Historic Moment for Casualty Actuaries

by Manuel Almagro and Tom Ghezzi

February 1998 was a historic month for casualty actuaries: the U.S. Supreme Court decided the case of Atlantic Mutual Insurance Co. vs. Commissioner of Internal Revenue after having received expert witness testimony from four members of the CAS. Irene Bass, James MacGinnitie, Ray Nichols, and Ruth Salzmann each provided an opinion on the meaning of the phrase "reserve strengthening."

The case involved a law suit filed by Atlantic Mutual against the Commissioner of Internal Revenue in regard to the application of the Tax Reform Act of 1986 (TRA 1986). The TRA 1986 included provisions for the "forgiveness" of the amount of discount underlying the 1986 loss and loss expense reserves. In other words, although the calendar year 1987 losses and LAE that were used to determine taxable income were calculated using the discounted value of year-end 1987 outstanding losses and LAE minus the discounted value of year-end 1986 outstanding losses and LAE, the industry did not have to discount the year-end 1986 outstanding losses and LAE for the purposes of determining the calendar year 1986 taxable income—the amount of this discount was "forgiven." This "forgiveness" was known as one of the "fresh start" provisions. However, any "reserve strengthening" during 1986 it would not be subject to the fresh start provision.

The expert witness testimony focused on the meaning of "reserve strengthening," which was not defined in TRA 1986 but was defined in the IRS regulations both in words as well as through arithmetic examples. This case reached the U.S. Supreme Court on appeal by Atlantic Mutual after the Tax Court decision, which had originally accepted the insurer's definition, was reversed on appeal by the IRS to the U. S. Court of Appeals for the Third Circuit. The written testimony of the four CAS members, which was reviewed by the Court, had previously been presented to the lower courts.

The Supreme Court found that the term "reserve strengthening" was ambiguous, not having been defined in the legislative history or by industry use. Therefore, the Court ruled that the IRS had the right to define the term as it did.

Testifying for the IRS, Ray Nichols defined "reserve strengthening" as the difference between calendar year incurred losses and accident year incurred losses. In other words, if incurred losses for calendar year 1986 exceeded incurred losses for accident year 1986, then the difference represented reserve strengthening during 1986. This definition was consistent with that used by the IRS, which was ultimately upheld by the Court.

Ruth Salzmann, also testifying as an expert for the IRS, defined "reserve strengthening" as she had in her 1984 textbook, "Estimated Liabilities For Loss and Loss Expense," as any increase in the actual reserve redundancy (or decrease in the actual reserve deficiency) from the beginning of the year to the end of the year. In other words, if the actual redundancy at year-end 1986 exceeded the actual redundancy at year-end 1985, then the difference represented reserve strengthening during 1986. She also pointed out that the amount of any actual redundancy could not be known with complete accuracy until all the losses had been paid.

Irene Bass, providing testimony on behalf of Atlantic Mutual, defined "reserve strengthening" as follows: "With respect to reporting reserves in the Annual Statement, reserve strengthening is said to have occurred if there is 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."

Jim MacGinnitie was not available for comment, but the Actuarial Review understands that his testimony was consistent with the theoretical definition provided by Irene Bass, while expanding her work to include the specific situation of Atlantic Mutual.

The four expert witnesses involved in the case included three past presidents of the Casualty Actuarial Society—Irene Bass, Jim MacGinnitie and Ruth Salzmann—as well as an actuary with government sector experience, Ray Nichols. The Actuarial Review is not aware of any other court case involving testimony by any other CAS member that has reached the U.S. Supreme Court.