Acuity, A Mut. Ins. Co., & Subsidiaries v. Comm'r

T.C. Memo. 2013-209

UNITED STATES TAX COURT

ACUITY, A MUTUAL INSURANCE COMPANY, AND SUBSIDIARIES,
Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9421-11. Filed September 4, 2013.

Held: Evidence that insurance company A’s loss reserves (1)
were actuarially computed in accordance with the rules of the
National Association of Insurance Commissioners (NAIC) and the
Actuarial Standards of Practice (ASOPs) and (2) fell within a range of
reasonable reserve estimates as determined by A’s appointed actuary
in accordance with the ASOPs is highly probative in establishing that
A’s loss reserves are fair and reasonable and represent only actual
unpaid losses within the meaning of sec. 1.832-4(a)(14) and (b),
Income Tax Regs.

Held, further, A’s carried loss reserves of $660,639,385 for
2006 are fair and reasonable and represent only actual unpaid losses.
 -2-

[*2] Michael M. Conway, Richard F. Riley Jr., George R. Goodman, and

Katherine D. Spitz, for petitioner.

Alan M. Jacobson, Laurie A. Nasky, and Jan E. Lamartine, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined deficiencies of $1,072,933 for

2005 and $30,678,144 for 2006 in the Federal income tax of Acuity, A Mutual

Insurance Company (Acuity), and Subsidiaries (collectively, petitioner). After

concessions,1 the sole issue remaining for decision is whether Acuity’s yearend

reserves for unpaid losses and loss adjustment expenses (carried loss reserves) of

$660,639,385 for 2006, as used in computing “losses incurred” within the

meaning of section 832(b)(5),2 are a “fair and reasonable” estimate and represent

1
In the notice of deficiency, respondent disallowed petitioner’s claimed
deductions for guaranty fund expenses in the amounts of $3,065,523 and $222,250
for 2005 and 2006, respectively. Respondent now concedes that petitioner is
entitled to these deductions.
2
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the year at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. All amounts are rounded to the
nearest dollar.
 -3-

[*3] “only actual unpaid losses” within the meaning of section 1.832-4(a)(14) and

(b), Income Tax Regs.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of

facts, the supplemental stipulation of facts, and the accompanying exhibits are

incorporated herein by this reference.

I. Background on Acuity

Petitioner is a group of corporations that filed consolidated Federal income

tax returns for 2006. Acuity is the common parent of the consolidated group.3

Acuity is a mutual property and casualty insurance company organized as a

corporation under the laws of the State of Wisconsin.4 In 2006 Wisconsin was

Acuity’s State of domicile and principal place of business.

In the decade before 2006 Acuity’s mix of business changed dramatically.

In 1997 Acuity’s written premiums of approximately $229 million were divided

3
Acuity was incorporated on August 11, 1925, as the Mutual Automobile
Insurance Company of the Town of Herman. It changed its name in May 1954 to
Mutual Auto Insurance Company of Wisconsin and again in December 1957 to
Heritage Mutual Insurance Company. It adopted its present name of Acuity in
June 2001. For convenience of the reader, we henceforth refer to the company as
Acuity regardless of the legal name of the company in effect at the time of the
event described.
4
Acuity is owned by its policyholders.
 -4-

[*4] almost equally between personal lines and commercial lines. Acuity wrote

approximately 71% of the premiums in Wisconsin and the remaining

approximately 29% in 11 other States: Illinois, Indiana, Iowa, Kentucky,

Michigan, Minnesota, Nebraska, North Dakota, Ohio, South Dakota, and

Tennessee.

In the following years Acuity experienced tremendous growth, far in excess

of the property and casualty insurance industry averages. Acuity’s written

premiums grew by an average of 13.3% for the five-year period 1997-2001

compared to the industry average of 3.9% as reported on Acuity’s Annual Report

for 2001. Acuity continued posting double-digit growth each year from 2002 to

2004. Acuity’s growth tapered off in 2005 and 2006 to 9.3% and 6.1%,

respectively, but at the same time, industry growth was just 0.7% and 2.0% for

those two years as reported on Acuity’s Annual Report for 2006. All in all,

Acuity’s written premiums of approximately $803 million in 2006 had more than

tripled from 1997.

Acuity’s mix of business changed dramatically both by State and by line of

insurance. Acuity’s written premiums in Tennessee grew from $186,147 in 2000

to over $18 million in 2006. Acuity’s written premiums increased almost 5-fold in

Illinois and more than 18-fold in Michigan during this same time period. Other
 -5-

[*5] States saw more modest increases and some saw year-to-year decreases.

Acuity’s written premiums decreased in Ohio in 2004 and 2005 and decreased in

Indiana, Minnesota, Nebraska, and Wisconsin in 2006. Acuity also entered some

new States. It began writing insurance in Missouri in 2004 and in Arizona and

Kansas in 2006.

In its home State of Wisconsin, Acuity’s written premiums grew from

approximately $199.6 million in 2000 to approximately $328.2 million in 2006, an

average annual growth rate of almost 9%. However, as a percentage of its total

written premiums, Acuity’s written premiums in Wisconsin decreased every year

from 2000 to 2006. This is so because Acuity was growing at an even faster rate

in other States. In 2006 Acuity wrote approximately 40.9% of its total premiums

in Wisconsin compared to approximately 60.1% in 2000 and approximately 71%

in 1997. The composition of the premiums had also changed from an

approximately 50-50 split between commercial and personal lines in 1997.

Acuity’s growth rate in commercial lines was much faster than in personal lines,

so much so that in 2006 Acuity wrote approximately 80% of its total premiums in

commercial lines and only approximately 20% in personal lines.

The following table shows Acuity’s written premiums for 2006 for each of

the 15 States in which it did business:
 -6-

[*6] State Written premiums Percentage of total
Arizona $8,971,950 1.1
Illinois 114,379,204 14.2
Indiana 37,362,359 4.7
Iowa 43,238,597 5.4
Kansas 3,017,995 0.4
Kentucky 19,856,868 2.5
Michigan 33,839,133 4.2
Minnesota 61,131,468 7.6
Missouri 31,269,247 3.9
Nebraska 13,933,303 1.7
North Dakota 12,365,939 1.5
Ohio 45,047,564 5.6
South Dakota 31,602,368 3.9
Tennessee 18,970,695 2.4
Wisconsin 328,194,668 40.9
Total 803,181,358 100.0

II. Lines of Insurance

Acuity writes policies in many different lines of insurance. The following

table shows Acuity’s written premiums for 2006 by line of insurance as a

percentage of its total premiums as reported on Acuity’s Annual Statement for

2006:
 -7-

[*7] Annual statement lines Percentage of total premiums1

Fire 2.7
Allied lines 2.0
Homeowners multiple peril 5.3
Commercial multiple peril 9.8
Inland marine 3.1
Workers compensation 29.8
Other liability-occurrence 10.6
Products liability-occurrence 1.3
Private passenger auto liability 8.0
Commercial auto liability 14.5
Auto physical damage 12.2
Fidelity 0.1
Surety -0-
Burglary & theft -0-
Boilery & machinery 0.4
1
Percentages do not add up to 100% because of rounding.

Acuity’s insurance policies are written on an occurrence basis (as opposed

to a claims made basis). An insured is covered under an occurrence-based policy

if a covered event (i.e., an accident or injury) giving rise to a claim occurs during

the period the policy is in effect. In other words, coverage depends upon the date

of the covered event and not the date on which an insured files a claim. In some
 -8-

[*8] cases, Acuity may not even realize that it faces potential exposure until many

years later.5

A line of insurance can be classified as short tail coverage or long tail

coverage. Short tail coverage refers to a line of insurance in which claims are

generally less complicated and faster to resolve. Auto physical damage and the

property damage components of homeowners multiple peril and commercial

multiple peril are generally short tail coverages because the extent of damage to

property (i.e., an automobile, home, or building) can often be assessed quickly and

quantified accurately. Claims are often closed within a relatively short time.

In contrast, long tail coverage generally refers to more complicated claims

that can stay open for months or even years. These claims may involve damages

that are not readily observable or injuries that are difficult to ascertain. Workers

compensation, which constitutes nearly 30% of Acuity’s business by written

premiums, is generally long tail coverage because of the inherent uncertainty in

determining the extent of an injured worker’s need for medical treatment and loss

5
As discussed infra, events giving rise to a claim which have already
occurred but have not yet been reported to an insurance company are known as
“incurred but not reported” (IBNR).
 -9-

[*9] of wages for time off work.6 Other long tail coverage lines of insurance

include products liability-occurrence, other liability-occurrence, private passenger

auto liability, commercial auto liability, and the portion of homeowners multiple

peril and commercial multiple peril covering liability. Acuity both indemnifies its

policyholders and provides them with a legal defense.

III. Insurance Company Loss Reserves

The insurance industry is unique in that a consumer pays an insurance

company upfront in exchange for a promise of performance if and when a covered

event giving rise to claim occurs. At the point of sale the insurance company does

not know whether it will be called upon to fulfill its promise, when that might

happen, or what that might cost. Loss reserves are the standard means for

managing this uncertainty and for ensuring that an insurance company has

sufficient resources to meet its obligations.

6
Consider, for example, a young worker who suffers a back injury on the
job and undergoes an operation. If the operation is successful, then the worker
may be back to work in a matter of days. But there is a possibility that the
operation may be unsuccessful. Complications might arise necessitating further
treatment. In some cases the worker may require treatment for his or her entire
life, and thus Acuity may face exposure for decades. Moreover, on occasion
Acuity has to reopen closed claims because, for instance, a worker’s condition
unexpectedly worsens or a new medical procedure becomes available.
 - 10 -

[*10] Loss reserves are an estimate of an insurance company’s unpaid losses7

and loss adjustment expenses (LAE).8 In this context, losses refer to the dollar

amounts that an insurance company has paid or will pay to claimants. Losses do

not indicate that an insurance company is unprofitable. Losses are reduced by

salvage and subrogation (S & S)9 recoveries. Unpaid losses are equal to the sum

of an insurance company’s case reserves10 and IBNR.11 Unpaid losses can also be

7
Unpaid losses are the future amounts that an insurance company expects
to pay on claims existing as of a given date.
8
LAE are the costs of administering claims. LAE comprise two
components: (1) allocated loss adjustment expenses (ALAE) and (2) unallocated
loss adjustment expenses (ULAE). ALAE are LAE that are directly attributable to
individual claims, such as the costs of a medical examination or defense attorney.
ULAE are LAE that are not directly attributable to individual claims, such as the
overhead of the claims department.
9
Salvage is an amount that an insurer has recovered or expects to recover
from damaged property that it has obtained through the process of compensating a
claimant. Subrogation is an amount that an insurer has recovered or expects to
recover from a third party who has some responsibility for causing damage to an
insured for which the insurer compensated the insured.
10
Case reserves are estimates of unpaid amounts for claims established by a
claims department for known and reported claims.
11
IBNR is an estimate of the ultimate cost of claims that have not yet been
reported to an insurer, plus an estimate of the inadequacy or redundancy of the
case reserves.
 - 11 -

[*11] expressed as the difference between ultimate losses12 and paid losses.13 Loss

reserves are commonly computed by estimating ultimate losses and LAE and then

subtracting paid losses and LAE. Reinsurance recoveries are subtracted from loss

reserves computed on a direct or gross basis to arrive at loss reserves on a net

basis.

Loss reserves are a liability on an insurance company’s balance sheet.14

An insurance company is required to set aside liquid assets such as cash and

investments to back its loss reserves. There are statutory restrictions as to the type

of these assets and the manner in which they can be invested.

Adverse consequences can result if an insurance company sets its loss

reserves too low or too high. Underreserving accounts for more than 40% of all

insolvencies in the past four decades. Underreserving can lead to downgrades by

ratings agencies, loss of customers, and regulatory action. Overreserving limits

the capital an insurance company can use for other purposes, such as growth,

12
Ultimate losses are an estimate of the total amount that an insurance
company expects to pay on claims existing as of a given date. Ultimate losses
include amounts that have already been paid and amounts that have not yet been
paid.
13
Paid losses are the amounts that an insurance company has already paid
on claims existing as of a given date. Paid losses are known amounts.
14
Acuity’s loss reserves for 2006 were its largest liability.
 - 12 -

[*12] acquisitions, new product development, or geographic expansions.

Moreover, overreserving reduces the surplus of an insurance company, making it

appear less profitable.

Actuarial estimates are inherently uncertain because they are dependent on

future contingent events. The challenge of loss reserving is to predict not only the

incidence of unreported claims, but also the factors influencing the losses on

known claims. Actuarial science and statutory accounting provide a framework for

loss reserving.

IV. Actuarial Science

Actuarial science is the study of the financial costs of risk and uncertainty,

involving the application of mathematics, statistics, and financial theory to assess

the risk that an event will occur and to estimate the ultimate financial cost of events

or liabilities, such as insured events under an insurance company’s policies.

Actuarial science recognizes specific accepted methodologies for computing

insurance company loss reserves. Actuaries are credentialed professionals whose

work involves the application of the recognized standards of actuarial science.

To become an actuary in the United States, an individual needs at minimum

a bachelor’s degree and must pass a rigorous series of exams administrated by a

professional society. The Casualty Actuarial Society (CAS) is the professional
 - 13 -

[*13] society for actuaries who work in the property and casualty insurance

industry. An aspiring actuary must pass seven certification exams to become an

Associate of the CAS and nine certification exams to become a Fellow of the CAS

(FCAS). A credentialed actuary may also become a Member of the American

Academy of Actuaries (MAAA).

The Actuarial Standards Board (ASB) is vested by the professional

actuarial societies with the responsibility for promulgating Actuarial Standards of

Practice (ASOPs) for actuaries providing professional services in the United States.

Actuaries are required to follow the ASOPs by their actuarial societies. In June

2007 the ASB adopted ASOP 43, Property/Casualty Unpaid Claim Estimates, with

an effective date of September 1, 2007. ASOP 43 provides guidance to actuaries in

performing professional services relating to the estimating of unpaid losses and

LAE for property and casualty insurance companies. From May 1988 until June

2007, the Statement of Principles Regarding Property and Casualty Loss and Loss

Adjustment Expense Reserves (CAS Statement of Principles), as adopted by the

board of directors of the CAS, served as the primary guidance relating to the

estimating of unpaid losses and LAE for property and casualty insurance

companies. The CAS Statement of Principles states in relevant part:
 - 14 -

[*14] PRINCIPLES

1. An actuarially sound loss reserve for a defined group of claims
as of a given valuation date is a provision, based on estimates
derived from reasonable assumptions and appropriate actuarial
methods, for the unpaid amount required to settle all claims,
whether reported or not, for which liability exists on a particular
accounting date.

2. An actuarially sound loss adjustment expense reserve for a
defined group of claims as of a given valuation date is a provision,
based on estimates derived from reasonable assumptions and
appropriate actuarial methods, for the unpaid amount required to
investigate, defend and effect the settlement of all claims, whether
reported or not, for which loss adjustment expense liability exists
on a particular accounting date.

3. The uncertainty inherent in the estimation of required provisions
for unpaid losses or loss adjustment expenses implies that a range
of reserves can be actuarially sound. The true value of the liability
for losses or loss adjustment expenses at any accounting date can be
known only when all attendant claims have been settled.

4. The most appropriate reserve within a range of actuarially sound
estimates depends on both the relative likelihood of estimates
within the range and the financial reporting context in which the
reserve will be presented.

