1931 BTA LEXIS 1679">*1679 1. Additions made to reserve for unearned premiums in 1920 and 1924 held to have been made, not from capital, surplus or nontaxable income, but from income received upon insurance written.
2. Net decreases in reserve for unearned premiums in 1921 and 1925 held to be properly included in gross income for said years.
24 B.T.A. 225">*225 These proceedings, which were consolidated for hearing, involve the determination of petitioner's tax liability for the years 1921 and 1925, for which respondent has asserted deficiencies of $28,499.50, and $12,957.14, respectively. Petitioner alleges that respondent erred (a) in including in income for the year 1921 the sum of $115,832.74 of the net decrease in petitioner's "unearned premium reserve" for that year; (b) in including in income for the year 1925 the sum of $61,451.87 of the net decrease in petitioner's "unearned 24 B.T.A. 225">*226 premium reserve" for that year. At the hearing petitioner amended its petition in Docket No. 28942 to affirmatively allege that section 246 of the Revenue Act of 1924 is unconstitutional1931 BTA LEXIS 1679">*1680 if it be construed as permitting the inclusion in income, when released from reserve, of capital or surplus or tax-exempt items temporarily set aside into the reserve required by law.
FINDINGS OF FACT.
The petitioner is a Utah corporation, organized in 1886, having its principal office and place of business at Salt Lake City, Utah. It is engaged in the business of writing fire insurance.
For some time its business was confined within the States of Utah and Idaho, but after 1907 it extended its business until it was operating in some twenty-eight States.
As of October 1, 1919, petitioner entered into a contract of reinsurance with the Hartford Fire Insurance Company of Hartford, Conn., and, as a result, petitioner's business increased several fold.
Petitioner maintains on its books two classes of reserves. One is a reserve for unpaid losses and claims, which is set up after the books are closed for the year, the computation being based on the estimated amount required to settle outstanding and unpaid loses. The other is a reserve equivalent to the unearned premiums on insurance written during the year and is termed a "reinsurance reserve." This reserve is computed1931 BTA LEXIS 1679">*1681 and adjusted once a year - at the end of the year, upon information furnished by the agencies and companies through which it does business. In case of business written in the home office the computation is made from information furnished by the general agents. It is petitioner's practice to compute its reinsurance reserve after first adjusting and providing for all operating expenses and the reserve for unpaid losses and claims. On January 28, 1921, petitioner received from the Hartford Company the information relative to insurance written under its contract with that company which was necessary to compute its reinsurance reserve as of December 31, 1920.
Prior to 1921 and in anticipation of the expansion of its business to result from its contract of reinsurance with the Hartford Company, petitioner had issued and sold additional capital stock to the amount of $100,000 par value, at a premium of $250,000, thereby creating additional capital and paid-in surplus of $350,000.
The annual statement of the petitioner for the year 1920 reflects increases or decreases in its surplus as follows:
| Underwriting income earned | $914,953.88 | ||
| Losses incurred during 1920 | $589,937.76 | ||
| Underwriting expense | 518,323.95 | ||
| 1,108,261.71 | |||
| Loss from underwriting | 193,307.83 | ||
| INVESTMENTS | |||
| Income from dividends and | $55,046.35 | ||
| nontaxable interests | |||
| Taxable income | 93,150.50 | ||
| 148,196.85 | |||
| Loss on investments due to | $227,312.28 | ||
| change in book value, etc. | |||
| Investment Expense | 15,675.41 | ||
| 242,987.69 | |||
| Loss from investments | $94,790.84 | ||
| MISCELLANEOUS | |||
| Dividends declared | $96,000.00 | ||
| Charity | 163.50 | ||
| Total | 96,163.50 | ||
| Decrease of surplus | 384,262.17 |
1931 BTA LEXIS 1679">*1682 24 B.T.A. 225">*227 The decrease in surplus for 1920 included reductions on account of charity, $163.50; dividends declared, $96,000; and a reduction on the books of the value of bonds and stocks in the amount of $227,312.28; amounting in the aggregate to $323,475.78. The remaining decrease in surplus in the amount of $60,786.39 is attributable to operation as follows:
| Loss from underwriting, 1920 | $193,307.83 | |
| Taxable income from investments (net | $77,475.09 | |
| over expense) | ||
| Nontaxable income from dividends | 55,046.35 | |
| and interest | 132,521.44 | |
| Loss attributable to operation | 60,786.39 |
The condition of petitioner as shown by its annual statement as of December 31, 1920, was as follows:
| ASSETS | ||
| Ledger asserts, including real estate, | $2,345,397.65 | |
| mortgage loans, bonds, stocks, cash | ||
| on hand and agents' balances | ||
| Non-ledger assets: | ||
| Interest due and/or accrued | $29,046.49 | |
| on investments, mortgages, and bonds | ||
| Market value of stocks and bonds | 134,239.40 | |
| in excess of above ledger value | ||
| 163,285.89 | ||
| Gross assets | 2,508,683.54 | |
| LIABILITIES | ||
| Losses and claims | 282,820.58 | |
| Unearned premiums | 891,500.46 | |
| Sundry liabilities, due or accrued | 35,100.42 | |
| Total liabilities | 1,209,421.46 | |
| CAPITAL | ||
| Capital stock | $400,000.00 | |
| Surplus over all liabilities | 899,262.08 | |
| $1,299,262.08 | ||
| Total | 2,508,683.54 |
1931 BTA LEXIS 1679">*1683 24 B.T.A. 225">*228 The premiums written by petitioner during 1920 amounted to $1,322,399.38. Its unearned premiums as of December 31, 1919, amounted to $483,794.93; its unearned premiums as of December 31, 1920, amounted to $891,500.46; and the premiums earned during 1920 amounted to $914,693.85.
