On September 4, the United States Tax Court issued its opinion in Acuity v. Commissioner, T.C. Memo. 2013-209. In brief, the court concluded that Acuity’s reserves for unpaid losses and loss adjustment expenses for 2006, as used by the company in computing “losses incurred” within the meaning of IRC § 832(b)(5), were “fair and reasonable” estimates and represented “only actual unpaid losses” within the meaning of Treas. Reg. § 1.832-4(a)(14) and (b). In reaching this conclusion, the court gave great weight to the analysis performed by Acuity’s internal actuary in determining the company’s loss reserves for 2006, as well as the extensive review conducted by the company’s appointed actuary.
- Significantly, the Tax Court acknowledged that the applicable regulations do not require a taxpayer to show that the amount espoused by the IRS as a fair and reasonable estimate of loss reserves is, in fact, not fair or reasonable. Rather, as recognized by the court, the regulations only require the taxpayer to demonstrate that its loss reserves are fair and reasonable and represent only actual unpaid losses.
- The IRS also had challenged the deductions that Acuity had claimed in 2005 and 2006 for guaranty fund assessments. As noted by the Tax Court in its first footnote reference, the IRS conceded that Acuity was entitled to those deductions.
- As a memorandum opinion of the Tax Court, Acuity is not “controlling precedent.” See Darby v. Commissioner, 97 T.C. 51, 67 (1991). However, the Tax Court generally will “follow the same analytical approach that . . . [it] utilized in” a prior memorandum opinion in deciding a later case. Convergent Technologies, Inc. v. Commissioner, T.C. Memo.1995-320.
Acuity, a mutual property and casualty insurance company domiciled in Wisconsin, wrote insurance coverage in fifteen states during 2006. Much of Acuity’s business in 2006 constituted “long-tail” business, including workers compensation, products liability-occurrence, other liability-occurrence, private passenger auto liability, commercial auto liability, and the portion of homeowners multiple peril and commercial multiple peril covering liability. Those lines comprised approximately two-thirds of Acuity’s total written premiums in 2006.
For 2006, Acuity’s internal actuary computed a loss reserve range of $565,993,168 to $723,239,532 on a net basis, and expected loss reserves of $660,639,385, which amount was accepted by the company’s management. Acuity’s appointed actuary – an external actuary that was employed by the company’s financial statement auditor – subsequently computed a “point estimate” for the company’s loss reserves of $607,482,000, and a range of reasonable reserve estimates around the point estimate from $577,108,000 to $661,329,000, as part of his review of the company’s reported loss reserves. Because Acuity’s expected loss reserves of $660,639,385 fell within the range of estimates computed by the company’s appointed actuary, he provided the company with an opinion (a statement of actuarial opinion) that its loss reserves for 2006 made “a reasonable provision” for all of the company’s unpaid loss and loss adjustment expense obligations under the terms of its insurance contracts. The company filed the statement of actuarial opinion along with its Annual Statement for 2006, which reflected loss reserves of $660,639,385.
For federal tax purposes, Acuity reported discounted unpaid losses (which are used in computing “losses incurred” within the meaning of IRC § 832(b)(5)) of $622,717,658 for 2006. That figure represented Acuity’s loss reserves of $660,639,385 for 2006, discounted pursuant to IRC § 846. On audit, the IRS determined that Acuity’s loss reserves for 2006 were overstated by $96,129,294.
The Tax Court’s Analysis
The Tax Court framed the parties’ arguments as a disagreement over whether the Annual Statement provides any guidance in computing the amount of a loss reserve estimate and, if so, how that guidance factors into determining whether an amount so computed is “fair and reasonable” for federal tax purposes. Taking its initial cues from (i) the decisions of the U.S. Court of Appeals for the Seventh Circuit in Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858 (7th Cir. 1992) and State Farm Mutual Automobile Insurance Co. v. Commissioner, 698 F.3d 357 (7th Cir. 2012), regarding the primacy of the Annual Statement in computing deductible loss reserves under IRC § 832, and (ii) the underlying standards used for purposes of rendering a statement of actuarial opinion, the court reasoned that an appointed actuary’s analysis and determination “is highly probative for tax purposes,” and any assertion to the contrary was “unfounded and contrary to our caselaw.” In view of this reasoning, the court concluded that, in making the factual determination as to whether an insurance company’s loss reserves are fair and reasonable and represent only actual unpaid losses, “substantial weight” must be given to evidence that the loss reserves:
- Were actuarially computed in accordance with the NAIC rules and Actuarial Standards of Practice (ASOPs) for actuaries providing professional services in the U.S.; and
- Fell within a range of reasonable reserve estimates, as determined by the insurance company’s appointed actuary in accordance with the ASOPs.
After reviewing the processes that had been used by Acuity’s internal actuary and its appointed actuary in computing the company’s loss reserves for 2006, and comparing those loss reserves to those determined by the company’s expert witnesses at trial, the court concluded that “substantial evidence” had been introduced in support of the company’s position that its loss reserves for 2006 were fair and reasonable and represented only actual unpaid losses. Accordingly, the court upheld Acuity’s deduction for losses incurred. Significantly, in so holding, the court rejected the IRS’s arguments concerning:
- The alleged existence of a “margin” of approximately $60 million in Acuity’s loss reserves for 2006;
- An asserted failure of the company’s internal actuary to take into account the company’s prior loss development in computing its loss reserves for 2006;
- The import of the subsequent favorable development that occurred with respect to Acuity’s loss reserves for 2006;
- The reasonableness of the range of reserve estimates determined by the company’s appointed actuary, i.e., from $577,108,000 to $661,329,000, a range of approximately 14.6% of the lower bound; and
- The need for the company to “rebut” the loss reserves that had been determined by the expert witnesses brought forward by the IRS.
Sutherland Observation: The last two points described above largely follow from the Tax Court’s prior analysis in Utah Medical Insurance Association v. Commissioner, T.C. Memo. 1998-458. In that case, the taxpayer selected a loss reserve estimate that fell within a range of reserve estimates computed by the taxpayer’s actuary (which also was the company’s appointed actuary) for each of the years at issue. As relevant here, the taxpayer’s actuary computed ranges of approximately 26.1% and 26.3% of the lower bound for the two years at issue. Ultimately, the court concluded that, although these ranges were “large,” the taxpayer’s actuary had complied with all relevant actuarial standards and, as a result, the taxpayer’s loss reserves were fair and reasonable for the years at issue. (This conclusion can be contrasted with the conclusion reached by the Tax Court in a later case – Minnesota Lawyers Mutual Insurance Co. v. Commissioner, T.C. Memo. 2000-203, aff’d, 285 F.3d 1086 (8th Cir. 2002) – where the taxpayer’s appointed actuary computed ranges of approximately 70.3% and 119.9% of the lower bound for the second and third years at issue, ranges that the court found to be too large to be helpful.) The court further reasoned that, because the taxpayer had demonstrated that its loss reserves were fair and reasonable and represented only actual unpaid losses, no further inquiry was necessary.
Perhaps the most significant takeaway from Acuity is the Tax Court’s acknowledgment that the applicable regulations, i.e., Treas. Reg. § 1.832-4(a)(14) and (b), do not require a taxpayer to show that the amount espoused by the IRS as a fair and reasonable estimate of loss reserves is, in fact, not fair or reasonable. As recognized by the court, those regulations only require the taxpayer to demonstrate that its loss reserves are fair and reasonable and represent only actual unpaid losses. Thus, in the words of the Tax Court, when the taxpayer makes such a showing, the inquiry ends.