Petition — United States v. Penn Security Life Insurance Co. (No. 75-1285)

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mica | MAR 9 i976

UNITED STATES OF AMERICA, [PHOHAONDRAK, J2. clRRy

v.

Penn Securiry Lire INSURANCE COMPANY

_ PETITION FOR A WRIT OF CERTIORARI TO THE

. UNITED STATES COURT OF CLAIMS

ROBERT H. Bork,

Solicitor General,

Scotr P. CRAMPTON,

Assistant Attorney General,

STUART A. SMITH,

Assistant to the Solicitor General,

ERNEST J. BROWN,

Gary R. ALLEN,

Attorneys, .

Department of Justice,

Washington, D. C. 20530.

—_—_———————————————

Page

ESE RANE ae ee ee 1

II slits insteichisnthpnndinsverdyebtedsbikienatididsAabibeenies 1

Question presented _ NEE SMe es A 2

Statutes and inniiiien ela Le ae 2

RAR SET LT NT Eee eee 5

Reasons for granting the writ 000 10

ge EM il Sealed I de all 13

II seisthctencccmhcialaamanicboenes Mh J RS aaibe la

CITATIONS

Cases:

Consumer Life Insurance Co. v. United

States, 524 F.2d 1167, petition for a

writ of certiorari pending, No. 75- +

ae 11, 12, 13

Economy Finance Corp. v. United States,

501 F.2d 466, certiorari denied, 420

I i lprccipectariinglaniiciaakseuatiescan aia 10, 12, 13

First Railroad & Banking Co. of Ga. v.

United States, 514 F.2d 675 «11, 18

Superior Life Insurance Co. v. United

2, Grae ee 11

Statutes, regulations and rule:

Internal Revenue Code of 1954 (26

J.8.C.):

a Ni 2-3

Statutes, regulations and rule—Continued Page

Section 801(a) —....... soicstadiiniotl 2, 3, 8, 10, 11

| RRR SER 3-4

ase

Section 801(c) (2) 4,9, 10,11, 12

Section 801(¢c)(3) caine 4,10, 12

SI ad hleit lie nshatainasinasenmiinintneign 8

Vernon’s Ann. Mo. Stat. § 376.410

CEE wivecnpuneinsbadsiateiiiainiiaadmeniduaal: 12

Treasury Regulations on Income Tax (26

C.F.R.):

Section 1.801-3(¢)—.......... ................ 4

| | eee 5, 12

Court of Claims Rule 131(¢c) —W.. 2

Iu the Supreme Court of the United States

OCTOBER TERM, 1975

No.

UNITED STATES OF AMERICA, PETITIONER

Vv.

PENN SECURITY LIFE INSURANCE COMPANY

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF CLAIMS

The Solicitor General, on behalf of the United

States of America, petitions for a writ of certiorari

to review the judgment of the United States Court

of Claims in this case.

OPINION BELOW

The opinion of the Court of Claims (App., infra,

pp. la-60a), incorporating the opinion of the trial

judge with minor changes and some additions, is re-

ported at 524 F.2d 1155.

JURISDICTION

The judgment of the Court of Claims was entered

(1)

on October 22, 1975 (App., infra, pp. la, 60a).’

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 insur-

ance company whose life insurance reserves comprise

more than 50 percent of its “total reserves,” as that

term is defined by Section 801(c).

The question presented is whether an insurance

company which assumed the ultimate insurance risk

on accident and health insurance ceded to it by an-

other company under a reinsurance agreement is re-

quired for federal tax purposes to include in its total

reserves the reserves attributable to such non-life in-

surance so as to render it ineligible for preferential

tax treatment accorded to a “life insurance company,”

or whether, as the Court of Claims held, such reserves

are attributable to the ceding company which tem-

porarily holds the premiums paid in advance on such

policies.

STATUTES AND REGULATIONS INVOLVED

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

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

' The precise amount of the judgment will be determined in

further proceedings under Rule 131(c) of the Court of Claims.

ance Company Income Tax Act of 1959, 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 estimat-

ed on the basis of recognized mortality

or morbidity tables and assumed rates

of interest, and

(B) which are set aside to mature

or liquidate, either by payment or re-

insurance, future unaccrued claims

arising from life insurance, annuity,

and noncancellable health and accident

insurance contracts (including life in-

4

surance 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.

(c) Total Reserves Defined—For purposes

of subsection (a), the term “total reserves”

means—

(1) life insurance reserves,

(2) unearned premiums, and unpaid

losses (whether or not ascertained), not 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)).

Treasury Regulations on Income Tax (1954 Code)

(26 C.F.R.):

§ 1.801-3 Definitions.

(e) Unearned premiums. The term “unearn-

ed 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 prerniums, whether or not required by

law.

e . e o o

5

§1.801-5 Total reserves.

> > . 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 regula-

tions 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 was incorporated under the laws of

Missouri as a wholly-owned subsidiary of Aetna Fi-

nance Company, the assets of which are now owned

by a wholly-owned subsidiary of International Tele-

phone & Telegraph Corporation known as ITT Aetna

Corporation (App., infra, p. 30a). Aetna made con-

sumer loans through subsidiaries operating more

than 200 finance company offices in approximately

25 states (App., infra, p. 3a). In connection with

its loan transactions, it was common for Aetna’s

borrowers to apply for and receive credit life insur-

ance policies (or group insurance certificates), in-

cluding health and accident benefits, from one of

three insurance companies: Old Republic Life In-

surance Company, Pilot Life insurance Company,

6

and National Fidelity Life Insurance Company

(App., infra, pp. 3a-4a).

Under the life insurance provisions of these pol-

icies, the insurer was required to pay Aetna any

outstanding balance of the loan in the event of the

insured debtor’s death. The accident and health

(A&H) provisions of the policy required the insurer

to pay loan installments falling due while the insured

was totally disabled and unable to work. The terms

of the policies were coextensive with the term of the

related loan (App., infra, p. 4a).

A&H insurance was sold to Aetna’s borrowers only

together with life insurance. However, the amounts

of the A&H insurance premiums were separately

stated. The premiums were required to be paid in

full by the insured debtor at the inception of the

policy term (App., infra, pp. 33a, 39a-40a).

Respondent was organized by Aetna for the pur-

pose of reinsuring the policies issued to Aetna’s

loan customers by Old Republic, Pilot, and National

Fidelity. During 1963-1965, the taxable years at

issue, respondent’s business primarily consisted of

such reinsurance. Respondent conducted its reinsur-

ance business pursuant to reinsurance agreements

(“treaties”) with Old Republic, Pilot, and National

Fidelity during each of the years in issue (App.,

infra, pp. 3a, 4a, 40a).

Under its reinsurance treaties with these com-

panies, respondent assumed the entire insurance risk

by agreeing to reinsure 100 percent of the liability

of each company with respect to life insurance and

A&H insurance issued to Aetna and its borrowers.

