Coordinated Issues Paper - Insurance

Margins and Other Unsubstantiated Additions to Insurance Company Reserves for Unpaid Losses and Claims – 11-18-2009.

LMSB4-1109-041
EFFECTIVE DATE: November 18, 2009

Coordinated Issue Paper
Non-life Insurance Industry
• Health Insurance Companies
• Property-Casualty Companies
• Blue Cross Blue Shield Entities

Margins and Other Unsubstantiated Additions to Insurance Company Reserves for Unpaid Losses and Claims

UILs: 832.06-00 Losses Incurred
832.06-02 Unpaid Losses

Note: This issue paper is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.

ISSUE:
May margins or other additions to reserves for unpaid losses shown on an insurance company's Annual Statement be included in the computation of "losses incurred" for federal income tax purposes where the taxpayer fails to establish that the additional amounts are based upon the company's actual loss experience and the total reserve is in excess of a fair and reasonable estimate within the meaning of Treas. Reg. § 1.832-4(b)?

CONCLUSION:
For federal income tax purposes, estimates of insurance company unpaid losses must be fair and reasonable in amount and must represent actual unpaid losses. Margins or other additions to unpaid losses that are not based upon the company's actual loss experience cannot be included in the deduction for losses incurred. If a taxpayer cannot establish that a margin or other addition to unpaid losses represents actual unpaid losses, the deduction will be disallowed to the extent it exceeds a fair and reasonable estimate.

BACKGROUND
1. The Internal Revenue Code and the NAIC Annual Statement. Beginning with the Revenue Act of 1921, the structure for the taxation of property and casualty insurance companies has been based upon the Annual Statement that insurers file with state regulators in accordance with the forms and procedures approved by the National Association of Insurance Commissioners ("NAIC"). See I.R.C. § 831(b) ("In the case of an insurance company subject to the tax imposed by section 831. . . [t]he term “gross income” means the sum of . . . the combined gross amount earned during the taxable year, from investment income and from underwriting income as provided in this subsection, computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners.")

Among other things, the Annual Statement includes a schedule for computing "losses incurred," which is shown as the sum of losses paid during the year less salvage, increased by reinsurance assumed and reduced by reinsurance recovered, plus net losses unpaid at the end of the current year, minus net losses unpaid at the end of the prior year. Liabilities for unpaid losses are often called "loss reserves." Insurance Accounting & Systems Association, Inc. ["IASA"], Property-Casualty Insurance Accounting page 3-5 (7th ed. 1998). For purposes of computing losses incurred, any increase in the reserve for unpaid losses increases the amount of losses incurred, while any decrease in the reserve decreases losses incurred.

For federal income tax purposes, I.R.C. section 832(b)(5) sets forth a similar formula:

(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, deduct salvage and reinsurance recovered during the taxable year.

(ii) To the result so obtained, add . . . all discounted unpaid losses (as defined in section 846) outstanding at the end of the taxable year and deduct . . . all discounted unpaid losses outstanding at the end of the preceding taxable year.

(iii) To the results so obtained, add estimated salvage and reinsurance recoverable as of the end of the preceding taxable year and deduct estimated salvage and reinsurance recoverable as of the end of the taxable year.

The amount of estimated salvage recoverable shall be determined on a discounted basis in accordance with procedures established by the Secretary.

2. Statutory Accounting. NAIC accounting is described as "Statutory Accounting," as opposed to generally accepted accounting principles (GAAP). IASA, supra at page 1-15. See also Physicians Insurance Company of Wisconsin, Inc. v. Commissioner, T.C. Memo. 2001-304 ("Insurance companies are required to prepare their annual statements using a system of accounting known as the statutory or annual statement method, which does not necessarily conform to generally accepted accounting principles that govern the preparation of an insurance company’s financial statements"). In the past, NAIC accounting practices were not set out in a single document. In many cases the only sources were the forms, exhibits, and schedules of the Annual Statement, and the instructions to the Annual Statement. Recently, the NAIC has “codified” various accounting practices in a series of separate documents under the general title “Statement of Statutory Accounting Principles” ("SSAP"), which are set forth in the NAIC's Accounting Practices and Procedures Manual. SSAP No. 55 establishes statutory accounting principles for “Unpaid Claims, Losses and Loss Adjustment Expenses.”

