115 T.C. No. 12
UNITED STATES TAX COURT
BLUE CROSS & BLUE SHIELD OF TEXAS, INC., AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 361-98. Filed August 18, 2000.
Held: “Savings” relating to “coordination of benefits” between health insurance companies do not qualify under the transition rule of the Omnibus Budget Reconciliation Act of 1990, Pub. L. 101-508, sec. 11305(c)(3), 104 Stat. 1388-452. Claimed “special” deductions relating thereto are not allowed.
Held, further, the claimed “special” deductions also are not allowed under the safe harbor rule of sec. 1.832-4(f)(2), Income Tax Regs.
Richard Bromley, Glen H. Kanwit, R. Lee Christie, and
Tracy D. Williams, for petitioner.
John S. Repsis, Charles W. Maurer, Jr., Stephanie R. Jensen,
and Michael C. Prindible, for respondent. - 2 -
OPINION
SWIFT, Judge: For 1992 and 1993, respectively, respondent
determined deficiencies of $3,094,736 and $2,184,916 in
petitioner's Federal income taxes.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
After settlement of some issues, the issue for decision is
whether “savings” relating to “coordination of benefits” between
petitioner and other health insurance companies qualify under the
transition rule of the Omnibus Budget Reconciliation Act of 1990
(OBRA 1990), Pub. L. 101-508, section 11305(c)(3), 104 Stat.
1388-452. If not, we must decide whether the claimed “special”
deductions relating thereto are allowable under the safe harbor
rule of section 1.832-4(f)(2), Income Tax Regs.
We combine our findings of fact and opinion. Some of the
facts have been stipulated and are so found.
During the years in issue, petitioner constituted an
affiliated group of companies engaged in the business of
providing medical health insurance to individuals and businesses.
At the time the petition was filed, Blue Cross & Blue Shield of - 3 -
Texas, Inc., the common parent of petitioner’s affiliated group,
maintained its principal place of business in Richardson, Texas.
Hereinafter, petitioner will be referred to simply as Blue Cross.
Coordination of Benefits Provisions
Since the 1970's, medical health insurance plans written by
Blue Cross and by other health insurance companies typically
contain nearly identical “coordination of benefits” (COB)
provisions that are based on COB guidelines published by the
National Association of Insurance Commissioners and that are
required by most State insurance laws. The COB provisions
establish payment responsibility, as between two or more health
insurance companies, where insurance claims are filed that are
covered by more than one health insurance company. The COB
provisions are intended to prevent duplicate recovery on claims
with respect to the same medical expenses.
COB provisions are applicable where medical expenses are
incurred by individuals who are covered under two or more health
insurance plans. A common COB situation arises in a family
context where both parents are employed, with one parent covered
by one group health plan and the other parent covered by another
group health plan, with the spouse of each parent and each child
also covered by both of the parents’ group health plans. In such - 4 -
a situation, each member of the family has duplicate and
overlapping health insurance coverage –- coverage under the
father’s plan and coverage under the mother’s plan.
Under COB provisions, in such situations of duplicate and
overlapping health insurance coverage, the various health
insurance companies providing the overlapping insurance coverage
are treated as either primarily or secondarily responsible for
specific expenses and claims based on various and often arbitrary
factors. For example, under COB provisions, medical expenses
incurred by a husband would be treated as the primary
responsibility of the medical insurance plan covering the husband
directly as an employee. The insurance plan of the wife that
covers the injured husband only as the spouse of the wife would
be treated as secondarily responsible for the husband’s expenses.
As a further example, if the two health insurance plans of
the parents cover medical expenses of an injured child only
because the child is a dependent of the parents, under typical
COB provisions, the plan that covers the parent who has the
earlier birthday in the calendar year is treated as having
primary responsibility for the child’s expenses.
Under COB provisions, health insurance companies that are
treated as primarily responsible for medical expenses and claims
(hereinafter referred to as primary insurers) are obligated to - 5 -
pay claims submitted to them as they would in the absence of any
secondary responsibility by another insurance company.