7

In exchange for assuming the insurance risk, re-

spondent received the premiums less a 2 percent com-

mission to the issuing companies.’ The treaties pro-

vided for the payments of reinsurance premiums

with respect to life insurance coverage as they were

received by the issuing companies. However, the AGH

insurance premiums were paid to respondent on a

monthly basis and such payments represented that

portion of the premiums allocable to the prior month’s

coverage (App., infra, pp. 4a-5a, 40).

Respondent was generally entitled to receive 98

percent of the premiums earned with respect to credit

A&H insurance in force during the previous month.

Thus, for example, if the issuing company received a

$360 A&H premium on January 1, 1963, with respect

to a 36-month policy, 1/36 of this premium ($10)

would be allocable to coverage for the month of Janu-

ary and $9.80 would be paid over to respondent dur-

ing the month of February (App., infra, pp. 5a,

40a-41a). Under the reinsurance treaties, respondent

was liable to the issuing companies for the benefits

covered by reinsurance to the same extent as the

issuing companies were liable to the persons insured

for such benefits. As a result, whenever a claim was

made under a policy that the issuing company rein-

sured with respondent, respondent was required to

consider it to be a claim for the full amount of rein-

surance on the policy (App., infra, pp. 42a-43a).

For each of the years 1963, 1964, and 1965, re-

spondent filed an annual statement with the Mis-

?Old Republic retained an 11 percent commission (App.,

infra, p. 40a).

souri Division of Insurance. These annual statements

did not reflect any unearned premium reserves with

respect to policies issued by Old Republic, Pilot, and

National Fidelity, or with respect to respondent’s re-

insurance treaties with those companies (App.,

infra, pp. 46a-47a). After audits of respondent by

the Missouri Division of Insurance in 1965 and 1969,

respondent was not required to establish unearned

premium reserves with respect to A&H premiums

received by Old Republic, Pilot, and National Fidel-

ity, or with respect to reinsurance premiums received

by respondent under its A&H reinsurance treaties

with those companies (App., infra, pp. 47a-48a).

For each of its taxable years 1963, 1964, and

1965, respondent computed its taxable income on its

federal income tax returns as a life insurance com-

pany under Section 802 of the Code. On audit, the

Commissioner of Internal Revenue determined in-

come tax deficiencies, asserting that respondent was

not entitled to deduct certain losses in connection

with the computation of its reserves (App., infra,

pp. 8a, 57a). After respondent filed a petition in

the Court of Claims seeking a refund of the de-

ficiencies it paid, the Commissioner determined ad-

ditional deficiencies for 1963, 1964, and 1965, based

upon his conclusion that during those years respond-

ent did not qualify for the preferential tax treat-

ment accorded to a life insurance company. The

ground of the Commissioner’s determination was that

respondent’s life insurance reserves did not comprise

more than 50 percent of its total reserves as required

by Section 801(a) of the Code. The Commissioner’s

determination was based upon his inclusion of the

A&H reserves in respondent’s total reserves (App.,

infra, pp. 8a, 57a-58a).

Respondent thereupon paid the additional deficien-

cies and sought its refund in the suit it had already

commenced in the Court of Claims (App., infra, pp.

8a-9a).° With one judge dissenting, the Court of

Claims adopted its trial judge’s recommended decision

that the A&H insurance reserves could not be in-

cluded in respondent’s total reserves as “unearned

premiums” under Section 801(c)(2) of the Code be-

cause the various issuing companies were in physical

possession of the unearned portion of the premiums

paid in advance on the A&H policies under the rein-

surance treaties (App., infra, pp. 13a-2la). The

court concluded that respondent did not have to in-

clude the A&H insurance reserves as part of its total

reserves because each monthly payment of A&H

premiums made to respondent by the issuing com-

panies represented premiums allocable to coverage

for the prior month so they were not “unearned pre-

miums” within the meaning of Section 801(c) (2)

of the Code. In so holding, the court rejected the con-

trary conclusion on identical facts of the Seventh

* The provisions of the Old Republic treaty differed from

those of the Pilot and National Fidelity treaties as to the

effect of termination upon insurance in force. In order to

dispense with the need to consider the legal effect, if any,

of such differences and because the A&H reserves with respect

to the Old Republic treaty made no difference to the outcome

of this case, the government agreed in the court below that

they could be disregarded in computing respondent’s total

reserves (App., infra, p. 38a).

10

Circuit in Economy Finance Corp. v. United States,

501 F.2d 466, certiorari denied, 420 U.S. 947 (App.,

infra, pp. 18a-19a).

The court also ruled that respondent was not re-

quired by Missouri law to establish reserves for the

disability insurance, so that they were not “other

insurance reserves required by law” within the mean-

ing of Section 801(c)(3) of the Code. Accordingly,

the court held that respondent qualified °s a “life

insurance company” under Section 801(a) of the

Code (App., infra, pp. 21la-22a).

The dissenting judge argued that the Seventh Cir-

cuit in Economy Finance Corp. v. United States,

supra, construed Section 80l{a) “in a sound and

persuasive fashion” (App., infra, p. 28a). In this

view, the AGH insurance reserves should be included

in respondent’s reserves as “unearned premiums” un-

der Section 801(c) (2) of the Code because “it has ar-

ranged to have [such reserves] ostensibly carried

for it by others, though in reality, it bears the risk

of loss itself’ (App., infra, p. 29a). In so con-

cluding, the dissenting judge agreed with the con-

clusion of the Seventh Circuit in Economy Finance

that non-inclusion of such reserves “completely frus-

trates the purpose Congress ha[d] in mind in pre-

scribing the [50 percent] test [of Section 801(a)]”

(App., infra, p. 29a).

REASONS FOR GRANTING THE WRIT

As the Court of Claims recognized here (App.,

infra, pp. 15a-19a), and in its companion decision

11

in Consumer Life Insurance Co. v, United States,

524 F.2d 1167, 1174, petition for a writ of certiorari

pending, No. 75-1221, its holding directly conflicts

with Economy Finance Corp. v. United States, 501

F.2d 466 (C.A. 7), certiorari denied, 420 U.S. 947,

which was followed in First Railroad & Banking 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 decision below holding

that an insurance company is not required to include

in its total reserves those reserves attributable to

non-life insurance on which it bears the ultimate

insurance risk so that it may qualify for the pref-

erential tax treatment accorded to a “life insurance

company” as defined in Section 801(a) of the In-

ternal Revenue Code of 1954, is therefore in conflict

with those of two courts of appeals. The issue has

substantial impact upon the revenue and has been

and continues to be widely litigated. Resolution of

the conflict by this Court is therefore essential in

order that there be a uniform national rule.

For the reasons we have set forth at pp. 14-

21 in our petition for a writ of certiorari in Con-

sumer Life Insurance Co. v. United States, supra,*

we submit that the economic substance of respond-

ent’s reinsurance arrangement, which is typical of

those used in the industry, decisively establishes that

the A&H reserves are includable in respondent’s total

reserves as “unearned premiums” under Section 801

‘We are serving a copy of our petition in Consumer Life

Insurance Co. upon counsel for the respondent.

