                                T.C. Memo. 2014-225



                        UNITED STATES TAX COURT



       SECURITAS HOLDINGS, INC. AND SUBSIDIARIES, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 21206-10.                         Filed October 29, 2014.



      Michael Francis Kelleher, Elizabeth A. Erickson, and Justin E. Jesse, for

petitioner.

      Henry C. Bonney, Jr., and Lloyd T. Silberzweig, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      BUCH, Judge: Respondent issued a notice of deficiency determining

deficiencies of $13,801,906 for 2003 and $16,496,539 for 2004. The deficiencies

largely stem from respondent’s partial disallowance of deductions for interest

expenses and deductions for insurance expenses related to a captive insurance
                                        -2-

[*2] arrangement. The sole issue remaining for us to decide is whether petitioner

is entitled to deduct premiums paid through the captive insurance arrangement

established by its parent corporation. Respondent does not dispute that the

arrangement involved insurable risks, and we hold that the captive arrangement

shifted risks, distributed risks, and constituted insurance in the commonly

accepted sense. Therefore, the arrangement is insurance for Federal tax purposes,

and petitioner is entitled to the deduction under section 1621 for insurance

expenses.

                                 FINDINGS OF FACT

I. Parent-Subsidiary Structure

      Securitas AB is a public Swedish company. Beginning in the late 1980s and

continuing through the 1990s Securitas AB expanded its business outside of

Sweden by acquiring other companies throughout Europe. Securitas AB first

entered the U.S. security services market in 1999 when it established Securitas

Holdings, Inc. (SHI). SHI is the parent company of an affiliated group of U.S.

corporations (SHI Group or petitioner). During 2003 and 2004, the years in issue,


      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
                                        -3-

[*3] SHI had no employees, owned no vehicles, and did not provide any security

services itself. The SHI Group used the accrual method of accounting throughout

the years in issue.

      In 1999 SHI acquired Pinkerton’s, Inc. (Pinkerton’s), a Delaware

corporation, and its subsidiaries. Before its acquisition Pinkerton’s was a publicly

traded company that provided various security services and had approximately

48,000 employees in over 250 offices worldwide. In 2000 and 2001 SHI acquired

several additional security companies, including Burns International Services

Corp. (Burns), also a Delaware corporation, and its subsidiaries. Like Pinkerton’s,

Burns was a publicly traded company that provided various security services and

had approximately 75,000 employees in 300 offices in North America, South

America, and Europe.

      According to Securitas AB’s 2003 annual report, Securitas AB and its

subsidiaries (Securitas AB Group) accounted for 8% of the total world market for

security services. During 2003 and 2004 the Securitas AB Group employed over

200,000 people in 20 countries, mostly in North America and Europe.

II. Services

      In 2003 and 2004 the Securitas AB Group and the SHI Group provided

guarding services, alarm systems services, and cash handling services.
                                        -4-

[*4] Guarding services include providing uniformed security officers to maintain

a secure environment for clients as well as consulting and investigation services.

In 2003 and 2004 the SHI subsidiaries providing guarding services had

approximately 101,080 and 91,170 employees, respectively. These subsidiaries

also operated 2,250 and 2,495 vehicles, respectively. In mid-2003 many of the

SHI subsidiaries providing guarding services were consolidated into a newly

formed corporation and subsidiary of SHI, Securitas Security Services USA, Inc.

(SSUSA).

      Alarm systems services include the installation of alarm systems and alarm-

to-response solutions. Pinkerton’s Systems Integration, Inc., an SHI subsidiary,

provided alarm systems services. This company was later renamed Securitas

Security Systems USA, Inc., and employed approximately 270 people during 2003

and 2004.

      Cash handling services include cash transport, cash processing, and ATM

services. Loomis, Fargo & Co. (Loomis), an SHI subsidiary, provided cash

handling services and had approximately 7,122 employees in 2003 and 7,481

employees in 2004.
                                        -5-

[*5] III. Protectors

      Protectors Insurance Co. of Vermont (Protectors) was incorporated in

Vermont in 1986 as a licensed captive insurance company. As a result of various

acquisitions, the SHI Group acquired Protectors in early 2000, and Protectors

became a direct, wholly owned subsidiary of SHI in January 2003. Between

November 1, 1996, and December 30, 2002, Protectors did not write new or

renewal coverage, and its operations consisted solely of the runoff of previously

written coverage.

