Time to Make a Sec. 846(e) Election to Use Company Historical Payment Patterns

By Timothy Kovel, CPA, MST, Melville, N.Y.

Editor: Kevin D. Anderson, CPA, J.D.

Special Industries

Once every five years (referred to as a determination year) an insurer has an opportunity to elect to use its own payment pattern to discount losses (loss reserves and loss adjustment expenses) for tax purposes, as opposed to relying on the IRS industrywide pattern that the IRS derives from Best’s Aggregates & Averages to calculate consolidated industry loss payment patterns. For 2012, insurance companies that choose not to elect to use their own payment patterns must use the industry averages published in Rev. Proc. 2012-44.

Because 2012 is a determination year, insurance companies need to determine if this method is better for them than using the IRS’s industrywide loss calculations. This election, which needs to be made when filing 2012 tax returns (Sec. 846(e)(2)(C)) and can be revoked only with IRS consent (Sec. 846(e)(2)(B)), can reap significant reductions in current taxes payable, effectively increasing cash flow, an important advantage in the current environment of lower investment returns. This means that if the benefits are significant for many consecutive years, insurance companies can, in essence, turn a temporary benefit into a long-term benefit.

On the flip side, it is rare but possible that this could be used as a tax planning strategy if a taxpayer needed to generate additional current taxable income (i.e., an unfavorable company payment pattern) to help support its deferred tax assets and validate the lack of a valuation allowance.

Good candidates for this election are organizations with the following traits:

  • They pay claims faster than the industry average;
  • They have a consistent mix of predominantly long-tail business (i.e., lines of business in which losses may not be known for a long time and/or claims may take a long time to settle);
  • They have steady payment patterns; and
  • They are taxpaying entities.
What Is an Eligible Line of Business?

There are two scenarios to determine if a line of business is eligible for this election.

The first general eligibility test is:

A line of business is an eligible line of business in a determination year if, on the most recent annual statement filed by the taxpayer before the beginning of that determination year, the taxpayer reports losses and loss expenses incurred…for at least the number of accident years for which losses and loss expenses incurred for that line of business are required to be separately reported on that annual statement. [Regs. Sec. 1.846-2(b)(1)]

This is typically 10 years for long-tail lines and two years for short-tail lines.

If a line of business does not qualify according to the regulation shown above, there is a secondary procedure that may allow eligibility:

A business line will be considered an eligible line of business if two conditions are satisfied on the most recent annual statement filed before the beginning of the determination year. First, the insurer must have at least five accident years [AYs] of loss and loss expenses for the line. Second, the insurer’s cumulative fraction of loss and loss expense payments, as a percent of incurred losses, in each of the last two accident years for the line must equal or exceed the cumulative fraction for the earliest accident year shown on the published IRS table. [Rev. Proc. 92-76]

Example: The annual statement requires that the taxpayer separately report losses and loss expenses for the workers’ compensation line of business for 10 years, AY+0 through AY+9. The cumulative fraction published by the IRS for the workers’ compensation line of business for AY+9 for the 2012 determination year is 88.0286% (Rev. Proc. 2012-44).

Therefore, if the taxpayer does not satisfy the general eligibility test, for a line of business to be considered eligible, both of the following conditions must be satisfied:

  1. The taxpayer has at least five accident years of loss and loss expenses incurred for the line; and
  2. The taxpayer’s cumulative fraction of loss and loss expense payments (as a percentage of incurred losses) in each of at least two accident years for the line equals or exceeds 88.0286%.

If the line of business qualifies under this secondary test, the taxpayer would compute its loss payment pattern assuming the remaining unpaid losses would run off at the same rate as the unpaid losses for the workers’ compensation line of AY+9, or 1.2262%, until they are completely absorbed (Rev. Proc. 92-76).

Key Highlights
  1. The election applies to accident years ending with the determination year and four succeeding accident years (Sec. 846(e)(2)(B)).
  2. A taxpayer making this election must use its own pattern for each eligible line (Regs. Sec. 1.846-2(a)), and this taxpayer may not use its own pattern only for favorable lines.
  3. There is a two-year lag in data used to compute the payment pattern. Thus, a taxpayer uses the 2010 annual statement to compute its 2012 pattern (Sec. 846(e)(1) and Regs. Sec. 1.846-2(b)).
  4. If a line of business is ineligible in a determination year, it remains ineligible until a subsequent determination year (so, if a line of business is ineligible in 2012, it must wait until 2017 to redetermine eligibility).
  5. International and reinsurance business lines are ineligible (Sec. 846(e)(3)).

Sec. 338 treatment: For purposes of Sec. 338, the new and old targets are treated as the same corporation for purposes of determining whether they can elect under Sec. 846(e) (Regs. Sec. 1.338-1(b)(2)(vii)).


Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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