                        T.C. Memo. 1998-458



                      UNITED STATES TAX COURT



        UTAH MEDICAL INSURANCE ASSOCIATION, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11880-96.            Filed December 30, 1998.



     Tracy D. Williams, Richard Bromley, Glen H. Kanwit, and

Michael R. Schlessinger, for petitioner.

     Martha Sullivan, Peter Hochman, Alan Summers, David

Sorensen, and Nancy McCurley, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined that petitioner had

deficiencies in income tax of $5,280,264 for 1991 and $1,905,200

for 1992.
                                 -2-

     The sole issue for decision is whether petitioner may deduct

$45,650,249 for its reserves for discounted unpaid losses and

loss adjustment expenses for 1991 and $49,418,509 for 1992.      We

hold that it may.

     Section references are to the Internal Revenue Code.    Unless

otherwise indicated, Rule references are to the Tax Court Rules

of Practice and Procedure.

                      I.     FINDINGS OF FACT

A.   Petitioner

     Utah Medical Insurance Association (referred to as

petitioner) is a property and casualty insurance company the

principal place of business of which is in Salt Lake City, Utah.

Petitioner provides medical malpractice liability insurance for

physicians in Utah, Montana, and Idaho.    Medical malpractice

liability insurance indemnifies a physician against medical

professional liability claims for damages brought as a result of

the provision of, or the failure to provide, medical services.

Petitioner is, and during the years in issue was, taxed as a

property and casualty insurance company under sections 831-835.

Petitioner is managed by its board of directors, which is

composed of 12 of petitioner's policyholder-physicians.

B.   Medical Malpractice Insurance

     In the 1960's, medical malpractice liability insurance was

generally provided by commercial insurance companies.    Beginning

around 1965, commercial insurance companies experienced large
                                  -3-

underwriting losses as a result of a rapid increase in medical

malpractice claims and litigation.      As a result, they raised

rates, e.g., 400-600 percent in California from 1965 to 1971, to

cover their losses.   When rate increases failed to keep pace with

continued adverse loss experience, many commercial insurers

stopped issuing medical malpractice insurance.      As a result,

State medical societies formed physician-owned medical

malpractice insurance companies to offer medical malpractice

insurance to their members.

     In the early 1970's, the Utah Medical Association (UMA), the

leading professional association for doctors in Utah, endorsed

Aetna Life and Casualty Insurance Co. (Aetna) as the preferred

malpractice carrier in Utah.   Aetna, which wrote most of the

medical malpractice insurance in Utah during the 1970's,

increased rates several times in the late 1970's.

C.   Formation of Petitioner

     In response to Aetna's rate increases, about 900 doctors who

were members of UMA formed petitioner as an unincorporated inter-

insurance exchange1 or reciprocal company in November 1978.        They

executed subordinated loans which gave petitioner an initial

capitalization of $2.2 million.    Shortly thereafter, Aetna

withdrew from the insurance market in Utah.      Petitioner became

the principal medical malpractice insurer in Utah.

     1
       An inter-insurance exchange is a mutual insurance company
in which the members of a group insure each other's risks.
                                  -4-

     From 1978 to 1981, petitioner wrote medical malpractice

insurance only in Utah.    In 1982, petitioner began issuing

insurance policies to physicians practicing in Montana, and in

1991 to physicians practicing in Idaho.     During the years in

issue, about 85-90 percent of petitioner's insurance policies

were issued to doctors practicing in Utah.

     During those years, petitioner primarily wrote medical

malpractice liability insurance and also wrote a small amount of

general liability insurance for its covered physicians.

     From 1984 to 1992, the number of doctors insured by

petitioner increased as follows:

                 Year            Number of insureds

                 1984                   1,369
                 1985                   1,432
                 1986                   1,482
                 1987                   1,630
                 1988                   1,699
                 1989                   1,819
                 1990                   1,814
                 1991                   1,920
                 1992                   2,002

D.   Regulation of Petitioner by the Utah Department of Insurance

     Petitioner is principally regulated by the Utah Department

of Insurance (UDI).     Petitioner maintained its books and records

in accordance with UDI requirements and filed annual statements

with UDI.   Petitioner prepared each annual statement in the

format prescribed by the National Association of Insurance

Commissioners (NAIC), a voluntary association of State insurance

commissioners.
                                  -5-

     Insurance companies use "statutory accounting" principles to

prepare their annual statements.    Statutory accounting principles

are conservative and focus on maintaining the solvency of an

insurance company to protect insurance consumers.

     UDI required that annual statements due after December 31,

1991, be accompanied by an actuarial opinion concerning the

reasonableness of the insurance company's reserves.      The

actuarial firm of Tillinghast Towers Perrin (Tillinghast)

certified to UDI that petitioner's reserves for unpaid losses

shown on its 1991 and 1992 annual statements were computed in

accordance with accepted loss reserving standards and were fairly

stated in accordance with sound loss reserving principles, were

based on factors relevant to policy provisions, met the

requirements of the insurance laws of the State of Utah, and

provided sufficiently for all of petitioner's unpaid loss and

loss expense obligations.

E.   Reserves for Unpaid Losses

     On their annual statements, property and casualty insurers

are required to report estimates of amounts they expect to pay

for losses2 that have already occurred (unpaid losses) and

related loss adjustment expenses.       These estimates are known as


     2
       A loss is an injury sustained by a person who has a right
to hold the insured liable for that injury. A loss is incurred
when the event insured against occurs. Ocean Accident & Guar.
Corp. v. Southwestern Bell Tel. Co., 100 F.2d 441, 446 (8th Cir.
1939).
                                 -6-

reserves for unpaid losses.    A property and casualty company's

loss reserve is the amount that is needed to make all future

payments on claims that have already been incurred.    Utah Code

Ann. sec. 31A-17-402(1) (1997) requires insurers to report a

liability for unpaid losses equal to "the estimated amount

necessary to pay all its unpaid losses and claims incurred on or

prior to the date of statement, whether reported or unreported,

together with the expense of adjustment or settlement of the loss

or claim".

