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. �
1 and S. 742�
B
The rather sparse legislative history furnishes no better
support for the Government's position. Under the early Revenue
Acts, all insurance companies were taxed on the same basis as other
corporations. Both investment income and premium or underwriting
income were included in gross income, although there was a special
deduction for additions to reserves.
See, e.g., Revenue
Act of 1918, § 234(a)(10), 40 Stat. 1079.
By 1921, Congress became persuaded that this treatment did not
accurately reflect the nature of the life insurance enterprise,
since life insurance is often a form of savings for policyholders,
similar in some respects to a bank deposit.
See Hearings
on H.R. 8245 before the Senate Committee on Finance, 67th Cong.,
1st Sess., 83 (1921) (testimony of Dr. T. S. Adams, Tax Adviser to
Treasury Department). Under this view, premium receipts "were not
true income [to the life insurance company], but were analogous to
permanent capital investment."
Helvering v. Oregon Mutual Life
Ins. Co., 311 U. S. 267,
311 U. S. 269
(1940). The 1921 Act therefore provided, for the first time, that
life insurance companies would be taxed on investment income alone,
and not on premium receipts. Revenue Act of 1921, §§ 242-245, 42
Stat. 261. The same rationale did not apply to other forms of
insurance, and Congress continued to tax insurance companies other
than life on both underwriting and investment income. §§
246-247.
The 1921 Act was thus built on the assumption that important
differences between life and nonlife insurance called for markedly
different tax treatment. Strict adherence to this policy rationale
would dictate that any company insuring both types of risks be
required to segregate its life and nonlife business so that
appropriate tax rules could be applied to each. Congress considered
this possibility, but chose instead
Page 430 U. S. 743
a more convenient rule of thumb, [
Footnote 21] the 50% reserve ratio test. [
Footnote 22] The Treasury official
primarily responsible for the 1921 Act explained:
"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 this accident
and health business was more than 50 per cent 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 a life insurance company."
1921 Hearings,
supra at 85 (testimony of Dr. T. S.
Adams). This passage constitutes the only significant reference to
the test in the 1921 deliberations.
In succeeding years, controversy developed over the preferential
treatment enjoyed by life insurance companies. There were claims
that they were not carrying their fair share of the tax burden.
There were charges that stock companies were favored over mutuals,
or vice versa. There was
Page 430 U. S. 744
a nagging question over just how to compute a proper deduction
for additions to reserves. Congress tried a host of different
formulas to ameliorate these problems.
See H.R.Rep. No.
34, 86th Cong., 1st Sess., 2-7 (1959); S.Rep. No. 291, 86th Cong.,
1st Sess., 3-11 (1959);
Alinco Life Ins. Co. v. United
States, 178 Ct.Cl. 813, 831-837, 373 F.2d 336, 345-349 (1967).
But throughout these years the 50% test was not significantly
changed. [
Footnote 23]
In 1959, Congress passed legislation that finally established a
permanent tax structure for life insurance companies. Life
Insurance Company Income Tax Act of 1959, 73 Stat. 112. For the
first time since 1921, not only investment income, but also a
portion of underwriting income, was made subject to taxation.
[
Footnote 24] But even as
Congress was rewriting the substantive provisions for taxing life
insurance companies, it did not, despite occasional calls for
change, [
Footnote 25] make
any relevant alterations in § 801. Moreover, the few references to
that provision
Page 430 U. S. 745
in the committee reports shed little light on the issue
presented here. [
Footnote
26] They contain no explicit or implicit support for a rule
that reserves follow the risk.
C
More important than anything that appears in hearings, reports,
or debates is a provision added in 1959, § 820, concerning modified
coinsurance contracts between life insurance companies. [
Footnote 27] This section, although
designed to deal with a
Page 430 U. S. 746
problem different from the one presented here, is simply
unintelligible if Congress thought that § 801 embodied an unvarying
rule that reserves follow the risk.
A conventional coinsurance contract is a particular form of
indemnity reinsurance. [
Footnote
28] The reinsurer agrees to reimburse the ceding company for a
stated portion of obligations arising out of the covered policies.
In return, the reinsurer receives a similar portion of all premiums
received by the insurer, less a ceding commission to cover the
insurer's overhead. The reinsurer sets up the appropriate reserve
for its proportion of the obligation and, as is customary, the
ceding company takes
Page 430 U. S. 747
credit against its reserves for the portion of the risks
reinsured. A modified coinsurance contract is a further variation
in this esoteric area of insurance. As explained before the Senate
Finance Committee, a modified form of coinsurance developed because
some major reinsurers were not licensed to do business in New York,
and New York did not permit a ceding company to take credit against
its reserves for business reinsured with unlicensed companies.
Hearings on H.R. 4245 before the Senate Committee on Finance, 86th
Cong., 1st Sess., 608 (1959) (statement of Henry F. Rood). Denial
of credit places the ceding company in an undesirable position. It
has depleted its assets by paying to the reinsurer the latter's
portion of premiums, but its liability account for reserves remains
unchanged. Few companies would accept the resulting drain on
surplus, and unlicensed reinsurers wishing to retain New York
business began offering a modified form of coinsurance contract.
Obligations would be shared as before, but the ceding company,
which must in any event maintain 10% of the reserves, would be
permitted to retain and invest the assets backing the reserves. As
consideration for this right of retention, modified coinsurance
contracts require the ceding company to pay to the reinsurer, under
a complicated formula, the investment income on the reinsurer's
portion of the investments backing the reserve.
See id. at
609; E. Wightman, Life Insurance Statements and Accounts 150-151
(1952); D. McGill, Life Insurance 43540 (rev. ed.1967).
The 1959 legislation, as it passed the House, contained no
special treatment for these modified contracts. The income involved
therefore would have been taxed twice, once as investment income to
the ceding company and then as underwriting income to the
reinsurer. [
Footnote 29] The
Senate thought this double taxation inequitable, and therefore
added § 820, to which the House agreed. That section provides that,
for tax
Page 430 U. S. 748
purposes, modified coinsurance contracts shall be treated the
same as conventional coinsurance contracts if the contracting
parties consent to such treatment. For consenting companies,
Congress not only provided that gross investment income shall be
treated as if it were received directly (in appropriate share) by
the reinsurer, § 820(c)(1), but also expressly declared that the
reserves "shall be treated as a part of the reserves of the
reinsurer and not of the reinsured." § 820(c)(3).