Health insurance companies that are treated as secondarily
responsible for medical expenses and claims (hereinafter referred
to as secondary insurers) generally are obligated to pay only
that portion of claims representing the difference between the
amount the primary insurers pay and the total amount of the
claims. For example, if a child is injured and claims are filed
under health insurance plans maintained by both parents, the
primary insurer (i.e., the insurer issuing the plan of the parent
with the earlier birthday during the calendar year) would be
responsible for the total portion of the claim covered under its
plan (e.g., 80 percent of the amount of the claim) and the
secondary insurer would be responsible for the remaining
20 percent of the claim.
COB Savings
Each year, the difference between what health insurance
companies would pay if they were the primary insurer on all
claims covered by their medical insurance plans and what they
under COB provisions, as secondary insurers, actually pay on
claims are referred to in the health insurance industry as COB
“savings”. In the last illustration above, because the secondary
insurer pays only 20 percent of the amount of the claim,
60 percent of the amount of the claim represents, to the - 6 -
secondary insurer, COB savings (i.e., the additional amount the
secondary insurer would have had to pay if it had been primarily
responsible for the claim). Under the COB provisions, secondary
insurers hypothetically “save” such amounts because they do not
pay the additional portion of the claims that they would have
paid if they had been the primary insurer.
Under COB provisions, once claims that have overlapping
coverage have been filed and once primary and secondary
responsibility as between two insurance companies for the claims
has been identified, secondary insurers may wait for the primary
insurers to calculate and to make their payments on pending
claims before making the secondary payments (hereinafter referred
to as the “wait-and-pay” approach). Alternatively, under COB
provisions, secondary insurers may pay up front the full amount
of the pending claims (up to the maximum coverage thereof) and
then seek reimbursement from the primary insurers for amounts for
which the primary insurers are responsible (hereinafter referred
to as the “pay-and-pursue” approach).
Prior to and throughout the years in issue and unless paid
in error, Blue Cross routinely used the wait-and-pay approach.
Blue Cross only utilized the pay-and-pursue approach in the event
a claimant did not disclose (or in the event Blue Cross’s COB
investigation department did not identify) duplicate health
insurance coverage that would trigger coordination of benefits. - 7 -
Medicare-Related COB Savings
Another common situation that produces amounts included by
insurance companies in COB savings involves retired employees and
their spouses who are over 65 years of age and who are covered
under insurance plans issued by health insurance companies and
who also are covered under Medicare. Prior to and throughout the
years in issue, language was included in Blue Cross’ health
insurance plans that excluded from coverage (and from liability)
those medical expenses and claims that were covered “under the
Workers' Compensation law, or any other present or future laws
enacted by the Legislature of any state, or by the Congress of
the United States [such as Medicare].”
Under typical COB provisions, the difference between what
health insurance companies would be liable to pay for medical
expenses in the event there was no Medicare coverage and the
lesser amount the companies actually are liable for and pay after
taking into account payments to be made by Medicare are referred
to and represent “Medicare-related COB savings”.
For 1989, Blue Cross calculated a total of $243,646,504 in
total COB savings. Approximately 85 percent of the $243,646,504
reflects Medicare-related COB savings, which, as indicated, were
excluded from coverage under Blue Cross’ health insurance plans. - 8 -
Financial Reserves and Financial Statements
To assure eventual payment of expenses relating to injuries
incurred during a year but with respect to which the related
claims are not paid by yearend, health insurance companies are
required by insurance regulators to maintain financial reserves
relating to such estimated unpaid expenses (referred to as
“losses”) and to report such estimated unpaid losses on their
financial statements. Reserves for unpaid losses, then, reflect
actuarially estimated amounts health insurance companies set
aside for losses incurred during the year but with respect to
which claims are not paid by yearend.
As of December 31 of each year, Blue Cross and other health
insurance companies are required by insurance regulators and by
generally accepted accounting practices, as applicable to
insurance companies, to report the paid losses and the estimated
unpaid losses incurred during the year on specialized annual
financial statement forms (Annual Statements).
Paid losses reported on the Annual Statements reflect
amounts of medical expenses that are incurred during the year
that health insurance companies actually pay on claims.
