Casualty Actuarial Society
Loss Reserve Seminar
Income Tax Considerations
Richard Bromley
Partner, Foley & Lardner Chicago
1
Background
• “Losses incurred” – generally P&C insurer’s
biggest item of deduction for federal income
tax purposes
2
Background
• Business taxpayers generally entitled to
deduction when all events have occurred to
establish liability and amount can be
estimated with reasonable accuracy
3
Background
• Different standard for P&C insurers
• Since 1921 Internal Revenue Code: P&C insurer tax
liability to be computed “on the basis of the
underwriting and investment exhibit of the annual
statement approved by the NAIC”
– “All events test” not applicable
– Ability to estimate ultimate liability
4
Background
• Treasury Regs require
– only actual unpaid losses
– based on facts in each case and the company’s experience
with similar cases
– represent fair and reasonable estimate of amount company
will be required to pay
• Until 1986, method of computing “losses incurred”
deduction same as annual statement.
5
Background
• Beginning in 1987, “losses incurred” given special tax
definition:
– Still begins with amounts reported on annual statement
– Modified to include loss adjustment expenses
– Also includes estimated salvage recoverable on paid and
unpaid losses
– Subject to discounting under rules set forth in I.R.C.
• But “losses incurred,” “unpaid losses,” and “loss
adjustment expenses” as reported on annual statement
still the fundamental starting point
• If demonstrate that amounts reported on annual statement
are reasonable estimates, generally no other issue for tax
purposes
6
Background
• IRS frequently asserts “losses incurred” are
overstated
– Substantial amounts involved
– Imprecision of reserving process
– Belief that state regulators only concerned with
adequacy, not redundancy
– Concern that reserving is tax-motivated
– Statements made in annual reports, S.E.C. filings
7
Background
• Until fairly recently, actuaries not involved in
resolving tax disputes with IRS
– As a practical matter, what companies actually did
in setting reserves not taken into account
– No review of reserving methodologies,
assumptions, trends, etc.
8
Background
• Taxpayers and IRS used crude, mechanical
“rules of thumb”
– Develop reserves for specified years prior to tax
year (e.g., 5th – 7th)
– If run off of prior year reserves not redundant
beyond certain limits (15%; later no specified
tolerance), reserve for tax year deemed
reasonable
– If prior year run off too redundant, reserve for tax
year also deemed redundant
9
Utah Medical
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Case in Tax Court
Watershed change
First case where actuaries heavily involved
For taxpayer and IRS
Actuarial expert reports and oral testimony
concerning
– Reserving methodologies
– Ranges
– Selection of reserve estimate
• Confirmed by second actuary at trial
10
Utah Medical
• Also role of management
– Factors taken into account
• Court decided for Utah Medical based on
reasonableness of what actuary and
management did in establishing reserve
– Even though reserve consistently at high end of
range
11
Utah Medical
• Standard adopted by Tax Court:
– Was the reserve estimate reasonable?
• Consistent use of recognized actuarial
methodologies
– Not necessarily “most reasonable”
12
Utah Medical
• Standard adopted by Tax Court:
– Recognized can have more than one reasonable
estimate
– Fact that government’s actuary came up with a
different reasonable estimate did not render company’s
reserve estimate unreasonable
– For IRS to succeed in challenge must demonstrate
company’s reserve estimates unreasonable
– Actual subsequent development of reserves for tax
year not relevant
13
Utah Medical
• Subsequent cases have also involved
actuarial evidence
– Minnesota Lawyers
– Physicians Insurance of Wisconsin
14
Post Utah Medical
• Dealing with Loss Reserve Tax Controversies
– IRS Examination
• Done by Revenue Agent at the company
– Not an actuary
– May not be familiar with insurance concepts
– May have penchant to apply rules applicable to non-insurers
• Generally little or no actuarial involvement on IRS side
• Agents use various reserving software (e.g., Exhibit-Maker)
• May review actuarial reports, company annual reports,
Best’s reports, S.E.C. filings, etc.
15
Post Utah Medical
• Dealing with Loss Reserve Tax Controversies
– IRS Examination
• Company has opportunity to explain to Revenue Agent
why reserve reasonable
• May seek assistance from IRS Industry Coordinator
– Higher level of expertise
– May meet with company representatives
– Attempt to apply uniform standards nationwide
16
Post Utah Medical
• Dealing with Loss Reserve Tax Controversies
– IRS Examination (con’t)
• If Revenue Agent believes reserves redundant, issues
“30-Day Letter” setting up proposed adjustments
• Taxpayer has opportunity to file written protest,
administrative review at “higher level”
17
Post Utah Medical
• Dealing with Loss Reserve Tax Controversies
– Administrative review – “Appeals”
• Usually occurs at IRS office
– Often more experienced
– May seek involvement of appellate coordinator
– May involve actuary on IRS side
– Wider leeway to settle than exists at exam level
• Opportunity for taxpayer to present arguments to seek
reversal of Revenue Agent’s adjustments, or settlement
18
Post Utah Medical
• If not resolved at Appeals, can go to court
– IRS issues statutory notice (“90-Day Letter”)
asserting deficiency
– Taxpayer Alternatives
• File suit in Tax Court
• Within 90 days
• No need to pay asserted deficiency unless lose
• Pay deficiency and seek refund
• Bring refund suit either in Court of Federal Claims or
Federal District Court
19
Post Utah Medical
• Implications and roles for actuary at all stages
– Setting reserves
– At exam
– At appeals
– In court
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