      Protectors had no employees during 2003 and 2004. Protectors maintained

separate books and records, maintained a separate bank account for its operations,

prepared financial statements, and held annual meetings of its board of directors.

Throughout 2003 and 2004 none of the U.S. operating subsidiaries of SHI or the

non-U.S. operating subsidiaries of Securitas AB owned any interest in Protectors,

and it was managed by a company that was unrelated by ownership to SHI.

      During 2003 and 2004 Protectors was subject to regulation as a captive

insurance company in the State of Vermont and paid premium taxes to the State of

Vermont. In June 2003 Protectors requested permission from the Vermont

Department of Banking, Insurance, Securities & Health Care Administration

(Vermont regulators) to lend all but $1 million of its capital to SHI. The Vermont
                                        -6-

[*6] regulators approved this request. Further, in early 2004 the Vermont

regulators allowed the SHI Group to avoid contributing additional capital to

Protectors as a result of Protectors’ issuing an insurance policy for 2004 to

Loomis. The Vermont regulators also waived the premium taxes with respect to

the policy.

IV. Securitas Group Reinsurance Limited

      In late 2002 Securitas AB informed the Irish Department of Enterprise,

Trade, and Employment that it intended to establish a new captive reinsurance

company in Ireland called Securitas Group Reinsurance Ltd. (SGRL) and that it

intended SGRL to be fully operational before the end of 2002. The Irish

authorities responded that they had no objection, and SGRL was incorporated

under the laws of Ireland.

      Beginning in December 2002 and continuing through 2004, SGRL operated

as a wholly owned subsidiary of Securitas AB, and it was subject to regulation as a

reinsurance company in Ireland. SGRL’s total shareholders’ funds were

$51,456,000 at the end of 2003 and $77,497,000 at the end of 2004. During 2003

and 2004 none of the U.S. operating subsidiaries of SHI and none of the non-U.S.

operating subsidiaries of Securitas AB owned any interest in SGRL. SGRL

maintained separate books and records, maintained a separate bank account for its
                                        -7-

[*7] operations, prepared financial statements, and held meetings of its board of

directors.

V. Implementation of the Captive Insurance Program

      After wages, the cost of risk is the second largest cost for the Securitas AB

Group. The operating subsidiaries of the SHI Group had exposure to various

insurable risks, including: workers’ compensation, automobile, employment

practices, general, and fidelity liabilities. In 2002, 2003, and 2004 the SHI Group

obtained insurance coverage from third-party insurers. These third-party policies

had deductibles or self-insured retentions which were the responsibility of the SHI

Group subsidiaries.

      Several events converged in the early 2000s causing the insurance market to

harden and causing insurance rates to increase. In response to the increase, the

Securitas AB Group tried to control risks and to obtain more favorable insurance

rates. As part of this effort, the Securitas AB Group decided to implement a

captive insurance program to insure the risks within the deductible layers of the

existing third-party policies. A captive insurance program was attractive to the

Securitas AB Group for a variety of reasons, including that the cost of adopting

the program was less than the cost of reducing deductibles and purchasing

insurance from third parties. The captive program also allowed Securitas AB to
                                         -8-

[*8] centralize risks. Further, it allowed the subsidiaries to know their cost of risk

in advance. In the years since its implementation, the captive insurance program

has provided more cost-effective insurance coverage than would have otherwise

been available.

      It was part of the implementation that Securitas AB formed SGRL in 2002.

Because SGRL was a reinsurance company and could not issue policies directly,

Protectors provided insurance for U.S. subsidiaries, and XL Insurance Co. Ltd.

(XL Insurance), a United Kingdom company, provided insurance to the non-U.S.

subsidiaries.

VI. Insurance Coverages for U.S. Subsidiaries

      In December 2002 Protectors issued a loss portfolio transfer policy to SHI

to cover the unresolved or unreported losses for the insurable risks of most of the

SHI Group’s operating subsidiaries up to the deductibles or self-insured retentions

of the third-party policies. Protectors also issued a similar policy to Loomis in

December 2003.

