IRS Audit ActivityP&C Insurance Companies

A.M. Best Review & Preview ConferenceMarch 23, 2011

Moderated by: Brian Z. Brown, FCAS, MAAAPrincipal & Consulting Actuary262-796-3391brian.brown@milliman.com

Presented by: Susan J. Forray, FCAS, MAAAPrincipal & Consulting Actuary262-796-3328susan.forray@milliman.com

Richard F. Riley, Jr.PartnerFoley & Lardner LLP202-295-4712RRiley@foley.com

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Outline

§ Macroeconomic Context§ Industry Reserve Development

– By Calendar Year– By Statement Year

§ Typical Characteristics of Audited Companies§ “Isn’t This Just a Timing Issue?”§ Summary Observations§ Other Considerations

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MACROECONOMIC CONTEXT

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Federal Deficit(In Billions)

$236.24 $128.24

($157.76)

($377.59) ($412.73)($318.35)

($248.18)($160.70)

($458.55)

($1,412.69)($1,294.07)

-$1,600

-$1,400

-$1,200

-$1,000

-$800

-$600

-$400

-$200

$0

$200

$400

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Congressional Budget Office

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RESERVE DEVELOPMENTProperty & Casualty Industry

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Industry Reserve DevelopmentExcluding Mortgage & Financial GuarantyNet Loss & ALAE (In Billions), by Calendar Year

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

($6.3)($8.8)($9.4)

($3.7)

$1.1

$11.9

$22.8

$14.2 $10.5

$0.8

($6.8)($9.5)

($14.5)($11.5)($10.3)

-$20

-$15

-$10

-$5

$0

$5

$10

$15

$20

$25

$30

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

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Industry Reserve DevelopmentNet Loss & ALAE (In Billions), by Calendar YearSplit Between “Prior” and “Recent” Accident Years

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

$0.0 $1.6 ($2.5)

($6.2)

($11.6)($14.1)

($17.1) ($17.7) ($16.3) ($15.3)

$11.9

$21.2

$16.7 $16.7 $12.4

$7.3 $7.6 $3.2 $4.8 $5.0

-$25

-$15

-$5

$5

$15

$25

$35

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Accident Years 2000 & Prior

Accident Years 2001 & Subsequent

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Statement Year DevelopmentBy Calendar Period, as of December 31, 2010Net Loss & ALAE (In Billions)

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

-$40

-$20

$0

$20

$40

$60

$80

$100

$120

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th

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Development by Statement YearNet Loss & ALAE (In Billions)As of December 31, 2010

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

$5.3 $11.7

$27.3

$51.7

$80.2

$106.8 $105.7

$83.9

$52.7

$15.4

($8.3)

($28.6)($26.0)($16.4)

($10.3)

$0.0

-$40

-$20

$0

$20

$40

$60

$80

$100

$120

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

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TYPICAL CHARACTERISTICSProperty & Casualty Industry – Audited Companies

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Reserve Development by Company Size2006 – 2010(Net, In Billions)

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

($2.2)($13.1)

($14.4)

($23.1)

Largest 2nd Largest3rd Largest Smallest

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Line of Business2006 – 2010(Net, In Billions)

Reserve Development

EarnedPremium

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

Personal Auto($10.5)Auto Phys

Dam($8.5)

Homeowners($3.6)

GL($2.5)

Work Comp($0.4)

CMP($5.1)

Comm Auto($2.9)

MPL($9.8)

Other($9.4)

Personal Auto$474.7 Auto Phys

Dam$349.3

Homeowners$293.1

GL$203.7

Work Comp$183.3 CMP

$151.0

Comm Auto$90.2

MPL$47.7

Other$341.5

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Financial Strength2006 – 2010(Net, In Billions)

Reserve Development

EarnedPremium

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

A++$393.6 A+

$691.3

A$785.0 A-

$147.6

Other$62.7

Not Rated$54.1

A++($16.0)

A+($18.7)

A($10.1) A-

($6.1)Other$0.2 Not

Rated($2.0)

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Mutual Companies OnlyCalendar Year Reserve DevelopmentNet Loss and ALAE, In Billions

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

($3.7)

($4.2)

($3.5)

($2.7)

($1.2)

$0.3 $0.4

($1.1)

($1.6)

($2.1)

($2.6)($2.3)

($2.8)($2.6)

($4.2)

-$5

-$4

-$3

-$2

-$1

$0

$1

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

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Mutual Companies OnlyStatement Year Reserve DevelopmentNet Loss and ALAE, In Billions, as of December 31, 2010

Source: Milliman analysis of Property & Casualty Statutory Annual StatementsExcludes Mortgage & Financial Guaranty

($5.9)

($4.8)

($2.6)

($0.4)

$2.4

$4.2

$3.1

$0.8

($1.6)

($3.5)

($4.7)($5.3)

($6.0)

($4.8)($4.2)

$0.0

-$8

-$6

-$4

-$2

$0

$2

$4

$6

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

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“ISN’T THIS JUST A TIMING ISSUE?”

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“Isn’t this Just a Timing Issue?”In Some Ways, Yes

§ Eventually, reserves develop to ultimate– Over the long term, income will be recognized

§ Settlements with IRS affect subsequent tax years– Example: settlement of 2006 will affect 2007 tax

• 2006 income increases, 2007 income decreases– However…

• Requires claiming a refund• Can continue to audit subsequent years• IRS unlikely to settle subsequent years immediately

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“Isn’t this Just a Timing Issue?”In Other Ways, No

§ High interest rate on deficiencies– Currently 5% for “large corporate underpayments”– Increasing to 6% next quarter– Has been as high as 10% for 2006 tax year

§ IRS wasn’t actively auditing reserves in prior years– Can’t collect interest on prior year “overpayments”– Even if you could…

• Interest rate on overpayments 4.5% less• So currently 0.5%

– And reserve audits will likely slow again

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SUMMARY OBSERVATIONS

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Summary Observations§ P&C Industry Likely Not Over-Reserved

– In hindsight, 1995 – 2004 statement years under-reserved– 2005 & subsequent statement years

• Have run off favorably to date• But will likely develop adversely due to tail liabilities

§ Typical Characteristics of Audited Companies– Medium size– Mutual structure– Financially sound– Medical professional liability (sometimes)

§ Not Simply a Timing Issue– High interest rate on underpayments– Reserves audited selectively

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OTHER CONSIDERATIONS

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Other Considerations

§ Accompanying Oral Discussion– This document is not complete without the accompanying oral discussion and

explanation of the underlying information and concepts as well as any interpretational limitations.

§ Limited Distribution– This document should not be distributed, disclosed or otherwise furnished, in whole

or in part, without the express written consent of Milliman.

§ Data Reliance– We have relied upon data and other background information provided by the

Congressional Budget Office and A.M. Best without audit or independent verification. We have performed a limited review of the data for reasonableness and consistency and have not found material defects in the data. If there are material defects in the data, it is possible that they would be uncovered by a detailed, systematic review and comparison of the data to search for data values that are questionable or relationships that are materially inconsistent. Such a review was beyond the scope of our assignment.