The IRS Is Knocking Are You Ready?

Transcription

1 The IRS Is Knocking Are You Ready? Casualty Loss Reserve Seminar Denver, Colorado September 5-7, 2012 Presented by: Travis J Grulkowski, FCAS, MAAA Principal & Consulting Actuary Milliman, Inc travis.grulkowski@milliman.com Daniel E. Buttke, CPA Senior Manager Baker Tilly Virchow Krause, LLP daniel.buttke@bakertilly.com

2 Acknowledgement The material presented herein is based on a presentation originally prepared and presented by my colleague, Ms. Susan Forray 2

3 Outline Why the Insurance Industry? Income Loss Reserve Releases IRS Audits Sources of Dispute Audit Process IRS Coordinated Issue Paper Current Tax Court Cases Typical Characteristics of Audited Companies Summary Observations 3

4 A Discussion of Reserve Development WHY THE INSURANCE INDUSTRY? 4

5 Federal Deficit (In Billions) $400 $200 $ $0 -$200 -$400 -$600 ($157.76) ($377.59) ($412.73) ($318.35) ($248.18) ($160.70) ($458.55) -$800 -$1,000 -$1,200 -$1,400 -$1,600 ($1,412.69) ($1,293.49)($1,295.57) Source: Congressional Budget Office

6 $30 $25 $20 $15 $10 Industry Reserve Development Excluding Mortgage & Financial Guaranty Net Loss & ALAE (In Billions), by Calendar Year $5 $0 ($5) ($10) ($15) ($20) ($6.2) ($8.7) ($9.3) ($3.6) $1.2 $12.0 $22.9 $14.2 $10.6 $0.9 ($6.8) ($9.5) ($11.5) ($10.1) ($12.7) ($14.5) Source: 6 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty

7 Industry Reserve Development Net Loss & ALAE (In Billions), by Calendar Year Split Between Prior and Recent Accident Years $35 $25 $22.9 $19.1 $19.6 Accident Years 2001 & Prior Accident Years 2002 & Subsequent $15 $14.1 $8.4 $8.3 $5 $3.4 $5.0 $5.2 $2.5 -$5 $0.0 ($4.8) ($9.1) -$15 ($13.2) ($15.2) ($17.8) ($17.9) ($16.5) ($15.4) ($15.1) Source: 7 -$ Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty

8 $120 $100 $80 $60 $40 $20 -$20 Statement Year Development By Calendar Period, as of December 31, 2011 Net Loss & ALAE (In Billions) $0 -$ st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th Source: 8 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty

9 Development by Statement Year Net Loss & ALAE (In Billions) As of December 31, 2011 $120 $100 $80 $80.2 $107.1 $108.5 $86.7 $60 $51.8 $55.2 $40 $20 $0 $5.4 $11.8 $27.3 $17.4 $0.0 -$20 -$40 ($7.4) ($12.7) ($29.7)($28.8) ($23.8)($19.6) Source: 9 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty

10 A Brief Background and Deeper Perspective on: IRS AUDITS 10

11 Income Taxation of P&C Insurance Companies Classification as an insurance company General corporate tax rules apply Annual Statement is basis for income Discrete set of rules provided in Internal Revenue Code Part I, IRC tax treatment of life insurance companies Part II, IRC tax treatment of nonlife insurance companies Part III, IRC provisions that apply to all insurance companies 11

12 Income Taxation of P&C Insurance Companies Premiums and related accounts Claim of right doctrine Deductions for increase in unearned premiums reduced by 20% Losses and related accounts Reserves discounted by line of business by accident year IRS prescribes discount factors annually Other adjustments Salvage and subrogation Investment income (dividends, capital gains, etc.) Statutory exception to all-events test for certain liabilities 12

13 Sources of Dispute with IRS Status as insurance company e.g., captives more than half test must be satisfied Qualification of a policy as insurance or reinsurance Risk transfer must be present Extracontractual obligations State Farm, 2011 Retiree medical benefits as LAE Dividends paid or declared Guarantee fund assessments 13

14 Sources of Dispute with IRS Loss Reserves Easily the #1 source 14

15 Loss Reserves GAAP guidance 35-1 Changes in estimates of claim costs resulting from the continuous review process and differences between estimates and payments for claims shall be recognized in income of the period in which the estimates are changed or payments are made. [FAS 060, paragraph 18] 35-2 As discussed in paragraph , estimated recoveries on unsettled claims, such as salvage, subrogation, or a potential ownership interest in real estate, shall be evaluated in terms of their estimated realizable value and deducted from the liability for unpaid claims. [FAS 060, paragraph 18] 35-3 As discussed in paragraph , estimated recoveries on settled claims other than mortgage guaranty and title insurance claims also shall be deducted from the liability for unpaid claims. [FAS 060, paragraph 18] 35-4 Subsequent reductions in the reported amount and realized gains and losses on the sale of real estate acquired in settling claims shall be recognized as an adjustment to claim costs incurred. [FAS 060, paragraph 19] * Excerpted from FASB Codification section

16 Loss Reserves Statutory guidance Changes in estimates of the liabilities for unpaid claims or losses and loss/claim adjustment expenses resulting from the continuous review process, including the consideration of differences between estimated and actual payments, shall be considered a change in estimate and shall be recorded in accordance with SSAP No. 3 Accounting Changes and Corrections of Errors (SSAP No. 3). SSAP No. 3 requires changes in estimates to be included in the statement of operations in the period the change becomes known. This guidance also applies to the period subsequent to the March 1 filing deadline for annual financial statements through the filing deadline of June 1 for audited annual financial statements. * Excerpted from FASB Codification section