      For 2003 Protectors issued prospective insurance policies to cover the

insurable risks of most of the SHI Group’s operating subsidiaries up to the

deductible or self-insured retentions of the third-party policies. For 2004

Protectors issued similar policies except that the policies each had a $15,000
                                        -9-

[*9] deductible, making the subsidiaries responsible for losses up to that amount.

The insurance policies identified the insured, contained an effective period,

specified the covered risks, identified a premium amount, and were signed by an

authorized representative.2

      A. Parental Guaranty

      In 2000 the SHI Group acquired Centaur Insurance Co. (Centaur) as part of

the larger acquisition of Burns. Centaur is an Illinois insurance company that had

been in rehabilitation proceedings since 1987. Centaur has claimed to be tax

exempt under section 501(c)(15) since 1990 because it has received no premium

income.

      While preparing to implement the captive insurance program, the SHI

Group learned that reactivation of Protectors could adversely affect Centaur’s tax-

exempt status. The premium test under section 501(c)(15) limits the amount of

premiums that can make up gross receipts for an insurance company that seeks

tax-exempt status. The premium test is applied on a controlled group basis, and

Protectors and Centaur were part of the same controlled group during 2002, 2003,

and 2004.

      2
       Some of the policies were signed after the policy’s effective date. There is
no explanation for this in the record, and neither party argues that this renders the
policies ineffective.
                                       - 10 -

[*10] In late 2002 the SHI Group considered selling Centaur’s stock to a non-U.S.

affiliated company in order to remove Centaur from the U.S. controlled group. In

early December 2002 the SHI Group chose to have SHI execute a parental

guaranty guaranteeing the performance of Protectors, as opposed to selling

Centaur’s stock. Before the end of 2002 SHI executed a parental guaranty

guaranteeing the performance of Protectors with respect to the 2002 loss portfolio

transfer policy written by Protectors to the SHI Group’s subsidiaries. SHI also

executed an amended and restated guaranty guaranteeing the performance of

Protectors with respect to any and all agreements that were effective on or after

November 25, 2002, that were issued by Protectors regarding risks retained by the

SHI Group’s operating subsidiaries. The amended and restated guaranty replaced

the first guaranty. The amended and restated guaranty was in effect during 2003

and 2004. As a result of the amended and restated guaranty, it was the SHI

Group’s position that Protectors did not qualify as an insurance company for

Federal income tax purposes during 2002, 2003, and 2004. The intended effect of

this position was to remove Protectors from the premium test under section

501(c)(15) and, by extension, to preserve Centaur’s tax-exempt status. There is no

evidence in the record to suggest that any amount was ever paid out under the

guaranty.
                                         - 11 -

[*11] In 2003 the SHI Group continued to pursue the possibility of selling

Centaur’s stock. However, the SHI Group did not sell the stock during 2003 or

2004.

        B. Reinsurance

        All of the insurable risks covered under the two loss protection policies and

the prospective insurance policies were reinsured with SGRL. In 2003 SGRL

received premiums from over 25 separate entities. In 2004 SGRL received

premiums from over 45 separate entities. Like the policies that Protectors issued,

the reinsurance policies identified the insured, contained an effective period,

specified the covered risks, identified a premium amount, and were signed by an

authorized representative.3

        No guaranty was ever provided to SGRL by any party for any of the risks

reinsured under the agreement with Protectors. Additionally, neither the insurance

policies that Protectors issued nor the policies that SGRL issued contained a cut-

through provision that would allow the insured the right to seek claims payment

directly from the reinsurer on the primary insurer’s failure to meet its obligations

fully or on time.

        3
       Again, some of the policies were signed after the policy’s effective date.
There is no explanation for this in the record, and neither party argues that this
renders the policies ineffective.
                                        - 12 -

[*12] C. Premiums to SHI Group Subsidiaries

      During the years in issue outside actuaries reviewed the premiums and

determined they were reasonable.4 From January to July 1, 2003, Pinkerton’s paid

the 2003 premiums on behalf of the other SHI Group subsidiaries. From July 1,

2003, to the end of 2003, after the merger of many of the subsidiaries into SSUSA,

SSUSA paid the premiums on behalf of the other SHI Group subsidiaries.

