                                           STATE FARM MUTUAL AUTOMOBILE INSURANCE COMPANY &
                                                SUBSIDIARIES, PETITIONER v. COMMISSIONER OF
                                                      INTERNAL REVENUE, RESPONDENT
                                                        Docket No. 5426–05.                  Filed November 8, 2010.

                                                  P provided automobile liability insurance. P was found by
                                               the Supreme Court of Utah to be liable for punitive damages
                                               related to its claims processing on this liability coverage. P
                                               reflected the amount of the punitive damage award as a ‘‘loss
                                               incurred’’ within the meaning of sec. 832(b)(5), I.R.C., enti-
                                               tling it to increase its insurance loss reserve, as shown on its
                                               annual statement for insurance regulatory purposes. R chal-
                                               lenges this treatment for several reasons including that the
                                               punitive damage award was extracontractual to the insurance
                                               coverage P provided. Held: P may not include the punitive
                                               damage award in losses incurred under sec. 832(b)(5), I.R.C.

                                        Jerome B. Libin, James V. Heffernan, Mary E. Monahan,
                                      and Troy L. Olsen, for petitioner.
                                        Alan M. Jacobson, Jan E. Lamartine, and William F.
                                      Barry IV, for respondent.

                                                                                   OPINION

                                         GOEKE, Judge: Respondent determined deficiencies in peti-
                                      tioner’s income tax for the taxable years 1996 through 1999.
                                      Petitioner raised seven issues in its petition, six of which
                                      have been resolved. This Opinion addresses solely whether
                                      punitive damages and related costs of $202 million are
                                      includable in losses incurred under section 832(b)(5) 1 for tax-
                                      able years 2001 and 2002. For the reasons stated herein, we
                                      find that the $202 million is not properly included in losses
                                      incurred for Federal income tax purposes.
                                        1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect

                                      for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Proce-
                                      dure.


                                                                                                                                     543




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                                      544                135 UNITED STATES TAX COURT REPORTS                                        (543)


                                                                               Background
                                        Some of the facts have been stipulated and are so found.
                                      The stipulation of facts and the accompanying exhibits are
                                      incorporated herein by this reference. Petitioner is an Illinois
                                      mutual property and casualty insurance company taxed as a
                                      corporation. Its principal office is in Bloomington, Illinois.
                                      A. The Accident Case, Campbell I, and Campbell II 2
                                        Petitioner issued an automobile insurance contract to
                                      Curtis B. Campbell (Campbell) effective August 8, 1980 (the
                                      Campbell contract). Campbell was a resident of Utah. Under
                                      the Campbell contract, petitioner provided Campbell with
                                      automobile insurance coverage. The bodily injury coverage
                                      under the Campbell contract was limited to $25,000 for each
                                      person and $50,000 for each accident.
                                        The Campbell contract was in force on May 22, 1981. On
                                      that date an automobile accident (the accident) occurred in
                                      Utah involving Todd Ospital and Robert Slusher (Slusher)
                                      which resulted in the death of Todd Ospital and serious
                                      injury to Slusher. The manner in which Campbell was
                                      driving was alleged to have caused the accident. Litigation
                                      ensued (the accident case).
                                        In 1983 a Utah State court determined that Campbell was
                                      responsible for the accident and entered a judgment of
                                      $185,849 against him. That amount exceeded the per-
                                      accident limit of $50,000 under Campbell’s insurance policy.
                                      Petitioner appealed the judgment on behalf of Campbell to
                                      the Utah Supreme Court. Campbell obtained his own counsel
                                      for the appeal.
                                        In 1984 during the pendency of the appeal in the accident
                                      case, Ospital’s estate (Ospital), Slusher, and Campbell
                                      reached an agreement whereby Ospital and Slusher would
                                      not seek satisfaction of their claims against Campbell, and in
                                      exchange Campbell would (a) pursue an action asserting bad
                                      faith against petitioner, (b) be represented by Slusher’s and
                                      Ospital’s attorneys in that action, and (c) pay Ospital and
                                         2 The background of the accident case and the Campbell cases against petitioner for bad faith

                                      is set forth in various opinions: Slusher v. Ospital, 777 P.2d 437 (Utah 1989); Campbell v. State
                                      Farm Mut. Auto. Ins. Co., 840 P.2d 130 (Utah Ct. App. 1992); and Campbell v. State Farm Mut.
                                      Auto. Ins. Co., 65 P.3d 1134 (Utah 2001), revd. 538 U.S. 408 (2003), on remand 98 P.3d 409
                                      (Utah 2004).




