                         T.C. Memo. 1997-482



                       UNITED STATES TAX COURT



HOSPITAL CORPORATION OF AMERICA AND SUBSIDIARIES, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 10663-91, 13074-91        Filed October 27, 1997.
                 28588-91, 6351-92



     N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,

Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,

Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,

and John W. Bonds, Jr., for petitioners in docket No. 10663-91.

     N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,

Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,

Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,

John W. Bonds, Jr., and Daniel R. McKeithen, for petitioners in

docket No. 13074-91.
                                - 2 -


     N. Jerold Cohen, Walter H. Wingfield, Stephen F. Gertzman,

Amanda B. Scott, Reginald J. Clark, Randolph W. Thrower, Walter

T. Henderson, Jr., and John W. Bonds, Jr., for petitioners in

docket No. 28588-91.

     N. Jerold Cohen, Reginald J. Clark, Randolph W. Thrower,

Walter T. Henderson, Jr., and John W. Bonds, Jr., for petitioners

in docket No. 6351-92.

     Robert J. Shilliday, Jr., Vallie C. Brooks, and William B.

McCarthy, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     WELLS, Chief Judge:    These cases were consolidated for

purposes of trial, briefing, and opinion and will hereinafter be

referred to as the instant case.1   Respondent determined

deficiencies in petitioners' consolidated corporate Federal

income tax as follows:

1
     The instant case involves many issues, most of which have
been settled or decided already. Separate briefs of the parties
were filed for each of the distinct categories of issues involved
in the instant case. We decided tax accounting issues in
Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-105;
Hospital Corp. of Am. v. Commissioner, 107 T.C. 73 (1996); and
Hospital Corp. of Am. v. Commissioner, 107 T.C. 116 (1996). We
decided an issue related to the sale of the stock of certain
subsidiaries to HealthTrust, Inc.--The Hospital Company in
Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-559. We
decided a depreciation issue in Hospital Corp. of Am. v.
Commissioner, 109 T.C. 21 (1997). The instant opinion involves
the last remaining issues for decision, which issues the parties
have denominated the captive insurance or Parthenon Insurance Co.
issues.
                               - 3 -


              TYE                        Deficiency

              1978                      $2,187,079.00
              1980                         388,006.58
              1981                      94,605,958.92
              1982                      29,691,505.11
              1983                      43,738,703.50
              1984                      53,831,713.90
              1985                      85,613,533.00
              1986                      69,331,412.00
              1987                     294,571,908.00
              1988                      25,317,840.00

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.

     The issues to be decided are:

     (1)   Whether Parthenon Insurance Co. (Parthenon), a wholly

owned subsidiary of petitioner Hospital Corporation of America

(HCA), is an insurance company within the meaning of the Internal

Revenue Code; and

     (2)   if Parthenon is an insurance company, what portion of

its unpaid loss reserves and expenses are deductible pursuant to

section 832(c).2


2
     In accordance with the holding of the Court of Appeals for
the Sixth Circuit in Humana Inc. v. Commissioner, 881 F.2d 247
(6th Cir. 1989), affg. in part and revg. in part 88 T.C. 197
(1987), petitioners seek deductions only for reserve additions
attributable to reserves for claims against Parthenon's sister
subsidiaries, and not for reserve additions attributable to
reserves for claims against HCA itself. Absent stipulation of
the parties to the contrary, our decision in the instant case is
appealable to the Sixth Circuit.
                               - 4 -




                         FINDINGS OF FACT

     Some of the facts have been stipulated for trial pursuant to

Rule 91.   The parties' stipulations of fact are incorporated

herein by reference and are found as facts in the instant case.

In General

     Petitioners are members of an affiliated group of

corporations of which HCA is the common parent.    HCA was

incorporated during 1960 under the laws of the State of Tennessee

as Park View Hospital, Inc.   During 1968, Park View Hospital,

Inc. joined with 11 other hospitals to form HCA.    After that

date, and through the years in issue, HCA's stock was publicly

held and traded on the New York Stock Exchange.3

     HCA maintained its principal offices in Nashville,

Tennessee, on the date the petitions were filed.    For each of the

years involved in the instant case, HCA and its domestic

subsidiaries filed a consolidated Federal corporate income tax



3
     On Mar. 17, 1989, a group consisting of HCA key management
and certain outside investors acquired control of HCA and caused
it to purchase all of the stock held by the public shareholders,
and they then transformed HCA from a publicly held corporation to
a privately held corporation. On Mar. 4, 1992, HCA again went
public and changed its name to HCA-Hospital Corporation of
America. On Feb. 10, 1994, HCA was merged with and into Galen
Healthcare, Inc., a subsidiary of Columbia Healthcare Corp. of
Louisville, Kentucky, and the subsidiary changed its name to HCA-
Hospital Corp. of America. On that same date, the parent changed
its name to Columbia/HCA Healthcare Corporation.
                               - 5 -


return (consolidated return) on Form 1120 with the Director of

the Internal Revenue Service Center at Memphis, Tennessee.

     Petitioners' primary business is the ownership, operation,

and management of hospitals.   Petitioners' hospitals provide

health care customarily provided by hospitals.   Most of

petitioners' hospitals are acute care hospitals providing a

facility, personnel, equipment, and medical supplies and

pharmaceuticals needed to perform medical and surgical procedures

to treat sick or injured persons with various physical disorders.

Some of petitioners' facilities are psychiatric hospitals

providing medical treatment to persons with mental or emotional

disorders and drug and alcohol dependency problems.

Additionally, certain petitioners operate a variety of medically-

related businesses ancillary to petitioners' primary business.4

A fundamental component of petitioners' business philosophy is

the use of their combined purchasing power to obtain goods and

services at the lowest possible cost whenever practical to do so.

     At the outset of its organization, HCA generally placed all

newly constructed or acquired hospitals in separate corporations.

In later years, in some cases, HCA placed all newly acquired or

newly constructed hospitals located in a particular State in a


4
     See Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-
105, for a detailed description of petitioners' hospital
operations. We incorporate herein our findings of fact contained
in that Memorandum Opinion.
                                   - 6 -


separate corporation rather than having a separate corporation

for each hospital in that State.        In a few instances, HCA

acquired a group of hospitals that, for various business reasons,

were placed in a single corporation or were allowed to remain in

the acquired corporation.

     During the years ended 1981 through 1988, as of yearend HCA

owned the following number of subsidiaries and hospitals, and had

the following number of patient beds:

                        Number of          Hospitals            Patient
       Year           Subsidiaries           Owned                Beds
       1981                124                  188              29,298
       1982                124                  186              29,720
       1983                126                  196              31,393
       1984                123                  200              32,515
       1985                135                  230              37,423
       1986                122                  227              37,490
                           1                  1                 1
       1987                  74                 132               24,087
       1988                 74                  131              23,849


1
 During 1987, pursuant to a plan of reorganization, petitioners divested 104
hospitals from the HCA organization by selling the stock of the subsidiaries
owning those hospitals to HealthTrust, Inc.--The Hospital Co. See Hospital
Corp. of Am. v. Commissioner, T.C. Memo. 1996-559, for a detailed description
of that transaction.

     Prior to calendar year 1977, petitioners purchased general

and professional liability insurance from Continental Insurance

Co. (Continental).     The hospitals owned by petitioners were not

permitted to purchase insurance individually from other sources.

     Every State regulates the insurance companies licensed to do

business within its borders.       Insurance companies that are fully

licensed in a particular jurisdiction often are referred to as
                                - 7 -


admitted companies.    Admitted insurance companies can insure any

insurable risk.   Other insurance companies may be licensed to

write only on a surplus lines basis; i.e., they are allowed to

underwrite only risks that admitted companies in the State do not

or will not cover.    Admitted insurance companies are required to

file annual reports on a calendar year basis with the appropriate

State insurance department in a form specified by the National

Association of Insurance Commissioners (NAIC).

     A line of business refers to a group of insurance policies

involving similar risks.   Some lines of business, such as

workers' compensation, can be written only by admitted carriers.

Marketing is the process of selling policies to insureds.

Underwriting is the selection and pricing of risks to be insured.

The pricing portion of the underwriting function is the process

of setting premiums in amounts that are expected to be sufficient

to cover insured losses and the expenses of adjusting claims, and

the costs of operating the company and any planned underwriting

profit.   State regulatory agencies limit the premiums that may be

written by insurance companies to amounts that are prudent in

light of the companies' capitalization.   Premiums are usually set

by trained underwriters or actuaries, who may be employees or

outside consultants.   For certain lines of insurance, such as

workers' compensation, rates are set by law on the basis of

statistical information compiled by rating bureaus, with only
                                - 8 -


specified modifications permitted to take into account the loss

experience of the particular employer.

     The insurance laws of some States provide for a category of

limited purpose insurance companies, popularly called captive

insurance companies or captive insurers.    Captive insurance

company statutes generally apply to companies that insure on a

direct basis only the risks of companies related by ownership to

the insurer.    Because pure captive insurance companies   typically

are formed for the purpose of insuring the risks of related

companies, the function of risk selection, in essence, is

attained at the onset.

     The State of Colorado's Captive Insurance Company Act

(Colorado captive insurance statute) allows the formation of pure

captive insurance companies whose authority to write direct

insurance business is limited to insuring the risks of related

corporations.    The Colorado captive insurance statute requires a

pure captive insurance company licensed in that State to maintain

and to deposit with the commissioner of insurance minimum actual

capital of $300,000 and accumulated surplus of $200,000, which

deposit may be in the form of an irrevocable letter of credit.

     The State of Tennessee's Captive Insurance Company Act

(Tennessee captive insurance statute) requires a pure captive

insurance company licensed in that State to maintain minimum

capital and surplus of $750,000, with the surplus to be at least
                               - 9 -


$350,000.   For captive insurance companies, the Tennessee

Department of Commerce and Insurance, Division of Insurance

(Department of Insurance), requires the ratio of net written

premiums to policyholders' surplus (i.e., the net worth of an

insurance company) to be no greater than 3 to 1.   Captive

insurance company rates may not be excessive, inadequate, or

unfairly discriminatory.   The Tennessee captive insurance statute

does not require pure captive companies to use the NAIC format.

     Tennessee insurance company regulatory provisions require

less startup capital for "pure captive" insurers than for

companies licensed to sell insurance to the general public,

impose lower premium taxes in comparison to commercial companies,

and provide an exemption from participation in State involuntary

risk plans, such as assigned risk pools and guaranty funds.    The

business functions and operations of captive insurance companies

in Tennessee are subject to examination by the Department of

Insurance at least once in a 5-year period, or when the

Commissioner deems it prudent to conduct an examination.

Business functions include underwriting, marketing, investing,

claims adjusting, loss reserving, and financial reporting.

     Prior to the mid-1970's, the availability and price of

coverage for medical malpractice risks were not significant

concerns for an organization the size of HCA.   During the mid-

1970's, however, increases in the size and frequency of medical
                                - 10 -


malpractice awards led to a crisis in both the price and the

availability of medical malpractice insurance.   Some physicians

and hospitals formed mutual insurance associations or pools

because the insurance industry was unwilling or unable to provide

malpractice coverage at a price that the physicians and hospitals

considered reasonable.

     During 1976, in response to the uncertain availability and

high cost of medical malpractice insurance, petitioners

considered alternative methods to provide professional and

general liability coverage to hospitals which were owned directly

by petitioners at a lower cost than commercial insurance

available from various third party insurance companies.

Alternatives contemplated included self-insuring, joining with

competing hospital companies in the formation of a malpractice

insurance company, or forming a wholly owned captive insurance

company whose principal business would be to provide insurance

for the liability risks of petitioners' hospitals.   During the

time that petitioners were considering those alternatives,

approximately 40 to 45 percent of the revenues of petitioners'

hospitals came from reimbursement of costs for patient care by

the Federal Medicare program.    Consequently, the reimbursability

of premium costs by the Medicare program was a significant

consideration in evaluating the alternatives.
                               - 11 -


     At all relevant times, the Healthcare Financing

Administration (HCFA) of the U.S. Department of Health, Education

and Welfare (or its predecessor agencies) administered the

Medicare system of reimbursement.    During the mid-1970's,

existing Medicare regulations did not address reimbursement of

premiums payable to captive insurance companies. Medical industry

efforts, however, eventually resulted in the promulgation of

specific regulations during 1979 which allowed reimbursement of

liability premiums charged related entities by limited purpose or

captive insurance companies, provided that appropriate regulatory

standards were met.   The Medicare standards ultimately adopted

included requirements that the captive insurer be recognized as

an insurance company by an appropriate Government and be operated

in accordance with the jurisdiction's laws, that premiums be

determined according to actuarial standards, that only reasonable

premium costs be reimbursable, and that the arrangement represent

a prudent business decision.   Compliance with those requirements

was monitored through comprehensive annual audits.

     From 1981 through 1983, Medicare reimbursement to hospitals

for providing covered treatment was made on the basis of the

hospitals' direct costs and allocated indirect costs, including

premiums paid for qualifying general and professional liability

insurance (malpractice insurance).      Beginning in 1983, and over a

4-year transition period, a significant part of Medicare
                              - 12 -


reimbursement was made on the basis of diagnostic related

groupings, in which specific treatments or procedures are

reimbursed at set rates, although reimbursement of certain

outpatient and psychiatric procedures continued to be based on

cost.   Throughout the years at issue, petitioners wanted their

premium payments for general and professional liability insurance

to qualify as reimbursable costs for Medicare purposes, though

the direct financial benefit of such qualification was

comparatively less after 1983 than before.

     The determination as to whether liability insurance premiums

charged by limited purpose insurance companies would qualify for

Medicare reimbursement was reviewed by intermediaries employed

for that purpose by HCFA.   The intermediaries conducted annual

audits of captive insurance companies to determine whether the

premiums charged to insureds met HCFA standards.   Throughout the

years here in issue, Blue Cross/Blue Shield of Tennessee, Inc.

(Blue Cross) was the intermediary charged with auditing limited

purpose insurance companies formed in Tennessee to determine

whether the liability premiums that they charged their insureds

would qualify for Medicare reimbursement.

     Another consideration on the part of HCA management in

evaluating alternatives to commercial malpractice insurance was
                              - 13 -


the prospect of Federal income tax deductions for the reserves5

that would be maintained against insured labilities of the

operating companies.   HCA management believed that setting up a

legitimate U.S. insurance company managed by insurance

professionals would offer the best chance of obtaining that

deduction, though they realized that favorable tax treatment was

not assured.




