Atl Mutl Ins Co v. Commissioner IRS ( 1997 )

Opinions of the United
1997 Decisions States Court of Appeals
for the Third Circuit
4-24-1997
Atl Mutl Ins Co v. Commissioner IRS
Precedential or Non-Precedential:
Docket 96-7424
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UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
___________
No. 96-7424
___________
ATLANTIC MUTUAL INSURANCE COMPANY, and
Includible Subsidiaries
vs.
COMMISSIONER OF INTERNAL REVENUE
Appellant
___________
Appeal from the United States Tax Court
(Tax Court No. 93-25767)
___________
Argued
March 13, 1997
Before: MANSMANN and LEWIS, Circuit Judges,
and MICHEL, Circuit Judge.*
(Filed April 24, 1997)
___________
John S. Breckinridge, Jr., Esquire (ARGUED)
James H. Kenworthy, Esquire
LeBoeuf, Lamb, Greene & MacRae
125 West 55th Street
New York, NY 10019
Frederick B. Lacey, Esquire
LeBeouf, Lamb, Greene & MacRae
One Riverfront Plaza
Newark, NJ 07102
COUNSEL FOR APPELLEE
* Honorable Paul R. Michel of the United States Court of
Appeals for the Federal Circuit, sitting by designation.
1
Gary R. Allen, Esquire
David I. Pincus, Esquire
Edward T. Perelmuter, Esquire (ARGUED)
Loretta C. Argrett
Assistant Attorney General
United States Department of Justice
Tax Division
P.O. Box 502
Washington, D.C. 20044
COUNSEL FOR APPELLANT
___________
OPINION OF THE COURT
__________
MANSMANN, Circuit Judge.
In this appeal, we address the "fresh start" provision
of section 1023(e)(3) of the Tax Reform Act of 1986. There
Congress permitted property & casualty insurers a one-time
forgiveness of income resulting from the change in computing
"losses incurred deductions" from undiscounted to a discounted
basis as mandated by newly enacted section 846 of the Internal
Revenue Code. Specifically, the Commissioner challenges the
decision of the Tax Court which invalidated Treas. Reg. § 1.846-
3(c) to the extent that it defines all additions to a property &
casualty insurer's loss reserves as "reserve strengthening."
We find that the meaning of the term "reserve
strengthening" in section 1023(e)(3)(B) of the Tax Reform Act of
1986 is ambiguous. We thus turn to the legislative history to
determine Congress' intent. Utilizing the deference principles
of Chevron U.S.A., Inc. v. Natural Resources Defense Council,
Inc., 467 U.S. 837 (1984), we conclude that Treas. Reg. § 1.846-
3(c) is based on a permissible construction of the Act and
2
implements the intent of Congress in some reasonable manner.
Accordingly, we will reverse the decision of the Tax Court.
I.
The statutory provision at issue is section 1023 of
Pub. L. No. 99-514, 100 Stat. 2085, 2399, of the Tax Reform Act
of 1986 (TRA 1986), which added new section 846 of the Internal
Revenue Code. In enacting section 846, Congress included two
relief provisions--the "transition rule" and the "fresh start"--
to facilitate a smooth transition to the new rules. Atlantic
Mutual Insurance Co. v. Commissioner, 71 T.C.M. (CCH) 2154, 2156
(1996). The transition rule, set forth in section 1023(e)(2) of
TRA 1986, provided that for purposes of computing the losses
incurred deduction for 1987, the year-end 1986 reserves would be
discounted.1 Absent this relief provision, section 846 would
1. Property & casualty companies are taxed pursuant to
I.R.C. §§ 831 through 835. Under section 832(a), the taxable
income of such a company is defined as the gross income minus
allowable deductions. Section 832(c)(4) provides that these
deductions include "losses incurred" as defined in section
832(b)(5). Prior to 1986, section 832(b)(5) defined "losses
incurred" for all relevant purposes as the amount of "losses
paid" during the year plus the increase (or minus the decrease)
in "unpaid losses." In practice, the P&C company would deduct
the full amount of the estimated total loss in the year of the
loss-event, even though the claim might not be paid for several
years. When the claim was paid, the company would not receive
any additional deduction (assuming that the payment equalled the
original estimate) because the payment would be offset by a
corresponding reduction it its unpaid-loss reserve.
Prior to TRA 1986, property & casualty insurers
received an unsolicited benefit because the tax laws failed to
take into consideration the time value of money in calculating
the deduction for losses incurred. Congress addressed this
problem by enacting I.R.C. § 846 as part of TRA 1986, which
provides for the discounting of unpaid losses. The new
discounting rules apply to all taxable years commencing after
3
have required property & casualty ("P&C") insurers to compare
undiscounted 1986 reserves with discounted 1987 reserves for
purposes of computing their losses incurred deductions for 1987.