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                                      (543)     STATE FARM MUT. AUTO. INS. CO. & SUBS. v. COMMR.                                    545


                                      Slusher 90 percent of any damage award resulting from that
                                      action.
                                         Campbell filed a complaint against petitioner in Utah
                                      State court (Campbell I) in an action separate from but
                                      related to the accident case. Ospital and Slusher joined in
                                      Campbell’s complaint. The complaint in Campbell I alleged
                                      bad faith on the part of petitioner in its conduct with respect
                                      to the accident case. Petitioner successfully moved to have
                                      the complaint dismissed, offering to pay the entire judgment
                                      against Campbell if the accident case was upheld on appeal.
                                         In June 1989 the Utah Supreme Court affirmed the lower
                                      State court’s judgment in the accident case in favor of
                                      Ospital and Slusher. Petitioner paid $314,768 to Ospital and
                                      Slusher. These payments satisfied the judgment, including
                                      interest and costs.
                                         In August 1989 Campbell filed a second complaint against
                                      petitioner in Utah State court (Campbell II). The complaint
                                      alleged five causes of action: (a) Breach of covenant of good
                                      faith and fair dealing; (b) tort of bad faith; (c) breach of fidu-
                                      ciary duty; (d) misrepresentation; and (e) intentional inflic-
                                      tion of emotional distress. In February 1991 the State court
                                      in Campbell II granted petitioner’s motion for summary judg-
                                      ment, finding that petitioner had promptly satisfied the
                                      entire judgment in the accident case when it became final.
                                         In August 1992 the Utah Court of Appeals reversed the
                                      trial court’s grant of summary judgment to petitioner in
                                      Campbell II and remanded the case for trial. In August 1996
                                      the jury in Campbell II awarded Campbell $2.6 million in
                                      compensatory damages and $145 million in punitive damages
                                      against petitioner, plus attorney’s fees and costs. Petitioner
                                      challenged the award, and in August 1998 the trial court
                                      reduced Campbell’s award to $1 million in compensatory
                                      damages and $25 million in punitive damages. Both parties
                                      appealed.
                                         In October 2001 the Utah Supreme Court reinstated the
                                      $145 million punitive damages award and affirmed the $1
                                      million compensatory damage award against petitioner. On
                                      December 4, 2001, the Utah Supreme Court denied peti-
                                      tioner’s request for rehearing.
                                         In March 2002 petitioner filed a petition with the U.S.
                                      Supreme Court for a writ of certiorari seeking review of the
                                      2001 Campbell II decision. In June 2002 the Supreme Court




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                                      granted certiorari. On April 7, 2003, the Supreme Court
                                      reversed the 2001 Campbell II decision and remanded the
                                      case to the Utah Supreme Court for a redetermination of the
                                      punitive damages.
                                         In April 2004 the Utah Supreme Court held that petitioner
                                      was liable to Campbell in the amount of $9,018,781 in puni-
                                      tive damages. From May 2003 to August 2005, petitioner
                                      paid a total of $16,927,635 to or for the behalf of Campbell,
                                      as follows:
                                           May 8, 2003 .....................................................................    $2,642,348
                                           Oct. 15, 2004 ....................................................................   14,195,287
                                           Aug. 26, 2005 ...................................................................        90,000

                                      These payments fully satisfied the Campbell II judgment,
                                      including interest and costs.
                                      B. Statutory Accounting for Illinois Insurance Companies
                                         Petitioner is required to file an annual financial statement
                                      (annual statement) with the State of Illinois, petitioner’s
                                      State of domicile. The annual statement is a form by which
                                      insurance companies report to the State their financial condi-
                                      tion and historical information about their results.
                                         Petitioner filed Annual Statements for 2001 and 2002 with
                                      both the State of Illinois and the National Association of
                                      Insurance Commissioners (NAIC). The NAIC is an organization
                                      of State insurance regulators for all 50 States, the District of
                                      Columbia, and five U.S. territories. Other jurisdictions in
                                      which petitioner does business have access to and review the
                                      filings it makes with the NAIC.
                                         NAIC statutory accounting practices and procedures are set
                                      forth in the NAIC Accounting Practices and Procedures
                                      Manual. In 1998 the NAIC adopted a new Accounting Prac-
                                      tices and Procedures Manual (the new AP&P Manual). The
                                      NAIC recommended that States adopt the new AP&P Manual
                                      effective January 1, 2001. In December 2000 the Illinois
                                      Department of Insurance decided that, effective January 1,
                                      2001, the new AP&P Manual was to be used as the reporting
                                      standard for statutory financial statements filed in Illinois.
                                      Beginning with the March 31, 2001, quarterly financial state-
                                      ments, all insurance companies domiciled in the State of
                                      Illinois were required to follow the accounting practices and
                                      procedures set forth in the new AP&P Manual. The State of




