Petition — Hanover Insurance v. Commissioner
Supreme Court brief1979
Ask Donna
What actually matters in this document.
Text
Pires’ |
JUL 9 1979
ae
No.
—_—_—_ a
IN THE
Supreme Court of the Anited States
OCTOBER TERM, 1979
HANOVER INSURANCE COMPANY, SUCCESSOR IN
INTEREST TO: MASSACHUSETTS BONDING AND
INSURANCE COMPANY,
Petitioner,
VS.
COMMISSIONER OF INTERNAL REVENUE.
PETITION FOR A WRIT OF CERTIORARI TO
THE UNITED STATES COURT OF APPEALS
FOR THE FIRST CIRCUIT
PAUL A. TESCHNER
39 South LaSalle Street
Chicago, Illinois 60603
(312) 332-0346
Counsel for Petitioner
TESCHNER PROFESSIONAL CORPORATION
39 South LaSalle Street
Chicago, Illinois 60603
Gunthorp-Warren Printing Company, Chicago e Financial 6-6565
INDEX
PAGE
I GE OC CS A a Sue ka ce oN des oes 1
SS Pe Ne oad hi Si c'nis BAAD veel se ee 2
EE POI Sos Pn 5b sisids « Were aewis hain Hic ee 00: 2
Constitutional Provisions, Statutes, and Regulations In-
SE Se 9 ES et eer re. oe ae 3
AS RE a aN SRI, A SOG RES i 6
Reasons for Granting the Writ...................... 12
as Aigia'y's's' g's a s"hia sare see eS od oN eee dt 24
Appendix:
A. Opinion of the United States Court of Appeals
for the, Picet Cisouit {F.2d ds. Al
Judgment of the United States Court of Appeals. A19
Final Opinion of the United States Tax Court
a a NS Sa SA aon sh ah np ye jh Re oe A20
Final Decision of the United States Tax Court.. A41
Opinion of the United States Tax Court Denying
Petitioner’s Motion for Summary Judgment [65
Ry Ti aiice sitive sb ov ote a nie eee gare eiele ees A42
mo Of
CITATIONS
CASES:
Acker; Commissioner v., 361 U.S. 87, 92, 93-94...... 21
Bingham, Trust of, Vv. Commissioner, 325 U.S. 365..... 21
Bituminous Casualty Corporation v. Commissioner (1971)
Se ee A a a a eo os 6 See RET e REA 13
Brafman v. United States (5th Cir. 1967) 384 F. 2d 863,
SE eee oy a as as 8 ce CR ee ORR eee as 16
Calamaro; United States v., 354 U.S. 351, 358-359.... 21
Cartwright; United States v., 411 U.S. 546, 557....... 21
Commissioner v. Acker, 361 U.S. 87, 92, 93-94........ 21
Commissioner Vv. Standard Life & Accident Insurance Co.,
MSO Wie Gi -BARy BOT IGE, BOS ink ink Sa cc ceca 12, 14, 16
Consumer Life Insurance Co.; United States v., 430 U.S.
a a PN co ak vc bred wos CS RK eee 12, 14, 16
Continental Insurance Company v. United States (Ct. Cl.
1973) 474 #. 2d G6l, 666, 672: 2.4... 6 ces 17, 18, 19
Credit Alliance Corporation; Helvering v., 316 U.S. 107,
PE Wi ea ck Cia hee CURE Ba EVE 0 CNA ep 21
Dollar Savings Bank v. United States, 19 Wall. (86 U. S.)
Ps a oko Pes sakes) GA GONE a ole ae ws 20
Hanover Insurance Company v. Commissioner (1976) 65
Mtge HM itlate We 0 WEA 02 ERE ke AA Ras 4a 8 ai
Hanover Insurance Company Vv. Commissioner (1977) 69
Bi EE REC CNEL ke PEON ER OR aE a Oe 2,12
Hanover Insurance Company Vv. Commissioner (Ast. Cir.
1979) __. F.2d —., 79-1 U.S. T.C. 4 9366, 43
re fe ct Ae Re. SE |. as er ane ner 1, 12, 19,20
Helvering v. Credit Alliance Corporation, 316 U.S. 107,
EEE Circe ec chee nae + i asBeee sacks COO TS Ee A 21
iii
Helvering v. Janney, 311 U.S. 189, 194-195.......... 21
Helvering v. Sabine Transportation Co., Inc., 318 U.S.
DS RO OER 6nd ORs EOGANSS 0S CRAs as es 21
Iselin v. United States, 270 U.S. 245, 250-251........ 20
Janney; Helvering v., 311 U.S. 189, 194-195......... 21
Koshland v. Helvering, 298 U.S. 441, 446-447......... 21
M. E. Blatt Co. v. United States, 305 U.S. 267, 279.... 21
Miller v. Standard Nut Margarine Co. 284 U.S. 498, 508 20
Mutual Savings Life Insurance Co, v. United States (Sth
Cir. 1974) 488 F. 2d 1142, 1145-1146............ 16
Old Colony R.R. Co. v. Commissioner, 284 U.S. 552,
PE an shies we hei RK Oo oe ee le sa 20
Panama Refining Company v. Ryan 293 U.S. 388, 415,
Sian PARRA EERESs AARRCKES le oO ye
Sabine Transportation Co., Inc.; Helvering v., 318 U.S.
SA, SER EAD EE hook 4 vie ea a Fee A wt wos 21
Schechter Poultry Corporation v. United States, 295 U.S.
Gs TRI. 6 inc aincks Weeny. bad bd LNTLSs CORSA vo 22, 23
Standard Life & Accident Insurance Co.; Commissioner v.,
453-4)... 240, 168-964, 28 ii ees 12, 14, 16
Swift Company v. United States, 15 Otto (105 U.S.) 691,
GE hv te deve er eicens Mah ncn ewres UC Oe 20
Taft v. Helvering, 311 U.S. 195, 198-199............ 21
Tipton & Kalmbach, Inc. v. United States (10th Cir. 1973)
SOO F. 26 SEER, ISR ST TFA Be 16
United States v. Calamaro, 354 U. S. 351, 358-359..... 21
United States v. Cartwright, 411 U.S. 546, 557 ........ 21
United States v. Consumer Life Insurance Co. 430 U.S.
Cae TONG CUT We EOE. WOR Ca Ka a chs 12, 14, 16
> ee
iv
Western National Life Insurance Company of Texas v.
Commissioner (5th Cir. 1970) 432 F. 2d 298, 301.... 19
Weyerhaeuser Company v. United States (Ct. Cl. 1968)
395 F. 28 21005, MOOR wie ce sah Bie cane 8 Saeed 16
White v. Aronson, 302 U.S. 16, 20 .............0006s 21
Constitution of the United States:
Ament FH sctig aches ka nike ck tha heneie 3, 21
Internal Revenue Code of 1954 (26 U.S. C.):
Soction 1GRakEED. 2.5 ocak dink wae «ek 655s sap 4's 23
Section THGGE (<0 4: cass caren ee wie a ee 23
Saction SPIGA s. «iv 54.55 848d en ee eae oias ks 23
Section FFTRESPCS RBS: x 65's 4s de Cees ee wei ccs 23
Socticns BIO xaaic snd nde sie eke anes Rtas 23
Section GSECGERS iis oak case esse eee s ¥e80se 3
Section 832:
Section Wee.» owes ks Pakebceresh ssaneks 3
Soctiqn GRIGG. Gils ca alo ares eo 3, 19, 23
Section SSR C361) (A): ois Ves 4,15
Section BRAM) | esccdricnc oweeecewhsnes 4
Sect, SIDES CS) iit newb eande oy 68. cee wy 4,18
Section $32(b)(S)LAD: 33 bil ids cbbeie cd f085) 17
Section. 83Z2C}(S) CB)... os0isi0-s.vi6s o:s.sp canes 12
Section TOM... «cn sinter 4, 21, 23
Treasury Regulations on Income Taxes (26 C. F. R.):
Reg. § 1.446-1(a) (1) 2... cece ccccccecceceees 6, 13
Reg. § 1.446-1(e) (2) (ii) (a) «0... eee eee ee ee eee 6, 13
Reg. § 1.832-1( a). «si. i asicrcecscccccccceseves 5
Reg. $ 1.832-1(B) 2. sscgdcceecce 2, 5, 16, 19, 20, 21
Reg. § 1.83Z-1(6) 2... .cccccsecsccvsessvsevcns 17
IN THE
Supreme Court of the United States
OCTOBER TERM, 1979
HANOVER INSURANCE COMPANY, SUCCESSOR IN
INTEREST TO: MASSACHUSETTS BONDING AND
INSURANCE COMPANY,
Petitioner,
vs.
COMMISSIONER OF INTERNAL REVENUE.
PETITION FOR A WRIT OF CERTIORARI TO
THE UNITED STATES COURT OF APPEALS
FOR THE FIRST CIRCUIT
Paul A. Teschner, Esq., on behalf of Hanover Insurance
Company, Successor In Interest To Massachusetts Bonding
And Insurance Company, a New York Corporation, petitions
for a writ of certiorari to review the judgment of the United
States Court of Appeals for the First Circuit in this case.
OPINIONS BELOW
The opinion of the United States Court of Appeals [App. A,
pp. Al-A18j has been reported at ........... ee sa ; unofficially
it appears at 79-1 U.S. T.C. 4 9366 and 43 A.F.T.R. 2d
2
79-1165. The final opinion of the United States Tax Court
[App. C, pp. A20-A40] has been reported at 69 T.C. 260. An
earlier decision of the Tax Court [App. E, pp. A42-A52] has
been reported at 65 T. C. 715.
JURISDICTION
The opinion of the Court of Appeals was filed on May 8, 1979
at which time the final Judgment of that court was also filed
[App. B, p. Al9]. The jurisdiction of this Court is invoked
under 28 U.S. C. 1254(1).
QUESTIONS PRESENTED
(1) Whether Petitioner properly computed the unpaid losses
outstanding component of its underwriting income—as shown
on the Annual Statements [“Annual Statements”) Petitioner filed
with the National Association (formerly National Convention)
of Insurance Commissioners [“NAIC”]—by using the “case
method” of computing said unpaid losses outstanding; or wheth-
er, rather, Respondent properly reduced those unpaid losses
outstanding because in prior years Petitioner had reserved
amounts to pay its unpaid losses which hindsight subsequently
proved to be more than necessary to pay off the claims for which
those prior year reserves had been established.
(2) Whether Respondent properly reduced the unpaid losses
outstanding which Petitioner had calculated by the “case
method,” and used in computing the underwriting income shown
on its Annual Statements approved by the NAIC, even though
Respondent failed to follow his own Reg. Sec. 1.832-1(b) in
that he did not base his adjustments upon the facts of each case.
(3) Whether Respondent had authority to promulgate Reg.
Sec. 1.832-1(b) providing that a casualty insurance company
must establish to the satisfaction of the District Director that
unpaid losses at the close of the taxable year must represent a
3
fair and reasonable estimate of the amount the company will be
required to pay; and whether, if Congress did give Respondent
authority to promulgate that regulation, that delegation of legis-
lative power was invalid as being violative of the Fifth Amend-
ment’s Due Process Clause in that the delegation was unac-
companied by standards to determine and control its exercise.
CONSTITUTIONAL PROVISIONS, STATUTES,
AND REGULATIONS INVOLVED
Constitution of the United States:
Amendment V. “No person shall * * * be deprived of life,
liberty, or property, without due process of law * * *.”
Internal Revenue Code of 1954 (26 U. S. C.):
§ 831. Tax on insurance companies (other than life or
mutual), mutual marine insurance companies, and cer-
tain mutual fire or flood insurance companies.
(a) Imposition of tax.—Taxes computed as provided in
section 11 shall be imposed for each taxable year on the
taxable income of—
(1) every insurance company (other than a life or
mutual insurance company),
* * *
§ 832. Insurance company taxable income
(a) Definition of taxable income.—lIn the case of an in-
surance company subject to the tax imposed by section 831,
the term “taxable income” means the gross income as
defined in subsection (b)(1) less the deductions allowed
by subsection (c).
(b) Definitions—tIn the case of an insurance company
subject to the tax imposed by section 831—
4
‘(1) Gross income.—The term “gross income”
means the sum of
(A) the combined gross amount earned during
the taxable year, from investment income and
from underwriting income as provided in this
subsection computed on the basis of the under-
writing and investment exhibit of the annual
statement approved by the National Convention
of Insurance Commissioners.
* * *
(3) Underwriting income.—The term “under-
writing income” means the premiums earned on
insurance contracts earned during the taxable year
less losses incurred and expenses incurred.
* * *
(5) Losses incurred.—The term “losses incurred”
means losses incurred during the taxable year on in-
surance contracts, computed as follows:
(A) To losses paid during the taxable year, add
salvage and reinsurance recoverable outstanding
at the end of the preceding taxable year and
deduct salvage and reinsurance recoverable out-
standing at the end of the taxable year.
(B) To the result so obtained, add all unpaid
losses outstanding at the end of the taxable year
and deduct unpaid losses outstanding at the end
of the preceding taxable year.
* * *
§ 7805. Rules and regulations.
(a) Authorization—* * * [T]he Secretary or his dele-
gate shall prescribe all needful rules and regulations for the
enforcement of this title, including all rules and regulations
5
as may be necessary by reason of an alteration of law in
relation to internal revenue.
Treasury Regulations on Income Taxes (26 C. F. R.):
Reg. § 1.832-1 Gross Income
(a) Gross income as defined in section 832(b)(1)
means the gross amount of income earned during the tax-
able year from interest, dividends, rents, and premium in-
come computed on the basis of the underwriting and in-
vestment exhibit of the annual statement approved by the
National Convention of Insurance Commissioners. ***
The underwriting and investment exhibit is presumed to
reflect the true net income of the company and insofar as
it is not inconsistent with the provisions of the Code will
be recognized and used as a basis for that purpose. ***
(b) Every insurance company to which this section ap-
plies must be prepared to establish to the satisfaction of the
district director that the part of the deduction for “losses in-
curred” which represents unpaid losses at the close of the
taxable year comprises only actual unpaid losses stated in
amounts which, based upon the facts in each case and the
company’s experience with similar cases, can be said to
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 such losses which, in the opinion
of the district director are in excess of the actual liability
determined as provided in the preceding sentence will be dis-
allowed as a deduction. The district director may require
any such insurance company to submit such detailed infor-
mation with respect to its actual experience as is deemed
necessary to establish the reasonableness of the deduction
for “losses incurred.”
Reg. § 1.446-1 General Rules For Methods of Accounting
(a) General rule. (1) * * * The term “method of ac-
counting” inciudes not only the overall method of account-
ing of the taxpayer but also the accounting treatment of
any item.
* * *
(e) Requirement respecting the adoption or change of
accounting method.
(2)
(ii)(a) A change in the method of accounting in-
cludes a change in the overall plan of accounting for
gross income or deductions or a change in the treat-
ment of any material item used in such overall plan.
*
STATEMENT
Massachusetts Bonding and Insurance Company [Petitioner]
was organized and commenced doing business in 1907 as a
Massachusetts stock insurance company. It was merged into
Hanover Insurance Company [“Hanover”] on June 30, 1961. At
all times relevant to this case, Petitioner was authorized to write
all lines of insurance except title, life, endowment, and annui-
ties; and at all such times Petitioner has engaged in the casualty
insurance business by writing such lines of business as fire, ac-
cident and health, Workmen’s Compensation, liability, auto-
mobile liability, automobile physical damage and property
damage, fidelity, surety, burglary and theft, and nuclear physical
damage. (R. 35-37).*
In accordance with the requirements of Massachusetts law,
Petitioner filed Annual Statements for the calendar years 1959
(R. 414-463) and 1960 (R. 464-514), and for the six-month
1. “R.” references are to the Appendix filed in the Court of
7
period ended June 30, 1961 (R. 515-563), on the form ap-
proved by the National Association (formerly National Con-
vention) of Insurance Commissioners [“NAIC”] (App. C, p.
A22).
In computing its net income for the calendar years 1959 and
1960 and the period ended June 30, 1961, Petitioner deducted
as “losses incurred” the respective amounts of $19,264,486,
$21,067,480, and $8,925,671. Those losses incurred were de-
termined by adding to “Losses Paid—Current Year” the amount
of “Unpaid Losses Outstanding—Current Year” and deducting
therefrom the amount of “Unpaid Losses Outstanding—Prior
Year.” (App. C, p. A22).
From 18% to 28% of the reserves established by Petitioner
to pay for its unpaid losses outstanding were on account of
IBNR [“Incurred But Not Reported”] claims; from 9% to 11%
of the reserves were on account of Petitioner’s share of business
done through “pools”; and about 2% of those reserves were on
account of “Notice Claims” which were claims up to $500 for
auto property damage (App. C, pp. A24-A25). From 59% to
71% of the reserve was established by use of the individual case
method [“case method”’].
