Petition — United States v. Consumer Life Insurance Co.

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UNITED STATES OF AMERICA,

Vv. ; ah

Ce MER LIFE INSURANCE COMPANY

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF

“

INDEX

Page

Opinions below _.....- 1

PORE TENT A 2

Question presented ______. 2

Statutes and regulations involved _.. 3

i il I a Rg ae OE RS Ree RE 5

Reasons for granting the writ 13

Conclusion .........__.___. = 22

FE Pe ae ee la

IIL TEP ssnnccainssibasnidetiaieiianbenitiiianioNtldntiinalionapbive 67a

CITATIONS

Cases:

Commissioner v. Monarch Life Ins. Co.,

114 F.2d 314 15

Economy Finance Corp. v. United States,

501 F.2d 466, certiorari denied, 420

| EERE eS ES = 13, 17, 19, 21

First Railroad & Bank Co. of Ga. v.

United States, 514 F.2d 675 _.___. 13, 20, 21

Helvering v. Illinois Ins. Co., 299 USS.

RR aa Oe 21

Jefferson Standard Life Ins. Co. v. United

States, 408 F.2d 842, certiorari denied.

fy FS ee 14

McCoach v. Insurance Co. of North Amer-

*). ££) fF rere 21

National Protective Ins. Co. v. Commis-

sioner, 128 F.2d 948, certiorari denied,

I ia a 15

Cases—Continued Page

New York Life Ins. Co. v. Edwards, 271

ee se a 21

New World Life Insurance Co. v. United

States, 26 F. Supp. 444, affirmed, 311

I, WIS Sei hvreaanieclieei la ieee cada ce 15

Penn Security Life Insurance Co. v.

United States, 524 F.2d 1155 12,13

Superior Life Insurance Co. v. United

Ce US OG 13, 18

United States v. Atlas Life Ins. Co., 381

Sei SIE Saeivetlay neiabadsduniacedmatninesanstitiedhainats 14

United States v. Boston Insurance Co.,

3! RRA ee ee 21

Statutes, regulations and rule:

Internal Revenue Code of 1954 (26

- U.S.C.):

Nee 2, 3, 11, 12, 18,

15, 16, 17, 18, 19, 22

SIRS RES are Ac Nee 9 14

EER rR ed eA we 14

TI Oa SB es 14

Section 831 __. _ 15

I ee 15

Revenue Act of 1921, c. 136, 42 Stat. 227,

a 15

Treasury Regulations on Income Tax

(1954 Code) (26 C.F.R.):

Section 1.801-3 _ F 4

a 4

Section 1.801-5(b) —...... 4, 22

Rule 131(c) of the Court of Claims 2

Miscellaneous: , Page

Hearings on H.R. 8245, Internal Reve-

nue, before the Senate Committee on

Finance, 67th Cong., Ist Sess. (1921) _ 15

Iu the Supreme Court of the United States

OcTOBER TERM, 1975

No.

UNITED STATES OF AMERICA, PETITIONER

CONSUMER LIFE INSURANCE COMPANY

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF CLAIMS

;

The Solicitor General, on behalf of the ited

States of America, petitions for a writ of iorari

to review the judgment of the United States Court of

Claims in this case.

OPINIONS BELOW

The recommended decision of the trial judge (App.

A, infra, pp. la-66a) is not officially reported. The

opinion of the Court of Claims (App. B, infra, pp.

67a-97a) is reported at 524 F.2d 1167.

(1)

JURISDICTION

The judgment of the Court of Claims was entered

on October 22, 1975 (App. B, infra, pp. 67a, 129a).’

By order dated January 15, 1976, the Chief Justice

extended the time for filing a petition for a writ of

certiorari to and including March 20, 1976. The

jurisdiction of this Court is invoked under 28 U.S.C.

1255(1).

QUESTION PRESENTED

Section 801(a) of the Internal Revenue Code of

1954 defines a “life insurance company” as an in-

surance company whose life insurance reserves com-

prise more than 50 percent of its “total reserves,”

as that term is defined in Section 801(c).

The question presented is whether an insurance

company which bears the ultimate insurance risk on

accident and health insurance ceded to it by another

company or ceded by it to the other company under

reinsurance agreements is required for federal tax

purposes to include in its total reserves the reserves

attributable to such non-life policies so as to render

it ineligible for preferential tax treatment as a life

insurance company, or whether, as the Court of

Claims held, such reserves are attributable to the

other company which temporarily holds the premiums

paid in advance on such policies.

* The precise amount of the judgment will be determined

in further proceedings under Rule 131(c) of the Court of

Claims (App. B, infra, p. 129a).

STATUTES AND REGULATIONS INVOLVED

Internal Revenue Code of 1954 (26 U.S.C.):

SEC. 801 [as amended by Sec. 2(a), Life Insur-

ance Company Income Tax Act of 1959, P.L.

86-69, 73 Stat. 112). DEFINITION OF LIFE

INSURANCE COMPANY.

(a) Life Insurance Company Defined.—For

purposes of this subtitle, the term “life insur-

ance company” means an insurance company

which is engaged in the business of issuing life

insurance and annuity contracts (either sepa-

rately or combined with health and accident in-

surance) or noncancellable contracts of health

and accident insurance, if—

(1) its life insurance reserves (as de-

fined in subsection (b)), plus

(2) unearned premiums, and unpaid

losses (whether or not ascertained), on non-

eancellable life, health, or accident policies

not included in life insurance reserves,

comprise more than 50 percent of its total re-

serves as defined in subsection (c) ).

(b) Life Insurance Reserves Defined.—

(1) In general—For purposes of this

part, the term “life insurance reserves”

means amounts—

(A) which are computed or esti-

mated on the basis of recognized mor-

tality or morbidity tables and assumed

rates of interest, and

(B) which are set aside to mature or

liquidate, either by payment or reinsur-

ance, future unaccrued claims arising

from life insurance, annuity, and non-

cancellable health and accident insur-

ance contracts (including life insur-

ance or annuity contracts combined

with noncancellable health and accident

insurance) involving, at the time with

respect to which the reserve is com-

puted, life, health, or accident contin-

gencies.

* o * . oe

subsection (a), the term “total reserves”

means—

(1) life insurance reserves,

(2) unearned premiums, and unpaid

losses (whether or not ascertained), not in-

cluded in life insurance reserves, and

(3) all other insurance reserves required

by law.

The term “total reserves” does not include defi-

ciency reserves (within the meaning of subsec-

tion (b) (4)).

* > * *

Treasury Regulations on Incorne Tax (1954 Code)

(26 C.F.R.):

§ 1.801.3 Definitions.

* > . > *

(e) Unearned premiums. The term “unearned

premiums” means those amounts which shall

cover the cost of carrying the insurance risk for

the period for which the premiums have been

paid in advance. Such term includes all un-

earned premiums, whether or not required by

law. '

eo s > : *

§1.801-5 Total reserves.

> > eo a a

(b) Reserves required by law defined. For

purposes of part I, subchapter L, chapter 1 of

the Code, the term “reserves required by law”

means reserves which are required either by ex-

press statutory provisions or by rules and regu-

lations 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.

STATEMENT

Respondent is a wholly-owned subsidiary of South-

ern Discount Company. At the time of respondent’s

incorporation in 1957 under the Insurance Code of

Arizona, its parent, Southern Discount, was engaged

in the consumer finance business in Georgia and sev-

eral other states. At the time Southern Discount

made a loan, its borrowers usually purchased term

life and accident and health (“A&H”’’) insurance in

order to guarantee the payment of the loan in the

event of the borrower’s death or disability.

This type of insurance, known as credit life and

credit A&H insurance, is generally coextensive in

term and coverage with the term and amount of the

loan, and provides for the full payment of the loan

in the event of the borrower’s death or for the pay-

ment of monthly installments on the loan in the event

of his disability resulting from accident or sickness.

The premiums for such insurance are generally pay-

able by the borrower in advance for the full period

of coverage (App. B, infra, pp. 68a-69a, 94a-95a).

The Georgia law under which Southern Discount

was incorporated prohibited it from issuing credit

life and credit A&H insurance. However, it was

permitted to act as a sales agent for qualified insur-

ance companies issuing such policies. Prior to its

formation of respondent, Southern Discount acted as

a sales agent for American Bankers Life Assurance

Company, which issued credit life and credit A&H

policies to Southern Discount’s debtors. Under its

arrangement with American Bankers, Southern Dis-

count received a commission of approximately 50

percent of the premiums paid by the policyholders,

which was the maximum commission rate allowed by

law (App. B, infra, p. 69a).

In order to obtain a greater portion of the profits

from the credit insurance issued to its borrowers,

Southern Discount organized respondent in 1957 for

the purpose of underwriting the credit life and credit

A&H insurance for its borrowers. Under Georgia

law, respondent’s initial $38,000 capitalization was

insufficient to enable it to act as a direct insurer.

However, because of its status as an insurance com-

pany chartered in Arizona, respondent was permitted

to re:nsure policies issued by companies authorized to

issue insurance directly. As a result, on June 28,

1957, respondent entered a reinsursnce agreement or

treaty (“Treaty I”) with American Bankers under

which it reinsured all credit life and credit A&H poli-

cies thereafter issued by American Bankers to the

borrowers from Southern Discount and its subsidi-

aries (App. B, infra, pp. 69a-70a, 95a-99a).

Respondent freely conceded in the court below that

it assumed the entire insurance risk under Treaty I

on all credit life and credit A&H policies, in exchange

for which it received 871% percent (subsequently in-

creased to 901% percent) of all premiums collected by

American Bankers on such policies. American Bank-

ers collected the premiums in full when it issued the

policies, Pursuant to Treaty I, American Bankers

each month remitted to respondent its full share of

all life insurance premiums received by it during

the previous month. However, with respect to the

credit A&H premiums, American Bankers remitted

to respondent each month only that portion of the

premiums collected during the prior month that was

ratably allocable to the coverage for the prior month.

The remaining portions of respondent’s share of A&H

premiums were remitted monthly on a pro rata basis

over the balance of the term ot the policy.

Thus, while respondent received its share of life

insurance premiums almost immediately upon issu-

ance of the policies, it received its share of the AGH

premiums only after the periods of coverage attrib-

utable to the premiums had expired. The agreement

further provided that respondent would maintain its

reserves with respect to the life insurance and that

American Bankers would maintain reserves for “un-

earned premiums,” representing the amount of A&H

premiums attributable to the remaining unexpired

portions of the terms of the policies (App. B, infra,

pp. 70a-7la, 110a-117a).

By 1962, respondent’s capital increased sufficiently

to enable it to qualify as a direct insurer under Geor-

gia and North Carolina law. Thereafter, respondent

began to issue directly credit life and credit A&H

policies to Southern Discount’s borrowers. As a re-

sult of this change in respondent’s status, on April

18, 1962, American Bankers and respondent entered

into a new reinsurance agreement (“Treaty II’).

Under Treaty II, respondent became the primary in-

surer of the credit life and A&H policies issued to

Southern Discount’s borrowers. American Bankers

agreed in form to reinsure 80 percent of the A&H

policies issued by respondent. However, American

Bankers did not purport to reinsure any of the life

insurance issued by respondent (App. B, infra, pp.

72a-73a, 99a).

Treaty II provided that respondent was to remit

to American Bankers quarterly the premiums col-

lected on the ceded A&H policies, less its own com-

mission of 50 percent. The agreement further pro-

vided that American Bankers would return to re-

spondent a quarterly rebate or “experience refund”

equal to the total premiums ratably allocable to the

insurance ccverage for the quarter less the sum of:

(1) respondent’s 50 percent commission with respect

to such “earned” premiums; (2) three percent of

gross earned premiums allocable to such quarter;

and (3) the sum of all claims paid during the quar-

ter by American Bankers as reinsurer on such pol-

icies. In the event the sum of these three reductions

exceeded the earned premiums for any quarter, the

excess would be carried over to the succeeding quar-

ter and charged against the experience refund for

that quarter (App. B, infra, pp. 72a-74a).

As of December 31, 1964, Treaty II was amended

to provide that any negative carry-forward arising

from loss experience for a particular quarter would

be dropped after 20 quarters, in the event it was

not absorbed by that time. The effect of this amend-

ment was that American Bankers would be entitled

to its 3 percent commission and would incur no in-

surance loss unless it experienced average claims on

these policies exceeding 47 percent of premiums over

a period of more than 20 consecutive quarters. Con-

versely, there were no circumstances under which

American Bankers’ profit under Treaty II could

have exceeded its three percent commission. The

loss experience on A&H policies under Treaty II had

ranged from 28 to 30 percent of premiums paid. At

the time of the 1964 amendment, the loss experience

on A&H policies covered by Treaty II was only 18

percent of premiums paid* (App. B, infra, pp. 72a-

74a, 99a-100a, 118a-128a; App. A, infra, p. 48a).

During the period 1958-1964, respondent reported

2 The trial judge found that the likelihood that loss exper-

ience would run so high as to jeopardize American Bankers’

commission was so remote as to be negligible, and that the

parties knew this to be the fact (App. A, infra, p. 48a).

on the annual statements it was required to file with

the Arizona and Georgia insurance authorities that

it received income from life insurance premiums, Ac-

cordingly, it reported the life insurance reserves for

such policies prescribed by the appropriate actuarial

tables. However, with respect to the A&H policies

respondent reinsured with American Bankers under

Treaty I, respondent reported as income only the por-

tion of premiums paid to it by American Bankers,

which was attributable to the expired portions of the

terms of the policies.

Respondent did not report, either as income or as

an asset, any of the AGH premiums attributable to

the unexpired portions of the terms of the policies,

and it reported no reserves with respect to the AGH

policies. Similarly, respondent reported no reserves

on the A&H policies ceded to American Bankers un-

der Treaty II. American Bankers, on the other hand,

maintained unearned premium reserves with respect

to the A&H policies reinsured by respondent under

Treaty I as well as the A&H policies ceded by re-

spondent under Treaty II.

During 1958-1964, respondent was subjected to a

number of examinations by the insurance depart-

ments of Arizona, Georgia and other states in which

it did business, but its failure to maintain reserves

with respect to the A&H coverage under Treaty I

or II was never disapproved (App. B, infra, pp. 71a-

72a, 74a-76a, 101a-102a, 105a-107a).

Respondent filed its federal income tax returns for

the years 1958-1964 in accordance with its method of

reporting reserves on the annual statements filed

with the various state insurance authorities. Re

spondent took the position on its tax returns that it

qualified for the preferential tax treatment accorded

to a “life insurance company” as defined by Section

801(a) of the Internal Revenue Code because its life

insurance reserves exceeded 50 percent of its total re-

serves as it reported on its annual statements. On

audit, the Commissioner of Internal Revenue deter-

mined that the reserves on the A&H policies under

both Treaty I and II were includable in respondent’s

total reserves. When the A&H reserves were taken

into account, respondent failed to qualify as a “life

insurance company” under the Section 801(a) defini-

tion (App. B, infra, pp. 76a-77a, 92a-94a).

In this refund suit brought by respondent in the

Court of Claims, the trial judge’s recommended deci-

sion upheld the Commissioner’s determination that

respondent was required to include the reserves at-

tributable to the A&H insurance as part of its total

reserves so as to disqualify it as a “life insurance

company” as defined by Section 801(a) of the Code.

The trial judge premised his conclusion on the ground

that with respect to both Treaty I and II, respondent

was required by Georgia and Arizona law to main-

tain the reserves attributable to the A&H insurance

so that such reserves were includable in respondent’s

total reserves as “other insurance reserves required

by law” under Section 801(c)(3) of the Code. As

a result, the trial judge found it unnecessary to

decide whether respondent was required to include in

its total reserves the A&H reserves as “unearned pre-

miums” under Section 801(c) (2) of the Code (App.

A, infra, pp. 14a-23a).

With one judge dissenting, the Court of Claims dis-

agreed with the recommended decision of the trial

judge. In accordance with its decision of the same

date in Penn Security Life Insurance Co. v. United

States, 524 F.2d 1155, the majority held that the AGH

reserves could not be included in respondent’s total

reserves as “unearned premiums” under Section 801

(c)(2) of the Code because American Bankers was

in physical possession of the unearned portion of the

premiums paid in advance on the A&H policies un-

der both Treaty I and II (App. B, infra, p. 81a). In

rejecting the trial judge’s conclusion that respondent

was required by Georgia and Arizona law to include

the A&H reserves in its total reserves, the majority

relied upon the fact that respondent’s method of

reporting its income and reserves did not result in

the institution of any action by the Georgia or Ari-

zona insurance authorities (App. B, infra, pp. 81a-

92a).

The dissenting judge adhered to the views expressed

in his dissent in Penn Security Life Insurance Co. v.