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                                      (543)     STATE FARM MUT. AUTO. INS. CO. & SUBS. v. COMMR.                                    547


                                      Illinois also requires insurance companies domiciled in
                                      Illinois to follow the NAIC’s instructions for filling out Annual
                                      Statements.
                                         Statutory Accounting Principles (SAPs) provide the basis for
                                      insurers to prepare financial statements to be filed with and
                                      used by State insurance departments for financial regulation
                                      purposes. The promulgation of new SAP guidance by the NAIC
                                      ultimately requires action of the entire membership. Respon-
                                      sibility for proposing a new SAP is delegated through the NAIC
                                      committee structure to the Accounting Practices and Proce-
                                      dures Task Force (the task force). The task force employs two
                                      working groups with distinctly different functions to carry
                                      out the charge of maintaining SAPs.
                                         The Statutory Accounting Principles Working Group
                                      (SAPWG) has the exclusive responsibility for developing and
                                      proposing new Statements of Statutory Accounting Principles
                                      (SSAPs). SSAPs are pronouncements of accounting rules
                                      adopted by the NAIC. SSAPs are included in the new AP&P
                                      Manual.
                                         The Emerging Accounting Issues Working Group (EAIWG)
                                      responds to questions of application, interpretation, and
                                      clarification of SSAPs. Its work is generally much narrower in
                                      scope than development of a new SSAP. In no event shall a
                                      consensus opinion of the EAIWG amend, supersede, or other-
                                      wise conflict with existing, effective SSAPs. The consensus
                                      opinions of the EAIWG are called Interpretations (INTs).
                                      C. Petitioner’s Loss Reserve Accounting
                                        By statute Illinois requires property and casualty insur-
                                      ance companies at all times to maintain reserves in amounts
                                      estimated to provide for the payment of all losses and claims
                                      incurred, whether reported or unreported, which are unpaid
                                      and for which such companies may be liable, and to provide
                                      for the expenses of adjustment or settlement of such losses
                                      and claims. Petitioner’s personnel in the field generally
                                      establish reserves relating to specific coverages or claims
                                      under company contracts. Those reserves are aggregated and
                                      processed for reporting on petitioner’s Annual Statements.
                                      Petitioner’s reserve includes a bulk loss reserve amount
                                      established for certain reported claims to reflect the dif-
                                      ference between aggregate case or table reserves for such




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                                      claims and the aggregate anticipated ultimate settlement
                                      amount of such claims.
                                        Petitioner reported its reserves for unpaid losses in its
                                      2001 and 2002 Annual Statements. In determining its year-
                                      end unpaid loss reserve for 2001, petitioner increased its
                                      Bulk and Incurred But Not Reported (Bulk and IBNR) unpaid
                                      loss reserve by $202 million. This increase was attributable
                                      to the 2001 Campbell II decision and the denial by the Utah
                                      Supreme Court of petitioner’s request for rehearing in
                                      December 2001 and was composed of the following amounts:
                                           Compensatory damages ..................................................                     $1,000,000
                                           Punitive damages ............................................................              145,000,000
                                           Plaintiff ’s court costs ......................................................                400,000
                                           Plaintiff ’s attorney’s fees ................................................                  400,000
                                           Interest .............................................................................      55,200,000

                                              Total ..............................................................................    202,000,000

