for premiums paid to a captive insurer if the captive does not adequately shift risk away from the parent, reports Business Insurance (BI).

In an August 18 decision, the 6th US Circuit Court of Appeals overturned a US Tax Court decision that had granted the deduction to Malone & Hyde Inc. and eight of its subsidiaries for premiums paid to Bermuda-based captive reinsurer Eastland Insurance Ltd.

Bermuda Insurance Management Association president Mr. Dennis Higginbottom said the decision would not affect Bermuda captives.

"This decision points directly at the reason for the formation of the Eastland captive,'' he said.

"It serves as a good reminder to captive owners that the purpose of the captive should be legitimate,'' he said.

Eastland was formed in 1977 by Malone & Hyde to reinsure the wholesale food distributor's workmen's compensation, auto liability and general liability risks.

The captive was capitalised at $120,000.

The ruling counters a 1989 Circuit court decision which granted a tax deduction for premiums that Humana Inc., a hospital chain, paid to its Colorado captive, HCI.

BI said the Malone & Hyde decision did not surprise captive tax experts. But the language of the decision could create problems said New York Law firm LeBoeuf, Lamb, Greene & MacRae partner Mr. Bruce Wright.

"If the opinion is read to mean that there is no deduction when the captive reinsurer is undercapitalised and there is a hold-harmless agreement'' issued to the primary insurance company, that is acceptable,'' said Mr. Wright.

"But the language in the case is confusing and I hope it's not interpreted to mean that Humana's purpose becomes the standard'' to determine tax deductibility of captive premiums, he said. The Circuit Court said Humana had formed its captive because it was unable to get coverage from the standard market while Malone & Hyde formed its captive to reduce it insurance costs, he said.

In the Humana case, the court found that risk had been shifted and distributed, added Mr. Higginbottom, senior vice president with AIG in Bermuda.

Human was fully capitalised and subject to Colorado regulatory control.

Eastland undertook to reinsure the first $150,000 of each claim against Malone & Hyde while operating on the "extremely thin'' minimum capitalisation required by Bermuda law, the court said.

In its decision, a three-judge panel of the Circuit Court said its primary reason for denying the deduction for Malone & Hyde was because its captive arrangement was a "sham''.

"The record does not indicate that Bermuda exercised oversight similar to that which Colorado exercised over Humana's captive insurer,'' the court said.

"While a taxpayer is free to arrange it financial affairs to minimise his tax liability, 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 undercapitalised foreign insurance captive that is propped up by guarantees of the parent corporation,'' the court said.

"The captive in such a case is essentially a sham corporation and the payments to such a captive that are designated as insurance premiums to not constitute a bona fide business expense, entitling the tax payer to a deduction,'' it said.

BUC COA TAX