At some point in the process of estimating loss reserves an actuarial projection is made, either by an in-house actuary or by an outside consultant. However, the NAIC does not require that the amount shown on the Annual Statement must be determined by an actuary. Instead, SSAP No. 55 states that “[M]anagement shall record its best estimate of its liabilities for unpaid claims, unpaid losses, and loss/claim adjustment expenses.” Note that SSAP No. 55 refers to management’s best estimate, not the actuary’s best estimate.

The NAIC's instructions to the Annual Statement require that it include a Statement of Actuarial Opinion. The form of the actuarial opinion varies for different types of companies, but generally includes a declaration that the amounts stated are "in accordance with accepted actuarial standards" and "make a good and sufficient provision" for all unpaid obligations or make a "reasonable provision." See, e.g., Utah Medical Insurance Association v. Commissioner, T.C. Memo. 1998-458 ("computed in accordance with accepted loss reserving standards . . . and provided sufficiently for all of petitioner’s unpaid loss and loss expense obligations"); Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203, aff'd, 285 F.3d 1086 (8th Cir. 2002) ("were computed in accordance with the standards of practice issued by the Actuarial Standards Board . . . and made reasonable provision for all unpaid loss and loss expense obligations"). See also, Hospital Corporation of America v. Commissioner, T.C. Memo. 1997-482 (opinion letter to Commissioner of Insurance: "were computed in accordance with accepted loss reserving standards . . . and made good and sufficient provision for all . . . unpaid loss and loss expense obligations"); Physicians Insurance Company of Wisconsin, Inc. v. Commissioner, T.C. Memo. 2001-304, (opinion letter to Commissioner of Insurance: “Make a reasonable provision, in the aggregate, for all unpaid loss and loss adjustment expense obligations").

Again, note that the Statement of Actuarial Opinion does not state that the amount shown on the Annual Statement has been determined by an actuary, but only that such amount has been determined "in accordance with" accepted actuarial standards, and makes a "reasonable provision" for all unpaid obligations. See, e.g., Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203 ("Petitioner's actuaries did not assist in establishing petitioner's reserves in the first instance but were asked after the fact to review petitioner's carried reserves, for purposes of satisfying the statutory certification requirement").

3. Annual Statement conservatism. In general, state insurance regulators are concerned with the solvency of insurance companies, and accordingly state insurance regulatory accounting favors conservatism. Sears, Roebuck and Co. v. Commissioner, 96 T.C. 61, 72 (1991) ("State regulators are concerned with financial solvency and market conduct, including matters such as pricing and product content, and with regulation of the claims adjustment process. The primary goal of regulation is to preserve the financial assets and solvency of the company, thereby assuring that the insurer will satisfy loss claims").

The Preamble to the NAIC's Accounting Practices and Procedures Manual includes a "Statement of Concepts." The Preamble states that "The primary responsibility of each state insurance department is to regulate insurance companies in accordance with state laws with an emphasis on solvency for the protection of policyholders." Manual, p. P-5. The first "concept" described in the Preamble is the concept of conservatism: "In order to provide a margin of protection for policyholders, the concept of conservatism should be followed when developing estimates as well as establishing accounting principles for statutory reporting." Manual, p. P-6.

This preference for solvency and conservatism is reflected in the NAIC's Health Reserves Guidance Manual 9 (November 6, 2000):

F. Conservatism
1. General
Conservatism can be explicit or implicit depending on the method used. “Explicit conservatism” means that a preliminary reserve is determined using assumptions that represent expected experience; then, a separate provision for adverse deviations from expected -- the “load” or “margin” -- is added to provide conservatism. “Implicit conservatism” means that the reserve is determined using assumptions that are more conservative than what is actually expected. In some cases, reserves may be determined with some implicit conservatism, and then increased by an explicit load or margin to provide sufficient overall conservatism. [Emphasis added.]

