Final Regs on Discounting Unpaid Losses of Insurance

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to the discounting of unpaid losses of insurance companies for federal income tax purposes. Changes to the applicable law were made by the Tax Reform Act of 1986. The regulations affect insurance companies and provide the guidance needed to comply with these changes.

 EFFECTIVE DATE: The regulations are effective for taxable years beginning after December 31, 1986.

 FOR FURTHER INFORMATION CONTACT: Katherine A. Hossofsky (202) 622-3970 (not a toll-free call) or Ann H. Logan (202) 622-3970 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document sets forth final income tax regulations relating to the discounting of unpaid losses under section 846 of the Internal Revenue Code. Section 846 was added to the Code by section 1023(c) of the Tax Reform Act of 1986 (100 Stat. 2399). Proposed regulations under section 846 were published in the Federal Register on May 2, 1991 (56 FR 20161). Written comments were received from the public and a public hearing was held on September 24, 1991. Guidance on certain issues relating to section 846 was provided in Notice 88-100, 1988-2 C.B. 439.

EXPLANATION OF PROVISIONS

 The deduction for losses incurred provided to property and casualty insurance companies under section 832(b)(5)(A) of the Code takes into account changes in the amount of discounted unpaid losses for contracts other than life insurance contracts. In addition, section 807(c) requires life insurance companies to discount unpaid losses (other than losses on life insurance contracts) for purposes of sections 807(c)(2) and 805(a)(1). Section 846 provides rules for the discounting of unpaid losses. These regulations provide guidance on certain issues arising under section 846.

REQUIREMENTS FOR ELECTION TO USE OWN EXPERIENCE

Although taxpayers generally must discount unpaid losses using the loss payment patterns determined by the Secretary and published by the Internal Revenue Service (Service), section 846(e) allows a taxpayer to elect to discount unpaid losses using the company's own historical loss payment pattern. Under section 846(e), the taxpayer's loss payment pattern must be determined using the information provided on the most recent annual statement filed before the beginning of the accident year for which the loss payment pattern is computed. The election is made separately for each determination year (1987 and each fifth calendar year thereafter) and applies to all of the taxpayer's lines of business that are eligible lines during the determination year. Section 846(e)(4) directs the Secretary to provide that the election is not available for a line of business for which the taxpayer does not have sufficient historical experience to determine a loss payment pattern.

 The proposed regulations provided that a taxpayer's election to compute discounted unpaid losses based on its own historical loss payment pattern would apply to a line of business only if the taxpayer, on its most recent annual statement filed before the beginning of the determination year, reported unpaid losses for that line of business for at least the number of accident years for which unpaid losses in that line are required to be separately reported on the annual statement.

 Commentators have suggested that the "unpaid losses" standard is not the appropriate criterion for determining whether a taxpayer has sufficient historical experience in a line of business. A taxpayer with sufficient historical experience in a line of business could nevertheless report on its annual statement no unpaid losses for one or more of the requisite accident years. This could occur if, for a particular accident year, all of the losses incurred in a line of business have been paid.

 In response to these comments, the final regulations provide that a taxpayer's election to compute discounted unpaid losses based on its own historical payment pattern generally will apply to a line of business if the taxpayer, on its most recent annual statement filed before the beginning of the determination year, reports "losses and loss expenses incurred" for that line of business for at least the number of accident years for which losses and loss expenses incurred in that line are required to be separately stated. Further, in recognition of the need for flexibility to adapt to changes in business practice or annual statement presentation, the final regulations provide that for the 1992 and subsequent determination years a line of business will also be considered an eligible line of business if it satisfies conditions set forth in other published guidance provided by the Service. In connection with the finalization of these regulations, the Service is publishing Rev. Proc. 92-76, 1992-38 I.R.B. to address certain situations that have been identified in comments. Taxpayers may provide the Service with data concerning lines of business and loss payment patterns to enable the Service to determine if additional guidance is warranted.

 The final regulations include a transition rule for the 1987 determination year. The transition rule, which was initially published in Notice 88-100, provides that a taxpayer has sufficient historical experience for a line of business for the 1987 determination year if the taxpayer reports written premiums for at least the number of accident years for which unpaid losses for that line are required to be separately reported on the annual statement. The transition rule is not adopted for determination years after 1987 because a taxpayer may write premiums for several accident years before having unpaid losses relating to those premiums. Thus, the transition rule does not provide adequate assurance of the availability of loss payment information for each of those accident years to warrant its adoption as a final rule.

