t c memo united_states tax_court hospital corporation of america and subsidiaries petitioners v commissioner of internal revenue respondent docket nos filed date 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 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 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 n jerold cohen reginald j clark randolph w thrower walter t henderson jr and john w bonds jr for petitioners in docket no 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 respondent determined deficiencies in petitioners' consolidated corporate federal_income_tax as follows 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 tcmemo_1996_105 107_tc_73 and 107_tc_116 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 tcmemo_1996_559 we decided a depreciation issue in 109_tc_21 the instant opinion involves the last remaining issues for decision which issues the parties have denominated the captive insurance or parthenon insurance co issues tye deficiency dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure 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 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 if parthenon is an insurance_company what portion of its unpaid loss_reserves and expenses are deductible pursuant to sec_832 in accordance with the holding of the court_of_appeals for the sixth circuit in 881_f2d_247 6th cir affg in part and revg in part 88_tc_197 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 findings_of_fact some of the facts have been stipulated for trial pursuant to rule 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 under the laws of the state of tennessee as park view hospital inc during park view hospital inc joined with 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 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 on date 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 date hca again went public and changed its name to hca-hospital corporation of america on date 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 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 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 see hospital corp of am v commissioner tcmemo_1996_ for a detailed description of petitioners' hospital operations we incorporate herein our findings_of_fact contained in that memorandum opinion 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 through as of yearend hca owned the following number of subsidiaries and hospitals and had the following number of patient beds year number of subsidiaries hospitals owned patient beds big_number big_number big_number big_number big_number big_number big_number big_number 1during pursuant to a plan_of_reorganization petitioners divested 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 tcmemo_1996_559 for a detailed description of that transaction prior to calendar_year 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 admitted companies admitted insurance_companies can insure any insurable risk other insurance_companies may be licensed to write only on a surplus lines basis ie 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 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 dollar_figure and accumulated surplus of dollar_figure 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 dollar_figure with the surplus to be at least dollar_figure 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 ie the net_worth of an insurance_company to be no greater than to 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 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 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 to 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 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 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 through 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 and over a 4-year transition_period a significant part of medicare 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 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 the prospect of federal_income_tax deductions for the reserve sec_5 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 hca formed parthenon as a wholly owned subsidiary under the colorado captive insurance statute colorado rev stat secs to now codified at secs to hca management expected that in western natl mut ins co v commissioner 102_tc_5 affd 65_f3d_90 8th cir we defined the term reserve as follows in the insurance industry a policy reserve represents a liability ie 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 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 dollar_figure dollar_figure 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 date 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 dollar_figure per occurrence and was a claims-made policy form a 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 was dollar_figure that amount compared to a quotation of dollar_figure 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 dollar_figure 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 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 date on date 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 date 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 until date when he became president mr pierson continued as president of parthenon until date william w mcinnes became president of parthenon as of date he served in that position throughout the remainder of the years in issue 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 date hca contributed an additional dollar_figure million to parthenon as paid-in capital during date 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 ie 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 date 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 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 couch on insurance 3d sec_1 pincite to insurance as a condition to ideal mutual's willingness to complete the transaction hca executed a date 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 through 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 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 eg 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 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 date and on that date applied for a certificate of authority to transact insurance_business under the tennessee captive insurance statute on date parthenon insurance co colorado was merged into parthenon insurance co of tennessee hereinafter also referred to as parthenon which latter company became the surviving corporation during date 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 and an actuarial review effective date 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 date 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 date mr reeves as president of parthenon requested that hca contribute an additional dollar_figure 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 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 and 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 parthenon had employees by parthenon had employees during date all of the hca companies underwent a reduction in force and accordingly parthenon's staff was reduced by employees 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 through date parthenon occupied quarters in a building owned by hca from date to date the offices of parthenon were in a building leased by hca during the period through date 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 date 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 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 through parthenon issued to petitioners annual policies providing dollar_figure million in primary comprehensive hospital liability comprehensive personal injury liability comprehensive property damage liability and advertising liability coverages for the years through 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 