Unpaid losses reported on the Annual Statements generally
reflect actuarially estimated amounts of medical expenses that
are incurred during the year but that by yearend are not yet paid
by the health insurance companies. - 9 -
With regard to the calculation each year of the estimated
unpaid losses for which financial reserves are maintained, health
insurance companies that use the pay-and-pursue approach for COB
savings calculate their reserves for unpaid losses based on the
full, total amount of coverage on their health insurance plans –-
including amounts which, under the COB provisions, the reporting
insurance companies will pay and thereafter be reimbursed by
other insurance companies which are the primary insurers with
regard to the claims.
Health insurance companies, however, such as Blue Cross,
that use the wait-and-pay approach for COB savings, need only
estimate their financial reserves for unpaid losses after taking
into account and subtracting amounts which, under COB provisions,
the reporting insurance companies will not have to pay because of
the responsibility of other insurance companies as the primary
insurers to pay such amounts.
Because actual funds must be maintained by health insurance
companies in their financial reserves for amounts they calculate
as incurred but unpaid losses, significant financial and economic
differences exist for health insurance companies between
insurance company calculations of loss reserves that do not
subtract estimated COB savings and insurance company calculations
of loss reserves that do subtract estimated COB savings. - 10 -
Prior to and throughout the years in issue, for financial
statement and Annual Statement reporting purposes, and in
calculations of its financial loss reserves, Blue Cross
subtracted COB savings in its calculations of its unpaid losses.
Blue Cross therefore maintained financial reserves relating to
unpaid losses only for its estimated primary and secondary
payment responsibilities due on claims after primary insurers had
made their primary payments. In other words, Blue Cross did not
maintain financial reserves with respect to its COB savings
amounts.
Prior to and throughout the years in issue, Blue Cross also
included language in its health insurance plans that entitled
Blue Cross to recovery or subrogation of amounts Blue Cross had
paid on claims (1) where the injury was caused by third-party
tortfeasers or (2) where, under the COB provisions, the amounts
should have been paid by other health insurance companies. Such
amounts received from tortfeasers and from other health insurance
companies are treated and referred to by insurance companies as
“subrogation recoverable”.
The COB guidelines promulgated by the National Association
of Insurance Commissioners treat COB savings differently from
subrogation recoverable. Blue Cross also treats COB savings
differently from subrogation recoverable, and Blue Cross
maintains separate departments for each. - 11 -
1990 Change in the Tax Code
Generally, section 832(c)(4) allows health insurance
companies a deduction from taxable income for losses incurred.
For years prior to 1990, losses incurred were to be calculated by
health insurance companies based on losses paid during the year,
less “salvage” actually recovered during the year (i.e., less
amounts recovered from third-party tortfeasors or others relating
to claims they had paid), plus an adjustment for any increase or
decrease in estimated incurred but unpaid losses. See sec.
832(b)(5)(A), I.R.C. (1986).
For years prior to 1990, in their calculations of incurred
but unpaid losses, health insurance companies had the option of
taking into account estimated recoveries from third-party
tortfeasors and other health insurance companies. If health
insurance companies elected to not reduce the calculations of
their estimated incurred but unpaid losses by estimated
recoveries, the health insurance company calculations were
referred to as calculations of “unpaid losses gross of estimated
recoveries”. If health insurance companies elected to reduce the
calculations of their estimated incurred but unpaid losses by
estimated recoveries, the health insurance company calculations
were referred to as “unpaid losses net of estimated recoveries”.
In 1990, however, Congress amended section 832(b)(5)(A) for
years beginning January 1, 1990, to require all health insurance
companies, in calculating estimated incurred but unpaid losses - 12 -
and the deductions relating thereto, to take into account
estimates of salvage that might be recovered with respect to
estimated incurred but unpaid losses (i.e., to make their
calculations of unpaid losses net of estimated recoveries). See
OBRA 1990, sec. 11305(c), 104 Stat. 1388-451.
For health insurance companies that for years prior to 1990
had reported unpaid losses gross of estimated recoveries, the
above change in section 832(b)(5)(A) would constitute a change in
method of accounting and for 1990 would give rise to section 481
adjustments to income. Congress, however, granted transitional
relief and a one-time deduction to such companies by permanently
forgiving 87 percent of the amount that under section 481
otherwise would have been includable in gross income for 1990,
thereby reducing the section 481 adjustments that otherwise would
have been required to just 13 percent thereof, to be taken into
income ratably over 4 years beginning with 1990. See OBRA 1990,
sec. 11305(c)(2), 104 Stat. 1388-451.