As the Tax Court explained, "Such an ``apples-to-oranges'
comparison would have significantly reduced the losses incurred
deduction for the 1987 tax year." Id.
Notwithstanding the relief provided by the transition
rule, P&C insurers were still obligated to include in their 1987
taxable income the excess of the undiscounted year-end 1986 loss
reserves over the discounted year-end 1986 loss reserves, due to
the application of I.R.C. § 481.2 To avoid the application of
section 481, Congress allowed P&C insurers a one-time
"forgiveness" of income under the "fresh start" provision of
section 1023(e)(3) of TRA 1986. That section provides:
(3) Fresh Start.--
(A) In General.--Except as otherwise provided
in this paragraph, any difference between--
(i) the amount determined to be the
unpaid losses and expenses unpaid
for the year preceding the 1st
taxable year of an insurance
company beginning after December
31, 1986, determined without regard
to paragraph (2), [i.e., without
discounting] and
(ii) such amount determined with
regard to paragraph (2) [i.e., with
discounting],
(..continued)
December 31, 1986. Tax Reform Act of 1986, Pub. L. No. 99-514,
100 Stat. 2085, 2404.
2. Normally, section 481 would require a taxpayer to
recognize the excess as income, because the change in the basis
for computing losses incurred deductions from an undiscounted to
a discounted methodology constitutes a change in accounting
method. In this circumstance, I.R.C. § 481 requires the taxpayer
to make an appropriate adjustment to prevent it from obtaining a
double deduction created by the change in accounting method.
4
shall not be taken into account for purposes of the
Internal Revenue Code of 1986.
In substance, the fresh start rule overrides section 481 by
excluding from taxable income the difference between the amount
of the year-end 1986 undiscounted loss reserves and the
discounted amount of such reserves.
Congress anticipated, however, the potential for abuse
created by the fresh start provision -- that insurers could
manipulate the fresh start provision by inflating their reserves.
To prevent such abuse, Congress enacted section 1023(e)(3)(B) to
exclude any increases in loss reserves due to "reserve
strengthening." Section 1023(e)(3)(B) provides:
(B) RESERVE STRENGTHENING IN YEARS AFTER
1985.--Subparagraph (A) shall not apply to
any reserve strengthening in a taxable year
beginning in 1986, and such strengthening
shall be treated as occurring in the
taxpayer's 1st taxable year beginning after
December 31, 1986.
The meaning of the term "reserve strengthening," as used in
section 1023(e)(3)(B), lies at the heart of the controversy
before us. We turn now to the particular facts of this case.
II.
The parties fully stipulated to the following facts
before the United States Tax Court. Atlantic Mutual Insurance
Co. (Atlantic) is the common parent of an affiliated group of
corporations whose principal place of business is located in
Madison, New Jersey. Organized in 1842 under the laws of the
State of New York as a mutual marine insurer, Atlantic eventually
5
expanded its insurance underwriting activities to include
property & casualty insurance. Centennial Insurance Company, a
wholly owned subsidiary of Atlantic, is a P&C insurance company
included in Atlantic's consolidated income tax return. The
Commissioner's notice of deficiency relates to the activities of
both Atlantic and Centennial (collectively the "taxpayer").
From 1985 through 1993, the taxpayer filed annual
financial statements with the appropriate state insurance
departments.3 P&C insurers are required to report estimates of
amounts they expect to pay for losses that have already occurred
on the annual statement. These estimates are commonly referred
to as "loss reserves" (or simply "reserves").
For the years in issue, case reserves constituted the
majority of the taxpayer's loss reserves.4 The taxpayer set up
its case reserves by assigning a claims adjuster to examine each
reported claim and to estimate the amount, if any, that would be
paid to resolve it. For all years at issue, the taxpayer's case
3. Each annual statement was prepared in the format
prescribed by the National Association of Insurance Commissioners
(NAIC) in order to provide state insurance commissioners with
information concerning a P&C insurer's financial condition. The
accounting principles on which the NAIC-prescribed annual
statement is based generally have been incorporated into the
Internal Revenue Code sections applicable to P&C insurers.
4. In its P&C insurance business, the taxpayer maintained
three categories of loss reserves: (1) case reserves, which
reflect estimates of amounts to be paid to resolve claims that
have been reported to the taxpayer; (2) incurred but not yet
reported (IBNR) reserves, which consists of estimates of amounts
to be paid to resolve claims statistically presumed to have been
incurred but not yet reported to the taxpayer; and (3) loss
adjustment expense (LAE) reserves, which reflect estimates of
administrative costs to be paid in settling or otherwise
resolving claims.