Under a modified coinsurance contract, the reinsurer bears the
risk on its share of the obligations. Thus, if § 801 mandates that
reserves follow the risk, the reinsurer could not escape being
considered as holding its share of the reserve. Section 820(c)(3),
providing for attribution of the reserves to the reinsurer, would
be an elaborate redundancy. And although § 820(a)(2) specifics that
attribution under § 820 is optional, requiring the consent of the
parties, the parties would, in fact, have no option at all.
Plainly, § 820 is incompatible with a view that § 801 embodies a
rule that reserves follow the risk. [
Footnote 30]
Page 430 U. S. 749
The Commissioner himself, interpreting § 801 in light of § 820,
has implicitly acknowledged that reserves do not follow the risk.
Rev.Rul. 70-508, 1970-2 Cum.Bull. 136. Advice was requested by the
parties to a modified coinsurance contract who had not elected the
special treatment available under § 820. The ceding company had
carried the life insurance reserves on its books, although the
reinsurer bore the ultimate risk. The ceding company wanted to know
whether it could count those reserves in its ratio for purposes of
§ 801. Relying on § 801(b) and the Treasury Regulations
implementing it, the Commissioner ruled that it could. A "reserves
follow the risk" rule would have dictated precisely the opposite
result.
D
Section 820 affords an unmistakable indication that § 801 does
not impose the "reserves follow the risk" rule. Instead, Congress
intended to rely on customary accounting and actuarial practices,
leaving, as § 820 makes evident, broad discretion to the parties to
a reinsurance agreement to negotiate their own terms. This does not
open the door to widespread abuse.
"Congress was aware of the extensive, continuing supervision of
the insurance industry by the states. It is obvious that subjecting
the reserves to the scrutiny of the state regulatory agencies is an
additional safeguard against overreaching by the companies."
Mutual Benefit Life Ins. Co. v. Commissioner, 488 F.2d
1101, 1108 (CA3 1973),
cert. denied, 419 U.S. 882 (1974).
See Lamana-Panno-Fallo Industrial Ins. Co. v.
Commissioner, 127 F.2d 56, 58-59 (CA5 1942);
Alinco Life
Ins. Co. v. United States, 178 Ct.Cl. at 831, 373 F.2d at 345.
See also Prudential Ins. Co. v. Benjamin, 328 U.
S. 408,
328 U. S.
429-433 (1946); 15 U.S.C. § 1011 (McCarran-Ferguson
Act). In presenting the 1959 legislation to the full House, members
of the committee that drafted the bill were careful to underscore
the continuing primacy of state
Page 430 U. S. 750
regulation, with specific reference to the question of reserves.
[
Footnote 31] In two of the
cases before us, the courts below expressly found that the reserves
were held in accordance with accepted actuarial and accounting
standards, [
Footnote 32]
while the third court did not address the issue. In all three, it
was found that no state insurance department required any change in
the way the taxpayers computed and reported their reserves.
[
Footnote 33] 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, we hold that § 801(c)(2) does not permit
attribution to the taxpayers of the reserves held by the other
parties to the reinsurance treaties. [
Footnote 34]
V
The Government argues that even if attribution of reserves is
not required under § 801(c)(2), attribution is required
Page 430 U. S. 751
under § 801(c)(3), counting in total reserves "all other
insurance reserves required by law."
See n 4,
supra. Under state statutory
law, the Government suggests, these taxpayers were required to set
up and maintain the full unearned premium reserves.
Our attention is drawn to no statute in any of the affected
States that expressly requires this result. Instead the Government
returns to its main theme and asserts, in essence, that certain
general state statutory provisions embody the doctrine that
reserves follow the risk. [
Footnote 35] We would find it difficult to infer such a
doctrine from the statutory provisions relied on by the Government
even if there were no other indications to the contrary. But other
indications are compelling. The insurance departments of the
affected States consistently accepted annual reports showing
reserves held as the taxpayers claim they should be. [
Footnote 36] It is well
established
Page 430 U. S. 752
that the consistent construction of a statute "by the agency
charged with its enforcement is entitled to great deference by the
courts."
NLRB v. Boeing Co., 412 U. S.
67,
412 U. S. 75
(1973).
See Trafficante v. Metropolitan Life Ins. Co.,
409 U. S. 205,
409 U. S. 210
(1972);
Udall v. Tallman, 380 U. S.
1,
380 U. S. 118
(1965);
Skidmore v. Swift & Co., 323 U.
S. 134,
323 U. S.
139-140 (1944). This is no less the rule when federal
courts are interpreting state law administered by state regulatory
officials, [
Footnote 37] at
least where, as here, there is no reason to think that the state
courts would construe the statute differently. We find no basis for
holding that taxpayers were required by law, within the meaning of
§ 801(c)(3), to maintain the disputed unearned premium reserves.
[
Footnote 38]
Page 430 U. S. 753
VI
For the reasons stated, we hold for the taxpayers. The judgments
in Nos. 75-1221 and 75-1285 are affirmed. The judgment in No. 71260
is reversed, and the case is remanded for further proceedings
consistent with this opinion.
It is so ordered.
* Together with No. 71260,
First Railroad & Banking
Company of Georgia v. United States, on certiorari to the
United States Court of Appeals for the Fifth Circuit, and No.
75-1285,
United States v. Penn Security Life Insurance
Co., also on certiorari to the United States Court of
Claims.
[
Footnote 1]
Section 801(a) provides:
"(a) Life insurance company defined."
"For purposes of this subtitle, the term 'life insurance
company' means an insurance company which is engaged in the
business of issuing life insurance and annuity contracts (either
separately or combined with health and accident insurance), or
noncancellable contracts of health and accident insurance, if --
"
"(1) its life insurance reserves (as defined in subsection (b)),
plus"
"(2) unearned premiums, and unpaid losses (whether or not
ascertained), on noncancellable life, health, or accident policies
not included in life insurance reserves,"
"comprise more than 50 percent of its total reserves (as defined
in subsection (c))."
As may be seen, the statement in the text is somewhat
oversimplified. Reserves for noncancellable life, health, or
accident policies are added to life insurance reserves for purposes
of computing the ratio.
See generally Alinco Life Ins. Co. v.
