United States v. Consumer Life Ins. Co.
430 U.S. 725 (1977)

Annotate this Case

U.S. Supreme Court

United States v. Consumer Life Ins. Co., 430 U.S. 725 (1977)

United States v. Consumer Life Insurance Co.

No. 75-1221

Argued December 6, 1976

Decided April 26, 1977*

430 U.S. 725

CERTIORARI TO THE UNITED STATES COURT OF CLAIMS

Syllabus

Under § 801(a) of the Internal Revenue Code of 1954, an insurance company is considered a life insurance company for federal tax purposes if its life insurance reserves constitute more than 50% of its "total reserves," as that term is defined in § 801(c). Qualifying companies are accorded preferential tax treatment. The question here is how unearned premium reserves for accident and health (nonlife) insurance policies should be allocated between a primary insurer and a reinsurer for purposes of applying the 50% test. The unearned premium reserve is the basic insurance reserve in the casualty insurance business, and an important component of "total reserves" under § 801(c)(2). The taxpayers contend that, by virtue of certain reinsurance agreements ("treaties"), they have maintained nonlife reserves below the 50% level. These treaties were of two basic types: (1) Treaty I, whereby the taxpayer served as reinsurer, and the "other party" was the primary insurer or ceding company; and (2) Treaty II, whereby the taxpayer served as the primary insurer and ceded a portion of the business to the "other party," the reinsurer. Both types of treaties provided that the other party would hold the premium dollars derived from accident and health business until such time as the premiums were "earned," i.e., attributable to the insurance protection provided during the portion of the policy term already elapsed. The other party also set up on its books the corresponding unearned premium reserve, relieving the taxpayer of that requirement, even though the taxpayer assumed all substantial insurance risks. In each case, the taxpayer and the other party reported their affairs annually in this way to both the Internal Revenue Service and the appropriate state insurance departments. Despite the state authorities' acceptance of these annual statements, the

Page 430 U. S. 726

Government argues that the unearned premium reserves must be allocated or attributed for tax purposes from the other parties to the taxpayers, with the result that the taxpayers fail the 50% test, and thus are disqualified from preferential tax treatment, primarily because, in the Government's view, § 801 embodies a rule that "insurance reserves follow the insurance risk."

Held:

1. The reinsurance treaties served valid business purposes, and, contrary to the Government's argument, were not sham transactions without economic substance. Pp. 430 U. S. 736-739.

2. Since the taxpayers neither held the unearned premium dollars nor set up the corresponding unearned premium reserves, and since that treatment was in accord with customary practice as policed by the state regulatory authorities, § 801(c)(2) does not permit attribution to the taxpayers of the reserves held by the other parties to the reinsurance treaties. Pp. 430 U. S. 739-750.

(a) The language of § 801(c)(2) does not suggest that Congress intended a "reserves follow the risk" rule to govern determinations under § 801. Pp. 430 U. S. 740-741.

(b) Nor does the legislative history of § 801 furnish support for the Government's interpretation. Pp. 430 U. S. 742-745.

(c) Section 820 of the Code, prescribing the tax treatment of modified coinsurance contracts, affords an unmistakable indication that Congress did not intend § 801 to embody a "reserves follow the risk" rule. Pp. 430 U. S. 745-750

3. Nor is attribution of unearned premium reserves to the taxpayers required under § 801(c)(3), counting in total reserves "all other insurance reserves required by law." There is no indication that state statutory law in these cases required the taxpayers to set up and maintain the contested unearned premium reserves, especially since the insurance departments of the affected States consistently accepted annual reports showing reserves held as the taxpayers claim they should be. Pp. 430 U. S. 750-752.

No. 75-1221, 207 Ct.Cl. 638, 524 F.2d 1167, and No. 75-1285, 207 Ct.Cl. 594, 524 F.2d 1155, affirmed; No. 75-1260, 514 F.2d 675, reversed and remanded.

POWELL, J., delivered the opinion of the Court, in which BURGER, C.J., and BRENNAN, STEWART, BLACKMUN, REHNQUIST, and STEVENS, JJ., joined. WHITE, J., filed a dissenting opinion, in which MARSHALL, J., joined, post, p. 430 U. S. 753.

