Respondent determined an $89,366 Federal income tax deficiency for petitioner’s 1987 taxable year. The issue remaining in controversy is whether petitioner engaged in reserve strengthening within the meaning of section 1023(e)(3)(B) of the Tax Reform Act of 1986 (tra 86), Pub. L. 99-514, 100 Stat. 2404. In that context, we consider whether section 1.846-3(c), Income Tax Regs., is valid and more specifically whether the definition of reserve strengthening contained in the regulation comports with the statute and congressional intent.
FINDINGS OF FACT
The facts stipulated by the parties are incorporated by this reference. Petitioner, a property and casualty (PC) insurance company, is a corporation organized under the laws of the State of Minnesota with its principal office in Minneapolis, Minnesota.
Initially (petitioner was organized in 1900), most of petitioner’s insurance coverage involved dairy properties in Minnesota, Wisconsin, and Iowa. Since then petitioner has expanded its risk coverage by offering fire, homeowners, worker’s compensation, and automobile liability insurance. In connection with the period under consideration, petitioner’s business predominantly consisted of automobile coverage, followed by worker’s compensation, with fire, allied lines, and homeowners policies comprising most of the remaining insur-anee coverage. While a majority of petitioner’s business is in Minnesota, it is licensed to do business in Wisconsin, Iowa, North Dakota, and South Dakota.
For each State in which it is licensed to do business, a PC company is required to file an annual statement with the State insurance commissioner in the format prescribed by the National Association of Insurance Commissioners (NAIC). The primary purpose of the annual statement is to provide State regulatory agencies the information necessary for monitoring the financial solvency of the insurance companies, regulating insurance businesses, and verifying compliance with State insurance laws and regulations. The NAIC annual statement includes a balance sheet, a statement of income, a capital and surplus account, a statement of cash-flow, an underwriting and investment exhibit, historical data, schedules, and responses to questions, as well as information on premiums, losses, and dividends to policyholders. Petitioner filed its NAIC annual statements with the State commissioner of insurance for each State in which it was licensed to do business for the years 1984 through 1991.
PC companies are required to maintain loss reserves to ensure the payment of claims that have occurred but have not been paid by or reported to the insurer as of the NAIC annual statement filing date, typically December 31 of each year.
Petitioner’s loss reserves generally include four components or categories: (1) Claims already reported to petitioner (case reserves); (2) amounts that will be paid on claims that can statistically be presumed incurred but are not yet reported to petitioner (IBNR reserves); (3) expected future changes in the case reserves (bulk reserves); and (4) loss adjustment expenses not included in (1) through (3) (LAE reserves).1 Bulk reserves were not held by petitioner as of 1986 yearend for pre-1986 accident years.
Petitioner’s loss reserves consisted predominantly of case reserves. Its claims department established the case reserves from data contained in loss reports and policy files. These reserves were established and maintained on a case-by-case basis and the amounts were dependent on the facts and circumstances of each claim or case. Petitioner’s 1985 and 1986 case reserves were established in the same manner and totaled $23.6 million and $30 million, respectively.
From 1963 through the period in controversy, George Klouda, petitioner’s president and general manager, was responsible for establishing the amount of the IBNR reserve. The IBNR reserve was determined for each line of business by means of a computer program model which included a 1-year historical development of IBNR, the level of premiums, and judgmental factors (such as an estimate for inflation). If, at yearend, based on emerging claims experience against previous IBNR reserves, it was Mr. Klouda’s judgment that IBNR reserves were not adequate and an increase in IBNR reserves was warranted, any such increase to the IBNR reserves was reflected as part of the current accident year claims and not as an adjustment to IBNR for prior accident years. This method for computing IBNR was used to report IBNR on the 1985 and 1986 naic annual statement. Using this method, petitioner held IBNR reserves of $3.3 million for year 1985 and $4.4 million for 1986.
Petitioner did not change its reserve assumptions or methodology from prior years in computing its 1986 loss reserve. By the end of 1991 it was evident that petitioner’s 1985 and 1986 loss reserves were both deficient, as opposed to overstated.
Mr. Klouda was also responsible for determining petitioner’s LAE reserves. These were also computed by means of a formula. Mr. Klouda combined all of petitioner’s lines of business and compared total losses paid in a preceding 3-year period to the LAE paid during the same 3-year period. Total LAE was computed by applying the average 3 years of the paid-to-paid ratios to IBNR and by applying one-half of the ratios to case reserves. The final value was then judgmentally adjusted. This method was employed for 1985 and 1986. Using this method, petitioner held yearend LAE reserves of $3 million for 1985 and $4.2 million for 1986.
Respondent, mechanically following the calculation set forth in section 1.846-3(c), Income Tax Regs., determined that petitioner had engaged in reserve strengthening in the amount of $1,383,383 in 1986 with respect to pre-1986 claims. Using the discounting principles set forth in section 846,2 respondent determined that petitioner’s 1987 taxable income was understated by $223,025. Respondent did not question the approach, method, or any specific changes which occurred in connection with petitioner’s reserves. Instead, respondent employed the regulation’s formula, which assumes that any net increase to reserves constitutes reserve strengthening.
The formula set forth in section 1.846 — 3(c)(3)(i), Income Tax Regs., was employed for each of petitioner’s lines of business. That formula concerns accident years before 1986. Under that formula the reserves for 1985 as of the end of the 1985 year are reduced by claims and LAE paid regarding those reserves in 1986. To the extent that reserves for 1985 existing at the end of 1986 exceed that amount, it is treated as a net increase to the reserve. To the extent the result is less, it is negative and treated as a net decrease to the reserve.