                                      Petitioner applied a 2001 discount factor of 92.8052 percent
                                      to the $202 million, as required by sections 832(b)(5)(A) and
                                      846(d), and deducted the resulting $187,466,504 from its
                                      2001 taxable income.
                                        In determining its yearend unpaid loss reserve for the
                                      2002 Annual Statement, petitioner made no change in its
                                      Bulk and IBNR unpaid loss reserve with respect to the $202
                                      million reserved for the 2001 Campbell II decision. Petitioner
                                      applied a 2002 discount factor of 94.3541 percent to the $202
                                      million, then subtracted the 2001 discounted amount
                                      ($187,466,504)    from    the    2002    discounted    amount
                                      ($190,595,282), resulting in an increase in the loss reserve of
                                      $3,128,778. Petitioner deducted the $3,128,778 from its 2002
                                      taxable income.
                                        Following the 2003 Supreme Court decision reversing the
                                      2001 Campbell II decision, and before the 2004 Campbell II
                                      decision by the Utah Supreme Court, petitioner reduced its
                                      yearend 2003 Annual Statement Bulk and IBNR reserve for
                                      unpaid losses by $192 million. Petitioner retained $10 million
                                      attributable to Campbell II. Applying the 2003 discount
                                      factor of 89.301 percent to the remaining $10 million, then
                                      subtracting the resulting amount ($8,930,100) from the 2002
                                      discounted amount of $190,595,282, petitioner determined
                                      that the loss reserve should be decreased by $181,665,182.
                                      Petitioner increased its 2003 taxable income by $181,665,182.




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                                      (543)     STATE FARM MUT. AUTO. INS. CO. & SUBS. v. COMMR.                                    549


                                         Petitioner coded the Campbell II reserve on its records as
                                      relating to bodily injury coverage for the accident year 1981
                                      in the State of Utah. This coding was the same as the coding
                                      used for the accident itself.
                                         As required by the NAIC and by Illinois State law, peti-
                                      tioner’s 2001 and 2002 reported reserves were reviewed for
                                      adequacy by its outside auditors, PricewaterhouseCoopers
                                      (PwC). During the review, PwC was aware that petitioner
                                      had included the $202 million Campbell II judgment in its
                                      loss reserves. For both 2001 and 2002, PwC prepared and
                                      filed with the State of Illinois actuarial reports on peti-
                                      tioner’s loss and loss reserves. PwC’s reports set forth its
                                      opinion that petitioner’s reserves: (1) Met the requirements
                                      of Illinois insurance laws; (2) were computed in accordance
                                      with generally accepted reserve standards and principles;
                                      and (3) made a reasonable provision for all unpaid loss and
                                      loss adjustment expense obligations of petitioner under the
                                      terms of its policies and agreements. These reports also set
                                      forth PwC’s unqualified opinion that petitioner had prepared
                                      its 2001 and 2002 Annual Statements ‘‘using accounting
                                      practices prescribed or permitted by the Insurance Depart-
                                      ment of the State of Illinois.’’ These reports included the loss
                                      reserve amounts relating to Campbell II but did not refer to
                                      Campbell II directly.
                                         Petitioner’s 2001 and 2002 Annual Statements were also
                                      examined by a multistate team of insurance examiners (the
                                      examination team) under the auspices of the director of the
                                      Illinois Department of Insurance. Such examinations were
                                      required by State law and conducted primarily to ensure the
                                      solvency of insurance companies. The examination team was
                                      aware of Campbell II and of the fact that the $202 million
                                      had been included in petitioner’s loss reserve. On July 26,
                                      2002, during its examination of petitioner’s 2001 Annual
                                      Statement, the Examination Team requested more informa-
                                      tion regarding the $202 million unpaid loss reserve. Peti-
                                      tioner responded on July 30, 2002, that it had made a special
                                      adjustment in the reserve for Campbell v. State Farm Mut.
                                      Auto Ins. Co, 65 P.3d 1134 (Utah 2001). Petitioner further
                                      stated:
                                      The $202 million reserve adjustment represents the court award and esti-
                                      mated interest. The award was reduced by the Utah appellate court, but




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                                      reinstated by the Utah Supreme Court in 2001. At year end, we thought
                                      there was little chance that the US Supreme Court would agree to hear
                                      the case, but they recently did.

