1. Robert Gorey, Robert Gorey Consulting, (Moderator)
ITC Insurance Tax Conference Thursday, November 3, 2011, 2:00-3:00 PM Session B-2: P&C Reserves
Robert Gorey, Robert Gorey Consulting, (Moderator)
Peter Winslow, Scribner, Hall & Thompson, LLP
Howard Stecker, Ernst & Young, LLP

2. Unpaid Loss Reserves
LMSB Releases Coordinated Issue Paper for Non-life Insurance Companies
Effective Date: November 18, 2009
Margins and Other Unsubstantiated Additions to Insurance Company Reserves for Unpaid Losses and Claims
Issue Paper Conclusion: The deduction for such amounts will be disallowed to the extent it exceeds a fair and reasonable estimate within the meaning of Treas. Reg (b).

3. Unpaid Loss Reserves (continued)
In reaching this conclusion the Issue Paper notes that the standards for the deduction for unpaid losses are set forth in Treas. Reg. Sections (a)(14) and (b), and, that with respect to “margins” or other additions to unpaid losses two elements must be considered:

4. Unpaid Loss Reserves (continued)
(1) Estimates of unpaid losses must be fair and reasonable in amount
and
(2) Estimates of unpaid losses must represent actual unpaid losses.

5. Unpaid Loss Reserves (continued)
The Issue Paper directs IRS examiners to make an independent evaluation of the amount claimed without regard to the manner in which the taxpayer’s Annual Statement reserves were determined.
If examiner’s independent evaluation indicates reserves are redundant then “any excess over a fair and reasonable amount may be disallowed on that basis alone.”

6. Unpaid Loss Reserves (continued)
In addition, where a redundancy “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.”

7. Unpaid Loss Reserves (continued)
“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.”

8. Unpaid Loss Reserves (continued)
The last sentence of the Issue Paper states: “Under Rev. Proc , 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.”

9. Unpaid Loss Reserves (continued)
LMSB OBSERVATIONS & STATEMENTS SUMMARY
Not all Annual Statement reserves are allowable for tax purposes and the IRS is not bound by the reserve numbers or the opinion of the taxpayer’s actuary.
Formula reserves are not allowable because they are not based on actual loss events.
No administrative tolerance is allowed because the deduction for unpaid losses must represent a fair and reasonable estimate of the amount the company expects to pay.
The tax and Annual Statement standards for valuing unpaid losses are different.

10. Standard IRS Information Document Request for Reserve Margin
Description of reserving policy
Person having final decision
Margin changes; documents relied upon
Third-party input
Method used for margin
Documents supporting need for margin
Prior history supporting need for margin
Hindsight analysis

11. Statistical Approach to Claim Reserves
Mode
Median
Expected Value
Systematic emergence of profit
Opining actuary standard

12. Mode Most likely outcome
LB&I usually argues that mode is required by Treas. Reg. § (b): “fair and reasonable estimate of the amount the company will be required to pay”
Reserves based on mode generally inadequate because loss severity is not uniform over possible outcomes

13. Median
50th percentile
May be computed as “floor” by actuaries before margin add-on
LB&I also argues for this standard, sometimes confusing it with mode standard
Reserves based on median generally inadequate because loss severity is not uniform over possible outcomes

14. Expected Value Weighted average of possible outcomes
May be computed as “floor” by actuaries before margin add-on
LB&I fallback position if mode and median standards rejected by Appeals
Method “fronts” profit if margin for risk charges is not considered

15. Systematic Emergence of Profit
Margin added to correlate risk charges to exposure period, so that premium income is earned periodically
IFRS May 2007 Discussion Paper – Current Exit Value
IFRS July 2010 Exposure Draft – Risk Adjustment, plus Residual Margin
FASB September 2010 Discussion Draft – Composite Margin

16. Opining Actuary Standard
“Good and sufficient”
Moderately adverse conditions
Standard considers reserve volatility
Usually target confidence level of 85-90%