 Notice 88-100 also required that the amount of unpaid losses a taxpayer reports on its annual statement for a line of business be equal to or greater than the amounts reported by at least 10 percent of all other companies that report unpaid losses for that line of business. The final regulations do not adopt this rule because of its potentially adverse impact on small companies and because determination of the 10th percentile threshold amount was administratively burdensome for taxpayers.

ANTI-ABUSE RULES

Section 846(e)(4)(B) directs the Secretary to issue regulations to prevent the avoidance (through the use of separate corporations or otherwise) of the requirement that the election to use historical loss payment patterns apply to all lines of business of a taxpayer. In response to commentators' requests for an expansion of the lines of business eligible for the historical loss experience election, the final regulations adopt a less restrictive criterion for determining whether a taxpayer has sufficient historical experience in a line of business and authorize further guidance to expand the definition of eligible lines of business. In view of this liberalization, safeguards are provided to prevent the avoidance of the requirement that the election apply to all eligible lines through the use of reinsurance agreements or separate corporations. Specifically, the final regulations provide that the district director may (1) nullify a taxpayer's election to compute discounted unpaid losses based on its historical loss payment pattern, (2) adjust a taxpayer's historical loss payment pattern, or (3) make other proper adjustments, to prevent avoidance of the requirement of section 846 that the election apply to all eligible lines of business of a taxpayer.

DETERMINATION OF DISCOUNT TABLES TO BE USED

The final regulations generally provide for application of a composite schedule of discount factors to unpaid losses of a line of business for which the Service has not published discount factors.

  Rev. Proc. 91-21, 1991-1 C.B. 525, provided an administrative procedure under which certain taxpayers could elect to use composite discount factors for unpaid losses on certain insurance contracts written on a claims-made basis. Neither the revenue procedure nor the final regulations permit this election for unpaid losses attributable to the 1992 accident year or any subsequent accident year.

 If the groupings of individual lines of business on the annual statement change, taxpayers must discount unpaid losses on the resulting lines of business using the discounting patterns that would have applied to those unpaid losses based on their annual statement classification prior to the change. This is appropriate because the Service has published discount factors based on the classification of unpaid losses on the most recent annual statement filed before the beginning of the determination year.

 In certain cases, the final regulations specify other factors that must be applied to unpaid losses for which the Service has not published discount factors. For example, for purposes of discounting unpaid losses from nonproportional reinsurance for accident years after 1991, the proposed regulations are modified to reflect changes in the information required on the annual statement. As a result of the additional information contained in the 1990 annual statement, the Secretary is able to calculate discount tables from nonproportional reinsurance for short-tailed lines of business, long- tailed lines of business, and financial guarantee/surety type business.

 The final regulations also provide that the 90 percent rule applies to reinsurance and international business for all accident years. The 90 percent rule requires that reinsurance which is not allocated to a specific line of business must nonetheless be discounted using the factors associated with that line of business if 90 percent of the unallocated unpaid losses relate to underlying line of business.

FRESH START

The final regulations adopt with one modification the rules contained in the proposed regulations concerning the computation of the "fresh start" provided by section 1023(e)(3) of the Tax Reform Act of 1986 (the Act). The fresh start provides a double deduction by allowing a taxpayer to not take into account the difference between undiscounted and discounted losses as of the end of the last taxable year beginning before January 1, 1987. However, under section 1023(e)(3)(B) of the Act, the fresh start does not apply to any "reserve strengthening" in a taxable year beginning in 1986. Congress imposed this rule to limit the double deduction benefit allowed by the fresh start.

