Respondent determined deficiencies and an addition to petitioner’s Federal income taxes as follows:
Addition to tax Year Deficiency under sec. 6653(a)
1973 .$56,556.24
1974 . 169,687.01 $8,484.35
1975 . 157,315.55
1976 . 177,534.31
After concessions, the sole question presented for decision is whether petitioner qualified as a life insurance company during the years in issue under the provisions of section 801(a).1 Specifically, we must decide whether petitioner’s individual accident and health policies were "guaranteed renewable” within the meaning of section 1.801-3(d), Income Tax Regs.
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts are so found. The stipulation and the exhibits attached thereto are incorporated by this reference.
Petitioner is a Missouri corporation engaged in the business of issuing policies of insurance, with its principal office in University City, Mo. It filed its Federal income tax returns for each of the calendar years 1973 through 1976 with the Internal Revenue Service Center at Kansas City, Mo., on Forms 1120L, together with the annual convention statement for each year.
Petitioner was incorporated in 1964 as a life insurance company under the law of the State of Missouri. Petitioner underwrites insurance in numerous States. During the taxable years in controversy, it primarily wrote guaranteed renewable health and accident insurance policies (hereafter GRHA policies) and a small amount of life insurance and group accident and health insurance. Petitioner did not issue policies of insurance other than life, accident, and health insurance.
Under the terms of the individual accident and health policies written by petitioner (with minor exceptions not here material), petitioner may neither cancel nor refuse to renew coverage for life or to age 65, at a level premium. Petitioner may, however, adjust premiums by class based on experience, but at rates based upon the age and insurable condition of the insured'at the original date of issue. No changes in premium rates may be based on the insured’s increased age (from the time the policy was first issued), changes in health or occupation, or claims made under the policy.
Guaranteed renewable individual accident and health policies are a recognized product type within the health insurance industry. For purposes of classification by the insurance industry, the contractual provisions described in the preceding paragraph distinguish a guaranteed renewable individual accident and health policy from, other forms of health and accident, insurance. All of petitioner’s individual GRHA policies satisfy the industry definition and understanding of the guaranteed renewable product type.
All of petitioner’s GRHA policies are level premium policies, as distinguished from step-rate or 1-year term policies. A level premium policy is one under which the premium is based on original issue age, and does not increase based on attained age (although the insurer may adjust premiums by class under the guaranteed renewable provision). A step-rate policy is one under which the premiums provided for in the contract increase at specified periods based on attained age.
Guaranteed renewable level premium policies, which came into use in the early 1950’s, provide the insured with the benefit of a premium rate unaffected by changes in age and condition of health, but also enable the insurer, through its ability to change premium rates by class, to cope with inflation and changes in health care standards affecting claim costs. These policies, like policies of life insurance, present long-term hazards extending beyond the current premium payment period. The requirement of a reserve, in addition to the unearned premium reserve, recognizes that long-term or continuing risk.
At all times here relevant, petitioner was subject to regulation, supervision, and examination under the insurance laws of the State of Missouri by the Missouri Insurance Division, which was charged by State statute with the execution of laws in relation to insurance companies doing business in Missouri.
The Missouri minimum valuation standard classifies accident and health policies as type A, type B, type C, or type D, depending on the nature of the policy provisions. Type B policies are described therein as follows:
B. Policies which are guaranteed renewable for life or to a specified age * * * but under which the company reserves the right to change the scale of premiums.
With immaterial exceptions, áll petitioner’s individual GRHA policies satisfied the above-quoted definition of a type B policy.
As a minimum reserve standard for type B policies, the Missouri minimum valuation standard authorized use of one of the following three generally recognized reserve methods:
(1) Mean reserves diminished by appropriate credit for valuation net deferred premiums;
(2) Mid-terminal reserves plus gross pro rata unearned premium reserves;
(3) Mid-terminal reserves plus net pro rata unearned premium reserves.
In 1973 through 1976, petitioner estimated its active life reserve on its individual accident and health policies using method (2) referred to above.