Under the case method of reserving for unpaid losses out-
standing, a dollar value was established for estimated liability
with respect to each case (App. C, p. A23). Factors considered
in reserving for each individual case included the following: (1)
the facts of each individual occurrence; (2) the nature of the
injuries; (3) the venue of the trial; (4) the identity of the
plaintiffs lawyer; (5) the trend and development of the law;
(6) the trend of inflation; (7) the variance in state laws; (8)
the age and condition of a claimant; (9) the peculiar character-
istics—such as occupation, family relationships, and personality
—of an injured party; (10) the increasing litigious nature of the
public; and (11) the increasing ability and sophistication of
plaintiff's personal injury lawyers as a class. [R. 103-111; App.
C, p. A23).
Petitioner's IBNR reserves—like its case method reserves—
were established only after consideration was given to a multi-
tude of current facts; upon that point, Petitioner's Treasurer
testified as follows (R. 198-200):
“Q. Is there any reasonable alternative to the use of
formula reserves for I1.B.N.R. claims?
“A. No, there is no reasonable alternative at all.
“Q. Once a formula is developed to compute your
I.B.N.R. reserve, may it validly continue to be used without
change in the future?
“A. That's impossible, no, it can’t.
“Q. Well, how often would you have to review these?
“A. Well, to begin with, we’re talking about a formula
reserve. This formula reserve is based on past experience.
As I said I believe, it’s a preliminary I.B.N.R. reserve.
You don’t take a formula reserve in and accept it and
throw it in your annual statement and say—that’s an
I.B.N.R, reserve willy-nilly. That’s useless—it’s meaning-
less. It doesn’t mean a thing. We—that’s only the begin-
ning. We establish this formula reserve and then we con-
sider many other elements. In the first place we talk about
premiums in force which is a measure of the amount of
business you have in force—the contracts you have in
force. Well, you just can’t accept that in force figure at
its face value. You go back and see what occurred during
the year that might have affected that in force figure com-
pared to the year before. For example, you could have some
changes in rates—in premium rates on policies which could
have gone up with the result your in force would be in-
flated without a corresponding increase in exposure and
liability. You take that into consideration and make appro-
priate adjustments that are called for. You take a look at
the most recent development of I.B.N.R. You take a
look at your claim frequency. You take a look at your
average cost per claims and say to yourself—how are these
going to affect this I.B.N.R. formula reserve you come up
with. Do you have to adjust it or don’t you? Is inflation
a factor in here? Or is—how about your reinsurance trea-
ties? Are you retaining a greater portion of the loss than
you did before? How is that going to affect your I.B.N.R.?
There are many elements that affect it.”
9
Petitioner's pool reserves were not evaluated by Petitioner;
Petitioner’s pro-rata share of those reserves for unpaid losses
was accepted as determined by the pools. The reason for that
acceptance was expressed as follows by the NAIC examiners
(R. 782):
“Underwriting associations in which the Company par-
ticipated were not examined. Under a plan adopted by the
National Association of Insurance Commissioners in 1946,
separate examinations of associations, pools and syndicates
are required to be made under the supervision of the respec-
tive states wherein these associations maintain their prin-
cipal offices. Financial statements furnished by associations
were accepted in support of the Company’s proportionate
equities in associations. Additional information deemed
necessary was obtained through correspondence.”
The fourth category of Petitioner’s reserves for unpaid losses
outstanding was for the Notice Claims which were described as
follows by one of Petitioner’s witnesses (R. 240):
“We had a * * * system of on our claim reporting, rather
than prepare a complete claim file on every claim that came
in—on auto property damage and auto physical damage
claims up to $500 were very easily and quickly disposed
of or settled rather. So rather than set up a voluminous
claim file with all the necessary typing and multiplicity of
copies that were necessary, they were reserved on a for-
mula basis. * * * These were set—they were a formula
reserve. We called them notice. * * *”
Under Petitioner’s case method of reserving for unpaid losses
outstanding, which it used whenever possible (App. C, p. A31),
no reserve of $1,000 or more could be set up for any individual
case without the specific approval of Petitioner’s Vice President-
Claims (R. 110). That method also required that the employees
of Petitioner constantly be aware of the serious consequences of
“under reserving” (R. 116-118, 200, 217, 254) and be equally
alert to guard against the dangerous consequences of “over re-
serving” (R. 102, 200, 216, 252-255).
10
Under its case method of reserving, Petitioner at all times
did its best to avoid both over reserving and under reserving; it
had no basic philosophy to err, if necessary, either on the side
of over reserving or under reserving; and at all times it attempted
to establish adequate, proper, and reasonable reserves which
would be sufficient to pay off claims (R. 118, 200-201, 217,
255-256).
Every three years the books and affairs of casualty insurance
companies are examined by participating representatives of the
NAIC; Petitioner had its books and affairs examined by the
NAIC representatives as of the ends of 1950, 1953, 1956, and
1959 (R. 158-159). When they conducted an examination of
Petitioner, the NAIC examiners received all of Petitioner’s
records required for a complete audit, including the working
papers supporting the Annual Statements and a listing of all in-
dividual claim files (R. 208-209).
The listing of individual claim files which Petitioner supplied
to the NAIC examiners included a case-by-case listing of all
claims open as of the year end of the examination and a history
of those claims between the year end and the time of the exam-
ination (R. 211). During the course of each examination, Peti-
tioner supplied the NAIC examiners with thousands of individ-
ual claim files which the examiners would then review over a
period of six to eight months (R. 129-130).
In examining the individual claim files of Petitioner as of a
given year end, the NAIC examiners took into consideration
the history of all claims between the close of the year and the
time of the examination (R. 135, 759). When examining indi-
vidual claim files which were still open at the time of the exam-
ination, the NAIC examiners would discuss with Petitioner’s
Claims Vice President whether a particular loss reserve was
proper; and that inquiry would be concerned with whether the
reserve was too high as well as too low (R. 131).
The NAIC examiners who examined the period of December
31, 1959, through December 31, 1963, of Petitioner and of
11
Hanover severely criticized its formula handling of its small
(notice) claims and increased the reserve for unpaid losses
outstanding with respect to such formula small claims by
$630,874.35 (R. 869-870, 906).
When Petitioner filed its federal income tax returns for 1959,
1960, and for the six months period ended June 30, 1961, it
filed with and as part of those returns the respective Annua!
Statements approved by the NAIC for those years and for that
period (R. 212-213). Petitioner computed its taxable income
for those years and for that period on the basis of the net in-
come shown at line 20 of the underwriting and investment
exhibits of those Annual Statements (App. C, p. A22).
In due course, the Commissioner of Internal Revenue
[“Respondent”] audited Petitioner's federal income tax returns
for 1959, 1960, and the six months period ended June 30,
1961. In reviewing Petitioner’s reserves for its unpaid losses out-
standing, Respondent did not examine any of Petitioner’s in-
dividual claim files (R. 133). In reducing Petitioner’s said
reserves, Respondent did not base his adjustments on the facts
of each claim and Petitioner’s experience with similar claims,
nor did Respondent make a comparison of Petitioner’s unpaid
losses outstanding at the end of any period here involved with
subsequent payments of such losses. Respondent relied exclusive-
ly upon amounts of reserves for unpaid losses outstanding ap-
pearing on Petitioner’s Annual Statements for prior years and
then developed those amounts into future years to arrive at its
current year reductions of Petitioner’s unpaid losses outstanding.
(App. A, pp. A5-A8; App. C, pp. A25-A27; R. 62-70).
Respondent’s methodology was based on a conclusive presump-
tion “that the reserve redundancy or deficiency [for prior years]
remains a consistent percentage of the reserve carried [for the
current year].” (R. 930).
The deficiencies at issue in this case are attributable, in their
entirety, to Respondent’s reductions of the unpaid losses out-
standing used by Petitioner in computing its underwriting in-
12
come reflected by the underwriting and investment exhibits of
Petitioner’s Annual Statements. Petitioner filed a Petition For
Redetermination of those deficiencies with the United States Tax
Court.
Hanover Insurance Company v. Commissioner of Internal
Revenue, 65 T. C. 715 (1976), (App. E, pp. A42-A52),
denied Petitioner’s Motion For Summary Judgment. The final
opinion of the Tax Court is reported at Hanover Insurance
Company Vv. Commissioner of Internal Revenue, 69 T.C. 260
(1977), (App. C, pp. A20-A40). The opinion of the United
States Court of Appeals for the First Circuit, affirming that por-
tion of the opinion of the Tax Court which held against Peti-
tioner, appears at Hanover Insurance Company v. Commissioner
of Internal Revenue, —.... F. 2d —..... (1st Cir. 1979), (App.
A, pp. Al-A18). The opinion of the Court of Appeals has been
unofficially reported at 79-1 U.S. T. C. § 9366 (C. C.H.) and
43 A. F. T. R. 2d 79-1165 (P. H.).
REASONS FOR GRANTING THE WRIT
(1) The decisions of the courts below have upheld Re-
spondent’s reductions of Petitioner’s unpaid losses outstanding
even though those reductions constituted a change in Petitioner’s
method of accounting for its unpaid losses outstanding, an ac-
counting method specifically required, approved, and followed
by the National Association (formerly National Convention) of
Insurance Commissioners [“NAIC”]. For that reason, those de-
cisions are in conflict with this Court’s applicable decisions
in United States v. Consumer Life Insurance Co., 430 U. S. 725,
739, 749-750, and Commissioner of Internal Revenue v. Stand-
ard Life & Accident Insurance Co., 433 U.S. 148, 161-162,
163.
Under Section 832(b)(5)(B) of the Internal Revenue Code
of 1954 [“Code”], a casualty insurance company’s “unpaid losses
outstanding” constitute a major item in the computation of the
13
“losses incurred” component of “underwriting income” as de-
fined at Section 832(b)(3) of the Code. Respondent’s own |
regulations, therefore, affirm the conclusion that any change in
the method of computing a casualty insurance company’s unpaid
losses outstanding is a change in a method of accounting. Reg.
§ 1.446-1(aX1): “The term ‘method of accounting’ includes * *.*
the accounting treatment of any item.” Reg. § 1.446-1(e)2)ii)
(a): “A change in the method of accounting includes a change
in the overall plan of accounting for gross income or deduc-
tions or a change in the treatment of any material item used in
such overall plan.”
Bituminous Casualty Corporation v. Commissioner, 57 T. C.
58 (1971), held that the casualty insurance company correctly
included in its unearned premiums its reserves for premium re-
bates (retrospective rate credits and premium discounts). The
Court recognized the fact that by their very nature insurance
companies are not subject to ordinary tax accounting concepts
[S57 T.C. 58 at 76, 77]:
“* * * [Tjhe insurer cannot know what the losses will
be at the time the reserve must be estimated, even with
respect to expired policies. In the case of retro policies, it
may be as long as eight or nine years before all of the
facts which determine liability will have occurred.”
“The nature of casualty insurance requires accounting
rules substantially different from the accounting rules ap-
plicable to general commerce.
“In commerce generally, expenses come first and income
follows. The manufacturer must incur the cost of manu-
facturing his product before he gets paid for it. The mer-
chant must purchase his inventory before he can resell it.
“In the insurance industry, however, the reverse is true.
The policyholder pays the insurance company in advance
and the insurance company’s costs, which are primarily
the payment of claims, come afterward. If the premiums
were to be taxed as received and the deductions allowed
only as they later became fixed, the result would be to
tax very large sums of money as income when in fact
14
those amounts will never really become income because
they will have to be paid out to policyholders and other
claimants.”
In United States v. Consumer Life Insurance Company, 430
U. S. 725, this Court rejected the Government’s argument that
unearned life premium reserves should be attributed to the tax-
payer because it had performed the services with respect to
which the reserves were established. The Court rejected the
Government's attempt to rely upon garden variety accounting
concepts [430 U.S. 725 at 739]:
“18. The Government also relies on an asserted analo-
gy to Commissioner v. Hansen, 360 U.S. 446 (1959).
That case, dealing with a question of ordinary accrual ac-
counting, is inapposite. Life insurance accounting is a
world unto itself. See Brown v. Heivering, 291 U.S. 193,
201 (1934); Great Commonwealth Life Ins. Co., 491 F.
2d 109 (CA 5 1974). Mechanical application of ordinary
accounting principles will not necessarily yield a sound
result.”
The Court also recognized the special nature of the reguiated
insurance industry [430 U.S. 725 at 749-750]:
“Section 820 affords an unmistakable indication that
§ 801 does not impose the ‘reserves follow the risk’ rule.
Instead, Congress intended to rely on customary account-
ing and actuarial practices, leaving, as § 820 makes evi-
dent, broad discretion to the parties to a reinsurance agree-
ment to negotiate their own terms. This does not open the
door to widespread abuse. ‘Congress was aware of the
extensive, continuing supervision of the insurance industry
by the states. It is obvious that subjecting the reserves to
the scrutiny of the state regulatory agencies is an additional
safeguard against overreaching by the companies.’ * * *”
This Court affirmed the unique nature of insurance tax ac-
counting and the primacy of NAIC accounting requirements in
the case of Commissioner v. Standard Life & Accident Insur-
ance Co., 433 U.S. 148. The Court held that NAIC accounting
rules properly determined the federal income tax question at
issue there [433 U.S. 148 at 161-162, 163]:
15
“The fourth approach, in contrast, does have support in
the statute. This approach has been adopted by the NAIC
for the purpose of preparing the Annual Statement, and
therefore is firmly anchored in the text of § 818(a) which
establishes a preference for NAIC accounting methods.™
Under this view, the net valuation portion of the unpaid
premiums is included in reserves, assets, and gross pre-
mium income, while the loading portion is entirely ex-
cluded. This approach might be described as adopting the
fictional assumption that the net valuation portion of the
premium has been paid, but that the loading portion
has not.”
oe ok K
“Accordingly, we conclude that unpaid premiums must
be reflected in the computation of respondent’s tax lia-
bilities ‘in a manner consistent with the manner required
for purposes of the annual statement approved by the
National Association of Insurance Commissioners.’ To the
extent that the Secretary’s regulations require different
treatment of unpaid premiums, we hold that they are
inconsistent with § 818(a) and therefore invalid.”
At Section 832(b)(1)(A) of the Code, Congress specifically
has decreed that for a casualty insurance company “* * * [t]he
term ‘gross income’ means the sum of * * * the combined gross
amount earned during the taxable year from investment income
and from underwriting income as provided in this subsection
computed on the basis of the underwriting and investment
exhibit of the annual statement [“Annual Statement’] approved
by the National Convention [now Association] of Insurance
Commissioners.” Petitioner, in computing the amount of under-
writing income to be included in its Annual Statement, used the
case method of computing its unpaid losses outstanding (App.
“24. Evidence of congressional respect of NAIC accounting
methods is not limited to the portion of the Code concerning life
insurance companies. In defining ‘gross income’ and ‘expenses in-
curred’ for purposes of taxing certain other insurance companies,
Congress expressly requires computations to follow ‘the annual state-
ment approved by the National Convention of Insurance Commis-
sioners.” 26 U.S.C. §§ 832(b)(1) (A), (b)(6).”
16
C, pp. A23, A31). The NAIC examiners, in auditing the books
and affairs of Petitioner, likewise followed the case method in
evaluating Petitioner’s unpaid losses outstanding (R. 129-130,
131, 135, 208-209, 211, 759).
When Respondent refused to follow the case method of cal-
culating unpaid losses outstanding, and substituted a method
based upon a conclusive presumption that prior year “over-
statements” of unpaid losses outstanding (as determined by the
use of hindsight) continued unabated into the current tax year,
he changed Petitioner’s method of accounting for its unpaid
losses outstanding and followed a procedure which conflicted
absolutely with this Court’s Consumer Life Insurance Co. and
Standard Life & Accident Insurance Co, decisions.
(2) By failing to use the case method in reviewing Peti-
tioner’s unpaid losses outstanding, Respondent disregarded his
own Reg. § 1.832-1(b). That regulation requires that the de-
termination of a taxpayer’s unpaid losses be “based upon the
facts of each case.” Petitioner followed that regulation in com-
puting its income. The extent to which a taxpayer may rely
upon one of Respondent’s regulations, and the extent to which
Respondent may disregard his own regulations in assessing
deficiencies, present important questions of federal law which
should be settled by this Court.
Although other federal courts have on occasion held that
Respondent is bound by his own regulations (See, for example,
Mutual Savings Life Insurance Co. v. United States (Sth Cir.