6
reserves totalled $255,655,141 at year-end 1985 and $277,705,661
at year-end 1986.
The Commissioner tested for "reserve strengthening" by
applying the formula set forth in Treas. Reg. § 1.846-3(c)(3) to
each of the taxpayer's lines of P&C insurance for pre-1986
accident years. Under the formula, the taxpayer's reserves at
year-end 1985 were reduced by the claims and the loss adjustment
expense (LAE) paid in 1986 with respect to those reserves. To
the extent that, at year-end 1986, a reserve was greater than the
amount determined under the formula, the excess was treated as a
net increase to that reserve account (i.e., "reserve
strengthening"). Where, at year-end 1986, a reserve was less
than the amount determined under the formula, the difference was
treated as a net decrease to that reserve account (i.e., "reserve
weakening").
The Commissioner determined that, at year-end 1986, the
taxpayer's net "reserve strengthening" totalled $6,552,739.
Pursuant to I.R.C. § 846, the Commissioner then discounted the
$6,552,739, resulting in an understatement of the taxpayer's 1987
income of $1,339,039. The Commissioner further determined that
this understatement caused a deficiency of $519,987 in the
taxpayer's 1987 income tax liability and, accordingly, issued a
Notice of Deficiency on September 23, 1993. In response, the
taxpayer petitioned the Tax Court for a redetermination of the
deficiency.
After considering all of the evidence, the Tax Court,
on February 22, 1996, issued its decision concluding that the
7
taxpayer was not liable for the asserted deficiency. In reaching
this conclusion, the Tax Court held the taxpayer's reserve
increases did not constitute "reserve strengthening." Atlantic
Mutual, 71 T.C.M. at 2159. The Tax Court found that the doctrine
of stare decisis obligated it to reach the same result as that
obtained in Western National Mutual Ins. Co. v. Commissioner, 102
T.C. 338 (1994), aff'd 65 F.3d 90 (8th Cir. 1995), which the
court found to be factually indistinguishable from this case.
The Commissioner filed this timely appeal.
We have jurisdiction pursuant to 26 U.S.C. § 7482(a)
and we exercise plenary review over a legal challenge to the
validity of a treasury regulation. Tate & Lyle, Inc. v.
Commissioner, 87 F.3d 99, 102 (3d Cir. 1996) (citing Mazzochi Bus
Co., Inc. v. Commissioner, 14 F.3d 923, 927 (3d Cir. 1994)).
III.
Initially, we must determine whether the meaning of
"reserve strengthening" is clear from the plain language of
section 1023(e)(3)(B). Our review of an agency's interpretation
of a statute that it is empowered to administer is guided by the
well-established principles of Chevron U.S.A., Inc. v. Natural
Resources Defense Council, Inc., 467 U.S. 837 (1984); see also,
Appalachian States Low-Level Radioactive Waste Commission v.
O'Leary, 93 F.3d 103, 108 (3d Cir. 1996). The two-step inquiry
in Chevron requires us to first determine "whether Congress has
directly spoken to the precise question at issue." 467 U.S. at
842. If the intent of Congress is clear from the plain language
8
of the statute, then our inquiry ends there. If we conclude,
however, that Congress is silent or the statute is ambiguous
regarding the issue, then the second step of our inquiry is to
determine whether the agency's interpretation is based on a
permissible construction of the statute. Id. at 843.
Addressing the first prong of Chevron, we turn to the
plain language of section 1023(e)(3)(B). Clearly absent from the
text of the statute is any explanation of the meaning of the term
"reserve strengthening." We must determine, therefore, whether
Congress intended the meaning of reserve strengthening, as used
in the life insurance industry, to apply to P&C insurers. The
Tax Court, bound by its previous decision in Western National
which concluded that reserve strengthening as employed in section
1023(e)(3)(B) is a term of art adopted from the life insurance
industry, rejected the Commissioner's argument that the meaning
of "reserve strengthening" in the P&C insurance industry is
ambiguous. We note the distinction, however, that the
Commissioner did not present expert witnesses in Western
National.