12

(c)(2). As the Seventh Circuit stated in its con-

trary decision in Economy Finance Corp. v. United

States, supra, in characterizing the role of a com-

pany analogous to that of Old Republic, Pilot, and

National Fidelity in an arrangement virtually identi-

cal to respondent’s reinsurance treaty: “[it] per-

formed a banking and clearing-house function and

not an insurance function” (501 F.2d at 478). Simi-

larly, the three ceding companies in this case were

exposed to no insurance risk and therefore 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 Court of Claims’ conclusion (App., infra, pp. 2la-

22a) that respondent was not required under Missouri law

to establish a reserve for the A&H insurance does not detract

from our argument that the economic reality of the reinsur-

ance arrangement is controlling for federal tax purposes

under Section 801(c) (2). See p. 21, n. 7, of our petition for

a writ of certiorari in Consumer Life Insurance Co., No.

75-1221.

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

concluding that Missouri law did not require respondent to

establish a reserve for the A&H insurance. In so concluding,

the Court of Claims did not undertake an independent analy-

sis of the state statute but premised its conclusion upon the

fact that the Missouri insurance administrators did not re-

quire respondent to establish reserves with respect to the

A&H insurance (App., infra, pp. 22a, n. 4, 48a-49a). But

under the Missouri statute, Vernon’s Ann. Mo. Stat. § 376.410

(1968), the ceding companies were exempt from carrying re-

serves on the A&H insurance, so that respondent should have

established such reserves. Thus, the A&H reserves would be

includable in respondent’s total reserves on the independent

alternative ground that they were “other insurance reserves

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

also Treasury Regulations (26 C.F.R.), Section 1.801-5(b).

18

CONCLUSION

For the reasons stated above and in our petition

in Consumer Life Insurance Co., the petition for a

writ of certiorari should be granted.*

Respectfully submitted.

ROBERT H. BORK,

Solicitor General.

Scott P. CRAMPTON,

Assistant Attorney General.

Stuart A. SMITH,

Assistant to the Solicitor General.

ERNEST J. BROWN,

GarY R. ALLEN,

Attorneys.

MARCH 1976.

‘The Court may deem it appropriate to hold this case

pending its disposition of Consumer Life Insurance Co. The

two reinsurance arrangements of that case are respectively

identical to those considered by the conflicting decisions of

the Seventh and Fifth Circuits in Economy Finance Corp.

and First Railroad & Banking Co. of Ga. However, the re-

insurance treaty in this case corresponds to the arrangement

considered in Economy Finance Corp.

la

APPENDIX

IN THE UNITED STATES COURT OF CLAIMS

No. 109-68

(Decided October 22, 1975)

PENN SECURITY LIFE INSURANCE COMPANY

Vv.

THE UNITED STATES

John B. Jones, Jr., for plaintiff; Owen T. Arms-

trong, attorney of record. Lowenhaupt, Chasnoff,

Freeman, Holland d: Mellitz, Robert A. Kagan, John

T. Sapienza, Andrew W. Singer, and Covington &

Burling, of counsel.

Herbert Grossman, with whom was Assistant At-

torney General Scott P. Crampton, for defendant.

Gilbert E. Andrews and Roger A. Schwartz, of

counsel.

Before COWEN, Chief Judge, Davis, NICHOLS,

SKELTON, KASHIWA, KUNZIG, and BENNETT, Judges.

PER CURIAM:* Section 801(a) of the Internal

*This opinion incorporates the opinion of Trial Judge

Lloyd Fletcher, with minor changes and some additions.

2a

Revenue Code, as amended, defines a life insurance

company in the following language:

(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 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,

comprise more than 50 percent of its total re-

serves (as defined in subsection (c) ).'

In Alinco Life Insurance Company v. United

States, 178 Ct. Cl. 818, 373 F. 2d 386 (1967), the

court addressed its attention to the question of

whether an insurance company specializing in the

reinsuring of credit life insurance could qualify as

' Section 801 goes on to provide:

+ * * * *

“(c) Total Reserves Defined. —F¥or purposes of subsection

(a), the term ‘total reserves’ means—

(1) life insurance reserves.

(2) unearned premiums, and unpaid losses (whether or not

ascertained), not included in life insurance reserves, and

(3) all other insurance reserves required by law.

“The term ‘total reserves’ does not include deficiency re-

serves (within the meaning of subsection (b) (4) ).”

3a

a life insurance company under Section 801, and

held that it could, provided it met the 50 percent

test. As might have been easily predicted, the ques-

tion of life insurance company qualification is now

back before the court with emphasis, however, on

those provisions of Section 801 dealing, not with life

insurance, but with health and accident insurance.

In applying Section 801 to this case, we appreciate

that the statute was not “written for ordinary folk

** *” Tt is addressed to technical specialists (1.e.,

actuaries) and hence, its provisions “must be read

by judges with the minds of the specialists.” Frank-

furter, Some Reflections on the Reading of Statutes,

47 Cou. L. Rev. 527, 536 (1947).

On balance, we have concluded that plaintiff-tax-

payer has the better of the argument and qualifies

as a life insurance company so that it is entitled

to recover. To explain why requires, first of all, a

description of the taxpayer’s method of conducting

its insurance business during the years in issue,

namely, the calendar years 1963, 1964, and 1965.

In those years, plaintiff’s business consisted pri-

marily of reinsuring risks written by three unrelated

insurance companies under credit life, accident and

health policies on the lives and health of debtors of

plaintiff’s parent, Aetna Finance Company (Aetna).

Aetna was engaged in the business of making con-

sumer loans through subsidiaries operating over 200

finance company offices in approximately 25 states.

In connection with such loan transactions, it was

commonplace for Aetna’s borrowers to apply for

4a

and receive credit life insurance policies (or group

insurance certificates), including health and accident

benefits, from one of three insurance companies,

namely, Old Republic Life Insurance Company (Old

Republic), Pilot Life Insurance Company (Pilot),

and National Fidelity Life Insurance Company (Na-

tional Fidelity). Hereafter, these companies are fre-

quently referred to as “the ceding companies,” and

plaintiff had separate disability reinsurance treaties

in force with each of them during the years in-

volved.

Under the life insurance provisions of these policies,

the insurer was required to pay the creditor any

outstanding balance of the debt in the event of the in-

sured debtor’s death. The health and accident provi-

sions called for the insurer to pay debt installments

falling due while the insured was totally disabled and

unable to work. The terms of the policies (or group

certificates) were coextensive with the contractual

term of the related indebtness, usually two to three

years.

Under its reinsurance treaties with the ceding com-

panies, plaintiff agreed to reinsure 100 percent of

the liability of each ceding company with respect to

disability benefits included in credit life policies is-

sued to Aetna and its borrowers. These treaties pro-

vided for payment of reinsurance premiums to plain-

tiff on a monthly earned premium basis; i.¢., a re-

insurance premium was payable each month with

respect to reinsurance coverage provided during the

previous month based on a percentage of premiums

“earned” on covered policies during that month.