Page 430 U. S. 727

MR. JUSTICE POWELL delivered the opinion of the Court.

The question for decision is how unearned premium reserves for accident and health (A&H) insurance policies should be allocated between a primary insurer and a reinsurer for federal tax purposes. We granted certiorari in these three cases to resolve a conflict between the Circuits and the Court of Claims. 425 U.S. 990 (1976).

I

An insurance company is considered a life insurance company under the Internal Revenue Code if its life insurance reserves constitute more than 50% of its total reserves, IRC of 1954, § 801(a), 26 U.S.C. § 801(a), [Footnote 1] and qualifying companies

Page 430 U. S. 728

are accorded preferential tax treatment. [Footnote 2] A company close to the 50% line will ordinarily achieve substantial tax savings if it can increase its life insurance reserves or decrease nonlife reserves so as to come within the statutory definition.

The taxpayers here are insurance companies that assumed both life insurance risks and A&H -- nonlife -- risks. The dispute in these cases is over the computation for tax purposes of nonlife reserves. The taxpayers contend that, by virtue of certain reinsurance agreements -- or treaties, to use the term commonly accepted in the insurance industry -- they have maintained nonlife reserves below the 50% level. The Government argues that the reinsurance agreements do not have that effect, that the taxpayers fail to meet the 50% test, and that, accordingly, they do not qualify for preferential treatment. [Footnote 3]

Page 430 U. S. 729

Specifically, the dispute is over the unearned premium reserve, the basic insurance reserve in the casualty insurance business and an important component of "total reserves," as that term is defined in § 801(c). [Footnote 4] A&H policies of the type involved here generally are written for a two- or three-year term. Since policyholders typically pay the full premium in advance, the premium is wholly "unearned" when the primary insurer initially receives it. See Rev.Rul. 61-167, 1961-2 Cum.Bull. 130, 132. The insurer's corresponding liability can be discharged in one of several ways: granting future protection by promising to pay future claims; reinsuring the risk with a solvent insurer; or returning a pro rata portion of the premium in the event of cancellation. Each method of discharging the liability may cost money. The insurer thus establishes on the liability side of its accounts a reserve, as a device to help assure that the company will have the assets necessary to meet its future responsibilities. See O. Dickerson, Health Insurance 604-605 (3d ed. 1968) (hereinafter Dickerson). Standard accounting practice in the casualty field, made mandatory by all state regulatory authorities, calls

Page 430 U. S. 730

for reserves equal to the gross unearned portion of the premium. [Footnote 5] A simplified example may be useful: a policyholder takes out a three-year A&H policy for a premium, paid in advance, of $360. At first, the total $360 is unearned, and the insurer's books record an unearned premium reserve in the full amount of $360. At the end of the first month, one thirty-sixth of the term has elapsed, and $10 of the premium has become "earned." [Footnote 6] The unearned premium reserve may be reduced to $350. Another $10 reduction is permitted at the end of the second month, and so on.

II

The reinsurance treaties at issue here assumed two basic forms. [Footnote 7] Under the first form, Treaty I, the taxpayer served as reinsurer, and the "other party" was the primary insurer or "ceding company," in that it ceded part or all of its risk to the taxpayer. Under the second form, Treaty II, the taxpayer served as the primary insurer and ceded a portion of the business to the "other party," that party being the reinsurer. Both types of treaties provided that the other party

Page 430 U. S. 731

would hold the premium dollars derived from A&H business until such time as the premiums were earned -- that is, attributable to the insurance protection provided during the portion of the policy term that already had elapsed. The other party also set up on its books the corresponding unearned premium reserve, relieving the taxpayer of that requirement. In each case, the taxpayer and the other party reported their affairs annually in this fashion to both the Internal Revenue Service and the appropriate state insurance departments. These annual statements were accepted by the state authorities without criticism. Despite this acceptance, the Government argues here that the unearned premium reserves must be allocated or attributed for tax purposes from the other parties, as identified above, to the taxpayers, [Footnote 8] thereby disqualifying each of the taxpayers from preferential treatment.