Pinkerton’s, and later SSUSA, recorded general ledger accounts payable to SGRL

for the amounts of the premiums. These accounts payable were booked pro rata

on a monthly basis, except for the one for the first quarter of 2003, which was

booked at the end of March. Pinkerton’s and SSUSA paid claims that were

covered under the Protectors policies and recorded general ledger accounts

receivable from SGRL for those amounts. Pinkerton’s and SSUSA also paid

administrative fees relating to the Protectors policies and recorded general ledger

accounts receivable from SGRL for those amounts. These amounts were reversed

that same year when it was determined that administrative fees had not been taken

into account when setting the premiums. In July and August 2003 the excess of

the accounts payable over the accounts receivable was paid by wire transfer from

Pinkerton’s/SSUSA to Protectors. Protectors then paid that amount to SGRL,

      4
          Respondent does not challenge the reasonableness of the premiums.
                                       - 13 -

[*13] minus a $225,000 ceding commission that Protectors retained. Of the 2003

premiums, $56,242,080 was paid and deducted for Federal income tax purposes in

2003 and $5,144,918 was paid and deducted for Federal income tax purposes in

2004.

        The $16 million premium for the 2003 Protectors policy insuring Loomis

was paid to Protectors in 2003 by Loomis. Protectors then paid that amount to

SGRL, minus a $50,000 ceding commission.

        During 2003 SSUSA allocated the premiums among the subsidiaries as

follows:
                                      - 14 -

 [*14]                                                  Each entity’s percentage
                            Petitioner’s premium         of the total premium
          Entity            allocation per entity        payable to Protectors
 Pinkerton’s                       $8,658,886                    11.189
 Pinkerton Management                    2,204                     .003
 Guardian Uniforms                    254,446                      .329
 Renaissance Center                   131,956                      .171
 Pinkerton Protection
  Svcs                                242,031                      .313
 Pinkerton Government
  Svcs                              2,617,868                     3.382
 Burns                             19,489,689                    25.185
 Burns International
  Security Services of
  Florida                           1,279,162                     1.653
 Hall Security                          65,706                     .085
 SSUSA                             28,645,052                    37.015
 Loomis                            16,000,000                    20.675
  Total                            77,387,000

      SSUSA paid the 2004 premiums in a similar manner. SSUSA paid the

premiums on behalf of the other subsidiaries and recorded general ledger accounts

payable to SGRL. The accounts payable were booked pro rata on a monthly basis.

Throughout the year SSUSA paid claims and administrative fees that were covered

by the policies and recorded general ledger accounts receivable for those amounts.
                                     - 15 -

[*15] Again, the accounts receivable were booked pro rata on a monthly basis. In

July, October, and December 2004 the excess of the accounts payable over the

accounts receivable was paid by wire transfer from SSUSA to Protectors.

Protectors then paid the amount to SGRL, minus a $225,000 ceding commission

that Protectors retained. Of the 2004 premiums, $51,592,517 was paid and

deducted for Federal income tax purposes in 2004 and $1,132,573 was paid and

deducted for Federal income tax purposes in 2005.

      The $4,258,100 premium for the 2004 Protectors policy insuring Loomis

was paid to Protectors in 2004 by Loomis. Protectors then paid this amount over

to SGRL, minus a $25,000 ceding commission.

      During 2004 the premiums were allocated among the subsidiaries as

follows:

                                                       Each entity’s percentage
                              Petitioner’s premium      of the total premium
           Entity             allocation per entity     payable to Protectors
 SSUSA                            $50,342,514                   88.346
 Renaissance Center                    85,112                     .149
 Pinkerton Government
  Svcs                              2,297,464                    4.032
 Loomis                             4,258,100                    7.472
  Total                            56,983,190
                                        - 16 -

[*16] VII. Insurance Coverages for Non-U.S. Subsidiaries

      During 2003 and 2004 XL Insurance Co. Ltd. (XL Insurance) issued

insurance policies to cover general liability insurance risks for the non-U.S.

subsidiaries of Securitas AB. XL Insurance was unrelated by ownership to the

entities in the Securitas AB Group. Like the Protectors policies, the XL Insurance

policies provided only the first layer of coverage. In 2003 and 2004 XL Insurance

reinsured a portion of its risk under the insurance policies with SGRL. The

premiums for the 2003 and 2004 reinsurance agreements totaled $9,103,733,

which XL Insurance paid to SGRL. During these years no subsidiary was

allocated more than 50% of the premiums.

