                         T.C. Memo. 2000-203



                     UNITED STATES TAX COURT



  MINNESOTA LAWYERS MUTUAL INSURANCE COMPANY AND SUBSIDIARIES,
                          Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21181-97.          Filed June 30, 2000.



     Myron L. Frans, for petitioner.

     John C. Schmittdiel, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     THORNTON, Judge:    Respondent determined deficiencies in

petitioner’s Federal income taxes as follows:

          Taxable year               Deficiency

              1993                     $712,570
              1994                      436,295
              1995                      380,570
                                  -2-

     The sole issue for decision is what portion of petitioner’s

reserves for unpaid losses and related loss adjustment expenses

(unpaid loss reserves) should be included in its computation of

“losses incurred” as defined in section 832(b)(5).

     Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the taxable years in issue,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

                        FINDINGS OF FACT

     The parties have stipulated some of the facts, which are

incorporated by this reference.

Petitioner

     Petitioner, Minnesota Lawyers Mutual Insurance Co., was

incorporated in Minnesota on May 28, 1981, as a mutual property

and casualty insurance company.    Petitioner was formed after a

task force of the Minnesota State Bar Association recommended the

establishment of a self-insured program for professional

liability insurance for practicing lawyers in Minnesota.

     Before 1993, petitioner wrote exclusively professional

liability insurance in Minnesota.       In 1993, petitioner began

expanding its operations outside Minnesota and offering a

commercial multiple-peril policy.       Throughout its existence,

however, petitioner has sold primarily professional liability

insurance policies for lawyers.
                                  -3-

State-Imposed Requirements

     Since its incorporation in 1981, petitioner has been

regulated by the Minnesota Department of Commerce (the

department).   Petitioner's affairs, practices, and financial

condition are periodically subject to examination by the

department’s insurance division.

     Each year, petitioner is required to file with both the

department and the National Association of Insurance

Commissioners (NAIC) a copy of its NAIC annual statement, and to

deliver a statement of actuarial opinion regarding the adequacy

of its reserve levels.   At all times relevant to this case,

petitioner complied with these requirements.

     Throughout its existence, petitioner was required under

Minnesota State law to maintain a minimum surplus of $1 million.1

Petitioner’s Early Financial Problems and Remedial Actions

     Between 1982 and 1985, petitioner’s reported surplus

deteriorated from $1,433,544 to $1,011,148.    Petitioner’s audited

financial statements for 1985, issued by Ernst & Whinney on

May 10, 1986, restated petitioner’s December 31, 1985, surplus as

$7,995 and noted that petitioner did not meet the surplus level

required by Minnesota statutes.


     1
       Petitioner's surplus is the excess of its assets over its
liabilities, which include the amounts estimated to be necessary
to satisfy its obligations for unpaid losses and allocated loss
expenses. As a liability item on petitioner's balance sheet, its
loss reserves directly reduce petitioner's surplus.
                                  -4-

     In the mid-1980’s, the department began examining

petitioner’s financial condition and criticized petitioner for

its inadequate surplus, loss reserving practices, and reinsurance

arrangements.

     Petitioner began to take a variety of steps to improve its

financial condition.    In 1985, as part of its plan to improve its

operations and reduce expenses, petitioner hired Timothy Gephart

(Gephart) as vice president of claims.2    Under Gephart’s

direction, petitioner began the process of developing a claims

procedure manual and eventually hired two additional employees in

its claim department.    In late 1985 or early 1986, petitioner

doubled from $7,500 to $15,000 its minimum reserve for each claim

received.   In 1986, petitioner established a new bulk reserve for

“adverse loss development”.3    In 1986, the department approved

two premium increases for petitioner.

     On March 24, 1986, the department’s commissioner ordered a

special examination of petitioner and appointed a special

examiner to perform operations audits and underwriting

procedures.     In a May 14, 1986, report to the department’s

commissioner, the special examiner stated that even though

petitioner’s March 31, 1986, adjusted surplus was only $302,478,


     2
       Initially, petitioner had no claim department but instead
relied on an outside law firm to manage its claims.
     3
       As of Sept. 30, 1986, the adverse loss reserve had reached
a level of $626,000.
                                -5-

he did not recommend that petitioner be made a candidate for

“rehabilitation”, because of petitioner’s actions to increase its

premiums and reserves and to obtain additional paid-in capital.

The special examiner continued to review petitioner's activities

until December 31, 1987.

     In 1989, as part of its regular, triennial examination of

insurance companies, the department conducted an examination of

petitioner for its 1988 year of operation.   Its report, issued

June 21, 1990, found no reasons to recommend increased oversight

by the department but made several recommendations for

operational improvements that were later implemented by

petitioner.   With respect to petitioner’s loss reserves, the

department accepted petitioner’s estimates but stated:

          it should be noted that due to the short
          history of * * * [petitioner], the lack of
          credible industry data for this single line
          claims made coverage; coupled with the
          volatility of the severity and frequency of
          claims the ultimate loss development could
          vary substantially from the amounts reserved.

     In an examination for the 5-year period ended

December 31, 1993, the department declared petitioner’s loss

reserves to be “adequate”.   The department’s examination included

a review of petitioner’s claim department procedures, for which

the department made only one minor recommendation.4


     4
       The department recommended that petitioner establish a
separate reserve account for unallocated loss adjustment
                                                   (continued...)
                                      -6-

     For 1994 and 1995, petitioner submitted its annual

statements to the department, and they were accepted without any

further review or examination.

Summary of Petitioner’s Operating Experience

     Petitioner's surpluses as reported on its annual statements

for the years 1982 through 1995 were as follows:

                  Year                        Surplus

                  1982                      $1,433,544
                  1983                        1,419,147
                  1984                        1,106,819
                                             1
                  1985                         1,011,148
                  1986                        1,367,340
                  1987                        2,956,033
                  1988                        5,365,295
                  1989                        6,716,661
                  1990                        7,851,174
                  1991                      10,138,154
                  1992                      11,918,004
                  1993                      14,025,806
                  1994                      15,978,214
                  1995                      18,348,818
     1
         Adjusted by the department’s commissioner to $7,995.

     Beginning in 1988 and continuing through the years in issue,

petitioner declared dividends to its policyholders.             Petitioner's

declared dividends for the years 1988 through 1997, stated as




     4
      (...continued)
expenses. Petitioner established such an account for its first
report year (1995) after the department’s examination report was
received.
                                  -7-

dollar amounts and as a percentage of premiums paid, were as

follows:

                                          Percentage
         Year            Amount           of Premiums

         1988           $607,106                7.5
         1989            791,886               10
         1990            413,740                5
         1991            712,260                8
         1992          1,484,733               17.5
         1993          1,319,424               15
         1994          1,382,667               15
         1995          2,014,225               20
         1996          2,714,236               25
         1997          2,322,443               20

     During the years in issue, petitioner’s operations expanded.

