SERVICE PREVIEWS FORTHCOMING REGULATIONS ON DISCOUNTED UNPAID LOSSES OF INSURANCE COMPANIES.

For purposes of fresh start, the Service states that the regulations will provide that reserve strengthening (weakening) includes the following three categories; "(1) all additions to (subtractions from) unpaid losses attributable to an increase (decrease) in an estimate of the amount of a reserve for unpaid losses established for an accident year prior to 1986 (taking into account claims paid and loss adjustment expenses paid by property and casualty companies, with respect to that taxable year); (2) all additions to (subtractions from) reserves resulting from a change in the assumptions used in estimating losses for any accident year (other then changes in interest rates applicable to reserves for the 1986 accident year); and (3) all unspecified or unallocated additions to (subtractions from) loss reserves."

Reserve strengthening (weakening) does not include amounts reported to the insurance company from mandatory state or Federal assigned risk pools, if the amount of the loss reported is not discretionary with the insurance company, the Service adds. The Service then provides a method for calculating the amount that must be included in taxable income as a result of reserve strengthening and examples of the calculations are given.

With respect to an election by a taxpayer under section 846(e) to use its own historical loss experience in applying the general loss discounting rules, the taxpayer must have written premiums in that line of business for at least the number of years that unpaid losses are required to be reported for that line of business on the annual statement. Additionally, the taxpayer must write a "statistically significant" amount of business in that line of business. Until further guidance is issued, such "statistically significant" amount is at least the 10th percentile of the industry- wide reserves for a line of business for the determination year to which the election is made, the Service states. If a taxpayer makes the election under section 846(e), it must use its own historical loss experience for all eligible lines of business.

If a taxpayer uses its own experience to calculate discount factors under section 846 for the 1987 taxable year and the factor is either zero or negative, the factor shall be replaced by a positive discount factor (the "substitute discount factor"). The "substitute factor is determined by blending the positive discount factors immediately preceding and succeeding the negative discount factor. Where two or more consecutive negative factors occur, a taxpayer must first compute a substitute factor for the most recent accident year having a negative factor. That substitute factor is then used to compute a substitute factor for the preceding accident year. Examples are provided to illustrate this point.

With respect to losses for accident years not separately reported on annual statements, the regulations will provide that taxpayers cannot use information not appearing on their annual statements to allocate aggregated unpaid losses among several accident years. Rather, taxpayers must use a composite discount factor for such aggregated unpaid losses. The notice discusses how this composite discount factor is to be calculated.

For losses for which no payment pattern exists, the regulations will provide that losses for such lines of business shall be discounted using the composite Schedule P discount factors, except as otherwise directed by the Commissioner. If losses for which no payment pattern exists are not separately stated for an adequate number of accident years, then the rules discussed in the preceding paragraph will apply.

Until further notice, the Commissioner will permit a taxpayer to discount the case reserves of a title insurance company using discount factors developed by Treasury for the Miscellaneous Casualty line of business. Case reserves include only those amounts attributable to actual claims reported.

This notice serves as an administrative pronouncement under regulation section 1.6661-3(b)(2). For further information, contact William L. Blagg at (202 566-3238.

I. BACKGROUND

Section 846 of the Code provides rules for determining the discounted unpaid losses of property and casualty insurance companies. Discounted unpaid losses are a component of the deduction, under section 832(b)(5), for the amount of losses incurred during the taxable year on insurance contracts.

Pursuant to section 807(c), life insurance companies must also use section 846 to compute the amount of unpaid losses (other than losses on life insurance contracts) deductible under sections 807(c)(2) and 805(a)(1).

Section 846 provides that the amount of discounted unpaid losses as of the end of any taxable year is the sum of the discounted unpaid losses (as of such time) separately computed for each line of business attributable to each accident year. (See section 846(f) for the definition of the terms "line of business" and "accident year".) The amount of discounted unpaid losses is the present value of the losses, generally computed by applying discount factors determined under section 846 to the amount of unpaid losses shown in the annual statement (as defined in section 846(f)(3)) filed by the taxpayer for the year ending with or within the taxable year. Discount factors applicable to losses incurred in 1987 and earlier accident years are set forth in Rev. Rul. 87-34, 1987-1 C.B. 168. Discount factors applicable to accident year 1988 are set forth in Rev. Rul. 88-63, 1988-31 I.R.B. 5.

