UNITED STATES TAX COURT
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T.C. Memo. 1998-458
UNITED STATES TAX COURT
UTAH MEDICAL INSURANCE ASSOCIATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11880-96.
Filed December 30, 1998.
Tracy D. Williams, Richard Bromley, Glen H. Kanwit, and
Michael R. Schlessinger, for petitioner.
Martha Sullivan, Peter Hochman, Alan Summers, David
Sorensen, and Nancy McCurley, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge:
Respondent determined that petitioner had
deficiencies in income tax of $5,280,264 for 1991 and $1,905,200
for 1992.
-2The sole issue for decision is whether petitioner may deduct
$45,650,249 for its reserves for discounted unpaid losses and
loss adjustment expenses for 1991 and $49,418,509 for 1992.
We
hold that it may.
Section references are to the Internal Revenue Code.
Unless
otherwise indicated, Rule references are to the Tax Court Rules
of Practice and Procedure.
I.
A.
FINDINGS OF FACT
Petitioner
Utah Medical Insurance Association (referred to as
petitioner) is a property and casualty insurance company the
principal place of business of which is in Salt Lake City, Utah.
Petitioner provides medical malpractice liability insurance for
physicians in Utah, Montana, and Idaho.
Medical malpractice
liability insurance indemnifies a physician against medical
professional liability claims for damages brought as a result of
the provision of, or the failure to provide, medical services.
Petitioner is, and during the years in issue was, taxed as a
property and casualty insurance company under sections 831-835.
Petitioner is managed by its board of directors, which is
composed of 12 of petitioner's policyholder-physicians.
B.
Medical Malpractice Insurance
In the 1960's, medical malpractice liability insurance was
generally provided by commercial insurance companies.
Beginning
around 1965, commercial insurance companies experienced large
-3underwriting losses as a result of a rapid increase in medical
malpractice claims and litigation.
As a result, they raised
rates, e.g., 400-600 percent in California from 1965 to 1971, to
cover their losses.
When rate increases failed to keep pace with
continued adverse loss experience, many commercial insurers
stopped issuing medical malpractice insurance.
As a result,
State medical societies formed physician-owned medical
malpractice insurance companies to offer medical malpractice
insurance to their members.
In the early 1970's, the Utah Medical Association (UMA), the
leading professional association for doctors in Utah, endorsed
Aetna Life and Casualty Insurance Co. (Aetna) as the preferred
malpractice carrier in Utah.
Aetna, which wrote most of the
medical malpractice insurance in Utah during the 1970's,
increased rates several times in the late 1970's.
C.
Formation of Petitioner
In response to Aetna's rate increases, about 900 doctors who
were members of UMA formed petitioner as an unincorporated interinsurance exchange1 or reciprocal company in November 1978.
They
executed subordinated loans which gave petitioner an initial
capitalization of $2.2 million.
Shortly thereafter, Aetna
withdrew from the insurance market in Utah.
Petitioner became
the principal medical malpractice insurer in Utah.
1
An inter-insurance exchange is a mutual insurance company
in which the members of a group insure each other's risks.
-4From 1978 to 1981, petitioner wrote medical malpractice
insurance only in Utah.
In 1982, petitioner began issuing
insurance policies to physicians practicing in Montana, and in
1991 to physicians practicing in Idaho.
During the years in
issue, about 85-90 percent of petitioner's insurance policies
were issued to doctors practicing in Utah.
During those years, petitioner primarily wrote medical
malpractice liability insurance and also wrote a small amount of
general liability insurance for its covered physicians.
From 1984 to 1992, the number of doctors insured by
petitioner increased as follows:
D.
Year
Number of insureds
1984
1985
1986
1987
1988
1989
1990
1991
1992
1,369
1,432
1,482
1,630
1,699
1,819
1,814
1,920
2,002
Regulation of Petitioner by the Utah Department of Insurance
Petitioner is principally regulated by the Utah Department
of Insurance (UDI).
Petitioner maintained its books and records
in accordance with UDI requirements and filed annual statements
with UDI.
Petitioner prepared each annual statement in the
format prescribed by the National Association of Insurance
Commissioners (NAIC), a voluntary association of State insurance
commissioners.
-5Insurance companies use "statutory accounting" principles to
prepare their annual statements.
Statutory accounting principles
are conservative and focus on maintaining the solvency of an
insurance company to protect insurance consumers.
UDI required that annual statements due after December 31,
1991, be accompanied by an actuarial opinion concerning the
reasonableness of the insurance company's reserves.
The
actuarial firm of Tillinghast Towers Perrin (Tillinghast)
certified to UDI that petitioner's reserves for unpaid losses
shown on its 1991 and 1992 annual statements were computed in
accordance with accepted loss reserving standards and were fairly
stated in accordance with sound loss reserving principles, were
based on factors relevant to policy provisions, met the
requirements of the insurance laws of the State of Utah, and
provided sufficiently for all of petitioner's unpaid loss and
loss expense obligations.
E.
Reserves for Unpaid Losses
On their annual statements, property and casualty insurers
are required to report estimates of amounts they expect to pay
for losses2 that have already occurred (unpaid losses) and
related loss adjustment expenses.
2
These estimates are known as
A loss is an injury sustained by a person who has a right
to hold the insured liable for that injury. A loss is incurred
when the event insured against occurs. Ocean Accident & Guar.
Corp. v. Southwestern Bell Tel. Co., 100 F.2d 441, 446 (8th Cir.
1939).
-6reserves for unpaid losses.
