dissenting: I respectfully dissent. The issue presented for our decision in this case is whether petitioner’s accident and health policies which were in force 2 years or less, and with respect to which petitioner valued mid-terminal reserves on the 2-year preliminary term basis, qualified as "noncancellable” or "guaranteed renewable” accident and health policies for Federal tax purposes.
In resolving this issue, we are not provided with statutory guidance since the Internal Revenue Code nowhere defines the terms "noncancellable” or "guaranteed renewable” accident and health policies. Sections 1.801-3(c) and 1.803-3(d), Income Tax Regs., do define these terms, however, and we are thus called upon to interpret these regulations.
The specific terms of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., provide, inter alia, that, in order for a policy of accident and health insurance to be classified as "noncan-cellable” or "guaranteed renewable” for Federal tax purposes, it must be one which the issuing company is under an obligation to renew at a specified premium (in the case of noncancelable policies) or at a premium rate which can be adjusted by class according to experience (in the case of guaranteed renewable) and with respect to which a reserve in addition to unearned premiums must be carried to cover the obligation to renew. Thus, under the regulations, an insurance company must assume a long-term risk and be required to carry a reserve to cover that risk with respect to each policy which it seeks to classify as noncancelable or guaranteed renewable for Federal tax purposes.
There is no question that the policies under consideration are policies which the issuing company is under an obligation to renew at a specified premium or at a premium that can be adjusted only by class according to experience, and respondent does not contend otherwise. The focus of our inquiry is whether the "reserve” requirement imposed by the regulations is satisfied during the first 2 years of the policies’ existence under the 2-year preliminary term method of reserving as employed by petitioner. That is, can petitioner’s accident and health policies 2 years or less in force legitimately be considered to be policies "with respect to which a reserve in addition to unearned premiums must be carried” to cover petitioner’s obligation to renew?
The majority, answers the above question in the affirmative. In reaching this conclusion, the majority appears to rely upon two separate theories. First and primarily, it seems to feel that the sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., were meant to generally define those accident and health insurance policies which are long-term policies for which the issuing company may be required to establish reserves at some time. Under this interpretation, whether petitioner was required to actually establish reserves with respect to its policies during their first 2 years of existence thus becomes irrelevant since the policies in issue are clearly long-term policies which, by their nature, may require petitioner to begin to accumulate reserves at some future time. Second, the majority appears to have accepted petitioner’s argument that the reserves which petitioner has actually established during the years in issue are to be considered to be maintained "with respect to” accident and health policies in force 2 years or less within the intendment of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., even though such policies in no way contribute computationally to such reserves. Under this reasoning, the "additional reserve” requirement of the regulations is, according to the majority, satisfied with respect to all of petitioner’s renewable accident and health policies' from the date of issuance.
I do not think that either of the above two theories represents an adequate basis for the majority’s resolution of the issue presented in this case. In my opinion, the definitional regulations may only legitimately be read to require a "reserve in addition to unearned premiums” to be actually carried (i.e., computed and set aside) with respect to each policy, for each and every year the taxpayer seeks to classify a particular policy as noncancelable or guaranteed renewable for Federal tax purposes. It is my further belief that petitioner’s accident and health policies in force 2 years or less failed to meet these definitional standards under the 2-year preliminary term method employed by petitioner. The reasons for my respective conclusions are set out in the following subsections.
I. The Requirement of an Additional Reserve— Its Genesis and Rationale
A company which qualifies as a "life insurance company” under section 801(a)1 receives a preferred Federal tax status relative to that of other insurance companies and corporations. The question presented in the present case — i.e., whether petitioner’s accident and health policies 2 years or less in force qualified as noncancelable or guaranteed renewable policies for Federal tax purposes — is important only because its resolution will determine whether petitioner was qualified to receive the preferred tax status afforded to "life insurance companies.” The proper interpretation of the regulations that define "noncancellable” and "guaranteed renewable” accident and health policies must therefore be made in light of considerations that prompted Congress to afford favorable Federal tax treatment to "life insurance companies.” Otherwise, we risk employing an interpretation which would cause the regulations to fail to harmonize with the premise that underlies the statute they purport to interpret. Such a reading must clearly be avoided. See, e.g., Maximov v. United States, 373 U.S. 49 (1963); Burnet v. Guggenheim, 288 U.S. 280 (1933).
The unique system of Federal income taxation of life insurance companies had its genesis in the Revenue Act of 19212 (hereinafter the 1921 Act). Prior to 1921, life insurance companies had been taxed under a system comparable to other corporations in that all of the income of such companies, including income derived from investments, as well as premium receipts, was subject to tax.3 However, due to the peculiar nature of the life insurance business, fundamental inequities were perceived to flow from the application of general corporate taxation rules to life insurance companies.4 In particular, it was pointed out to Congress that the application of standard tax accounting conventions which, in end result, offset current expenses against current receipts and thereby arrive at the "taxable income” of a business for a particular year, could prove to be an inadequate measure of the annual income of companies issuing long-term life insurance policies. This is because companies issuing such policies assume long-term actuarial risk and are required by State law to set aside current receipts or other assets in reserves to cover those risks. When a company is required to set aside current receipts in reserve to pay future claims under a policy, such receipts are not currently available for general corporate purposes, or for distribution to shareholders. As such, amounts required to be reserved by a life insurance company are, in the words of the Supreme Court "not true income, but analogous to permanent captial investment.” (Fn. ref. omitted.) Helvering v. Oregon Mutual Life Insurance Co., 311 U.S. 267, 269 (1940). See also National Life Insurance Co. v. United States, 277 U.S. 508 (1928); Economy Finance Corp. v. United States, 501 F.2d 466, 481 (7th Cir. 1974), cert. denied 420 U.S. 947 (1975); Group Life & Health Insurance Co. v. United States, 434 F.2d 115, 117 (5th Cir. 1970), cert. denied 402 U.S. 944 (1971); Alinco Life Insurance Co. v. United States, 178 Ct. Cl. 813, 373 F.2d 336 (1967).