Between 1993 and 1995, the number of attorneys insured by

petitioner increased from 3,378 to 3,815; the number of law firms

insured by petitioner increased from 1,411 to 1,674; the number

of policies issued by petitioner increased from 1,411 to 1,674;

and the amount of net premiums written by petitioner increased

from $6,352,712 to $7,397,240.

A.M. Best Rating

     For the years in issue, petitioner received an “A

(Excellent)” rating from A.M. Best (Best).5   In its reports for

petitioner’s 1995 year (the 1995 Best report) and for

petitioner’s 1994 year (the 1994 Best report), Best states that

among petitioner’s positive rating factors is the fact that


     5
        A.M. Best (Best) rates the financial condition of
property and casualty insurers each year. Ratings are based on
the insurer’s prior year’s activity.
                                -8-

petitioner’s pricing and reserving are “conservative by industry

standards”.   The 1994 and 1995 Best reports also state:

“Somewhat offsetting these positive rating factors is a

concentration of underwriting risk as the company is primarily a

one state, one line writer and is subject to changes in insurance

regulation and judicial climate."

     The 1995 Best report states:

          Favorable underwriting gains continued for the
     tenth consecutive year in 1995, despite a high
     frequency claim year. Underwriting income benefitted
     from the take down of approximately $3 million of
     redundant reserves from prior report years. This
     reduction has been a consistent pattern since 1987.
     [Emphasis added.6]

     Additionally, in regard to petitioner's reserve quality, the

1995 Best report concludes:

          The company's carried loss reserve position is
     strong, with significant accident year redundancies
     recorded over the last ten years reflective of the very
     conservative reserving practices and commitment to
     reserve adequacy. Management believes that
     professional liability is a very volatile line of
     business, so they reserve very conservatively in the
     early years of development and retire any redundant
     reserves after claims are more seasoned and
     predictable. Given the volatility and the low
     mathematical credibility of the company's development
     patterns this course of action insures that reserves
     set aside by report year will be adequate to cover
     future development. Therefore, despite annual
     reductions on old report years, the company continues
     to be very conservatively reserved. [Emphasis added.]


     6
       Similarly, the 1994 Best report states: “Bulk reserves on
years prior to 1994 which were deemed redundant were reduced by
$1.7 million last year. This take down of reserves has been a
consistent pattern since 1987.” (Emphasis added.)
                                -9-


Petitioner’s Liability for Policy Claims

     Since 1982, petitioner has written professional liability

insurance policies on a claims-made basis.    Under such policies,

petitioner is liable only for claims that are made and reported

during the effective dates of a policy.    For example, if an

insured was covered by a policy effective January 1 through

December 31, 1993, the insured would have professional liability

protection for claims made and reported during that policy year.

If the insured terminated insurance coverage effective January 1,

1994, any claims made thereafter would not be covered unless the

insured purchased an extended reporting period endorsement

(ERE).7

Petitioner's Loss Reserves Process

     Petitioner annually determines its loss and loss adjustment

expense reserves (loss reserves) for purposes of reporting such

amounts on the NAIC annual statement, particularly schedule P

thereto.   Petitioner’s total unpaid loss reserve comprises two

components:   An incurred loss case reserve (case reserve) and a




     7
       From 1982 until 1986, petitioner offered its insureds the
opportunity to purchase ERE’s with an unlimited tail period. In
order to receive this type of coverage, the insured was required
to purchase a policy endorsement that provided for extended
coverage for claims that were made and reported after the claims-
made policy period had expired. Since 1986, petitioner has
offered to its insureds ERE’s, with up to five annual renewals,
that provide only for a 1-year extended reporting period.
                                -10-

reserve for adverse loss development (adverse development

reserve).

     1.     Case Reserve

     Petitioner’s case reserve is the aggregate of the amounts

determined by petitioner’s claim department to represent the

company’s total exposure for each claim.   Upon receiving a claim,

petitioner’s claim department conducts an investigation to

determine petitioner’s potential liability and damages resulting

from the claim.    Based upon this claim investigation, petitioner

establishes a case reserve.

     During the years in issue, petitioner reserved a minimum of

$15,000 for each claim when it was received.    Petitioner seeks to

estimate its exposure for each claim more firmly by reviewing

each claim at least three times shortly after it is reported (15

days, 45 days, and 100 days after being reported).   Ultimately,

petitioner closes approximately one-half of all claims received

without making any payments.

     The case reserve includes two components:   Indemnity and

expenses.    The indemnity component of the case reserve includes

judgments, settlements, and plaintiff’s attorney’s fees.    The

expense component of the case reserve includes fees charged by

an attorney retained by petitioner to defend claims and all

expenses incurred by petitioner or with petitioner’s consent in

the investigation and negotiation of any claims.
                                -11-

     For the years in issue, petitioner’s case reserves, net of

any reinsurance, for its professional liability insurance were

as follows:
                                    Net Case
                  Year              Reserve

                  1993             $8,478,000
                  1994              7,833,000
                  1995              7,888,000

     Throughout petitioner’s period of operations, petitioner’s

claim department was periodically reviewed and examined by

either reinsurance companies or the department.     Reinsurance

companies reviewed petitioner’s claim department operations to

assess petitioner’s overall claim handling procedures for

purposes of determining whether to enter into, or renew, a

reinsurance agreement with petitioner.      The department examined

petitioner’s claim department as part of its triennial

examination of petitioner’s operations.     These reports and

examinations have generally approved petitioner’s procedures in

processing claims and establishing reserves for its case

reserves.8

         2.   Adverse Development Reserve

     In addition to the case reserve set by the claim

department, petitioner’s incurred loss reserve also comprises an


     8
       The department’s examination for petitioner’s 1993 year
included a review of petitioner’s claim department procedures.
There was only one minor recommendation regarding petitioner’s
claim department procedures, which petitioner implemented after
the examination.
                                -12-

adverse development reserve.    The adverse development reserve is

established by its CEO and president, Joseph H. Bixler (Bixler),

and its controller to address the possibility that the reserves

set by the claim department might be understated because of the

discovery of new information or unforeseeable events.      This

reserve is a “bulk” reserve rather than one calculated case by

case.9   For the years in issue, the adverse development

reserves, when added to petitioner’s case reserves, increased

petitioner’s total unpaid loss reserves by amounts ranging from

about 37 percent to about 50 percent.

     For estimated claims under $100,000, the adverse

development reserve includes an amount that represents a

percentage of such claims.    The percentage varies from year to

year and reflects at least an element of judgment or

subjectivity.   Petitioner operates under the principle that as

the claims mature and more information is known about them, it

can develop a higher expectation of accuracy on its case

reserve.   Consequently, in computing its adverse development

reserve, petitioner includes a higher percentage of open claims

from the most current claim year and a smaller percentage for

each succeeding older year.    For each year in issue, petitioner


     9
       On its annual statement, petitioner’s adverse development
reserve is labeled as “Bulk + IBNR”. The term “IBNR” stands for
“incurred but not reported”. Petitioner did not compute an IBNR
reserve because it considered only reported claims in its reserve
analysis.
                                    -13-

applied to open claims from the most current claim year a factor

that was between roughly 35 and 45 percent; this factor was then

reduced for each succeeding older claim year.10           For claims over

$100,000, petitioner makes a separate and additional allowance

in the adverse development reserve based not upon any percentage

factor but rather upon a subjective assessment of the number of

such losses and how much they might cost.11

      Petitioner's adverse development reserves for the years in

issue were as follows:

                     Year              Amount

                     1993           $3,155,000
                     1994             3,748,000
                                     1
                     1995              4,048,000
      1
        For 1995, petitioner included in its adverse development reserve, for
the first time, an additional component, “unallocated loss expenses unpaid”,
in the amount of $532,000.