5a

All of the credit insurance policies issued by the

ceding companies called for payment of insurance

premiums (both a life insurance premium and, where

applicable, a disability premium) at the inception of

the policy term. When a disability premium is first

received under such a policy, it is wholly “unearned”

in the sense that the entire premium is attributable

to the unexpired portion of the policy. As the term

of the policy expires each month, a proportionate

part of the premium becomes “‘earned”’; i.e., attribut-

able to insurance protection provided during that

month.

Thus, to use plaintiff’s illustration, if a ceding

company received a $360 disability premium on Jan-

uary 1, 1963, with respect to a policy providing

insurance coverage for 36 months, one-thirty-sixth

of this premium (or $10) would be considered

“earned” during the month of January and each

succeeding month. The “unearned” premium would

be $350 at the end of January, $340 at the end of

February, and so on. Under its disability reinsurance

treaties, plaintiff was entitled to a monthly rein-

surance premium equal to a percentage of the $10

“earned” premium for reinsurance coverage actually

provided each month. The ceding companies retained

all unearned premiums on volicies covered under the

disability reinsurance treaties and established an un-

earned premium reserve in the amount of such un-

earned premiums for the benefit of their policyholders

in accordance with the applicable restrictions of

state law and in satisfaction of the reserve require-

6a

ments of the various states in which they did busi-

ness.

Since plaintiff received no unearned premiums from

the ceding companies, it was not required to estab-

lish an unearned premium reserve by the State of

Missouri. No actuary or state regulatory authority

required plaintiff to establish an unearned premium

reserve under its disability reinsurance treaties with

the ceding companies, since plaintiff never received

premiums thereunder for insurance to be provided

in the future or premiums which it might otherwise

be required to refund.

Approximately two-thirds of the unearned pre-

mium reserves held by the ceding companies rep-

resented unearned “loading” charges made to cover

profits and sales and office expenses. The remaining

one-third of such unearned premium reserves rep-

resented unearned net premiums charged to policy-

holders to cover the expected cost of providing dis-

ability insurance benefits; this portion alone (known

in the industry as the morbidity element) reflected

the amount that the companies were actuarially re-

quired to hold in order to pay disability claims as

they matured. Unearned loading charges are held

as part of unearned premium reserves because the

casualty insurance industry has traditionally deter-

mined its reserve requirements with regard to the

full amount of premiums that would have to be re-

funded if all policies in force were simultaneously

canceled instead of reserving only for the cost of

carrying the insurance risk (the unearned net pre-

miums) as in life insurance.

Ta

As insureds grow older, the mortality or morbidity

costs increase and when an accident and health policy

is written for a long term of years, the guaranteed

level premium charged will not be sufficient to pro-

vide benefits after the insured reaches a specified

age. In those instances, a reserve, in addition to

the pro rata gross unearned premium reserve, is set

up out of current premiums to provide for the excess

of future benefits over future premiums. No such

reserves were created by the three insurers with re-

gard to the credit accident and health policies re-

insured with taxpayer, presumably because such poli-

cies were relatively short-term.

In addition to its reinsurance treaties with the

ceding companies during the years in issue, plain-

tiff also issued its own group annuity policy on De-

cember 22, 1965 (Group Annuity Contract No. 101)

to the St. Louis Union Trust Company as trustee of

Pension Fund No. 6 of the International Telephone

Retirement Plan for Salaried Employees, which con-

tract has remained outstanding and in effect to the

present time. Plaintiff received securities valued at

$5,929,057.24 for the purchase of single premium

annuities under Group Annuity Contract No. 101 on

or about December 22, 1965. Prior to this transac-

tion, no group annuity or individual annuity con-

tracts had been purchased by any trustee of any

pension fund under the International Telephone Re-

tirement Plan for Salaried Employees on the lives

of the individuals covered under Group Annuity Con-

tract No. 101.

8a

Plaintiff maintained a reserve of $6,072,004 on De-

cember 31, 1965, with respect to its liabilities under

Group Annuity Contract No. 101 on that date. Such

reserve was computed on the basis of a recognized

mortality table (1959 G.A.) and an assumed rate

of interest (314%), and was set aside to mature

or liquidate future unaccrued claims arising under

Group Annuity Contract No. 101.

On April 4, 1968, plaintiff filed a petition with this

court seeking a refund of income taxes for the years

in issue on the grounds, inter alia, that it was entitled

to deduct accrued and unpaid losses under Section

809(d)(1) of the Code and to take such losses into

account in determining the increase in its reserves

for those years as provided in Section 809(d) (2)

of the Code. On October 24, 1968, a novice of deficiency

was mailed to plaintiff with respect to the years cov-

ered in plaintiff’s petition. The deficiencies proposed

therein were based upon the assertion that plaintiff

did not qualify as a life insurance company during

the years 1963, 1964, and 1965 under Section 801(a)

of the Code, and upon that assertion, by an Amended

Answer, defendant filed a counterclaim herein.

On February 14, 1969, after the time provided by

statute for petitioning the Tax Court had expired but

while plaintiff’s tax liability for the years covered

by the notice of deficiency was still before this court,

the Commissioner of Internal Revenue assessed the

amount of the asserted deficiencies in plaintiff’s in-

come tax, together with interest on such deficiencies,

and demanded payment thereof. Plaintiff contested

9a

the validity of this assessment, but paid such amounts

under protest on March 5, 1969. On March 30, 1970,

plaintiff filed its First Amended Petition with this

court seeking recovery of the amounts claimed in its

original petition as well as the amounts of the asserted

deficiencies paid on March 5, 1969. In its Answer to

plaintiff’s First Amended Petition, defendant stated

that “since the Plaintiff has paid the taxes for which

the counterclaim was filed and amended its petition

to include a claim for refund for these taxes, a counter-

claim by the defendant is no longer necessary, nor re-

quired by law.”

Plaintiff attacks the validity of the assessment de-

scribed in the preceding paragraph. The argument is

that, at a time when plaintiff had a refund suit pend-

ing in this court for the years 1963, 1964, and 1965,

defendant determined additional deficiencies for those

same years thus bringing into play the provisions of

Section 7422(e) of the Internal Revenue Code. In

pertinent part, that section reads as follows:

(e) Stay of proceedings.—If tne Secretary or

his delegate prior to the hearing of a suit brought

by a taxpayer in a district court or the Court of

Claims for the recovery of any income tax, * * *

mails to the taxpayer a notice that a deficiency

has been determined in respect of the tax which

is the subject matter of taxpayer’s suit, the pro-

ceedings in taxpayer’s suit shall be stayed during

the period of time in which the taxpayer may file

a petition with the Tax Court for a redetermina-

tion of the asserted deficiency, and for 60 days

thereafter. If the taxpayer files a petition with

10a

the Tax Court, the district court or the Court of

Claims, as the case may be, shall lose jurisdiction

of taxpayer’s suit to whatever extent jurisdiction

is acquired by the Tax Court of the subject mat-

ter of taxpayer’s suit for refund. [f the taxpayer

does not file a petition with the Tax Court for a

redetermination of the asserted deficiency, the

United States may counterclaim in the taxpayer’s

suit, * * * within the period of the stay of pro-

ceedings notwithstanding that the time for such

pleading may have otherwise expired. The tax-

payer shall have the burden of proof with respect

to the issues raised by such counterclaim * * *

of the United States except as to the issue of

whether the taxpayer has been guilty of fraud

with intent to evade tax.