Petitioner's income from all sources for the year 1920 was $1,470,952.14, including $55,046.35 of nontaxable income. After charging up its operating expenses and setting up its estimated reserve for unpaid losses and claims there was income remaining in the amount of $346,919.14. The net addition which petitioner was required to make to its reinsurance reserve as of December 31, 1920, was $407,705.53. Its books disclosed therefore that its remaining income, excluding nontaxable income of $55,046.35, was $60,786.39 short of the amount required to make the necessary additions to its reserve. The sum of these two figures is $115,832.74, the amount which petitioner claims it transferred from surplus and nontaxable income in 1920 to its reserve and which is in controversy in the year 1921.
Petitioner's gross premiums allocable to business originating under the reinsurance contract with the1931 BTA LEXIS 1679">*1684 Hartford Insurance Company amounted to $1,059,286.79 for the year 1920. Of this amount the Hartford Company withheld $370,750.38 to cover commissions and underwriting expenses, and $314,863.17 to cover losses and claims paid by it on account of business reinsured with the petitioner, and made a net cash remittance to petitioner of $373,673.24. In addition to the losses and claims thus paid directly by the Hartford Company, petitioner added the sum of $163,942.75 to its reserve for losses and unpaid claims at the close of 1920 to cover further liabilities incurred and allocated to its reinsurance risks under the Hartford contract.
The premiums written by petitioner during 1921 amounted to $347,028.53, its unearned premiums as of December 31, 1921, amounted to $447,544.18, and the premiums earned during 1921 amounted to $790,984.81.
The contract with the Hartford Fire Insurance Company was canceled as of July 1, 1921. All the business then in force thereunder was released by petitioner and turned back to the Hartford Company and the returned premiums were charged against the reinsurance reserve. The immediate effect of this transaction was to release the sum of $603,553.051931 BTA LEXIS 1679">*1685 from the reinsurance reserve. The 24 B.T.A. 225">*229 net decrease in petitioner's reinsurance reserve for the full year 1921 was $443,956.28.
On November 4, 1921, petitioner entered into a reinsurance contract with the Citizens Insurance Company of Missouri, with the result that its business was almost doubled in 1924.