1974) 488 F. 2d 1142, 1145-1146; Tipton and Kalmbach, Inc.
v. United States (10th Cir. 1973) 480 F.2d 1118, 1121;
Weyerhaeuser Company v. United States (Ct. Cl. 1968} 395
F.2d 1005, 1008; and Brafman v. United States (Sth Cir.
1967) 384 F. 2d 863, 866), no decision of this Court so holding
has been found. It is respectfully suggested that those questions
are vital to the proper administration of the revenue laws and
should be settled in this case.
17
A good example of the importance of the question presented
is the case of Continental Insurance Company vy. United States
(Ct. Cl. 1973) 474 F. 2d 661. The question there was whether
Respondent’s Reg. § 1.832-1(c), as written, was binding upon
him or whether he was entitled to construe it to mean something
different from what it seemed to mean. Like Petitioner here,
Continental Insurance Company was a stock fire and casualty
insurance company. In a unanimous en banc decision, the Court
of Claims granted Continental’s motion for summary judgment.
The question presented in the Continental Insurance case was
whether the taxpayer could exclude from its “salvage recover-
able outstanding” adjustments, allowable under Section 832(b)
(5) (A) of the Code, all salvage not yet reduced to cash or its
equivalent. The insurance departments of some (but by no
means all) states in which the taxpayer did business had rules
or regulations prohibiting credit for salvage until reduced to
cash or its equivalent.
The Annual Statements filed by Continental Insurance Com-
pany included in “salvage recoverable outstanding” only salvage
which had been reduced to cash or its equivalent. Those com-
putations were based on the requirements that items reflected
in an Annual Statement apply equally to all of an insurance
company’s business, wherever conducted, and that none of the
assets or liabilities, or items of income or deduction, are to be
allocated on a state-by-state basis. —
The Commissioner assessed federal income tax deficiencies
because the amounts of salvage recoverable outstanding shown
on the Annual Statements of Continental Insurance company
were less than the amounts he considered to be reasonable. By
Reg. § 1.832-1(c), Respondent had decreed that the statutory
phrase of Section 832(b)(5)(A), “salvage recoverable out-
standing,” would mean “salvage in course of liquidation * * *
except that [salvage] which may not be included by reason of
express statutory provisions (or rules and regulations of an
insurance department) of any state * * *.”
18
The Commissioner interpreted his own Regulation to mean
that a casualty insurance company, in computing its “losses
incurred” under Section 832(b) (5) for federal income tax pur-
poses, must take into consideration all salvage in course of
liquidation except that with respect to which a particular state
applied a contrary rule. Some states did indeed have rules and
regulations forbidding the use of salvage estimates.
The taxpayer chose to base its case upon a challenge of the
Commissioner’s interpretation of the Regulation. It argued that
even under the Commissioner’s own standard a casualty insur-
ance company was not required to reduce losses paid by any
“salvage in the course of liquidation” if the rules or regulations
of the insurance department of any state in which it did business
did not permit that salvage to be taken into account.
The United States Court of Claims, in granting the taxpayer’s
motion for summary judgment, noted the heavy state regula-
tion of the insurance business, then concluded by stressing the
fact that there was no good tax reason to support the Commis-
sioner’s redetermination of Continental’s salvage recoverable
outstanding as reported on its Annual Statement [474 F. 2d 661
at 666, 671):
“At the outset it must be recognized that the casualty
insurance business is a thoroughly regulated industry. The
terminology and concepts of the Internal Revenue Code
and Regulation provisions dealing with casualty insurance
are based directly on industry usage developed in response
to state regulation. * * *”
“Finally, we have considered the fact that in the long
run it will make no substantial difference in the amount of
taxes paid whether salvage recoveries are treated on a
“paid” basis or whether estimates are required to be made.
Sooner or later salvage recoveries must be taken into in-
come for tax purposes. Thus, there is no question of tax
avoidance presented here, but merely a question of when
salvage is to be taken into account for purposes of the
federal income tax. * * * In these circumstances it seems
best not to overthrow long-established practice merely to
19
accelerate the receipt of taxes. Such a course of action
would cause needless trouble and expense to insurance
companies without the realization of any significant off-
setting advantage to the government.”
In disagreeing with the Continental Insurance case, the Court
of Appeals stated (App. A, p. Al3, n 16):
“To the extent that the Court of Claims found no
‘significant offsetting advantage to the government’ in al-
lowing taxpayer’s exclusions and resultant reduction of its
taxable income, we find Continental Insurance, supra, in-
applicable to the present case. For example, given the
deficiency of $331,664.28 assessed here and an annual
interest rate, before compounding, of 7%, the disadvantage
in delayed receipt of these funds of one year amounts to
$23,215.10—not an insignificant figure.”
(3) Section 832(b) provides that a casualty insurance com-
pany’s gross income, a component of which is its unpaid losses
outstanding, shall be computed on the basis of the insurance
company’s Annual Statement approved by the NAIC. By Reg.
§ 1.832-1(b), Respondent has attempted to change the statute
to provide that the computation of gross income and unpaid
losses for federal income tax purposes will be on the basis of
Annual Statements unless a district director determines that a
casualty insurance company’s unpaid losses exceed “a fair and
reasonable estimate of the amount the company will be required
to pay.”
If Congress had intended the Annual Statement to be less
than conclusive for federal income tax purposes, it knew how
to accomplish that objective. See, for example, Western Na-
tional Life Insurance Company of Texas v. Commissioner of
Internal Revenue, 432 F.2d 298 (Sth Cir. 1970), where the
Court grounded its decision upon the fact that in the statute
itself Congress had provided that life insurance company taxes
would not always be based exclusively upon Annual Statements
[432 F. 2d 298 at 301]:
“We also agree with the decisions in these two cases to
the effect that the Congress did not adopt the N. A. I. C.
20
‘form of statement for its accounting method as to determin-
ing its tax base for [life] insurance companies. As will ap-
pear from the statute itself, the N.. A. I. C. annual statement
was referred to as being the proper standard ‘except as pro-
vided in the preceding sentence,’ the preceding sentence
providing that all computations should be under an accrual
method of accounting. * * *”
Congress did not, of course, place similar limitations upon the
computation of federal income tax liabilities of casualty in-
surance companies; the statute itself makes no exceptions to the
rule that tax liability is to be computed on the basis of Annual
Statements of such insurers.
The Court of Appeals upheld the validity of the regulations
because “[s]tandards for the exercise of this power are found in
the substantive provisions of the Code which are enforced by the
regulations in question” (App. A, p. A1l6). This test would
have meaning if the regulations had, for example, interpreted
the purview of “on the basis of the underwriting and investment
exhibit of the annual statement * * *.” The regulations did not
do that, however, and one searches the substantive provisions
of the statute in vain for any touchstone by which the regulations
may be grounded to the statute.
Because it is not grounded to the pertinent provisions of the
Code, Reg. § 1.832-1(b) is in direct conflict with applicable
decisions of this Court which have invalidated regulations by
Respondent which have sought to change or add to the statutory
provisions. Some of the cases of this Court with which the lower
court decisions conflict include: Dollar Savings Bank v. United
States, 19 Wall. (86 U.S.). 227, 236-237; Swift Company v.
United States, 15 Otto (105 U.S.) 691, 694-695; Iselin v.
United States, 270 U.S. 245, 250-251; Old Colony Railroad
Co. v. Commissioner, 284 U.S. 552, 561 (“If there were doubt
as to the connotation of the term, and another meaning might
be adopted, the fact of its use in a tax statute would incline the
scale to the construction most favorable to the taxpayer.”);
Miller v. Standard Nut Margarine Co., 284 U.S. 498, 508;
21
Koshland v. Helvering, 298 U.S. 441, 446-447; White v.
Aronson, 302 U.S. 16, 20; M. E. Blatt Co. v. United States,
305 U.S. 267, 279; Helvering v. Janney, 311 U.S. 189, 194-
195; Taft v. Helvering, 311 U.S. 195, 198-199; Helvering v.
Credit Alliance Corporation, 316 U.S. 107, 113; Helvering v.
Sabine Transportation Co., Inc., 318 U. S. 306, 311-312; Trust
of Bingham v. Commissioner, 325 U.S. 365; United States v.
Calamaro, 354 U. S. 351, 358-359; Commissioner v. Acker, 361
U. S. 87, 92, 93-94; and United States v. Cartwright, 411 U. S.
546, 557.
Assuming arguendo that Congress intended to vest Respond-
ent with authority to promulgate Reg. § 1.832-1(b)—and there
are no words which would indicate such an intent—the next
inquiry would be whether such an intent was properly expressed.
Because there are no particular delegations of power here, pre-
sumably Respondent finds his authority in the general, catchall
provisions of Section 7805 of the Code. Section 7805 delegates
to Respondent authority to make all “needful rules and regula-
tions” for enforcement of the Internal Revenue Code. The ques-
tion is whether that delegation—as applied to the facts of this
particular case—was accompanied by sufficient standards to
meet due process essentials.
Panama Refining Company v. Ryan, 293 U. S. 388, held that
certain regulations relating to the oil industry which had been
prescribed under Section 9(c) of the National Industrial Re-
covery Act were invalid because Congress had not declared a
policy to guide the administrator [293 U.S. at 415, 430]:
“* * * [The statute] does not seek to lay down rules for
the guidance of state legislatures or state officers. * * *
[It] does not state whether, or in what circumstances nor
under what conditions, the President is to prohibit the
transportation of the amount of petroleum or petroleum
products produced in excess of the State’s permission. It
establishes no criterion to govern the president’s cause. ***
So far as this section is concerned, it gives to the President
an unlimited authority to determine the policy and to lay
22
down the prohibition, or not to lay it down, as he may see
m,.° * 2
“Thus, in every case in which the question has been
raised, the Court has recognized that there are limits of
delegation which there is no constitutional authority to
transcend.*** [T]he Congress has declared no policy, has
established no standard, has laid down no rule. There is
no requirement, no definition of circumstances and condi-
tions, in which the transportation is to be allowed or
prohibited.”
Mr. Justice Cardozo dissented from the Panama Refining
case because, he thought, there had been an adequate delega-
tion of standards in that the legislature had defined the subject
matter of the delegated power as being the need for controlled
transportation in interstate and foreign commerce in petroleum
and petroleum products; but later he joined a unanimous Court
in the famous “sick chicken” case of Schechter Poultry Corpora-
tion v. United States, 295 U.S. 495. In concurring in that de-
cision, which invalidated the N. R. A. Codes for the governance
of trades and business, Mr. Justice Cardozo remarked [295
U. S. at 551): ;
“The delegated power of legislation which has found ex-
pression in this Code is not canalized within banks that
keep it from overflowing. It is unconfined and vagrant. * * *
“* * * Here, in the case before us, is an attempted delega-
tion not confined to any single act nor to any class or group
of acts identified or described by reference to a standard.
Here in effect is a roving commission to inquire into evils
and upon discovery correct them.”
While we have long honored Mr. Justice Cardozo for his
multiple admirable qualities, up until now clairvoyance has not
been recognized as one of them. But does he not summarize
precisely what Respondent has done here: having discovered
the “evils” of a tax statute which defines gross income by
reference to a standard he is unable to control, Respondent
would exorcise them by rewriting the statute to meet his own
idea of virtue.
23
Had Congress wished, it easily could have delegated power
to Respondent in such a way that it would have been “canalized
within banks that keep it from overflowing” so that it would not
be “unconfined and vagrant.” Some examples from the Code
itself would include Section 820 which vests Respondent with
particular power to issue regulations with respect to “Optimal
Treatment Of Polices Reinsured Under Modified Coinsurance
Contracts,” Section 171(b) (3) (B) which specifically states that
amortization of bond premium is to be “in accordance with
regulations prescribing reasonable methods” of amortization;
and Section 166(c) which allows, in lieu of a direct deduction
for wholly or partially worthless business bad debts, “(in the
discretion of the Secretary) a deduction for a reasonable addi-
tion to a reserve for bad debts.”
Canalization of Respondent’s power might also have been
accomplished albeit perhaps not so effectively had Congress at
least legislated a “reasonable” requirement in Section 832(b)
itself. Congress also is familiar with this legislative technique;
witness, for example, Section 162(a)(1) which includes as de-
ductible trade or business expenses “a reasonable allowance for
salaries or other compensation for personal services actually
rendered” and Section 167(a) which allows “as a depreciation
deduction a reasonable allowance for” depreciation [emphasis
supplied]. If Congress had done that, then an argument could
indeed be made that regulations defining “reasonable” would
have been “needful” within the meaning of Section 7805, hence
properly canalized within the meaning of the Panama Refining
and Schechter cases.
24
CONCLUSION.
The Petition For A Writ Of Certiorari should be granted.
Respectfully submitted,
PauL A. TESCHNER
39 South LaSalle Street
Chicago, Illinois 60603
(312) 332-0346
Counsel for Petitioner
TESCHNER PROFESSIONAL CORPORATION
39 South LaSalle Street
Chicago, Illinois 60603
July 1979
Al
APPENDIX A
OPINION OF THE UNITED STATES
COURT OF APPEALS
UNITED STATES CouRT OF APPEALS
For the First Circuit
No. 78-1407
HANOVER INSURANCE COMPANY,
Successor in interest to:
MASSACHUSETTS BONDING AND
INSURANCE COMPANY,
Petitioner-A ppellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-A ppellee.
ON APPEAL FROM THE DECISION OF THE
UNITED STATES TAX COURT
Before
CorFIN, Chief Judge,
BOwnkgs, Circuit Judge,
PETTINE, District Judge.*
Paul A. Teschner for appellant.
Daniel F. Ross, Attorney, Tax Division, Department of Jus-
tice, with whom M. Carr Ferguson, Assistant Attorney General,
* Of the District of Rhode Island, sitting by designation.
A2
Gilbert E. Andrews and Richard W. Perkins, Attorneys, Tax
Division, Department of Justice, were on brief for appellee.
May 8, 1979
PETTINE, District Judge. Appellant Hanover Insurance Com-
pany (Hanover) seeks this Court’s review of a decision of the
United States Tax Court upholding the Commissioner’s de-
termination of a deficiency in the income tax of Massachusetts
Ronding and Insurance Company (MBI) for the taxable year
1960. Hanover is the successor in interest to MBI, which was
merged into Hanover on June 30, 1961.
MBI filed federal income tax returns for its calendar years
1959 and 1960 and its taxable period ending on June 30, 1961
(the date of its merger into Hanover) with the District Director
of the Internal Revenue Service in Boston, Massachusetts. On
December 20, 1970 the Commissioner issued a Notice of De-
ficiency to Hanover in which he determined a deficiency of
$441,081.10 for 1959 and $446,206.34 for 1960. On March
30, 1978 the United States Tax Court entered its final decision
in this matter, in which it found that there was a deficiency
in MBI’s 1960 income tax of $331,644.28." It is that determina-
tion which is challenged before this Court.
MBI was a casualty insurance company with its principal
place of business in Massachusetts.? During the years at issue
1. The Tax Court denied Hanover’s motion to dismiss on
January 7, 1976. Hanover Insurance Company vy. Commissioner of
Internal Revenue, 65 T.C. 715; appeal dismissed, No. 1557-71
(May 11, 1976). In accordance with its opinion on the merits,
Hanover Insurance Company v. Commissioner of Internal Revenue,
69 T. C. 260 (1977), the Tax Court held that no deficiency existed
in MBI’s 1959 tax, but it recomputed the deficiency in MBI’s 1960
tax in the final amount of $331,644.28.
Both parties filed timely notice of appeal. The Commissioner has
dismissed his appeal, leaving only Hanover’s chailenge as to the
1960 deficiency pending before this Court.
2. Fora more detailed discussion of the facts and financial data
involved in this case, the reader is referred to the opinion of the Tax
Court on the merits, 69 T. C. at 262-268.
A3
here, it wrote 24 lines of casualty insurance. MBI filed annual
statements with the Massachusetts Commissioner of Insurance,
utilizing the form of an annual statement approved by the Na-
tional Association of Insurance Commissioners (N. A. I. C.).?
That form also was utilized by MBI in its computation of tax-
able income for federal tax purposes pursuant to the require-
ments of I. R.C. § 832.
I.R.C. § 832(a) defines “insurance company taxable in-
come” as “the gross income as defined in subsection (b) (1) less
the deductions allowed by subsection (c).” Subsection (b)(1)
(A) defines “gross income” for this purpose as
the combined gross amount earned during the taxable
year, from investment income and from underwriting in-
come as provided in this subsection, computed on the basis
of the underwriting and investment exhibit of the annual
statement approved by the [N. A. I. C.].
