Opinion ID: 3014809
Heading Depth: 1
Heading Rank: 5

Heading: Capital’s Valuation

Text: The Tax Court’s “finding of fact with respect to valuation is to be reviewed under the clearly erroneous standard.” R.M. Smith, 591 F.2d at 251. Here, the Tax Court concluded that Capital had failed to meet its burden of proving the 1987 fair market value of its lost contracts. Its basis for this conclusion was a litany of perceived flaws in Capital’s valuation. Most importantly, the Tax Court found that Capital’s “reinsurance model” for valuing the lost contracts was flawed, 122 T.C. at 249-51; that the valuation did not completely take into account individual characteristics of the group contracts, id. at 251-55; and that the valuation was based on defective assumptions regarding the expected life of the contracts, id. at 255-57. We address each of these findings in turn. On appeal, the Commissioner has added numerous instances of perceived error in Capital’s valuation; we address those claims in the course of our consideration of the Tax Court’s conclusions. 21
The Tax Court’s most significant criticism of Capital’s valuation concerned the “reinsurance model” used by Daniel McCarthy, Capital’s actuarial valuation expert, see supra n.2.
McCarthy valued the contracts at issue at their “highest and best use.” He concluded that this use could be determined using a “reinsurance model,” whereby he asked how much the 376 contracts cancelled in 1994 would have been worth if they had been sold together in a reinsurance transaction in 1987. McCarthy argued that this is the highest and best use of the contracts, and that they would be worth more sold together in a reinsurance transaction than they would be if they were sold separately. In fact, it seems unlikely that any such contracts could be sold separately. See Trigon, 215 F. Supp. 2d at 706 (“It is an undisputed fact that there are no known sales of single group health insurance contracts between insurance carriers either before January 1, 1987, or after.”). Blocks of contracts can, however, be sold, and McCarthy represented that the 376 contracts lost in 1994 would have constituted a “credible” block that could have been sold between insurers. See 122 T.C. at 250. The Trigon court reasoned that these contracts are properly valued under a willing-buyer model that assumes a buyer with facilities comparable to those of Capital: [Group] contracts must be valued on the theory that they would be sold to a hypothetical willing buyer having facilities comparable to those of the seller. Attempting to value the contracts on a stand-alone basis (which the government appears to advocate), rather than as part of a going concern, results in an improper determination of “liquidation value,” rather than fair market value. 215 F. Supp. 2d at 708-09 (citation omitted). We find this analysis persuasive. We reject the government’s argument that a one-at-a-time 22 sale model is required. The government cites cases holding that minority shares of stock must be valued according to their own value, without taking into account a control premium that might inhere in a larger block of stock. See Ahmanson Found. v. United States, 674 F.2d 761, 772 (9th Cir. 1981); Rev. Rul. 93-12, 1993-1 C.B. 202. But such cases are inapposite: the control premium for a majority stock holding has a separate value over and above the value of each individual share, while McCarthy’s use of the reinsurance model is designed not to capture additional value but to account for the transaction costs involved in selling a single contract.4 Capital need not value its contracts only at their liquidation value, rather it may use the reinsurance model to determine its basis.