The expert testimony here makes clear that the term
"reserve strengthening" as used in section 1023(e)(3)(B) is
subject to more than one interpretation.5 Indeed, the Tax Court
5. The Commissioner and the taxpayer introduced expert reports
in the Tax Court proceedings concerning the meaning of "reserve
strengthening" within the P&C industry. The taxpayer's first
expert, Irene R. Bass, construed "reserve strengthening" as
involving "a one-time (or, at least, unusual and non-periodic),
significant change in the assumptions and/or methodologies used
to compute the reserves which results in a material change to the
relative level of adequacy of the total reserve inventory." Bass
conceded, however, that "[w]ithin the context of the reserve
9
(..continued)
setting process, the term reserve strengthening is not a well-
defined PC insurance or actuarial term of art to be found in PC
actuarial, accounting, or insurance regulatory literature." She
then opined that "the lack of a well recognized definition of
reserve strengthening in PC insurance literature can be
attributed to the recursive nature of the reserve setting process
and the fact that identification of reserve strengthening is not
a requirement of the normal process of setting reserves."
The taxpayer's second expert, W. James MacGinnitie,
concurred with the expert opinion of Irene Bass. MacGinnitie
then described the concept of reserve strengthening in terms of
the adequacy of reserves to satisfy future claims, equating
adequacy to reserve strengthening and inadequacy to reserve
weakening. He further opined that this determination was one
that could not be definitively made until all claims covered by
the reserves in question had been finally settled. According to
MacGinnitie, in order to determine whether reserve strengthening
has occurred one must compare the adequacy of the current reserve
for a line of business to the adequacy of a previous reserve for
that same line of business.
The Commissioner submitted expert reports prepared by
Raymond S. Nichols and Ruth Salzmann. In his report, Nichols
stated: "In the property-casualty industry the term ``reserve
strengthening' has various meanings, rather than a single
universal meaning. However, in determining a property-casualty
insurer's underwriting income, ``reserve strengthening' generally
refers to a positive amount resulting from the difference between
calendar year incurred losses and accident year incurred losses."
Nichols opined that "[a]ny definition of ``reserve strengthening'
that restricts the words to the idiosyncrasies of individual
company reserve assumptions and methods will miss the impact of
reserve strengthening during underwriting cycles. For this
reason alone, the common definition of ``reserve strengthening'
does not restrict the meaning to changes in reserve assumptions
and methods."
Finally, the Commissioner's second expert, Ruth
Salzmann, proffered her definition of reserve strengthening:
"Reserve strengthening (or reserve weakening) is a term used in
connection with P/C income statements. It refers to the dollar
change in the margin of adequacy in the beginning and ending
reserves for unpaid losses for that accounting period. The
change can be for whatever reason and for any amount. If ending
reserves are more adequate (or less inadequate) than the
beginning reserves, there is reserve strengthening in the
accounting period and net income is understated; conversely, if
ending reserves are less adequate (or more inadequate), there is
reserve weakening and net income for the accounting period is
overstated."
10
in Western National commented that the opinions and testimony of
the numerous expert witnesses failed to establish a "universal
and precise definition of reserve strengthening." 102 T.C. at351 n.10. The Tax Court nonetheless found that it was able to
glean from the expert testimony the conceptual elements of
reserve strengthening as they are commonly used in the insurance
industry; it concluded that the concept of reserve strengthening
has the same meaning in the context of the P&C and life insurance
business. Id. at 351 n. 10 and 354. We part company with the
Tax Court's holding in this regard.
In determining that "reserve strengthening" has the
same meaning for both life and P&C insurers, the Tax Court in
Western National focused on the fact that Congress, in drafting
the language of Subchapter L of the Internal Revenue Code,
recognized the unique and highly specialized nomenclature of the
insurance industry. Moreover, the court observed that "[i]n
enacting the fresh-start provision of the DEFRA [Deficit
Reduction Act of 1984], Congress used an industry term of art in
a manner consistent with its traditional definition[]" within the
life insurance business.6 102 T.C. at 359. Accordingly, the Tax
Court concluded that "reserve strengthening" was a term of art
6. When Congress enacted the fresh start provision for
certain life insurance rules in DEFRA, it specifically defined
"reserve strengthening" to include only changes in assumptions
and methodology. The Commissioner argued that "reserve
strengthening" has a different meaning in the P&C insurance
industry. In rejecting this argument, the Tax Court "concluded
that ``Congress could not have expected a different quantitative
or qualitative meaning for the term' depending on the type of
insurer." Atlantic Mutual, 71 T.C.M. at 2158 (quoting Western
Nat'l, 102 T.C. at 354).