Active life reserves are reserves for future claims or liabilities not yet incurred; "claim reserves” are for claims and liabilities already incurred, but not yet paid. Active life reserves include (a) the "unearned premium reserve,” which is a reserve for claims or liabilities which will be incurred during the remainder of the term or period for which the premium has been paid, and (b) the "additional reserve,” generally designated as the "mid-terminal” reserve in technical insurance terminology, which is a reserve for claims or liabilities that will be incurred after the end of the current premium period. This additional or mid-terminal reserve is normally concerned only with policies which place on the insurer a risk extending beyond the current premium payment period for which future premiums at some point will be inadequate.
Premiums are treated as earned by the passage of time. A pro rata unearned premium reserve, whether gross or net, diminishes as time passes, and is necessarily reduced to zero at the end of the current policy term or premium payment period. The mid-terminal or additional reserve represents an amount held back or reserved from premiums which would otherwise be treated as earned, and remains at the end of the current premium or policy term when the unearned premium reserve is at zero.
The gross premium is the total premium actually paid by the insured. It consists of (a) the net premium or net valuation premium, which, with assumed earnings, is the amount deemed necessary to meet claims and obligations arising under the policy, and (b) the "loading” factor, which is required to pay commissions, taxes, and expenses, and (in the case of stock insurers) to provide a profit margin. The unearned premium reserve, whether computed on a gross or net basis, is calculated on a pro rata basis, and no part of the unearned premium reserve is left at the termination of the premium payment period. The additional (mid-terminal) reserve remains in effect at that time, which is the reason for the "terminal” part of its designation, i.e., unlike the unearned premium reserve, it is still in effect at termination of the period for which the premium was paid. The term "mid-terminal” reflects the use of an average figure based upon the assumption that policies are sold at uniform intervals, so that all policies issued in any given calendar year may be deemed to have a mean, average, or "mid-terminal” date of July 1.
The reserve, in addition to net unearned premiums, arises from petitioner’s long-term obligation stemming from the guaranteed renewable feature of the policies. This reserve is the measurement of petitioner’s liability for future contingent claims — those not yet incurred under its individual policies— and is equal to the present value of future benefits payable under those policies minus the present value of future net level premiums receivable.
Under Missouri law and State insurance codes, generally, it is the professional task of the actuary to place a sound value on the company’s policy liabilities. At all times here relevant, petitioner employed E. Paul Barnhart, its consulting actuary, to value, or to supervise the valuing of, the active life reserves petitioner was required to carry for all of its individual GRHA policies in force.
A variety of computational methods are available to the actuary for use in calculating the reserve in addition to unearned premiums. The method selected in a particular case is subject to actuarial judgment guided by professional standards in light of the circumstances at hand, and to the minimum requirements of State law. The actuary may use any reasonable method that will place a sound value on the company’s policy liabilities, and that will produce an amount satisfying the minimum requirements of State law.
Under the Missouri minimum valuation standard, as well as good actuarial practice, the mid-terminal reserve may be computed either on a net level basis or on a preliminary term basis. The preliminary term method or basis of computing reserves is a recognized and accepted actuarial method, and has been accepted by the National Association of Insurance Commissioners (hereafter NAIC) and by the pertinent regulatory agencies of those States in which petitioner does business. It is the method most commonly used for valuing reserves on individual accident and health policies with level premiums based on original age at issue. At all times here relevant, petitioner computed the mid-terminal reserves on its individual GRHA policies on a 2-year preliminary term basis, using appropriate valuation tables constructed by its actuary for this purpose and based on recognized mortality and morbidity tables and an assumed rate of interest at 3-percent compounded. Petitioner’s actuary, E. Paul Barnhart, instructed company personnel in the proper use of such valuation tables to compute the mid-terminal reserve.
■' Mechanically, the computation of a 2-year preliminary term basis of the mid-terminal reserves with respect to petitioner’s individual health and accident policies was, during the taxable years here in controversy, as follows:
(a) An outside statistical firm retained by petitioner for that purpose broke down the policies by calendar year of issue, treating all policies issued in a calendar year as being issued on July 1 of that year for these purposes.
(b) An amount was computed for each policy in force more than 2 years as of the valuation date by applying to each such policy the unit reserve factors (from the appropriate valuation table) which would have been applied had the net level basis óf computation been used and had the policy been issued 2 years later than its actual issue date, at an issue age 2 years older than its actual issue age. If the amount so computed was positive, it was added to the mid-terminal reserves.
(c) If the amount computed as described in preceding clause (b) was zero or negative, zero was added to the mid-terminal reserves.