United States, supra (App. B, infra, p. 92a). He

argued that the AGH reserves should be included in

respondent’s total reserves as “unearned premiums”

under Section 801(c)(2) of the Code because “Tre-

spondent] has arranged to have [such reserves]

ostensibly carried for it by others, though in reality

it bears the risk of loss itself” (524 F.2d at 1167 ).

In so concluding, the dissenting judge agreed with

the decision of the Seventh Circuit in Economy

Finance Corp. v. United States, 501 F.2d 466, cer-

tiorari denied, 420 U.S. 947, which held, on facts

essentially identical to those of Treaty I, that non-

inclusion of such reserves “completely frustrates the

purpose Congress ha[d] in mind in prescribing the

[50 percent] test [of Section 801(a)]” (524 F.2d at

1167).

REASONS FOR GRANTING THE WRIT

1. As the Court of Claims recognized in its com-

panion decision in Penn Security Life Insurance Co.

v. United States, 524 F.2d 1155, 1161-1162, its hold-

ing there and in this case (see App. B, infra, p. 81a)

directly conflicts with Economy Finance Corp. v.

United States, 501 F.2d 466 (C.A. 7), certiorari de-

nied, 420 U.S. 947, which was followed in First Rail-

road & Bank Co. of Ga. v. United States, 514 F.2d

675 (C.A. 5). See also Superior Life Insurance Co.

v. United States, 462 F.2d 945 (C.A. 4). The deci-

sion below holding that an insurance company is not

required to include in its total reserves those re-

serves attributable to non-life insurance on which

it bears the ultimate insurance risk so that it may

qualify for the preferential income tax treatment

accorded to a “life insurance company” as defined in

Section 801(a) of the Internal Revenue Code of

1954, is therefore in conflict with those of two courts

of appeals. The issue has been and continues to be

widely litigated, and resolution of the conflict by

this Court is essential in order that there be a uni-

form national rule.

Moreover, the effect of the decision below upon the

revenue is substantial. We are advised by the In-

ternal Revenue Service that there are at present pend-

ing administratively 90 cases involving the issue with

more than $28 million of taxes at stake. Since any

insurance company may sue for a refund in the Court

of Claims and invoke the authority of its decision in

this case, the fiscal significance of the decision below

potentially encompasses every pending case involving

the issue. A decision with such far reaching impact

upon the federal revenues involving the basic statu-

tory definition of a “life insurance company” calls

for review by this Court.

2. a. Under the Internal Revenue Code of 1954,

life insurance companies enjoy tax treatment which

is markedly more favorable than that of other types

of insurance companies. Pursuant to Section 802 of

the Code, a life insurance company is generally sub-

ject to a current tax only on (1) a prescribed portion

of its investment income (Section 804); and (2)

one-half of the amount by which its “gain from op-

erations” (Section 809) exceeds its “taxable invest-

ment income.”* On the other hand, other types

of stock insurance companies, such as those engaged

in the sale of cancellable accident and health insur-

ance and other forms of casualty insurance, are gen-

* The structure and operation of the present statutory sys-

tem for the taxation of life insurance companies are sum-

marized in United States v. Atlas Life Ins. Co., 381 U.S. 233,

235-238, and Jefferson Standard Life Ins. Co. v. United States,

408 F.2d 842, 844-846 (C.A. 4), certiorari denied, 396 U.S.

828.

erally taxable on their total annual net income. See

Sections 831 and 832 of the Code.

Like respondent, many insurance companies do not

deal exclusively in either life or non-life insurance

but in a combination of the two types of policies. Ac-

cordingly, as early as Section 242 of the Revenue

Act of 1921, c. 136, 42 Stat. 227, 261, Congress pro-

vided for an objective mathematical test designed to

limit the preferential life insurance company tax

treatment to those companies whose predominant

business was the assumption of life insurance risks.“

See, e.g., National Protective Ins. Co. v. Commis-

sioner, 128 F.2d 948, 950 (C.A. 8), certiorari denied,

317 U.S. 655; New World Life Insurance Co. v.

United States, 26 F. Supp. 444, 461 (Ct. Cl.), af-

firmed on another issue, 311 U.S. 620; Commissioner

v. Monarch Life Ins. Co., 114 F.2d 314, 324-325

(C.A. 1).

The current statutory test is set forth in Section

801(a) of the 1954 Code, supra, p. 3, which defines

¢ As Dr. T. S. Adams of the Treasury Department explained

to the Senate Finance Committee in 1921 (Hearings on H.R.

8245, Internal Revenue, before the Senate Committee on Fi-

nance, 67th Cong., lst Seas. 85 (1921) )—

Some companies mix with their life business accident

and health insurance. It is not practicable for all com-

panies to disassociate those business:s so that we have

assumed that if this accident and health business was

more than 50 percent of their business, as measured by

their reserves, it could not be treated as a life insurance

company. On the other hand, if their accident and health

insurance were incidental and represented less than 50

percent of their business we treated them as a life in-

surance company.

a “life insurance company” as an insurance com-

pany whose life insurance reserves plus its unearned

premiums and unpaid losses on noncancellable life,

health or accident policies comprise more than 50

percent of its total reserves. Section 801(c) in turn

defines the term “total reserves” as consisting of:

(1) life insurance reserves; (2) unearned premiums

and unpaid losses not included in life insurance re-

serves; and (3) all other insurance reserves required

by law.

b. The question presented in this case concerns

respondent’s eligibility as a “life insurance company”

under Section 801(a) of the Code. During the tax-

able years at issue, respondent bore the ultimate in-

surance risk with respect to both life and non-life

(A&H—accident and health) insurance under two

successive reinsurance agreements (Treaty I and

II) with another insurance company, American

Bankers Life Assurance Company. The resolution

of the question presented turns on whether the re-

serves attributable to the non-life policies are in-

cludable in respondent’s total reserves or in American

Bankers’ total reserves. As the court below stated:

“Tf those reserves are includable in [respondent’s]

total reserves, it concededly does not pass the 50 per-

cent test of Section 801. If, as [respondent] says,

they are chargeable to American Bankers rather than

to itself, it does” (App. B, infra, p. 79a).°

* Respondent does not contend that the accident and health

policies were “noncancellable life, health, or accident policies”

which would be eligible for inclusion in both the numerator

Here, the Court of Claims held that the A&H re-

serves were includable in American Bankers’ total

reserves under both reinsurance transactions to which

respondent was a party. We submit, however, that

a careful analysis of the economic substance of the

Treaty I and II arrangements, which are typical of

those used in the industry, decisively establishes that

the A&H reserves under both treaties are includable

in respondent’s total reserves as “unearned premi-

ums” under Section 801(c) (2).

Under Treaty I, respondent reinsured all of the

credit life and A&H policies issued by American

Bankers in exchange for 901% percent of the pre-

miums collected by American Bankers. But the court

below recognized with respect to Treaty I that all

life and A&H policies first issued by American Bank-

ers “were to be fully reinsured with [respondent]

which, as it freely concedes, thereby assumed the en-

tire insurance risk represented by each of the policies

involved; A&H as well as life’ (App. B, infra,

p. 70a). Since respondent and not American Bank-

ers assumed the full risk under the A&H policies,

those policies reflected its insurance business and

not that of American Bankers, whose role was lim-

mited to that of a commission agent.

and the denominator under the 50 percent test of Section

801(a) (2). Under the accident and health coverage in ques-

tion, the insured did not have a guaranteed option to renew

on the expiration of the initial terrs. Thus, it was not “non-

cancellable” within the meaning of the statute. See Econ-

omy Finance Corp. Vv. United States, supra, 501 F.2d at 480-

482.

Simply put, the insurance reserves necessarily fol-

low the insurance risk, as evidenced by respondent’s

retention of 9014 percent of the A&H premiums to

meet the claims under the policies. Thus, the re-

serves necessary to meet the A&H insurance risk

were properly includable in respondent’s insurance

reserves. Indeed, to conclude, as the Court of Claims

did, that the A&H reserves were part of Ameri-

can Bankers’ total reserves because that company

temporarily held the “unearned” portions of the AGH

premiums before ratably paying them to respondent

is to exalt the form of the transaction over its eco-

nomic substance by ignoring the fact that the final

destination of the A&H premiums was respondent

and not American Bankers. Cf. Superior Life In-

surance Co. v. United States, supra, 462 F.2d at 950.

The fundamental error of the Court of Claims in

holding that the AGH reserves were attributable to

American Bankers was its assumption that that com-

pany held “unearned premiums” of the A&H policies

in the sense that term is used in Section 801(c) (2).

However, the term “unearned premiums” in the stat-

ute connotes an insurance company’s maintenance of

a reserve from premiums to meet the risk of claims

it has assumed. But here American Bankers did not

hold “unearned premiums” to meet any insurance

risk it had assumed. To the contrary, it was holding

such premiums under an obligation to pay them over

to respondent, which had assumed the risk under the

A&H policies throughout the term of their coverage.

Under these circumstances, American Bankers can-

not be deemed to possess a reserve under the A&H

policies simply because it was temporarily holding

the A&H premiums on behalf of respondent. As the

Seventh Circuit stated in its contrary decision in

Economy Finance Corp. v. United States, supra, in

characterizing the role of a company analogous to

American Bankers in an arrangement virtually iden-

tical to Treaty I: “[it] performed a banking and

clearing house function and not an insurance func-

tion” (501 F.2d at 478). Like the ceding company

in Economy Finance, American Bankers was ex-

posed to no insurance risk under Treaty I. Pursuant

to that arrangement, American Bankers cannot be

deemed to have any insurance reserves. The A&H

reserves must therefore be included in respondent’s

total reserves under Section 801(c) (2).

The foregoing observations are equally applicable to

Treaty II. Under that more elaborate but econom-

ically equivalent arrangement, respondent directly is-

sued the A&H policies and American Bankers pur-

ported to reinsure them. But in addition to respond-

ent’s initial retention of 50 percent of the A&H

premiums as a commission, American Bankers was

required to pay over to respondent 47 percent of

the premiums after deduction of any claims paid.

Moreover, pursuant to a loss carryover mechanism

under Treaty II, American Bankers could incur no

insurance loss unless it experienced average claims

exceeding 47 percent of A&H premiums for more

than five consecutive years. Since the loss experi-

ence under Treaty II ranged from 18 to 30 percent

of A&H premiums, the trial judge was amply justi-

fied in finding that the likelihood that American

Bankers would be exposed to any insurance risk was

so remote as to be negligible, and that the parties

knew that to be the fact (App. A, infra, p. 48a).

In sum, as in the case of Treaty I, American

Bankers’ role under Treaty II did not constitute an

insurance function but was limited to a banking and

clearing house function of receiving premiums and

disbursing payment for claims in exchange for a com-

mission equal to no more than three percent of the

premiums.* Thus, under Treaty II, American Bank-

ers assumed no risk of insurance. That risk remained

with respondent, which kept 97 percent of the A&H

premiums to meet the claims under the policies.

Respondent can therefore no more avoid inclu-

sion of the A&H reserves in its total reserves under

Treaty II than it can under Treaty I. As the Fifth

Circuit in First Railroad & Bank Co. of Ga. v.

United States, supra, 514 F.2d at 677, correctly con-

cluded in its contrary holding with respect to an ar-

rangement identical to Treaty II: “Reinsurer under

the arrangement did not bear any risks except the out-

side possibility of insolvency of Insurer. We hold

therefore there was no substance to the agreement

as reinsurance” (footnote omitted). The lack of sub-

stance to Treaty II as reinsurance likewise renders

* The court below acknowledged as much in stating: “* * *

there were no circumstances under which American Bankers’

return under Treaty II could exceed the 3 percent allotted to

it therein” (App. B, infra, p. 74a).

respondent ineligible for “life insurance company”

status during the years that latter arrangement was

in force.’

? The fact that the Court of Claims also concluded (App.

B, infra, pp. 8la-9la) that respondent was not required

under Georgia or Arizona law to establish a reserve for the

A&H policies does not weaken our argument that the eco-

nomic reality of the reinsurance transactions is controlling

for federal tax purposes under Section 801(c) (2). Indeed,

in the life insurance area, this Court has repeatedly indi-

cated that state insurance statutes or administrative prac-

tices do not determine the question whether certain re-

serves should be taken into account for federal tax pur-

poses, even though they were required under state law.

See, e.g., McCoach v. Insurance Co. of North America, 244

U.S. 585, 589 (reserve for unpaid losses); United States V.

Boston Insurance Co., 269 U.S. 197 (loss claim reserves) ;

New York Life Ins. Co. v. Edwards, 271 U.S. 109, 119 (re-

serve for unreported losses) ; Helvering V. Illinois Ins. Co., 299

U.S. 88, 90-91 (reserve to meet obligation to provide a ton-

tine fund). In the present context, “[t]he fact that the

state insurance authorities required or permitted [American

Bankers] to hold the reserve for solvency purposes does not

answer the question of whose business the reserves measure.”

Economy Finance Corp. v. United States, supra, 501 F.2d at

478-479. As the Fifth Circuit similarly observed in First

Railroad & Bank Co. of Ga. v. United States, supra, 514 F.2d

at 677 n. 8: “The fact that the state insurance authorities

permitted the ‘reserves’ to be handled as done by Insurer and

Reinsurer cannot overcome these economic realities.”

At all events, we submit that the Court of Claims erred

in concluding that Georgia and Arizona law did not require

respondent to establish a reserve for the A&H policies under

both Treaty I and II. While the Court of Claims did not

appear to refute the trial judge’s analysis of the applicable

state statutes (App. A, infra, pp. 15a-16a, 20a-23a), it prem-

ised its conclusion on the fact that neither the Georgia nor

Arizona authorities took any action against respondent’s

CONCLUSION

For the reasons stated, the petition for a writ of

certiorari should be granted.

Respectfully submitted.

ROBERT H. BorRK,

Solicitor General.

Scott P. CRAMPTON,

Assistant Attorney General.

STUART A. SMITH,

Assistant to the Solicitor General.

ERNEST J. BROWN,

GARY R. ALLEN,

Attorneys.

FEBRUARY 1976.

failure to establish such a reserve for state reporting purposes.

But the Georgia chief examiner testified that respondent’s

failure to report in its annual statement any unearned prem-

ium reserve was permitted “unwittingly” by Georgia (Tr.

380) and was contrary to that state’s policy (Tr. 335-337,

341-342, 353-359, 370, 380, 382, 385, 409-413). Similarly, the

Arizona examiner who had conducted respondent’s triennial

examination for that state for 1963 also testified that it

should have been required to maintain the unearned premium

reserves under Treaty II, but had been permitted to take

credit for the reserves because it was the first time that the

Arizona insurance commissioner had encountered that situa-

tion (Tr. 423, 425-429).

Thus, the A&H reserves under both Treaty I and II would

be includable in respondent’s total reserves on the independ-

ent alternative ground that they were “other insurance re-

serves required by law” under Section 801(c) (3) of the Code.

See also Treasury Regulations, Section 1.801-5(b).

APPENDIX A

IN THE UNITED STATES COURT OF CLAIMS

TRIAL DIVISION

No. 463-70

(Filed Dec. 13, 1974)

CONSUMER LIFE INSURANCE COMPANY

v. |

THE UNITED STATES

E. Michael Masinter, attorney of record, for plain-

tiff. James H. Landon and Hansell, Post, Brandon

& Dorsey, of counsel.

Herbert Grossman, with whom was Assistant At-

torney General Scott P. Crampton, for defendant.

Gilbert E. Andrews, of counsel.

OPINION *

WILLI, Trial Judge: This is a single issue tax

refund suit that arises out of a smal] loan com-

pany’s entry into the insurance business through

a whoily owned subsidiary that it formed especially

for that purpose. The question is whether that sub-

* The trial judge’s recommended decision and conclusion of

law are submitted in accordance with Rule 134(h).

sidiary, the plaintiff in this proceeding, qualified

for the discrete tax treatment accorded a “life in-

surance company” by the Internal Revenue Code.

The facts, which are basically uncontested, are

fully detailed in the findings of fact accompanying

this opinion and will be repeated herein only to the

extent necessary to an understanding of the result

reached.

In 1957 Southern Discount Company (Southern),

a Georgia corporation, was operating a well estab-

lished and successful consumer finance business. Its

customer-borrowers typically purchased term life and

accident and health (A & H) insurance at the time

that they obtained their loans. The premium charge

for the entire coverage involved was thereupon paid

in full. The customers bought this protection, co-

extensive in both time and amount with the curtail-

ment requirements of th:.r borrowings, to provide

a means of automatically servicing their debts to

Southern in case of death or disability prior to full

repayment. Georgia law prohibited Southern, as a

loan company, from acting as an insurance under-

writer with respect to such coverages. It was not

forbidden, however, from functioning as a sales

agent for insurance underwritten by a carrier duly

qualified to concuct an insurance business in Georgia.

