Rev. Proc. 75-56

Section 1. Purpose.

The purpose of this Revenue Procedure is to effect the reconsideration of Com. Mimeograph R.A. 1366 dated July 1, 1944. While this document was not published by the Internal Revenue Service its contents were widely circulated among practitioners and the insurance industry.

Sec. 2. Background, Law and Regulations.

.01 Com. Mim. R.A. 1366 was issued during the World War II emergency period on the same day that the regulations (predecessor of section 1.832-4(a) of the present Income Tax Regulations) first permitted casualty insurance companies to make a fair and reasonable estimates of the "unpaid losses" portion of the deduction for "losses incurred" allowed under the predecessor of section 832(b)(5) of the Internal Revenue Code of 1954. It provided a rule of thumb auditing technique for Schedule "O" losses that could be used by examining agents in determining whether the estimates by such Schedule "O" unpaid losses were excessive. Adjustments were made only if the average of the preceding five years' estimated losses exceeded 115 percent of the average development losses for such years. The mimeograph was silent with respect to Schedule "P" losses (bodily injury liability and workmen's compensation losses) other than to say that proper comparison should be made.

.02 All items of income and deductions are governed by the provisions of the Code. With respect to insurance companies taxable under section 821 of the Code, statutory underwriting income, as defined in section 823, is computed under section 832. The Annual Statement referred to in section 832(b)(1)(A) is a guide only and not controlling for Federal income tax purposes.

.03 In section 832(c)(4) of the Code it is provided that in computing the taxable income of an insurance company subject to tax imposed by section 831, there shall be allowed as a deduction losses incurred, as defined in section 832(b)(5).

.04 Losses incurred, as defined in section 832(b)(5) of the Code, include liability for claims reported, whether adjusted, in the course of adjustment, or resisted, as well as the liability for claims arising during the taxable year but not reported. They do not include loss adjustment expenses. Losses incurred are computed as follows:

(a) To losses paid during the taxable year, add salvage and reinsurance recoverable outstanding at the end of the preceding taxable year and deduct salvage and reinsurance recoverable outstanding at the end of the taxable year.

(b) To the result so obtained, add all unpaid losses outstanding at the end of the taxable year and deduct unpaid losses outstanding at the end of the preceding taxable year.

.05 In section 1.832-4(a)(5) of the Income Tax Regulations, implementing section 832(b)(5) of the Code, it is provided that in computing losses incurred the determination of the unpaid losses at the close of each year must represent actual unpaid losses as nearly as it is possible to ascertain them. In section 1.832-4(b) it is provided that every insurance company to which sections 823 and 832 apply must be prepared to establish to the satisfaction of the District Director that the part of the deduction for losses incurred which represents unpaid losses at the close of the taxable year comprises only actual unpaid losses stated in amounts that, based upon the facts in each case and the company's experience with similar cases, can be said to represent a fair and reasonable estimate of the amount the company will be required to pay.

.06 In section 1.832-4(c) of the regulations it is provided that that part of the deduction for losses incurred that represents an adjustment to losses paid for salvage and reinsurance recoverable shall include all salvage in course of liquidation and all reinsurance in process of collection not otherwise taken into account as a reduction of losses paid, outstanding at the end of the taxable year. Salvage in course of liquidation includes all property (other than cash), real or personal, tangible or intangible, except that which may not be included by reason of express statutory provisions or rules or regulations of an insurance department of any State or Territory or the District of Columbia in which the company transacts business. Such salvage in course of liquidation shall be taken into account to the extent of the value thereof at the end of the taxable year determined from a fair and reasonable estimate based upon either the facts in each case or the company's experience with similar cases. Cash received during the taxable year with respect to items of salvage or reinsurance shall be taken into account in computing losses paid during such taxable year.

Sec. 3. Procedure.

.01 The long term administrative practice enunciated in Com. Mim. R.A. 1366 can no longer be justified in view of the technological advances made by the insurance industry in the area of statistical collection and analysis. Instead the standard of reasonableness in computing unpaid losses will be that set forth in sections 1.832-4(a)(5) and 1.832-4(b) of the regulations as set forth above in Sec. 2.

.02 Both unpaid losses, determined on an estimated basis as provided in section 1.832-4(b) of the regulations, and losses paid are part of the computation of the deduction for losses incurred. The losses paid part of the computation shall be adjusted for cash received during the taxable year with respect to items of salvage and reinsurance as well as for reinsurance in process of collection. Salvage in course of liquidation, which includes amounts from property rights acquired through subrogation, shall also be taken into account except that which may not be included by reason of express statutory provisions (or rules and regulations of an insurance department) of any State or Territory or the District of Columbia in which the company transacts business. Salvage shall be reasonably estimated either on the basis of the facts in each case or on the company's experience with similar cases and shall be taken into account at the end of the taxable year during which the right to property giving rise to such salvage becomes fixed.

.03 Generally, similar cases, within the meaning of section 1.832-4(b) of the regulations, are those cases in which the losses or claims so resemble one another as to type of loss that they are allocated to a designated particular line or lines of business in the Annual Statement. Unpaid losses outstanding at the end of the taxable year taken into account in computing the deduction for losses incurred shall be the aggregate of the reasonable estimates for each line of business at the end of the taxable year. Such reasonable estimates for each line shall be made on the basis of the facts in each case or claim in that line and the company's experience with similar cases or claims whether or not presently in that line. The estimates for each line of business shall be separately tested on such basis to determine whether the estimate of unpaid losses for that line is reasonable. After the estimates of every line of business are adjusted upward or downward, as appropriate then such estimates are aggregated to arrive at the total adjusted estimate of unpaid losses.

.04 If Schedule "O" and Schedule "P" (or any schedule that combines the two in the event Schedule "O" and "P" are unified) do not contain sufficient data to examine properly the reasonableness of the estimates of unpaid losses for each line of business, it is, pursuant to section 1.832-4(b) of the regulations and section 6001 of the Code, incumbent upon the company to provide such statistical data necessary for the examination. In this connection it is required for the company to retain such data in machine-sensible form, together with computer retrieval programs to facilitate retrieval of data at time of audit.

Sec. 5. Effective Date.

This Revenue Procedure is applicable to all taxable years. The absence of a provision for a tolerance factor, however, will be applicable only for taxable years beginning after the date of publication of this Revenue Procedure