This characterization of the life insurance business led Congress to conclude that "life insurance companies” should be taxed differently from other corporations. In enacting corrective measures, however, Congress did not choose to adopt statutory provisions which ferret out each portion of an insurance company’s gross receipts which were not the proper subject for current taxation. Instead, extremely broad standards were adopted. Under the 1921 Act, "life insurance companies” were allowed to exclude 100 percent of annual premium receipts from gross income.5 Significantly, however, those companies which were to be afforded this preferential tax status were defined by reference to the qualitative nature of their reserves. Thus, only a "life insurance company” was to be afforded the above-noted beneficial tax treatment and such a company was defined in the 1921 Act as:
an insurance company engaged in the business of issuing life insurance and annuity contracts * * * the reserve funds of which held for the fulfillment of such contracts comprise more than 50 per centum of its total reserve funds.[6]
The expressed goal of the above reserve ratio test was to distinguish between those companies whose predominate business for any given year was the issuance of "life insurance” from those companies whose predominate business for any given year was the issuance of accident and health insurance. As explained by T. S. Adams, then tax adviser to the Treasury, the rationale underlying the 50-percent life insurance qualification formula was as follows:
Some companies mix with their life business accident and health insurance. It is not practicable for all companies to disassociate those businesses so that we have assumed that if the accident and health business was more than 50 percent of their business, as measured by their reserves, it could not be treated as a life insurance company. On the other hand, if their accident and health insurance were incidental and represented less than 50 percent of their business we treated them as life insurance companies.!7!
The distinction between predominately life companies and predominately accident and health companies was necessary under the statutory scheme because, in 1921, accident and health policies were essentially short-term policies, and current premium receipts were therefore treated as entirely earned by the issuing company at the end of the current periodic premium-paying period. As such, premiums received with respect to such policies were not required to be segregated into long-term reserves, and companies whose predominate business, as measured by their reserves, consisted of the issuance of such policies should not, in Congress’ view, be entitled to exclude annual premium receipts from current taxable income. That is, the "true income” of such a company could be adequately measured annually by invoking standard tax accounting conventions, since no long-term reserve requirement accompanied such policies.
As the insurance industry evolved after 1921, the accident and health business sold by life-type companies began to vary and expand considerably.8 Such companies began writing accident and health policies which were renewable at the option of the insured at a level, unadjustable premium rate over a long period of time. Later, such companies developed an analogous long-term accident and health policy whose premium rate could be adjusted by class in accordance with the issuing company’s experience under the policy, but could not be adjusted due to the increased age and underwriting status of the insured. Since both of these types of long-term accident and health policies impose actuarial risks upon the issuing company which will not be sufficiently offset by premium receipts in the later years of the policies, Congress perceived that a certain percentage of current premiums received with respect to such policies would be required to be segregated into long-term reserves to cover such risks. When the predominate business of a company for any given year was of a nature which required the company to treat a significant percentage of current premium receipts as unearned (i.e., to establish long-term reserves with respect thereto), Congress concluded that such companies should be afforded the same preferential tax treatment as "life insurance companies.”
When Congress expanded the definition of a "life insurance company” in 1942 and 19599 to include those companies predominately issuing "noncancellable” and "guaranteed renewable” accident and health policies, respectively, the need to establish long-term reserves against increased future risks with respect to such policies was thus explicitly recognized as justifying the expansion. In fact, the legislative history indicates that Congress considered the sole reason those policies should be treated as "life insurance policies” for purposes of the reserve ratio test of section 801 was because a long-term reserve was perceived as required with respect to such policies. Thus, in its report on the 1942 Act, the Senate Finance Committee stated:10
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. * * * 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 unearned premiums must be carried to cover the renewal obligation. [Emphasis supplied.]
In light of the above-outlined history of taxation of life insurance companies and, in particular, the Senate report quoted immediately above, I find that I must take issue with the majority’s primary conclusion that, for purposes of resolving the issue before us, the reserves arise from, rather than define, the nature of the contract. Quite to the contrary, it is apparent that the sole reason Congress considered itself justified in expanding the definition of a "life insurance company” to include companies predominately issuing non-cancelable and guaranteed renewable accident and health policies was because such policies "require the accumulation of substantial reserves.” For purposes of determining the Federal tax classification of such a policy, therefore, the reserve does in fact define the contract. The mere fact that a policy of accident and health insurance is a long-term policy was not intended to be the determining factor in classifying the policy for Federal tax purposes.
Sections 1.801-3(c) and 1.801-3(d) of the regulations recognize this fundamental fact. Under these regulations, a policy of accident and health insurance will only qualify as noncan-celable or guaranteed renewable for Federal tax purposes if it is one which the issuing company is under an obligation to renew for á specified period and with respect to which a reserve in addition to unearned premiums must be carried to cover that obligation to renew. Moreover, since the Federal tax classification of an insurance company must be made on an annual basis, it seems fundamental to me that the specific definitional requirements of policies which are to contribute to a company’s classification as a "life insurance company” must also be satisfied for each and every year the preferred classification is sought. Although a policy may be a level premium policy which the company is under an obligation to renew, unless the company is required to currently establish long-term reserves to cover its obligation to renew the policy is simply not the type of policy which Congress intended to contribute to a company’s current classification as a "life insurance company.”
