The first issue presented for decision involves the deduction for losses incurred for each of the taxable years 1963 through 1966 and 1971, liabilities for the first 3 years properly being before the Court by reason of loss carryovers.

70 T.C. 944">*947 The following schedule reflects the loss incurred deduction involved in each of the years:

The adjustments to the loss incurred deduction made by the Commissioner in his statutory1978 U.S. Tax Ct. LEXIS 55">*62 notice of deficiency were based upon his determination that loss recoveries in each of the years were not excludable from the related loss incurred deductions. Petitioner challenges that determination in the alternative. Petitioner's primary contention is that it is entitled to additional unpaid loss deductions brought about by satisfying claims during each of the years reflected above for less than was estimated as of December 31, 1962, to be its liability for such claims pending on that date.

Petitioner, on its annual statement as of December 31, 1962, reported its unpaid losses at $ 2,729,746. This amount represented petitioner's evaluation of the amount of money necessary to meet all contingencies of claims against its insurance policies on that date. It was composed of $ 2,600,472 for losses which had been reported to it by its policyholders and analyzed case-by-case to ascertain the projected ultimate liability and $ 129,274, representing an estimate of the losses incurred but not reported to petitioner by its policyholders as of December 31, 1962. Prior to December 31, 1962, the loss incurred account on petitioner's books and records and financial statements had no effect1978 U.S. Tax Ct. LEXIS 55">*63 on the Federal taxation of petitioner's income because mutual insurance companies were not taxable on underwriting income prior to the taxable year 1963. The loss incurred account as of December 31, 1962, did, however, affect petitioner's tax liabilities for taxable years beginning with the taxable year 1963 because of the manner in which the loss incurred deduction is computed. The unpaid losses outstanding at the end of the taxable year are added to the losses paid during the taxable year and the unpaid losses at the beginning of the taxable year are deducted from that total. Sec. 832(b)(5), supra. The portion of 70 T.C. 944">*948 petitioner's unpaid loss deduction which was estimated for losses not yet reported as of December 31, 1962 ($ 129,274), was converted during the taxable year 1963 to reported losses. As losses were reported to the petitioner by policyholders in 1963 petitioner evaluated its liability for the claims, added such estimated liability to the portion of its losses incurred for reported losses, and reduced the portion attributable to unreported losses.

Petitioner's unpaid loss account balance at December 31, 1962, affected not only its loss incurred deduction1978 U.S. Tax Ct. LEXIS 55">*64 for the taxable year 1963 but all of its taxable years through 1975 because all of the claims pending on December 31, 1962, were not finally settled until 1975. In 1963 and each of the subsequent years petitioner evaluated its unpaid losses in like manner as of December 31 which not only included claims filed in each year but also the unsettled claims which had been pending on December 31, 1962, which it had evaluated as of December 31, 1962. The unpaid loss evaluation for December 31, 1963, and subsequent dates, unlike the evaluation on December 31, 1962, affected petitioner's loss incurred deduction and its tax liability for each immediately preceding and each immediately succeeding taxable year because of the effect on the formula prescribed by section 832(b)(5), supra; i.e., beginning and ending of the year balances of unpaid losses.

The parties have stipulated the following description of the method employed by petitioner in accounting for the settlement of claims: "As each claim was disposed of, net payments were charged to the losses incurred account while the balance in the unpaid loss account for such claim was credited to the losses incurred account, thus clearing 1978 U.S. Tax Ct. LEXIS 55">*65 the unpaid loss account for that claim." Although the description of accounting for settlement of the claims (unpaid losses) which were pending as of December 31, 1962, is not a very clear statement of how petitioner accounted for such items, the result is not in dispute. Because petitioner (subsequent to December 31, 1962) settled claims pending at December 31, 1962, for amounts less than it estimated them to be on that date, petitioner understated its deduction for losses incurred in the aggregate amount of $ 402,314.59 between January 1, 1963, and December 31, 1975. Such understatements of the loss incurred deduction can best be understood by some examples.

70 T.C. 944">*949 Section 832(b)(5) provides for computation of the loss incurred deduction as follows:

1. Losses paid during the taxable year.

+ 2. Salvage and reinsurance recoverable at the end of preceding taxable year.