The Formation of Parthenon

     During 1976, HCA formed Parthenon as a wholly owned

subsidiary under the Colorado captive insurance statute, Colorado

Rev. Stat. secs. 72-36-1 to 72-36-30 (1963), now codified at

secs. 10-6-101 to 10-6-130 (1991).     HCA management expected that


5
     In Western Natl. Mut. Ins. Co. v. Commissioner, 102 T.C.
338, 350-351 (1994), affd. 65 F.3d 90 (8th Cir. 1995), we defined
the term "reserve" as follows:

     In the insurance industry a policy reserve represents a
     liability; i.e., it represents an obligation to the
     policyholders. Historically, reserves have been described
     in PC [property and casualty] insurance literature as
     estimated liabilities for losses and loss adjustment
     expenses. To some extent, loss reserves are estimates
     extrapolated from past trends, patterns, averages, and
     inferences and predictions as to the future. Accordingly,
     "The reserve simply operates as a charge on so much of an
     insurance company's assets as must be maintained in order
     for the company to be able to meet its future commitments
     under the policies it has issued." The general concept for
     reserves is the same for life and PC insurance companies.
     [Fn. ref. omitted; citations omitted.]
                             - 14 -


an appropriate portion of the premiums would be reimbursable to

the hospitals under the then-applicable Medicare regulations and

deductible under the Federal income tax laws.    Petitioners

incorporated Parthenon in the State of Colorado because HCA's

chief financial officer, who also was the executive responsible

for petitioners' insurance programs, believed that the goal of

building a legitimate insurance company would be advanced by

having a State-regulated captive insurer, rather than an offshore

company, and because at that time the State of Colorado was the

only State that had adopted a captive insurance statute.    In

accordance with Colorado law, the initial capitalization of

Parthenon was $1,500,000, $1 million of which was represented by

an unconditional standby letter of credit in favor of the

Insurance Commissioner of Colorado, and the remainder of which

was in cash.

     Parthenon commenced business during January 1977.   At all

relevant times, HCA owned all of Parthenon's common stock.

Parthenon did not own stock in any of HCA's other subsidiaries.

Parthenon's Operations During Its Early Years

     Parthenon submitted the policy form to be used for general

and hospital professional liability insurance to the Colorado

Insurance Department for approval.    The initial policy form

issued by Parthenon to petitioners provided coverage limits of

$250,000 per occurrence and was a claims-made policy form.      A
                              - 15 -


claims-made policy covers only losses from occurrences within the

policy period that are reported during the period, as opposed to

an occurrence-basis policy, which covers losses whenever

reported.   Other things being equal, premiums on an occurrence

basis are generally greater than premiums under a claims-made

policy form.

     Parthenon retained the Wyatt Co. (Wyatt), an international

actuarial and insurance consulting firm, to recommend the initial

premium amount to be charged by Parthenon to petitioners.   The

recommended premium amount for policy year 1977 was $4,500,000.

That amount compared to a quotation of $5,232,000 from

Continental for a policy providing the same limits to the same

insureds but on an occurrence basis.

     During a portion of its first year of existence, Parthenon's

day-to-day operations were managed by Frank B. Hall and Company

of Colorado, an independent consulting firm.   Senior HCA

management, however, decided that Parthenon should be operated by

its own employed management and staff, based in part on a

recommendation of an insurance industry consultant to the effect

that a properly staffed and operated company could produce a

savings for petitioners of more than $1 million per year in

premiums.

     Parthenon's first president was the late John A. Hill (Mr.

Hill), then the Chairman of HCA.   Formerly, Mr. Hill had served
                              - 16 -


as a president of the Aetna Insurance Co.   He was Parthenon's

president until mid-1977, at which time he became Chairman of

Parthenon's Board of Directors.   Mr. Hill served in that capacity

until October 1985.

     On August 16, 1977, Parthenon hired Robert A. Reeves (Mr.

Reeves) as its president.   He also served as HCA's vice president

of insurance.   Prior to being retained by Parthenon, Mr. Reeves

had been employed as president of Ashland Oil Company's two

captive insurance company subsidiaries.   He continued as

Parthenon's president until October 1, 1985.

     After becoming president of Parthenon, Mr. Reeves hired

experienced insurance executives to fill key managerial

positions, including Robert E. Pierson (Mr. Pierson), Maurice J.

Castille (Mr. Castille), and Charles Anderson (Mr. Anderson).

Mr. Pierson, a Chartered Property and Casualty Underwriter, had

been employed as a claims manager for the St. Paul Insurance

Companies.   Mr. Pierson was hired initially to serve as

Parthenon's claims manager.   He also was a vice president of

Parthenon from 1978 until October 1985, when he became president.

Mr. Pierson continued as president of Parthenon until February

20, 1987.6



6
     William W. McInnes became president of Parthenon as of June
8, 1987. He served in that position throughout the remainder of
the years in issue.
                              - 17 -


     Mr. Castille, who had been the risk manager of Humana Inc.,

a competing hospital chain, was hired to head Parthenon's loss

prevention and quality assurance operation.   Mr. Anderson, a

former controller of an insurance brokerage firm in the State of

Kentucky, became head of Parthenon's financial operations.

     On October 28, 1977, HCA contributed an additional $1

million to Parthenon as paid-in capital.

     During March 1978, HCA management learned that Continental,

which had been providing workers' compensation insurance to

petitioners, was not interested in renewing coverage under any

type of insurance plan.   As a captive insurer, Parthenon could

not insure workers' compensation risks directly, but it could

reinsure7 the risks of an admitted company, if the admitted

company agreed to "front" the business; i.e., to insure the risks

and then reinsure them with Parthenon.   In that event, the States

would look to the admitted company for payment of the losses, and

the admitted company would look to Parthenon for reimbursement.

Accordingly, during March 1978, HCA, Ideal Mutual Insurance Co.

(Ideal Mutual), and Parthenon negotiated an arrangement whereby

Ideal Mutual agreed to provide workers' compensation insurance to

petitioners and Parthenon agreed to reinsure Ideal Mutual on that

7
     Reinsurance is a contract with a second insurer in which the
second insurer agrees to provide coverage of risks that the first
insurer has already assumed under an insurance contract with
another party. 1 Couch on Insurance 3d, sec. 1:4, at 1-8 to 1-9
(1995).
                              - 18 -


insurance.   As a condition to Ideal Mutual's willingness to

complete the transaction, HCA executed a May 18, 1978 "comfort

letter".   That letter provided as follows:

     In consideration of the issuance of the Workers'
     Compensation and Employers Liability Policies by Ideal
     Mutual Insurance Company ("Ideal") to Hospital Corporation
     of America ("HCA"), its affiliated and subsidiary companies
     and certain of its managed hospitals and the reinsuring of
     said policies with Parthenon Insurance Company
     ("Parthenon"), HCA agrees that in the event, refusal or
     inability of Parthenon to provide or maintain the required
     Letter of Credit or to pay Ideal the cash advance against
     reinsurance losses recoverable under the Reinsurance
     Agreement, HCA will pay itself on behalf of Parthenon or
     cause Parthenon to pay all the reinsured losses recoverable
     by Ideal from Parthenon in accordance with the terms of the
     Reinsurance Agreement until all such claims have been
     settled or otherwise disposed of.

     The general and hospital professional liability policy form

used by Parthenon for policy years 1978 through 1985 was

substantially unchanged and covered all losses arising out of

occurrences during the policy period.   For each of those years

Parthenon issued one policy of general and hospital professional

liability insurance to "Hospital Corporation of America, or its

owned hospitals, corporations, and other subsidiaries".

     Premiums for the liability insurance coverage provided by

Parthenon to petitioners were based on actuarial analyses of the

projected loss and loss expense adjustment, using industry loss

experience (and, subsequently, using the hospitals' loss

experience supplemented by industry experience), to which was

added Parthenon's operating expenses and the reinsurance costs.
                              - 19 -


The rate making process involved first estimating the total

covered losses that would be experienced by the hospitals and

then making an actuarial determination of premium rates, adjusted

on the basis of geographical differences in loss costs, that

could be multiplied by the number of exposure units (e.g.,

occupied beds, outpatient visits, and emergency room visits) of

each insured hospital to reach a premium sufficient, in the

aggregate, to cover the estimated losses of the entire group.

Each insured hospital would pay only the geographically adjusted

average loss represented by the applicable rate times its units

of loss exposure.

Parthenon's Reincorporation in the State of Tennessee

     The Colorado Insurance Commissioner objected to Parthenon's

decision to base its full-time staff and operations in Nashville,

Tennessee.   Consequently, during 1978, after the enactment of the

Tennessee captive insurance statute, which statute is

substantially identical to the Colorado captive insurance

statute, HCA decided to reincorporate Parthenon in the State of

Tennessee.   Accordingly, Parthenon Insurance Co. of Tennessee was

incorporated under the laws of that State on December 13, 1978,

and on that date applied for a Certificate of Authority to

transact insurance business under the Tennessee captive insurance

statute.   On December 18, 1978, Parthenon Insurance Co.

(Colorado) was merged into Parthenon Insurance Co. of Tennessee
                              - 20 -


(hereinafter also referred to as Parthenon), which latter company

became the surviving corporation.   During December 1978,

Parthenon submitted to the Department of Insurance for review and

approval the form of general and hospital liability policy to be

issued to petitioners in 1979, and an Actuarial Review.

Effective January 1, 1979, Parthenon was licensed by the State of

Tennessee as a captive insurance company.

     As a licensed captive insurance company under Tennessee law,

Parthenon was subject to the regulatory supervision of the

Department of Insurance.   During August 1979, Parthenon adopted

procedures and guidelines to govern the investment of its reserve

and surplus funds, including an incorporation of the Tennessee

regulations governing insurance company investments.

     During December 1979, Mr. Reeves, as president of Parthenon,

requested that HCA contribute an additional $1 million to

Parthenon's capital.

Parthenon's Operations During the Years in Question

     HCA management required that the hospitals owned by

petitioners acquire their liability insurance from Parthenon.

Parthenon did not market liability insurance coverage to

hospitals owned by petitioners because they were automatically

covered by the Parthenon policy.    For each of the years in issue,

Parthenon issued one liability insurance policy which covered

HCA, its owned hospitals, corporations, and other subsidiaries.
                               - 21 -


     Parthenon had no planned underwriting profit.    It was a pure

captive insurance company but nonetheless submitted annual

reports using the NAIC format for all years in issue except 1982

and 1983.   Its premium charges for liability and workers'

compensation coverages were made using rates applied to occupied

beds and patient visits for liability coverage and payroll

amounts for workers' compensation coverage.     Those amounts were

charged on a hospital by hospital basis.

     Hospitals not owned but managed by petitioners (managed

hospitals) could elect to be insured by Parthenon.    Only a small

percentage of the managed hospitals were insured by Parthenon.

Parthenon performed the risk selection element of underwriting

with respect to its coverage of managed hospitals.    Parthenon

engaged in marketing of insurance to the managed hospitals.

Separate liability insurance policies were issued to each managed

hospital that elected to be insured by Parthenon.    Respondent has

not adjusted the insurance transactions of managed hospitals

reported by petitioners on their consolidated tax returns and its

insurance of managed hospitals is not in issue in the instant

case.

     During 1981, Parthenon had 16 employees.    By 1986, Parthenon

had 47 employees.   During January 1987, all of the HCA companies

underwent a reduction in force, and accordingly Parthenon's staff

was reduced by 12 employees.
                               - 22 -


     Parthenon did not utilize HCA's centralized cash management

program, but maintained its own separate banking arrangements and

cash management system.    It also maintained its own accounting

records, computerized information management system, and

personnel files.   Parthenon's employees were issued monthly

checks by HCA's payroll department, which furnished payroll

services to Parthenon, but Parthenon reimbursed HCA for the wage,

salary, and benefit amounts paid to or on behalf of Parthenon's

employees each month.

     From 1981 through July 1985, Parthenon occupied quarters in

a building owned by HCA.    From July 1985 to February 1988, the

offices of Parthenon were in a building leased by HCA.    During

the period 1981 through February 1988, Parthenon had either a

separate written lease or sublease agreement with HCA or occupied

the premises without a written lease, for which it was charged a

monthly amount as rent.    From February 1988 through the end of

that year, Parthenon occupied quarters in a building owned by

HCA, but HCA charged Parthenon no rent and there was no formal

lease agreement between the parties.

     Parthenon's investments were the responsibility of an

investment committee appointed by its Board of Directors, subject

to policies and procedures which included a requirement of

compliance with the investment mandates and restrictions of the

Tennessee Insurance Code.    Parthenon employed outside investment
                              - 23 -


advisers to manage the company's investments under the

supervision of its investment committee.   Additionally,

Parthenon's investment committee received informal investment

advice and counsel from HCA's corporate investment staff, under

the direction of William McInnes, HCA's vice president for

finance.   Parthenon's investment portfolio complied with the

requirements of the Tennessee statute and was typical of the

portfolios maintained by property and casualty insurance

companies generally.

     For the years 1981 through 1986, Parthenon issued to

petitioners annual policies providing $10 million in primary

comprehensive hospital liability, comprehensive personal injury

liability, comprehensive property damage liability, and

advertising liability coverages.   For the years through 1985, the

coverage offered by Parthenon was on an "occurrence" basis, which

meant that Parthenon indemnified the insureds against all covered

liabilities arising out of any occurrence that caused injury

during the policy period, no matter when the claim arising out of

that injury was reported.   For 1986 and subsequent years,

Parthenon provided liability insurance to petitioners on a

"claims made" basis, which meant that coverage was extended only

for claims actually made against an insured during the policy

period arising out of events subsequent to a designated
                              - 24 -


"Retroactive Date", which in the instant case was January 1,

1986.

     During 1981 through 1984, Parthenon assumed reinsurance of

workers' compensation risks written for petitioners by Ideal

Mutual.   Under the reinsurance arrangement, Ideal Mutual ceded

premiums (with associated liabilities) to Parthenon, less a

ceding commission designed to cover Ideal Mutual's costs and an

element of profit.

     Ideal Mutual became insolvent and was placed into

liquidation by the New York Insurance Department effective

December 26, 1984.   Following that development, HCA entered into

an agreement with Continental and the New York Insurance

Department whereby Continental agreed to assume the direct

workers' compensation risks that Ideal Mutual had insured prior

to its insolvency.   As a condition of agreeing to substitute its

own policies for those of Ideal Mutual, Continental required, and

HCA provided, an agreement indemnifying Continental against

liabilities, other than Continental's obligations under its

policies, that might result from the agreement to cede insurance

obligations entered into as of September 6, 1985, between HCA and

the Superintendent of Insurance of the State of New York as

Rehabilitator of Ideal Mutual.   After 1984, Parthenon reinsured

the workers' compensation risks assumed by Continental, receiving

the premium less a ceding commission designed to cover
                               - 25 -


Continental's expenses and an element of profit.   The reinsurance

contracts covering workers' compensation risks required Parthenon

to post a letter of credit to secure its reinsurance obligations.