(d) Zero was added to the mid-terminal reserves for each policy in force 2 years or less as of the valuation date.
As an example of the foregoing computation, if an insured purchased a policy in 1971 at the age of 30, petitioner would have added zero with respect to such policy to the mid-terminal reserves computed as of December 31, 1971, and December 31, 1972. Commencing with the December 31, 1973, valuation date (assuming renewal), petitioner would have added to the mid-terminal reserves that amount (not less than zero) which would have been required on a net level reserve basis had the policy been issued in 1973 to the insured at the age of 32.
The preliminary term method of valuation recognizes that an insurer’s administrative expenses in the first years of a policy are much higher than those in renewal years, and that conversely, claims costs will increase with age. Thus for 2 policy years or even longer, the insurer may have a substantial unliquidated initial expense before getting up reserves. For these reasons, the recommendations of the NAIC Task Force 4, and the NAIC Industry Advisory Committee on Reserves for Individual Health Insurance Policies, provide for a preliminary period of 2 years in the minimum reserve basis for individual accident and health policies.
While the reserve is mechanically developed by applying "unit” reserve factors to "unit” benefits of single policies, separate reserves are not held on single policies. Rather, the additional reserve is an aggregate reserve and has actuarial meaning only with respect to an entire group of policies. Mortality tables are used in the calculation of unit reserve values, and a mortality table assumes a large population of policyholders who are expected to die or become ill according to certain yearly death rates. The additional reserves are an aggregate amount which, together with future net premiums, will meet the benefit payments arising from the group of policies valued as such benefits accrue in the future. The application of a formula for the calculation of such reserves to an individual policy (or small group of policies) does not produce a meaningful result, since few policyholders will experience average morbidity.
As required by Missouri law, petitioner prepared for each of the years 1973 through 1976, under oath, comprehensive financial information which it included on its annual statement (hereinafter referred to as the NAIC statement). For each of the years 1973 through 1976, petitioner filed the NAIC statement with the director of the Missouri insurance division.
The purpose of the NAIC statement, which is filed by insurance companies with the insurance regulatory agency of each State in which the company is doing an insurance business, as well as with the Federal income tax return, is to provide information on the solvency of the company and with respect to whether the company is conducting its affairs in accordance with State legal requirements.
The NAIC form filed by life and accident and health companies contains a part called exhibit 9, and entitled "Aggregate Reserve for Accident & Health Policies.” Exhibit 9 of the NAIC statement is subdivided into section A (hereafter called exhibit 9A), the active life reserve section, and section B, the claim reserve section. The first line of exhibit 9A is entitled "unearned premium reserve.” The second line is entitled "additional reserves.”
The entry in line 1 of exhibit 9A of the NAIC statements of petitioner in each of the taxable years in controversy consisted solely of the gross pro rata unearned premium on all of its GRHA policies in force. The entry in line 2 in each such year consisted solely of the mid-terminal reserve computed on the 2-year preliminary term basis as previously described. During the years before the Court (1973-76), petitioner’s active life insurance reserve included additional reserves attributable to the guaranteed renewable feature of its policies.
Petitioner’s unearned premium reserves (line 1 of exhibit 9A) and additional reserves (line 2) on its individual accident and health policies, as reported on its NAIC statements, amounted to the following at the dates shown below:
Date Unearned, premium, reserves1 Additional reserves
12/31/73 $977,064.89 $32,567
12/31/74 1,197,047.00 56,742
12/31/75 1,521,578.00 92,877
12/31/76 2,089,056.00 118,686
Gross pro rata unearned premiums computed on—
Valuation date Policies in force 2 years or less Policies in force more than 2 years
12/31/73 $815,912.82 $161,212.07
12/31/74 939,802.58 257,173.65
12/31/75 1,208,063.84 313,514.16
12/31/76 1,707,736.80 381,319.20
Petitioner began issuing accident and health policies in 1968. The amounts shown on line 2 as additional reserves in each of the foregoing statements reflect the fact that in those years the bulk of petitioner’s accident and health policies in force were composed of policies in force 2 years or less.