V. Statutory Accounting for Insurance Companies

The National Association of Insurance Commissioners (NAIC) is an

organization of insurance regulators from all 50 States, the District of Columbia,

and five U.S. territories. The NAIC is a forum for regulators to coordinate

regulatory efforts and to develop uniform regulatory policy, where uniformity is
 - 15 -

[*15] appropriate. The NAIC describes itself as the United States’ standard-setting

and regulatory support organization for the insurance industry. The NAIC

promulgates a standard financial statement form known as the Annual Statement.

Insurance companies in Wisconsin are regulated by the Wisconsin Office of

the Commissioner of Insurance (WOCI). Acuity is subject to regulation and

oversight by the WOCI. Wisconsin does not have its own Annual Statement

instructions. Instead, insurance companies domiciled in Wisconsin (as is Acuity)

are required to use the NAIC instructions for the Annual Statement. Changes in the

Annual Statement form made by the NAIC are automatically adopted in Wisconsin.

Annual Statements are required to be prepared on the basis of statutory

accounting principles (SAP).15 These accounting principles are specifically made

applicable to insurance companies under State law. Accuracy and completeness of

the Annual Statements are critical to States’ ability to meaningfully monitor

insurance companies’ financial condition, including solvency. Annual Statements

are also reviewed and relied upon by customers, investors, insurance agents,

financial rating organizations, and other insurance industry participants as a report

of an insurance company’s financial condition.

15
Annual Statements are not prepared on the basis of generally accepted
accounting principles (GAAP).
 - 16 -

[*16] Annual Statements are filed with the applicable State insurance regulators

and are public documents. They are signed by officers of insurance companies

under penalty of perjury. Acuity is required to file an Annual Statement of its

financial condition and quarterly statements with the WOCI and with each State in

which it does business.16 In addition, Acuity is required to file a statement of

actuarial opinion prepared and signed by a qualified actuary. This qualified actuary

is known as the appointed actuary. ASOP 36, Statements of Actuarial Opinion

Regarding Property/Casualty Loss and Loss Adjustment Expense Reserves (March

2000), provides guidance to the appointed actuary in preparing the statement of

actuarial opinion.17

NAIC statutory accounting practices and procedures are set forth in the

Accounting Practices and Procedures Manual (AP&P Manual), which is sometimes

referred to as a “codification”. The AP&P Manual is used as the reporting standard

for Annual Statements in Wisconsin. Statements of Statutory Accounting

16
The Annual Statement must be filed with the WOCI on or before
March 1.
17
The ASB adopted ASOP 36 in March 2000 with an effective date of
October 15, 2000. The ASB adopted a revised edition of ASOP 36 in December
2010 with an effective date of May 1, 2011. The revised edition provides
additional clarity and guidance and eliminates redundant language and guidance
that existed between the earlier version of ASOP 36 and ASOP 43. References to
ASOP 36 are to the version adopted in March 2000 except as otherwise noted.
 - 17 -

[*17] Principles (SSAPs) are pronouncements of accounting rules adopted by the

NAIC and are included in the AP&P Manual. SSAP No. 55 entitled “Unpaid

Claims, Losses and Loss Adjustment Expenses” states, among other things, that

“management [of an insurance company] shall record its best estimate of its

liabilities for unpaid claims, unpaid losses, and loss/claim adjustment expenses.”

VI. The Computation of Acuity’s Loss Reserves for 2006

Benjamin M. Salzmann is Acuity’s president and chief executive officer.

He is not an actuary. He did not attempt to compute Acuity’s loss reserves for

2006 (or for any other year). Instead, he and other members of Acuity’s

management deferred to and relied upon the professional judgment of Acuity’s

three fully credentialed actuaries on staff, led by Patrick Tures, FCAS, MAAA.

Mr. Tures graduated from St. Norbert College in De Pere, Wisconsin, in

1987 with degrees in mathematics and business administration. Right after college

he started his actuarial career at Acuity as a pricing analyst. While at Acuity he

began taking the certification exams administered by the CAS. In 1990 he moved

to Kemper Insurance. He worked there for 12 years, rising in the ranks from

actuarial analyst to assistant manager to manager to director. In 1995 he passed the

last of the certification exams and became an FCAS. Soon after he became an

MAAA.
 - 18 -

[*18] In 2002 Mr. Tures returned to Acuity as its vice president--actuarial and

strategic information, the same position that he held in 2006 and as of the date of

trial. Working with Sarah Kemp, FCAS, MAAA, Associate Actuary; Cathy Staats,

FCAS, MAAA, Actuary; and Nathan Baseman, Actuarial Analyst, Mr. Tures

prepared Acuity’s actuarial data and reserve analysis for 2006. He computed

Acuity’s loss reserves for 2006 both on a quarterly basis and at yearend.

Mr. Tures produced approximately 900 pages of actuarial analysis in

performing his loss reserve computations. He used eight separate actuarial

methods to compute Acuity’s estimated ultimate losses.18 The eight methods are

the: (1) paid development method; (2) incurred development method; (3) paid

Bornhuetter-Ferguson (BF) method using ultimate premiums and an expected loss

ratio; (4) incurred BF method using ultimate premiums and an expected loss ratio;

(5) paid BF method using ultimate counts and expected severity; (6) incurred BF

method using ultimate counts and expected severity; (7) paid method using a

weighted average; and (8) incurred method using a weighted average. Mr. Tures

18
The CAS Statement of Principles states: “Selection of the most
appropriate method of reserve estimation is the responsibility of the actuary.
Ordinarily the actuary will examine the indications of more than one method when
estimating the loss and loss adjustment expense liability for a specific group of
claims.”
 - 19 -

[*19] also performed computations under the Brosius method, but in his

professional judgment he decided not to rely upon any of those computations.

The starting point for each of the eight methods is actual data. Where

appropriate, Mr. Tures used Acuity’s historical data. He and his staff had complete

access to Acuity’s claims, underwriting, marketing, and sales data. In States where

Acuity lacked sufficient historical data, he consulted industry data. However, he

did not uncritically substitute industry data in place of Acuity’s historical data.

Instead, he used his best professional judgment in adjusting the industry data and

development patterns to account for Acuity’s trends.19

Each of the eight methods then calls for the selection of various inputs.20

Unlike the actual data that enters into the methods, the inputs are, by and large,

estimated or projected figures selected on the basis of an actuary’s assumptions and

judgment. The inputs and the manner in which they are used vary from method to

method. For example, the paid development method and the incurred development

19
The adjustments resulted in lower loss reserves than would have been the
case had Mr. Tures used the industry data without adjustments.
20
We use the term “inputs” to refer generally to figures an actuary selects
for use in an actuarial method.
 - 20 -

[*20] method use loss development factors21 to estimate ultimate losses. The paid

BF method using ultimate premiums and an expected loss ratio and the incurred BF

method using ultimate premiums and an expected loss ratio use loss development

factors from the paid development method and the incurred development method,

respectively, and a weighting between actual losses and expected losses to estimate

ultimate losses. The paid BF method using ultimate claim counts and expected

severity and the incurred BF method using ultimate claim counts and expected

severity use projected ultimate claim counts and projected ultimate severity to

estimate ultimate losses.

Mr. Tures used his best professional judgment in selecting inputs, taking

into account Acuity’s changing mix of business, rapid growth, evolving claims

patterns,22 increasing litigation costs,23 and other factors.24 He computed estimated

21
Development is defined as the change between dates in the observed
value of some quantity. A loss development factor is a ratio of losses as of one
valuation date to losses as of another valuation date.
22
The frequency (the number of claims per exposure unit of payroll) of
workers compensation claims at Acuity was decreasing but the severity (the
average payment on each claim) was increasing.
23
For example, in Illinois, where Acuity’s business was rapidly increasing,
a greater percentage of claims resulted in litigation as than in Wisconsin.
24
The CAS Statement of Principles states: “Understanding the trends and
changes affecting the data base is a prerequisite to the application of actuarially
(continued...)
 - 21 -

[*21] ultimate losses using each method for each of Acuity’s lines of insurance.25

For some lines, and in particular those with short tail coverages, the methods

24
(...continued)
sound reserving methods. A knowledge of changes in underwriting, claims
handling, data processing and accounting, as well as changes in the legal and
social environment, affecting the experience is essential to the accurate
interpretation and evaluation of observed data and the choice of reserving
methods.”
25
Mr. Tures organized Acuity’s data into 10 lines of insurance for the
reserving process. The following table shows those lines and the corresponding
lines as presented on Acuity’s Annual Statement for 2006:
Acuity’s lines of insurance Annual statement lines of insurance
Homeowners Homeowners multiple peril
Workers compensation Workers compensation
Business Package (Bis-Pak) Commercial multiple peril
Commercial auto liability Commercial auto liability
Commercial auto physical damage Auto physical damage
General liability Products liability-occurrence;
Other liability-occurrence
Property, inland marine, glass, crime, Fire; allied lines; inland marine;
surety and fidelity fidelity; surety; burglary and
theft; boiler and machinery
Umbrella Other liability-occurrence
Personal auto liability Private passenger auto liability
Personal auto physical damage Auto physical damage
 - 22 -

[*22] produced similar outputs.26 For example, for Acuity’s commercial auto

physical damage line, the lowest output was an estimated ultimate loss of

$27,971,596 while the highest output was an estimated ultimate loss of

$28,904,742 for accident year 2006. For other lines, and in particular those with

long tail coverages, the outputs of the methods varied considerably. For example,

for Acuity’s umbrella line, the lowest output was an estimated ultimate loss of

$283,988 while the highest output was an estimated ultimate loss of $33,429,330

for accident year 2006.

Mr. Tures likewise used his best professional judgment in selecting

estimated ultimate losses from the outputs of the eight methods. His selection

techniques, varying by accident year and line of insurance, included taking the

simple average of the outputs of all eight methods, the weighted average of the

outputs of two or more methods, and the output of a particular method. For the

more recent accident years, where the data is immature, he placed greater reliance

upon the BF methods. He arrived at total expected27 estimated ultimate losses of

$2,694,363,797 as of yearend for 2006.

26
We use the term “outputs” to refer generally to the results produced by an
actuarial method.
27
Mr. Tures used the terms “expected” and “selected” synonymously in
referring to his best estimates.
 - 23 -

[*23] Mr. Tures used three actuarial methodologies28 in computing estimated

ultimate ALAE and anticipated ultimate S & S. As was the case with estimated

ultimate losses, Mr. Tures used his best professional judgment in selecting inputs to

and outputs from the methods. He arrived at total expected estimated ultimate

ALAE of $231,549,614 and total expected anticipated ultimate S & S of

($143,706,661) as of yearend for 2006. He added the total expected estimated

ultimate losses, total expected estimated ultimate ALAE, and ULAE reserves,

netted out the total expected anticipated ultimate S & S, and subtracted the paid

losses and LAE to arrive at expected loss reserves of $716,097,187 on a direct

basis for 2006. He subtracted ceded reserves attributable to reinsurance recoveries

of $55,457,797 from the expected loss reserves of $716,097,187 on a direct basis to

arrive at expected loss reserves of $660,639,385 on a net basis for 2006.29

28
He used the paid ALAE development method, the paid ALAE to paid
loss development method, and the BF method in computing his estimated ultimate
ALAE. He used the paid S & S method, the paid S & S to paid loss development
method, and the BF method in computing his anticipated ultimate S & S.
29
Three sheets in Mr. Tures’ workpapers showing reconciliation to
schedule P of the Annual Statement, a reserve review, and reserve ranges show
Acuity’s loss reserves as $660,639,379, $660,639,387, and $660,639,390,
respectively. The record does not reflect what the small differences in these
reserve amounts are attributable to (they may be attributable to rounding). We
find that these small differences are de minimis. We further find that Mr. Tures’
best estimate for Acuity’s loss reserves was $660,639,385, the average of the three
(continued...)
 - 24 -

[*24] In addition to his expected loss reserves, Mr. Tures computed a loss reserve

range and loss reserves under two hypothetical scenarios. He selected the outputs

of the methods that produced in the aggregate across all accident years and lines of

insurance the lowest and highest estimated ultimate losses, estimated ultimate

ALAE, and anticipated ultimate S & S, in computing the lower and upper bounds,

respectively, of the loss reserve range.30 He arrived at a loss reserve range of

$565,993,168 to $723,239,532 on a net basis for 2006.31 In a process he called

“scenario testing”, Mr. Tures modified his selection of inputs in the methods to

compute loss reserves under two hypothetical scenarios reflecting assumptions that

were more favorable (optimistic scenario) and less unfavorable (pessimistic

scenario) to Acuity than those used in computing his expected loss reserves. He

computed the loss reserves under the optimistic and pessimistic scenarios

independently of his expected loss reserves using the same methods but with

29
(...continued)
amounts and the amount that Acuity’s management adopted and reported on its
Annual Statement for 2006. See infra pp. 25-26, 31.
30
Because S & S reduces losses, Mr. Tures used the lowest anticipated
ultimate S & S in computing the upper bound of the loss reserve range and vice
versa.
31
The loss reserve range would have been much wider had Mr. Tures
selected the lowest or highest output for each accident year or line of insurance
separately.
 - 25 -

[*25] different inputs. He arrived at loss reserves of $600,581,261 under the

optimistic scenario and loss reserves of approximately $714 million under the

pessimistic scenario.32 The following table shows the loss reserves Mr. Tures

computed for 2006:

Net loss reserves Amount
Lower bound of range $565,993,168
Optimistic scenario 600,581,261
Best estimate/expected 660,639,385
Pessimistic scenario 714,000,000
Upper bound of range 723,239,532

VII. Acuity’s Management Approves Mr. Tures’ Expected Loss Reserves

Mr. Tures submitted to Acuity’s management his expected loss reserves of

$660,639,385 for approval. His expected loss reserves were his best estimate of

the amount Acuity would ultimately be expected to pay for all losses, including

LAE, over the amount it had already paid as of yearend 2006. In his professional

opinion, his expected loss reserves made a reasonable provision for Acuity’s

unpaid losses and LAE.33 He did not request management’s approval for any other

32
The record does not reflect the exact amount Mr. Tures computed for the
loss reserves under the pessimistic scenario.
33
Mr. Tures did not consider Federal income tax consequences in his loss
reserve analysis.
 - 26 -

[*26] loss reserve amount, nor did management suggest that he do so.

Management approved of his expected loss reserves of $660,639,385 and adopted

that amount without change as Acuity’s carried loss reserves for 2006.34

VIII. Independent Analysis of Acuity’s Loss Reserves

As part of his “systematic checks and balances”, Mr. Salzmann had an

outside consulting actuary independently review Acuity’s loss reserves each year

and prepare a statement of actuarial opinion. Acuity’s board of directors selected

John R. Kryczka as Acuity’s appointed actuary for 2006.

Mr. Kryczka is an FCAS, a Fellow of the Canadian Institute of Actuaries

(FCIA), and an MAAA. He has worked in the insurance industry since 1983 with a

concentration primarily in property and casualty insurance. In November 1992 he

joined the accounting firm of PricewaterhouseCoopers LLP (PwC) as a senior

consulting actuary.35 In 2006 he was a director at PwC, and he had been promoted

to managing director by the time of trial.