Section 846(f)(2) provides that, for purposes of section 846, the term "unpaid losses" includes any unpaid loss adjustment expenses shown on the annual statement. However, loss adjustment expenses of life insurance companies, which under section 811 may not be deducted until the all events test of section 461 is satisfied, are not included in unpaid losses for purposes of section 846. See H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess. II-361 (1986); 1986-3 (Vol. 4) C.B. 361.

II. FRESH START

In determining taxable income, section 1023(e)(3)(A) of the 1986 Act provides generally that a taxpayer need not take into account the difference between the unpaid losses at the end of the last taxable year beginning before January 1, 1987, determined on an undiscounted basis and the unpaid losses at such time determined on a discounted basis (using the interest rate and loss payment patterns applicable to accident years ending with calendar year 1987). The exclusion of such amount in determining taxable income is referred to herein as "fresh start."

Section 1023(e)(3)(B) of the 1986 Act provides that fresh start shall not apply to any "reserve strengthening" in a taxable year beginning in 1986. Thus, although reserve strengthening in a taxable year beginning in 1986 may be taken into account in calculating income according to the taxpayer's normal method of accounting, an amount calculated as set forth below must be taken into income in the first taxable year beginning after December 31, 1986. To the extent provided below, reserve strengthening may be offset by reserve weakening.

For purposes of fresh start, the regulations will provide that reserve strengthening (weakening) includes the following three categories: (1) all additions to (subtractions from) unpaid losses attributable to an increase (decrease) in an estimate of the amount of a reserve for unpaid losses established for an accident year prior to 1986 (taking into account claims paid, and loss adjustment expenses paid by property and casualty companies, with respect to that accident year); (2) all additions to (subtractions from) reserves resulting from a change in the assumptions used in estimating losses for any accident year (other than changes in assumed interest rates applicable to reserves for the 1986 accident year); and (3) all unspecified or unallocated additions to (subtractions from) loss reserves. These categories are referred to herein as "category 1, 2, or 3 strengthenings (weakenings)."

These additions (subtractions) shall be treated as reserve strengthening (weakening) regardless of the reasonableness of, or the taxpayer's discretion in establishing, the reserve amount. Reserve strengthening (weakening), however, does not include amounts reported to the insurance company from mandatory state or Federal assigned risk pools, if the amount of the loss reported is not discretionary with the insurance company. For purposes of this section, a reserve is the aggregate of the unpaid loss estimates for each individual loss (and incurred but not reported losses) within each line of business for each accident year.

The amount that must be included in taxable income as a result of reserve strengthening is calculated as follows. First, reserve strengthening and weakening must be calculated separately for each accident year of each line of business, except to the extent that the calculations are made using aggregated unpaid losses for accident years for which a composite discount factor is used under section V of this notice. The amount of reserve strengthening with respect to any accident year of any line of business may not exceed the amount of the reserve for such line of business/accident year as of the end of 1986.

Second, each individual reserve strengthening and weakening amount shall be multiplied by an amount equal to the difference between 100 percent and the discount factor applicable to the relevant line of business and accident year. The product of these amounts is referred to herein as the "strengthening discount" or the "weakening discount," respectively.

Third, the strengthening discounts and weakening discounts attributable to all category 1 strengthenings and weakenings are netted, as are those attributable to category 3 strengthenings and weakenings. No netting is allowed among category 2 strengthenings and weakenings, or among the categories. For example, strengthening discounts attributable to category 1 strengthenings cannot be netted against weakening discounts attributable to category 2 or category 3 weakenings. After netting, the sum of all strengthening discount amounts shall be included in taxable income for the first taxable year beginning after December 31, 1986.