Petitioner had its annual convention statement for each of the years 1973 through 1976 signed and certified by E. Paul Barnhart as consulting actuary. Mr. Barnhart’s qualifications fully satisfied those prescribed for a consulting actuary by the director of the Missouri insurance division. The amounts carried in petitioner’s balance sheet on account of the unearned premium reserve, and the additional reserves for individual accident and health policies which contained the clause of guaranteed renewability, as shown in exhibit 9 of petitioner’s NAIC statement for each of the years 1973 through 1976—
(a) were computed in accordance with commonly accepted actuarial standards consistently applied and were fairly stated in accordance with sound actuarial principles;
(b) were based on actuarial assumptions which were in accordance with, or stronger than, those called for in policy provisions;
(c) met the requirements of the insurance laws of Missouri;
(d) made good and sufficient provision for all unmatured obligations of petitioner guaranteed under the terms of its policies;
(e) were computed on the basis of assumptions consistent with those used in computing the corresponding items in the annual convention statement on the preceding yearend; and
(f) included provision for all actuarial reserves and related statement items which ought to be established.
Based on the advice of Mr. Barnhart, petitioner established a premium structure for its individual guaranteed renewable policies. The annual premiums charged for these policies were approximately 20 percent higher than the annual premiums petitioner would have charged for comparable policies provided on a cancelable basis. The excess premium charged (relative to identical cancelable coverage) was introduced into the pricing of petitioner’s policies in order to cover the additional cost inherent in the insurer’s obligation to renew the coverage in later years when the insured is older.
There are no differences in the terms and provisions of National States’ GRHA policies, or in the company’s obligations thereunder based upon how long the policies have been in force. Specifically, with respect to guaranteed renewability, National States is contractually bound to precisely the same extent under a GRHA policy that has been in force for 2 years or less, as it is under a GRHA policy that has been in force for a longer period.
National States’ exposure to long-term morbidity risks under its GRHA policies in force for 2 years or less was not materially different from its exposure to long-term morbidity risks under its GRHA policies in force over 2 years. Both its policies of less than 2 years duration and its policies of over 2 years duration carried long-term morbidity risks, based on one and the same provision obligating the company to renew.
OPINION
We are called upon to determine whether petitioner is a life insurance company within the meaning of section 801. Section 801 provides the following definition of a life insurance company:
SEC. 801(a). Life Insurance Company Defined. — For purposes of this subtitle, the term "life insurance company” means an insurance company which is engaged in the business of issuing life insurance and annuity contracts (either separately or combined with health and accident insurance), or noncancellable contracts of health and accident insurance, if—
(1) its life insurance reserves (as defined in subsection (b)), plus
(2) unearned premiums, and unpaid losses (whether or not ascertained), on noncancellable life, health, or accident policies not included in life insurance reserves,
comprise more than 50 percent of its total reserves (as defined in subsection (c)).
Section 801(e) provides that "guaranteed renewable life, health, and accident insurance shall be treated in the same manner as noncancellable life, health, and accident insurance.”
Accordingly, petitioner will qualify as a life insurance company if its life insurance reserves, plus unearned premiums and unpaid losses on its GRHA policies, exceed 50 percent of its total reserve (hereafter the reserve rátio test). The total reserves, as defined in section 801(c), include life insurance reserves, unearned premiums and unpaid losses not included in life insurance reserves, and all other reserves required by law. In the case of guaranteed renewable health and accident insurance policies, unearned premiums and unpaid losses are inserted in both the numerator and the denominator of this fraction — both above and below the line. If that is done in this case, it is conceded that petitioner easily qualifies as a life insurance, company. Respondent contends that unearned premiums and unpaid losses are includable only in the denominator because petitioner’s policies are not guaranteed renewable. Respondent concedes that petitioner’s policies meet the industry definition of a GRHA policy, but argues they are not guaranteed renewable within the meaning of the Federal income tax regulations. The regulations provide:
Guaranteed renewable life, health, and accident insurance policy. The term "guaranteed renewable * * * policy” means a * * * contract * * * which is not cancellable by the company but under which the company reserves the right to adjust premium rates by classes * * * , and with respect to which a reserve in addition to the unearned premiums * * * must be carried to cover that obligation. * * * [Sec. 1.801-3(d), Income Tax Regs. See sec. 1.801-3(c), Income Tax Regs, (applying to noncancelable health and accident policies).]