Any other reading of these regulations, in my opinion, would not be in keeping with the premise underlying the expansion of the definition of a "life insurance company” to include those companies issuing predominately "noncancellable” or "guaranteed renewable” accident and health policies.
The long-term liability to renew under a level premium accident ánd health policy may exist from the date the policy is first issued. However, such a liability can in no way be considered an "accrued” liability, since the time and amount of ultimate payment under the policy depends upon future events. The reserve quantifies this otherwise unquantifiable obligation through implementation of actuarial theory and requires the segregation of assets which would otherwise remain available for general corporate use. Until the company takes that reserving step with respect to premiums received on a particular policy, the above-cited legislative history indicates that the policy is not the type of policy that was intended to contribute positively to a company’s "life insurance company” status.
I would therefore read sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., to require a long-term reserve to be actually established (i.e., computed and set aside) to cover the company’s obligation to renew a policy before that policy is to be classified as noncancelable or guaranteed renewable for Federal tax purposes. Cf. Economy Finance Corp. v. United States, supra at 482, where the Seventh Circuit Court of Appeals cited with approval a Revenue Ruling (Rev. Rul. 71-367, 1971-2 C.B. 258), which adopts this interpretation.
II. Do Petitioner’s Policies Qualify?
A. Operation of the 2-Year Preliminary Term Method
I would thus read sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., to require that a long-term reserve be currently maintained with respect to a policy of accident and health insurance before that policy will be classified as noncancela-ble or guaranteed renewable for Federal tax purposes. Were these definitional requisites met by petitioner’s policies 2 years or less in force under the 2-year preliminary term method of reserving employed by petitioner? A close examination of the operation of the 2-year preliminary term method leads me to conclude that the answer to this question must be in the negative.
As already stated, the policies in dispute in this case were clearly long-term policies which were renewable at. the option of the insured at a level premium., Thus, in establishing the premium rate to be charged for its!: renewable policiesb jt was . necessary -that ctfc term as wéll ás thé cost of the long-term risks, áetuaríally computed, represented by petitioner’s promise to renew the policy at a level premium. This latter amount (i.e., the amount petitioner charged which was allocable to its obligation to renew) is quite clearly that amount which Congress contemplated to be required to be set aside as a "reserve in addition to unearned premiums” before a policy would be classified as noncancelable or guaranteed renewable for Federal tax purposes. As the relevant Senate report states, "reserves in addition to unearned premiums” are:
those amounts which must be reserved * * * , to provide for the additional cost of carrying [noncancelable policies] in later years when the insured will be older and subject to greater risks and when the cost of carrying the risk will be greater than the premiums being received.[11]
The amount which is required to cover petitioner’s "obligation to renew” a particular level premium policy as that term is used in sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., is thus an actuarially quantifiable dollar amount which can be computed on each periodic premium payment made with respect to each policy in force. Such amount (i.e., the amount representing petitioner’s obligation to renew), actuarially computed, equals the amount by which the present value of future benefits to be paid under a particular policy exceeds the present value of future net valuation premiums (i.e., generally all future premiums to be received by the company) under that policy.
However, under the 2-year preliminary term method of computing mid-terminal reserves, the fact that petitioner included in its gross premium charge an amount intended to cover its obligation to renew which it admittedly incurred under its level premium policies was completely ignored for purposes of reserving. In fact, for purposes of reserving, policies less than 3 years old are treated as though they were nonrenewable, short-term policies under the 2-year preliminary term method. Thus, with respect to policies 2 years or less in force, petitioner was required to establish only short-term (unearned premium and unpaid loss) reserves and no provision was made to cover petitioner’s obligation to renew. (For further discussion of this point, see infra.)
This point is made clear by the mechanics petitioner employed in computing its mid-terminal reserves. As the parties have stipulated: "Under a preliminary term method, the dollar amount of that [terminal] reserve is the excess of the present value of future benefits over the present value of future net valuation premiums on each renewable policy which has been in force for more than the preliminary term at the statement date, but does not include any amount representing the excess of the present value of future benefits over the present value of future net valuation premiums on those renewable policies which have been in force for a period equal to or shorter than the preliminary term being used.”12 (Emphasis supplied.)
Thus, although it is clear that petitioner incurred an obligation to renew, and that that obligation to renew could be represented by an actuarially quantifiable dollar amount, it is also clear that, under the 2-year preliminary term method of reserving employed by petitioner, that amount representing its obligation to renew was not required to be placed into a terminal reserve until and unless the policy entered its third year. Premiums received with respect to all of petitioner’s renewable policies in force 2 years or less were treated as totally earned at the end of each year and were therefore subject to unrestricted corporate use. In my opinion, there is simply no legitimate way that these policies 2 years or less in force can be said to be policies with respect to which a reserve in addition to unearned premiums must be carried to cover petitioner’s obligation to renew within the meaning of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs. Although the obligation to renew may exist during the policies’ first 2 years, this obligation was not acknowledged and quantified by a reserve as these regulations specifically require.
The majority, in reaching the opposite result, appears to have been influenced by the testimony of the petitioner’s experts that the 2-year preliminary term method is an actuarially sound method of computing reserves. Thus, the majority states in the companion case of National States Insurance Co. v. Commissioner, 81 T.C. 325 (1983) (Court reviewed), that the net level and the preliminary term methods of reserving are, from the viewpoint of actuarial soundness, "tweedledum and tweedledee.” From this the majority concludes that since the policies reserved under the net level method would satisfy the definitional requisites of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., then policies reserved under the 2-year preliminary term method should also.