     The reserve for unpaid losses3 includes all incurred losses.

Incurred losses include insured events for which a claim has been

filed (reported losses), and insured events for which no claim

has been filed with the company; i.e., incurred but not reported

(IBNR) losses.

     The first step in estimating loss reserves is to estimate

the total amount that will ultimately be paid for a coverage year

for all claims existing on a given date (ultimate losses).

Ultimate losses equal paid losses plus an estimate of unpaid

losses at the end of the year.    Unpaid losses are generally

estimated not later than the year in which the insured event

giving rise to the loss occurred (the accident year).4   In

     3
       Unless otherwise indicated, we use the terms "loss" and
"unpaid loss" to include both losses and loss adjustment
expenses; that is, amounts paid to defend or settle claims.
     4
         Unless otherwise indicated, we use the term "coverage
                                                     (continued...)
                                -7-

estimating its ultimate losses each year, petitioner adjusted its

prior estimates of earlier years' ultimate losses to factor in

its loss experience.

     Petitioner's president, Martin J. Oslowski (Oslowski),

recommended an amount to report as annual statement unpaid losses

to the board of directors.   Oslowski was petitioner's claims

manager before he became president in December 1986.

     Petitioner wrote only one line of insurance, and thus

petitioner could not offset reserve deficiencies with surpluses

in another line as multiline companies could do.

F.   Occurrence Basis and Claims-Made Basis Policies

     Medical malpractice insurance may be written on an

"occurrence" basis or on a "claims-made" basis.    An occurrence

basis policy covers losses that occur within the policy period

whenever reported.   A claims-made basis policy covers only losses

from occurrences during the policy period (or a previous policy

period) for which claims are made or which are otherwise reported

during the period.   From 1978 to 1985, petitioner and most of the

medical malpractice insurance industry offered only occurrence

basis policies.

     In 1984, petitioner's financial position was tenuous because

its losses in the early 1980's were significantly larger than its


     4
      (...continued)
year" instead of "accident year" because this case involves both
occurrence and claims-made coverage.
                                   -8-

reserves.    Petitioner believed that a switch from occurrence to

claims-made basis policies would improve its financial condition.

In 1985, based on the recommendation of Tillinghast, petitioner

began offering claims-made instead of occurrence basis policies

to its physicians.    Petitioner's claims-made policies had a 1-

year term and an anniversary date5 of January 1.   Occurrence

basis medical malpractice insurance policies are "long-tailed"

because it can take 10 years or more for claims to be received

and resolved.

G.   Petitioner's Actuaries

     Petitioner has hired outside actuaries to perform all of its

actuarial services since it was formed.

     1.     Milliman & Robertson

     From 1978 to 1985, the actuarial firm of Milliman &

Robertson (M&R) provided actuarial services to petitioner to help

it estimate its annual statement unpaid losses.

     Petitioner followed M&R's recommendations.    However, M&R

underestimated petitioner's unpaid losses.    As this unfavorable

trend emerged, petitioner gradually increased its estimates of

unpaid losses each year.

     To improve its financial condition, in 1984 petitioner asked

UDI for permission to discount its loss reserves for the


     5
       The anniversary date is the date when insurance coverage
begins. Modern Am. Life Ins. Co. v. Commissioner, 92 T.C. 1230,
1232 (1989).
                                  -9-

occurrence basis years.    UDI approved petitioner's request.

However, UDI required petitioner to begin filing quarterly

statements and to provide UDI with loss and investment

information.    UDI, in effect, began to oversee petitioner's

operations.

     2.     Tillinghast

     In 1984, petitioner hired Tillinghast to determine whether

petitioner had sufficient assets and surplus to meet its

liabilities.    Tillinghast concluded that petitioner did not.

     3.     Tillinghast's Loss Reserve Reviews and Rate Reviews

     Tillinghast began preparing loss reserve reviews6 and rate

reviews7 for petitioner at the end of 1985.

     Sometimes actuaries estimate ultimate losses as a range with

high and low bounds (a "bounded range") instead of as a single

number (a "point estimate").     Actuarial Standard of Practice No.

9 states:     "The uncertainty inherent in the estimation of

required provisions for unpaid losses or loss adjustment expenses

implies that a range of reserves can be actuarially sound."

Tillinghast estimated petitioner's ultimate losses within a

bounded range.

     Beginning in 1989, James Hurley (Hurley), an actuary

     6
       Loss reserve reviews project an insurer's ultimate losses
based on its loss data.
     7
       Tillinghast analyzed petitioner's rates (i.e., premiums),
to help petitioner decide how much to charge its insureds in the
upcoming year.
                                               -10-

employed by Tillinghast, prepared annual rate reviews and

semiannual loss reserve reviews for petitioner.                       In preparing his

reserve reviews, Hurley received information from petitioner

about its paid losses and case reserves.8                       Petitioner's claims

investigators generally established petitioner's case reserves

based on their initial impression of each claim and revised them

as they acquired more information.

