P&C LOSS RESERVES AFTER THE ACUITY DECISION

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1 TUESDAY NOVEMBER 12, AM CENTRAL TIME P&C LOSS RESERVES AFTER THE ACUITY DECISION Thomas Wheeland Partner BKD, LLP Richard Riley Partner Foley & Lardner Michael Conway Partner Foley & Lardner TO RECEIVE CPE CREDIT Participate in entire webinar Answer polls when they are provided If you are viewing this webinar in a group Complete group attendance form with Title & date of live webinar Your company name Your printed name, signature & address All group attendance sheets must be submitted to training@bkd.com within 24 hours of live webinar Answer polls when they are provided If all eligibility requirements are met, each participant will be ed their CPE certificates within 15 business days of live webinar 2 // experience access 1

2 AGENDA Introductions Quick Summary of Acuity decision: P&C insurer s A/S loss reserve upheld in full for tax purposes Fair & Reasonable Standard Code & Regulations Judicial History Utah Medical, Minnesota Lawyers, Wisconsin Physicians Annual Statement Tax Conformity Principle: Sears & State Farm Coordinated Issue Paper Acuity Decision Facts & Trial Strategy Elements of the Tax Court s Decision Question & Answer 3 // experience access INTRODUCTIONS Tom Wheeland Partner, BKD, LLP Tax advisor to insurers facing loss reserve challenges Dick Riley Partner, Foley & Lardner LLP, Washington DC Lead tax counsel for taxpayer in Acuity case Mike Conway Partner, Foley & Lardner LLP, Chicago Lead litigation counsel for taxpayer in Acuity case 4 // experience access 2

3 QUICK SUMMARY OF ACUITY DECISION ACUITY, A Mutual Insurance Company: multiline multistate P&C insurer based in WI. WC is largest line In 2006, per its usual practice, Acuity recorded in-house professional actuary s loss reserve estimate on Ann Stmt Confirmed as reasonable by outside Appointed Actuary IRS asserted reserve was 15% overstated Challenged actuarial selections as too conservative Pointed to history of reserve redundancy US Tax Court, in 98-page opinion issued Sept. 4, 2013, upheld taxpayer s reserve in full Loss reserve determined in accordance with NAIC & ASOP standards is evidence of fair & reasonable reserve for tax purposes 5 // experience access FAIR & REASONABLE STANDARD Internal Revenue Code 832(b)(5) defines losses incurred Losses paid (net of salvage & reinsurance), plus Discounted unpaid losses at end of current year (net), less Discounted unpaid losses at end of prior year (net) Treas. Reg (b) states every insurance company must be prepared to establish (with detailed information) its unpaid losses Represent only actual unpaid losses Are a fair & reasonable estimate of such losses 6 // experience access 3

4 UTAH MEDICAL TAX COURT DECISION (1998) Monoline single-state MPL insurer Outside actuary employed consistent actuarial methods with increasing reliance on company data; actuary familiar with company s business Actual loss experience factored into reserves by actuary Actuary developed range of estimates; company chose its reserve from within range, near high end. Court upheld Reserves must be fair & reasonable but are not required to be accurate based on hindsight Midpoint of range is not the only fair &d reasonable estimate 7 // experience access MINNESOTA LAWYERS TAX COURT DECISION (2000) Monoline single-state lawyers professional liability insurer Ann Stmt reserves consisted of claims department s case reserves plus management-determined adverse development reserve = 37% to 50% of total reserve Tax Court (upheld by 8th Circuit) ruled taxpayer s reserves did not meet fair & reasonable standard No actuarially based support for adverse development reserve Evidence of a fair & reasonable reserve was outside actuary s point estimate 8 // experience access 4

5 WISCONSIN PHYSICIANS TAX COURT DECISION (2001) Monoline single-state MPL insurer Outside actuaries provided point estimates Management increased actuaries estimates by about 10%, pointing to various factors showing increased uncertainty Tax Court ruled taxpayer s reserves did not meet fair & reasonable standard Management s 10% add-ons not supported by actuarial analysis; court dubious about uncertainty factors Evidence of a fair & reasonable reserve was outside actuary s point estimate 9 // experience access COORDINATED ISSUE PAPER (2009) Conclusions Margins or other additions to unpaid losses that are not based upon the company s actual loss experience cannot be included in the deduction for losses incurred Unallowable margin can be explicit (management add-on to actuary s point estimate) or implicit (overly conservative assumptions buried in actuarial computations) The Service is not bound by the numbers shown on the annual statement The Service is not bound by the Statement of Actuarial Opinion included in the Annual Statement, & the actuary s opinion is not entitled to any presumption of deference 10 // experience access 5

6 ACUITY TAX COURT DECISION - FACTS Multiline, multi-state writer of personal & commercial insurance on an occurrence basis; significant WC & other long-tail business; fastgrowing company In-house credentialed actuary developed 2006 loss reserve estimate of $661M, which management adopted without change on Ann Stmt Actuary used multiple actuarial computational methodologies Actuarial inputs & selections reflected his professional judgment based on knowledge of company s business Outside Appointed Actuary made independent analysis, developed range; company s reserve fell within range IRS actuary rejected company actuary s analysis, determined fair & reasonable estimate about $100M less than company 11 // experience access ACUITY TAX COURT DECISION TRIAL STRATEGY Comprehensive factual presentation by taxpayer Eleven witnesses testified for Acuity CEO, Claims VP & CFO testified about company s approach to reserving (let actuaries do their job but establish checks & balances; how case reserves set; how reserves accounted for) In-house actuary (the key witness) walked through his analysis step-by-step, explained his computations & judgments Outside Appointed Actuary explained independent analysis Outside audit partner confirmed reserves were reasonable for financial statement purposes 12 // experience access 6

7 ACUITY TAX COURT DECISION TRIAL STRATEGY Three non-actuarial experts Former WI insurance commissioner explained regulatory function of loss reserves Insurance Information Institute economist explained macro function of insurance loss reserves Conning Research consultant explained industry-wide impact of insurance loss reserves Two outside actuary expert witnesses (Milliman & Towers Watson) each performed independent analysis & developed ranges of estimates confirming Acuity s reserve was reasonable Three IRS witnesses Two actuarial experts testified IRS estimate was reasonable & taxpayer unreasonable; AM Best witness under subpoena 13 // experience access ACUITY TAX COURT DECISION - HOLDING Complete win for taxpayer. Ann Stmt reserve of $661M upheld as fair & reasonable for tax purposes 1. Reserve estimates prepared in accordance with NAIC accounting standards & Actuarial Standards of Practice are the persuasive evidence of a fair & reasonable reserve for tax purposes a. May seem obvious but IRS has strongly challenged NAIC & ASOP standards in determining fair & reasonable under tax regulations 2. Favorable development of reserves (redundancy) does not show taxpayer s NAIC/ASOP-based reserve was unreasonable. IRS redundancy argument reads into Federal tax law a requirement that does not exist 14 // experience access 7

8 ACUITY TAX COURT DECISION - HOLDING 3. Uncertainty in the insurance business makes reserve estimates difficult, & shows importance of sound actuarial judgment based on knowledge of the company s business 4. Actuarially sound ranges of estimates are important tools in determining whether a reserve is fair & reasonable 5. Acuity is an implicit margin case, but Court s language on uncertainty, judgment & ranges can support taxpayers with explicit margins 6. When testimony of in-house actuary, Appointed Actuary & outside experts showed reserve was reasonable, our inquiry ends & taxpayer prevails. Taxpayer does not have to disprove IRS s contrary estimate 15 // experience access Questions? 8

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