17 What Does an Audit Look Like? Taxpayer receives notification from IRS that they will be audited for specific year(s) Opening conference is scheduled Typically attended by taxpayer, IRS field examiner and taxpayer s representative Discuss scope of audit and anticipated timing, contact information, timing of responses for Information Document Requests (IDRs) and Notices of Proposed Adjustments (NOPAs) and form and frequency of communication 17

18 What Does an Audit Look Like? IRS audit examination plan Highlights year(s) being examined IRS personnel Examination schedule IDR Requests for documents and records Substantiation of information provided General inquiries Fieldwork Recommended to take place outside of taxpayer s office Length will vary depending on circumstances of examination IRS actuaries brought in as needed 18

19 What Does an Audit Look Like? NOPA drafted by field examiner Lays out the issue, facts, law, taxpayer s position, discussion and conclusion Can be presented throughout the audit process Responses to NOPAs Agree Agree in part Disagree Have additional information 19

20 What Does an Audit Look Like? Disagreed NOPAs Generally, a meeting takes place between the field examiner, the IRS manager on the case, the taxpayer and the taxpayer s representative to arrive at an agreement Can involve several meetings and discussions IRS can agree to taxpayer s position due to additional facts or documentation, or keep the original adjustments IRS is often willing to negotiate if several NOPAs remain open at the end of an audit 20

21 What Does an Audit Look Like? Closing meeting Attended by all parties Negotiations are finalized Closing agreements discussed and issued Next step: Appeals vs. Fast track settlement Don t like Appeals offer? Appeals mediation Litigation 21

22 IRS Coordinated Issue Paper Annual Statement a general guide Statutory accounting favors conservatism ; tax rules do not Conclusion: For federal income tax purposes, estimates of insurance company unpaid losses must be fair and reasonable in amount and must represent actual unpaid losses. 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. If a taxpayer cannot establish that a margin or other addition to unpaid losses represents actual unpaid losses, the deduction will be disallowed to the extent it exceeds a fair and reasonable estimate. 22

23 Current Tax Court Cases Acuity Insurance Company Filed April 2011 Scheduled for trial September 4, 2012 Single issue: loss reserves $100 million proposed adjustment IRS to use two outside actuarial experts IRS conceded guarantee fund issue 23

24 Current Tax Court Cases Sentry Insurance Company Filed July 2011 Not yet scheduled for trial Issues Loss reserves Accounting for acquisition Income as state work comp servicing carrier Multi-year contracts Uncollectible reinsurance 24

25 Property & Casualty Industry Audited Companies TYPICAL CHARACTERISTICS 25

26 Typical Characteristics Well run, financially sound A rated or better Often mutual insurers Size threshold $100 million+ net earned premium Both multi-line and mono-line writers 26

27 Line of Business (Net, In Billions) Comm Auto ($2.7) CMP ($6.3) MPL ($10.8) Other ($11.1) Reserve Development Work Comp $0.6 GL ($5.7) Auto Phys Dam ($8.2) Personal Auto ($10.4) Work Comp $175.6 CMP $149.8 Comm Auto $87.3 MPL $46.8 Homeowners ($3.6) GL $199.8 Other $350.4 Homeowners $303.5 Auto Phys Dam $345.4 Personal Auto $479.5 Earned Premium Source: 27 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty

28 $2 Mutual Companies Only Calendar Year Reserve Development Net Loss and ALAE, In Billions $ $0 -$1 -$2 -$3 -$4 -$5 (0.6) (0.9) (1.3) (1.7) (2.0) (2.3) (2.4) (2.8) (3.1) (3.5) (3.9) (3.8) (4.1) (4.2) Source: 28 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty

29 $10 $8 $6 $4 $2 $0 -$2 Mutual Companies Only Statement Year Reserve Development Net Loss and ALAE, In Billions, as of December 31, 2011 ($0.3) $2.5 $6.4 $8.3 $7.0 $4.4 $1.2 ($1.3) $0.0 -$4 -$6 -$8 ($3.3) ($3.6) ($3.8) ($4.9) ($5.1) ($6.7) ($6.0) ($6.4) Source: 29 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty

30 30 SUMMARY OBSERVATIONS

31 Summary Observations P&C Industry May Not Be Over-Reserved In hindsight, statement years under-reserved 2005 & subsequent statement years Have run off favorably to date But may develop adversely due to tail liabilities Typical Characteristics of Audited Companies Mutual structure Financially sound Medical professional liability (often) Reserves audited selectively 31

32 Antitrust Notice The Casualty Actuarial Society is committed to adhering strictly to the letter and spirit of the antitrust laws. Seminars conducted under the auspices of the CAS are designed solely to provide a forum for the expression of various points of view on topics described in the programs or agendas for such meetings. Under no circumstances shall CAS seminars be used as a means for competing companies or firms to reach any understanding expressed or implied that restricts competition or in any way impairs the ability of members to exercise independent business judgment regarding matters affecting competition. It is the responsibility of all seminar participants to be aware of antitrust regulations, to prevent any written or verbal discussions that appear to violate these laws, and to adhere in every respect to the CAS antitrust compliance policy.