We are, however, not called upon in this case to determine the relative actuarial soundness of the preliminary term method reserving vis-a-vis the net level method. Considerations which give rise to an actuary’s conclusion that a particular method of reserving is "sound” in any given context are, in my view, quite irrelevant for purposes of the issue we have before us in this case. Of primary concern to actuarial theory is the solvency of a company over time. As noted above, the Internal Revenue Code provisions here involved are ultimately concerned with the proper Federal tax classification of an insurance company.
Moreover, although no one will dispute that under the 2-year preliminary term method of reserving the amount accumulated in a reserve for a particular policy will ultimately be the same as under the net level method if the policy remains in force for the entire policy term, this fact should not be determinative. The salient fact here is that under the net level method, long-term reserves are required to be accumulated beginning with the first policy year, while under the 2-year preliminary term method, no long-term reserves are required to be established until and unless the policy enters its third year.
Policies reserved under the net level method thus meet the specific requirements of the sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., in their first year, their second year, and every subsequent year the policy is in force.13 A certain percentage of each annual premium received with respect to such policies will therefore not be useable by the issuing company in the year received, and such policies should contribute positively to the issuing company’s life insurance status, under the statutory scheme.
With respect to policies reserved on the 2-year preliminary term basis, however, the situation is quite different. No portion of the premiums received with respect to such policies will be required to be set aside in long-term reserves on either of the first 2 years of the policies’ existence; nor will any contribution to the reserve with respect to those policies be made from any other source.14 One hundred percent of such premiums will therefore be totally available to the issuing company for general corporate purposes and the specific requirement of an additional reserve contained in sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., will not be satisfied during those 2 years. If the policy is canceled before it enters its third year, no additional reserve will have ever been required or maintained with respect to that policy and the specific definitional requirement of the regulations will therefore never have been satisfied.
This fundamental fact cannot be ignored. Accident and health insurance has, as a general rule, a relatively high early cancellation rate, and it cannot be doubted that a certain percentage of petitioner’s renewable policies will be canceled by the insured before they enter their third year. This fact is, of course, considered by the actuary in determining whether a preliminary term method is "actuarially sound” since there is no actuarial reason for establishing long-term reserves with respect to policies which can be predicted to be essentially short term.
Thus, although the 2-year preliminary term method of reserving may be actuarially sound, it is clearly not so because it requires the company to establish reserves in addition to unearned premiums to cover the company’s long-term obligation to renew during the policies’ first 2 years. It may be actuarially sound for reasons (e.g.,' high early cancellation rate) which are completely irrelevant for purposes of determining the Federal tax classification of the policies with respect to which it is employed. The salient point here is that, under the method, no reserve in addition to unearned premiums is required to be established to cover petitioner’s obligation to renew its policies 2 years or less in force and there can, in my opinion, simply be no argument based upon the relative actuarial soundness of the preliminary term method vis-a-vis the net level method.
B. Petitioner’s "Aggregate” Theory of Reserving
Petitioner argues that even though its policies in force 2 years or less did not contribute computationally to its mid-terminal reserves under the 2-year preliminary term method, it nonetheless should be considered to have maintained a reserve in addition to unearned premiums to cover its obligation to renew with respect to such policies. Petitioner argues that its mid-terminal reserves, as reflected on line 1, part 3A of schedule H of its annual statement, are properly viewed only as an aggregate liability carried with respect to all of its renewable policies within the intendment of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., whether a particular policy contributes computationally to the reserve or not. The majority appears to have accepted this contention; I cannot.
Initially, the very language of the regulations we are interpreting in this case militates against such a conclusion. Sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., are drafted in the singular. They require that in order for a policy to be classified as noncancelable or guaranteed renewable it must be an accident and health contract which the insurance company is under an obligation to renew and with respect to which a reserve in addition to unearned premiums must be carried to cover that obligation to renew.
As noted above, the obligation to renew a particular policy can be represented by an actuarially quantifiable dollar amount. This amount constitutes the amount by which the present value of future benefits to be paid under the policy exceeds the present value of future net valuation premiums on that policy. Despite the fact that each of petitioner’s policies 2 years or less in force may produce a positive dollar amount if it was subjected to the above calculation, under the preliminary term method of reserving, no amount will be contributed to a mid-terminal reserve with respect to that policy. Moreover, the amounts which actually contributed to a mid-terminal reserve with respect to other policies which have passed their third year of existence are only those amounts assumed sufficient to cover the actuarial risks attributable to those policies (see note 14 supra). No amounts are contributed to cover risks incurred on policies 2 years or less in force.
• It can be conceded that the total dollar amount of a reserve is, in a sense, an aggregate amount, and that the term "reserve” has only limited significance when not viewed in the aggregate. To use respondent’s example, the insured under a $1,000 face amount life insurance policy either will or will not die during the current policy year and the company’s liability under the policy either will or will not mature. Thus, while the actuarial probability of death could be computed at the beginning of the policy year at, say, .00426, it would be meaningless to speak of a reserve of $4.26 to provide for the risk that the issuing company would have to pay a $1,000 death claim. The reserve simply means that the probability is that out of 1 million persons similarly situated, about 4,260 can be predicted to die within the period. Thus, the reserve is simply computed by multiplying .00426 by the number of $1,000 life exposures falling within the class, and the aggregate amount thus computed makes up the reserve.
However, the fundamental fact here is that the total dollar value of a reserve does not arise in a vacuum. This dollar figure is a result of the summation of actuarially computed dollar amounts derived from premiums paid on each individual policy which, under the valuation method selected by the insurer, are to contribute to the reserve. The aggregate amount thus computed represents the actuarial estimate of the amount assumed sufficient to meet claims which arise under those policies which contribute computationally to the reserve. I do not think that these reserves can legitimately be considered to be maintained "with respect to” such noncontributing policies within the meaning of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., by invoking a convoluted "aggregate theory” of reserves. Indeed, the Supreme Court has, in an analogous context, specifically rejected the proposition that "reserves follow the risks.” See United States v. Consumer Life Insurance Co., 430 U.S. 725 (1977).