American Bankers Life Insurance Company (Ameri-

can Bankers), a Florida corporation, was such a

carrier.

Until 1957 Southern acted as a commission sales

agent for American Bankers in respect to life and

A & H insurance issued by the latter to Southern’s

borrowers. Under this arrangement, Southern re-

ceived the maximum commission rate allowed by

law; amounting to approximately 50 percent of the

policyholder premiums. Despite the attractiveness

of that return, for which it apparently had to do

little more than place American Bankers’ policies

with its own borrowers, Southern concluded that it

could reap even greater profits from this source if

it could participate as an underwriter rather than

just a sales agent. It was that determination that

prompted Southern to form the plaintiff as a wholly

owned subsidiary.

Southern surveyed state law to locate the jurisdic-

tion that had the most modest capitalization require-

ments for a licensed insurer and found that it was

Arizona. Plaintiff was organized July 1, 1957 as

an insurance company under an Arizona charter

with an initial balance of invested capital and paid-

in surplus of only $38,000. These resources were

not sufficient to permit it to qualify as a direct in-

surer under Georgia law. It could, however, use

its Arizona charter authority to operate as a re-

insurer of Georgia and North Carolina coverages

written by American Bankers—a duly authorized

insurer in both of those states. American Bankers

was willing to enter into a reinsurance treaty ar-

rangement with plaintiff, under which it surrendered

substantially all underwriting profit in return for a

relatively minimal fixed fee, because it knew that

if it refused, Southern would have no difficulty in

replacing it with another qualified carrier. Thus,

its alternative was outright exclusion from the in-

surance business generated by Southern’s borrowers.

Thereupon, on June 28, 1957, American Bankers

entered into the first of two consecutive insurance

treaties (Treaty I and Treaty II, respectively), with

the plaintiff.

Two premises are assumed for purposes of this

decision; first, that insofar as germane to this case

the relationship between plaintiff and American

Bankers was arm’s-length and, second, that while

tax considerations no doubt were an influencing fac-

tor, there were business considerations underlying

plaintiff’s participation in the arrangements with

American Bankers that are the subject of this suit.

This is particularly true of the first of the two

treaties to be discussed.

Under Treaty I, the entire text of which is set

forth in finding 10, infra, all life and A & H policies

issued by American Bankers to debtors of plain-

tiff’s affiliates (including the parent, Southern), on

and after July 1, 1957 were to be fully reinsured

with plaintiff which, as it freely concedes, thereby

assumed the entire insurance risk represented by

each of the policies involved; A & H as well as life.

As compensation for its reinsurance function, plain-

tiff was to receive 8714 percent (later increased to

901% percent) of all premiums collected by American

Bankers from the policyholders. The timing of these

payments by American Bankers to plaintiff differed,

however, as between life and A & H, although the

agreement required monthly remittances in each in-

stance. As already noted, American Bankers col-

lected all premiums in full at the inception of cover-

age. The Treaty stipulated that as to life policies,

American Bankers was, at the end of each month,

to pay plaintiff its entire share of all life premiums

collected from policyholders during that month. As

to A & H, however, American Bankers was to pay

plaintiff only the portion of its total share of pre-

mium receipts during that month that was ratably

allocable to that month’s coverage; the agreement

being to pay over the remainder monthly on a pro

rata basis spread over the balance of the coverage

period. Thus, in respect to A & H, plaintiff never

actually held any premium dollars attributable to a

future period of coverage and risk exposure.

Finally, Treaty I provided for termination by

either party upon thirty days’ written notice to the

other. Termination was to be wholly prospective, the

relevant clause specifying: ‘Upon termination by

either party, this agreement shall continue to apply

to all policies reinsured hereunder before such ter-

mination becomes effective.” Finding 10, infra.

As required by state law, plaintiff filed annual re-

ports of its activities under Treaty I with the in-

surance regulatory authorities in Arizona and Geor-

gia. On those reports it characterized its life and

A & H dealings differently. It did so by reporting

both premium income and related reserves solely

on the basis of actual dollar receipts for the year

involved. This meant that for the life coverages it

declared as premium income its entire percentage

share of the premiums paid by policyholders during

that year. Consonantly, it reported the full tabular

reserve for all of such policies. As to A & H, how-

ever, it limited reported premium income to the

annual aggregate of the incremental payments that

had been received monthly from American Bankers.

Moreover, it showed nothing on the asset side of the

report representing the premiums on existing A &

H policies that it was entitled under the Treaty to

receive in the future. With premium income and

asset balances thus restricted, plaintiff reported no

reserves whatever in respect to the A & H coverages

that it reinsured under Treaty I. As to those cover-

ages, American Bankers included on its own annual

reports an unearned premium reserve based on the

amount of A & H premiums collected from policy-

holders but not yet paid over to the plaintiff. Find-

ing 15, infra. Neither the Georgia nor the Arizona

regulatory authorities ever challenged or disapproved

the method by which plaintiff reported its A & H

reinsurance activities under Treaty I. Finding 16,

infra.

By 1962 plaintiff had accumulated enough earn-

ings from operations under Treaty I to enable it to

qualify as a direct insurer under Georgia and North

Carolina law. It thereupon applied for and received

such authority from the State of Georgia. From

then on plaintiff operated as the issuing company on

all life and A & H policies sold to the loan cus-

tomers of Southern and its affiliates. Treaty I, in

which plaintiff’s role was solely that of a reinsurer,

was consequently no longer suited to its purposes.

Accordingly, effective March 1, 1962, plaintiff and

American Bankers entered into a new insuranc¢e

treaty under which their roles were reversed; plain-

tiff functioning as the issuing or ceding carrier and

American Bankers denominated the “reinsurer’’.

Treaty II, the text of which is set forth in full

at finding 17, infra, applied only to A & H insurance;

plaintiff having determined to underwrite all future

life insurance by itself. The Treaty provided that

plaintiff, as the issuing or ceding company, would

reinsure 80 percent of all future A & H policies

with American Bankers. To that extent, plaintiff

was to pay over to American Bankers on a quarterly

basis all of the premiums collected from policyholders,

American Bankers to return 50 percent of such

amounts to the plaintiff as commissions. The Treaty

contained a clause, entitled Experience Refunds, es-

tablishing a quarterly rebate due plaintiff in the

amount of the total premium dollars ratably alloc-

able to the expired portion of the term of policies

for which such premiums had been collected, less

the following deductions: (a) the amount of com-

missions paid plaintiff that was proportionate to

the expired portion of the term of policies on which

such commissions had been paid; (b) 3 percent of

the earned premium dollars previously described; and

during the quarter by American Bankers as rein-

surer. For all practical purposes, this clause served

to fix American Bankers’ stake in the undertaking

at a flat 3 percent of the premium dollars that it

initially received from the plaintiff. Only if loss

xperience under the reinsured coverages exceed 97

percent of premiums would American Bankers’ 3

percent return be encroached. Moreover, such a pat-

tern of adverse experience would have had to per-

sist for the ensuing twenty consecutive quarters be-

fore such an encroachment became permanent. Loss

experience on A & H policies under Treaty I had

ranged from 28 to 30 percent. Finally, there were

no circumstances under which American Bankers’

return under Treaty II could exceed the 3 percent

allotted to it therein.

On its annual reports to the state regulatory au-

thorities covering 1962 and subsequent years, plain-

tiff declared no reserves relative to that portion of

the A & H policies covered by the reinsurance lan-

guage of Treaty II. Again, no state regulatory au-

thority took exception to this aspect of plaintiff’s

reports.

For each of the years 1958 through 1964 plain-

tiff computed its federal income tax liabilities and

filed its returns on the premise that it was taxable

as a “life insurance company” within the meaning

of that term as defined by Section 801 of the Internal

Revenue Code of 1954. On audit, the Revenue Serv-

ice determined that plaintiff did not qualify as a life

insurance company entitled to the preferential tax

treatment accorded such an entity’* and assessed de-

‘Economy Finance Corp. v. United States, 501 F.2d 466,

474 (7th Cir. 1974), presents a succinct and lucid exposition

ficiencies accordingly (except for 1961 in which ad-

ditional liability was fully expunged by other adjust-

ments not in dispute). Plaintiff paid the assessments

and upon formal disallowance of its seasonably filed

claims for refund, brought this action, in which the

sole question for decision is that concerning plain-

tiff’s qualification as a life insurance company for

federal tax purposes in the years 1958, 1959, 1960,

1962, 1963 and 1964.

As pertinent here, Section 801 defines a life in-

surance company as follows:

SEC. 801 [as amended by Sec. 2, Life Insur-

ance Company Income Tax Act of 1959,

P.L. 86-69, 73 Stat. 112]. DEFINITION

OF LIFE INSURANCE COMPANY.

(a) Life Insurance Company Defined.—For

purposes of this subtitle, the term “life insur-

ance company” means an insurance company

which is engaged in the business of issuing life

insurance and annuity contracts (either sepa-

rately or combined with health and accident in-

surance), or noncancellable contracts of health

and accident insurance, if—

(1) its life insurance reserves (as de-

fined in subsection (b)), plus

(2) unearned premiums, and unpaid

losses (whether or not ascertained), on non-

cancellable life, health, or accident policies

not included in life insurance reserves,

of the policy considerations justifying special tax treatment

for life insurance companies.

10a

comprise more than 50 percent of its total re-

serves (as defined in subsection (c) ).

* 7 * .

subsection (a), the term “total reserves”

means—

(1) life insurance reserves,

(2) unearned premiums, and _ unpaid

losses (whether or not ascertained), not in-

cluded in life insurance reserves, and

(3) all other insurance reserves required

by law.

The term “total reserves” does not include de-

ficiency reserves (within the meaning of sub-

section (b)(4)).

* * * *

Life insurance company status, it is seen, is made

to depend solely on the character and composition

of an insurance company’s reserves. An insurance

company merits life insurance company tax treat-

ment if its life reserves amount to half or more of

its total insurance reserves. Section 801(c) expressly

directs that total reserves, the denominator portion

of the fractional test, shall include three separate

categories: (1) life reserves; (2) reserves for un-

earned premiums and for certain unpaid losses (the

latter element not being involved in this suit); and

(3) all other reserves required by law.’

* The last-mentioned category has been traditionally and

centrally implicated in the federal taxation of insurance com-

panies. See Brown Vv. Helvering, 291 U.S. 192, 201 (1934),

and cases cited therein.

lla

Sections 1.801-3(e) and 1.801-5(b) of the Treas-

ury Regulations on Income Tax (1954), endorsed

by both parties to the present controversy, define

unearned premium reserves and reserves required

by law, respectively, as follows:

Unearned premiums. The term “unearned pre-

miums” means those amounts wh‘ch shall cover

the cost of carrying the insurance risk for the

period for which the premiums have been paid

in advance. Such term includes all unearned

premiums, whether or not required by law.

Reserves required by law defined. For pur-

poses of part I, subchapter L, chapter 1 of the

Code, the 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, Terri-

tory, or the District of Columbia when promul-

gated 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.

In this case there is no disagreement as to either

the fact or the particular amount of plaintiff’s life

insurance reserves for each of the years in suit. Its

qualification depends entirely on the question of its

chargeability with reserves incident to the A & H

policies to which it was a party under Treaties I and

II; there being no dispute that reserves must be

maintained by someone in respect to those policies.

12a

If those reserves are includable in plaintiff’s total

reserves, it concededly does not pass the 50-percent

test of Section 801. If, as plaintiff says, they are

chargeable to American Bankers rather than to it-

self, it does.

The cornerstone of plaintiff’s position herein is its

unduly restricted conception of the reserve criteria

of Section 801. In effect, its approach reads out of

the statute that portion of it {Section 801(c) (3) ]

specifying that “total reserves”, for purposes of the

fractional test, shall include “all other insurance

reserves required by law”. It consequently char-

acterizes the issue to be decided solely in terms of

whether it was obliged to maintain a reserve for un-

earned premiums, within the meaning of Section 801

two Treaties.* In fairness, it should be noted that

in earlier litigation with others, litigation that pro-

duced precedents that plaintiff urges should control

this case, the Government’s apprehension of the is-

sue was apparently as limited as plaintiff says that

it should be here. That background could under-

standably have encouraged plaintiff to adopt its pres

ent litigating perspective. Nonetheless, while it is

* On brief, plaintiff posits the question presented, as follows:

May the Commissioner of Internal Revenue require

plaintiff to include, for purposes of measuring plaintiff’s

reserves for purposes of qualification as a life insurance

company, under the Internal Revenue Code, premiums,

or reserves based on those premiums, held by an unre-

lated party pursuant to the terms of reinsurance treaties

entered into for valid business reasons?

18a

true that the Government’s presentation herein is

largely addressed to the issue as framed by the

plaintiff, the presentation does include the supplemen-

tary contention that plaintiff was chargeable with

A & H reserves, whether or not cast in the mold of

unearned premiums, because such were required of

it by state law.

To dispel the notion that it was required to main-

tain A & H reserves of a type comprehended by

Section 801, plaintiff relies on (1) the language of

the two insurance treaties under which it operated

with American Bankers; (2) the testimony of a well-

traveled actuarial expert, Arthur Crooks Eddy; (3)

the fact that the state insurance regulatory per-

sonnel tacitly approved plaintiff's annual report

forms shov‘ng no A & H reserves; and (4) the trial

court’s opinion in Economy Finance Corp. v. United

States, 30 AFTR 2d 72-5446 (S.D. Ind. July 25,

1972), and this court’s trial judge’s opinion in Penn

Security Life Ins. Co. v. United States (Ct. Cl. No.

109-68, decided March 2, 1973).

Simpliciter, the argument is that plaintiff was

chargeable with no A & H unearned premium re-

serves because under both of the Treaties it re-

ceived premium dollars only after the period of ex-

posure to which those dollars related had expired.

Accordingly, plaintiff says, since all the premiums

that it received were, in point of time, already

“earned” when it got them, there was no occasion

for it to maintain a reserve for “unearned” pre-

miums. Testifying as plaintiff's expert, Mr. Eddy

l4a

repeatedly opined that this feature of the Treaties,

governing custody of prepaid premium dollars, was

dispositive of the participants’ respective reserve ob-

ligations, 7.e., that since it was American Bankers

that physically held all of the A & H premium dol-

lars allocable to the unexpired portion of the terms

of the underlying policies, it was American Bankers,

not plaintiff that was obligated to carry the reserves

for those policies. In this regard, his testimony was

the same as it apparently had been in Economy

Finance, supra, and Penn Security, supra. At least

in the latter case, if not the former as well, the

relevant particulars of the factual situations involved

were virtually identical to those presented by Treaty

I. Certainly in the present case and seemingly in

neither of his appearances in the earlier ones did

Mr. Eddy undertake to canvass or discuss the par-

ticular provisions of applicable state law governing

an insurer’s reserve obligations—this even though he

was testifying throughout in the context of a reve-

nue statute that in part expressly relates such ob-

ligations to the requirements of state law.

It is unnecessary to decide specifically whether

plaintiff was chargeable with any A & H unearned

premium reserves covered by Section 801(c) (2) be-

cause however that might be, it was clearly required

by state law to maintain reserves, cognizable by

Section 801(c) (3), for the A & H policies to which

it was a party under each of the Treaties.

15a

As earlier noted, plaintiff freely acknowledges that

it ultimately bore the entire insurance risk under

Treaty I.

Section 56-908 of the Georgia Code Annotated,

reproduced in full in finding 26, infra, expressly

requires that: “For all accident and sickness policies

the insurer shall maintain an active life reserve

which shall place a sound value on its liabilities un-

der such policies * * *.” To the degree that risk

exposure is the hallmark of an insurer, this pro-

vision squarely imposes a reserve obligation on plain-

tiff with respect to the A & H liabilities concededly

assumed by it under Treaty I. While there are other

and more compelling statutory reserve requirements,

it may be noted that both Section 56-906 of the

Georgia Code Annotated, finding 26, infra, and Sec-

tion 20-506 of the Arizona Revised Statutes, finding

27, infra, employing generally similar language, re-

quire an “insurer” of coverages such as A & H

maintain an unearned premium reserve in an indi-

cated amount. It would seem that as the bearer of

the ultimate policy risk exposure under Treaty I.

plaintiff was an “insurer” within the contemplation

of those provisions and was not the less so simply

because it voluntarily elected to accept premiums

piecemeal rather than in gross at the inception of

coverage.

Finally, and whatever the case as to unearned

premium reserves, an additional and important fea-

ture of state law applicable here plainly required

16a

plaintiff to maintain A & H reserves in respect to

Treaty I operations.

The express language of Treaty I, including that

dealing with termination, vested plaintiff with an

absolute right to receive, albeit in incremental in-

stallments, its full share (ultimately 90.5 percent)

of all premiums collected from A & H policyholders

whose coverages once became subject to the Treaty.