United States, 178 Ct.Cl. 813, 831-847, 373 F.2d 336, 345-355
(1967). Since none of these cases, as they reach us, involves any
issue concerning noncancellable policies, we may ignore this
factor.
Statutory citations, unless otherwise indicated, are to the
Internal Revenue Code of 1954.
[
Footnote 2]
The major benefit is that only 50% of underwriting income is
taxed in the year of receipt, the balance being taxed only when
made available to stockholders. The scheme for taxing life
insurance companies is described in
United States v. Atlas Life
Ins. Co., 381 U. S. 233
(1965), and
Jefferson Standard Life Ins. Co. v. United
States, 408 F.2d 842, 844-846 (CA4),
cert. denied,
396 U.S. 828 (1969).
Stock companies that fail to qualify as life insurance companies
are taxed under the less favorable provisions of § 831. Most mutual
insurance companies other than life are taxed under § 821, a
section not implicated here, since taxpayers are all stock
companies.
[
Footnote 3]
In two of the cases, the Court of Claims held for the taxpayer.
Consumer Life Ins. Co. v. United States, 207 Ct.Cl. 638,
524 F.2d 1167 (1975);
Penn Security Life Ins. Co. v. United
States, 207 Ct.Cl. 594, 524 F.2d 1155 (1975). In the third
case, the Court of Appeals for the Fifth Circuit ruled in favor of
the Government.
First Railroad & Banking Co. of Georgia v.
United States, 514 F.2d 675 (1975). It relied on an earlier
holding to the same effect in
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.
[
Footnote 4]
Section 801(c) provides in relevant part:
"(c) Total reserves defined."
"For purposes of subsection (a), the term 'total reserves' means
--"
"(1) life insurance reserves"
"(2) unearned premiums, and unpaid losses (whether or not
ascertained), not included in life insurance reserves, and"
"(3) all other insurance reserves required by law."
"Life insurance reserves" is defined in § 801(b).
[
Footnote 5]
See Treas.Reg. § 1.801-3(e) (1960) (defining unearned
premiums), explained in Rev.Rul. 69-270, 1969-1 Cum.Bull. 185;
Utah Home Fire Ins. Co. v. Commissioner, 64 F.2d 763
(CA10),
cert. denied, 290 U.S. 679 (1933); nn. 16 and 20,
infra. See generally Massachusetts Protective Assn. v.
United States, 114 F.2d 304 (CA1 1940);
Commissioner v.
Monarch Life Ins. Co., 114 F.2d 314 (CA1 1940).
[
Footnote 6]
This figure is derived from a straight-line or
pro rata
method of computing earned premiums. Some companies use a
sum-of-the-digits method known as the Rule of 78, described in
detail by the Court of Claims in the
Penn Security case,
No. 75-1285, Pet. for Cert. 34a-36a (Findings of Fact Nos. 10, 11).
The difference in computation methods is not material for present
purposes.
[
Footnote 7]
Each was an indemnity reinsurance treaty, obligating the
reinsurer to reimburse the ceding company for its share of losses.
Such treaties constitute contracts between the companies only; the
policyholders are not involved, and usually remain unaware that
part or all of the risk has been reinsured.
[
Footnote 8]
The Government makes this attribution not under the familiar
allocation rules of §§ 269 and 482, but rather based primarily on
its interpretation of § 801(c). Indeed, the former sections could
not apply except in No. 75-1260, the
First Railroad case,
for only that case involves a reinsurance agreement between
corporations controlled by the same interests. The Government
invokes neither section here, though it has on occasion attempted
to use both in its efforts to impose higher taxes on companies
engaged in the credit life insurance business.
See Commissioner
v. First Security Bank of Utah, 405 U.
S. 394 (1972) (§ 482);
Alinco Life Ins. Co. v.
United States, 178 Ct.Cl., at 822-830, 373 F.2d at 340-345 (§
268).
[
Footnote 9]
Consumer Life's premium was later increased to 90 1/2%.
[
Footnote 10]
Consumer Life did set up the full tabular reserve for the life
insurance policies.
See n 20,
infra.
[
Footnote 11]
Under Treaty II, the life business was not reinsured; Consumer
Life, by itself, assumed the full liability.
[
Footnote 12]
In addition to reviewing reports filed on prescribed forms,
state regulatory authorities conduct regular triennial examinations
of insurance companies, commonly pooling their efforts through the
National Association of Insurance Commissioners (NAIC). Such
examinations ordinarily include a thorough review of all
reinsurance agreements.
See generally NAIC, Examiners
Handbook A30-A35 (3d ed. rev.1970, 2d printing 1974). While these
treaties were in effect, each company was examined twice, Consumer
Life in 1959 and 1963 and American Bankers in 1960 and 1963. The
Court of Claims found that the reinsurance treaties were examined
in detail, and that the provisions for maintenance of reserves were
approved in the course of all four examinations. 207 Ct.Cl. at 647,
524 F.2d at 1172.
[
Footnote 13]
Some of the details differ from Treaty II in
Consumer
Life, but the differences are not important for present
purposes.
[
Footnote 14]
The Government does not seek to base attribution of reserves on
this relationship.
See n 8,
supra.
[
Footnote 15]
Treaty I type reinsurance is therefore different from the
relation of agent and insurer found in
Superior Life Ins. Co.
v. United States, 462 F.2d 945 (CA4 1972) (credit A&H
premiums were held by the finance company until earned, and only
then paid to the insurance company; the court held that, under
state law, the finance company was a mere agent, and the insurance
company would be treated as holding the unearned premium
reserve).
[
Footnote 16]
Surplus drain may be illustrated by the following example: a
company issues a one-year A&H policy for a premium of $120,
paying its agent a $60 commission at the time of issuance. The
state insurance department will require the company to set up a
reserve on the liability side of its balance sheet equivalent to
the gross unearned premium -- $120 at the beginning of coverage.
But after paying the commission, the company shows a cash asset of
only $60. The $60 difference results in a $60 decrease in
surplus.
As each month elapses, $10 -- one-twelfth of the annual premium
-- becomes "earned," and is therefore released from the reserve. A
company whose business is level, writing new policies only as an
equivalent number of old policies expire, will therefore experience
no surplus drain, assuming that claims experience is within the
expected range; the
pro rata release from reserves as
premiums become earned will match the burden imposed by new
policies. But companies whose business is expanding, and especially
new companies, will have a continuing surplus-drain problem.