Respondent’s computations resulted in the following “increases” or “decreases” to reserves in petitioner’s lines of business:
Increase Line of insurance (decrease)
Auto liability . $554,503
Other liability. 238,533
Worker’s compensation. 1,729,542
Multiple peril . (135,345)
Fire . (300)
Allied lines. 500
Inland marine . (23,265)
Auto physical damage. (1,083,226)
Glass . (437)
Burglary and theft . -0-
Reinsurance . 102,878
Net totals . 1,383,383
OPINION
Background
Subchapter L, involving insurance companies, is a highly specialized portion of the Internal Revenue Code which is replete with the unique nomenclature of the insurance industry. We are asked here to construe the term “reserve strengthening”, a specialized insurance concept which was used by Congress in TRA 86 section 1023(e)(3). As part of TRA 86, Congress changed certain aspects for reporting income by property and casualty companies. Because some of these changes would have likely resulted in the reporting of more income, Congress permitted some relief from the initial change by exempting certain items. However, to avoid abuse, the portion of the increase in the taxpayers’ reserves which constituted reserve strengthening was not to be exempted. The parties maintain distinctly different definitions of the term “reserve strengthening”. To better understand the unique terms and nuances in the parties’ arguments, it is helpful to first consider some of the background concerning the taxation of PC insurance companies.
Prior to TRA 86, PC insurance companies recognized premium income when earned rather than when received, sec. 832(b)(3) and (4); sec. 1.832-4(a)(3), Income Tax Regs., and claims or losses of claimants were deducted when “incurred” without consideration of when such losses were paid. Sec. 832(b)(6). This was in contrast to the accrual method of tax accounting under which the liability must be fixed and determinable with reasonable accuracy. Prior to TRA 86, PC companies were generally entitled to deduct the full amount of their unpaid losses in calculating taxable income. Treatment for tax purposes generally followed the amount of unpaid losses accounted for in the NAIC annual statement. Because PC companies do not use the more traditional versions of the cash or accrual methods of accounting, the annual statement has been used as a guideline for determining the timing of taxable income. Sec. 832(b)(1). The NAIC annual statement accounting principles are incorporated, with qualifications, into certain provisions of the Internal Revenue Code applicable to PC companies.
Prior to TRA 86, the PC companies were entitled to a deduction for “losses incurred” computed as (1) losses paid during the taxable year (plus or minus the change in salvage and reinsurance recoverable for the year), plus (2) all unpaid losses outstanding at the end of the taxable year, minus (3) unpaid losses outstanding at the end of the preceding year. A deduction was also allowed for “expenses incurred”, including estimates of future costs of adjusting claims (loss adjustment expenses or LAE). In this way, PC insurance companies were permitted to deduct the full amount of the net increase in their unpaid losses in calculating taxable income. Accordingly, prior to 1987 PC companies could deduct more than the current cost of claimed losses. The longer the period between the accident or loss year and the year the claim was actually paid, the greater the benefit attributable to the insurer’s deduction. Having concluded that prior law did not accurately measure the income of PC’s, Congress, in tra 86, changed the tax treatment of unpaid loss deductions for such companies.
The change was accomplished by means of a discounting method. To implement the discounting of unpaid losses, section 832(b)(5) was amended to provide that the deduction for losses incurred is to be determined by reference to discounted unpaid losses. In other words, the deduction for these reserves is limited to the amount of discounted unpaid losses and LAE. Section 846 was added to define “discounted unpaid losses”. The discounted unpaid loss provisions are generally effective for tax years beginning after December 31, 1986, with the exception of certain transitional rules, discussed infra.
The amount of the discounted unpaid losses as of the end of any tax year is the sum of the discounted unpaid losses separately computed with respect to unpaid losses in each line of business attributable to each accident year. Sec. 846(a)(1). The term “unpaid losses” under section 846(f)(2) includes reported losses, incurréd but not reported losses, resisted claims, and loss adjustment expenses. The discounting methodology is applied by line of business for each accident year and is set forth in section 846(a)(2). Where the unpaid losses shown on the NAIC statement have already been discounted, and certain other criteria are met, a company may gross up its discounted unpaid losses to determine its undiscounted unpaid losses.
The availability of this grossup, however, provides taxpayers an opportunity to artificially inflate their undiscounted losses by overstating the amount by which their unpaid losses are discounted in the annual statement. To close this loophole by which taxpayers could effectively negate the application of the discounting requirements, tra 86 provides that the amount of the discounted unpaid losses cannot exceed the aggregate amount of unpaid losses with respect to any line of business for an accident year as reported on the annual statement. Sec. 846(a)(3).
Although the loss reserve discounting provisions generally apply to tax years beginning after December 31, 1986, it was necessary to select a starting point for the discounting of unpaid losses. TRA 86 section 1023(e)(2) provides a transitional rule with respect to unpaid losses on the effective date of the provision. Under the transitional rule, the unpaid losses as of the beginning of the first tax year beginning after December 31, 1986, are determined as if the loss reserve discounting provisions had applied. The discount for the pre-1987 unpaid losses (assuming a calendar year PC) is determined under the method set forth in section 846(a)(2) concerning the loss payment pattern applicable to accident years ending in 1987.
The transitional rules also provide for a “fresh start” with respect to unpaid losses applicable to the last tax year beginning before January 1, 1987. This is accomplished by determining the difference between the amount of the unpaid losses for the year preceding the first tax year beginning after December 31, 1986, and the amount determined under sec. 846(a)(2) for unpaid losses as of the beginning of the first tax year beginning after December 31, 1986. This difference is the fresh start and is not taken into account for purposes of determining taxable income after the effective date. Commentary in the legislative history describes the fresh-start adjustment as “a forgiveness of income — for the reduction in reserves resulting from discounting the opening reserves in the first post-effective date taxable year of the provision.” H. Conf. Rept. 99-841 (1986), 1986-3 C.B. (Vol. 4) 1, 367. Accordingly, the difference between the undiscounted and discounted unpaid loss is forgiven.3 The congressional commentary also contains an indication that the fresh start will not apply to any reserve strengthening in a tax year beginning in 1986, and such strengthening is treated as occurring in the taxpayer’s first tax year beginning after December 31, 1986. Reserve strengthening for tax years beginning after December 31, 1985, is not treated as a reserve amount for purposes of determining the fresh-start amount. Instead, reserve strengthening additions to loss reserves for tax years beginning in 1986 are treated as changes to reserves in tax years beginning in 1987, and are subject to discounting. TRA 86 sec. 1023(e)(3)(B); H. Conf. Rept. 99-841, supra, 1986-3 C.B. (Vol. 4) at 367; Staff of Joint Comm, on Taxation, General Explanation of the Tax Reform Act of 1986, at 618 (J. Comm. Print 1987) (hereinafter General Explanation).