     When the New York Insurance Department placed Ideal Mutual

in liquidation during 1984, the receiver placed a freeze on the

payment of any claims for workers' compensation against

petitioners' hospitals made under policies with Ideal.    At that

time, HCA operated 26 hospitals in the State of Florida that were

subject to a Florida law which would tie up the bank accounts of

those hospitals unless the claims of nurses and others on

disability under the workers' compensation law were paid.   In

order to prevent the tie-up of those bank accounts, HCA, or the

applicable subsidiaries, paid those workers' compensation claims.

     Through 1986, HCA paid premiums to Ideal Mutual or

Continental for workers' compensation insurance and charged the

applicable hospitals on the same basis that total premiums were

set by the insurer; i.e., by the application of statutorily-set

rates per dollar of payroll.   Commencing policy year 1987, the

underlying workers' compensation policies were rated

retrospectively; i.e., premiums were adjusted after the policy

year to reflect the actual losses from that year, subject to

minimum and maximum premium limits.

     In addition to workers' compensation reinsurance, Parthenon

during the years in question also assumed other reinsurance from
                               - 26 -


unrelated insurance companies that had written direct insurance

covering petitioners--for example, Arkwright-Boston, which wrote

direct property coverage for petitioners.   The amounts involved

are less than 1 percent of total reserves at December 31, 1986,

and Parthenon is not claiming a deduction for an addition to its

reserves for those liabilities.

     During policy years 1981 through 1986, Parthenon negotiated

reinsurance agreements with a number of professional reinsurance

companies in the United States and England covering portions of

the risks of petitioners and of the managed hospitals that

Parthenon had insured.   During policy year 1981, Parthenon ceded

all potential liabilities in excess of $350,000 per occurrence to

reinsurers.   Liabilities in the layer $650,000 excess of $350,000

were ceded to General Reinsurance Corp. (General Re), the largest

reinsurance company in the United States.   Liabilities in the

layer $4 million excess of $1 million were ceded 80 percent to

General Re and 20 percent to various syndicates at Lloyds of

London.   The remaining liabilities were ceded 20 percent to

General Re, 40 percent to INA Reinsurance Co., and 40 percent to

a consortium of Lloyds syndicates and British reinsurance

companies.    General Re, Parthenon's principal reinsurer, reviewed

Parthenon's claims and other operations on an ongoing basis to

ensure that the reinsured business was conducted in accordance

with appropriate standards.
                              - 27 -


     During policy years after 1981, General Re and Parthenon

entered into an agreement rescinding the reinsurance formerly

provided by General Re in the layer $650,000 excess of $350,000,

with the result that Parthenon thereafter effectively retained $1

million in liability exposure for its own account until 1986,

when the retention was increased to $2 million.   Through policy

year 1986, Parthenon reinsured its excess exposures in a manner

similar to the reinsurance arrangements described above for

policy year 1981.   Respondent does not dispute deductions for the

reinsurance premiums.

Formation of Parthenon Casualty Insurance Company

     During 1984, HCA's management decided to form a company to

enter into the business of marketing professional liability

insurance to physicians who practiced at petitioners' hospitals.

Under applicable State law, that insurance could be provided only

by an insurance company licensed on an admitted or surplus lines

basis in each relevant jurisdiction.   That company could not at

the same time qualify as a captive insurance company under the

Tennessee captive insurance statute.   In order to meet the

requirements of relevant States that the carriers they admit have

a prescribed period of operating history in their domiciliary

jurisdiction, HCA decided to use Parthenon (Old Parthenon) as the

corporate entity that would qualify as a new surplus lines
                              - 28 -


company, and to form a new corporation (New Parthenon) to

continue to fulfill Parthenon's former captive insurance role.

     Accordingly, HCA incorporated New Parthenon during 1984

under the Tennessee captive insurance statute to continue

providing captive insurance to petitioners.    New Parthenon

originally was named Parthenon Casualty Insurance Company, but

subsequently changed its name to Parthenon Insurance Company upon

beginning operations.   During 1985 and subsequent years, New

Parthenon issued policies and reinsurance contracts covering the

general and professional liability risks of petitioners on the

same basis as the old insurance company of the same name and

using basically the same staff of employees.

     During March 1985, Old Parthenon changed its name to

Parthenon Casualty Insurance Company (PCIC), qualified as a

licensed surplus lines insurance company in a number of States,

and ceased its former role of a pure captive insurance company.

The accounting records and account balances for the previously

written captive business remained with PCIC, even though its

principal activity was to underwrite the professional liability

risks of third-party physicians.   Additionally, during March

1985, PCIC declared and paid to HCA a dividend in the amount of

$2,250,000.   HCA contributed that dividend to New Parthenon as

paid-in surplus.
                              - 29 -


     During 1985 and subsequent years, PCIC issued policies to

individual physicians.   The employees of New Parthenon and PCIC

during 1985 were basically the same and they continued to service

the pre-1985 captive block of insurance, which had continued on

PCIC's books after the name change and new underwriting

direction.   PCIC and New Parthenon entered into an intercompany

pooling agreement during 1985 whereby each ceded to and assumed

reinsurance from the other, with the end result that risks

written by the entities combined were shared on an 85/15 basis.

     New Parthenon and PCIC executed a portfolio transfer

reinsurance agreement during 1986, to realign each company's

portfolio of business to correspond more nearly to the primary

business purpose of each company.   The net result sought by the

portfolio transfer was to place the captive insurance business

from the beginning with New Parthenon and the physicians'

insurance business from the beginning with PCIC.   Effective April

15, 1988, HCA sold all of its shares of PCIC to an unrelated

purchaser under an agreement whereby, by executing a reinsurance

contract, New Parthenon acquired PCIC's pre-sale physicians'

insurance business.

     The combined capital and surplus for both New Parthenon and

PCIC, where appropriate, for the years 1977 through 1988, is as

follows:
                             - 30 -


          Year                Total Capital and Surplus

          1977                         $2,587,916
          1978                          2,956,429
          1979                          5,611,805
          1980                          7,814,415
          1981                         10,788,729
          1982                         23,013,556
          1983                         29,504,345
          1984                         38,905,712
          1985                         47,607,864
          1986                         60,006,224
          1987                         85,853,294
          1988                        102,949,055

     Hereinafter, we use the term "Parthenon" to refer to the HCA

subsidiary providing insurance and reinsurance for petitioners.

     During the years in issue, Parthenon did not declare any

formal dividends to HCA, other than the $2,250,000 dividend paid

to HCA during 1985.

Premium Setting

     During the years at issue, Parthenon set the premiums

charged by Parthenon for insurance coverage of petitioners from

information provided by Parthenon's actuary.    Up to and including

a portion of policy year 1986, actuarial services regarding

premium rates were provided by Wyatt, principally through Eldon

Klaassen (Mr. Klaassen), a consulting actuary.      For a portion of

policy year 1986 and thereafter, actuarial services were provided

by Terry J. Biscoglia (Mr. Biscoglia), first as a consulting

actuary with Coopers & Lybrand, an international public

accounting and consulting firm, and then in the same capacity

with Wakely & Associates, a national firm of consulting
                              - 31 -


actuaries.8   For exposures above Parthenon's retained limits, the

reinsurers set their own premium requirements.

     Premium rates for liability coverages were designed to be

applied to an exposure base consisting of licensed beds (after

1981, average occupied beds), emergency room patient visits (for

those hospitals choosing emergency room physicians' coverage),

and (after 1981) outpatient visits.    The rates to be applied to

the exposure base were adjusted to reflect relative risk exposure

by geographical area, on the basis of loss information available

to the consulting actuary.   Parthenon's rate manuals also

contained schedules allowing for the application of debits or

credits against the published rates to reflect specific

conditions affecting the risk of any particular hospital.

     On a quarterly basis, Parthenon's accounting personnel

applied the determined rates to the corresponding exposure units

from the latest available census of patient information from each

hospital and billed HCA for the total premium amount thus

determined, and also the premiums attributable to the reinsurance

8
     The parties stipulated that Wyatt Co. (Wyatt) provided
actuarial services to Parthenon through policy year 1986 and that
Mr. Biscoglia provided actuarial services for policy years after
1986. Both Mr. Klaassen and Mr. Biscoglia, however, testified
that Wyatt was replaced during 1986 and other evidence in the
record clearly supports a finding that Mr. Biscoglia provided
some actuarial services for Parthenon for a portion of that year.
Although we do not lightly disregard the stipulations of the
parties, when appropriate, we may do so where the stipulated
facts are clearly contrary to facts disclosed by the record.
Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976).
                              - 32 -


coverages of risks above Parthenon's retained limits of

liability.   Final adjustments were made at the end of each year

to recalculate the ultimate premium reflected by the actual

number of appropriate exposure units.

     After receiving bills from Parthenon, HCA generally paid the

premium amounts in a timely fashion by check or wire transfer

and, using the schedules provided by Parthenon's accounting

department described above, charged each hospital its individual

premium, determined by application of rates to that hospital's

exposure base and adding the hospital's share of the reinsurance

premium.

     During early 1985, Mr. Klaassen concluded that Parthenon's

losses were developing more adversely than originally had been

anticipated.   Additionally, Parthenon made certain procedural

changes to improve its claims reporting process that had the

effect of making actuarial predictions temporarily more

difficult.

     Accordingly, on four occasions during 1985 through 1987,

Parthenon's consulting actuary advised Parthenon that its

reserves were no longer adequate.   Consequently, HCA paid

Parthenon payments classified by HCA as additional premiums to

fund reserve deficiencies.   In each case, the additional amount
                                   - 33 -


(reserve strengthening payment)9 was collected by Parthenon from

HCA, which in turn used schedules prepared by Parthenon's

accounting department to charge each of the hospitals a pro rata

share of the total additional amount.          A breakdown of the reserve

strengthening payments petitioners paid to Parthenon is as

follows:

                   Reserves Strengthened and Amounts Paid
Date        Professional     Workers'
Paid        and General    Compensation    Other          Total
                                                            1
7/29/85      $11,977,587       $6,098,709           -        $18,076,296
12/9/85       12,438,804          342,662        $5,338       12,786,804
                                                             2
4/24/86       42,487,000             -              -          42,487,000
3/31/87       13,000,000             -              -         13,000,000
1
 Allocated to reserves for years ended 1977 through 1984.
2
 Allocated to reserves for years ended 1982 through 1985.

       As of yearend 1985 and 1986, Parthenon recorded additional

amounts of $42.5 million and $13 million, respectively, as



9
     Use of the term "reserve strengthening" is for convenience
only and should not be construed as a finding that the additional
payments constitute a reserve strengthening within the meaning of
sec. 1023(e)(3)(B) of the Tax Reform Act of 1986 (TRA-1986), Pub.
L. 99-514, 100 Stat. 2404, or within a technical meaning commonly
understood by the insurance industry. See, e.g., Western Natl.
Mut. Ins. Co. v. Commissioner, supra; Atlantic Mut. Ins. Co. v.
Commissioner, T.C. Memo. 1996-75, revd. 111 F.3d 1056 (3d Cir.
1997); sec. 1.846-3(c), Income Tax Regs. The parties have
reached an agreement on the computation of the "fresh start"
provisions of sec. 1023(e)(3) of TRA-1986. Accordingly, we do
not address the conflicting opinions of the Court of Appeals for
the Eighth Circuit in Western Natl. Mut. Ins. Co. v.
Commissioner, supra (rejecting respondent's definition of
"reserve strengthening" as promulgated in sec. 1.846-3, Income
Tax Regs., and accepting our definition), and the Court of
Appeals for the Third Circuit in Atlantic Mut. Ins. Co. v.
Commissioner, supra (upholding the regulatory definition).
                              - 34 -


premiums receivable for statutory accounting and financial

reporting purposes, and recorded corresponding yearend additions

to reserves.   Mr. Klaassen considered Parthenon's allocation

method to be reasonable from an actuarial standpoint.     Blue Cross

found the additional premiums to be reasonable and necessary and

allowable for Medicare reimbursement purposes.     The Department of

Insurance concluded that the additional amounts collected should

be treated as premiums for the business that had been in force

and charged Parthenon premium taxes on them accordingly.

     During late 1985, Roger E. Mick (Mr. Mick) was appointed

senior vice-president and chief financial officer of HCA.     He

thought that petitioners' loss experience did not justify the

amounts of premiums that Parthenon's consulting actuaries

projected were needed to fund its loss reserve requirements.       He

believed that petitioners' actual professional liability losses

would be much less than the actuaries were predicting.      He

thought that the funds petitioners were paying to Parthenon could

be used more effectively in other areas of petitioners' core

hospital business.

     During 1986, Mr. Mick ordered a study be done to consider

alternatives to petitioners' purchasing their primary liability

insurance coverage from Parthenon.     Petitioners delayed making

the quarterly premiums due Parthenon for the 1986 policy year.

Subsequently, Charles L. Kown, Associate General Counsel of HCA
                               - 35 -


and a board member and Secretary of Parthenon, wrote Parthenon's

president on September 11, 1986, and advised that, as an

insurance company subject to State regulation, it was critical

that Parthenon require premiums to be paid when due.    Petitioners

paid the 1986 premiums during late 1986.

     Workers' compensation premiums charged petitioners by Ideal

Mutual and, subsequently, by Continental, were set under State

law by rating bureaus, which are organizations that compile

statistical loss information to determine actuarially appropriate

premium rates.    By statute in the relevant States, those rates

were subject to adjustment on the basis of the actual loss

experience of the individual insureds.

Reserve Setting

     Hospital professional liability insurance, like other

medical malpractice coverages, is relatively "long tailed"; i.e.,

claims are often not reported until months or years after the

occurrence claimed to have resulted in liability.    Because the

full extent of liabilities from reported claims may take a long

time to develop, reserves against future liabilities constitute

the bulk of total incurred losses during the first several years

following a policy year.    Incurred but not reported (IBNR) losses

account for a significant portion of those reserves.

     During the years in issue, Parthenon employed consulting

actuaries to assist in determining the appropriate reserves to
                               - 36 -


record for each of its "accident years"; i.e., calendar years

whose associated liabilities would be covered by the policies

issued for those years.    The actuarial focus was on determining

appropriate IBNR reserves.    Parthenon's claims personnel set the

amounts of case reserves on reported claims.

     Typically, reserve adequacy studies would be made by the

actuary in the first or second quarter of a year, assessing the

adequacy of reserves posted by Parthenon as of December 31 of the

previous year.    For 1986 and prior years, reserve studies were

made under the direction of Mr. Klaassen.    For 1986 and later

years, reserve studies were made by Mr. Biscoglia.

     During late 1984, Parthenon instituted a practice of

assigning statistically developed average reserve values to newly

opened claims' files pending actual investigation and evaluation

of the claim, in contrast to the previous practice of assigning a

nominal reserve amount for that interim period.    During early

1985, Parthenon's claims department implemented new procedures

for increasing the efficiency of loss incident reporting.    The

acceleration in timing and amount of reported losses caused by

those developments raised problems with the actuarial prediction

of IBNR losses.