The Tax Court nonetheless took the reinsurance model as evidence that Capital’s contracts could not be valued individually. It found that, at most, McCarthy had proven the value of the 376contract block sold by Capital, but it had not proven the value of each individual contract: [A]s it must, petitioner does not claim a single loss deduction in 1994 upon the termination of the 376 group contracts. Rather, petitioner claims 376 separate loss deductions relating to the termination of each of the 376 separate group contracts. What is required to support petitioner’s claimed loss deductions under section 165 are valuations of the group contracts that reflect a value for each contract as a separate and discrete contract. . . . [A]ll 4 A fairer analogy might be to odd-lot sales of stock. A shareholder who sells stock in even lots—traditionally, of 100 shares—will usually get a better price and/or pay a lower commission than one who sells “odd lots” of, say, one or six or twenty-three shares. As far as we are aware, shareholders may always value their stock on the assumption that it would be sold in normal market transactions, not in inefficient odd-lot transactions. McCarthy’s method is no more objectionable than this. 23 petitioner has done is establish that the group contracts are capable of being valued in blocks. Petitioner has not, however, established that the group contracts are capable of being valued separately and independently as individual assets. 122 T.C. at 250-51; see also Trigon, 215 F. Supp. 2d at 709 (“[T]he issue is not whether the highest and best use of Trigon’s contracts is as part of an ongoing health insurance company. . . . The issue, instead, is whether specific contracts can be valued separately from the block of contracts to which they belong.”). Capital argues that the contracts can be valued separately, and that McCarthy did in fact value each contract separately. McCarthy testified to this effect, noting that his valuation methodology in this case was consistent with his practice in appraising insurance contracts when advising insurers that are demutualizing: It was consistent, in that it took into account the characteristics of each contract being valued. It was consistent, in that it took into account as the standard of that to be discounted of the emerging stream of expected statutory earnings, and it was consistent, in that they were discounted to present value. He referred to this as a “seriatim or one-at-a-time valuation.” He readily admitted, however, that he calculated the contracts’ value based on an assumption that they would be sold in batches. We think that the Tax Court, and the Commissioner, misunderstood the requirements of separate valuation. As noted above, Newark Morning Ledger, 507 U.S. at 566, requires that a taxpayer wishing to deduct his losses of intangible assets must show that those assets are susceptible of separate valuation. In many cases, this will be impossible, simply because the taxpayer really possesses a single indivisible asset whose whole is incommensurable with the sum of its parts, a single mass “composed of constantly fluctuating components.” Id. at 567. Thus, for instance, a company may not depreciate its “assembled work force,” because new employees are constantly being trained to replace old ones, and because there is no meaningful way to assign 24 distinct values to each member of this workforce. Id. at 560. The value inheres in the “assembly” of the workforce, not in any one individual. Insurance contracts are different. They are valued all the time; indeed, Daniel McCarthy, Capital’s expert, has spent much of his career valuing health and life insurance contracts in order to advise insurers and regulators on the fairness of demutualization transactions. While the Tax Court and the Commissioner have numerous quibbles with Capital’s valuation, they do not persuade us that these contracts do not each have an individual value. As Capital succinctly puts it, “the Tax Court erred because it confused (1) the question of whether an intangible has a value and useful life separate from goodwill . . . , with (2) the question of what the asset’s value is.” The Commissioner cites several pre-Newark Morning News cases for the proposition that taxpayers may not use average values to compute the value of specific accounts. Sunset Fuel, 519 F.2d at 785-86; Skilken v. Comm’r, 420 F.2d 266, 270 (6th Cir. 1969). But the averaging procedures in those cases were far cruder than McCarthy’s sophisticated statistical methods here. McCarthy represented that the 376 contracts lost in 1994 constituted a “fully credible” block of contracts, such that a willing-buyer reinsurer would expect high- and low-value contracts to cancel each other out, and would therefore purchase the community-rated contracts based on average rather than individual experience. Experiencerated contracts were, at all points, valued individually. The evidence is clear that McCarthy’s voluminous, thorough, and professional valuation was meant to determine a value for each individual insurance contract. As part of that individual valuation, McCarthy used various averaging procedures, sometimes to check his work, but sometimes as part of his initial calculations. The undisputed evidence appears to be that such averaging procedures were consistent with industry standards for valuing group insurance contracts for the purposes of reinsurance or demutualization. McCarthy’s use of industry-standard statistical methods does not render his appraisal invalid, or support the Tax Court’s conclusion that Capital’s contracts could not be valued individually. We thus hold that that conclusion was clearly erroneous. 25
