P&C Insurers Seek Clarity in Insurance Reserves Regs

May 29, 2020

Secretary of the Treasury
c/o Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224

Re: Proposed Regulations on Computation and Reporting of Reserves for Life Insurance Companies (REG-132529-17)

Dear Mr. Secretary:

We file these comments on the Proposed Regulations on behalf of a group of U.S. property-casualty insurance companies (P&C Companies). The proposed regulations apply principally to life insurance reserves that relate to contracts issued by life insurance companies taxed under Part I of Subchapter L of the Internal Revenue Code. The proposed regulations properly recognize that under I.R.C. § 832(b)(4), nonlife insurance companies subject to tax under Part II of Subchapter L are required to compute their deduction for life insurance reserves under I.R.C. § 807 in the same manner as life insurance companies. Specifically, the proposed regulations correctly provide that I.R.C. § 807(f) applies to changes in basis of computing reserves of both life insurance companies and nonlife insurance companies.

These comments make two recommendations:

The automatic consent procedures in Rev. Proc. 2019-43 should be expanded to unearned premiums and loss reserves of nonlife companies.

The Preamble to the proposed regulations notes the intention of Treasury and the IRS to revise Rev. Proc. 2019-43 for changes in accounting for certain insurance reserves. Specifically, revisions will be made to section 26.04 of Rev. Proc. 2019-43, which provides automatic consent for changes in computing all I.R.C. § 807(c) reserves of life insurance companies, but only for changes of life insurance reserves for nonlife insurance companies. As explained below, in the usual case, changes in reserves of nonlife insurance companies are changes in estimates, not changes in accounting methods. However, when such changes in accounting do occur, the tax policy considerations underlying the automatic change rules for life insurance companies equally apply to nonlife insurance companies, and all insurance reserves for both types of companies should be included in the automatic consent change rules.

The principle that a change in estimation approach is not a change in accounting method is well-established. A nonlife insurance company's method of accounting for losses (as for loss adjustment expenses (LAE) and unearned premium reserves) is the reserve method, under which losses are taken into account on an estimated basis. A nonlife insurance company routinely uses numerous actuarial approaches in determining its unpaid loss estimate for each line of business. Each actuarial approach, or combination of approaches, does not constitute a different method of accounting. Thus, the IRS has ruled that adjustments in a reserve method are not changes of an accounting method. The basis for this conclusion is explained in PLR 8406001 (Mar. 11, 1983), as follows:

The rationale for not treating refinements in a reserve method as a change in method of accounting under § 446 of the Code is that at best, the method is an estimation method which is subject to a reasonable estimation standard. Thus, on audit, the taxpayer must satisfy the Service that the reserve is reasonable in amount. If the taxpayer is unable to satisfy the Service, then it is prevented from adding any amounts to the reserve for current and future years, until the excess amount is used up.

Accordingly, since the LAE is a reserve method, any refinement of this sort is not a change in method of accounting. However, the agent can challenge the amount of the reserve if he believes it is in excess of a reasonable amount. Although the refinement in taxpayer's reserve technically results in a “timing” difference, the overall result is based on a change in taxpayer's experience factor. Such a change is analogous to a change in a bad debt reserve based upon a rediscovery of taxpayer's experience.

Under the above principles, because changes in P&C reserve estimation approaches, or weightings of multiple approaches in selecting a final reserve estimate, are not changes in method of accounting, most reserve changes are not changes in accounting. However, accounting changes can arise when a mathematical error is repeated in two or more tax years — e.g., repeated failure to follow the annual statement reserves cap rule for discounted unpaid losses of I.R.C. § 846(a)(3). The IRS's position is that, if such a math error is repeated on at least two tax returns, it becomes a method of accounting, and correction of such an error would necessitate the taxpayer's making a request to the IRS under I.R.C. § 446(e) for consent of a change of accounting.

Another source of accounting changes with respect to P&C reserves is a change in the law. For example, after the 20% unearned premium reserve haircut of I.R.C. § 832(b)(4)(B) was adopted in the Tax Reform Act of 1986, different methods of taking into account items like installment premiums or retrospective premium debits and credits had an effect on taxable income for the first time, depending whether or not they were recorded in the unearned premium reserve. Methods of accounting such as the so-called “western method” of taking installment premiums into account had the effect of producing less of an unearned premium reserve than the “eastern method,” though both methods produced the same net income before the effect of the unearned premium reserve haircut. Likewise, treatment of retro debits and credits had an impact on tax liability for the first time, depending whether one or the other or both were taken into account in the unearned premium reserve. As a result of this new significance of these issues after the statutory change, some taxpayers sought permission to change to more advantageous methods of accounting for these items, and IRS agents sought to force other taxpayers to change to less advantageous (for the taxpayer) methods. After a period of inconsistency and conflict, ultimately the issues were resolved by T.D. 8857 (2000), promulgating new earned premium regulations in Treas. Reg. § 1.832-4, and the safe harbor premium expense rules of Rev. Proc. 2002-46, 2002-2 C.B. 105.