Similar to concerns of artificial manipulation addressed by section 846(a)(3), the denial of the fresh-start provisions to 1986 reserve strengthening is explained in the conference report and General Explanation as follows:
This provision [denying fresh start for reserve strengthening] is intended to prevent taxpayers from artificially increasing the amount of income that is forgiven under the fresh start provision. [H. Conf. Rept. 99-841, supra, 1986-3 C.B. (Vol. 4) at 367.]
The Parties’ Positions
Respondent determined that petitioner understated its 1987 income by failing to include $223,025 in income. That amount is the discount (determined under the 1987 formula) attributable to petitioner’s total net additions of $1,383,383 to its unpaid losses and LAE reserves established for pre-1986 accident years.4 Respondent contends that any increase to reserves (the $1,383,383 addition in this case) constitutes reserve strengthening by petitioner.
Petitioner contends that the term “reserve strengthening” used by Congress in TRA 86 section 1023(e)(3) is an insurance industry term of art and should be interpreted in a manner consistent with its commonly understood usage. More specifically, petitioner contends that reserve strengthening, as used in the PC industry: (1) Is nonperiodic; (2) involves a material change in methodology and/or assumptions from one valuation date to the next; (3) results in a change in the reserve’s adequacy level from what it otherwise would have been; and (4) applies to the aggregate yearend reserves of an insurance company. Petitioner maintains that the increases to its 1986 reserves for pre-1986 accident years as determined by respondent do not constitute “reserve strengthening” as that term is used in the insurance industry. Further, petitioner maintains that industry usage and prior legislation support the position that reserve strengthening, as used in the statute, has an established meaning which would not include any of the additions made to petitioner’s reserves. Finally, petitioner maintains that even if respondent’s interpretation of the legislative history is correct and the separate application of a mechanical test to reserves for pre-1986 accident years is required, respondent’s regulations do not accurately implement the mechanical test. Petitioner asserts that erroneous results are reached because the regulations mistakenly apply the mechanical test to loss reserves on an accident year/line-of-business basis, rather than to each separate claim reserve.5
Respondent maintains that any increase to a reserve is reserve strengthening. Respondent relies upon the committee reports and the regulation for her position. Accordingly, respondent does not agree that strengthening is attributable only to a change in reserve-setting methodology or that it is necessary to consider whether there is an element of artificiality in the reserve setting action. Respondent acknowledges that reserve strengthening has an established definition in the life insurance industry, but contends that the term has no commonly accepted or recognized meaning within the PC industry.
It is important to note that respondent agrees that petitioner’s additions to its reserves were reasonable and that the reserves were determined in accord with petitioner’s prior practices and procedures.6 Because respondent argues that any addition to the reserve constitutes reserve strengthening and is therefore not entitled to the fresh start, respondent’s position renders the nature of or reason for the increase irrelevant. Respondent does not question whether petitioner’s reserve additions would represent reserve strengthening by reference to the definition advanced by petitioner. Due to respondent’s concession in this case, we do not have to address the question of whether petitioner attempted to “artificially” increase its reserve to take advantage of the fresh-start provisions.
The Statute, Regulations, and Legislative History
tra 86 section 1023(e)(3)(B), 100 Stat. 2404, provides as follows:
(B) Reserve strengthening in years after 1985. — * * * [The fresh start] shall not apply to any reserve strengthening in a taxable year beginning in 1986, and such strengthening shall be treated as occurring in the taxpayer’s 1st taxable year beginning after December 31, 1986.
The statute contains but does not define the term “reserve strengthening”. Section 1.846-3(c), Income Tax Regs.,7 on the other hand, provides rules for determining reserve strengthening, in pertinent part as follows:
(c) Rules for determining the amount of reserve strengthening (weakening). — (1) In general. The amount of reserve strengthening (weakening) is the amount that is determined under paragraph (c)(2) or (3) to have been added to (subtracted from) an unpaid loss reserve in a taxable year beginning in 1986. For purposes of section 1023(e)(3)(B) of the 1986 Act, the amount of reserve strengthening (weakening) must be determined separately for each unpaid loss reserve by applying the rules of this paragraph (c). This determination is made without regard to the reasonableness of the amount of the unpaid loss reserve and without regard to the taxpayer’s discretion, or lack thereof, in establishing the amount of the unpaid loss reserve. The amount of reserve strengthening for an unpaid loss reserve may not exceed the amount of the reserve, including any undiscounted strengthening amount, as of the end of the last taxable year beginning before January 1, 1987. For purposes of this section, an “unpaid loss reserve” is the aggregate of the unpaid loss estimate for losses (whether or not reported) incurred in an accident year of a line of business.
Hi ‡ if: ^ ‡ i|c
(3) Accident years before 1986. (i) In general. For each taxable year beginning in 1986, the amount of reserve strengthening (weakening) for an unpaid loss reserve for an accident year before 1986 is the amount by which the reserve at the end of the taxable year exceeds (is less than)—
(A) The reserve at the end of the immediately preceding taxable year; reduced by
(B) Claims paid and loss adjustment expenses paid (“loss payments”) in the taxable year beginning in 1986 with respect to losses that are attributable to the reserve. * * *
Essentially, the regulation provides that any increase in a reserve for a pre-1986 accident year is a strengthening.8 Although petitioner argues that the regulation is ambiguous and could be read either way, we are convinced that the regulation defines any increase to the reserve as a reserve strengthening which should be excluded from the fresh-start provisions. Respondent’s interpretation of reserve strengthening and the promulgation of the regulations are based upon the following language found in the conference report:
Reserve strengthening is considered to include all additions to reserves attributable to an increase in an estimate of a reserve established for a prior accident year (taking into account claims paid with respect to that accident year), and all additions to reserves resulting from a change in the assumptions (other than changes in assumed interest rates applicable to reserves for the 1986 accident year) used in estimating losses for the 1986 accident year, as well as all unspecified or unallocated additions to loss reserves. * * * [H. Conf. Rept. 99-841 (1986), 1986-3 C.B. (Vol. 4) 1, 367; emphasis supplied.]