The parties have diametrically opposed interpretations* of this regulation. Petitioner contends that the regulation, taken from the relevant congressional committee reports (discussed infra), identifies level premium contracts with long-term obligations that by their nature require a reserve for later years when benefit costs will exceed premium income. It is undisputed that petitioner’s contracts meet this definition, and petitioner argues that that ends the matter. Petitioner contends that other provisions of the regulations make it abundantly clear that its interpretation is correct.
Petitioner emphasizes that the same long-term risks exist on all its contracts from date of issuance, whether they have been in effect less or more than 2 years. It points out that reserves are established on an aggregate basis for all its policies, and that the reserves on an individual policy basis have no actuarial meaning. The particular reserving methods adopted and the computational mechanics of that reserve, petitioner concludes, are tools the actuary uses to meet the reserve obligation arising from the nature of the contracts — they arise from, rather than define, the nature of the contract. Accordingly, petitioner asserts its contracts qualify.
Respondent argues that the regulation reflects the intent of Congress that reserves in addition to unearned premiums be computed for all noncancelable and GRHA policies. Respondent contends that unless a policy is reserved under a method that creates these additional reserves, the unearned premiums and unpaid losses attributable to that policy cannot be included in determining whether petitioner meets the reserve ratio test qualifying it for life insurance company status. Respondent recognizes that the long-term risk inherent in petitioner’s policies requires reserves. But he points out that policies in effect for less than 2 years neither enter into the computation of, nor contribute to, the additional reserves. Accordingly, he concludes premium reserves on policies in force less than 2 years go into the denominator but not the numerator of the qualifying fraction. Therefore, petitioner is not a life insurance company. We agree with petitioner on this close issue of first impression.2
Since the Code directs that GRHA policies be treated in the same manner as noncancelable health policies, we begin with the legislative history of the 1942 Revenue Act. This act expanded the definition of a life insurance company to include companies issuing noncancelable contracts of health and accident insurance. The rationale for this expansion is found in the committee reports:
Technical changes are made to distinguish in a clearer manner the types of insurance contracts included and to emphasize the fact that the unearned premiums and unpaid losses on noncancelable life, health, or accident policies, not included in life insurance reserves, are included for purposes of the definition of a life insurance company only. Since noncancelable contracts of health and accident insurance require the accumulation of substantial reserves against increased future risks, the writing of such insurance is analogous to life insurance and the definition has been changed to permit such companies to be taxed as life insurance companies. The unearned premiums and unpaid losses on noncancelable life, health, or accident policies, not included in life insurance reserves, are added to such reserves in determining whether a company is to be considered a life insurance company. The life insurance reserves defined in subsection (c)(2) as they pertain to noncancelable health and accident insurance policies are those amounts which must be reserved, in addition to unearned premiums, to provide for the additional cost of carrying such policies in later years when the insured will be older and subject to greater risk and when the cost of carrying the risk will be greater than the premiums then being received. As the term is used in the industry, a noncancelable insurance policy means a contract which the insurance company is under an obligation to renew at a specified premium, and with respect to which a reserve in addition to the unearned premium must be carried to cover the renewal obligation. * * * [S. Rept. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 504, 611-612. Emphasis added.][3]
Congress included noncancelable contracts of health and accident insurance because they "require the accumulation of substantial reserves against future risks” and therefore the writing of such insurance is "analogous to life insurance.” Petitioner’s policies require "the accumulation of substantial reserves against future risks,” and these risks commence on the date the policy is issued. Both of these characteristics make petitioner’s policies "analogous to life insurance” in the specific sense Congress used those words.
Respondent recognizes the long-term risks involved, but argues that the preliminary term method is defective because reserves are not actually computed under this method during the first 2 years. However, this hardly creates a marked difference from life insurance contracts. The preliminary term method had its origin in, and is used extensively in, the life insurance field, and the use of the preliminary term method is clearly compatible with a policy’s status as life insurance. Congress identified the long-term risks necessitating reserves as the characteristic that is "analogous to life insurance,” and the preliminary term method has long been extensively used in reserving life insurance policies against those long-term risks. Since this method has been used without any adverse tax consequences to the life insurance status of those policies, the disparity respondent introduces here is at war with the legislative history. Indeed, the analogy to life insurance is enhanced, not diminished by the use of the preliminary term method. In identifying the "types of insurance” it intended to include as "analogous to life insurance,” Congress focused not on a particular reserving mechanism, but on the necessity for reserves arising from long-term risks.
