Although petitioner's accounting affected the allocation to the loss reserve, petitioner did not consider the amounts relating to the Campbell II case in petitioner's ratemaking calculations.

Respondent audited petitioner's returns for taxable years 1996 through 1999 and issued a notice of deficiency with respect to those years on December 22, 2004. Respondent 2010 U.S. Tax Ct. LEXIS 42">*55 determined deficiencies in petitioner's Federal income taxes of $12,830,522, $55,903,247, $25,981,117, and $14,249,973 for 1996, 1997, 1998, and 1999, respectively. In the notice of deficiency respondent disallowed the deductions petitioner claimed as a result of the adjustments made to the Bulk and IBNR reserve for unpaid losses in 2001 and 2002 attributable to the judgment of the Utah Supreme Court in Campbell II.

Petitioner timely filed its petition with this Court on March 21, 2005, disputing a portion of the deficiency determined for 1996 and disputing the entire deficiency determined for each of 1997, 1998, and 1999. In addition, petitioner claimed overpayments of $156,917,448, $214,471,611, and $138,570,516 for 1997, 1998, and 1999, respectively, due to alternative minimum tax (AMT) net operating loss carrybacks from the taxable years 2001 and 2002. Respondent timely filed his answer on May 19, 2005, reasserting the deficiencies and denying that petitioner had made any overpayments.

In March 2005 petitioner sought assurance from the Illinois Department of Insurance that the accounting with regard to the Campbell II amount was valid. James Hanson, acting assistant deputy director 2010 U.S. Tax Ct. LEXIS 42">*56 of the department, gave such assurance in a reply letter.

All of the issues raised in the petition were settled, except for the AMT issue and the loss reserve issue. This Court agreed to consider those two issues separately. The 135 T.C. 543">*551 Court issued an opinion on the AMT issue on June 23, 2008. A trial on the loss reserve issue was held on December 9 and 10, 2009, in Washington, D.C. At trial, petitioner and respondent introduced several expert reports regarding the proper method of accounting for the $202 million judgment entered against petitioner by the Utah Supreme Court in 2001.

Petitioner bears the burden of proving, by a preponderance of the evidence, that respondent's determinations in the notice of deficiency are incorrect. Sec. Rule 142(a); Welch v. Helvering, 290 U.S. 111">290 U.S. 111, 290 U.S. 111">115, 54 S. Ct. 8">54 S. Ct. 8, 78 L. Ed. 212">78 L. Ed. 212, 1933-2 C.B. 112 (1933). Deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any claimed deductions. Rule 142(a)(1); INDOPCO, Inc. v. Commissioner, 503 U.S. 79">503 U.S. 79, 503 U.S. 79">84, 112 S. Ct. 1039">112 S. Ct. 1039, 117 L. Ed. 2d 226">117 L. Ed. 2d 226 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435">292 U.S. 435, 292 U.S. 435">440, 54 S. Ct. 788">54 S. Ct. 788, 78 L. Ed. 1348">78 L. Ed. 1348, 1934-1 C.B. 194 (1934). However, this case is not resolved on the burden of proof. Rather, the facts are largely undisputed, and the question 2010 U.S. Tax Ct. LEXIS 42">*57 is primarily one of law.

Petitioner argues that section 832 requires petitioner to follow the annual statement method of accounting and that the $202 million was properly included in loss reserves on the 2001 and 2002 Annual Statements. Petitioner also contends that regardless of the annual statement method, the $202 million was properly included in loss reserves under section 832(b)(5) as a loss incurred on an insurance contract.

Respondent argues that the $202 million is not deductible under section 832(b)(5) and that it should instead have been accounted for as a business expense under section 832(c). Respondent also contends that the amounts petitioner reported on its Annual Statements do not control for tax purposes and that NAIC accounting principles do not support including the $202 million in loss reserves. Finally, respondent argues that the $202 million is not deductible as a loss incurred because it is not a fair and reasonable estimate of an actual unpaid loss.

Petitioner argues that the annual statement method of accounting controls for Federal tax purposes and that the 2010 U.S. Tax Ct. LEXIS 42">*58 $202 million was properly included in the annual statement loss reserves. Respondent offers several reasons the annual statement method of accounting does not control for Federal income tax purposes and the $202 million was not properly included in the annual statement loss reserves. The parties disagree about the applicability of the Court of Appeals for the Seventh Circuit's opinion in Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858">972 F.2d 858 (7th Cir. 1992), affg. in part and revg. in part 96 T.C. 61">96 T.C. 61 (1991), modified 96 T.C. 671">96 T.C. 671 (1991).

Respondent is correct in characterizing the loss in question as extracontractual. It is not a loss covered by the liability policy of an insured. The State of Illinois Department of Insurance treats it as such for purposes of computing insured losses incurred. The parties dispute whether Sears dictates that this construction by the insurance regulators controls for Federal tax purposes.