Petitioner’s experts in this case have made much of the fact that all of the assets retained in petitioner’s mid-terminal reserves are potentially available to meet the claims of insureds holding any renewable policy. However, this fact should not lead to the conclusion that such reserves are carried "with respect to” petitioner’s renewable policies 2 years or less in force within the intendment of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs. As petitioner’s expert conceded, the assets maintained in petitioner’s mid-terminal reserve with respect to a particular class of policies, as well as other company assets, may become subject to the claims of any policyholder, whether the particular policy under which the insured asserts his claim contributed to the specific reserve or not. For example, if a company, issuing both a class of cancelable policies with respect to which no mid-terminal reserves are maintained, and a class of policies with respect to which it has accumulated mid-terminal reserves, finds that its unearned premiums and unpaid loss reserves are insufficient to satisfy claims arising under its cancelable policies during a particular year, it would nonetheless be required to satisfy claims arising under such policies out of its accumulated mid-terminal reserves (assuming unallocated surplus was insufficient to satisfy such claims). The same would be true with respect to petitioner’s renewable policies in force less than 2 years. That is, if the gross unearned premium reserve maintained with respect to such policies proved inadequate to satisfy claims arising under such policies in a given year, petitioner would nevertheless be required to satisfy those claims out of its accumulated mid-terminal reserves even though such policies had never contributed any portion of their premiums to such reserve. In this sense, the company’s liability on all of its contracts of insurance is an aggregate liability. This fact should not be distorted to lead us to conclude that the additional reserve requirements of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., were satisfied by policies that in no way contribute to a long term reserve.
III. Did Petitioner’s Unearned Premium Reserves Contain Reserves in Addition to Unearned Premiums?
The majority found it unnecessary to address petitioner’s argument that its unearned premium reserves on policies 2 years or less in force somehow contained a "reserve in addition to unearned premiums.” Since I feel that the theories that the majority relies upon do not support its ultimate conclusion, I find it necessary to consider this argument.
Specifically, petitioner maintains that the term "unearned premiums,” as defined in section 1.801-3(e), Income Tax Regs., was intended to refer to net rather than gross unearned premiums, and since petitioner maintained gross unearned premium reserves with respect to all of its renewable policies, including those in force 2 years or less, it in fact maintained reserves in addition to "unearned premiums” as that term is defined by the regulations. Additionally, petitioner points out that the premium charged for its renewable accident and health policies included an element which was intended to cover petitioner’s obligation to renew the policy at a level premium. To the extent that this additional premium charge was included in the unearned premium reserve maintained with respect to each of its renewable policies, petitioner contends that reserves in addition to unearned premiums were required or carried to cover its obligation to renew such policies as required by sections 1.801-3(c) and 1.801-3(d), Income Tax Regs.
Sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., require that, in order to be classified as a noncancelable or guaranteed renewable policy for Federal tax purposes, a reserve in addition to unearned premiums must be carried to cover the issuer’s obligation to renew or continue the policy at a specified premium. In its report accompanying the 1942 Act, the Senate Finance Committee clearly articulated the types of reserves which it contemplated to fall within the definition of "reserves in addition to unearned premiums.” Such reserves included:
Those amounts must be reserved * * * to provide for the additional cost of carrying [noncancelable] 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 being received. [Emphasis supplied.}15!
The reserve contemplated is thus a long-term reserve. However, the unearned premium reserve, whether maintained on a gross or net basis, and whether maintained with respect to cancelable or renewable policies, is inherently incapable of serving this long-term function. Such reserve merely represents the pro rata portion of the current gross or net premium which remains unearned on the annual statement date, and is intended to cover the cost of claims (if the net unearned premium is used), or the cost of claims and non-insurance expenses (if the gross unearned premium is used), which arise during the unexpired portion of the current premium-paying period. The unearned premium reserve, again whether maintained on a gross or net basis, diminishes ratably over the premium-paying period, so that at the end of such period, no amount of the current premium can ever remain in the reserve to cover future risks under the policy.16 Thus, no portion of the gross or net unearned premium reserve can even arguably serve the function of a "reserve in addition to unearned premiums” as that term was intended in sections 1.801-3(c) and 1.801-3(d), Income Tax Regs. Cf. Economy Finance Corp. v. United States, supra at 481; Group Life & Health Insurance Co. v. United States, supra.
Moreover, an acceptance of petitioner’s interpretation of section 1.801-3(e) would necessarily lead to the conclusion that any company which maintains unearned premium reserves on the gross, rather than the net basis, carries a reserve "in addition” to unearned premiums within the intendment of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs. This conclusion would necessarily follow even though such reserves are maintained with respect to cancelable policies, and would require us to equate the "additional reserves” required by sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., with the loading element contained in the gross unearned premium reserve. Such a conclusion would be demonstratably fallacious.
No obligation to renew accompanies a cancelable policy, and it is therefore axiomatic that the issuer of such policies will never be required to maintain a reserve in addition to unearned premiums within the intendment of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs. Nevertheless, the absolute minimum reserve required for cancelable accident and health insurance in petitioner’s State of incorporation, is the gross pro rata unearned premium. See sec. 219.1 N.Y. Insurance Regs. This application of petitioner’s proposed interpretation of section 1.801-3(e), Income Tax Regs., shows quite clearly that the Treasury could not have intended to limit the definition of unearned premium reserves to "net” unearned premiums.