11
adopted from the insurance industry. Opining that the
legislative history contained contradictory explanations and, in
part, supported the Commissioner's regulatory position, the Tax
Court nonetheless concluded that Congress intended "reserve
strengthening" to be interpreted in a manner consistent with
industry usage. Id. at 360.7
The Tax Court's reliance on cases, revenue rulings and
legislation involving life insurance reserves is misplaced. For
federal income tax purposes, life insurance companies and P&C
insurers are taxed in entirely separate manners. Gross income as
well as loss reserves are computed on different bases and
assumptions. Actuarial assumptions about interest rates and
mortality rates are an integral part of computing future losses
which form the basis of the loss reserves in life insurance. On
the other hand, P&C loss reserves are determined primarily based
7. The Court of Appeals for the Eight Circuit affirmed the
decision of the Tax Court, holding that Treas. Reg. § 1.846-3(c)
was invalid to the extent that it defines "reserve strengthening"
in a manner contrary to industry usage. Western National Mutual
Ins. Co. v. Commissioner, 65 F.3d 90, 93 (8th Cir. 1995). In
reaching this conclusion, the court of appeals opined that
Congress intended to deny the fresh start deduction only to those
property & casualty companies that computed their 1986 unpaid
loss reserves on the basis of methodologies or assumptions that
were different from those employed in calculating the same
reserves in prior years. Id. at 93. As a corollary to this
conclusion, the court of appeals also found that the term
"reserve strengthening" was not ambiguous. Id. (footnote
omitted). Accordingly, the court held that it was not required
to consider the legislative history to divine the meaning of
"reserve strengthening." Id. The court of appeals nonetheless
proceeded to examine the legislative history, "out of an
abundance of caution," and determined that it failed to provide
persuasive rationale for interpreting "reserve strengthening"
contrary to industry usage. Id. We respectfully disagree.
12
on past claims experience and the judgments of the individual
claims adjusters.
In the life insurance industry, reserve strengthening
constitutes an unusual increase resulting generally from a change
in one of the fundamental reserve assumptions (i.e., interest
rate, mortality rate, method), as contrasted to normal increases
in life insurance reserves, which result from the receipt of
additional premiums or accrued interest. We find it illogical to
apply the life insurance definition of reserve strengthening to
P&C insurers -- whose reserves are not predicated upon the same
actuarial assumption. If we did so apply it, arguably there
would never be any reserve strengthening in the P&C area since
interest rates, mortality assumptions and methodologies are not
underlying components of the P&C loss reserves. The Commissioner
makes a persuasive argument that the differences between life
insurance and P&C loss reserves "render the wholesale importation
of life insurance concepts into the P&C unpaid-loss reserve area
quite dubious at best."
The revenue rulings cited by the Tax Court and the
taxpayer8 are inapposite to the issue of reserve strengthening by
P&C insurers. These revenue rulings address life insurance
reserves maintained by P&C insurers who also write life
insurance. In both rulings, the taxpayers requested advice on
how to compute life insurance reserves in a given factual
situation. The rulings do not define reserve strengthening with
8. Rev. Rul. 65-240, 1965-2 C.B. 236, Rev. Rul. 78-354,
1978-2 C.B. 190.
13
respect to P&C loss reserves in the context of life insurance
reserves.
Moreover, we find that the reserve strengthening
provision in DEFRA differs from the provision in TRA 1986 and,
thus, supports the Commissioner's argument that Congress did not
intend to import the life insurance definition of reserve
strengthening into section 1023(e)(3)(B). The 1984 statute
specifically links reserve strengthening by life insurance
companies to changes in the reserve practice used on the most
recent annual financial statement. A similar limitation was
contained in the Senate amendment to section 1023(e)(3)(B) but
was intentionally eliminated by the Conference Committee. The
Supreme Court addressed a similar situation involving the RICO
statute and held:
[W]here Congress includes particular language in one
section of a statute, but omits it in another
section of the same Act, it is generally
presumed that Congress acts intentionally and
purposely in the disparate inclusion or
exclusion. Had Congress intended to restrict
§ 1963(a)(1) to an interest in an enterprise,
it presumably would have done so expressly as
it did in the immediately following
subsection (a)(2). * * * The short answer is
that Congress did not write the statute that
way. We refrain from concluding here that
the differing language in the two subsections
has the same meaning in each. We would not
presume to ascribe this difference to a
simple mistake in draftsmanship.
Russello v. United States, 464 U.S. 16, 23-24 (1983).
Accordingly, the reserve strengthening provision of DEFRA does
not support the taxpayer's position here.
14
Given the lack of an explicit statutory definition of
reserve strengthening, the conflicting definitions of reserve
strengthening provided by the expert witnesses, and our finding
that the meaning attributed to reserve strengthening in the life
insurance industry is not applicable to P&C insurers, we conclude
that the meaning of "reserve strengthening" is ambiguous.
Accordingly, we find the Tax Court erred as a matter of law in
holding that the meaning of reserve strengthening in section
1023(e)(3)(B) was plain.
15
IV.
