minimum
statutory requirement pursuant to Bermuda's insurance law.
Malone & Hyde, Inc. v. Commissioner, 62 F.3d at 836. Malone &
Hyde decided that initially Eastland only would reinsure selected
risks of the parent and the subsidiaries. Accordingly, Eastland
agreed to reinsure the first $150,000 of each workers'
compensation, auto liability, and general liability claim
primarily insured by Northwestern National Insurance Co.
(Northwestern). Eastland provided Northwestern with an
irrevocable letter of credit, initially in the amount of $250,000
but subsequently increased to $600,000, to cover amounts unpaid
under the reinsurance agreement. Additionally, Malone & Hyde
executed hold harmless agreements wherein it agreed to indemnify
Northwestern against any liability in the event that Eastland
defaulted on its reinsurance obligations. Malone & Hyde paid
insurance premiums to Northwestern and Northwestern in turn paid
Eastland reinsurance premiums for the insurance risks assumed by
Eastland. Malone & Hyde allocated to the operating subsidiaries
- 54 -
their portion of the premiums paid to Northwestern. Malone &
Hyde, Inc. v. Commissioner, T.C. Memo. 1989-604.
In our first opinion in Malone & Hyde, Inc., we sustained
respondent's determination that there was no shifting of risks
from the parent and the sister subsidiaries to Eastland for the
portion of the insurance premiums that Malone & Hyde paid to
Northwestern and which Northwestern then paid to Eastland as
reinsurance premiums. Malone & Hyde, Inc. v. Commissioner, T.C.
Memo. 1989-604. Following the reversal of Humana Inc. & Subs. v.
Commissioner, 88 T.C. 197 (1987), we reconsidered our first
decision in Malone & Hyde, Inc. in light of language in Humana
Inc. v. Commissioner, 881 F.2d at 255, that in applying the
balance sheet and net worth analysis we look solely at the impact
a claim of loss would have on the assets of the insured. In our
Supplemental Opinion in Malone & Hyde, Inc., using that criteria,
and applying our three-prong test (i.e., (1) whether insurance
risks are involved, (2) whether risk shifting and risk
distribution is present, and (3) whether insurance in its
commonly accepted sense exists), we found that the premiums paid
by the sister subsidiaries were deductible as insurance. Malone
& Hyde, Inc. v. Commissioner, T.C. Memo. 1993-585.
The Court of Appeals for the Sixth Circuit reversed our
decision. The court stated:
We believe the tax court put the cart before the horse
in this case. It should have determined first whether
- 55 -
Malone & Hyde created Eastland for a legitimate business
purpose or whether the captive was in fact a sham
corporation. A taxpayer is "free to arrange his financial
affairs to minimize his tax liability." Thus, "the presence
of tax avoidance motives will not nullify an otherwise bona
fide transaction." However, the establishment of a tax
deduction is not, in and of itself, an "otherwise bona fide
transaction" if the deduction is accomplished through the
use of an undercapitalized foreign insurance captive that is
propped-up by guarantees of the parent corporation. The
captive in such a case is essentially a sham corporation,
and the payments to such a captive that are designated as
insurance premiums do not constitute bona fide business
expenses, entitling the taxpayer to a deduction under ยง
162(a). [Malone & Hyde, Inc. v. Commissioner, 62 F.3d at
840; citations omitted.]
The court noted that Malone & Hyde did not have any problem
obtaining insurance from an unrelated insurer but, without a
legitimate business reason, it had deviated from normal behavior
and had devised a circuitous scheme to obtain tax deductions
through the use of a captive insurer. Id. The court also
observed that there was no indication that Bermuda exercised
oversight over Eastland's activities. Id. at 841. The court
further noted that Eastland operated on extremely thin
capitalization and that Malone & Hyde had furnished Northwestern
with hold harmless agreements on two occasions. The court stated
that the presence of the hold harmless agreements and
undercapitalization (two factors which had been identified in
Humana Inc. v. Commissioner, 881 F.2d at 254 n.2, as weaknesses
that in themselves provided a sufficient basis on which to find
no risk shifting) "indicates that the captive insurance scheme
established by Malone & Hyde was not an 'otherwise bona fide
- 56 -
transaction,' but a sham." Malone & Hyde, Inc. v. Commissioner,
62 F.3d at 841.
The Court of Appeals stated:
If Humana's scheme had involved a thinly-capitalized
captive foreign insurance company that ended up with a large
portion of the premiums paid to a commercial insurance
company as primary insurer, and had included a hold harmless
agreement from Humana indemnifying the unrelated insurer
against all liability, we believe the result in Humana would
have been different. This court accepted the bona fides of
the transaction in Humana and recognized the premiums paid
to the captive insurance company as deductible business
expenses since Humana established the captive to address a
legitimate business concern (the loss of insurance
coverage), and the captive was not a sham corporation; the
captive in Humana was fully capitalized, domestically
incorporated, and established without guarantees from the
parent or other related corporations. Because Humana acted
in a straightforward manner, without any evidence of an
intent to create an unwarranted tax deduction based on
payments that largely ended up in its subsidiary's coffers,
this court accepted the bona fides of the transaction before
examining the brother-sister issue.
We disagree with Malone & Hyde's contention that
footnote 2 in Humana refers only to the question of whether
Humana's premium payments for its own coverage, as opposed
to the coverage extended its subsidiaries, involved risk
shifting. Footnote 2 clearly applies to the fundamental and
decisive question of whether there was risk shifting from
any insured--parent or subsidiary--to the captive insurer.
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.
It is true that Eastland operated as an insurance
company. As the tax court found, it "established reserve
accounts, paid claimed losses only after the validity of
those claims had been established, and was profitable." For
purposes of determining the correct tax treatment of
premiums paid to Eastland by Malone & Hyde, however, we
- 57 -
cannot be blind to the realities of the case. The
"interdependent" separate agreements, when considered
together indicate an arrangement under which there was no
risk shifting. Under the hold harmless agreement, the
ultimate risk for workers' compensation, auto liability, and
general liability remained with Malone & Hyde. This being
so, the transactions did not result in Malone & Hyde or the
subsidiaries receiving "insurance" from Eastland within the
meaning of that term under the Internal Revenue Code.
[Malone & Hyde, Inc. v. Commissioner, 62 F.3d at 842-843;
citations omitted; emphasis added.]