Furthermore, petitioner’s interpretation cannot withstand scrutiny even when applied to renewable policies. The loading element contained in a gross unearned premium represents that portion of the gross premium designed to cover non-insurance costs, such as commissions and administrative expenses, and also includes a margin for profit. Such amounts clearly are not carried to cover the insurer’s obligation to renew or continue the policy at a specified premium, and therefore are not capable of being classified as "reserves in addition to unearned premiums” under sections 1.801-3(c) and 1.801-3(d), Income Tax Regs. Petitioner’s proposed interpretation of section 1.801-3(e), Income Tax Regs., would, however, lead directly to such a result.
The fact that petitioner charged a greater premium rate in the case of renewable policies than it would have charged for policies with the same terms but without the renewable feature is, in my opinion, completely without significance for purposes of the present case. Although it is clear that the premium charged with respect to petitioner’s renewable policy included an amount which was intended to cover petitioner’s obligation to renew at a level premium, under the 2-year preliminary method, petitioner was entitled to assume, for purposes of reserving, that the entire premiums paid with respect to its renewable policies during each of their first 2 years of existence would be used to pay expenses and insur-anee claims occuring during each of the first 2 policy years. As such, no amounts of those premiums remained available at the end of the first 2 policy years with which petitioner could establish mid-terminal reserves.
The entire concept of an insurance company’s taxable status is based upon the qualitative nature of the reserves the company is required to maintain. Group Life & Health Insurance Co. v. United States, supra at 117; Alinec Life Insurance Co. v. United States, 178 Ct. Cl. at 833-834, 373 F.2d at 347; Commissioner v. Swift & Co. Employees Benefit Association, 151 F.2d 625 (7th Cir. 1945). Premiums charged with respect to particular types of policies are irrelevant for these purposes. The salient point here is that the unearned premium reserve, whether maintained on the gross or net basis, and whether maintained with respect to cancelable or noncancelable policies, is simply not, in my opinion, the qualitative type of reserve that the Treasury intended to include within its definition of a "reserve in addition to unearned premiums” under sections 1.801-3(c) and 1.801-3(d), Income Tax Regs.
Finally, notwithstanding petitioner’s contention to the contrary, I think that the specific language of section 1.801-3(e), Income Tax Regs., militates against petitioner’s effort to limit the definition of the unearned premium reserve to net unearned premiums. Section 1.801-3(e), Income Tax Regs., defines "unearned premiums” as "those amounts which shall cover the cost of carrying the insurance risk for the period for which the premiums have been paid in advance.” These amounts are defined to include "all unearned premiums, whether or not required by law.” It is clear that the draftsman of the regulation considered the unearned premium to represent the pro rata portion of the total premium allocable to the unexpired portion of the policy term when that term was defined to encompass all unearned premiums, even though the gross unearned premium may contain an element of loading. As stated by the Court of Appeals in Superior Life Insurance Co. v. United States, 462 F.2d 945, 951 (4th Cir. 1972):
The universally accepted meaning of "premium” is the amount paid by the insured for coverage. It does not refer to any particular portion of the sum paid by the insured. * * * Our interpretation is not inconsistent with * * * [sec. 1.801-3(e), Income Tax Regs.]; both the morbidity portion and the loading portion are, we think, "costs” of insuring. * * * Until a prorated portion of the premium is earned, no loading costs are considered due against it. In this sense, the total unearned premium is a "reserve” for future obligations. [Emphasis in original; fn. ref. omitted.]
See also Union Mutual Life Insurance Co. v. United States, 570 F.2d 382 (1st Cir. 1978), cert. denied 439 U.S. 821 (1978); Group Life & Health Insurance Co. v. United States, supra.
I would therefore reject petitioner’s contention that the gross pro rata unearned premium reserve which was maintained with respect to its renewable policies contained a reserve in addition to unearned premiums as required by sections 1.801-3(c) and 1.801-3(d), Income Tax Regs.
IV. Other Points
The majority feels that certain other provisions of subchap-ter L and the regulations thereunder support its ultimate conclusion on the main issue in this case. For the reasons stated hereafter, I do not agree.
A. Section 818(c)
Life insurance companies, like all insurance companies, are permitted to deduct annual additions to reserves for purposes of computing taxable income. If a company qualifies as a life insurance company, and values mid-terminal reserves on a preliminary term method, it may elect to compute the deduction for annual additions to reserves on the net-level basis, even though it, in reality, uses a preliminary term method. Sec. 818(c).
The election under section 818(c) may, from a tax perspective, prove beneficial to a life insurance company in one year, and prove disadvantageous to such company in a later year. However, once the election is made, it cannot be withdrawn by the company without permission of the Commissioner.
The majority asserts that our interpretation of the regulations would "undermine section 818(c).”
This argument, in my opinion, places the cart before the horse. Only "life insurance companies” are entitled to the specific relief contained in section 818(c). Section 818(c) has nothing to do with the definition of such a company. Indeed, the legislative history of section 818(c), cited by the majority, speaks of "life insurance companies” throughout, and refers to the equalization of reserve deduction treatment among "life insurance companies.”
If it is determined that the company does not meet the "life insurance company” test of section 801, such company was simply not intended to benefit from the provisions of 818(c). Thus, only if one presupposes that the companies we have before us are the types of companies Congress intended to treat as "life insurance companies,” can one conclude that my interpretation of the regulations "undermines section 818(c).” In fact, Congress, in my opinion, did not intend such companies to be treated as "life insurance companies.” Congress, in section 818(c), simply noted one possible adverse tax consequence of the use by a "life insurance company” of the preliminary term method, and chose to provide relief, and has not seen fit to legislate with respect to the effect of the preliminary term method on an insurance company’s tax status. We clearly may not do so here.