* * *

The level of conservatism needed typically will vary by, among other factors, the size of the block of business and the type of coverage. . . . Note, however, that reserve adequacy ultimately is to be judged in the aggregate for a reporting entity. For example, a high degree of conservatism might be appropriate for small-group hospital claims on a stand-alone basis; when a reporting entity combines its reserves for hospital and physician claims, and small and large groups, the necessary degree of conservatism is likely to be substantially less than the sum of the margins developed on a stand-alone basis.

Several factors in the process of determining liabilities would impact the level of conservatism. As the process more precisely adjusts for large claims and for increases and decreases in inventory, the amount of additional margin needed would be decreased. Other factors that impact the margin level are the potential variance in the trend in claim costs at the valuation date and the rate of growth in the line of business.

The level of conservatism needed will also vary according to the sophistication of the reserving process. Less margin should be needed to the extent that the process explicitly and accurately reflects such items as atypically large claims; changes in the level of claim inventory or “backlog” (claims received but not yet processed); trend in claim costs; seasonality of claim costs; changes in provider reimbursement arrangements (e.g., switches between capitation and fee-for-service payments); and changes in the demographic characteristics of the covered lives (age/sex mix, etc.). This list is not exhaustive, and other techniques may also reduce the need for conservatism in the reserve. However, unless such techniques have been in use for a significant period of time, the acceptable reduction in conservatism will be largely a matter of judgment.

The NAIC has recognized a possible conflict between the discussion of "margins" in the Health Reserves Guidance Manual, and SSAP 55, which directs management to record its "best estimate" of its unpaid claim liability. The matter was referred to the NAIC's Emerging Accounting Issues Working Group, which adopted the following "interpretation" of SSAP 55:

The working group reached a consensus that the concept of conservatism is inherent to the estimation of reserves and as such should not be specifically prohibited in the consideration of management’s best estimate. On the other hand, the working group does not believe there should be a specific requirement to include a provision of adverse deviation in claims as the application of estimates varies greatly from company to company and requires the careful judgment of management.

INT 01-28 (October 16, 2001, Accounting Practices and Procedures Manual B-150 (2008). Note that while the working group endorsed the concept of conservatism, it did not believe there should be a specific requirement to include a provision for adverse deviation in claims. In other words, while the concept of a "best estimate" does not prohibit a consideration of conservatism, statutory accounting does not require the addition of a "margin" or other provision for adverse deviation in claims.

4. "Margins" and other "add-ons." As described in the Health Reserves Guidance Manual, an “explicit" margin is distinct and identifiable and is generally added on after an initial determination of the reserve amount necessary to discharge the company’s liability. The taxpayer or its actuary determines a preliminary reserve for unpaid losses based upon expected experience, and then a margin or other amount is added to the preliminary reserve above and beyond the amount needed to meet the expected experience. In contrast, the phrase "implicit conservatism" describes a situation where the taxpayer or its actuary determines the overall reserve using assumptions that are more conservative than what is actually expected, resulting in an overstatement of the overall reserve. In that case, there is only one figure, the final reserve number, rather than a preliminary figure with a separate figure for the explicit margin. In both cases the effect is the same: the overall reserve is overstated, but in the case of an explicit margin, the overstatement is a direct result of the explicit margin, while in the case of implicit conservatism the cause of the overstatement may not be immediately apparent.

The NAIC's Health Reserves Guidance Manual refers to "explicit margins" and "implicit conservatism." The NAIC's Emerging Accounting Issues Working Group, in INT 01-28, refers to a "provision for adverse deviation." Insurers may make additions to Annual Statement loss reserves under other labels or descriptions, such as "reserve for adverse development," or "add-ons." See, e.g., Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203, ("bulk reserve for 'adverse loss development'"); Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304 ("add-ons to [the actuary's] point estimates").