“Underwriting income” is defined thereafter as ‘the premiums
earned on insurance contracts during the taxable year less losses
incurred and expenses incurred.” § 832(b)(2). § 832(c) also
authorizes the deduction from taxable income of losses incurred.
The present dispute involves the computation of MBI’s “losses
incurred” under § 832(b) (3). The Code provides for computa-
tion of this figure as follows:
The term “losses incurred” means losses incurred during
the taxable year on insurance contracts, computed as
follows:
(A) To losses paid during the taxable year, add salvage
and reinsurance recoverable outstanding at the end of the
preceding taxable year and deduct salvage and reinsurance
recoverable outstanding at the end of the taxable year.
(B) To the results so obtained, add all unpaid losses
outstanding at the end of the taxable year and deduct un-
3. See M.G.L.A. c. 175 § 25.
A4
paid losses outstanding at the end of the preceding taxable
year. :
I. R. C. § 832(b) (5).
Treas. Reg. § 1.832-1 (1960)* repeats the requirements of
I. R. C. § 832 and admonishes insurance companies to “be pre-
pared 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 stated in amounts
which, based upon the facts in each case and company’s
experience with similar cases, can be said to represent a
fair and reasonable estimate of the amount the company
will be required to pay.
The regulation warns further that amounts in excess of actual
liability so determined will be disallowed as deductions, and
that the District Directors may require submission of informa-
tion sufficient to establish “the reasonableness of the deduction
for ‘losses incurred’ ”’.®
Thus the Code recognizes that “unpaid losses outstanding”
can only be estimated for a given year when that year’s return is
filed, because the amount of payments which will be made on all
4. As amended by T.D. 6867, 30 F.R. 15094, (December
12, 1975).
5. The regulation also refers to the N. A. I. C. form:
The underwriting and investment exhibit [of the N.A.I.C.
form} is presumed to reflect the true net income of the com-
pany, and insofar as it is not inconsistent with the provisions of
» the Code will be recognized and used as a basis for that pur-
pose. All items of the exhibit, however, do not reflect an
insurance company’s income as defined in the Code... .
The regulation goes on to require that certain items on the N. A. I. C.
form be excluded in the computation of taxable income, and that, in
computation of the item entitled “losses incurred”, “the determina-
tion of unpaid losses at the close of each year must ‘represent actual
unpaid losses as nearly as it is possible to ascertain them.”
§ 1.832-1(a).
AS
outstanding claims cannot be ascertained until settlement or
litigation of all claims arising during that year. Treas. Reg.
§ 1.832-1(b) anticipates that insurance companies will deduct
only a “fair and reasonable estimate” of actual unpaid losses
outstanding. The Commissioner’s notice of deficiency for 1959
and 1960 was the result of the parties’ differences of opinion as
to the proper amount of deduction which should be allowed in
the computation of MBI’s taxable income for those years.
MBI calculated its unpaid loss reserve—the same figure it
claimed as a deduction—according to two methods. One method
involved examination of individual cases by claims examiners
who estimated the dollar value of liability. A second approach,
used to estimate the value of claims which presumably had oc-
curred but were not yet reported, involved application of a
formula based on historical experience to premiums in force for
a given period.®
For the taxable year 1960, the Comunissioner’s method for
testing the reasonableness of an insurance company’s unpaid
loss deduction was based on a historical analysis of prior years’
estimated and actual losses.’ The Commissioner examined the
6. See 69 T. C. 263-264.
7. The Commissioner’s testing method applicable to the year
1960 was set forth in Mimeo R. A. No. 1366, issued by the Com-
missioner of Internal Revenue on July 1, 1944. It provides in rele-
vant part:
In the determination of unpaid losses . . . consideration should
be given to the following requirements:
1. That 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... .
2. That the Bureau is not required to accept the figures
shown in the [N. A.I.C.] Annual Statement... .
3. That particular attention be given, in the investigation
of the books and records of the taxpayers, for evidence
of “leading” [should be “loading”] in the computation
of the deduction for unpaid losses.
4. That an adjustment at the close of each year...
should be made if the information available indicates
(Footnote continued on next page.)
A6
taxpayer's experience in years prior to the taxable year in ques-
tion to determine whether reserves for losses were greater or
less than actual losses for the prior years. The actual, or “de-
veloped” losses were ascertained after they were paid out in
subsequent years. Although the testing method varied among
(Footnote continued from preceding page.)
the estimates of unpaid losses for 1944 or subsequent
years are excessive. .. .
With respect to Item 4 above, the policy of the Bureau will be
as follows:
A. That the total of unpaid losses at the end of any year
should be the aggregate of the reasonable estimates of
the outstanding losses made approximately as of the
close of the year on the basis of the facts in each
claim and the taxpayer’s experience with similar claims.
B. That in determining whether or not the estimate of
unpaid losses is reasonable, a comparison should be
made with the past experience of the company and
with subsequent payments of such losses, or by any
other proper comparison.
C. In the application of B the following method of veri-
fying the reasonableness of unpaid losses of casualty
and surety companies on all lines other than Work-
men’s Compensation and Public Liability is suggested:
Information that will disclose the reasonableness of the
unpaid loss liability as set up by the taxpayer may be
secured from Schedule O of the Annual Statement.
A comparison of the amounts still estimated as unpaid
at the end of such year, (developed losses) should be
made with the previous year’s estimate of unpaid losses
(estimated losses) to determine the ratio of “estimated
losses” to one-year “developed losses”. Such compari-
son should be made separately for each year for the
previous five years. If the average “estimated losses”
of the previous five years is found to be not more than
115% of the five-year average of the one-year “de-
veloped losses”, the estimates made will be regarded
as being reasonably correct, and no adjustment for the
current year would ordinarily be required.
In the event that the five-year average of “estimated
losses” is in excess of 115% of the five-year average
of the one-year “developed losses” then the unpaid
loss liability of the company will be deemed to be ex-
cessive in the current year and an adjustment will
ordinarily be required. In determining the extent of the
(Footnote continued on next page.)
A7
different categories of insurance,* the ultimate rule of thumb
was the same for all lines of insurance. If reserves for prior
years proved to have exceeded developed losses for those years
(Footnote continued from preceding page.)
adjustment to be made to the outstanding losses at
the end of the year, in accordance with the preceding
sentence, due regard should be given to the actual
amount paid thereon as shown by subsequent develop-
ments, as corroborative evidence of the overstatement
of the liability.
D. In the application of B of (sic) following method or
verifying the reasonableness of the unpaid losses (ex-
clusive of ocean marine) of companies doing business
in fire insurance and allied lines, is suggested:
A development of the outstanding losses of the
current year alone, (or of the current year and one or
more of the previous years at the election of the tax-
payer) shall be used to ascertain the reasonableness
of the liability as claimed. Where the amounts paid
on the current year’s losses (or on as many years as
are used by the taxpayer) discloses that the estimate
was not in excess of 115% of the amounts paid in
respect thereto the estimates shall be considered as
reasonable. Where such estimate was in exccss of
115%, it will be considered excessive and an adjust-
ment will ordinarily be required.
E. Discrepancies of 15% between the estimate for un-
paid losses and the amounts required to be paid there-
on, will ordinarily be presumed to be reasonable vari-
ances due to the nature of the insurance business in
general... .
This procedure is no longer followed. Rev. Proc. 75-76, 1975-2 C. B.
112, [should be, Rev. . 75-56, 1975-2 C. B. 596] supersedes
Mimeo R. A. 1366, and notes that “[t]he long term administrative
ractice enunciated in [the prior procedure] can no longer be justified
in view of the technological advances made by the insurance indust
in the area of statistical collection and analysis”. Rev. Proc. 75-76,
§ 3.01. A standard of reasonableness in unpaid loss estimates is still
applied; however, the 15% tolerance formerly allowed is no longer
applicable.
8. In making such comparisons respondent applied a longer
testing or development period for so-called Schedule P lines than
for Schedule O lines of insurance in determining petitioner’s experi-
ence rate’. Schedule P of the Annual Statement included Auto Lia-
bility, Liability other than Auto, and Workmen’s Compensation.
Schedule O covered most of the remaining lines of insurance. 69
T. C. 264-65.
A8
by more than 15 percent, ,the deduction for the taxable year in
question was presumed to overstate reality by the same propor-
tion. The Commissioner would reduce the deduction allowed
for the year at issue by a percentage equal to the percentage
by which prior years’ estimates were excessive by more than
15 percent. Thus, for example, if the “experience rate” (past
estimates divided by actual losses) was 123 percent, the Com-
missioner would assume that the claimed deduction for the
year at issue represented 123 percent of actual losses for that
year. A loss deduction would be allowed only equal to 115 per-
cent of the amount determined by the Commissioner to be the
proper figure based on the taxpayer’s experience rate.’
The Tax Court also heard evidence concerning audits of
MBI’s annual statements by the National Association of Insur-
ance Commissioners. Those audits, conducted at three-year in-
tervals by Massachusetts state officials together with N. A. I. C.
representatives, showed significant overstatements in MBI’s un-
paid losses outstanding reserves for 1956 and 1959. However,
MBI did not make adjustments to its books and accounts as
a result of those audits.
The Commissioner presented testimony from “a well qualified
actuary with much experience in the casualty insurance field”?°
before the Tax Court. This expert applied his own testing tech-
nique, which was different from that used by the Commissioner,
9. Thus, if a loss deduction of $30 million were claimed for the
year in question, but the insurance company’s experience rate there-
tofore was 123%, the Commissioner would allow a loss deduction
for that year of only $28,048,779, computed as follows:
123 = $30,000,000, presumed actual losses = $24,390,243.
100° presumed actual
, losses
The Commissioner would. allow up to 115% of presumed actual
losses. (1.15) X ($24,390,243) = $28,048,779.
“10. Hanover “takes éxception” to the Tax Court’s finding that
the Commissioner’s expert witness, Mr. David Skurnick, is “well
qualified”. We find no abuse of discretion in the Tax Court’s ad-
mission of his testimony. Salem v. United States Lines Co., 370
U.S. 31, 35 (1962).
gg
A9
to find significant -overstatements in unpaid loss reserves for
1959, 1960, and the taxable period ending on June 30, 1961
comparable in magnitude to _— determined vfs the Com-
missioner."?
The Tax Court set forth the following schedule’? to ‘demon-
strate the development of MBI’s unpaid losses for which deduc-
tions were claimed in 1959 and 1960, as compared with the
amount of deductions allowed by the Commissioner:
19591960
Unpaid losses claimed
(per Annual Statement) |
by MBI $30,390,690 $29,965,729
Subsequent development ;
to 12/31/62 (actual
losses ) $28, 108, 225% $27,715,704
Unpaid losses as adjusted .
by the Commissioner $29, 286, 116. $29, 275, 181
1. Includes unpaid losses on pooled business. at full amount
claimed by MBI, i.e., $2,857,749.
2. Includes unpaid losses on pooled indienne at full amount
claimed by MBI, i.e., $3,189,724.
3. Balance of claimed losses after deducting the Commissioner’s
ao. and 1960 adjustments of a, 104,574 and $690,548, eer
It should be noted that the siaieaasiaias made by the Commis-
sioner was only for the purpose of determining the proper loss
deduction for federal tax purposes and had ‘no effect on the
reserves actually © “held by MBI to cover payment of unpaid
losses. The table set forth above merely demonstrates that, had
MBI maintained reserves in accordance with the Commissioner’s
calculation rather than its own, it still would have had sufficient
funds in reserve to cover unpaid losses arising from 1960 claims.
As we have indicated, the adjustment made by the Commis-
sioner was the basis of the deficiency. he assessed for 1960: whieh,
11. See 69 T.C. at 267. ri
12. Id. at 268.
Al10
in turn, was recomputed by the Tax Court and is the subject
of this appeal.
Hanover first argues that it correctly computed its gross in-
come on the basis of the underwriting and investment exhibit
of the annual statement approved by the N. A. I.C. Because
I. R. C. § 832(b)(1)(A) and Treas. Reg. § 1.832-1 require
computation of insurance company income on this basis, Han-
over claims that its computations are insulated thereby from
adjustment by the Commissioner. It relies on this Court’s de-
cision in Commissioner of Internal Revenue v. New Hampshire
Fire Insurance Company, 146 F.2d 697 (1st Cir. 1945) in
support of this contention.
Hanover’s reliance on our decision in New Hampshire Fire
Insurance, supra, is misplaced. In that case we merely enforced
Congress’s requirement that the N. A. I. C. form be followed as
the only acceptable method for computing an insurance com-
pany’s gross income. We recognized explicitly that “as a funda-
mental principle tax returns must represent income, and...
returns based exclusively on the [N. A.I.C.] form do not.”
Id. at 700. Despite this recognition, we held that the form must
be followed because Congress, when it imposed this requirement
on insurance companies, was faced with the “axiomatic fact
that insurance bookkeeping and accounting are highly compli-
cated processes” and its choice of reliance on the N. A.I.C.
form was the result of “an apparent search for a simple method
for reporting income for tax purposes.” Jd.
There is no support in New Hampshire Fire Insurance, supra,
for the contention that the mere inclusion of certain figures on
the congressionally-approved annual statement can prevent the
Commissioner’s adjustment for the purpose of identifying tax
deficiencies. As the Tax Court concluded in its denial of Han-
over’s motion to dismiss, accepting this position
would entail our speculating and concluding that the First
Circuit’s blessing of the [N. A. I. C. form] . . . was tanta-
All
mount to a sanctification of the estimated figures as well as
the form itself, no matter how unfair or unreasonable.
65 T.C. at 719.
Hanover’s reliance on Western Casualty and Surety Company
v. Commissioner, 571 F. 2d 514 (10th Cir. 1978) is also mis-
placed. In that case the Tenth Circuit Court of Appeals con-
sidered the question of whether an insurance company may in-
clude as deductions commissions on deferred premium install-
ments in its computation of “expenses incurred” using the
N. A. I. C. form as required by I. R. C. § 832(b) (6). The Court
held that
the N. A. I. C. forms are not absolute and . . . where they
conflict with the ordinary requirements of [I. R. C.] § 162
(“Trade or business expenses”], the latter prevails.
Deference to the N. A.I.C. would allow the deduction
of commissions which had not been actually paid and
were mere accounting entries.
Id. at 517-18.
We must conclude that the Tax Court was correct in holding
that MBI’s adherence to the N. A. I. C. annual statement did
not prevent the Commissioner from contesting the figures con-
tained therein. Congress’ “preference for N. A. I. C. accounting
methods”, Commissioner v. Standard Life and Accident Insur-
ance Company, 433 U.S. 148, 161 (1977), should not
be interpreted to inhibit the Commissioner’s authority to enforce
I. R. C. § 832. His inquiry into the validity and accuracy of
the figures reported under that provision, guided by the stand-
ard of reasonableness found in Treas. Reg. § 1.832-1,** is a
necessary step in his exercise of that authority. -
Hanover’s second contention is that the Commissioner’s regu-
lation enforcing I. R. C. § 832, Treas. Reg. 1.832-1, is violative
13. Hanover also challenges the validity of the “reasonableness”
standard contained in § 1.832-1. See discussion at 14-17, infra.
Al2
of the so-called McCarran-Ferguson Act, 15 U.S.C. § 1011
et seq. (1976). That law provides that no act of Congress may
“be construed to invalidate, impair, or supersede any law en-
acted by any state for the purpose of regulating the business of
insurance .. . unless such Act specifically relates to the business
of insurance . . .”. Hanover gives two reasons for its position:
that the regulation and the Commissioner’s enforcement proce-
dure" do not, in the long run, increase federal tax revenues and
therefore constitute an unwarranted intrusion upon the account-
ing practices of insurance companies; and the Commissioner's
enforcement of Treas. Reg. § 1.832-1 subjected the unpaid
losses of MBI to restrictions whereby the Commissioner could
regulate this item in violation of the McCarran-Ferguson Act.
The court disagrees that enforcement of § 832 in the manner
accomplished in this case does not increase federal tax reve-
nues,’* Although revenues lost through overstated deductions in
a given year presumably will be recaptured in succeeding years,
a consistent pattern of overstatement will result in a “float” or
tax deferral which is of real advantage to a taxpayer and cor-
responding disadvantage to the federal treasury. It can amount
to an interest-free loan from the federal government.'®
14. See notes 5 and 7, supra.
15. Even if this contention were valid, it does not necessarily
follow that enforcement of Treas. Reg. § 1.832-1 constitutes regu-
lation of the insurance industry; the absence of financial benefit to
the government seems irrelevant to the question of whether there
is a regulatory effect on the industry.