For purposes of fresh start and the reserve strengthening limitation, reinsurance assumed during 1986 shall be treated as new business written in that year. Thus, a change in reserves related to such reinsurance does not constitute category 1 reserve strengthening but may cause category 2 reserve strengthening. Premiums paid in 1986 to cede reinsurance to another insurance company shall be treated as claims paid in that year.

An insurance company assuming reinsurance in 1986 shall allocate the unpaid loss reserve at the end of 1986 for each line of business/accident year between its pre-1986 business and new business (including reinsurance assumed) written during 1986. The claims and loss adjustment expenses paid in 1986 with respect to each line of business/accident year also shall be allocated between the insurance company's pre-1986 business and the new business (including reinsurance assumed) written during 1986.

Reinsurance transactions that attempt to circumvent the reserve strengthening limitation to fresh start will be subject to section 845 of the Code.

EXAMPLE (1). X, a calendar year taxpayer, is a property and casualty insurance company. As of the end of 1985, X had an unpaid loss reserve of $1,000,000 in the workers' compensation line of business for the 1984 accident year, and $900,000 in that reserve at the end of 1986. During 1986, the claims and loss adjustment expenses paid with respect to this line of business/accident year were $300,000. Had X not changed its estimate of unpaid losses during 1986, the reserve at the end of 1986 would have been $700,000 ($1,000,000 opening reserve less $300,000 claims and loss adjustment expenses paid), rather than $900,000. However, X increased its estimate of the 1984 reserve in 1986, and is thus treated as making a $200,000 category 1 strengthening of the reserve for this line of business/accident year.

Assuming that no other reserve strengthening or weakening occurred, the amount that X is required to include in income in 1987 is $54,361.40 ($200,000 x (100% - 72.8193%)). (The discount factors and fractions of losses unpaid used in this notice are taken from Rev. Rul. 87-34.)

EXAMPLE (2). The facts are the same as in Example 1, except that the claims and loss adjustment expenses paid during 1986 were $1,100,000. Had X not changed its estimate of unpaid losses during 1986, the reserve at the end of 1986 would have been negative $100,000 ($1,000,000 opening reserve less $1,100,000 claims and loss adjustment expenses paid), rather than $900,000. The amount of reserve strengthening is, however, limited to the amount of the reserve at the end of 1986. Accordingly, X is treated as making a $900,000 category 1 strengthening to the reserve for this line of business/accident year.

Assuming that no other reserve strengthening or weakening occurred, the amount that X is required to include in income is $244,626.30 ($900,000 x (100% - 72.8193%)).

EXAMPLE (3). Y, a calendar year taxpayer, is a property and casualty insurance company. As of the end of 1985, Y had an unpaid loss reserve of $1,000,000 in the auto physical damage line of business for the 1985 accident year, and $600,000 in that reserve at the end of 1986. During 1986, $300,000 in claims and loss adjustment expenses was paid with respect to this line of business/accident year. Absent any change in the estimate of unpaid losses during 1986, the reserve at the end of 1986 would have been $700,000 ($1,000,000 opening reserve less $300,000 claims and loss adjustment expenses paid), rather than $600,000. Accordingly, Y is treated as making a $100,000 category 1 weakening to the reserve.

The only effect of the category 1 reserve weakening is to reduce the amount that Y is required to include in income as a result of any category 1 reserve strengthening in other lines of business/accident years.

EXAMPLE (4). The facts are the same as in Example (1) except that X is also treated as making a $100,000 category 1 weakening of its reserves in the auto physical damage line of business for the 1985 accident year. At the end of 1986, the reserve discount factor with respect to this line of business/accident year is 93.3400. Thus, the amount that X is required to include in income in 1987 may be reduced by $6,660 ($100,000 x (100% -93.3400%)). The required inclusion amount is reduced to $47,701.40 ($54,361.40 - $6,660). The inclusion amount would remain the same regardless of the amounts of any category 2 or 3 weakenings.