We turn next to our consideration of the facts present in
the instant case in light of the holdings of the Sixth Circuit
Court of Appeals in Humana and Malone & Hyde, Inc.. Golsen v.
Commissioner, 54 T.C. 742 (1970). In the instant case,
respondent concedes that the professional and general liability
risks and workers' compensation risks covered by Parthenon are
insurable risks. Furthermore, respondent does not dispute the
presence of risk distribution in the instant case, inasmuch as
the number of hospitals insured and the number of hospital beds
involved in the instant case far exceed the number of hospitals
and beds insured that the Court of Appeals in Humana found
sufficient for risk distribution to have occurred. Humana Inc.
v. Commissioner, 881 F.2d at 256-257. Accordingly, the questions
we must resolve are (1) whether bona fide insurance transactions
exist and, (2) if they do, whether the sister subsidiaries
shifted those risks to Parthenon.
- 58 -
The Transactions Between Parthenon and HCA and the Sister
Subsidiaries Are Insurance Transactions
Pursuant to the principles of Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943), respondent does not contend
that Parthenon's separate corporate existence should be ignored
for Federal income tax purposes or that Parthenon itself is a
sham corporation. Respondent contends, however, that the
transactions between Parthenon and petitioners during the years
in issue, including the issuance of insurance policies and
setting of reserves, were not bona fide insurance transactions
and were motivated by tax concerns.
Respondent contends that petitioners intended to, and did,
treat Parthenon as a form of self-insurance to carry out a loss
prevention and risk management program for their hospitals.
Respondent concedes that Parthenon was licensed and regulated as
a captive insurance company by the State of Tennessee, and that
it satisfied the applicable regulatory criteria for operation as
a captive insurer. Respondent, however, maintains that the
regulatory criteria, as well as Blue Cross' annual audits and
Continental's annual reviews, were no more than what would be
necessary for a self-insurance plan. Respondent contends that
petitioners formed Parthenon as a captive insurance company in
- 59 -
order to create tax deductions for amounts that in fact are self-
insurance.
Petitioners contend that the transactions were in respect of
an insurance company and that respondent's self-insurance
argument is an attempt to recharacterize an insurance
relationship between separate legal entities as self-insurance by
a single economic family.
In the instant case, Parthenon, in form, operated as an
insurance company. It was licensed as a captive insurer, fully
staffed, and performed typical insurance functions, including
underwriting, the setting of premiums and reserves, investment
management, and claims administration. Nonetheless, we must look
beyond the formalities and consider the realities of the
purported insurance transactions between Parthenon and
petitioners. Malone & Hyde, Inc. v. Commissioner, 62 F.3d at
842-843. Based on the record developed in the instant case, we
conclude that Parthenon provided insurance to HCA and to the
sister subsidiaries.
Respondent asserts the following differences to distinguish
the instant case from Humana, Inc. v. Commissioner, supra: (1)
The sister subsidiaries, in effect, were stockholders in
Parthenon; (2) Parthenon was not subject to strict regulatory
- 60 -
control by the Department of Insurance; (3) approval of the rates
between Parthenon and its sister subsidiaries, and protection of
Parthenon's assets, was not accomplished on an annual basis by
the State of Tennessee; (4) there was an agreement by which the
sister subsidiaries or HCA would contribute additional capital to
Parthenon; (5) HCA's hospital subsidiaries contributed additional
amounts to Parthenon; (6) the insurance policies that Parthenon
issued to the sister subsidiaries did not constitute bona fide
insurance contracts as commonly understood in the insurance
industry; (7) HCA's hospital subsidiaries as corporate entities
did not operate the individual hospitals; (8) the premiums were
both overstated (for 1986, 1987, and 1988) and understated (for
1984) at the whim of HCA based on HCA's needs at the time the
premiums were determined; and (9) Parthenon filed its income tax
return on a consolidated basis with HCA and its subsidiaries but
not on the insurance company forms required by the income tax
regulations. Accordingly, respondent contends that Humana, Inc.
v. Commissioner, supra, does not control the outcome of the
instant case because the facts are distinguishable.
Respondent contends further that HCA's decision during 1985
to use the assets and reserves of Parthenon to organize a surplus
lines company to provide medical malpractice insurance to
- 61 -
physicians who referred patients to HCA hospitals, the payment of
additional premiums for prior years during 1986 while failing to
pay current premiums, and the decision during 1987 to raise HCA's
and the sister subsidiaries' general and professional liability
insurance deductible to $10 million and thereby effectively
terminate Parthenon's premium income demonstrate that Parthenon
was controlled at all times by HCA for the benefit of HCA.
Additionally, respondent contends that the comfort letter given
by HCA to Ideal Mutual to guarantee the performance of Parthenon,
the payment of workers' compensation claims in 1984 by HCA in
connection with its Florida hospitals upon the insolvency of
Ideal Mutual, the transfer of Parthenon's reserves to PCIC, the
reserve strengthening payments totaling $86 million, an alleged
$60 million excessive premium charged for the 1986 claims-made
policy at the rate for a policy on an occurrence basis, the
failure of HCA to pay the quarterly premiums for the first three
quarters of 1986, and the decision by HCA during 1987 to pay
claims less than $10 million out of working capital, all support
the conclusion that neither HCA nor the sister subsidiaries
shifted risks to Parthenon.
Petitioners contend, however, that the facts in the instant
case are similar to those in Humana, Inc. v. Commissioner, supra.
- 62 -
Petitioners contend that they established Parthenon to address a
legitimate business concern, that petitioners acted in a
straightforward manner, with no intent to create an unwarranted
tax deduction, and that Parthenon was fully capitalized,
domestically incorporated, regulated by the State, and was not
propped up by guaranties from HCA or the sister subsidiaries.
Petitioners contend further that Parthenon did not act solely as
a reinsurer of risks but directly insured the general and
professional liability risks of HCA and the sister subsidiaries.
Additionally, petitioners contend that the comfort letter
HCA gave to Ideal Mutual was a normal kind of reinsurance
security arrangement that had no effect on risk transfer.
Petitioners contend that the comfort letter HCA gave to Ideal
Mutual affected only a modest portion of Parthenon's business and
was not in effect when Continental became the commercial carrier
for the workers' compensation insurance during 1984 following
Ideal Mutual's insolvency. Accordingly, petitioners maintain,
the comfort letter did not "prop up" Parthenon. Additionally,
petitioners contend that the indemnity provision of the agreement
between HCA and Continental is not relevant to the reinsurance
provided by Parthenon because the subject matter of the indemnity
- 63 -
agreement was risks that were not covered by the reinsured
policies.