16. Hanover relies on Continental Insurance Company v. United
States, 474 F.2d 661 (Ct. Cl. 1973), wherein the Court of Claims
ruled on the propriety of an insurance company’s exclusion of cer-
tain items from salvage recoverable adjustments to losses deducted
from gross income pursuant to I. R. C. § 832. The issue was whether
such adjustments should include paid salvage recoveries or estimates
of recoveries to be realized in the future. The court upheld the tax-
payer's exclusion and noted that
..» « in the long run it will make no substantial difference in
the amount of taxes paid whether salvage recoveries are treated
on a “paid” basis or whether estimates are required to be made.
(Footnote continued on next page.)
(\
Al3
Hanover contends that Treas. Reg. § 1.832-1(b) gives IRS
District Directors a “visitorial power” to review unpaid losses
claims and thereby allows improper regulation in violation of
the McCarran-Ferguson Act. This argument fails for two rea-
sons. First, I. R. C. § 832 “specifically relates to the business
of insurance”—it deals exclusively with taxation of insurance
companies—and, therefore, the McCarran-Ferguson Act ‘is in-
applicable by its own terms. Because “the power of the federal
government to tax was not delegated to the states” by the Act,
Industrial Life Insurance Company v. United States, 481 F.2d
609, 610 (4th Cir. 1973), the application of federal tax laws
to insurance companies is not inconsistent with the intent of
Congress to refrain from interfering with state regulation of the
insurance business, See United States v. Sylvanus, 192 F. 2d 96
(ist Cir. 1951) (McCarran-Ferguson Act did not prevent en-
forcement of federal statute punishing mail fraud).
In addition, we cannot accept Hanover’s contention that en-
forcement of Treas. Reg. § 1.832-1(b) constitutes regulation.
MBI was free to maintain reserves in any amount for unpaid
losses. I. R. C. § 832 and accompanying regulations do not limit
(Footnote continued from preceding page. )
Sooner or later salvage recoverics must be taken into income
for tax purposes. Thus, there is no question of tax avoidance
mapa here, but merely a question of when salvage is to
oe — a account for purposes of the federal income tax.
. at 671. toy .
In allowing this exclusion, the Court of Claims was mindful of the
need for uniformity in treatment of salvage items throughout the
states. Relevant Treasury Regulations provided that “if any state
in which an insurer did business excluded estimates of future sal-
vage recoveries . . . such estimates would be excluded for federa
income purposes.” Jd. at 668. ‘oy ows
To the extent that the Court of Claims found “no significant
offsetting advantage to the government” in allowing taxpayér'’s ex-
clusions and resultant reduction of its taxable income,’ we find
Continental Insurance, supra, my pwr to the present:case. For
example, given the deficiency of $331,664.28 assessed here and an
annual interest rate, befors. compounding, of 7%, the waa are te
in delayed ene of these funds of one year amounts to $23,215.10
—not an insignificant figure.
Al4
an insurance company’s freedom to keep records in whatever
manner it chooses for financial or state regulatory use. Any in-
creased burden on the insurance company is no greater than
that borne by other taxpayers who use different data for tax
purposes as opposed to other purposes.
Hanover challenges directly the validity of Treas. Reg.
§ 1.832-1 because, by purporting to authorize the Commissioner
to determine whether unpaid loss deductions exceed “a fair and
reasonable estimate of the amount the company will be required
to pay” and to assess tax deficiencies based upon such deter-
minations, the regulation allegedly exceeds the scope of the
statute it interprets, I. R. C. § 832. Because this statute does not
empower explicitly the Commissioner to apply it according to
a “fair and reasonable” requirement, Hanover’s argument is
that there is no authority for such a requirement and that the
regulation is invalid to that extent.
In support of its argument Hanover relies on cases holding
that there is no power in an administrator to construe an un-
ambiguous statute, see, e.g., United States v. Fisher, 6 U.S. (2
Cranch) 358 (1804); Dollar Savings Bank v. United States,
86 U.S. (19 Wall.) 227 (1874); Swift Company v. United
States, 105 U. S. 691 (1882), together with cases in which tax
regulations have been struck down because of direct conflict
with specific provisions of the Code. See, e.g., Koshland v.
Helvering, 298 U.S. 441 (1936). These authorities are inap-
posite for two reasons. First, I. R. C. § 7805 specifically em-
powers the Secretary of the Treasury, or his delegate, to “pre-
scribe all needful rules and regulations for the enforcement” of
Code provisions. The United States Supreme Court has indi-
cated that “regulations promulgated under [the Secretary's] au-
thority, if found to ‘implement the congressional mandate in
some reasonable manner’ must be upheld.” United States v.
Cartwright, 411 U.S. 546, 550 (1973) (citations omitted);
Commissioner Vv. Winslow, 113 F. 2d 418, 423 (1st Cir. 1940).
The regulation in question clearly meets this test; Treas. Reg.
Al5
§ 1.832-1 retlects explicitly the computation method for losses
and gross income which is set forth in the statute, I. R. C. § 832.
By providing that District Directors may determine whether de-
ductions “can be said to represent a fair and reasonable estimate
of the amount the company will be required to pay,” the regu-
lation does no more than give notice to the taxpayer that the
Code will be enforced pursuant to the mandate of § 7805. To
hold otherwise would vitiate this section of the Code; insurance
company taxpayers could deduct any amount calculated ac-
cording to the method in § 832(b) and claim immunity from
administrative review. Clearly this was not the intent of Con-
gress.""
Moreover, Hanover ignores the fundamental premise that
taxpayers must prove their entitlement to deductions. There is
no burden on the Commissioner to justify his disallowance of a
claimed deduction. New Colonial Company v. Helvering, 292
U. S. 435, 440 (1934); Welch v. Helvering, 290 U.S. 111, 115
(1933). The regulation at issue here restates that principle,
providing that insurance companies “must be prepared to estab-
lish” the validity of their loss deduction reserves “in amounts
which, based upon the facts in each case and the company’s
experience with similar cases,” are close to actual experience.
The imposition of this requirement on insurance company tax-
payers is not an impermissible expansion upon I. R. C. § 832.
Alternatively, Hanover claims to have suffered a denial of
due process by the Commissioner's application of Treas. Reg.
§ 1.832-1 to MBI. Its argument is that I. R. C. § 7805, which
delegates authority to issue regulations under the Code, contains
17. The validity of the regulation is also supported by “the
settled principle that ‘Treasury regulations and interpretations long
continued without substantial change, applying to unamended or
substantially reenacted statutes, are deemed to have received con-
gressional approval and have the effect of law’.” United States v.
Correll, supra, 299 U.S. at 305-306 (citations omitted). As the
Commissioner points out, the regulation or its substantially similar
predecessors have been in existence for over 34 years. Appellce’s
Brief at 28.
Al6
insufficient standards for the exercise of that authority, There-
fore, Hanover contends, this delegation of legislative authority
operated to deprive MBI of property without due process.
Hanover relies on Panama Refining Company v. Ryan, 293
U. S. 388 (1935) and the old war horse of Schechter Poultry
Company v. United States, 295 U.S. 495 (1935), both cases
in which the Supreme Court invalidated New Deal legislation
which delegated legislative authority to administrative bodies
without sufficient standards or policies to govern the adminis-
trative exercise of that authority. Because there is no require-
ment of “reasonableness” pertaining to unpaid loss deductions in
I. R. C. § 832(b), Hanover contends that the promulgation of
Treas. Reg. § 1.832-1 was not “needful” within the meaning
of I. R. C. § 7805. Thus the regulation, which does require that
loss deductions be “fair and reasonable” estimates of actual
losses, constitutes an expansion of § 832 not governed by a
statutory standard. This, it claims, is a denial of due process.
This argument is frivolous. The Supreme Court has made
repeated reference to Congress’ delegation of authority under
I. R. C. § 7805. See, e.g., United States v. Cartwright, supra,
411 U.S. at 550; Bingler v. Johnson, 394 U.S. 741, 750-751;
United States v. Correll, 389 U.S. 299, 306-307. Standards for
the exercise of this power are found in the substantive provisions
of the Code which are enforced by the regulations in question.
I. R. C. § 7805 explicitly requires that regulations be “needful
. . . for enforcement” of the Code. “The role of the judiciary in
cases of this sort begins and ends with assuring that the Com-
missioner’s regulations fall within his authority to implement the
congressional mandate [of § 7805] in some reasonable manner.”
United States v. Correll, supra, 299 U.S. at 307.
Clearly, the purpose of I. R. C. § 832(b)(5) is the accurate
computation of losses incurred, and an element of the requisite
calculation is the “unpaid losses outstanding” figure. Treas. Reg.
§ 1.832-1 does no more than require that the amount of unpaid
losses estimated and deducted by insurance companies should
Al7
comport with reality. Where the Code explicitly allows deduc-
tion of an item which cannot be valued precisely at the time the
deduction is claimed, no more reasonable manner of implement-
ing Congress’ purpose can be found than a regulation which
requires the deduction to be a “fair and reasonable” estimate
of actual experience. It is spurious to suggest that in so doing
the Commissioner has acted without the benefit of the Con-
gressional direction contained in § 832 itself.
In a final challenge to the assessment of this deficiency Han-
over claims that its determination of unpaid loss reserves was,
in fact, accurate and that the Commissioner’s adjustment was
in error and reached in violation of his own regulation. For
the reasons set forth below, we find this claim to be without
merit.
The determination of a fair and reasonable estimate of a
taxpayer’s unpaid losses in essentially a valuation issue and a
question of fact. Thus, the scope of our inquiry is limited to
deciding whether the Tax Court’s determination on this issue
was clearly erroneous. Commissioner v. Duberstein, 363 U.S.
278, 291 (1960). As we have noted, it was Hanover’s burden
to prove its entitlement to a deduction beyond that allowed by
the Commissioner. Welch v. Helvering, supra, 290 U.S. at 115.
The Tax Court heard ample evidence of MBI’s overstatement
of unpaid loss reserves. Apart from the financial data submitted
by the government on this point,’® the N.A.I.C. itself, in
examinations conducted in 1956 and 1959, had determined that
MBI’s losses were overstated. In addition, the Commissioner’s
expert testified that, in his opinion, MBI’s reserves were “un-
reasonably high.” In response to this evidence, MBI merely
relied on its own computation methods.’®
Having examined the record and financial data presented by
the parties, we cannot say that the Tax Court’s determination
18. This data is found at pp. 628-631 of the record appendix.
19. See n. 6, supra.
Al8
was clearly erroneous. While Hanover has attempted to show
that the reserves allowed by the Commissioner resulted in under-
statement of developed losses, it has done so based on the as-
sumption that the Commissioner allowed only 100% of what
he determined to be actual losses for 1960. In fact, the Com-
missioner allowed 115% of actual losses (as determined ac-
cording to Mimeo RA 1366), and a comparison of his
allowance with actual experience demonstrates that it adequately
covered actual losses for 1960.”
Finally, Hanover contends that the Commissioner violated
Treas. Reg. § 1.832-1(b) because he did not examine each of
MBI’s cases to determine whether the Company’s loss estimates
were reasonable. This argument misses the mark because the
regulation does not require the Commissioner to undertake such
an analysis. It provides that the taxpayer “must be prepared
to establish” that its unpaid loss deduction “comprises only
actual losses stated in amounts which, based upon the facts in
each case and company’s experience with similar cases” are fair
and reasonable estimates. The Commissioner’s method of ascer-
taining deductions he will allow is not circumscribed by the
regulation.
In conclusion, we find that MBI’s unpaid loss deduction was
not insulated from the Commissioner’s review by I. R. C. § 832,
and that the McCarran-Ferguson Act does not bar application
of this Code section to insurance companies through Treas.
Reg. § 1.832-1. We reject Hanover’s arguments regarding the
validity of that regulation, and we find that the decision of the
Tax Court upholding a recomputed deficiency for 1960 was not
clearly erroneous,
The decision of the Tax Court is, therefore, affirmed.
20. See p. 14 [Ai4], supra.
Al9
APPENDIX B
UNITED STATES COURT OF APPEALS
For the First Circuit
No. 78-1407.
HANOVER INSURANCE COMPANY, ETC.,
Petitioner, Appellant,
VS.
COMMISSIONER OF INTERNAL REVENUE,
Respondent, Appellee.
JUDGMENT
Entered May 8, 1979
This cause came on to be heard on appeal from the United
States Tax Court, and was argued by counsel.
Upon consideration whereof, It is now here ordered, adjudged
and decreed as follows: The decision of the Tax Court is hereby
affirmed.
By the Court:
/s/ DANA H. GALLUP,
Clerk.
A20
APPENDIX C
FINAL OPINION OF THE
UNITED STATES TAX COURT
[69 T. C. 260]
UNITED STATES TAX COURT
HANOVER INSURANCE COMPANY, SUCCESSOR IN INTEREST TO:
MASSACHUSETTS BONDING AND INSURANCE COMPANY,
PETITIONER V. COMMISSIONER OF INTERNAL REVENUE,
RESPONDENT
Docket No. 1557-71. Filed November 22, 1977.
Held, respondent correctly recomputed the amount of the
reserves for unpaid losses carried by petitioner’s predecessor, a
casualty insurance company, at the end of 1959, 1960, and the
period ending June 30, 1961 (which losses are included in the
computation of “losses incurred” under sec. 832(b) (5), I. R. C.
1954). Held, further, petitioner’s 1958 yearend reserve for un-
paid losses adjusted under sec. 481, I. R. C. 1954.
Paul A. Teschner, for the petitioner.
Williard J. Frank and W. Terrence Mooney, for the
respondent.
OPINION
WILEs, Judge: This case was assigned to Special Trial Judge
Lehman C. Aarons (pursuant to Rules 180, et seq., of the Tax
Court Rules of Practice and Procedure) to conduct the trial
thereof or otherwise proceed im accordance with said Rules. His
report was filed on July 15, 1977, and subsequently both parties
filed exceptions to his report. The exceptions have been con-
sidered and are rejected. The Court agrees with and adopts the
report set forth below.
A21
OPINION OF THE SPECIAL TRIAL JUDGE
Aarons, Special Trial Judge: Respondent determined defi-
ciencies in petitioner’s' Federal income tax for the taxable years
ended December 31, 1959 and 1960, in the respective amounts
of $441,081.10 and $446,206.34. The taxable period ended
June 30, 1961, is also involved because of respondent’s adjust-
ment of a net operating loss for that period which was carried
back to 1959. Although respondent, in an amendment to his
answer, Claimed increased deficiencies such increases have been
conceded by respondent.
The issues remaining for decision are (1) whether the re-
serves for unpaid losses carried by petitioner at the end of 1959,
1960, and the period ending June 30, 1961 (which are included
in the computation of “losses incurred” under section 832(b)
(5)), were unreasonable in amount and were properly reduced
by respondent, and (2) if (1) is answered in the affirmative,
whether a comparable reduction must be made to the reserve
for unpaid losses carried by petitioner at the end of 1958, and
deducted (under sec. 832(b)(5)) in determining 1959 losses
incurred.? ;
1. “Petitioner,” as used hereinbelow, refers to Massachusetts
Bonding & Insurance Co., the predecessor of Hanover Insurance Co.
2. Petitioner continues to urge the invalidity of sec. 1.832-4(b)
(formerly sec. 1.832-1(b)), Income Tax Regs. Although, indeed,
that contention appears to constitute the a thrust of petitioner’s
opening brief, it is not an issue now before the Court; it was adjudi-
cated at an earlier stage of this case in Hanover Insurance Co, v.+
Commissioner, 66 T. C. 715 (1976). .
A22
FINDINGS OF FACT
Many of the facts have been stipulated and are found ac-
cordingly. The stipulation of facts and attached exhibits are
incorporated by this reference. Only those facts necessary for an
understanding of the opinion will be summarized below.
Petitioner was a casualty insurance company having its prin-
cipal office in Massachusetts. The returns for the years involved
were filed with the District Director, Boston, Mass. Such re-
turns were for the calendar years 1959 and 1960 and for the
period ending June 30, 1961. Petitioner was merged into Han-
over Insurance Co., and went out of existence as of June 30,
1961. Hanover Insurance Co., likewise has its principal office
in Massachusetts.
Petitioner, during the period here at issue, wrote 24 lines of
casualty (non-life) insurance. Petitioner filed annual statements
with the Insurance Department of the Commonwealth of
Massachusetts on the form approved by the National Associa-
tion (formerly National Convention) of Insurance Commis-
sioners (NAIC). With relatively negligible exceptions (which
are not here at issue), petitioner computed its taxable income
for each period here involved on the basis of the net income
shown at line 20 of the underwriting and investment exhibit of
such annual statement.