Most recently, amendments to the loss reserve discounting rules of I.R.C. § 846 made by the TCJA mandated certain changes in accounting for discounted unpaid loss (including LAE) reserves and salvage reserves. In Rev. Proc. 2019-30, 2019-33 I.R.B. 638 (July 22, 2019), the IRS provides procedures for an insurance company to obtain automatic consent to change its method of accounting to comply with section I.R.C. § 846, as amended by TCJA, for the first (and potentially second) taxable year beginning after December 31, 2017. Most importantly, Rev. Proc. 2019-30 provides that the requirement for the company to file Form 3115, Application for Change in Accounting Method, is waived.

It would lessen the administrative burden on nonlife insurance companies and the IRS to revise Rev. Proc. 2019-43 to include these types of nonlife insurance changes in its automatic consent procedures. This would not preclude the IRS from providing specific guidance to limit or condition the consent procedures in response to particular circumstances, such as a change in law with provisions that the IRS believes require additional guidance.

Prop. Reg. § 1.807-4(a) should be revised to substitute a cross-reference to the IRS consent procedures implementing I.R.C. § 481(c) instead of Treas. Reg. § 1.446-1(e), because I.R.C. §446(e) does not apply to life insurance reserves. If this recommendation is not adopted, however, it should be made clear that I.R.C. § 446(b) does not apply to insurance reserves.

The P&C Companies believe that, consistent with long-standing authorities, the consent procedures in I.R.C. § 446(e) do not apply to changes in basis of computing life insurance reserves subject to I.R.C. § 807(f). Nothing in the TCJA changed this result. Attached as Appendix A to this comment letter is a detailed legal analysis that explains why I.R.C. § 446(e) does not apply. Accordingly, the reference to Treas. Reg. § 1.446-1(e) in Prop. Reg. § 1.807-4(a) should be deleted.

Although the consent procedures under I.R.C. § 446(e) do not apply to I.R.C. § 807(f) changes, the IRS's consent is needed under I.R.C. § 481(c) to reflect a multi-year spread of an I.R.C. § 481(a) adjustment that may result from a change in basis of computing life insurance reserves. As a result, the P&C Companies agree that it is appropriate to include a requirement in the regulations to obtain consent to a change in accounting for life insurance reserves, but the consent should be limited to the I.R.C. § 481(a) adjustment, not to the consent referred to in I.R.C. § 446(e) to effectuate the change in computing tax reserves.

If it is determined not to revise Prop. Reg. § 1.807-4(a) to refer to the consent procedure under I.R.C. § 481(c), rather than I.R.C. § 446(e), the P&C Companies recommend that the final regulations, or the explanation in their Preamble, make clear that I.R.C. § 446(b) does not apply to insurance reserves. I.R.C. § 446(b) provides in substance that if the taxpayer has failed to adopt an accounting method, or if the accounting method it has used does not clearly reflect income, the IRS has the authority to require a change in method of accounting to a method which “in the opinion of the Secretary” does clearly reflect income. I.R.C. § 446(b) is superseded for insurance reserves by I.R.C. § 811(a) for reserves of life insurance companies and by I.R.C. §§ 832 and 846 for reserves of nonlife insurance companies.

The fundamental components of P&C taxation (including reserves for losses, loss adjustment expenses, and unearned premium reserves) are based on the annual statement of the NAIC. I.R.C. § 446(b) cannot override this principle. Under I.R.C. § 832(b)(1)(A) the two components of gross income of such companies — investment income and underwriting income — are “computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners.” The formula of I.R.C. §832(b)(5) for determining “losses incurred” (with “premiums earned,” the two elements of “underwriting income”) was taken virtually word-for-word from the annual statement at the time the term was first adopted, in the Revenue Act of 1921, and remains fundamentally unchanged in both the current annual statement and the current Code (aside from the addition of discounting). Likewise, I.R.C. § 832(b)(6) specifies that expenses incurred means “all expenses shown on the annual statement approved by the National Association of Insurance Commissioners” and further provides that unpaid loss adjustment expenses “shown on the annual statement . . . shall be included in unpaid losses.” In turn, I.R.C. § 846 determines the procedures for discounting undiscounted unpaid losses and refers variously to amounts “included on the annual statement,” “shown in the annual statement,” and “reported on the annual statements.” See Appendix B.

The P&C Companies recommend that the final regulations or the Preamble to the final regulations reconfirm that, although I.R.C. § 446(e) may have limited application to reserves of nonlife insurance companies, it is NAIC accounting rules that apply to determine the amount and timing of reserve deductions, and not the general accounting provisions of I.R.C. § 446(b).

Sincerely yours,

Peter H. Winslow

Gregory K. Oyler

Samuel A. Mitchell

Scribner, Hall & Thompson, LLP
Washington, DC