                                      The Examination Team issued a report after examining both
                                      Annual Statements. These reports referred to the loss
                                      reserve amounts relating to Campbell II but did not refer to
                                      Campbell II directly. The director of the Illinois Department
                                      of Insurance adopted each of these reports.
                                         Although petitioner’s accounting affected the allocation to
                                      the loss reserve, petitioner did not consider the amounts
                                      relating to the Campbell II case in petitioner’s ratemaking
                                      calculations.
                                         Respondent audited petitioner’s returns for taxable years
                                      1996 through 1999 and issued a notice of deficiency with
                                      respect to those years on December 22, 2004. Respondent
                                      determined deficiencies in petitioner’s Federal income taxes
                                      of $12,830,522, $55,903,247, $25,981,117, and $14,249,973 for
                                      1996, 1997, 1998, and 1999, respectively. In the notice of
                                      deficiency respondent disallowed the deductions petitioner
                                      claimed as a result of the adjustments made to the Bulk and
                                      IBNR reserve for unpaid losses in 2001 and 2002 attributable
                                      to the judgment of the Utah Supreme Court in Campbell II.
                                         Petitioner timely filed its petition with this Court on
                                      March 21, 2005, disputing a portion of the deficiency deter-
                                      mined for 1996 and disputing the entire deficiency
                                      determined for each of 1997, 1998, and 1999. In addition,
                                      petitioner     claimed     overpayments     of    $156,917,448,
                                      $214,471,611, and $138,570,516 for 1997, 1998, and 1999,
                                      respectively, due to alternative minimum tax (AMT) net oper-
                                      ating loss carrybacks from the taxable years 2001 and 2002.
                                      Respondent timely filed his answer on May 19, 2005, re-
                                      asserting the deficiencies and denying that petitioner had
                                      made any overpayments.
                                         In March 2005 petitioner sought assurance from the
                                      Illinois Department of Insurance that the accounting with
                                      regard to the Campbell II amount was valid. James Hanson,
                                      acting assistant deputy director of the department, gave such
                                      assurance in a reply letter.
                                         All of the issues raised in the petition were settled, except
                                      for the AMT issue and the loss reserve issue. This Court
                                      agreed to consider those two issues separately. The




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                                      (543)     STATE FARM MUT. AUTO. INS. CO. & SUBS. v. COMMR.                                    551


                                      Court issued an Opinion on the AMT issue on June 23, 2008.
                                      State Farm Mut. Auto. Ins. Co. & Subs. v. Commissioner, 130
                                      T.C. 263 (2008). A trial on the loss reserve issue was held on
                                      December 9 and 10, 2009, in Washington, D.C. At trial, peti-
                                      tioner and respondent introduced several expert reports
                                      regarding the proper method of accounting for the $202 mil-
                                      lion judgment entered against petitioner by the Utah
                                      Supreme Court in 2001.

                                                                                Discussion
                                      I. Burden of Proof
                                         Petitioner bears the burden of proving, by a preponderance
                                      of the evidence, that respondent’s determinations in the
                                      notice of deficiency are incorrect. See Rule 142(a); Welch v.
                                      Helvering, 290 U.S. 111, 115 (1933). Deductions are a matter
                                      of legislative grace, and the taxpayer bears the burden of
                                      proving entitlement to any claimed deductions. Rule
                                      142(a)(1); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
                                      (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
                                      (1934). However, this case is not resolved on the burden of
                                      proof. Rather, the facts are largely undisputed, and the ques-
                                      tion is primarily one of law.
                                      II. Arguments of the Parties
                                         Petitioner argues that section 832 requires petitioner to
                                      follow the annual statement method of accounting and that
                                      the $202 million was properly included in loss reserves on
                                      the 2001 and 2002 Annual Statements. Petitioner also con-
                                      tends that regardless of the annual statement method, the
                                      $202 million was properly included in loss reserves under
                                      section 832(b)(5) as a loss incurred on an insurance contract.
                                         Respondent argues that the $202 million is not deductible
                                      under section 832(b)(5) and that it should instead have been
                                      accounted for as a business expense under section 832(c).
                                      Respondent also contends that the amounts petitioner
                                      reported on its Annual Statements do not control for tax pur-
                                      poses and that NAIC accounting principles do not support
                                      including the $202 million in loss reserves. Finally,
                                      respondent argues that the $202 million is not deductible as
                                      a loss incurred because it is not a fair and reasonable esti-
                                      mate of an actual unpaid loss.