See generally Dickerson 606;
Utah Home Fire Inc. Co.
v. Commissioner, 64 F.2d at 764; n. 20,
infra.
Reinsurance can provide amelioration. Assume the company in the
example above reinsures half its business under a treaty with
simpler provisions than Treaty I or Treaty II. This treaty calls
for the reinsurer to establish a reserve equal to 50% of the gross
unearned premium in return for immediate payment of 50% of the
primary insurer's net premium income. The primary company then
takes credit against its reserve for the business ceded; its
reserve is reduced from $120 to $60. At the same time, it remits
half its net income, $30, retaining a cash asset of $30. Each
policy written on this basis therefore drains surplus only by $30,
the difference between the $60 reserve and the $30 asset. Under the
treaty, the company can issue twice as many policies as before for
the same total depletion in surplus.
[
Footnote 17]
Consumer Life, No. 75-1221, Pet. for Cert. 97a-98a,
100a, 105a (Findings of Fact Nos. 18, 19, 25, 37);
First
Railroad, No. 75-1260, Pet. for Cert. 14a-15a (District Court
finding of fact accepted by the Court of Appeals, 514 F.2d at
677).
[
Footnote 18]
The Government also relies on an asserted analogy to
Commissioner v. Hansen, 360 U. S. 446
(1959). That case, dealing with a question of ordinary accrual
accounting, is inapposite. Life insurance accounting is a world
unto itself.
See Brown v. Helvering, 291 U.
S. 193,
291 U. S. 201
(1934);
Great Commonwealth Life Ins. Co. v. United States,
491 F.2d 109 (CA5 1974). Mechanical application of ordinary
accounting principles will not necessarily yield a sound
result.
[
Footnote 19]
It is not difficult to conceive of changes in the treaties,
however, that would make it much harder to determine whether the
other party bore a substantial risk. And if any risk that may be
called substantial is sufficient to permit the parties to escape
the attribution for which the Government argues, then surely a
Government victory here would be short-lived.
Cf. Commissioner
v. Brown, 380 U. S. 563,
380 U. S. 580
(1965) (Harlan, J., concurring).
[
Footnote 20]
It is clear, in any event, that the traditional actuarial and
accounting treatment of A&H reserves is not built entirely on a
logic of risk. The premium charged the policyholder consists of two
parts, an expense portion, or "loading," to cover commissions,
administrative expenses, and profit, and a claims portion. Only the
latter, the net premium or "morbidity" element, represents the
company's estimate of what it must now take in and invest to meet
its responsibilities as claims arise; that is, only the latter
represents the company's risk. The expense portion is relatively
fixed. Nearly all of it is paid out, for commissions and
administrative expenses connected with issuing the policy, at the
time the premiums are received. Since these expenses already have
been paid, the only future liabilities for which a reserve strictly
is needed are claims. Nevertheless, state insurance departments
uniformly require that A&H reserves be set up equivalent to the
gross unearned premium. A&H reserves thus stand on a different
footing from life insurance reserves, which are typically computed
on the basis of mortality tables and assumed rates of interest.
See § 801(b). Life reserves contain no loading
element.
Although gross unearned premium reserves may not strictly
comport with a logic of risk, from the viewpoint of insurance
regulators this approach yields advantages in simplicity of
computation. Establishing the larger reserve also tends to assure
conservative operation and the availability of means to pay refunds
in the event of cancellation.
See generally Mayerson,
Ensuring the Solvency of Property and Liability Insurance
Companies, in Insurance, Government and Social Policy 146, 171-172
(S. Kimball & H. Denenberg eds.1969); Dickerson 604 606;
Utah Home Fire Ins. Co. v. Commissioner, 64 F.2d at
764.
[
Footnote 21]
Since Congress thus has not adhered completely to the policy
underlying its choice to tax life insurance companies differently
from other insurance companies, we believe the court in
Economy
Finance Corp. v. United States, 501 F.2d 466 (CA7 1974),
relied too heavily on its reading of that policy in finding that
unearned premium reserves should be attributed from the ceding
company to the reinsurer in a Treaty I type agreement.
See Penn
Security, 207 Ct.Cl. at 608, 524 F.2d at 1162.
[
Footnote 22]
Section 242 of the 1921 Act, 42 Stat. 261, provided:
"That when used in this title the term 'life insurance company'
means an insurance company engaged in the business of issuing life
insurance and annuity contracts (including contracts of combined
life, health, and accident insurance), the reserve funds of which
held for the fulfillment of such contracts comprise more than 50
per centum of its total reserve funds."
[
Footnote 23]
In 1942, Congress did add a definition of "total reserves,"
specifying the same three elements that appear in the definition
today. Revenue Act of 1942, § 163, 56 Stat. 867, amending § 201(b)
of the Internal Revenue Code of 1939. The 1942 committee reports
take note of the addition, but do not elaborate. There is no
glimmer of a "reserves follow the risk" rule. H.R.Rep. No. 2333,
77th Cong., 2d Sess., 109 (1942); S.Rep. No. 1631, 77th Cong., 2d
Sess., 145 (1942).
[
Footnote 24]
See n 2,
supra.
[
Footnote 25]
During the hearings, a number of witnesses and legislators
expressed a concern that so-called specialty companies,
particularly credit life insurance companies, were reaping
excessive benefits from preferential life insurance company
taxation.
See, e.g., Hearings before the Subcommittee on
Internal Revenue Taxation of the House Committee on Ways and Means,
85th Cong., 2d Sess., 78, 242-244, 330, 422-434 (1958); Hearings on
H.R. 4245 before the Senate Committee on Finance, 86th Cong., 1st
Sess., 885 (1959). Some proposed to deny them these benefits by
altering the definition in § 801.
See House Hearings,
supra at 78, 330; Senate Hearings,
supra, at 85.
No one addressed the question of reserve allocation under
reinsurance contracts like those involved here, but Congress
clearly was made aware that § 801 often led to what some considered
undesirable results when applied to credit life insurance
companies.
See also H.R.Rep. No. 1098, 84th Cong., 1st
Sess., 3-7 (1955); S.Rep. No. 1571, 84th Cong., 2d Sess., 3-8
(1956).