B. Section 1.801-3(b) (2), Income Tax Regs.
Section 1.801-3(b)(2), Income Tax Regs., 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. [Emphasis supplied.]
The majority believes that my interpretation of sections 1.801-3(c) and 1.801-3(d) of the regulations (i.e., that a company must carry a "reserve in addition to unearned premiums” with respect to every policy that it seeks to classify as noncancelable or guaranteed renewable), is incompatible with the above regulation. The majority states that the situation contemplated in section 1.801-3(b)(2), Income Tax Regs, (i.e., that a company could qualify as a "life insurance company” even though it has no "life insurance reserves”), could never arise under our interpretation of sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., since the company would have to have "life insurance reserves” in order for its policies to qualify as "noncancellable” or "guaranteed renewable” in the first place. I disagree.
"Life insurance reserve” is a term of art, specifically defined in section 801(b). See also sec. 1.801-4(a), Income Tax Regs. Briefly stated, in order to qualify as a "life insurance reserve,” such reserve must generally meet a five-part test.
(1) It must be computed or estimated on the basis of recognized mortality or morbidity tables;
(2) It must have assumed rates of interest;
(3) It must be set aside to mature or liquidate future unaccrued claims;
(4) It must involve life, health, or accident contingencies; and
(5) It must be required by law.
Whether a particular reserve established by a company qualifies as a technical "life insurance reserve” has been a much-litigated issue. See, e.g., Helvering v. Inter-Mountain Life Insurance Co., 294 U.S. 686 (1935); Maryland Casualty Co. v. United States, 251 U.S. 342 (1920); Group Life & Health Insurance Co. v. United States, 660 F.2d 1042 (5th Cir. 1981); Mutual Benefit Life Insurance Co. v. Commissioner, 488 F.2d 1101 (3d Cir. 1973), affg. 58 T.C. 679 (1972), cert. denied 419 U.S. 882 (1974); Lamana-Panno-Fallo Industrial Insurance Co. v. Commissioner, 127 F.2d 56 (5th Cir. 1942); Delta Life Insurance Co. v. United States, 363 F. Supp. 410 (E.D. La. 1973); Central National Life Insurance Co. of Omaha v. United States, 216 Ct. Cl. 260, 574 F.2d 1067 (1978).
However, in order to be classified as a "noncancellable” or "guaranteed renewable” accident or health policy, sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., do not require that policy to first run the gauntlet of section 801(b). That is, under these regulations, whether the company maintains technical "life insurance reserves” with respect to such policies is irrelevant in their Federal tax classification. All sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., require is that the health or accident policy be a "long-term” policy "with respect to which a reserve in addition to unearned premiums must be carried” to cover the company’s long-term obligation under the policy. The regulations do not require that the policy be one with respect to which a technical "life insurance reserve” be carried. The Treasury, when drafting these regulations did not deem it necessary to inquire whether a "reserve in addition to unearned premiums” met the technical "life insurance reserves” test of section 801(b) when the reserves were being examined solely for purposes of determining whether policies should be classified as noncan-celable or guaranteed renewable. For these purposes, it is sufficient that the reserves be carried to cover a company’s long-term obligation under the policy to renew at a level premium, a test somewhat less stringent than that provided for technical "life insurance reserves.”
Of course, if the "reserve in addition to unearned premiums” does not meet the technical "life insurance reserve” definition of section 801(b) and section 1.801-4(a), Income Tax Regs., it will not be placed in the numerator of the section 801 qualification ratio since under section 801 only "life insurance reserves” and unearned premiums and unpaid losses on noncancelable or guaranteed renewable life, health, or accident policies are so included by the specific terms of the statute. Nevertheless, this regulation recognizes that a company issuing "guaranteed renewable” or "noncancellable accident” and health policies will qualify as a "life insurance company” if the more than 50-percent test of section 801(a) is met, even if the "reserve in addition to unearned premiums” which the company is required to carry for definitional purposes under sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., does not meet all of the technical requirements of a "life insurance reserve” contained in section 801(b). See Rev. Rul. 67-224, 1967-2 C.B. 231. Moreover, under such circumstances the 50-percent test will only be satisfied if unearned premiums and unpaid losses on such policies comprise (exclusive of "additional reserves”) more than 50 percent of the company’s total reserves.
V. Are Sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., Valid?
Petitioner contends that these regulations, as I would interpret them, are invalid exercises of the Treasury’s interpretive authority. Petitioner contends that Congress intendéd the industry definition of "noncancellable” and "guaranteed renewable” accident and health policies to be controlling for Federal tax purposes and that its policies clearly meet the definitional standards of the insurance industry. The majority appears to have been swayed by this argument.
Petitioner’s three experts testified that petitioner’s policies would indeed be classified as "noncancellable” or "guaranteed renewable” in the insurance industry. However, these experts also testified that the insurance industry classifies such policies solely by reference to the terms of the policies and does not consider whether a "reserve in addition to unearned premiums” is required to cover the issuer’s obligation to renew to be a relevant definitional criterion. In fact, the parties have stipulated that:
"Noncancellable” and "guaranteed renewable” A & H contracts or policies are recognized product types in the insurance industry, which bases such classification solely upon the terms or provisions of the policy (or rider). [Emphasis supplied.]
However, Congress was clear when it stated the requisites for "noncancellable” and "guaranteed renewable” status for Federal tax purposes. Such a 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 unearned premiums must be caused to cover the renewal obligation. [S. Rept. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 612. Emphasis supplied.]