- 3. Salvage and reinsurance recoverable at the end of the taxable year.

+ 4. Unpaid losses at the end of the taxable year.

- 5. Unpaid losses at the end of the preceding taxable year (or beginning of taxable year).

= 6. Loss incurred deduction.

It is readily apparent that in all events the unpaid losses at1978 U.S. Tax Ct. LEXIS 55">*66 the beginning of the taxable year will reduce the loss incurred deduction. If the unpaid losses at the beginning of any taxable year after January 1, 1963, are overestimated and such estimated loss is paid for less than the estimated amount, such overestimation will merely shift the impact of the overestimate from one taxable year to another. But an overestimate of the amount of unpaid losses as of December 31, 1962, does not merely shift the impact from one taxable year to another because the amount of unpaid losses on December 31, 1962, affects petitioner's tax liability for the first time as it was not taxable on underwriting income for prior taxable years. Because the amount of unpaid losses on December 31, 1962, reduces the loss incurred deduction for 1963 the effect of overstating that amount results in offsetting either the losses paid or the unpaid losses pending at the end of 1963 portions of the deduction to which petitioner would otherwise be entitled.

For example, assume that petitioner estimated all of its unpaid losses at $ 1 million on December 31, 1962, and included was a claim estimated at $ 500,000 which was settled in 1963 for $ 200,000. Assume further that 1978 U.S. Tax Ct. LEXIS 55">*67 during 1963 petitioner paid claims not pending on December 31, 1962, in the amount of $ 100,000 and on December 31, 1963, in addition to the unpaid losses which were pending on December 31, 1962, and not settled during 1963, it had unpaid losses of $ 800,000 which were reported to petitioner by the policyholders during 1963. When petitioner settled the $ 500,000 claim for $ 200,000, it reduced the unpaid loss account by $ 500,000 because the settled claim no longer represented a liability of petitioner to the policyholder. Because salvage and reinsurance recoverable are not involved, petitioner's 70 T.C. 944">*950 loss incurred deduction would be computed as follows, applying the formula set forth above:

If petitioner had estimated the claim in the example at the amount it was settled for ($ 200,000) instead of its overestimate ($ 500,000), line 6 above would be $ 900,000 as follows:

1978 U.S. Tax Ct. LEXIS 55">*68 It is apparent, therefore, that petitioner would have been deprived of $ 300,000 of its loss incurred deduction.

The formula which the Code prescribes for computation of the loss incurred deduction is similar to the following formula used in the computation of cost of goods sold where inventories are utilized:

Beginning inventory

+Purchases

-Ending inventory

=Cost of goods sold

At the end of each of the taxable years involved, petitioner had the facts available to adjust that portion of its opening balance in the unpaid loss account for claims existing on December 31, 1962, which were settled during such taxable year. Because the adjustment could be made within the taxable year involved in closing the books for that year there is no violation of the concept of the annual accounting period. Such an adjustment is similar to an adjustment of an inventory. We have long held that a taxpayer is permitted to adjust inventories to conform to the facts in years before the Court. Elm City Nursery Co. v. Commissioner, 6 B.T.A. 89">6 B.T.A. 89 (1927). In that case the taxpayer deliberately inflated inventory figures on its balance sheets to 70 T.C. 944">*951 present a better1978 U.S. Tax Ct. LEXIS 55">*69 financial picture for borrowing funds to finance the operations of the business. The Commissioner based his determination of tax upon the inflated amounts appearing on the books of the taxpayer. We found that the taxpayer proved that the books did not correctly reflect the beginning and ending inventories and we adjusted the cost of goods sold accordingly. The Commissioner acquiesced in that decision. VI-2 C.B. 2.

In Baumann Rubber Co. v. Commissioner, 4 B.T.A. 671">4 B.T.A. 671 (1926), the taxpayer adjusted its opening inventory for crude rubber it had failed to include. The Commissioner, in his statutory notice of deficiency, allowed a lesser amount to be added to the opening inventory which could be substantiated and which we upheld.