EXAMPLE (5). Z, a calendar year taxpayer, is a property and casualty insurance company. The unpaid losses of Z in the workers' compensation line of business for the 1984 accident year were $1,000,000 at the end of 1985, and were $1,100,000 at the end of 1986. The unpaid losses at the end of 1986 for the 1984 accident year included $250,000 attributable to reinsurance that Z assumed on September 1, 1986. The claims and loss adjustment expenses paid in 1986 with respect to this line of business/accident year were $230,000, which included $60,000 attributable to the reinsurance assumed by Z. In addition, on May 1, 1986, Z paid $130,000 to cede a portion of its workers compensation line of business for the 1984 accident year to an unrelated reinsurer. Z wrote no new business in 1986 other than the reinsurance.

Since the reinsurance assumed during 1986 is treated in the same manner as new business written in that year, Z must allocate its unpaid loss reserve at the end of 1986 ($1,100,000) between its pre-1986 business ($850,000) and the reinsurnnce Z assumed during 1986, ($250,000). The claims and loss adjustment expenses paid in 1986 ($230,000) also are allocated between Z's pre-1986 business ($170,000) and the reinsurance Z assumed during 1986 ($60,000). The sum of the claims and loss adjustment expenses attributable to Z's pre-1986 business ($170,000) and the amount Z paid to cede a portion of its pre-1986 business ($130,000) equals the total claims and loss adjustment paid in 1986 ($300,000) for purposes of applying the reserve strengthening limitation.

Absent any change in the estimate of unpaid losses during 1986, Z's unpaid loss reserve at the end of 1986 for its pre- 1986 business would have been $700,000. ($1,000,000 opening reserve less $300,000 claims and loss adjustment expenses paid). However, Z increased its estimate of the 1984 reserve in 1986, and is thus treated as making a $150,000 category 1 strengthening of the reserve for this line of business/accident year. Assuming that no other reserve strengthening or weakening occurred, the amount that Z must include in income in 1987 is $40,771.05 ($150,000 x (100% - 72.8193%)).

III. ELECTION BY TAXPAYER TO USE ITS OWN EXPERIENCE

A taxpayer may elect under section 846(e) to use its own historical loss experience in applying the general loss discounting rules. In order to use its own experience for a particular line of business, a taxpayer must have written premiums in that line of business for at least the number of years that unpaid losses are required to be reported for that line of business on the annual statement. In addition, a taxpayer must write a statistically significant amount of business in that line of business. Until further guidance is issued, such statistically significant amount is business in at least the 10th percentile of industry-wide reserves for a line of business for the determination year with respect to which the election is made. See H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess. II-361 (1986); 1986-3 (Vol. 4) C.B. 361. If a taxpayer makes the election under section 846(e), it must use its own historical loss experience for all eligible lines of business.

IV. NEGATIVE DISCOUNT FACTORS

A reserve discount factor for a particular accident year of a line of business may be zero or negative if a taxpayer uses its own experience to calculate discount factors under section 846 for the 1987 taxable year. In such a situation, any zero or negative discount factor shall be replaced by a positive discount factor (the "substitute discount factor").

The substitute discount factor shall be determined by blending the positive discount factors immediately preceding and succeeding the negative discount factor. This blending is accomplished by adding to the discount factor for such immediately succeeding accident year the quotient of (a) the difference between the discount factors for such immediately preceding and succeeding accident years, divided by (b) the number of years separating those two discount factors. Where two or more consecutive negative discount factors occur, a taxpayer must first compute a substitute factor for the most recent accident year having a negative factor. That substitute factor is then used in computing a substitute factor for the preceding accident year.

EXAMPLE (1). Assume that for a particular line of business the discount factor for AY+5 is 80%, the discount factor for AY+6 is negative 30%, and the discount factor for AY+7 is 84%. The negative discount factor for AY+6 is disregarded. The substitute discount factor will be 82% (80% + ((84% - 80%) / 2)).

EXAMPLE (2). Assume that for a particular line of business the discount factor for AY+6 is 80%, the discount factor for AY+7 is negative 10%, the discount factor for AY+8 is negative 5%, and the discount factor for AY+9 is 89%. The negative discount factors for AY+7 and AY+8 are disregarded. The substitute discount factor for AY+7 will be 83% (80% + ((89% - 80%) / 3)). The substitute discount factor for AY+8 will be 86% (83% + ((89% - 83%) /2)).