In arriving at its net income for annual statement purposes
(and its gross profit for Federal income tax purposes), one of
the principal deductions claimed by petitioner was “losses in-
curred.” “Losses incurred” as claimed by petitioner for the years
1959 and 1960, and the period ended June 30, 1961, were
respectively $19,264,486, $21,067,480, and $8,925,671. Basi-
cally, those figures were determined by adding to “losses paid-
current year” the amount of “unpaid losses outstanding—cur-
rent year” and deducting therefrom the amount of “unpaid losses
—-prior year.”
A23
The disputed adjustments (which result in reduction of
“losses incurred”) relate to the “unpaid losses” outstanding at
the end of the periods here involved. The aggregate amounts of
such unpaid losses (for all lines of insurance) claimed by peti-
tioner and the aggregate adjustments asserted by respondent
are:
Respondent's net
Claimed reduction
SOG: BR EGE Socks wwe $30,390,690 $1,104,574
i SS 00l 29,965,729 690,548
i ee. 27,415,563 113,180
In determining the amounts of the foregoing net reductions,
respondent gave credit for the prior reductions in conformity
with the requirement of the Internal Revenue Code that, in de-
termining losses incurred, unpaid losses at the end of the preced-
ing year are to be deducted from the sum of losses paid during
the taxable year and unpaid losses outstanding at the end of the
taxable year. However respondent made no adjustment to the
unpaid losses claimed by petitioner as of the end of 1958 in
the aggregate amount of $31,257,371. The aggregate amount of
unpaid losses claimed by petitioner at the end of 1953, accord-
ing to its annual statement for that year, was $30,097,672.
Petitioner used two basic methods to determine its reserves
for unpaid losses. The so-called individual case method was used
wherever possible; if not possible, a formula method was used.
Under the case method, petitioner’s home office claims examiner
after receiving a report from the field, would establish a dollar
value on estimated liability with respect to each case. The claims
examiner was supposed to take into account a myriad of factors
such as the severity of the injury or occurrence; negligence and
contributory negligence; age, health, personal and emotional
factors; location of the occurrence and the effect of local law;
identity of lawyers; and other imponderable factors. The volume
of individual cases was heavy. The only claims examiner who
testified at the trial, examined as many as 150 claims per day.
A24
Establishment of case reserves of $1,000 or more required ap-
proval of petitioner’s claims vice president. As further reports
were received from the field the examiner would revise the case
reserve upwards or downwards. The total amount of the case
reserves was determinable at any time from the computer. No
yearend adjustments were made to such reserves, nor (except as
noted above) were changes in such reserves made by anyone at
any time. It was contrary to petitioner’s policy to inform claims
examiners of their past performance based on development
figures of previous loss claims.
Petitioner’s primary use of a formula method of reserving
for unpaid losses (i.e., the second basic method used by peti-
tioner to determine such reserves) was with respect to liability
for occurrences which presumably had already taken place but
which had not yet been reported to the claims department.
IBNR (incurred but not reported) reserves were tentatively
established by multiplying the premiums in force at the end of
the accounting period by the ratio of the prior 2 years’ average
IBNR losses as developed over a 21-month period, to the aver-
age premiums in force during the current period. This tentative
figure was then revised to take into account variables such as
inflation and changes in rates. IBNR reserves constituted ap-
proximately 18 percent of the total claimed unpaid losses for
1959, and approximately 28 percent for 1960 and for the period
ended June 30, 1961.
In connection with its business done through “pools” (syndi-
cates formed to spread risks among several companies), peti-
tioner also used a formula reserve figure which was supplied to
it by the pool. Pools were separately audited, and were likewise
regulated by NAIC, Petitioner did not make any independent
investigation of its pooled claims. Pooled unpaid loss reserves
constituted approximately 9 percent of petitioner's total claimed
unpaid losses for 1959 and approximately 11 percent for 1960.
A formula was also used by petitioner in miscellaneous other
situations. For example, to avoid unnecessary and unproductive
A25
paperwork so-called “notice claims” (e.g., claims up to $500
for auto property damage) were reserved by petitioner’s sta-
tistical department on an actuarial basis. “Notice claims” con-
stituted approximately 2 percent of petitioner’s total claimed
unpaid losses.
Respondent’s method of testing the reasonableness of peti-
tioner’s unpaid loss reserves was based on the development (i.e.,
actual payments in subsequent years) of prior years’ claimed
unpaid losses. If a comparison between the current year’s esti-
mate and past years’ experience in the seme line of insurance
indicated a current year overstatement of more than 15 percent,
respondent reduced the current year’s estimate to 115 percent
of the average past years’ experience.
In making such comparisons respondent applied a longer
testing or development period for so-called Schedule P lines
than for Schedule O lines of insurance in determining petitioner's
“experience rate.” Schedule P of the annual statement included
auto liability, liability other than auto, and workmen’s compen-
sation. Schedule O covered most of the remaining lines of in-
surance, ‘
As to Schedule O, respondent’s testing method applicable to
the years before the Court is summarized as follows in Mim.
R. A. No. 1366, issued by the Commissioner of Internal Revenue
on July 1, 1944;
Information that will disclose the reasonableness of the
unpaid loss liability as set up by the taxpayer may be
secured from Schedule O of the Annual Statement. A com-
parison of the amounts paid in the first succeeding year
plus the amount still estimated as unpaid at the end of
such year, (developed losses) should be made with the
previous yeat’s estimate of unpaid losses (estimated losses)
to determine the ratio of “estimated losses” to one-year
“developed losses.” Such comparison should be made sepa-
rately for each year for the previous five years. If the
average “estimated losses” of the previous five years is
found to be not more than 115 percent of the five-year
A26
average of the one-year “developed losses,” the estimates
made will be regarded as being reasonably correct, and no
adjustment for the current year would ordinarily be re-
quired.
In the event that the five-year average of “estimated
losses” is in excess of 115 percent of the five-year average
of the one-year “developed losses” then the unpaid loss
liability of the company will be deemed to be excessive in
the current year and an adjustment will ordinarily be re-
quired. * * *
With respect to Schedule P, respondent applied a similar
testing method, but because Schedule P lines represented per-
sonal injury type claims that require a longer development in
order to ascertain actual loss, a 5-year average of five years’
development was used by respondent rather than a 5-year aver-
age of 1 year’s development as in the case of Schedule O. For
example, in adjusting the 1959 unpaid losses outstanding for
workmen’s compensation, the claimed unpaid losses outstanding
for each of the years 1950 through 1954 were compared to the
development of those claimed unpaid losses outstanding as de-
rived from the 1955 through 1959 annual statements. The
unpaid losses outstanding claimed as of 1950 were developed to
1955, unpaid losses outstanding claimed as of 1951 were de-
veloped to 1956, and so forth. The average of these experience
rates was used to adjust the 1959 claimed unpaid losses for
workmen’s compensation.
In each line of insurance, for each of the years involved, where
the overstatement thus ascertained by comparison with prior
experience exceeded the 15-percent tolerance, an adjustment
was made by respondent down to the 15-percent tolerance point.
Thus, if the applicable ratio of claimed unpaid losses to de-
veloped losses (the “experience rate”) was 123 percent (as in
the case of workmen’s compensation), respondent adjusted the
1959 claimed unpaid losses to a figure representing 115 percent
of the figure determined by respondent to be the proper figure
based on petitioner’s experience rate. In the case of lines show-
A27
ing an experience rate of claimed unpaid losses to developed
losses of less than 115 percent, no adjustment was made by
respondent.
There were no instances in which respondent determined an
understatement of unpaid losses. However, there were only rare
instances of lines of insurance where the “experience rate” of
petitioner was under 100 percent, and there were no instances
during the years before the Court, where the “experience rate”
thus computed by respondent (i.e., the ratio of estimated unpaid
losses to developed losses) was less than 85 percent.
The NAIC made audits of petitioner’s annual reports every
3 years for the primary purpose of determining petitioner's
solvency and ability to pay its claims. (Such audits were actually
made by the Division of Insurance of the Massachusetts Depart-
ment of Banking and Insurance, and participating representa-
tives of NAIC. They were commonly referred to as “convention
examinations” and are referred to herein as NAIC examina-
tions.) In its report of examination for 1956 and 1959, NAIC
determined that petitioner’s unpaid losses outstanding should be
decreased in the respective net amounts of $2,076,181.86 and
$1,093,175. According to petitioner's witnesses, petitioner
regarded NAIC examinations “seriously.” However, petitioner
never made adjustments to its books and accounts as a con-
sequence of the adjustments made by NAIC auditors. There is
no substantial correlation on a line by line basis between the
NAIC adjustments and respondent’s adjustments,
Respondent’s expert witness, David Skurnick, is a well-
qualified actuary with much experience in the casualty insurance
field. He applied a testing technique which differed from that
applied by respondent in that the loss development of prior years
was compared by Mr. Skurnick to a base consisting of premiums
in force (or in automobile lines, earned premiums) rather than
to the base of claimed unpaid losses (used by respondent), for
the 5 year series of years prior to the year at issue. An average of
the ratios of claimed unpaid losses to premiums in force (or
A28
earned) in each of the lines of insurance was then applied by
Mr. Skurnick to the premiums in force (or earned) in the tax-
able year in order to determine the proper unpaid loss reserve
for the taxable year.
Mr. Skurnick’s method indicated aggregate overstatements
as follows:
1959 1960 1961
Total overreserved lines........... $3,974,279 $3,785,112 $2,729,093
Total underreserved lines.......... 261,360 0 170,841
Net overstatement ..........00000> 3,712,919 3,785,112 2,558,252
Respondent’s method of testing petitioner’s reserves for unpaid
losses indicated aggregate overstatements, before allowing the
15-percent tolerance, as follows:
IDSD occcccechecccccceccccsccecscccceces $4,463,344
I9GO wrcccccccvccsctenccesceccenveccceess 5,313,739
IDGE .nccccdccccccsccccccccccccenercvesas 5,130,229
Mr. Skurnick acknowledged that there are many methods of
testing the reasonableness of reserves for unpaid losses and that
no single method is “the correct method.” He viewed respond-
ent’s method as being less accurate than his own method because
respondent’s method would not give credit for any correction in
a past reserve inaccuracy. However, in this case, he felt that
because petitioner has been reserving “consistently,” this defect
in method did not distort the results of respondent’s method.
Mr. Skurnick also expressed the opinion that the 15-percent
tolerance allowed by respondent “makes the IRS method con-
servative.” It was also his opinion that under his own method
“The stability of the ratios of reserve runoff [development] to
premiums indicates that a smaller tolerance would be satisfac-
tory.” In his opinion a 5-percent tolerance is adequate under
his method.
As to the individual case method used by petitioner, Mr.
Skurnick’s view was that “the case reserve will be fairly accurate
as long as there is no bias in the individual reserves” but that the
existence of bias is very common. Further, he pointed out that
A29
some other method must be applied to IBNR since the individual
case method provides only for the reserve of known claims.
The following schedule sets forth the subsequent development
(to December 31, 1962) of petitioner’s total unpaid losses for
all lines of insurance as claimed by petitioner for 1959 and
1960, in comparison with the amount of the reserve balance
remaining after respondent’s adjustment:
1959 1960
Unpaid losses claimed
(per annual statement)
eo a $30,390,690 $29,965,729
Subsequent development
re AE Se 128,108,225 27,715,704
Unpaid losses as adjusted
by respondent® ............ 29,286,116 29,275,181
1. Includes unpaid losses on pooled business at full amount
claimed by petitioner, i.e., $2,857,749.
2. Includes unpaid losses on poser business at full amount
claimed by petitioner, i.e., $3,189,724.
3. Balance of claimed losses after deducting respondent’s 1959
and 1960 adjustments of $1,104,574 and $690,548, respectively.
OPINION
There are two issues to be decided by the Court: (1) The
propriety of respondent’s adjustments to petitioner’s unpaid loss
reserves as of December 31, 1959, December 31, 1960, and
June 30, 1961, and (2) if respondent is sustained as to (1), the
propriety of respondent’s failure to make a corresponding adjust-
ment to petitioner’s unpaid loss reserve as of December 31, 1958.
Issue I. “Unpaid Loss” Deductions for Taxable Years and
Taxable Period at Issue
During the years and period here at issue, petitioner? was a
casualty insurance company taxable under section 831 of the
3. See n.1 supra.
A30
Code.* Section 832(b)(1)(A) defines “gross income” of com-
panies subject to tax under section 831 as including
(1) Gross INcomE.—The term “gross income” means the
sum of—
(A) the combined gross amount earned during the tax-
able year, from investment income and from underwriting
income «as provided in this subsection, computed on the
basis of the underwriting and investment exhibit of the
annual statement approved by the National Association of
Insurance Commissioners * * *
The term “underwriting income” is defined in section
832(b)(3) as meaning premiums earned less “losses incurred
and expenses incurred.” Section 832(b)(5) defines “losses
incurred” as follows:
(5) LossEs INCURRED.—The term “losses incurred”
means losses incurred during the taxable year on insurance
contracts, computed as follows:
(A) To losses paid during the taxable year, add
salvage and reinsurance recoverable outstanding at
the end of the preceding taxable year and deduct
salvage and reinsurance recoverable outstanding at
the end of the taxable year.
(B) To the result so obtained, add all unpaid
losses outstanding at the end of the taxable year and
deduct unpaid losses outstanding at the end of the
preceding taxable year.
Since 1941, the regulations (as now embodied in sec. 1.832-
4(a)(5) and 4(b), Income Tax Regs.) have addressed them-
selves to the subject of “unpaid losses” in the following terms:
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.
4. Statutory references are to the Internal Revenue Code of
1954, as amended, unless otherwise indicated.
A31
(b) 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
stated in amounts which, based upon the facts in each case
and the company’s experience with similar cases, can be
said to 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 such losses which,
in the opinion of the district director are in excess of the
actual liability determined as provided in the preceding
sentence will be disallowed as a deduction. The district
director may require any such insurance company to sub-
mit such detailed information with respect to its actual
experience as is deemed necessary to establish the reason-
ableness of the deduction for “losses incurred.”
The Court sustained the validity of this regulation in Hanover
Insurance Co. v. Commissioner, 65 T.C. 715 (1976). All that
remains here to be decided (under Issue I.) is whether respond-
ent’s adjustments to petitioner’s yearend estimates of unpaid
losses were justified under the “fair and reasonable” test imposed
by the regulation.
Petitioner, wherever possible, used the individual case method
of estimating unpaid losses. These estimates were revised from
time to time on the basis of developments in the particular case,
but the total reserves were not tested by petitioner on the basis
of prior experience. Respondent tested the reasonableness of
petitioner’s unpaid loss reserve for each year and the taxable
period at issue, by an “experience rate” testing technique which
had been in use since 1944, as follows: for each of the separate
lines of insurance coverage, respondent compared the unpaid loss
reserves established in years prior to the year under examination
with the loss actually paid with respect to such years.® For each
5. For the lines of coverage listed on Schedule O, the 5-year
periods immediately preceding each of the years at issue were used.
For the lines listed on Schedule P, respondent used the 10th through
the 6th years preceding each of the years at issue.
A32
line of coverage where this comparison showed that a reserve in
prior years had been overstated by an average of more than
15 percent, the reserve in that line for the year under examina-
tion was reduced to the 15 percent “tolerance” figure.
The issue before the Court is essentially a valuation issue, i.e.,
the assignment of a fair and reasonable value to “unpaid losses,”
and the petitioner has the burden of proving the respondent's
determination to be wrong. Welch v. Helvering, 290 U.S. 111
(1933); Rule 142(a), Tax Court Rules of Practice and Pro-
cedure. Section 1.832-4(b), Income Tax Regs., specifically
places the burden upon the petitioner to establish “to the satis-
faction of the district director” that the “unpaid losses” compo-
nent of “losses incurred” comprises “actual unpaid losses.”
Having sustained the validity of this regulation in Hanover
insurance Co. v. Commissioner, supra, it clearly follows that the
burden of proving error in respondent’s determination rests upon
the petitioner.®
Petitioner has not succeeded in carrying that burden. Peti-
tioner’s direct proof consisted primarily of a description of the
methods it used in placing a dollar figure on its estimated
liability on each case reported to it. The greater part of its loss
reserves was the aggregate amount of such individual case
reserves. Theoretically and ideally, the aggregate of the indi-
vidual case reserves should equal a fair and reasonable total
reserve. But the only individual claims examiner who testified
for petitioner stated that she set up reserves on as many as 150
cases per day. If she had worked an 8-hour day without inter-
ruption, that would indicate an average of approximately 3
minutes per claim. While it is true that this witness did not
6. Indeed, it might well be , in the light of the language
of the regulation, that petitioner bears the burden of showing not
only that its unpaid loss reserves were reasonable but also that the
respondent’s adjustments constituted an abuse of discretion. Such a
contention would be based upon the analogy of the bad debt reserve
cases. See, e.g., Westchester Development Co. v. Commissioner, 63
T. C. 198, 211 (1974). However, it is not here held that petitioner
bears this double burden.