Petitioner’s Reserve Experience

      For each of the years 1982 through 1985, petitioner's

initial estimates of losses turned out to be lower than actual

losses.    For each of the years 1986 through 1995, petitioner’s


      10
       For example, to compute the adverse development reserve
for 1995, petitioner applied a factor of approximately 45 percent
to its case reserve estimate for open 1995 claims, a factor of
approximately 40 percent for open 1994 claims, a factor of
approximately 38 percent for open 1993 claims, and so on. The
adverse development reserve for 1995 is the sum of the separately
computed adverse development reserve amounts for each year with
open claims as of Dec. 31, 1995.
      11
       The record does not reveal the mechanics of this separate
and additional allowance for claims over $100,000.
                                 -14-

estimates of losses turned out to be significantly higher than

actual losses.    For example, petitioner's estimated loss reserve

for claims arising in 1995, as stated in its 1997 annual

statement, was $7,254,000, in contrast to the $12,500,000 that

was initially stated in its 1995 annual statement.12

     Similarly, for each of the years in issue, petitioner’s

initial estimates of losses, stated as a percentage of premiums

earned for the year, turned out to be much higher than actual

losses.   For example, as of the end of 1993, petitioner

estimated that it would pay out in net loss and loss expenses on

1993 claims 94.7 percent of the premiums earned for that year.

By the end of 1995 petitioner had revised that figure to 60

percent, and by the end of 1997 petitioner had further revised

that figure to 44.2 percent.13


     12
       Petitioner’s reserves for claims arising in the years
1993 through 1995, as originally reported and as adjusted as of
the time petitioner completed its 1997 annual statement, were as
follows:


                      As Originally        As Estimated on
           Year         Reported        1997 Annual Statement

           1993        $11,633,000           $4,934,000
           1994         11,576,000            4,330,000
           1995         12,490,000            7,254,000


     13
       The following table sets out petitioner's estimated
percentage of premiums earned that would be paid out in losses
and loss expenses, net of reinsurance, initially and as later
                                                  (continued...)
                                -15-

     For the years in issue, petitioner’s reserve analyses show

“redundancies” (excesses) in its case reserves in the following

amounts:

                 Year             Redundancy

                 1993              $129,374
                 1994             1,159,685
                 1995             1,751,656

Petitioner’s Reporting of Loss Reserves for Annual Statement
Purposes

     Each year, pursuant to State law, petitioner appoints a

qualified actuary before yearend for purposes of obtaining a

loss reserve opinion for that year.      Shortly after yearend,

petitioner estimates its final unpaid loss reserve and submits

material to the qualified actuary for purposes of the actuary’s

review for its loss reserve opinion.      Each February, the

qualified actuary issues her statement of actuarial opinion

regarding petitioner’s loss reserve.      Each March, petitioner

files its annual statement with the department and the NAIC.



     13
      (...continued)
adjusted:

                         Year of Estimate
Loss Year     1993      1994        1995          1996         1997

   1993       94.7%     80.3%           60.0%     43.2%        44.2%
   1994                 83.1            67.0      60.2         42.5
   1995                                102.2      79.7         77.9
                               -16-

Petitioner then files its Federal income tax return.

     For each of the years in issue, petitioner used on its

annual statement the same unpaid loss reserve estimate that it

presented to its appointed actuary for review and also used this

same estimate on its Federal income tax return.

Statements of Actuarial Opinion

     Petitioner’s actuarial opinion for 1993 (the Witcraft

opinion) was prepared by Susan E. Witcraft (Witcraft) of

Milliman & Robertson, Inc.   The Witcraft opinion states that

petitioner’s 1993 carried reserves met the requirements of the

insurance laws for the State of Minnesota; were computed in

accordance with the standards of practice issued by the

Actuarial Standards Board (including the Casualty Actuarial

Society's statement of principles regarding property and

casualty loss and loss adjustment expense reserves); and made

reasonable provision for all unpaid loss and loss expense

obligations.

     In her actuary’s report, Witcraft explained that she had

projected ultimate losses using six methods:   The paid loss

development method, the incurred loss development method (“both

unadjusted and adjusted for an apparent increase in reserve

adequacy”), the reserve development method (“both unadjusted and

adjusted for an apparent increase in reserve adequacy”), and the

average claim cost method.   The report states that, on the basis
                                -17-

of these projections, she selected estimates of petitioner’s

ultimate losses.    The report states that Witcraft’s best

estimate of the reserve for petitioner’s unpaid losses and loss

adjustment expenses, net of reinsurance, was approximately $7.8

million.   The report specifically notes that Witcraft’s best

estimate was significantly lower than petitioner’s booked

reserve of $11.6 million.14

     For 1994 and 1995, Patricia A. Teufel (Teufel) of KPMG Peat

Marwick issued petitioner’s statements of actuarial opinion (the

Teufel opinions).    The 1994 and 1995 Teufel actuarial reports

that accompanied the Teufel opinions each state that her

evaluation of petitioner’s loss reserve was made using the paid

development method, the incurred development method, and the




     14
       In exhibits accompanying her report, Susan E. Witcraft
(Witcraft) noted that for 1993, there was a $4,210,000 aggregate
“redundancy” in petitioner’s booked net reserve, comprising
redundancies with respect to petitioner’s booked net reserves for
preceding years in the following amounts:

                      Year             Amount

                      1985            $19,000
                      1986             22,000
                      1987             70,000
                      1988            123,000
                      1989            281,000
                      1990            304,000
                      1991            803,000
                      1992          1,099,000
                      1993          2,421,000
                                 -18-

Bornhuetter-Ferguson method.15    The Teufel opinions state that

petitioner’s carried reserves meet the requirements of Minnesota

insurance laws, were computed in accordance with accepted loss

reserving principles and standards, and make reasonable

provision for all of petitioner’s unpaid loss and loss expense

obligations.   In addition, Teufel’s 1994 and 1995 reports each

provide a range for petitioner’s unpaid loss reserves, as well

as recommended point estimates.    For 1994, Teufel’s range for

reserves net of reinsurance extends from $7,956,093 to

$13,550,446, and her point estimate is $10,096,656.    For 1995,

Teufel’s range is from $5,851,559 to $12,867,450, and her point

estimate is $8,706,428.