        The high end of Tillinghast's estimate of petitioner's

ultimate losses in 1986 and the high end reestimates of its

ultimate losses in later years were as follows:

            Tillinghast's High End Estimates Of Petitioner's
        Ultimate Net Losses & Allocated Loss Adjustment Expenses1
                             (in thousands)

Year        1986    1987     1988     1989       1990    1991      1992     1993     1994

1986    $3,544      $2,481   $2,293   $2,186    $2,700   $2,700    $2,750   $2,875   $2,850
1987      --         8,450    6,840    6,655     6,300    7,250     7,250    7,000    6,900
1988      --          --     12,791   11,372     9,900    9,250     8,750    8,250    7,750
1989      --          --       --     13,782    12,500   12,250    11,000   10,250    9,000
1990      --          --       --       --      16,000   15,250    14,500   13,500   12,500
1991      --          --       --       --        --     15,500    15,000   14,000   13,250
1992      --          --       --       --        --       --      17,500   17,000   16,500
1993      --          --       --       --        --       --        --     15,000   15,000
1994      --          --       --       --        --       --        --        --    16,500

IBNR                  665    1,476    1,777      1,361   1,625      1,034   3,284     4,657

Total       3,544   11,596   23,400   35,772    48,761   63,825    77,784   91,159   104,907
        1
            Allocated loss adjustment expense is defined above at par.

I-E.

        Petitioner discounted the part of its reserves that related



        8
       Case reserves are estimates made by an insurer of the
unpaid loss amounts expected to be paid in connection with
specific known claims.
                                -11-

to occurrence-based policies during the years in issue.    In those

years, petitioner followed the same procedures in establishing

its annual statement unpaid losses that it had used in prior

years.    It gave data to Tillinghast which Tillinghast used to

make development method9 and pure premium method10 projections.

In the property and casualty industry, "development" is the

actual experience (both paid and unpaid) regarding a loss

estimate over time.

     The number of petitioner's claims greatly increased in 1990

and remained at a higher level for 1991 and 1992.    The severity

(i.e., the average cost per claim) of petitioner's claims also

increased in 1991 and 1992.

     Tillinghast's 1991 and 1992 loss reserve reviews used a

range bounded by a high and low end estimate of projected

ultimate losses.    The bounds of Tillinghast's range are the sums

of the high and low end estimates of ultimate loss for each

coverage year, at the December 31 valuation date.    Tillinghast's


     9
       Under the development method, a series of loss development
factors (one for each "age" of coverage year, e.g., coverage year
+ 0 is the current year, coverage year + 1 is the preceding year,
coverage year + 2 is the second preceding year) are developed
based on the past experience of a given coverage year's paid or
incurred losses over time. These factors are then multiplied by
the paid or incurred losses as of the annual statement date for
the corresponding age of coverage year.
     10
       The pure premium method projects expected losses by
multiplying historical average losses per exposure unit; e.g.,
per doctor by the number of exposure units covered for the
coverage year.
                               -12-

ranges were relatively large because, in Hurley's opinion,

medical malpractice losses are difficult to project accurately.

     Tillinghast projected that, as of December 31, 1991,

petitioner had ultimate losses ranging from $88,483,000 to

$99,645,000 (before discounting), and that reserves ranging from

$45,426,000 to $57,289,000 (before discounting) for coverage

years 1978 to 1991 would be reasonable.   As of December 31, 1992,

Tillinghast projected that petitioner had ultimate losses ranging

from $100,101,000 to $112,204,000 (before discounting), and that

reserves ranging from $49,066,000 to $61,948,000 (before

discounting) for the coverage years 1978 to 1992 would be

reasonable.   Tillinghast separated the projected ultimate losses

by coverage year.

     Joseph Perry, petitioner's vice president of finance/chief

financial officer, subtracted from these ultimate loss estimates

petitioner's paid losses as of December 31, 1991, and December

31, 1992, to determine a range of unpaid losses for all of the

coverage years included in the 1991 and 1992 unpaid loss

reserves.   Petitioner reported on its annual statements that it

had undiscounted unpaid losses of $56,847,261 for 1991 and

$61,971,100 for 1992.   Petitioner had a conservative reserve

philosophy to ensure that it could pay future losses.   Petitioner

selected reserves below the low end of Tillinghast's range for

1986 and at the high end of Tillinghast's ranges for 1987 to

1992.
                                -13-

     UDI examined petitioner's 1990-93 annual statements.     It did

not adjust the amount of unpaid losses and loss adjustment

expenses that petitioner reported.

     Estimates of unpaid losses by the medical malpractice

insurance industry (both physician-owned and commercial,

multiline carriers) and petitioner were similar as shown below:

          Estimates of Unpaid Losses For 1992 and Earlier

 As of    Medical malpractice   Percentage                  Percentage
Dec. 31   insurance industry    of original   Petitioner    of original

 1992     $21,879,689,000              --     $61,971,100       --
 1995      17,709,112,000              81      48,931,000       79

H.   Petitioner's Financial Condition

     1.   A.M. Best Ratings

     A.M. Best (Best) rates the financial condition of property

and casualty insurers each year.   From 1984 to 1992, Best gave

petitioner the following ratings:11

     11
       A.M. Best describes its ratings as follows:
          a. A (Excellent). Assigned to companies which in
     Best's opinion have achieved excellent overall performance
     when compared to the norms of the property/casualty
     insurance industry. A rated insurers generally have shown a
     strong ability to meet their policyholder and other
     contractual obligations.

          b. B+ (Very good). Assigned to companies which in
     Best's opinion have achieved very good overall performance
     when compared to the norms of the property/casualty
     insurance industry. B+ rated insurers generally have shown
     a very good ability to meet their policyholder and other
     contractual obligations.

          c. B (Good). Assigned to companies which in Best's
     opinion have achieved good overall performance when compared
                                                   (continued...)
                                -14-

                      Year               Rating

                      1984                 B
                      1985               unknown
                      1986                 NA-7
                      1987                 NA
                      1988                 B+
                      1989                 B+
                      1990                 A-
                      1991                 A-
                      1992                 A-

     2.   Surpluses

     Petitioner reported on its 1985 to 1992 annual statements

that it had the following surpluses:

               Year                    Surplus reported
               1985                       $4,533,310
               1986                        5,481,798
               1987                        8,842,442
               1988                       10,371,232
               1989                       12,319,227
               1990                       14,382,840
               1991                       15,876,858
               1992                       18,195,874