The prior Senate Finance Committee report, however, did not use the all additions language, but instead defined reserve strengthening as follows:
The committee intends that any adjustments to reserves that are attributable to changes in reserves on account of changes in the basis for computing reserves (i.e., reserve strengthening or reserve weakening) * * * [S. Rept. 99-313 (1986), 1986-3 C.B. (Vol. 3) 1, 510; emphasis supplied.]
Accordingly, we are confronted with a situation where Congress utilized a technical insurance industry term in a statute, but the statute itself does not define it. Further, in the promulgation of the regulation, there was reliance upon a possible explanation of the term in the legislative history which is substantially different from and broader than the customary industry usage. Moreover, the portion of the legislative history relied upon by respondent conflicts with other portions of the legislative history and seems broader than is necessary to accomplish the stated purpose of preventing abuse from artificial increases. This situation is further complicated by the fact that Congress used the same term in prior legislation (1984) concerning life insurance companies, wherein it is clear that the term was used in its technical industry parlance. These somewhat circuitous circumstances make the path to the solution of this controversy more perplexing. Common to the consideration of all of the parties’ arguments is the meaning of the term “reserve strengthening”. Accordingly, we consider that concept first.
The Definition of Reserve Strengthening
a. Insurance Reserves
The term “reserve” is used differently in the insurance industry than it is in certain other commercial situations. In insurance parlance, reserves are not considered to be trust funds or funds in escrow. Security Ben. Life Ins. Co. v. United States, 517 F. Supp. 740, 747 (D. Kan. 1980), affd. 726 F.2d 1491 (10th Cir. 1984). In the insurance industry a policy reserve represents a liability; i.e., it represents an obligation to the policyholders. Historically, reserves have been described in PC insurance literature as estimated liabilities for losses and loss adjustment expenses.9 To some extent, loss reserves are estimates extrapolated from past trends, patterns, averages, and inferences and predictions as to the future. Accordingly, “The reserve simply operates as a charge on so much of an insurance company’s assets as must be maintained in order for the company to be able to meet its future commitments under the policies it has issued.” Id. at 747. The general concept of reserves is the same for life and PC insurance companies.
b. Reserve Strengthening10
Generally, increases in a company’s reserves are either attributable to (1) normal additions made each year to fund existing and increasing obligations under policies in force; or (2) additions required when a method or assumption used in calculating policy reserves is changed so as to produce higher reserves. The latter or less usual occurrence has been described as reserve strengthening. See Jefferson Standard Life Ins. Co. v. United States, 272 F. Supp. 97, 121 (M.D.N.C.1967), affd. in part, revd. in part and remanded 408 F.2d 842 (4th Cir. 1969).
In National Life & Accident Ins. Co. v. United States, 381 F. Supp. 1034 (M.D. Tenn. 1974), affd. 524 F.2d 559 (6th Cir. 1975), the Court of Appeals analyzed sections 809 and 810 and recognized a distinction between normal reserve increases and reserve increases “ ‘attributable to reserve strengthening’”. 524 F.2d at 560 (quoting section 1.809-5(a)(III), Income Tax Regs.). Reserve strengthening/weakening was defined by the District Court as resulting from a change in an actuarial assumption which produces a larger/ smaller reserve than would have been achieved had the old assumption been used. National Life & Accident Ins. Co. v. United States, 381 F. Supp. at 1037. Reserve strengthening is but one way in which a company’s reserves could be increased in a given year, and all other reserve increases (not attributable to reserve strengthening) are “normal reserve increases”. Id. at 1038.
A normal reserve addition for claims incurred in previous periods is made by an insurance company to reflect new information (such as the number or magnitude of claims) relating to that company’s liability for such claims. In contrast, reserve strengthening is limited to a change in the formula or mechanism for calculating a reserve, which would produce a larger reserve amount without regard to such new information.11 Thus, the term “reserve strengthening” is confined to a change in the basis for calculating the current reserve for claims incurred in a previous period (for which a reserve computed on a different basis had been held prior to the current period).12
Respondent acknowledges that the term “reserve strengthening” has a commonly understood industry meaning in the life insurance area, but argues that no such industry-wide definition exists in the PC insurance field. Petitioner counters that it is a common practice of all insurance companies, PC as well as life, to extrapolate from past trends in order to make educated predictions about the future.13 Also, petitioner relies heavily on the fact that in enacting the life insurance provisions contained in the Deficit Reduction Act of 1984 (defra), Pub. L. 98-369, 98 Stat. 494, Congress used the term “reserve strengthening” in a manner consistent with its classic definition. In that earlier legislation, which modified the provisions of subchapter L relating to the computation of life insurance reserves, Congress also provided a fresh-start transition rule. To provide relief from the effect of the new provisions, defra section 216(b), 98 Stat. 758, provided a fresh start under which any change in reserve methods attributable solely to the new rules was not regarded as a change in method for calculating reserves, and therefore would not cause recognition of the resulting gain or loss. Under the fresh start of DEFRA section 216(b), the difference between a company’s closing 1983 reserves and its opening 1984 reserves attributable to the required change in reserve computation was disregarded; i.e., forgiven, for tax purposes. Similarly to TRA 86, DEFRA limited the fresh-start adjustment. Under defra’s restrictions the fresh-start benefit was unavailable for certain reinsurance transactions and for “any reserve strengthening reported for Federal income tax purposes after September 27, 1983, for a taxable year ending before January 1, 1984.” defra sec. 216(b)(3)(A)(ii), 98 Stat. 759.