• In actuarial theory and practice, and as a matter of State regulation, it is the nature of an insurance contract that defines the reserve requirement. There are no differences in the terms of petitioner’s GRHA policies, or in the company’s obligations thereunder, based on how long the policies have been in force. Petitioner is contractually bound to the same terms and exposed to the same risks under a GRHA policy that has been in force for 2 years or less as it is under a GRHA policy that has been in force for a longer period.
Again, petitioner’s exposure to long-term morbidity risks under its GRHA policies in force for 2 years or less was not materially different from its exposure to long-term morbidity risks under GRHA policies in force for more than 2 years. All of these policies carried long-term morbidity risks, based on the same provisions obligating the company to renew.4
Accordingly, it is difficult to see how respondent’s- 2-year distinction is relevant in determining whether in the words of Congress, these policies are "analogous to life insurance,” in exposing the company to long-term risks necessitating reserves. We are not aware that respondent makes any distinction in the analogous area of life insurance on the basis of policies that are reserved on the preliminary term method. It is hardly treating noncancelable and guaranteed renewable health and accident insurance policies in an analogous way to introduce a distinction solely in this area.
Additionally, Congress focused on, and adopted, the definition of a noncancelable insurance policy "as the term is used in the industry.” Indeed, Congress specifically stated that "As the term is used in the industry, a noncancelable insurance policy means a contract which the insurance company is under an obligation to renew at a specified premium, and with respect to which a reserve in addition to the unearned premium must be carried to cover the renewal obligation.” S. Rept. 1631, supra, 1942-2 C.B. at 612 (emphasis added). See also H. Rept. 2333, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 372, 454 (using virtually identical language). This definition, which is the same today as when Congress adopted it, applies to GRHA policies with modifications not relevant to the present controversy. We think this is significant (cf. Alinco Life Insurance Co. v. United States, 178 Ct. Cl. 813, 373 F.2d 336, 353 (1967)), for the parties have stipulated, and we have found, that all of petitioner’s GRHA policies satisfy the industry definition.
The language of the disputed regulation is taken almost verbatim from the 1942 committee reports set out above. It is difficult to see how respondent can stipulate that petitioner’s policies meet the industry definition of a guaranteed renewable contract and at the same time contend that the language of the committee report (as incorporated in the regulations) precludes petitioner from qualifying. We believe the language of the committee report makes it clear that Congress intended to identify a product "type,” and employed the term "noncan-celable” (and guaranteed renewable) "as that term is used in the industry.” The regulation, lifted virtually verbatim from the committee reports, must be interpreted accordingly.
The parties analyzed various arcane aspects of actuarial theories at some length. Petitioner argues that in accordance with the specific requirements of the actuarial authorities and State law, the additional reserves from its GRHA policies are aggregate reserves applicable to all its GRHA policies on which it incurs the same risk from the date of issue. Petitioner emphasizes that insurance is spreading the risk through averages incorporated in mortality and morbidity tables. While unit reserves are applied to individual policies, petitioner continues, it makes no sense to view reserves as applicable to one policy (or a small number of policies), since one policyholder either lives or dies, or gets sick or remains well during the year, but does not experience averages. Respondent, as he must, concedes most of this, but says it begs the question, the question being to what group the aggregates apply. He contends the aggregates are applicable to the groups of policies on which they are computed and from which they are derived — those in effect 2 years and longer.
Petitioner has the better of this argument. Both in actuarial theory and as a matter of law, the reserves computed on the preliminary term basis are applicable to all of petitioner’s policies — whether in effect more or less than 2 years. The reserves are aggregates and are applicable to all petitioner’s policies in precisely the same way as reserves computed on a net level premium basis — there is simply no difference in the scope of this application. It is true that under the mechanics of computing the mid-terminal reserve on the preliminary term basis, a zero amount is added to the reserve for the policies that have not yet passed their second anniversary, while larger amounts are added for policies beyond their second anniversary date. But the method of derivation cannot obscure the fact that, both in legal and actuarial theory, the amount derived under both the preliminary term and net level premium bases is an aggregate reserve equally applicable in both instances to policies under and over 2 years of age.
