Acuity Insurance, a multiline property & casualty insurance company based in Wisconsin, was entitled to deduct its full reported 2006 loss reserve for federal income tax purposes, according to the U.S. Tax Court. The Court rejected the Internal Revenue Service position that the company's Annual Statement loss reserve exceeded a "fair and reasonable estimate" of unpaid losses as allowed by IRS regulations, and should have been reduced by $96 million, or 15 percent of the total reported reserve. The case was decided in a 98-page opinion by Judge Juan F. Vasquez issued September 4, 2013 (ACUITY, A Mutual Ins. Co. v. Commissioner of Internal Revenue, Tax Court Memorandum 2013-209 (Sept. 4, 2013)). Over $30 million in tax was at stake for 2006 (with the company's net tax savings under the Court's decision being less over time since reserve deductions are primarily a timing issue).*
In upholding Acuity's $660 million 2006 loss reserve in full as "fair and reasonable," the standard for a tax deduction under IRS regulations, the Tax Court relied on evidence and trial testimony showing that the company's reserve –
- was actuarially computed in accordance with state-law insurance accounting rules developed by the National Association of Insurance Commissioners ("statutory accounting") and with the published standards of the actuarial profession (Actuarial Standards of Practice or ASOPs), and
- fell within a range of reasonable estimates determined by the company's appointed actuary in accordance with the ASOPs, and also within reasonable ranges developed by independent actuarial consultants who testified as expert witnesses for Acuity.
Acuity's computation and confirmation of its loss reserve in accordance with NAIC accounting standards and Actuarial Standards of Practice allowed the Court to find that the company's loss reserve was "fair and reasonable" for tax purposes. Because the taxpayer's evidence proved that its reported loss reserve was fair and reasonable, the Court stated, "our inquiry ends" and ruled for Acuity. The Court found it unnecessary to decide whether the IRS's much lower estimate was or was not also "fair and reasonable."
The Foley & Lardner LLP team representing Acuity consisted of Chicago Litigation Partner Mike Conway, Washington, D.C. Tax Partner Dick Riley, Chicago Tax counsel George Goodman, and Milwaukee Litigation Associate Kate Spitz (contact information below).
Background and Discussion
Loss reserve deductions under the "fair and reasonable" test. Property & casualty insurance companies deduct any increase in "unpaid losses" each year in determining taxable income under the special tax rules applicable to insurance companies. Those rules are based on the accounting methods reflected in the NAIC Annual Statement filed by insurance companies with state regulators. The largest input in this computation is the insurance company's year-end estimate of unpaid losses (that is, estimated amounts to be paid out to policyholders and other claimants in the future on claims existing as of year-end), referred to as the "loss reserve."
IRS regulations limit an insurance company's loss reserve deduction to a "fair and reasonable estimate" of the company's "actual unpaid losses." While loss reserve accounting is compelled by the NAIC Annual Statement and adopted by law in the Internal Revenue Code, the specific dollar amount of the loss reserve – that is, whether the reserve is a "fair and reasonable" estimate – is a question of fact, not a legal determination. In the Acuity case, the Court expressly found that Acuity's 2006 year-end loss reserve of $660 million, computed by the company's internal actuary in accordance with NAIC accounting standards and professional actuarial standards, adopted unchanged by management, and confirmed by a professional outside actuarial opinion, was, in fact, a "fair and reasonable" estimate. Thus, the Court found no justification for the $96 million adjustment asserted by the IRS or any other change in the loss reserve.
Broad IRS challenge to insurance loss reserves based on a Coordinated Issue Paper. The Internal Revenue Service is engaged in a broadly based challenge to many insurance companies' loss reserve deductions under the "fair and reasonable" regulation. The IRS position is explained in an IRS Coordinated Issue Paper on loss reserves published in November 2009, which serves as the internal guideline for IRS audits of insurance company loss reserves. The Acuity case was the first case based on the theory of the IRS Coordinated Issue Paper to be tried and decided by a court. The IRS paper states that any "margin" added to or included in an Annual Statement loss reserve must be disallowed for tax purposes, regardless of whether the reserve is acceptable for insurance regulatory purposes. The IRS paper says that reserves may be overstated by inclusion of either an "implicit margin" generated by overly conservative actuarial assumptions, or an "explicit margin" such as a flat percentage added to an actuarially computed reserve. According to the IRS, inclusion of any such "margin," implicit or explicit, causes the reserve to be overstated beyond a fair and reasonable level, and must be disallowed as a tax deduction.
The IRS argued that Acuity's loss reserve included both an "implicit" margin and an "explicit" margin that had to be disallowed for tax purposes. The Tax Court rejected both assertions, and approved the company's full reported loss reserve as "fair and reasonable" and thus allowable as a tax deduction.