A property and casualty company's
loss reserve is the amount that is needed to make all future
payments on claims that have already been incurred.
Utah Code
Ann. sec. 31A-17-402(1) (1997) requires insurers to report a
liability for unpaid losses equal to "the estimated amount
necessary to pay all its unpaid losses and claims incurred on or
prior to the date of statement, whether reported or unreported,
together with the expense of adjustment or settlement of the loss
or claim".
The reserve for unpaid losses3 includes all incurred losses.
Incurred losses include insured events for which a claim has been
filed (reported losses), and insured events for which no claim
has been filed with the company; i.e., incurred but not reported
(IBNR) losses.
The first step in estimating loss reserves is to estimate
the total amount that will ultimately be paid for a coverage year
for all claims existing on a given date (ultimate losses).
Ultimate losses equal paid losses plus an estimate of unpaid
losses at the end of the year.
Unpaid losses are generally
estimated not later than the year in which the insured event
giving rise to the loss occurred (the accident year).4
In
3
Unless otherwise indicated, we use the terms "loss" and
"unpaid loss" to include both losses and loss adjustment
expenses; that is, amounts paid to defend or settle claims.
4
Unless otherwise indicated, we use the term "coverage
(continued...)
-7estimating its ultimate losses each year, petitioner adjusted its
prior estimates of earlier years' ultimate losses to factor in
its loss experience.
Petitioner's president, Martin J. Oslowski (Oslowski),
recommended an amount to report as annual statement unpaid losses
to the board of directors.
Oslowski was petitioner's claims
manager before he became president in December 1986.
Petitioner wrote only one line of insurance, and thus
petitioner could not offset reserve deficiencies with surpluses
in another line as multiline companies could do.
F.
Occurrence Basis and Claims-Made Basis Policies
Medical malpractice insurance may be written on an
"occurrence" basis or on a "claims-made" basis.
An occurrence
basis policy covers losses that occur within the policy period
whenever reported.
A claims-made basis policy covers only losses
from occurrences during the policy period (or a previous policy
period) for which claims are made or which are otherwise reported
during the period.
From 1978 to 1985, petitioner and most of the
medical malpractice insurance industry offered only occurrence
basis policies.
In 1984, petitioner's financial position was tenuous because
its losses in the early 1980's were significantly larger than its
4
(...continued)
year" instead of "accident year" because this case involves both
occurrence and claims-made coverage.
-8reserves.
Petitioner believed that a switch from occurrence to
claims-made basis policies would improve its financial condition.
In 1985, based on the recommendation of Tillinghast, petitioner
began offering claims-made instead of occurrence basis policies
to its physicians.
Petitioner's claims-made policies had a 1-
year term and an anniversary date5 of January 1.
Occurrence
basis medical malpractice insurance policies are "long-tailed"
because it can take 10 years or more for claims to be received
and resolved.
G.
Petitioner's Actuaries
Petitioner has hired outside actuaries to perform all of its
actuarial services since it was formed.
1.
Milliman & Robertson
From 1978 to 1985, the actuarial firm of Milliman &
Robertson (M&R) provided actuarial services to petitioner to help
it estimate its annual statement unpaid losses.
Petitioner followed M&R's recommendations.
underestimated petitioner's unpaid losses.
However, M&R
As this unfavorable
trend emerged, petitioner gradually increased its estimates of
unpaid losses each year.
To improve its financial condition, in 1984 petitioner asked
UDI for permission to discount its loss reserves for the
5
The anniversary date is the date when insurance coverage
begins. Modern Am. Life Ins. Co. v. Commissioner, 92 T.C. 1230,
1232 (1989).
-9occurrence basis years.
UDI approved petitioner's request.
However, UDI required petitioner to begin filing quarterly
statements and to provide UDI with loss and investment
information.
UDI, in effect, began to oversee petitioner's
operations.
2.
Tillinghast
In 1984, petitioner hired Tillinghast to determine whether
petitioner had sufficient assets and surplus to meet its
liabilities.
3.
Tillinghast concluded that petitioner did not.
Tillinghast's Loss Reserve Reviews and Rate Reviews
Tillinghast began preparing loss reserve reviews6 and rate
reviews7 for petitioner at the end of 1985.
Sometimes actuaries estimate ultimate losses as a range with
high and low bounds (a "bounded range") instead of as a single
number (a "point estimate").
9 states:
Actuarial Standard of Practice No.
"The uncertainty inherent in the estimation of
required provisions for unpaid losses or loss adjustment expenses
implies that a range of reserves can be actuarially sound."
Tillinghast estimated petitioner's ultimate losses within a
bounded range.
Beginning in 1989, James Hurley (Hurley), an actuary
6
Loss reserve reviews project an insurer's ultimate losses
based on its loss data.
7
Tillinghast analyzed petitioner's rates (i.e., premiums),
to help petitioner decide how much to charge its insureds in the
upcoming year.
-10employed by Tillinghast, prepared annual rate reviews and
semiannual loss reserve reviews for petitioner.
In preparing his
reserve reviews, Hurley received information from petitioner
about its paid losses and case reserves.8
Petitioner's claims
investigators generally established petitioner's case reserves
based on their initial impression of each claim and revised them
as they acquired more information.