Reinsurance

     During the years in issue, petitioner purchased reinsurance

coverage from reinsurance companies.    Before July 19, 1994,

petitioner retained 100 percent of the insurance coverage for

claims up to $100,000, ceding to reinsurers all losses greater

than this amount.   From July 19, 1994, to April 18, 1995,

petitioner increased its retention levels to include, in

addition to 100 percent retention of losses up to $100,000, 60

percent of losses greater than $100,000, up to $250,000.     On



     15
       The Bornhuetter-Ferguson method is an actuarial technique
widely used for long-tailed lines of insurance like professional
malpractice. See Utah Med. Ins. Association v. Commissioner,
T.C. Memo. 1998-458.
                                -19-

April 19, 1996, petitioner again increased its retention levels

to include 15 percent of losses greater than $250,000, up to

$500,000.

     In a newsletter to policyholders dated September 1996,

Bixler explained these changes in its reinsurance philosophy as

follows:

     If certain reinsured layers are relatively predictable and
     the company’s financial strength can readily absorb unusual
     activity in those layers, then it may be advisable for the
     company to retain that portion instead of buying
     reinsurance on it. * * *
     * * * [Petitioner] has pursued a strategy of surplus growth
     and will soon achieve our immediate goal of $20,000,000.
     Meanwhile, we have had the opportunity to observe the loss
     activity in each band of risk and have found many of the
     lower layers to be relatively stable under various
     conditions over several years. Therefore, * * *
     [petitioner] has progressively assumed a larger share of
     risk on each claim over the past few years.

     For annual statement purposes, petitioner’s unpaid loss

reserves were shown both gross and net of estimated reinsurance

proceeds recoverable.    Similarly, petitioner’s appointed

actuaries computed both gross and net unpaid loss reserves but

netted out larger amounts of estimated reinsurance proceeds

recoverable than did petitioner.16     The differences in

petitioner’s estimates of reinsurance proceeds (as reflected on

schedule F of its annual statements) and the actuaries’

estimates (as indicated by the difference between the actuaries’




     16
          The record does not explain these variances.
                                  -20-

gross and net reserve point estimates) are shown below (in

millions of dollars):

     Estimates of Reinsurance Proceeds Recoverable

                      Petitioner’s        Actuaries’
     Year               Estimate           Estimate

     1993               $4.397             $6.9
     1994                4.507              4.804
     1995                4.255              5.863

Petitioner’s Tax Returns and Respondent’s Determinations

     Petitioner timely filed Forms 1120PC, U.S. Property and

Casualty Insurance Company Income Tax Return, for 1993, 1994,

and 1995.

     Respondent determined that for each year petitioner

overstated its unpaid losses for professional liability

insurance.17   The following table shows the unpaid losses

outstanding at yearend (net of reinsurance and before

discounting) on professional liability insurance, as reported by

petitioner and as allowed by respondent for each year in issue:

    Year       Reported by petitioner      Allowed by respondent

    1993            $11,663,000                $7,134,000
    1994             11,576,000                 5,531,000
    1995             12,490,000                 5,010,000




     17
       For each year in issue, petitioner also claimed losses
incurred with respect to its commercial multiple peril policies,
as follows: 1993-–$3,000; 1994-–$5,000; and 1995--$9,000.
Respondent did not adjust the unpaid losses claimed by petitioner
on these policies.
                                   -21-

                               OPINION

I.   Applicable Law

     Petitioner, as a mutual property and casualty insurance

company, must compute its taxable income under section 832.        See

sec. 831.    Taxable income equals gross income less allowable

deductions.     See sec. 832(a).   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 means

“the premiums earned on insurance contracts during the taxable

year less losses incurred and expenses incurred.”       Sec.

832(b)(3).     Insurance companies are also allowed various

deductions under section 832(c), including a deduction for

“losses incurred”, as defined in section 832(b)(5).       Sec.

832(c)(4).18

     “Losses incurred” generally means (with qualifications

inapplicable here) losses paid (net of salvage and reinsurance

recovered) on insurance contracts during the year plus any

increment from the preceding year in discounted “unpaid losses”,

less any increment from the preceding year in estimated


     18
       Although such a deduction would appear potentially
duplicative of losses incurred taken into account in determining
underwriting income under sec. 832(b)(3), the statute
specifically prohibits the same item from being deducted more
than once. See sec. 832(d).
                               -22-

recoverable salvage and reinsurance.   Sec. 832(b)(5)(A).19

“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.”   Sec. 846(b)(1).

Unpaid losses include any unpaid loss adjustment expenses.    See

sec. 832(b)(6).

     The relevant regulations state:

     (a)(5) 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


     19
          Sec. 832(b)(5)(A) provides in relevant part:

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

                 (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.
                               -23-

     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.” [Sec. 1.832-4(a)(5) and (b), Income Tax Regs.]

     The validity of these longstanding regulations is well

established, see, e.g., Hanover Ins. Co. v. Commissioner, 69

T.C. 260, 272 (1977), affd. 598 F.2d 1211 (1st Cir. 1979);

Hanover Ins. Co. v. Commissioner, 65 T.C. 715, 719 (1976), and

is not in dispute.

     Although the annual statement methodology is normally

controlling for tax purposes, when the annual statement

methodology is predicated upon the use of estimates, those

estimates must be the “best possible.”   Bituminous Cas. Corp. v.

Commissioner, 57 T.C. 58, 78 (1971).

     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 Western Cas. & Sur. Co. v. Commissioner, 65 T.C.

897, 917 (1976), affd. 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
                                -24-

be based on the actual loss experience of the insurance company.

See Maryland Deposit Ins. Fund Corp. v. Commissioner, 88 T.C.

1050, 1060 (1987); Hospital Corp. of Am. v. Commissioner, T.C.

Memo. 1997-482.

      Whether the taxpayer’s estimate of unpaid losses is fair

and reasonable is essentially a valuation issue and thus a

question of fact.   See Hanover Ins. Co. v. Commissioner, 69 T.C.

at 270.   The burden of proof is on the taxpayer to substantiate

its claimed deduction.   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).

II.   The Parties’ Positions

      Petitioner asserts that its case reserves were established

by evaluating the facts of each claim, that its adverse

development reserves were reasonable given the inherent

uncertainty of its case reserve determinations, that its unpaid

loss reserves were approved by knowledgeable persons including

its expert witness, and that respondent's determination,

including the analysis of his expert, is wholly unsupported.

Petitioner argues that factual similarities between the instant

case and Utah Med. Ins. Association v. Commissioner, T.C. Memo.

1998-458, favor its position.

      Respondent argues that petitioner’s unpaid loss reserves

were not fair and reasonable as they did not represent
                                   -25-

petitioner’s actual unpaid losses as nearly as they could be

ascertained.       On brief, respondent acknowledges that

petitioner’s case reserves are “at least facially” in compliance

with the regulatory requirement that unpaid losses be calculated

“based on the facts in each case.”        Sec. 1.832-4(b), Income Tax

Regs.       Respondent contends, however, that petitioner has failed

to establish that the portion of its total unpaid loss reserves

represented by its adverse development reserve was necessary or

reasonable.