The Tax Court also rejected McCarthy’s reinsurance model on the grounds that McCarthy made only “some type of vague expense adjustment” to account for intangibles such as goodwill that were associated with the 376 terminated contracts. 122 T.C. at 250-51. A larger adjustment for the intangibles, which the Commissioner believes is justified, would lead to a smaller tax deduction. McCarthy subtracted some $300 million from his total valuation of all of Capital’s contracts, to account for the value added by Capital’s name, reputation, and other goodwill factors, as well as by its workforce and provider network. These factors made up a part of the value of Capital’s contracts, but were not lost when those contracts were lost; therefore, Capital did not—and could not—claim them as part of its deduction. The dispute here is over the method of calculating this goodwill adjustment. McCarthy used a rental charge, whereby he valued these intangibles based on what it would cost Capital to rent them in a market transaction. The Commissioner argued, and the Tax Court agreed, that this was improper. Instead, the Tax Court found that McCarthy should have deducted a “capital charge” from the value of the contracts, based on a valuation of the intangible factors that takes into account the market rate of return on those factors. Although the Commissioner has not attempted to calculate what such a charge would look like, we assume that it would lead to a greater offset for these intangibles, and so to a smaller tax deduction. Capital argues, however, that McCarthy’s method, which used a rental charge rather than a capital charge, was proper and indeed standard. The Tax Court found that McCarthy’s explanation for not taking a capital charge for the related intangibles was “not credible.” Id. at 251. Capital claims that this contradicted the “undisputed testimony of all the experts,” which was that rental charges are normally used in insurance valuation, and that McCarthy’s use of them was proper. The Commissioner responds that McCarthy’s charge for the related intangibles was based on their cost to Capital rather than their market value, and that this method of deducting the other intangibles overstated the value of the lost contracts. Capital’s characterization of the record appears to be 26 mistaken. The Commissioner’s witnesses did not concede that McCarthy’s approach was correct, although neither did they claim that it was professionally untenable. They did argue for an alternative method, which presumably would have given a different, and greater, value to Capital’s goodwill. Given the dispute in the record between well-qualified experts, and the Tax Court’s greater familiarity with the issue, we cannot conclude that the Tax Court’s finding here was clearly erroneous. Indeed, this finding seem s conceptually correct—Capital’s goodwill factors should be subtracted at their value, not their cost—although Capital argues that McCarthy’s rental charge was meant to estimate value and not cost. We thus accept the Tax Court’s conclusion that McCarthy should have used a capital charge, rather than a rental charge, to extract goodwill from his valuation of the contracts. But, as explained above, see supra Part IV.B, Capital does not lose its entire deduction merely because the Commissioner has found some flaws in its method. On the remand that our other holdings require, the Commissioner will have the opportunity to explain what McCarthy should have done differently in this regard, relying on specific calculations of cash flows rather than on generic names like “capital charge” versus “rental charge.” The Commissioner will also be able to propose an alternate valuation for the $300 million goodwill adjustment. Capital, meanwhile, will have another opportunity to demonstrate to what extent McCarthy’s method captures the factors raised by the Commissioner. Ultimately, the Tax Court must determine what goodwill adjustment is appropriate, using either McCarthy’s rental charge, a capital charge proposed by the Commissioner on remand, or some other adjustment taking into account the arguments of both sides. In sum, the mere fact that McCarthy’s charge is flawed does not mean that the Tax Court may reject Capital’s entire valuation.
The Tax Court next found that Capital’s “expert utilized incomplete information and made erroneous assumptions relating to the characteristics of the group contracts that alone would support disallowance of the $4 million in loss deductions claimed.” 122 T.C. at 251. The Tax Court identified several instances of what 27 it considered incomplete data or erroneous assumptions, and found that these errors made McCarthy’s valuation so uncertain as to be almost meaningless. Most importantly, the Tax Court found that McCarthy “[i]gnored or did not consider historical premium payment and claim patterns and renewal expectations relating to each contract.” 