The high end of Tillinghast's estimate of petitioner's
ultimate losses in 1986 and the high end reestimates of its
ultimate losses in later years were as follows:
Tillinghast's High End Estimates Of Petitioner's
Ultimate Net Losses & Allocated Loss Adjustment Expenses1
(in thousands)
Year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1986
1987
1988
1989
1990
1991
1992
1993
1994
$3,544
---------
$2,481
8,450
--------
$2,293
6,840
12,791
-------
$2,186
6,655
11,372
13,782
------
$2,700
6,300
9,900
12,500
16,000
-----
$2,700
7,250
9,250
12,250
15,250
15,500
----
$2,750
7,250
8,750
11,000
14,500
15,000
17,500
---
$2,875
7,000
8,250
10,250
13,500
14,000
17,000
15,000
--
$2,850
6,900
7,750
9,000
12,500
13,250
16,500
15,000
16,500
665
1,476
1,777
1,361
1,625
1,034
3,284
4,657
11,596
23,400
35,772
48,761
63,825
77,784
91,159
104,907
IBNR
Total
3,544
1
Allocated loss adjustment expense is defined above at par.
I-E.
Petitioner discounted the part of its reserves that related
8
Case reserves are estimates made by an insurer of the
unpaid loss amounts expected to be paid in connection with
specific known claims.
-11to occurrence-based policies during the years in issue.
In those
years, petitioner followed the same procedures in establishing
its annual statement unpaid losses that it had used in prior
years.
It gave data to Tillinghast which Tillinghast used to
make development method9 and pure premium method10 projections.
In the property and casualty industry, "development" is the
actual experience (both paid and unpaid) regarding a loss
estimate over time.
The number of petitioner's claims greatly increased in 1990
and remained at a higher level for 1991 and 1992.
The severity
(i.e., the average cost per claim) of petitioner's claims also
increased in 1991 and 1992.
Tillinghast's 1991 and 1992 loss reserve reviews used a
range bounded by a high and low end estimate of projected
ultimate losses.
The bounds of Tillinghast's range are the sums
of the high and low end estimates of ultimate loss for each
coverage year, at the December 31 valuation date.
Tillinghast's
9
Under the development method, a series of loss development
factors (one for each "age" of coverage year, e.g., coverage year
+ 0 is the current year, coverage year + 1 is the preceding year,
coverage year + 2 is the second preceding year) are developed
based on the past experience of a given coverage year's paid or
incurred losses over time. These factors are then multiplied by
the paid or incurred losses as of the annual statement date for
the corresponding age of coverage year.
10
The pure premium method projects expected losses by
multiplying historical average losses per exposure unit; e.g.,
per doctor by the number of exposure units covered for the
coverage year.
-12ranges were relatively large because, in Hurley's opinion,
medical malpractice losses are difficult to project accurately.
Tillinghast projected that, as of December 31, 1991,
petitioner had ultimate losses ranging from $88,483,000 to
$99,645,000 (before discounting), and that reserves ranging from
$45,426,000 to $57,289,000 (before discounting) for coverage
years 1978 to 1991 would be reasonable.
As of December 31, 1992,
Tillinghast projected that petitioner had ultimate losses ranging
from $100,101,000 to $112,204,000 (before discounting), and that
reserves ranging from $49,066,000 to $61,948,000 (before
discounting) for the coverage years 1978 to 1992 would be
reasonable.
Tillinghast separated the projected ultimate losses
by coverage year.
Joseph Perry, petitioner's vice president of finance/chief
financial officer, subtracted from these ultimate loss estimates
petitioner's paid losses as of December 31, 1991, and December
31, 1992, to determine a range of unpaid losses for all of the
coverage years included in the 1991 and 1992 unpaid loss
reserves.
Petitioner reported on its annual statements that it
had undiscounted unpaid losses of $56,847,261 for 1991 and
$61,971,100 for 1992.
Petitioner had a conservative reserve
philosophy to ensure that it could pay future losses.
Petitioner
selected reserves below the low end of Tillinghast's range for
1986 and at the high end of Tillinghast's ranges for 1987 to
1992.
-13UDI examined petitioner's 1990-93 annual statements.
It did
not adjust the amount of unpaid losses and loss adjustment
expenses that petitioner reported.
Estimates of unpaid losses by the medical malpractice
insurance industry (both physician-owned and commercial,
multiline carriers) and petitioner were similar as shown below:
Estimates of Unpaid Losses For 1992 and Earlier
As of
Dec. 31
Medical malpractice
insurance industry
1992
1995
$21,879,689,000
17,709,112,000
H.
Percentage
of original
Petitioner
Percentage
of original
-81
$61,971,100
48,931,000
-79
Petitioner's Financial Condition
1.
A.M. Best Ratings
A.M. Best (Best) rates the financial condition of property
and casualty insurers each year.
From 1984 to 1992, Best gave
petitioner the following ratings:11
11
A.M. Best describes its ratings as follows:
a. A (Excellent). Assigned to companies which in
Best's opinion have achieved excellent overall performance
when compared to the norms of the property/casualty
insurance industry. A rated insurers generally have shown a
strong ability to meet their policyholder and other
contractual obligations.
b. B+ (Very good). Assigned to companies which in
Best's opinion have achieved very good overall performance
when compared to the norms of the property/casualty
insurance industry. B+ rated insurers generally have shown
a very good ability to meet their policyholder and other
contractual obligations.
c. B (Good). Assigned to companies which in Best's
opinion have achieved good overall performance when compared
(continued...)
-14-
2.
Year
Rating
1984
1985
1986
1987
1988
1989
1990
1991
1992
B
unknown
NA-7
NA
B+
B+
AAA-
Surpluses
Petitioner reported on its 1985 to 1992 annual statements
that it had the following surpluses:
Year
1985
1986
1987
1988
1989
1990
1991
1992
3.