These cases demonstrate that a taxpayer's beginning inventory is not etched in concrete if an appropriate adjustment is proposed during the correct accounting period before the Court. We see no reason why the same reasoning should not be applied to the original estimate of unpaid losses of petitioner at December 31, 1962.

Respondent opposes the adjustment on several grounds. First, he argues that the unpaid loss account is not1978 U.S. Tax Ct. LEXIS 55">*70 an accrual in the traditional accounting sense. We recognize that the unpaid loss entry at the end of each accounting period is nothing more than an educated guess as to petitioner's liability for claims filed during that year against insurance policies which are in force and effect on that date. We fail to see, however, why an adjustment should be precluded for that reason. Recognizing the amount to be an estimate to us seems all the more reason to permit adjustment of the amount in the annual accounting period during which transactions occur, making it apparent that the estimate is incorrect. The hindsight which respondent abhors occurs within the annual accounting period. That is not the same situation as adjusting an account in a subsequent accounting period long after ordinary business transactions demonstrate the error of the estimate.

The need to permit petitioner to adjust for the overestimation of unpaid losses as of December 31, 1962, is even more compelling in view of its being the first time that the unpaid loss account had any bearing on petitioner's tax liability. In Rev. Rul. 58-126, 1958-1 C.B. 13, which respondent vainly1978 U.S. Tax Ct. LEXIS 55">*71 tries to distinguish, the Commissioner held that a savings and loan association could adjust its reserve for losses in 1957 established 70 T.C. 944">*952 prior to 1952 when it was not subject to taxation without resulting in the production of income unless it diminished the reserve below the additions to the reserve after 1951 and less chargeoffs for bad debt losses after 1951 and plus recoveries charged to the reserve after 1951. If the reserve were so diminished, gross income was held to be realized to the extent of the diminution. We hold that the same rationale should apply here and petitioner is entitled to make the adjustments which it proposes.

Respondent also relies upon Pacific Mutual Life Insurance Co. v. Commissioner, 48 T.C. 118">48 T.C. 118 (1967), revd. on other grounds, 413 F.2d 55">413 F.2d 55 (9th Cir. 1969). That case is distinguishable. The taxpayer adjusted its beginning reserves for certain categories of insurance based upon payments of some claims and upon a revaluation, using methods different from those originally used when the reserves were established. We found that the taxpayer had used "actuarial hindsight" in adjusting its beginning1978 U.S. Tax Ct. LEXIS 55">*72 reserves downward. Petitioner here does not advocate such a procedure; its hindsight is strictly based upon actual settlements of the pending claims during the years it proposes adjustments. In the instant case petitioner does not rely upon "actuarial hindsight" but, instead, on "actuality hindsight." Petitioner here actually settled the claims, previously estimated, for which it seeks adjustment. The methods employed in establishing reserves for future claims to be filed against life insurance policies and those for casualty insurance policies are vastly different. In the case of life insurance the estimate is based upon averages or probabilities which are actuarily developed. By contrast, reserves for claims against casualty insurance policies which are involved here, are based upon applying the factor of settlement experience to each claim which has been actually filed.

Petitioner here proved what Pacific Mutual failed to prove; i.e., the exact liability incurred with respect to the claims included in the December 31, 1962, estimate. See 48 T.C. 118">Pacific Mutual Life Insurance Co. v. Commissioner, supra, at 130, 131. Such failure of proof by Pacific1978 U.S. Tax Ct. LEXIS 55">*73 Mutual led us to state at page 131, "we cannot conclude that the reserves in question were either overstated or understated." In the instant case respondent raises no such question; he recognizes that the reserve on December 31, 1962, was overstated. In Pacific Mutual we also held that the legislative history of the applicable section (not the section 70 T.C. 944">*953 involved here) did not support the taxpayer's position. There is no legislative history for section 832(b)(5) to examine in the instant case. Moreover, there is no showing that the taxpayer relied upon Rev. Rul. 58-126, supra, in Pacific Mutual.