Key elements of the Acuity decision. The Tax Court's 98-page opinion in the Acuity case is well crafted and full of important observations about the insurance loss reserving process, and aspects of the insurance business that should be taken into account in a "fair and reasonable" loss reserve estimate for tax purposes. Insurance companies will find much of value in the Court's discussion. Key elements of the decision include the following:
- NAIC/ASOP loss reserve standards apply in determining "fair and reasonable" reserves for tax purposes. The most important element of the Acuity decision is its confirmation that when a company demonstrates that its loss reserves qualify as reasonable under the NAIC statutory accounting standards that insurers must follow under state law, and are consistent with the official Actuarial Standards of Practice, that represents substantial and persuasive evidence that the reserve is also "fair and reasonable" for tax purposes. This is contrary to the approach of the IRS Coordinated Issue Paper, and of the IRS position in the Acuity case and other recent audits of insurance companies. The IRS argues that compliance with NAIC Annual Statement standards and the standards for actuarial opinions does not establish that a reserve is "fair and reasonable" for tax purposes, and that the factual showing for tax purposes is somehow different. However, the Acuity decision does not accept this IRS approach. While the Annual Statement loss reserve is not per se conclusive for tax purposes, nevertheless the same evidence showing a "reasonable" reserve for Annual Statement and ASOP purposes can also demonstrate a "fair and reasonable" reserve for tax purposes.
- Subsequent "favorable development" does not demonstrate that a loss reserve estimate was unreasonable. The IRS argued in the Acuity case that, because Acuity's pre-2006 loss reserves had shown "favorable development" (that is, claims paid by Acuity ended up being less than initially estimated) when reviewed as of 2006, and because the 2006 reserves had also developed favorably when reviewed as of 2011, such development history demonstrated that Acuity's 2006 reserves exceeded a fair and reasonable estimate. The Court rejected this kind of "hindsight" analysis, and found that subsequent favorable development does not prove that a loss reserve estimate was unreasonable when it was first determined. Among other things, the Court observed that there is no authority for the notion that subsequent favorable development of reserves demonstrates unreasonableness while unfavorable development (or alternating years of favorable and unfavorable development) evidences a "fair and reasonable" reserve. Instead, both favorable and unfavorable developments viewed in hindsight simply show the uncertainty inherent in any reserve estimate. The IRS treatment of reserve development, according to the Court, "reads into Federal tax law a requirement that does not exist."
- Inherent uncertainty of the insurance business makes sound, well-informed actuarial judgment crucial. The Court's legal analysis is based on detailed findings of fact on the substantial and unavoidable uncertainty in Acuity's insurance business. This requires the application of sound and sensitive professional actuarial judgment in computing loss reserves. The Court observed that, in the 10 years culminating in 2006, Acuity had grown its business, had focused more and more on "long tailed" coverage such as workers compensation in which estimating losses is especially uncertain, and had expanded into new states where litigation patterns and other factors were less predictable. The Court ruled that these sources of uncertainty made the application of sound actuarial judgment, based on a thorough knowledge of Acuity's business, especially important in determining a reasonable loss reserve. The Court heard detailed testimony from the company's internal actuary who computed the $660 million loss reserve that was reported on the Annual Statement, and from the outside opining actuary who signed the actuarial opinion confirming that the reserve was reasonable. The Court found their testimony about how they exercised their professional judgment to be credible and persuasive.
- Use of actuarial ranges of loss reserve estimates. The Acuity decision supports the use of actuarially sound ranges of reserve estimates in appropriate circumstances, to support a particular reserve as "fair and reasonable." In the Acuity case, among the persuasive evidence that supported the company's reported reserve in the Court's eyes was the fact that it fell within a range of estimates determined contemporaneously by the outside opining actuary, and also within ranges of reasonable estimates independently determined by two outside consulting actuaries, from the Milliman and Towers Watson actuarial firms respectively, who testified as expert witnesses for Acuity. Because the ranges developed by all these actuarial witnesses were themselves found to be reasonable, they served as evidence that the company's reported reserve was fair and reasonable.
- Margins. In the terms of the IRS 2009 Coordinated Issue Paper, the Acuity case is an "implicit margin" case in which the IRS was challenging the actuarial assumptions and judgments underlying the company's loss reserve determination as too conservative, resulting in an excessive loss reserve estimate. Based on the evidence presented, the Court accepted the Acuity actuaries' assumptions and judgments as reasonable, and rejected the IRS challenge on this score. The IRS also argued that Acuity's reserve included a hidden "explicit margin," but the Court found as a fact that no such explicit margin existed.
- "Our inquiry ends." Acuity demonstrated the reasonableness of its carried reserve based on testimony and documents from (i) its internal actuary who computed the reserve, (ii) other top officers who adopted the reserve on the Annual Statement, (iii) the company's outside opining actuary who independently developed a range of reasonable estimates supporting the reported reserve, and (iv) two independent consulting actuaries who prepared expert witness reports confirming that the reserve fell within their professionally determined ranges of reasonable estimates. This credible evidence as to the "reasonableness" of Acuity's reported reserve under NAIC standards and ASOP requirements persuaded the Court, as explained above, that the reserve qualified as "fair and reasonable" for tax purposes. The Court was very explicit that, at that point, "our inquiry ends" – in other words, the case was over and Acuity prevailed. Because of the unavoidable uncertainty in the loss reserve process, testimony from two IRS expert actuarial witnesses, asserting a lower "fair and reasonable" reserve amount, was treated by the Court as essentially irrelevant. While insurance company taxpayers must show that their own reserve estimates are "fair and reasonable," the Acuity case indicates they are not required to bear the additional burden of disproving a contrary reserve estimate determined by the IRS.
* The IRS will have 90 days following the Tax Court's official entry of decision (roughly until the end of 2013) to decide whether to file an appeal. An appeal would go to the U.S. Court of Appeals for the Seventh Circuit.
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