There have been a number of reasons put forth on why captive insurers are formed. Among the reasons are tax advantages based on premium deductibility [9], [10]; direct access by the parent firm to reinsurance markets [3], [6]; cost reduction to the parent firm from better loss control [8], [9]; lower overhead [13]; recapture of excessive underwriting profits [11]; foreign tax credits [14]; and improved coverage availability [7]. None of the above studies have empirically tested the impact of the Federal Government's attack on deductibility of premiums paid to captives and the resultant effect on firm value of the captive's parent. This study addresses this question of the impact on the captive's parent firm's value by examining the impact of Revenue Ruling 77-316 and the Carnation decision. The captive benefits, if present, would improve the financial performances of the parent companies and thus increase parent firm value. In fact, Cross, Davidson, and Thornton [4] found that captives' parent companies earned statistically significant excess returns during the period surrounding the formation of the captive insurance companies. On December 26, 1978, the United States Tax Court ruled that since the Carnation Company's risk was reinsured with its wholly owned captive subsidiary (Three Flowers Insurance Company), that:
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Cross et al. (1988) studied this question.