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 retroactive date which in the instant case was date during through 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 date 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 date between hca and the superintendent of insurance of the state of new york as rehabilitator of ideal mutual after parthenon reinsured the workers'_compensation risks assumed by continental receiving the premium less a ceding commission designed to cover 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 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 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 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 ie by the application of statutorily-set rates per dollar of payroll commencing policy year the underlying workers'_compensation policies were rated retrospectively ie 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 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 percent of total_reserves at date and parthenon is not claiming a deduction for an addition to its reserves for those liabilities during policy years through 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 parthenon ceded all potential liabilities in excess of dollar_figure per occurrence to reinsurers liabilities in the layer dollar_figure excess of dollar_figure were ceded to general reinsurance corp general re the largest reinsurance company in the united_states_liabilities in the layer dollar_figure million excess of dollar_figure million were ceded percent to general re and percent to various syndicates at lloyds of london the remaining liabilities were ceded percent to general re percent to ina reinsurance co and 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 during policy years after general re and parthenon entered into an agreement rescinding the reinsurance formerly provided by general re in the layer dollar_figure excess of dollar_figure with the result that parthenon thereafter effectively retained dollar_figure million in liability exposure for its own account until when the retention was increased to dollar_figure million through policy year parthenon reinsured its excess exposures in a manner similar to the reinsurance arrangements described above for policy year respondent does not dispute deductions for the reinsurance premiums formation of parthenon casualty insurance_company during 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 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 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 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 date 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 date pcic declared and paid to hca a dividend in the amount of dollar_figure hca contributed that dividend to new parthenon as paid-in_surplus during and subsequent years pcic issued policies to individual physicians the employees of new parthenon and pcic during 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 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 basis new parthenon and pcic executed a portfolio transfer reinsurance agreement during 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 date 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 through is as follows year total capital and surplus dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number 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 dollar_figure dividend paid to hca during 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 actuarial services regarding premium rates were provided by wyatt principally through eldon klaassen mr klaassen a consulting actuary for a portion of policy year 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 actuaries 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 average occupied beds emergency room patient visits for those hospitals choosing emergency room physicians' coverage and after 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 the parties stipulated that wyatt co wyatt provided actuarial services to parthenon through policy year and that mr biscoglia provided actuarial services for policy years after both mr klaassen and mr biscoglia however testified that wyatt was replaced during 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 66_tc_312 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 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 through 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 reserve strengthening payment 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 dollar_figure dollar_figure - 1dollar_figure big_number big_number dollar_figure big_number big_number - - big_number big_number - - big_number 1allocated to reserves for years ended through 2allocated to reserves for years ended through as of yearend and parthenon recorded additional_amounts of dollar_figure million and dollar_figure million respectively as 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 of the tax_reform_act_of_1986 tra-1986 publaw_99_514 100_stat_2404 or within a technical meaning commonly understood by the insurance industry see eg western natl mut ins co v commissioner supra atlantic mut ins co v commissioner tcmemo_1996_75 revd 111_f3d_1056 3d cir sec_1_846-3 income_tax regs the parties have reached an agreement on the computation of the fresh_start provisions of sec_1023 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 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 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 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 policy year subsequently charles l kown associate general counsel of hca and a board member and secretary of parthenon wrote parthenon's president on date 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 premiums during late 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 ie 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 record for each of its accident years ie 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 of the previous year for and prior years reserve studies were made under the direction of mr klaassen for and later years reserve studies were made by mr biscoglia during late 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 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 date 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 insuring all losses from occurrences in the policy year to insuring only those losses that resulted in claims made during the year during date mr biscoglia estimated that the general and professional liability reserves needed as of yearend were in a range between dollar_figure million and dollar_figure million on an undiscounted basis and in a range between dollar_figure million and dollar_figure 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 date and he recommended reserves for parthenon and pcic of approximately dollar_figure million on an undiscounted basis and dollar_figure million on a discounted basis mr klaassen also suggested an undiscounted value of dollar_figure million or dollar_figure million on a discounted basis if parthenon wanted an percent probability that the reserve would be adequate mr klaassen did not know that parthenon had adopted a claims-made policy for the policy year had he known the portion of his estimate attributable to the occurrences would have been reduced by about percent during date parthenon requested and received permission from the department of insurance to reduce the amount of the reserves for losses and expense payments that it was required to fund by discounting its professional liability reserves parthenon requested permission to book total_reserves of dollar_figure 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 date mr klaassen certified that the amounts carried on parthenon balance sheets on account of reserves for unpaid_losses and loss adjustment expense for yearend 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 dollar_figure represented the total