     Effective January 1, 1986, the policy issued by Parthenon

was a claims made policy, not an occurrence policy as had been

the case in prior years.     Consequently, Parthenon went from
                              - 37 -


insuring all losses from occurrences in the policy year to

insuring only those losses that resulted in claims made during

the year.

     During January 1987, Mr. Biscoglia estimated that the

general and professional liability reserves needed as of yearend

1986 were in a range between $218 million and $250 million, on an

undiscounted basis, and in a range between $176 million and $203

million, on a discounted basis.   Subsequently, Mr. Klaassen was

asked to give a second opinion regarding the reserves for

professional liability losses and loss expenses evaluated as of

December 31, 1986, and he recommended reserves for Parthenon and

PCIC of approximately $221 million on an undiscounted basis and

$182 million on a discounted basis.    Mr. Klaassen also suggested

an undiscounted value of $259.7 million, or $202.4 million on a

discounted basis, if Parthenon wanted an 80 percent probability

that the reserve would be adequate.    Mr. Klaassen did not know

that Parthenon had adopted a claims-made policy for the 1986

policy year.   Had he known, the portion of his estimate

attributable to the 1986 occurrences would have been reduced by

about 65 percent.

     During February 1987, Parthenon requested and received

permission from the Department of Insurance to reduce the amount

of the 1986 reserves for losses and expense payments that it was

required to fund by discounting its professional liability
                              - 38 -


reserves.   Parthenon requested permission to book total reserves

of $187,023,000.   That request was supported by actuarial studies

prepared by Mr. Klaassen and Mr. Biscoglia, but it was above the

amount recommended by Mr. Klaassen and at the lower middle of the

range recommended by Mr. Biscoglia.    In a letter addressed to the

Tennessee Commissioner of Insurance dated March 27, 1987, Mr.

Klaassen certified that the amounts carried on Parthenon balance

sheets on account of reserves for unpaid losses and loss

adjustment expense for yearend 1986 were computed in accordance

with accepted loss reserving standards and were fairly stated in

accordance with sound loss reserving principles, were based on

factors relevant to policy provisions, met the requirements of

the insurance laws of the State of Tennessee, and made good and

sufficient provision for all of Parthenon's unpaid loss and loss

expense obligations.

     The amount of $187,023,000 represented the total of what

then already was booked as liability reserves on Parthenon's

books, and $13 million that HCA had previously booked as a

liability on the consolidated financial statements and agreed to

pay Parthenon as additional premium, and was in the range of

amounts recommended by its actuaries.   For financial reporting

purposes, HCA recorded consolidated reserves for general and

hospital professional liabilities as of December 31, 1986, of

$120 million over and above the $187 million reserves for the
                              - 39 -


liabilities recorded as of that date by Parthenon.   That amount

was equal to the difference between the low point of the range of

ultimate losses of petitioners predicted as of that time by Mr.

Biscoglia and the loss amounts recorded on the books of Parthenon

at that time.   HCA management considered the $120 million

difference as an amount it was required to record for

consolidated financial reporting purposes under generally

accepted accounting principles, but which Parthenon did not have

to record because it represented liabilities that Parthenon did

not cover, and consisted of the amount of the discount for

investment income that Parthenon was permitted by the Department

of Insurance to remove from its reserves and the difference

between claims made and occurrence exposure for the 1986 policy

year.

     Petitioners retained John A. Mackie (Mr. Mackie), a

certified public accountant (C.P.A.) who specializes, among other

fields, in insurance accounting, to assist petitioners to

determine Parthenon's undiscounted reserve amounts for use in

Parthenon's 1986 annual statement based on a $187 million

discounted general and professional liability reserve.     Mr.

Mackie used discount factors to calculate that Parthenon would

need an undiscounted reserve of approximately $238 million for

unpaid losses and expenses relating to the general and

professional liability insurance that it had issued though 1986.
                               - 40 -


     For 1987 and thereafter, the liability policy issued by

Parthenon to petitioners was modified to incorporate a $10

million deductible, causing petitioners to be substantially self-

insured for general and professional liability risks for policy

years after 1986.    Parthenon continued to provide petitioners

risk management services and claims administration, and insured

high-level excess exposures, but no longer provided insurance for

any substantial portion of the day-to-day professional and

general liability risks faced by petitioners.    Parthenon

continued to provide reinsurance of the workers' compensation

risks of petitioners on the same basis as before, with the

exceptions that a retrospectively rated feature was added in

1987, and charges to hospitals were made on the basis of

actuarial calculations of loss experience beginning in 1988.

     As a result of the retrospectively rated premium plan for

workers' compensation insurance during policy years 1987 and

1988, Parthenon received a premium installment in the year the

policy was issued, followed by a payment in the second year

designed, within limits, to cover the losses plus expenses

actually incurred.    Parthenon recorded annual statement

liabilities during the first year only to the extent that they

corresponded with the amount of that year's premium installment,

adjusting both premiums and liabilities in the second year to

reflect estimated total losses and corresponding premium amounts.
                                - 41 -


     During 1987 and 1988, Parthenon recorded reserves for

general and professional liability losses that were higher than

the reserves suggested in Mr. Biscoglia's letter reports to

Parthenon, while its reserves for workers' compensation liability

were lower than the actuary's figures, which reflected his view

that all of the anticipated workers' compensation liabilities

should have been recorded in the first year.      The undiscounted

reserve amounts Parthenon reported on its annual statement and

the actuary recommended for Parthenon and PCIC for policy years

1987 and 1988 are as follows:

                                 1987
                                         General and
                      Workers'           Professional
                    Compensation          Liability        Total

Annual Statement     $50,551,000         $192,397,000   $242,948,000
Actuary's
  Recommendation      67,289,000          177,730,000    245,019,000
Difference           (16,738,000)          14,667,000     (2,071,000)




                                 1988
                                         General and
                      Workers'           Professional
                    Compensation          Liability        Total

Annual Statement     $57,417,000         $172,789,000   $230,206,000
Actuary's
  Recommendation      72,217,000          143,731,000    215,948,000
Difference           (14,800,000)          29,058,000     14,258,000
                               - 42 -


For policy years 1987 and 1988, Mr. Biscoglia submitted formal

reports to HCA setting forth his professional and general

liability reserve recommendations for HCA and the sister

subsidiaries based on a range of values.    Those reserve

recommendations included the professional and general liability

funded internally by HCA and the sister subsidiaries as well as

the professional and general liabilities transferred to Parthenon

and PCIC.    In those reports, Mr. Biscoglia did not attempt to

allocate the reserve recommendations among the various entities.

In supplemental addenda for policy years 1987 and 1988, Mr.

Biscoglia set forth discounted reserve recommendations for

Parthenon and PCIC based on fixed dollar values for the reserves.

Accounting

     Parthenon's accounting department recorded and reported the

results of Parthenon's insurance operations.    Parthenon

maintained its own separate accounting system from that of HCA,

including its own journals, general and subsidiary ledgers, and

other appropriate accounting records.    Those records were kept in

accordance with HCA's Accounting Manual.

     From its inception through November 1986, Parthenon's

accounting department prepared monthly financial statements and

reports referred to as "management reports."    After 1986, no

management reports were prepared because the need for the reports

ceased.
                               - 43 -


     The Department of Insurance permitted Parthenon to report

its results in management report format.   For all years except

1982 and 1983, Parthenon and/or PCIC submitted to the Department

of Insurance annual statements in a form prescribed by the

National Association of Insurance Commissioners.   The Department

of Insurance conducted examinations of the financial condition,

affairs, and management of Parthenon during 1979, 1984, and 1989.

Each examination report concluded that Parthenon had conducted

its operations in conformity with the requirements of the

Tennessee captive insurance statute.    The examination report for

the period ending December 31, 1979, noted that Parthenon's

current policy forms and rates were filed and approved by the

Department of Insurance.   From time to time Parthenon consulted

with and secured the approval of the Department of Insurance for

changes or developments in the conduct of its business, including

corporate restructuring to accommodate marketing to individual

physicians, additional premium collection to fund reserve

deficiencies, and discounting of professional liability reserves

for the time-value of money.

Auditing by Medicare Intermediary

     During each of the years in issue, Parthenon was audited by

Blue Cross/Blue Shield of Tennessee (Blue Cross), as an

intermediary acting on behalf of HFCA (or its predecessor

agencies) for the purpose of determining whether premiums paid by
                              - 44 -


petitioners' hospitals qualified for reimbursement under the

Federal Medicare program.   To make that determination, Blue Cross

was required to confirm that the premiums charged by Parthenon to

petitioners were reasonable in light of comparable commercial

rates, that both premiums and reserves were based on actuarial

determinations, that premiums did not reflect a profit factor,

that Parthenon was duly licensed and met appropriate criteria for

insurance companies set out by the State of Tennessee, that it

had adequate claims administration and adequate risk management,

and that there were no loans or transfers of funds from Parthenon

to any affiliated company other than payment of covered claims.

For each of the years in issue, Blue Cross found that Parthenon

met the required criteria. In audit reports issued for those

years, Blue Cross specifically confirmed the reasonableness,

prudence, and actuarial foundation of the premiums charged by

Parthenon, including the additional premiums charged to fund

deficiencies in the 1984-86 reserves.

Tax Treatment

     Parthenon has been included in the consolidated returns

filed by petitioners since it began business during 1977.

Because of disagreement between petitioners and respondent as to

the proper tax treatment of premiums HCA and the sister

subsidiaries paid to Parthenon for earlier tax years petitioners

did not claim a deduction for the increase in insurance reserves
                               - 45 -


relating to premiums received by Parthenon from members of the

affiliated group on their consolidated returns for the years in

issue.    In the petitions filed in the instant case, petitioners

claim that Parthenon is entitled to be treated as an insurance

company for the years in issue, that petitioners are entitled to

deduct premiums they paid to Parthenon for insurance coverage for

those years, and that Parthenon is entitled to deduct the

increase in its reserves associated with those premiums, in

amounts of premiums not less than the following:

              Professional        Reinsurance
              and General         of Workers'
               Liability         Compensation
Year           Insurance           Insurance             Total

1981           $15,571,167         $3,404,406         $18,975,573
1982            21,742,220          4,514,782          26,257,002
1983            17,630,680          5,364,185          22,994,865
1984            12,016,909          2,598,288          14,615,197
1985                                                   36,796,826
1986                                                   80,247,632
                                                           1
1987
                                                           1
1988
1
 Specific amounts were not stated in the petitions.

       Petitioners claim that overpayments of tax with respect to

the transactions with Parthenon result in tax in issue for the

years in issue as follows:

            TYE               Increase (Decrease) in Tax

            1981                    ($8,703,732)
            1982                    (12,247,563)
            1983                    (11,520,738)
            1984                     (6,128,314)
            1985                    (22,228,950)
            1986                    (52,934,878)
                              - 46 -


          1987                      32,602,710
          1988                         306,593
          Total                    (80,854,872)



                              OPINION

      On a number of prior occasions, this Court has confronted

the issue of the deductibility of purported insurance premiums

paid to a wholly owned captive insurance company.   E.g., Sears,

Roebuck & Co. and Affiliated Corps. v. Commissioner, 96 T.C. 61,

modified 96 T.C. 671 (1991), affd. on this issue, revd. in part

and remanded 972 F.2d 858 (7th Cir. 1992); Humana Inc. v.

Commissioner, 88 T.C. 197 (1987), affd. in part and revd. in part

881 F.2d 247 (6th Cir. 1989); Clougherty Packing Co. v.

Commissioner, 84 T.C. 948 (1985), affd. 811 F.2d 1297 (9th Cir.

1987); Carnation Co. v. Commissioner, 71 T.C. 400 (1978), affd.

640 F.2d 1010 (9th Cir. 1981); see also Malone & Hyde, Inc. v.

Commissioner, T.C. Memo. 1992-661, revd. and remanded 62 F.3d 835

(6th Cir. 1995).   Our position has been to consider all of the

facts and circumstances when faced with the task of determining

whether a transaction nominally labeled "insurance" should be

recharacterized as "self-insurance" or as some other arrangement

that negates transfer of risk.   Sears, Roebuck & Co. v.

Commissioner, 96 T.C. at 96; see also Amerco, Inc. v.

Commissioner, 979 F.2d 162, 165 (9th Cir. 1992) ("many

considerations can come into play when one attempts to decide
                                - 47 -


whether a deduction of a purported insurance premium will be

allowed"), affg. 96 T.C. 18 (1991).      Additionally, we

consistently have rejected respondent's "economic family"

theory,10 expressed in Rev. Rul. 77-316, 1977-2 C.B. 53.      E.g.,

Sears, Roebuck & Co. v. Commissioner, supra; Humana v.

Commissioner, 88 T.C. at 214.    We have concluded, moreover, that

true insurance arrangements may exist between a captive insurance

company subsidiary and its parent, or among a captive insurance

company subsidiary and its sister subsidiaries, where the captive

insurer does substantial unrelated insurance business in addition

to the captive insurance business.       See Sears, Roebuck & Co. v.

Commissioner, supra; Harper Group & Subs. v. Commissioner, 96

T.C. 45 (1991); Amerco, Inc. v. Commissioner, 96 T.C. 18 (1991).

     The Court of Appeals for the Sixth Circuit, to which the

instant case would be appealable absent stipulation to the

10
     Pursuant to the "economic family" theory, a parent cannot
shift risk of loss to a wholly owned subsidiary because the
parent and its subsidiaries, even though separate corporate
entities, represent one economic family. Consequently, the
ultimate economic risk of loss falls on the same persons and the
premiums remain within the economic family. Rev. Rul. 77-316,
1977-2 C.B. 53, 54; see also Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1301-1302 (9th Cir. 1987), affg. 84
T.C. 948 (1985. But see Rev. Rul. 92-93, 1992-2 C.B. 45 (parent
may deduct premiums paid to its wholly owned insurance subsidiary
for insurance on the life of an employee of the parent), which
distinguishes Rev. Rul 77-316. "The 'economic family' concept is
based on the theory that when a captive receives a dollar, its
net worth and its parent's net worth increases by that amount,
and that when the captive pays out a dollar the converse occurs."
Gulf Oil Corp. v. Commissioner, 89 T.C. 1010, 1024 n.7 (1987),
affd. 914 F.2d 396 (3d Cir. 1990)
                              - 48 -


contrary, has considered captive insurance company issues on two

occasions.   See Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835

(6th Cir. 1995), revg. T.C. Memo. 1992-661; Humana Inc. v.

Commissioner, 881 F.2d 247 (6th Cir. 1989), affg. in part and

revg. in part 88 T.C. 197 (1987).   We must follow the rationale

of those cases to the extent that the facts presented in them are

squarely on point with the facts in the instant case.        Golsen v.

Commissioner, 54 T.C. 742, 756-757 (1970), affd. 445 F.2d 985

(10th Cir. 1971).