Congress thus specified the essential prerequisite of a long-term reserve to the Federal tax classification of an accident and health policy as "noncancellable” or "guaranteed renewable.” Since the industry standard, as articulated by petitioner’s experts, would not impose such a prerequisite, I cannot find the industry definition to be controlling. Cf. Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979); Modern Life & Accident Insurance Co. v. Commissioner, 49 T.C. 670, 672 (1968), affd. 420 F.2d 36 (7th Cir. 1969). As the Seventh Circuit Court of Appeals has stated in Economy Finance Corp. v. United States, supra at 482:
Taxpayers further contend that in the insurance industry, "npncancella-ble” means a policy which the insurance ebmpafty cannot ‘cancel, and that Congress intended the meahing.attaehed by the businesá which evolved the term. But Congress was specific as to the combined features of a "noncancellable” policy for tax purposes. Taxpayers’ policies do not fit within the framework of the statutory definition. [Emphasis supplied. Fn. ref. omitted.]
See also Group Life & Health Insurance Co. v. United States, supra.
In short, sections 1.801-3(c) and 1.801-3(d), Income Tax Regs., are clearly not "unreasonable and plainly inconsistent” with sections 801(a) and 801(e) and must, therefore, be sustained. Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501 (1948).
For the above reasons, I would hold that, for Federal tax purposes, petitioner failed to meet the statutory test of a "life insurance company” for the period before us, it being conceded that it fails to meet the over-50-percent test of section 801(a), unless its unearned premiums and unpaid losses attributable to its long-term health and accident policies, during their first 2 years of existence, are added to the numerator of the statutory fraction. Since the majority holds to the contrary, I dissent.
Fay, Sterrett, Chabot, and Parker, JJ, agree with this dissenting opinion.All section references herein are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue, unless otherwise expressly indicated.
Ch. 136, secs. 242-247, 42 Stat. 227, 261-264 (1921).
A special deduction was allowed for certain additions to net reserve funds. See generally 1 T. Nash, Federal Income Taxation of Life Insurance Companies, sec. 5 (1982).
See, e.g., Testimony of T. S. Adams, Senate Hearings on H.R. 8245, 67th Cong., 1st Sess. 83(1921).
See sec. 244(a) of the 1921 Act. This approach to the taxation of "life insurance companies” was modified by the Life Insurance Income Tax Act of 1959. See Pub. L. 86-69, 73 Stat. 112 (applicable retroactively to taxable years beginning after Dec. 31,1957). Under the 1959 Act, "life insurance companies” are effectively entitled to exclude only one-half of their underwriting income from current taxation. See secs. 802(b)(3), 815(dX2).
See sec. 242 of the 1921 Act. 42 Stat. 227,261.
Hearings on H.R. 8245 Before the Senate Comm. on Finance, 67th Cong., 1st Sess. 85 (1921).
See G. Lenrow, R. Milo & A. Rua, Federal Income Taxation of Life Insurance Companies, ch. 9 (3d ed. 1979),
See ch. 619,56 Stat. 798 (1942); sec. 201(b), sec. 801(e), I.R.C. 1954.
S. Rept. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. at 611-612. See also S. Rept. 291, 86th Cong., 1st Sess. (1959), 1959-2 C.B. 770, 793, in relevant part.
S. Rept. 1631, supra, 1942-2 C.B. at 612.
See also Report of the Advisory Committee to the National Association of Insurance Commissioners, 1964; J. Magee, Life Insurance 564 (3d. ed. 1958); J. Maclean, Life Insurance 134-140 (8th ed. 1956).
The operation of the net level method of reserving in contrast to the 2-year preliminary term method is made apparent by certain stipulations of the parties in this case. As noted supra, the parties have stipulated (and the commentators bear this out, see note I % supra), thsfuñSer tfie 2-year preHmi&ary term method» the dpifeptamaunfo? tüe terminal reserve k%tgR.py.te<? íiy bshiig ttfé esp$6sl of Re present valué óffuture benefits to be'paid over the valué of ftiture net valuation premiums on each pohey that hag been in force for more than 2 years at the annual statement date, but does not include the amount representing the present value of future benefits over the present value of future net valuation premiums on policies in force less than 3 years. Under the net level method, on the other hand, the dollar amount of the terminal reserve consists of the excess of the present value of future benefits over the present value of futuré net valuation premiums on each, policy, regardless of the length of time the policy has been in force.
Although policies reserved under the 2-year preliminary term method will contribute to the terminal reserve at an accelerated rate vis-a-vis the net level method ¿/“such policies remain in force for more than 2 years, it is clear that the purpose of this accelerated contribution is to allow that particular policy to "catch up” for prior years when no amounts were contributed to offset risks which attached to that policy. These accelerated amounts therefore cannot be considered to be maintained “with respect to” policies still within the 2-year preliminary term. An example may aid in understanding this point. If petitioner issued a renewable accident and health insurance policy to an insured at age 30, the mid-terminal reserve would not include any amount attributable to such policy for the first 2 policy years under the 2-year preliminary term method. Only in the third policy year would the total mid-terminal reserve be affected by such policy, when an amount would then be added to or included in that total reserve. This amount would be based upon the excess of the present value of the future benefits over the present value of future net valuation premiums on such policy, computed as though the policy were then newly issued to an insured at age 32, and the additional reserve were being computed under the net level method.
S. Rept. 1631, supra, 1942-2 C.B. at 612.
And this will be true even if under the actual experience of the company, the entire unearned premium reserve is not expended for current claim costs and expenses. Such excess amounts do not become part of a terminal or mid-terminal reserve, but rather become company surplus. See J. Maclean, supra at 134-140.