of what then already was booked as liability reserves on parthenon's books and dollar_figure 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 date of dollar_figure million over and above the dollar_figure million reserves for the 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 dollar_figure 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 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 annual_statement based on a dollar_figure million discounted general and professional liability reserve mr mackie used discount factors to calculate that parthenon would need an undiscounted reserve of approximately dollar_figure million for unpaid_losses and expenses relating to the general and professional liability insurance that it had issued though for and thereafter the liability policy issued by parthenon to petitioners was modified to incorporate a dollar_figure million deductible causing petitioners to be substantially self- insured for general and professional liability risks for policy years after 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 and charges to hospitals were made on the basis of actuarial calculations of loss experience beginning in as a result of the retrospectively rated premium plan for workers'_compensation insurance during policy years and 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 during and 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 and are as follows general and workers' professional compensation liability total annual_statement dollar_figure dollar_figure dollar_figure actuary's recommendation big_number big_number big_number difference big_number big_number big_number general and workers' professional compensation liability total annual_statement dollar_figure dollar_figure dollar_figure actuary's recommendation big_number big_number big_number difference big_number big_number big_number for policy years and 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 and 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 date parthenon's accounting department prepared monthly financial statements and reports referred to as management reports after no management reports were prepared because the need for the reports ceased the department of insurance permitted parthenon to report its results in management report format for all years except and 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 and 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 date 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 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 reserves tax treatment parthenon has been included in the consolidated_returns filed by petitioners since it began business during 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 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 dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number 1specific 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 dollar_figure big_number big_number big_number big_number big_number big_number big_number total big_number 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 96_tc_61 modified 96_tc_671 affd on this issue revd in part and remanded 972_f2d_858 7th cir 88_tc_197 affd in part and revd in part 881_f2d_247 6th cir 84_tc_948 affd 811_f2d_1297 9th cir 71_tc_400 affd 640_f2d_1010 9th cir see also malone hyde inc v commissioner tcmemo_1992_661 revd and remanded 62_f3d_835 6th cir 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 t c pincite see also 979_f2d_162 9th cir many considerations can come into play when one attempts to decide whether a deduction of a purported insurance premium will be allowed affg 96_tc_18 additionally we consistently have rejected respondent's economic family theory expressed in revrul_77_316 1977_2_cb_53 e g sears roebuck co v commissioner supra humana v commissioner t c pincite 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 96_tc_45 96_tc_18 the court_of_appeals for the sixth circuit to which the instant case would be appealable absent stipulation to the 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 revrul_77_316 1977_2_cb_53 see also 811_f2d_1297 9th cir affg 84_tc_948 but see revrul_92_93 1992_2_cb_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 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 89_tc_1010 n affd 914_f2d_396 3d cir contrary has considered captive_insurance_company issues on two occasions see 62_f3d_835 6th cir revg tcmemo_1992_661 881_f2d_247 6th cir affg in part and revg in part 88_tc_197 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 54_tc_742 affd 445_f2d_985 10th cir in humana inc the taxpayer parent together with various of its subsidiaries owned and operated between hospitals containing big_number beds and hospitals containing big_number beds during the years in issue humana inc v commissioner t c pincite during humana incorporated health care indemnity inc hci a colorado captive_insurance_company with dollar_figure 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 pincite of the initial dollar_figure million in capitalization dollar_figure was paid_by irrevocable letters of credit issued in favor of the commissioner of insurance of the state of colorado id pincite no agreements existed between humana or its subsidiaries and hci requiring the parent or sister subsidiaries to contribute additional capital to hci for the payment of any losses id during the last year in issue however humana did contribute dollar_figure additional capital to hci id hci was not included in the consolidated_returns filed by humana and its subsidiaries id pincite 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 pincite 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 881_f2d_247 6th cir the court concluded that pursuant to the principles of 319_us_436 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 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 f 2d pincite citation omitted the court_of_appeals specifically adopted the balance_sheet and net_worth analysis described in clougherty packing co v commissioner f 2d pincite to analyze whether risks had in 811_f2d_1297 9th cir affg 84_tc_948 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 shifted from the sister subsidiaries to hci the court stated that if we look solely to the insured's assets ie 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 f 2d pincite 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 pincite 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 ie 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 pincite emphasis added distinguishing the cases relied on by the commissioner 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 f 2d pincite n 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 pincite 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 pincite in malone hyde inc v commissioner tcmemo_1989_604 supplemented by tcmemo_1993_585 the taxpayer parent primarily a wholesale food distributor together with those cases were 797_f2d_920 10th cir 774_f2d_414 cir 71_tc_400 affd 640_f2d_1010 9th cir approximately eight operating subsidiaries provided goods and services required by their independent retail grocery store owner customers during 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 dollar_figure the minimum statutory requirement pursuant to bermuda's insurance law malone hyde inc v commissioner f 3d pincite malone hyde decided that initially eastland only would reinsure selected risks of the parent and the subsidiaries accordingly eastland agreed to reinsure the first dollar_figure 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 dollar_figure but subsequently increased to dollar_figure 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 their portion of the premiums_paid to northwestern malone hyde inc v commissioner tcmemo_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 tcmemo_1989_604 following the reversal of 88_tc_197 we reconsidered our first decision in malone hyde inc in light