Income Tax Considerations- Loss Reserves

1. Income Tax Considerations- Loss Reserves September 9, 2003 R. Lee Christie Tracy D. Williams Frederick J. Krull Partner Partner Partner Foley & Lardner Foley & Lardner Ernst & Young, LLP (312) 832-4525 (312) 832-4593 (312) 879-2117

2. Agenda • General Overview of Tax Issues Related to Loss Reserves • Discussion of Case Law for Establishment of Loss Reserves • IRS Examinations Process – Exam through Court Decisions • Questions and Answers

3. General Overview of Tax Issues Related to Loss Reserves • Reliance on the NAIC Annual Statement • Discounting for Tax – Company vs. Industry

4. Reliance on the NAIC Annual Statement • “Unpaid losses” for tax are defined as the unpaid losses shown in the annual statement filed by the taxpayer, including any unpaid loss adjustment expenses shown on the annual statement. • “Annual statement” is defined as the statement approved by the NAIC which the taxpayer is required to file with State authorities. • If undiscounted losses cannot be determined with information shown on the annual statement, book discounted losses as shown are used for tax purposes.

5. Reliance on the NAIC Annual Statement Years Not Separately Stated on the Annual Statement: • Notice 88-100 prohibits the use of information not appearing in annual statement • Loss payment pattern may be required to be extended to a maximum of sixteen years • Annual statement only provides for eleven years of unpaid losses • Composite discount factor must be used

6. Reserves Discounted for Annual Statement Purposes • Total unpaid losses and unpaid loss adjustment expenses disclosed on Annual Statement in Liabilities, Surplus, and Other Funds. • Components of unpaid losses (reported and incurred) and loss adjustment expenses disclosed on Underwriting and Investment Exhibit. • Detailed disclosure of unpaid losses provided in Schedule P by line of business and by accident year. • Losses may be discounted on Annual Statement for certain lines of business.

7. Loss Reserve Discount (IRC 846) • Amount of discounted unpaid losses is the present value of losses determined by applying a discount factor to unpaid losses shown in the Annual Statement . • If unpaid losses are shown discounted on Annual Statement, information must be provided in the Annual Statement to computed undiscounted book losses in order to use undiscounted book losses for tax purposes. • Discounted by line of business by accident year.

8. Loss Reserve Discount (IRC 846) Discount Factors: • Discount factor is based on the applicable interest rate and the applicable loss payment pattern • Once a series of discount factors is applied to an accident year for a line of business it continues to be used as that accident year “ages” (“Vintaging”) • Based upon either industry data published annually by IRS or upon the company’s own experience • Election to use industry or company factors for an eligible line of business every five years (“Determination year”)

9. Loss Reserve Discount (IRC 846)Company vs. Industry Factors • Discount Factor may be based on the industry loss payment pattern or the company’s own historical payment pattern. • Industry payment pattern published yearly by the IRS for each line of business. • IRS loss payment pattern information from AM Best. • Company payment pattern based on historical data for each line of business • Choosing to use industry or company may provide additional benefit to company with larger deduction

10. Discussion of Case Law for Establishment of Loss Reserves • Case History • Utah Medical • Minnesota Lawyers • Wisconsin PIC • Impact of Codification • IRS Technical Pronouncements

11. IRS Examinations Process – Exam through Court Decisions • Exam to Appeals to Court • Information requests • How to respond • E-mail correspondence • Language • Behavior

12. Questions?