17. IRS Appeals Resolution of Loss Reserve Issues
Appeals generally disagrees with Coordinated Issue Paper’s position that loss reserves for tax purposes must be the actuary’s most likely point estimate
Appeals looks for contemporaneous actuarially-determined ranges of reasonable reserves
Appeals uncomfortable with confidence levels over 70% where history of redundant reserves
Appeals uncomfortable with explicit margins where history shows that margins were never needed

18. Key Rulings and Cases Dealing with Loss Reserves

19. Key Rulings and Cases Dealing with Loss Reserves
“Ancient History” – Commissioner’s Mimeograph R.A 1366, T.S. No. 320 (1944) [not officially published] specified an auditing technique for verifying the reasonableness of unpaid losses on all lines of business other than worker’s compensation and public liability
Compared the amounts paid in the first succeeding year plus the amount still estimated as unpaid at the end of that year with the previous year’s estimate of unpaid losses to determine ratio of estimated losses to one-year developed losses
Computation was to be performed for the five previous years and if the average exceeded 115% of the average developed loss an adjustment was to be made in the current tax year

20. Key Rulings and Cases Dealing with Loss Reserves
Revenue Procedure 75-56, CB Provides that Comm Mim R. A 1366 is no longer justified in light of technological advances made by insurance industry in statistical collection and analysis
The standard of reasonableness in computing unpaid losses is set forth in Regulation section (a)(5)
Unpaid losses must represent actual unpaid losses and the estimates must be based upon the facts in each case and the company’s past experience 20

21. Key Rulings and Cases Dealing with Loss Reserves (continued)
Insurance Industrywide Examination Minutes, Minutes of Meeting in Hartford, CT on June 21 – 25, 1976, pages
Affirms continued use of historical testing
Made changes in years to be included in the Schedule P analysis and provided that companies could rebut proposed adjustments only based upon paid claims
Hannover Insurance Co, 65 TC Court held Service has authority to test taxpayer’s estimates of unpaid losses for reasonableness 21

22. Key Rulings and Cases Dealing with Loss Reserves (continued)
Western Casualty and Surety Co, 65 TC 897 – Court reversed the Service adjustment to unpaid losses on basis that redundancies were not offset by deficiencies in determining overall reasonableness
Hannover Insurance Co, 69 TC 260 – Court held taxpayer failed to show the Service’s use of the Com. Min. R.A methodology was unreasonable
Home Mutual Ins. Co v. Comm, 639 F. 2d 333 (7th Cir. 1980), rem’g 70 TC 944 (1978) - Court reversed the Tax Court and denied taxpayer’s retroactive adjustment to unpaid losses in subsequent years 22

23. Key Rulings and Cases Dealing with Loss Reserves (continued)
1980 – Internal Service memorandum (not publically released) described new approach to testing reasonableness of reserves that considered individual cases closed during the development period – Closed Case methodology
Closed Case II Method – 1982 Service memorandum modifies the methodologies to deal with problems experienced under the original closed case method 23

24. Key Rulings and Cases Dealing with Loss Reserves (continued)
Technical Advice Memorandum , October 29, 1981 – Service rules that change in unpaid loss by Examiner in prior tax year which results in changes to subsequent tax years opening reserve balances is not a change in accounting method under section 446
Technical Advice Memorandum , December 16, Services rules audit of unpaid loss reserves in accordance with RP which results in overstatement of reserves is appropriate and unless taxpayer provides support for “add-on” reserves to taxpayer’s IBNR they should be disallowed
Technical Advice Memorandum – Service upholds Examining Agent’s use of closed claim method 24

25. Key Rulings and Cases Dealing with Loss Reserves (continued)
Technical Advice Memorandum , November 2, 1982 – Service denies taxpayer offset of deficiencies in loss adjustment expenses against redundancies in unpaid loss reserves on basis RP does not include loss adjustment expenses in incurred losses
Technical Advice Memorandum – Service allows taxpayer to retroactively adjust its unpaid loss reserves to correct errors in its computation of its proportional share of quota share reinsurance 25