Surplus reported
$4,533,310
5,481,798
8,842,442
10,371,232
12,319,227
14,382,840
15,876,858
18,195,874
Ultimate Loss Estimates
Petitioner reported the following initial estimates and
reestimates of its ultimate losses on its annual statements from
11
(...continued)
to the norms of the property/casualty insurance industry. B
rated insurers generally have shown a good ability to meet
their policyholder and other contractual obligations.
d. NA (Not Assigned). Approximately 400 or 25 percent
of the companies reported on in Best's Insurance Reports are
not eligible for a Best's Rating (A+ to C). Companies with
an NA rating are assigned to one of 10 classifications to
identify why the company was not eligible for a Best's
Rating.
e. NA-7. Below Minimum Standards. Assigned to a
company that meets Best's minimum size and experience
requirements, but does not meet the minimum standards
for a Best's Rating of "C".
-151986 to 1996:
Ultimate Net Losses & Allocated Loss Adjustment Expenses
(Schedule P - Part 2 - Summary Of Annual Statement)1
(in thousands)
Year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1986
$3,865
-----------
1987
$2,492
9,077
----------
1988
$2,414
7,270
15,127
---------
989
$2,191
6,655
11,372
15,559
--------
1990
$2,191
7,050
9,400
12,250
17,403
-------
1991
$2,205
7,250
9,250
12,250
15,278
17,125
------
1992
$2,205
7,250
9,250
11,250
14,528
15,000
17,534
-----
1993
$2,257
7,054
8,624
10,346
13,882
14,520
17,607
16,225
----
1994
$2,256
6,961
8,045
9,077
12,905
13,747
17,046
16,110
18,141
---
1995
$2,255
6,958
7,751
8,564
12,153
13,556
16,769
15,746
17,532
18,758
--
1996
$6,908
7,501
7,439
11,129
11,979
16,682
15,797
17,122
19,137
21,520
Total
3,865
11,569
24,811
35,777
48,294
63,358
77,017
90,515
104,288
120,042
135,214
2
1
The initial estimate is the first entry for each year in the vertical
axis; the reestimates are shown on the horizontal axis.
2
The 1986 information was not individually available on the 1996 annual
statement.
In 1991 and 1992, medical malpractice loss experience was
favorable for coverage years 1986-90.
4.
Dividends
Petitioner declared and paid dividends to its policyholders
from 1988 to 1992 as follows:
5.
Year
Dividend amount
1988
1989
1990
1991
1992
$1,500,000
1,500,000
2,000,000
2,000,000
2,000,000
Premiums
The premiums petitioner charged for its medical malpractice
insurance policies changed as follows:
-16-
I.
Year ending
Percentage change from
preceding year or period
12/1/79
12/1/80
12/1/81
12/1/82
12/1/83
12/1/84
12/1/85
12/1/86
12/1/87
1/1/89
1/1/90
1/1/91
1/1/92
7/1/92
-5.0%
12.1
11.8
24.6
14.9
42.0
67.0
30.5
4.5
2.6
0.0
-3.2
-13.6
-7.0
Reinsurance
During the years at issue, petitioner bought reinsurance12
coverage for losses falling in a certain loss "layer"; i.e., for
losses and allocated loss adjustment expenses in excess of a
certain minimum and below a certain maximum per loss.
Petitioner's reinsurance treaty13 during the years at issue
covered losses from $300,000 plus an indexed amount to a maximum
of $1 million per loss.
The indexed amount equaled the product
of (a) $25,000, and (b) the number of "December 31sts" occurring
12
Reinsurance is an agreement between an insurer (the
ceding company) and a second insurer (the reinsurer), under which
the ceding company passes to the reinsurer some or all of the
risks that the ceding company assumes through the direct
underwriting of insurance policies. See Trans City Life Ins. Co.
v. Commissioner, 106 T.C. 274, 278 (1996).
13
A reinsurance treaty is a contract between two insurers
in which the reinsurer agrees to provide coverage of risks that
the primary insurer has already assumed under an insurance
contract with another party. See Trans City Life Ins. Co. v.
Commissioner, supra.
-17between the loss event and the time when petitioner first became
obligated to make a payment in respect to the loss event.14
Losses exceeding $1 million were covered by a separate
reinsurance treaty.
Based on its pattern for paying significant claims,
petitioner's average "retention"15 by the time those claims would
be paid was about $375,000 to $400,000 during the years in issue
($300,000 plus $25,000 for each December that passed between the
coverage year and the year of final payment of the claim).
J.
Income Tax Returns and Notice of Deficiency
Petitioner timely filed Forms 1120-PC, U.S. Property and
Casualty Insurance Company Income Tax Return, for 1991 and 1992.
Petitioner had undiscounted unpaid losses of $56,847,261 for
1991 and $61,971,100 for 1992.
Petitioner reported on its
Federal income tax returns that it had discounted unpaid losses
of $45,650,249 for 1991 and $49,418,509 for 1992, which it
deducted as part of losses incurred under section 832(b)(5).
II.
A.
OPINION
Issue for Decision
The sole issue for decision is whether petitioner may deduct
$45,650,249 for its reserves for unpaid losses and loss
14
For example, if, in May 1994, petitioner paid $800,000 to
settle a covered 1991 loss event, the 1991-92 treaty would
provide reimbursement of $425,000, that is, $800,000 minus the
indexed amount of $375,000 ($300,000 plus $25,000 each for Dec.
31, 1991, Dec. 31, 1992, and Dec. 31, 1993).