Respondent agrees that the use of reserve strengthening in connection with defra was in accord with life insurance industry usage,14 but contends the term has no well-defined meaning in the PC industry. In support of this contention, respondent, quoting from the report of petitioner’s expert, Irene Bass, points out that the NAIC does not specifically define reserve strengthening with respect to reporting requirements for the filing of information contained in the annual statement for PC insurers. Ms. Bass’ report includes the statement, however, that although NAIC does not specifically define the term, the annual statement provides guidelines useful in identifying the characteristics of reserve strengthening as it is understood by actuaries in the PC industry. With respect to the reporting requirements for life insurance companies, the NAIC annual statement similarly does not specifically define reserve strengthening, yet respondent acknowledges that the term does have a commonly understood industry definition in the life area.15
We are convinced that reserve strengthening concepts are as applicable to PC companies as life companies, although the need for reserve strengthening seems to occur with more frequency with respect to life insurance reserves. Although Federal tax literature seems to contain more references to reserve strengthening in association with life companies, no specific distinction between life and casualty companies regarding reserves is evident.16 More specifically, the concept of reserve strengthening would have the same meaning in the context of PC and life business. So, for example, reserve strengthening in the context of life companies would not be more broadly or narrowly construed than it would in the context of PC companies. Accordingly, in enacting TRA 86 section 1023, Congress could not have expected a different quantitative or qualitative meaning for the term “reserve strengthening”, depending upon whether it was used in connection with tax provisions specifically designed for life or PC companies. The fact that the same terminology was used as was employed in similar legislation 2 years earlier in the same subchapter of the Code creates the presumption that no change in meaning was intended. Zuanich v. Commissioner, 77 T.C. 428, 443 n.26 (1981) (quoting Dickerson, Interpretation and Application of Statutes 224 (1975)).
Respondent contends that the explanation of reserve strengthening found in the legislative history for TRA 86 is controlling and that all additions to petitioner’s 1986 reserves constitute reserve strengthening.17 Although support for respondent’s interpretation and the regulatory definition of the term can be found in the legislative history, the legislative history provides no persuasive rationale for interpreting the statutory term “reserve strengthening” in a manner different from industry usage. Congress used a technical term in a specialized portion of the Internal Revenue Code. Had Congress intended to exclude any addition to the reserves from the application of the fresh-start provisions as respondent contends, the statute could have included that language. Instead, the statute contains a term of art used in an unconditional manner. Had Congress used such plain language as “all additions” or “all increases”, we would agree with respondent and attribute the everyday plain meaning to those words. See Commissioner v. Soliman, 506 U.S. _, 113 S. Ct. 701 (1993); Hanover Bank v. Commissioner, 369 U.S. 672 (1962); Crane v. Commissioner, 331 U.S. 1 (1947). The provisions of subpart L have been drafted by Congress in language peculiar to the insurance industry and have been held to have the meaning generally attributed thereto by experts in that industry. Alinco Life Ins. Co. v. United States, 178 Ct. Cl. 813, 373 F.2d 336, 352 (1967).18
Petitioner’s contention that reserve strengthening does not apply to all increases to its reserves comports with the rationale contained in the congressional history and apparent purpose of the statute,19 but not with the regulatory definition.20 It appears that Congress intended to permit PC companies a fresh start for normal reserve increases (ones which are not artificial in nature) for the designated period. By excluding reserve strengthening from the fresh-start relief, Congress intended to prevent PC companies from inflating the amounts which would be afforded the special treatment. This conceptually intermeshes with the legislative history reference to “artificial” reserve increases. This is so because reserve strengthening is essentially an artificial (nonperiodic) change in the assumptions and/or methodology used to compute the reserves. Generally, such changes in assumptions or methodology result in a material change in the reserve’s level and may affect the adequacy of the total reserve.
Respondent contends that the exclusions from the fresh-start provisions are not restricted to artificial increases in reserves. However, as previously noted, the conference agreement expressly states that the purpose of denying the fresh start for amounts attributable to reserve strengthening was to prevent taxpayers from abusing the provision by “artificially increasing the amount of income forgiven under the fresh start”.
Conceptually, section 1.846-3(c), Income Tax Regs., accomplishes the computation of additions to reserves by comparing two specific points in time — the yearends of 1985 and 1986. That computational approach looks back to see what the additions to the reserves were, rather than analyzing whether the reserves were adequate. Conceptually, the process of reserve strengthening considers the assumptions or methodology and employs changes to increase the reserve from what it would have been had the underlying assumptions or methodology remained unchanged. The additions made by petitioner for the critical period under the regulation were routine adjustments to the reserves based upon past reserving practices. There were no increases to the reserves for the period in question attributable to changes in assumptions or methodology in computing the reserves or additions thereto.
Having analyzed the concepts concerning reserve strengthening, we proceed to consider the validity of the regulation section in controversy.
Validity of Section 1.846-3(c), Income Tax Regs.
Regulations may be either legislative or interpretative in character. Estate of Pullin v. Commissioner, 84 T.C. 789, 795 (1985). An interpretative regulation is issued under the general authority vested in the Secretary by section 7805, whereas a legislative regulation is issued pursuant to a specific congressional delegation to the Secretary. Unlike TRA 86 section 1023(c), which added section 846 to the Code, TRA 86 section 1023(e), which contains the fresh-start provision, does not specifically delegate regulatory authority to the Secretary. Section 846(g) contains express legislative regulation authority, but it is limited to carrying out the purposes of section 846. The challenged regulation, which is an attempt to carry out the purpose of the fresh-start provisions of section 1023(e), is not a part of section 846 but is a separate transitional provision and is accordingly interpretative.21
An interpretative regulation, while entitled to deference, is not entitled to as much deference as accorded a legislative regulation. United States v. Vogel Fertilizer Co., 455 U.S. 16, 24 (1982). Moreover, the standard of deference accorded an interpretative regulation only sets “the framework for judicial analysis; it does not displace it.” United States v. Cartwright, 411 U.S. 546, 550 (1973).
A regulation may not contradict the unambiguous language of a statute. Citizen’s Natl. Bank v. United States, 417 F.2d 675 (5th Cir. 1969); Hefti v. Commissioner, 97 T.C. 180, 189 (1991), affd. 983 F.2d 868 (8th Cir. 1993). Even if a regulation does not directly contradict or limit the language of the statute it purports to interpret, the regulation may still be invalid if it is fundamentally at odds with or inconsistent with the statute’s origin and purpose. United States v. Vogel Fertilizer Co., supra at 26; CWT Farms, Inc. v. Commissioner, 79 T.C. 1054, 1062 (1982), affd. 755 F.2d 790 (11th Cir. 1985). Unless an interpretative regulation is unreasonable and plainly inconsistent with the statute, it should be sustained. Bingler v. Johnson, 394 U.S. 741, 750 (1969).