     3.   Ultimate Loss Estimates

     Petitioner reported the following initial estimates and

reestimates of its ultimate losses on its annual statements from


     11
      (...continued)
     to the norms of the property/casualty insurance industry. B
     rated insurers generally have shown a good ability to meet
     their policyholder and other contractual obligations.

          d. NA (Not    Assigned). Approximately 400 or 25 percent
     of the companies   reported on in Best's Insurance Reports are
     not eligible for   a Best's Rating (A+ to C). Companies with
     an NA rating are   assigned to one of 10 classifications to
     identify why the   company was not eligible for a Best's
     Rating.

          e. NA-7. Below Minimum Standards. Assigned to a
     company that meets Best's minimum size and experience
     requirements, but does not meet the minimum standards
     for a Best's Rating of "C".
                                                        -15-

1986 to 1996:

        Ultimate Net Losses & Allocated Loss Adjustment Expenses
          (Schedule P - Part 2 - Summary Of Annual Statement)1
                             (in thousands)
Year     1986     1987     1988     989     1990     1991     1992     1993      1994      1995      1996
                                                                                                        2
1986    $3,865   $2,492   $2,414   $2,191   $2,191   $2,205   $2,205   $2,257    $2,256    $2,255
1987      --      9,077    7,270    6,655    7,050    7,250    7,250    7,054     6,961     6,958    $6,908
1988      --       --     15,127   11,372    9,400    9,250    9,250    8,624     8,045     7,751     7,501
1989      --       --       --     15,559   12,250   12,250   11,250   10,346     9,077     8,564     7,439
1990      --       --       --       --     17,403   15,278   14,528   13,882    12,905    12,153    11,129
1991      --       --       --       --       --     17,125   15,000   14,520    13,747    13,556    11,979
1992      --       --       --       --       --       --     17,534   17,607    17,046    16,769    16,682
1993      --       --       --       --       --       --       --     16,225    16,110    15,746    15,797
1994      --       --       --       --       --       --       --       --      18,141    17,532    17,122
1995      --       --       --       --       --       --       --       --        --      18,758    19,137
1996      --       --       --       --       --       --       --       --        --        --      21,520


Total    3,865   11,569   24,811   35,777   48,294   63,358   77,017   90,515   104,288   120,042   135,214

      1
        The initial estimate is the first entry for each year in the vertical
axis; the reestimates are shown on the horizontal axis.
         2
       The 1986 information was not individually available on the 1996 annual
statement.

         In 1991 and 1992, medical malpractice loss experience was

favorable for coverage years 1986-90.

         4.       Dividends

         Petitioner declared and paid dividends to its policyholders

from 1988 to 1992 as follows:

                            Year                                Dividend amount

                            1988                                   $1,500,000
                            1989                                    1,500,000
                            1990                                    2,000,000
                            1991                                    2,000,000
                            1992                                    2,000,000

         5.       Premiums

         The premiums petitioner charged for its medical malpractice

insurance policies changed as follows:
                               -16-

                                Percentage change from
     Year ending               preceding year or period

          12/1/79                       -5.0%
          12/1/80                       12.1
          12/1/81                       11.8
          12/1/82                       24.6
          12/1/83                       14.9
          12/1/84                       42.0
          12/1/85                       67.0
          12/1/86                       30.5
          12/1/87                        4.5
          1/1/89                         2.6
          1/1/90                         0.0
          1/1/91                        -3.2
          1/1/92                       -13.6
          7/1/92                        -7.0

I.   Reinsurance

     During the years at issue, petitioner bought reinsurance12

coverage for losses falling in a certain loss "layer"; i.e., for

losses and allocated loss adjustment expenses in excess of a

certain minimum and below a certain maximum per loss.

Petitioner's reinsurance treaty13 during the years at issue

covered losses from $300,000 plus an indexed amount to a maximum

of $1 million per loss.   The indexed amount equaled the product

of (a) $25,000, and (b) the number of "December 31sts" occurring

     12
       Reinsurance is an agreement between an insurer (the
ceding company) and a second insurer (the reinsurer), under which
the ceding company passes to the reinsurer some or all of the
risks that the ceding company assumes through the direct
underwriting of insurance policies. See Trans City Life Ins. Co.
v. Commissioner, 106 T.C. 274, 278 (1996).
     13
       A reinsurance treaty is a contract between two insurers
in which the reinsurer agrees to provide coverage of risks that
the primary insurer has already assumed under an insurance
contract with another party. See Trans City Life Ins. Co. v.
Commissioner, supra.
                                 -17-

between the loss event and the time when petitioner first became

obligated to make a payment in respect to the loss event.14

Losses exceeding $1 million were covered by a separate

reinsurance treaty.

     Based on its pattern for paying significant claims,

petitioner's average "retention"15 by the time those claims would

be paid was about $375,000 to $400,000 during the years in issue

($300,000 plus $25,000 for each December that passed between the

coverage year and the year of final payment of the claim).

J.   Income Tax Returns and Notice of Deficiency

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

Casualty Insurance Company Income Tax Return, for 1991 and 1992.

     Petitioner had undiscounted unpaid losses of $56,847,261 for

1991 and $61,971,100 for 1992.    Petitioner reported on its

Federal income tax returns that it had discounted unpaid losses

of $45,650,249 for 1991 and $49,418,509 for 1992, which it

deducted as part of losses incurred under section 832(b)(5).

                          II.    OPINION

A.   Issue for Decision

     The sole issue for decision is whether petitioner may deduct

$45,650,249 for its reserves for unpaid losses and loss

     14
       For example, if, in May 1994, petitioner paid $800,000 to
settle a covered 1991 loss event, the 1991-92 treaty would
provide reimbursement of $425,000, that is, $800,000 minus the
indexed amount of $375,000 ($300,000 plus $25,000 each for Dec.
31, 1991, Dec. 31, 1992, and Dec. 31, 1993).
     15
       Retention is the dollar level of risk up to which an
insurance company is self-insured; i.e., is not reinsured. See
Dockery v. Commissioner, T.C. Memo. 1998-114.
                                 -18-

adjustment expenses for 1991 and $49,418,509 for 1992.

