102 T.C. 338 (1994), 11620-91, Western National Mutual Insurance Co. v. C.I.R.

• Citation: 102 T.C. 338
• Opinion Judge: GERBER, Judge:
• Party Name: WESTERN NATIONAL MUTUAL INSURANCE CO., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Attorney: Jay B. Kelly, St. Paul, MN, E.P. Baker, and Peter H. Winslow, Washington, DC, for petitioner. J. Anthony Hoefer, Omaha, NE, for respondent.
• Judge Panel: HAMBLEN, PARKER, SHIELDS, CLAPP, SWIFT, JACOBS, WRIGHT, PARR, COLVIN, CHIECHI and LARO, JJ., agree with this majority opinion. CHABOT, J., concurs in the result only. HALPERN, Judge, dissenting: WELLS, WHALEN, and BEGHE, JJ., agree with this dissent.
• Case Date: February 28, 1994
• Court: U.S. Tax Court

Page 338

102 T.C. 338 (1994)

WESTERN NATIONAL MUTUAL INSURANCE CO., Petitioner,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 11620-91.

United States Tax Court.

February 28, 1994

Page 339

Jay B. Kelly, St. Paul, MN, E.P. Baker, and Peter H. Winslow, Washington, DC, for petitioner.

J. Anthony Hoefer, Omaha, NE, for respondent.

Under the Tax Reform Act of 1986, Congress changed the manner in which property and casualty insurance companies account for income. In essence, the companies were no longer allowed to deduct the full amount of their loss reserves. This change was accomplished by means of discounting the loss reserves. Because the new method would likely result in increased income being reported, Congress permitted a one-time exemption for certain items, but specifically excluded " reserve strengthening" from the exemption. Reserve strengthening is not defined in the statute, and the legislative history contains conflicting descriptions as to what might have been meant by the use of that term. In promulgating sec. 1.846-3(c), Income Tax Regs., the Secretary adopted a meaning of the term which included any increase to a company's prior year reserve. R, relying heavily on the legislative history, contends this is a valid interpretation which satisfies congressional intent. P contends that reserve strengthening has an established meaning in the industry and that Congress intended that meaning in an unambiguous statute. P also points out that the same term had been used in prior tax legislation involving insurance companies, and as R agrees, had been used more strictively consistent with industry usage.

Held: The regulatory use of the term " reserve strengthening" does not comport with the statutory use and purpose of the term and, accordingly, to that extent the regulation is not valid.

GERBER, Judge:

Respondent determined an $89,366 Federal income tax deficiency for petitioner's 1987 taxable year. The issue remaining in controversy is whether petitioner engaged in reserve strengthening within the meaning of section 1023(e)(3)(B) of the Tax Reform Act of 1986 (TRA 86), Pub.L. 99-514, 100 Stat. 2404. In that context, we consider whether section 1.846-3(c), Income Tax Regs., is valid and more specifically whether the definition of reserve strengthening contained in the regulation comports with the statute and congressional intent.

FINDINGS OF FACT

The facts stipulated by the parties are incorporated by this reference. Petitioner, a property and casualty (PC) insurance company, is a corporation organized under the laws of the State of Minnesota with its principal office in Minneapolis, Minnesota.

Initially (petitioner was organized in 1900), most of petitioner's insurance coverage involved dairy properties in Minnesota, Wisconsin, and Iowa. Since then petitioner has expanded its risk coverage by offering fire, homeowners, worker's compensation, and automobile liability insurance. In connection with the period under consideration, petitioner's business predominantly consisted of automobile coverage, followed by worker's compensation, with fire, allied lines, and homeowners policies comprising most of the remaining insurance

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coverage. While a majority of petitioner's business is in Minnesota, it is licensed to do business in Wisconsin, Iowa, North Dakota, and South Dakota.

For each State in which it is licensed to do business, a PC company is required to file an annual statement with the State insurance commissioner in the format prescribed by the National Association of Insurance Commissioners (NAIC). The primary purpose of the annual statement is to provide State regulatory agencies the information necessary for monitoring the financial solvency of the insurance companies, regulating insurance businesses, and verifying compliance with State insurance laws and regulations. The NAIC annual statement includes a balance sheet, statement of income, a capital and surplus account, statement of cash flow, an underwriting and investment exhibit, historical data, schedules, responses to questions, as well as information on premiums, losses, and dividends to policyholders. Petitioner filed its NAIC annual statements with the State commissioner of insurance for each State in which it was licensed to do business for the years 1984 through 1991.