TAXPAYER'S POSITION
In preparing the Annual Statement that is filed with state insurance regulators, some taxpayers have increased the reserve for unpaid losses by adding explicit margins or other distinct and identifiable amounts that are not based upon the company's actual experience. Other taxpayers have determined the overall reserve using assumptions that are more conservative than what is actually expected. In both situations the taxpayer's Annual Statement includes a Statement of Actuarial Opinion. In both situations the taxpayer uses the Annual Statement reserve amount in preparing its federal income tax returns. In general, taxpayers argue that the Annual Statement numbers must be accepted for federal income tax purposes. Various specific arguments typically raised by taxpayers are addressed below.

DISCUSSION

While section 832 refers to the Annual Statement that insurance companies file with state regulators, for federal income tax purposes the Annual Statement is only a general guide. The Code contains numerous modifications to Annual Statement accounting. While the Annual Statement includes a provision for unpaid losses, for federal income tax purposes the requirements for the deduction are set forth in Treas. Reg. §§ 1.832-4(a)(14) [formerly § 1.832-4(a)(5)] and 1.832-4(b):

§ 1.832-4 Gross income

(a)(14) In computing “losses incurred” the determination of unpaid losses at the close of each year must represent actual unpaid losses as nearly as it is possible to ascertain them.

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

In summary, for federal income tax purposes, the deduction for unpaid losses is limited to actual unpaid losses, and the deduction must be stated in amounts that represent a fair and reasonable estimate of the amount the company will be required to pay.

Several conclusions follow from these general principles:

1. Not all "reserves" shown on the Annual Statement or allowed by state insurance regulators are allowable as deductions for federal income tax purposes. The Internal Revenue Code specifies the items that are deductible for federal income tax purposes. To the extent that a state statute requires a reserve in addition to or in excess of those reserves necessary for the protection of policyholders, the reserve is merely a solvency reserve. Additions to solvency reserves have no bearing on what part of an insurance company’s gross income is treated as net income for tax purposes. United States v. Boston Insurance Co., 269 U.S. 197 (1925); McCoach v. Insurance Company of North America, 244 U.S. 585 (1909); Colonial Surety Co. v. United States, 178 F.Supp. 600, 602 (Ct. Cl. 1959) ("reserves to take care of the other contingencies, although they are proper to insure solvency, are not deductible for tax purposes"). See also, Rev. Rul. 83-174, 1983-2 C.B. 108; Rev. Rul. 76-56, 1976-1 C.B. 185.

2. The Service is not bound by the numbers shown on the Annual Statement. It has long been the position of the Internal Revenue Service that the NAIC Annual Statement is merely a "general guide" in computing insurance company taxable income. Rev. Rul. 61-167, 1961 C.B. 130; Rev. Rul. 60-306, 1960-2 C.B. 211. See Commissioner v. U.S. Guarantee Company, 190 F.2d 152 (2d Cir. 1951), rev’g and rem’g, 8 CCH Tax Ct. Mem. 510 (1949); Commissioner v. General Reinsurance Corp., 190 F.2d 148 (2d Cir. 1951), rev’g and rem’g, 9 CCH Tax Ct. Mem. 141 (1950); Pacific Insurance Co., Ltd. v. United States, 90 F. Supp. 328 (Hawaii D.C. 1950), aff’d, 188 F.2d 571 (9th Cir. 1951); and Pacific Employers Insurance Company v. Commissioner, 89 F.2d 186 (9th Cir. 1937), aff’g 33 B.T.A. 501 (1935). Contra New Hampshire Fire Insurance Co. v. Commissioner, 146 F.2d 697 (1st Cir. 1945), aff’g, 2 T.C. 708 (1943); and Columbia Casualty Co. v. Commissioner, 7 CCH Tax Ct. Mem. 282 (1948).

Annual Statement numbers for loss reserves are not determinative for federal income tax purposes. Hanover Insurance Company v. Commissioner, 598 F.2d 1211, 1217 (1st Cir. 1979), aff'g 65 T.C. 715 (1976). Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304. The taxpayer must satisfy the Treasury Regulation's requirement that the part of the deduction for “losses incurred” which represents unpaid losses must comprise only actual unpaid losses, stated in amounts that represent a "fair and reasonable" estimate of the amount the company will be required to pay.