V. LOSSES FOR ACCIDENT YEARS NOT SEPARATELY REPORTED ON ANNUAL STATEMENT

Section 846 sometimes requires a series of reserve discount factors to be applied to unpaid losses for accident years that are not separately reported on the annual statement. For example, the 1986 annual statement does not require separate reporting of unpaid losses on Schedule P for accident years more than nine years earlier than the annual statement year. Rather, unpaid losses for AY+10 and earlier accident years are aggregated. For certain Schedule P lines of business, however, section 846(d)(3)(C) assigns a discount factor unique to unpaid losses allocable to each accident year from AY+10 through AY+15. Similarly, unpaid losses with respect to reinsurance and international lines of business are reported on Schedule O of the annual statement. The 1986 annual statement does not require separate reporting of unpaid losses on Schedule O for more than two accident years earlier than the annual statement year. Section 846(d)(3)(E), however, requires reinsurance and international lines of business to be discounted using composite Schedule P discount factors. Composite Schedule P discount factors include different discount factors for AY+3 through AY+15.

Regulations under section 846 will provide that taxpayers cannot use information not appearing on their annual statements to allocate aggregated unpaid losses among several accident years. Rather, taxpayers must use a composite discount factor for such aggregated unpaid losses.

This composite discount factor shall be calculated by (i) determining the fraction of losses unpaid at year-end for each such accident year includible in the payment pattern for a given line of business under section 846(d)(3)(C) or (E) of the Code (whichever is applicable), (i) determining the discounted fraction of losses unpaid for each of these accident years, using the applicable rate of interest under section 846(c), and (iii) dividing the sum of the fractions determined under subparagraph (ii) by the sum of the fractions determined under subparagraph (i).

EXAMPLE. The medical malpractice line of business is a line of business to which section 846(d)(3)(C) applies. For the 1987 taxable year, the respective fractions of losses unpaid at yearend for AY+10 through AY+14 are 22.1436%, 19.4073%, 16.6709%, 13.9346%, and 11.1982%. The sum of these amounts is 83.3546%. The respective discounted fractions of losses unpaid for these years are 17.7431%, 16.1874%, 14.5198%, 12.7321%, and 10.8156%. The sum of these amounts is 71.9980%. The quotient of the sum of discounted fractions of losses unpaid divided by the sum of fractions of losses unpaid is 0.863756 (71.9980% / 83.3546%). To determine discounted unpaid losses for the medical malpractice line of business for AY+10 and earlier, the composite reserve discount factor of 86.3756% is applied to the aggregate unpaid losses shown on the annual statement for AY+10 and earlier. See Rev. Rul. 87-34.

VI. LOSSES FOR WHICH NO PAYMENT PATTERN EXISTS

Section 846 requires loss payment patterns and discount factors to be developed for each line of business. In addition, section 846(f)(6) provides special rules for discounting the unpaid losses of certain accident and health lines of business. However, the Secretary has not published loss payment patterns or discount factors for certain lines of business to which section 846(f)(6) does not apply.

Regulations under section 846 will provide that losses for such lines of business shall be discounted using composite Schedule P discount factors, except as otherwise directed by the Commissioner. If losses for which no payment pattern exists are not separately stated for an adequate number of accident years, the rules of section V of this notice shall apply.

Until further notice, the Commissioner will permit a taxpayer to discount the case reserves of a title insurance company using discount factors developed by the Secretary for the Miscellaneous Casualty line of business. Case reserves include only amounts attributable to actual claims reported. The loss payment pattern to be applied for purposes of discounting a title insurer's unearned premium reserve shall be the period and pattern over which the reserves for that year are to be included in income in accordance with applicable State law. See H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess. II-366 (1986); 1986-3 (Vol. 4) C.B. 366.

VII. ADMINISTRATIVE PRONOUNCEMENT

This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or a revenue procedure.

VIII. FURTHER INFORMATION

For further information regarding this notice, contact William L. Blagg on (202) 566-3238 (not a toll-free call).