A

No. 75-1221, United States v. Consumer Life Ins. Co. In 1957, Southern Discount Corp. was operating a successful consumer finance business. Its borrowers, as a means of assuring payment of their obligations in the event of death or disability, typically purchased term life insurance and term A&H insurance at the time they obtained their loans. This insurance -- commonly known as credit life and credit A&H -- is usually coextensive in term and coverage with the term and amount of the loan. The premiums are generally paid in full

Page 430 U. S. 732

at the commencement of coverage, the loan term ordinarily running for two or three years. Prohibited from operating in Georgia as an insurer itself, Southern served as a sales agent for American Bankers Life Insurance Co., receiving in return a sizable commission for its services.

With a view to participating as an underwriter and not simply as agent in this profitable credit insurance business, Southern formed Consumer Life Insurance Co., the taxpayer here, as a wholly owned subsidiary incorporated in Arizona, the State with the lowest capital requirements for insurance companies. Although Consumer Life's low capital precluded it from serving as a primary insurer under Georgia law, it was nonetheless permitted to reinsure the business of companies admitted in Georgia.

Consumer Life therefore negotiated the first of two reinsurance treaties with American Bankers. Under Treaty I, Consumer Life served as reinsurer and American Bankers as the primary insurer or ceding company. Consumer Life assumed 100% of the risks on credit life and credit A&H business originating with Southern, agreeing to reimburse American Bankers for all losses as they were incurred. In return, Consumer Life was paid a premium equivalent to 87 1/2% of the premiums received by American Bankers. [Footnote 9] But the mode of payment differed as between life and A&H policies. With respect to life insurance policies, American Bankers each month remitted to the reinsurer -- Consumer Life -- the stated percentage of all life insurance premiums collected during the prior month. With respect to A&H coverage, however, American Bankers each month remitted the stated percentage of the A&H premiums earned during the prior month, the remainder to be paid on a pro rata basis over the balance of the coverage period.

Again an example might prove helpful. Assume that a

Page 430 U. S. 733

policyholder buys from American Bankers on January 1 a three-year credit life policy and a three-year credit A&H policy, paying on that date a $360 premium for each policy. On February 1, under Treaty I, American Bankers would be obligated to pay Consumer Life 87 1/2% of $360 for reinsurance of life risks. This represents the total life reinsurance premium; there would be no further payments for life reinsurance. But for A&H reinsurance, American Bankers would remit on February 1 only the stated percentage of $10, since only $10 would have been earned during the prior month. It would remit the same amount on March 1 for A&H coverage provided during February, and so on for a total of 36 months.

Treaty I permitted either party to terminate the agreement upon 30 days' notice. But termination was to be prospective; reinsurance coverage would continue on the same terms until the policy expiration date for all policies already executed. This is known as a "runoff provision."

Because it held the unearned A&H premium dollars, and also under an express provision in Treaty I, American Bankers set up an unearned premium reserve equivalent to the full value of the premiums. Meantime, Consumer Life, holding no unearned premium dollars, established on its books no unearned premium reserve for A&H business. [Footnote 10] Annual statements filed with the state regulatory authorities in Arizona and Georgia reflected this treatment of reserves, and the statements were accepted without challenge or disapproval.

By 1962, Consumer Life had accumulated sufficient surplus to qualify under Georgia law as a primary insurer. Treaty I was terminated, and Southern began placing its credit insurance business directly with Consumer Life. The parties then negotiated Treaty II, under which American Bankers served as reinsurer of the A&H policies issued by Consumer

Page 430 U. S. 734

Life. [Footnote 11] Ultimately, Consumer Life retained the lion's share of the risk, but Treaty II was set up in such a way that American Bankers held the premium dollars until they were earned. This required rather complicated contractual provisions, since Consumer Life, as primary insurer, did receive the A&H premium dollars initially.