III.    Expert Witnesses

       The parties each called an expert witness to opine on the

reasonableness of petitioner's reserves.       We evaluate expert

opinions in light of all the evidence in the record and may

accept or reject the expert testimony, in whole or in part,

according to our own judgment.       See Helvering v. National

Grocery Co., 304 U.S. 282, 295 (1938); Estate of Mellinger v.

Commissioner, 112 T.C. 26, 39 (1999).

       A.     Roger M. Hayne

       Petitioner’s expert, Roger M. Hayne (Hayne), is a

consulting actuary in the firm of Milliman & Robertson, Inc.20

He is a member of the American Academy of Actuaries.        He holds a


       20
       Although Milliman & Robertson, Inc., is the actuarial
firm that provided the Witcraft opinion and report for
petitioner’s 1993 year, there is no indication in the record that
Roger M. Hayne (Hayne) was involved in the preparation of the
Witcraft opinion or report.
                               -26-

Ph.D. in mathematics from the University of California

(Riverside) and has more than 21 years of actuarial consulting

experience.

     In forming his opinion, Hayne relied primarily on

information supplied by petitioner, the Witcraft opinion, and

the Teufel opinions, as well as petitioner’s annual statements

and annual statements of other insurers specializing in legal

professional liability insurance.

     Hayne did not attempt to estimate petitioner’s unpaid

losses.   He testified that he had no actuarial opinion as to the

amount of unpaid loss reserves petitioner should use for either

annual statement or Federal income tax purposes.     Instead, his

goal, as stated by petitioner on brief, was to “assess the

volatility present in petitioner’s data and the effect of that

volatility on projections based on that very data.”

     Hayne testified that petitioner’s loss development was

historically volatile and difficult to predict with certainty.

He found that petitioner had substantially fewer expected paid

claims than the number generally needed each year for full

statistical credibility.   He attempted to quantify the level of

uncertainty and to test petitioner’s carried reserves using two

statistical analyses, the incurred loss development method and

the paid loss development method.     Under these two methods,

Hayne determined that the range of outcomes for petitioner’s
                                -27-

paid and incurred loss reserves for the years in issue were as

follows (rounded, in millions of dollars):

                      Incurred Loss           Paid Loss
     Year           Development Method    Development Method

     1993             $6.0 to $9.6          $3.9 to $19.9
     1994              4.9 to 8.7            7.0 to 31.9
     1995              4.8 to 9.4            8.3 to 39.2

Hayne’s expert report states:

     If the message given by the paid patterns * * * were indeed
     correct, one could conclude that * * * [petitioner’s]
     carried reserves would not be adequate. If, however, the
     message given by the incurred patterns were correct, one
     could conclude that the carried reserves may be sufficient,
     or perhaps even redundant.

Hayne concluded that given the wide range of potential outcomes

from these two statistical analyses, he “could not conclude that

* * * [petitioner’s] carried reserves were, in total, so high as

to be unreasonable.”    Or, as petitioner summarizes Hayne’s

opinion on brief:    “there was so much volatility in petitioner’s

data that petitioner’s reserves were reasonable.”

     Hayne also presented a comparison of petitioner's

development factors to those of a selected “peer” group of

companies, comprising eight companies that are single-line,

legal malpractice insurers operating in other States.       He

compared the ratio of petitioner's paid to ultimate losses and

allocated loss adjustment expenses to the peer group.       Hayne

also compared the ratios of bulk and IBNR losses and allocated

loss adjustment expenses to ultimate losses for petitioner with

the same ratios for the selected group.    Hayne did not define
                                -28-

the bounds of the selected group’s range but concluded that

petitioner's ratio fell within the middle 50 percent of the peer

group’s range.

     B.   James P. Streff

     Respondent’s expert, James P. Streff (Streff), is an

independent consulting actuary.    He is president of Streff

Insurance Services, an actuarial consulting firm in Red Wing,

Minnesota.   He has a bachelor's degree in mathematics from the

College of St. Thomas and a master’s degree in statistics from

the University of Minnesota.    He is a fellow in the Casualty

Actuarial Society and a member of the American Academy of

Actuaries.   He has worked as an actuary in the insurance

industry since 1970.    He is the appointed actuary for a number

of companies and is under contract to provide actuarial

assistance to the State of Michigan's Department of Insurance.

     In preparing his expert report, Streff relied on four

primary sources:    Petitioner's annual statements dating back to

1982; certain internal data requested from petitioner; industry

statistics obtained from Best publications; and the reports

prepared by petitioner's appointed actuaries for years 1993

through 1995.

     Streff performed an actuarial analysis.    He acknowledged

that petitioner’s low claim volume reduced its statistical

credibility.    Streff reviewed other aspects of petitioner’s
                               -29-

business and claim trends to satisfy himself that petitioner’s

underlying loss and loss adjustment expense patterns were stable

and consistent.21

     Like Hayne, Streff used two accepted actuarial methods,

involving projections of both incurred and paid losses.     Streff

computed his development factors22 for both incurred losses and

paid losses using petitioner’s last five to seven annual

statements.   Streff expressed the development as a ratio or

arithmetic percentage showing the change in paid, or incurred,

losses from one year to the next.     Streff computed a weighted

3-year average and a weighted average for all years presented,

and then selected the development factor to be applied to each

interval on the basis of his judgment and experience as an

actuary.

     Streff applied the development factor determined for each

year to the paid or incurred losses for that year, as


     21
       James P. Streff (Streff) reviewed the following types of
information: (1) Financial considerations, such as written
premium, surplus, etc.; (2) marketing and loss exposure
considerations, such as the size of insured law firms, policy
limits, rate changes, and reinsurance; (3) loss reserve
considerations, such as reserve tests; (4) underlying loss
patterns, such as claim closure rate, claims closed without
payment, loss frequency and severity, and claim migration (i.e.,
movement of a claim from one reinsurance layer to another as a
result of deviations in its original estimation).
     22
       In general, development factors express the ratios of
amounts at one age to those at the immediately prior age.
Actuaries use development factors, along with other methods, to
estimate loss and loss expense reserves.
                               -30-

appropriate, to project the ultimate losses for that year.    In

this respect, Streff’s approach is similar to methods used by

petitioner’s appointed actuaries.

     Streff then reduced the ultimate losses by the amounts

already paid for each year to determine the projected loss

reserve.   He did this for both incurred losses and paid losses.

Streff equally weighted the projected losses using incurred loss

development and paid loss development to arrive at his selected

loss reserve for each of the years in issue.

     Streff separately calculated the amount to be reserved for

allocated loss expenses.   He reviewed the historical

relationship between paid losses and paid loss expenses to

determine a ratio for each year in which claims remained open.

Streff then applied this ratio to his projected unpaid losses to

determine the amount of projected allocated loss expenses.

Streff also calculated a reserve for unallocated loss expenses.