We conclude that, with a few significant differences, the
facts of the instant case are strikingly similar to the facts
presented in Humana Inc. v. Commissioner, supra. Both Humana and
HCA owned and operated hospitals that were facing difficulties in
obtaining medical malpractice insurance at the time that they
formed their captive insurance companies. Both formed fully
capitalized, domestic captive insurance companies to provide on a
direct basis general and professional liability insurance for
themselves and their operating subsidiaries. Respondent does not
dispute that Parthenon was formed and operated for legitimate
business purposes.
Except as discussed infra, we are not persuaded that the
"distinctions" between the facts of Humana and those of the
instant case are material. Respondent contends that the sister
subsidiaries had an equity interest in Parthenon. We do not
agree. We are not persuaded that the reserve strengthening
payments HCA and the sister subsidiaries paid to Parthenon during
1985, 1986, and 1987, or an alleged $60 million overcharge paid
for 1986, were the equivalent of capital contributions, which, in
substance, gave the sister subsidiaries an ownership interest in
- 64 -
Parthenon. Neither Parthenon nor the sister subsidiaries
intended to or did treat the reserve strengthening payments as
equity investment. Additionally, both the Department of
Insurance and Blue Cross treated the reserve strengthening
payments as insurance premiums. We conclude that, in fact and in
substance, the sister subsidiaries did not own any of Parthenon's
stock.
Respondent contends further that the Department of Insurance
did not strictly regulate Parthenon. The record in the instant
case establishes that the Tennessee Department of Insurance did
not promise, and we are persuaded that it did not extend special
privileges to Parthenon. The supervision that the Department of
Insurance exercised over Parthenon's operations, including
periodic financial examinations, was no different from the
supervision exercised over any other captive insurer licensed in
the State of Tennessee. Although the Department of Insurance did
not annually establish or approve the premium rates between
Parthenon and its sister subsidiaries, the examination report of
Parthenon prepared by the Department of Insurance as of December
31, 1979, indicates that the basic premium rating process used by
Parthenon for that period had the approval of the Department of
Insurance. Parthenon's process for setting premium rates did not
- 65 -
change significantly during the years in issue from the process
used during 1979. Annual approval of Parthenon's premium rates
is not required by the Tennessee captive insurance statute.
Furthermore, contrary to respondent's contention, there is no
indication that HCA used or could use Parthenon's assets except
in conformity with the Tennessee captive insurance statute.
Respondent contends that, from its inception, HCA agreed to
contribute additional capital to Parthenon. Neither HCA nor the
sister subsidiaries, however, agreed to, nor did the Department
of Insurance require HCA or the sister subsidiaries to agree to
be responsible for, any losses of Parthenon when Parthenon was
reincorporated in Tennessee during 1979. Although the Department
of Insurance, and HCA's management, may have expected HCA to
provide financial help if Parthenon were to experience financial
difficulties, there was no legal requirement or binding agreement
that HCA or the sister subsidiaries do so.
Respondent contends that the sister subsidiaries' lack of
choice as to insurer or insurance coverage demonstrates that the
insurance policies purchased by HCA and the sister subsidiaries
from Parthenon were not insurance policies as commonly understood
in the industry and that those policies were not entered into as
bona fide arm's-length contracts by the subsidiaries. Respondent
- 66 -
therefore argues that the transactions between Parthenon and
petitioners were in the nature of self-insurance. We are unable
to reach such a conclusion and, furthermore, are persuaded that
the lack of choice plays no role in deciding whether the policies
between Parthenon and its sister subsidiaries constituted
insurance as commonly understood in the industry. The policies
covered typical insurance risks, including medical malpractice,
property damages, and workers' compensation liability. HCA,
moreover, had a legitimate business reason for requiring the
sister subsidiaries to acquire insurance from Parthenon.
Additionally, we find no merit to respondent's contention
that the sister subsidiaries merely held legal title to the
hospitals they owned and therefore played no part in the
insurance relationship between Parthenon and those hospitals.
Respondent's position would have us, in effect, ignore the
separate existence of the sister subsidiaries even though
respondent agrees that they were formed and operated for
legitimate business purposes and should be recognized as separate
corporate entities. We find no basis in fact or law for doing
so. See Moline Properties, Inc. v. Commissioner, 319 U.S. 436
(1943).
- 67 -
Nonetheless, we agree that some significant factual
distinctions exist between the present case and Humana, Inc. v.
Commissioner, supra. We next consider the effect of those
differences.
One significant factual distinction between the instant case
and Humana is the presence of the comfort letter that HCA gave to
Ideal Mutual whereby HCA agreed to indemnify Ideal Mutual against
Parthenon's nonperformance relating to workers' compensation
liabilities that Ideal Mutual reinsured with Parthenon. Humana
had taken no steps to insure HCI's performance. Humana Inc. v.
Commissioner, 881 F.2d at 253. Malone & Hyde, however, gave
Northwestern, the insurance company primarily liable for
insurance risks reinsured by Eastland, a hold harmless agreement
relating to Eastland's reinsurance obligations. Malone & Hyde,
Inc. v. Commissioner, 62 F.3d at 836.
In Malone & Hyde, Inc., the Court of Appeals stated that the
presence of the hold harmless agreement, along with the fact that
Eastland was undercapitalized, indicated that the captive
insurance arrangement was a sham. Id. at 841. Eastland's
activities, however, were limited to providing reinsurance for
risks primarily insured by Northwestern, and the indemnity
agreement applied to all of those reinsured risks. In the
- 68 -
instant case, the comfort letter applied to only one line of
business, and that line of business was not the primary insurance
coverage provided by Parthenon to HCA and the sister
subsidiaries. Parthenon insured, on a direct basis, general and
professional liabilities for which no indemnity agreement was in
effect. The comfort letter, furthermore, was not in effect after
Ideal Mutual's insolvency during 1984. The indemnity agreement
between HCA and Continental related to liabilities arising from
the agreement to cede insurance obligations that HCA had entered
into with the Superintendent of Insurance of the State of New
York as Rehabilitator of Ideal Mutual Insurance Co., but it
specifically excluded Continental's own obligations under its
policies. Accordingly, the indemnity agreement was restricted to
obligations relating to Ideal Mutual's policies, and it did not
involve Continental's own policies. Under such circumstances, we
conclude that in the instant case the successive indemnity
agreements between HCA and Ideal Mutual and between HCA and
Continental are not a sufficient basis for finding that the
transactions between Parthenon and the sister subsidiaries were
not bona fide.13
13
In accordance with Malone & Hyde, Inc. v. Commissioner, 62
F.3d 835 (6th Cir. 1995), however, risk shifting is absent for
(continued...)