Roughly described, Treaty II provided as follows: Consumer Life paid over the A&H premiums when they were received. American Bankers immediately returned 50% of this sum as a ceding commission meant to cover Consumer Life's initial expenses. Then, at the end of each quarter, American Bankers paid to Consumer Life "experience refunds" based on claims experience. If there were no claims, American Bankers would refund 47% of the total earned premiums. If there were claims (and naturally there always were), Consumer Life received 47% less the sums paid to meet claims. It is apparent that American Bankers would never retain more than 3% of the total earned premiums for the quarter. Only if claims exceeded 47% would this 3% be encroached, but, even in that event, Treaty II permitted American Bankers to recoup its losses by reducing the experience refund in later quarters. Actual claims experience never approached the 47% level.

Again, since American Bankers held the unearned premiums, it set up the unearned premium reserve on its books. Consumer Life, which initially had set up such a reserve at the time it received the premiums, took credit against them for the reserve held by American Bankers. Annual statements filed by both companies consistently reflected this treatment of reserves under Treaty II, and at no time did state authorities take exception. [Footnote 12]

Page 430 U. S. 735

The taxable years 1958 through 1960, and 1962 through 1964, are at issue here. For each of those years, Consumer Life computed its § 801 ratio based on the reserves shown on its books and accepted by the state authorities. According to those figures, Consumer Life qualified for tax purposes as a life insurance company. The Commissioner of Internal Revenue determined, however, that the A&H reserves held by American Bankers should be attributed to Consumer Life, thereby disqualifying the latter from favorable treatment. Consumer Life paid the deficiency assessed by the Commissioner and brought suit for a refund. The Court of Claims, disagreeing with its trial judge, held for the taxpayer.

B

No. 75-1260, First Railroad & Banking Company of Georgia v. United States. The relevant taxable entity in this case is First of Georgia Life Insurance Co., a subsidiary of the petitioner First Railroad & Banking Co. of Georgia. Georgia Life was party to a Treaty II type agreement, [Footnote 13] reinsuring its A&H policies with an insurance company, another subsidiary of First Railroad. [Footnote 14] On the basis of the reserves carried on its books and approved by state authorities, Georgia Life qualified

Page 430 U. S. 736

as a life insurance company for the years at issue here, 1961-1964. Consequently First Railroad excluded Georgia Life's income from its consolidated return, pursuant to § 1504(b)(2) of the Code. The Commissioner determined that Georgia Life did not qualify for life insurance company status or exclusion from the consolidated return, and so assessed a deficiency. First Railroad paid and sued for a refund. It prevailed in the District Court, but the Court of Appeals for the Fifth Circuit reversed, relying heavily on Economy Finance Corp. v. United States, 501 F.2d 466 (CA7 1974), cert. denied, 420 U.S. 947, rehearing denied, 421 U.S. 922 (1975), motion for leave to file second petition for rehearing pending, No. 74-701.

C

No. 75-1285, United States v. Penn Security Life Ins. Co. Penn Security Life Insurance Co., a Missouri corporation, is, like Consumer Life, a subsidiary of a finance company. Under three separate Treaty I type agreements, it reinsured the life and A&H policies of three unrelated insurers during the years in question, 1963-1965. The other companies reported the unearned premium reserves, and the Missouri authorities approved this treatment. Because one of the three treaties did not contain a runoff provision like that present in Consumer Life, the Government conceded that the reserves held by that particular ceding company should not be attributed to the taxpayer. But the other two treaties were similar in all relevant respects to Treaty I in Consumer Life. After paying the deficiencies assessed by the Commissioner, Penn Security sued for a refund in the Court of Claims. Both the trial judge and the full Court of Claims ruled for the taxpayer.

III

The Government commences its argument by suggesting that these reinsurance agreements were sham transactions

Page 430 U. S. 737

without economic substance, and therefore should not be recognized for tax purposes. See, e.g., Gregory v. Helvering,293 U. S. 465, 293 U. S. 470 (1935); Knetsch v. United States,364 U. S. 361 (1960). We do not think this is an accurate characterization.