 The proposed regulations provided a mechanical test which was applied to reserves to determine the existence of reserve strengthening for purposes of the fresh start provisions. Commentators suggested a number of different alternatives to the mechanical test. One commentator proposed that the final regulations provide specific instances and safe harbors under which certain reserve adjustments would not be treated as reserve strengthening under section 1023(e)(3)(B) of the Act. The commentator suggested that reserve strengthening should not be deemed to occur in situations where a taxpayer's reserves, based on hindsight, were deficient at the beginning of 1986 and also suggested that the following types of reserve increases not be treated as reserve strengthening under section 1023(e)(3)(B): (a) reserve increases based on normal business practice, (b) reserve increases attributable to changes in law, (c) reserve increases attributable to writing off reinsurance recoverable from reinsurers that became impaired, (d) reserve increases for reinsurance attributable to increases in reserves reported to the taxpayer by the primary insurer, (e) reserve increases resulting from the acquisition in 1986 of an insolvent insurer that was under-reserved, (f) losses paid or reserves established in 1986 where there was no reserve at the end of 1985 for pre-1986 accident years, (g) reserve increases for a particular line of business, to the extent that other companies with which the taxpayer has entered into a pool or quota share arrangement have combined reserve weakening for that line of business, and (h) reserve increases attributable to correction of an error in reserve determinations for one or more prior years. Alternatively, the commentator suggested the use of a facts and circumstances test.

 Another commentator asked that reserve strengthening be defined to exclude reserve increases necessary for business reasons. An alternative suggestion was that non-artificial reserve increases be identified based on a runoff of the taxpayer's loss reserves held at the end of 1986.

 The final regulations generally adopt the mechanical test of the proposed regulation. 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 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, 98th 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.

 Proposed section 1.846-3(c)(3)(iii) provided that, for purposes of the reserve strengthening rule applicable to pre-1986 accident years:

reinsurance assumed (ceded) in the final quarter of a taxable year beginning in 1985 is treated as assumed (ceded) during the immediately succeeding taxable year if the appropriate unpaid loss reserve is not adjusted to take into account the reinsurance until that immediately succeeding year.

Several commentators noted that reporting lags of more than one calendar quarter frequently occur in the ceding company's reporting of 1985 loss information to the assuming company. In response to these comments, the final regulations include within the rule reinsurance assumed (ceded) at any time in the taxable year beginning in 1985, if the reserve is not adjusted until the first taxable year beginning in 1986.

 The final regulations also clarify the treatment of reinsurance assumed during the taxable year beginning in 1986 in the determination of reserve strengthening. The final regulations provide that taxpayers take into account neither the end of the year reserve nor the payments made Prior to the end of the year with respect to the assumed reinsurance in determining reserve strengthening. A corresponding clarification is made in the example illustrating this rule.

ADJUSTMENT OF ANNUAL STATEMENT RESERVES

 The final regulations incorporate existing guidance for the two situations in which reserves shown on the annual statement may be increased due to disclosure of additional information. The first situation corresponds to the adjustment of reserves under section 846(b)(2), and the second situation makes the treatment of estimated salvage recoverable in determining unpaid losses symmetrical with the treatment of salvage recoverable provided in the regulations under section 832 of the Code.

TITLE INSURERS

 The final regulations do not allow title insurance companies to make an election to use their historic loss payment pattern for purposes of discounting case reserves. This modification is necessary as the annual statement does not provide the taxpayer with the information necessary to calculate its historical loss payment pattern. Further, as the annual statement does not provide the Secretary with the information necessary to construct a loss payment pattern specifically for case reserves of title insurers, the final regulations requires title insurers to discount their case reserves based on a miscellaneous casualty pattern.

OTHER COMMENTS THAT WERE NOT ADOPTED

 Commentators suggested a number of additional modifications to the proposed regulations. In the consolidated return context, several commentators suggested that a net reserve weakening for one member of an affiliated group should be netted with a net reserve strengthening of another member. Another commentator proposed that the final regulations permit companies included in intercompany pooling arrangements to demonstrate historical experience on a group basis. These comments have not been adopted.

NOTICE 88-100

Sections II, III, and VI of Notice 88-100, 1988-2 C.B. 439, are now obsolete.

EFFECTIVE DATE

 Notice 88-100 set forth guidance regarding the forthcoming regulations that taxpayers were able to rely upon prior to the publication of final regulations. The final regulations follow most of the guidance in Notice 88-100 and provide relief from certain of its rules. Therefore, retaining the effective date announced in Notice 88-100 is appropriate.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Chief Counsel for Advocacy of the small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal authors of these regulations are Katherine A. Hossofsky and Ann H. Logan of the Office of the Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service. Other personnel from the Service and Treasury Department participated in their development.