Unlike Hayne, Streff provided a “most likely estimate” of

petitioner's net loss reserve for each of the years in issue as

follows:

                 Year            Amount

                 1993          $8,240,000
                 1994           7,273,000
                 1995           6,212,000
                                 -31-

     Streff determined a reasonable range of deviation extending

from $570,000 below to $1,140,000 above his most likely reserve

estimates.

     As part of his report, Streff “restated” petitioner’s

carried reserves for each year of its history by considering

subsequent payments and changing reserve levels for successive

years through 1995.   According to this analysis, petitioner’s

initial reserves for each of the years 1982 through 1985, were

lower than their restatement in 1995, whereas petitioner’s

initial reserves for each of the years 1987 through 1994 were 27

to 52 percent higher than their restatement in 1995.23




     23
       Streff’s expert report indicates that on the basis of
information in petitioner’s annual statements, petitioner’s
“restated” reserves as of Dec. 31, 1995, and the resulting
deficiency or redundancy in the initial booked reserve, were as
follows (in millions of dollars):

                      Original       1995        Deficiency
          Year        Reserve     Restatement   (Redundancy)

          1982          $105          $302           $197
          1983           498         1,397            899
          1984         1,245         2,320          1,075
          1985         2,138         2,961            823
          1986         4,323         2,792         (1,531)
          1987         5,557         3,116         (2,441)
          1988         5,989         4,388         (1,601)
          1989         7,837         5,165         (2,672)
          1990         9,618         4,656         (4,962)
          1991        10,127         4,954         (5,173)
          1992        10,550         5,577         (4,973)
          1993        11,636         6,953         (4,683)
          1994        11,581         7,885         (3,696)
          1995        12,500        12,500
                                  -32-

IV.   Analysis

      A.   Whether Petitioner Has Proved That Its Estimates of
           Unpaid Losses Were Fair and Reasonable

              1.    Necessity and Reasonableness of Adverse
                    Development Reserve

      As described above, petitioner’s total unpaid loss reserve

comprises a case reserve, as established by its claim

department, and an adverse development reserve, set by Bixler

and its controller.      For the years in issue, the adverse

development reserve increased petitioner’s total unpaid loss

reserves by amounts ranging from about 37 percent to about 50

percent.

      Although Bixler testified generally about the uncertainty

inherent in petitioner’s reserves, petitioner can point to no

concrete evidence or analysis showing, for the years in issue,

the necessity for or reasonableness of the adverse development

addition to the case reserves as estimated by petitioner’s claim

department.      The record does not suggest that the claim

department’s estimates of unpaid losses were low or failed to

reflect potential adverse development.      In fact, Bixler

acknowledged that he had no reason to be critical of

petitioner’s case reserves.

      In Western Cas. & Sur. Co. v. Commissioner, 65 T.C. at 917,

the taxpayer had established in three schedule P lines of

coverage “voluntary loss reserves”, which were an additional

amount that the taxpayer voluntarily included in its loss
                                -33-

reserves for certain lines “in which the reserves otherwise

computed have historically proven inadequate.”   The Commissioner

had argued that the voluntary loss reserves were greater than

historical deficiencies in the schedule P lines of coverage and

were intended to cover deficiencies in certain schedule O lines

of coverage.   Rejecting the Commissioner’s arguments, we held

that the test of reasonableness should be directed at the total

unpaid loss reserves rather than at individual lines of

coverage, and that the taxpayer’s total estimated reserves were

not only reasonable but actually understated in light of prior

experience.    See id. at 919-920.

     In the instant case, by contrast, petitioner has not shown

that, for the years in issue, it established adverse development

reserves to ensure the adequacy of reserves that historical

experience had proved inadequate, or that its total reserves are

reasonable in light of prior experience.   To the contrary, the

evidence strongly suggests that for each year in issue,

petitioner’s recent historical experience had proved

petitioner’s case reserves to be generous.   For example,

petitioner’s own reserve analyses for the years in issue

indicate significant redundancies in its case reserves.

Petitioner’s appointed actuary noted that as of yearend 1993,

there was total “redundancy” in petitioner’s total booked net

loss reserve of $4,210,000–-which exceeds the $3,155,000 adverse

development reserve that petitioner established for 1993.   The
                              -34-

1994 and 1995 Best reports indicate that petitioner was very

conservatively reserved and had demonstrated a pattern since

1987 of writing down excess reserves established in prior years.

     In sum, petitioner has failed to prove the necessity of the

adverse development reserve for the years in issue, during which

neither its own reserve analyses nor historical experience

indicated deficiencies in its case reserves.   Even if we were to

assume arguendo that petitioner has demonstrated a need for

adverse development reserves for the years in issue, petitioner

nonetheless has failed to carry its burden to show that its

unpaid loss reserve estimates were fair and reasonable.    It has

not shown what specific factors, if any, were taken into account

in establishing the extra percentage of case reserves that would

be included in the adverse development reserve, nor has it shown

how the factors might have been weighted.   Other than summary

reserve analyses, petitioner presented no work papers or other

documentation showing what facts it considered or analyzed in

determining its adverse development reserve.   There is no

specific indication in the record, for example, why petitioner,

in computing its adverse development reserve for 1995, applied a

factor of 45 percent for 1995 open claims of $100,000 or less,

rather than some lower or higher factor, or why the factor

applied to current-year claims varied from year to year.

Similarly, although Bixler testified that petitioner made

separate and additional allowance for claims over $100,000,
                                -35-

there is no indication how that separate allowance was made, how

it purported to avoid redundancy with the case reserve developed

by the claim department, or to what extent petitioner took into

account its reinsurance proceeds recoverable for claims over

$100,000.

              2.   Variance from Actuarial Estimates

     In Utah Med. Ins. Association v. Commissioner, T.C. Memo.

1998-458, the taxpayer’s actuary used consistent actuarial

methods and standard actuarial loss development techniques to

estimate the taxpayer’s ultimate loss within a bounded range

instead of recommending a point estimate.    The taxpayer then

selected reserves at the high end of the actuary’s indicated

range.    On the basis of the evidence in the record, including

the testimony of the actuary, we concluded that the actuary’s

indicated range of reserves was reasonable, that each point in

the actuary’s range was reasonable, and that the taxpayer’s

reserves were fair and reasonable.

     By contrast, here the evidence does not indicate that

petitioner used consistent actuarial methods and standard

actuarial loss development techniques in establishing its loss

reserves.24   Petitioner’s actuaries did not assist in


     24
       The Witcraft opinion for 1993 states that petitioner’s
carried reserves were “computed in accordance with Standards of
Practice issued by the Actuarial Standards Board (including the
Casualty Actuarial Society’s Statement of Principles regarding
Property and Casualty Loss and Loss Adjustment Expense
                                                  (continued...)
                              -36-

establishing petitioner’s reserves in the first instance but

were asked after the fact to review petitioner’s carried

reserves, for purposes of satisfying the statutory certification

requirement.