Findings 10 and 13, infra. Mr. Eddy acknowledged

at the trial that an insurer legally entitled to re-

ceive premiums in the future with respect to ex-

isting coverages is obliged to reflect such a right

as an asset, in the nature of a receivable, on its re-

ports to cognizant state regulatory authorities. He

further recognized that such an asset gives rise to

a concomitant liability in the nature of a reserve

relating to the underlying exposure assumed in con-

junction with and in consideration of the right to

receive premiums in the future on the subject cover-

ages. The laws of both Georgia and Arizona, find-

ings 26 and 27, infra, bear out Mr. Eddy’s testi-

mony in this respect. Consequently, on the basis of

the unambiguous language of Treaty I and the un-

contradicted testimony of plaintiff’s expert, both con-

sidered in the light of applicable state law, plain-

tiff was definitely obliged to maintain reserves in

respect to the A & H policies to which it was a

party under Treaty I. This is so whether or not

such reserves are conceptually accommodated by

Code Section 801(c) (2), speaking to “unearned pre-

miums”.

17a

Plaintiff’s reliance on Penn Security Life Ins. Co.

v. United States, supra, as commending a contrary

result is not well-taken.

An examination of the pertinent findings of fact

in that case discloses that the plaintiff there, a Mis-

souri corporation, was situated in circumstances fac-

tually identical to the present plaintiff operating un-

der Treaty I. Finding 28, infra. There, as here, the

plaintiff, as a reinsurer, was committed by express

treaty provision to assumption of the entire in-

surance risk on all A & H policies subject to it and

was, in turn, guaranteed the right to receive, on a

deferred, incremental basis, its entire share of pre-

miums collected from policyholders on A & H cover-

ages in force at any time that the treaty was termi-

nated. In short, the plaintiff in Penn Security had

the same enforceable right to receive premium monies

in the future as did the present plaintiff under

Treaty I. Although Arthur Crooks Eddy testified

as the plaintiff’s expert in Penn Security, supra, his

testimony did not include the acknowledgment that

it did in the instant case, viz, that an insurer with

an enforceable right to receive premiums in the

future is obliged by state law to show the value of

that right on the asset side of its annual report and

to concurrently establish a related reserve reflecting

the future insurance risk exposure in consideration

of which it is entitled to receive such premiums.

Additionally, the court, in Penn Security, supra,

was apparently not given the benefit, by Mr. Eddy

or anyone else, of an exposition of the provisions

18a

of state law affecting insurers’ reserve responsi-

bilities. Thus, the court found (finding 28, infra):

* * * [T)he mere fact that the ceding com-

panies obtained reinsurance from plaintiff under

these treaties did not affect their responsibility,

under state law or under actuarial principles,

to set up an unearned premium reserve to re-

flect the unearned premiums actually held by

those companies on policies covered by reinsur-

ance treaties with plaintiff. * * * [Emphasis

added ]

VERNON’S ANNOTATED MISSOURI STATUTES provide

in relevant part (finding 30, infra) :

376.410. Insurance companies to maintain re-

serves—exemptions

Except as provided in subdivision (6) of this

section, all companies organized under the laws

of this state, and engaged in writing policies of

accident or health insurance, or combination

policies of accident and health insurance, and all

other companies transacting such kinds of busi-

ness in this state, sha!] maintain reserves there-

on in accordance with the following require-

ments:

& + * €

(4) In the calculation of reserves re-

quired to be maintained under this section,

proper credit shall be allowed for reinsur-

ance in other companies licensed to do busi-

ness in this state; [Emphasis added]

19a

For the various foregoing reasons, Penn Security,

supra, really furnishes no support for the result

urged by plaintiff under Treaty I.

The other precedent on which plaintiff relies,

Economy Finance Corp. v. United States, 30 AFTR

2d 72-5446 (S.D. Ind. 1972), involved the reserve

responsibilities of an A & H reinsurer that received

premium remittances from a ceding carrier on an “as

earned” basis similar to that involved here. The

comparability to Treaty I of the treaty there in-

volved is not nearly so clear as in the Penn Security

situation.

It suffices for present purposes to note that the

trial court’s decision was reversed on appeal, albeit

by a divided court. Economy Finance Corp. v. United

States, 501 F.2d 466 (7th Cir. 1974). The dissent

in that case‘ suggests that the majority reached

its conclusion by applying a qualification test not

authorized by Section 801 of the Revenue Code. What-

ever the case in that regard, clarity requires an

affirmative acknowledgment that the issue appre-

hended for purposes of the present opinion differs

from that addressed by the majority in Economy

Finance, supra, to wit (at 471):

* * * The issue raised by the government is not

whether taxpayers should actually have estab-

lished H & A reserves but how such reserves

should be considered for the limited purpose of

determining taxpayers’ qualifying ratio. This is

not a question of form over substance but rather

*501 F.2d at 483-86.

20a

one of the proper characterization of the sub-

stance. [Emphasis added]

The issue decided herein is precisely that of whether

the plaintiff, operating under Treaty I, should ac-

tually have established A & H reserves. Section

1.801-5(b) of the applicable Treasury Regulations,

supra, permits no lesser standard where the in-

quiry is, as here, whether a reserve is comprehended

by Code Section 801(c) (3). The evidence presented

in this record, including the testimony of plaintiff’s

own expert, conclusively demonstrates that more than

one facet of applicable state law required that plain-

tiff should actually have done so. To invalidate that

conclusion requires much more than an implication

based on the bare fact of the state regulatory au-

thorities’ failure to affirmatively challenge plaintiff's

omission of A & H reserves from its annual reports

covering Treaty I years. Exculpatory possibilities

accounting for such unexplained inaction are limited

only by the fertility of one’s imagination. Moreover,

in this instance the Treasury Regulation’ defining

“reserves required by law” for purnoses of Code

Section 801—a regulation to which plaintiff un-

reservedly subscribes on brief—notably casts state

statutory provisions and administrative practice rela-

tive thereto in disjunctive, not conjunctive terms.

That plaintiff was chargeable by state law with

A & H reserves under its Treaty II activities follows

from a much simpler analysis than required for

‘Treasury Regulations, Section 1.801-5(b).

2la

Treaty I. Those A &-H policies, unlike the cover-

ages subject to the earlier Treaty, were issued by

the plaintiff to the individual policyholders from

whom it concurrently collected the full amount of

the underlying premiums. It was, then, in the first

instance the “insurer” of those policies, as that term

is used in the relevant Georgia insurance statutes.

Finding 26, infra. As such, it was subject at the

outset to the reserve obligations imposed on insurers

by Sections 56-905 and 56-908 of the Georgia Code

Annotated, supra. Plaintiff’s initial status as the

insurer of all A & H policies issued by it was simply

unaffected by Treaty II.

The essence of insurance is risk-shifting and risk

distribution. Helvering v. LeGierse, 312 U.S. 531,

539 (1941). Reinsurance, which has a settled and

traditionally understood meaning,’ is insurance by

the first insurer of the whole or some part of his

interest in the risk created by his original contract

of insurance. Treaty II effected no reinsurance be-

cause under it American Bankers assumed no part

of the risk represented by the A & H policies issued

by the plaintiff.

By virtue of the provisions of Articles I, II, IV

and XIII, and particuiariy those of Article VI deal-

ing with Experience Refunds, plaintiff retained the

entire insurance risk under all of the A & H policies

covered by Treaty II. Finding 17, infra. Because

* Allemannia Fire Ins. Co. v. Firemen’s Ins. Co., 209 U.S.

$26 (1908).

22a

of Article VI, American Bankers’ pecuniary interest

in Treaty II, aside from an investment return on

premiums temporarily held, was fixed at 3 percent

of the A & H premiums covered by the Treaty,

without regard to loss experience. Only if losses

under the subject policies exceeded 97 percent of

premium income could American Bankers’ receipt

of its 3 percent participation be delayed to a sub-

sequent quarterly period. The likelihood that loss

experience would run as high as 97 percent was so

remote as to be negligible and the parties knew this

in advance on the basis of extensive prior experience

with similar coverages. Finding 20, infra. Under

these circumstances, American Bankers had no in-

surance role under Treaty II. Instead, it functioned

essentially as a fixed-fee supplier of clerical services

and a temporary, albeit beneficial custodian of pre-

mium monies that it was contractually obligated to

return to the plaintiff on what amounted to a pre-

determined schedule. Its returns for these undertak-

ings were substantially unaffected by the insurance

risk appurtenant to the policies with which it was

concerned. That the plaintiff voluntarily elected to

relinquish control over A & H premiums, subject

to a contractual right to fully regain them in in-

cremental installments over a period of time, made

it no less the real insurer of the risk represented

by the policies to which those premiums pertained.

The state authorities’ acceptance of plaintiff’s Treaty

II-era annual reports showing no A & H reserves

for the exposures on which American Bankers was

23a

a nominal reinsurer is of no greater substantive con-

sequence than their similar conduct in respect to

Treaty I reports, as previously discussed.

Since plaintiff was required by law to maintain

reserves with respect to the A & H policies covered

by both Treaties I and II, it failed the fractional

reserve test of Section 801 for tax treatment as a

life insurance company. It therefore must be denied

recovery.

FINDINGS OF FACT

1. Plaintiff was incorporated in Arizona on June

26, 1957 as a stock insurance company under the

insurance code of that state. Its Articles of Incor-

poration authorized the following activities:

(a) To insure, in its own proper and corpor-

ate name, the lives of persons and all insurance

appertaining thereto, including, but not limiting

the generality of the foregoing: term, industrial,

retirement income, ordinary, modified, single

premium, limited payment, group and all other

types and forms of contracts of insurance upon

or relating to the lives of persons in connection

with the extension of credit to such persons.

(b) To reinsure all or a part of any risk,

class of risks, or all of the risks of the Company

with any other insurance company or companies,

and to accept such reinsurance from any other

insurance company or companies, as allowed by

law.

2. Plaintiff’s outstanding stock has been owned

throughout by Southern Discount Company (South-

24a

ern) which, at all times pertinent hereto, was a

Georgia corporation licensed under the consumer fi-

na .ce laws of the states in which it operated, to con-

duct a consumer finance business.

3. Credit life and accident and health insurance

are sold in connection with a loan of money or an

installment sale of tangible personal property. Credit

life insurance, generally defined, is term insurance on

the lives of debtors, with their creditors as benefi-

ciaries, in amounts at least sufficient to discharge

their indebtedness in case of death. The life coverage

is frequently combined with accident and health cov-

erage. The latter type pays the debtor’s monthly in-

stallments during the period within the policy term

in which he is totally disabled (i.e., unable to work)

because of accident or sickness, provided that the

disability lasts beyond a minimum or “waiting”

period. Coverage may be conditioned upon the per-

manent as well as total disability of the debtor. When

life and accident and health coverage are provided in

one contract, the respective premiums are separately

stated. Premiums under both types of policy are col-

lected in full from the insured at the inception of cov-

erage.

4. Southern formed plaintiff because under the

laws of Georgia and those of the other states in

which it operated it was prohibited from acting as

an insurance company. It was permitted, however,

to act as an agent for authorized insurance com-

panies and prior to plaintiff’s formation it did so on

behalf of various such companies, principally Amer-

25a

ican Bankers Life Insurance Company (American

Bankers), in respect to life and accident and health

(A & H) policies sold to Southern’s borrowers.

5. Acting as “sales agent” Southern received a

commission of forty percent of premiums in North

Carolina and fifty percent of premiums in Georgia,

the maxima permitted by the laws of those jurisdic-

tions. It was in order to obtain a greater proportion

of the total profit on insurance sold to its borrowers

that Southern formed the plaintiff. American Bank-

ers was willing to permit Southern, through its plain-

tiff subsidiary, to realize a greater portion of the

total profit obtained from insuring its debtors because

it (American Bankers) realized that if it did not

participate in an arrangement providing that result

its alternative was total exclusion from the under-

taking with a consequent loss of any profit participa-

tion at all. In short, American Bankers preferred

half a loaf to nothing at all.

6. American Bankers is an insurance company

licensed to engage in the life and disability insurance

business under the laws of the State of Florida.

7. Other than as a party to certain treaties de-

scribed more particularly below, American Bankers

was totally unrelated to plaintiff at its inception and

has remained an unrelated company except for its

ownership of a nominal amount of stock (approxi-

mately 24 percent) in plaintiff’s parent, Southern

Discount, from March 15, 1962 until March 25, 1969,

and approximately 1 percent acquired in 1972 and

disposed of in the following year.

26a

8. Each of the states has its own minimum capi-

talization requirements for one seeking charter au-

thority to conduct an insurance business. Arizona

has the most moderate of such requirements. Thus,

Southern qualified plaintiff under Arizona law, in-

tending that it operate initially thereunder as a re-

insurer, and was able to do so with an initial balance

of invested capital and paid-in surplus of only

$38,000.

9. Immediately following its formation plaintiff

entered into an agreement (Treaty I) with American

Bankers governing all future life and accident and

health policies issued in respect to debtors of plain-

tiff’s parent, Southern, and any of its other subsid-

iaries and affiliates.

0. Insofar as pertinent to this litigation, Treaty I

provided :

ARTICLE I

American Bankers agrees to cede to Consumer

Life and Consumer Life agrees to accept rein-

surance to the extent set forth below:

One Hundred Per Cent (100%) of each and

every Life policy and each and every Health and

Accident policy (herein called “Life policies” and

“Health and Accident policies”) issued by Amer-

ican Bankers in respect to debtors of Conswmer

Life and its subsidiary and affiliated corpora-

tions. The liability of Consumer Life under said

Life and Health and Accident policies shall fol-

low the liability of American Bankers except that

the liability of Conswmer Life arising under its

27a

reinsurance of said Health and Accident policies

is On a month to month basis only and is limited

solely to such amounts as shall become payable

by Consumer Life under the provisions of Arti-

cle V prior to the termination of this agreement.

ARTICLE II

pe . yy tree om — to all said policies is-

y American Bankers on or afte

day of July, 1957. —

ARTICLE III

American Bankers shall furnish Consumer

Life on or before the 20th day of July, 1957 and

on or before the 20th day of each month there-

after, a statement showing the following infor-

mation on transactions of the preceding month:

A. On all Life policies the statement will

show:

(1) The amount of premiums collected:

(2) The amount of premiums returned

on account of cancellation or other

reason; and

(3) The amount of losses paid.

B. On all Health and Accident lici

statement will show: ae

(1) The amount of premiums collected ;

(2) The amount of premiums returned

on account of cancellation or other

reason ;

(3) The amount of losses paid;

28a

(4) The amount of losses reported and

unpaid and the estimated amount of

losses incurred and unreported at the

end of the preceding month; and

(5) The amount of premiums earned.

For the purpose of computing premiums earn-

ed during any month on Health and Accident

policies under this Article III, the sum of the

premiums collected on policies written during the

month less any premium returned because of

cancellation or other reason during the month,

shall be added to the unearned premium reserve

at the beginning of the month on policies then in

force, and from the total sum so obtained shall

be subtracted the unearned premium reserve at

the end of the month on policies in force at that

time.

For the purpose of computing losses, losses

reported and unpaid and losses incurred and un-

reported, the allocated loss expense shall be

added to the amount of loss claims. In this con-

nection the allocated loss expense shall be all

claim expenses over and above the usual claim

expenses incurred in the routine handling of a

claim in the ordinary course of business, it being

the intent of the parties hereto to include such

expenses as the hiring of a special investigator,

unusual travel expense in connection with the

handling of a claim, attorney’s fees arising from

a claim and other expenses not incurred in the

usual and ordinary course of handling a claim.

29a

ARTICLE IV

In addition to the monthly statement set forth

in Article III, American Bankers agrees to fur-

nish Consumer Life on or before the 20th day

of January each year and from time to time as

may be requested by Consumer Life, but in no

event more often than monthly, a statement con-

taining the following information as at the end

of the month preceding the statement:

A. The amount of reserve on all life policies

then in force; :

B. The amount of losses on Life policies re-

ported and unpaid and the estimated

amount of losses incurred but unreported;

C. The amounts of insurance on all Life

policies;

D. Such other information as may be re-

quired to complete annual statements or

other statements as required by law.

Consumer Life shall, at all reasonable times

during this agreement, have full and free access

to all books, records and files of American Bank-

ers’ office with respect to the business covered by

this agreement.

