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Senior management had discretion in determining the size of the
adjustments. Management made downward adjustments to
petitioner's IBNR reserves of $1,200,000 for 1985 and $100,000
for 1986. Overall, petitioner's IBNR reserves totaled
$93,713,687 at yearend 1985 and $111,708,986 at yearend 1986.
Petitioner established its LAE reserves through a
combination of individual case estimates, formulas, and
judgmental factors. To arrive at an estimate of LAE reserves,
petitioner calculated the ratio of LAE it paid during a preceding
3-year period to total losses it paid during the same period and
used that ratio as a component in certain formulas. Petitioner
maintained two categories of LAE reserves: (1) Allocated loss
adjustment expenses (ALAE), which consisted of expenses
assignable to individual claims (e.g., legal fees and costs), and
(2) unallocated loss adjustment expenses (ULAE), which consisted
of expenses not assignable to individual claims (e.g., rent
allocable to the claims department). Petitioner used different
formulas to compute each category of its LAE reserves.
Petitioner's management then adjusted the ALAE (but not the ULAE)
estimate based on quarterly loss and LAE reviews. Overall,
petitioner's LAE reserves totaled $72,317,450 at yearend 1985 and
$84,066,519 at yearend 1986.
Respondent tested for "reserve strengthening" by applying
the formula set forth in section 1.846-3(c)(3), Income Tax Regs.,
to each of petitioner's lines of insurance business for pre-1986
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