[
Footnote 26]
H.R.Rep. No. 34, 86th Cong., 1st Sess., 22-23 (1959); S.Rep. No.
291, 86th Cong., 1st Sess., 41-44 (1959).
[
Footnote 27]
Section 820 provides in relevant part:
"§ 820. Optional treatment of policies reinsured under modified
coinsurance contracts."
"(a) In general."
"(1) Treatment as reinsured under conventional coinsurance
contract."
"Under regulations prescribed by the Secretary or his delegate,
an insurance or annuity policy reinsured under a modified
coinsurance contract (as defined in subsection (b)) shall be
treated, for purposes of this part (other than for purposes of
section 801), as if such policy were reinsured under a conventional
coinsurance contract."
"(2) Consent of reinsured and reinsurer."
"Paragraph (1) shall apply to an insurance or annuity policy
reinsured under a modified coinsurance contract only if the
reinsured and reinsurer consent, in such manner as the Secretary or
his delegate shall prescribe by regulations -- "
"(A) to the application of paragraph (1) to all insurance and
annuity policies reinsured under such modified coinsurance
contract, and"
"(B) to the application of the rules provided by subsection (c)
and the rules prescribed under such subsection."
"Such consent, once given, may not be rescinded except with the
approval of the Secretary or his delegate."
"(b) Definition of modified coinsurance contract."
"For purposes of this section, the term 'modified coinsurance
contract' means an indemnity reinsurance contract under the terms
of which -- "
"(1) a life insurance company (hereinafter referred to as 'the
reinsurer') agrees to indemnify another life insurance company
(hereinafter referred to as 'the reinsured') against a risk assumed
by the reinsured under the insurance or annuity policy
reinsured,"
"(2) the reinsured retains ownership of the assets in relation
to the reserve on the policy reinsured,"
"(3) all or part of the gross investment income derived from
such assets is paid by the reinsured to the reinsurer as a part of
the consideration for the reinsurance of such policy, and"
"(4) the reinsurer is obligated for expenses incurred, and for
Federal income taxes imposed, in respect of such gross investment
income."
"(c) Special rules."
"Under regulations prescribed by the Secretary or his delegate,
in applying subsection (a)(1) with respect to any insurance or
annuity policy the following rules shall (to the extent not
improper under the terms of the modified coinsurance contract under
which such policy is reinsured) be applied in respect of the amount
of such policy reinsured:"
"
* * * *"
"(3) Reserves and assets."
"The reserve on the policy reinsured shall be treated as a part
of the reserves of the reinsurer and not of the reinsured, and the
assets in relation to such reserve shall be treated as owned by the
reinsurer and not by the reinsured."
[
Footnote 28]
Coinsurance carries a substantially different meaning in the
life insurance field than it does in the case of liability or
property insurance.
See Steffen, Life and Health
Reinsurance, in Life and Health Insurance Handbook 1035 n. 1 (D.
Gregg ed.1964); S. Huebner, K. Black, & R. Cline, Property and
Liability Insurance 95-100 (2d ed.1976).
[
Footnote 29]
This was not a problem under prior law, since the underwriting
income of life insurance companies was not taxed.
[
Footnote 30]
This conclusion is not weakened by the provision in § 820(a)(1)
that the special treatment under § 820 shall not apply for purposes
of § 801. This exception simply means that, for purposes of § 801,
the reserves are invariably treated as held by the ceding company;
the companies are unable to elect to have those reserves follow the
risk.
Cf. Rev.Rul. 70-508, 1970-2 Cum.Bull. 136, described
in the text
infra.
The Government argues that § 820 has no bearing on attribution
of A&H reserves, since it applies only to reinsurance
agreements in the life insurance field. We find this unpersuasive.
The Government derives its "reserves follow the risk" rule from the
definition of "reserve" and the fact that a reserve is a liability,
not an asset.
See supra at
430 U. S.
739-740. Life reserves.are as much liabilities as are
A&H reserves. Although there are important differences in the
ways the two are computed,
see n 20,
supra, none of those differences are
germane to the reasoning by which the Government derives its rule.
Either the "reserves follow the risk" rule is valid for all
insurance risks or it is valid for none.
[
Footnote 31]
See 105 Cong.Rec. 2569, 2576-2577 (1959) (remarks of
Reps. Mills and Simpson, chairman and ranking minority member,
respectively, of the Subcommittee on Internal Revenue
Taxation).
[
Footnote 32]
See Consumer Life, No. 75-1221, Pet. for Cert. 108a
(Finding of Fact No. 47);
First Railroad, No. 75-1260,
Pet. for Cert. 16a (finding by the District Court; the Court of
Appeals did not take issue with this finding).
[
Footnote 33]
Consumer Life, 207 Ct.Cl. at 643-647, 524 F.2d at
1170-1172;
First Railroad, No. 75-1260, Pet. for Cert. 16a
(finding by the District Court), noted without disapproval by the
Court of Appeals, 514 F.2d at 677 n. 8;
Penn Security, 207
Ct.Cl. at 599, 524 F.2d at 1157.
See also Penn Security,
No. 75-1285, Pet. for Cert. 48a (Finding of Fact No. 29).
[
Footnote 34]
The current statute bases the § 801 determination on reserves,
not on other criteria Congress could have chosen that might
arguably give a better indication of the relative importance of a
company's life insurance business.
See Economy Finance Corp. v.
United States, 501 F.2d at 483 (Stevens, J., dissenting). We,
of course, are called upon to apply the statute as it is written.
Furthermore, the interpretation for which the Government contends
"would have wide ramifications which we are not prepared to visit
upon taxpayers, absent congressional guidance in this direction."
Commissioner v. Brown, 380 U.S. at
380 U. S. 575.
If changes are thought necessary, that is Congress' business.
[
Footnote 35]
For example, Ariz.Rev.Stat.Ann. § 20-506 (1975) provides in part
that "every insurer shall maintain an unearned premium reserve on
all policies in force." Under § 20-104, "
I
nsurer' includes every person engaged in the business of making
contracts of insurance." Section 20-103 of the Arizona statute
defines "insurance" as "a contract whereby one undertakes to
indemnify another. . . ." After summarizing these provisions, the
Government concludes:
"The significant aspect of these state statutes is that they
require the establishment of a reserve by the company that is
ultimately liable to meet policy claims whether or not it has
actually received the premiums for the coverage."