     In Humana, Inc. the taxpayer parent, together with various

of its subsidiaries, owned and operated between 62 hospitals

containing 8,586 beds and 92 hospitals containing 16,529 beds

during the years in issue.   Humana Inc. v. Commissioner, 88 T.C.

at 199.   During 1976, Humana incorporated Health Care Indemnity,

Inc. (HCI), a Colorado captive insurance company, with $1 million

in capitalization, to provide fire, general liability, medical

malpractice, and other casualty insurance for Humana and its

subsidiaries after Humana learned that it could no longer obtain

insurance coverage from a third-party insurer.   Id. at 200-202.

Of the initial $1 million in capitalization, $750,000 was paid by

irrevocable letters of credit issued in favor of the Commissioner

of Insurance of the State of Colorado.   Id. at 202.    No

agreements existed between Humana or its subsidiaries and HCI

requiring the parent or sister subsidiaries to contribute
                                - 49 -


additional capital to HCI for the payment of any losses.     Id.

During the last year in issue, however, Humana did contribute

$1,323,000 additional capital to HCI.    Id.   HCI was not included

in the consolidated returns filed by Humana and its subsidiaries.

Id. at 205.   Relying on precedent, we held that the premiums paid

by Humana to HCI on its own behalf as well as the premiums paid

by Humana and then allocated and charged back to the sister

subsidiaries were not deductible but were equivalent to additions

to a reserve for losses.    Id. at 206-207, 213-214.

     The Court of Appeals for the Sixth Circuit affirmed our

decision that payments Humana had made to HCI for insurance on

behalf of its own hospitals were not deductible, but reversed our

similar decision as to those payments made on behalf of hospitals

owned by the sister subsidiaries.    Humana Inc. v. Commissioner,

881 F.2d 247 (6th Cir. 1989).    The court concluded that, pursuant

to the principles of Moline Properties, Inc. v. Commissioner, 319

U.S. 436 (1943), the sister subsidiaries must be treated as

separate corporations from the parent.   In its analysis as to

whether risks had shifted to HCI, the Court of Appeals noted

that:

          Health Care Indemnity met the State of Colorado's
     statutory minimum requirements for an insurance company, was
     recognized as an insurance company following an audit and
     certification by the State of Colorado, and is currently a
     valid insurance company subject to the strict regulatory
     control of the Colorado Insurance Department. The State of
     Colorado has either approved or established the premium rate
     for insurance between the Humana affiliates and Health Care
                             - 50 -


     Indemnity. As a valid insurance company under Colorado law,
     Health Care Indemnity's assets cannot be reached by its
     shareholders except in conformity with the statute.

          Health Care Indemnity was fully capitalized and no
     agreement ever existed under which the subsidiaries or
     Humana Inc. would contribute additional capital to Health
     Care Indemnity. The hospital subsidiaries and Humana Inc.
     never contributed additional amounts to Health Care
     Indemnity nor took any steps to insure Health Care
     Indemnity's performance. It is also undisputed that the
     policies purchased by the hospital subsidiaries and Humana
     Inc. were insurance policies as commonly understood in the
     industry. The hospital subsidiaries and Humana Inc. entered
     into bona fide arms length contracts with Health Care
     Indemnity. Health Care Indemnity was formed for legitimate
     business purposes. Health Care Indemnity and the hospital
     subsidiaries conduct legitimate businesses and are devoid of
     sham. No suggestion has been made that the premiums were
     overstated or understated. Health Care Indemnity did not
     file its income tax returns on a consolidated basis with
     Humana Inc. and its subsidiaries. Humana Inc.'s insured
     subsidiaries own no stock in Health Care Indemnity, nor vice
     versa. [Humana, Inc. v. Commissioner, 881 F.2d at 253;
     citation omitted.]

     The Court of Appeals specifically adopted the balance sheet

and net worth analysis described in Clougherty Packing Co. v.

Commissioner, 811 F.2d at 1305,11 to analyze whether risks had

11
     In Clougherty Packing Co. v. Commissioner, 811 F.2d 1297
(9th Cir. 1987), affg. 84 T.C. 948 (1985), the taxpayer parent
incorporated a Colorado captive insurance company to reinsure a
portion of the workers' compensation risks primarily insured by a
third party insurance carrier. In affirming our decision that
risks had not shifted to the captive insurer, the Court of
Appeals for the Ninth Circuit neither adopted nor rejected
respondent's economic family concept, stating as follows:

          In reaching our holding, we do not disturb the
     separate legal status of the various corporate entities
     involved, either by treating them as a single unit or
     otherwise. Rather, we examine the economic
     consequences of the captive insurance arrangement to
                                                   (continued...)
                               - 51 -


shifted from the sister subsidiaries to HCI.   The court stated

that "If we look solely to the insured's assets, i.e., those of

the various affiliates of Humana Inc., and consider only the

effect of a claim on those assets, it is clear that the risk of

loss has shifted from the various affiliates to Health Care

Indemnity."   Humana Inc. v. Commissioner, 881 F.2d at 252.      The

court explained as follows:

      The economic reality of insurance between a parent and a
      captive insurance company is that the captive's stock is
      shown as an asset on the parent's balance sheet. If the
      parent suffers an insured loss which the captive has to pay,
      the assets of the captive will be depleted by the amount of
      the payment. This will reduce the value of the captive's
      shares as an asset of the parent. In effect, the assets of
      the parent bear the true economic impact of the loss. The
      economic reality, however, of insurance between the Humana
      subsidiaries and Health Care Indemnity, where the
      subsidiaries own no stock in the captive and vice versa, is
      that when a loss occurs and is paid by Health Care Indemnity
      the net worth of the Humana affiliates is not reduced
      accordingly. The subsidiaries' balance sheets and net worth
      are not affected by the payment of an insured claim by
      Health Care Indemnity. In reality, therefore, when the
      Humana subsidiaries pay their own premiums under their own
      insurance contracts, as the facts show, they shift their
      risk to Health Care Indemnity. [Id. at 253.]



11
     (...continued)
       the "insured" party to see if that party has, in fact,
       shifted the risk. In doing so, we look only to the
       insured's assets, i.e., those of Clougherty, to
       determine whether it has divested itself of the adverse
       economic consequences of a covered workers'
       compensation claim. Viewing only Clougherty's assets
       and considering only the effect of a claim on those
       assets, it is clear that the risk of loss has not been
       shifted from Clougherty. [Id. at 1305; emphasis
       added.]
                             - 52 -


     Distinguishing the cases relied on by the Commissioner,12

the Court of Appeals stated further that the       undercapitalization

of the captive insurer or the presence of an indemnification

agreement running from the parent to the captive insurer "alone

provided a sufficient basis from which to find no risk shifting

and to decide the cases in favor of the Commissioner."       Humana v.

Commissioner, 881 F.2d at 254 n.2.

     The Court of Appeals also stated:

     In general, absent specific congressional intent to the
     contrary, as is the situation in this case, a court cannot
     disregard a transaction in the name of economic reality and
     substance over form absent a finding of sham or lack of
     business purpose under the relevant tax statute. [Id. at
     255; citations omitted.]

The court noted that we had found that Humana had a valid

business purpose for incorporating the captive insurer.       Id.   The

court found both risk sharing and risk distribution involved in

the transactions between the Humana subsidiaries and HCI.       Id.

Risk distribution was involved because losses were spread among a

number of Humana's subsidiaries.     Id. at 257.

     In Malone & Hyde, Inc. v. Commissioner, T.C. Memo. 1989-604,

supplemented by T.C. Memo. 1993-585, the taxpayer parent,

primarily a wholesale food distributor, together with


12
     Those cases were: Beech Aircraft Corp. v. United States,
797 F.2d 920 (10th Cir. 1986); Stearns-Roger Corp. v. United
States, 774 F.2d 414 (10 Cir. 1985); Carnation Co. v.
Commissioner, 71 T.C. 400 (1978), affd. 640 F.2d 1010 (9th Cir.
1981).
                               - 53 -


approximately eight operating subsidiaries provided goods and

services required by their independent retail grocery store owner

customers.   During 1977, Malone & Hyde incorporated Eastland

Insurance, Ltd. (Eastland) as a wholly owned Bermuda captive

insurance company to provide insurance for itself and its

subsidiaries at less cost than was available from third-party

insurers.    Eastland was capitalized at $120,000, the minimum

statutory requirement pursuant to Bermuda's insurance law.

Malone & Hyde, Inc. v. Commissioner, 62 F.3d at 836.     Malone &

Hyde decided that initially Eastland only would reinsure selected

risks of the parent and the subsidiaries.    Accordingly, Eastland

agreed to reinsure the first $150,000 of each workers'

compensation, auto liability, and general liability claim

primarily insured by Northwestern National Insurance Co.

(Northwestern).    Eastland provided Northwestern with an

irrevocable letter of credit, initially in the amount of $250,000

but subsequently increased to $600,000, to cover amounts unpaid

under the reinsurance agreement.    Additionally, Malone & Hyde

executed hold harmless agreements wherein it agreed to indemnify

Northwestern against any liability in the event that Eastland

defaulted on its reinsurance obligations.    Malone & Hyde paid

insurance premiums to Northwestern and Northwestern in turn paid

Eastland reinsurance premiums for the insurance risks assumed by

Eastland.    Malone & Hyde allocated to the operating subsidiaries
                                - 54 -


their portion of the premiums paid to Northwestern.   Malone &

Hyde, Inc. v. Commissioner, T.C. Memo. 1989-604.

     In our first opinion in Malone & Hyde, Inc., we sustained

respondent's determination that there was no shifting of risks

from the parent and the sister subsidiaries to Eastland for the

portion of the insurance premiums that Malone & Hyde paid to

Northwestern and which Northwestern then paid to Eastland as

reinsurance premiums.   Malone & Hyde, Inc. v. Commissioner, T.C.

Memo. 1989-604.   Following the reversal of Humana Inc. & Subs. v.

Commissioner, 88 T.C. 197 (1987), we reconsidered our first

decision in Malone & Hyde, Inc. in light of language in Humana

Inc. v. Commissioner, 881 F.2d at 255, that in applying the

balance sheet and net worth analysis we look solely at the impact

a claim of loss would have on the assets of the insured.    In our

Supplemental Opinion in Malone & Hyde, Inc., using that criteria,

and applying our three-prong test (i.e., (1) whether insurance

risks are involved, (2) whether risk shifting and risk

distribution is present, and (3) whether insurance in its

commonly accepted sense exists), we found that the premiums paid

by the sister subsidiaries were deductible as insurance.    Malone

& Hyde, Inc. v. Commissioner, T.C. Memo. 1993-585.

     The Court of Appeals for the Sixth Circuit reversed our

decision.   The court stated:

          We believe the tax court put the cart before the horse
     in this case. It should have determined first whether
                             - 55 -


     Malone & Hyde created Eastland for a legitimate business
     purpose or whether the captive was in fact a sham
     corporation. A taxpayer is "free to arrange his financial
     affairs to minimize his tax liability." Thus, "the presence
     of tax avoidance motives will not nullify an otherwise bona
     fide transaction." However, 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 undercapitalized foreign insurance captive that is
     propped-up by guarantees of the parent corporation. The
     captive in such a case is essentially a sham corporation,
     and the payments to such a captive that are designated as
     insurance premiums do not constitute bona fide business
     expenses, entitling the taxpayer to a deduction under §
     162(a). [Malone & Hyde, Inc. v. Commissioner, 62 F.3d at
     840; citations omitted.]

     The court noted that Malone & Hyde did not have any problem

obtaining insurance from an unrelated insurer but, without a

legitimate business reason, it had deviated from normal behavior

and had devised a circuitous scheme to obtain tax deductions

through the use of a captive insurer.   Id.   The court also

observed that there was no indication that Bermuda exercised

oversight over Eastland's activities.   Id. at 841.   The court

further noted that Eastland operated on extremely thin

capitalization and that Malone & Hyde had furnished Northwestern

with hold harmless agreements on two occasions.   The court stated

that the presence of the hold harmless agreements and

undercapitalization (two factors which had been identified in

Humana Inc. v. Commissioner, 881 F.2d at 254 n.2, as weaknesses

that in themselves provided a sufficient basis on which to find

no risk shifting) "indicates that the captive insurance scheme

established by Malone & Hyde was not an 'otherwise bona fide
                              - 56 -


transaction,' but a sham."   Malone & Hyde, Inc. v. Commissioner,

62 F.3d at 841.

     The Court of Appeals stated:

          If Humana's scheme had involved a thinly-capitalized
     captive foreign insurance company that ended up with a large
     portion of the premiums paid to a commercial insurance
     company as primary insurer, and had included a hold harmless
     agreement from Humana indemnifying the unrelated insurer
     against all liability, we believe the result in Humana would
     have been different. This court accepted the bona fides of
     the transaction in Humana and recognized the premiums paid
     to the captive insurance company as deductible business
     expenses since Humana established the captive to address a
     legitimate business concern (the loss of insurance
     coverage), and the captive was not a sham corporation; the
     captive in Humana was fully capitalized, domestically
     incorporated, and established without guarantees from the
     parent or other related corporations. Because Humana acted
     in a straightforward manner, without any evidence of an
     intent to create an unwarranted tax deduction based on
     payments that largely ended up in its subsidiary's coffers,
     this court accepted the bona fides of the transaction before
     examining the brother-sister issue.

          We disagree with Malone & Hyde's contention that
     footnote 2 in Humana refers only to the question of whether
     Humana's premium payments for its own coverage, as opposed
     to the coverage extended its subsidiaries, involved risk
     shifting. Footnote 2 clearly applies to the fundamental and
     decisive question of whether there was risk shifting from
     any insured--parent or subsidiary--to the captive insurer.
     When the entire scheme involves either undercapitalization
     or indemnification of the primary insurer by the taxpayer
     claiming the deduction, or both, these facts alone
     disqualify the premium payments from being treated as
     ordinary and necessary business expenses to the extent such
     payments are ceded by the primary insurer to the captive
     insurance subsidiary.

          It is true that Eastland operated as an insurance
     company. As the tax court found, it "established reserve
     accounts, paid claimed losses only after the validity of
     those claims had been established, and was profitable." For
     purposes of determining the correct tax treatment of
     premiums paid to Eastland by Malone & Hyde, however, we
                             - 57 -


     cannot be blind to the realities of the case. The
     "interdependent" separate agreements, when considered
     together indicate an arrangement under which there was no
     risk shifting. Under the hold harmless agreement, the
     ultimate risk for workers' compensation, auto liability, and
     general liability remained with Malone & Hyde. This being
     so, the transactions did not result in Malone & Hyde or the
     subsidiaries receiving "insurance" from Eastland within the
     meaning of that term under the Internal Revenue Code.
     [Malone & Hyde, Inc. v. Commissioner, 62 F.3d at 842-843;
     citations omitted; emphasis added.]

     We turn next to our consideration of the facts present in

the instant case in light of the holdings of the Sixth Circuit

Court of Appeals in Humana and Malone & Hyde, Inc..    Golsen v.