Although we hold for petitioner, we cannot agree with its reasons for permitting the adjustments. Petitioner attempts to characterize the overestimation of the unpaid loss account as resulting in an overstatement of income. Such characterization is erroneous. The overestimation had no bearing upon petitioner's gross income from its underwriting activities. The overestimation affected its deduction for losses incurred. After making such an erroneous characterization, petitioner argues the applicability of the tax benefit1978 U.S. Tax Ct. LEXIS 55">*74 rule. We know of no case which holds that the absence of a tax benefit in the prior year gives rise to a deduction in the current year. Here, there was no tax benefit in the prior year. Cf. TennesseeCarolina Transportation, Inc. v. Commissioner, 65 T.C. 440">65 T.C. 440 (1975), affd. 582 F.2d 378">582 F.2d 378 (6th Cir. 1978). Indeed, we have recognized that, although we have not identified our theory as the tax benefit rule, when a casualty insurance company releases its excessive reserves, it constitutes taxable income only to the extent that the amount released consists of amounts previously deducted. Dallas Title & Guaranty Co. v. Commissioner, 40 B.T.A. 1022">40 B.T.A. 1022, 40 B.T.A. 1022">1031 (1939), revd. on other grounds 119 F.2d 211">119 F.2d 211 (5th Cir. 1941). See also Maryland Casualty Co. v. United States, 251 U.S. 342">251 U.S. 342 (1920). However, the taxpayer must prove what portion of the released reserve did not create a deduction in a prior taxable year. Massachusetts Fire & Marine Insurance Co. v. Commissioner, 16 B.T.A. 625">16 B.T.A. 625 (1929).

Petitioner also relies upon the1978 U.S. Tax Ct. LEXIS 55">*75 Commissioner's audit policy to demonstrate that the unpaid loss account as adjusted is within the percentage of tolerance that a revenue agent is to allow. This argument is unpersuasive.

Because we have held that petitioner may adjust its estimate of unpaid losses pending on December 31, 1962, it is unnecessary for us to decide its alternative position as to the treatment of recoveries on losses paid prior to January 1, 1963.

70 T.C. 944">*954 3. Special Transitional Underwriting Loss

This issue involves the appropriate point at which the special transitional underwriting loss may be utilized to reduce statutory underwriting income; i.e., is it allowable against underwriting gain before the protection against loss (PAL) deduction or allowable against statutory underwriting income after the protection against loss deduction?

Petitioner sustained underwriting losses aggregating $ 936,698.29 for the taxable years 1957 through 1961. Such losses may be allowed as a special transitional underwriting loss under section 821(e) for petitioner's taxable years 1965, 1966, and 1967.

Because we have adopted petitioner's position with respect1978 U.S. Tax Ct. LEXIS 55">*76 to adjustments for the overestimation of unpaid losses as of December 31, 1962, we need not consider petitioner's alternative contention as to respondent's restoring to underwriting gain recoveries on claims settled prior to January 1, 1963. Petitioner's underwriting gain is, therefore, properly computed as follows:

The table on p.956 depicts the parties' respective positions as to the appropriate point at which to allow the special transitional underwriting loss:

Section 821(e)(2) applicable to the years before the Court allows a reduction of statutory underwriting income1978 U.S. Tax Ct. LEXIS 55">*77 for the underwriting losses of the 5 preceding taxable years not previously utilized. ³

70 T.C. 944">*955 Section 823(a) provides for the determination of statutory underwriting income. ⁴ In summary, that section determines statutory underwriting income under sections 831 and 832, and allows a deduction under section 824(a).

1978 U.S. Tax Ct. LEXIS 55">*78 Petitioner argues that section 821(e)(2) and section 824(a)(1) both allow deductions, that they are "locked in a collision course" and legislative history supports allowance of the special transitional underwriting loss as a deduction against underwriting gain. We disagree.

Section 821(e)(2) provides for a reduction of statutory underwriting income for the previous years' underwriting losses. Because it provides for a reduction of the statutory underwriting income, it is necessary to refer to section 823(a) which determines the statutory underwriting income and that section, together with sections 831 and 832, clearly allow the PAL deduction against underwriting gain in computing statutory underwriting income.

There is no ambiguity in the statutory scheme, and the legislative history does not conflict with our interpretation.

Decision will be entered under Rule 155.