LIST OF SUBJECTS

 26 CFR 1.801-1 through 1.846

 Income taxes; Insurance companies

Treasury Decision 8433

ADOPTION OF AMENDMENTS TO THE REGULATIONS

For the reasons set forth in the preamble, 26 CFR part 1 is amended as follows:

Part 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 is amended by adding the following citation:

Authority: 26 U.S.C. 7805 * * * Sections 1.846-1 through 1.846-4 also issued under 26 U.S.C. 846.

Par. 2. Sections 1.846-0 through 1.846-4 are added to read as follows:

SECTION 1.846-0 OUTLINE OF PROVISIONS.

The following is a list of the headings in sections 1.846-1 through 1.846-4.

 SECTION 1.846-1 APPLICATION OF DISCOUNT FACTORS.

(a) IN GENERAL -- (1) RULES. A separate series of discount factors are computed for, and applied, to undiscounted unpaid losses attributable to each accident year of each line of business shown on the annual statement (as defined by section 846(f)(3)) filed by that taxpayer for the calendar year ending with or within the taxable year of the taxpayer. See section 1.832-4(b) relating to the determination of unpaid losses. Paragraph (b) of this section provides rules relating to applicable discount factors and section 1.846-3(b) contains guidance relating to discount factors applicable to accident years prior to the 1987 accident year. Once a taxpayer applies a series of discount factors to unpaid losses attributable to an accident year of a line of business, that series of discount factors must be applied to discount the unpaid losses for that accident year for that line of business for all future taxable years. The discount factors cannot be changed to reflect a change in the taxpayer's loss payment pattern during a subsequent year or to reflect a different interest rate assumption. However, discount factors may be changed for taxpayers who elect to use their own historical loss payment pattern, if information upon which the pattern is based is adjusted upon examination by the district director.

(2) EXAMPLES. The following examples illustrate the principles of paragraph (a)(1) of this section:

EXAMPLE 1. A taxpayer discounts unpaid losses attributable to all accident years prior to 1992 using discount factors published by the Service. In 1992, the taxpayer elects, under section 1.846-2, to compute discount factors using its own historical loss payment pattern. The taxpayer must continue to discount unpaid losses attributable to pre-1992 accident years using the discount factors published for those accident years by the Service.

EXAMPLE 2. On its annual statements through 1987, a taxpayer did not allocate unpaid losses attributable to proportional reinsurance to the line of business associated with the risks being reinsured. Beginning with the 1988 annual statement, the taxpayer allocated those losses for all accident years to the line of business being reinsured. The taxpayer must continue to discount the unpaid losses attributable to proportional reinsurance from pre-1988 accident years using the discount factors that were used in determining tax reserves for the 1987 tax year. (See paragraph (b)(3) of this section for rules relating to the application of discount factors to reinsurance unpaid losses.)

(3) INCREASE IN DISCOUNTED UNPAID LOSSES SHOWN ON THE ANNUAL STATEMENT. If the amount of unpaid losses shown on the annual statement is determined on a discounted basis, and the extent to which the unpaid losses were discounted can be determined on the basis of information disclosed on or with the annual statement, the amount of the unpaid losses to which the discount factors are applied shall be determined without regard to any reduction attributable to the discounting reflected on the annual statement.

(4) INCREASING UNPAID LOSSES WHICH TAKE INTO ACCOUNT ESTIMATED SALVAGE RECOVERABLE. If the amount of unpaid losses shown on the annual statement reflects a reduction for estimated salvage recoverable and the extent to which the unpaid losses were reduced by estimated salvage recoverable is appropriately disclosed as required by section 1.832-4(d)(2), the amount of unpaid losses shall be determined without regard to the reduction for salvage recoverable.

(b) APPLICABLE DISCOUNT FACTORS -- (1) IN GENERAL. Except as otherwise provided in section 846(f)(6) (relating to certain accident and health lines of business), in section 1.846-2 (relating to a taxpayer's election to use its own historical loss payment pattern), in this paragraph (b), or in other guidance published in the Internal Revenue Bulletin, the following factors must be used --

(i) DISCOUNT FACTORS PUBLISHED BY THE SERVICE. If the Service has published discount factors for a line of business, a taxpayer must discount unpaid losses attributable to that line by applying those discount factors; and

(ii) COMPOSITE DISCOUNT FACTORS. If the Service has not published discount factors for a line of business, a taxpayer must discount unpaid losses attributable to that line by applying composite discount factors.