122 T.C. at 251-52. The Tax Court also noted that, for many of the contracts that he valued, McCarthy used average premium or claims data, because individual contract data was lacking. Id. at 252-53. Capital argues that the Tax Court was in error, because the experience-rated contracts were appraised based on “premium rates in effect on January 1, 1987, which reflect each of these factors on a contract-specific basis.” Capital expert Constance Foster, an insurance attorney and former Insurance Commissioner of Pennsylvania, testified that “The demographics or any information about the customer is embedded in the rate. All we would do in renewing is look at their past claims experience and how many people are represented to project new rates.” Put differently, the experience rating process was intended to capture each group’s claims and payment experience in calculating each year’s premium rate. Thus, McCarthy was able to value the experience-rated contracts using only rate information, because the rate information captured the information that the Tax Court found missing. Capital also explains that some 24 of the experience-rated contracts, which together accounted for approximately $2.5 million of its $4 million claimed deduction, were valued taking into account all of those contract-specific factors, without any averaging or missing data regarding premiums or claims. As an example of McCarthy’s failure to accurately appraise the value of experience-rated contracts, the Tax Court cited the case of Pennsylvania Farmer’s Union. This client group maintained three experience-rated contracts that had a cumulative deficit of some $700,000 in January 1988. By 1994, the deficit was $4 million, and the contract was cancelled the following year, leaving Capital to absorb the deficit. 122 T.C. at 255. The Tax Court noted that, despite these deficits, McCarthy assigned the three Farmer’s Union contracts “a total positive value of $479,000, or nearly 20 percent of the total value attributed to all of petitioner’s experience-rated group contracts that were terminated in 1994.” Id. The Tax Court’s reasoning is flawed because it assumes that 28 the contract was not of positive value in 1987 merely because the contract ultimately caused Capital a loss. As Capital persuasively observes, it would not have renewed experience-rated contracts that it expected to result in a loss, so it can reasonably be assumed that in 1987 its contracts had a positive expected value. Indeed, one of Capital’s experts testified that deficit accounts have “a bit of more value” “as long as they stay with Capital Blue Cross,” because such accounts “produce[] more margin” in that Capital will raise premium rates going forward for contracts with high claims rates. Testimony also indicated that such deficit contracts did stay with Capital Blue Cross, or at least that their lapse rates were not materially greater than those of other contracts. As it turned out, Capital continued to lose money on the Farmer’s Union contract, and the group ultimately cancelled the contract rather than paying a significantly increased premium, leaving Capital with a large accumulated deficit. Capital’s Chief Financial Officer, Robert Markel, testified that Farmer’s Union had a deficit that was not “unusually large” as of 1987, which grew larger in later years. He also testified that Farmer’s Union breached its contract by transferring low-risk employees to another carrier, and that Capital cancelled the contract in 1994 upon learning of the breach. Capital submits that, if this breach had not occurred, it would have been able to recoup its losses from the contract and make it profitable. Capital’s position is that Farmer’s Union’s ballooning deficit and contract breach were not foreseeable in 1987; therefore, a reasonable buyer would have assigned the contract a relatively large positive value. We believe that McCarthy’s valuation was reasonable. First, some 60% of Capital’s claimed deductions come from experiencerated contracts in which averaging was not used and the data is complete. His assumptions about experience-rated contracts, including those with a deficit in 1987, were economically sensible; the fact that the Farmer’s Union contract turned out to be disastrous does not prove that it had zero or negative value as of January 1, 1987. The Commissioner also seeks to defend the Tax Court’s decision about the characteristics of group contracts by pointing to the community-rated contracts, for which significant averaging was used. He notes, as did the Tax Court, that a small change in the expected claims ratio could have an enormous effect on the 29 expected value of the contract: “use of a claims ratio just 1 percent higher than the aggregate average claims ratio used by petitioner’s expert for community-rated group contracts would reduce petitioner’s projected profit relating to the contracts by more than half.” 122 T.C. at 254. But the Commissioner has not demonstrated that there is anything wrong with using averaging, and the evidence indicates that an actual willing-buyer reinsurer would use an averaging method essentially identical to McCarthy’s. The Tax Court is, of course, correct that averaging is sensitive to initial assumptions: here, for instance, the valuation of the community-rated contracts depends on the average claims ratio; the appropriate discount rate will also have a significant effect. But there is little in the record before us to suggest that McCarthy should have used different assumptions. In view of this fact, we must remand to the Tax Court to allow it to consider McCarthy’s procedure in more detail. On remand, the Commissioner may explain his objections to specific assumptions in McCarthy’s valuation, as regards both individual experience-rated contracts and the collective assumptions about community-rated contracts. If the Tax Court finds that these assumptions were incorrect, it may find more appropriate figures and use them to calculate a more appropriate valuation of Capital’s contracts. But if McCarthy’s assumptions were correct, or were those that a reasonable buyer would make, then the fact that his calculations were sensitive to his assumptions does not render his valuation incorrect.