In determining legislative intent the Supreme Court in West Virginia University Hospitals, Inc. v. Casey, 499 U.S. 83, 98-99 (1991), stated:
The best evidence of that purpose is the statutory text adopted by both Houses of Congress and submitted to the President. Where that contains a phrase that is unambiguous — that has a clearly accepted meaning in both legislative and judicial practice — we do not permit it to be expanded or contracted by the statements of individual legislators or committees during the course of the enactment process. * * * [Citations omitted.]
Petitioner urges that the regulation’s mechanical test to define and determine reserve strengthening premised on respondent’s interpretation of language contained in the conference committee report should be rejected. Petitioner contends that respondent’s reliance on the reference to “all additions to reserves” in the legislative history to support her position that the statute requires a mechanical test is contrary to: (1) The description of reserve strengthening in the Senate Finance Committee report,22 (2) the statement of legislative purpose in the conference committee report, and (3) the meaning of reserve strengthening in the parallel fresh-start transition rule of DEFRA section 216(b). In addition, petitioner asserts that respondent’s approach leads to “manifestly absurd results” that were not intended by Congress.23
Respondent maintains that the regulation’s mechanical test for determining whether strengthening occurred satisfies congressional intent. Under the test articulated in Chevron U.S.A. v. Natural Res. Def. Council, 467 U.S. 837 (1984), the first question a court must ask when reviewing an agency’s construction of a statute is whether Congress has directly spoken to the precise question at issue and has expressed a clear intent as to its resolution. This examination should begin with the language of the statute. Consumer Product Safety Commission v. GTE Sylvania, Inc., 447 U.S. 102, 108 (1980); Abourezk v. Reagan, 785 F.2d 1043, 1053 (D.C. Cir. 1986). The statute in issue, TRA 86 section 1023(e)(3), simply uses the term “reserve strengthening”. There is the strong presumption that Congress expresses its intention through the language it chooses. INS v. Cardoza-Fonseca, 480 U.S. 421, 432 n.12 (1987). In employing the traditional tools of statutory construction, a court should assume that Congress uses language in a consistent manner, unless otherwise indicated. United States v. Olympic Radio & Television, Inc., 349 U.S. 232, 235-236 (1955).24
In enacting the fresh-start provision of DEFRA, Congress used an industry term of art in a manner consistent with its traditional definition. The provisions of subpart L have been drafted by Congress in language peculiar to the insurance industry and therefore are intended to have the meaning generally attributed thereto by experts in that industry. Alinco Life Ins. Co. v. United States, 178 Ct. Cl. 813, 373 F.2d 336, 352 (1967). There is no reason to conclude that the use in tra 86 of the term “reserve strengthening” was other than as a word of art.
As stated in Abourezk v. Reagan, supra at 1054-1055 n.11, it is:
plainly wrong as a general matter, and in this case in particular, to regard committee reports as drafted more meticulously and as reflecting the congressional will more accurately than the statutory text itself. Committee Reports, we remind, do not embody the law. Congress, as Judge Scalia recently noted, votes on the statutory words, not on different expressions packaged in committee reports. Hirschey v. FERC, 111 F.2d 1, 7-8 & n.1 (D.C. Cir. 1985) (Scalia, J., concurring).
In order to adopt respondent’s regulatory use of the term “reserve strengthening”, we would have to redefine an insurance concept so as to reach a definition different from its established industry meaning. Considering the record in this case, we are unable to accept respondent’s regulatory definition. The statute here is neither silent nor ambiguous with respect to the specific issue in question. Reserve strengthening is a term that was adopted from the insurance industry and certain legal sources, and nothing in the statute rebuts the strong presumption that in expressing its will Congress intended the term to have any other meaning. Although we recognize that the legislative history contains contradictory explanations and to some extent supports respondent’s regulatory position, we conclude that Congress intended the term as it appears in the statute to be interpreted in a manner consistent with industry usage.25 By excluding reserve strengthening, as technically defined, Congress intended to limit PC companies’ ability to obtain an advantage by artificially changing their prior reserving practices and artificially increasing 1986 yearend reserves over what they would have been. Congress knew that the new discounting rules of section 846 would cause a one-time distortion in taxable income and intended a fresh start as a remedy.
We have reached the conclusion that section 1.846-3(c), Income Tax Regs., is invalid to the extent the term “reserve strengthening” has been inappropriately used, after weighing the following factors: (1) The statute is not ambiguous and uses a term of art in a portion of the Internal Revenue Code which has been specially designed for a particular industry and generally contains industry jargon; (2) the legislative history materials are internally contradictory in that there are references to all increases to reserves and explanations regarding artificial increases or a specific type of increase; (3) the regulatory definition of the term “reserve strengthening” does not comport with insurance industry usage; (4) the regulatory definition of the term “reserve strengthening” does not harmonize with its congressional use 2 years earlier in related and parallel statutes involving life, rather than PC, insurance companies; (5) the regulatory approach would result in anomalous results; and (6) the traditional industry definition of the term comports with the concept that Congress was attempting to limit any attempts by taxpayers to take advantage of the fresh-start provisions by means of artificial increases to reserves. Further, it appears that promulgation of the regulation was to some extent driven by concerns for administrative convenience and compliance.26 It should also be noted that section 1.846-3, Income Tax Regs., is a transitional rule applicable to a single taxable year — a year for which the normal 3-year period of assessment had expired. Sec. 6501(a). Additionally, the regulation was not approved until August 1992 and did not appear in the Federal Register until September of that year, some 5 years after the close of the taxable year, a time when most if not all affected taxpayers should have already filed returns. Accordingly, administrative convenience and compliance concerns, at this juncture, should not have much bearing on the outcome.
We accordingly hold that section 1.846-3(c), Income Tax Regs., is invalid to the extent that it defines all additions to reserves as reserve strengthening.
To reflect the foregoing and due to agreements between the parties,
Decision will be entered for petitioner.
Reviewed by the Court.
Hamblen, Parker, Shields, Clapp, Swift, Jacobs, Wright, Parr, Colvin, Chiechi, and Laro, JJ., agree with this majority opinion. Chabot, J., concurs in the result only.Loss adjustment expenses (LAE) are typically divided into two general categories, allocated expenses (those which can be assigned to a specific claim, such as attorney’s fees and court costs) and unallocated expenses (those not assigned to a specific claim such as, costs associated with an in-house claims department and overhead).