(iii) ANNUAL STATEMENT CHANGES. If the groupings of individual lines of business on the annual statement changes, taxpayers must discount the unpaid losses on the resulting lines of business with the discounting patterns that would have applied to those unpaid losses based on their annual statement classification prior to the change.

(2) TITLE INSURANCE COMPANY RESERVES. A title insurance company may only take into account case reserves (relating to claims which have been reported to the insurance company). Unless the Service publishes other guidance, the reserves must be discounted using the "Miscellaneous Casualty" discount factors published by the Service. Section 832(b)(8) provides rules for determining the discounted unearned premiums of a title insurance company.

(3) REINSURANCE BUSINESS -- (i) PROPORTIONAL REINSURANCE FOR ACCIDENT YEARS AFTER 1987. For the 1988 accident year and subsequent accident years, unpaid losses for proportional reinsurance must be discounted using discount factors applicable to the line of business to which those unpaid losses are allocated as required on the annual statement.

(ii) NON-PROPORTIONAL REINSURANCE -- (A) ACCIDENT YEARS AFTER 1991. For the 1992 accident year and subsequent accident years, unpaid losses for non-proportional reinsurance must be discounted using the applicable discount factors published by the Service for the appropriate reinsurance line of business.

(B) ACCIDENT YEARS 1988 THROUGH 1991. For the 1988, 1989, 1990, and 1991 accident years unpaid losses for non-proportional reinsurance must be discounted using composite discount factors.

(iii) REINSURANCE FOR ACCIDENT YEARS BEFORE 1988. If on its annual statement a taxpayer does not allocate unpaid losses to the applicable line of business for proportional or nonproportional reinsurance attributable to the 1987 accident year or a prior accident year, those losses must be discounted using composite discount factors. If on its annual statement a taxpayer allocates to the underlying line of business reinsurance unpaid losses that are attributable to the 1987 accident year or a prior accident year, those losses must be discounted using discount factors applicable to the underlying line of business.

(iv) 90 PERCENT EXCEPTION. For purposes of section 1.846-1(b)(3)(ii) and (iii), if more than 90 percent of all the unallocated losses of a taxpayer for an accident year relate to one underlying line of business, the taxpayer must discount all unallocated reinsurance unpaid losses attributable to that accident year using the discount factors published by the Service for the underlying line of business.

(4) INTERNATIONAL BUSINESS. For any accident year, unpaid losses which are attributable to international business must be discounted using composite discount factors unless more than 90 percent of all losses for that accident year relate to one underlying line of business. If more than 90 percent of all losses for an accident year relate to one underlying line of business, the taxpayer must discount the losses attributable to that accident year using discount factors published by the Service for the underlying line of business.

(5) COMPOSITE DISCOUNT FACTORS. For purposes of the regulations under section 846, "composite discount factors" means the series of discount factors published annually by the Service determined on the basis of the appropriate composite loss payment pattern.

SECTION 1.846-2 ELECTION BY TAXPAYER TO USE ITS OWN HISTORICAL LOSS PAYMENT PATTERN.

(a) IN GENERAL. If a taxpayer has one or more eligible lines of business in a determination year, the taxpayer may elect on the taxpayer's timely filed Federal income tax return for the determination year to discount unpaid losses using its own historical loss payment pattern instead of the industry-wide pattern determined by the Secretary. A taxpayer making the election must use its own historical loss payment pattern in discounting unpaid losses for each line of business that is an eligible line of business in that determination year. The election applies to accident years ending with the determination year and to each of the four succeeding accident years. If a taxpayer makes the election for the 1987 determination year, the taxpayer must use its 1987 loss payment pattern (determined by reference to its 1985 annual statement) to discount unpaid losses attributable to all accident years prior to 1988.

(b) ELIGIBLE LINE OF BUSINESS -- (1) IN GENERAL. A line of business is an eligible line of business in a determination year if, on the most recent annual statement filed by the taxpayer before the beginning of that determination year, the taxpayer reports losses and loss expenses incurred (in Schedule P, part 1, column 24 of the 1990 annual statement or comparable location in an earlier or subsequently revised blank) for at least the number of accident years for which losses and loss expenses incurred for that line of business are required to be separately reported on that annual statement. For example, for the 1987 determination year, the 1985 annual statement is used. The annual statement to be used to determine eligibility in subsequent determination years is the annual statement for each fifth year after 1985 (e.g., 1990, 1995, etc.).