A central part of McCarthy’s valuation was his “lifing analysis,” that is, the method by which he estimated the expected life of each contract as of 1987. McCarthy used historical lapse rates to determine the probability that each group’s contract would lapse in any given year. These lapse rates were used to compute the expected life of each contract, which was essential to calculating its fair market value. 5 McCarthy used historical data from Capital’s 5 Essentially, the FMV of one of Capital’s contracts in 1987 equaled (a) the present value of all future premium payments on that contract, minus (b) the present value of all future claims paid out under 30 1982-1986 experience that “indicated that each group contract had a 2.2-percent to 7.5-percent probability of lapsing from year to year, depending on factors such as group size and duration of the contract.” 122 T.C. at 255. The Tax Court had two objections to McCarthy’s lifing analysis: first, that McCarthy did not take into account the uncertainty in the insurance market in 1987, and second, that he did not take into account certain “human elements” that influence lapse rates.6
First, the Tax Court found that the lapse rates did “not account for foreseeable (as of January 1, 1987) and significant changes in the health insurance marketplace.” 122 T.C. at 255-56. More specifically, the Court found that McCarthy did not consider the impact that increased competition from HMOs and other new insurance products would have on Capital’s lapse rates. In 1987, the argument goes, a willing buyer could have predicted that increased competition would lead to greater lapse rates, and thus that contract, over (c) the expected life of the contract. Cf. Sunset Fuel, 519 F.2d at 783 (“[The value] of a particular account is a function of the flow of future income . . . discounted by the risk of discontinuance or nonpayment of that particular account . . . .”). Since premiums would normally exceed claims, this present value would be higher for contracts with a long expected life than for those with a short life. Lapse rates were used to determine the expected life of each contract, and thus its expected value. 6 Earlier in its opinion, the Tax Court also suggested that McCarthy “incorrectly assumed a 20-year useful life for all of petitioner’s separate health insurance group contracts.” 122 T.C. at 249. Capital points out that McCarthy simply used 20 years as the maximum cutoff for projections, not as an assumed useful life for all of the contracts. In its criticism of McCarthy’s lifing analysis, however, the Tax Court seems to have correctly understood the 20-year cutoff. 122 T.C. at 255 (“[I]n his attempt to account for the reality that not all of petitioner’s group contracts would remain in existence for 20 years, petitioner’s expert utilized historical lapse rates . . . .”). We therefore assume that its earlier error regarding the 20-year assumption did not affect the Tax Court’s decision. 31 would have valued Capital’s contracts at a rate lower than McCarthy ascribed to them using historic lapse rates. Capital submits that this line of reasoning reflects a misunderstanding of the evidence. Capital’s CEO testified that, in the 1980s, Capital was aware of the competition from HMOs, but expected that this competition would not significantly affect its market share or lapse rates because central Pennsylvania, where Capital operates, has a traditional market with relatively few hospital choices and a strong organized-labor presence. McCarthy testified that he took the competitive situation into account, but determined that most of the “competitive factors” that led to lapses had already taken effect in the 1982-1986 period that he used to determine lapse rates. The Commissioner’s experts reasoned that “[i]n the presence of such significant market changes, the assumption that future lapse rates would be consistent with past lapse rates is, at best, problematic,” and that the lapse rates were “speculative in the extreme, given what was going on in the group health insurance market at the time.” We are unconvinced. First of all, McCarthy, unlike the Commissioner’s experts, seems to have spoken to Capital management and considered circumstances unique to Capital’s central Pennsylvania market, while the Commissioner’s experts considered only the national health insurance market. Capital presented evidence that its market was (for reasons suggested above) uniquely resistant to the competitive pressures introduced by HMOs and PPOs; therefore, McCarthy’s calculations based on Capital’s own past data may well have been more accurate than the Commissioner’s projections based on national trends. Furthermore, there does not seem to be any evidence that McCarthy’s lapse rates were incorrect. Instead, Capital’s evidence tends to show that subsequent experience proved Capital’s projections correct: it has not lost significant market share to HMOs, and its historic lapse rates from 1987 were very close to those predicted by McCarthy. McCarthy’s table of historically derived lapse rate assumptions—ranging from a 2.2% lapse rate for groups of 10-24 members whose contracts had been in effect