of language in humana inc v commissioner f 2d pincite 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 ie whether insurance risks are involved whether risk shifting and risk_distribution is present and 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 tcmemo_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 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 sec_162 malone hyde inc v commissioner f 3d pincite 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 pincite 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 f 2d pincite n 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 transaction ' but a sham malone hyde inc v commissioner f 3d pincite 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 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 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 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 f 3d pincite 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 54_tc_742 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 f 2d pincite accordingly the questions we must resolve are whether bona_fide insurance transactions exist and if they do whether the sister subsidiaries shifted those risks to parthenon the transactions between parthenon and hca and the sister subsidiaries are insurance transactions pursuant to the principles of 319_us_436 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 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 f 3d pincite 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 the sister subsidiaries in effect were stockholders in parthenon parthenon was not subject_to strict regulatory control by the department of insurance 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 there was an agreement by which the sister subsidiaries or hca would contribute additional capital to parthenon hca's hospital subsidiaries contributed additional_amounts to parthenon the insurance policies that parthenon issued to the sister subsidiaries did not constitute bona_fide insurance contracts as commonly understood in the insurance industry hca's hospital subsidiaries as corporate entities did not operate the individual hospitals the premiums were both overstated for and and understated for at the whim of hca based on hca's needs at the time the premiums were determined and 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 to use the assets and reserves of parthenon to organize a surplus lines company to provide medical malpractice insurance to physicians who referred patients to hca hospitals the payment of additional premiums for prior years during while failing to pay current premiums and the decision during to raise hca's and the sister subsidiaries' general and professional liability insurance deductible to dollar_figure 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 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 dollar_figure million an alleged dollar_figure million excessive premium charged for the 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 and the decision by hca during to pay claims less than dollar_figure 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 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 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 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 and or an alleged dollar_figure million overcharge paid for were the equivalent of capital contributions which in substance gave the sister subsidiaries an ownership_interest in 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 date 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 change significantly during the years in issue from the process used during 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 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 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 319_us_436 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 f 2d pincite 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 f 3d pincite 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 pincite 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 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 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 fidedollar_figure in accordance with 62_f3d_835 6th cir however risk shifting is absent for continued 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 dollar_figure 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 continued parthenon's workers'_compensation obligations to the extent and during the time that the indemnity agreement with ideal mutual was in effect 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 and policy years were understated while the premium for the 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 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 or overstated for or 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 lerner et al federal income_taxation of corporations filing consolidated_returns to the 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 peel consolidated tax returns sec_1 pincite 3d ed 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 103_tc_398 affd 62_f3d_136 5th cir pursuant to sec_1_1502-32 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 pincite the net positive or negative adjustment only affects hca however inasmuch as it is parthenon's sole stockholder the basis_adjustment does not 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 dollar_figure dividend from parthenon to effectuate the formation of pcic the failure of hca and the sister subsidiaries to timely pay quarterly premiums for the policy year and the calculation of the premium for the 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 quarterly premiums while hca management reconsidered its insurance objectives the 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 quarterly premiums or calculate the 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 881_f2d_247 6th cir 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 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 62_f3d_835 6th cir 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 see also sec_1_801-3 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 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 sec_831 imposes taxes computed as provided in sec_11 on the taxable_income of insurance_companies other than life_insurance companiesdollar_figure sec_832 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 dollar_figure sec_832 defines losses_incurred as an amount equal for taxable years beginning prior to date sec_831 imposed tax as provided in sec_11 on insurance_companies other than life_insurance_companies and mutual insurance_companies sec_832 provides in pertinent part as follows c deductions allowed --in computing the taxable_income of an insurance_company subject_to the tax imposed by sec_831 there shall be allowed as deductions all ordinary and necessary expenses_incurred as provided in sec_162 relating to trade_or_business_expenses losses_incurred as defined in subsection b of this section for tax_year ended sec_832 provides as follows continued to the losses paid during the taxable_year reduced by salvage and reinsurance recovered during that year plus all unpaid_losses discounted for years after outstanding pincite continued 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 and sec_832 provides as follows 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 sec_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 the end of the taxable_year less all unpaid_losses outstanding at the end of the preceding_taxable_year plus estimated salvage and reinsurance recoverable at the end of the preceding_taxable_year 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 income_tax regsdollar_figure 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 sec_1_832-4 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 sec_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 