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                                      III. Whether Section 832 Conforms to the Annual Statement
                                           Method of Accounting
                                         Petitioner argues that the annual statement method of
                                      accounting controls for Federal tax purposes and that the
                                      $202 million was properly included in the annual statement
                                      loss reserves. Respondent offers several reasons the annual
                                      statement method of accounting does not control for Federal
                                      income tax purposes and the $202 million was not properly
                                      included in the annual statement loss reserves. The parties
                                      disagree about the applicability of the Court of Appeals for
                                      the Seventh Circuit’s opinion in Sears, Roebuck & Co. v.
                                      Commissioner, 972 F.2d 858 (7th Cir. 1992), affg. in part and
                                      revg. in part 96 T.C. 61 (1991), modified 96 T.C. 671 (1991).
                                         Respondent is correct in characterizing the loss in question
                                      as extracontractual. It is not a loss covered by the liability
                                      policy of an insured. The Illinois Department of Insurance
                                      treats it as such for purposes of computing insured losses
                                      incurred. The parties dispute whether Sears dictates that
                                      this construction by the insurance regulators controls for
                                      Federal tax purposes.
                                         The Court of Appeals in Sears held that the insurance
                                      annual statement controls as to the timing of the deduction
                                      of insured losses, and petitioner would have us apply this
                                      holding to the State’s determination that these
                                      extracontractual losses should be included in current losses
                                      under the insurance contracts.
                                         As petitioner’s principal place of business is in Illinois, the
                                      Court of Appeals for the Seventh Circuit would normally
                                      have appellate jurisdiction over this case. Sec. 7482(b)(1)(B).
                                      The Tax Court will ‘‘generally defer to the rule adopted by
                                      the Court of Appeals for the circuit to which appeal would
                                      normally lie, if that Court of Appeals has ruled with respect
                                      to the identical issue.’’ Becker v. Commissioner, T.C. Memo.
                                      2006–264; see also Golsen v. Commissioner, 54 T.C. 742, 757
                                      (1970), affd. 445 F.2d 985 (10th Cir. 1971).
                                         Respondent would distinguish Sears from the present case,
                                      arguing that factual differences render Sears irrelevant to
                                      our decision here. Respondent argues five points: (1) The
                                      losses in Sears arose from insured events and were not
                                      extracontractual; (2) petitioner has not shown the $202 mil-
                                      lion is a fair and reasonable estimate of the amount peti-




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                                      (543)     STATE FARM MUT. AUTO. INS. CO. & SUBS. v. COMMR.                                    553


                                      tioner would have been required to pay; (3) Sears did not
                                      concern a possible contravention of NAIC statutory accounting
                                      principles; (4) Sears did not address punitive damages; and
                                      (5) Sears did not involve a possible mismatching of income
                                      and losses incurred. We focus on points (1) and (4).
                                         In Sears, PMI Mortgage Insurance Co. (PMI) had estab-
                                      lished $35.9 million in IBNR reserves for estimated losses and
                                      deducted that amount from income. The Commissioner con-
                                      tended that this deduction should be limited to $19.5 million,
                                      arguing that the insurance company should not be allowed
                                      deductions in excess of that amount for estimated losses. The
                                      Tax Court upheld the Commissioner on this issue, holding
                                      the ‘‘insurer cannot incur a loss until the insured has suf-
                                      fered the defined economic loss, to wit, after the lender takes
                                      title to the mortgaged property.’’ Sears, Roebuck & Co. v.
                                      Commissioner, 96 T.C. at 114.
                                         The Court of Appeals for the Seventh Circuit reversed the
                                      decision of the Tax Court in that respect, stating: ‘‘Section
                                      832 is no ordinary rule. It expressly links federal taxes to the
                                      NAIC’s annual statement’’. Sears, Roebuck & Co. v. Commis-
                                      sioner, 972 F.2d at 865–866. The court held that because sec-
                                      tion 832(b)(1)(A) requires insurers to use the NAIC annual
                                      statement to determine gross income, section 832 required an
                                      insurer to compute losses incurred according to the annual
                                      statement as well. Id. at 866. With respect to the Commis-
                                      sioner’s attempt to ignore the requirement that companies
                                      report their losses in accordance with the Annual Statement,
                                      the court stated: ‘‘An Internal Revenue Service eager to dish
                                      out the medicine of literalism must be prepared to swallow
                                      it.’’ Id. at 868. The court concluded that ‘‘State insurance
                                      commissioners’ preferences about reserves thus are not some
                                      intrusion on federal tax policy; using their annual statement
                                      is federal tax law.’’ Id. at 866. Having so found, the Court of
                                      Appeals ruled that because PMI followed the NAIC annual
                                      statement it was entitled to deduct the $35.9 million in loss
                                      reserves. Id. at 867. However, all the quoted analysis is in
                                      the context of the timing of recognition of insured losses.
                                      IV. How Does Section 832 Apply in the Present Case?
                                        The parties dispute the proper application of section 832 in
                                      this case. Petitioner maintains the result is dictated by the