The purpose of Mr. Kryczka’s engagement was to determine whether

Acuity’s carried loss reserves of $660,639,385 (i.e., Mr. Tures expected loss

34
Carried loss reserves are the loss reserves reported by an insurance
company on its Annual Statement.
35
The accounting firm was known as Coopers & Lybrand at the time.
 - 27 -

[*27] reserves as adopted by Acuity’s management) fell within a range of

reasonable reserve estimates.36 Mr. Kryczka was not asked to opine on a particular

amount that he believed Acuity should report as its carried loss reserves.37 Under

ASOP 36, sec. 3.3.2, Mr. Kryczka could issue one of five types of opinions:

a. Determination of Reasonable Provision--When the stated reserve
amount is within the actuary’s range of reasonable reserve estimates
(see section 3.6.4), the actuary should issue a statement of actuarial
opinion that the stated reserve amount makes a reasonable provision
for the liabilities associated with the specified reserves.

b. Determination of Deficient or Inadequate Provision--When the
stated reserve amount is less than the minimum amount that the
actuary believes is reasonable, the actuary should issue a statement
of actuarial opinion that the stated reserve amount does not make a
reasonable provision for the liabilities associated with the specified
reserves. * * *

c. Determination of Redundant or Excessive Provision--When the
stated reserve amount is greater than the maximum amount that the
actuary believes is reasonable, the actuary should issue a statement
of actuarial opinion that the stated reserve amount does not make a
reasonable provision for the liabilities associated with the specified
reserves. * * *

36
ASOP 36, sec. 3.6.4, states in relevant part: “The actuary may determine
a range of reasonable reserve estimates that reflects the uncertainties associated
with analyzing the reserves. A range of reasonable estimates is a range of
estimates that could be produced by appropriate actuarial methods or alternative
sets of assumptions that the actuary judges to be reasonable.”
37
ASOP 36, sec. 3.3, states in relevant part: “The actuary should document
the scope and intended use of the statement of actuarial opinion.”
 - 28 -

[*28] d. Qualified Opinion--When, in the actuary’s opinion, the reserves
for a certain item or items are in question because they cannot be
reasonably estimated or the actuary is unable to render an opinion
on those items, the actuary should issue a qualified statement of
actuarial opinion. Such a qualified opinion should state whether the
stated reserve amount makes a reasonable provision for the
liabilities associated with the specified reserves, except for the item,
or items, to which the qualification relates. * * *

e. No Opinion--The actuary’s ability to give an opinion is
dependent upon data, analyses, assumptions, and related
information that are sufficient to support a conclusion. If the
actuary cannot reach a conclusion due to deficiencies or limitations
in the data, analyses, assumptions, or related information, then the
actuary may issue a statement of no opinion. * * *

Mr. Kryczka performed an independent actuarial analysis of Acuity’s loss

reserves for 2006 spanning approximately 900 pages. Acuity provided Mr.

Kryczka with its actual data--the same data that Mr. Tures used in his analysis.38

Acuity did not dictate to Mr. Kryczka what actuarial methods to use or what

assumptions to make. Mr. Kryczka and his team met with Acuity’s actuarial team

and its management, including Mr. Salzmann and the vice presidents of claims,

personal lines, and commercial lines, to better understand the changes that were

38
Mr. Kryczka did not have access to Mr. Tures’ workpapers in performing
his actuarial analysis or in issuing his statement of actuarial opinion for 2006. He
could not recall whether he received Mr. Tures’ workpapers afterwards.
 - 29 -

[*29] taking place within Acuity.39 Mr. Kryczka then used his own professional

judgment in determining appropriate actuarial methods to use and selecting inputs

to and outputs from the methods.40

39
ASOP 36, sec. 3.5.2, states in relevant part:

The actuary should consider the likely effect of changing conditions
on the subject loss and loss adjustment expense reserves. The actuary
should consider whether there have been significant changes in
conditions particularly with regard to claims, losses, or exposures that
are new or unusual and that are likely to be insufficiently reflected in
the experience data or in the assumptions used to estimate loss and
loss adjustment expense reserves. * * *
40
ASOP 36, sec. 3.5, states in relevant part:

The appropriate type and extent of reserve analysis will vary with the
nature of the claims and exposures, the historical pattern of loss
development, and the expectation of future conditions as they affect
the liabilities associated with unpaid losses and loss adjustment
expenses. A number of reserve analysis methods are available to and
are used by actuaries. Selection of specific methods, a modification
of such methods, or the development of new methods, should be
based on an understanding of the nature of the claims, the
development characteristics associated with these claims, and the
applicability of various methods to the available data. * * *

Mr. Kryczka used the (1) paid loss development method, (2) incurred loss
development method, (3) BF method using ultimate premiums and paid loss, and
(4) BF method using ultimate premiums and incurred loss to compute estimated
ultimate losses. He used the (1) paid ALAE development method, (2) BF method
using ultimate loss and paid ALAE, and (3) ratio of incremental paid ALAE to
paid loss method to compute estimated ultimate ALAE. He used the (1) S & S
development method and (2) BF method using ultimate loss and S & S to compute
(continued...)
 - 30 -

[*30] Mr. Kryczka computed a point estimate41 of $607,482,000 and a narrow

range of reasonable reserve estimates from $577,108,000 to $661,329,000 around

the point estimate using a PwC process known as Actuarially Determined

Insurance Assets and Liabilities (ADIAL). Under ADIAL, an insurance company’s

loss reserves are reasonable if they fall within the narrow range. No further inquiry

is required. If the loss reserves fall outside the narrow range, the ADIAL process

calls for further analysis to determine whether there is additional variability not

reflected in the narrow range and for a second review by a different actuary in

PwC’s national office to determine whether a wider range of reasonable reserve

estimates might be appropriate and, if so, whether the loss reserves fall within that

wider range.

Mr. Kryczka determined that Acuity’s carried loss reserves of $660,639,385

fell within his narrow range and concluded that the reserves were reasonable. He

prepared and signed a statement of actuarial opinion opining that Acuity’s carried

loss reserves for 2006:

(a) Meet the requirements of the insurance laws of Wisconsin.

40
(...continued)
anticipated ultimate S & S.
41
Mr. Kryczka defined a point estimate as a single number that comes out
of his analysis.
 - 31 -

[*31] (b) Are computed in accordance with generally accepted actuarial
standards and principles.

(c) Make a reasonable provision for all unpaid loss and loss
adjustment expense obligations of the Company [Acuity] under the
terms of its contracts and agreements.

On February 16, 2007, Mr. Kryczka provided the statement of actuarial

opinion to Acuity. Acuity filed the statement of actuarial opinion and its Annual

Statement for 2006 with the WOCI. In the Underwriting and Investment Exhibit of

its Annual Statement for 2006, Acuity reported “Losses” of $507,746,203 and

“Loss adjustment expenses” of $152,893,182,42 the sum of which is Acuity’s

carried loss reserves of $660,639,385. Mr. Salzmann and two other officers of

Acuity signed the Annual Statement for 2006 under penalty of perjury.

IX. Audit of Acuity’s Financial Statements

Acuity prepared its financial statements in accordance with SAP as required

by State insurance regulators. In addition, Acuity prepared a separate set of

financial statements in accordance with GAAP for internal management purposes

and to maintain transparency. Acuity engaged PwC to audit both sets of financial

statements for 2006. Thomas L. Brown (Tom Brown), then a partner at PwC, was

42
The “Losses” and “Loss adjustment expenses” refer to unpaid losses and
LAE on a net basis.
 - 32 -

[*32] in charge of the audit, and Mr. Kryczka served as the actuarial specialist on

the audit team.43

As relevant here, Tom Brown and his team evaluated Acuity’s quality

controls and tested the integrity of the claims that comprised Acuity’s loss reserves,

a material item on Acuity’s balance sheet. The audit team examined a sampling of

claims on a number of criteria, including accuracy of the dates and dollar amounts,

validity under the terms of the insurance contracts, and completeness of the

population as a whole (i.e., no missing claims or sequential gaps).44 The audit team

did not find anything that would render Acuity’s financial statements unreasonable

or potentially misleading, and so PwC issued Acuity an “unqualified opinion”45 as

to both the SAP and GAAP financial statements.

X. A.M. Best Company

The A.M. Best Company (Best) is a rating agency specializing in the

insurance industry. Best evaluates the financial condition of insurance companies

43
At the time of trial, Tom Brown was the chief financial officer of RLI
Corp., an insurance company unaffiliated with Acuity.
44
Some of the items examined by the audit team are part of Acuity’s actual
data entering into the actuarial methods. The audit team did not perform an
actuarial analysis of Acuity’s loss reserves.
45
An “unqualified opinion” is an opinion that a company’s financial
statements are fairly represented in all material respects.
 - 33 -

[*33] and rates them on the basis of the insurance company’s financial solvency,

ability to pay claims, and other factors. Best annually publishes Best’s Insurance

Reports--Property/Casualty, which are a compilation of Best’s individual ratings on

all property and casualty insurance companies it rates.

Best annually reviews Acuity. Gerard Altonji, a financial analyst and

assistant vice president at Best, was the team leader for Acuity’s 2006 review.

Representatives from Best, including Mr. Altonji, met with Acuity’s management,

including Mr. Salzmann, with respect to the review. On March 7, 2007, Wendy

Rae Schuler, Acuity’s treasurer and vice president--finance, sent Best a letter (Best

letter) containing financial information on Acuity. It was standard practice to send

Best this type of letter. Among the many topics discussed in the Best letter was a

paragraph on Acuity’s loss reserves that stated:

As of December 31, 2006, the actuarial net indicated reserves
were $600.5 million with the carried reserves at $660.6 million.
This represents a reserve margin of 10.0% of the indicated reserve
or $60.1 million. ACUITY continues to adhere to the philosophy
that an adequate reserve position is the bedrock of our business
model. This is exhibited in our Claim Department’s rigorous
attention to case reserve adequacy and our heavy scrutiny of
indicated IBNR levels. ACUITY maintains a reserve position
consistent with the risks inherent in the exposure growth we have
assumed from opportunities in the current market.
 - 34 -

[*34] Ms. Schuler, who is not an actuary, wrote this paragraph using information

from Mr. Tures’ workpapers. She did not speak with Mr. Tures in writing the

paragraph. She intended to convey in the first two sentences the information

shown on a sheet in Mr. Tures’ workpapers entitled “12/31/06 Reserve Review”

(Reserve Review sheet).

On the Reserve Review sheet, Mr. Tures shows a comparison in tabular

form between Acuity’s carried loss reserves and the loss reserves he computed

under the optimistic scenario. He used the column heading “Carried” to refer to

Acuity’s carried loss reserves, the column heading “Indicated”46 to refer to the loss

reserves he computed under the optimistic scenario, and the column headings

“Strength” and “% Strength” to refer to the differences in absolute and percentage

terms, respectively, between the “Carried” and “Indicated” reserves.

Ms. Schuler used the term “reserve margin” in the Best letter in place of the

terms “Strength” and “% Strength” in referring to the difference between Acuity’s

carried loss reserves and the loss reserves under the optimistic scenario. She

copied the last three sentences of the paragraph almost word for word from a sheet

46
The CAS Statement of Principles states that an indicated loss reserve is
the result of the application of a particular loss reserving evaluation procedure.
 - 35 -

[*35] entitled “12/31/2006 Reserve Analysis ACUITY Actuarial Results”, which

was part of a presentation to Acuity’s board of directors.

As part of its review, Best calculates a Best Capital Adequacy Ratio

(BCAR) score, which is a ratio of an insurance company’s adjusted policyholder’s

surplus divided by the capital required to support its business risks. The BCAR

score is computed using a risk-based model that assesses the risk of an insurance

company’s assets and liabilities, including loss reserves, for purposes of

determining the capital required to support each of those risks. In computing

Acuity’s BCAR score for 2006, Best determined that Acuity’s carried loss reserves

of $660,639,385 might be deficient by 0.30%.47 The BCAR analysis did not

suggest, either explicitly or implicitly, that Acuity should change its carried loss

reserves. Best provided the BCAR analysis to Acuity’s management.

On April 18, 2007, Mr. Altonji and his team completed Best’s report on

Acuity for 2006. Best gave Acuity an “A+ (Superior)” rating for 2006. Best

described Acuity’s “Reserve Quality” as “maintains conservative reserving

practices, as evidenced by consistently favorable loss reserve development on both

a calendar year and accident year basis. Favorable development has been driven by

47
Applying this percentage to Acuity’s carried loss reserves of
$660,639,385, Best calculated in the BCAR analysis that the carried loss reserves
might be deficient by $1,980,000.
 - 36 -

[*36] the workers’ compensation line although most other major lines of business

have developed favorably as well.”

XI. Loss Reserve Development

“Favorable development” and “unfavorable development” are terms used to

describe downward and upward revisions to loss reserves, respectively. Insurance

companies periodically revise their loss reserve estimates as new information on

existing claims comes to light. The following table shows the development on

Acuity’s carried loss reserves for accident years before 2006 when measured as of

yearend 2006:

Annual Loss and Change in
statement date ALAE reserves reserves % Change
1
12/31/1997 $208,485 ($59,962) (28.76)
12/31/1998 198,935 (40,483) (20.35)
12/31/1999 207,532 (33,159) (15.98)
12/31/2000 222,274 (17,354) (7.81)
12/31/2001 258,496 (13,978) (5.41)
12/31/2002 302,427 (4,933) (1.63)
12/31/2003 384,374 (32,802) (8.53)
12/31/2004 487,263 (58,887) (12.09)
12/31/2005 553,593 (35,157) (6.35)

1
All numbers are in thousands.
 - 37 -

[*37] The following table shows the development on Acuity’s carried loss reserves

for accident year 2006 when measured as of yearend for 2007 through 2011:

Development 2006 Loss and Cumulative
through ALAE reserves change % Change
1
12/31/2007 $623,027 ($25,729) (4.13)
12/31/2008 623,027 (41,027) (6.59)
12/31/2009 623,027 (47,855) (7.68)
12/31/2010 623,027 (71,281) (11.44)
12/31/2011 623,027 (79,919) (12.83)

1
All amounts are in thousands.
XII. Federal Income Taxes

On or about September 12, 2007, petitioner filed Form 1120-PC, U.S.

Property and Casualty Insurance Company Income Tax Return, for 2006. On

Schedule F, Losses Incurred--Section 832, petitioner reported discounted unpaid

losses of $622,717,658.48 That figure represents Acuity’s carried loss reserves of

$660,639,385 for 2006 discounted pursuant to section 846. On February 22, 2011,

respondent mailed petitioner a notice of deficiency in which he determined, inter

alia, that Acuity’s carried loss reserves for 2006 were overstated by $96,129,294.

48
Discounted unpaid losses are used in computing “losses incurred” within
the meaning of sec. 832(b)(5).
 - 38 -

[*38] Respondent adjusted petitioner’s taxable income upward by $96,129,294 and

then made a corollary downward adjustment of $8,699,701 to reflect discounting

under section 846. Petitioner timely petitioned the Court for redetermination.

OPINION

I. Applicable Law

Acuity, as a nonlife insurance company, must compute its taxable income

under section 832. See sec. 831. Under these statutory provisions, gross income

includes amounts earned from investment and underwriting income, “computed on

the basis of the underwriting and investment exhibit of the annual statement

approved by the National Association of Insurance Commissioners”. Sec.

