Atlantic Mutual Insurance Company v. Commissioner
| Decision Date | 22 February 1996 |
| Docket Number | Docket No. 25767-93. |
| Citation | 71 T.C.M. 2154 |
| Parties | Atlantic Mutual Insurance Company and Includible Subsidiaries v. Commissioner. |
| Court | U.S. Tax Court |
John S. Breckinridge, Jr., and James H. Kenworthy, New York, N.Y., for the petitioners. Phillip A. Pillar and Maureen Nelson, for the respondent.
Respondent determined a deficiency of $519,987 in petitioners' Federal income tax for the 1987 taxable year as a result of alleged "reserve strengthening". Under the Tax Reform Act of 1986 (TRA `86), Pub. L. 99-514, sec. 1023, 100 Stat. 2085, 2404, any increases in the loss reserves maintained by property and casualty insurance companies that constitute "reserve strengthening" do not qualify for a one-time tax benefit. In this case, respondent contends that the term "reserve strengthening" refers to all increases in loss reserves, while petitioners maintain that the term refers to only those increases in loss reserves that are attributable to changes in computation methods or assumptions. Respondent's interpretation of the term "reserve strengthening" is set forth in section 1.846-3(c), Income Tax Regs. The deficiency in this case is based on that regulation. In light of this Court's decision in Western Natl. Mut. Ins. Co. v. Commissioner [Dec. 49,695], 102 T.C. 338 (1994), affd. [95-2 USTC ¶ 50,478] 65 F.3d 90 (8th Cir. 1995), we hold for petitioners.
The facts have been fully stipulated under Rule 122 of the Tax Court Rules of Practice and Procedure and are so found. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the year in issue.
Atlantic Mutual Insurance Co. (Atlantic) is the common parent of an affiliated group of corporations within the meaning of section 1504(a). Atlantic filed consolidated income tax returns on behalf of the group for all relevant years. At the time the petition in this case was filed, Atlantic's principal place of business was in Madison, New Jersey.
Atlantic was organized in 1842 under the laws of the State of New York as a mutual marine insurer. Over the years, Atlantic has expanded its insurance underwriting activities to include most lines of insurance business available to a property and casualty (P&C) insurer. Centennial Insurance Co. (Centennial), a wholly owned subsidiary of Atlantic, is a P&C insurance company included in Atlantic's consolidated return. Because respondent's notice of deficiency relates to the activities of both Atlantic and Centennial, we will refer to the two corporations together as petitioner.
From 1985 through 1993, petitioner filed an annual statement with the insurance department of each State in which petitioner was licensed to conduct insurance business. Each annual statement was prepared in the format prescribed by the National Association of Insurance Commissioners (NAIC). A primary purpose of the annual statement is to provide State insurance commissioners with information concerning a P&C insurer's financial condition. The accounting principles on which the NAIC-prescribed annual statement is based generally have been incorporated into the Internal Revenue Code sections applicable to P&C insurers.
On the annual statement, P&C insurers are required to report estimates of amounts they expect to pay to cover losses that have already occurred. These estimates are commonly referred to as "loss reserves" (or simply "reserves"). Petitioner maintained three categories of loss reserves: (1) Case reserves, which reflect estimates of amounts to be paid to resolve claims that have been reported to petitioner; (2) incurred but not yet reported (IBNR) reserves, which reflect estimates of amounts to be paid to resolve claims statistically presumed to have been incurred but not yet reported to petitioner; and (3) loss adjustment expense (LAE) reserves, which reflect estimates of administrative costs to be paid in settling or otherwise resolving claims. For the years in issue, case reserves constituted the majority of petitioner's loss reserves.
Petitioner established its case reserves by assigning a claims adjuster to examine each reported claim and estimate the ultimate amount, if any, that would be paid to resolve it. Case reserves simply comprised the aggregate of those estimates. Overall, petitioner's case reserves totaled $255,655,141 at yearend 1985 and $277,705,661 at yearend 1986.