ARTICLE V

In consideration of the reinsurance as set

forth in Article I, the American Bankers agrees

to pay monthly to Consumer Life, based on the

statement set forth in Article III for the preced-

ing month, and payable at the same time: (1)

Eighty-seven and One-half Per Cent (8714% )

30a

of the premiums collected less any premiums re-

turned on all Life policies, and (2) Eighty-seven

and One-half Per Cent (8714%) of the pre-

miums earned on all Health and Accident pol-

icies. )

Consumer Life agrees to reimburse American

Bankers before the 30th day of the month after

such statement is submitted, for all losses actu-

ally paid during the preceding month on Life

policies and all losses actually paid during the

preceding month on Health and Accident poli-

cies plus any increase or less any decrease dur-

ing said month in the amount of Health and

Accident losses reported and unpaid and incur-

red and unreported.

ARTICLE VI

American Bankers shall maintain all unearned

premiums, loss and other reserves as may be re-

quired by law against all Health and Accident

policies. Conswmer Life shall maintain pelicy

and other reserves as may be required by law

on all Life policies.

ARTICLE VII

American Bankers agrees to pay all state,

county, or city taxes which may be or become

due in connection with the insurance sold or pre-

miums collected on policies reinsured under this

agreement.

ARTICLE VIII

American Bankers has furnished to Consumer

Life and Consumer Life has acknowledged hav-

8la

ing received from American Bankers specimen

forms upon which all said policies covered hereby

are currently written. American Bankers re-

serves the right to make changes in such forms

from time to time, but shall promptly notify

Consumer Life of all such changes.

ARTICLE IX

The supervision and payment of all claims on

policies covered by this agreement shall be han-

dled by American Bankers and the decision of

American Bankers in settling, rejecting or de-

fending such claims shall be binding on Con-

sumer Life.

ARTICLE X

In the event of the insolvency of the American

Bankers, all reinsurance shall be payable directly

to the liquidator, receiver or statutory successor

of said American Bankers, without diminution

because of the insolvency of American Bankers.

In the event of insolvency of American Bank-

ers, the liquidator, receiver or statutory succes-

sor shall give Consumer Life written notice of

the pendency of a claim on the policy reinsured

within a reasonable time after such claim is filed

in the insolvency proceeding. During the pen-

dency of any such claim, Consumer Life may

investigate such claim and interpose in the name

of American Bankers (its liquidator, receiver or

statutory successor,) but at its own expense, in

the proceeding where such claims are to be ad-

judicated, any defense or defenses which Con-

sumer Life may deem available to American

32a

Bankers or its liquidator, receiver or statutory

successor.

ARTICLE XI

All disputes and differences between the two

contracting parties upon which an amicable un-

derstanding cannot be reached are to be decided

by arbitration and the arbitrators, who shall re-

gard this agreement from the standpoint of

practical business and equity rather than from

that of the strict law, are empowered to deter-

mine as to the interpretation of the agreement

obligation.

The court of arbitrators which is to be held

in the city of Miami, Florida, shall consist of

three arbitrators who must be officers of life

insurance companies other than the two parties

of this agreement. One of the arbitrators is to

be appointed by American Bankers, the second

by Consumer Life and the third is to be selected

by these two representatives before the begin-

ning of the arbitration. Should one of the par-

ties decline to appoint an arbitrator or should

the two arbitrators be unable to agree upon the

choice of a third, the appointment shall be left

to the president of the American Life Conven-

tion.

The arbitrators are not bound by any rules of

law. They shall decide by a majority of votes

and from their written decision there can be no

appeal. The cost of arbitration, including the

fees of the arbitrators, shall be borne by the

losing party unless the arbitrators shall decide

otherwise.

ee ee

83a

ARTICLE XII

This agreement constitutes the entire contract

between the parties and may not be altered,

modified or in any ways amended except by an

instrument in writing duly executed by the

proper official of both parties.

ARTICLE XIII

This agreement may be terminated by either

party effective on the last day of any month upon

at least thirty (30) days written notice of the

other party.

Upon termination by either party, this agree-

ment shall continue to apply to all policies rein-

sured hereunder before such termination becomes

effective.

IN WITNESS WHEREOF, the parties hereto

have caused this instrument to be signed and

sealed by their duly authorized officers on this

28 day of June, 1957.

11. By amendments effective November 1, 1957

and April 1, 1958, American Bankers’ retained share

of the total premiums received annually in excess of

$200,000 was reduced from 12% percent, as pro-

vided in Article V of Treaty I, finding 10, supra, to

914 percent.

12. Treaty I was further amended May 28, 1958,

effective as of July 1, 1957, to revise the extent of

plaintiff’s interim liability as the reinsurer of Amer-

ican Bankers’ exposure under the A & H coverages

subject to the Treaty. At all times, however, plaintiff

84a

reinsured the entire risk represented by those cov-

erages, the only change being in the timing of its

loss indemnity payments to American Bankers. At

the time of this amendment plaintiff had accumu-

lated a surplus fund of $130,000 from A & H pre-

mium receipts out of which to meet its reinsurance

obligations which were averaging approximately

$3,000 per month.

13. By virtue of the provisions of Articles I, II, V

and XIII of Treaty I, finding 10, supra, plaintiff at

all relevant times had an enforceable right to receive,

albeit on an “as earned” basis, its entire share of

premiums collected by American Bankers on A & H

insurance sold by it to the debtors of Southern and

its subsidiaries and affiliates after July 1, 1957. Un-

der the provisions of the Treaty, construed in light

of all of the factual circumstances on which it op-

erated, the possibility that plaintiff would not receive

its full share of all A & H premiums collected by

American Bankers on coverages subject to the Treaty

was so remote as to be negligible.

14. By virtue of the provisions of Articles I and

XIII plaintiff assumed and completely retained the

entire insurance risk of all A & H coverages sold by

American Bankers after July 1, 1957 to Southern’s

debtors and those of its subsidiaries and affiliates.

15. For each of the years in suit plaintiff pre-

pared and filed annual reports with the proper au-

thorities in Arizona and Georgia, as required by the

laws of those states. On those reports covering the

years in which Treaty I was in force plaintiff re-

35a

ported premium income from life insurance in the

full amount of its 8714 percent share of premiums

collected during the year by American Bankers. Cor-

respondingly, it reported as a liability the full tabu-

lar reserve attributable to those life premiums. On

A & H insurance, however, plaintiff reported as

premium income only those amounts received from

American Bankers representing an amortized por-

tion of total premiums attributed to exposure deemed

to have expired on a month-to-month basis. It re-

ported no asset or other item representing the por-

tion of A & H premiums on existing policies that

it was contractually entitled to receive from Ameri-

can Bankers in the future. Those premiums and a

correlative reserve therefor were carried by Ameri-

can Bankers on its own reports and had no effect

on its status as a life insurance company for federal

tax purposes. Thus, plaintiff reported no unearned

premium reserve in respect to the A & H coverages

that it reinsured and it reflected no other reserve

liability relative to the A & H premiums that it

was to receive in the future from American Bankers

in accordance with the provisions of Treaty I.

16. The Georgia authorities never challenged

plaintiff’s reporting treatment of its Treaty I ac-

tivities. The Arizona authorities examined plain-

tiff’s report for 1961 and required no change in re-

spect to Treaty I items.

17. By 1962 plaintiff had accumulated a sufficient

surplus from profits realized under Treaty I to en-

able it to qualify under the laws of Georgia and

36a

North Carolina to write insurance directly under the

laws of those states. Accordingly, on April 18,

1962 plaintiff entered into a new insurance agree-

ment, effective March 1, 1962, with American Bank-

ers. That agreement, referred to herein as Treaty

II, provided:

Article I

BASIS OF REINSURANCE

1. On and after the effective date hereof, the

Ceding Company’s liability under Credit Acci-

dent and Sickness policies issued directly by the

Ceding Company on the policy forms specified

in Schedule A, attached hereto, shall be rein-

sured automatically to the degree and in the

manner hereinafter specified.

2. The reinsurance liability of American

Bankers during 1962 shall be 80% of each policy

issued by the Ceding Company; thereafter, with

respect to new business, such reinsurance liabil-

ity may be reduced at the option of the ceding

company at the beginning of each subsequent

calendar year.

3. Reinsurance hereunder shall apply and be

subject to all benefits and limitations included

in policies issued by the Ceding Company and

subject to reinsurance hereunder.

Article II

MODE OF CESSION

1. Reinsurance of Credit Accident and Sick-

ness insurance issued or renewed by the Ceding

37a

Company on and after the effective date of this

Agreement shall be effected by the Ceding Com-

pany’s mailing to American Bankers a rein-

surance cession on a form of which a sample is

attached hereto and marked Schedule B, not later

than the twentieth day following the last day of

the calendar quarter covered by the reinsurance

cession. The liability of American Bankers shall:

(a) commence as of the effective dates of

the reinsurance premiums, and

(b) continue only for the period covered by

the reinsurance premiums. ,

2. In no event shall the reinsurance be in

force and binding unless the policy issued by the

Ceding Company to the insured is in force.

Article III

REINSURANCE PREMIUMS

1. The reinsurance premiums to be paid the

American Bankers by the Ceding Company shall

be the premiums charged the insured by the

Ceding Company during the calendar quarter

for the coverage reinsured.

2. The American Bankers will pay to the

Ceding Company a commission of 50% of re-

insurance premiums received, as specified in this

Article, on reinsurance hereunder.

88a

Article IV

OVERSIGHTS

1. American Bankers shall be bound as the

Ceding Company is bound, and it is expressly

understood and agreed that if non-payment of

premiums within the time specified or failure

to comply with the terms of this Agreement is

shown to be uninientional and the result of mis-

understanding or oversight on the part of either

the Ceding Company or American Bankers, both

the Ceding Company and American Bankers

shall be restored to the positions they would

have occupied had no such error or oversight

occurred.

Article V

PAYMENT OF CLAIMS

1. At the end of each calendar quarter Ameri-

can Bankers shall reimburse the Ceding Com-

pany for American Bankers share of all claim

payments made by the Ceding Company during

the calendar quarter on policies reinsured here-

under.

2. It is hereby understood and agreed that

the American Bankers shall be liable only for

claims incurred on or after the effective date

hereof.

Article VI

EXPERIENCE REFUNDS

1. Reinsurance ceded hereunder shall be eligi-

ble for an Experience Refund. The Experience

39a

Refund for a given calendar quarter shall be

computed as follows:

Experience Refund = (P-Co-E-Cl)

where P = earned reinsurance premiums

during the calendar quarter as

determined by American Bank-

ers.

Co = earned reinsurance commissions

during the calendar quarter as

determined by American Bank-

ers.

E = an expense, profit, and contin-

gency charge equal to .03P.

Cl = incurred reinsurance claims dur-

ing the calendar quarter as de-

termined by American Bankers.

2. If P-Co-E-Cl is negative for a given cal-

endar quarter such negative amount will be

treated as an addition to the incurred claims in

calculating the Experience Refund for the fol-

lowing calendar quarters.

Article VII

TAXES, ASSESSMENTS AND EXPENSES

Neither party hereto shall be liable to the

other for taxes, assessments, or any expenses

resulting from reinsurance hereunder. The Ced-

ing Company shall furnish the American Bank-

ers with all necessary information so that Aimer-

ican Bankers will not be required to perform

aly office work other than the regular book-

40a

keeping entries made in connection with re-

insurance accounting.

Article VIII

INSPECTION OF RECORDS

American Bankers shall have the right at any

reasonable ‘ime to inspect at the office of the

Ceding Company all books and documents relat-

ing to the reinsurance under this Agreement.

Article IX

INSOLVENCY

1. In the event of insolvency of the Ceding

Company, all reinsurance in force shall be pay-

able to its liquidator or receiver without diminu-

tion because of the insolvency of the Ceding

Company by any court of competent jurisdiction

or any justice or judge thereof, or by any re-

ceiver or liquidator having authority to deter-

mine and allow such claims. It is understood,

however, that in the event of the insolvency of

the Ceding Company, the liquidator, receiver

or statutory successor of the Ceding Company

shall give written notice of the pendency of a

claim against the Ceding Company on the policy

reinsured with[in] a reasonable time after such

claim is filed in the insolvency procedings and

that during the pendency of such claim the

American Bankers may investigate such claim

and interpose, at its own expense, in the pro-

ceeding where such claim is to be adjudicated

any defense or defenses which it may deem avail-

4la

able to the Ceding Company or its liquidators

or receivers or statutory successor.

2. ™ >; expense thus incurred by American

Bankers shall be chargeable against the Ceding

Company as part of the expense of liquidation

to the extent of a proportionate share of the

benefit which may accrue to the Ceding Com-

pany solely as a result of the defense undertaken

by American Bankers.

Article X

SETTLEMENT OF CLAIMS

1. American Bankers shall be liable to the

Ceding Company for the benefits covered by re-

insurance hereunder to the same exvent as the

Ceding Company is liable to the insured for such

benefits and all reinsurance shall be subject to

the terms and conditions of the particular form

of policy under which the Ceding Company shall

be liable.

2. It is hereby understood and agreed that

the American Bankers shall be liable only for

claims incurred on or after the effective date

hereof.

3. Whenever a claim is made under a policy

of the Ceding Company, which has been rein-

sured hereunder, it shall be taken and considered

by American Bankers to be a claim for the

amount of reinsurance on such risk and Ameri-

can Bankers shall abide the issue as it shall

be settled by the Ceding Company and shall pay

the amount of reinsurance covered by the policy

of reinsurance when the Ceding Company shall

settle with the Claimant.

42a

4. Any suit or claim may be contested or

compromised on the part of the Ceding Com-

pany and in case of a reduction of the claim

made upon the Ceding Company, American

Bankers and the Ceding Company shall partici-

pate in such reduction in the ratio that each

company’s net liability bore to the total net

liability prior to the reduction of the claim.

Any unusual expenses incurred by the Ceding

Company in defending or investigating any

claim or taking up or rescinding any policy re-

insured hereunder aside from routine investi-

gations and other expenses incidental to the

settlement of claims shall be shared in the

same proportion.

5. In every case of loss, copies of proofs ob-

tained by the Ceding Company shall likewise be

taken as sufficient by American Bankers and

copies thereof, together with a statement show-

ing the amount paid on such claim by the Ceding

Company shall be furnished to American Bank-

ers before payment shall be demanded of it.

Article XI

ARBITRATION

1. All disputes and differences between the

two contracting parties upon which an amicable

understanding cannot be reached are to be de-

cided by arbitration and the arbitrators, who

shall regard this treaty from the standpoint of

practical business and equity rather than from

that of the strict law, are empowered to de-

termine as to the interpretation of the treaty

obligation.

43a

2. The court of arbitrators which is to be

held in the City of Miami, Florida, shall con-

sist of three arbitrators who must be officers

of life insurance companies other than the two

parties of this Agreement. One of the arbitra-

tors is to be appointed by the Ceding Company,

the second by American Bankers and the third

is to be selected by those two representatives

before the beginning of the arbitration. Should

one of the parties decline to appoint an arbi-

trator or should the two arbitrators be unable to

agree upon the choice of a third, the appointment

shall be left to the counsel for the Consumer

Credit Insurors Association.

3. The arbitrators are not bound by any

rules of law. They shall decide by a majority of

votes and from their written decision there can

be no appeal. The cost of arbitration, including

the fees of the arbitrators, shall be borne by

the losing party unless the arbitrators shall de-

cide otherwise.

Article XII

PARTIES TO AGREEMENT

This is an agreement solely between the Ced-

ing Company and American Bankers. The ac-

ceptance of reinsurance hereunder shall not cre-

ate any right or legal relation whatever be-

tween American Bankers and the insured or the

beneficiary under any policy of the Ceding Com-

pany which may be reinsured hereunder.

44a

Article XIII

DURATION

1. This agreement shall be effective as of the

lst day of March 1962, and may be terminated

as of the end of any calendar quarter by either

party giving to the other not less than 30 days’

written notice.

2. Upon termination, as provided in this Ar-

ticle, the Ceding Company shall, within 30 days

of the termination date, supply American Bank-

ers with the information necessary to calculate

the final experience refund as of the termination

date. Payment of (a) the final experience re-

fund,

(b) the unearned premium reserve held by

American Bankers less unearned com-

missions thereon, and

American Bankers.

45a

SURANCE COMPANY OF FLORIDA, a cor-

poration duly organized and existing under and

by virtue of the laws of the State of Florida

and having its executive office in the City of

Miami, and State of Florida, hereinafter desig-

nated as “Company’”’.

WITNESSETH:

WHEREAS, the Company and the Ceding Com-

pany entered into a Reinsurance Agreement on

the 1st day of March, 1962; and

WHEREAS, the parties are mutually desirous

of amending said Agreement as hereinafter set

forth.

NOW, THEREFORE, IT IS MUTUALLY UN-

DERSTOOD AND AGREED AS FOLLOWS:

1. The terms and conditions of said Reiiusur-

ance Agreement are incorporated within the

terms of this Agreement.