To provide similar or parallel tax treatment for health
insurance companies, such as Blue Cross, that prior to 1990 had
reported unpaid losses net of estimated recoveries, Congress
granted similar transitional or “special” deductions equaling
87 percent of the amount of “estimated salvage recoverable” that
the companies had taken into account during 1989, to be deducted
ratably over 4 years beginning with 1990. The special deduction - 13 -
rule of OBRA 1990, section 11305(c)(3), 104 Stat. 1388-452 (the
special deduction rule), provided as follows:
Treatment of companies which took into account salvage recoverable.–-In the case of any insurance company which took into account salvage recoverable in determining losses incurred for its last taxable year beginning before January 1, 1990, 87 percent of the discounted amount of estimated salvage recoverable as of the close of such last taxable year shall be allowed as a deduction ratably over its 1st 4 taxable years beginning after December 31, 1989.
For 1990 through 1993, Blue Cross timely filed consolidated
U.S. Corporation income tax returns. Blue Cross calculated that
under the special deduction rule a total of $70,950,582 reflected
Blue Cross' estimated salvage recoverable relating to incurred
but unpaid losses for its last taxable year beginning before
January 1, 1990. Accordingly, Blue Cross multiplied the total
$70,950,582 by 87 percent and by a discount factor of
approximately 4 percent, to produce a figure of $59,352,862, and
Blue Cross deducted one fourth of the $59,352,862, or
$14,838,215, for each of the years 1990 through 1993 as its
special deduction.
On audit for years 1992 and 1993, respondent disallowed each
of Blue Cross' claimed $14,838,215 special deductions.1
1 The evidence does not indicate respondent's treatment of the special deductions claimed by Blue Cross on its 1990 and 1991 Federal corporation income tax returns. - 14 -
Approximately 94 percent of the total $70,950,582 claimed by
Blue Cross as estimated salvage recoverable reflected COB
savings. Further, as previously indicated, approximately
85 percent of the COB savings amount reflected Medicare-related
COB savings.
Only approximately 3 percent of the $70,950,582 claimed by
Blue Cross as estimated salvage recoverable reflected amounts
that Blue Cross actually paid and then recovered from tortfeasors
and from other insurance companies.2
The relevant statutory provisions do not define what is
meant by “estimated salvage recoverable”. E.g., OBRA 1990,
sec. 11305(c), 104 Stat. 1388-451. It is therefore necessary to
look beyond the statutory language to the limited regulatory and
case authority on point.
Section 1.832-4(c), Income Tax Regs., provides that
estimated salvage recoverable includes --
2 Approximately 1 percent of the $70,950,582 Blue Cross calculated as total estimated salvage recoverable reflected amounts for which it was both primary and secondary insurer, or “blue on blue”. The parties recognize that with respect to blue- on-blue duplicate coverage, Blue Cross could not recover salvage from itself. Another approximate 2 percent reflected amounts for which Blue Cross did not assume the health insurance risks of employees and dependents, but provided employers with administrative services only. Blue Cross concedes that this 2 percent clearly does not represent genuine salvage recoverable. - 15 -
all anticipated recoveries on account of salvage, whether or not the salvage is treated, or may be treated, as an asset for state statutory accounting purposes. * * * [And] includes anticipated recoveries on account of subrogation claims arising with respect to paid or unpaid losses.
Case law relevant to the meaning of estimated salvage
recoverable is limited. The Supreme Court in a century-old case
explained salvage rights as follows: “[T]he insurer, when he has
paid * * * the assured * * * is entitled, by way of salvage, to
the benefit of anything that may be received”. Phoenix Ins. Co.
v. Erie & W. Transp. Co., 117 U.S. 312, 321 (1886), cited in
Continental Ins. Co. v. United States, 200 Ct. Cl. 552, 474 F.2d
661 (1973). (Emphasis added.)
Black's Law Dictionary 1280, 1340 (7th ed. 1999) defines
“recovery” as “the regaining or restoration of something lost or
taken away”, and it defines “salvage” (utilized largely in the
property and casualty insurance industry) as “property saved or
remaining after a fire or other loss, sometimes retained by an
insurance company that has compensated the owner for the loss.”