15
Retention is the dollar level of risk up to which an
insurance company is self-insured; i.e., is not reinsured. See
Dockery v. Commissioner, T.C. Memo. 1998-114.
-18adjustment expenses for 1991 and $49,418,509 for 1992.
On March 13, 1996, respondent sent a notice of deficiency to
petitioner in which respondent determined that petitioner
overstated its discounted unpaid losses by $5,816,776 for 1991
and $3,904,930 for 1992, and that petitioner's discounted unpaid
losses should have been $39,833,473 ($45,650,249 - $5,816,776)
for 1991 and $39,696,803 ($49,418,509 - ($3,904,930 and
$5,816,776)) for 1992.
Respondent amended its answer after trial
to assert that petitioner overstated its undiscounted unpaid
losses by $13,070,000 for 1991 and by $19,394,000 for 1992, and
that petitioner's undiscounted unpaid losses should have been
$43,765,000 for 1991 and $42,577,000 for 1992.16
Petitioner
bears the burden of proving that respondent's determination in
the notice of deficiency is erroneous, Welch v. Helvering, 290
U.S. 111, 115 (1933), and respondent bears the burden of proving
that petitioner's discounted unpaid losses should have been less
than the amounts determined in the notice of deficiency for 1991
and 1992.
Rule 142(a).
However, our holding is not affected by
who bears the burden of proof.
16
Respondent redetermined petitioner's discounted unpaid
losses in the notice of deficiency, whereas respondent's
adjustments in the amended answer were to petitioner's
undiscounted unpaid losses. The taxpayer is required to report
discounted unpaid losses on its income tax return. Secs.
832(b)(5)(A)(ii) and 846.
-19B.
Background
Insurance companies may deduct ordinary and necessary
expenses and losses incurred.
Sec. 832(c)(1), (4).17
Losses
incurred are (1) losses paid during the taxable year, (2) reduced
by salvage and reinsurance recovered during that year, (3) plus
all unpaid losses (discounted for years after 1986) outstanding
at the end of the taxable year, (4) less all unpaid losses
outstanding at the end of the preceding taxable year, (5) plus
estimated salvage and reinsurance recoverable at the end of the
preceding taxable year, (6) less estimated salvage and
reinsurance recoverable at the end of the taxable year.
832(b)(5).18
17
Sec.
Property and casualty insurance companies have
Sec. 832(c) provides in pertinent part as follows:
SEC. 832(c). DEDUCTIONS ALLOWED.--In computing
the taxable income of an insurance company subject to
the tax imposed by section 831, there shall be allowed
as deductions:
(1) all ordinary and necessary expenses incurred, as
provided in section 162 (relating to trade or business
expenses);
*
*
*
*
*
*
*
(4) losses incurred, as defined in subsection
(b)(5) of this section;
18
Sec. 832(b)(5)(A) provides as follows:
(5)
Losses Incurred.-(continued...)
-20accounting reserves for unpaid losses.
Atlantic Mut. Ins. Co. v.
Commissioner, 523 U.S. ___, 118 S. Ct. 1413, 1415 (1998).
Unpaid
losses are those that have been reported but not yet paid, or
those that have been incurred, but not yet reported.
Western
Natl. Mut. Ins. Co. v. Commissioner, 65 F.3d 90, 91 (8th Cir.
1995), affg. 102 T.C. 338 (1994).
Unpaid losses must include
only actual unpaid losses as nearly as it is possible to
18
(...continued)
(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
unpaid losses on life insurance contracts plus all
discounted unpaid losses (as defined in section 846)
outstanding at the end of the taxable year and deduct
all unpaid losses on life insurance contracts plus 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.
-21ascertain them.
Sec. 1.832-4(a)(5), (b), Income Tax Regs.19
The
estimate of unpaid losses must be fair and reasonable based on
the facts in each case and the company's experience with similar
cases.
Id.
The reserve for unpaid losses is an estimate, made at the
close of a taxable year, of the insurer's liability for claims
that it will be required to pay in future years.
Western Cas. &
Sur. Co. v. Commissioner, 65 T.C. 897, 917 (1976), affd. on
another issue 571 F.2d 514 (10th Cir. 1978).
A fair and
reasonable estimate of a taxpayer's unpaid losses is essentially
a valuation issue and a question of fact.
Hanover Ins. Co. v.
Commissioner, 69 T.C. 260, 270 (1977), affd. 598 F.2d 1211 (1st
Cir. 1979).
19
Sec. 1.832-4(b), Income Tax Regs., provides as follows:
(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."
-22C.
Fair and Reasonable Estimate of Petitioner's Unpaid Losses
1.
Expert Testimony
Both parties called expert witnesses to give their opinions
about the reasonableness of petitioner's reserves for unpaid
losses for 1991 and 1992.
We may accept or reject expert
testimony according to our own judgment, and we may be selective
in deciding what parts of an expert's opinion, if any, we will
accept.
Helvering v. Natl. Grocery Co., 304 U.S. 282, 295
(1938).
There were six expert witnesses at the trial.
actuaries:
Four were
Hurley (an actuary for Tillinghast) and Owen Gleeson
(Gleeson) for petitioner, and Frederick Kilbourne (Kilbourne) and
Raymond Nichols (Nichols)20 for respondent.
James Schacht
(Schacht) and Lawrence Smarr (Smarr) also testified for
petitioner.
2.
Hurley
We find Hurley's estimates of petitioner's reserves for
unpaid losses to be reasonable.
during the years in issue.