- 69 -
An additional distinction between the instant case and
Humana, Inc. v. Commissioner, supra, is that on four separate
occasions during the years in issue HCA and the sister
subsidiaries made reserve strengthening payments to Parthenon
totaling in the aggregate $86,350,100. Respondent contends that
the reserve strengthening payments and a payment by HCA relating
to Florida hospital workers' compensation claims when Ideal
Mutual became insolvent show that the ultimate responsibility for
insurance coverage provided by Parthenon remained with HCA. We
agree that those are factors to consider but conclude they are
not dispositive of the instant case.
HCA and the sister subsidiaries made the reserve
strengthening payments following determinations by Parthenon's
consulting actuary that Parthenon's reserves were not adequate
because its losses were developing more adversely than originally
estimated. The payments were treated as insurance premiums not
only by petitioners but also by the Department of Insurance and
by Blue Cross acting in its capacity as intermediary for HCFA.
The need for the additional payments arose not because Parthenon
13
(...continued)
Parthenon's workers' compensation obligations to the extent and
during the time that the indemnity agreement with Ideal Mutual
was in effect.
- 70 -
was thinly capitalized, but because, when the reserve
strengthening payments were made, earlier actuarial projections
made by Parthenon's independent consulting actuaries of unpaid
losses appeared insufficient to cover all of those losses. Under
the circumstances, we conclude that HCA and the sister
subsidiaries made the reserve strengthening payments to secure
insurance protection and that the fact of such payments does not
require a conclusion that the insurance arrangement with
Parthenon was a sham. Additionally, we believe that HCA's
decision to pay the Florida workers' compensation claims rather
than having the hospitals' assets frozen by the State of Florida
was a sound business decision relating to the continued
operations of those hospitals, and not evidence of a sham
arrangement with Parthenon.
Respondent contends further that the premiums for the 1986,
1987, and 1988 policy years were understated while the premium
for the 1984 policy year was overstated. Respondent relies on
Mr. Merlino's opinion to support that contention. Petitioners
contend that their independent actuarial consultants recommended
the premiums based on estimates of the risks assumed by
Parthenon. Petitioners contend that whether the actuarial
calculations produced premiums that proved to be higher or lower
- 71 -
than the losses actually incurred does not mean that the
actuarial opinions were wrong or misstatements of the premium
amounts. The premiums were neither subject to change at the whim
of HCA or its officers nor calculated so as to give petitioners
an unwarranted tax advantage. Accordingly, assuming arguendo
that the premiums were understated for 1984 or overstated for
1986, 1987, or 1988, we conclude that in the instant case the
understatement and overstatements would not render the insurance
arrangement between Parthenon and HCA and the sister subsidiaries
a sham.
Another distinction between Humana and the instant case is
that HCI filed a separate return from Humana and the sister
subsidiaries while in the instant case Parthenon filed its return
on a consolidated basis with HCA and the sister subsidiaries.
Although filing a consolidated return may be a factor to consider
in analyzing whether a transaction is bona fide, we do not find
the factor conclusive as to respondent's contention that the
arrangement in the instant case was a sham. A consolidated
income tax return treats members of the affiliated group as a
single entity for some purposes and as separate entities for
other purposes. 1 Lerner et al., Federal Income Taxation of
Corporations Filing Consolidated Returns 6-1 to 6-2 (1996). The
- 72 -
consolidated return regulations in effect for the years in issue
calculate income of each corporation in an affiliated group
separately as a threshold matter and for that purpose treat each
member of a consolidated return as a separate corporation. 1
Peel, 1 Consolidated Tax Returns sec. 1:01, at 1-2 (3d ed. 1992).
In that respect the tax treatment of insurance premiums is
reflected on a separate basis, not on a consolidated basis. HCA,
moreover, operated Parthenon as a separate entity. It was
separately staffed and managed. It maintained its own personnel
files, accounting records, information management system, cash
management system, and banking arrangements.
The consolidated return regulations require that a parent's
basis in the stock of its subsidiary be adjusted on the basis of
the subsidiary's earnings and profits. CSI Hydrostatic Testers,
Inc. v. Commissioner, 103 T.C. 398, 404 (1994), affd. 62 F.3d 136
(5th Cir. 1995). Pursuant to section 1.1502-32(b)(1)(ii), Income
Tax Regs., a positive basis adjustment is to be made in an amount
equal to an allocable part of the undistributed earnings and
profits of a subsidiary for the taxable year. CSI Hydrostatic
Testers, Inc. v. Commissioner, supra at 410. The net positive or
negative adjustment only affects HCA, however, inasmuch as it is
Parthenon's sole stockholder. The basis adjustment does not
- 73 -
affect the existence of Parthenon as a separate corporate entity.
Accordingly, we conclude that the fact that Parthenon filed on
the consolidated return with HCA and the sister subsidiaries does
not render the insurance arrangement between Parthenon and HCA
and the sister subsidiaries a sham.
Additionally, respondent further contends that HCA's use of
a $2,250,000 dividend from Parthenon to effectuate the formation
of PCIC, the failure of HCA and the sister subsidiaries to timely
pay quarterly premiums for the 1986 policy year, and the
calculation of the premium for the 1986 claims-made policy on the
rate for an occurrence basis policy, show that Parthenon was
controlled at all times by HCA for HCA's benefit and support a
conclusion that the insurance arrangement between Parthenon and
HCA and the sister subsidiaries was a sham. Although those
events are factors to consider, we do not find them dispositive.
Respondent does not contend that payment of the dividend to HCA
or its use in forming a surplus lines insurance company was
prohibited by statute or regulation. HCA formed PCIC because, as
a captive insurer, Parthenon could not provide medical
malpractice insurance to unrelated parties. HCA and the sister
subsidiaries delayed payment of the 1986 quarterly premiums while
HCA management reconsidered its insurance objectives. The 1986
- 74 -
premium was calculated on an occurrence policy basis to increase
Parthenon's reserves. There is no evidence that decisions to pay
the dividend, establish PCIC, delay payment of the 1986 quarterly
premiums, or calculate the 1986 premium using an occurrence
policy basis were tax motivated.