Commissioner, 54 T.C. 742 (1970).   In the instant case,

respondent concedes that the professional and general liability

risks and workers' compensation risks covered by Parthenon are

insurable risks. Furthermore, respondent does not dispute the

presence of risk distribution in the instant case, inasmuch as

the number of hospitals insured and the number of hospital beds

involved in the instant case far exceed the number of hospitals

and beds insured that the Court of Appeals in Humana found

sufficient for risk distribution to have occurred.    Humana Inc.

v. Commissioner, 881 F.2d at 256-257.   Accordingly, the questions

we must resolve are (1) whether bona fide insurance transactions

exist and, (2) if they do, whether the sister subsidiaries

shifted those risks to Parthenon.
                               - 58 -


The Transactions Between Parthenon and HCA and the Sister
Subsidiaries Are Insurance Transactions

     Pursuant to the principles of Moline Properties, Inc. v.

Commissioner, 319 U.S. 436 (1943), respondent does not contend

that Parthenon's separate corporate existence should be ignored

for Federal income tax purposes or that Parthenon itself is a

sham corporation.    Respondent contends, however, that the

transactions between Parthenon and petitioners during the years

in issue, including the issuance of insurance policies and

setting of reserves, were not bona fide insurance transactions

and were motivated by tax concerns.

     Respondent contends that petitioners intended to, and did,

treat Parthenon as a form of self-insurance to carry out a loss

prevention and risk management program for their hospitals.

Respondent concedes that Parthenon was licensed and regulated as

a captive insurance company by the State of Tennessee, and that

it satisfied the applicable regulatory criteria for operation as

a captive insurer.    Respondent, however, maintains that the

regulatory criteria, as well as Blue Cross' annual audits and

Continental's annual reviews, were no more than what would be

necessary for a self-insurance plan.    Respondent contends that

petitioners formed Parthenon as a captive insurance company in
                                - 59 -


order to create tax deductions for amounts that in fact are self-

insurance.

     Petitioners contend that the transactions were in respect of

an insurance company and that respondent's self-insurance

argument is an attempt to recharacterize an insurance

relationship between separate legal entities as self-insurance by

a single economic family.

     In the instant case, Parthenon, in form, operated as an

insurance company.    It was licensed as a captive insurer, fully

staffed, and performed typical insurance functions, including

underwriting, the setting of premiums and reserves, investment

management, and claims administration.    Nonetheless, we must look

beyond the formalities and consider the realities of the

purported insurance transactions between Parthenon and

petitioners.    Malone & Hyde, Inc. v. Commissioner, 62 F.3d at

842-843.     Based on the record developed in the instant case, we

conclude that Parthenon provided insurance to HCA and to the

sister subsidiaries.

     Respondent asserts the following differences to distinguish

the instant case from Humana, Inc. v. Commissioner, supra:     (1)

The sister subsidiaries, in effect, were stockholders in

Parthenon; (2) Parthenon was not subject to strict regulatory
                              - 60 -


control by the Department of Insurance; (3) approval of the rates

between Parthenon and its sister subsidiaries, and protection of

Parthenon's assets, was not accomplished on an annual basis by

the State of Tennessee; (4) there was an agreement by which the

sister subsidiaries or HCA would contribute additional capital to

Parthenon; (5) HCA's hospital subsidiaries contributed additional

amounts to Parthenon; (6) the insurance policies that Parthenon

issued to the sister subsidiaries did not constitute bona fide

insurance contracts as commonly understood in the insurance

industry; (7) HCA's hospital subsidiaries as corporate entities

did not operate the individual hospitals; (8) the premiums were

both overstated (for 1986, 1987, and 1988) and understated (for

1984) at the whim of HCA based on HCA's needs at the time the

premiums were determined; and (9) Parthenon filed its income tax

return on a consolidated basis with HCA and its subsidiaries but

not on the insurance company forms required by the income tax

regulations.   Accordingly, respondent contends that Humana, Inc.

v. Commissioner, supra, does not control the outcome of the

instant case because the facts are distinguishable.

     Respondent contends further that HCA's decision during 1985

to use the assets and reserves of Parthenon to organize a surplus

lines company to provide medical malpractice insurance to
                              - 61 -


physicians who referred patients to HCA hospitals, the payment of

additional premiums for prior years during 1986 while failing to

pay current premiums, and the decision during 1987 to raise HCA's

and the sister subsidiaries' general and professional liability

insurance deductible to $10 million and thereby effectively

terminate Parthenon's premium income demonstrate that Parthenon

was controlled at all times by HCA for the benefit of HCA.

Additionally, respondent contends that the comfort letter given

by HCA to Ideal Mutual to guarantee the performance of Parthenon,

the payment of workers' compensation claims in 1984 by HCA in

connection with its Florida hospitals upon the insolvency of

Ideal Mutual, the transfer of Parthenon's reserves to PCIC, the

reserve strengthening payments totaling $86 million, an alleged

$60 million excessive premium charged for the 1986 claims-made

policy at the rate for a policy on an occurrence basis, the

failure of HCA to pay the quarterly premiums for the first three

quarters of 1986, and the decision by HCA during 1987 to pay

claims less than $10 million out of working capital, all support

the conclusion that neither HCA nor the sister subsidiaries

shifted risks to Parthenon.

     Petitioners contend, however, that the facts in the instant

case are similar to those in Humana, Inc. v. Commissioner, supra.
                              - 62 -


Petitioners contend that they established Parthenon to address a

legitimate business concern, that petitioners acted in a

straightforward manner, with no intent to create an unwarranted

tax deduction, and that Parthenon was fully capitalized,

domestically incorporated, regulated by the State, and was not

propped up by guaranties from HCA or the sister subsidiaries.

Petitioners contend further that Parthenon did not act solely as

a reinsurer of risks but directly insured the general and

professional liability risks of HCA and the sister subsidiaries.

     Additionally, petitioners contend that the comfort letter

HCA gave to Ideal Mutual was a normal kind of reinsurance

security arrangement that had no effect on risk transfer.

Petitioners contend that the comfort letter HCA gave to Ideal

Mutual affected only a modest portion of Parthenon's business and

was not in effect when Continental became the commercial carrier

for the workers' compensation insurance during 1984 following

Ideal Mutual's insolvency.   Accordingly, petitioners maintain,

the comfort letter did not "prop up" Parthenon.   Additionally,

petitioners contend that the indemnity provision of the agreement

between HCA and Continental is not relevant to the reinsurance

provided by Parthenon because the subject matter of the indemnity
                              - 63 -


agreement was risks that were not covered by the reinsured

policies.

     We conclude that, with a few significant differences, the

facts of the instant case are strikingly similar to the facts

presented in Humana Inc. v. Commissioner, supra.    Both Humana and

HCA owned and operated hospitals that were facing difficulties in

obtaining medical malpractice insurance at the time that they

formed their captive insurance companies.   Both formed fully

capitalized, domestic captive insurance companies to provide on a

direct basis general and professional liability insurance for

themselves and their operating subsidiaries.   Respondent does not

dispute that Parthenon was formed and operated for legitimate

business purposes.

     Except as discussed infra, we are not persuaded that the

"distinctions" between the facts of Humana and those of the

instant case are material.   Respondent contends that the sister

subsidiaries had an equity interest in Parthenon.   We do not

agree.   We are not persuaded that the reserve strengthening

payments HCA and the sister subsidiaries paid to Parthenon during

1985, 1986, and 1987, or an alleged $60 million overcharge paid

for 1986, were the equivalent of capital contributions, which, in

substance, gave the sister subsidiaries an ownership interest in
                               - 64 -


Parthenon.   Neither Parthenon nor the sister subsidiaries

intended to or did treat the reserve strengthening payments as

equity investment.   Additionally, both the Department of

Insurance and Blue Cross treated the reserve strengthening

payments as insurance premiums.   We conclude that, in fact and in

substance, the sister subsidiaries did not own any of Parthenon's

stock.

     Respondent contends further that the Department of Insurance

did not strictly regulate Parthenon.    The record in the instant

case establishes that the Tennessee Department of Insurance did

not promise, and we are persuaded that it did not extend special

privileges to Parthenon.    The supervision that the Department of

Insurance exercised over Parthenon's operations, including

periodic financial examinations, was no different from the

supervision exercised over any other captive insurer licensed in

the State of Tennessee.    Although the Department of Insurance did

not annually establish or approve the premium rates between

Parthenon and its sister subsidiaries, the examination report of

Parthenon prepared by the Department of Insurance as of December

31, 1979, indicates that the basic premium rating process used by

Parthenon for that period had the approval of the Department of

Insurance.   Parthenon's process for setting premium rates did not
                              - 65 -


change significantly during the years in issue from the process

used during 1979.   Annual approval of Parthenon's premium rates

is not required by the Tennessee captive insurance statute.

Furthermore, contrary to respondent's contention, there is no

indication that HCA used or could use Parthenon's assets except

in conformity with the Tennessee captive insurance statute.

     Respondent contends that, from its inception, HCA agreed to

contribute additional capital to Parthenon.   Neither HCA nor the

sister subsidiaries, however, agreed to, nor did the Department

of Insurance require HCA or the sister subsidiaries to agree to

be responsible for, any losses of Parthenon when Parthenon was

reincorporated in Tennessee during 1979.   Although the Department

of Insurance, and HCA's management, may have expected HCA to

provide financial help if Parthenon were to experience financial

difficulties, there was no legal requirement or binding agreement

that HCA or the sister subsidiaries do so.

     Respondent contends that the sister subsidiaries' lack of

choice as to insurer or insurance coverage demonstrates that the

insurance policies purchased by HCA and the sister subsidiaries

from Parthenon were not insurance policies as commonly understood

in the industry and that those policies were not entered into as

bona fide arm's-length contracts by the subsidiaries.   Respondent
                              - 66 -


therefore argues that the transactions between Parthenon and

petitioners were in the nature of self-insurance.   We are unable

to reach such a conclusion and, furthermore, are persuaded that

the lack of choice plays no role in deciding whether the policies

between Parthenon and its sister subsidiaries constituted

insurance as commonly understood in the industry.   The policies

covered typical insurance risks, including medical malpractice,

property damages, and workers' compensation liability.   HCA,

moreover, had a legitimate business reason for requiring the

sister subsidiaries to acquire insurance from Parthenon.

      Additionally, we find no merit to respondent's contention

that the sister subsidiaries merely held legal title to the

hospitals they owned and therefore played no part in the

insurance relationship between Parthenon and those hospitals.

Respondent's position would have us, in effect, ignore the

separate existence of the sister subsidiaries even though

respondent agrees that they were formed and operated for

legitimate business purposes and should be recognized as separate

corporate entities.   We find no basis in fact or law for doing

so.   See Moline Properties, Inc. v. Commissioner, 319 U.S. 436

(1943).
                              - 67 -


     Nonetheless, we agree that some significant factual

distinctions exist between the present case and Humana, Inc. v.

Commissioner, supra.   We next consider the effect of those

differences.

     One significant factual distinction between the instant case

and Humana is the presence of the comfort letter that HCA gave to

Ideal Mutual whereby HCA agreed to indemnify Ideal Mutual against

Parthenon's nonperformance relating to workers' compensation

liabilities that Ideal Mutual reinsured with Parthenon.    Humana

had taken no steps to insure HCI's performance.    Humana Inc. v.

Commissioner, 881 F.2d at 253.   Malone & Hyde, however, gave

Northwestern, the insurance company primarily liable for

insurance risks reinsured by Eastland, a hold harmless agreement

relating to Eastland's reinsurance obligations.    Malone & Hyde,

Inc. v. Commissioner, 62 F.3d at 836.

     In Malone & Hyde, Inc., the Court of Appeals stated that the

presence of the hold harmless agreement, along with the fact that

Eastland was undercapitalized, indicated that the captive

insurance arrangement was a sham.   Id. at 841.   Eastland's

activities, however, were limited to providing reinsurance for

risks primarily insured by Northwestern, and the indemnity

agreement applied to all of those reinsured risks.   In the
                              - 68 -


instant case, the comfort letter applied to only one line of

business, and that line of business was not the primary insurance

coverage provided by Parthenon to HCA and the sister

subsidiaries.   Parthenon insured, on a direct basis, general and

professional liabilities for which no indemnity agreement was in

effect.   The comfort letter, furthermore, was not in effect after

Ideal Mutual's insolvency during 1984.   The indemnity agreement

between HCA and Continental related to liabilities arising from

the agreement to cede insurance obligations that HCA had entered

into with the Superintendent of Insurance of the State of New

York as Rehabilitator of Ideal Mutual Insurance Co., but it

specifically excluded Continental's own obligations under its

policies.   Accordingly, the indemnity agreement was restricted to

obligations relating to Ideal Mutual's policies, and it did not

involve Continental's own policies.    Under such circumstances, we

conclude that in the instant case the successive indemnity

agreements between HCA and Ideal Mutual and between HCA and

Continental are not a sufficient basis for finding that the

transactions between Parthenon and the sister subsidiaries were

not bona fide.13


13
     In accordance with Malone & Hyde, Inc. v. Commissioner, 62
F.3d 835 (6th Cir. 1995), however, risk shifting is absent for
                                                   (continued...)
                              - 69 -


     An additional distinction between the instant case and

Humana, Inc. v. Commissioner, supra, is that on four separate

occasions during the years in issue HCA and the sister

subsidiaries made reserve strengthening payments to Parthenon

totaling in the aggregate $86,350,100.   Respondent contends that

the reserve strengthening payments and a payment by HCA relating

to Florida hospital workers' compensation claims when Ideal

Mutual became insolvent show that the ultimate responsibility for

insurance coverage provided by Parthenon remained with HCA.   We

agree that those are factors to consider but conclude they are

not dispositive of the instant case.

     HCA and the sister subsidiaries made the reserve

strengthening payments following determinations by Parthenon's

consulting actuary that Parthenon's reserves were not adequate

because its losses were developing more adversely than originally

estimated.   The payments were treated as insurance premiums not

only by petitioners but also by the Department of Insurance and

by Blue Cross acting in its capacity as intermediary for HCFA.

The need for the additional payments arose not because Parthenon



13
   (...continued)
Parthenon's workers' compensation obligations to the extent and
during the time that the indemnity agreement with Ideal Mutual
was in effect.
                              - 70 -


was thinly capitalized, but because, when the reserve

strengthening payments were made, earlier actuarial projections

made by Parthenon's independent consulting actuaries of unpaid

losses appeared insufficient to cover all of those losses.    Under

the circumstances, we conclude that HCA and the sister

subsidiaries made the reserve strengthening payments to secure

insurance protection and that the fact of such payments does not

require a conclusion that the insurance arrangement with

Parthenon was a sham.   Additionally, we believe that HCA's

decision to pay the Florida workers' compensation claims rather

than having the hospitals' assets frozen by the State of Florida

was a sound business decision relating to the continued

operations of those hospitals, and not evidence of a sham

arrangement with Parthenon.