Hurley was petitioner's actuary
See Hospital Corp. of Am. v.
Commissioner, T.C. Memo. 1997-482 (the opinion of an expert who
was taxpayer's actuary during the years in issue is entitled to
some deference).
20
Hurley considered the facts that were unique to
Nichols did not do an actuarial reserve study of
petitioner.
-23petitioner in estimating its reserves.
Unlike respondent's
expert, Kilbourne, who was unfamiliar with petitioner's business
and who merely prepared a report essentially critiquing Hurley's
actuarial analysis, Hurley's loss reserve reviews were
specifically based on petitioner and its business.
Because
Hurley prepared petitioner's rate reviews, he knew that
estimating excessive loss reserves would result in higher
insurance premiums for petitioner's insureds.
He recognized that
petitioner had an incentive not to overstate its reserves.
Hurley prepared semiannual loss reserve reviews and annual
rate indication studies for petitioner.
He used consistent
actuarial methods and standard actuarial loss development and
pure premium methods to estimate petitioner's unpaid loss
reserves for 1991 and 1992.
Hurley used petitioner's and industry data in his
projections.
Over time, he increased the weight he gave to
petitioner's data relative to industry data because more of
petitioner's data was available.
Hurley estimated only actual unpaid losses in establishing
petitioner's annual statement unpaid losses.
He based his
projections on petitioner's database containing information about
its past loss payments and case reserves.
Hurley's report for
the 1991 and 1992 annual statements estimated unpaid losses
within an actuarially reasonable range.
Each point in Hurley's
-24range was reasonable.
His reports met all relevant actuarial
standards.
Hurley applied one exposure (i.e., pure premium) and four
development methods.
The development and exposure methods
produced ultimates, which were weighted, as coverage years aged,
against petitioner's loss experience reflected primarily in the
development methods.
Hurley's weighting of the two types of
methods was similar to a Bornhuetter-Ferguson method,21 which is
widely used for long-tailed lines of insurance like medical
malpractice.
Estimates as of December 1990 of petitioner's ultimates for
coverage years 1986 through 1990 were lower than estimates made
previously for those years.
Hurley reduced his estimate of
petitioner's ultimates for 1991 and 1992 because his projected
ultimates for prior coverage years were reduced.
Hurley's range was large because: (a) petitioner is a
relatively modestly capitalized, single-line insurer that serves
a limited geographic area; (b) it has relatively few claims, but
the average cost of a claim is high; and (c) medical malpractice
insurance is highly risky and longer-tailed.
projecting losses difficult.
These facts makes
See Hospital Corp. of America v.
Commissioner, supra.
21
The Bornhuetter-Ferguson method is an actuarial technique
used to estimate the value of a company's reserves by subtracting
its paid losses from its reserves.
-25Gleeson and Schacht each said that Hurley's estimates of the
reserves were reasonable.
3.
We find their analysis to be credible.
Kilbourne
Kilbourne analyzed Hurley's loss reserve reviews and the
reasonableness of petitioner's reserves for unpaid losses as
shown on its 1991 and 1992 annual statements.
Kilbourne averaged the four 1991 and 1992 yearend point
estimate results of Hurley's development methods with Hurley's
pure premium range, based on the facts existing at the end of
1991 and 1992.
Kilbourne noted that the results of the four
development methods were clustered and that Hurley's reports did
not indicate that any method was preferable.
Kilbourne concluded
that reasonable best estimates of petitioner's unpaid losses and
loss adjustment expenses at the end of 1991 and 1992 could be
made by averaging the four point estimate results of Hurley's
four development methods with his pure premium method range.
Kilbourne analyzed Hurley's loss reserve reviews as of the
end of 1991 and 1992.
He concluded that Hurley's lookback
approach for selecting an initial estimate of ultimate loss for
the current year was flawed.
He believed that Hurley's approach
essentially ignored the point estimate results and that Hurley's
ranges overstated petitioner's actuarially supported reserves for
1991 and 1992.
He concluded that the best estimates of
petitioner's ultimate losses were $43,765,000 for 1991 and
-26$42,577,000 for 1992.
D.
Analysis
1.
Whether Petitioner's Reserves Were Fair and Reasonable
Respondent contends that respondent's adjustments to the
unpaid loss reserves are needed to make the reserves fair and
reasonable as required by section 1.832-4(b), Income Tax Regs.
Respondent argues that respondent's proposed reduction of
petitioner's undiscounted unpaid losses for 1991 and 1992 is
reasonable.
A taxpayer's reserve for unpaid losses must be fair and
reasonable based on the facts in each case and the company's
experience with similar cases.
Sec. 1.832-4(b), Income Tax Regs.
Petitioner could not offset reserve deficits with reserve
surpluses in another line of insurance because it wrote a single,
relatively volatile line of business in a limited market.
The
inability to offset deficits with surpluses makes petitioner's
business more risky and reasonably led petitioner to establish
higher reserves.
For the years in issue, the medical malpractice industry
overstated reserves to virtually the same extent as petitioner.
This suggests that petitioner's estimates were fair and
reasonable.
UDI made a triennial examination of petitioner's 1990-93
annual statements.
It did not adjust petitioner's reporting of
-27unpaid losses and loss adjustment expenses.
Cf. Hanover Ins. Co.
v. Commissioner, 69 T.C. at 270-272 (the Commissioner's
adjustments to the taxpayer's reserves for unpaid losses were
reasonable; the taxpayer failed to adjust its loss reserves after
NAIC examiners found substantial overstatements).