     On March 13, 1996, respondent sent a notice of deficiency to

petitioner in which respondent determined that petitioner

overstated its discounted unpaid losses by $5,816,776 for 1991

and $3,904,930 for 1992, and that petitioner's discounted unpaid

losses should have been $39,833,473 ($45,650,249 - $5,816,776)

for 1991 and $39,696,803 ($49,418,509 - ($3,904,930 and

$5,816,776)) for 1992.     Respondent amended its answer after trial

to assert that petitioner overstated its undiscounted unpaid

losses by $13,070,000 for 1991 and by $19,394,000 for 1992, and

that petitioner's undiscounted unpaid losses should have been

$43,765,000 for 1991 and $42,577,000 for 1992.16    Petitioner

bears the burden of proving that respondent's determination in

the notice of deficiency is erroneous, Welch v. Helvering, 290

U.S. 111, 115 (1933), and respondent bears the burden of proving

that petitioner's discounted unpaid losses should have been less

than the amounts determined in the notice of deficiency for 1991

and 1992.   Rule 142(a).   However, our holding is not affected by

who bears the burden of proof.

     16
       Respondent redetermined petitioner's discounted unpaid
losses in the notice of deficiency, whereas respondent's
adjustments in the amended answer were to petitioner's
undiscounted unpaid losses. The taxpayer is required to report
discounted unpaid losses on its income tax return. Secs.
832(b)(5)(A)(ii) and 846.
                                   -19-

B.   Background

     Insurance companies may deduct ordinary and necessary

expenses and losses incurred.      Sec. 832(c)(1), (4).17    Losses

incurred are (1) losses paid during the taxable year, (2) reduced

by salvage and reinsurance recovered during that year, (3) plus

all unpaid losses (discounted for years after 1986) outstanding

at the end of the taxable year, (4) less all unpaid losses

outstanding at the end of the preceding taxable year, (5) plus

estimated salvage and reinsurance recoverable at the end of the

preceding taxable year, (6) less estimated salvage and

reinsurance recoverable at the end of the taxable year.        Sec.

832(b)(5).18      Property and casualty insurance companies have

     17
          Sec. 832(c) provides in pertinent part as follows:

          SEC. 832(c). DEDUCTIONS ALLOWED.--In computing
     the taxable income of an insurance company subject to
     the tax imposed by section 831, there shall be allowed
     as deductions:

          (1) all ordinary and necessary expenses incurred, as
     provided in section 162 (relating to trade or business
     expenses);

            *         *       *         *     *       *         *

          (4) losses incurred, as defined in subsection
     (b)(5) of this section;
     18
          Sec. 832(b)(5)(A) provides as follows:

            (5)    Losses Incurred.--
                                                          (continued...)
                              -20-

accounting reserves for unpaid losses.    Atlantic Mut. Ins. Co. v.

Commissioner, 523 U.S. ___, 118 S. Ct. 1413, 1415 (1998).    Unpaid

losses are those that have been reported but not yet paid, or

those that have been incurred, but not yet reported.    Western

Natl. Mut. Ins. Co. v. Commissioner, 65 F.3d 90, 91 (8th Cir.

1995), affg. 102 T.C. 338 (1994).    Unpaid losses must include

only actual unpaid losses as nearly as it is possible to




     18
      (...continued)
               (A) 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.

     The amount of estimated salvage recoverable shall be
     determined on a discounted basis in accordance with
     procedures established by the Secretary.
                                 -21-

ascertain them.    Sec. 1.832-4(a)(5), (b), Income Tax Regs.19   The

estimate of unpaid losses must be fair and reasonable based on

the facts in each case and the company's experience with similar

cases.    Id.

     The reserve for unpaid losses is an estimate, made at the

close of a taxable year, of the insurer's liability for claims

that it will be required to pay in future years.    Western Cas. &

Sur. Co. v. Commissioner, 65 T.C. 897, 917 (1976), affd. on

another issue 571 F.2d 514 (10th Cir. 1978).    A fair and

reasonable estimate of a taxpayer's unpaid losses is essentially

a valuation issue and a question of fact.    Hanover Ins. Co. v.

Commissioner, 69 T.C. 260, 270 (1977), affd. 598 F.2d 1211 (1st

Cir. 1979).



     19
          Sec. 1.832-4(b), Income Tax Regs., provides as follows:

     (b) Losses incurred. Every insurance company to which this
     section applies must be prepared to establish to the
     satisfaction of the district director that the part of the
     deduction for "losses incurred" which represents unpaid
     losses at the close of the taxable year comprises only
     actual unpaid losses. See Section 846 for rules relating to
     the determination of discounted unpaid losses. These losses
     must be stated in amounts which, based upon the facts in
     each case and the company's experience with similar cases,
     represent a fair and reasonable estimate of the amount the
     company will be required to pay. Amounts included in, or
     added to, the estimates of unpaid losses which, in the
     opinion of the district director, are in excess of a fair
     and reasonable estimate will be disallowed as a deduction.
     The district director may require any insurance company to
     submit such detailed information with respect to its actual
     experience as is deemed necessary to establish the
     reasonableness of the deduction for "losses incurred."
                                -22-

C.   Fair and Reasonable Estimate of Petitioner's Unpaid Losses

     1.   Expert Testimony

     Both parties called expert witnesses to give their opinions

about the reasonableness of petitioner's reserves for unpaid

losses for 1991 and 1992.    We may accept or reject expert

testimony according to our own judgment, and we may be selective

in deciding what parts of an expert's opinion, if any, we will

accept.   Helvering v. Natl. Grocery Co., 304 U.S. 282, 295

(1938).