The Court of Appeals in Sears held that the insurance annual statement controls as to the timing of the deduction of insured losses, and petitioner would have us apply this holding to the State's determination that these extracontractual losses should be included in current 2010 U.S. Tax Ct. LEXIS 42">*59 losses under the insurance contracts.

As petitioner's principal place of business is in Illinois, the Court of Appeals for the Seventh Circuit would normally have appellate jurisdiction over this case. Sec. 7482(b)(1)(B). The Tax Court will "generally defer to the rule adopted by the Court of Appeals for the circuit to which appeal would normally lie, if that Court of Appeals has ruled with respect to the identical issue." Becker v. Commissioner, T.C. Memo. 2006-264; see also Golsen v. Commissioner, 54 T.C. 742">54 T.C. 742, 54 T.C. 742">757 (1970), affd. 445 F.2d 985">445 F.2d 985 (10th Cir. 1971).

Respondent would distinguish Sears from the present case, arguing that factual differences render Sears irrelevant to our decision here. Respondent argues five points: (1) The losses in Sears arose from insured events and were not extracontractual; (2) petitioner has not shown the $202 million is a fair and reasonable estimate of the amount petitioner 135 T.C. 543">*553 would have been required to pay; (3) Sears did not concern a possible contravention of NAIC statutory accounting principles; (4) Sears did not address punitive damages; and (5) Sears2010 U.S. Tax Ct. LEXIS 42">*60 did not involve a possible mismatching of income and losses incurred. We focus on points (1) and (4).

In Sears, PMI Mortgage Insurance Co. (PMI) had established $35.9 million in IBNR reserves for estimated losses and deducted that amount from income. The Commissioner contended that this deduction should be limited to $19.5 million, arguing that the insurance company should not be allowed deductions in excess of that amount for estimated losses. The Tax Court upheld the Commissioner on this issue, holding the "insurer cannot incur a loss until the insured has suffered the defined economic loss, to wit, after the lender takes title to the mortgaged property." Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61">96 T.C. 114.

The Court of Appeals for the Seventh Circuit reversed the decision of the Tax Court in that respect, stating: "Section 832 is no ordinary rule. It expressly links federal taxes to the NAIC's annual statement". Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858">972 F.2d at 865-866. The court held that because section 832(b)(1)(A) requires insurers to use the NAIC annual statement to determine gross income, section 832 required an insurer to compute losses incurred according to the annual statement 2010 U.S. Tax Ct. LEXIS 42">*61 as well. 972 F.2d 858">Id. at 866. With respect to the Commissioner's attempt to ignore the requirement that companies report their losses in accordance with the Annual Statement, the court stated: "An Internal Revenue Service eager to dish out the medicine of literalism must be prepared to swallow it." 972 F.2d 858">Id. at 868. The court concluded that "State insurance commissioners' preferences about reserves thus are not some intrusion on federal tax policy; using their annual statement is federal tax law." 972 F.2d 858">Id. at 866. Having so found, the Court of Appeals ruled that because PMI followed the NAIC annual statement it was entitled to deduct the $35.9 million in loss reserves. 972 F.2d 858">Id. at 867. However, all the quoted analysis is in the context of the timing of recognition of insured losses.

The parties dispute the proper application of section 832 in this case. Petitioner maintains the result is dictated by the 135 T.C. 543">*554 requirement in section 832(b)(1) that an insurance company's gross income consists of investment income and underwriting income "computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of 2010 U.S. Tax Ct. LEXIS 42">*62 Insurance Commissioners".

Petitioner maintains that it correctly included the Campbell II punitive damages as losses incurred on the Annual Statements and this treatment was accepted by its outside accountants and the Illinois State insurance regulators. Therefore, petitioner reasons that the deductibility of the loss on its tax returns is dictated by the inclusion of the punitive damage award in its Annual Statements.

Respondent's position begins with a detailed examination of the Campbell I and Campbell II lawsuits for purposes of demonstrating that the punitive damage award is not a loss covered on an insurance contract but rather a liability petitioner incurred because of its own misconduct, not any act of its insured. Respondent is correct, and to bring the argument within section 832, respondent focuses on the phrase "losses incurred * * * on insurance contracts" in section 832(b)(5)(A). Respondent asserts that section 832 by its terms applies the annual statement rule only to insured losses, and the accounting treatment of the punitive damage award does not control the tax treatment.

Petitioner counters that the word "on" should be read to mean "related to", "caused by", "derived 2010 U.S. Tax Ct. LEXIS 42">*63 from", or "because of". The implication of petitioner's counterargument is that Congress has delegated to the insurance regulators the job of deciding which losses are caused by insurance contracts, and respondent has no business second guessing the regulators' acceptance of petitioner's effort to find a causal connection between the punitive damage award and petitioner's automobile insurance contracts.