Because we find the meaning of the term "reserve
strengthening" ambiguous with regard to P&C insurers, we turn to
the second prong of the Chevron inquiry. In so doing, we are
required to take a deferential approach to ascertaining whether
the agency's interpretation is a permissible one. Appalachian
States Low-Level Radioactive Waste Commission v. O'Leary, 93 F.3d
at 110. Thus, "we must determine ``whether the regulation
harmonizes with the plain language of the statute, its origin,
and purpose. So long as the regulation bears a fair relationship
to the language of the statute, reflects the views of those who
sought its enactment, and matches the purpose they articulated,
it will merit deference.'" Id. (quoting Sekula v. F.D.I.C., 39
F.3d 448, 452 (3d Cir. 1994)).
We begin our analysis by turning to the legislative
history of section 1023(e)(3)(B). The provision requiring P&C
insurers to discount their loss reserves originated in a House
bill. H.R. 3838, 99th Cong., 1st Sess., §§ 1021-1027 (1985). In
the Senate version, the provision was amended to include the
fresh start provision as well as the exclusion for reserve
strengthening. The pertinent language of the Senate bill states:
(3) FRESH START.--
(A) IN GENERAL.--Except as otherwise provided in
this paragraph, any difference between the
amount determined to be the unpaid losses and
expenses unpaid for the year preceding the first
taxable year of an insurance company beginning
after December 31, 1986, determined without
regard to paragraph (2), and such amount
determined with regard to paragraph (2), shall
not be taken into account for purposes of the
Internal Revenue code of 1954.
16
(B) RESERVE STRENGTHENING AFTER MARCH 1, 1986.
[The fresh start provision] shall not apply to any reserve
strengthening reported for Federal income tax
purposes after March 1, 1986, for a taxable year
beginning before January 1, 1987, and such
strengthening shall be treated as occurring in
the taxpayer's 1st taxable year beginning after
December 31, 1986. The preceding sentence shall
not apply to the computation of reserves on any
contract if such computation employs the reserve
practice used for purposes of the most recent
annual statement filed on or before March 1,
1986, for the type of contract with respect to
which reserves are set up.
H.R. 3838, 99th Cong., 2d Sess., § 1022(e) (as reported by the
Senate Finance Committee, May 29, 1986) (emphasis added). The
Senate Finance Committee explained this provision as follows:
Any reserve strengthening after March 1, 1986, is to be
treated as reserve strengthening for the
first taxable year beginning after December
31, 1986. The committee intends that any
adjustments to reserves that are attributable
to changes in reserves on account of changes
in the basis for computing the reserves
(i.e., reserve strengthening or reserve
weakening) in a taxable year beginning before
January 1, 1987, are not taken into account
in determining taxable income after the
effective date.
S. Rep. No. 99-313, 1986-3 C.B. (Vol. 3) 510.
The Conference Committee reconciled the differences
between the House and Senate versions of H.R. 3838 by eliminating
the last sentence of the Senate amendment (section 1022(e)(3)(B))
that linked reserve strengthening to changes in reserve setting
practices. Although the final bill did not define "reserve
strengthening," the Conference Committee report accompanying the
final bill did, in fact, provide a definition of that term. The
Conference Committee's definition, which was more expansive than
17
that contained in the Senate Finance Committee report, reads as
follows:
Reserve strengthening is considered to include all
additions to reserves attributable to an
increase in an estimate of a reserve
established for a prior accident year (taking
into account claims paid with respect to that
accident year), and all additions to reserves
resulting from a change in the assumptions
(other than changes in assumed interest rates
applicable to reserves for the 1986 accident
year) used in estimating losses for the 1986
accident year, as well as all unspecified or
unallocated additions to loss reserves. This
provision is intended to prevent taxpayers
from artificially increasing the amount of
income that is forgiven under the fresh start
provision.
H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess., at II-367
(1986), reprinted in 5 U.S.C.C.A.N. 4075, 4455 (1986).9 Further
evidence of the Conference Committee's expansion of the
definition of reserve strengthening is found in Senator Wallop's
criticism of the Committee's action:
Presumably, the intent is to prevent insurers
from artificially increasing the opening
reserve in order to increase income forgiven
under fresh start. Implicit in this
provision is the notion that reserve
strengthening actions taken by insurance
companies during 1986 for prior accident
years is heavily motivated by the desire to
avoid Federal income taxes. Nothing could be
further from the truth. While it certainly
can be acknowledged that increases in
reserves decrease an insurance company's
Federal tax burden, there are substantial and
legitimate nontax reasons10 for increasing
9. The Tax Court here acknowledged that the Conference
Committee's definition of reserve strengthening was more
expansive than that contained in the Finance Committee report.