Brief for United States 69-70. We do not think these general
provisions can be read to support such a sweeping conclusion.
[
Footnote 36]
In
Consumer Life and
First Railroad, the
Government introduced the testimony of certain insurance department
officials from Arizona and Georgia. They indicated that the
omission of unearned premium reserves from these two taxpayers'
annual reports was permitted "unwittingly," or only because the
departments were unfamiliar at the time with these types of
reinsurance agreements. But we do not think this after-the-fact
testimony from single officials should outweigh the formal,
official approval rendered under the names of the commissioners
after opportunity for full review. Moreover, this formal approval
withstood careful triennial audits.
See n 12,
supra.
[
Footnote 37]
The relevant Treasury Regulations also seem to make state
practice determinative:
"[T]he term 'reserves required by law' means reserves which are
required either by express statutory provisions or by rules and
regulations of the insurance department of a State, Territory, or
the District of Columbia when promulgated in the exercise of a
power conferred by statute,
and which are reported in the
annual statement of the company and accepted by state regulatory
authorities as held for the fulfillment of the claims of
policyholders or beneficiaries."
Treas.Reg. § 1.801-5(b) (1960) (emphasis added).
See also § 1.801-5(a) (indicating that the reserve
"must have been actually held during the taxable year for which the
reserve is claimed").
[
Footnote 38]
The Government suggests that state regulatory practice cannot be
deemed controlling under the doctrine of
McCoach v. Insurance
Co. of North America, 244 U. S. 585
(1917), and the many cases in this Court that followed it.
See,
e.g., United States v. Boston Ins. Co., 269 U.
S. 197 (1925);
New York Ins. Co. v. Edwards,
271 U. S. 109
(1926);
Helvering v. Inter-mountain Life Ins. Co.,
294 U. S. 686
(1935). Those cases held that certain reserves mandated by state
insurance authorities were not reserves "required by law" within
the meaning of the early Revenue Acts, because they were not
technical insurance reserves. In those cases, however, the question
was not whether the taxpayers qualified for preferential tax
treatment. Rather, the question was whether the taxpayers would be
allowed a deduction for additions to various reserves, and the
skeletal provisions of the earlier Acts necessitated a restrictive
view.
See McCoach, supra at
244 U. S. 589.
The same restrictive view is not appropriate for purposes of
applying § 801.
See National Protective Ins. Co. v.
Commissioner, 128 F.2d 948, 950-952 (CA8),
cert
denied, 317 U.S. 655 (1942). Moreover, those early cases
generally have little bearing on questions that arise under the
more recent enactments. The definition of "life insurance reserves"
that now appears in § 801(b), and which originated with the 1942
Revenue Act, substantially replaced the problematic concept of
technical reserves developed in
McCoach. See United
States v. Occidental Life Ins. Co., 385 F.2d 1, 4-7 (CA9
1967).
MR. JUSTICE WHITE, with whom MR. JUSTICE MARSHALL joins,
dissenting.
The Court today makes it possible for insurance companies doing
almost no life insurance business to qualify for major tax
advantages Congress meant to give only to companies doing mostly
life insurance business. I cannot join in the creation of this
truckhole in the law of insurance taxation.
I
Congress has chosen to give life insurance companies extremely
favorable federal income tax treatment. The reason for this
preferential tax treatment is the nature of life insurance risks.
They are long-term risks that increase over the period of coverage
and that will ultimately require the payment of a claim. Companies
that assume life insurance risks therefore must accumulate
substantial reserve funds to meet future claims; these reserve
funds are invested, and a large portion of the investment income is
then added to the funds already accumulated. In recognition of the
special
Page 430 U. S. 754
characteristics of life insurance risks, Congress has allowed a
substantial portion of life insurance company income to escape
taxation. [
Footnote 2/1]
Other types of insurance, such as the accident and health
(A&H) coverage provided by the taxpayers in these cases, do not
involve the assumption of long-term risks that inevitably will
require the payment of benefits at some point in the relatively
distant future. Consequently, Congress has provided for taxation of
such nonlife insurance companies in much the same manner as any
other corporation.
See Internal Revenue Code of 1954, §§
831, 832, 26 U.S.C. §§ 831, 832. Many companies mix nonlife
insurance business with their life insurance business, and Congress
has decided to tax such "mixed" enterprises according to whether
the majority of the company's business is life or nonlife:
"[I]f this accident and health business was more than 50 per
cent 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 per cent of their business, we treated them as a life
insurance company."
Hearings on H.R. 8245 before the Senate Committee on Finance,
67th Cong., 1st Sess., 85 (1921) (testimony of Dr. T. S. Adams, Tax
Adviser to the Treasury Department), also quoted
ante at
430 U. S.
743.
Page 430 U. S. 755
In order to measure the proportion of life insurance business
done by an insurance company, Congress used the fraction of total
insurance reserves consisting of life insurance reserves, as
defined by § 801. The purpose of this reserve ratio test is, of
course, to determine whether a majority of an insurance company's
business is life insurance. [
Footnote
2/2]
More than 50% of the business of the taxpayer insurance
companies for the taxable years in question here was nonlife,
rather than life, insurance business as measured by the reserves
accumulated to cover all life and nonlife risks assumed by the
taxpayers. [
Footnote 2/3] The
taxpayers sought to obtain preferential treatment as life insurance
companies under § 801 by arranging with other companies to hold the
necessary reserves for the taxpayers. I agree with the majority
that these arrangements had economic substance in that the
companies holding the reserves performed two additional
Page 430 U. S. 756
functions for the taxpayers: a clearinghouse function,
collecting premiums and paying out claims, and a financing
function, lending the difference between the reserves established
for the policy and the premiums, less selling expenses, received
from the policyholder.
See ante at
430 U. S.
737-738, and n. 16;
Economy Finance Corp. v. United
States, 501 F.2d 466, 477-478 (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. But I cannot agree that these
arrangements enable the taxpayers to qualify for tax savings
Congress intended to give only to insurance companies whose
predominant business is the assumption of insurance risks.
II
The majority holds that the taxpayers may obtain these tax
savings despite the predominantly nonlife character of their
insurance business,
"[s]ince the taxpayers neither held the unearned [A&H]
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. . . ."