     Respondent contends further that the premiums for the 1986,

1987, and 1988 policy years were understated while the premium

for the 1984 policy year was overstated.   Respondent relies on

Mr. Merlino's opinion to support that contention.   Petitioners

contend that their independent actuarial consultants recommended

the premiums based on estimates of the risks assumed by

Parthenon.   Petitioners contend that whether the actuarial

calculations produced premiums that proved to be higher or lower
                                - 71 -


than the losses actually incurred does not mean that the

actuarial opinions were wrong or misstatements of the premium

amounts.   The premiums were neither subject to change at the whim

of HCA or its officers nor calculated so as to give petitioners

an unwarranted tax advantage.    Accordingly, assuming arguendo

that the premiums were understated for 1984 or overstated for

1986, 1987, or 1988, we conclude that in the instant case the

understatement and overstatements would not render the insurance

arrangement between Parthenon and HCA and the sister subsidiaries

a sham.

     Another distinction between Humana and the instant case is

that HCI filed a separate return from Humana and the sister

subsidiaries while in the instant case Parthenon filed its return

on a consolidated basis with HCA and the sister subsidiaries.

Although filing a consolidated return may be a factor to consider

in analyzing whether a transaction is bona fide, we do not find

the factor conclusive as to respondent's contention that the

arrangement in the instant case was a sham.    A consolidated

income tax return treats members of the affiliated group as a

single entity for some purposes and as separate entities for

other purposes.   1 Lerner et al., Federal Income Taxation of

Corporations Filing Consolidated Returns 6-1 to 6-2 (1996).     The
                                - 72 -


consolidated return regulations in effect for the years in issue

calculate income of each corporation in an affiliated group

separately as a threshold matter and for that purpose treat each

member of a consolidated return as a separate corporation.     1

Peel, 1 Consolidated Tax Returns sec. 1:01, at 1-2 (3d ed. 1992).

In that respect the tax treatment of insurance premiums is

reflected on a separate basis, not on a consolidated basis.      HCA,

moreover, operated Parthenon as a separate entity.    It was

separately staffed and managed.    It maintained its own personnel

files, accounting records, information management system, cash

management system, and banking arrangements.

     The consolidated return regulations require that a parent's

basis in the stock of its subsidiary be adjusted on the basis of

the subsidiary's earnings and profits.    CSI Hydrostatic Testers,

Inc. v. Commissioner, 103 T.C. 398, 404 (1994), affd. 62 F.3d 136

(5th Cir. 1995).   Pursuant to section 1.1502-32(b)(1)(ii), Income

Tax Regs., a positive basis adjustment is to be made in an amount

equal to an allocable part of the undistributed earnings and

profits of a subsidiary for the taxable year.    CSI Hydrostatic

Testers, Inc. v. Commissioner, supra at 410.    The net positive or

negative adjustment only affects HCA, however, inasmuch as it is

Parthenon's sole stockholder.    The basis adjustment does not
                             - 73 -


affect the existence of Parthenon as a separate corporate entity.

Accordingly, we conclude that the fact that Parthenon filed on

the consolidated return with HCA and the sister subsidiaries does

not render the insurance arrangement between Parthenon and HCA

and the sister subsidiaries a sham.

     Additionally, respondent further contends that HCA's use of

a $2,250,000 dividend from Parthenon to effectuate the formation

of PCIC, the failure of HCA and the sister subsidiaries to timely

pay quarterly premiums for the 1986 policy year, and the

calculation of the premium for the 1986 claims-made policy on the

rate for an occurrence basis policy, show that Parthenon was

controlled at all times by HCA for HCA's benefit and support a

conclusion that the insurance arrangement between Parthenon and

HCA and the sister subsidiaries was a sham.   Although those

events are factors to consider, we do not find them dispositive.

Respondent does not contend that payment of the dividend to HCA

or its use in forming a surplus lines insurance company was

prohibited by statute or regulation.   HCA formed PCIC because, as

a captive insurer, Parthenon could not provide medical

malpractice insurance to unrelated parties.   HCA and the sister

subsidiaries delayed payment of the 1986 quarterly premiums while

HCA management reconsidered its insurance objectives.    The 1986
                                - 74 -


premium was calculated on an occurrence policy basis to increase

Parthenon's reserves.    There is no evidence that decisions to pay

the dividend, establish PCIC, delay payment of the 1986 quarterly

premiums, or calculate the 1986 premium using an occurrence

policy basis were tax motivated.

     Accordingly, considering all of the facts and circumstances

presented in the instant case, we conclude that the transactions

between Parthenon and HCA and the sister subsidiaries constituted

a bona fide insurance arrangement.

The Sister Subsidiaries Shifted Risks to Parthenon

     Under the rationale of Humana Inc. v. Commissioner, 881 F.2d

247 (6th Cir. 1989), petitioners do not contend that HCA shifted

its own insurance risks to Parthenon.     Petitioners do contend,

however, that the sister subsidiaries shifted their insurance

risks to Parthenon.     Respondent contends that no risk shifting

occurred.

     Petitioners contend that, pursuant to Humana, the economic

impact of loss payments on the assets of the insured must be

analyzed to determine whether risks have shifted.     Petitioners

contend that in the instant case, when losses occurred and were

paid by Parthenon, the sister subsidiaries' balance sheets and

net worth were unaffected by the payment.     Accordingly,
                              - 75 -


petitioners contend, the sister subsidiaries' premium payments

shifted their risks to Parthenon.    We agree.   Under the balance

sheet and net worth analysis adopted by the Court of Appeals for

the Sixth Circuit in Humana Inc. v. Commissioner, supra, the

sister subsidiaries shifted insurance risks to Parthenon, except

for the workers' compensation liability covered by the

indemnification agreement between HCA and Ideal Mutual.    Pursuant

to Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th Cir.

1995), there is no risk shifting of the workers' compensation

liability that was subject to the indemnification agreement

between HCA and Ideal Mutual, and, consequently, any addition to

the workers' compensation reserves attributable to the Ideal

Mutual policies is not deductible.

     Accordingly, we conclude that Parthenon provided insurance

for the sister subsidiaries for the years in issue and, thus,

functioned as an insurance company.    Sec. 816(a); see also sec.

1.801-3(a)(1), Income Tax Regs.

     The second issue we must decide is what portion of

Parthenon's reserves for unpaid losses and expenses is deductible

for the years in issue.   The parties have agreed as to all

adjustments relating to Parthenon's unpaid losses reserves except

the question of whether any or all of the adjustments set out in
                               - 76 -


the report of respondent's expert, Mr. Merlino, should be made.

Should we decide that a portion, but not all, of the reserve

adjustments proposed by Mr. Merlino should be made, the parties

have agreed upon a methodology for computing the resulting

adjustments to income.

     Section 831 imposes taxes computed as provided in section 11

on the taxable income of insurance companies other than life

insurance companies.14   Section 832(c) provides deductions

for purposes of computing the taxable income of an insurance

company, inter alia, for all ordinary and necessary expenses

incurred and for losses incurred.   Sec. 832(c)(1), (4).15

Section 832(b)(5)16 defines "losses incurred" as an amount equal

14
     For taxable years beginning prior to Jan. 1, 1987, sec. 831
imposed tax as provided in sec. 11 on insurance companies other
than life insurance companies and mutual insurance companies.
15
     Sec. 832(c) provides in pertinent part as follows:

     (c) DEDUCTIONS ALLOWED.--In computing the taxable income of
an insurance company subject to the tax imposed by section 831,
there shall be allowed as deductions:

          (1) all ordinary and necessary expenses incurred, as
     provided in section 162 (relating to trade or business
     expenses);
          *       *       *       *       *       *       *
          (4) losses incurred, as defined in subsection
     (b)(5) of this section;

16
     For tax year ended 1986, sec. 832(b)(5) provides as follows:
                                                   (continued...)
                               - 77 -


to (1) the losses paid during the taxable year, (2) reduced by

salvage and reinsurance recovered during that year, (3) plus all

unpaid losses (discounted for years after 1986) outstanding at


16
     (...continued)
            (5) LOSSES INCURRED.--The term "losses incurred" means
       losses incurred during the taxable year on insurance
       contracts, computed as follows:

                (A) To losses paid during the taxable year, add
      salvage and reinsurance recoverable outstanding at the end
      of the preceding taxable year and deduct salvage and
      reinsurance recoverable outstanding at the end of the
      taxable year.

                (B) To the result so obtained, add all unpaid
      losses outstanding at the end of the taxable year and
      deduct unpaid losses outstanding at the end of the
      preceding taxable year.

For tax years ended 1987 and 1988, section 832(b)(5)(A) provides
as follows:

           (5)LOSSES INCURRED.--

                (A) In general.--The term "losses incurred" means
           losses incurred during the taxable year on insurance
      contracts, computed as follows:

                     (i) To losses paid during the taxable year,
           add salvage and reinsurance recoverable outstanding at
           the end of the preceding taxable year and deduct
           salvage and reinsurance recoverable outstanding at the
           end of the taxable year.
                     (ii) To the result so obtained, add all
           unpaid losses on life insurance contracts plus all
           discounted unpaid losses (as defined in section 846)
           outstanding at the end of the taxable year and deduct
           unpaid losses on life insurance contracts plus all
           discounted unpaid losses outstanding at the end of the
           preceding taxable year.
                              - 78 -


the end of the taxable year, (4) less all unpaid losses

outstanding at the end of the preceding taxable year, (5) plus

estimated salvage and reinsurance recoverable at the end of the

preceding taxable year, (6) less estimated salvage and

reinsurance recoverable at the end of the taxable year.       The

portion of "losses incurred" that represents unpaid losses must

comprise only actual unpaid losses as nearly as it is possible to

ascertain them.   Sec. 1.832-4(b), Income Tax Regs.17   The

estimate of actual outstanding unpaid losses must be fair and

reasonable based on the facts in each case and the company's

experience with similar cases.   Id.



17
     Sec. 1.832-4(b), Income Tax Regs., provides as follows:

     (b) Losses incurred. Every insurance company to which this
     section applies must be prepared to establish to the
     satisfaction of the district director that the part of the
     deduction for "losses incurred" which represents unpaid
     losses at the close of the taxable year comprises only
     actual unpaid losses. See Section 846 for rules relating to
     the determination of discounted unpaid losses. These losses
     must be stated in amounts which, based upon the facts in
     each case and the company's experience with similar cases,
     represent a fair and reasonable estimate of the amount the
     company will be required to pay. Amounts included in, or
     added to, the estimates of unpaid losses which, in the
     opinion of the district director, are in excess of a fair
     and reasonable estimate will be disallowed as a deduction.
     The district director may require any insurance company to
     submit such detailed information with respect to its actual
     experience as is deemed necessary to establish the
     reasonableness of the deduction for "losses incurred."
                                - 79 -


       The reserve for unpaid losses at the end of the taxable year

is an estimate, made at the close of the current taxable year, of

the insurer's liability for claims that it will be required to

pay in future years.     Home Mutual Ins. Co. v. Commissioner, 70

T.C. 944, 951 (1978), affd. in part, revd. in part and remanded

639 F.2d 333 (7th Cir. 1980); Western Casualty & Surety Co. v.

Commissioner, 65 T.C. 897, 917 (1976), affd. on another issue 571

F.2d 514 (10th Cir. 1978).     The unpaid loss reserve at the end of

the taxable year for purposes of computing the "losses incurred"

deduction consists of the aggregate unpaid loss reserves for all

lines of business of the insurance company.     Hanover Ins. Co. v.

Commissioner, 69 T.C. 260, 271 (1977), affd. 598 F.2d 1211 (1st

Cir. 1979); Western Casualty Surety Co. v. Commissioner, supra at

917.18    The resolution of a fair and reasonable estimate of a

taxpayer's unpaid losses is essentially a valuation issue and a

question of fact.     Hanover Ins. Co. v. Commissioner, supra at

270.     Calculation of unpaid losses may not be based on estimates

of potential losses that might be incurred in future years.



18
     See also Rev. Proc. 75-56, 1975-2 C.B. 596, 597, sec. 3.03
(the deduction for unpaid losses incurred shall be the aggregate
of the reasonable estimates for each line of business at the end
of each taxable year). Rev. Proc. 75-56 sets forth procedures
for computing the deduction for losses incurred pursuant to sec.
832(b)(5).
                                - 80 -


Rather, unpaid losses must be based on the actual loss experience

of the insurance company.    See Maryland Deposit Ins. Fund Corp.

v. Commissioner, 88 T.C. 1050, 1060 (1987); Modern Home Life Ins.

Co. v. Commissioner, 54 T.C. 935, 939-940 (1970).    The taxpayer

has the burden to establish "to the satisfaction of the district

director" that the unpaid losses comprise actual unpaid losses.

Sec. 1.832-4(b), Income Tax Regs.; see also Hanover Ins. Co. v.

Commissioner, supra.

     Based on Mr. Merlino's calculations, respondent contends

that, when established, the unpaid loss reserves claimed by

Parthenon for years ended 1984, 1986, 1987, and 1988 were not

reasonable based on acceptable actuarial methods within the

meaning of section 832(b)(5).    Respondent contends that

Parthenon's professional and general liability reserves should be

increased for year ended 1984 by $16,177,587 and decreased for

years ended 1986, 1987, and 1988 by $67,384,000, $14,978,000, and

$29,058,000, respectively.   Additionally, respondent contends

that Parthenon's workers' compensation liability reserve should

be increased for years ended 1984, 1987, and 1988 by $6,098,709,

$4,131,000, and $3,616,000, respectively.    Accordingly,

respondent contends that net adjustments to Parthenon's total
                              - 81 -


reserves for years ended 1984, 1986, 1987, and 1988 should be

made as follows:

                                     Increase (Decrease)
          TYE                         in Total Reserves

           1984                          $22,276,000
           1986                          (67,384,000)
           1987                          (10,847,000)
           1988                          (25,442,000)

An increase in reserve results in a larger allowable deduction

and a decrease in reserve results in a smaller allowable

deduction for the applicable year.

     Petitioners do not dispute the increase in reserves for

unpaid losses proposed by Mr. Merlino for year ended 1984, but

they deny that any adjustment to the reserves is required for

years ended 1986, 1987, and 1988.    They contend that the reserves

for years ended 1986 through 1988 fall within the range of

reasonable estimates made at the time by Parthenon's independent

consulting actuary.

     Petitioners presented Mr. Biscoglia as their expert witness

relating to the reasonableness of the professional and general

liability reserves of Parthenon and PCIC as of December 31, 1986.

For purposes of the trial, Mr. Biscoglia did not perform a

subsequent independent analysis of the reserves as of yearend

1986.   Rather, he reviewed the reserve analysis report dated
                               - 82 -


February 17, 1987 (1986 report), that had been prepared

previously for Parthenon.    In his expert witness report, Mr.