3. The Service is not bound by the Statement of Actuarial Opinion included in the Annual Statement, and the actuary's opinion is not entitled to any presumption or deference. First, under the procedures of SSAP No. 55, the unpaid loss reserve numbers reflected on the Annual Statement are selected by management. The Statement of Actuarial Opinion included in the Annual Statement merely confirms that the numbers selected by management are "in accordance with accepted actuarial standards" and "make a good and sufficient provision" for all unpaid obligations or make a "reasonable provision." In other words, the Statement of Actuarial Opinion does not determine the numbers that are shown on the Annual Statement.

Second, the Statement of Actuarial Opinion included in the Annual Statement -- or any related actuarial study -- is prepared for purposes of the Annual Statement, not for federal income tax purposes. Accordingly, it reflects the standards of Annual Statement accounting, such as conservatism, and not the standards of the Treasury Regulations. The fact that the Statement of Actuarial Opinion concludes that the numbers shown on the Annual Statement make a "reasonable provision" for unpaid losses does not establish that those numbers are "fair and reasonable" for federal income tax purposes. Hanover Insurance Company v. Commissioner, supra, 598 F.2d at 1217.

Third, the Service is not required to accord deference to the opinion of the taxpayer’s actuary. In Vinson & Elkins v. Commissioner, 99 T.C. 9, 16-17 (1992), aff’d, 7 F.3d 1235 (5th Cir. 1993), the Tax Court, explained that in the context of a defined benefit plan under I.R.C. § 412(c)(3) the Service was only permitted to retroactively challenge an actuary’s assumptions if the assumptions were “substantially unreasonable.” In the context of I.R.C. § 832, deference to the taxpayer's actuary is not applicable with respect to estimates of unpaid loss reserves for property and casualty insurers, where a different statutory scheme applies and where Treas. Reg. § 1.832-4 specifically authorizes the Service to adjust a taxpayer’s reserves if they are not fair and reasonable in amount. Treas. Reg. § 1.832-4 does not require that the Service must establish that a reserve is “substantially unreasonable” prior to making any adjustment.

4. For federal income tax purposes, the deduction for unpaid losses must be based on actual loss events. "Formula" reserves are not allowable. Treasury Reg. § 1.832-4(a)(14) (formerly Treas. Reg. § 1.832-4(a)(5)) requires that a taxpayers’ estimate of unpaid losses at the close of each year “represent actual unpaid losses as nearly as it is possible to ascertain them." The predecessor to Treas. Reg. § 1.832-4(a)(14) was promulgated in 1943. See T.D. 5236, 1943 C.B. 519. At that time, the NAIC required insurers to establish unpaid loss reserves equal to the greater of two separately-calculated reserves: (1) a case-based reserve representing the aggregate reserves for specific claims estimated by the insurer’s claims adjusters or; (2) a formula reserve representing a specified percentage of the insurer’s premium volume. See Charles W. Tye, The Convention Form and Insurance Company Tax Problems, 6 Tax Law Rev. 245, 245-246 (1951). Prior to the promulgation of T.D. 5236, the Service had successfully litigated its position that insurers were only entitled to deduct unpaid losses that were calculated on the case method, thereby preventing insurers from using the formula method for tax purposes. See, e.g., Pacific Employers Ins. Co. v. Commissioner, 33 B.T.A. 501 (1935), aff’d, 89 F.2d 186 (9th Cir. 1937); American Title Co. v. Commissioner, 29 B.T.A. 479 (1933), aff’d, 76 F.2d 332 (3d Cir. 1935). Accordingly, the language presently contained in Treas. Reg. § 1.832-4(a)(14) was initially included in the regulations in an attempt to emphasize the Service’s longstanding position that insurers were not entitled to use the formula method for tax purposes. See also Rev. Rul. 61-167, supra (percentage reserve for fidelity and surety business: "The reserve maintained by the taxpayer in this case does not comprise actual losses which, based on the facts of each case and the company's experience in similar cases, can be said to represent a fair and reasonable estimate of the amount the company will be required to pay but, in fact, constitutes a contingency reserve, computed on the basis of a percentage rate established by the Treasury Department, which the taxpayer is required to maintain as a condition of writing surety bonds on United States Government contracts.").