for over ten years to a 7.5% rate for groups of 1-9 members whose contracts had been in force for under one year — squares relatively well with Capital’s actual 1987-1994 experience. McCarthy testified that the experienced lapse rate by number of contracts was 32 5.6%, while the lapse weighted rate by total premiums lost was just under 3%. As McCarthy explained, the former number corresponds reasonably well to his predicted lapse rates for small groups, which were the most numerous, while the latter corresponds quite well to his predicted rates for large groups, which made up the bulk of Capital’s premiums. Of course, it is theoretically possible that McCarthy’s predicted lapse rates were speculative, but nonetheless turned out to be correct. But the general accuracy of his predictions is certainly strong evidence that they had a foundation in reasonable analysis rather than speculation. The Commissioner denies that McCarthy’s lapse rate predictions were accurate, although he has not pointed to any statistical evidence to refute the numbers we have cited above. Instead, the Commissioner cites a Capital marketing plan from 1993, which states that “[s]ignificant losses from existing accounts are being incurred from HMO’s,” and that the Berkshire Health Plan PPO had “targeted Blue Cross and Blue Shield customers and [had] been successful in enrolling a significant number of accounts through selective underwriting.” This document certainly supports the Commissioner’s thesis that Capital faced competition from HMOs. But McCarthy’s testimony was that this competition had already developed by the 1982-1986 period that he used to estimate post-1987 lapse rates, and that his use of historical rates therefore accurately captured Capital’s 1987 expectation of future rates. He testified that, based on discussions with Capital executives, he concluded that “the phenomena [of increased competition, including from HMOs and PPOs] had really already developed in the period of time I used for purposes of the lapse study . . . . And so I felt, after listening to them, that based on the situation in 1986, it was not necessary to modify those experience rates that i [sic] had derived for purposes of projecting in the future.” Without any contradictory evidence, we have no choice but to accept McCarthy’s representations that his predicted lapse rates turned out to be accurate. Moreover, his procedure—relying on recent historical rates that he concluded incorporated the developing changes in the insurance industry, and discussing his predictions with Capital management to get a sense of their predictions as of 1987—does not strike us as “speculative in the extreme.” The Tax Court appears to have ignored Capital’s 33 evidence that McCarthy’s lapse rates were accurate, and to have unduly credited the Commissioner’s experts’ conclusory assertions that those rates were speculative. We thus reject as clearly erroneous the Tax Court’s conclusion that “petitioner’s expert largely ignored the industry changes of which petitioner’s management, as of January 1, 1987, was aware.” 122 T.C. at 25657.
Tax Court also rejected McCarthy’s lifing analysis because it found that McCarthy did not consider various “human elements” that would influence lapse rates, viz., various subjective factors that might make customers cancel their at-will contracts. It held that “These human elements associated with petitioner’s group contracts created a significant element of unpredictability with regard to the useful life of petitioner’s group contracts.” 122 T.C. at 257. The Tax Court’s conclusion here reflects a fundamental misunderstanding of McCarthy’s method, if not of the nature of the insurance industry and actuarial methods. McCarthy took into account the human factors in the way that all actuaries do: actuarially. He divided the contracts into groups based on distinctions that he found relevant, computed average lapse rates, and used them to project future lapse rates. Capital quite wittily cites Ehrhart v. Comm’r, 57 T.C. 872, 873 (1972) (“Actuaries are highly skilled mathematicians who deal with various contingencies affecting human life.”), for the proposition that an actuary of McCarthy’s experience is well equipped to deal mathematically with the human factors affecting the lapse rates of insurance contracts. Furthermore, the Tax Court did not identify any “human factors” that McCarthy’s valuation failed to take into account. The Tax Court’s reliance on Ithaca II, supra, 17 F.3d at 689-90, and Globe Life & Accident, supra, 54 Fed. Cl. 132, is misplaced. Those cases concerned workforces, which are much harder to value than insurance contracts; the valuations involved there were far less careful and thorough than McCarthy’s valuation here; and those cases concerned amortization (where precise lapse rates are essential) rather than deductions for the direct loss of contracts. Because it ignored undisputed evidence and misunderstood 34 the nature of McCarthy’s calculations, the Tax Court’s rejection of Capital’s lifing analysis on the theory that McCarthy failed to take into account any subjective “human factors” was clearly erroneous and must be set aside.