Biscoglia concluded that the 1986 report had employed accepted

and commonly used actuarial techniques, methodologies, and

assumptions.    He further concluded that the aggregate $187

million discounted reserves carried by Parthenon and PCIC for

year ended 1986 were reasonable relative to the $176 million to

$203 million range for the discounted reserves that was estimated

for both companies in the 1986 report.

     Additionally, petitioners contend that the reserves recorded

on Parthenon's annual statements for years ended 1987 and 1988

represent fair and reasonable estimates of the loss and loss

expense payments that Parthenon would be required to make in

future years.    In support of that contention, petitioners rely on

the reserve analysis reports Mr. Biscoglia prepared during 1988

(for 1987 reserve requirements) and 1989 (for 1988 reserve

requirements).

     Respondent contends that the reserve analysis reports

prepared by Mr. Biscoglia are irrelevant because they deal with

both Parthenon and PCIC and the reserves applicable to each

company cannot be segregated from the overall reserves applicable

to both of them.    Respondent contends further that, inasmuch as
                              - 83 -


Mr. Biscoglia's reserve analysis report for the policy year 1986

addresses only professional and general liability reserves, he

cannot render an opinion as to the adequacy of the total loss and

loss expense reserves of Parthenon.    Additionally, respondent

contends that petitioners' computations that are based on Mr.

Biscoglia's 1986 report are not relevant to the fairness and

reasonableness of the unpaid losses reserves because Mr.

Klaassen, not Mr. Biscoglia, served as Parthenon's actuary for

year ended 1986.   Respondent contends further that Mr. Klaassen's

computations are erroneous because they are based on an

occurrence policy rather than a claims-made policy.    Respondent

maintains that the adjustments to the unpaid losses reserves

proposed by Mr. Merlino are correct.

     Petitioners contend that Mr. Biscoglia's reserve analysis

reports are relevant even though they address both Parthenon and

PCIC because the relevant question in the consolidated return

setting is whether the total reserves for both companies are

reasonable in each applicable year.    Additionally, petitioners

contend, the 1986 annual statements of Parthenon and PCIC show

the respective reserve amounts that each booked.

     Mr. Merlino did not calculate independently the amount or

range that he believes represents a fair and reasonable estimate
                                - 84 -


of the unpaid losses and expenses that Parthenon actually would

pay out.   Rather, for purposes of his reserve recommendations,

Mr. Merlino focused on the reasonableness of the reserves from

the viewpoint of whether the unpaid losses reserves as reported

by Parthenon on its annual statements were either inadequate or

excessive in comparison to the reserves recommended by

Parthenon's independent consulting actuary.

     With respect to the 1984 policy year, Mr. Merlino concluded

that Parthenon had recorded total reserves in an amount that was

$22,276,000 below the actuary's recommendation, and he

recommended an upward reserve adjustment in that amount.      As

stated above, neither party disputes the accuracy of the

adjustment for the year ended 1984.      Accordingly, we accept as

reasonable the increase in the unpaid losses reserves for that

year proposed by Mr. Merlino.

     With respect to the 1986 policy year, Mr. Merlino concluded

that the professional and general liability reserves were

overstated by $67,384,000.   Mr. Merlino calculated that

adjustment by (1) reducing to $221 million the undiscounted

reserve estimate of $238 million selected by Parthenon (to

conform the unpaid losses reserve to Mr. Klaassen's original

estimated recommended reserve level), and then (2) reducing that
                              - 85 -


$221 million by approximately $50 million to correct for Mr.

Klaassen's use of occurrence policy factors in formulating his

estimate.   Mr. Merlino ignored the $218 million to $250 million

range that Mr. Biscoglia recommended for the general and

professional liability reserves for the 1986 policy year because

of Mr. Merlino's belief that Mr. Klaassen served as Parthenon's

consulting actuary for purposes of establishing the unpaid losses

reserves for that year.   That belief is based on the fact that

Mr. Klaassen certified the adequacy of the reserves for the 1986

policy year.

     The assumption that Mr. Klaassen served as Parthenon's

actuary for purposes of establishing the 1986 policy year unpaid

losses reserve levels is not supported by the record.   The

recommended reserve levels generally are calculated shortly after

the close of the policy year for which the reserves relate.    Both

Mr. Klaassen and Mr. Biscoglia testified that Mr. Biscoglia

replaced Mr. Klaassen as Parthenon's actuary during 1986.

Additionally, the reserve recommendation report prepared by Mr.

Klaassen for the 1986 policy year specifically states that he was

requested to supply a second opinion relating to the reserves for

professional liability losses and loss expenses as of the end of

1986.   Based on the foregoing, we are persuaded that Mr.
                              - 86 -


Biscoglia, not Mr. Klaassen, served in the function of

Parthenon's consulting actuary for purposes of computing

recommended unpaid losses reserves for the 1986 policy year.

     Mr. Merlino's challenge to the reasonableness of the unpaid

losses reserves Parthenon claimed for the year ended 1986 is

focused on the variance between the amount Parthenon reported on

its annual statement for that year and the amount recommended by

the consulting actuary.   The $238 million unpaid losses reserve

Parthenon reported for the year ended 1986 for professional and

general liabilities is within the range of reasonable reserves

recommended by Mr. Biscoglia for that year.   Mr. Merlino did not

challenge the unpaid losses reserves for any other line of

business carried by Parthenon.   Accordingly, the adjustment to

the unpaid losses reserves proposed by Mr. Merlino for the year

ended 1986 finds no support in the record.

     Respondent's other arguments relating to the reasonableness

of the unpaid losses reserves for the 1986 policy year are

irrelevant in light of the parties' stipulation that:    "In the

event that the Court concludes [which we have] that Parthenon is

an insurance company, the parties have agreed on all adjustments

to reserves except for the single issue whether all or any

portion of the reserve adjustments proposed by respondent's
                              - 87 -


expert witness Matthew P. Merlino and set out in his report dated

October 27, 1994, should be made."     Mr. Merlino's adjustment for

the year ended 1986 is based on an erroneous assumption and is

not otherwise supported in the record.    Accordingly, we conclude

that the adjustment proposed by Mr. Merlino for year ended 1986

is not warranted.

     With respect to the 1987 and 1988 policy years, Mr. Merlino

proposed adjusting Parthenon's reserves to conform to the

reserves recommended in Mr. Biscoglia's reserve analysis reports

for those years, but after first reducing the workers'

compensation reserves by $12.5 million for 1987 and $11.2 million

for 1988.   For policy years 1987 and 1988, Mr. Biscoglia had

recommended unpaid losses reserves for workers' compensation

liabilities of $67,289,000 and $72,217,000, respectively.     On the

annual statements for those years, Parthenon had reported unpaid

losses reserves for workers' compensation liabilities of

$50,551,000 and $57,417,000, respectively.

     The workers' compensation policy for 1987 and 1988 was

retrospective.   Parthenon accordingly received a premium

installment in the year of coverage (policy year) that was

designed to cover only a portion of the ultimate losses

anticipated on that line of business for that year.    During the
                              - 88 -


next year (retrospective year), Parthenon received a

retrospective premium that was designed to cover the remaining

losses for the policy year.

     In his calculation of the workers' compensation unpaid

losses reserve requirements for the policy year, Mr. Biscoglia

estimated workers' compensation reserves for the entire year

(including the portion of the liability paid during the

retrospective year).   On the annual statement for the policy

year, however, Parthenon reported workers' compensation

liabilities relating only to the first-year installment premium.

Parthenon recorded the balance of the expected losses for the

policy year on the annual statement for the retrospective year

when the retrospective premium was paid.

     In calculating his adjustment to the workers' compensation

unpaid losses reserves, Mr. Merlino reduced Mr. Biscoglia's

estimate of the required workers' compensation unpaid losses

reserve for each year to exclude the portion of the workers'

compensation unpaid losses reserve related to the retrospective

payment because he believed that petitioners would receive an

undue tax advantage if Parthenon were allowed to deduct the total

liability for the policy year without at the same time recording

an offsetting amount of premium income.
                              - 89 -


     Petitioners contend that the unpaid losses reserve for

workers' compensation liabilities should include the total

anticipated liability regardless of the year during which payment

is recorded.   We agree with petitioners.   We find no basis for

Mr. Merlino's adjustment in the workers' compensation unpaid

losses reserves to account for unpaid premiums.    Section 832(c)

provides a deduction from the taxable income of an insurance

company for "losses incurred" during the taxable year.    Losses

incurred includes a fair and reasonable estimate of actual

outstanding unpaid losses that an insurance company will be

required to pay sometime in the future.     Sec. 1.832-4(b), Income

Tax Regs.   Neither the Code nor the regulations correlate unpaid

losses to premiums paid.   Accordingly, we conclude that Mr.

Merlino's reduction of the unpaid losses reserve of $12.5 million

for 1987 and $11.2 million for 1988 is not warranted.

     Mr. Merlino further reduced the unpaid losses reserves for

years ended 1987 and 1988 to conform the claimed unpaid losses

reserves for workers' compensation and professional and general

liabilities to the unpaid losses reserves for those lines of

business recommended in Mr. Biscoglia's reserve analysis reports

for those years.   Respondent contends that those adjustments are

required to bring the reserves to a level which meets the fair
                             - 90 -


and reasonable test of section 1.832-4(b), Income Tax Regs.

Petitioners contend that the adjustments are not required because

the unpaid losses reserves for years ended 1987 and 1988 fall

within the range of reasonable estimates made by Mr. Biscoglia.

Petitioners contend that Mr. Merlino's conclusion that the

reserves should be reduced to the extent that the amounts exceed

the amounts set out in Mr. Biscoglia's reserve analysis reports

is incorrect inasmuch as the total reserves recorded by Parthenon

fall within the ranges he recommended.

     We agree with petitioners that the aggregate unpaid losses

reserves for all lines of business for the applicable year, and

not the individual reserves for each line of business, must meet

the fair and reasonable test, Hanover Ins. Co. v. Commissioner,

69 T.C. at 271; Western Casualty Surety Co. v. Commissioner, 65

T.C. at 917, 919, but we do not agree that Mr. Biscoglia's

reserve analysis reports and testimony establish that Parthenon's

total unpaid losses reserves for years ended 1987 and 1988 in

fact represent fair and reasonable estimates of Parthenon's

actual unpaid losses and expenses.    Petitioners have the burden

of establishing that the unpaid losses comprise actual unpaid

losses, Hanover Ins. Co. v. Commissioner, supra at 270, but have

failed to do so in the instant case.
                              - 91 -


     Petitioners contend that Mr. Merlino's adjustments for years

ended 1987 and 1988 do not take into account that the total

reserves are in fact within the range that Mr. Biscoglia

recommended.   The reserve analysis reports relating specifically

to Parthenon for years ended 1987 and 1988, however, do not

delineate recommended ranges for Parthenon's unpaid losses

reserves for professional and general liabilities for those

years.   Rather, they set forth fixed dollar values for those

reserves.   On brief, petitioners attempt to extrapolate a

recommended range for Parthenon's unpaid losses reserves for

professional and general liabilities for each year based on data

setting forth recommended   ranges for unpaid losses reserves for

all of HCA's and the sister subsidiaries' professional and

general liabilities, including liabilities funded internally and

those transferred to HCA's captive insurance companies.    The

consolidated reports prepared for that purpose make no attempt to

distribute the recommendations among the various entities.    We

are not prepared to accept petitioners' naked assertion on brief

that the assumptions and principles petitioners used to

extrapolate ranges for the unpaid losses reserves for Parthenon's

professional and general liabilities approximate fair and

reasonable estimates of Parthenon's actual outstanding unpaid
                             - 92 -


losses for the years ended 1987 and 1988.   Mr. Biscoglia's

summary testimony that he examined the reserves recorded by

Parthenon for 1987 and 1988 and found that the total amounts were

within an acceptable range for each year is not supported by any

detailed explanation or documentation.   Mr. Merlino, on the other

hand, in his expert report compared the ultimate losses recorded

on Parthenon's annual statements as of yearend 1987 and as of

yearend 1988 for the 1984 through 1988 policy years with the

ultimate losses recorded on the annual statement as of yearend

1993 and concluded that the comparison indicated that the

professional and general liability reserves for policy years 1987

and 1988, in retrospect, were materially overstated.   Based on

the foregoing, we conclude that petitioners have not established

the reasonableness of the unpaid losses reserves they are

claiming for the unpaid professional and general liability

losses, and, therefore, in keeping with the parties' stipulation,

we hold that the adjustments proposed by Mr. Merlino conforming

the unpaid losses reserves for workers' compensation and

professional and general liabilities for the years ended 1987 and

1988 to the amounts recommended in Mr. Biscoglia's reserve

analysis reports for those lines of business should be made.
                               - 93 -


     In his report, Mr. Merlino recommends adjustments to

Parthenon's workers' compensation unpaid losses reserves and

professional and general liabilities reserves to conform those

reserves to the amounts recommended by Mr. Biscoglia.   Respondent

has adopted Mr. Merlino's position to support the Government's

position.   We deem that action to be a concession by respondent

that the values recommended by Mr. Biscoglia for the unpaid

losses reserves for workers' compensation and professional and

general liabilities are a fair and reasonable estimate of

Parthenon's actual unpaid losses for those lines of business for

years ended 1987 and 1988.   In his report Mr. Merlino proposes no

adjustment to the unpaid losses reserves for other lines of

business carried by Parthenon for years ended 1987 and 1988.    We

deem that inaction as a concession by respondent that the

reserves for those lines of business are a fair and reasonable

estimate of Parthenon's actual unpaid losses for those lines of

business for those years.    We conclude that Parthenon is entitled

to deduct additions to its reserves for the years in issue in

amounts to be calculated by the parties in accordance with their

stipulations and the foregoing.

     Additionally, respondent contends that petitioners have

failed to substantiate their claims regarding the reserves in
                                - 94 -


question because respondent is not able to review the methods and

assumptions underlying petitioners' actuary's work inasmuch as

petitioners did not supply sufficient information and they did

not reconcile the actuarial information presented at trial with

the annual statements of Parthenon and PCIC.       We view

respondent's substantiation argument as a separate issue from

whether Mr. Merlino's adjustments are correct, and, thus, that

position is contrary to the parties' stipulation.       In the Tax

Court, a stipulation is treated as a conclusive admission by the

parties, and the Court will not permit a party to change or

contradict a stipulation, except in extraordinary circumstances.

Rule 91(e); Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976).

We find no extraordinary circumstances present here to cause us

to disregard the stipulation.    Accordingly, we do not address

respondent's argument that petitioner failed to provide

sufficient information or to reconcile the actuarial information

presented at trial with the annual statements of Parthenon and

PCIC.

     To reflect the foregoing,


                                      Decisions will be entered

                                 under Rule 155.