(Emphasis added.)
In essence, Blue Cross contends that, because under its
health insurance plans it is contractually liable for the full
potential amount of all claims covered by its insurance plans, it
should be regarded as having a contractual right of recovery or
salvage for all portions of claims with respect to which other
insurance companies and Medicare also have a liability to pay the - 16 -
claims or portions thereof. Blue Cross argues that, as injuries
occur and as medical expenses relating thereto are incurred by
insured individuals, Blue Cross accrues the right to recover from
other insurance companies and Medicare that also have insured the
same individuals. In sum, Blue Cross argues that the insured
individuals’ right to recover from other insurance companies and
Medicare is subrogated to Blue Cross where Blue Cross also has
issued insurance plans covering the same individuals.
Blue Cross argues that there is no significant economic
difference between “taking immediate possession” from the insured
individuals of the intangible rights of recovery and salvage with
respect to COB savings (as it does under a pay-and-pursue
approach) and “leaving” with the insured individuals the rights
of recovery and salvage with respect to COB savings (as it does
under a wait-and-pay approach). Blue Cross argues that under
either approach, for Federal income tax purposes, it should be
treated as economically realizing the recovery and salvage rights
with respect to COB savings. Accordingly, Blue Cross contends
that its COB savings relating to incurred but unpaid losses
before January 1, 1990, reflect salvage recoverable and should be
included in the calculations of estimated salvage recoverable
under the special deduction rule. - 17 -
Respondent contends that because Medicare-related benefits
are excluded from coverage under Blue Cross’ health insurance
plans, Blue Cross’ Medicare-related COB savings give rise to no
liability on the part of Blue Cross. Respondent therefore
concludes that the portion of claims covered by Medicare gives
rise to no right of recovery or salvage in favor of Blue Cross
and that the portion of Blue Cross’ claimed salvage recoverable
that is based on and that relates to Medicare-related COB savings
should not, under the special deduction rule, be treated as
salvage recoverable and the claimed loss deductions relating
thereto should not be allowable. We agree with respondent.
The language contained in Blue Cross' medical insurance
plans clearly indicates that Blue Cross is not liable to pay
amounts covered by Medicare. Without contractual liability and
without payment of Medicare-covered benefits, Blue Cross’
Medicare-related COB savings do not constitute estimated salvage
recoverable.
Non-Medicare-Related COB Savings
Because Blue Cross utilized the wait-and-pay approach with
respect to its non-Medicare-related COB savings, respondent
contends that such non-Medicare-related COB savings likewise do
not constitute estimated salvage recoverable under the special
deduction rule. Respondent argues that Blue Cross never expected - 18 -
to pay COB savings amounts (i.e., amounts that primary insurers
were responsible for and pay) and that Blue Cross never acquired
fixed and genuine rights of recovery and salvage with regard
thereto. We again agree with respondent.
The applicable regulation under section 832 requires that
unpaid losses, to be taken into account in computing losses
incurred, are to represent a fair and reasonable estimate of the
amount health insurance companies actually will be required to
pay, not of what they theoretically might have to pay. Section
1.832-4(b), Income Tax Regs., in relevant part provides:
Every insurance company to which this section applies must be prepared to establish to the satisfaction of the district director that the part of the deduction for “losses incurred” which represents unpaid losses at the close of the taxable year comprises only actual unpaid losses. * * * These losses must be stated in amounts which, based upon the facts in each case and the company's experience with similar cases, represent a fair and reasonable estimate of the amount the company will be required to pay. * * *
The evidence shows that in the years before 1990, Blue Cross
consistently used the wait-and-pay approach and did not pay
(unless in error), reserve for, or expect to make payments with
respect to its COB savings.
Blue Cross argues that because it could, after 1989, elect
to use the pay-and-pursue approach or that primary insurers could
fail to make their payments (e.g., in the event a primary insurer
becomes insolvent), Blue Cross’ COB savings, without the benefit - 19 -
of hindsight, theoretically could reflect salvage recoverable
taken into account as of December 31, 1989.
