A recent US Tax Court ruling has strengthened the validity of captive insurance arrangements, tax specialists with Ernst & Young Bermuda have reported in a tax alert to clients.

The Tax Court ruled in favour of the taxpayer, Hospital Corporation of America and subsidiaries (HCA), in the case brought by the Commissioner of the Internal Revenue Service (IRS).

The IRS tried to show that an insurance transaction between the first party and its wholly-owned captive insurer, Parthenon Insurance Co., was not valid and that the premiums paid to the US captive from its insureds were not deductible, but rather capital contributions to the insurer.

But the Tax Court disagreed, deciding that the transactions were in fact bona fide insurance arrangements with adequate risk shifting under the balance sheet.

A report on the issue was prepared by Ernst & Young's manager of tax services Patrick L. Hackenberg and tax manager Julie Henderson.

HCA operated US hospitals that had trouble getting commercial insurance coverage. The group capitalised a captive insurer for that purpose.

The IRS had unsuccessfully claimed that reserve strengthening premium payments made by the subsidiaries to the captive insurer created an equity interest in the captive, creating a situation where there was no economic risk of loss.

But the court said that payments were treated as insurance premiums not just by HCA, but also by the state's insurance regulators and by Blue Cross.

Reserve strengthening payments were made not because the captive was thinly capitalised, but when the actuaries determined that the company's reserves were not adequate because of adversely developing losses beyond original estimates.

The Tax Court rejected the IRS assertion that the captive was not strictly regulated. The case showed that there was no difference or special supervision of the captive than any other captive insurer.

It was also stated that the captive used, or could use, its assets except in conformity with the state captive insurance statute.

The Tax Court in addition, rejected the IRS contention that the lack of choice of an insurer by the HCA subsidiaries made the transactions self-insurance.

The two Ernst & Young CPAs summarised that the court ruling is not likely to be the last word on the issue of what constitutes a valid insurance arrangement between a captive insurance company and its parent, and, or its subsidiaries.

They concluded: "Comfort may be taken in the fact that this case is appealable to the same US circuit court that decided the Humana case in favour of the tax payer.'' COURTS CTS