Opinion ID: 3014809
Heading Depth: 2
Heading Rank: 2

Heading: Specific Contract Characteristics

Text: 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.