A court found an insurance company providing automobile liability insurance liable for punitive damages related to its claims processing on its liability coverage. It reflected the amount of the punitive damage award as a “loss incurred” within the meaning of Internal Revenue Code (IRC) Section 832(b)(5), entitling it to increase its insurance loss reserve, as shown on its annual statement for insurance regulatory purposes.
The IRS challenged this treatment for several reasons, including that the punitive damage award was extra-contractual to the insurance coverage provided. The court held that the insurance company could not include the punitive damage award in losses incurred. [State Farm Mutual Automobile Insurance Company and Subsidiaries v. Commissioner, 135 TC No. 26.]
The company issued an automobile insurance contract to Curtis Campbell. The bodily injury coverage under the Campbell contract was limited to $25,000 for each person, and $50,000 for each accident.
An automobile accident occurred involving Todd Ospital and Robert Slusher, and resulted in Ospital’s death and serious injury to Slusher. Campbell’s manner of driving allegedly caused the accident. A court determined 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 his policy.
During the appeal, Ospital's estate, 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 the company, (b) be represented by Slusher's and Ospital's attorneys in that action, and (c) pay Ospital and Slusher 90 percent of any damage award from that action. Campbell filed a complaint against the company. Ospital and Slusher joined in the complaint. The complaint alleged bad faith on the part of the insurance company in its conduct of the case.
A court of appeals awarded Campbell $2.6 million in compensatory damages and $145 million in punitive damages. Later, the award was reduced to $1 million in compensatory damages and $25 million in punitive damages.
Law required the insurance company to file an annual financial statement with Illinois, their state of domicile. The annual statement is a form by which insurance companies report to the state their financial condition and historical information about their results.
The Illinois Department of Insurance decided that, effective January 1, 2001, the new Accounting Practices and Procedures Manual (AP&P Manual) should be used as the reporting standard for statutory financial statements. Beginning with the March 31, 2001 quarterly financial statements, all insurance companies domiciled in Illinois are required to follow the accounting practices and procedures set forth in the new AP&P Manual.
The insurer reported its reserves for unpaid losses in its annual statements. The company claimed that a $202 million reserve adjustment represented the court award and estimated interest. The IRS disallowed the deductions that the company claimed as a result of the adjustments made to the reserve for unpaid losses attributable to the court’s judgment.
The company sought assurance from the Illinois Department of Insurance that its accounting was valid. The acting assistant deputy director of the Department gave such assurance in a reply letter.
The company argued that IRC Section 832 required them to follow the annual statement method of accounting, and that the $202 million was properly included in loss reserves on the annual statements. It also contended that regardless of the annual statement method, the $202 million was properly included in loss reserves as a loss incurred on an insurance contract.
The IRS argued that the $202 million was not deductible, and that instead, it should have been accounted for as a business expense. The IRS also contended that the amounts that the company reported on its annual statements did not control for tax purposes, and that accounting principles did not support including the $202 million in loss reserves. Finally, it argued that the $202 million was not deductible as a loss incurred because it was not a fair and reasonable estimate of an actual unpaid loss.
The company then contended 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.” It maintained that it correctly included the punitive damages as losses incurred on the annual statements, and this treatment was accepted by its outside accountants and the Illinois insurance regulators. Therefore, the company reasoned that the deductibility of the loss on its tax returns was dictated by the inclusion of the punitive damage award in its annual statements.
The IRS argued that the punitive damage award was not a loss covered on an insurance contract, but rather a liability that the company incurred because of its own misconduct, not any act of its insured. It said that this loss was not an insured loss, because punitive damages were in the nature of a punishment to modify behavior, not a foreseen result of meeting an obligation to cover an insured event. The IRS further asserted that the accounting treatment of the punitive damage award did not control the tax treatment.
The insurance company's argument was that the annual statement controlled the tax treatment for non-claim payments as well as claim payments.
The court held that the IRS was correct in characterizing the loss as extra-contractual. It was not a loss covered by the liability policy of an insured.
The court held that insurance accounting is an evolving area, and the inclusion of extra-contractual losses in loss reserves moves the annual statement treatment beyond the accounting of insurance policies revenue to broader issues of liability. The court was not convinced that Section 832(b) was intended to have the annual statement control the treatment of extra-contractual 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). 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 the company’s position would require that its contingent liability for a punitive damage award incurred on account of its own misconduct and was foreign to its normal experience of underwriting risks be allowed under Section 832(b)(5) as losses incurred.
Therefore, the company could not include the Campbell award in loss reserves.