VIII. Notice of Deficiency

      On July 1, 2010, the IRS issued a notice of deficiency to the SHI Group for

its 2003 and 2004 taxable years. In the notice the IRS disallowed portions of the

SHI Group’s deductions for interest expenses and insurance premiums and made

other computational adjustments. The adjustments resulted in tax increases of

$13,801,906 for 2003 and $16,496,539 for 2004.

      Because the parties stipulated the interest expense deductions, the only issue

remaining is whether the SHI Group is entitled to deduct insurance premiums paid.

Of the $72,242,080 deduction amount claimed on its 2003 return, the IRS
                                        - 17 -

[*17] disallowed deductions of $47,729,741 and allowed deductions of

$24,512,339. The amount allowed consists of $8,512,339 in actual paid claims

and expenses and the $16 million premium paid for the Loomis loss protection

policy.5 Of the $61,394,596 deduction amount claimed on its 2004 return, the IRS

disallowed deductions of $41,270,724 and allowed deductions of $20,123,872.

The amount allowed consists of $15,466,711 in actual paid claims and expenses

and $4,657,161 in premiums that Loomis paid.

      The SHI Group, while maintaining its principal place of business in

California, timely petitioned.

                                     OPINION

I. Insurance Premium Deduction

      Section 162(a) permits a deduction for “all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or

business”. Insurance premiums may be deductible business expenses.6 Although

insurance premiums may be deductible, amounts placed in reserve as self-



      5
       Although the insurance transaction involving Loomis appears strikingly
similar to the transaction involving the rest of the SHI Group subsidiaries,
respondent could provide no explanation at trial regarding why the premiums paid
by Loomis were allowed and the other premiums were not.
      6
          Sec. 1.162-1(a), Income Tax Regs.
                                        - 18 -

[*18] insurance are not.7 Such amounts can be deducted only at the time that the

loss for which the reserve was established is actually incurred.8

      Neither the Code nor the regulations define “insurance”. However, the

Supreme Court has stated that “[h]istorically and commonly insurance involves

risk-shifting and risk-distributing.”9 Over time, courts have looked primarily to

four criteria in deciding whether an arrangement constitutes insurance for Federal

income tax purposes: (1) the arrangement must involve insurable risks; (2) the

arrangement must shift the risk of loss to the insurer; (3) the insurer must

distribute the risks among its policyholders; and (4) the arrangement must be

insurance in the commonly accepted sense.10 Although these criteria are not

independent or exclusive, they establish a framework for determining whether

insurance exists under the Federal tax law.11


      7
       Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir. 1978);
Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78, 80 (10th Cir. 1930), aff’g
13 B.T.A. 189 (1928).
      8
          United States v. General Dynamics Corp., 481 U.S. 239, 243-245 (1987).
      9
          Helvering v. Le Gierse, 312 U.S. 531, 539 (1941).
      10
        Harper Grp. v. Commissioner, 96 T.C. 45, 58 (1991), aff’d, 979 F.2d 1341
(9th Cir. 1992); AMERCO v. Commissioner, 96 T.C. 18, 38 (1991), aff’d, 979
F.2d 162 (9th Cir. 1992).
      11
           AMERCO v. Commissioner, 96 T.C. at 38.
                                           - 19 -

[*19] Respondent does not dispute that the arrangement here involved insurable

risks.

         A. Risk Shifting

         In order for an arrangement to be considered insurance, it must shift risk of

loss from the insured to the insurer.12 “From the insured’s perspective, insurance

is protection from financial loss provided by the insurer upon payment of a

premium, i.e., it is a risk-transfer device.”13 Risk shifting transfers the threat of an

economic loss from the insured to the insurer because “[i]f the insured has shifted

its risk to the insurer, then a loss by or a claim against the insured does not affect it

because the loss is offset by the proceeds of an insurance payment.”14 When

evaluating whether risk shifting occurred, we consider separate but related

insurance contracts, such as insurance and reinsurance, together.15

         In brother-sister corporation arrangements, such as the arrangement before

us, we look to what has become known as the balance sheet and net worth analysis


         12
        Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir.
1987), aff’g 84 T.C. 948 (1985).
         13
              Harper Grp. v. Commissioner, 96 T.C. at 57.
         14
              Clougherty Packing Co. v. Commissioner, 811 F.2d at 1300.
         15
     Helvering v. Le Gierse, 312 U.S. at 540-542; Carnation Co. v.
Commissioner, 71 T.C. 400, 408-409 (1978), aff’d, 640 F.2d 1010 (9th Cir. 1981).
                                         - 20 -