Ante at
430 U. S. 750.
This rule would permit an A&H insurance company to qualify for
preferential treatment as a life insurance company by selling a few
life policies and then arranging, by means similar to those
employed here, for a third party to hold the A&H premiums and
the corresponding reserves. Under the majority's rule, these
reserves held by the third party to cover risks assumed by the
A&H company would not be attributed to that company; its total
reserves for purposes of § 801 would consist almost entirely of
whatever life insurance reserves it held; and the company would
satisfy the reserve ratio test. [
Footnote 2/4] I
Page 430 U. S. 757
cannot believe that Congress intended to allow an insurance
company to shelter its nonlife insurance income from taxation
merely by assuming an incidental amount of life insurance risks and
engaging another company to hold its reserves through arrangements
with the requisite economic substance and state regulatory approval
to satisfy the standard announced by the majority today.
The language of § 801 and its accompanying regulations does not
require such a result. Section 801(a) provides that any insurance
company may qualify as a life insurance company "if
its
life insurance reserves . . . comprise more than 50 percent of
its total reserves . . ." (emphasis added); § 801(c)(2)
includes "unearned premiums" in the definition
Page 430 U. S. 758
of "total reserves" for purposes of § 801(a). It is clear that,
as required by Treasury Regulations, unearned premium reserves were
set up to "cover the cost of carrying the [A&H] insurance risk
for the period for which the premiums have been paid in advance,"
Treas.Reg. § 1.801-3(e) (1972), and that these reserves "have been
actually held during the taxable year[s]" at issue here. §
1.801-5(a)(3) (1960). The question is whether the A&H reserves
set up to cover risks assumed by each taxpayer are considered to be
"its" reserves even though they are in the physical possession and
under the nominal control of another company.
The Regulations explicitly answer this question in the
affirmative for life insurance reserves:
"[Life insurance]
reserves held by the company with respect
to the net value of risks reinsured in other solvent companies . .
. shall be deducted from the company's life insurance
reserves. For example, if an ordinary life policy with a
reserve of $100 is reinsured in another solvent company on a yearly
renewable term basis, and the reserve on such yearly renewable term
policy is $10, the reinsured company shall include $90 ($100 minus
$10) in determining its life insurance reserves."
§ 1.801-4(a)(3) (1972). (Emphasis added.)
Accord, §
1.801-4(d)(5). Thus, for purposes of the reserve ratio test of §
801, life insurance reserves are attributable to the company
assuming the risk under a reinsurance agreement. The same
attribution rule should be used in calculating the denominator of
the reserve ratio (life plus nonlife reserves) as for the numerator
(life reserves); as the majority recognizes,
ante at
430 U. S. 748
n. 30, there is no reason not to adopt a consistent approach to
allocation of both life and nonlife reserves in determining life
insurance company status.
The rule that life and nonlife reserves are attributable to the
risk bearer reflects the familiar principles of cases such as
Lucas v. Earl, 281 U. S. 111
(1930), where income earned by
Page 430 U. S. 759
a taxpayer was attributed to him notwithstanding a contractual
arrangement under which the income was paid over to a third party.
In that case, the salary derived from the taxpayer's business
activity was treated as "his" income even though he did not receive
or hold it. Similarly, the reserves applicable to the A&H
insurance business of each of the taxpayers here should be treated
as "its" reserves.
Cf. Commissioner v. Hansen,
360 U. S. 446
(1959). [
Footnote 2/5]
III
The majority insists nonetheless that these predominantly
nonlife insurance companies be given preferential tax treatment
intended only for predominantly life insurance companies. To reach
this result, the majority relies not on the language or legislative
history of the § 801 reserve ratio test, but on § 820 of the Code,
which was added nearly 40 years after the reserve ratio test was
adopted and which gives life insurance companies the choice of
whether to have reserves
Page 430 U. S. 760
under certain "modified coinsurance contracts" attributed to the
reinsurer who bears the risk or to the reinsured who holds the
reserves under the contract.
See ante at
430 U. S.
745-748. The majority finds this section at once
"redundan[t]" and "incompatible" with the Commissioner's
interpretation of § 801.
Ante at
430 U. S. 748.
What the majority overlooks is that § 820 applies
only to
companies that have
already qualified as life insurance
companies by virtue of § 801; it prescribes not how those
companies qualify for life insurance company status, but rather how
they are to be taxed once they have qualified for such status --
specifically, how they can avoid double taxation on investment
income received by the reinsurer but paid over to the reinsured
pursuant to the particular type of reinsurance contract defined in
§ 820(b). The option to attribute reserves for these contracts
either to the reinsurer or the reinsured is given only to life
insurance companies which qualify under § 801,
see §
820(b)(1), and is expressly made inapplicable "for purposes of
section 801" in determining whether they so qualify, §
820(a)(1).
The majority notes that § 820(a)(1) denies insurance companies
the choice of how to allocate their modified coinsurance contract
reserves for purposes of the § 801 reserve ratio test, but
interprets this exception to § 820 to "[mean] that, for purposes of
§ 801, the reserves are invariably treated as held by the ceding
company. . . ."
Ante at
430 U. S. 748
n. 30. This "explanation" simply assumes the conclusion that the
majority is attempting to justify: what the parties to these cases
are arguing about is whether, for § 801 purposes, reserves are
invariably attributable to the company holding them, rather than to
the company bearing the risks that the reserves were set up to
cover. Mandatory attribution to the risk-bearer under § 801 is just
as consistent with the inapplicability of the § 820 option as is
mandatory attribution to the holder of those reserves, and is more
consistent with the attribution rule prescribed by the Regulations
for life insurance reserves.
See
Page 430 U. S. 761
supra at
430 U. S. 758.
Moreover, the definition of nonlife reserves under §§ 801(c)(2) and
(3) is explicitly made applicable only "[f]or purposes of [the]
subsection [801](a)" reserve ratio test. The attribution rule at
issue in these cases thus does not apply to the § 820 rules for
taxing the income of life insurance companies from modified
coinsurance contracts (or to the taxation of any other insurance
income). In short, the majority's conclusion that § 820 "affords an
unmistakable indication" of congressional intent with respect to
attribution of reserves under § 801,
ante at
430 U. S. 749,
is refuted by the language of the Code itself. [
Footnote 2/6]
For the reasons stated, I respectfully dissent.