Atlantic Mutual, 71 T.C.M. at 2157.
10. Senator Wallop offered two legitimate nontax reasons
for increasing reserves: (1) reserves are based on estimates
computed from statistical models that are subject to error and,
18
the provision for unpaid losses in prior
accident years. . . .
. . .
The reserve strengthening definition as currently
written in the conference report is
arbitrary and inconsistent with one of the
goals of tax reform, that is, fostering
positive behavioral response from corporate
and individual taxpayers toward the Federal
tax system.
The Senate bill's reserve strengthening
provision was fair. The Internal Revenue
Service, as it does under current law, would
combat abusive reserving practices. The
conference modification substitutes a
simplistic, cookbook approach that is
entirely inappropriate and will likely create
tensions causing companies to underreserve to
the potential detriment of their
policyholders.
132 Cong. Rec. 32625 (daily ed. October 16, 1986).
Treas. Reg. § 1.846-3(c) (1992),11 which is predicated
on the definition of "reserve strengthening" set forth in the
Conference Committee report, provides in pertinent part:
(c) Rules for determining the amount of
reserve strengthening (weakening)--(1) In
general. The Amount of reserve strengthening
(weakening) is the amount that is determined
under paragraph (c)(2) or (3) to have been
added to (subtracted from) an unpaid loss
reserve in a taxable year beginning in 1986.
For purposes of [the fresh start], the
amount of reserve strengthening (weakening)
must be determined separately for each unpaid
loss reserve by applying the rules of this
(..continued)
thus, must be reevaluated from time to time; and (2) P&C insurers
have historically been underreserved and reserve strengthening
for them occurs is a normal part of doing business.
11. In 1988, the IRS issued a notice of forthcoming
regulations regarding the application of section 1023(e)(3)(B).
I.R.S. Notice 88-100, 1988-2 C.B. 439. Proposed regulations were
issued in 1991, Proposed Treas. Reg. § 1.846-3, 56 F.R. 20161
(May 2, 1991), and eventually, final regulations were promulgated
on September 4, 1992.
19
paragraph (c). this determination is made
without regard to the reasonableness of the
amount of the unpaid loss reserve and without
regard to the taxpayer's discretion, or lack
thereof, in establishing the amount of the
unpaid loss reserve. The amount of reserve
strengthening for an unpaid loss reserve may
not exceed the amount of the reserve,
including any undiscounted strengthening
amount, as of the end of the last taxable
year beginning before January 1, 1987. For
purposes of this section, an "unpaid loss
reserve" is the aggregate of the unpaid loss
estimate for losses (whether or not reported)
incurred in an accident year of a line of
business.
. . .
(3) Accident years before 1986--(i) In
general. For each taxable year beginning in
1986, the amount of reserve strengthening
(weakening) for an unpaid loss reserve for an
accident year before 1986 is the amount by
which the reserve at the end of that taxable
year exceeds (is less than)--
(A) The reserve at the end of the immediately
preceding taxable year; reduced by
(B) Claims paid and loss adjustment expenses
paid ("loss payments") in the taxable year
beginning in 1986 with respect to losses that
are attributable to the reserve. . . .
In the explanation accompanying the final regulations, the IRS
noted its reason for not adopting the commentators' suggested
alternatives to the mechanical test:
Congress did not limit the imposition of the reserve
strengthening rule to tax motivated
transactions. The legislative history
indicates that for purposes of the fresh
start adjustment the term "reserve
strengthening" includes "all additions to
reserves attributable to an increase in an
estimate of reserves established for a prior
accident year (taking into account claims
paid with respect to that accident year), and
all additions to reserves resulting from a
change in the assumptions (other than changes
20
in the assumed interest rates applicable to
reserves for the 1986 accident year) used in
estimating losses for the 1986 accident year,
as well as all unspecified or unallocated
additions to loss reserves". See 2 H.R.
Conf. Rep. 841, 99th Cong., 2d Sess. II-367
(1986), 1986-3 (Vol. 4) C.B. 367. Thus,
Congress adopted an expansive and mechanical
definition of reserve strengthening that is
reflected in the final regulations.
1992-2 C.B. 146, 148.
A close examination of Treas. Reg. § 1.846-3(c)(3)
reveals that virtually all additions to reserves constitute
reserve strengthening. The regulation also contains two narrow
exceptions, neither of which applies here. The regulation can be
reconciled with the Conference Committee's description of reserve
strengthening which is all-inclusive: "all additions to reserves
attributable to an increase in an estimate of a reserve
established for a prior accident year (taking into account claims
paid with respect to that accident year). . . ." H.R. Conf. Rep.
