A Captive Insurance History: The Cases, Part 1, An Introduction

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   Over a period of nearly forty years, taxpayers and the Service fought a protracted legal battle over the validity of various captive insurance structures and arrangements.  But despite the persistent threat of government challenges that existed through the late 1990s, taxpayers and their advisers continued to utilize this concept.  The reason is simple: captives provided coverage that was either unavailable in the commercial market or too expensive for potential insureds to buy. 

​   One of the earliest captive cases involved a company that owned property in a flood plain.  Due to recent flooding, no commercial insurance was available.[1]  Despite losing this case, the Service issued Revenue Ruling 64-72 in which it stated it would not follow the Weber decision’s holding.[2]  But despite this publicly expressed opposition, business necessity continued to drive the formation of new captives.  In the early 1970s, a heavy construction company named Stearns Rogers “found it difficult or impossible to obtain from traditional insurance companies the types and huge amounts of coverage”[3] needed by the company.  Unavailability of coverage was but one business problem solved by captives.  Insurance cost was a primary reason for the taxpayer in Ocean Drilling, who, because of the newness of their business (offshore drilling) faced very high insurance rates.[4]  Mobil Oil determined that forming a captive would allow them to better coordinate and manage the insurance purchasing practices of their numerous international subsidiaries.[5]  The Beech Aircraft Company formed their captive because it allowed them to write their own insurance policy, granting them complete control over the attorneys used in litigation.[6]  As these examples illustrate, all the captives in the case law had a fundamental business reason for being formed.
   
       Despite the absence of tax evasion as a primary reason for forming these captives, the Service had concerns regarding the substance of these captives.  This concern was that none had pooled a sufficiently diverse pool of risk to be considered an insurance company.  For example, taxpayer in Ocean Drilling was the sole source of funds for its captive[7] meaning that, for tax purposes, the captive was a not an insurance company but an accounting reserve.  The Ocean Drilling fact pattern was common.[8]  Because the parent was the sole source of not only capital but insurance premiums, there was no co-mingling of funds.  So, when the captive made an insurance payment to the parent, it was nothing more than a return of the parent’s payments, making the captive an accounting reserve, not a bona fide insurer. 

   The sequence of cases litigating the concept of captive insurance companies can be understood best by looking at early and later phases of litigation.  This Part will look at these cases to understand the development of the captive concept.  Section 2 discussed the first period, which encompasses two cases tried in the 1950s.  Although the cases had remarkably similar facts, the government won one and lost the other.  Section 3 addresses the second round of litigation, which occurred between 1978 and 1987.  In it, the government achieved a number of victories involving smaller insurance companies.  Section 4 looks at the third stage, which began as taxpayers started winning their arguments, with litigation that involved captives that were large enough to convince the courts that they provided the requisite risk distribution. 


[1] United States v. Weber Paper Co., 320 F.2d 199, 201 (9th Cir. 1963)(“As a result of the serious flood losses suffered by the taxpayer and others, a demand for flood insurance arose.  None was available.  Existing insurance carriers concluded that such risks could not soundly be underwritten.”)

[2] Rev. Rul. 64-72 (I.R.S. 1964)(“Although certiorari was not applied for in the Weber Paper Company case, the decision will not be followed as a precedent in the disposition of similar cases, and the position of the Service, as set forth in Revenue Ruling 60-275, C.B. 1960-2, 43, will be maintained pending further judicial tests.”)

[3] Stearns-Rogers Corp. v. United States, 577 F. Supp. 833, 834 (D. Col. 1984)

[4] Ocean Drilling and Exploration Co. v. United States, 24 Cl. Ct. 714, 715 (1991)(“Because of the limited experience in insuring the new rigs and a number of substantial losses on these rigs, insurance rates increased sharply.”); Kidde Industries, Inc. v. United States, 40 Fed. Cl, 42 (1977)(“In 1976, in the midst of a products liability insurance crisis in which many insurance companies either ceased or significantly restricted their coverage of products liability … Travelers informed Kidde that it would not renew Kidde’s products liability insurance policy for 1977); Malone and Hyde, Inc. v. Comm’r of Internal Revenue, T.C. Memo 1989-604 (1989) (“By the mid-1970s, the Hyde Insurance Agency found that insurance premiums were increasing each year and certain insurance was not obtainable for some clients”)

[5] Mobil Oil. Corp. v. United States, 8 Cl. Ct. 555, 556 1985)(After determining that “the outside insurance purchased by Mobil Overages was not bought efficiently,” the company commissioned an internal report.  “The Adams Report concluded the methods of Mobil Overseas and its affiliates of insuring against physical damage should be revised.  The report states (in part): Mobil Overseas should … Form an insurance affiliate to cover our risks where possible.”)

[6] Beech Aircraft Corp. v. United States, 1984 U.S. Dist. LEXIS 15251 (D. Kan. 1984)(Beech aircraft was sued under a product’s liability claim.  The company’s insurance policy granted the insurer complete control of the attorneys used in litigation.  Beech tried to remove counsel before trial, but the motion was denied.  The captive was formed after the company lost a judgment of $25 million).

[7] Ocean Drilling at 716 (“In 1968 plaintiff established Mentor as a wholly-owned subsidiary incorporated in Bermuda.  The initial capitalization for Mentor as $12,000.  Plaintiff increased the capitalization to Mentor to $200,000 by the end of 1968.”  However, the company was the captive’s only source of funding.)

[8] Stearns Rogers v. United States, 577 F. Supp. 833, 834 (D. Col. 1984)(To ensure sufficient protection for third-party insureds, Stearns Rogers executed an indemnification agreement by which it agreed to indemnify [its captive] for losses and damages up to $3,000,000.”); Beech at ___, The Bermuda Insurance Company was named Travel Air Insurance Company, and it issued 120,000 shares of common stock, of which Beech acquired 109,000.); Carnation Co. v. Comm’r of Internal Revenue, 71 T.C. 400, 401 (1978)(“Under an agreement dated September 1. 9171, Carnation’s initial capital contribution to the capital of [its captive] was the purchase of $120,000 shares of common stock at its par value of $1 per share.); Malone and Hyde, Inc. v. Comm’r of Internal Revenue, T.C. Memo 1989-604 (“Eastland was authorized to issue 120,000 shares at $1 per share.  Malone and Hyde purchased all these shares on June 21, 2977 for $120,000.”)