2. Article I, Paragraph (2) is hereby amended

18. On December 2, 1964, effective October 1, to read:

1964, plaintiff and American Bankers executed the The reinsurance liability of American

following amendment to Treaty II: Bankers shall be 65% of each policy is-

sued by the Ceding Company; there-

ADDENDUM TO REINSURANCE after, with respect to new business,

AGREEMENT such reinsurance liability may be re-

duced at the option of the Ceding Com-

THIS AGREEMENT, made this 2nd day of De- pany at the beginning of each subse-

cember, 1964, and effective the Ist day of Oc- quent calendar year.

tober, 1964, by and between CONSUMER LIFE

INSURANCE COMPANY OF PHOENIX, ARI-

ZONA, hereinafter designated as “Ceding Com-

pany” and AMERICAN BANKERS LIFE AS-

3. All other conditions are to remain the same.

46a

19. On December 29, 1964, effective December

31, 1964, plaintiff and American Bankers executed

the following further amendment to Treaty II:

AMENDMENT TO Reinsurance Agreement be-

tween Consumer Life Insurance Company of

Phoenix, Arizona, and American Bankers Life

Assurance Company of Florida, of Miami, Flor-

ida, dated April 18, 1962. Article VI of above

mentioned Reinsurance Agreement is hereby

amended to read as follows:

Article VI

EXPERIENCE REFUNDS

1. Reinsurance ceded hereunder shall be eligi-

ble for an Experience Refund. The Experience

Refund for a given calendar quarter shall be

computed as follows:

Experience Refund = (P-Co-E-Cl-N)

where P = earned reinsurance premiums

during the calendar quarter as

determined by American Bank-

ers.

Co = earned reinsurance commissions

during the calendar quarter as

determined by American Bank-

ers.

E = an expense, profit, and contin-

gency charges equal to .03P.

Cl = incurred reinsurance claims dur-

ing the calendar quarier as de-

termined by American Bankers.

47a

N = negative carry-forward from

prior quarter.

2. If a negative amount is obtained from the

calculation of the Experience Refund for a given

calendar quarter, such negative amount will be

carried forward in calculating the Experience

Refund for the following calendar quarter, pro-

vided, however, that any unamortized balance of

such negative carry-forward will be dropped

from the refund calculation after 20 quarters.

The “first-in, first-out” principle will apply tc

the unamortization of two or more negative

carry-forwards arising from the experience of

different calendar quarters.

IN WITNESS WHEREOF the parties hereto

have caused this Amendment to be executed

in duplicate this 29th day of December, 1964,

and to be effective for calculating the Experi-

ence Refund due for the calendar quarter end-

ing December 31, 1964.

20. By virtue of the provisions of Articles I, II,

VI and XIII, and particularly those of Article VI

dealing with Experience Refunds, plaintiff assumed

the entire insurance risk under all of the A & H

policies covered by Treaty II. Because of Article

VI, American Bankers’ pecuniary interest in Treaty

II, aside from investment return on premiums tem-

porarily held, was fixed at 3 percent of the A & H

premiums covered by the Treaty, without regard

to loss experience. Only if loss experience under the

subject coverages exceeded 97 percent of premium

income could American Bankers’ receipt of its 3

48a

percent participation be delayed to a subsequent

quarterly period. The likelihood that loss experience

on the A & H coverages subject to Treaty II would

run as high as 97 percent was so remote as to be

negligible and the parties knew this. They had ac-

cumulated extensive prior loss experience, both under

Treaty I and prior thereto, with such coverage. That

experience reflected losses ranging from 28 to 30

percent of premiums earned. On December 29, 1964

when the parties excuted the amendment of Article

VI of Treaty II, as set forth in finding 19, supra,

loss experience on A & H coverages subject thereto

was running at the rate of 18 percent.

21. On its annual reports covering the A & H

transactions subject to Treaty II plaintiff did not

reflect any unearned premium reserves; this on the

premise that by virtue of Treaty II, American

Bankers was the reinsurer of the A & H coverages

subject thereto and that, to the extent of such re-

insurance, plaintiff was entitled to take a credit

against (i.e., to reduce) the reserves that it would

otherwise be required to maintain as the originat-

ing carrier of such coverages. American Bankers

conformed with this approach in preparing its own

reports but its recognition of the reserves in ques-

tion had no disqualifying effect on its status as a

life insurance company for federal tax purposes.

22. The essence of insurance is risk-shifting and

risk-distribution.

49a

23. Reinsurance is insurance by the first insurer

of the whole or some part of his interest in the risk

created by his original contract of insurance.

24. Under Treaty I plaintiff reinsured the entire

insurance risk created by American Bankers under

the A & H coverages subject thereto. Under Treaty

II American Bankers did not function as a reinsurer.

Its function was rather that of a supplier of essen-

tially clerical services for a fixed fee with plaintiff

assuming and retaining the entire insurance risk

under the coverages subject thereto. :

25. In the opinion of Mr. Arthur Crooks Eddy, an

actuary who testified as an expert for the plaintiff in

this proceeding and for the plaintiff in Penn Security

Life Insurance Co. v. United States, Ct. Cl. No, 109-

68 (Tr. Judge Op. March 2, 1973), and Economy

Finance Corp. v. United States, 501 F.2d 466 (7th

Cir. 1974), an insurer having an enforceable con-

tractual right to receive premiums in the future re-

specting existing coverage on which it bears some or

all of the insurance risk is obliged by prevailing state

law and practice to reflect the amount of those pre-

miums receivable as an asset on its annual reports

and to concurrently reflect a concomitant liability,

in the nature of an unearned premium reserve in the

case of A & H coverage—a reserve relating to the

underlying exposure assumed in consideration of the

right to receive such premiums in the future.

26. The Georgia Code Annotated contains the fol-

lowing provisions, by section, applicable to the insur-

ance activities in suit:

50a

56-901. “Assets” defined.—In any determina-

tion of the financial condition of an insurer, there

shall be allowed as assets only such assets as are

owned by the insurer and which consist of:

(6) Premiums in the course of collection,

other than for life insurance and annuity con-

siderations, not more than three months past

due, less commissions payable thereon. The fore-

going limitation shall not apply to premiums

payable directly or indirectly to the United

States Government or by any state of the Union

or by any of their instrumentalities;

(7) Installment premiums other than life in-

surance premiums to the extent of the unearned

premium reserves carried thereon;

(8) Notes and like written obligations not

past due, taken for premiums other than life in-

surance premiums, on policies permitted to be

issued on such basis, to the extent of the un-

earned premium reserves carried thereon;

(9) The full amount of reinsurance recover-

able by a ceding insurer from a solvent rein-

surer and which reinsurance is authorized under

section 56-413;

(10) Amounts receivable by an assuming in-

surer representing funds withheld by a solvent

ceding insurer under a reinsurance treaty;

> . * *

56-905. Liabilities—In any determination of

the financial condition of an insurer, capital

stock and liabilities to be charged against its

assets shall include:

5la

(3) With reference to life and disability in-

surance and annuity contracts:

(a) The amount of reserves on life insurance

policies and annuity contracts in force, valued

according to the tables of mortality, rates of in-

terest, and methods adopted pursuant to this

Title which are applicable thereto,

(b) Reserves for disability benefits, for both

active and disabled lives,

(d) Any additional reserves which may be re-

quired by the Commissioner consistent with prac-

tice formulated or approved by him, on account

of such insurance;

56-906. Unearned premium reserve.—(1)

With reference to insurance against loss or dam-

age to property (except as provided in section

56-907) and with reference to all general cas-

ualty insurance and surety insurance, every in-

surer shall maintain an unearned premium re-

serve on all policies in force.

(2) The Commissioner may require that such

reserves shall be equal to the unearned portions

of the gross premiums in force after deducting

reinsurance in solvent insurers as computed on

each respective risk from the policy’s date of

issue. If the Commissioner does not so require,

the portions of the gross premium in force, less

reinsurance in solvent insurers to be held as a

premium reserve, shall be computed according

to the following table:

Term for Which Policy Reserved for Unearned

Was Written Premium

1 year or less 1/2

2 years l[st year 3/4

2nd year 1/4

3 years Ist year 5/6

2nd year 1/2

3rd year 1/6

4 years l[st year 7/8

2nd year 5/8

3rd year 3/8

4th year 1/8

5 years Ist year 9/10

2nd year 7/10

3rd year 1/2

4th year 3/10

5th year 1/10

Over 5 years pro rata.

(3) Unearned premium reserves on policies

written for an intermediate period shall be cal-

culated on a monthly pro rata basis.

(4) In lieu of computation according to the

foregoing table, all of such reserves may be com-

puted, at the option of the insurer, on a monthly

or more frequent pro rata basis.

(5) After adopting a method of computing

such reserve, a domestic insurer shall not change

methods without approval of the Commissioner

and a foreign or alien insurer shall not change

methods without approval of the insurance su-

pervisory official of the state of its domicile.

(6) This section does not apply to title insur-

ance.

* * * *

53a

56-908. Reserves for accident and sickness in-

surance.—For all accident and sickness policies

the insurer shall maintain an active life reserve

which shall place a sound value on its liabilities

under such policies and which shall not be less

in the aggregate than the reserve according to

the standards set forth in regulations issued by

the Commissioner and, in no event, less than the

pro rata gross unearned premium reserve for

such policies.

27. The following sections of the Arizona Revised

Statutes are germane to the insurance activities in

§ 20-223. Annual statement

A. Each authorized insurer shall annually on

or before March 31 file with the director a true

statement of its financial condition, transactions

and affairs as of the December 31 preceding.

The statement shall be in such general form and

context as approved by the national association

of insurance commissioners for the kinds of in-

surance to be reported upon, and as supple-

mented for additional information required by

the director.

§ 20-501. “Assets” defined

In any determination of the financial condition

of an insurer, there shall be allowed as assets

only such assets as are owned by the insurer and

which consist of:

54a

5. Premiums in the course of collection, other

than for life insurance, not more than three

months past due, less commissions payable

thereon. The foregoing limitation shall not apply

to premiums payable directly or indirectly by the

United States or by any of its instrumentalities.

6. Installment premiums other than life in-

surance premiums, in accordance with regula-

tions prescribed by the director consistent with

practice formulated or adopted by the national

association of insurance commissioners.

7. Notes and like written obligations not past

due, taken for premiums other than life insur-

ance premiums, on policies permitted to be is-

sued on such basis, to the extent of the unearned

premium reserves carried thereon.

8. The full amount of reinsurance recoverable

by a ceding insurer from a solvent reinsurer and

which reinsurance is authorized under § 20-261.

9. Amounts receivable by an assuming in-

surer representing funds withheld by a solvent

ceding insurer under a reinsurance treaty.

§ 20-505. Liabilities

In any determination of the financial condi-

tion of an insurer, capital stock and liabilities

to be charged against its assets shall include:

* * * e

3. With reference to life and disability insur-

ance and annuity contracts:

(a) The amount of reserves on life insurance

policies and annuity contracts in force, valued

according to the tables of mortality, rates of in-

55a

terest, and methods adopted pursuant to this

title which are applicable thereto.

(b) Reserves for disability benefits, for both

active and disabled lives,

(d) Any additional reserves which may be re-

quired by the director consistent with practice

formulated or approved by the national associa-

tion of insurance commissioners, on account of

such insurance.

§ 20-506. Unearned premium reserve

A. With reference to insurance against loss or

damage to property, except as provided in

§ 20-507, and with reference to all general casu-

alty insurance, disability insurance, except as

provided in §§ 20-508 and 20-510, and surety in-

surance, every insurer shall maintain an unearn-

ed premium reserve on all policies in force.

B. The director may require that such reserve

be equal to the unearned portions of the gross

premiums in force after deducting reinsurance

in solvent insurers as computed on each respec-

tive risk from the policy’s date of issue, If the

director does not so require, the portions of the

gross premiums in force, less reinsurance in sol-

vent insurers to be held as a premium reserve,

shall be computed according to the following

table: |

56a

57a

Term for Which Policy Reserve for Unearned 4, Plaintiff’s principal business, until ap-

Was Written Premium ie? proximately 1966, consisted of reinsuring death

1 year or less 1/2 and disability risks underwritten by unrelated

2 years ist year 3/4 insurance companies in respect to credit life in-

2nd year 1/4 surance policies issued by those companies to

3 years ist year 5/6 Aetna and its loan customers. By 1967, plain-

2nd year 1/2 tiff’s volume of business increased to the point

8rd year 1/6 at which it became more profitable for it to write

4 years lst year 7/8 its own credit insurance policies than to reinsure

2nd year 5/8 other companies. Plaintiff today writes a com-

8rd year 3/8 plete portfolio of the standard forms of ordinary

= ie 40 and term insurance contracts including individ-

5 years Bw — ~f = ual and group life, accident and health, and sur-

ord ss sy gical coverages, as well as credit insurance for

4th year 3/10 borrowers and installment purchasers.

5th year 1/10 * * . *

Over 5 years Pro rata 15. The determination of the Commissioner of

Internal Revenue that plaintiff was not a “life

28. On the basis of the proofs and representations

of the parties the following numbered findings of fact

were made by the Trial Judge in Penn Security Life

Insurance Co. v. United States, Ct. Cl. No. 109-68:

insurance company” as defined in Section 801 of

the Code in 1963, 1964, and 1965 was based upon

his inclusion in plaintiff’s “total reserves” of un-

earned gross premiums actually held by the

1. Plaintiff was incorporated on August 8,

1955, under the statutes of the State of Missouri

applicable to the organization of life insurance

companies. It is empowered by its Articles of

Incorporation and authorized by the insurance

authorities of the State of Missouri to engage in

the business of issuing contracts insuring or re-

insuring against death or disability, and has

carried on such business exclusively.

ceding companies (i.e., Old Republic, Pilot, and

National Fidelity) in respect of disability bene-

fits under credit life insurance policies (com-

bined with health and accident insurance) issued

by those companies to Aetna and its loan cus-

tomers. The amounts of “unearned premiums”

added by the Commissioner of Internal Revenue

to plaintiff’s “total reserves” as of December 31,

1962, 1963, 1964, and 1965 were as follows:

58a

Unearned Premiums Attributed

to Plaintiff

From 12-31-62 12-31-63 12-31-64 12-31-65

Old

Republic $ 183,342 $ 147,375 $ 145,833 $ 191,416

Pilot 728,821 782,726 724,445 829,480

National

Fidelity 413,973 495,288 570,083 773,670

1,326,635 1,425,389 1,440,351 1,794,566

The Government now concedes that unearned

premiums under the Old Republic Disability Re-

insurance Treaty are not attributable to tax-

payer for purposes of qualification as a life in-

surance company.

16. The unearned premiums attributed to

plaintiff by the Commissioner of Internal Rev-

enue as of December 31, 1962, 1963, 1964, and

1965 were actually held by the ceding companies

on those dates and were included in the unearned

premium reserves shown on the annual state-

ments which they submitted to the insurance au-

thorities of the various states in which they did

business. In recognition of their continuing obli-

gations to their policyholders, the ceding com-

panies were required, both from an actuarial

standpoint and under state law, to establish such

unearned premium reserves while they actually

held the unearned premiums in order to have

funds available to pay claims and refunds to

their policyholders and to reflect the fact that

they had received premiums from policyholders

for insurance protection to be provided after the

statement date. The annual statements of those

59a

companies, in which the unearned premiums

which the Commissioner of Internal Revenue

now seeks to include in plaintiff’s reserves were

shown as unearned premiums of the ceding com-

panies, were accepted by the insurance author-

ities in all the states in which the ceding com-

panies did business.

* * * *

18. Plaintiff had separate reinsurance treaties

covering life insurance risks and disability in-

surance risks with each of the ceding companies

during the years in issue. Under the disability

reinsurance treaties, plaintiff agreed to reinsure

100 percent of the liability of each ceding com-

pany with respect to disability benefits included

in credit life insurance policies issued to Aetna

and its loan customers. The treaties provided for

payment of a monthly reinsurance premium

equal to 98 percent (89 percent under the Old

Republic treaty) of the premiums earned with

respect to credit accident and health insurance

in force during the previous month. The follow-

ing excerpts from the Pilot treaty are typical:

Article I.

* * * Pilot Life agrees to reinsure with [Tax-

payer] one hundred per cent (100%) of the total

of all Credit Accident and Health issued by Pilot

Life covering the debtors of Aetna Finance Com-

pany. * * *, and [Taxpayer] agrees to accept

such reinsurance automatically.

Article II.

1. The liability of [Taxpayer] on all reinsur-

ances shall begin simultaneously with that of

60a

Pilot Life and in no event shall the reinsurance

of [Taxpayer] be in force and binding unless

the policy issued by Pilot Life is in force.

2. In all reinsurances the liability of [Tax-

payer] shall cease when the liability of Pilot Life

ceases.

* * . .

Article III.