Petitioner argues that Sears fully supports the preeminence of the annual statement in tax accounting for insurance losses. Although Sears addressed only the timing of inclusion of insured losses in computing gross income, petitioner maintains that the opinion of the Court of Appeals supports petitioner's position that Congress has ceded the computation of insurance premium gross income to the insurance industry regulators. Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858">972 F.2d at 866.

135 T.C. 543">*555 Petitioner also references the legislative history and the regulations to support the position that neither Congress nor the Secretary envisioned exceptions to the reliance on the annual statement to dictate the computation of insurance gross income beyond the exception noted in the regulations regarding salvage 2010 U.S. Tax Ct. LEXIS 42">*64 value. See S. Rept. 99-313, at 499, 501, 503 (1986), 1986-3 C.B. (Vol. 3) 1, 499, 501, 503; H. Conf. Rept. 99-841 (Vol. II), at II-358 (1986), 1986-3 C.B. (Vol. 4) 1, 358; sec. 1.832-4(c), Income Tax Regs. Petitioner also cites section 846(b)(1), which provides the details for the computation of "discounted unpaid losses" used in section 832(b)(5)(A). Section 846(b)(1) defines "undiscounted unpaid losses" as "the unpaid losses shown in the annual statement filed by the taxpayer for the year ending with or within the taxable year of the taxpayer." ³

Respondent's principal counterargument is that this loss was not an insured loss. Punitive damages are in the nature of a punishment to modify behavior, not a foreseen result of meeting an obligation to cover an insured event.

Petitioner accounted for the $202 million by increasing its unpaid loss reserves on its 2001 and 2002 Annual Statements. On their facts, SSAPs Nos. 5 and 55 and INT 03-17 do not 2010 U.S. Tax Ct. LEXIS 42">*65 clearly state whether a loss such as that in Campbell II can be properly included in loss reserves. However, the Illinois Department of Insurance expressed through its actions that the initial Campbell II award was properly included in loss reserves.

As required by Illinois law, petitioner's Annual Statements were reviewed by PwC and by the State Examination Team acting for the Illinois Director of the Department of Insurance. Both PwC and the Examination Team were aware of the Campbell II litigation and petitioner's inclusion the $202 million (discounted) in its loss reserves. In spite of this awareness, neither PwC nor the Examination Team indicated that such accounting was improper. PwC filed a report with the State of Illinois setting forth PwC's opinion that petitioner's reserves: (1) Met the requirements of Illinois insurance laws; (2) were computed in accordance with generally accepted reserve standards and principles; and (3) 135 T.C. 543">*556 made a reasonable provision for all unpaid loss and loss adjustment expense obligations of petitioner. The Examination Team issued a report which included the loss reserve amount relating to Campbell II. This report was adopted by the director of the Illinois2010 U.S. Tax Ct. LEXIS 42">*66 Department of Insurance.

Petitioner's argument is that the Annual Statement controls the tax treatment for nonclaim payments as well as claim payments, and petitioner relies upon Sears for this proposition. As we stated previously, Sears addressed estimated insured losses and this case is about extracontractual losses. While sections 832(b)(5) and 846(d) do not provide specifically that the term "losses" is limited to the payment of claims on insured coverage, section 832(b)(5) follows the definitions of "underwriting income" and "premiums earned on insurance contracts" in section 832(b)(3) and (4), and the context implies that losses incurred are insured losses on the payments of claims. The question is whether respondent may diverge from the Annual Statement treatment in the context of these extracontractual losses. We believe respondent has the better side of this argument.

Insurance accounting is an evolving area, and the inclusion of extracontractual losses in loss reserves moves the Annual Statement treatment beyond the accounting of insurance policies revenue to broader issues of liability. While it is not our province to make judgments on the appropriateness of this insurance 2010 U.S. Tax Ct. LEXIS 42">*67 regulating treatment, we are charged with determining whether the tax provisions were intended to cede decisions on the deductibility for income tax purposes of extracontractual payments to the insurance regulators. In the light of the statutory regime we are not convinced that section 832(b) was intended to have the Annual Statement control the treatment of extracontractual losses for Federal tax purposes. Punitive damage awards are not an inherent component of insurance underwriting and can arise in many contexts. Ordinary and necessary expenses of an insurance company are generally allowable under section 832(c)(1) as provided in section 162. There is no reason to presume that Congress intended that section 832(b)(5) be the applicable section to determine tax deductions for punitive damage awards. To adopt petitioner's position would require that its contingent liability for a punitive damage award that was incurred on account of its own misconduct and was foreign 135 T.C. 543">*557 to its normal experience of underwriting risks be allowed under section 832(b)(5) as losses incurred. We hold to the contrary. Accordingly, we do not consider the Court of Appeals' analysis in972 F.2d 858">Sears controlling regarding 2010 U.S. Tax Ct. LEXIS 42">*68 these extracontractual losses.

Having reached the conclusions explained above, we do not reach respondent's alternative arguments.

We hold petitioner may not include the original Campbell II award in loss reserves under section 832(b)(5). We have considered all arguments made, and to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under Rule 155.