832(b)(1)(A). Underwriting income is defined as “the premiums earned on

insurance contracts during the taxable year less losses incurred and expenses

incurred.” Sec. 832(b)(3). “Losses incurred” means losses incurred during the

taxable year on insurance contracts and includes increases for the year in

“discounted unpaid losses (as defined in section 846)”. Sec. 832(b)(5)(A).49 As

49
Sec. 832(b)(5)(A) provides:

In general.--The term “losses incurred” means losses incurred during
the taxable year on insurance contracts computed as follows:

(continued...)
 - 39 -

[*39] defined in section 846(b)(1), “unpaid losses” generally means “unpaid losses

shown in the annual statement filed by the taxpayer for the year ending with or

within the taxable year of the taxpayer.” Unpaid losses include unpaid LAE. Sec.

832(b)(6).

Taxable income equals gross income, as described supra, less various

deductions allowed pursuant to section 832(c). Sec. 832(a). One of the deductions

allowed is for “losses incurred” as defined in section 832(b)(5).50 Sec. 832(c)(4).

49
(...continued)
(i) To losses paid during the taxable year, deduct salvage and
reinsurance recovered during the taxable year.

(ii) To the result so obtained, add all unpaid losses on life
insurance contracts plus all discounted unpaid losses (as defined in
section 846) outstanding at the end of the taxable year and deduct all
unpaid losses on life insurance contracts plus all discounted unpaid
losses outstanding at the end of the preceding taxable year.

(iii) To the results so obtained, add estimated salvage and
reinsurance recoverable as of the end of the preceding taxable year
and deduct estimated salvage and reinsurance recoverable as of the
end of the taxable year.

The amount of estimated salvage recoverable shall be
determined on a discounted basis in accordance with procedures
established by the Secretary.
50
Although such a deduction would appear potentially duplicative of losses
incurred that are taken into account in determining the underwriting income
component of gross income under sec. 832(b)(3), the statute specifically prohibits
the same item from being deducted more than once. See sec. 832(d).
 - 40 -

[*40] The applicable regulations, which have remained substantively unchanged

since their promulgation in 1944, require the taxpayer to establish that its estimate

of unpaid losses is “fair and reasonable” and represents “only actual unpaid losses.”

Sec. 1.832-4(a)(14), (b), Income Tax Regs. (applicable regulations); see Md.

Deposit Ins. Fund Corp. v. Commissioner, 88 T.C. 1050, 1059 (1987). The

applicable regulations provide as follows:

(14) In computing “losses incurred” the determination of
unpaid losses at the close of each year must represent actual unpaid
losses as nearly as it is possible to ascertain them.

(b) Losses incurred. Every insurance company to which this
section applies must be prepared to establish to the satisfaction of
the district director that the part of the deduction for “losses
incurred” which represents unpaid losses at the close of the taxable
year comprises only actual unpaid losses. See section 846 for rules
relating to the determination of discounted unpaid losses. These
losses must be stated in amounts which, based upon the facts in
each case and the company’s experience with similar cases,
represent a fair and reasonable estimate of the amount the company
will be required to pay. Amounts included in, or added to, the
estimates of unpaid losses which, in the opinion of the district
director, are in excess of a fair and reasonable estimate will be
disallowed as a deduction. The district director may require any
insurance company to submit such detailed information with respect
to its actual experience as is deemed necessary to establish the
reasonableness of the deduction for “losses incurred.”

The validity of the applicable regulations is well established, see, e.g., Hanover Ins.

Co. v. Commissioner, 69 T.C. 260, 272 (1977), aff’d, 598 F.2d 1211 (1st Cir.
 - 41 -

[*41] 1979); Hanover Ins. Co. v. Commissioner, 65 T.C. 715, 719 (1976), and is

not in dispute.

A reserve for unpaid losses is an estimate of the insurer’s liability for

claims that it will be required to pay in future years. See W. Cas. & Sur. Co. v.

Commissioner, 65 T.C. 897, 917 (1976), aff’d on another issue, 571 F.2d 514 (10th

Cir. 1978). Unpaid losses may not be based on estimates of potential losses that

might be incurred in future years but instead must be based on the actual loss

experience of the insurance company. See Md. Deposit Ins. Fund Corp. v.

Commissioner, 88 T.C. at 1060; Hosp. Corp. of Am. v. Commissioner, T.C. Memo.

1997-482. The burden of proof is on the taxpayer to substantiate its claimed

deduction.51 See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Time

Ins. Co. v. Commissioner, 86 T.C. 298, 313-314 (1986).

51
On August 27, 2012, petitioner filed a motion in limine to exclude two of
respondent’s exhibits and to shift the burden of proof to respondent. By order
dated September 4, 2012, the Court took so much of petitioner’s motion as moved
to shift the burden of proof under advisement. In its opening brief, petitioner
withdrew the part of its motion relating to the burden of proof. Accordingly,
petitioner bears the burden of proof.
 - 42 -

[*42] II. The NAIC Annual Statement

A. Seventh Circuit Law

The Court of Appeals for the Seventh Circuit, to which an appeal in this

case would lie absent a stipulation to the contrary, see sec. 7482(b)(1)(A), (2), has

stated that “State insurance commissioners’ preferences about [loss] reserves * * *

are not some intrusion on federal tax policy; using their annual statement is federal

tax law.” Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858, 866 (7th Cir.

1992) (Sears, Roebuck & Co.), aff’g in part and rev’g in part 96 T.C. 61 (1991). In

State Farm Mut. Auto. Ins. Co. v. Commissioner, 698 F.3d 357, 363 (7th Cir. 2012)

(State Farm), aff’g in part, rev’g in part and remanding 135 T.C. 543 (2010), the

Court of Appeals stated that

[b]oth section 832(b)(1) and section 846 * * * refer to the
NAIC-approved annual statement as the source of the unpaid losses
used in calculating gross income. Underwriting income, which
includes losses incurred, must be computed based on the annual
statement. Any doubt about whether the unpaid losses (included in
those losses incurred) are also to be computed according to the
annual statement is resolved by the specific reference to that
statement in section 846. We agree * * * that the NAIC-approved
annual statement provides the rule for computing deductible loss
reserves under section 832, at least where the NAIC has in fact
provided a rule. [Emphasis added.]
 - 43 -

[*43] B. The Parties’ Arguments

The parties dispute what role, if any, the Annual Statement plays in

determining whether an insurance company’s loss reserves are fair and reasonable.

Respondent argues that the “relationship between the Annual Statement and section

832 does not prove that petitioner’s Carried [Loss] Reserve is fair and reasonable.”

Respondent further argues that State Farm and Sears, Roebuck & Co. “hold that the

annual statement controls for what is includible in the loss reserve but not the

amount of the loss reserve itself.”

Petitioner argues that respondent “simply fails to give due recognition to

the expansive embrace of the Annual Statement in determining P&C loss reserves

for tax purposes in State Farm * * * and * * * Sears, Roebuck, and Co.” Petitioner

further argues that “[n]o tax case supports an adjustment to a P&C insurance

company’s ordinary unpaid loss reserves determined by professional actuaries

through accepted actuarial methodologies, and reported on the Annual Statement in

accordance with NAIC statutory accounting guidance--which, of course, is exactly

the situation presented in Acuity’s case.”

The law is well settled that the mere inclusion of an estimated figure on the

Annual Statement, including a loss reserve estimate, does not conclusively

establish its reasonableness for tax purposes. See Hanover Ins. Co. v.
 - 44 -

[*44] Commissioner, 598 F.2d at 1217; Pac. Employers Ins. Co. v. Commissioner,

89 F.2d 186, 187 (9th Cir. 1937), aff’g 33 B.T.A. 501 (1935); Hanover Ins. Co. v.

Commissioner, 65 T.C. at 719 (“[T]he cited cases which held the annual statement

to be conclusive did not involve the reasonableness of the estimated figures

appearing on such statement, but rather the format or methodology of such

statement[.]”). The parties agree to that much. The parties’ disagreement, as we

understand it, is whether the Annual Statement provides any guidance in

computing the amount of a loss reserve estimate, and if so, how does that guidance

factor into determining whether an amount so computed is fair and reasonable for

tax purposes.

C. SSAP No. 55

The relevant NAIC rule governing loss reserves is SSAP No. 55, which

“establishes statutory accounting principles for recording liabilities for unpaid

claims and claim adjustment expenses for * * * unpaid losses and loss adjustment

expenses for property and casualty insurance contracts.” The NAIC recognized in

SSAP No. 55 that “no single claim or loss and loss/claim adjustment expense

reserve can be considered accurate with certainty.” We similarly recognized in

Physicians Ins. Co. of Wis., Inc. v. Commissioner, T.C. Memo. 2001-304

(Physicians Ins.), slip op. at 24, that there is no single “correct” loss reserve
 - 45 -

[*45] estimate, except possibly in hindsight. SSAP No. 55 instead provides that

“management [of an insurance company] shall record its best estimate of its

liabilities for unpaid claims, unpaid losses, and loss/claim adjustment expenses.”

This requirement is in accord with Bituminous Cas. Corp. v. Commissioner, 57

T.C. 58, 78 (1971), wherein we stated that when the Annual Statement

methodology is predicated upon the use of estimates, those estimates must be the

“best possible.”

SSAP No. 55 provides some general principles and considerations in

computing the amount of a loss reserve estimate:

The liability for claim reserves and claim liabilities, unpaid
losses, and loss/claim adjustment expenses shall be based upon the
estimated ultimate cost of settling the claims (including the effects
of inflation and other societal and economic factors), using past
experience adjusted for current trends, and any other factors that
would modify past experience. * * *

Various analytical techniques can be used to estimate the
liability for IBNR claims, future development on reported
losses/claims, and loss/claim adjustment expenses. These
techniques generally consist of statistical analysis of historical
experience and are commonly referred to as loss reserve
projections. The estimation process is generally performed by line
of business, grouping contracts with like characteristics and policy
provisions. The decision to use a particular projection method and
the results obtained from that method shall be evaluated by
considering the inherent assumptions underlying the method and the
appropriateness of those assumptions to the circumstances. No
single projection method is inherently better than any other in all
 - 46 -

[*46] circumstances. The results of more than one method should
be considered.
[Emphasis added.]

SSAP No. 55 reflects the NAIC’s recognition that past experience needs to

be adjusted for current trends and other factors. SSAP No. 55 further reflects the

NAIC’s understanding that each actuarial method has its own set of assumptions

and a single actuarial method is not appropriate in all cases. These principles are

consistent with the applicable regulations, which provide that unpaid “losses must

be stated in amounts which, based upon the facts in each case and the company’s

experience with similar cases, represent a fair and reasonable estimate.” (Emphasis

added.) They are also consistent with our caselaw, which provides that a fair and

reasonable estimate of a taxpayer’s unpaid losses is essentially a valuation issue

and a question of fact. See Hanover Ins. Co. v. Commissioner, 69 T.C. at 270;

Physicians Ins., slip op. at 23; Minn. Lawyers Mut. Ins. Co. v. Commissioner, T.C.

Memo. 2000-203 (Minn. Lawyers), slip op. at 24, aff’d, 285 F.3d 1086 (8th Cir.

2002); Utah Med. Ins. Ass’n v. Commissioner, T.C. Memo. 1998-458 (Utah Med.),

slip op. at 21.

D. The ASOPs, Appointed Actuaries, and Actuarial Opinions

The NAIC rules also require an insurance company to file a statement of

actuarial opinion, prepared and signed by its appointed actuary, with the Annual
 - 47 -

[*47] Statement. The statement of actuarial opinion sets forth, among other things,

the appointed actuary’s opinion as to the reasonableness of the insurance

company’s loss reserves. The appointed actuary is required to follow the ASOPs.

The ASOPs provide objective principles and considerations in computing

loss reserve estimates and ranges, among other things. Thus, the ASOPs provide a

basis for a taxpayer to “objectively validate that the methods and assumptions it

relied upon to make its estimate are reasonable.” Physicians Ins., slip op. at 24.

ASOP 36, in particular, provides guidance to an appointed actuary in issuing a

statement of actuarial opinion. ASOP 36, sec. 3.2.1, provides that the appointed

actuary should consider the CAS Statement of Principles.

Relying on Minn. Lawyers, respondent argues that “[p]etitioner’s attempted

reliance on [Acuity’s appointed actuary at] PwC is unwarranted because PwC did

not review or opine on whether * * * [Acuity’s] Carried Reserve met the standards

for a federal income tax deduction for unpaid losses.” Respondent further argues

that “[p]etitioner’s effort to conflate state regulatory requirements with federal tax

requirements is without merit.” Respondent’s argument misses the mark.

In Minn. Lawyers, the taxpayer’s management added an “adverse

development reserve” onto the case reserves established by the taxpayer’s claims

department. Minn. Lawyers, slip op. at 9-13. We found that the taxpayer failed to
 - 48 -

[*48] prove the necessity of the adverse development reserve. Id. at 34. The

taxpayer’s appointed actuary at Milliman & Robertson, Inc. (Milliman), and

KPMG Peat Marwick (KPMG) issued a statement of actuarial opinion for the first

year in issue and the second and third years in issue, respectively, certifying to the

State regulator that the taxpayer’s loss reserves made a reasonable provision for the

taxpayer’s unpaid losses and LAE. Id. at 38. However, the record did not establish

that such a certification was equivalent to the requirement in the applicable

regulations that loss reserves must be fair and reasonable. Id.

We placed little weight on the appointed actuaries’ certifications that the

taxpayer’s loss reserves were reasonable because the actuarial reports prepared by

those same actuaries indicated the contrary. The taxpayer’s appointed actuary at

Milliman did not compute a range of reasonable reserve estimates. Id. at 36. The

actuary instead computed a “best estimate” that was significantly lower than the

taxpayer’s loss reserves, and the taxpayer did not provide any explanation for the

difference. Id. The taxpayer’s appointed actuary at KPMG likewise computed a

“selected point estimate” that was significantly lower than the taxpayer’s loss

reserves. Id. at 37. Although the actuary computed a range of reasonable reserve

estimates that encompassed the taxpayer’s loss reserves, the range was so large that
 - 49 -

[*49] we could not determine whether every point in the range was fair and

reasonable. Id. at 37-38.

We found that the taxpayer failed to prove that its loss reserves were fair

and reasonable. Id., at 42-43. We concluded that the point estimate of the

Commissioner’s actuarial expert, which exceeded the point estimate of the

taxpayer’s appointed actuary at Milliman, was the best estimate of the taxpayer’s

loss reserves for the first year in issue, and the point estimates of the taxpayer’s

appointed actuary at KPMG were the best estimates for the second and third years

in issue. Id. at 43-45.

In the instant case, Mr. Kryczka, Acuity’s appointed actuary at PwC, issued

a statement of actuarial opinion certifying to the WOCI that Acuity’s carried loss

reserves are reasonable. Petitioner does not argue that Mr. Kryczka’s certification

is tantamount to a sanctification of Acuity’s carried loss reserves as fair and

reasonable for tax purposes. Rather, petitioner argues that “Mr. Kryczka performed

his work and provided his opinion in conformity with professional actuarial and

statutory accounting standards, and opined that Acuity’s carried reserve was

reasonable under those standards. These are the standards that this Court has

looked to in prior loss reserve cases.” We agree.
 - 50 -

[*50] As we determined in Minn. Lawyers, the mere certification by an appointed

actuary that an insurance company’s loss reserves are reasonable is of little

probative value for tax purposes. However, contrary to respondent’s argument,

such is not the case with respect to the actuarial computations of the appointed

actuary underlying that certification. In Minn. Lawyers, while we rejected the

certifications of the taxpayer’s appointed actuary at KPMG, we accepted the point

estimates actuarially computed by the KPMG actuary as the best estimates of the

taxpayer’s loss reserves for the second and third years in issue.