Accordingly, considering all of the facts and circumstances
presented in the instant case, we conclude that the transactions
between Parthenon and HCA and the sister subsidiaries constituted
a bona fide insurance arrangement.
The Sister Subsidiaries Shifted Risks to Parthenon
Under the rationale of Humana Inc. v. Commissioner, 881 F.2d
247 (6th Cir. 1989), petitioners do not contend that HCA shifted
its own insurance risks to Parthenon. Petitioners do contend,
however, that the sister subsidiaries shifted their insurance
risks to Parthenon. Respondent contends that no risk shifting
occurred.
Petitioners contend that, pursuant to Humana, the economic
impact of loss payments on the assets of the insured must be
analyzed to determine whether risks have shifted. Petitioners
contend that in the instant case, when losses occurred and were
paid by Parthenon, the sister subsidiaries' balance sheets and
net worth were unaffected by the payment. Accordingly,
- 75 -
petitioners contend, the sister subsidiaries' premium payments
shifted their risks to Parthenon. We agree. Under the balance
sheet and net worth analysis adopted by the Court of Appeals for
the Sixth Circuit in Humana Inc. v. Commissioner, supra, the
sister subsidiaries shifted insurance risks to Parthenon, except
for the workers' compensation liability covered by the
indemnification agreement between HCA and Ideal Mutual. Pursuant
to Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th Cir.
1995), there is no risk shifting of the workers' compensation
liability that was subject to the indemnification agreement
between HCA and Ideal Mutual, and, consequently, any addition to
the workers' compensation reserves attributable to the Ideal
Mutual policies is not deductible.
Accordingly, we conclude that Parthenon provided insurance
for the sister subsidiaries for the years in issue and, thus,
functioned as an insurance company. Sec. 816(a); see also sec.
1.801-3(a)(1), Income Tax Regs.
The second issue we must decide is what portion of
Parthenon's reserves for unpaid losses and expenses is deductible
for the years in issue. The parties have agreed as to all
adjustments relating to Parthenon's unpaid losses reserves except
the question of whether any or all of the adjustments set out in
- 76 -
the report of respondent's expert, Mr. Merlino, should be made.
Should we decide that a portion, but not all, of the reserve
adjustments proposed by Mr. Merlino should be made, the parties
have agreed upon a methodology for computing the resulting
adjustments to income.
Section 831 imposes taxes computed as provided in section 11
on the taxable income of insurance companies other than life
insurance companies.14 Section 832(c) provides deductions
for purposes of computing the taxable income of an insurance
company, inter alia, for all ordinary and necessary expenses
incurred and for losses incurred. Sec. 832(c)(1), (4).15
Section 832(b)(5)16 defines "losses incurred" as an amount equal
14
For taxable years beginning prior to Jan. 1, 1987, sec. 831
imposed tax as provided in sec. 11 on insurance companies other
than life insurance companies and mutual insurance companies.
15
Sec. 832(c) provides in pertinent part as follows:
(c) DEDUCTIONS ALLOWED.--In computing the taxable income of
an insurance company subject to the tax imposed by section 831,
there shall be allowed as deductions:
(1) all ordinary and necessary expenses incurred, as
provided in section 162 (relating to trade or business
expenses);
* * * * * * *
(4) losses incurred, as defined in subsection
(b)(5) of this section;
16
For tax year ended 1986, sec. 832(b)(5) provides as follows:
(continued...)
- 77 -
to (1) the losses paid during the taxable year, (2) reduced by
salvage and reinsurance recovered during that year, (3) plus all
unpaid losses (discounted for years after 1986) outstanding at
16
(...continued)
(5) LOSSES INCURRED.--The term "losses incurred" means
losses incurred during the taxable year on insurance
contracts, computed as follows:
(A) To losses paid during the taxable year, add
salvage and reinsurance recoverable outstanding at the end
of the preceding taxable year and deduct salvage and
reinsurance recoverable outstanding at the end of the
taxable year.
(B) To the result so obtained, add all unpaid
losses outstanding at the end of the taxable year and
deduct unpaid losses outstanding at the end of the
preceding taxable year.
For tax years ended 1987 and 1988, section 832(b)(5)(A) provides
as follows:
(5)LOSSES INCURRED.--
(A) In general.--The term "losses incurred" means
losses incurred during the taxable year on insurance
contracts, computed as follows:
(i) To losses paid during the taxable year,
add salvage and reinsurance recoverable outstanding at
the end of the preceding taxable year and deduct
salvage and reinsurance recoverable outstanding at the
end of the taxable year.
(ii) To the result so obtained, add all
unpaid losses on life insurance contracts plus all
discounted unpaid losses (as defined in section 846)
outstanding at the end of the taxable year and deduct
unpaid losses on life insurance contracts plus all
discounted unpaid losses outstanding at the end of the
preceding taxable year.
- 78 -
the end of the taxable year, (4) less all unpaid losses
outstanding at the end of the preceding taxable year, (5) plus
estimated salvage and reinsurance recoverable at the end of the
preceding taxable year, (6) less estimated salvage and
reinsurance recoverable at the end of the taxable year. The
portion of "losses incurred" that represents unpaid losses must
comprise only actual unpaid losses as nearly as it is possible to
ascertain them. Sec. 1.832-4(b), Income Tax Regs.17 The
estimate of actual outstanding unpaid losses must be fair and
reasonable based on the facts in each case and the company's
experience with similar cases. Id.
17
Sec. 1.832-4(b), Income Tax Regs., provides as follows:
(b) Losses incurred. Every insurance company to which this
section applies must be prepared to establish to the
satisfaction of the district director that the part of the
deduction for "losses incurred" which represents unpaid
losses at the close of the taxable year comprises only
actual unpaid losses. See Section 846 for rules relating to
the determination of discounted unpaid losses. These losses
must be stated in amounts which, based upon the facts in
each case and the company's experience with similar cases,
represent a fair and reasonable estimate of the amount the
company will be required to pay. Amounts included in, or
added to, the estimates of unpaid losses which, in the
opinion of the district director, are in excess of a fair
and reasonable estimate will be disallowed as a deduction.
The district director may require any insurance company to
submit such detailed information with respect to its actual
experience as is deemed necessary to establish the
reasonableness of the deduction for "losses incurred."