     There were six expert witnesses at the trial.    Four were

actuaries:    Hurley (an actuary for Tillinghast) and Owen Gleeson

(Gleeson) for petitioner, and Frederick Kilbourne (Kilbourne) and

Raymond Nichols (Nichols)20 for respondent.   James Schacht

(Schacht) and Lawrence Smarr (Smarr) also testified for

petitioner.

     2.   Hurley

     We find Hurley's estimates of petitioner's reserves for

unpaid losses to be reasonable.    Hurley was petitioner's actuary

during the years in issue.    See Hospital Corp. of Am. v.

Commissioner, T.C. Memo. 1997-482 (the opinion of an expert who

was taxpayer's actuary during the years in issue is entitled to

some deference).   Hurley considered the facts that were unique to



     20
       Nichols did not do an actuarial reserve study of
petitioner.
                               -23-

petitioner in estimating its reserves.    Unlike respondent's

expert, Kilbourne, who was unfamiliar with petitioner's business

and who merely prepared a report essentially critiquing Hurley's

actuarial analysis, Hurley's loss reserve reviews were

specifically based on petitioner and its business.    Because

Hurley prepared petitioner's rate reviews, he knew that

estimating excessive loss reserves would result in higher

insurance premiums for petitioner's insureds.    He recognized that

petitioner had an incentive not to overstate its reserves.

     Hurley prepared semiannual loss reserve reviews and annual

rate indication studies for petitioner.    He used consistent

actuarial methods and standard actuarial loss development and

pure premium methods to estimate petitioner's unpaid loss

reserves for 1991 and 1992.

     Hurley used petitioner's and industry data in his

projections.   Over time, he increased the weight he gave to

petitioner's data relative to industry data because more of

petitioner's data was available.

     Hurley estimated only actual unpaid losses in establishing

petitioner's annual statement unpaid losses.    He based his

projections on petitioner's database containing information about

its past loss payments and case reserves.    Hurley's report for

the 1991 and 1992 annual statements estimated unpaid losses

within an actuarially reasonable range.    Each point in Hurley's
                                -24-

range was reasonable.    His reports met all relevant actuarial

standards.

     Hurley applied one exposure (i.e., pure premium) and four

development methods.    The development and exposure methods

produced ultimates, which were weighted, as coverage years aged,

against petitioner's loss experience reflected primarily in the

development methods.    Hurley's weighting of the two types of

methods was similar to a Bornhuetter-Ferguson method,21 which is

widely used for long-tailed lines of insurance like medical

malpractice.

     Estimates as of December 1990 of petitioner's ultimates for

coverage years 1986 through 1990 were lower than estimates made

previously for those years.    Hurley reduced his estimate of

petitioner's ultimates for 1991 and 1992 because his projected

ultimates for prior coverage years were reduced.

     Hurley's range was large because: (a) petitioner is a

relatively modestly capitalized, single-line insurer that serves

a limited geographic area; (b) it has relatively few claims, but

the average cost of a claim is high; and (c) medical malpractice

insurance is highly risky and longer-tailed.    These facts makes

projecting losses difficult.    See Hospital Corp. of America v.

Commissioner, supra.


     21
       The Bornhuetter-Ferguson method is an actuarial technique
used to estimate the value of a company's reserves by subtracting
its paid losses from its reserves.
                               -25-

     Gleeson and Schacht each said that Hurley's estimates of the

reserves were reasonable.   We find their analysis to be credible.

     3.   Kilbourne

     Kilbourne analyzed Hurley's loss reserve reviews and the

reasonableness of petitioner's reserves for unpaid losses as

shown on its 1991 and 1992 annual statements.

     Kilbourne averaged the four 1991 and 1992 yearend point

estimate results of Hurley's development methods with Hurley's

pure premium range, based on the facts existing at the end of

1991 and 1992.   Kilbourne noted that the results of the four

development methods were clustered and that Hurley's reports did

not indicate that any method was preferable.    Kilbourne concluded

that reasonable best estimates of petitioner's unpaid losses and

loss adjustment expenses at the end of 1991 and 1992 could be

made by averaging the four point estimate results of Hurley's

four development methods with his pure premium method range.

     Kilbourne analyzed Hurley's loss reserve reviews as of the

end of 1991 and 1992.   He concluded that Hurley's lookback

approach for selecting an initial estimate of ultimate loss for

the current year was flawed.   He believed that Hurley's approach

essentially ignored the point estimate results and that Hurley's

ranges overstated petitioner's actuarially supported reserves for

1991 and 1992.   He concluded that the best estimates of

petitioner's ultimate losses were $43,765,000 for 1991 and
                                 -26-

$42,577,000 for 1992.

D.   Analysis

     1.   Whether Petitioner's Reserves Were Fair and Reasonable

     Respondent contends that respondent's adjustments to the

unpaid loss reserves are needed to make the reserves fair and

reasonable as required by section 1.832-4(b), Income Tax Regs.

Respondent argues that respondent's proposed reduction of

petitioner's undiscounted unpaid losses for 1991 and 1992 is

reasonable.

     A taxpayer's reserve for unpaid losses must be fair and

reasonable based on the facts in each case and the company's

experience with similar cases.    Sec. 1.832-4(b), Income Tax Regs.

     Petitioner could not offset reserve deficits with reserve

surpluses in another line of insurance because it wrote a single,

relatively volatile line of business in a limited market.   The

inability to offset deficits with surpluses makes petitioner's

business more risky and reasonably led petitioner to establish

higher reserves.

     For the years in issue, the medical malpractice industry

overstated reserves to virtually the same extent as petitioner.

This suggests that petitioner's estimates were fair and

reasonable.