In Physicians Ins., the taxpayer retained the firm Tillinghast-Towers Perrin

(Tillinghast) to compute its loss reserves. Physicians Ins., slip op. at 6. The

taxpayer’s actuary at Tillinghast served as its appointed actuary. Id. at 31. We

found that the taxpayer’s loss reserves were unreasonable because the taxpayer’s

management added a margin of approximately 10% onto the point estimates

actuarially computed by the Tillinghast actuary. Id. at 36. However, as was the

case in Minn. Lawyers for the second and third years in issue, we accepted the

Tillinghast actuary’s point estimates as the best estimates of the taxpayer’s loss

reserves for the two years in issue. Id. at 40.

In Utah Med., the taxpayer also retained the firm of Tillinghast to compute

its loss reserves. Utah Med., slip op. at 9-12. The taxpayer’s actuary at Tillinghast
 - 51 -

[*51] also served as its appointed actuary. Id. at 5. However, unlike the taxpayer

in Physicians Ins., the taxpayer in Utah Med selected its loss reserves each year

from within a range of reasonable reserve estimates actuarially computed by the

Tillinghast actuary. Id. at 12, 22, 27-28. We found that the Tillinghast actuary

complied with all relevant actuarial standards (i.e., the ASOPs). Id. at 24. We

concluded that the taxpayer’s loss reserves were fair and reasonable for the years in

issue. Id. at 35.

In sum, the statement of actuarial opinion is an integral part of the Annual

Statement. The NAIC rules require an insurance company to file a statement of

actuarial opinion prepared and signed by its appointed actuary. The appointed

actuary is required to follow the ASOPs. And the ASOPs, in particular ASOP 36,

provide objectively reasonable guidance to the appointed actuary in computing loss

reserve estimates and ranges for the purpose of opining on the reasonableness of

the insurance company’s loss reserves. Consequently, we find that an appointed

actuary’s actuarial analysis and determination is highly probative for tax purposes.

Respondent’s assertion that petitioner cannot rely on Acuity’s appointed actuary at

PwC is unfounded and contrary to our caselaw.
 - 52 -

[*52] E. Annual Statement Conclusion

“Section 832 is no ordinary rule. It expressly links federal taxes to the

NAIC’s annual statement”. Sears, Roebuck & Co., 972 F.2d at 865-866. And the

“NAIC-approved annual statement provides the rule for computing deductible loss

reserves under section 832, at least where the NAIC has in fact provided a rule.”

State Farm, 698 F.3d at 363. As discussed supra, the NAIC rules do not provide a

mechanical formula, nor does one exist, to calculate the precise amount of loss

reserves required for each insurance company.

Instead, the NAIC rules provide principles and considerations for

computing an estimate of an insurance company’s loss reserves. These principles

and considerations are objectively reasonable and consistent with the applicable

regulations and our caselaw. The ASOPs further provide objectively reasonable

guidance to actuaries for computing loss reserve estimates and ranges. In addition,

the NAIC rules require an insurance company’s appointed actuary to evaluate the

reasonableness of the insurance company’s loss reserves in a statement of actuarial

opinion. The ASOPs, in particular ASOP 36, provide objectively reasonable

guidance to the appointed actuary in this task.

Accordingly, in the factual determination whether an insurance company’s

loss reserves are fair and reasonable and represent only actual unpaid losses, we
 - 53 -

[*53] assign substantial weight to evidence that the loss reserves (1) were

actuarially computed in accordance with the NAIC rules and ASOPs and (2) fell

within a range of reasonable reserve estimates as determined by the insurance

company’s appointed actuary in accordance with the ASOPs.52

III. Mr. Tures’ Actuarial Analysis

A. Qualified Actuary

Mr. Tures, FCAS, MAAA, a qualified and credentialed actuary, computed

Acuity’s loss reserves for 2006. He had at the time almost 20 years of actuarial

experience, including several years as Acuity’s vice president--actuarial and

strategic information. He was intimately familiar with Acuity’s business and had

complete access to Acuity’s claims, underwriting, marketing, and sales data.

52
As described supra p. 27, ASOP 36, sec. 3.3.2(a), provides that “[w]hen
the stated reserve amount is within the actuary’s range of reasonable reserve
estimates (see section 3.6.4), the actuary should issue a statement of actuarial
opinion that the stated reserve amount makes a reasonable provision for the
liabilities associated with the specified reserves.” The revised edition of ASOP 36
renumbered this section and changed some of the terminology, but the concept
remains largely the same. The revised edition of ASOP 36, sec. 3.7, provides that
an “actuary should consider a reserve to be reasonable if it is within a range of
estimates that could be produced by an unpaid claim estimate analysis that is, in
the actuary’s professional judgment, consistent with both ASOP No. 43,
Property/Casualty Unpaid Claim Estimates, and the identified stated basis of
reserve presentation.”
 - 54 -

[*54] B. Selection of Inputs

Mr. Tures began his reserve analysis with actual data based on past

experience. Where appropriate, he used Acuity’s historical data. In States where

Acuity lacked sufficient historical data, he consulted industry data. Following

SSAP No. 55, the CAS Statement of Principles, and the ASOPs, he examined and

adjusted the data to account for Acuity’s changing mix of business, rapid growth

rate, evolving claims patterns, increasing litigation costs, and other factors. Using

his best professional judgment, he then selected appropriate and reasonable inputs

into his actuarial methods.

Respondent argues that Mr. Tures was biased in his selection of inputs,

relying upon high assumptions that are not supported by Acuity’s past experience.

Respondent attacks Mr. Tures’ judgment in selecting paid loss development factors

for accident year 2006 in the workers compensation analysis that were “the average

of the last five years rather than the more recent three years in which the trend was

going down for [development at] 12-24 and 24-36 months.” Respondent similarly

attacks Mr. Tures’ judgment in selecting incurred loss development factors that

were “higher than Acuity’s actual Loss Development.” Respondent shows in his
 - 55 -

[*55] brief the following table of incurred loss development factors selectively

quoted53 from Mr. Tures’ workpapers:

Accident year Development at Development at
12-24 months 24-36 months
2003 1.016 .997
2004 1.022 .987
2005 1.045 .996
Selected [for 2006] 1.078 1.020

Respondent omits from his table earlier accident years, which were shown

on the same page of Mr. Tures’ workpapers and considered in his analysis. For

example, the incurred loss development factor of 1.078 that Mr. Tures selected for

development at 12-24 months for accident year 2006 is lower than Acuity’s

incurred loss development factors of 1.121 for accident year 2001 and 1.187 for

accident year 2002. Furthermore, the incurred loss development factor of 1.078 is

the five-year average (2001-05). Respondent has not cited a single SSAP, ASOP,

or other objective source, nor have we found any, supporting his argument that a

three-year average loss development factor is reasonable whereas a five-year

average loss development factor is somehow unreasonable.

53
Respondent misquotes Mr. Tures’ workpapers in that the incurred loss
development figures for development at 24-36 months respondent shows in his
brief relate to accident years 2002-04 and not 2003-05.
 - 56 -

[*56] Respondent attacks several other figures in Mr. Tures’ workpapers as being

“inappropriately excessive”, “inconsistent with * * * [Acuity’s] actual experience”,

and a product of “Mr. Tures’ poor ‘judgment.’” We are unpersuaded by

respondent’s criticisms of Mr. Tures’ actuarial selections.

SSAP No. 55 states that loss reserves shall be computed “using past

experience adjusted for current trends, and any other factors that would modify past

experience.” The underlying premise is that past experience can be used to predict

future experience. However, implicit in this premise is the recognition that past

experience should not be viewed in a vacuum. Changing conditions both inside

and outside an insurance company can cause future experience to diverge from past

experience. Past experience must thus be appropriately adjusted to reflect these

changing conditions. This is where actuarial judgment comes into play. As the

CAS Statement of Principles appropriately states: “Understanding the trends and

changes affecting the data base is a prerequisite to the application of actuarially

sound reserving methods.”

Mr. Tures credibly testified as to the process by which he used Acuity’s

historical data and industry data, adjusted the data to reflect changing conditions

within and without Acuity, and selected inputs using his sound actuarial judgment.
 - 57 -

[*57] Mr. Tures’ workpapers, consisting of approximately 900 pages of actuarial

analysis, corroborate his testimony.

We find that Mr. Tures made a reasonable selection of inputs in accordance

with his best professional judgment and the principles and considerations embodied

in SSAP No. 55, the CAS Statement of Principles, and the ASOPs. We decline to

substitute respondent’s judgment for Mr. Tures’ professional judgment. See, e.g.,

Physicians Ins., slip op. at 37 (declining to second-guess the professional judgment

of the taxpayer’s actuary).

C. Actuarial Methods and Outputs

Mr. Tures used eight actuarially recognized methods to compute Acuity’s

estimated ultimate losses and three additional methods to compute estimated

ultimate ALAE and anticipated ultimate S & S. He performed computations under

the eight methods and then used his best professional judgment in selecting among

the outputs of the methods. Respondent argues that “[t]he Paid Loss Development

Method and the Paid using 5-year Weighted Average Method have the least

amount of assumptions to be made by the actuary, but Mr. Tures never selected

either of these methods.”54 Respondent seems to imply that those two methods

54
From respondent’s brief, it appears that respondent is referring
specifically to Acuity’s workers compensation line of insurance. Mr. Tures did
(continued...)
 - 58 -

[*58] would have been more appropriate to rely upon because they require fewer

assumptions. However, his argument is contradicted by the express language of

SSAP No. 55, which provides that “[n]o single projection method is inherently

better than any other in all circumstances.”

SSAP No. 55 provides that an actuary should consider the inherent

assumptions underlying each method and the appropriateness of those assumptions

under the circumstances in deciding which methods to rely upon. Mr. Tures did

just that. He performed computations under the Brosius method but in his best

professional judgment decided not to rely upon them. For the more recent accident

years, where the data is immature, he placed greater reliance upon the BF methods.

Other times he selected a simple average, a weighted average, or the output of a

particular method. We find that his choice of methods and selection of outputs

were reasonable and consistent with SSAP No. 55, the CAS Statement of

Principles, and the ASOPs.

54
(...continued)
incorporate the Paid Loss Development Method and the Paid using 5-year
Weighted Average Method into his selections in other lines. As an example, for
Acuity’s commercial auto liability line, Mr. Tures took the simple average of the
outputs of all eight methods for accident years 1999, 2000, and 2001.
 - 59 -

[*59] D. No Margin Added

Mr. Tures arrived at expected loss reserves of $660,639,385 on a net basis

for 2006. He credibly testified that his expected loss reserves were his best

estimate of the amount Acuity would ultimately be expected to pay for all losses,

including LAE, over the amount it had already paid as of yearend 2006. He further

credibly testified that Acuity’s management adopted his expected loss reserves

without change. Mr. Salzmann likewise credibly testified that Acuity’s

management did not make any adjustments to Mr. Tures’ expected loss reserves.

Likening this case to Physicians Ins. and Minn. Lawyers, respondent argues

that Acuity added a margin onto Mr. Tures’ actuarially computed loss reserves.55

Respondent argues that Mr. Tures computed indicated loss reserves of

$600,581,261 and then “deliberately increased his indicated reserve by

$60,000,000.” Respondent further argues that “[b]ecause the Court has been clear

about the non-deductibility of margins, * * * [Acuity] attempted to make it appear

as though its $60 million self-described margin was actuarially determined.”

Respondent asserts that Acuity “tried to hide its $60 million margin” by having Mr.

55
Respondent interchangeably uses the terms “margin”, “add-on”, and
“mark-up” in his brief.
 - 60 -

[*60] Tures revise “the actuarial assumptions within * * * [his] workpapers to

support * * * [Acuity’s] target of a Carried Reserve with a 10% margin.”

1. Reserve Review Sheet

Respondent points to the Reserve Review sheet in support of his argument.

The Reserve Review sheet contains a table with the column headings “Carried”,

“Indicated”, “Strength”, and “% Strength”. Underneath the column heading

“Carried” are amounts for the components comprising Acuity’s carried loss

reserves (i.e., ALAE IBNR, ULAE IBNR, case reserves, etc). The sum of the

amounts is Acuity’s carried loss reserves of $660,639,385.56 Underneath the

column heading “Indicated” are amounts for the same components adding up to

$600,581,261, which Mr. Tures testified to be the amount of the loss reserves he

computed under the optimistic scenario. We find Mr. Tures to be a very credible

witness. See Diaz v. Commissioner, 58 T.C. 560, 564 (1972) (stating that the

process of distilling truth from the testimony of witnesses, whose demeanor we

observe and whose credibility we evaluate, is the daily grist of judicial life). The

“Strength” and “% Strength” columns show the differences between the “Carried”

and “Indicated” columns.

56
The amounts add up to $660,639,387, a difference of $2 from Acuity’s
carried loss reserves. We treat this difference as de minimis and immaterial (it
may be due to rounding). See supra note 29.
 - 61 -

[*61] Respondent attaches great significance to Mr. Tures’ use of the term

“Indicated”, arguing that “[t]he use of the term ‘indicated’ throughout * * *

[Acuity’s] own documents and its use by other actuaries confirms that * * *

[Acuity] added a 10% margin to its actuarially indicated Carried Reserve.”

Respondent further argues that “[i]f ‘indicated’ were defined as ‘optimistic,’ Mr.

Tures’ workpapers or analysis would be nonsensical.” We disagree.

The CAS Statement of Principles states that “[a]n indicated loss reserve is

the result of the application of a particular loss reserving evaluation procedure.”

That definition is consistent with Mr. Tures’ use of the term in his workpapers. On

the Reserve Review sheet, we find that he used the term “Indicated” to refer to the

result he computed under the optimistic scenario. He used the term “Indicated” on

the sheet directly preceding the Reserve Review sheet to refer to his expected loss

reserves, i.e., the result he computed using his best estimates. On a sheet entitled

“Reserve Ranges 12/31/2006” in which Mr. Tures compared in tabular form his

expected loss reserves with the lower and upper bounds of his loss reserve range,

he used the term “Indicated Reserves - Direct” to refer to the amounts he computed

on a direct basis, the term “Indicated Ceded Reserves” to refer to the amounts of
 - 62 -

[*62] reinsurance, and the term “Indicated Reserves - Net” to refer to the amounts

he computed on a net basis.57

Respondent has failed to persuade us that Mr. Tures’ use of the term

“Indicated” on the Reserve Review sheet, or elsewhere, supports his argument that

Mr. Tures computed an actuarially indicated loss reserve of $600,581,261 and

subsequently hid a 10% margin within his actuarial computations.

2. Best Letter

In a similar vein, respondent points to the Best letter in support of his

argument, relying heavily upon two sentences in which Ms. Schuler stated: “As of

December 31, 2006, the actuarial net indicated reserves were $600.5 million with

the carried reserves at $660.6 million. This represents a reserve margin of 10.0%

of the indicated reserve or $60.1 million.” Respondent also relies upon Mr.