- 79 -
The reserve for unpaid losses at the end of the taxable year
is an estimate, made at the close of the current taxable year, of
the insurer's liability for claims that it will be required to
pay in future years. Home Mutual Ins. Co. v. Commissioner, 70
T.C. 944, 951 (1978), affd. in part, revd. in part and remanded
639 F.2d 333 (7th Cir. 1980); Western Casualty & Surety Co. v.
Commissioner, 65 T.C. 897, 917 (1976), affd. on another issue 571
F.2d 514 (10th Cir. 1978). The unpaid loss reserve at the end of
the taxable year for purposes of computing the "losses incurred"
deduction consists of the aggregate unpaid loss reserves for all
lines of business of the insurance company. Hanover Ins. Co. v.
Commissioner, 69 T.C. 260, 271 (1977), affd. 598 F.2d 1211 (1st
Cir. 1979); Western Casualty Surety Co. v. Commissioner, supra at
917.18 The resolution of a fair and reasonable estimate of a
taxpayer's unpaid losses is essentially a valuation issue and a
question of fact. Hanover Ins. Co. v. Commissioner, supra at
270. Calculation of unpaid losses may not be based on estimates
of potential losses that might be incurred in future years.
18
See also Rev. Proc. 75-56, 1975-2 C.B. 596, 597, sec. 3.03
(the deduction for unpaid losses incurred shall be the aggregate
of the reasonable estimates for each line of business at the end
of each taxable year). Rev. Proc. 75-56 sets forth procedures
for computing the deduction for losses incurred pursuant to sec.
832(b)(5).
- 80 -
Rather, unpaid losses must be based on the actual loss experience
of the insurance company. See Maryland Deposit Ins. Fund Corp.
v. Commissioner, 88 T.C. 1050, 1060 (1987); Modern Home Life Ins.
Co. v. Commissioner, 54 T.C. 935, 939-940 (1970). The taxpayer
has the burden to establish "to the satisfaction of the district
director" that the unpaid losses comprise actual unpaid losses.
Sec. 1.832-4(b), Income Tax Regs.; see also Hanover Ins. Co. v.
Commissioner, supra.
Based on Mr. Merlino's calculations, respondent contends
that, when established, the unpaid loss reserves claimed by
Parthenon for years ended 1984, 1986, 1987, and 1988 were not
reasonable based on acceptable actuarial methods within the
meaning of section 832(b)(5). Respondent contends that
Parthenon's professional and general liability reserves should be
increased for year ended 1984 by $16,177,587 and decreased for
years ended 1986, 1987, and 1988 by $67,384,000, $14,978,000, and
$29,058,000, respectively. Additionally, respondent contends
that Parthenon's workers' compensation liability reserve should
be increased for years ended 1984, 1987, and 1988 by $6,098,709,
$4,131,000, and $3,616,000, respectively. Accordingly,
respondent contends that net adjustments to Parthenon's total
- 81 -
reserves for years ended 1984, 1986, 1987, and 1988 should be
made as follows:
Increase (Decrease)
TYE in Total Reserves
1984 $22,276,000
1986 (67,384,000)
1987 (10,847,000)
1988 (25,442,000)
An increase in reserve results in a larger allowable deduction
and a decrease in reserve results in a smaller allowable
deduction for the applicable year.
Petitioners do not dispute the increase in reserves for
unpaid losses proposed by Mr. Merlino for year ended 1984, but
they deny that any adjustment to the reserves is required for
years ended 1986, 1987, and 1988. They contend that the reserves
for years ended 1986 through 1988 fall within the range of
reasonable estimates made at the time by Parthenon's independent
consulting actuary.
Petitioners presented Mr. Biscoglia as their expert witness
relating to the reasonableness of the professional and general
liability reserves of Parthenon and PCIC as of December 31, 1986.
For purposes of the trial, Mr. Biscoglia did not perform a
subsequent independent analysis of the reserves as of yearend
1986. Rather, he reviewed the reserve analysis report dated
- 82 -
February 17, 1987 (1986 report), that had been prepared
previously for Parthenon. In his expert witness report, Mr.
Biscoglia concluded that the 1986 report had employed accepted
and commonly used actuarial techniques, methodologies, and
assumptions. He further concluded that the aggregate $187
million discounted reserves carried by Parthenon and PCIC for
year ended 1986 were reasonable relative to the $176 million to
$203 million range for the discounted reserves that was estimated
for both companies in the 1986 report.
Additionally, petitioners contend that the reserves recorded
on Parthenon's annual statements for years ended 1987 and 1988
represent fair and reasonable estimates of the loss and loss
expense payments that Parthenon would be required to make in
future years. In support of that contention, petitioners rely on
the reserve analysis reports Mr. Biscoglia prepared during 1988
(for 1987 reserve requirements) and 1989 (for 1988 reserve
requirements).
Respondent contends that the reserve analysis reports
prepared by Mr. Biscoglia are irrelevant because they deal with
both Parthenon and PCIC and the reserves applicable to each
company cannot be segregated from the overall reserves applicable
to both of them. Respondent contends further that, inasmuch as
- 83 -
Mr. Biscoglia's reserve analysis report for the policy year 1986
addresses only professional and general liability reserves, he
cannot render an opinion as to the adequacy of the total loss and
loss expense reserves of Parthenon. Additionally, respondent
contends that petitioners' computations that are based on Mr.
Biscoglia's 1986 report are not relevant to the fairness and
reasonableness of the unpaid losses reserves because Mr.
Klaassen, not Mr. Biscoglia, served as Parthenon's actuary for
year ended 1986. Respondent contends further that Mr. Klaassen's
computations are erroneous because they are based on an
occurrence policy rather than a claims-made policy. Respondent
maintains that the adjustments to the unpaid losses reserves
proposed by Mr. Merlino are correct.
Petitioners contend that Mr. Biscoglia's reserve analysis
reports are relevant even though they address both Parthenon and
PCIC because the relevant question in the consolidated return
setting is whether the total reserves for both companies are
reasonable in each applicable year. Additionally, petitioners
contend, the 1986 annual statements of Parthenon and PCIC show
the respective reserve amounts that each booked.