     With respect to petitioner’s 1993 taxable year, Witcraft

specified no recommended range of reasonableness (unlike the

taxpayer’s actuary in Utah Medical), but instead provided a

“best estimate” that was significantly lower than petitioner’s

carried net reserve, while noting historical redundancies in

petitioner’s carried net reserves.    Petitioner has not explained

the variance between this “best estimate” and the estimate

petitioner used for tax purposes.25


     24
      (...continued)
Reserves)”. The Teufel opinions for 1994 and 1995 each state
that petitioner’s carried reserves were “computed in accordance
with accepted loss reserving standards and principles”. It is
unclear, however, whether these statements are meant to refer to
the actuaries’ assessment of computational techniques of
petitioner’s management as opposed to the actuaries’ own
computations in independently evaluating the adequacy of
petitioner’s reserves. The actuaries were not called as
witnesses to resolve such ambiguities.
     25
       Petitioner states on brief that it did not call its
actuaries to testify in part because “Petitioner was, and is,
satisfied with the accuracy and clarity of the qualified
actuaries’ reports.”

     On brief, respondent complains about the lack of opportunity
to cross-examine the actuaries. Respondent had equal
opportunity, however, to call the actuaries as witnesses, either
as part of his case-in-chief or as rebuttal witnesses, issuing a
subpoena if necessary. Respondent chose not to. Accordingly, we
do not infer that the actuaries’ testimony would have been either
favorable or unfavorable to petitioner. See Sisson v.
                                                  (continued...)
                              -37-

     Similarly, for petitioner’s 1994 and 1995 years, Teufel

provided a “selected point estimate” that was significantly

lower than petitioner’s carried net reserves.   For each of these

years, Teufel also provided a recommended range.   Relative to

the recommended range of the taxpayer’s actuary in Utah Medical,

Teufel’s recommended ranges are very large.26   The evidence in

the record is insufficient for us to evaluate adequately whether

Teufel’s 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



     25
      (...continued)
Commissioner, T.C. Memo. 1994-545.

     At trial, respondent raised a hearsay objection to the
admission into evidence of the actuaries’ opinions and reports.
The Court overruled the objection but invited respondent to renew
his objection on brief. Respondent has not done so. We conclude
that respondent has abandoned his objection. In any event,
respondent’s objection is without merit, as petitioner presented
adequate foundation testimony to qualify the actuarial opinions
and reports as business records. See Fed. R. Evid. 803(6).
Furthermore, respondent’s expert witness stated that he relied
upon the actuarial reports as one of four primary sources of
information, from which we conclude that respondent’s own expert
deemed the information therein to be trustworthy.
     26
       In Utah Med. Ins. Association v. Commissioner, T.C. Memo.
1998-458, we accepted the reserves carried by the taxpayer even
though they were near the upper limit of the actuary's range. We
characterized the actuary's range as large, but not so large as
to be unreasonable. See id. The upper limit of the actuary's
range in Utah Medical was approximately 26 percent above the
lower limit of the range for each year in issue. In the instant
case, by contrast, for 1994 the upper limit of Teufel’s
recommended range was approximately 70 percent higher than the
lower limit, and for 1995 the upper limit was approximately 120
percent higher than the lower limit.
                                -38-

“represent actual unpaid losses as nearly as it is possible to

ascertain them.”    Sec. 1.832-4(a)(5), Income Tax Regs.; see

Hanover v. Commissioner, 69 T.C. at 270.

            3.     Significance of Actuarial Certification and
                   State Review or Lack Thereof

     For each of the years in issue, Witcraft’s and Teufel’s

actuarial reports certify that petitioner’s unpaid loss reserves

make reasonable provision for petitioner’s unpaid losses and

loss expenses.   The record does not establish, however, that

this certification was meant to be equivalent to the regulatory

requirement that petitioner’s reserves be “fair and reasonable”

within the meaning of section 1.832-4(b), Income Tax Regs.

Given the wide variance between petitioner’s carried reserves

and the appointed actuaries’ best estimates, it is unclear that

any such equivalence was intended.     Indeed, because Teufel and

Witcraft each anticipated that their opinions would

be reviewed by the State regulator,27 it would appear likely that

their focus was on conservatism and petitioner’s solvency.

     For 1993, the department reviewed petitioner’s reserves and

determined that they were “adequate”.    For 1994 and 1995, the

department accepted petitioner's filing of the annual statements

without any adjustments.    Although this is a positive factor in

evaluating the fairness and reasonableness of petitioner’s


     27
       Each of the Teufel opinions states: “This statement of
opinion is intended solely for filing with state regulatory
agencies.” The Witcraft opinion contains a similar statement.
                                -39-

reserves, see Utah Med. Ins. Association v. Commissioner, supra,

it is not conclusive.   As stated in Sears, Roebuck & Co. v.

Commissioner, 96 T.C. 61, 110 (1991), revd. on other grounds 972

F.2d 858 (7th Cir. 1992):

     The objectives of State regulation * * * are not identical
     to the objectives of Federal income taxation. State
     insurance regulators are concerned with the solvency of the
     insurer. McCoach v. Insurance Company of North America,
     244 U.S. 585, 589 (1917). * * * In contrast, Federal tax
     statutes are concerned with the determination of taxable
     income on an annual basis. Burnet v. Sanford & Brooks Co.,
     282 U.S. 359, 365 (1931).

The record does not establish that the State regulators would

have been concerned with excesses in petitioner’s reserves.

Thus, their silence on this point is not necessarily

significant.

     Given the clear directive of the regulations regarding the

Commissioner’s discretion to review the amount of deducted loss

reserves, and the holding in Hanover Ins. Co. v. Commissioner,

69 T.C. 260 (1977), upholding the validity of these regulations,

there is no merit to the argument that the Commissioner’s review

function is supplanted by the certifying actuaries or the State

regulators.    A taxpayer's determination and reporting of unpaid

losses and loss expenses to a State insurance commission does

not limit the Commissioner’s obligation to enforce the

regulations and to examine and adjust, as necessary, the amounts

claimed for Federal income tax purposes.   See Home Mut. Ins. Co.

v. Commissioner, 639 F.2d 333, 339-340 (7th Cir. 1980), affg. in
                                -40-

part, revg. in part on another issue, and remanding 70 T.C. 944

(1978); Hanover Ins. Co. v. Commissioner, 69 T.C at 272.

              4.   Hayne’s Testimony

     The testimony of petitioner’s expert, Hayne, falls short in

assisting the Court in determining whether petitioner’s

estimates of unpaid losses were fair and reasonable, or what

estimates might be fair and reasonable.    He did not opine on the

ultimate value of petitioner’s unpaid losses.    His testimony

suggests that because of the low volume and volatility of

petitioner’s claims data, almost any estimate within a very wide

range might have statistical credibility.    His report implies,

for example, that for petitioner’s 1995 year, any estimate in a

range from $4.8 million to $39.2 million might be considered

reasonable.