Altonji’s testimony that he understood the two sentences to mean that Acuity

“believes that they have a comfortable cushion in the loss reserves.” Respondent

argues that “Ms. Schuler understood that her use of the term ‘margin’ meant

‘margin’ and that her use of the term ‘actuarial indicated’ meant actuarially

determined.”

57
“Indicated Reserves - Net” is the difference between the “Indicated
Reserves - Direct” and the “Indicated Ceded Reserves”.
 - 63 -

[*63] However, Ms. Schuler is not an actuary. As described supra pp. 33-35, she

wrote the paragraph on Acuity’s loss reserves in the Best letter using information

from Mr. Tures’ workpapers. She did not speak with Mr. Tures in writing the

paragraph. The information for the two sentences in question came from the

Reserve Review sheet, but Ms. Schuler inadvertently took that information out of

context.

On the Reserve Review sheet, Mr. Tures compared Acuity’s carried loss

reserves with the loss reserves he computed under the optimistic scenario. Mr.

Tures used the terms “Strength” and “% Strength” to refer to the differences in

absolute and percentage terms, respectively, between Acuity’s carried loss reserves

and the loss reserves under the optimistic scenario. Ms. Schuler used the term

“reserve margin” in place of “Strength” and “% Strength”. She credibly testified

that she understood the word margin to mean “difference” as in the “difference

between the indicated or optimistic scenario and the carried.”58 She further

credibly testified that Acuity’s carried loss reserves are Mr. Tures’ best estimate

and do not contain any cushion.

58
We note that her understanding is consistent with Merriam Webster’s
Collegiate Dictionary 711 (10th ed. 1996), which defines “margin” as, inter alia,
“measure or degree of difference”.
 - 64 -

[*64] Mr. Altonji’s understanding of the two sentences in question, while

relevant, is certainly not determinative, and it is contradicted by the credible

testimony of Mr. Tures, Mr. Salzmann, and Ms. Schuler. We are simply

unpersuaded that Ms. Schuler’s inartful wording of two sentences in the Best letter

establishes that Acuity added a hidden 10% margin to its loss reserves.

3. Mathematical Computations

Respondent argues that “Mr. Tures did not estimate a reserve of

$660,639,387 and, then, subtract 9.0909090771483172255970865993795%

($60,058,126 / $660,639,387) from that to determine an ‘optimistic’ estimate.

He estimated a reserve of $600,581,261 and added a 10% ‘strength’ or ‘margin’ to

it.” However, the bare fact that Mr. Tures’ expected loss reserves are 10% higher

than the loss reserves he computed under the optimistic scenario does not establish

that one was used to compute the other.59 Mr. Tures credibly testified that he

computed the loss reserves under the optimistic scenario independently of his

expected loss reserves using the same methodologies but varying his assumptions

and inputs, and we so find.

59
We note that dividing Mr. Tures’ expected loss reserves by 1.1 would
also result in the loss reserves under the optimistic scenario.
 - 65 -

[*65] 4. Conclusion on Margin

Substantial credible evidence in the record supports petitioner’s position

that Acuity’s carried loss reserves contain no margin. Mr. Tures credibly testified

that his expected loss reserves were his best estimate of Acuity’s unpaid losses and

LAE. He further credibly testified that he did not add a margin onto a lower

estimate to arrive at his expected loss reserves. His workpapers corroborate his

testimony and show in great detail the computation of his expected loss reserves.

Both of respondent’s actuarial experts reviewed Mr. Tures’ workpapers, and

neither of them noted the existence of a hidden margin.60 Mr. Salzmann and Ms.

Schuler both credibly testified that Acuity adopted Mr. Tures’ expected loss

reserves without change. On the basis of the foregoing, we find that Acuity’s

carried loss reserves are Mr. Tures’ actuarially computed best estimate with no

implicit or explicit margin.

E. Prior Loss Reserve Development

Respondent cites Acuity’s history of favorable development for accident

years before 2006 as evidence that Acuity’s carried loss reserves for 2006 are not

fair and reasonable. Respondent argues that Acuity had an average redundancy of

60
Brian Brown, one of petitioner’s actuarial experts, also reviewed Mr.
Tures’ workpapers, and he too did not observe any kind of hidden margin.
 - 66 -

[*66] over 11% from 1997 through 2005. Respondent further argues that Acuity

had actual knowledge of its “over-reserving” practice but failed to explain how Mr.

Tures adjusted his methods or assumptions to incorporate Acuity’s “over-

reserving” experience. Petitioner argues that there has been substantial variability

in Acuity’s loss reserves and that five of the six years preceding 2006 show

favorable development of under 10%. Petitioner further argues that Mr. Tures took

this prior experience into account in his loss reserve analysis for 2006. We agree

with petitioner.

The fact that a taxpayer’s loss reserve estimate proves, with hindsight, to be

higher than actual payments does not establish that the taxpayer’s estimate was

unreasonable. See Utah Med., slip op. at 29. A taxpayer’s loss reserve estimate

must be fair and reasonable, but is not required to be accurate based on hindsight.

Id.; Physicians Ins., slip op. at 39. In Utah Med., we approved of the “lookback

method”, whereby the taxpayer’s actuary reestimated ultimate loss estimates for

prior coverage years in computing the ultimate loss estimates for the years at issue.

See Utah Med., slip op. at 31. Similarly, in Physicians Ins. we approved of the fact

the taxpayer’s actuary took into account developing redundancies in establishing

loss reserve estimates. See Physicians Ins., slip op. at 39.
 - 67 -

[*67] We find that Mr. Tures took Acuity’s prior development into account in his

actuarial analysis. He credibly testified that this occurs as “the actual losses

replace the expected losses on [each loss development] triangle.” He further

credibly testified that he used the “latest data available” in his analysis.

Respondent asserts that

Mr. Tures took into account the redundancies in prior years only as
data inputs into the Loss triangles in later years. This new data did
not ‘supplant’ or replace the old data; the new data added another
‘diagonal’ to the Loss Triangles, that is, the old data remained under
the correct accident year, with an increase to its age (maturity) and
the new data provided another year’s worth of information.

We find this distinction to be immaterial. Whether the latest data supplemented or

supplanted prior data, the record establishes that Mr. Tures incorporated Acuity’s

development into his actuarial analysis. Further evidencing the reasonableness of

his analysis, Acuity’s favorable development decreased from an average of

approximately 21.7% for 1997-99 to approximately 7.2% for 2002-05.61 See supra

p. 36.

F. Conclusion on Mr. Tures’ Actuarial Analysis

Mr. Tures performed his actuarial analysis in accordance with the NAIC

rules, the CAS Statement of Principles, and the ASOPs. He used his best

61
The years before the year at issue in which Mr. Tures was Acuity’s vice
president–actuarial and strategic information are 2002-05.
 - 68 -

[*68] professional judgment in selecting appropriate and reasonable inputs to and

outputs from his actuarial methods. He computed expected loss reserves of

$660,639,385 for 2006. Acuity’s management adopted that amount without

change. Respondent’s attacks on Mr. Tures’ actuarial analysis are all

unconvincing. We find the foregoing to be substantial evidence that Acuity’s

carried loss reserves for 2006 are fair and reasonable. See supra pp. 52-53.

IV. Mr. Kryczka’s Actuarial Analysis and Determination

The NAIC rules require an insurance company to file a statement of

actuarial opinion, prepared and signed by a qualified actuary, with the Annual

Statement. Mr. Tures was perfectly qualified to issue and capable of issuing the

statement of actuarial opinion. However, Mr. Salzmann wanted to create an

additional level of review. He wanted an outside consulting actuary to

independently review Acuity’s loss reserves and issue the statement of actuarial

opinion. This was part of his “systematic checks and balances”. Consequently,

Acuity’s board of directors selected John R. Kryczka, FCAS, FCIA, MAAA, to be

Acuity’s appointed actuary for 2006.

A. Qualified Actuary

Like Mr. Tures, Mr. Kryczka was and is a qualified and credentialed

actuary. He had more than 20 years of actuarial experience at the time he issued
 - 69 -

[*69] his statement of actuarial opinion. He too familiarized himself with the latest

changes to Acuity’s business before performing his actuarial analysis. He credibly

testified that he and his team met with Acuity’s management, including Mr.

Salzmann, “to understand what’s going on with [the] company’s book of business,

* * * we need to understand what is going on with the company in order to make

the proper actuarial judgments in our reports so we can try to project what’s going

to happen in the future.”

B. Determination of Reasonable Provision

Mr. Kryczka performed his actuarial analysis in accordance with the

ASOPs, in particular ASOP 36 governing statements of actuarial opinion. He used

his best professional judgment and took into account the latest changes to Acuity’s

business in selecting appropriate and reasonable inputs to and outputs from his

actuarial methods. He computed a narrow range of reasonable reserve estimates

from $577,108,000 to $661,329,000 around a point estimate of $607,482,000. He

determined that Acuity’s carried loss reserves of $660,639,385 fell within his

narrow range and issued a statement of actuarial opinion opining that Acuity’s

carried loss reserves for 2006:

(a) Meet the requirements of the insurance laws of Wisconsin.
 - 70 -

[*70] (b) Are computed in accordance with generally accepted actuarial standards
and principles.

(c) Make a reasonable provision for all unpaid loss and loss
adjustment expense obligations of the Company [Acuity] under the
terms of its contracts and agreements.

C. No Range “Stretching”

Respondent’s principal argument is that Mr. Kryczka “stretched” his range

to ensure that it encompassed Acuity’s carried loss reserves.62 Respondent argues

that “[t]his is merely accommodating petitioner, not checking or balancing the

Carried Reserve.” We find that respondent’s argument is contrary to the evidence

in the record.

ASOP 36, sec. 3.3, provides that an appointed actuary should document the

scope and intended use of a statement of actuarial opinion. Mr. Kryczka was

appointed by Acuity’s board of directors to perform an independent review of

Acuity’s carried loss reserves for the purpose of determining whether the reserves

were reasonable. In the first paragraph of his statement of actuarial opinion, Mr.

62
Respondent also argues on brief that Mr. Kryczka “stretched” or
“extended” his point estimate to ensure that he could create a range that
encompassed Acuity’s carried loss reserves. Respondent does not explain how a
number (as opposed to a range) can be “stretched” or “extended”. We understand
his argument to be that Mr. Kryczka computed an unreasonably high point
estimate by using assumptions and selections in his actuarial analysis that were
biased high. We reject this argument. See infra pp. 77-78.
 - 71 -

[*71] Kryczka wrote that “my responsibility is to express an opinion on loss and

loss adjustment expense reserves based on my review.”

As explained supra pp. 27-28, under ASOP 36, 3.3.2, Mr. Kryczka could

express one of five types of opinions: (1) determination of reasonable provision;

(2) determination of deficient or inadequate provision; (3) determination of

redundant or excessive provision; (4) qualified opinion; or (5) no opinion. He did

not “accommodate petitioner” and rubber stamp Acuity’s carried loss reserves. To

the contrary, he performed an independent actuarial analysis consisting of

approximately 900 pages pursuant to ASOP 36, sec. 3.5, and computed a range of

reasonable reserve estimates for the purpose of determining whether Acuity’s

carried loss reserves fell within that range.

ASOP 36, sec. 3.6.4, supports Mr. Kryczka’s approach. It states that an

“actuary may determine a range of reasonable reserve estimates that reflects the

uncertainties associated with analyzing the reserves. A range of reasonable

estimates is a range of estimates that could be produced by appropriate actuarial

methods or alternative sets of assumptions that the actuary judges to be

reasonable.” Mr. Kryczka credibly testified that if Acuity’s carried loss reserves

fell outside of his range of reasonable reserve estimates, he would not have issued a

determination of reasonable provision opinion under ASOP 36, sec. 3.3.2(a).
 - 72 -

[*72] Mr. Kryczka used a PwC process known as ADIAL to compute his range of

reasonable reserve estimates. He computed separate ranges for each of Acuity’s

lines of insurance and then applied a weighted average to the individual ranges to

compute an overall range. He described the range he computed as a “narrow

range” or a “stage one range”.

Mr. Kryczka credibly testified that if an insurance company’s loss reserves

fall within an actuary’s narrow range of reasonable reserve estimates computed

under ADIAL, the actuary’s inquiry ends and the actuary issues an opinion opining

that the loss reserves are reasonable. He further credibly testified that if an

insurance company’s loss reserves fall outside of the actuary’s narrow range, the

actuary would have discussions with the insurance company to try and understand

whether there was some additional variability that was not reflected in the actuary’s

analysis, and if so, the actuary might revise the narrow range. If the actuary

determined that a revision was not warranted, PwC’s internal process calls for a

second review by a different actuary in PwC’s national office to determine whether

a wider range of reasonable reserve estimates would be justified. Mr. Kryczka

described this wider range as a “stage two range”.

Acuity’s carried loss reserves of $660,639,385 fell within Mr. Kryczka’s

narrow range of reasonable reserve estimates from $577,108,000 to
 - 73 -

[*73] $661,329,000.63 Consequently, his inquiry ended and he issued a statement

of actuarial opinion opining that Acuity’s carried loss reserves make a reasonable

provision for Acuity’s unpaid losses and LAE.

D. Appropriate and Reasonable Range

Respondent argues that Mr. Kryczka’s range was “so large that petitioner

cannot show that every point within * * * [the] range represents actual unpaid

losses as nearly as it is possible to ascertain them.” Respondent further argues that

“[n]ot only can a range not be entered on a Federal income tax return or NAIC

annual statement, but the range itself is so wide as to be meaningless.”

We reject the implication in respondent’s argument that Mr. Kryczka’s

decision to compute a range may have been inappropriate. ASOP 36, sec. 3.6.4,

specifically authorizes the computation of a range of reasonable reserve estimates.

Likewise, the CAS Statement of Principles states that “[t]he uncertainty inherent in

the estimation of required provisions for unpaid losses or loss adjustment expenses

implies that a range of reserves can be actuarially sound.” Mr. Kryczka computed a

63
In Utah Med. Ins. Ass’n v. Commissioner, T.C. Memo. 1998-458, slip
op. at 12, the taxpayer selected a loss reserve estimate at the high end of a range of
reasonable reserve estimates computed by the taxpayer’s actuary for each of the
years at issue. We rejected respondent’s argument that the midpoint of an
actuarially sound range is the only fair and reasonable estimate. See id., slip op. at
29.
 - 74 -

[*74] range of reasonable reserve estimates for the purpose of expressing an

opinion on whether the loss reserve estimate computed by Mr. Tures and adopted

by Acuity’s management without change was reasonable. He did not compute a

range for the purpose of entering it on petitioner’s Federal income tax return or

Acuity’s Annual Statement.

Furthermore, we find that Mr. Kryczka’s range was reasonable. He

computed a range with a width of approximately 14.6% as a percentage of the

lower bound.64 Respondent attacks the reasonableness of Mr. Kryczka’s range and

the ranges computed by petitioner’s two actuarial experts (which had widths of

20.6% and either 21.3% or 22.2% as discussed infra) in the same section of his

brief and argues that a “range with a spread that exceeds 20% of the lower bound is

unwarranted in this case and is simply provided by petitioner’s actuaries to

encompass its Carried Reserve.” Respondent offers no explanation as to how he

arrived at a seemingly arbitrary 20% cap, and he cites no authority in support of

that figure. Furthermore, Mr. Kryczka’s range with a width of 14.6% would, in

fact, be reasonable under respondent’s 20% cap.