1. Reinsurance payments to [Taxpayer] shall

be made on or before the twenty-fifth of each

calendar month, on a monthly term basis, based

on all accident and health insurance in force

during the previous month on policies reinsured

with [Taxpayer].

2. The premium payable in any month shall

be ninety-eight per cent (98%) of the earned

premiums the previous month for all accident

and health policies reinsured hereunder. Earned

premiums for any month on such policies are all

premiums written during such month, less re-

turned premiums on such policies during such

month, plus unearned premium reserves on such

policies at the beginning of the month, and less

the unearned premium reserves on such policies

at the end of such month.

3. From the reinsurance premium due [Tax-

payer] shall be deducted and withheld by Pilot

Life:

A. The following expenses which are as-

sumed by [Taxpayer]:

(1) All premium, occupational and privi-

lege taxes applicable to the insurance.

(2) The cost of policy forms.

6la

(3) Any special claim expense incurred

by Pilot Life in accordance with Section 3 of

Article IV hereof, and

(4) Any commissions paid to or retained

by agents for writing the insurance; and

B. The total of all claims paid under re-

insured policies during the period for which

the premium is due,

4. If, at the time established for making any

premium remittance, the total of the deductions

listed in the preceding Section of this Article

exceeds ninety-eight per cent (98%) of the

earned premium for the period covered, [Tax-

payer] shall pay to Pilot Life the amount of

such excess upon receipt of a statement of the

amount of such excess.

5. If this agreement is terminated as to new

insurance, Pilot Life shall nevertheless be liable

to [Taxpayer] for payment of monthly rein-

surance premiums until all premiums on policies

reinsured with [Taxpayer] prior to the termina-

tion have been earned, and [Taxpayer] shall

nevertheless be liable to Pilot Life for payment

of all claims arising out of policies reinsured

with [Taxpayer] prior to the termination. After

all reinsurance premiums have been paid, [Tax-

payer] shall pay Pilot Life the amount of any

claims on such reinsured policies, which claims

were paid by Pilot Life and not deducted from

reinsurance premiums, upon receipt of a state-

ment of the amount of any such claims.

. . . *

19. Plaintiff's disability reinsurance treaties

with the ceding companies fell into the category

62a

of “reinsurance ceded’; i.e., they were solely

contracts of insurance between two insurance

companies (the “ceding company” and the “re-

insurer”), and did not create any contractual

obligation running from the reinsurer (plain-

tiff) to the policyholders of the ceding companies.

Such reinsurance did not relieve the ceding com-

panies of contractual liabilities to their policy-

holders, e.g., the obligation to pay benefits and

to refund unearned premiums in the event of

cancellation or other termination of a policy

before the expiration of its full term. Conse-

quently, the mere fact that the ceding companies

obtained reinsurance from plaintiff under these

treaties did not affect their responsibility, under

state law or under actuarial principles, to set

up an unearned premium reserve to reflect the

unearned premiums actually held by those com-

panies or policies covered by reinsurance treaties

with plaintiff. Ceding companies, however, may

obtain a credit on their annual statement forms

for unearned premium reserves actually trans-

ferred to a reinsurer since, as explained by

plaintiff’s expert, the liability for an unearned

premium reserve “depends on whether you’ve

got the money or not. . .”

29. By virtue of Articles I and III, subpara-

graph 5, of the Treaty set forth under paragraph

18 of the preceding finding the plaintiff in Penn

Security assumed the entire insurance risk under

the coverages subject thereto and had an enforce-

able contractual right to receive, over the respective

lives of the individual coverages involved, substan-

tially the entire premiums collected thereon from

63a

the insureds by the ceding carriers. According to

the testimony of Arthur Crooks Eddy in the present

proceeding, a right to receive premiums in the fu-

ture, such as Penn Security had under the treaties

to which it was a party, must be reported to the

state regulatory authorities as an asset and musi

be accompanied by a liability item in correlative

amount, in the nature of an unearned premium

reserve against the asset receivable.

30. During the period in suit in Penn Security,

VERNON’S ANNOTATED MISSOURI STATUTES included

the following provision: |

376.410. Insurance companies to maintain re-

serves—exemptions

Except as provided in subdivision (6) of this

section, all companies organized under the laws

of this state, and engaged in writing policies

of accident or health insurance, or combination

policies of accident and health insurance, and

all other companies transacting such kinds of

business in this state, shall maintain reserves

thereon in accordance with the following re-

quirements:

(1) On all such policies actually written there

shall be maintained an unearned gross premium

reserve which reserve may be computed on a

pro rata basis or such reserve may be computed

at not less than fifty per cent of the gross pre-

miums in force

(2) On all such policies written on a nom-

cancellable plan and under the terms of which

64a

the company is obligated to renew or continue

for a stated period, or to a stated age or for

life, there shall be maintained active life reserves

and reserves for losses in amounts not less than

such minimum standards which the superin-

tendent of insurance shall determine and pre-

scribe after giving proper consideration to the

terms and conditions of the policies involved;

(3) On all such policies other than those writ-

ten on a noncancellable plan there shall be main-

tained reserves for losses in amounts not less

than the minimum standards which the super-

intendent of insurance shall determine and pre-

scribe after giving proper consideration to the

terms and conditions of the policies involved;

(4) In the calculation of reserves required to

be maintained under this section, proper credit

shall be allowed for reinsurance in other com-

panies licensed to do business in this state;

(5) In addition to the minimum reserves men-

tioned above the superintendent of insurance

may also require such companies to maintain

reserves for extraordinary losses in amounts not

less than such minimum standards which the

superintendent of insurance shall determine and

prescribe after giving proper consideration to

the terms and conditions of the policies involved;

(6) This section shall not be applicable to

total and permanent disability benefits, or to

accidental death benefits, contained in or sup-

plementary to life insurance policies or other

contracts and for which benefits the standard of

valuation is prescribed by section 376.380.

65a

31. In its federal income tax returns for the years

in issue, plaintiff treated the reinsurance treaties

(Treaties I and II) as it had in its annual state-

ments. It reported the reserves on the life insurance

policies on which it was reinsurer under Treaty I

and on the life policies which it wrote directly dur-

ing the subsequent period when Treaty II was in

force but it did not report any unearned premium

reserves on the accident and health policies covered

by either treaty. By not taking those reserves into

account, plaintiff’s life insurance reserves were shown

on its returns as totaling more than 50 percent of

its total reserves. It therefore claimed qualification

as a life insurance company under Section 801 of

the Internal Revenue Code of 1954.

32. Following an audit the Internal Revenue Serv-

ice issued notices of deficiency for the years in issue

disallowing plaintiff’s taxable status as a life in-

surance company. It did so on the premise that

the unearned premiums on the accident and health

insurance covered by Treaties I and II should have

been included in taxpayer’s total reserves. Had they

been so included, plaintiff’s life insurance reserves

would have constituted less than 50 percent of its

total reserves and it would not therefore have quali-

fied as a life insurance company. Deficiencies were

duly assessed accordingly. Following payment and

the rejection of refund claims filed by plaintiff, this

suit was seasonably brought.

66a

CONCLUSION OF LAW

Upon the foregoing findings of fact, which are

adopted by the court and made a part of the judg-

ment herein, the court concludes as a matter of law

that the plaintiff is not entitled to recover and its

petition is dismissed.

67a

APPENDIX B

IN THE UNITED STATES COURT OF CLAIMS

No. 463-70

(Decided October 22, 1975)

CONSUMER LIFE INSURANCE COMPANY

THE UNITED STATES

E. Michael Masinter, attorney of record, for plain-

tiff. James H. Landon and Hansell, Post, Brandon

& Dorsey, of counsel.

Herbert Grossman, with whom was Assistant At-

torney General Scott P. Crampton, for defendant.

Theodore D. Peyser, of counsel.

Before COWEN, Chief Judge, LARAMORE, Senior

Judge, SKELTON, NICHOLS, KASHIWA, KUNZIG, and

BENNET, Judges.

OPINION

KASHIWA, Judge, delivered the opinion of the

court:

68a

This is a single issue tax refund suit that arises

out of a small loan company’s entry into the insur-

ance business through a wholly owned subsidiary

that is formed especially for that purpose. The

question is whether that subsidiary, the plaintiff

in this proceeding, qualified for the tax treatment

accorded a “life insurance company” by §§ 801 et

seq. of the Internal Revenue Code of 1954. We hold

for the plaintiff.

This case is before this court on a review of a

recommended decision of Trial Judge George Willi.

The court disagrees with the conclusions. A similar

case, Penn Security Life Insurance Co. v. United

States (Ct. Cl. No. 109-68), is decided contemporan-

eously herewith. Issues decided therein and appli-

cable herein are disposed of by reference to said

decision; but as hereafter shown, plaintiff in this

case has raised new questions based on state regula-

tory statutes. This decision discusses these state

statutes which defendant claims are relevant.

The facts are fully detailed in the findings of fact

accompanying this opinion and will be repeated here-

in only to the extent necessary to an understanding

of the result reached.

In 1957 Southern Discount Company (Southern),

a Georgia corporation, was operating a well estab-

lished and successful consumer finance business. Its

customer-borrowers typically purchased term life and

accident and health (A & H) insurance at the time

that they obtained their loans. The premiuin charge

for the entire coverage involved was thereupon paid

69a

in full. The customers bought this protection, co-

extensive in both time and amount with the curtail-

ment requirements of their borrowings, to provide

a means of automatically servicing their debts to

Southern in case of death or disability prior to full

repayment. Georgia law prohibited Southern, as a

loan company, from acting as an insurance under-

writer with respect to such coverages. It was not

forbidden, however, from functioning as a sales agent

for insurance underwritten by a carrier duly quali-

fied to conduct an insurance business in Georgia.

American Bankers Life Insurance Company (Ameri-

can Bankers), a Florida corporation, was such a

carrier.

Until 1957 Southern acted as a commission sales

agent for American Bankers in respect to life and

A & H insurance issued by the latter to Southern’s

borrowers. Under this arrangement, Southern re-

ceived the maximum commission rate allowed by law;

amounting to approximately 50 percent of the policy-

holder premiums. Despite the attractiveness of that

return, for which it apparently had to do little more

than place American Bankers’ policies with its own

borrowers, Southern concluded that it could reap even

greater profits from this source if it could participate

as an underwriter rather than just a sales agent.

It was that determination that prompted Southern

to form the plaintiff as a wholly owned subsidiary.

Southern surveyed state law to locate the jurisdic-

tion that had the most modest capitalization require-

ments for a licensed insurer and found that it was

70a

Arizona. Plaintiff was organized July 1, 1957 as an

insurance company under an Arizona charter with

an initial balance of invested capital and paid-in

surplus of only $38,000. These resources were not

sufficient to permit it to qualify as a direct insurer

under Georgia law. It could, however, use its Ari-

zona charter authority to operate as a reinsurer of

Georgia and North Carolina coverages written by

American Bankers—a duly authorized insurer in

both of those states. American Bankers was willing

to enter into a reinsurance treaty arrangement with

plaintiff, under which it surrendered substantially

all underwriting profit in return for a relatively

minimal fixed fee, because it knew that if it re-

fused, Southern would have no difficulty in replac-

ing it with another qualified carrier. Thus, its al-

ternative was outright exclusion from the insurance

business generated by Southern’s borrowers. There-

upon, on June 28, 1957, American Bankers entered

into the first of two consecutive insurance treaties

(Treaty I and Treaty II, respectively) with the plain-

tiff.

Under Treaty I, all life and A & H policies issued

by American Bankers to debtors of plaintiff’s affi-

liates (including the parent, Southern) on and after

July 1, 1957 were to be fully reinsured with plain-

tiff which, as it freely concedes, thereby assumed

the entire insurance risk represented by each of the

policies involved; A & H as well as life. As com-

pensation for its reinsurance function, plaintiff was

to receive 8714 percent (later increased to 901%

T7la

percent) of all premiums collected by American

Bankers from the policyholders. The timing of these

payments by American Bankers to plaintiff differed,

however, as between life and A & H, although the

agreement required monthly remittances in each in-

stance. As already noted, American Bankers col-

lected all premiums in full at the inception of cover-

age. The Treaty stipulated that as to life policies,

American Bankers was, at the end of each month,

to pay plaintiff its entire share of all life premiums

collected from policyholders during that month. As

to A & H, h ever, American Bankers was to pay

plaintiff only “h. portion of its total share of pre-

mium receipts during that month that was ratably

allocable to that month’s coverage; the agreement

being to pay over the remainder monthly on a pro

rata basis spread over the balance of the coverage

period. Thus, in respect to A & H, plaintiff never

actually held any premium dollars attributable to a

future period of coverage and risk exposure.

Finally, Treaty I provided for termination by

either party upon thirty days written notice to the

other. Termination was to be wholly prospective,

the relevant clause specifying: “Upon termination

by either party, this agreement shall continue to

apply to all policies reinsured hereunder before such

termination becomes effective.”

As required by state law, plaintiff filed annual

reports of its activities under Treaty I with the in-

surance regulatory authorities in Arizona and Geor-

gia. On those reports it characterized its life and

72a

A & H dealings differently. It did so by reporting

both premium income and related reserves solely on

the basis of actual dollar receipts for the year in-

volved. This meant that for the life coverages it

declared as premium income its entire percentage

share of the premiums paid by policyholders during

that year. Consonantly, it reported the full tabular

reserve for all of such policies. As to A & H, how-

ever, it limited reported premium income to the

annual aggregate of the incremental payments that

had been received monthly from American Bankers.

Moreover, it showed nothing on the asset side of the

report representing the premiums on existing A &

H policies that it was entitled under the Treaty to

receive in the future. With premium income and

asset balances thus restricted, plaintiff reported no

reserves whatever in respect to the A & H coverages

that it reinsured under Treaty I. As to those cover-

ages, American Bankers included on its own annual

reports an unearned premium reserve based on the

amount of A & H premiums collected from policy

holders but not yet paid over to the plaintiff. Neither

the Georgia nor the Arizona regulatory authorities

ever challenged or disapproved the method by which

plaintiff reported its A & H reinsurance activities

under Treaty I.

By 1962 plaintiff had accumulated enough earn-

ings from operations under Treaty I to enable it to

qualify as a direct insurer under Georgia and North

Carolina law. It thereupon applied for and received

such authority from the State of Georgia. From then

73a

on plaintiff operated as the issuing company on all

life and A & H policies sold to the loan customers

of Southern and its affiliates. Treaty i, in which

plaintiff's role was solely that of a reinsurer, was

consequently no longer suited to its purposes. Accord-

ingly, effective March 1, 1962, plaintiff and Ameri-

can Bankers entered into a new insurance treaty

under which their roles were reversed; plaintiff func-

tioning as the issuing or ceding carrier and Ameri-

can Bankers denominated the “reinsurer’’.

Treaty II applied only to A & H insurance; plain-

tiff having determined to underwrite all future life

insurance by itself. The treaty provided that plain-

tiff, as the issuing or ceding company, would re-

insure 80 percent of all future A & H policies with

American Bankers. To that extent, plaintiff was to

pay over to American Bankers on a quarterly basis

all of the premiums collected from policyholders,

American Bankers to return 50 percent of such

amounts to the plaintiff as commissions. The Treaty

contained a clause, entitled Experience Refunds, es-

tablishing a quarterly rebate due plaintiff in the

amount of the total premium dollars ratably alloc-

able to the expired portion of the term of policies

for which such premiums had been collected, less

the following deductions: (a) the amount of com-

missions paid plaintiff that was proportionate to the

expired portion of the term of policies on which

such commissions had been paid; (b) 3 percent of

the earned premium dollars previously described;

and (c) the sum of all claim payments made to

T4a

plaintiff during the quarter by American Bankers

as reinsurer. For all practical purposes, this clause

served to fix American Bankers’ stake in the under-

taking at a flat 3 percent of the premium dollars

that it initially received from the plaintiff. Only if

loss experience under the reinsured coverages ex-

ceeded 47 percent of premiums would American

Bankers’ 3 percent return be encroached. Moreover,

such a pattern of adverse experience would have had

to persist for the ensuing twenty consecutive quarters

before such an encroachment became permanent. Loss

experience on A & H policies under Treaty I had

ranged from 28 to 30 percent. Finally, there were

no circumstances under which American Bankers’

return under Treaty II could exceed the 3 percent

allotted to it therein.

On its annual reports to the state regulatory au-

thorities covering 1962 and subsequent years, plain-

tiff declared no reserves relative to that portion of

the A & H policies covered by the reinsurance lan-

guage of Treaty II. Again, no state regulatory au-

thority took exception to this aspect of plaintiff’s

reports.

The insurance industry is regulated by the states.