(2) OTHER PUBLISHED GUIDANCE. A line of business is also an eligible line of business for purposes of the election if the line is an eligible line under requirements published for this purpose in the Internal Revenue Bulletin.

(3) SPECIAL RULE FOR 1987 DETERMINATION YEAR. A line of business is an eligible line of business in the 1987 determination year if it is eligible under paragraph (b)(1) or (2) of this section, or if on the most recent annual statement filed by the taxpayer before the beginning of the 1987 determination year, the taxpayer reports written premiums for the line of business for at least the number of accident years that unpaid losses for that line of business are required to be separately reported on that annual statement.

(c) ANTI-ABUSE RULE. To prevent avoidance of the requirement that the election to use historical loss payment patterns apply to all eligible lines of business of a taxpayer, the district director may --

(1) Nullify a taxpayer's election to compute discounted unpaid losses based on its historical loss payment pattern;

(2) Adjust a taxpayer's historical loss payment pattern; or

(3) Make other proper adjustments.

SECTION 1.846-3 FRESH START AND RESERVE STRENGTHENING.

(a) IN GENERAL. Section 1023(e) of the Tax Reform Act of 1986 ("the 1986 Act") provides rules relating to fresh start and reserve strengthening. For purposes of section 1023(e) of the 1986 Act, a taxpayer must discount its unpaid losses as of the end of the last taxable year beginning before January 1, 1987. The excess of undiscounted unpaid losses over discounted unpaid losses as of that time is not required to be included in income, except (as provided in paragraph (e) of this section) to the extent of any "reserve strengthening" in a taxable year beginning in 1986. The exclusion from income of this excess is known as "fresh start." The amount of fresh start is, however, included in earnings and profits for the first taxable year beginning after December 31, 1986.

(b) APPLICABLE DISCOUNT FACTORS -- (1) CALCULATION OF BEGINNING BALANCE. For purposes of section 1023(e) of the 1986 Act, a taxpayer discounts unpaid losses as of the end of the last taxable year beginning before January 1, 1987 --

(i) By using the same discount factors that are used in the succeeding taxable year to discount unpaid losses attributable to the 1987 accident year and prior accident years (see section 1023(e)(2) of the 1986 Act); and

(ii) By applying those discount factors as if the 1986 accident year were the 1987 accident year.

(2) EXAMPLE. The following example illustrates the principles of this paragraph (b):

EXAMPLE. X, a calendar year taxpayer, does not make an election in 1987 to use its own historical loss payment pattern. When X computes discounted unpaid losses for its last taxable year beginning before January 1, 1987, the discount factor for AY+0 published in Rev. Rul. 87-34, 1987-1 C.B. 168, must be applied to unpaid losses attributable to the 1986 accident year; the discount factor for AY+1 is applied to unpaid losses attributable to the 1985 accident year; etc.

(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 section 1023(e)(3)(B) of the 1986 Act, the amount of reserve strengthening (weakening) must be determined separately for each unpaid loss reserve by applying the rules of this 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 estimates for losses (whether or not reported) incurred in an accident year of a line of business.

(2) ACCIDENT YEARS AFTER 1985 -- (i) IN GENERAL. The amount of reserve strengthening (weakening) for an unpaid loss reserve for an accident year after 1985 is the amount by which that reserve at the end of the last taxable year beginning in 1986 exceeds (is less than) a hypothetical unpaid loss reserve.

(ii) HYPOTHETICAL UNPAID LOSS RESERVE. For purposes of this paragraph (c)(2), the term "hypothetical unpaid loss reserve" means a reserve computed for losses the estimates of which were included, at the end of the last taxable year beginning in 1986, in the unpaid loss reserve for which reserve strengthening (weakening) is being determined. The hypothetical unpaid loss reserve must be computed using the same assumptions, other than the assumed interest rates in the case of reserves determined on a discounted basis for annual statement reporting purposes, that were used to determine the 1985 accident year reserve, if any, for the line of business for which the hypothetical reserve is being computed. If there was no 1985 accident year reserve for that line of business, the hypothetical unpaid loss reserve is the reserve, at the end of the last taxable year beginning in 1986, for which reserve strengthening (weakening) is being determined (and thus there is no reserve strengthening or weakening).