Both taxpayers who were parties to Treaty I agreements entered into them only after arm's-length negotiation with unrelated companies. The ceding companies gave up a large portion of premiums, but, in return, they had recourse against the taxpayers for 100% of claims. The ceding companies were not just doing the taxpayers a favor by holding premiums until earned. This delayed payment permitted the ceding companies to invest the dollars, and, under the treaties, they kept all resulting investment income. Nor were they mere "paymasters," as the Government contends, for indemnity reinsurance of this type does not relieve the ceding company of its responsibility to policyholders. Had the taxpayers become insolvent, the insurer still would have been obligated to meet claims. [Footnote 15]

Treaty II also served most of the basic business purposes commonly claimed for reinsurance treaties. See W. Hammond, Insurance Accounting Fire & Casualty 86 (2d ed.1965); Dickerson 563 564. It reduced the heavy burden on the taxpayer's surplus caused by the practice of computing casualty reserves on the basis of gross unearned premiums even though the insurer may have paid out substantial sums in commissions and expenses at the commencement of coverage. By reducing this drain on surplus, the

Page 430 U. S. 738

taxpayer was able to expand its business, resulting in a broader statistical base that permitted more accurate loss predictions. [Footnote 16] Through Treaty II, each taxpayer associated itself with a reinsurance company more experienced in the field. Moreover, under Treaty II, the taxpayers were shielded against a period of catastrophic losses. Even though the reinsurer would eventually recapture any such deep losses, it would be of substantial benefit to the ceding company to spread those payments out over a period of months or years. Both courts

Page 430 U. S. 739

below that passed on Treaty II agreements found expressly that the treaties served valid and substantial nontax purposes. [Footnote 17] Tax considerations well may have had a good deal to do with the specific terms of the treaties, but even a "major motive" to reduce taxes will not vitiate an otherwise substantial transaction. United States v. Cumberland Pub. Serv. Co.,338 U. S. 451, 338 U. S. 455 (1950). [Footnote 18]

IV

Whether or not these were sham transactions, however, the Government would attribute the contested unearned premium reserves to the taxpayers, because it finds in § 801(c)(2) a rule that "insurance reserves follow the insurance risk." Brief for United States 34. This assertion, which forms the heart of the Government's case, is based on the following reasoning. Section 801 provides a convenient test for determining whether a company qualifies for favorable tax treatment as a life insurance company, a test determined wholly by the ratio of life reserves to total reserves. Reserves, under accepted accounting and actuarial standards, represent liabilities. Although often carelessly referred to as "reserve funds," or as being available to meet policyholder claims, reserves are not assets; they are entered on the liability side of the balance sheet. Under standard practice, they are mathematically equivalent to the gross unearned premium dollars already

Page 430 U. S. 740

paid in, but conceptually the reserve a liability -- is distinct from the cash asset. This much of the argument is indisputably sound.

The Government continues: since a reserve is a liability, it is simply an advance indicator of the final liability for the payment of claims. The company that finally will be responsible for paying claims -- the one that bears the ultimate risk -- should therefore be the one considered as having the reserves. In each of these cases, the Government argues, it was the taxpayer that assumed the ultimate risk. The other companies were merely paymasters holding on to the premium dollars until earned in return for a negligible percentage of the gross premiums.

A

We may assume for present purposes that the taxpayers did take on all substantial risks under the treaties. [Footnote 19] And, in the broadest sense, reserves are, of course, set up because of future risks. Cf. Helvering v. Le Gierse,312 U. S. 531, 312 U. S. 539 (1941). The question before us, however, is not whether the Government's position is sustainable as a matter of abstract logic. [Footnote 20] Rather it is whether Congress intended a "reserves follow the risk" rule to govern determinations under § 801.

Page 430 U. S. 741

There is no suggestion in the plain language of the section that this is the case. See nn. 1 and | 1 and S. 725fn4|>4, supra. If anything, the language is a substantial obstacle to accepting the Government's position. The word "risk" does not occur. Moreover, in § 801(c)(2), Congress used the phrase "unearned premiums," rather than "unearned premium reserve." The Government argues that, taken in context, "unearned premiums" must be regarded as referring to reserves -- to the liability account for unearned premium reserves, and not the asset represented by the premium dollars. We agree that the reference is to reserves, but still the use of the truncated phrase suggests that Congress intended a mechanical application of the concept. In other words, this phrase suggests that, in Congress' view, unearned premium reserves always would be found in the same place as the unearned premiums themselves. If so, reserves would follow mechanically the premium dollars, as taxpayers contend, and would not necessarily follow the risk.

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