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. 262-796-3319 travis.grulkowski@milliman.com Daniel E. Buttke, CPA Senior Manager Baker Tilly Virchow Krause, LLP 920-739-3348 daniel.buttke@bakertilly.com
Acknowledgement The material presented herein is based on a presentation originally prepared and presented by my colleague, Ms. Susan Forray 2
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
A Discussion of Reserve Development WHY THE INSURANCE INDUSTRY? 4
Federal Deficit (In Billions) $400 $200 $128.24 $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) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 5 Source: Congressional Budget Office
$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) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: 6 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty
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 -$25 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty
$120 $100 $80 $60 $40 $20 -$20 Statement Year Development By Calendar Period, as of December 31, 2011 Net Loss & ALAE (In Billions) $0 -$40 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th Source: 8 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty
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) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: 9 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty
A Brief Background and Deeper Perspective on: IRS AUDITS 10
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 801-818 tax treatment of life insurance companies Part II, IRC 831-835 tax treatment of nonlife insurance companies Part III, IRC 841-848 provisions that apply to all insurance companies 11
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
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
Sources of Dispute with IRS Loss Reserves Easily the #1 source 14
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 944-40-30-2, 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 944-40-30-3, 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 944-40-35 15
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 944-40-35 16
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
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
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
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
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
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. http://www.irs.gov/businesses/article/0,,id=215618,00.html 22
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
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
Property & Casualty Industry Audited Companies TYPICAL CHARACTERISTICS 25
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
Line of Business 2007 2011 (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
$2 Mutual Companies Only Calendar Year Reserve Development Net Loss and ALAE, In Billions $1 1.1 0.9 $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) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: 28 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty
$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) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: 29 Milliman analysis of Property & Casualty Statutory Annual Statements Excludes Mortgage & Financial Guaranty
30 SUMMARY OBSERVATIONS
Summary Observations P&C Industry May Not Be Over-Reserved In hindsight, 1995 2004 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
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