A33
handle the “heavy” personal injury cases, the Court is left to
surmise how such examiners were able to apply in practice the
myriad of factors to which petitioner’s officers attached impor-
tance in the evaluation of claims.
It appears to be true, as respondent’s expert witness conceded,
that there are many methods for testing the reasonableness of
unpaid loss reserves. But the evidence in this case does not
establish that with respect to the bulk of its reserve, i.e., the
aggregate of its individual case reserves, the petitioner em-
ployed any method of doublechecking or testing the aggregate
amounts set aside.
Petitioner argues that if it had actually set aside the amounts
of unpaid loss reserves deemed proper by respondent, the
subsequent development of such losses would have created a
deficit, and the reserves would have been insufficient to meet
loss claims. But the figures used by petitioner to illustrate this
point do not take into account the 15-percent tolerance allowed
by respondent.” This tolerance figure was an integral factor in
respondent’s testing technique for the taxable periods here at
issue. After taking the tolerance factor into account, the 1959
and 1960 reserves allowed by respondent exceeded the unpaid
losses for those years (as developed to December 31, 1962) by
$1,177,891 and $1,559,477, respectively. As recently stated by
this Court in Western Casualty & Surety Co. v. Commissioner, 65
T. C. 897, 919 (1976), on appeal (10th Cir., June 17, 1976),
respondent’s test of reasonableness should be directed at the
total unpaid loss reserve. In the light of the respondent’s
tolerance factor, petitioner has not demonstrated error in
respondent's method. In so holding, there is no implication that
7. Under respondent’s current procedure (see Rev. Proc. 75-56,
1975-2 C. B. 596), respondent stated that, because of technological
advances made by the insurance industry, he can no longer justify
the use of the 15-percent tolerance factor. No opinion is expressed
aan as to respondent’s current position reflected by Rev. Proc.
A34
petitioner acted otherwise than in good faith, that it deliberately
undertook to overstate its reserves for unpaid losses, or that
petitioner was in any way “mismanaged” (as asserted by
respondent). It is held simply that petitioner failed to persuade
the Court that respondent’s method of testing the reasonableness
of such reserves was itself an unreasonable testing method.°
A final comment seems to be appropriate as to the basic legal
issue in this case. As indicated at the outset, petitioner’s primary
contention in its opening brief was the reiteration of the
argument made in Hanover Insurance v. Commissioner, supra,
that the figures shown on the NAIC form of the Annual
Statement are legally binding and conclusive on respondent and
that section 1.832-4(b), Income Tax Regs., is invalid. It is
worthy of note that two of the findings proposed in petitioner's
opening brief are:
3.68 Mass. Bonding [petitioner] regarded the N. A. I. C.
examination seriously and not as perfunctory or merely
routine.
3.69 Although the N.A.I.C. examiners did make
adjustments to Mass. Bonding’s reserves for Unpaid Losses
Outstanding, Mass. Bonding never made adjustments to its
books and accounts as a consequence of those adjustments.
In successive breaths, the petitioner (1) insists on the sanctity
of the Annual Statement, (2) states that the examinations by the
regulatory authorities are taken seriously, and (3) that no
adjustments were made by petitioner despite the examiners’
findings of very substantial overstatements of reserves for unpaid
losses (albeit, mostly in lines of coverage different from those
adjusted herein by respondent). This sequence of nonsequiturs
8. The Court is not here faced with the problem presented in
Western Casualty & Surety Co. v. Commissioner, 65 T. C. 897, 919
(1976), on appeal (10th Cir., June 17, 1976), of respondent’s
failure to make an upward adjustment where the reserve was under-
stated by more than 15 percent. The evidence in this case does not
disclose any instance where the reserve was understated by more
than 15 percent.
A35
serves to reaffirm the correctness of the Court’s 1976 opinion
in this case.
Issue II, “Unpaid Loss” Adjustment as of December 31, 1958
During the trial of this case, the Court requested counsel, in
their briefs, to comment upon the question whether respondent’s
adjustments of petitioner’s reserves for unpaid losses effectuate
a change in method of accounting, and whether section 481 of
the Code is applicable. Petitioner’s opening brief appears to
argue against the applicability of section 481 although its reply
brief asserts that respondent's adjustments constituted a change
in method of computing unpaid loss reserves. Respondent's
opening brief does not cite section 481, but in his reply brief
respondent argues that the adjustments were not tantamount to
a change in method, and that section 481 does not apply.
Section 481° prescribes the rules of computation of taxable
income under a “method of accounting” different from the
method employed by the taxpayer. Its purpose is to prevent any
income from escaping tax or being doubly taxed solely because
of such change in method. If the change in method was initiated
by the Internal Revenue Service, amounts applicable to pre-1954
years should not be taken into account. Section 481 does not
define “change in method of accounting.” But section 1.446-
9. SEC. 481. ADJUSTMENTS REQUIRED BY CHANGES
IN METHOD OF ACCOUNTING.
(a) GENERAL RULE.—In computing the taxpayer’s taxable in-
come for any taxable year (referred to in this section as the “year
of the change” )—
(1) if such computation is under a method of accounting
different from the method under which the taxpayer’s taxable
income for the preceding taxable year was computed, then
(2) there shall be taken into account those adjustments
which are determined to be necessary solely by reason of the
change in order to prevent amounts from being duplicated or
omitted, except there shall not be taken into account any ad-
justment in respect of any taxable year to which this section
does not apply unless the adjustment is attributable to a change
in the method of accounting initiated by the taxpayer.
A36
1(e) (2) (ii) (a), Income Tax Regs., states that a “change in
method of accounting” includes “a change in the treatment of
any material item.” Under those regulations: “A material item is
any item which involves the proper time for the inclusion of the
item in income or the taking of a deduction.” Sec. 1.446-1(e)
(2) (ii) (a), Income Tax Regs.; Schuster’s Express, Inc. v. Com-
missioner, 66 T.C. 588, 594-595 (1976), affd. per curiam
et 2 ES (2d Cir. 1977, 40 AFTR 2d 77-5293, 77-2
USTC par. 9495); Western Casualty & Surety Co. V. Commis-
sioner, supra at 912 et seq.
The statutory scheme for determining “unpaid losses” is akin
to an inventory type of accounting in that the deduction for each
year is the sum of losses paid during the year plus unpaid losses
at the end of the year minus unpaid losses at the end of the
preceding year. In the case of adjustments by respondent based
upon his rejection of a longstanding and continuing practice of
undervaluation of inventory, this Court has held that such
adjustments constituted a change in method of accounting,
obviously initiated by the respondent. Fruehauf Trailer Co. v.
Commissioner, 42 T. C. 83, 105 (1964), affd. on another issue
356 F.2d 975 (6th Cir. 1966), cert. denied 385 U.S. 822.
Contrast Korn Industries, Inc. v. United States, 532 F. 2d 1352
(Ct. Cl. 1976), where the Court of Claims held that an account-
ant’s error over a 4-year period in omitting 3 out of 14 elements
of cost in valuing inventory was more analogous to a mathe-
matical or posting error than to a change in accounting method.
But note Rev. Rul. 77-134, 1977-18 I. R.B. 11, in which
respondent (seemingly at odds with the position he has taken
in the instant case as to the applicability of section 481) disagrees
with Korn Industries on the ground that any change in a con-
sistent pattern of inventory valuation is a “change in method”
of accounting. And in the same vein, note example 7 of section
1.446-1(e) (2) (iii), Income Tax Regs., stating that a longstand-
ing practice of undervaluing inventories is a method of account-
ing, and a change is such practice involves the treatment of a
A37
material item used in the overall practice of valuing inventory,
and constitutes a change in method of accounting.
The applicability of Schuster’s Express, Inc., and Western
Casualty & Surety Co., supra, has also been considered.
Schuster’s Express held that respondent's rejection of the deduc-
tion of additions to a reserve for certain estimated expenses, to
the extent they exceeded actual disbursements, was not a change
in method of accounting. The critical distinction between
Schuster's Express and the instant case is that the challenged
deductions simply represented improper accruals. They did not
carry over from year to year as does the inventory-type of
accounting involved in the instant case. As stated by the Court
in Schuster’s Express, Inc., at pages 596 and 597:
The deductions claimed for insurance expenses in excess of
actual expenditures do not appear to properly belong in any
taxable period. Thus, we do not have before us a case
involving the proper time for taking of a deduction. Under
the regulations, a change in method of accounting does not
include a change in the treatment of an item which does not
involve the proper time for the inclusion of the item of
income or the taking of a deduction. Sec. 1.446-1(e) (2)
(ii) (b), Income Tax Regs.
The adjustments in the instant case do clearly involve the proper
time for the taking of deductions since, under the analogy of
inventory-type of accounting—absent the adjustments—income
would eventually be increased when the overstated loss claims
are finally liquidated.
Western Casualty & Surety Co., involved (so far as pertains to
the section 481 issue) the respondent’s rejection of the tax-
payer’s inclusion of unpaid commissions on deferred premiums in
determining underwriting income. The Court sustained respond-
ent’s adjustment. In that case both parties had agreed that a
change in the treatment of such unpaid commissions constitutes
a change in treatment of a material item (not initiated by the
taxpayer) requiring an adjustment under section 481. The
A38
manner of computing such adjustment is reflected in the
following excerpt from the Court's opinion (65 T. C. at 913):
In making the adjustment required by section 481,
respondent included in petitioner’s 1967 income the entire
accumulated reserve for unpaid commissions as of the close
of 1966 ($6,527,381) less the amount applicable to pre-
1954 years ($122,939), or $6,404,442. The parties dispute
the propriety of respondent's adjustment under section 481
by which the entire accumulated reserve was included in
petitioner’s 1967 income. We are unpersuaded by petition-
er’s arguments, and we hold for respondent.
It is concluded that a section 481 adjustment should be made
herein, patterned after the adjustment in Western Casualty
& Surety Co., supra.’®
In the instant case, by failing to adjust petitioner’s 1958
yearend reserve for unpaid losses, respondent has effectively
included in petitioner’s 1959 income the entire amount of prior
years’ reserves to the extent that those reserves were similarly
overstated. This is true because in determining the 1959 deduc-
tion for unpaid losses the 1958 yearend reserve is deducted from
10. The conclusion that a sec. 481 adjustment should be made
is not in conflict with Commissioner v. Standard Life & Accident
Insurance Co., 433 U.S. 148 (1977, 40 AFTR 2d 77-5191, 77-
2 USTC par. 9480). Although that case involved life insurance com-
pany accounting, the Supreme Court commented in n. 24:
“Evidence of congressional respect of NAIC accounting
methods is not limited to the portion of the Code concerning
life insurance companies. In defining ‘gross income’ and ‘ex-
penses incurred’ for purposes of taxing certain other insurance
companies, Congress expressly requires computations to follow
‘the annual statement approved by the National Convention of
Insurance Commissioners.’ 26 U.S.C. § 832(b)(1)(A),(b)
(6).” ?
The Supreme Court’s use of the term “accounting methods,” as set
forth above, was not in the context of sec. 481, and is not incon-
sistent with this Court’s opinion in Hanover Insurance Co., supra,
that although the NAIC form is to be followed, the actual figures
are not likewise sanctified. Standard Life & Accident Insurance Co.,
did not deal with the validity of the regulation (sec. 1.832-4(b))
upon which respondent here relies in justification of his method of
testing petitioner’s estimates of unpaid losses.
A39
the sum of losses paid in 1959 and unpaid losses estimated at the
end of 1959. But the Court must determine how much of the
1958 yearend overstatement was attributable to post-1953 years,
since it is only to that extent that such prior accumulative over-
statement may be taxed in 1959, The acounting method rejected
by respondent, i.e., petitioner’s failure to employ an adequate
testing method in determining its total unpaid loss reserve, was
a consistent method employed by petitioner. In making such
computation it may therefore be fairly assumed that the 1958
yearend reserve for unpaid losses (claimed in the amount of
$31,257,371) was overstated in the same proportion as
respondent’s 1959 reduction ($1,104,574) bears to the total
1959 yearend reserve claimed by petitioner ($30,390,690), i.e.,
3.63 percent. Applying this percentage to the 1958 yearend
reserve, produces an overstatement of unpaid loss reserve for
1958 of $1,134,642.
As above stated, the amount of overstatement of this same
reserve must be determined as of the 1953 yearend. Petitioner’s
1953 yearend unpaid loss reserve was $30,097,672. Applying the
3.63 percentage factor to determine the 1953 overstatement,
produces an overstatement for that year in the amount of
$1,092,545.
Under section 481 as it applies to years prior to the first
taxable year in issue, respondent may tax in 1959 only the excess
of the 1958 yearend overstatement over the 1953 yearend
overstatement, i.e., $1,134,642 less $1,092,545 or $42,097.
Accordingly, it is held that petitioner’s 1958 yearend unpaid
loss reserve, as adjusted, should be $31,257,371 (the reserve as
reported) less $1,134,642 (the total overstatement of such
reserve) plus $42,097 (the portion of such overstatement
attributable to post-1953 years). This adjustment is in accord
with the method of compliance with section 481 which was
sustained by this Court in Western Casualty & Surety Co., supra.
In accordance with the foregoing, it is held that respondent is
sustained in his adjustments for the years 1959, 1960, and tbe
A40
period ending June 30, 1961, with the exception that a further
adjustment should be made as to the year 1959 to conform to the
holding hereinabove set forth under Issue Il.
Decision will be entered under Rule 155.
A41
APPENDIX D
UNITED STATES TAX COURT
HANOVER INSURANCE COMPANY, SUC- >
CESSOR IN INTEREST TO: MAssa-
CHUSETTS BONDING AND INSURANCE
COMPANY,
Petitioner,
VS. + Docket No. 1557-71
COMMISSIONER OF INTERNAL
REVENUE,
Respondent. }
DECISION
Pursuant to the opinion of the Court filed November 22, 1977
and incorporating herein the facts recited in the respondent’s
computation as the findings of the Court, it is
Ordered and Decided: That there is no deficiency in income
tax due from, or overpayment due to, the petitioner for the
taxable year 1959; and
That there is a defiicency in income tax due from the peti-
tioner for the taxable year 1960 in the amount of $331,644.28.
(signed) Darrell D. Wiles
Judge.
Entered: Mar 30 1978
A42
APPENDIX E
OPINION OF THE UNITED STATES TAX COURT
DENYING PETITIONER’S MOTION FOR
SUMMARY JUDGMENT
[65 T. C. 715]
UNITED STATES TAX COURT
HANOVER INSURANCE COMPANY, SUCCESSOR IN INTEREST TO:
MASSACHUSETTS BONDING AND INSURANCE COMPANY,
PETITIONER v. COMMISSIONER OF INTERNAL REVENUE,
RESPONDENT
Docket No. 1557-71. Filed Januaggt7, 1976.
Petitioner’s predecessor, a casualty insurance company, re-
flected its income on its returns substantially on the basis of
the underwriting exhibit of the annual statement approved by the
National Association of Insurance Commissioners. Respondent
adjusted the estimated figures for “unpaid losses” and “expenses
unpaid,” as shown on such returns and underwriting exhibit,
under the “fair and reasonable estimate” test embodied in the
predecessor to sec. 1.832-4(b), Income Tax Regs. Petitioner
sought summary judgment on the grounds that sec. 832(b) (1),
I. R. C. 1954; automatically precludes respondent’s adjustments
and that the regulation under which respondent acted in making
the adjustments is invalid under that statute, under the Con-
stitution, and under the McCarran-Ferguson Act. Held, the
regulation is valid; and petitioners motion for summary
judgment will be denied.
Paul A. Teschner, for the petitioner.
Willard J. Frank and Justin S. Holden, for respondent.
A43
OPINION
Dawson, Chief Judge: This case was assigned to Special Trial
Judge Lehman C. Aarons (pursuant to Rule 180 ei seq. of the
Tax Court Rules of Practice and Procedure) to conduct the trial
thereof or otherwise proceed in accordance with said Rules. This
Court agrees with and adopts his opinion, set forth below, on
petitioner's Motion for Summary Judgment.
OPINION OF THE SPECIAL TRIAL JUDGE
Aarons, Special Trial Judge: This case is presently before the
Court on petitioner’s Motion for Summary Judgment, filed
September 8, 1975. Because of the importance of the legal
question involved, the Court felt justified in entertaining
petitioner’s motion even though a delay in the trial was thereby
entailed.
Petitioner is a casualty insurance company having its principal
office in Massachusetts. The returns for the years involved were
filed with the District Director, Boston, Mass. Such returns were
for the calendar years 1959 and 1960 and for the period ending
June 30, 1961, and were filed by Massachusetts Bonding &
Insurance Co. (hereinbelow referred to as taxpayer). Taxpayer
was merged into Hanover Insurance Co. (the petitioner herein)
as of June 30, 1961.