[*20] to determine whether risk has been shifted.16 Under the balance sheet and

net worth analysis, we examine the economic consequences of the captive

insurance arrangement to determine whether the insured party has shifted the

risk.17 In doing so, we look only at the insured’s assets to determine whether the

insured “divested itself of the adverse economic consequences” of a claim covered

by the insurance policy.18 Additionally, we generally afford related corporate

entities separate tax status and treatment.19

      Respondent argues that the guaranty from SHI to Protectors prevents risk

from shifting from the SHI Group subsidiaries to SGRL because SHI bore the

ultimate risk of loss. In making this argument, respondent relies on three cases,

Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th Cir. 1995), rev’g T.C.

Memo. 1993-585, Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42 (1997), and

Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1997-482. We recently

addressed Malone & Hyde and Kidde in the opinion of the Court and the

      16
        Rent-A-Center, Inc. v. Commissioner, 142 T.C. ___, ___ (slip op. at 33)
(Jan. 14, 2014).
      17
           Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305.
      18
           Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305.
      19
        Clougherty Packing Co. v. Commissioner, 811 F.2d at 1307 (citing Moline
Props., Inc. v. Commissioner, 319 U.S. 436 (1943)); see also Rent-A-Center, Inc.,
142 T.C. at ___ (slip. op. at 17).
                                        - 21 -

[*21] concurring opinion in Rent-A-Center, Inc. v. Commissioner, 142 T.C. ___,

___ (slip op. at 36-37) (Jan. 14, 2014). In that case, we distinguished the facts of

Malone & Hyde and Kidde on the basis that they all involved undercapitalized

captives where the parent corporation provided indemnification or additional

capitalization in order to persuade a third-policy insurer to issue policies.20 We

did not address Hospital Corp.

      A close examination of the facts of Hospital Corp. reveals that it is wholly

consistent with our conclusion both here and in Rent-A-Center. In Hospital Corp.,

various subsidiaries obtained most of their primary insurance through a captive

insurance company. Workers’ compensation liabilities were handled differently.

The subsidiaries of Hospital Corporation obtained primary insurance for those

liabilities with a third party, and the captive insurance company provided

reinsurance. When the third-party insurer became insolvent, the parent

corporation agreed to indemnify it. Later, the parent agreed to indemnify another

third-party insurer as a condition of the agreement that it would take over the risks

of the insolvent insurer (but only as to the liabilities of the insolvent insurer). We

held that there was no risk shifting as to the workers’ compensation liability.


      20
        Rent-A-Center, Inc. v. Commissioner, 142 T.C. at ___ (slip op. at 36-37);
see also id. at ___ (slip op. at 45-47) (Buch, J., concurring).
                                          - 22 -

[*22] This falls squarely within our analysis in Rent-A-Center, where we

distinguished a line of cases, stating that the parental guaranty at issue in

Rent-A-Center did not shift the ultimate risk of loss; did not involve an

undercapitalized captive; and was not issued to, or requested by, an unrelated

insurer.21 The indemnity agreement at issue in Hospital Corp. was issued to an

unrelated insurer because of the insolvency of the primary insurer. That is very

different from the facts before us here, where indemnity was not provided to a

third-party insurer and where the captive insurer is sufficiently capitalized.

       Respondent argues that the presence of the parental guaranty mitigates risk

shifting because of the theoretical possibility that SHI may have to pay in

accordance with the guaranty. However, this is the case whenever a guaranty from

the parent is involved, and we have previously held that the existence of a parental

guaranty by itself is not enough to justify disregarding the captive insurance

arrangement.22 The guaranty was provided only to preserve the tax-exempt status

of Centaur and here, as in Rent-A-Center, no amount was paid out under the

guaranty. Accordingly, we must decide whether something else was present to

vitiate risk shifting.


