On November 5, 2018, the United States Treasury Department (Treasury) and Internal Revenue Service (IRS) issued proposed regulations (REG-103163-18) that, in part, provide guidance on the new rules for discounting loss reserves under Section 846, which was amended by the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97) for tax years beginning after December 31, 2017.

"Applicable interest rate" determined under Section 846(c)(2)

In line with the language in P.L. 115-97, the proposed regulations provide that the applicable interest rate under Section 846(c), for tax years beginning after December 31, 2017, is determined by the Secretary on the basis of the corporate bond yield curve as defined in Section 430(h)(2)(D)(i), but "60-month period" is substituted for "24-month period." The corporate bond yield curve data published by the Treasury is accumulated by month and by 0.5 year maturities up to 100 years. Previously, the Secretary determined the applicable interest rate based upon the Federal mid-term rates (as defined in Section 1274(d) but based on annual compounding) over a 60-month period ending before the beginning of the calendar year for which the determination was made. Unlike the Federal mid-term rate, which requires the use of a time to maturity segment of the rate table greater than three years but not over nine years, Section 846(c) now refers to the corporate bond yield curve, which does not specify a maturity segment of the rate table to be used to compute the applicable interest rate.

The proposed regulations define the maturity segment of the corporate bond yield curve to be used by defining the upper end of the range of maturities at 17.5 years; however, an exact range is not specified. Unless otherwise specified by further guidance, this would make the maturity segment 0.5 years to 17.5 years. Further, the proposed regulations do not specify that the segment range must be fixed from year-to-year, which could lead to variability in the applicable interest rate from one year to the next. Treasury and the IRS indicated in the preamble to the regulations (Preamble) that they considered and rejected various alternative maturity segments and are requesting comments on the method of determining the annual rate on the basis of the corporate bond yield curve.

The Preamble provides background explaining that Treasury and the IRS determined Section 846(c) requires the use of a single annual applicable rate and discussed several alternative approaches that were not adopted. Interestingly, in requesting comments on the different options to determine the annual rate, the Preamble indicates that the legal basis for these alternatives should be provided, along with an explanation of how such options would more clearly reflect income.

Modification to computation of loss payment patterns under Section 846(d)(3)

Consistent with the new rules presented in the TCJA, the proposed regulations retain the rules for short-tailed lines of business under which any losses unpaid at the end of the first year following the accident year (AY+1) are treated as paid equally in the second (AY+2) and third (AY+3) years following the accident year. For long-tailed lines of business, the proposed regulations make changes to reflect a change to help smooth out negative payment patterns and extend the penultimate loss year. Losses that would be treated as paid in the 10th year following the accident year (AY+10) are treated as being paid in the 10th year and each subsequent year in an amount equal to the average of losses paid in the 7th, 8th, and 9th year succeeding the accident year (AY+7 to AY+9), unless that average brings the cumulative loss payments through AY+10 over 100%. Previously, the amount of loss payment recognized in the 10th year following the accident year and later was based solely on the 9th accident year following the accident year (AY+9). The calculated average ((AY+7, AY+8, AY+9)/3) is used in each subsequent accident year until cumulative payments reach 100% or until the 24th year after the accident year is reached, at which point all remaining losses are treated as paid (previously such losses were treated as fully paid in the 15th year following the accident year).

As Section 846(d)(3)(E) and 846(d)(3)(F) were repealed as part of the TCJA, the Code no longer provides explicit guidance on how to determine the loss payment patterns for reinsurance and international lines of business. Since proportional reinsurance is required to be included in the line of business to which it relates in Schedule P of the annual statement, the reinsurance lines of business relate to non-proportional reinsurance. These lines of business are not included in the list of long-tailed lines of business in Section 846(d)(3)(A)(ii). Under prior law, Section 846(d)(3)(E) provided special treatment that applied a composite factor based upon all long-tailed lines of business to the reinsurance and international lines of businesses. However, with the repeal of Section 846(d)(3)(E), the reinsurance and international lines of businesses are not included in the definition of long-tailed lines of business, and such losses should revert to the three-year discounting under Section 846(d)(3)(i). In the Preamble, Treasury and the IRS are looking for comments to support the position that these lines of business should have tails longer than three years.

Smoothing adjustments to eliminate oddities in loss payment patterns

The proposed regulations address the issue of abnormal payment patterns resulting from using aggregated industry annual statement data. Payment patterns may change significantly from year-to-year in such a way that results in a negative incremental loss payment for a specific accident year. While the TCJA and the proposed regulations use an averaging component in calculating payment patterns towards the end of a line of business's tail, those averages may still result in negative numbers. Additionally, there may be negative numbers calculated in earlier stages within the line of business's tail. The proposed regulations provide a suggested approach to eliminating such abnormalities, but the Treasury and the IRS are also requesting comments on, and plan to include in future published guidance, discount factors information regarding what smoothing adjustment they made to the industry data.

Payment pattern election

Consistent with what was written in P.L. 115-97, the company payment pattern election formerly permitted under Section 846(e) has been repealed.

Elimination of the use of composite factor pursuant to Notice 88-100

In Notice 88-100, the IRS provided guidance on calculating discount factors for accident years not separately stated on annual statements. The IRS has published composite factors since 2002 for taxpayers to apply to old accident years not separately stated. However, the Preamble suggests eliminating the use of a composite factor, and instead requiring that taxpayers obtain the detail for those aggregated years and apply the appropriate discount factor published by the IRS. What is not discussed is whether the additional reserves must somehow be disclosed in the annual statement. However, Notice 88-100, Section V provides that taxpayers cannot use information not appearing on their annual statement to allocate aggregate unpaid losses among several accident years. Assuming Treasury and the IRS do incorporate this rule into the final regulations, it would appear all insurance companies with aggregate accident year data on their annual statement will be required to make a disclosure with the annual statement of the breakout of such aggregate data. The Preamble also states that moving away from using the composite method would be a change in accounting method — the IRS and Treasury anticipate providing rules for implementing this change, which would be automatic. This change in method would seem to be a part of the transition adjustment as of the beginning of the first tax year after 2017 under Section 13523(e) of P.L.115-97.

Salvage and subrogation

The proposed regulations indicate that separate discount factors for salvage and subrogation recoverable will no longer be published or provided. Instead, the same discount factors used for undiscounted losses will be used for salvage and subrogation recoverable. As a result of this change, it should no longer be necessary to gross up loss reserves to separate salvage and subrogation receivables to be separately discounted. In the Preamble, Treasury and the IRS request comments on whether net payment data (loss payments less salvage recovered) and net losses incurred data (loss incurred less salvage recoverable) should be used to compute loss discount factors.

Comment period and hearing

The Preamble indicates that comments on the proposed regulations may be submitted on or before December 7, 2018, and a public hearing has been scheduled for December 20, 2018 at the Internal Revenue Service national office in Washington, D.C.

Next Steps

The issuance of the proposed regulations begins to bring clarity to several issues raised by the changes made by the TCJA (P.L. 97-115). In particular, taxpayers have some idea of what interest rate might ultimately be used to compute discount factors under Section 846; however, questions remain. Several of the comments in the Preamble raise new questions regarding how to apply certain aspects of the loss reserve discounting rules. Taxpayers should look at their particular factual situation and determine how these changes to long-standing rules will impact their process for computing loss reserve discounting.

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