The basic difference between the net level method and the preliminary term method is the amount of front-end expense allowance and the additional net premium subsequently necessary to fund this expense allowance. If petitioner’s GRHA policies are viewed as 2-year term policies (for which no reserves are set up) followed by a permanent policy issued to an insured 2 years older and for a premium payment period 2 years shorter, the net premiums after the first 2 years must be larger. See D. Gregg & V. Lucas, Life and Health Insurance Handbook 165 (3d ed. 1973). The increase in the net premium (with a consequent reduction of the loading element in the level gross premium) will be equal to the annual sum necessary to amortize the first 2-year reserve not established under the preliminary term method. Gradually, the reserves grade to net level over the premium paying period of the policy. Put differently, the amount ultimately accumulated will be the same under either method.
In summary, on the record before us, the two reserving methods are, over time and from the viewpoint of actuarial soundness, tweedledum and tweedledee. Neither changes the nature of the insurance policies it addresses, but responds to the identical characteristics of those policies necessitating reserves — long-term risks. With this in mind, it is idle theoretical discourse to speculate about companies whose entire inventories of policies are over 2 years or under 2 years. Congress has legislated through the years not with theoretical constructs in mind, but for companies participating in a dynamic industry year after year. As a new company, a greater proportion of petitioner’s policies were less than 2 years old, but many of its policies were more than 2 years old. As in any dynamic business, this distribution would change from year to year and generally the portion attributable to policies in force 2 years or more will increase the longer a company is in business. However, a sharp increase in business for 2 years could subsequently alter the proportion again in favor of policies under 2 years in age.
Under respondent’s interpretation, an admittedly qualified insurance company that branches into noncancelable health policies reserved on the preliminary term basis could lose its life insurance status. In 3 years or so, as their policies age, they could requalify. If they had a sharp increase in sales a couple of years later, they would be disqualified again, only to re-requalify later. We doubt that Congress intended any such distinction between the preliminary term and net level reserving methods, particularly since it has encouraged the use of the preliminary term method. See sec. 818(c) and discussion infra.
Possibly it was with these thoughts in mind that respondent promulgated section 1.801-3(b)(2) of the regulations, which plainly resolves any remaining doubts in petitioner’s favor. That regulation provides:
•An insurance company writing only noncancellable life, health, or accident policies and having no "life insurance reserves” may qualify as a life insurance company if its unearned premiums, and unpaid losses (whether or not ascertained), on such policies comprise more than 50 percent of its total reserves.
This language unequivocally states that a company issuing only noncancelable health policies may qualify under the reserve ratio test on the basis of its unearned premiums and unpaid losses alone.5 Although policies reserved under the preliminary term method produce zero life insurance reserves during the first 2 years, the language of this regulation plainly permits this.
Additionally, if we interpret the earlier regulation (section 1.801-3(d), Income Tax Regs., defining guaranteed renewable policies) as referring to policies that by their nature require reserves to reflect long-term risks, both regulations are entirely consistent. On the other hand, respondent’s reading of the regulation defining guaranteed renewable policies.requires reserves for each policy in every year and makes those two regulations difficult to reconcile. Indeed, if respondent’s position is correct, the situation contemplated in the above regulation could hardly arise because the company would have to have "life insurance reserves” (i.e., additional reserves, see sec. 1.801-4(d)(3), Income Tax Regs.) in order for its policy to qualify as "guaranteed renewable” in the first place. Accordingly, we conclude that although policies reserved under the preliminary term method produce zero life insurance reserves during the first 2 years, the regulations clearly permit this as consistent with life insurance status.6
We also believe respondent’s position is incompatible with the congressional purpose underlying section 818(c). Without belaboring the complications, higher reserves reduce both the phase I and phase II tax computations. Solely for tax computation purposes, Congress in section 818(c) permits companies under the preliminary term method to constructively recompute their reserves on a net level method in order to equalize the computation of the reserves-earnings deductions. The legislative history explains:
Most life insurance companies compute their reserve funds on the basis of a level net premium. A number of life insurance companies, however, especially smaller companies in the early stages of operation, compute their reserve funds by some form of preliminary term method, such as full preliminary term, modified preliminary term (Illinois standard) or select and ultimate. These reserve standards require lower reserves in the earlier years of a policy than does the more usual level net premium method. In order to equalize the computation of the reserve earnings deduction, an additional amount equal to 7 per cent of the life insurance reserves computed on a preliminary term basis is to be added in computing the adjusted reserves. [H. Rept. 2333, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 372, 454. See S. Rept. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 504, 612; see also S. Rept. 291, 86th Cong., 2d Sess. (1959), 1959-2 C.B. 770, 792.]