26. Key Rulings and Cases Dealing with Loss Reserves (continued)
Technical Advice Memorandum , October 9, 1986 – Service determines reserves held by insurance company for run-off claims established for potential liability under minimum premium plans if it is terminated do not constitute losses incurred
Technical Advice Memorandum , July 28, 1987 – Service concludes Examining Agent’s use of RP methodology to test unpaid losses was appropriate and further agreed that redundancies in taxpayer’s unpaid losses cannot be offset by deficiencies in estimates of loss adjustment expenses 26

27. Key Rulings and Cases Dealing with Loss Reserves (continued)
Property/Casualty Insurance Industry Specialist Coordinated Issue on Unpaid Losses, July 1, 1990 – Provides an outline of the testing methodology examination teams were to follow to test Annual Statement Schedule “O” and “P” loss reserves and unpaid loss adjustment expenses and provides a summary technical analysis of unpaid loss adjustment expenses. Testing methodologies are to establish that unpaid losses are reasonable in accordance with the guidance provided in Rev. Proc Methodology outline is largely the Closed Case II Method. 27

28. Key Rulings and Cases Dealing with Loss Reserves (continued)
Sears, Roebuck and Co and Affiliated Corporations v. Comm., 972 F. 2d 858 (7th Circuit 1992), affg. in part and revg. in part 96 T.C 61, 1991 WL 4979 (1991) modified 96 T.C. 671, 1991WL (1991) – Court allowed PMI Mortgage to deduct loss reserves related to loans in default in cases where the lender had not yet acquired title
See also American International Group, Inc. and United Guaranty Corporation v. US, 38 Fed Cl. 274 (1997)
FSA – Service instructs Examining Agent to follow Sears and AIG 28

29. Key Rulings and Cases Dealing with Loss Reserves (continued)
Utah Medical Insurance Association vs. Comm., T.C. Memo – Court concluded taxpayer’s unpaid loss reserves were fair and reasonable. Company actuary had provided a range for loss reserves and the company chose reserve estimates at the high end of the range. Court stated there was no authority requiring the taxpayer to chose the mid-point of the range and that each point in the range was reasonable. 29

30. Key Rulings and Cases Dealing with Loss Reserves (continued)
FSA , March 24, 1992 (release delayed until 1999) – Deals with proper treatment of punitive damages paid by an insurance company to an insured.
FSA , September 22, 1999 – Service applies Utah Medical to taxpayer facts and determines it should not litigate the case.
FSA , December 1, 1999 – Service recommends additional factual development related to whether or not unpaid losses are fair and reasonable on basis of Utah Medical 30

31. Key Rulings and Cases Dealing with Loss Reserves (continued)
Minnesota Lawyers Mutual Insurance Company and Subsidiaries v Comm., 285 F. 3rd 1086 (8th Cir. 2002) aff’g T.C. Memo (“MLM”) - Court upheld Service’s determination the unpaid loss reserves were not fair and reasonable estimates and the taxpayer failed to support its computations with detailed information related to its own experience. 31

32. Key Rulings and Cases Dealing with Loss Reserves (continued)
Physicians Insurance Company of Wisconsin, T.C. Memo (2001) - IRS maintained that the taxpayer’s reserves for the tax years 1993 and 1994 were overstated by 45%. Despite hindsight evidence of significant redundancies, the Tax Court approved the point estimates determined by the taxpayer’s actuaries. The reserves allowed by the Court exceeded the reserves proposed by the IRS by 59% and 69% in 1993 and The reserves not allowed by the Court related to a 10% add-on by the Company’s Treasurer. 32

33. Key Rulings and Cases Dealing with Loss Reserves (continued)
Technical Advice Memorandum , December 21, 2000 – Service discusses a variety of questions related to the deduction for losses incurred taking into account recent case law
Significant focus is on fair and reasonableness of the unpaid losses and how that must be supported by the taxpayer 33