       21
            Rent-A-Center, Inc. v. Commissioner, 142 T.C. at ___ (slip op. at 37).
       22
            Rent-A-Center, Inc. v. Commissioner, 142 T.C. at ___ (slip op. at 35-38).
                                         - 23 -

[*23] Although respondent argues that Protectors was undercapitalized, we do not

agree. After consulting with the Vermont regulators, Protectors decided to

maintain a premium-to-surplus ratio of 7.5. to 1.0. At times, the SHI Group would

have to provide additional capital or seek permission to avoid going above the 7.5

to 1.0 ratio. SHI Group’s expert, Ann Conway, stated that the industry standard

net premium-to-surplus ratio for long-tail casualty exposures,23 which constitute

most of the exposures here, is 4.0 to 1.0. Respondent’s argument is that Protectors

was undercapitalized because it did not maintain a premium-to-surplus ratio of 4.0

to 1.0 or lower. However, respondent fails to take into account the fact that

Protectors’ risks were reinsured. Because Protectors reinsured 100% of its risks

through SGRL, Protectors’ net premium-to-surplus ratio was 0 to 1, which falls

below the industry standard. Ms. Conway testified that SGRL was adequately

capitalized, and respondent did not refute this assertion. Considering the insurance

and reinsurance contracts together, we find that Protectors was adequately

capitalized for its role as a primary insurer that reinsured all of its risks with

SGRL.

      23
        Policies relating to workers’ compensation, automobile liability, and
general liability are typically referred to as long-tail coverage because “claims may
involve damages that are not readily observable or injuries that are difficult to
ascertain.” Acuity, A Mut. Ins. Co., & Subs. v. Commissioner, T.C. Memo. 2013-
209, at *8-*9.
                                       - 24 -

[*24] Respondent further argues that the SHI Group financial arrangement

resulted in SHI maintaining the risk of loss. Respondent maintains that

Pinkerton’s and SSUSA paid the claims of the operating subsidiaries and then

sought reimbursement directly from SGRL, thus effectively eliminating Protectors

from the captive arrangement. Because, in respondent’s view, Protectors did not

pay the claims as required, SGRL’s legal obligation to reimburse Protectors did

not arise, and Protectors’ failure to pay the claims meant that SHI remained

responsible. Again, we previously addressed a similar point and stated that “it is

unrealistic to expect members of a consolidated group to cut checks to each other”

and using journal entries to keep track of the flow of funds is “commonplace”.24

Pinkerton’s and SSUSA kept records showing the amounts payable to and

receivable from SGRL, and the parties have stipulated that the amount due to

SGRL was first transferred to Protectors and then to SGRL. Respondent has not

alleged, and we do not find, that the journal entries were inaccurate or incomplete.

Accordingly, we do not agree that the SHI Group’s manner of paying the claims

and premiums prevented the risk from shifting.




      24
        Rent-A-Center, Inc. v. Commissioner, 142 T.C. at ___ (slip op. at 49)
(Buch, J., concurring) (citing Kahle v. Commissioner, T.C. Memo. 1991-203).
                                         - 25 -

[*25] On the basis of the foregoing and evaluating the captive arrangement as a

whole, we find that the arrangement adequately shifted risk. The balance sheet

and net worth analysis indicates that the captive insurance arrangement has shifted

any economic consequence of a risk from the SHI Group subsidiaries to Protectors

and then to SGRL.

      B. Risk Distribution

      We evaluate risk distribution through the actions of the insurer. The insurer

achieves risk distribution when it pools a large enough collection of unrelated

risks, those that are not generally affected by the same circumstance or event.25

“Distributing risk allows the insurer to reduce the possibility that a single costly

claim will exceed the amount taken in as a premium * * * [because] [b]y assuming

numerous relatively small, independent risks that occur randomly over time, the

insurer smoothes out losses to match more closely its receipt of premiums.”26 Risk

distribution incorporates the law of large numbers which has been described as

follows: “‘As the size of the pool increases, the chance that the loss per policy




      25
           Rent-A-Center, Inc. v. Commissioner, 142 T.C. at ___ (slip op. at 38).
      26
           Clougherty Packing Co. v. Commissioner, 811 F.2d at 1300.
                                       - 26 -

[*26] during any given period will deviate from the expected loss by a given

amount (or proportion) declines.’”27

      Protectors, and ultimately SGRL, insured five types of risks: workers’

compensation, automobile, employment practice, general, and fidelity liabilities.