Hurley adjusted petitioner's loss reserves each year to
account for petitioner's actual loss experience.
This suggests
petitioner's loss estimates were fair and reasonable.
See
Roanoke Vending Exch., Inc. v. Commissioner, 40 T.C. 735, 741
(1963) (bad debt reserve); Home Ice Cream & Ice Co. v.
Commissioner, 19 B.T.A. 762, 765 (1930) (same).
Hurley and Schacht testified that insurance companies have
an incentive not to overstate their unpaid losses because
overstating their losses may result in higher premiums, may make
them less competitive with other companies, and could diminish
their surplus to the point that they cannot write new policies.
Petitioner's insureds would prefer to keep their medical
malpractice insurance premiums low.
This tension between
petitioner and its insureds suggests that petitioner's reserve
for unpaid losses was fair and reasonable.
2.
Whether Petitioner's Reserve Estimates Were Within the
Range of Hurley's Estimates
Petitioner contends that its unpaid loss reserves for years
ended 1991 and 1992 fall within the range of estimates made by
Hurley and are fair and reasonable.
Respondent erroneously
-28contended that petitioner's reserves were above the high end of
Hurley's ranges because respondent considered the discounted
total reserves column rather than the undiscounted total reserves
column.
Petitioner selected reserves from the undiscounted
column as required by sections 846(b)(1) and (2).
Petitioner
deducted paid losses from Tillinghast's projected reserves to
account for the difference between the paid losses in
petitioner's records and the paid losses in Tillinghast's
records.
Finally, Oslowski testified credibly that petitioner
chose reserves from the high end, but not above the high end, of
Tillinghast's reserve estimates.
We find that petitioner's
reserves were within the ranges of Tillinghast's reserve
estimates.
3.
Whether Petitioner's Selection of Tillinghast's High
End Values for 1991 and 1992 Was Fair and Reasonable
Respondent argues that, because petitioner overstated its
unpaid loss reserves for 1986 to 1990, petitioner's establishment
of reserves using amounts at the high end of Tillinghast's range
in 1991 and 1992 was not fair and reasonable.
Respondent
contends that the favorable development for 1986-90 was apparent
when Tillinghast made the unpaid loss estimates in question,
which meant petitioner's estimates were overstated.
We disagree.
Petitioner properly considered the fact that
the frequency and severity of its claims began to increase
significantly in 1990.
That fact, along with petitioner's prior
-29history of inadequate reserves in 1980-85, makes reasonable
petitioner's estimates of reserves for 1991 and 1992.
The fact
that petitioner's loss estimates for 1986-92 proved, with
hindsight, to be higher than actual payments does not make
petitioner's choice of values unreasonable.
Petitioner's
reserves for unpaid losses must be fair and reasonable, but are
not required to be accurate based on hindsight.
Sec. 1.832-4(b),
Income Tax Regs.
4.
Whether Only the Midpoint of an Actuarially Sound Range
Is the Fair and Reasonable Estimate
Respondent argues that, for tax purposes, the midpoint of an
actuarially sound range, which respondent characterizes as "tax
equipoise", is the only fair and reasonable estimate since it
gives no tax advantage to either the taxpayer or to Treasury.
We disagree.
Respondent cites no authority for the
proposition that tax equipoise equates with the fair and
reasonable standard.
We have held in a different context that
the high end of a range of reasonable values may be reasonable.
See Vinson & Elkins v. Commissioner, 99 T.C. 9, 49 (1992) (for
purposes of assessing the actuarial assumptions of a defined
benefit plan, court adopted as reasonable a retirement age
assumption that was at high end of reasonableness range), affd. 7
F.3d 1235 (5th Cir. 1993).
Hurley testified that any loss
reserve amount selected from within the actuarial range he gave
petitioner would be reasonable.
-305.
Whether Petitioner's Reserves Must Be Probable To Be
Fair and Reasonable
Respondent argues that petitioner's reserves were not fair
and reasonable because it is improbable that petitioner's losses
will reach Tillinghast's highest estimates for 6 or 7 consecutive
years.
Respondent contends that, to be fair and reasonable, the
estimates of unpaid losses selected by the taxpayer must be at
least equally likely to occur as any other estimate of unpaid
loss.
We disagree.
The regulations require that the taxpayer make
a fair and reasonable estimate of losses based on the facts of
each case and on the taxpayer's experience with similar cases.
Sec. 1.832-4(b), Income Tax Regs.
The regulations do not provide
or even suggest that only one estimate is correct.
6.
Whether Petitioner's Lookback Method Was Proper
Respondent argues that Hurley's lookback method22 for
estimating the high end of its range ignored the most recent
actual loss data and included the preceding year's overstated
initial estimate in the initial high end estimate for the next
year.
For example, respondent contends that Hurley used his
initial $16 million high end estimate made at the end of 1990
rather than using the most recent estimate for 1990 ($15.2
million), reestimated at the end of 1991.
22
Hurley looked back at prior years' losses to estimate
current loss reserves.
-31We disagree that Hurley improperly reestimated the prior
years' ultimate losses.
Hurley reestimated the ultimate losses
for each prior coverage year when he estimated reserves for 1991
and 1992.
Hurley adjusted his ranges for 1991 and 1992 based on
petitioner's favorable experience from 1986 to 1990.
Respondent's contention that he merely included the prior year's
initial estimates in the current year's high end estimate is
mistaken.
Instead, he compared the results of the development
methods for the current year to the initial estimates for the
prior year.
In calculating the ultimate loss estimates for 1991
and 1992, Hurley used reestimated ultimate loss estimates for
prior coverage years.