All section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
Example: XYZ insurance company’s undiscounted and discounted unpaid losses as of Dec. 31, 1986, are:
Undiscounted unpaid losses — 12/31/86 $100.00
Discounted unpaid losses — 12/31/86 96.58
Fresh start 3.42
Under prior law, a current deduction was allowed for the full amount of future loss payments; i.e., a deduction of $100. Under the Tax Reform Act of 1986 (TRA 86), Pub. L. 99-514, 100 Stat. 2085, the unpaid losses as of Dec. 31, 1986, are required to be discounted and a fresh start is provided. Accordingly, the difference between the undiscounted and discounted unpaid loss is forgiven, and XYZ receives a benefit of $3.42 from the fresh start.
While the regulation provides a separate formula for calculating reserve strengthening for a reserve established for the 1986 accident year, respondent's determination is based solely on additions to reserves determined under the formula applicable to reserves established for pre-1986 accident years.
We conclude that the regulations promulgated by the Secretary do encompass all additions to the reserve. Further, we conclude that should we determine that the phrase “all additions to reserves” encompasses upward revisions of losses incurred in prior periods, we find no basis for rejecting respondent’s regulatory approach in favor of petitioner’s claim-by-claim analysis.
On brief, respondent stated:
Respondent does not dispute petitioner’s allegations regarding the propriety of its reserving methods or its motivations in determining its reserves. * * *
Respondent, in her notice of deficiency, attributed the petitioner with no artificial increase to its reserves. Respondent did not proscribe the method that petitioner used to compute its reserves. Respondent did not premise her determination on the occurrence of artificial additions to the reserves. Indeed, respondent has stipulated that petitioner’s unpaid loss reserves for 1986 and the additions thereto were fair and reasonable estimates.
It should be noted that this regulation was not proposed or adopted in final form until after petitioner filed its returns for the taxable periods under consideration and petitioned this Court for redetermination. More specifically, the sec. 846 regulations concerning TRA 86 were not formally adopted until sometime in 1992.
Petitioner points out that the mechanical approach of the regulation can cause absurd results. For example, if a PC company establishes four case reserves of $500 each, it will have total reserves of $2,000. If two of the cases are settled for $750 each or a total of $1,500 in the following year, the remaining loss reserve would be $1,000. Under the mechanical method of the regulation, this would result in $500 of reserve strengthening. This is so because computation of “reserve strengthening" under sec. 1.846-3(c), Income Tax Regs., would require the second-year reserves ($1,000) to be reduced by $500, which is the difference between the first-year reserves of $2,000 and the second-year payments of $1,500. Under the approach in the regulation reserve strengthening exists only by the regulation’s mechanical definition, but no strengthening exists in fact.
Reserves are ‘“best estimates’ of future settlement costs.” Salzmann, Estimated Liabilities For Losses & Loss Adjustment Expenses 155 (1984).
The parties offered numerous expert witnesses to address the concept of reserve strengthening. Their opinions and testimony did not establish a universal and precise definition of reserve strengthening, but provided sufficient guidance to enable our recognition of the conceptual elements involved in industry jargon. Although, in general industry usage, the term reserve strengthening denotes an increase, it is not applied to every increase to an insurance company’s reserves.
The strengthening of reserves is necessary when experience renders invalid the original reserve assumptions. One of the primary purposes of policy reserves is to permit an orderly development of the company’s financial position. If underlying assumptions in the reserves no longer reflect current and future experience, in the absence of reserve strengthening, the company’s financial position will become distorted. This distortion may then create future drains on surplus as the actual losses materialize. In short, if reserves are not strengthened, true surplus becomes overstated. The company, in recognizing this danger, must then revise its reserves and use more realistic assumptions, which revision is called reserve strengthening. The ordinary increases in reserves during each year are charged to net gain from operation. It would be inappropriate, however, to include in this annual charge the one-time, extraordinary increase due to reserve strengthening, so the latter increase is charged instead directly to surplus. * * * [Carter, “Capital and Surplus Accounts”, in Insurance Accounting and Statistical Association, Life Insurance Accounting 147, 163 (Strain ed. 1977).]
However, the legislative history of TRA 86 sec. 1023(e)(3) provides that, for purposes of that section, the term also includes a change in the basis (except for a change in assumed interest rates applicable to reserves for the 1986 accident year) for calculating the reserves for taxable years beginning in 1986 for claims incurred in that year (for which no reserves had previously been computed). We infer that this aspect of the committee report refers to the use of a basis that is different from the one employed to compute the reserves for similar claims incurred in prior periods. See H. Conf. Kept. 99-841 (1986), 1986-3 C.B. (Vol. 4) 1, 367.
The term “reserve strengthening” appears in the glossary section of a treatise on the Federal taxation of insurance companies with a signal to see “policy reserve strengthening”. Policy reserve strengthening is defined as
The voluntary transfer of amounts from surplus to policy reserves to provide for the future policy benefits on more conservative assumptions. Such a transfer may be due to the use of a lower interest assumption or a different experience table coupled with the assumption of the same or a lower rate of interest in the valuation of the respective benefit contracts than was employed in the respective valuation of the previous year end. [KPMG Peat Marwick, Federal Taxation of Insurance Companies, par. 40.01, at 4038 (1993).]
It is interesting to note that in this text which covers both life insurance companies and PC companies, the definition (unlike some other glossary entries) does not specify that it is a term applicable to only life insurance companies.
It should also be noted that the concept of reserve strengthening also appears in its traditional insurance industry parlance in sec. 1.810 — 2(c)(2), Income Tax Regs., which requires that increases or decreases attributable to a change in the basis of computing reserves should not be taken into account as ordinary decreases in reserves, but rather are to be taken into account as provided by sec. 810(d) and sec. 1.810-3(a), Income Tax Regs. That regulation uses the term “reserve strengthening or weakening” to describe such increases or decreases attributable to a change in the basis of computing such reserves. The phrase “change in the basis of computing such reserves” also appeared in sec. 818(c), where “basis” has been interpreted to mean “method”. Reserve Life Ins. Co. v. United States, 229 Ct. Cl. 529, 640 F.2d 368, 377 (1981).
