| December 19, 1990 | |
| E.H. Gauthier, Director | N. Goldstein |
| Special Audits Division | Financial Industries |
| Specialized Industries Section | Division |
| Revenue Canada Taxation | (613) 952-9853 |
| Attention: Mary Loveday | 7-902589 |
SUBJECT:
We are writing in response to your memorandum of September 24, 1990, in which you requested our opinion on the following issues:
1. Is a taxpayer entitled to claim a reserve under paragraph 1400(e) of the Income Tax Regulations ("Regulations") in respect of so called "common cause" claims?
2. Is a taxpayer required to reduce its reserves for amounts retroceded by the taxpayer's head office?
Our opinions and reasons therefore are as follows:
Issue 1
Facts
24(1)
The Income Tax Act
Paragraph 1400(e) of the Regulations: [deduction allowed for] a policy where an event his occurred before the end of the year that has given or is likely to give rise to a claim under the policy (in this paragraph referred to as the "liability"), such amount as the corporation may claim not exceeding the lessor of
i) a reasonable amount in respect of the liability as at the end of the year, and
ii) the reserve, in respect of the liability, reported by the corporation in its annual report for the year to the relevant authority.
| (emphasis added) |
Analysis
Paragraph 1400(e) of the Regulations prescribes that the following three elements be present in order to qualify for a reserve thereunder:
1. that an event has occurred;
2. that the event is likely to give rise to a claim;
3. that the amount is reasonable.
In normal IBNR situations the event has either occurred or the likelihood that it has occurred is established using reliable historical statistics. In the case of common causes, the issues are when an event occurs and whether the event can be established as being likely to give rise to a claim.
The judicial interpretation of what constitutes an "event" is not well defined. In Kelly v. Norwich Union Fire Insurance Society Ltd., ([1989] 2 All E.R.), the British Court of Appeal found that the "event" referred to in an insurance policy occurred when the insured against peril happened, not when the damage manifested itself. Black's Law Dictionary (5th Edition) defines event as "the consequence of anything, the issue or outcome of a action as finally determined; that in which an action, operation or series of operations, terminates. Noteworthy happening or occurrence. Something that happens". This definition appears to require that the damage manifest itself prior to "an event" occurring.
24(1) 21(1)(b)
In addition, the taxpayer must establish that the event is likely to give rise to a claim. The term "likely" has been judicially considered to mean "more than possible, but, perhaps, less than probable" (Bennignton v. Peter, [1984] RTR 383). In the context of insurance, the phrase "likely to give rise to a claim" was interpreted to mean "refers to claims or potential claims, not possibilities of claims" (Sayle et al v. Jevco Insurance Company of Ltd. Management Company, (1984), 9 CCLI, 54 (BSSC)). The significance of these decisions is that by using the term "likely", the Act requires the taxpayer to demonstrate more than an event had occurred and might give rise to a claim. At this point, at least with respect to environmental sorts, and in 1986, with respect to asbestos, it is doubtful that the taxpayer could do more than guess that events of these sorts, would occur ad make an even less reliable guess that the event would likely give rise to a claim. Furthermore, is arguable that the term "likely" imports into the Act a requirement that something be demonstrated statistically, using the traditional formula of frequency times severity. In 1986, the taxpayer probably could not do this.
Interrelated to the "likely" requirement is the "reasonable" requirement.
24(1) 21(1)(b)
Whether or not the ultimate numbers arrived at prove with hindsight to have been reasonable is not relevant. The numbers must be reasonable at the time the claim is being made under paragraph 1400(e) of the Regulations which necessarily means that the method of arriving at those numbers must be reasonably founded.
More generally, these reserves may be analogous to catastrophes, which have been considered by the CICA, in Financial Reporting for Property and Casualty Insurers, A Research Study, 1974. The report did not specifically address common causes, but in making recommendations respecting catastrophes, suggested the following:
1. Claims, including those of a catastrophe nature, should be charged as an expense in the period in which they are incurred.
2. If it is considered necessary to earmark a portion of the equity to provide for future losses due to catastrophes, appropriations of retained earnings should be made and there should be no charge to current earnings.
The justification for this approach, versus an increase in reserves, was the inability to predict or to measure catastrophe losses with reasonable approximations. The CICA also pointed out that those who prefer to provide for a catastrophe reserve against income appear to require the existence of measurable costs and an allocation to fiscal period when the losses are expected to occur.
Conclusion
21(1)(b) 24(1)
Issue 2
The Facts
Our understanding of the facts is that 24(1)
Analysis
Section 1402 of the Regulations states that for the purpose of sections 1400 and 1401 of the Regulations, any amount determined under those sections shall be determined on a net of reinsurance ceded basis.
Retrocession is, by definition, a reinsurance of reinsurance. Therefore any retrocession would be considered reinsurance ceded. For the purpose of sections 1400 and 1401 of the Regulations, the taxpayer is required to reduce its reserves by the amount of the retrocession effected by Head Office.
It is not relevant that the taxpayer branch may be unaware of the Head Office retrocession. The branch and Head Office are one entity and the actions of the Head Office are considered those of the Branch. Even if the branch is unaware of the retrocession, the retrocession is effective to reduce the amount of risk the branch/Head Office is exposed to and the reserves for tax purposes must also be reduced.
COMMENTS
24(1) 21(1)(b)
We trust the foregoing is of assistance.
for DirectorFinancial Industries DivisionRulings Directorate