Plaintiff asserts that the procedure prescribed in

Section 7422(e) invalidates the assessment described

above because the section must be read as calling ex-

clusively for a counterclaim. While the argument is

an ingenious one, we find it without merit.

First of all, it overlooks the permissive, as opposed

to mandatory, wording of Section 7422(e) which

merely states that the Government “may counter-

claim in the taxpayer’s suit.” The effect of such lan-

guage is explained in Bar L Ranch, Inc. v. Phinney,

400 F.2d 90, 92 (5th Cir. 1968) as follows:

In Flora v. United States, 1958, 362 U.S. 145,

80 S.Ct. 630, 4 L. Ed.2d 623, the Supreme Court

explained that when a taxpayer chooses to re-

main in the district court in a case similar to

the instant case, “the Government may—but

seemingly is not required to—bring a counter-

lla

claim; and if it does, the taxpayer has the bur-

den of proof.” This language indicates that the

counterclaim is a permissive one, and that other

methods may be used for the collection of the

tax. Thus the Court assumed that any assess-

ment of the tax would be valid since a separate

collection suit would have to be based on a valid

assessment. See also Florida v. United States,

8th Cir. 1960, 285 F.2d 596.

The Circuit Court then went on to hold that an

assessment, in essence similar to the one disputed

here, was valid.

Secondly, plaintiff apparently would ignore the

limitations provisions contained in Section 6501 of

the Code. That section requires the Government to

assess “within 3 years after the return was filed

** *” By Section 6501(c)(4) that period may be

extended by mutual consent of the taxpayer and the

Government, a procedure presumably well known to

the able and sophisticated tex counsel for this plain-

tiff. No effort is made to explain why this was not

done in the present case.

However, lastly and in all events, the decision for

plaintiff on the merits, as below, would seem to ren-

der this procedural point moot.

The Section 801 Issue

Turning to the merits, it is necessary at the out-

set to determine whether plaintiff, under Section

801 of the Internal Revenue Code, qualifies for tax-

ation as a life insurance company. As was pointed

out in Alinco, supra at 838, 373 F.2d at 350, the

12a

qualification formula in Section 801 may be ex-

pressed in terms of the following fraction, the quo-

tient of which must be more than 50 percent in order

for an insurance company to qualify as a life insur-

ance company:

Qualifying reserves a Total reserves

(numerator ) (denominator )

1. Tabular reserves on life, an- 1. Tabular reserves on life, an-

nuity, and noncancellable ac- nuity, and noncancellable ac-

cident and health policies cident and health policies

2. Unearned premiums on non- 2. Unearned premiums not in-

cancellable life, health, or ac- cluded in (1)

cident policies not included

in (1)

3. Unpaid losses on non cancel- 3. Unpaid losses not included

lable life, health, or accident in (1)

policies not included in (1)

4. All other insurance reserves

required by law.

If one goes no further than plaintiff’s own books

and records, it is clear from the figures set out in

finding 14, infra, that plaintiff’s quotient (or reserve

test ratio, it is frequently called) exceeded 50 percent

in each taxable year. Defendant does go further,

however. Using a process somewhat reminiscent of

a Section 482 allocation of income between related

corporations, defendant would allocate or, to use its

word, attribute to plaintiff the unearned premium

reserves of the ceding companies established by them

with respect to their disability policies reinsured by

plaintiff. Defendant justifies this attribution upon

the theory that reserves must follow the risk and, by

increasing the denominator of the above fraction,

the effect is to decrease plaintiff’s reserve test ratio

below 50 percent in each year.

13a

Plaintiff, of course, objects vigorously to this at-

tribution to it from unrelated companies of unearned

premium reserves which it was not required to hold,

had no right to hold, and did not in fact hold. It

points out that, under its reinsurance treaties with

the ceding companies, plaintiff neither received nor

had any right to receive “unearned premiums” as

that term is defined in Treas. Reg. Section 1.801-3

(e),’ because those treaties provided that the monthly

reinsurance premiums were payable only after they

had been earned by plaintiff, not in advance. Plain-

tiff is correct in these contentions.

Presented with a credit reinsurance arrangement

essentially identical to the present case, the U.S. Dis-

trict Court for the Southern District of Indiana held

for the taxpayer. Economy Finance Corp. v. United

States, 30 AFTR 2d 72-5446 (July 25, 1972), rev'd.

501 F.2d 466 (7th Cir. 1974), cert. denied, 420 U.S.

947 (1975). There, as here, the Government sought

to disqualify from life insurance company status

reinsurers by adding “unearned premiums” held by a

ceding company to their “total reserves.” Again like

the present case, the reinsurance treaties provided

for payment of the reinsurance of credit accident

and health risks on a monthly earned premium basis.

The District Court found that such “reinsurance on

a month-to-month basis is not an uncommon or un-

? The regulation states that the term “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

* * *” (Emphasis supplied.)

l4a

accepted reinsurance arrangement” and in a compre-

hensive and well-reasoned opinion refused to attribute

the ceding company’s unearned premium reserves to

the reinsurer. 30 AFTR 2d at 72-5451. In this re-

spect, the court found the mode of premium payment

conclusive, saying:

* * * An unearned premium reserve is required

to be established only with respect to that por-

tion of the premium (or reinsurance premium)

which has been received by the insurance com-

pany prior to the expiration of the period of cov-

erage to which that premium relates. An insur-

ance company is not required to establish an

unearned premium reserve with respect to pre-

miums or reinsurance premiums to be received in

the future. Since under the terms of the acci-

dent and health Reinsurance Treaties reinsur-

ance premiums were due from Standard Life

to National Life and United Life only in the

month succeeding the month for which the two

reinsurers assumed the risk on the credit acci-

dent and health insurance policies issued by

Standard Life, those reinsurance premiums were

fully earned when received. It therefore would

have been improper for National Life or United

Life to establish any unearned premium reserve.

Since National Life and United Life received

only reinsurance premiums which represented

payments for the assumption of insurance risks

by those companies which had already expired

by each reserve date, they were not required to

set up unearned premium reserves. No state

regulatory agency would have required National

Life or United Life to set up unearned premium

l5a

reserves with respect to the credit accident and

health insurance which was issued by Standard

Life and reinsured by National Life and United

Life. Even without the cancellation provisions

in the credit accident and health Reinsurance

Treaties, it would not have been proper for Na-

tional Life or United Life to set up unearned

premium reserves since under the terms of those

treaties they reinsured risks on a month-to-

month basis. Since under the terms of the credit

accident and health Reinsurance Treaties Na-

tional Life or United Life were given the rig! *

to cancel the treaties upon giving 30 days’ no-

tice, in which event they would have been subject

to only a limited amount of liability on policies

then in force, an additional reason exists for

their not being required to establish unearned

premium reserves.