In his appellate briefs, the Commissioner builds on the Tax Court’s findings by arguing that McCarthy’s lapse rate assumptions were flawed in other respects. Specifically, McCarthy only used average rates for contracts of a given size and age, and did not calculate different rates for different kinds of coverage or contract, different premium payment histories, changing sizes, or financial condition of the client group. Capital responds that McCarthy complied with actuarial principles in coming to his conclusions, and that the Commissioner has not shown that McCarthy’s valuations would be different if he took into account the more specific factors that the Commissioner urges. We agree with Capital. McCarthy’s efforts were thorough, and it appears to be undisputed that he followed actuarial standards. The Commissioner has identified some factors that he did not consider, but this alone does not seem to be a reason to reject McCarthy’s lapse rate calculations. As the Tax Court has previously stated, “lapse rates may be determined from a statistical analysis of actual past experience of policies in force at specified intervals of time or from an informed judgment of a person who has had experience in the field.” Union Bankers, 64 T.C. at 816. Simply put, it would be impossible for McCarthy to take into account every factor that might distinguish one contract from another. McCarthy did not classify contracts based on what percentage of individuals in each group was left-handed, but the Commissioner would not be heard to argue that this was a flaw in his methodology. The Commissioner cannot invalidate McCarthy’s methodology simply by pointing to factors that McCarthy neglected; instead, he must also make a reasonable case that such a factor would have changed his conclusions. The Commissioner has not even attempted to do so here, and we see no reason to reject McCarthy’s lifing analysis.
35 In his appellate brief, the Commissioner has not confined himself to defending the Tax Court’s opinion on its own terms. He has also put forward several other purported grounds for affirmance. The Commissioner now objects to the completeness and accuracy of Capital’s records, arguing that coding errors and missing data render many of Capital’s conclusions suspect. He also argues that McCarthy drew improper inferences from the aggregate value of Capital’s 23,526 contracts in 1987 to the value of the 376 contracts cancelled in 1994, without first demonstrating that those 376 contracts were a representative sample of the whole. Without the benefit of explicit factual findings by the Tax Court on these issues, we will not undertake to decide them. Instead, we will allow the Tax Court to consider these arguments in the first instance. This consideration will involve both a determination whether the Commissioner is correct about the alleged flaws in Capital’s data and methodology and a decision about the extent to which those flaws invalidate McCarthy’s ultimate valuation.
Two themes emerge from the above discussion. First and foremost, we have rejected as clearly erroneous the Tax Court’s ultimate conclusion that Capital “has not . . . established that the group contracts are capable of being valued separately and independently as individual assets.” T.C. 251. We find that McCarthy’s model, including his use of some averaging assumptions, established an individual value for each contract with sufficient specificity to carry Capital’s burden under Newark Morning Ledger. See supra Part IV.B. Second, we have rejected as clearly erroneous some, but not all, of the Tax Court’s specific findings of flaws in Capital’s valuation. Because of the centrality of these findings to the decision we are constrained to reverse and remand. Because it is clear that Capital had some basis in the contracts, we do not think that even the Tax Court’s valid objections prevent Capital from taking a deduction. On remand, the Commissioner will have the opportunity to quantify his objections to Capital’s valuation, and the Tax Court will be able to decide the proper valuation. Thus, for instance, the Commissioner may dispute McCarthy’s goodwill adjustment by 36 proposing his own capital charge, see supra Part V.A.3, and the Tax Court may determine what the appropriate goodwill adjustment should be. Similarly, the Commissioner may explain which of McCarthy’s initial assumptions—about contract claims rates, discount rates, etc.—were erroneous, see supra Part V.B, and the Tax Court may adjust McCarthy’s valuation if it finds that his assumptions need to be changed. That said, we expect that the Commissioner will not continue to rely solely on experts who testify that the lost contracts are impossible to value: without a competing valuation argument, it would seem that the Tax Court will have little choice but to grant Capital its claimed deduction. As we have stressed above, see supra Part IV.B, once Capital has carried its burden of showing that the contracts may be valued individually—as we believe it has—the Tax Court’s role is to find the correct valuation. Because there is no real dispute that the contracts had value in 1987, and because we find that they may be valued individually, a valuation of zero is unlikely to be the correct result. Because we find that Capital’s lost insurance contracts are susceptible of individual valuation as of January 1, 1987, the Tax Court’s conclusion that Capital is not entitled to a deduction for the loss of those contracts must be set aside. We reverse and remand for a determination of Capital’s basis in those contracts, informed by the record and any further submissions from the parties that the Tax Court may consider appropriate.