Mr. Merlino did not calculate independently the amount or
range that he believes represents a fair and reasonable estimate
- 84 -
of the unpaid losses and expenses that Parthenon actually would
pay out. Rather, for purposes of his reserve recommendations,
Mr. Merlino focused on the reasonableness of the reserves from
the viewpoint of whether the unpaid losses reserves as reported
by Parthenon on its annual statements were either inadequate or
excessive in comparison to the reserves recommended by
Parthenon's independent consulting actuary.
With respect to the 1984 policy year, Mr. Merlino concluded
that Parthenon had recorded total reserves in an amount that was
$22,276,000 below the actuary's recommendation, and he
recommended an upward reserve adjustment in that amount. As
stated above, neither party disputes the accuracy of the
adjustment for the year ended 1984. Accordingly, we accept as
reasonable the increase in the unpaid losses reserves for that
year proposed by Mr. Merlino.
With respect to the 1986 policy year, Mr. Merlino concluded
that the professional and general liability reserves were
overstated by $67,384,000. Mr. Merlino calculated that
adjustment by (1) reducing to $221 million the undiscounted
reserve estimate of $238 million selected by Parthenon (to
conform the unpaid losses reserve to Mr. Klaassen's original
estimated recommended reserve level), and then (2) reducing that
- 85 -
$221 million by approximately $50 million to correct for Mr.
Klaassen's use of occurrence policy factors in formulating his
estimate. Mr. Merlino ignored the $218 million to $250 million
range that Mr. Biscoglia recommended for the general and
professional liability reserves for the 1986 policy year because
of Mr. Merlino's belief that Mr. Klaassen served as Parthenon's
consulting actuary for purposes of establishing the unpaid losses
reserves for that year. That belief is based on the fact that
Mr. Klaassen certified the adequacy of the reserves for the 1986
policy year.
The assumption that Mr. Klaassen served as Parthenon's
actuary for purposes of establishing the 1986 policy year unpaid
losses reserve levels is not supported by the record. The
recommended reserve levels generally are calculated shortly after
the close of the policy year for which the reserves relate. Both
Mr. Klaassen and Mr. Biscoglia testified that Mr. Biscoglia
replaced Mr. Klaassen as Parthenon's actuary during 1986.
Additionally, the reserve recommendation report prepared by Mr.
Klaassen for the 1986 policy year specifically states that he was
requested to supply a second opinion relating to the reserves for
professional liability losses and loss expenses as of the end of
1986. Based on the foregoing, we are persuaded that Mr.
- 86 -
Biscoglia, not Mr. Klaassen, served in the function of
Parthenon's consulting actuary for purposes of computing
recommended unpaid losses reserves for the 1986 policy year.
Mr. Merlino's challenge to the reasonableness of the unpaid
losses reserves Parthenon claimed for the year ended 1986 is
focused on the variance between the amount Parthenon reported on
its annual statement for that year and the amount recommended by
the consulting actuary. The $238 million unpaid losses reserve
Parthenon reported for the year ended 1986 for professional and
general liabilities is within the range of reasonable reserves
recommended by Mr. Biscoglia for that year. Mr. Merlino did not
challenge the unpaid losses reserves for any other line of
business carried by Parthenon. Accordingly, the adjustment to
the unpaid losses reserves proposed by Mr. Merlino for the year
ended 1986 finds no support in the record.
Respondent's other arguments relating to the reasonableness
of the unpaid losses reserves for the 1986 policy year are
irrelevant in light of the parties' stipulation that: "In the
event that the Court concludes [which we have] that Parthenon is
an insurance company, the parties have agreed on all adjustments
to reserves except for the single issue whether all or any
portion of the reserve adjustments proposed by respondent's
- 87 -
expert witness Matthew P. Merlino and set out in his report dated
October 27, 1994, should be made." Mr. Merlino's adjustment for
the year ended 1986 is based on an erroneous assumption and is
not otherwise supported in the record. Accordingly, we conclude
that the adjustment proposed by Mr. Merlino for year ended 1986
is not warranted.
With respect to the 1987 and 1988 policy years, Mr. Merlino
proposed adjusting Parthenon's reserves to conform to the
reserves recommended in Mr. Biscoglia's reserve analysis reports
for those years, but after first reducing the workers'
compensation reserves by $12.5 million for 1987 and $11.2 million
for 1988. For policy years 1987 and 1988, Mr. Biscoglia had
recommended unpaid losses reserves for workers' compensation
liabilities of $67,289,000 and $72,217,000, respectively. On the
annual statements for those years, Parthenon had reported unpaid
losses reserves for workers' compensation liabilities of
$50,551,000 and $57,417,000, respectively.
The workers' compensation policy for 1987 and 1988 was
retrospective. Parthenon accordingly received a premium
installment in the year of coverage (policy year) that was
designed to cover only a portion of the ultimate losses
anticipated on that line of business for that year. During the
- 88 -
next year (retrospective year), Parthenon received a
retrospective premium that was designed to cover the remaining
losses for the policy year.
In his calculation of the workers' compensation unpaid
losses reserve requirements for the policy year, Mr. Biscoglia
estimated workers' compensation reserves for the entire year
(including the portion of the liability paid during the
retrospective year). On the annual statement for the policy
year, however, Parthenon reported workers' compensation
liabilities relating only to the first-year installment premium.
Parthenon recorded the balance of the expected losses for the
policy year on the annual statement for the retrospective year
when the retrospective premium was paid.
In calculating his adjustment to the workers' compensation
unpaid losses reserves, Mr. Merlino reduced Mr. Biscoglia's
estimate of the required workers' compensation unpaid losses
reserve for each year to exclude the portion of the workers'
compensation unpaid losses reserve related to the retrospective
payment because he believed that petitioners would receive an
undue tax advantage if Parthenon were allowed to deduct the total
liability for the policy year without at the same time recording
an offsetting amount of premium income.
- 89 -
Petitioners contend that the unpaid losses reserve for
workers' compensation liabilities should include the total
anticipated liability regardless of the year during which payment
is recorded. We agree with petitioners. We find no basis for
Mr. Merlino's adjustment in the workers' compensation unpaid
losses reserves to account for unpaid premiums. Section 832(c)
provides a deduction from the taxable income of an insurance
company for "losses incurred" during the taxable year. Losses
incurred includes a fair and reasonable estimate of actual
outstanding unpaid losses that an insurance company will be
required to pay sometime in the future. Sec. 1.832-4(b), Income
Tax Regs. Neither the Code nor the regulations correlate unpaid
losses to premiums paid. Accordingly, we conclude that Mr.