A particular insurance company must meet the vari-

ous industry requirements of its home state, and must

satisfy the requirements of all states in which it is

qualified to act as an insurer. The state requirements

include standards for investments, maintenance of

reserves, and accounting practices. The state insur-

ance departments supervise policy forms, agency re-

75a

lationships, and the general financial activities of the

companies within their jurisdictions. This regulation

is designed to preserve the solvency of the insurance

companies for the protection of the policyholders. To

implement their regulatory function, state insurance

departments require companies to file annual reports.

Because reports are required in all states in which a

company is qualified to act as an insurer, a standard

report form has been developed by the National Asso-

ciation of Insurance Commissioners, which is used in

all fifty states. These reports disclose, among other

things, the reserves being maintained by each com-

pany.

In addition to requiring annual reports, the various

state insurance departments conduct regular triennial

examinations of insurance companies. Where the vol-

ume of business warrants it as to a particular com-

pany, it is customary for representatives of several

state insurance departments to work together on

these examinations. The examinations are carried

out at the offices of the company in question and may

take as long as several months for large companies.

Among the matters which are investigated in the

course of such an examination are the reinsurance

treaties to which a particular company is a party.

When a state insurance department is presented

with a reinsurance agreement in existence between

parties, its investigation will include a determination

that each party has established adequate reserves ac-

cording to its respective liabilities pursuant to the

terms of the reinsurance agreement.

76a

Plaintiff was the subject of triennial examinations

in 1959 and 1963 by the insurance department of

Arizona. American Bankers was the subject of trien-

nial examinations in 1960 and 1963. Participants in

the 1960 examination were from the insurance de-

partments of Florida, North Carolina, Georgia, and

Texas; and participants in the 1963 examination were

from the insurance departments of Florida, Georgia,

Arizona, and Arkansas. The reinsurance treaties

between plaintiff and American Bankers were exam-

ined in detail in the course of the aforesaid examina-

tions. The existence of reserves for accident and

health insurance held by American Bankers on the

policies covered by those treaties was clear to the

examiners. Also the maintenance of the reserves by

American Bankers under the treaties during Period I

and Period II was approved in the course of the four

examinations; no requirement or even suggestion was

made in the examination reports that the reserves

should be otherwise maintained.

For each of the years 1958 through 1964 plaintiff

computed its federal income tax liabilities and filed

its returns on the premise that it was taxable as a

“life insurance company” within the meaning of that

term as defined by Section 801 of the Internal Rev-

enue Code of 1954. On audit, the Revenue Service

determined that plaintiff did not qualify as a life

insurance company entitled to the preferential tax

treatment accorded such an entity and assessed defi-

ciencies accordingly (except for 1961 in which addi-

tional liability was fully expunged by other adjust-

77a

ments not in dispute). Plaintiff paid the assessments

and upon formal disallowance of its seasonably filed

claims for refund, brought this action in which the

sole question for decision is that concerning plaintiff’s

qualification as a life insurance company for federal

tax purposes in the years 1958, 1959, 1960, 1962,

1963, and 1964.

As pertinent here, Section 801 defines a life insur-

ance company as follows:

SEC. 801 [as amended by Sec. 2, Life Insurance

Company Income Tax Act of 1959, P.L. 86-69,

73 Stat. 112]. DEFINITION OF LIFE IN-

SURANCE COMPANY.

(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 com-

bined 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 noncancel-

lable life, health, or accident policies not in-

cluded in life insurance reserves,

comprise more than 50 percent of its total re-

serves (as defined in subsection (c) ).

* * od * *

subsection (a), the term “total reserves”

means—

78a

(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.

The term “total reserves” does not include defi-

ciency reserves (within the meaning of subsec-

tion (b) (4)).

e > e > s

Life insurance company status, it is seen, is made

to depend solely on the character and composition of

an insurance company’s reserves. An insurance com-

pany merits life insurance company tax treatment

if its life reserves amount to half or more of its

total insurance reserves, Section 801(c) expressly

directs that total reserves, the denominator portion of

the fractional test, shall include three separate cate-

gories: (1) life reserves; (2) reserves for unearned

premiums and for certain unpaid losses (the latter

element not being involved in this suit); and (3) all

other reserves required by law.*

Sections 1.801-3(e) and 1.801-5(b) of the Treas-

ury Regulations on Income Tax (1962), endorsed by

both parties to the present controversy, define un-

earned premiums and reserves required by law,

respectively, as follows:

The last-mentioned category has been traditionally and

centrally implicated in the federal taxation of insurance

companies. See Brown Vv. Helvering, 291 U.S. 193, 201

(1934), and cases cited therein.

79a

Unearned premiums. The term “unearned

premiums” means those amounts which shall

cover the cost of carrying the insurance risk for

the period for which the prem‘ums have been

paid in advance. Such term includes all unearned

premiums, whether or not required by law.

s > e e >

Reserves required by law defined. For pur-

poses of part I, subchapter L, chapter 1 of the

Code, the 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, Terri-

tory, or the District of Columbia when promul-

gated 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.

In this case there is no disagreement as to either

the fact or the particular amount of plaintiff’s life

insurance reserves for each of the years in suit. Its

qualification depends entirely on the question of its

chargeability with reserves incident to the A & H

policies to which it was a party under Treaties I and

II; there being no dispute that reserves must be main-

tained by someone in respect to those policies. If those

reserves are includable in plaintiff’s total reserves, it

concededly does not pass the 50 percent test of Sec-

tion 801. If, as plaintiff says, they are chargeable

to American Bankers rather than to itself, it does.

To dispel the notion that it was required to main-

tain A & H reserves of a type comprehended by Sec-

80a

tion 801, plaintiff relies on (1) the language of the

two insurance treaties under which it operated with

American Bankers; (2) the testimony of a well-

traveled actuarial expert, Arthur Crooks Eddy; (3)

the fact that the state insurance regulatory personnel

tacitly approved plaintiff’s annual report forms show-

ing no A & H reserves; and (4) Trial Judge Fletch-

er’s opinion in Penn Security Life Ins. Co. v. United

States (Ct. Cl. No. 109-68, decided March 2, 1973).

Plaintiff’s argument is simply that plaintiff was

chargeable with no A & H unearned premium re-

serves because under both of the Treaties it received

premium dollars only after the period of exposure

to which those dollars related had expired. Accord-

ingly, plaintiff says, since all the premiums that it

received were, in point of time, already “earned”

when it got them, there was no occasion for it to

maintain a reserve for “unearned” premiums. Testi-

fying as plaintiff’s expert, Mr. Eddy repeatedly

opined that this feature of the Treaties, governing

custody of prepaid premium dollars, was dispositive

of the participants’ respective reserve obligations,

i.e., that since it was American Bankers that phys-

ically held all of the A & H premium dollars allocable

to the unexpired portion of the terms of the under-

lying policies, it was American Bankers, not plaintiff,

that was obligated to carry the reserves for those

policies. In this regard, his testimony was the same

as it apparently had been in Penn Security, supra.

In the latter case, the relevant particulars of the fac-

Sla

tual situations involved were virtually identical to

those presented by Treaty I.

Defendant’s argument is that plaintiff’s total re-

serves in the reserve ratio must include the unearned

premium reserves on the accident and health policies

because those reserves must be attributed to the com-

pany ultimately liable for the insurance risks, Alter-

natively, if the unearned premium reserves must be

required by law to be recognized, they were so re-

quired here.

Issued contemporaneously with this opinion is the

per curiam decision in Penn Security Life Insurance

Co. v. United States (Ct. Cl. No. 109-68). That case

involves life insurance company qualification and the

provisions of § 801 dealing with health and accident

insurance. The situation is similar to this case with

that taxpayer reinsuring risks written by three un-

related insurance companies under credit life and

accident and health policies on the lives and health of

debtors of taxpayer’s parent which made consumer

loans through subsidiaries operating finance offices.

That opinion disposes of the issue under § 801(c)

(2), unearned premiums, with the court concluding

against attribution to plaintiff of the unearned pre-

mium reserves held by the ceding companies. We,

therefore, consider the question settled. However, this

leaves for determination here the § 801(c)(3) issue,

insurance reserves required by law.

The defendant’s major argument in this case is

that the reserves were required by law because Ari-

zona Revised Statutes Annotated § 20-501(5) and

82a

(9)* apply in that the premiums were assets of the

?§ 20-501. “Assets” defined

“In any determination of the financial condition of an in-

surer, there shall be allowed as assets only such assets as

are owned by the insurer and which consist of:

“1. Cash in the possession of the insurer, or in transit

under its control, and including the true balance of any de-

posit in a solvent bank or trust company

* ~ -_ *

“5. Premiums in the course of collection, other than for

life insurance, not more than three months past due, less

commissions payable thereon. The foregoing limitation shall

not apply to premiums payable directly or indirectly by the

United States or by any of its instrumentalities.

“6. Installment premiums other than \ife insurance pre-

miums, in accordance with regulations prescribed by the di-

rector consistent with practice formulated or adopted by the

national association of insurance commissioners.

“7. Notes and like written obligations not past due, taken

for premiums other than life insurance premiums, on poli-

cies permitted to be issued on such basis, to the extent of

the unearned premium reserves carried thereon.

“8. The full amount of reinsurance recoverable by a ced-

ing insurer from a solvent reinsurer and which reinsurance

is authorized under § 20-261.

“9. Amounts receivable by an assuming insurer repre-

senting funds withheld by a solvent ceding insurer under a

reinsurance treaty.

“10. Deposits or equities recoverable from underwriting

associations, syndicates and reinsurance funds, or from

any suspended banking institution, to the extent deemed by

the director available for the payment of losses and claims

and at values to be determined by him.

“11. All assets, whether or not consistent with the provi-

sions of this section, as may be allcwed pursuant to the

annual! statement form approved by the national association

of insurance commissioners for the kinds of insurance to be

reported upon therein.

“12. Other assets, not inconsistent with the provisions of

this section, deemed by the director to be available for the

83a

plaintiff because they were “the course of collection”

and they were “withheld by a solvent ceding insurer

under a reinsurance treaty.” We interpret these sec-

tions to mean that they refer to amour.s already

due and unpaid. The definition of assets under § 20-

501 refers to items in the possession of the taxpayer

or to which the taxpayer has an enforceable claim.

Without including the unearned premium in tax-

payer’s assets, there can be no unearned premium

reserve charged against that item. The Arizona

provisions do not apply to plaintiff’s circumstances.

Turning to the liability side of the statute, de-

fendant argues that § 20-505° requires that plain-

tiff establish reserves on the accident and health

payment of losses and claims, at values to be determined by

him.”

*§ 20-505. Liabilities

“In any determination of the financial condition of an in-

surer, capital stock and liabilities to be charged against its

assets shall include:

e * bal a

“3. With reference to life and disability insurance and

annuity contracts:

* ” x *

“(b) Reserves for disability benefits, for both active and

disabled lives,

o * + ik

“(d) Any additional reserves which may be required by

the director consistent with practice formulated or approved

by the national association of insurance commissioners, on

account of such insurance.

“4. With reference to insurance other than specified in

paragraph 3 of this section, and other than title insurance,

the amount of reserves equal to the unearned portions of the

gross premiums charged on policies in force, computed in ac-

cordance with this article.”

s * s *

84a

policies. It would appear from reading this statute

that liabilities of an insurer “charged against its

assets” implies that there were corresponding assets

in the first place. Since there were not, this statute

is inapplicable. Section 20-506A,‘ referring to dis-

ability insurance, provides that “every insurer shall

maintain an unearned premium reserve on all poli-

cies in force.” If there are two or more insurers

on the same policy, they are not all meant to keep

a reserve. This is how the state administrative

practice operates. As long as someone has the re-

serve, this is sufficient.

Under Treaty II plaintiff resinsured with Amer-

ican Bankers. This was authorized under Code

of Georgia Annotated § 56-413.° Section 56-906

*§ 20-506. Unearned premium reserve

“A. With reference to insurance against loss or damage to

property, except as provided in § 20-507, and with reference

to all general casualty insurance, disability insurance, ex-

cept as provided in §§ 20-508 and 20-510, and surety in-

surance, every insurer shall maintain an unearned premium

reserve on all policies in force.”

°§ 56-413. Authorized reinsurance.—“(1) An _ insurer

shall reinsure its risks, or any part thereof, only in solvent

insurers having surplus to policy holders or trusteed funds

on deposit in the United States for the benefit of their policy-

holders not less in amount than the paid-in capital required

under this Title of a domestic stock insurer authorized to

transact like kinds of insurance.

“(2) An insurer shall so reinsure in such alien insurers

only as either (a) are authorized to transact insurance in

at least one state of the United States, or (b) have in the

United States a duly authorized attorney-in-fact to accept

service of legal process against the insurer as to any liability

which might arise on account of such reinsurance, or (c)

85a

(2)* provides for a deduction of reinsurance from

may be approved by the Commissioner. In the event rein-

surance is placed which is not in compliance with the fore-

going provisions, the ceding insurer shall not be allowed

credit for such reinsurance either as an asset or deduction

from liability, nor may it increase any amounts it is author-

ized to have at risk because of such reinsurance.

“(3) No credit shall be allowed, as an asset or as a deduc-

tion from liability, to any ceding insurer for reinsurance nor

increase the amount it is authorized to have at risk unless

the reinsurance is in insurers either authorized to do busi-

ness in this State, or which have been approved by written

order of the Department filed in its office and which order

has not been subsequently disapproved; Provided, however,

that such credit shall be allowed for reinsurance ceded to

unauthorized alien assuming insurers, if such insurers have

maintained in the United States for not less than 10 years

immediately preceding such reinsurance a trust fund of not

less than $50,000,000 available for the purpose of protecting

policyholders in the United States. Nor shall such credit be

allowed unless the reinsurance is payable by the assuming

insurer on the basis of the liability of the ceding insurer

under the contracts reinsured without diminution because of

the insolvency of the ceding insurer.

* . * *

“(5) Notwithstanding the provisions of this Code, full

credit shall be allowed a ceding insurer, as an asset or as a

deduction from liability, for all reinsurance which may be in

effect or which may be hereafter effected under any contract

or reinsurance in effect on the 3lst day of December 1959,

and any continuations or renewals of such contract of re-

insurance. Provided, however, that no new insurance risk

shall be ceded after two years from the effective date of this

Title unless such reinsurance contract meets all the stand-

ards set forth in this Title.”

* § 56-906

“(2) The Commissioner may require that such reserves shall

be equal to the unearned portions of the gross premiums in

force after deducting reinsurance in solvent insurers as com-

86a

gross premiums before computing the unearned pre-

mium reserve. Arizona Revised Statutes Annotated

§ 20-261° and § 20-506B* are similar. Defendant

puted on each respective risk from the policy’s date of is-

sue. If the Commissioner does not so require, the portions

of the gross premium in force, less reinsurance in solvent

insurers to be held as a premium reserve, shall be computed

according to the following table:”

* * * *

*§ 20-261. Authorized reinsurance

“A. An insurer shall reinsure its risks, or any part there-

of, only in solvent insurers having surplus to policyholders

not less in amount than the paid-in capital required under

this title of a domestic stock insurer, other than a limited

stock insurer, authorized to transact like kinds of insurance.

A domestic limited stock life insurer may accept reinsurance

of the risks of other such limited stock insurers and of do-

mestic benefit insurers.

“B. An insurer shall so reinsure in such alien insurers

only as either are authorized to transact insurance in at

least one state of the United States, or have in the United

States a duly authorized attorney-in-fact to accept service

of legal process against the insurer as to any liability which

might arise on account of such reinsurance.

“C. No credit shall be allowed, as an asset or as a deduc-

tion from liability, to any ceding insurer for reinsurance

unless the reinsurance is payable by the assuming insurer on

the basis of the liability of the ceding insurer under the con-

tracts reinsured without diminution because of the insol-

vency of the ceding insurer nor unless under the reinsurance

contract the liability for such reinsurance is assumed by the

assuming insurer or insurers as of the same effective date.”

* * . .

® § 20-506

“B. The director may require that such reserves be equal

to the unearned portions of the gross premiums in force

after deducting reinsurance in solvent insurers as computed

87a

argues that Treaty II is a Surplus Aid contract in

that since plaintiff did not reinsure its risks despite

the formalities, the treaty did not qualify as author-

ized reinsurance and plaintiff could not take credit

for the reserves. In answer to this, it can only be

said that plaintiff did reinsure its risk, American

Bankers was responsible for the risk and even though

it only kept 3 percent of the premiums, in the event

that losses had eaten into the 3 percent, this would

have been American Bankers’ loss, not plaintiffs.

Defendant then argues that even if Treaty II is

operative, plaintiff would have to re-establish the

reserve as an offsetting liability to the asset required

under paragraph 8 of § 20-501 of the Arizona law.

That section is directed primarily toward loss re-

imbursements for losses paid directly by the ceding

company. Therefore, there is no asset belonging to

plaintif

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