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                                      requirement in section 832(b)(1) that an insurance company’s
                                      gross income consists of investment income 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’’.
                                         Petitioner maintains that it correctly included the
                                      Campbell II punitive damages as losses incurred on the
                                      Annual Statements and this treatment was accepted by its
                                      outside accountants and the Illinois State insurance regu-
                                      lators. Therefore, petitioner reasons that the deductibility of
                                      the loss on its tax returns is dictated by the inclusion of the
                                      punitive damage award in its Annual Statements.
                                         Respondent’s position begins with a detailed examination
                                      of the Campbell I and Campbell II lawsuits for purposes of
                                      demonstrating that the punitive damage award is not a loss
                                      covered on an insurance contract but rather a liability peti-
                                      tioner incurred because of its own misconduct, not any act of
                                      its insured. Respondent is correct, and to bring the argument
                                      within section 832, respondent focuses on the phrase ‘‘losses
                                      incurred * * * on insurance contracts’’ in section
                                      832(b)(5)(A). Respondent asserts that section 832 by its terms
                                      applies the annual statement rule only to insured losses, and
                                      the accounting treatment of the punitive damage award does
                                      not control the tax treatment.
                                         Petitioner counters that the word ‘‘on’’ should be read to
                                      mean ‘‘related to’’, ‘‘caused by’’, ‘‘derived from’’, or ‘‘because
                                      of ’’. The implication of petitioner’s counterargument is that
                                      Congress has delegated to the insurance regulators the job of
                                      deciding which losses are caused by insurance contracts, and
                                      respondent has no business second guessing the regulators’
                                      acceptance of petitioner’s effort to find a causal connection
                                      between the punitive damage award and petitioner’s auto-
                                      mobile insurance contracts.
                                         Petitioner argues that Sears fully supports the pre-
                                      eminence of the annual statement in tax accounting for
                                      insurance losses. Although Sears addressed only the timing
                                      of inclusion of insured losses in computing gross income, peti-
                                      tioner maintains that the opinion of the Court of Appeals
                                      supports petitioner’s position that Congress has ceded the
                                      computation of insurance premium gross income to the insur-
                                      ance industry regulators. Sears, Roebuck & Co. v. Commis-
                                      sioner, 972 F.2d at 866.




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                                      (543)     STATE FARM MUT. AUTO. INS. CO. & SUBS. v. COMMR.                                    555


                                         Petitioner also references the legislative history and the
                                      regulations to support the position that neither Congress nor
                                      the Secretary envisioned exceptions to the reliance on the
                                      annual statement to dictate the computation of insurance
                                      gross income beyond the exception noted in the regulations
                                      regarding salvage value. See S. Rept. 99–313, at 499, 501,
                                      503 (1986), 1986–3 C.B. (Vol. 3) 1, 499, 501, 503; H. Conf.
                                      Rept. 99–841 (Vol. II), at II–358 (1986), 1986–3 C.B. (Vol. 4)
                                      1, 358; sec. 1.832–4(c), Income Tax Regs. Petitioner also cites
                                      section 846(b)(1), which provides the details for the computa-
                                      tion of ‘‘discounted unpaid losses’’ used in section
                                      832(b)(5)(A). Section 846(b)(1) defines ‘‘undiscounted unpaid
                                      losses’’ as ‘‘the unpaid losses shown in the annual statement
                                      filed by the taxpayer for the year ending with or within the
                                      taxable year of the taxpayer.’’ 3
                                         Respondent’s principal counterargument is that this loss
                                      was not an insured loss. Punitive damages are in the nature
                                      of a punishment to modify behavior, not a foreseen result of
                                      meeting an obligation to cover an insured event.
                                         Petitioner accounted for the $202 million by increasing its
                                      unpaid loss reserves on its 2001 and 2002 Annual State-
                                      ments. On their facts, SSAPs Nos. 5 and 55 and INT 03–17 do
                                      not clearly state whether a loss such as that in Campbell II
                                      can be properly included in loss reserves. However, the
                                      Illinois Department of Insurance expressed through its
                                      actions that the initial Campbell II award was properly
                                      included in loss reserves.
                                         As required by Illinois law, petitioner’s Annual Statements
                                      were reviewed by PwC and by the State Examination Team
                                      acting for the Illinois Director of the Department of Insur-
                                      ance. Both PwC and the Examination Team were aware of
                                      the Campbell II litigation and petitioner’s inclusion of the
                                      $202 million (discounted) in its loss reserves. In spite of this
                                      awareness, neither PwC nor the Examination Team
                                      indicated that such accounting was improper. PwC filed a
                                      report with the State of Illinois setting forth PwC’s opinion
                                      that petitioner’s reserves: (1) Met the requirements of Illinois
                                      insurance laws; (2) were computed in accordance with gen-
                                      erally accepted reserve standards and principles; and (3)
                                        3 We note that petitioner’s arguments regarding congressional purposes are similar to those