As previously indicated, for the years in issue and in
subsequent years, Blue Cross generally did not make payments for
which other companies under the COB provisions were primarily
responsible. We conclude that (because Blue Cross used the wait-
and-pay approach before making secondary payments) Blue Cross’
COB savings do not qualify as estimated salvage recoverable and
are not allowable as a deduction under the special deduction
rule.
To qualify as estimated salvage recoverable for purposes of
the special deduction rule there must exist an expectation of
actual payment. The mere fact that a loss has been incurred on
the date of an injury does not mean that health insurance
companies expect to be responsible for and expect to pay the full
amount of claims relating to the injury.
With respect, however, to the 3 percent of the $70,950,582
that Blue Cross calculated as its total estimated salvage
recoverable reflecting amounts Blue Cross actually paid and then
recovered from third-party tortfeasors and other health insurance
companies, such amounts do represent genuine subrogation
recoverable and do qualify as estimated salvage recoverable under
the special deduction rule.
Safe Harbor Relief - 20 -
Blue Cross also contends that its estimate of salvage
recoverable and related deductions under the special deduction
rule qualify for safe harbor relief. Under section 1.832-
4(f)(2), Income Tax Regs., it is provided that, if the
requirements for safe harbor are satisfied, respondent may be
precluded from making an adjustment to the amounts of “bona fide”
estimated salvage recoverable reported and claimed by health
insurance companies.
Health insurance companies seeking to qualify under the safe
harbor provision, among other things, were required to file with
State insurance regulators by September 16, 1991, a statement
that identifies the extent to which the companies' incurred
losses for each line of business, as reported on their 1989
Annual Statements, were reduced by bona fide estimated salvage
recoverable. The pertinent language of section 1.832-4(f)(2)(i),
Income Tax Regs., provides as follows:
(2) Safe Harbor. The requirements of paragraph (f)(1) of this section are deemed satisfied and the amount that the company reports as bona fide estimated salvage recoverable is not subject to adjustment by the district director, if–-
(i) The company files with the insurance regulatory authority of the company's state of domicile, on or before September 16, 1991, a statement disclosing the extent to which losses incurred for each line of business reported on its 1989 annual statement were reduced by estimated salvage recoverable. - 21 -
On or before September 16, 1991, Blue Cross filed a letter
with the Texas Department of Insurance, the entire contents of
which are set forth below:
As you are aware, in reporting to your department [BLUE CROSS] has always followed actuarially accepted and certified practices for determining and reporting its losses incurred and its incurred unpaid claim reserves. In OBRA 1990, Congress granted a special one time deduction to insurance carriers who report losses incurred as we do. IRS regulations provide that a notification filed with your office will establish the amount of this allowable tax deduction.
The sole purpose of this letter is to notify you that we have determined our special tax deduction to be 87% of $74,780,518 discounted at 96.1538% for recoveries related to our losses incurred deduction prior to 1990 and reported in the 1989 Annual Statement.
OUR REPORTING TO YOU HAS NOT CHANGED AND WILL NOT CHANGE IN ANY RESPECT FROM THE ACCEPTED METHODS AND APPROACHES WE HAVE ALWAYS USED. Our incurred unpaid claim reserves will continue to be determined using the same methods, include the same actuarial certifications as always and continue to be in full compliance with established methods and practices approved and routinely examined by your department. [Emphasis in original.]
As respondent notes, the language of the above letter does
not begin to disclose to Texas insurance regulators the extent to
which Blue Cross' losses that were incurred for each line of
business, as reported on its 1989 Annual Statement, were reduced
by estimated salvage recoverable. No separate lines of business
are disclosed, and the words “estimated salvage recoverable” are - 22 -
not even used in the letter. We conclude that Blue Cross did not
satisfy the disclosure requirement for safe harbor relief under
section 1.832-4(f)(2), Income Tax Regs.
Further, as previously held, Blue Cross’ calculation of its
estimated salvage recoverable (consisting predominantly of COB
savings) does not reflect “bona fide” or genuine salvage
recoverable, and therefore Blue Cross’ disclosure of that
calculation would not satisfy the disclosure required for safe
harbor relief under section 1.832-4(f)(2), Income Tax Regs.
To reflect the foregoing,
Decision will be entered
under Rule 155.