PC companies are required to maintain loss reserves to ensure the payment of claims that have occurred but have not been paid by or reported to the insurer as of the NAIC annual statement filing date, typically December 31 of each year.

Petitioner's loss reserves generally include four components or categories: (1) Claims already reported to petitioner (case reserves); (2) amounts that will be paid on claims that can statistically be presumed incurred but are not yet reported to petitioner (IBNR reserves); (3) expected future changes in the case reserves (bulk reserves); and (4) loss adjustment expenses not included in (1) through (3) (LAE reserves).^[1] Bulk reserves were not held by petitioner as of 1986 yearend for pre-1986 accident years.

Petitioner's loss reserves consisted predominantly of case reserves. Its claims department established the case reserves from data contained in loss reports and policy files. These reserves were established and maintained on a case-by-case

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basis and the amounts were dependent on the facts and circumstances of each claim or case. Petitioner's 1985 and 1986 case reserves were established in the same manner and totaled $23.6 million and $30 million, respectively.

From 1963 through the period in controversy, George Klouda, petitioner's president and general manager, was responsible for establishing the amount of the IBNR reserve. The IBNR reserve was determined for each line of business by means of a computer program model which included a 1-year historical development of IBNR, the level of premiums, and judgmental factors (such as an estimate for inflation). If, at yearend, based on emerging claims experience against previous IBNR reserves, it was Mr. Klouda's judgment that IBNR reserves were not adequate and an increase in IBNR reserves was warranted, any such increase to the IBNR reserves was reflected as part of the current accident year claims and not as an adjustment to IBNR for prior accident years. This method for computing IBNR was used to report IBNR on the 1985 and 1986 NAIC annual statement. Using this method, petitioner held IBNR reserves of $3.3 million for year 1985 and $4.4 million for 1986.

Petitioner did not change its reserve assumptions or methodology from prior years in computing its 1986 loss reserve. By the end of 1991 it was evident that petitioner's 1985 and 1986 loss reserves were both deficient, as opposed to overstated.

Mr. Klouda was also responsible for determining petitioner's LAE reserves. These were also computed by means of a formula. Mr. Klouda combined all of petitioner's lines of business and compared total losses paid in a preceding 3-year period to the LAE paid during the same 3-year period. Total LAE was computed by applying the average 3 years of the paid-to-paid ratios to IBNR and by applying one-half of the ratios to case reserves. The final value was then judgmentally adjusted. This method was employed for 1985 and 1986. Using this method, petitioner held yearend LAE reserves of $3 million for 1985 and $4.2 million for 1986.

Respondent, mechanically following the calculation set forth in section 1.846-3(c), Income Tax Regs., determined that petitioner had engaged in reserve strengthening in the amount of $1,383,383 in 1986 with respect to pre-1986 claims. Using the discounting principles set forth in section

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846, ^[2] respondent determined that petitioner's 1987 taxable income was understated by $223,025. Respondent did not question the approach, method, or any specific changes which occurred in connection with petitioner's reserves. Instead, respondent employed the regulation's formula, which assumes that any net increase to reserves constitutes reserve strengthening.

The formula set forth in section 1.846-3(c)(3)(i), Income Tax Regs., was employed for each of petitioner's lines of business. That formula concerns accident years before 1986. Under that formula the reserves for 1985 as of the end of the 1985 year are reduced by claims and LAE paid regarding those reserves in 1986. To the extent that reserves for 1985 existing at the end of 1986 exceed that amount, it is treated as a net increase to the reserve. To the extent the result is less, it is negative and treated as a net decrease to the reserve.

Respondent's computations resulted in the following " increases" or " decreases" to reserves in petitioner's lines of business:

Line of Increase

Insurance (Decrease)

Auto liability $554,503

Other liability 238,533

Worker's compensation 1,729,542

Multiple peril (135,345)

Fire (300)

Allied lines 500

Inland marine (23,265)

Auto physical damage (1,083,226)

Glass (437)

Burglary & theft -0-

Reinsurance 102,878

Net totals 1,383,383

OPINION Background Subchapter L, involving insurance companies, is a highly specialized portion of the Internal Revenue Code which is Page 343 replete with the unique nomenclature of the insurance industry. We are asked here to construe the term " reserve strengthening", a specialized insurance concept which was used by Congress in TRA 86 section 1023(e)(3). As part of TRA 86, Congress changed certain aspects for reporting income by property and casualty companies. Because some of these changes would have likely resulted in the reporting of more income, Congress permitted some relief from the initial change by exempting certain items. However to avoid abuse, the portion of the increase in the taxpayers' reserves which constituted reserve strengthening was not to be exempted. The parties maintain distinctly different definitions of...