The annual statement of petitioner for the year 1924 reflects increases or decreases in its surplus as follows:
| UNDERWRITING | |||
| Underwriting income earned | $727,912.77 | ||
| Losses incurred during 1924 | $509,747.47 | ||
| Provision for income tax | 5,709.49 | ||
| Underwriting expense | 321,703.22 | ||
| 837,160.18 | |||
| Loss from underwriting | 109,347.41 | ||
| INVESTMENTS | |||
| Income from dividends and | 54,368.39 | ||
| nontaxable interest | |||
| Taxable income | 60,274.69 | ||
| Subtotal | 114,643.08 | ||
| Increase in market value of | 11,463.65 | ||
| stocks and bonds | 126,106.73 | ||
| Loss on sale of assets | $3,328.10 | ||
| Collateral loans deducted as | 44,202.41 | ||
| nonadmitted | |||
| Investment expense | 12,310.54 | ||
| 59,841.05 | |||
| Gain from investments | 66,265.68 | ||
| 43,081.73 | |||
| MISCELLANEOUS | |||
| Dividends declared | 72,000.00 | ||
| Decrease of surplus | 115,081.73 |
The decrease1931 BTA LEXIS 1679">*1686 in surplus for 1924 included reductions on account of dividends declared, $72,000, provision for income tax, $5,709.49, doubtful collateral loans, $44,202.41, and an increase in market value of stocks and bonds, $11,463.65, amounting in the aggregate to $110,448.25. The remaining decrease in surplus in the amount of $4,633.48 is attributable to operations as follows:
| Loss from underwriting in 1924 (including | $109,347.41 | |
| provision for income tax, $5,709.49) | ||
| Taxable income from investments (net over | $44,636.05 | |
| expenses and loss on sale of assets) | ||
| Nontaxable income from dividends and interest | 54,368.39 | |
| 99,004.44 | ||
| 10,342.97 | ||
| Less provision for income tax | 5,709.49 | |
| Balance attributable to loss from operations | 4,633.48 |
24 B.T.A. 225">*230 The condition of petitioner as shown by its annual statement as of December 31, 1924, was as follows:
| ASSETS | ||
| Ledger assets, including real | $2,186.690.15 | |
| estate, mortgage loans, loans on | ||
| collateral, bonds, stocks, cash on | ||
| hand and on deposit and reinsurance | ||
| due on paid losses | ||
| Nonledger assets: Interest due and/or | 31,586.22 | |
| accrued on investments, on mortgages | ||
| and on bonds | ||
| 2,218,276.37 | ||
| DEDUCT ASSETS NOT ADMITTED | ||
| Collateral loans of doubtful value | $44,202.41 | |
| Book value of bonds and stocks | 21,662.13 | |
| over market value | ||
| 65,864.54 | ||
| 2,152,411.83 | ||
| LIABILITIES | ||
| Losses and claims | $199,362.21 | |
| Estimated expenses of investigation and | 3,000.00 | |
| adjustment of losses | ||
| Unearned premiums | 719,412.25 | |
| Sundry liabilities, due or accrued | 54,000.00 | |
| Total liabilities | 975,774.46 | |
| CAPITAL | ||
| Capital stock | $400,000.00 | |
| Surplus over all liabilities | 776,637.37 | |
| 1,176,637.37 | ||
| Total | 2,152,411.83 |
1931 BTA LEXIS 1679">*1687 The premiums written by petitioner during 1924 amounted to $812,824.74; its unearned premiums as of December 31, 1923, amounted to $634,818.72; its unearned premiums as of December 31, 1924, amounted to $719,412.25, and the premiums earned during 1924 amounted to $728,231.21.
Petitioner's income from all sources for the year 1924 was $927,467.82, including $54,368.39 of nontaxable income. After charging up its operating expenses and setting up its estimated reserve for unpaid losses and claims and accruing income tax in the amount of $5,709.48, there was income remaining in the amount of $74,250.56 before deducting depreciation subsequently allowed by the Commissioner in the amount of $2,450. The net addition which petitioner was required to make to its reinsurance reserve as of December 31, 1924, was $84,593.53. The books disclose that its remaining income, including nontaxable income of $54,368.39, was $7,083.48 short of the 24 B.T.A. 225">*231 amount required to make the necessary additions to its reserve. The sum of these two amounts is $61,451.87, the amount petitioner claims it transferred from surplus and nontaxable income in 1924 to its reserve and which is in controversy1931 BTA LEXIS 1679">*1688 in the year 1925.
The premiums written by the petitioner for the year 1925 amounted to $522,238.57; its unearned premiums as of December 31, 1925, amounted to $571,123.90; and the premiums earned during 1925 amounted to $670,526.92.
The contract of reinsurance with the Citizens Insurance Company of Missouri was canceled and one-half of the reinsurance which petitioner then had was turned back to the Citizens Company in 1925. The immediate effect of this transaction was to release a proportional amount of petitioner's reinsurance reserve. The net decrease in petitioner's reinsurance reserve for the year 1925 was $148,288.35.
A committee of experts appointed by the insurance commissioners of the various States with which petitioner was doing business examines its books and records about once every three years. No exception to the manner in which petitioner conducts its business has been made by this committee.
The respondent has included the full amount of the net decrease in petitioner's reinsurance reserve for the years 1921 and 1925 in gross income for those years. In computing the net income of the petitioner for the calendar year 1925 he allowed as a deduction a1931 BTA LEXIS 1679">*1689 net loss of $3,755.38 sustained in the year 1924.
OPINION.