30 AFTR 2d at 72-5452.

We agree with the District Court’s reasoning and

result. The Seventh Circuit reversed the District

Court but we cannot accept the rationale of the ma-

jority of the Court of Appeals. It should be noted,

first, that the facts in Economy Finance Corporation

differed from those in the present case in one im-

portant respect. Those taxpayers had agreements

with the ceding company under which the latter was

required to invest most of the unearned premium

reserves in subordinated debentures of the parent

of one of the taxpayers, and then to turn over the

interest income received on those debentures as an

“additional commission” to the insurance agency

partnership composed of stockholders of one of the

related taxpayers. See 501 F.2d at 470. Thus, the

16a

Economy Finance taxpayers in effect received the

proceeds of the unlearned reserves even while in the

hands of the ceding company. That arrangement

was quite different from the one involved in the case

at bar and could be understood as making that ced-

ing company the agent of those taxpayers.

But the Court of Appeals, though it referred to

that side-arvangement (see 501 F.2d at 471 n. 5, 477),

did not center its decision thereon. Recognizing that

the literal terms of § 801 favor the taxpayer (501

F.2d at 477), the Court of Appeals refused to apply

the statute as written because, in its view, that inter-

pretation failed to further Congress’s purpose in

giving special tax treatment to life insurance com-

panies. That dominant objective the Seventh Circuit

took to be the legislative desire to postpone half of

the tax on investment income which accrues with re-

‘spect to much life insurance and which cannot be

accurately determined “until the life contract has

been completely performed.” See 501 F.2d at 474,

476-77. Since such investment income is not a factor

for the health and accident policies involved in Econ-

omy Finance and here, the court considered that it

would distort the Congressional purpose to allow

those policies to be taken into account (without off-

setting reserves) in determining whether the com-

panies are entitled to “life insurance company” treat-

ment.

We are far less certain than the Seventh Circuit

that this was Congress’s overriding aim. Section 801

is a technical provision, carefully worked out in some

17a

detail over the years. As Circuit Judge Stevens

pointed out in dissent in the Economy Finance case,

Congress could have differentiated “life insurance

companies” from others for tax purposes by selecting

any of a number of measuring rods, but it chose a

simple reserve-ratio test which has the advantage of

being hinged to the requirements of state authorities

as to the maintenance of adequate reserves, 501 F.2d

at 483. The legislative history does not indicate that

Congress zeroed in on policies connected with under

writing income. Indeed, the reserve-ratio criterion

was initially selected by Congress decades before the

enactment of the current provisions for deferring

part of the underwriting gain, at a time when Con-

gress viewed premium receipts as not taxable be-

cause not true income but rather as analogous to

permanent capital investment. See Helvering v. Ore-

gon Mutual Life Ins. Co., 311 U.S. 267, 268-69

(1940); Alinco Life Ins. Co. v. United States, supra

at 831, 373 F.2d at 346. Moreover, Congress im-

posed statutory limits on the amount of deferrable

underwriting income (see § 815(d)(4)), and there

is no certainty that a company qualified as a “life

insurance company” would be able to take full ad-

vantage of that privilege, perhaps not at all.

Still another indication, in our view, that Congress

probably did not intend to restrict the concept of

“life insurance company” to those firms having a

predominance of policies yielding deferrable under-

writing income is the Code’s treatment of “modi-

fied coinsurance.” In that situation the ceding com-

18a

pany holds the reserves on reinsured risks, but also

pays over the investment income from the reserve to

the reinsurer. Congress has provided in § 820 that

the reinsurer may, though it need not, take the

ceding company’s reserve into account but only if

both parties consent to this treatment. See also Rev.

Rul. 70-508, 1970-2 C.B. 136. As taxpayer points

out, this would result in the anomaly, under the

Seventh Circuit’s opinion, that a reinsurer may suc-

cessfully avoid attribution if it has the ceding com-

pany pay over gross investment income from the re-

serve, but must accept attribution when the ceding

company not only holds the reserve but keeps the

investment income. Defendant’s response is that

§ 820 does not relate to qualification as a “life in-

surance company” but only to the determination of

taxable-investment income and gain, once qualifica-

tion has been established. This is true but does not

destroy the point that it is doubtful that Congress

gave special treatment to life insurance companies

primarily because of their underwriting income.

In addition, the consequences of the general rule

laid down by the Court of Appeals are uncertain and

unclear. Judge Stevens thought the majority’s stand-

ard might well exclude from coverage under § 801

such a common form of life insurance as term insur-

ance. See 501 F.2d at 486 n.7. There may be other

untoward gaps or disharmonies. We cannot tell be-

cause the consequences of departing from the text of

§ 801 are opaque.

In these circumstances, it seems to us preferable

to accept the statute as written, leaving to Congress

19a

the function of closing loopholes (if they exist) or re-

structuring the provision in greater detail. The sec-

tion is technical and specific, directed to a compli-

cated but very narrow segment of the law. If there

be some anomalies under the statute as it stands, the

Congress is in far better position to clarify its pur-

pose and to harmonize § 801 with the other provi-

sions of the insurance portion of the Code. Though

there may be some results which can be questioned

on economic or actuarial grounds, the literal words

of the section do not produce absurd results, or re-

sults which one can say are clearly contrary to the

legislative purpose. Cf. United States v. Olympic

Radio & Television Co., 349 U.S. 232, 236 (1955).

We agree therefore with Circuit Judge Stevens, dis-

senting in Economy Finance (501 F.2d at 485):

“* * * the government’s conclusion that life insur-

ance represents less than half of taxpayers’ total in-

surance business rests on a non-statutory standard.

Congress may have acted unwisely in giving prefer-

ential tax treatment to life insurance companies, and

it may have been unwise to select a reserve-ratio test

as the definition of a life insurance company for tax

purposes. Nevertheless, we must, of course, apply

the test which Congress has specified.”

Defendant also urges that a different result is

called for by a recent decision by the Fourth Circuit

Court of Appeals in Superior Life Insurance Com-

pany v. United States, 462 F.2d 945 (4th Cir. 1972).

In our view, defendant’s reliance on that case is en-

tirely misplaced. Superior Life did not involve rein-

20a

surance. The unearned premiums there involved

were collected and held by the taxpayer’s parent com-

pany (a finance company, not an insurer) under a

group insurance policy issued by the taxpayer. The

parent acted merely as the taxpayer’s agent and “in

reality the fund in [the parent’s] hands was subject

to being used to pay taxpayer’s obligations and for

the benefit of taxpayer whenever taxpayer so de-

sired.” See Superior Life Ins. Co. v. United States,

supra, at 950. None of the facts on which the deci-

sion in Superior Life turned—(1) the agency rela-

tionship between the holder of the premiums and the

insurance company, (2) the free availability of the

unearned premiums to the insurance company, and

(3) identity of control between the parent-agent and

subsidiary-insurance company—is present here. Since

the taxpayer in Superior Life “constructively re-

ceived” unearned premiums under long-accepted prin-

ciples of tax law, the Fourth Circuit’s decision is en-

tirely consistent with the fact that the existence of

unearned premium depends upon the mode of pre-

mium payment.