     UDI made a triennial examination of petitioner's 1990-93

annual statements.   It did not adjust petitioner's reporting of
                              -27-

unpaid losses and loss adjustment expenses.   Cf. Hanover Ins. Co.

v. Commissioner, 69 T.C. at 270-272 (the Commissioner's

adjustments to the taxpayer's reserves for unpaid losses were

reasonable; the taxpayer failed to adjust its loss reserves after

NAIC examiners found substantial overstatements).

     Hurley adjusted petitioner's loss reserves each year to

account for petitioner's actual loss experience.    This suggests

petitioner's loss estimates were fair and reasonable.    See

Roanoke Vending Exch., Inc. v. Commissioner, 40 T.C. 735, 741

(1963) (bad debt reserve); Home Ice Cream & Ice Co. v.

Commissioner, 19 B.T.A. 762, 765 (1930) (same).

     Hurley and Schacht testified that insurance companies have

an incentive not to overstate their unpaid losses because

overstating their losses may result in higher premiums, may make

them less competitive with other companies, and could diminish

their surplus to the point that they cannot write new policies.

Petitioner's insureds would prefer to keep their medical

malpractice insurance premiums low.   This tension between

petitioner and its insureds suggests that petitioner's reserve

for unpaid losses was fair and reasonable.

     2.   Whether Petitioner's Reserve Estimates Were Within the
          Range of Hurley's Estimates

     Petitioner contends that its unpaid loss reserves for years

ended 1991 and 1992 fall within the range of estimates made by

Hurley and are fair and reasonable.   Respondent erroneously
                                -28-

contended that petitioner's reserves were above the high end of

Hurley's ranges because respondent considered the discounted

total reserves column rather than the undiscounted total reserves

column.    Petitioner selected reserves from the undiscounted

column as required by sections 846(b)(1) and (2).     Petitioner

deducted paid losses from Tillinghast's projected reserves to

account for the difference between the paid losses in

petitioner's records and the paid losses in Tillinghast's

records.    Finally, Oslowski testified credibly that petitioner

chose reserves from the high end, but not above the high end, of

Tillinghast's reserve estimates.    We find that petitioner's

reserves were within the ranges of Tillinghast's reserve

estimates.

     3.    Whether Petitioner's Selection of Tillinghast's High
           End Values for 1991 and 1992 Was Fair and Reasonable

     Respondent argues that, because petitioner overstated its

unpaid loss reserves for 1986 to 1990, petitioner's establishment

of reserves using amounts at the high end of Tillinghast's range

in 1991 and 1992 was not fair and reasonable.    Respondent

contends that the favorable development for 1986-90 was apparent

when Tillinghast made the unpaid loss estimates in question,

which meant petitioner's estimates were overstated.

     We disagree.   Petitioner properly considered the fact that

the frequency and severity of its claims began to increase

significantly in 1990.   That fact, along with petitioner's prior
                               -29-

history of inadequate reserves in 1980-85, makes reasonable

petitioner's estimates of reserves for 1991 and 1992.   The fact

that petitioner's loss estimates for 1986-92 proved, with

hindsight, to be higher than actual payments does not make

petitioner's choice of values unreasonable.   Petitioner's

reserves for unpaid losses must be fair and reasonable, but are

not required to be accurate based on hindsight.   Sec. 1.832-4(b),

Income Tax Regs.

     4.   Whether Only the Midpoint of an Actuarially Sound Range
          Is the Fair and Reasonable Estimate

     Respondent argues that, for tax purposes, the midpoint of an

actuarially sound range, which respondent characterizes as "tax

equipoise", is the only fair and reasonable estimate since it

gives no tax advantage to either the taxpayer or to Treasury.

     We disagree.   Respondent cites no authority for the

proposition that tax equipoise equates with the fair and

reasonable standard.   We have held in a different context that

the high end of a range of reasonable values may be reasonable.

See Vinson & Elkins v. Commissioner, 99 T.C. 9, 49 (1992) (for

purposes of assessing the actuarial assumptions of a defined

benefit plan, court adopted as reasonable a retirement age

assumption that was at high end of reasonableness range), affd. 7

F.3d 1235 (5th Cir. 1993).   Hurley testified that any loss

reserve amount selected from within the actuarial range he gave

petitioner would be reasonable.
                                    -30-

        5.      Whether Petitioner's Reserves Must Be Probable To Be
                Fair and Reasonable

        Respondent argues that petitioner's reserves were not fair

and reasonable because it is improbable that petitioner's losses

will reach Tillinghast's highest estimates for 6 or 7 consecutive

years.        Respondent contends that, to be fair and reasonable, the

estimates of unpaid losses selected by the taxpayer must be at

least equally likely to occur as any other estimate of unpaid

loss.

        We disagree.     The regulations require that the taxpayer make

a fair and reasonable estimate of losses based on the facts of

each case and on the taxpayer's experience with similar cases.

Sec. 1.832-4(b), Income Tax Regs.          The regulations do not provide

or even suggest that only one estimate is correct.

        6.      Whether Petitioner's Lookback Method Was Proper

        Respondent argues that Hurley's lookback method22 for

estimating the high end of its range ignored the most recent

actual loss data and included the preceding year's overstated

initial estimate in the initial high end estimate for the next

year.        For example, respondent contends that Hurley used his

initial $16 million high end estimate made at the end of 1990

rather than using the most recent estimate for 1990 ($15.2

million), reestimated at the end of 1991.


        22
       Hurley looked back at prior years' losses to estimate
current loss reserves.
                                -31-

     We disagree that Hurley improperly reestimated the prior

years' ultimate losses.   Hurley reestimated the ultimate losses

for each prior coverage year when he estimated reserves for 1991

and 1992.   Hurley adjusted his ranges for 1991 and 1992 based on

petitioner's favorable experience from 1986 to 1990.