(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. The amount by which a reserve is reduced as a result of reinsurance ceded during a taxable year beginning in 1986 is treated as a loss payment made in that taxable year.

(ii) EXCEPTIONS. Notwithstanding paragraph (c)(3)(i) of this section, the amount of reserve strengthening (weakening) for an unpaid loss reserve for an accident year before 1986 does not include --

(A) An amount added to the reserve in a taxable year beginning in 1986 as a result of a loss reported to the taxpayer from a mandatory state or federal assigned risk pool if the amount of the loss reported is not discretionary with the taxpayer; or

(B) Payments made with respect to reinsurance assumed during a taxable year beginning in 1986 or amounts added to the reserve to take into account reinsurance assumed for a line of business during a taxable year beginning in 1986, but only to the extent that the amount does not exceed the amount of a hypothetical reserve for the reinsurance assumed. The amount of the hypothetical reserve is determined using the same assumptions (other than the assumed interest rates) that were used to determine a reserve for reinsurance assumed for the line of business in a taxable year beginning in 1985.

(iii) CERTAIN TRANSACTIONS DEEMED TO BE REINSURANCE ASSUMED (CEDED) IN 1986. For purposes of this paragraph (c)(3), reinsurance assumed (ceded) in a taxable year beginning in 1985 is treated as assumed (ceded) during the succeeding taxable year if the appropriate unpaid loss reserve is not adjusted to take into account the reinsurance transaction until that succeeding taxable year.

(d) SECTION 845. Any reinsurance transaction that has as one of its purposes the avoidance of the reserve strengthening limitation is subject to section 845.

(e) TREATMENT OF RESERVE STRENGTHENING. The fresh start provision of section 1023(e)(3)(A) of the 1986 Act does not apply to the portion of the taxpayer's unpaid losses attributable to reserve strengthening. Thus, the difference between the undiscounted unpaid losses attributable to reserve strengthening and the discounted unpaid losses attributable to reserve strengthening must be included in income and, therefore, included in earnings and profits for the first taxable year beginning after December 31, 1986. The amount that a taxpayer must include in income for its first taxable year beginning after December 31, 1986, as a result of reserve strengthening is equal to the excess (if any) of --

(1) The sum of each amount of reserve strengthening multiplied by the difference between 100 percent and the discount factor that, under paragraph (b) of this section, is applicable to the unpaid loss reserve which was strengthened; over

(2) The sum of each reserve weakening multiplied by the difference between 100 percent and the discount factor that, under paragraph (b) of this section, is applicable to the unpaid loss reserve which was weakened.

(f) EXAMPLES. The following examples illustrate the principles of this section. For purposes of these examples, it is assumed that the taxpayers are property and casualty insurance companies that in 1987 did not elect to use their own historical loss payment patterns.

EXAMPLE 1. (i) As of the end of 1985, X, a calendar year taxpayer, had undiscounted unpaid losses of $1,000,000 in the workers' compensation line of business for the 1984 accident year. The same reserve had undiscounted unpaid losses of $900,000 at the end of 1986. During 1986, X's loss payments for this reserve were $300,000. Accordingly, under paragraph (c)(3)(i) of this section, X has a reserve strengthening of $200,000 ($900,000 - ($1,000,000 - $300,000)).

(ii) This was X's only reserve strengthening or weakening. Thus, under paragraph (e) of this section, for 1987 X must include in income $54,361.40 ($200,000 x (100% - 72.8193%)). The factor of 72.8193% is the AY+2 factor from the workers' compensation series of discount factors published in Rev. Rul. 87-34, 1987-1 C.B. 168.

EXAMPLE 2. The facts are the same as in Example 1, except that X's 1986 loss payments for the reserve were $1,100,000. If only paragraph (c)(3)(i) of this section were applied, X would have a $1,000,000 reserve strengthening ($900,000 - ($1,000,0000 - $1,100,000)). Under paragraph (c)(1) of this section, however, the amount of reserve strengthening for the reserve is limited to the amount of the reserve at the end of 1986. Accordingly, X has a reserve strengthening of $900,000 and for 1987 must include in income $244,626.30 ($900,000 x (100% - 72.1893%)).