34. Key Rulings and Cases Dealing with Loss Reserves (continued)
Sentry Insurance A Mutual Company, and Subsidiaries v. Comm., T.C. Docket Service proposed adjustments to unpaid loss reserves to bring them into line with the fair and reasonable standard
Acuity, A Mutual Insurance Company and Subsidiaries v. Comm., T.C. Docket Service proposed adjustments to unpaid loss reserves to bring them into line with the fair and reasonable standard 34

35. Other Miscellaneous Reserve Issues
Premium deficiency reserves
Loss adjustment expenses
Extra-contractual obligations/Punitive Damages
Resisted Claims
Uncollectible reinsurance
Guaranty fund assessments 35

36. Premium Deficiency Reserves SSAP No. 53 (para. 15)
Required when anticipated future policy costs exceed UPR and future installment premiums
Future policy costs include yet-to-be incurred claims and LAE, policy maintenance expenses, and unexpensed commissions and acquisition costs
Annual Statement disclosure required

37. Premium Deficiency Reserves (continued)
Incurred loss reserve? Problem: losses not yet incurred
UPR? Problem: reserve considers future unaccrued expenses
North American Reassurance Co. v. Commissioner, 29 BTA 683 (1934) (held deficiency reserves not insurance reserves)
For life companies, deficiency reserves part of statutory reserves, but not part of life insurance reserves. I.R.C. § 807(d)(3)(C), § 816(h)

38. Loss Adjustment Expenses
Classification of company dictates timing of deduction
Nonlife company – LAE deducted on reserve basis as part of claim reserves
Life company – IRS position is that LAE deductible only on accrual basis

39. Loss Adjustment Expenses I.R.C. § 404(a)(5) Issue
I.R.C. § 404(a)(5) requires employer’s deduction for deferred compensation to be deferred until it is includible in employee’s income
IRS Position – I.R.C. § 404(a)(5) overrides loss reserve rules – TAMs ,
Taxpayer Position – specific loss reserve rules of I.R.C. § 832 govern and I.R.C. § 404(a)(5) does not apply to reductions of gross income
Rev. Proc – safe harbor for incentive payments to health care providers when payments normally made within 12 months

40. Extracontractual Obligations/Punitive Damages
State Farm Mutual Automobile Insurance Company & Subsidiaries v. Comm., 135 T.C. 543 (2010) – Court held insurance company cannot include punitive damage judgment as a loss incurred and increase its unpaid loss reserves
Punitive damages/State Farm case pending

41. Resisted Claims
Resisted losses are deducted as part of unpaid losses on a discounted reserve basis
Rev. Rul
GCM 33008
100% of discounted resisted losses are tested for reasonableness on an aggregate basis with other unpaid losses
TAM
Rev. Proc
Western Casualty & Surety Co. 41

42. Resisted Claims (cont’d)
Same treatment applies to unpaid losses of life companies (other than on life insurance contracts)
I.R.C. § 807(c)
S. Rep. No. 313, 99th Cong. 2nd Sess (1986)
GCM 33183
Estimated legal and other expenses related to resisted claims are part of unpaid losses

43. Resisted Claims Unresolved Issues
Other extracontractual claims/Market conduct claims
Premium disputes
ASO disputes

44. Uncollectible Reinsurance
TAM – Estimates of uncollectible reinsurance with respect to both paid and unpaid losses are taken into account on an estimated basis as part of losses incurred
Despite this, IRS agents test uncollectible reinsurance separately and require actual evidence of uncollectibility; IRS agents reject formula-based estimates
Sentry case pending in Tax Court raises issue

45. Guaranty Fund Assessments
Safe harbor accounting method for premium acquisition expenses applies for nonlife companies – Rev. Proc
Capitalization not required for possible premium tax credits – Treas. Reg. § 1.263(a)-4
IRS agents looking for disallowance for estimates based on future assessments or insolvencies, or assessments based on future premiums
Acuity case pending in Tax Court raises issue