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 70_tc_944 affd in part revd in part and remanded 639_f2d_333 7th cir 65_tc_897 affd on another issue 571_f2d_514 10th cir 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 69_tc_260 affd 598_f2d_1211 1st cir western casualty surety co v commissioner supra at dollar_figure 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 pincite calculation of unpaid_losses may not be based on estimates of potential losses that might be incurred in future years see also revproc_75_56 1975_2_cb_596 sec dollar_figure 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 revproc_75_56 sets forth procedures for computing the deduction for losses_incurred pursuant to sec_832 rather unpaid_losses must be based on the actual_loss_experience of the insurance_company see 88_tc_1050 54_tc_935 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 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 and were not reasonable based on acceptable actuarial methods within the meaning of sec_832 respondent contends that parthenon's professional and general liability reserves should be increased for year ended by dollar_figure and decreased for years ended and by dollar_figure dollar_figure and dollar_figure respectively additionally respondent contends that parthenon's workers'_compensation liability reserve should be increased for years ended and by dollar_figure dollar_figure and dollar_figure respectively accordingly respondent contends that net adjustments to parthenon's total_reserves for years ended and should be made as follows increase decrease tye in total_reserves dollar_figure big_number big_number big_number 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 but they deny that any adjustment to the reserves is required for years ended and they contend that the reserves for years ended through 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 date for purposes of the trial mr biscoglia did not perform a subsequent independent analysis of the reserves as of yearend rather he reviewed the reserve analysis report dated date report that had been prepared previously for parthenon in his expert witness report mr biscoglia concluded that the report had employed accepted and commonly used actuarial techniques methodologies and assumptions he further concluded that the aggregate dollar_figure million discounted reserves carried by parthenon and pcic for year ended were reasonable relative to the dollar_figure million to dollar_figure million range for the discounted reserves that was estimated for both companies in the report additionally petitioners contend that the reserves recorded on parthenon's annual statements for years ended and 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 for reserve requirements and for 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 mr biscoglia's reserve analysis report for the policy year 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 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 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 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 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 policy year mr merlino concluded that parthenon had recorded total_reserves in an amount that was dollar_figure 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 accordingly we accept as reasonable the increase in the unpaid_losses reserves for that year proposed by mr merlino with respect to the policy year mr merlino concluded that the professional and general liability reserves were overstated by dollar_figure mr merlino calculated that adjustment by reducing to dollar_figure million the undiscounted reserve estimate of dollar_figure million selected by parthenon to conform the unpaid_losses reserve to mr klaassen's original estimated recommended reserve level and then reducing that dollar_figure million by approximately dollar_figure million to correct for mr klaassen's use of occurrence policy factors in formulating his estimate mr merlino ignored the dollar_figure million to dollar_figure million range that mr biscoglia recommended for the general and professional liability reserves for the 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 policy year the assumption that mr klaassen served as parthenon's actuary for purposes of establishing the 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 additionally the reserve recommendation report prepared by mr klaassen for the 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 based on the foregoing we are persuaded that mr biscoglia not mr klaassen served in the function of parthenon's consulting actuary for purposes of computing recommended unpaid_losses reserves for the policy year mr merlino's challenge to the reasonableness of the unpaid_losses reserves parthenon claimed for the year ended 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 dollar_figure million unpaid_losses reserve parthenon reported for the year ended 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 finds no support in the record respondent's other arguments relating to the reasonableness of the unpaid_losses reserves for the 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 expert witness matthew p merlino and set out in his report dated date should be made mr merlino's adjustment for the year ended 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 is not warranted with respect to the and 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 dollar_figure million for and dollar_figure million for for policy years and mr biscoglia had recommended unpaid_losses reserves for workers'_compensation liabilities of dollar_figure and dollar_figure respectively on the annual statements for those years parthenon had reported unpaid_losses reserves for workers'_compensation liabilities of dollar_figure and dollar_figure respectively the workers'_compensation policy for and 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 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 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 sec_832 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 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 dollar_figure million for and dollar_figure million for is not warranted mr merlino further reduced the unpaid_losses reserves for years ended and 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 and reasonable test of sec_1_832-4 income_tax regs petitioners contend that the adjustments are not required because the unpaid_losses reserves for years ended and 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 t c pincite western casualty surety co v commissioner t c pincite 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 and 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 pincite but have failed to do so in the instant case petitioners contend that mr merlino's adjustments for years ended and 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 and 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_losses for the years ended and mr biscoglia's summary testimony that he examined the reserves recorded by parthenon for and 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 and as of yearend for the through policy years with the ultimate losses recorded on the annual_statement as of yearend and concluded that the comparison indicated that the professional and general liability reserves for policy years and 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 and to the amounts recommended in mr biscoglia's reserve analysis reports for those lines of business should be made 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 and in his report mr merlino proposes no adjustment to the unpaid_losses reserves for other lines of business carried by parthenon for years ended and 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 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 e 66_tc_312 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