Are Reserves For Bad Faith Claims Deductible By A Life Insurance Company?

In an important decision for insurance companies, the Seventh Circuit held in State Farm that extra-contractual obligations (“ECOs”) of a property/casualty company that are claims-related compensatory damages (e.g., bad faith claims) are properly included in deductible unpaid losses under I.R.C. § 832(b)(5). State Farm had included a $202 million award of compensatory and punitive damages (and related interest) in its loss reserves on its annual statements and tax returns for 2001 and 2002. On audit, the IRS disallowed the loss reserve deduction arguing that the damages did not arise as claims under an insurance contract and, therefore, should be deducted on an accrual basis in the same manner as other contested liabilities. The Tax Court agreed with the IRS’s position, holding that the damages were not losses incurred “on insurance contracts” as required by I.R.C. § 832(b) (5).

In the Tax Court litigation, neither the parties nor the court made any distinction between compensatory ECOs and punitive damages. This situation changed on appeal in the Seventh Circuit. Several property/casualty insurance trade associations jointly filed an amicus brief with the court in which they argued that statutory accounting principles distinguish between compensatory ECOs and punitive damages. Claims-related compensatory ECOs are properly included in losses, i.e., treated for accounting purposes as claims. Relying on the amicus brief, the Seventh Circuit reversed the Tax Court’s decision as it related to compensatory ECOs but upheld the lower court denying a loss reserve deduction for contested punitive damages.

The Seventh Circuit’s opinion has received a lot of attention because of its rejection of the IRS’s position on a fundamental principle of insurance company taxation. The Internal Revenue Code provisions governing property/casualty insurance company taxation defer to NAIC accounting for computation of underwriting income. The IRS’s position is that the Code’s deference to NAIC accounting does not encompass the types of items that are taken into account in underwriting income for federal income tax purposes; the Code only defers to annual statement accounting once the elements of under-writing income are determined by interpreting the Code and regulations. In the case of ECOs, the IRS pursued its position arguing that NAIC accounting guidance is irrelevant and that claims-related compensatory ECOs cannot be characterized as insurance claims. The IRS contended ECOs flunk a threshold tax test for loss reserve treatment-ECOs are not losses incurred “on insurance contracts.”

The Seventh Circuit rejected the IRS’s narrow interpretation of the Code’s deference to NAIC accounting principles. The court noted that the statute requires the use of NAIC annual statement accounting for underwriting income generally, and for unpaid losses specifically. The court concluded that, to the extent the NAIC has dictated that claims-related compensatory ECOs are required to be included in underwriting income as part of losses incurred, there is no room in the statute for the IRS to second-guess the NAIC and contend that particular classes of losses are not “on insurance contracts” within a non-NAIC tax definition imposed by I.R.C. § 832(b)(5). In other words, the deference to NAIC accounting broadly includes the measurement of underwriting income as a whole, not just the timing of particular items once the items included in underwriting income are determined by tax law.