On this phase of the case, mention should be made

of plaintiff’s argument that defendant’s “reserves

follow the risk” rule has been recently rejected by

this court in Title Guarantee Co. v. United States,

193 Ct. Cl. 1, 482 F.2d 1363 (1970). Defendant

continues to urge, however, that the earlier decision

of Colonial Surety Co. v. United States, 147 Ct. Cl.

643, 178 F. Supp. 600 (1959), established a “re-

serves follow the risk” rule for tax purposes. But in

2la

Title Guarantee the court rejected that argument and

distinguished the Colonial Surety case as follows:

* * * The plaintiff [in the Colonial Surety case]

sought to deduct unearned commissions and not

unearned premiums. * * *

The government argues that the portion of

the trust fund attributable to the parts of the

policies reinsured should not be considered as

unearned premiums * * * for the reason that

the taxpayer is no longer carrying the risk on

the parts reinsured. We cannot accept this

theory. Even though plaintiff has obtained rein-

surance, it is still liable to the policyholder in

ease of loss and is, therefore, still carrying the

risk despite the reinsurance.

Title Guarantee Co. v. United States, supra, 193 Ct.

Cl. at 25, 432 F.2d at 1376. (emphasis added).

Finally, at a later stage in this litigation the court

itself injected an issue which had not been presented

to the trial judge or to the three-judge panel of the

court which first heard the argument. As a result of

the decision by a different trial judge in Consumer

Life Ins. Co. v. United States, No. 463-70, the court

ordered the parties to brief and argue the question

of whether state law required the taxpayer to estab-

blish an insurance reserve for the unearned pre-

miums involved here (if so the case would be gov-

erned by Section 801(c)(3), supra note 1, and the

taxpayer would lose). The case was then ordered to

be heard en banc.’ It has since been held awaiting

* This was done before the three-judge panel had rendered

its decision.

22a

the decision in Consumer Life Ins. Co. which was

argued somewhat later. That case is also being de-

cided today, and on the new issue of the require-

ments of state law we dispose of this case on the

reasoning of the court’s opinion in Consumer Life—

Missouri law did not require taxpayer to establish

reserves for the premiums involved here.*

From all the foregoing, it is concluded that defend-

ant’s attempt to attribute to plaintiff the unearned

premiums reserves actually held by the ceding com-

panies is incorrect. Accordingly, plaintiff’s reserve

test ratio for 1963 was 68.50 percent, for 1964 was

54.48 percent, and for 1965 was 85.76 percent. See

finding 14, infra. Therefore, plaintiff qualified in

those years as a life insurance company under Sec-

tion 801, and it is unnecessary to reach alternative

arguments made by counsel for the parties.

Plaintiffs Group Annuity Policy No. 101

On December 22, 1965, plaintiff issued its own

group annuity policy No. 101 to the St. Louis Union

Trust Co. as trustee of Pension Fund No. 6 of the

International Telephone Retirement Plan for Salaried

Employees. At December 31, 1965, plaintiffs reserve

* See Findings of Fact 19, 20, 21, 22, 28, and especially 29

infra. Defendant relies mainly on Vernon’s Annotated Mis-

souri Statutes § 376.410(1), (3), and (4), but the text of

those provisions fully harmonizes with the interpretation of

Missouri law spelled out in our findings and followed by the

Missouri insurance administrators, i.e., that Missouri law did

not during the years in question require this taxpayer to set

up the reserves in question.

23a

held with respect to annuities purchased under this

policy was $6,072,004. In computing the amount of

its reserves under Section 801(b)(5) which requires

life insurance companies to use the mean of reserves

held at the beginning and end of the year, plaintiff

included $3,036,002 (0+$6,072,004--2) with respect

to this annuity policy.

Defendant recomputed the annuity reserves un-

der Section 806(a) by adjusting them on a daily

basis. This adjustment was accomplished by apply-

ing a fraction to the reserve, the numerator of which

was the number of days during the year in which the

reserve was held and the denominator of which was

the number of days in the year, and the result was

to reduce plaintiff’s year-end reserve to $502,156.

Claiming this adjustment to be entirely erroneous,

plaintiff asserts that neither the language nor the

purpose of Section 806(a) covers reserves held un-

der a newly issued policy by the original insurer, as

was the case of Annuity Policy No. 101. Section

806(a) reads:

For purposes of this part, if, during the taxable

year, there is a change in life insurance reserves

attributable to the transfer between the tax-

payer and another person of liabilities under

contracts taken into account in computing such

reserves, then, under regulations prescribed by

the Secretary or his delegate, the means of such

reserves, and the mean of the assets, shall be

approximately adjusted, on a daily basis, to re-

flect the amounts involved in such transfer. This

subsection shall not apply to reinsurance ceded

to the taxpayer or to another person.

24a

Plaintiff argues that this section was designed by

Congress exclusively to deal with acquisitions of re-

serves by one insurance company from another insur-

ance company in those cases (commonly referred to

as “assumption reinsurance’) where the acquiring

company becomes solely liable in place’of the trans-

feror company on the insurance contracts under

which the acquired reserves are held. Clearly this

did not occur in the present case, and the argument

is that, therefore, Section 806(a) cannot apply but

instead the mere general averaging provisions of

Section 801(b)(5) govern.

From the admittedly rather sparse legislative his-

tory, plaintiff would seem to be correct in this con-

tention. For example, the following appears in S.

Rep. No. 291, 86th Cong., Ist Sess. 51 (1959) (1959-

2 C.B. 807):

* * * Subsection (a) of your committee’s new

section 806 relates to situations where there is a

change in life insurance reserves (either in-

creases or decreases) attributable to the trans-

fer of liabilities under contracts taken into ac-

count in computing such reserves. This occurs,

for example, when life insurance company I pur-

chases all or a part of the business of life insur-

ance company X under an arrangement (some-

times referred to as “assumption reinsurance” )

whereby company I becomes solely liable to the

policy holders. Both I and X will have to make

the adjustments provided by subsection (a).

The illustration which follows the above excerpt, as

well as the examples given in Treas. Reg. Section

25a

1.806-3(a), all deal with transactions and transfers

between insurance companies.