During the years in issue the Securitas AB Group employed over 200,000 people

in 20 countries, and the SHI Group, alone, employed approximately 100,000

people each year and operated over 2,250 vehicles. In 2003 SGRL received

premiums from over 25 separate entities. In 2004 SGRL received premiums from

over 45 separate entities. However, respondent argues that there is not adequate

risk distribution because most of the premiums paid to SGRL were attributable to

Protectors, and after mid-2003 most of those premiums were attributable to

SSUSA.

      Risk distribution is viewed from the insurer’s perspective. As a result of the

large number of employees, offices, vehicles, and services provided by the U.S.

and non-U.S. operating subsidiaries, SGRL was exposed to a large pool of

statistically independent risk exposures. This does not change merely because

multiple companies merged into one. The risks associated with those companies

did not vanish once they all fell under the same umbrella. As the SHI Group’s

      27
           AMERCO v. Commissioner, 96 T.C. at 33 n.14 (quoting expert witness).
                                       - 27 -

[*27] expert, Dr. Neil Doherty, explained in his expert report: “It is the pooling of

exposures that brings about the risk distribution--who owns the exposures is not

crucial.” We agree and find that by insuring the various risks of U.S. and non-

U.S. subsidiaries, the captive arrangement achieved risk distribution.

      C. Insurance in the Commonly Accepted Sense

      The final factor that we look to is whether the captive arrangement

constitutes insurance in the commonly accepted sense. Previously, this Court has

looked to factors such as whether: (1) the insurer was organized, operated, and

regulated as an insurance company; (2) the insurer was adequately capitalized;

(3) the insurance policies were valid and binding; (4) the premiums were

reasonable; and (5) the premiums were paid and the losses were satisfied.28

      Protectors and SGRL were both organized, operated, and regulated as

insurance companies. Protectors was subject to regulation under the laws of

Vermont, kept its own books and records, maintained separate bank accounts,

prepared financial statements, and held meetings of its board of directors.

Similarly, SGRL was regulated under the laws of Ireland and also kept its own




      28
       See Rent-A-Center, Inc. v. Commissioner, 142 T.C. at ___ (slip op. at 39);
Harper Grp. v. Commissioner, 96 T.C. at 60.
                                       - 28 -

[*28] books and records, maintained separate bank accounts, prepared financial

statements, and held meetings of its board of directors.

      As stated above, Protectors was adequately capitalized. Further, Ms.

Conway testified that SGRL was adequately capitalized on the basis of her finding

that SGRL’s financial ratio met or exceeded industry standards. Respondent did

not challenge Ms. Conway’s assertion, and we agree with it as well.

      The insurance and reinsurance policies issued by Protectors and SGRL were

valid and binding. Each insurance policy identified the insured, contained an

effective period for the policy, specified what was covered by the policy, stated the

premium amount, and was signed by an authorized representative of the company.

      The premiums set by Protectors and SGRL were reasonable. They were

reviewed by outside actuaries and determined to be within the range of reasonable

premiums. Additionally, respondent does not challenge the reasonableness of the

premium amounts.

      Finally, the premiums were paid, and the losses were satisfied. The SHI

Group subsidiaries kept ledger entries corresponding to the accounts payable and

receivable. These amounts were booked pro rata on a monthly basis. During each

year, the subsidiaries would pay Protectors the amounts due, which Protectors

would then pay to SGRL after subtracting its ceding commission.
                                       - 29 -

[*29] Considering all the facts and circumstances, we find that the captive

arrangement constituted insurance in the commonly accepted sense.

II. Conclusion

      We find that the captive arrangement is insurance for Federal tax purposes.

The captive arrangement shifted risk from the SHI Group to Protectors and

ultimately to SGRL. Further, the captive arrangement distributed risk by insuring

a large pool of differing risks. Lastly, the captive arrangement constitutes

insurance in the commonly accepted sense. Accordingly, the premiums paid by

the SHI Group are deductible under section 162 as insurance expenses.

      To reflect the foregoing and the concessions of the parties,


                                                Decision will be entered

                                       for petitioner.