The Supreme Court in Commissioner v. Standard Life & Accident Ins. Co., 433 U.S. 148 (1977), indicated that the accounting system approved by the National Association of Insurance Commissioners (NAIC) provides guidance for courts in considering problems that relate to the income taxation of insurance companies. The NAIC approved accounting system recognizes the difference between routine adjustments to reserves and extraordinary increases or decreases resulting from a change in the underlying assumptions.
For example, in Rev. Rui. 65-240, 1965-2 C.B. 236, a casualty insurance company, writing life as well as casualty insurance, changed the basis of computing reserves on its guaranteed renewable health policies from the preliminary term basis to the net level premium basis. Although there was no indication that casualty insurance reserves were involved, respondent ruled that increases or decreases attributable to this basis change represented reserve strengthening or weakening. The fact that the taxpayer was a casualty company did not affect its ability to engage in reserve strengthening or weakening.
While respondent agrees that petitioner’s 1986 unpaid loss reserve estimates and increases included therein were fair and reasonable estimates within the meaning of sec. 1.832-4(b), Income Tax Regs., respondent asserts that petitioner’s allegations regarding its methods for determining reserves and its motivations in making those determinations is irrelevant.
The U.S. Court of Claims (quoting Justice Frankfurter’s article “Some Reflections on the Reading of Statutes”, 47 Colum. L. Rev. 527, 536-537 (1947)) noted in Alinco Life Ins. Co. v. United States, 178 Ct. Cl. 813, 373 F.2d 336, 352 (1967):
If a statute is written for ordinary folk, it would be arbitrary not to assume that Congress intended its words to be read with the minds of ordinary men. If they are addressed to specialists, they must be read by judges with the minds of specialists.
* 4 * * * * *
Words of art bring their art with them. They bear the meaning of their habitat whether it be a phrase of technical significance in the scientific or business world, or whether it be loaded with the recondite connotations of feudalism. * * * The peculiar idiom of business or of administrative practice often modifies the meaning that ordinary speech assigns to language. And if a word is obviously transplanted from another legal source, whether the common law or other legislation, it brings the old soil with it.
The stated purpose of the fresh-start adjustment contained in the conference agreement reads as follows:
This provision is intended to prevent taxpayers from artificially increasing the amount of income that is forgiven under the fresh start provision. [H. Conf. Rept. 99-841 (1986), 1986-3 C.B. (Vol. 4) 1, 367.]
It should be noted that the joint committee staff stated that
Reserve strengthening does not include amounts reported to the insurance company from mandatory state or Federal assigned risk pools, if the amount of the loss reported is not discretionary with the insurance company. [Staff of Joint Comm, on Taxation, General Explanation of the Tax Reform Act of 1986, at 618 (J. Comm. Print 1987).]
Respondent concedes, solely for purposes of this case, that such additions to petitioner’s reserves would not be excluded from the fresh start as being reserve strengthening. Respondent does not otherwise concede that there should be any exception to the regulations’ broad definition of additions to the reserves which should not be part of the fresh start provisions. The joint committee staffs exception, however, does comport with the principle that such amounts are not artificial and would not be defined, by industry standards, as reserve strengthening.
Even if sec. 1.846-3(c), Income Tax Regs., was a legislative regulation, the standard for review of legislative regulations would not have caused a difference in the outcome here.
The Senate Finance Committee report to which petitioner refers provides in pertinent part:
Such fresh start adjustment is to be taken into account in full in the first taxable year to which the discounting provisions apply (i.e., the first taxable year beginning after December 31, 1986), for purposes of calculating any adjustments to earnings and profits. Any reserve strengthening after March 1, 1986, is to be treated as reserve strengthening for the first taxable year beginning after December 31, 1986. The committee intends that any adjustments to reserves that are attributable to changes in reserves on account of changes in the basis for computing reserves (i.e., reserve strengthening or reserve weakening) in a taxable year beginning before January 1, 1987, are not taken into account in determining taxable income after the effective date. [S. Rept. 99-313 (1986), 1986-3 C.B. (Vol. 3) 1, 510; emphasis supplied.]
Pursuant to sec. 1.846 — S(c)(3)(i), Income Tax Regs., to determine whether reserves have been strengthened from a company’s yearend 1985 reserves to its yearend 1986 reserves, losses paid during 1986 are subtracted from the yearend 1985 reserves. Under the regulation’s test, a reserve strengthening is an amount added to an unpaid loss reserve. This test is applied separately to each unpaid loss reserve. As noted by one commentator,
because the test is applied to each unpaid loss reserve, rather than to each separate loss, the test does not take into account the fact that a particular loss payment may exceed, or be less than, the initial estimates of the amount of the loss for which the payment was made. This may result in a failure to include, or an erroneous inclusion of, certain amounts in the computation of reserve strengthening of a particular reserve. [12 Mertens, Law of Federal Income Taxation, sec. 44.14, at 16 (Supp. 1993).]
In that case, the Supreme Court concluded that for purposes of sec. 122(d)(6) it would be unfaithful to the statutory scheme to attribute a different meaning to the term “paid or accrued” than it has in other parts of the same chapter of the Internal Revenue Code.
This is not the type of situation which has generated the continuing debate on the amount of deference that should be afforded to the legislative history. This case presents a different perspective because the statute is neither ambiguous nor imprecise.
On brief respondent denies that administrative burdens and compliance-related concerns are the cornerstone of her argument and asserts that the regulation’s validity rests in the reasonableness with which it has provided a meaning to a term which is used but not defined in the statute. However, in the Notice of Proposed Rulemaking, 56 Fed. Reg. 20162 (May 2, 1991), the acknowledged limitations of the mechanical test adopted were justified as follows:
Because the test is applied to each unpaid loss reserve, rather than to each separate loss, the test does not take into account the fact that a particular loss payment may exceed, or be less than, the initial estimate of the amount of the loss for which payment was made. This may result in a failure to include, or an erroneous inclusion of, certain amounts in the computation of reserve strengthening for a particular reserve. For most unpaid loss reserves, however, any potential inaccuracies are likely to offset each other in the aggregate. Further, the absence of total accuracy is justified by the reduction in compliance and administrative burdens. [Emphasis supplied.]