1. Casualty Actuaries Society Tax Issues Associated with Unpaid Losses September 12, 2006

2. Panel Dick Bromley-Foley & Lardner Craig Pichette-KPMG WNT Joseph Long-Internal Revenue Service

3. Section 832(b)(5) A deduction is allowed for “losses incurred” including “discounted unpaid losses” as defined in section 846 “Undiscounted unpaid losses” means “…the unpaid losses shown on the annual statement shown in the annual statement filed by the taxpayer…” (section 846(b)(1)) Unpaid losses includes LAE

4. Regs. Sec. 1.832-4 (a)(5) 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…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…

5. Utah Medical Utah Medical Insurance Assn. v. Comm. TC Memo. 1998-458 Monoline medical malpractice company Tillinghast prepared reserve estimates for years at issue (1991-1992) using five methods and complying with actuarial standards Unpaid losses were $45.6 M at 12/31/1991 and $49.4 M at 12/31/1992 IRS asserted gross undiscounted redundancies of $13 M for 1991 and $19.3M for 1992

6. Utah Medical Court held for the taxpayer Taxpayer’s reserve was within the range, although at the high end Need not use the midpoint of the range Need not choose the “best” estimate, only a “fair and reasonable” estimate

7. Minnesota Lawyers Minnesota Lawyers Mutual Ins. Co. v. Comm., TC Memo. 2000-23 Primarily wrote professional liability insurance for lawyers during 1993-1995 Total reserves at EOY’s was approximately $11-12M 1993 actuary’s report had a best estimate of $7.8 M v. $11.6 M booked by company 1994 and 1995 actuarial reports developed ranges and point estimates. Carried reserves were at the high end of the ranges and in excess of the point estimates. Company’s reserve methodology was based upon development of case reserves with an additional bulk reserve for “adverse development” of $3-4 M per year. IRS disallowed the adverse development reserve and a portion of the case reserves

8. Minnesota Lawyers Court held for the IRS that reserve for “adverse development” reserve Actuarial methods not used to develop the reserve, only used to evaluate reserves for statutory certification Court allowed deduction for highest point estimate determined by an actuary

9. Physicians Insurance Physicians Insurance Co. of Wisconsin, TC Memo 2001- 304 Medical malpractice writer in Wisconsin Tillinghast estimated reserves using five actuarial methods Company used reserves approximately 10 percent higher than Tillinghasts for years at issue (1993-1994) Audit firm held that company’s reserve were reasonable because of lack of historical experience IRS disallowed approximately 40 percent of the reserves on audit

10. Physicians Mutual Court disallowed the 10 percent excess of company reserves over Tillinghast point estimate 10 percent excess “not actuarial in nature” IRS’ criticism of Tillinghast calculations was not compelling

11. TAM 200115002 “National Office position for the deduction of ‘losses incurred’” Taxpayer is not required to use the “most accurate estimate”, only a “fair and reasonable” estimate Taxpayer’s estimate will be considered “fair and reasonable” if it is estimated on the basis of a recognized methodology that is appropriate for the particular line of business, is in accordance with actuarial standards, and takes into account prior experience. Use of hindsight is inappropriate

12. SSAP 55 9. Various analytical techniques can be used to estimate the liability for IBNR claims, future development on reported losses/claims, and loss/claim adjustment expenses. These techniques generally consist of statistical analysis of historical experience and are commonly referred to as loss reserve projections…The decision to use a particular projection method and the results obtained from that method shall be evaluated by considering the inherint assumptions underlying the method and the appropriateness of those assumptions to the circumstances. No single projection method is inherintly better than any other in all circumstances. The results of more than one method should be considered.

13. SSAP 55 10. For each line of business and for all lines of business in the aggregate, management shall record its best estimate of its liabilities for unpaid claims, unpaid losses, and loss/claim adjustment expenses. Because the ultimate settlement of claims is subject to future events, no single claim or loss and loss/claim adjustment reserve can be considered accurate with certainty. Management’s analysis of the reasonableness of claim or loss and loss/claim adjustment expense reserve estimates shall include an analysis of the amount of variability in the estimate. If, for a particular line of business, management develops its estimate considering a range of claim or loss and loss/claim adjustment expense reserve estimates bounded by a high and a low estimate, management’s best estimate of the liability within that range shall be recorded. The high and low ends of the range shall not correspond to an absolute best-and-worst case scenario of ultimate settlements because such estimates may be the result of unlikely assumptions. Management’s range shall be realistic and, therefore, shall not include the set of all possible outcomes but only those outcomes that are considered reasonable.

14. SSAP 55 12. In the rare circumstance when, for a particular line of business, after considering the relative probability of the points within management’s estimated range, it is determined that no point within management’s estimate of the range is a better estimate than any other point, the midpoint within management’s estimate of the range shall be accrued. It is anticipated that using the midpoint in the range will be applicable only when there is a continuous range of possible values, and no amount within that range is any more probable than any other…This guidance is not applicable when there are several point estimates which have been determined as equally possible values, but those point estimates do not constitute a range. If there are several point estimates with equal probabilities, management should determine its best estimate of the liability.

15. ASOP 36 3.3.2(c) Determination of Redundant or Excessive Provision-When the stated reserve amount is greater than the maximum amount that the actuary believes is reasonable, the actuary should issue a statement of actuarial opinion that the stated reserve amount does not make a reasonable provision for the liabilities associated with the specified reserves.

16. ASOP 36 4.6(e)-If the actuary determines that thte stated reserve amount is redundant or excessive, the actuary should disclose the amount by which the stated reserve amount exceeds the maximum amount that the actuary believes is reasonable.

17. SOX 404 Documentation of procedures around methodology for determination of reserve amounts Documentation of controls around the determination of the reserve amount

18. Current Environment Deference to actuarial computations v. management determinations Hindsight Importance of ranges SSAP 55 requirements Documentation and control environment Actuarial standards

19. Current Environment Relatively few adjustments on exam –Cycle of underreserving? –Taxpayer friendly court decisions? –Better documentation and controls? –Appeals Conference experience? Current IRS exam approach –Use of actuaries –Audit techniques

20. Questions