64
Mr. Kryczka computed a range from $577,108,000 to $661,329,000
($661,329,000 - $577,108,000 / $577,108,000 = 14.6%).
 - 75 -

[*75] Petitioner argues that Mr. Kryczka’s range (as well as the ranges of its two

actuarial experts) are reasonable under our caselaw. In Utah Med., the taxpayer’s

actuary at Tillinghast computed ranges with widths of approximately 26.1% and

26.3% for the two years in issue.65 See Utah Med., slip op. at 12. We characterized

the ranges as “large” but found that they were reasonable because the high amount

of uncertainty in the taxpayer’s business made “projecting losses difficult.”66 See

id. at 24. In contrast, in Minn. Lawyers, the taxpayer’s actuary at KPMG computed

ranges with widths of approximately 70.3% and 119.9% for the second

65
The actuary computed a range from $45,426,000 to $57,289,000
($57,289,000 - $45,426,000 / $45,426,000 = 26.1%) for the first year in issue and
a range from $49,066,000 to $61,948,000 ($61,948,000 - $49,066,000 /
$49,066,000 = 26.3%) for the second year in issue. See Utah Med., slip op. at 12.
66
We found that: (1) the taxpayer was a relatively modestly capitalized,
single-line insurer serving a limited geographic area; (2) the taxpayer had claims
with a relatively low frequency and high severity; and (3) the taxpayer issued
policies in a highly risky and longer-tailed line of insurance. See Utah Med., slip
op. at 24.
 - 76 -

[*76] and third years in issue.67 See Minn. Lawyers, slip op. at 18, 37 n.26. We

stated that

[r]elative to the recommended range[s] of the taxpayer’s actuary in
Utah Medical, * * * [the KPMG actuary’s] recommended ranges are
very large. The evidence in the record is insufficient for us to
evaluate adequately whether * * * [the] recommended ranges are so
large as to be unreasonable, or whether every point in each
recommended range would satisfy the requirement that the
determination of unpaid losses ‘represent actual unpaid losses as
nearly as it is possible to ascertain them.’ [Fn. ref. omitted]

Id. at 37-38.

Mr. Kryczka’s range (as well as the ranges of petitioner’s two actuarial

experts) are narrower than the ranges that we found to be reasonable in Utah Med.

and significantly narrower than the ranges that we did not approve of in Minn.

Lawyers. And while Acuity was a more diversified insurance company than the

taxpayer in Utah Med., there was still a significant degree of uncertainty in

estimating Acuity’s loss reserves for 2006.

SSAP No. 55 makes clear that loss reserves are inherently uncertain.

Moreover, sources of uncertainty particular to Acuity’s business in 2006 included:

67
For the first year in issue, the taxpayer’s actuary at Milliman did not
compute a range. See Minn. Lawyers, slip op. at 36. The taxpayer’s actuary at
KPMG computed a range from $7,956,093 to $13,550,446 ($13,550,446 -
$7,956,093 / $7,956,093 = 70.3%) for the second year in issue and a range from
$5,851,559 to $12,867,450 ($12,867,450 - $5,851,559 / $5,851,559 = 119.9%) for
the third year in issue. See id. at 18.
 - 77 -

[*77] (1) Acuity’s rapid growth; (2) Acuity’s expansion into new States; (3)

Acuity’s dramatic shift towards riskier, long tail coverage lines of insurance; (4)

the decreasing frequency and increasing severity of claims in workers

compensation, Acuity’s largest line of insurance; and (5) the rising litigation costs

in Illinois, Acuity’s second-largest State by written premiums. ASOP 36, sec. 3.6,

states that an “actuary should consider the implications of uncertainty in loss and

loss adjustment expense reserve estimates in determining a range of reasonable

reserve estimates”. We find that Mr. Kryczka (as well as petitioner’s two actuarial

experts) properly considered the uncertainties in Acuity’s business and computed

reasonable ranges of reserve estimates.

E. Respondent’s Other Arguments

Respondent argues that Mr. Kryczka’s actuarial analysis was “flawed and

biased.” Respondent takes issue with a number of the assumptions and selections

in Mr. Kryczka’s analysis, in much the same fashion as he did with Mr. Tures’

analysis. For example, respondent asserts that Mr. Kryczka selected loss

development factors and loss ratios in excess of Acuity’s historical experience.

However, SSAP No. 55 specifically provides that a loss reserve estimate shall be

computed “using past experience adjusted for current trends, and any other factors

that would modify past experience.” Likewise, ASOP 36, sec. 3.5.2, provides that
 - 78 -

[*78] an “actuary should consider the likely effect of changing conditions on the

subject loss and loss adjustment expense reserves.”

Mr. Kryczka credibly testified that a “mechanical approach would just be to

select one of the [historical] averages, but we were incorporating judgment as

well.” He and his team met with Acuity’s management and its actuarial team. He

learned of the changes taking place in Acuity’s business, including the increasing

severity in the workers compensation line of insurance, the double digit growth,

and the expansion into new States. Then, using his best professional judgment, he

adjusted Acuity’s historical data to account for these changes in making his

selections. We find that his selections were appropriate and reasonable.

Respondent argues that Acuity did not provide PwC with a copy of the Best

letter. This argument is a red herring. The Best letter contains financial

information on Acuity, much of which is not related to the computation of loss

reserves. Ms. Schuler wrote the Best letter to assist Mr. Altonji and his team with

their financial review of Acuity for 2006. Acuity provided Mr. Kryczka with its

actual data--the same data that Mr. Tures used in his actuarial analysis.

Furthermore, Mr. Kryczka and his team personally met with Acuity’s management

“to understand what is going on with the company in order to make the proper

actuarial judgments”.
 - 79 -

[*79] F. Conclusion on Mr. Kryczka’s Actuarial Analysis and Determination

Mr. Kryczka performed his actuarial analysis in accordance with the

ASOPs. He computed a range of reasonable reserve estimates from $577,108,000

to $661,329,000. Acuity’s carried loss reserves fell within his range. His range

was reasonable--respondent’s arguments to the contrary are all unconvincing. We

find the foregoing to be substantial evidence that Acuity’s carried loss reserves for

2006 are fair and reasonable. See supra pp. 52-53.

V. Financial Audit

Petitioner argues that “PwC’s unqualified 2006 statutory and GAAP audit

opinions give the Court an additional level of support, specifically from an

accounting perspective, for the conclusion that Acuity’s 2006 loss reserve of

$660.6 million was a fair and reasonable estimate.” Respondent argues that

petitioner misconstrues the scope of financial and statutory audits. Respondent

further argues that Tom Brown and his team tested data, controls, and the accuracy

of claim recording and not the reasonableness of Acuity’s carried loss reserves.

Tom Brown did not perform an independent actuarial analysis. He relied

on Mr. Kryczka to opine on the reasonableness of Acuity’s loss reserves. We have

already concluded that Mr. Kryczka’s actuarial analysis and determination is

entitled to substantial weight. Additional weight given to PwC’s unqualified
 - 80 -

[*80] opinions would be duplicative. While respondent does not seem to question

the integrity of Acuity’s actual data, we note that PwC’s unqualified opinions

affirm that the actuaries in this case could reasonably rely on Acuity’s actual data,

where appropriate, in their actuarial methodologies.

VI. Subsequent Loss Reserve Development

Respondent argues that “[a]lthough hindsight certainly does not decide the

valuation question herein, * * * [Acuity’s] subsequent reduction of the 2006

Carried Reserve by over $79 million is relevant to * * * [Acuity’s] pattern of

continued over-reserving in spite of repeated confirmation that its actuarial

assumptions are biased high.” Respondent further argues that “[h]indsight may

also show a continued pattern of ignoring repeated overstatements.” We reject

respondent’s characterization of Acuity’s favorable development as a “pattern of

continued over-reserving” and the implication that Acuity’s carried loss reserves

for 2006 are thus unreasonable.

Mr. Altonji credibly testified from a financial analyst’s perspective that a

long history of favorable development is not an indication that an insurance

company’s loss reserves were excessive or unreasonable when originally
 - 81 -

[*81] established.68 He further credibly testified that “[e]very single actuary is

always wrong, because no one knows for sure with 100 percent certainty that * * *

[a loss] reserve is adequate until the time passes.” Anthony Grippa, one of

respondent’s actuarial experts (discussed infra) credibly testified that “the end

result, when all the claims are finally paid out, the chance that the end result will be

exactly the same as my number [for the loss reserves] is infinitesimally small.”

An insurance company will virtually always experience some measure of

favorable or unfavorable development on its loss reserves as new information

comes to light. Federal tax law thus requires loss reserves to be the “best

possible”--it does not require that an insurance company guess its loss reserves

exactly right. See Physicians Ins., slip op. at 23-24. Respondent has not cited a

single authority, nor can we find any, for the proposition that unfavorable

development in consecutive years, or favorable and unfavorable development in

alternating years, is reasonable whereas favorable development in consecutive

years indicates “a pattern of continued over-reserving” and is somehow

unreasonable. Respondent essentially reads into the Federal tax law a requirement

that does not exist; that is, a requirement that an insurance company record its best

68
In fact, for purposes of the BCAR analysis, Best determined that Acuity’s
carried loss reserves for 2006 might be deficient by 0.30% or $1,980,000.
 - 82 -

[*82] estimate of its loss reserves without going over the amount that in hindsight

turns out to be the correct amount.

Petitioner argues that “favorable reserve development considered in

‘hindsight’ does not make a loss reserve estimate unreasonable if the taxpayer

shows that it was reasonable when established.” We agree. See id. at 39; Utah

Med., slip op. at 29. Petitioner also argues that the development of Acuity’s carried

loss reserves for 2006 closely matches reserve development in the property and

casualty insurance industry. Petitioner asserts that “to the extent post-2006 reserve

development is considered by the Court at all * * * [it is] a factor that confirms

Acuity’s 2006 loss reserve as a fair and reasonable estimate.”

Petitioner introduced expert testimony and other evidence on loss reserve

development in the property and casualty insurance industry as a whole and the

segment of the industry reporting net earned premiums between $100 million and

$1 billion in 2006. Respondent challenges the evidence upon which petitioner

relies, arguing that the evidence does not provide a valid basis of comparison to

Acuity and that the evidence is contradicted by other evidence in the record.

Respondent further argues that it is a “logical fallacy” to presume that “because

everyone else is doing it, therefore it must be reasonable.”
 - 83 -

[*83] In Utah Med., slip op. at 26, we found that the medical malpractice

insurance industry overstated reserves to virtually the same extent as the taxpayer,

which suggested that the taxpayer’s loss reserves were fair and reasonable.

However, the taxpayer in that case wrote policies primarily in a single line of

insurance (medical malpractice) and primarily in a single State (Utah) during the

years in issue. See id., at 4. Acuity is a larger and more diversified insurance

company. In 2006 Acuity wrote policies in fifteen lines of insurance as reported on

its Annual Statement and in fifteen different States.

There is insufficient evidence in the record for us to determine whether

Acuity was similarly situated to the property and casualty industry as a whole or to

the segment of the industry reporting net earned premiums between $100 million

and $1 billion for 2006. Cf. Minn. Lawyers, slip op. at 41 (the taxpayer’s expert

witness’s report and testimony “provide little basis for assessing whether his

peer-group ratio comparisons account for possible differences in reserving, claim

management, and underwriting philosophies among the eight companies that he

selected for comparison, or whether those eight companies are in fact the

appropriate peer group.”).
 - 84 -

[*84] In sum, we find that the subsequent development of Acuity’s 2006 carried

loss reserves has little probative value, one way or the other, in determining

whether the reserves were fair and reasonable when originally established.

VII. Expert Witnesses

Both parties called expert witnesses to offer their opinions regarding the

reasonableness of Acuity’s carried loss reserves. We evaluate expert opinions in

light of all the evidence in the record, and we may accept or reject the expert

testimony, in whole or in part, according to our independent evaluation of the

evidence in the record. See Helvering v. Nat’l Grocery Co., 304 U.S. 282, 295

(1938); Malachinski v. Commissioner, 268 F.3d 497 (7th Cir. 2001), aff’g T.C.

Memo. 1999-182; Estate of Davis v. Commissioner, 110 T.C. 530, 538 (1998).

Petitioner offered expert testimony of two qualified and credentialed

actuaries--Katharine Barnes, FCAS, MAAA, and Brian Z. Brown, FCAS, MAAA

(Mr. Brown). Respondent likewise offered expert testimony of two qualified and

credentialed actuaries--Matthew P. Merlino, FCAS, MAAA, and Anthony J.

Grippa, FCAS, MAAA.
 - 85 -

[*85] A. Ms. Barnes’ Actuarial Analysis

Ms. Barnes is a consulting actuary and director at Towers Watson.69 She

received a bachelor’s degree in mathematics from Wellesley College in 1981 and a

Master’s degree in mathematics from Brandeis University in 1983. She has 28

years of actuarial experience in loss reserving and pricing for property and casualty

insurance companies.

Ms. Barnes performed an independent actuarial analysis in accordance with

ASOP 43 and the revised edition of ASOP 36, both of which had become effective

by that time. She computed estimated ultimate losses using nine accepted actuarial

methodologies: (1) paid loss development method (unadjusted); (2) adjusted paid

loss development method; (3) reported loss development method (unadjusted); (4)

adjusted reported loss development method; (5) paid BF method (unadjusted); (6)

adjusted paid BF method; (7) reported BF method (unadjusted); (8) adjusted

reported BF method; and (9) frequency times severity method.70 In her best

professional judgment, she ultimately decided to rely upon the results of the four

adjusted methods and the frequency times severity method.

69
Tillinghast was a predecessor firm to Towers Watson.
70
Ms. Barnes used other accepted actuarial methodologies in computing
estimated ultimate ALAE, ULAE, and S & S.
 - 86 -

[*86] Ms. Barnes persuasively explains in her expert report why she rejected the

unadjusted methods as being unreliable:

Acuity Mutual experienced significant growth between
approximately 2000 and 2006. For example, the Company’s earned
premium volume for 2006 was more than three times the 2000
earned premium for workers compensation and general liability
insurance. Similar and even greater growth was experienced in
other lines of business. Much of the growth was in states other than
the historical Wisconsin base. I have observed that the non-
Wisconsin business exhibits different characteristics than the
historic Wisconsin business (e.g., loss development, claim severity).
As a result, the historical development patterns that are based
predominantly on Wisconsin experience are not representative of
the future development of losses to be expected for Acuity Mutual
as of year-end 2006.

* * * * * * *
My analysis shows that the Company experienced significant
changes in the frequency of claims (number of claims per insured
exposure unit or policy) and in the severity of claims (average loss
per claim) in recent accident years as of year-end 2006. I have
noted that the frequency of claims dropped significantly while the
average cost of reported claims (i.e., severity) increased. * * *
These types of changes (lower frequency and higher severity)
occurring simultaneously cause a low bias to occur with the
traditional [unadjusted] actuarial development techniques, since the
lower frequency phenomenon will likely be reflected in the
actuarial data sooner than the higher severity.

In the adjusted methods, Ms. Barnes adjusted Acuity’s loss and LAE data to

account for these and other “substantial changes in the Company’s operation and

business”. Her adjustments are supported by ASOP 43, sec. 3.6.7, which states
 - 87 -

[*87] that an “actuary should consider whether there have been significant changes

in conditions, particularly with regard to claims, losses, or exposures, that are likely

to be insufficiently reflected in the experience data or in the assumptions used to

estimate the unpaid claims.”

