# Petition — Hanover Insurance v. Commissioner > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385006_0624%3A1 ## Record - **Collection:** Supreme Court brief - **Document type:** Petition - **Published:** January 1, 1979 - **Citation:** 444 U.S. 915 ## 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 impro [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385006_0624%3A1. Public record. Not legal advice.