Respondent contends that because Hurley reestimated by
gradually reducing the high end ultimate losses for the post-1985
coverage years as of the end of 1991 and 1992, he compounded
petitioner's overstated reserves for those years by carrying the
overstatements forward.
We disagree that Hurley compounded
petitioner's overstated reserves by his approach.
As
petitioner's loss experience began to improve, Hurley reduced the
estimates for that coverage year.
7.
Kilbourne's Criticism of Petitioner's Methods
Respondent argues that Kilbourne's method is reasonable and
points out that it is very similar to petitioner's actual
experience, as reflected in the development of petitioner's
-32losses for coverage years 1987 through 1992, reestimated at the
end of 1996.
Respondent's argument misses the mark.
Although we agree
that Kilbourne's method is reasonable, we need not decide whether
his method is more reasonable than petitioner's method.
Section
1.832-4(b), Income Tax Regs., requires that the taxpayer show
that its unpaid losses were actual unpaid losses and that its
estimate of loss reserves be fair and reasonable.
Petitioner has
satisfied the requirements of the regulations, and thus our
inquiry ends.
Cf. Molsen v. Commissioner, 85 T.C. 485, 498
(1985); Peninsula Steel Prods. & Equip. Co. v. Commissioner, 78
T.C. 1029, 1045 (1982) (the Commissioner cannot require a
taxpayer to change from an accounting method which clearly
reflects income to an alternate method merely because the
Commissioner concludes that the alternate method more clearly
reflects the taxpayer's income).
8.
Whether Gleeson Confirmed That Hurley's Ranges Were Not
Actuarially Sound
Respondent argues that Gleeson confirmed Kilbourne's
conclusion that Hurley's ranges were not actuarially sound.23
disagree.
23
We
Gleeson applied a probability distribution test to
Kilbourne said that Hurley's approach ignored the point
estimate results of his four actuarial methods and that his
ranges were skewed so that even the low ends of his ranges as of
the end of 1991 and 1992 were higher than what in Kilbourne's
opinion were actuarially reasonable "best estimates" of
petitioner's ultimate losses.
-33Hurley's initial high end estimate of ultimate loss for 1992.
Gleeson testified that Hurley's $17,500,000 high end estimate was
a reasonable estimate of petitioner's ultimate losses for 1992 as
of the end of 1992.
On cross-examination, respondent asked Gleeson to add
coverage years 1987 to 1991 to his test.
Respondent asked
Gleeson to review Exhibits 86, 87, and 88,24 which purport to
show that petitioner's net ultimate losses as reestimated for
coverage years 1987 to 1992 fell increasingly to the right of the
range moving back from 1992 to 1990 and fell outside the range
for 1989 to 1987.
Gleeson testified that respondent's
computations in Exhibits 86, 87, and 88 were accurate.
Respondent argues that Gleeson agreed that petitioner's estimates
for coverage years 1987 to 1992, taken together, failed his test.
We disagree.
Gleeson testified that respondent's
probability distribution graphs did not change his conclusion
that Hurley's work was reasonable.
He pointed out that Exhibits
86, 87, and 88 (particularly Exhibit 87) used basic limits data,
that is, data about claims that are paid or reserved at $100,000
or less.
In Gleeson's opinion, basic limits data shows more
rapid development than total limits data because the smaller and
easier to settle claims are paid first.
24
He also pointed out that
Exhibit 86 contains several probability distribution
graphs showing factors for 1987 to 1992. Exhibit 87 is a 1992
report showing updated development factors that had been
contained in an attachment to Gleeson's report. Exhibit 88
contains loss development factors. These exhibits extended
Gleeson's probability distribution test back through 1987.
-34the basic limits data contained in respondent's exhibits does not
show claims that are paid or reserved at more than $100,000.
Gleeson pointed out that petitioner's retention was about
$350,000 and that the basic limits data does not account for the
development between the $100,000 basic limits and petitioner's
$350,000 retention amount.25
Thus, Gleeson found Hurley's ranges
to be actuarially sound.
9.
Whether Respondent's Use of Hindsight Was Proper
Respondent points out that hindsight may be used in deciding
whether to sustain respondent's proposed adjustments.
Hanover
Ins. Co. v. Commissioner, 69 T.C. at 270 (the Commissioner
reasonably used hindsight to test the reasonableness of the
taxpayer's reserves); Hospital Corp. of Am. v. Commissioner, T.C.
Memo. 1997-482 (the taxpayer did not prove that its reserves were
reasonable because the Commissioner's expert used hindsight to
show that the taxpayer's reserves were overstated).
Respondent
relies on petitioner's 1996 annual statement to support
respondent's contention that the development of petitioner's
actual losses shown in the reestimates of ultimate losses for
coverage years 1987 to 1992 as of the end of 1996 confirms that
respondent's proposed adjustments are reasonable.
We need not
decide whether respondent's adjustments are reasonable since
petitioner's loss reserves were fair and reasonable.
25
Compare
Gleeson testified that petitioner's retention was about
$350,000. We have found that it was $375,000-$400,000. The
difference in retention amounts does not affect Gleeson's
explanation.
-35Hanover Ins. Co. v. Commissioner, 69 T.C. at 270.
E.
Conclusion
We conclude that petitioner's reserves for unpaid losses and
loss adjustment expenses for 1991 and 1992 were fair and
reasonable estimates of petitioner’s actual unpaid losses.
To reflect the foregoing,
Decision will be entered
under Rule 155.
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