No. 99-841. As it applies to reserve strengthening for pre-1986
accident years, Treas. Reg. § 1.846-3(c) does not contradict the
Conference explanation and is somewhat more generous to the
taxpayer by providing two, albeit narrow, exceptions.
Our remaining inquiry is whether the regulation
harmonizes with the articulated purpose of section 1023(e)(3)(B).
The purpose of the reserve strengthening exception, as
articulated by the Conference Committee, is "to prevent taxpayers
from artificially increasing the amount of income that is
forgiven under the fresh start provision." The Commissioner and
the taxpayer disagree as to the meaning to be ascribed to the
21
Committee's use of the word "artificially" in delineating the
purpose of the limitation. This dispute stems from the Tax
Court's statement, in Western National, that the word
"artificial" suggests a dichotomy between routine, normal
additions to reserves and irregular or nonperiodic increases
attributable to changes in actuarial assumptions or methodology.
The Tax Court's analysis, however, cannot be reconciled with the
Conference Committee's broad definition of reserve strengthening
which includes normal additions. Thus, the Conference Committee
used the term "artificial" in a general sense, to refer to any
increases in the reserves other than those resulting from the
difference attributed to the discounting of reserves. To accept
the Tax Court's construction of "artificial" would mean that the
Conference Committee intentionally contradicted itself one
sentence later.
In light of the above discussion, we cannot say that
Treas. Reg. § 1.846-3(c)(3) is inconsistent with Congress'
intent, as evidenced by the Conference report. Accordingly, we
find that Treas. Reg. § 1.846-3(c) meets the second prong of the
Chevron test and, thus, constitutes a valid interpretation of
section 1023(e)(3)(B).
The taxpayer makes several arguments12 suggesting that
the application of the Treasury regulation will cause anomalous
12. The taxpayer further contends that despite numerous
comments during the promulgation process as to the proposed
regulation's infirmities, the Commissioner went forward in
adopting a mechanical test for determining the amount of reserve
strengthening. In particular, the taxpayer takes issue with the
test's reserve-by-reserve approach as opposed to a claim-by-claim
calculation. The Conference Report, however, supports a reserve-
22
results. These involve unrealistic assumptions about the size
and number of claims. We agree with the Commissioner that, to
the extent the mechanical test is flawed, the taxpayer should
seek relief from Congress and not the courts. "Judges cannot
override the specific policy judgments made by Congress in
enacting the statutory provisions with which we are here
concerned." United States v. Sotelo, 436 U.S. 268, 279 (1978).
We must not focus on the Act's policy, but rather, on what
Congress intended in enacting the statute.13 Id. at 280.
The Treasury Department considered proposed
alternatives to Treas. Reg. § 1.846-3 but ultimately concluded
that the interpretation was consistent with Congress' intent. As
the Supreme Court observed in United States v. Correll, 389 U.S.
299, 306-07 (1967):
Alternatives to the Commissioner's . . . rule are of
course available. Improvements might be
imagined. But we do not sit as a committee
of revision to perfect the administration of
the tax laws. Congress has delegated to the
Commissioner, not to the courts, the task of
prescribing "all needful rules and
regulations for the enforcement" of the
(..continued)
by-reserve approach ("all additions to reserves attributable to
an increase in an estimate of a reserve established for a prior
accident year.")(emphasis added).
13. We agree with the Commissioner that the regulation need
not provide the "perfect solution in every case to be valid."
Indeed, in Mourning v. Family Publications Services, Inc., 411
U.S. 356, 371 (1973), the Court held the fact that another
remedial provision might be preferred irrelevant to determining
whether the agency overstepped its authority. The Court stated:
"We have consistently held that where reasonable minds may
differ as to which of several remedial measures should be chosen,
courts should defer to the informed experience and judgment of
the agency to whom Congress delegated appropriate authority."
Id. at 371-72 (citations omitted).
23
Internal Revenue Code. In this area of
limitless factual variations, "it is the
province of Congress and the Commissioner,
not the courts, to make the appropriate
adjustments." The role of the judiciary in
cases of this sort begins and ends with
assuring that the Commissioner's regulations
fall within his authority to implement the
congressional mandate in some reasonable
manner.
(footnote and citation omitted). Because Treas. Reg. § 1.846-
3(c) implements the intent of Congress in some reasonable manner,
the Tax Court erred in holding that the regulation was invalid.
V.
For the reasons set forth above, we will reverse the
decision of the Tax Court.
_________________________
TO THE CLERK:
Please file the foregoing opinion.
_____________________________
Circuit Judge
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