On the Annual Statement, unpaid losses include losses that are "incurred but not reported" ("IBNR"), and the Service allows IBNR losses to be included in the estimate of unpaid losses for federal income tax purposes. Rev. Rul. 70-643, 1970-2 C.B. 141. Although IBNR losses are, by definition, "unreported," the deduction for unpaid losses is limited to losses that have actually been incurred and cannot include estimates of potential future losses or mere contingency reserves. The Tax Court described this distinction in State of Maryland Deposit Insurance Fund Corp. v. Commissioner, 88 T.C. 1050, 1060 (1987):

Clearly, estimates are permissible in calculating IBNR insurance losses. By definition, an insurance company will not yet know the specific amount of such losses at the end of the taxable year (because they have not yet been reported). The authorities are clear, however, that the calculation of IBNR losses must be based on estimates of actually incurred losses as of the end of the year. This is to be distinguished from an impermissible calculation based on estimates of potential losses that might be incurred in future years. Maryland Savings-Share Ins. Corp. v. United States, 226 Ct. Cl. at 499-500, 507, 644 F.2d at 24, 28; Home Mutual Ins. Co. v. Commissioner], 70 T.C. 944, 951 (1978), affd. in part, revd. in part and remanded in part 639 F.2d 333 (7th Cir. 1980); Modern Home Life Ins. Co. v. Commissioner, 54 T.C. 935, 939 (1970).

5. For federal income tax purposes, the deduction for unpaid losses must represent a fair and reasonable estimate of the amount the company expects to pay. No administrative "margin" or "tolerance" is required or allowable. Treasury Reg. § 1.832-4(b) requires that the part of a taxpayer’s deduction for “losses incurred” which represents unpaid losses at the close of the taxable year "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." (Emphasis added.) The predecessor to Treas. Reg. § 1.832-4(b) was promulgated in 1944, in part to address concerns raised by the 1943 promulgation of T.D. 5236, which required that unpaid losses must represent "actual" unpaid losses, "as nearly as it is possible to ascertain them.” That language appeared to set forth an exact standard with respect to an estimated item that was inherently uncertain. Practitioners raised questions concerning the manner in which the Service would determine whether case-based reserves were overstated. See Charles W. Tye, Federal Taxation of Insurance Companies and Their Problems, 21 Taxes 594, 616 (November 1943) (“The [Service], if it is to try and treat the computation of ’unpaid losses’ as an exact science on a case basis should give the companies more of a guide to their intention in the matter than to merely state that ‘unpaid losses must represent actual unpaid losses as nearly as it is possible to ascertain them’”). The Service addressed these concerns by promulgating T.D. 5387, which authorized the Service to make adjustments to reserves that it deemed impermissibly excessive, i.e., not “fair and reasonable."

Along with T.D. 5387 the Service issued Comm. Mim. R.A. No. 1366, which set forth a rule of thumb for auditing agents to use in determining whether estimates of unpaid losses were reasonable. Specifically, it directed agents to make adjustments to loss reserves for certain lines of insurance only if the average of the preceding five years’ estimated losses exceeded 115 percent of the average one year development of those estimates.

While Comm. Mim. R.A. No. 1366 was not published by the Service its contents were widely circulated among practitioners and the insurance industry. Comm. Mim. R.A. No. 1366 did not represent a legal interpretation but merely provided administrative guidance for examining estimates of unpaid losses.

