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ITC Insurance Tax ConferenceThursday, 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

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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. 1.832-4(b).

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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 1.832-4(a)(14) and 1.832-4(b), and, that with respect to “margins” or other additions to unpaid losses two elements must be considered:

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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.

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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.”

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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.”

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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.”

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Unpaid Loss Reserves (continued)

• The last sentence of the Issue Paper states: “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.”

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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.

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 analysis10

Statistical Approach to Claim Reserves

• Mode

• Median

• Expected Value

• Systematic emergence of profit

• Opining actuary standard

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Mode

• Most likely outcome

• LB&I usually argues that mode is required by Treas. Reg. § 1.832-4(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

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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

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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

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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

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Opining Actuary Standard

• “Good and sufficient”

• Moderately adverse conditions

• Standard considers reserve volatility

• Usually target confidence level of 85-90%

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IRS AppealsResolution 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

Key Rulings and Cases Dealing with Loss Reserves

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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

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Key Rulings and Cases Dealing with Loss Reserves

• Revenue Procedure 75-56, 1975-2 CB 596 - 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 1.832-4(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

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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 107-116– 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 715 - Court held Service has authority to test taxpayer’s estimates of unpaid losses for reasonableness

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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. 1366 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

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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

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• Technical Advice Memorandum 8208006, 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 8213007, December 16, 1981 - Services rules audit of unpaid loss reserves in accordance with RP 75-56 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 8248006 – Service upholds Examining Agent’s use of closed claim method

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• Technical Advice Memorandum 8304010, November 2, 1982 – Service denies taxpayer offset of deficiencies in loss adjustment expenses against redundancies in unpaid loss reserves on basis RP 75-56 does not include loss adjustment expenses in incurred losses

• Technical Advice Memorandum 8614004 – Service allows taxpayer to retroactively adjust its unpaid loss reserves to correct errors in its computation of its proportional share of quota share reinsurance

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• Technical Advice Memorandum 8705003, 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 8817001, July 28, 1987 – Service concludes Examining Agent’s use of RP 75-56 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

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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 75-56. Methodology

outline is largely the Closed Case II Method.

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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 61250 (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 200023008 – Service instructs Examining Agent to follow Sears and AIG

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• Utah Medical Insurance Association vs. Comm., T.C. Memo 1998-458 – 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.

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• FSA 19991054, March 24, 1992 (release delayed until 1999) – Deals with proper treatment of punitive damages paid by an insurance company to an insured.

• FSA 199952011, September 22, 1999 – Service applies Utah Medical to taxpayer facts and determines it should not litigate the case.

• FSA 200010016, December 1, 1999 – Service recommends additional factual development related to whether or not unpaid losses are fair and reasonable on basis of Utah Medical

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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 2000-203 (“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.

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• Physicians Insurance Company of Wisconsin, T.C. Memo 2001-304 (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 1994. The reserves not allowed by the Court related to a 10% add-on by the Company’s Treasurer.

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• Technical Advice Memorandum 200115002, 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

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Key Rulings and Cases Dealing with Loss Reserves (continued)

• Sentry Insurance A Mutual Company, and Subsidiaries v. Comm., T.C. Docket 17495-1 - 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 9421-11 - Service proposed adjustments to unpaid loss reserves to bring them into line with the fair and reasonable standard

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Other Miscellaneous Reserve Issues

• Premium deficiency reserves

• Loss adjustment expenses

• Extra-contractual obligations/Punitive Damages

• Resisted Claims

• Uncollectible reinsurance

• Guaranty fund assessments

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Premium Deficiency ReservesSSAP 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

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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)

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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

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Loss Adjustment ExpensesI.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 9723005, 200939019

• 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. 2004-41 – safe harbor for incentive payments to health care providers when payments normally made within 12 months

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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

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Resisted Claims

• Resisted losses are deducted as part of unpaid losses on a discounted reserve basis

– Rev. Rul. 70-643– GCM 33008

• 100% of discounted resisted losses are tested for reasonableness on an aggregate basis with other unpaid losses

– TAM 200115002– Rev. Proc. 75-56– Western Casualty & Surety Co.

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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. 500-501

(1986)– GCM 33183

• Estimated legal and other expenses related to resisted claims are part of unpaid losses

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Resisted ClaimsUnresolved Issues

• Other extracontractual claims/Market conduct claims

• Premium disputes

• ASO disputes

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Uncollectible Reinsurance

• TAM 9732004 – 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

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Guaranty Fund Assessments

• Safe harbor accounting method for premium acquisition expenses applies for nonlife companies – Rev. Proc. 2002-46

• 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