EXAMPLE 3. (i) As of the end of 1985, Y, a calendar year taxpayer, had undiscounted unpaid losses of $1,000,000 in the auto physical damage line of business for the 1985 accident year. The same reserve included undiscounted unpaid losses of $600,000 at the end of 1986. During 1986, Y had loss payments of $300,000 for this line of business. Under paragraph (c)(3)(i) of this section Y has a $100,000 reserve weakening ($600,000 - ($1,000,000 - $300,000)).

(ii) Under paragraph (e) of this section, the only effect of the reserve weakening is to reduce the amount that Y is required to include in income as a result of any strengthening of another reserve.

EXAMPLE 4. The facts are the same as in Example 1 except that X also has a $100,000 reserve weakening for the 1985 accident year in its auto physical damage line of business. Under paragraph (b) of this section, the reserve discount factor for the reserve is 93.3400, the AY+1 factor from the auto physical damage series of discount factors published in Rev. Rul. 87-34. Thus, under paragraph (e) of this section, the amount that X is required to include in income in 1987 is reduced by $6,660 ($100,000 x (100% - 93.3400%)), resulting in an amount of $47,761.40 ($54,361.40 - $6,660).

EXAMPLE 5. (i) At the end of 1985, Z, a calendar year taxpayer, had undiscounted unpaid losses of $1,000,000 in the workers' compensation line of business for the 1984 accident year. On May 1, 1986, Z ceded $130,000 of the reserve to an unrelated reinsurer. Z added $250,000 to the 1985 year end reserve to take into account workers' compensation risks for the 1984 accident year that Z assumed in a reinsurance transaction on September 1, 1986. Z had $230,000 of 1986 loss payments related to the 1984 accident year of its workers' compensation line, $60,000 of which was attributable to the reinsurance assumed by Z. At the end of 1986, Z's reserve for the workers' compensation line for the 1984 accident year was $1,100,000.

(ii) If only paragraph (c)(3)(i) of this section were applied, Z would have a $460,000 reserve strengthening ($1,100,000 - ($1,000,000 - 230,000 - $130,000)). Under paragraph (c)(3)(ii)(B) of this section, however, reserve strengthening does not include the $250,000 that Z added to the reserve to take into account the reinsurance assumed. Also, none of the $60,000 of loss payments attributable to the reinsurance assumed in 1986 are taken into account. Accordingly, Z has $150,000 of reserve strengthening ($460,000 - $250,000 - $60,000). If this is Z's only reserve strengthening or weakening, then the amount that Z must include in income for 1987 under paragraph (e) of this section is $40,771.05 ($150,000 x (100% - 72.8193%)). The factor of 72.8193% is the AY+2 factor from the workers' compensation series of discount factors published in Rev. Rul. 87-34.

EXAMPLE 6. (i) X was a calendar year taxpayer before July 1, 1986, the date on which X became a member of an affiliated group of corporations that files a consolidated return with a June 30 year end. Thus, X had two taxable years beginning in 1986: a short taxable year ending June 30, 1986, and a fiscal taxable year ending June 30, 1987.

(ii) As of the end of 1985, X had undiscounted unpaid losses of $800,000 in the automobile liability line of business for the 1983 accident year. At the end of the short taxable year, X had reserves of $700,000 of undiscounted unpaid losses, and on June 30, 1987, had reserves of $600,000 of undiscounted unpaid losses. During the short taxable year, ending June 30, 1986, X's loss payments for this reserve were $120,000. During the taxable year ending June 30, 1987, X's loss payments for this reserve were $180,000. Under paragraph (c)(3)(i) of this section, X has a $100,000 reserve strengthening: of which $20,000 ($700,000 - ($800,000 - $120,000)) is attributable to the short taxable year ending June 30, 1986 and $80,000 ($600,000 - ($700,000 - $180,000)) is attributable to the taxable year ending June 30, 1987.

(iii) The amount of reserve strengthening for this line of business is determined pursuant to the principles of paragraph (c)(2) of this section.

SECTION 1.846-4 EFFECTIVE DATE.

Sections 1-846-1 through Sections 1.846-3 apply to taxable years beginning after December 31, 1986.