In 1975, the Service issued Rev. Proc. 75-56, 1975-2 C.B. 596, which effectively revoked Comm. Mim. R.A. No. 1366. Rev. Proc. 75-56 stated that "The long term administrative practice enunciated in Com. Mim. R.A. 1366 can no longer be justified in view of the technological advances made by the insurance industry in the area of statistical collection and analysis. Instead the standard of reasonableness in computing unpaid losses will be that set forth in sections 1.832-4(a)(5) [now section 1.832-4(a)(14)] and 1.832-4(b) of the regulations." Emphasis added.

Comm. Mim. R.A. No. 1366 is sometimes described as providing a 15% "tolerance" for estimates of unpaid loss reserves: that no adjustment should be made if the taxpayer's estimate is not more than 15% greater than the Service's estimate. That procedure no longer applies. Rev. Proc. 75-56 specifically supersedes Comm. Mim. R.A. No. 1366. No tolerance may be allowed.

6. For federal income tax purposes, the determination of a fair and reasonable estimate of unpaid losses is a factual determination to be made based on the standards set forth in Treas. Reg. §§ 1.832-4(a)(14) and 1.832-4(b), and not on the standards of the Annual Statement. The taxpayer must establish that the deduction for unpaid losses is comprised of only actual unpaid losses, and the taxpayer may be required to submit detailed information with respect to its actual experience as is deemed necessary to establish the reasonableness of the deduction. As a preliminary matter, it should first be emphasized that any adjustment to an insurance company's deduction for losses incurred for federal income tax purposes has no effect on the company's loss reserves for Annual Statement or state regulatory purposes. As the Court of Appeals stated in Hanover Insurance Company v. Commissioner, supra, 598 F.2d at 1218:

[The taxpayer] was free to maintain reserves in any amount for unpaid losses. I.R.C. § 832 and accompanying regulations do not limit an insurance company’s freedom to keep records in whatever manner it chooses for financial or state regulatory use. Any increased burden on the insurance company is no greater than that borne by other taxpayers who use different data for tax purposes as opposed to other purposes.

Second, it should also be emphasized that valuation standards for Annual Statement purposes are different from valuation standards for federal income tax purposes, and in any particular case the different standards may produce different results. For federal income tax purposes the question is not whether the amount shown on the Annual Statement makes a "reasonable provision" for unpaid losses. That is an issue for the state insurance regulators, applying their standards of conservatism. Nor is the question whether a "reasonable provision" for Annual Statement purposes should be considered a "fair and reasonable estimate" for federal income tax purposes. Annual Statement valuation standards do not apply for federal income tax purposes.

As indicated above, a taxpayer may overstate its Annual Statement reserve for unpaid losses either by adding an "explicit" margin or by applying "implicit conservatism" in determining the overall reserve. Two cases have dealt with what may be considered "explicit" margins: Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203, aff'd, 285 F.3d 1086 (8th Cir. 2002) ("bulk reserve for 'adverse loss development'") and Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304 ("add-ons to [the actuary's] point estimates"). The taxpayer in the Minnesota Mutual case made arguments similar to those discussed above, which the Court of Appeals summarized as follows:

MLM contends the deductions claimed on its 1994 and 1995 tax returns should be presumed fair and reasonable because the estimates were selected by professional management and not tax-motivated; certified as reasonable by a qualified actuary; within a range of reasonable actuarial estimates; and reported in MLM's annual statement and accepted by the Minnesota Department of Commerce (MDC) without change. MLM invites us to adopt a test which conclusively establishes the fairness and reasonableness of unpaid loss estimates for tax purposes when the estimates meet these four criteria.

We decline MLM's invitation and affirm the tax court. The fairness and reasonableness of unpaid loss estimates is a factual issue determined by the tax court on a case-by-case basis. The four criteria outlined by MLM should be considered by the tax court in reaching its factual determination, but they are not conclusive. The tax court need not defer to estimates set forth in an annual statement and accepted by a state insurance regulator if the taxpayer cannot otherwise defend its estimates with detailed information related to its own experience. [285 F.3d at 1088.]

The tax court found MLM failed to demonstrate either the necessity or reasonableness of the ALD [adverse loss development] reserves. As a factual matter, the tax court found that MLM did not establish the ALD reserve to hedge against historically inadequate reserves because MLM's recent experience had proven its case reserves to be generous. . . .