                                      this Court rejected in evaluating estimates of losses used in an annual report in Physicians Ins.
                                      Co. of Wis. & Subs. v. Commissioner, T.C. Memo. 2001–304.




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                                      556                135 UNITED STATES TAX COURT REPORTS                                        (543)


                                      made a reasonable provision for all unpaid loss and loss
                                      adjustment expense obligations of petitioner. The Examina-
                                      tion Team issued a report which included the loss reserve
                                      amount relating to Campbell II. This report was adopted by
                                      the director of the Illinois Department of Insurance.
                                         Petitioner’s argument is that the Annual Statement con-
                                      trols the tax treatment for nonclaim payments as well as
                                      claim payments, and petitioner relies upon Sears for this
                                      proposition. As we stated previously, Sears addressed esti-
                                      mated insured losses and this case is about extracontractual
                                      losses. While sections 832(b)(5) and 846(d) do not provide
                                      specifically that the term ‘‘losses’’ is limited to the payment
                                      of claims on insured coverage, section 832(b)(5) follows the
                                      definitions of ‘‘underwriting income’’ and ‘‘premiums earned
                                      on insurance contracts’’ in section 832(b)(3) and (4), and the
                                      context implies that losses incurred are insured losses on the
                                      payments of claims. The question is whether respondent may
                                      diverge from the Annual Statement treatment in the context
                                      of these extracontractual losses. We believe respondent has
                                      the better side of this argument.
                                         Insurance accounting is an evolving area, and the inclusion
                                      of extracontractual losses in loss reserves moves the Annual
                                      Statement treatment beyond the accounting of insurance
                                      policies revenue to broader issues of liability. While it is not
                                      our province to make judgments on the appropriateness of
                                      this insurance regulating treatment, we are charged with
                                      determining whether the tax provisions were intended to
                                      cede decisions on the deductibility for income tax purposes of
                                      extracontractual payments to the insurance regulators. In
                                      the light of the statutory regime we are not convinced that
                                      section 832(b) was intended to have the Annual Statement
                                      control the treatment of extracontractual losses for Federal
                                      tax purposes. Punitive damage awards are not an inherent
                                      component of insurance underwriting and can arise in many
                                      contexts. Ordinary and necessary expenses of an insurance
                                      company are generally allowable under section 832(c)(1) as
                                      provided in section 162. There is no reason to presume that
                                      Congress intended that section 832(b)(5) be the applicable
                                      section to determine tax deductions for punitive damage
                                      awards. To adopt petitioner’s position would require that its
                                      contingent liability for a punitive damage award that was
                                      incurred on account of its own misconduct and was foreign




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                                      (543)     STATE FARM MUT. AUTO. INS. CO. & SUBS. v. COMMR.                                    557


                                      to its normal experience of underwriting risks be allowed
                                      under section 832(b)(5) as losses incurred. We hold to the
                                      contrary. Accordingly, we do not consider the Court of
                                      Appeals’ analysis in Sears controlling regarding these
                                      extracontractual losses.
                                      V. Alternative Arguments
                                        Having reached the conclusions explained above, we do not
                                      reach respondent’s alternative arguments.
                                      VI. Conclusion
                                         We hold petitioner may not include the original Campbell
                                      II award in loss reserves under section 832(b)(5). We have
                                      considered all arguments made, and to the extent not men-
                                      tioned above, we conclude they are moot, irrelevant, or with-
                                      out merit.
                                         To reflect the foregoing,
                                                                         Decision will be entered under Rule 155.

                                                                               f




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