GOODRICH: That the amount of the net decrease in reinsurance or unearned premium reserve disclosed by a fire insurance company at he close of a taxable period, or, in other words, the actual amount of premiums earned during the period, is to be included in gross income for that period is too well established to merit further discussion here. The method to be followed in computing the taxable income of an insurance company, and the various provisions of the statutes under which its tax liability arises, have likewise previously been determined. See ; ; ; , and cases there cited.
This petitioner does not quarrel with the principal laid down in the cases above cited, but contends that, of the net decrease in its reinsurance reserve for the year 1921, the amount of $115,832.74 represented the return of capital or surplus which, in the year1931 BTA LEXIS 1679">*1690 1920, it had been forced to transfer to its reinsurance reserve because its income for the year 1920 lacked that much of meeting its required increases to that reserve; that, of the net decrease in its reinsurance reserve for the year 1925, the amount of $61,451.87 represented 24 B.T.A. 225">*232 the return of capital or surplus which, in the year 1924, it had been forced to transfer to its reinsurance reserve because its income for the year 1924 lacked that much of meeting its required increases to that reserve; and that to include these amounts in its income for the years 1921 and 1925, respectively, as a part of the funds released from the reinsurance reserve in those years, would be to tax, not income, but capital. In short, it contends that these amounts, when added to its reserve, were not derived from premiums received upon insurance written, but were transferred or borrowed from capital account and should be permitted to return to that source without tax.
We can not accept petitioner's views of the case, because we are not convinced that these amounts, or any part of them, came from capital or surplus when added to petitioner's unearned premium reserve. On the contrary, we believe1931 BTA LEXIS 1679">*1691 there is no doubt but that they were derived from premiums received upon insurance written and that, therefore, when released from that reserve they are to be included in gross income. This must be so because of the very nature of the unearned premium reserve. Huebner, in his work on Property Insurance, p. 217, says:
The reserve in fire insurance has its origin in the fact that the insurer collects the whole premium in advance, whereas protection can only be given as time elapses during the one, two or five-year policy period. It may be defined as that portion of the premium which the Company has not yet had time to earn.
This unearned portion of the premium constitutes the reserve. * * *
And this reserve, the unearned premium on reinsurance reserve, is the only true reserve of a fire or marine insurance company within the meaning of the Federal statutes imposing taxes upon net income. ; .
How, then, can it be said that the income of a fire insurance company is insufficient to provide for the requisite additions to its unearned1931 BTA LEXIS 1679">*1692 premium reserve? It would seem that its income would always be sufficient to provide for this reserve, for the reason that the reserve, and all additions thereto, comes into existence only when premiums are actually received, paying in advance for protection over a future period. The unearned portion of such premium necessarily 24 B.T.A. 225">*233 is added to the reserve, and since the whole premium has been received before the addition is made, certainly the reserve has been provided for from income. It is true that as a result of its bookkeeping, by giving priority to other entries and charges, by first charging its expenses, its claims or losses against its receipts, a company may show that transfers must be made, on its books, from capital, from surplus, or from nontaxable income, to account for the required additions to its reserve because the remaining portion of its receipts is insufficient for this purpose, but bookkeeping methods can not gainsay the fact that the income was sufficient to provide for the necessary additions to the reserve, for the funds for that purpose were actually received.
So with the case at bar. If petitioner preferred to first pay its expenses from funds1931 BTA LEXIS 1679">*1693 received and then accrue its losses and claims against the unearned premium reserve, and then replace the reserve from nontaxable income and surplus, it may not for that reason claim a deduction from the amounts released from reserve in a subsequent year because that reserve represents income received, either in cash or by credits, but not taxed in a prior year and not a combination of income and various capital accounts as petitioner contends.
Since we hold that no part of petitioner's reinsurance reserve was in fact derived from capital, surplus, or nontaxable income, it is unnecessary to consider the amendment made to its petition alleging that section 246 of the Revenue Act of 1924 is unconstitutional if construed as permitting the inclusion in income of such items, temporarily set aside into reserve as required by law, when released from such reserve.
Reviewed by the Board.
Judgment will be entered for respondent.
MURDOCK, concurring: I believe that the correct result has been reached in this case. The only question in the case is, How much, by way of premiums, did the company earn during the year? This being so, it seems to me unnecessary1931 BTA LEXIS 1679">*1694 to discuss the question of where the actual dollars came from which went into the reserve or which were released from the reserve. If in prior years, surplus had to be reduced in order to set up the reserve, that fact has no effect upon income for the current year.