Congress wanted to assist new and smaller companies using the preliminary term method. But if respondent is correct, this attempt at equalization is futile, since small new companies issuing principally noncancelable or guaranteed renewable policies reserved on the preliminary term method would be unable to qualify as life insurance companies for several years. We are unwilling to assume an interpretation that, in addition to many other difficulties, undermines section 818(c).
When contracts are reserved on the preliminary term method, respondent would apply the benefits of section 818(c) to those contracts after 2 years, when at that time they become noncancelable or GRHA contracts in accordance with his interpretation of the regulations. But applying section 818(c) at this point would be perverse, since reserves accumulated under a guaranteed renewable policy after the second year are higher on a preliminary term basis than they would be on a net level basis.
The parties have added embellishments to the arguments previously discussed, and we have carefully reviewed them. They do not warrant adding to the length and complexity of this opinion.7 Suffice it to say that the preliminary term method, developed for new and smaller companies by State insurance officials, is the most common method in use for GRHA policies. We are convinced the profound distinctions respondent proposes to introduce between this method and the net level method are warranted by neither the statute nor the underlying congressional intent.
Decision will be entered under Rule 155.
Reviewed by the Court.
All section references are to the Internal Revenue Code of 1954 as amended, unless otherwise stated.
The distribution of unearned premiums by policies in effect under 2 years and over 2 years, is as follows:
Bqth parties agree that the question before us has not been the subject of prior litigation. Group Life & Health Insurance Co. v. United States, 434 F.2d 115 (5th Cir. 1970), declaring sec. 1.801-3(d), Income Tax Regs., valid, dealt with a step-rate premium permitting adjustments in response to an increase in the actuarial risk. 434 F.2d at 119. Group life established neither the existence of, nor the need for, reserves on the type of policy involved, and the Government’s actuary testified additional reserves were not required. 434 F.2d at 120.
When Congress required GRHA policies to be treated the same as noncancelable health policies, it again referred to the "type of insurance contracts” it had in mind.
"The type of insurance contracts referred to are life, health, and accident policies which are not cancelable by the company but under which the insurance company reserves the right to adjust premium rates by classes, in accordance with experience under the type of policy involved. [S. Rept. 291, 86th Cong., 2d Sess. (1959), 1959-2 C.B. 770, 793. (Emphasis added.) See also H. Rept. 34,86th Cong., 1st Sess. (1959), 1959-2 C.B. 736,748.]”
Petitioner on brief offers the following example. Assume petitioner sells B a GRHA policy at age 50. His twin brother purchases an identical policy 2 years later, when they are both 52. Although the obligations and risks are identical, respondent claims one is guaranteed renewable, the other is not. We agree with the petitioner that this is a thin distinction.
Guaranteed renewable policies are treated in the same manner as noncancelable policies, which are defined in sec. 1.801-3{c), Income Tax Regs. See sec. 801(e).
Petitioner emphasizes that respondent, until recently, agreed with its interpretation of sec. 1.801-3(d), Income Tax Regs. The parties have stipulated a 1964 Technical Advice Memorandum wherein respondent stated:
"To interpret section 1.801-3(d) of the Regulations as requiring an additional reserve in order that a particular policy may qualify as a guaranteed renewable life, health, and accident contract would obviously be inconsistent with section 801(e) and section 1.801-3(b)(2) which indicate clearly that policies may be 'noncancellable’ even though no 'life insurance reserves’ are held with respect thereto. Accordingly, it is concluded that the words 'with respect to which a reserve in addition to unearned premiums * * * must be carried * * * ’ are only intended as a general description of the long-term, increasing risks usually covered in noncancellable or guaranteed renewable health and accident policies, which over the life of the contracts require a reserve in addition to gross unearned premiums. It should not be construed as a specific requirement that such a reserve must actually be held in the earlier years of the policy term.”
Petitioner notes its earlier years were closed by an agent consistent with this interpretation, and that they have now been unfairly caught in midstream by an impermissible retroactive change. In view of our decision, we need not rule on this matter.
The major argument we have avoided concerns whether some portions of petitioner’s unearned premium reserves are "additional reserves.”