Taxpayer was taxable under sections 831 and 832 of the
Internal Revenue Code of 1954, as amended. Section 832
provides, in part:
1. Since this is a pretrial motion for summary judgment and
since, solely for P of this motion, it has been assumed (as
hereinbelow set forth) that there is no genuine issue of material
fact, the Court has concluded that the posttrial procedures of Rule
182, Tax Court Rules of Practice and Procedure, are not applicable
in these particular circumstances. This conclusion is based on the
authority of the “otherwise provided” language of that rule.
A44
(b) DBFINITIONS.—In the case of an insurance com-
pany subject to the tax imposed by section 831—
(1) Gross INCOME.—The term “gross income”
means the sum of—
(A) the combined gross amount earned dur-
ing the taxable year, from investment income and
from underwriting income as provided in this
subsection, computed on the basis of the under-
writing and investment exhibit of the annual
statement approved by the National Convention
of Insurance Commissioners * * *
Substantially the same provisions have existed in predecessor
statutes since 1921.
Since 1944, the regulations (as now embodied in sec. 1.832-
4(b), Income Tax Regs., and hereinbelow referred to as the
challenged regulation) have provided substantially as follows:
(b) 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
stated in amounts which, based upon the facts in each case
and the company’s experience with similar cases, can be
said to 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 such losses which,
in the opinion of the district director are in excess of the
actual liability determined as provided in the preceding
sentence will be disallowed as a deduction. The district
director may require any such insurance company to submit
such detailec information with respect to its actual experi-
ence as is deemed necessary to establish the reasonableness
of the deduction for “losses incurred.”
Acting under these regulations, the revenue agent, in auditing
taxpayer’s returns for the taxable years and period here involved
determined that “losses incurred” had been overstated for each
such year and for such period. In his amended answer, respond-
A45
ent additionally determined that “loss adjustment expense” had
been understated on each of taxpayer’s said returns. Other
adjustments made on audit are not in issue.
For purposes of this motion for summary judgment it will be
assumed that discrepancies between “losses incurred” and “loss
expense incurred” as set forth in the annual statement on the one
hand and the tax returns on the other hand do not raise issues of
material fact. Although as shown by the affidavit filed by
petitioner in support of its motion such discrepancies did exist,
they did not in any case exceed approximately 1 percent of the
respective amounts shown on the aunual statement. Moreover,
such affidavit indicates that “unpaid losses outstanding” and
“unpaid loss expenses outstanding” (which appear to be the
crucial disputed components in “losses incurred” and “loss
expense incurred”) were in identical amounts on taxpayer’s
annual statements and its tax returns. Solely for purposes of the
Motion for Summary Judgment the correctness of this affidavit
will be assumed.
In contrast, of course, the statutory notice of deficiency does
raise issues of material fact, but petitioner maintains that under
the statute and existing case law the annual statement is legally
binding and conclusive upon respondent and that the challenged
regulation (pursuant to which the respondent acted in making
the disputed adjustments) is invalid under the Constitution and
also under the McCarran-Ferguson Act (15 U.S.C. secs. 1011-
1015) which confirmed to the States exclusive jurisdiction to
regulate insurance companies.
At this point it should be noted that “losses incurred” and
“expenses incurred” are (and have been for many years before
the years here involved) also defined in the statute as elements
or components of the term “underwriting income,” which in turn
is one of the terms used in defining “gross income” in section
832(b) (1), above quoted. See sec. 832(b) (3), (5), and (6).
One of the elements in “losses incurred” is “unpaid losses” at the
end of the year. Sec. 832(b)(5)(B). Similarly, one of the
A46
elements of “expenses incurred” is “expenses unpaid” at the end
of the year. Sec. 832(b)(6). The determination of “unpaid
losses” and “expenses unpaid” involves the making of estimates
and it is the reasonableness of such estimates which the respond-
ent is challenging in this case. These terms are terms of insurance
art and constitute annual statement terminology. See Bituminous
Casualty Corp., 57 T. C. 58, 80 (1971).
The history of sections 831 and 832, and the reasons prompt-
ing Congress to turn to the annual statement for the computation
of insurance company income for Federal tax purposes, are set
forth in New Hampshire Fire Insurance Co., 2 T.C. 708
(1943), affd. 146 F. 2d 697 (1st Cir. 1945), and need not be
repeated here. See also Bituminous Casualty Corp., supra at
79, 80, reviewing the development of the case law and observing
that the Fourth Circuit (United States v. Fidelity & Deposit Co.,
177 F. 2d 805 (4th Cir. 1949)), agreed with the First Circuit
(New Hampshire Fire Insurance Co., supra) that Congress
intended to follow the annual statement form “precisely” in
respect to the items specified (which include “losses incurred”
and “expenses incurred”), whereas the Second Circuit (Com-
missioner v. General Reinsurance Corp., 190 F.2d 148 (2d
Cir. 1951)) and the Ninth Circuit (Pacific Employers Ins. Co.
v. Commissioner, 89 F.2d 186 (9th Cir. 1937), and Pacific
Ins. Co. v. United States, 188 F. 2d 571 (9th Cir. 1951)), held
that the annual statement was intended to serve only as a guide
and was not to be binding where inconsistent with the ordinary
meaning of the terminology.
The primary rationale for adhering conclusively to the annual
statement was the extreme complexity and technicality of insur-
ance industry accounting and the search by Congress for an
easy and simple taxing method. It is also to be noted, as peti-
tioner points out, that in upholding the specialized type of
accounting embodied in the annual statement, the courts have
adopted a “long run” approach as an exception to the annual
accounting principle (see Security Flour Mills Co., 321 U.S.
A47
281 (1944)). Indeed, in the First Circuit decision in New
Hampshire Fire Insurance Co., supra, the court states in so
many words that returns based on the convention form do not
truly reflect income. But one of the counterbalancing considera-
tions cited by that court was that “in the long run” it will not
make any difference whichever method is used. Here too (al-
though petitioner’s briefs do not contain an analysis on this
point) it may be that this could be true since an overstatement of
“unpaid losses” and “expenses unpaid” at the end of the year
might eventually be adjusted by the amount of losses and ex-
penses actually paid in an ensuing year.
Aside from the fact that the First Circuit decision in New
Hampshire Fire Insurance Co., supra, represents an aflirmance
of this Court’s decision, the instant case is appealable to the First
Circuit and we would feel bound by New Hampshire Fire Insur-
ance Co., if the issue of the validity of the challenged regulation
(which was not in effect in the years there involved) were not
inescapably involved in this motion. Jack E. Golsen, 54 T.C.
742 (1970). To apply Golsen to this motion would entail our
speculating and concluding that the First Circuit’s blessing of the
convention form in New Hampshire Fire Insurance Co. was
tantamount to a sanctification of the estimated figures as well as
the form itself, no matter how unfair or unreasonable, and that
the respondent’s regulation of 31 years’ vintage represents an
invalid trespass into this hallowed area.
None of the cases cited above, nor any case cited to us,
directly involved the validity of the challenged regulation. It
appears that such validity was bolstered by this Court’s opinion
in Bituminous Casualty Corp., supra, in holding invalid the
“all events” test embodied in Rev. Rul. 67-225, 1967-2 C. B.
238, as being contrary to the “legislative history” of the regula-
tions with reference to the determination as to when a “liability”
exists (see also Rev. Rul. 73-302, 1973-2 C. B. 220), and in
finding that the reserves involved in that case “were computed
in a reasonable manner.” 57 T.C. at 58, 82. Moreover, the
A48
cited cases which held the annual statement to be conclusive
did not involve the reasonableness of the estimated figures
appearing on such statement, but rather the format or method-
ology of such statement (e.g., whether or not reinsurance trans-
actions with unadmitted companies should be taken into account
(New Hampshire Fire Insurance Co., supra), or e.g., whether
contrary to the then requirement of the annual statement form,
the “case method” rather than the “formula method” could be
used by the Internal Revenue Service where the former resulted
in a lower unpaid loss figure (see Columbia Casualty Co., a
Memorandum Opinion of this Court dated May 13, 1948 (7
T. C. M. 282)).
In any event, we feel that we would be remiss in failing to
apply to this case “the settled principle that ‘Treasury regula-
tions and interpretations long continued without substantial
change, applying to unamended or substantially reenacted
statutes, are deemed to have received congressional approval
and have the effect of law.’ Helvering v. Winmill, 305 U. S. 79,
83; Fribourg Nav. Co. v. Commissioner, 383 U. S. 272, 283.”
United States v. Correll, 389 U.S. 299, 305 (1967). See also
Commissioner v. Noel Estate, 380 U.S. 678 (1965).
In addition to the reason above set forth, we note the apparent
fact that ihe affected industry, rather than contesting such
validity at or about the time the challenged regulation was
promulgated, adapted its practices to such regulation. The
“apparent fact” referred to is not part of the record herein but
has been called to the Court’s attention by the excerpt quoted on
page 23 of petitioner’s reply brief from the Government's appli-
cation for an extension of time within which to file petition for
writ of certiorari in United States v. Fidelity & Deposit Co. of
Maryland, 177 F. 2d 805 (4th Cir. 1949).
A portion of that application for extension of time, which
follows directly after the portion quoted in petitioner’s reply
brief, reads:
A49
However, we are informed that there has been scheduled
for the first week of April, 1950, a meeting of the Com-
mittee on Blanks of the National Association of Insurance
Commissioners to which recommendations will be sub-
mitted by certain groups in the insurance industry to amend
the convention form of annual statement to conform to the
predominant tax treatment of certain items involved in
these tax controversies. If the convention form of annual
statement is satisfactorily revised to meet the Treasury
Department’s objections applicable to 1950 and future
years, the Government would not wish to ask for certiorari
in these cases. Hence, the extension herein is sought to
protect the Government's interests pending the action of
the Convention of Insurance Commissioners, and thus to
avoid burdening this Court with a petition for certiorari
that might not otherwise be filed.
(See Tye, “The Convention Form and Insurance Company Tax
Problems,” 6 Tax L. Rev. 245 (1951)). That article, in addi-
tion to quoting the above application for extension of time states
that (effective in 1950) the “Convention Form” was amended
by the National Association of Insurance Commissioners so that
thereafter Schedule P incurred losses would be set forth in the
underwriting exhibit purely on the basis of “case estimates.”
Such incurred losses had theretofore been reflected on the exhibit
on a “formula” method if it produced a higher figure than the
“case” method. After the 1950 change in the convention form
any excess in incurred losses under the “formula” method was
treated as a surplus adjustment on the statement rather than an
income adjustment. The challenged regulation likewise requires
the application of the “case” method.
While normally the attitude of an affected industry might not
be relevant in the case of a challenge by one of its members as to
the validity of a regulation, the situation here is a unique one.
The statute itself prescribes that the affected industry’s approved
form (as approved by the State regulatory authorities) shall be
the basis on which income is determined, and thus a change in
such form effectively becomes a change in the applicable law.
AS50
Because of this unique interrelationship, the apparent adaptation
of industry financial reporting to the concept of the challenged
regulation would seem to lend additional support to the validity
of the regulation.
Petitioner has additionally raised the question whether the
challenged regulation is violative of the McCarran-Ferguson Act,
15 U.S.C. ses. 1011-1015 (Mar. 9, 1945), as an attempt to
regulate the insurance industry in contravention of the following
express congressional intent:
No Act of Congress shall be construed to invalidate, impair,
or supersede any law enacted by any State for the purpose
of regulating the business of insurance, or which imposes a
fee or tax upon such business, unless such Act specifically
relates to the business of insurance. 15 U.S. C. § 1012(b).
As can be gleaned from the legislative history of that Act (H.
Rept. No. 143, 79th Cong., Ist Sess. (1945)) the business of
insurance had traditionally been regarded as a local matter
properly subject to and regulated by State laws. However, the
Supreme Court in United States v. South-Eastern Underwriters
Association, 322 U.S. 533 (1944), had held that the business
of insurance was commerce and therefore subject to the Sherman
Act..Subsequently, considerable uncertainty arose with respect
to the constitutionality of State tax laws as well as other State
regulatory provisions applicable to insurance companies. To
alleviate this confusion the McCarran-Ferguson Act contained
the provision as set forth in the above excerpt; and also sus-
pended for a 3-year period the application to insurance com-
panies of the Sherman, Clayton, and Federal Trade Commission
Acts (except to the extent that the business of insurance was not
regulated by State law). See Securities & Exchange Commission
v. Variable Annuity Life Insurance Co. of America, 359 U.S.
65 (1959).
The application of Federal law to insurance companies, in-
cluding Federa! income tax (although it uses the annual
statement as a basis for the tax), is not inconsistent with the
intent of Congress to refrain from interfering with State regula-
AS51
tion of insurance companies. Cf. Board of Insurance v. Todd
Shipyards Corp., 370 U.S. 451 (1962); United States v.
Sylvanus, 192 F. 2d 96 (7th Cir. 1951), cert. denied 342 U.S.
943 (1952). Congress did not, under the McCarran-Ferguson
Act, surrender to the States the power of the Federal Govern-
ment to tax insurance companies and to issue regulations imple-
menting the taxing statute. Industrial Life Insurance Co. Vv.
United States, 344 F.Supp. 870 (D.S.C. 1972), affd. 481
F. 2d 609 (4th Cir. 1973), cert. denied 414 U. S. 1143 (1974).
In the latter case, the taxpayer asked the court to invalidate
Treasury regulation section 1.801-3(a) defining an “insurance
company” for purposes of taxation under the Internal Revenue
Code as contrary to the McCarran-Ferguson Act. The court
declined to do so finding that the regulation reasonably imple-
mented the power of Congress to tax insurance companies.
The crucial question in this regard is whether the regulation
challenged in the instant case implements the statute in a reason-
able manner, and does not take away an intended benefit. The
National Life & Accident Insurance Co. v. United States, 524
F. 2d 559 (6th Cir. 1975). The intended benefit, as we under-
stand petitioner's argument, is the right of the taxpayer to be
“regulated” by the States (including, in particular, the right to
follow State-imposed accounting requirements for all purposes
_ including Federal income taxation).
In a sense all taxation is “regulation” in that it imposes
sanctions if prescribed paths of conduct are not followed. But
in the narrower sense it has consistently been held that account-
ing requirements of a regulatory authority (as in the case of
savings and loan associations (Bellefontaine Federal Savings
& Loan Association, 33 T. C. 808 (1960) ); of railroads (Old
Colony R. R. Co. v. Gommissioner, 284 U.S. 552 (1932));
of power companies (Gulf Power Co., 10 T. C. 852 (1948));
and of airlines (National Airlines, Inc., 9 T. C. 159 (1947)),
must yield to the requirements imposed under Treasury regula-
tions. In other words, because a savings and loan association
A52
must file one set of figures with the Home Loan Bank Board,
another with the State regulatory authority, and a third with the
Internal Revenue Service, the latter agency has not thereby
usurped the regulatory authority of the first two. Much less, it
seems to us, can a regulated taxpayer claim such usurpation,
when all that the Treasury regulation attempts to do is to de-
termine whether the figures representing estimates are fair and
reasonable. What petitioner’s argument would lead us to con-
clude is that McCarran-Ferguson Act would tie the Federal in-
come tax to estimates which could be unfair and unreasonable
because to question such estimates for Federal tax purposes
would be tantamount to “regulation.” We cannot so conclude
and in our view the challenged regulation reasonably imple-
ments section 832 and does not take away any true benefit which
the statute was intended to confer.
The brief answer to petitioner’s argument that the challenged
regulation intruded upon an area of regulation which belongs
to the States is set forth in the following excerpt from Penn
Mutual Indemnity Ce., 32 T.C. 653, 658 (1959), and the
cases cited therein:
Whether the business of the taxpayer can be subjected
to Federal regulation has no bearing upon the validity of
an exercise of taxing power with respect to that taxpayer.
Steward Machine Co. v. Davis, 301 U.S. 548, 582; Flint
v. Stone Tracy Co., 220 U.S. 107, 152-158.
The “exercise of taxing power” necessarily encompasses the
authority to issue needful regulations. Sec. 7805, I. R. C. 1954;
Brushaber v. Union Pacific Railroad Co., 240 U.S. 1 (1916).
We find that a regulation which permits the respondent to dis-
allow a deduction based upon an estimate which is unfair or
unreasonable is indeed “needful.”
In sum, we have carefully considered all of petitioner’s con-
tentions in support of its Motion for Summary Judgment and
have determined that the motion must be denied.
An appropriate order will be entered.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.