The tax court further determined that MLM did not carry its burden of showing the ALD amounts were fair and reasonable -- even assuming MLM could demonstrate the need for an ALD reserve. The tax court noted MLM did not show what specific factors, if any, were taken into account in establishing the extra reserve or how such factors might have been weighed. Indeed, MLM produced no documentation of any kind to show what data it analyzed in determining the amount of the ALD reserve. . . . [285 F.3d at 1090, emphasis added.]

MLM relies principally upon Utah Med. Ins. Ass'n v. Comm'r, 76 T.C.M. (CCH) 1100, 1998 WL 906665 (1998). . . .

The tax court distinguished Utah Med. because, notwithstanding the fact that MLM's unpaid loss estimates fell within an actuary's range of reasonable estimates and were accepted by a state insurance regulator, MLM neglected to present “detailed information with respect to its actual experience,” Treas. Reg. § 1.832-4(b), to establish the reasonableness of its ALD reserve. [285 F.3d at 1091, emphasis added.]

Similarly, in Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304 the Tax Court stated:

Petitioner contends that because it reported the same estimates of unpaid losses on its annual statements and tax returns, and because it estimated these unpaid losses in a reasonable manner, using sound business practices, these estimates should be accorded deference for Federal income tax purposes. . . .

Petitioner's contention is at bottom a rehashing of long-rejected arguments that the Code reflects a congressional expectation that the estimates of unpaid losses used for tax purposes should conform to the precise figures shown on the annual statement. [Citing Hanover Ins. Co. v. Commissioner, 598 F.2d 1211, 1217 (1st Cir. 1979).]

Summary and Conclusions:
For federal income tax purposes the standards for the deduction for unpaid losses are set forth in Treas. Reg. §§ 1.832-4(a)(14) and 1.832-4(b). With respect to "margins" or other additions to unpaid losses two elements must be considered:

Estimates of unpaid losses must be fair and reasonable in amount,
and the estimates must represent actual unpaid losses. Margins or other
additions to unpaid losses that are not based on the company's actual experience cannot be included in the deduction for losses incurred.

Estimates of unpaid losses must be fair and reasonable in amount.

For federal income tax purposes the first and principal criterion in the examination of unpaid losses is that amounts included in or added to the estimates of unpaid losses must represent a fair and reasonable estimate of the amount the company will be required to pay. Accordingly, the first step in the examination of unpaid losses is to make an independent evaluation of the amount claimed as a deduction, without regard to the manner in which the taxpayer's Annual Statement reserves were determined or the labels or descriptions which the taxpayer attaches to any additions to its Annual Statement reserves.

If, as a result of this independent evaluation, it appears that the amount claimed by the taxpayer as unpaid losses is in excess of a fair and reasonable estimate, the Service may require the taxpayer to submit detailed information to establish the reasonableness of its deduction for losses incurred as demonstrated by its actual experience. Depending on the specific facts of any particular case, any excess over a fair and reasonable amount may be disallowed on that basis alone.

Estimates of unpaid losses must represent actual unpaid losses.

In addition, depending on the specific facts of the case, where an overstatement of loss reserves is due to distinct and identifiable additions to unpaid losses, including “explicit” margins or other "add-ons," any excess over a fair and reasonable amount may be disallowed on the basis that it does not comprise actual unpaid losses. In those circumstances, the reserve addition fails the “fair and reasonable” standard and also constitutes an unallowable contingency reserve or solvency reserve.

No distinction shall be made or deference given based on who determined or recommended that the margin be added to reserves. While careful consideration should be given to full disallowance of the overstatement for each examination year, the margin or other unsubstantiated addition must, at a minimum, be disallowed. Under Rev. Proc. 75-56, no portion of these additions can be compromised unless the taxpayer provides compelling evidence that the margin or reserve addition meets the documentary requirements of the Regulations, which require that all reserve components be based on the actual historical experience of the taxpayer.





Page Last Reviewed or Updated: November 19, 2009
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