Petitioner established its IBNR reserves by applying a "counts and averages" methodology to each line of insurance business. Under this method, petitioner computed its IBNR reserves by multiplying (1) the number of claims that it presumed would be reported after the accident year by (2) the average cost it projected to resolve each late-reported claim. Petitioner based its estimate of these numbers on its experience in prior accident years and then adjusted the results to reflect actuarial quarterly reviews of the loss reserves for the preceding year. Senior management had discretion in determining the size of the adjustments. Management made downward adjustments to petitioner's IBNR reserves of $1,200,000 for 1985 and $100,000 for 1986. Overall, petitioner's IBNR reserves totaled $93,713,687 at yearend 1985 and $111,708,986 at yearend 1986.
Petitioner established its LAE reserves through a combination of individual case estimates, formulas, and judgmental factors. To arrive at an estimate of LAE reserves, petitioner calculated the ratio of LAE it paid during a preceding 3-year period to total losses it paid during the same period and used that ratio as a component in certain formulas. Petitioner maintained two categories of LAE reserves: (1) Allocated loss adjustment expenses (ALAE), which consisted of expenses assignable to individual claims (e.g., legal fees and costs), and (2) unallocated loss adjustment expenses (ULAE), which consisted of expenses not assignable to individual claims (e.g., rent allocable to the claims department). Petitioner used different formulas to compute each category of its LAE reserves. Petitioner's management then adjusted the ALAE (but not the ULAE) estimate based on quarterly loss and LAE reviews. Overall, petitioner's LAE reserves totaled $72,317,450 at yearend 1985 and $84,066,519 at yearend 1986.
Respondent tested for "reserve strengthening" by applying the formula set forth in section 1.846-3(c)(3), Income Tax Regs., to each of petitioner's lines of insurance business for pre-1986 accident years. Under the formula, petitioner's reserves at yearend 1985 were reduced by the claims and the LAE paid in 1986 with respect to those reserves. To the extent that, at yearend 1986, a reserve was greater than the amount determined under the formula, the excess was treated as a net increase to that reserve account (i.e., "reserve strengthening"). To the extent that, at yearend 1986, a reserve was less than the amount determined under the formula, the difference was treated as a net decrease to that reserve account (i.e., "reserve weakening").
Respondent determined that, at yearend 1986, petitioner's "reserve strengthening" totaled the following amounts:
Reserve Strengthening
Line of Business (Weakening)
Auto liability ............ ($10,559,423)
Other liability ........... (1,279,374)
Workers' compensation ..... 4,691,659
Multiple peril ............ 15,585,877
Schedule O1 (1985) ........ (3,870,000)
Schedule O (pre-1985) ..... 1,984,000
____________
Net total ............... 6,552,739
1 Schedule O a part of the annual statement filed with the
National Association of Insurance Commissioners, contains
combined loss data on several lines of insurance business
with resect to which claims are filed and settled within a
relatively short period
Respondent then discounted, pursuant to section 846, the amount determined as "reserve strengthening" in order to calculate the effect on petitioner's gross income.1 After discounting the amounts shown in the foregoing chart, respondent determined that petitioner understated its 1987 income as follows:
Line of Business Income Adjustment
Auto liability ............... ($1,211,842)
Other liability .............. (309,970)
Workers' compensation ........ 1,211,652
Multiple peril ............... 1,783,897
Schedule O (1985) ............ (239,446)
Schedule O (pre-1985) ........ 104,748
__________
Net total .................. 1,339,039
Respondent further determined that this $1,339,039 understatement of petitioner's 1987 income resulted in a $519,987 understatement of petitioner's 1987 income tax liability.
TRA `86 substantially revised the rules that govern the taxation of P&C insurance companies by requiring P&C insurers to discount loss reserves for purposes of section 832(b)(5) (discussed below). The change from undiscounted to discounted methodology eliminated a tax benefit attributable to the time value of money. It also required taxpayers to change their accounting methods. To facilitate a smooth transition to the new rules, Congress included two relief provisions in the legislation—the "transition rule" and the "fresh start".
Section 832(c)(4) permits P&C insurers to deduct "losses incurred", as defined in section 832(b)(5), in each taxable year. Under section 832(b)(5), losses incurred are defined as the excess of (1) the sum of (a) losses paid during the current tax year and (b) yearend reserves in the current tax year over (2) yearend reserves in the preceding tax year. Prior to 1986, section 832 provided P&C insurers with a significant tax benefit. It permitted them to take current deductions for future payments without requiring them to make any adjustments for the time value of...
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