Respondent's contention that he merely included the prior year's

initial estimates in the current year's high end estimate is

mistaken.   Instead, he compared the results of the development

methods for the current year to the initial estimates for the

prior year.   In calculating the ultimate loss estimates for 1991

and 1992, Hurley used reestimated ultimate loss estimates for

prior coverage years.

     Respondent contends that because Hurley reestimated by

gradually reducing the high end ultimate losses for the post-1985

coverage years as of the end of 1991 and 1992, he compounded

petitioner's overstated reserves for those years by carrying the

overstatements forward.   We disagree that Hurley compounded

petitioner's overstated reserves by his approach.    As

petitioner's loss experience began to improve, Hurley reduced the

estimates for that coverage year.

     7.     Kilbourne's Criticism of Petitioner's Methods

     Respondent argues that Kilbourne's method is reasonable and

points out that it is very similar to petitioner's actual

experience, as reflected in the development of petitioner's
                                -32-

losses for coverage years 1987 through 1992, reestimated at the

end of 1996.

     Respondent's argument misses the mark.   Although we agree

that Kilbourne's method is reasonable, we need not decide whether

his method is more reasonable than petitioner's method.   Section

1.832-4(b), Income Tax Regs., requires that the taxpayer show

that its unpaid losses were actual unpaid losses and that its

estimate of loss reserves be fair and reasonable.   Petitioner has

satisfied the requirements of the regulations, and thus our

inquiry ends.   Cf. Molsen v. Commissioner, 85 T.C. 485, 498

(1985); Peninsula Steel Prods. & Equip. Co. v. Commissioner, 78

T.C. 1029, 1045 (1982) (the Commissioner cannot require a

taxpayer to change from an accounting method which clearly

reflects income to an alternate method merely because the

Commissioner concludes that the alternate method more clearly

reflects the taxpayer's income).

     8.     Whether Gleeson Confirmed That Hurley's Ranges Were Not
            Actuarially Sound

     Respondent argues that Gleeson confirmed Kilbourne's

conclusion that Hurley's ranges were not actuarially sound.23     We

disagree.   Gleeson applied a probability distribution test to


     23
       Kilbourne said that Hurley's approach ignored the point
estimate results of his four actuarial methods and that his
ranges were skewed so that even the low ends of his ranges as of
the end of 1991 and 1992 were higher than what in Kilbourne's
opinion were actuarially reasonable "best estimates" of
petitioner's ultimate losses.
                               -33-

Hurley's initial high end estimate of ultimate loss for 1992.

Gleeson testified that Hurley's $17,500,000 high end estimate was

a reasonable estimate of petitioner's ultimate losses for 1992 as

of the end of 1992.

     On cross-examination, respondent asked Gleeson to add

coverage years 1987 to 1991 to his test.    Respondent asked

Gleeson to review Exhibits 86, 87, and 88,24 which purport to

show that petitioner's net ultimate losses as reestimated for

coverage years 1987 to 1992 fell increasingly to the right of the

range moving back from 1992 to 1990 and fell outside the range

for 1989 to 1987.   Gleeson testified that respondent's

computations in Exhibits 86, 87, and 88 were accurate.

Respondent argues that Gleeson agreed that petitioner's estimates

for coverage years 1987 to 1992, taken together, failed his test.

     We disagree.   Gleeson testified that respondent's

probability distribution graphs did not change his conclusion

that Hurley's work was reasonable.    He pointed out that Exhibits

86, 87, and 88 (particularly Exhibit 87) used basic limits data,

that is, data about claims that are paid or reserved at $100,000

or less.   In Gleeson's opinion, basic limits data shows more

rapid development than total limits data because the smaller and

easier to settle claims are paid first.    He also pointed out that


     24
       Exhibit 86 contains several probability distribution
graphs showing factors for 1987 to 1992. Exhibit 87 is a 1992
report showing updated development factors that had been
contained in an attachment to Gleeson's report. Exhibit 88
contains loss development factors. These exhibits extended
Gleeson's probability distribution test back through 1987.
                                -34-

the basic limits data contained in respondent's exhibits does not

show claims that are paid or reserved at more than $100,000.

Gleeson pointed out that petitioner's retention was about

$350,000 and that the basic limits data does not account for the

development between the $100,000 basic limits and petitioner's

$350,000 retention amount.25   Thus, Gleeson found Hurley's ranges

to be actuarially sound.

     9.   Whether Respondent's Use of Hindsight Was Proper

     Respondent points out that hindsight may be used in deciding

whether to sustain respondent's proposed adjustments.     Hanover

Ins. Co. v. Commissioner, 69 T.C. at 270 (the Commissioner

reasonably used hindsight to test the reasonableness of the

taxpayer's reserves); Hospital Corp. of Am. v. Commissioner, T.C.

Memo. 1997-482 (the taxpayer did not prove that its reserves were

reasonable because the Commissioner's expert used hindsight to

show that the taxpayer's reserves were overstated).    Respondent

relies on petitioner's 1996 annual statement to support

respondent's contention that the development of petitioner's

actual losses shown in the reestimates of ultimate losses for

coverage years 1987 to 1992 as of the end of 1996 confirms that

respondent's proposed adjustments are reasonable.   We need not

decide whether respondent's adjustments are reasonable since

petitioner's loss reserves were fair and reasonable.    Compare


     25
       Gleeson testified that petitioner's retention was about
$350,000. We have found that it was $375,000-$400,000. The
difference in retention amounts does not affect Gleeson's
explanation.
                                 -35-

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

E.   Conclusion

     We conclude that petitioner's reserves for unpaid losses and

loss adjustment expenses for 1991 and 1992 were fair and

reasonable estimates of petitioner’s actual unpaid losses.

     To reflect the foregoing,


                                             Decision will be entered

                                        under Rule 155.