Merlino's reduction of the unpaid losses reserve of $12.5 million
for 1987 and $11.2 million for 1988 is not warranted.
Mr. Merlino further reduced the unpaid losses reserves for
years ended 1987 and 1988 to conform the claimed unpaid losses
reserves for workers' compensation and professional and general
liabilities to the unpaid losses reserves for those lines of
business recommended in Mr. Biscoglia's reserve analysis reports
for those years. Respondent contends that those adjustments are
required to bring the reserves to a level which meets the fair
- 90 -
and reasonable test of section 1.832-4(b), Income Tax Regs.
Petitioners contend that the adjustments are not required because
the unpaid losses reserves for years ended 1987 and 1988 fall
within the range of reasonable estimates made by Mr. Biscoglia.
Petitioners contend that Mr. Merlino's conclusion that the
reserves should be reduced to the extent that the amounts exceed
the amounts set out in Mr. Biscoglia's reserve analysis reports
is incorrect inasmuch as the total reserves recorded by Parthenon
fall within the ranges he recommended.
We agree with petitioners that the aggregate unpaid losses
reserves for all lines of business for the applicable year, and
not the individual reserves for each line of business, must meet
the fair and reasonable test, Hanover Ins. Co. v. Commissioner,
69 T.C. at 271; Western Casualty Surety Co. v. Commissioner, 65
T.C. at 917, 919, but we do not agree that Mr. Biscoglia's
reserve analysis reports and testimony establish that Parthenon's
total unpaid losses reserves for years ended 1987 and 1988 in
fact represent fair and reasonable estimates of Parthenon's
actual unpaid losses and expenses. Petitioners have the burden
of establishing that the unpaid losses comprise actual unpaid
losses, Hanover Ins. Co. v. Commissioner, supra at 270, but have
failed to do so in the instant case.
- 91 -
Petitioners contend that Mr. Merlino's adjustments for years
ended 1987 and 1988 do not take into account that the total
reserves are in fact within the range that Mr. Biscoglia
recommended. The reserve analysis reports relating specifically
to Parthenon for years ended 1987 and 1988, however, do not
delineate recommended ranges for Parthenon's unpaid losses
reserves for professional and general liabilities for those
years. Rather, they set forth fixed dollar values for those
reserves. On brief, petitioners attempt to extrapolate a
recommended range for Parthenon's unpaid losses reserves for
professional and general liabilities for each year based on data
setting forth recommended ranges for unpaid losses reserves for
all of HCA's and the sister subsidiaries' professional and
general liabilities, including liabilities funded internally and
those transferred to HCA's captive insurance companies. The
consolidated reports prepared for that purpose make no attempt to
distribute the recommendations among the various entities. We
are not prepared to accept petitioners' naked assertion on brief
that the assumptions and principles petitioners used to
extrapolate ranges for the unpaid losses reserves for Parthenon's
professional and general liabilities approximate fair and
reasonable estimates of Parthenon's actual outstanding unpaid
- 92 -
losses for the years ended 1987 and 1988. Mr. Biscoglia's
summary testimony that he examined the reserves recorded by
Parthenon for 1987 and 1988 and found that the total amounts were
within an acceptable range for each year is not supported by any
detailed explanation or documentation. Mr. Merlino, on the other
hand, in his expert report compared the ultimate losses recorded
on Parthenon's annual statements as of yearend 1987 and as of
yearend 1988 for the 1984 through 1988 policy years with the
ultimate losses recorded on the annual statement as of yearend
1993 and concluded that the comparison indicated that the
professional and general liability reserves for policy years 1987
and 1988, in retrospect, were materially overstated. Based on
the foregoing, we conclude that petitioners have not established
the reasonableness of the unpaid losses reserves they are
claiming for the unpaid professional and general liability
losses, and, therefore, in keeping with the parties' stipulation,
we hold that the adjustments proposed by Mr. Merlino conforming
the unpaid losses reserves for workers' compensation and
professional and general liabilities for the years ended 1987 and
1988 to the amounts recommended in Mr. Biscoglia's reserve
analysis reports for those lines of business should be made.
- 93 -
In his report, Mr. Merlino recommends adjustments to
Parthenon's workers' compensation unpaid losses reserves and
professional and general liabilities reserves to conform those
reserves to the amounts recommended by Mr. Biscoglia. Respondent
has adopted Mr. Merlino's position to support the Government's
position. We deem that action to be a concession by respondent
that the values recommended by Mr. Biscoglia for the unpaid
losses reserves for workers' compensation and professional and
general liabilities are a fair and reasonable estimate of
Parthenon's actual unpaid losses for those lines of business for
years ended 1987 and 1988. In his report Mr. Merlino proposes no
adjustment to the unpaid losses reserves for other lines of
business carried by Parthenon for years ended 1987 and 1988. We
deem that inaction as a concession by respondent that the
reserves for those lines of business are a fair and reasonable
estimate of Parthenon's actual unpaid losses for those lines of
business for those years. We conclude that Parthenon is entitled
to deduct additions to its reserves for the years in issue in
amounts to be calculated by the parties in accordance with their
stipulations and the foregoing.
Additionally, respondent contends that petitioners have
failed to substantiate their claims regarding the reserves in
- 94 -
question because respondent is not able to review the methods and
assumptions underlying petitioners' actuary's work inasmuch as
petitioners did not supply sufficient information and they did
not reconcile the actuarial information presented at trial with
the annual statements of Parthenon and PCIC. We view
respondent's substantiation argument as a separate issue from
whether Mr. Merlino's adjustments are correct, and, thus, that
position is contrary to the parties' stipulation. In the Tax
Court, a stipulation is treated as a conclusive admission by the
parties, and the Court will not permit a party to change or
contradict a stipulation, except in extraordinary circumstances.
Rule 91(e); Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976).
We find no extraordinary circumstances present here to cause us
to disregard the stipulation. Accordingly, we do not address
respondent's argument that petitioner failed to provide
sufficient information or to reconcile the actuarial information
presented at trial with the annual statements of Parthenon and
PCIC.
To reflect the foregoing,
Decisions will be entered
under Rule 155.
Hospital Corp. of Am. v. Commissioner
Court: United States Tax Court
Date filed: 1997-10-27
Citations: 1997 T.C. Memo. 482, 74 T.C.M. 1020, 1997 Tax Ct. Memo LEXIS 565
Copy CitationsCombined Opinion