[
Footnote 2/1]
Life insurance company taxable income is calculated by a
complicated three-stage process outlined in
Jefferson Standard
Life Ins. Co. v. United States, 408 F.2d 842, 844-846 (CA4),
cert. denied, 396 U.S. 828 (1969). The end result of these
intricate calculations is a substantial narrowing of the tax base
of such companies.
See Clark, The Federal Income Taxation
of Financial Intermediaries, 84 Yale L.J. 1603, 1637-1664 (1975).
In addition to deferring taxation on 50% of underwriting income,
ante at
430 U. S. 728
n. 2, life insurance companies are not taxed on an estimated 70% to
75% of their net investment income. Clark,
supra at
1642-1643, and n. 152.
See United States v. Atlas Life Ins.
Co., 381 U. S. 233,
381 U. S.
236-237,
381 U. S.
247-249 (1965).
[
Footnote 2/2]
In order to qualify under § 801 as a "life insurance company,"
the taxpayer first must qualify as an "insurance company." For this
purpose, as well as for qualifying as a "life insurance company,"
the "primary and predominant business activity" of the company
determines its tax status:
"The term 'insurance company' means a company whose primary and
predominant business activity during the taxable year is the
issuing of insurance or annuity contracts or the reinsuring of
risks underwritten by insurance companies. Thus, though its name,
charter powers, and subjection to State insurance laws are
significant in determining the business which a company is
authorized and intends to carry on,
it is the character of the
business actually done in the taxable year which determines whether
a company is taxable as an insurance company under the
Internal Revenue Code."
Treas.Reg. § 1.801(a)(1) (1972). (Emphasis added.)
[
Footnote 2/3]
The majority assumes that "the taxpayers did take on all
substantial risks" under the arrangements by which the A&H
reserves in relation to these risks were held by other companies.
Ante at
430 U. S. 740.
The taxpayers concede, and the courts below found, that, if these
A&H reserves are attributable to the taxpayers, they do not
qualify as life insurance companies under the reserve ratio test.
207 Ct.Cl. 638, 645, 524 F.2d 1167, 1171 (1975); 207 Ct.Cl. 594,
604-605, 524 F.2d 1155, 1160 (1975); 514 F.2d 675 (CA5 1975).
[
Footnote 2/4]
The majority evidently hopes that state regulatory authorities
will prevent "widespread abuse" of this type,
ante at
430 U. S. 749,
by requiring a company assuming insurance risks to hold the
corresponding reserves. But, as the Court of Claims below in No.
71221 observed, the goal of state insurance regulation is not to
protect the federal treasury from tax avoidance by insurance
companies doing predominantly nonlife business, but rather to
protect policyholders by making sure that funds are set aside out
of premium receipts for payment of claims. 207 Ct.Cl. at 645, 524
F.2d at 1171. The majority suggests no reason why, as long as the
insurer has made some arrangement for the establishment of
reserves, the state regulatory authorities will care who holds
them.
The majority's hope that the States will prevent insurance
companies from taking advantage of the loophole it has created is
further undermined by its holding that the A&H reserves
involved in these cases were not attributable to the taxpayers
under § 801(c)(3) as "other insurance reserves required by [state]
law."
Ante at
430 U. S.
750-752. The majority reasons that the taxpayers were
not required by state law to maintain thee A&H reserves
because
"[t]he insurance departments of the affected States consistently
accepted annual reports showing reserves held as the taxpayers
claim they should be."
Ante at
430 U. S. 751.
(Footnote omitted.) The majority relies on this failure of state
regulatory authorities to require inclusion of the A&H reserves
in the taxpayers' annual statements, despite uncontradicted
testimony of state insurance officials that the reason for this
failure was the state officials' unfamiliarity with these
particular arrangements purporting to shift reserves to
non-risk-bearing companies.
Ante at
430 U. S. 751
n. 36. Thus, if a company's arrangements for shifting reserve
allocations are sufficiently novel, complex, or well disguised in
its annual statements to escape detection by state insurance
officials, state regulation will not help at all to close the door
to widespread federal income tax avoidance.
[
Footnote 2/5]
In
Hansen, accrual basis automobile dealers had sold
customer installment obligations to finance companies, who required
the dealers to reimburse them for losses arising from nonpayment by
the customers. To cover this risk of loss, the dealers retained a
portion of the purchase price of the obligations as a reserve. The
funds in these reserve accounts were ultimately paid over to the
dealers, less amounts applied to cover the losses from nonpayment.
The Court held that these reserve accounts were income that accrued
to the dealers when the accounts were established, because, at that
time, the reserve funds "were vested in and belonged to the
respective dealers, subject only to their . . . contingent
liabilities to the finance companies." 360 U.S. at
360 U. S. 463.
Similarly, the taxpayers in these cases allowed other parties to
retain the purchase price of A&H insurance policies and to
apply part of those funds to the payment of taxpayers' contingent
liabilities under the A& policies; the balance, as in
Hansen, was remitted to the taxpayers. These reserves,
like the dealer reserves held by the finance companies in
Hansen, should be attributed to the risk bearers for tax
purposes.
The majority distinguishes
Hansen by fiat, stating only
that "[l]ife insurance accounting is a world unto itself."
Ante at
430 U. S. 739
n. 18. This is hardly a reason to ignore accepted principles of
federal income taxation.
[
Footnote 2/6]
The majority attempts to find support for its position in a
Revenue Ruling requested by the parties to a modified coinsurance
contract under § 820(b). Rev.Rul. 70-508, 1970-2 Cum.Bull. 136. As
permitted by § 820(a), the parties chose to attribute to the
reinsured company the reserves on the portion of the risks
reinsured with the other company. The reinsured company was assumed
to be a life insurance company for purposes of § 801; the question
was how its reserves should be calculated for purposes of the tax
on life insurance companies imposed under § 802.
See
Rev.Rul. 70-508,
supra. Because the definition of life
insurance company reserves in § 801(b) is used to define "life
insurance company taxable income" under § 802,
see §§
802(b), 804(a)(1), 805(a) and (c), the Commissioner had to decide
whether the reserves in question were within the § 801(b)
definition for purposes of calculating the tax imposed under § 802.
In ruling that the reserves did come within this definition, the
Commissioner did not decide how reserves should be attributed for
companies seeking to qualify for life insurance company status.
That issue was not before him, because the companies had already
qualified.