In her expert report, Ms. Barnes computed a range of reasonable reserve

estimates from $560,662,380 to $681,770,059. The revised edition of ASOP 36,

sec. 3.7, states that an “actuary should consider a reserve to be reasonable if it is

within a range of estimates that could be produced by an unpaid claim estimate

analysis that is, in the actuary’s professional judgment, consistent with both ASOP

No. 43, Property/Casualty Unpaid Claim Estimates, and the identified stated basis

of reserve presentation.”71 Ms. Barnes determined that Acuity’s carried loss

reserves fell within her range and concluded that the reserves represent a “fair and

reasonable estimate of amounts the Company will be required to pay after 2006 to

settle claims incurred as of year-end 2006.”

Mr. Merlino found a technical error in Ms. Barnes’ analysis relating to the

conversion of loss reserves on a gross basis to a net basis. In his rebuttal report, he

proposed corrections to fix the error using alternative net-to-gross ratios. His

71
Under ASOP 43, sec. 3.7.3, a range of estimates is an appropriate stated
basis of reserve presentation.
 - 88 -

[*88] proposed corrections result in a downward adjustment to Ms. Barnes’ range

of $19,792,000 on the low end and $21,014,000 on the high end. After applying

his corrections, he computed Ms. Barnes’ range to be $540,870,000 to

$660,756,000.72

Ms. Barnes admits that she made a technical error in her expert report in

applying her selected net-to-gross ratios, which resulted in an inconsistency

between her gross and net paid losses.73 To correct the error, she produced at trial a

revised report in which she applied her net-to-gross ratios to the gross unpaid

losses instead of the gross ultimate losses. Her corrections result in a downward

adjustment to the range she computed of $1,529,038 on the low end and

$3,292,757 on the high end. After applying her corrections, she computed a

revised range of reasonable reserve estimates from $559,133,342 to $678,477,302.

She credibly testified at trial that Acuity’s carried loss reserves for 2006 fall within

her revised range and thus her opinion that Acuity’s reserves are reasonable has not

changed.

72
Mr. Merlino notes in his rebuttal report that “[a]dditonal adjustment to
ALAE may be necessary”, but he does not offer any further explanation or propose
any additional adjustments.
73
Ms. Barnes described the error as a spreadsheet error.
 - 89 -

[*89] Respondent argues that “Ms. Barnes attempted to fix the problem” that Mr.

Merlino found but “failed to correct the problem; doing so properly would have

meant that the Carried Reserve exceeded her high estimate.” Respondent asserts

that Mr. Merlino’s proposed corrections “resulted in a reduction of * * * [Ms.

Barnes’] range by over $19 million at the low end and $21 million at the high end;

the change to the high end reduces [it] to $658 million, meaning that the Carried

Reserve is higher than the corrected range.”

Respondent has not shown any computation nor offered any explanation as

to how he arrived at $658 million for the high end of Ms. Barnes’ range.

Respondent cites pages 4-7 and exhibit 2 of Mr. Merlino’s rebuttal report;

however, these show Mr. Merlino’s computation of his proposed corrections and

not Ms. Barnes’ range after applying the proposed corrections.

In exhibit 1 of his rebuttal report, Mr. Merlino “compiled comparisons of

reserves by component and by reserving segment.” He states: “In my comparisons

* * * for Barnes I used adjusted net reserves by line consistent with the corrections

discussed previously.” He shows the low end of Ms. Barnes’ range to be

$540,870,000 and the high end to be $660,756,000.74 We arrive at the same

74
These amounts are also consistent with the percentages Mr. Merlino
computed for Ms. Barnes’ range in table 9 of his rebuttal report.
 - 90 -

[*90] amounts when rounding to the nearest thousand (low end: $560,662,380 -

$19,792,000 = $540,870,380; high end: $681,770,059 - $21,014,000 =

$660,756,059). Moreover, regardless of whether we accept Mr. Merlino’s

proposed corrections or Ms. Barnes’ proposed corrections, Acuity’s carried loss

reserves for 2006 fall within Ms. Barnes’ range of reasonable reserve estimates as

corrected.

Respondent makes a number of additional arguments as to why Ms. Barnes’

range is unreasonable. We find these arguments to be unpersuasive. Respondent

argues that Ms. Barnes’ assumptions and selections were biased high. However, as

described supra p. 86, Ms. Barnes explains in her expert report the factors she

considered and the judgment she employed in making her selections. We find them

to be reasonable.

Respondent also argues that Ms. Barnes’ range was too wide. She explains

in her expert report that the “internal and environmental changes [in Acuity’s

business] create additional uncertainty in the estimation of the liabilities, and

therefore cause the range of estimates considered to be reasonable to be wider than

it would be with more stable conditions.” We compute the width of her range to be

21.3% in applying her corrections ($678,477,302 - $559,133,342 / $559,133,342 =

21.3%) or 22.2% in applying Mr. Merlino’s corrections ($660,756,000 -
 - 91 -

[*91] $540,870,000 / $540,870,000 = 22.2%). Either way, her range as corrected is

narrower than the ranges we found to be reasonable in Utah Med. and, as described

supra pp. 73-77, we find it to be reasonable in this case.

In sum, we find that Ms. Barnes’ actuarial analysis supports petitioner’s

position that Acuity’s carried loss reserves for 2006 are fair and reasonable.

B. Mr. Brown’s Actuarial Analysis

Mr. Brown is a consulting actuary and principal at Milliman. He received a

bachelor’s degree in economics from Illinois State University in 1980. He has over

25 years of actuarial experience in loss reserving and pricing for property and

casualty insurance companies. He served on the board of directors of the CAS

from 2006 to 2009.

Mr. Brown performed an independent actuarial analysis in accordance with

ASOP 43 and the revised edition of ASOP 36.75 Before performing his

75
Mr. Brown did not review Acuity’s homeowners, commercial auto
physical damage, or personal auto physical damage lines of insurance. These lines
are all short tail coverage lines of insurance with a far lower degree of uncertainty
than Acuity’s other lines. The portion of Acuity’s carried loss reserves for 2006
attributable to these lines is $11.5 million. He also did not review Acuity’s ULAE
of $37.6 million. He accepted Acuity’s estimates for the three lines and ULAE
without review. In his expert report, he states that “it is professionally appropriate
to review 90%-95% of the reserves for a client and rely on the client’s estimate for
a small percentage of the reserves.” He relies on ASOP 43, sec. 3.4, which states
in pertinent part that an “actuary may choose to disregard items that, in the
(continued...)
 - 92 -

[*92] analysis, he met with members of Acuity’s management, its claims and

underwriting departments, and its actuarial team. He then used his best

professional judgment in selecting loss development factors, expected loss ratios,

frequency and severity trends, and other inputs. He used six accepted actuarial

methods to compute estimated ultimate losses: (1) paid loss development method;

(2) incurred loss development method; (3) frequency and severity method; (4) loss

ratio method; (5) paid BF method; and (6) incurred BF method. He used three

additional accepted actuarial methods to compute estimated ultimate ALAE and

S & S.

He arrived at a range of reasonable reserve estimates from $572,102,336 to

$689,721,061. He determined that Acuity’s carried loss reserves fell within his

range and concluded that the reserves were reasonable. He credibly testified that in

75
(...continued)
actuary’s professional judgment, are not material to the unpaid claim estimate
given the intended purpose and use.” On brief, respondent does not challenge Mr.
Brown’s judgment in accepting Acuity’s estimates for the three lines and the
ULAE. We treat respondent’s silence as a concession that Mr. Brown’s judgment
on this matter was appropriate and reasonable. See Rule 151(e)(4) and (5);
Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989).
 - 93 -

[*93] his professional opinion any loss reserve estimate that falls within the range

he computed is reasonable.76

Respondent argues that Mr. “Brown’s assumptions and selections are

biased so high that his estimate does not represent actual unpaid losses, nor does it

represent unpaid losses as nearly as possible to ascertain them given the size of his

range.”77 We disagree. Mr. Brown’s assumptions were informed by his meetings

with key personnel at Acuity and his selections were the product of those

assumptions and his best professional judgment. We find them to be reasonable.

76
He credibly testified that to the best of his knowledge the term “fair and
reasonable” is not used in the actuarial literature.
77
One selection that respondent questions in particular is Mr. Brown’s
asbestos and environmental (A & E) reserve segment of $7,434,000 to
$10,888,000. Acuity’s claims department did not establish a case reserve for
asbestos liability. It established a case reserve of $889,113 for environmental
liabilities. Mr. Brown determined in his best professional judgment that Acuity
faces potential exposure to A & E liabilities in excess of Acuity’s case reserves.
He stated in his expert report that “[a]sbestos claims and pollution claims are
significantly different from the rest of Acuity’s claims. The payments in 2006 and
beyond are due to events from older accident years. Asbestos disease typically
takes 10 or 20 or more years to manifest and pollution at a site may take decades
to discover.” He used three industry-based methods to compute the A & E reserve
segment: (1) A.M. Best survival ratio method; (2) exposure-adjusted survival
ratio method; and (3) market share method. On the basis of the foregoing, we
cannot say that Mr. Brown’s judgment in including an A & E reserve segment was
unreasonable. Furthermore, even assuming arguendo that an A & E reserve
segment was unnecessary, and that segment was removed from Mr. Brown’s
range, Acuity’s carried loss reserves for 2006 would still fall within Mr. Brown’s
range as recomputed.
 - 94 -

[*94] We compute the width of Mr. Brown’s range to be 20.6% ($689,721,061 -

$572,102,336 / $572,102,336 = 20.6%). His range is narrower than the ranges we

found to be reasonable in Utah Med. and, as described supra pp. 73-77, we find it

to be reasonable in this case.

Separately from his actuarial analysis, Mr. Brown reviewed Mr. Tures’

workpapers. He determined that Mr. Tures’ analysis “consisted of professionally

recognized and commonly utilized actuarial methods applied appropriately to the

data at hand.” He determined that Mr. Tures’ analysis was “well documented and

can be followed by another actuary qualified to perform reserve analyses.” He did

not observe any kind of hidden margin within Mr. Tures’ actuarial analysis. While

he did not agree with every one of Mr. Tures’ selections, he determined that the

selections were reasonable in total.78

He found that Mr. Tures’ best estimates for Acuity’s commercial auto

liability and property reserve segments exceeded the upper bound of his range for

those segments. He opined that in his experience an insurance company’s loss

78
Mr. Brown noted in his expert report and credibly testified at trial that he
would have selected higher values for some of Mr. Tures’ selections and lower
values for others. In his rebuttal report Mr. Grippa points out that “there are
literally thousands of individual selections (judgments) made by each actuary in
arriving at his/her estimates of loss reserves.” Common sense dictates that one
would not expect two actuaries to arrive at identical values for every one of the
thousands of individual selections.
 - 95 -

[*95] reserves for a particular segment commonly fell outside of his range even

though the company’s total reserves fell within his range. He determined that Mr.

Tures’ expected loss reserves (i.e., Mr. Tures’ total reserves for all segments

including LAE) fell within his range and thus concluded that the reserves were

reasonable. His conclusion is consistent with our caselaw, under which “the

aggregate unpaid loss reserves for all lines of business for the applicable year, and

not the individual reserves for each line of business, must meet the fair and

reasonable test, Hanover Ins. Co. v. Commissioner, 69 T.C. at 271; Western

Casualty Surety Co. v. Commissioner, 65 T.C. at 917, 919”. Hosp. Corp. of Am. v.

Commissioner, T.C. Memo. 1997-482, slip op. at 90.

In sum, we find that Mr. Brown’s actuarial analysis and his review of Mr.

Tures’ workpapers support petitioner’s position that Acuity’s carried loss reserves

for 2006 are fair and reasonable.

C. Mr. Merlino’s and Mr. Grippa’s Actuarial Analyses

Mr. Merlino is a consulting actuary at Merlinos & Associates, Inc. He

received a bachelor’s degree in applied mathematics from Brown University in

1978. He has 30 years of experience as an actuarial consultant, a substantial

portion of which is in the field of loss reserving for property and casualty insurance

companies. Mr. Grippa is a principal at Strategic Actuarial & Risk Consultants,
 - 96 -

[*96] LLC. He received a bachelor’s degree in economics from Tulane University.

He has over 30 years of actuarial and insurance management experience, including

21 years at the National Council on Compensation Insurance.

Mr. Merlino and Mr. Grippa each performed an independent actuarial

analysis. Like Ms. Barnes, they each made technical errors in their analysis that

they later corrected. Mr. Merlino computed a range from $544,600,000 to

$602,200,000 around a central estimate of $573,800,000. Mr. Grippa did not

compute a range. He computed a central estimate of $561,692,000 and an estimate

at the 75th percentile confidence level of $587,798,000. Mr. Merlino and Mr.

Grippa determined that Acuity’s carried loss reserves for 2006 exceeded the upper

bound of their range and estimate at the 75th percentile confidence level,

respectively.

Respondent argues that Mr. Grippa “determined a central estimate for * * *

[Acuity] that is fair and reasonable and that represents actual unpaid losses of

* * * [Acuity]. His estimate is supported by respondent’s other expert actuary,

Matthew Merlino.” On the other hand, petitioner argues that Mr. Grippa’s

selections were “aggressively low” and that his estimate at the 75th percentile

confidence level is “inconsistent with standard actuarial practice.” Petitioner

further argues that Mr. Merlino evidenced a “low bias” in his selections, failed to
 - 97 -

[*97] take into account the changes in Acuity’s business, and computed an

“unreasonably narrow range”.

We perceive no need to address these arguments because neither Mr.

Merlino’s nor Mr. Grippa’s actuarial analysis convinces us that Acuity’s carried

loss reserves for 2006 were anything other than fair and reasonable. The applicable

regulations require the taxpayer to show that its loss reserves are fair and

reasonable and represent only actual unpaid losses. Where, as here, the taxpayer

has made such a showing, “our inquiry ends.” Utah Med., slip op. at 32. The

applicable regulations do not require a taxpayer to show that the amount espoused

by the Commissioner as a fair and reasonable loss reserve estimate is, in fact, not

fair or reasonable. Thus, we need not and do not decide whether Mr. Merlino’s or

Mr. Grippa’s loss reserve estimate would also be fair and reasonable.

VIII. Conclusion

Petitioner introduced substantial evidence in support of its position that

Acuity’s carried loss reserves for 2006 are fair and reasonable and represent only

actual unpaid losses. Mr. Tures’ actuarial computation of his expected loss

reserves in accordance with the NAIC rules and ASOPs, and Acuity’s adoption of

that amount without change as its carried loss reserves, strongly support

petitioner’s position. Mr. Kryczka’s determination that Acuity’s carried loss
 - 98 -

[*98] reserves fell within his range of reasonable reserve estimates actuarially

computed in accordance with the ASOPs strongly supports petitioner’s position.

Ms. Barnes’ and Mr. Brown’s actuarial analyses and expert opinions that Acuity’s

carried loss reserves are reasonable further support petitioner’s position.

Respondent has not introduced any persuasive evidence to the contrary. On the

basis of the foregoing, we hold that Acuity’s carried loss reserves of $660,639,385

for 2006 are fair and reasonable and represent only actual unpaid losses within the

meaning of the applicable regulations.

Because the parties settled some issues before trial,

Decision will be entered under

Rule 155.