     Hayne’s testimony is difficult to square with petitioner’s

qualified actuary reports.    These reports reflect the

application of a variety of standard actuarial techniques to

arrive at best estimates or selected point estimates.28

Moreover, Hayne’s premise as to the volatility of petitioner’s

data is difficult to square with Bixler’s September 1996

statement to petitioner’s shareholders that “we have had the

opportunity to observe the loss activity in each band of risk

and have found many of the lower layers to be relatively stable


     28
       The Witcraft report was prepared by another actuary in
the same actuarial firm with which Hayne is affiliated. Hayne
testified that he had no reason to believe that Witcraft did not
do her analysis properly.
                                  -41-

under various conditions over several years.”

     Hayne’s expert 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.29

             5.   Other Factors

     Citing Utah Med. Ins. Association v. Commissioner, T.C.

Memo. 1998-458, petitioner argues that a number of other factors

support the fairness and reasonableness of its estimates of

unpaid losses.    Petitioner contends, for example, that it could

not offset reserve deficits with other reserve surpluses,

because it wrote primarily lawyer’s professional liability

insurance.   During the years in issue, however, petitioner had,

at a minimum, a surplus of $14 million.   In an April 1995 report

to policyholders, Bixler characterized petitioner’s surplus as

“an impressive safeguard against adversity.”

     Petitioner also argues that it adjusted its loss reserve

each year to account for actual loss experience.    The

development of petitioner’s case reserves from 1986 to 1992,



     29
       Hayne testified that in identifying his peer group, he
tried to “get as many of the small, localized, lawyer mutual type
companies that I could easily identify in insurance publications”
and that he located through electronic services. Best defines
petitioner’s peer group as the National Association of Bar
Related Insurance Companies (NABRICO). Hayne did not explain how
petitioner’s ratios compared to the NABRICO composite.
                               -42-

however, should have alerted petitioner that its prior reserve

estimates were more than adequate.    There is no evidence that

petitioner took this prior experience into account in evaluating

or amending its reserving philosophy and practices, especially

as regards its adverse development reserve.    Cf. Hanover Ins.

Co. v. Commissioner, 69 T.C. at 270-271 (taxpayer failed to

prove that it employed any method of testing its reserves on the

basis of prior experience, even though it revised its reserve

estimates from time to time on the basis of developments in

particular cases).

     Petitioner argues that it had competing business concerns–-

such as ensuring solvency and competitiveness--not to overstate

its loss reserves.   Apart from such generalities, however,

petitioner fails to articulate with particularity how such

concerns–-which would appear to relate principally to annual

statement reporting–-should govern the determination of fair and

reasonable estimates of unpaid losses for Federal income tax

purposes.   In any event, the record does not indicate that

petitioner’s solvency was in jeopardy during the years in issue,

when its surplus consistently exceeded $14 million.

             6.   Conclusion

     On the basis of the totality of evidence in the record, we

conclude and hold that petitioner has failed to establish that

its estimates of unpaid losses, as used in computing “losses
                               -43-

incurred” within the meaning of section 832(b)(5), represent a

“fair and reasonable estimate of the amount the company will be

required to pay.”   Sec. 1.832-4(b), Income Tax Regs.

     B.   Determination of Fair and Reasonable Unpaid Losses
          for 1993

     The analysis of respondent’s expert, Streff, was in key

respects similar to that of petitioner's appointed actuaries.

He testified that he agreed with the actuaries’ data and

techniques and disagreed only with their assumptions.

     For taxable year 1993, we find Streff’s analysis and

conclusions to be credible.   We accept as fair and reasonable

his $8,240,000 estimate of petitioner’s net unpaid losses as of

yearend 1993.   We note that this estimate exceeds Witcraft’s

best net reserve estimate of $7,800,000, as well as the

$7,134,000 net reserve estimate determined in respondent’s

notice of deficiency.30

     30
       Streff’s 1993 estimate of petitioner’s net unpaid loss
reserve is lower than petitioner’s 1993 net carried case reserve
of $8,478,000. At first blush, this result may seem anomalous,
given respondent’s statement on brief that petitioner’s case
reserves are “at least facially” in compliance with the
regulatory requirement that unpaid losses be calculated “based on
the facts of each case.” Sec. 1.832-4(b), Income Tax Regs. We
do not interpret respondent’s statement on brief as a concession,
however, that petitioner’s net case reserves reflect a fair and
reasonable estimate of petitioner’s unpaid losses. Respondent’s
statement on brief appears to refer to petitioner’s estimate of
its gross unpaid losses and not to address possible effects of
proceeds recoverable through petitioner’s reinsurance
arrangements, which proceeds are taken into account in computing
losses incurred, within the meaning of sec. 832. See sec.
832(b)(5)(A)(iii). In this regard, we note that for each year in
                                                  (continued...)
                               -44-

     C.   Determination of Fair and Reasonable Unpaid Losses
          for 1994 and 1995

     For taxable years 1994 and 1995, Streff estimated

petitioner’s reserves to be lower than their 1993 levels.   This

analysis is difficult to square with the undisputed facts, which

show that from 1993 to 1995, petitioner’s operations were

increasing, as measured by numbers of attorneys insured,

policies issued, and premiums written, and that petitioner was

assuming a larger share of risks formerly ceded to reinsurers.

     Streff’s testimony indicates that his downward-trending

estimates for 1994 and 1995 were predicated on his assumptions

regarding a perceived increase in petitioner’s average open

claim reserve in 1993.   His report indicates that while such a

phenomenon might indicate a true increase in ultimate claim

costs, it might also represent a change in case reserve

attitude, or “reserve strengthening”.   He testified that for

1993 he assumed that the increases were “real”, but then

adjusted his estimates downward for 1994 and 1995 on the basis

of his conclusion that the 1993 increases had resulted from

reserve strengthening.   On cross-examination, however, Streff

admitted that he had neither heard nor seen any evidence to lead


     30
      (...continued)
issue, petitioner’s estimates of reinsurance proceeds recoverable
are significantly lower than the estimates used by its appointed
actuaries–-thus tending to result in higher net unpaid loss
reserves than recommended by the actuaries. Neither party has
specifically addressed these variances.
                                 -45-

him to believe that there had been reserve strengthening in

1993.   He testified that when he was preparing his expert

opinion, he did not necessarily have the knowledge of the

uncontradicted testimony offered by petitioner’s officers at

trial, which indicated that there was no reserve strengthening.

     We conclude that Streff’s estimates of petitioner’s unpaid

losses for 1994 and 1995 were based on faulty assumptions

regarding petitioner’s 1993 increases in its case reserves.    For

each of the years 1994 and 1995, we conclude that the best

available evidence of a fair and reasonable estimate of

petitioner’s unpaid losses is the point estimate selected by

petitioner’s qualified actuary.    Therefore, we conclude and hold

that fair and reasonable estimates of petitioner’s unpaid losses

for 1994 and 1995 are $10,096,656 and $8,706,428, respectively.

     To reflect the foregoing,


                                        Decision will be entered

                                   under Rule 155.
