Carnation Case

Summary of Carnation Case

A suit in which the U.S. Tax Court denied, for income tax purposes, the deduction of sums paid by the Carnation Company to its wholly owned Captive insurance company (read this and related legal terms for further details) as premiums for insurance coverage. The Internal Revenue Service asserted that the premiums paid by Carnation to its subsidiary, Three Flowers Insurance Company, a Bermuda corporation, did not result in a genuine transfer of risk from the parent to the captive, but were in fact contributions to a self-insurance fund and as such were not deductible. Carnation’s position was diminished by the fact that Three Flowers was thinly capitalized ($120,000), and the presence of an agreement between Carnation and American Home Insurance (an unrelated party) that American Home would reinsure 90 percent of its Carnation policy risks for Three Flowers’ additional capital as required to respond for Three Flowers’ obligations to American Home under the reinsurance arrangement.

The Tax Court held that insurance requires a transfer of risk from the insured to the insurer, which was absent in this case. Because Carnation remained directly responsible for any losses sustained by Three Flowers, no risk had been shifted to the captive. The decision of the Tax Court was upheld by the Court of Appeals and denied further review by the U.S. Supreme Court.

The effect of the Carnation case has been to clarify the respective relationships between a captive insurance company and its parent and affiliated companies. Among the points established are:

1. A captive must be adequately capitalized to bear the risks it has undertaken, and this capitalization must be in the form of true assets, rather than guarantees on the part of the parent to provide resources in the event of significant losses.

2. The captive must operate at arm’s length from the parent, and the premiums charged to the parent or affiliated companies must be reasonable.

3. The captive must be structured as an ongoing business directed toward the generation of profit from the issuance of contracts of insurance. As a practical matter, this means that the captive must derive a sufficient volume of its premiums from unrelated third parties so as to establish its status as a bona fide insurer.

On this last point, it is unclear what percentage of total premium income must be derived from unrelated sources in order to satify the definition of an insurer, although various experts recommend that third-party premiums be not less than 25 to 50 percent of total premium income.

See SUBPART F.

(Main Author: William J. Miller)