Starting in 2008 and continuing today, the IRS has ramped up challenges to loss reserve deductions taken by property and casualty insurance companies in computing taxable income. P&C insurers need to understand the IRS audit position, how to prepare for a loss reserve audit in light of the current IRS position, and what to do once the IRS makes a challenge.
The reserve for unpaid losses is typically the largest deduction on a P&C insurer's tax return, so challenges to the reserve represent the IRS “hunting where the ducks are.” A successful challenge to the reserve deduction can generate substantial additional tax revenue from an insurance company taxpayer. However, from the IRS's perspective, there is more to the issue than that. IRS insurance experts believe that many insurers have been systematically overstating loss reserves in recent years, and the current audit effort is designed as a pushback.
IRS Issues Paper on Excessive Loss Reserves
The IRS position on P&C loss reserves is explained in a Coordinated Issue Paper published by the IRS Large & Mid Size Business (LMSB) Division (since renamed Large Business & International or LB&I) in November 2009, entitled, Margins and Other Unsubstantiated Additions to Insurance Company Reserves for Unpaid Losses and Claims. As the title suggests, the IRS asserts that many insurers are adding unjustified “margins” to their loss reserves, resulting in excessive tax deductions.
The general rule for tax purposes, stated in longstanding IRS regulations, is that the end-of-year reserve for unpaid losses, on which a P&C insurer's tax deduction is based, must represent the company's “actual unpaid losses as nearly as it is possible to ascertain them.” According to the regulations, “These losses must be stated in amounts which, based upon the facts in each case and the company's experience with similar cases, represent a fair and reasonable estimate of the amount the company will be required to pay.”
According to the IRS, there are two ways in which a “margin” can make a company's loss reserve exceed the “fair and reasonable estimate” allowed by tax regulations. First is an explicit margin, representing a dollar amount simply added on top of an actuarially determined estimate of unpaid losses. Some court cases have disapproved such explicit additions to loss reserves, unsupported by professional actuarial analysis. To the extent the IRS Coordinated Issue Paper is raising questions about explicit add-ons to loss reserves, made by company management without sufficient actuarial support, the IRS has some legal basis for its position.
The second kind of margin is what the Coordinated Issue Paper calls an implicit margin, or the supposedly improper use of “implicit conservatism” in developing a company's loss reserves. This is the more troubling and aggressive aspect of the IRS position, and potentially harder for companies to defend against. The IRS argues that, even when P&C loss reserves are developed by credentialed actuaries and are fully consistent with professional actuarial standards, the reserves are still subject to tax challenge if they are based on some inappropriate — and unspecified — degree of “conservatism” in the company's estimation of its unpaid losses.
There is little legal precedent to support this IRS rejection of any degree of “conservatism” in developing loss reserves. In some ways, the estimation of unpaid losses seems inevitably conservative, taking into account the many risks generated by a company's insurance business, given that companies are necessarily averse to driving themselves out of business by ignoring the array of risks they might encounter. Professional actuarial standards and NAIC accounting standards are consistent with this kind of “conservatism.” Be that as it may, however, companies must be aware that the current IRS audit position is to reject any perceived “conservatism” in loss reserves. IRS agents and in-house IRS actuaries are on the lookout for reserves to challenge, and companies should be prepared.
Companies also should understand that the IRS does not agree that the loss reserve number reported on the annual statement should control for tax purposes. This is despite important court decisions that have confirmed the crucial importance of annual statement loss reserves in determining tax deductions.
What Is the IRS Looking for in Loss Reserves?
What will IRS agents look for in deciding whether to claim that a company's loss reserves include an “explicit margin” or reflect “inherent conservatism,” making the reserves subject to challenge?
- An “explicit” margin could be any kind of managerial addition to what a company's in-house or external professional actuarial consultants have estimated as the company's unpaid losses. In reported court cases, such “explicit” margins have included “bulk” reserves not developed in accord with actuarial standards, and a 10-percent “add-on” included in the reserve by a company's financial managers without consultation with or support from actuaries.
- “Implicit conservatism” raising questions in the mind of the IRS could be evidenced by company management's statements to the financial community or other outside audiences that refer to “conservative” reserving practices. The IRS also searches for a consistent pattern of favorable development of reserves (that is, reserve take-downs) during subsequent years. We have seen IRS agents claim that companies are purposefully “stuffing” their reserves to increase tax deductions, with the idea of writing them down in later years as the actual losses develop more favorably than estimated.
IRS agents following the Coordinated Issue Paper have proposed, and continue to propose, some very substantial reductions in P&C insurance companies' loss reserve deductions. We have worked with multiple companies recently facing these IRS audits. Our experience is that IRS Appeals, the independent office within the IRS that hears administrative challenges to IRS audits, has serious questions about at least some aspects of the LMSB Coordinated Issue Paper on loss reserves. Nevertheless, IRS Appeals believes it has to take all loss reserve adjustments proposed by IRS agents seriously, so companies must be prepared to respond to these substantial proposed adjustments.
Insurance Company Strategy for IRS Audits
- Assure the company has a well-documented internal loss reserving process in place, performed by or under the supervision of trained and credentialed actuaries implementing professional actuarial standards.
- Assure qualitative input from underwriting and claims during the reserving process.
- Actuarial recommendations should be discussed at regular meetings throughout the year.
- Obtain an opinion or “reality check” from outside actuarial consultants and/or auditors.
- Know what company executives are saying to the investment community, regulators, A.M. Best, and others. Make sure executives understand the potential sensitivities of a focus on “conservatism.”
Once the IRS audit has begun:
- Involve outside tax professionals at an appropriate stage.
- Have a process for careful preparation and pre-submission review of all responses to IRS information document requests.
- Consider engagement of independent outside actuarial consultants to support the company's booked reserve. Take account of confidentiality and privilege concerns: consider possible engagement of outside actuaries by counsel to help the attorneys frame their legal advice.
- Look ahead to IRS Appeals and possible litigation, and plan your strategy accordingly.