Defendant agrees that the examples cited all illus-

trate transfers between insurance companies but

counters with the observation that the regulations

and Committee Reports do not specifically limit the

section in the manner contended for by plaint.

and points to the language of the statute which covers

transfers “between the taxpayer and another per-

son.” (emphasis supplied.) If Congress intended to

limit the applicability of Section 806(a) to transfers

between insurance companies, defendant suggests it

would have used the phrase “insurance company” in-

stead of the word “person.” This is an appealing

argument, but, in our view, it is clearly offset by

plaintiff’s rational rejoinder that Congress used the

term “person” with a view to reaching all acquisi-

tions of reserves under pre-existing insurance con-

tracts, including those in which the transferor may

not qualify as an insurance company for tax pur-

poses, and not to require a special adjustment of

reserves when a new policy is issued to the trustee

of a pension plan, such as St. Louis Union Trust Co.

Plaintiff also seems on sound ground in contending

that the inapplicability of Section 806(a) to the issu-

ance of a new insurance contract is manifest in de-

fendant’s inability to show here any “liabilities” on

the part of the transferor, any “transfer” of such

“liabilities,” and any reserves computed on the basis

of the transferor’s “liabilities.” It is not disputed

that under the IT&T pension plan the employer had

26a

no liability for the payment of benefits nor that un-

der the trust agreement the trustee was not liable

for losses other than those resulting from its own

neglect.

Nonetheless, says defendant, their fiduciary duties

and obligations under the plan constituted ‘essen-

tially an insurance function.” However, as plaintiff

observes, this misconceives the nature of the fiduciary

relationship. It is hornbook law that a trustee is

not an insurer but at most has the responsibility

prudently to manage the trust funds in accordance

with the purpose set forth in the trust instrument.

See 3 Scott on Trusts §204 (8d ed. 1967).

Finally, it can hardly be disputed that the annuity

reserves in question were established as a result of

liabilities incurred by plaintiff under its annuity

policy No. 101 and were not attributable to “liabili-

ties” assumed by plaintiff under the pension plan

or the trust agreement. Hence, Section 806(a) does

not apply.

The Unpaid Losses Deduction Issue

It is not disputed that in computing its “gain from

operations” as defined in Section 3809(b), plaintiff

was entitled to a deduction under Section 809(d) (1)

for accrued and unpaid losses of $120,596 in 1963,

$55,605 in 1964, and $30,000 in 1965. The present

problem arises because plaintiff asks to deduct them

again under Section 809(d)(2) which allows a de-

duction for an increase in certain reserves, includ-

ing the reserve for unpaid losses. If this were per-

27a

mitted, the Government contends that the same item

would be deducted twice in violation of Section 818

(f) which reads:

(f) Denial of double deductions.—Nothing in

this part shall permit the same item to be de-

ducted more than once under subpart B and

once under subpart C.

The Government also points to Treas. Reg. Section

1.809-5(b) which expressly bars the double deduc-

tion of unpaid losses and an increase in unpaid

loss reserves in the following language:

(b) Denial of double deduction. Nothing in

section 809(d) shall permit the same item to

be deducted more than once in determining gain

or loss from operations. For example, if an item

is allowed as a deduction for the taxable year

by reason of its being a loss incurred within

such taxable year (whether or not ascertained)

under section 809(d)(1), such item, or any

portion thereof, shall not also be allowed as a

deduction for such taxable year under section

809(d) (2).

There can simply be no doubt that the example

given in the above regulation specifically proscribes

the 809(d)(2) deduction here claimed by plaintiff.

Therefore, to hold for plaintiff would necessarily re-

quire a determination that the regulation is invalid,

and such a determination is not permissible in our

view.

Plaintiff has made no showing that the depart-

mental construction exemplified in this regulation is

so unreasonable as to require a holding of invalidity,

28a

and long ago the Supreme Court had the following

to say in Boske v. Comingore, 177 U.S. 459 at 470

(1900) :

Those who insist that * * * a regulation is in-

valid must make its invalidity so manifest that

the court has no choice except to hold that the

Secretary has exceeded his authority and em-

ployed means that are not at all appropriate

to the end specified in the act of Congress.

Plaintiff’s heavy reliance on Title Guarantee, supra,

is misplaced, for there the court was not confronted

with the necessity of holding a regulation invalid.

Hence, as to this issue it is our view that the Gov-

ernment’s position is correct.

Since, however, plaintiff should prevail on other

remaining issues, as discussed above, it is entitled

to recover with the amount thereof to be determined

in further proceedings under Rule 131(c).

NICHOLS, Judge, dissenting:

Upon a careful reading of Economy Finance Corp.

v. United States, 501 F. 2d 466 (7th Cir. 1974),

cert. denied, 420 U.S. 947 (1975), I find it applies

the text in IRC § 801(a), defining a Life Insurance

Company in a sound and persuasive fashion. To

avoid needless expansion of these remarks, I in-

corporate herein the analysis of the panel majority

by reference so far as pertinent here. Were they

less convincing than they are—unless plainly wrong

29a

—our respect for stare decisis and our dislike for

going into conflict with another court should have

carried the day. The objectionable consequences of

conflicting lines of decisions in Federal tax cases

are fully set forth in the Preliminary Report of the

Commission on Revision of the Federal Court Appel-

late System, App. IV. This deals with the “Relitiga-

tion Policy” attributed to defendant, but relitigation

by diverse taxpayers pursuing a common scheme or

plan of tax avoidance is just as objectionable.

Defendant, with the authority of the Seventh Cir-

cuit behind it, would “impute” to plaintiff reserves

under H & A policies it has arranged to have os-

tensibly carried for it by others, though in reality it

bears the risk o. loss itself. When such reserves are

so “imputed” the plaintiff fails to pass the 50%

test and is not entitled to the special advantages

enjoyed by life insurance companies. As the Seventh

Circuit shows, non-imputation completely frustrates

the purpose Congress has in mind in prescribing the

test. The contrary view is simply another instance

of stating: “we see what you mean, Congress, but

you said it wrong.” To a simple, uncomplicated

mind, the imputation is fully justified by the ancient

maxim: “Qui facit per alium, facit per se.” Plain-

tiff maintains the reserves for purposes of the 801

(a) test, though for no other purposes, because it has

arranged, itself or through its affiliates, and using

the economic leverage they jointly possess, to have

these reserves available to satisfy the right the H &

30a

A policy holders possess to have their risks covered

by legally acceptable reserves.

FINDINGS OF FACT

The court, having considered the evidence, the de-

cision and findings of Trial Judge Lloyd Fletcher,

and the briefs and arguments of counsel, makes find-

ings of fact as follows:

General Background

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 anthorities of the State

of Missouri to engage in the business of issuing con-

tracts insuring or reinsuring against death or dis-

ability, and has carried on such business exclusively.

2. Plaintiff is a wholly owned subsidiary of ITT

Aetna Corporation, a second tier subsidiary of In-

ternational Telephone and Telegraph Corporation

(IT&T). Prior to August 31, 1964, plaintiff’s capi-

tal stock was owned by the Aetna Finance Com-

pany. On that date, Aetna Finance Company sold

all of its assets (including plaintiff’s stock) to IT&T,

which subsequently transferred those assets to ITT

Aetna Corporation as a contribution to capital. (Ref-

erences made hereafter to “Aetna” refer either to

Aetna Finance Company and its subsidiaries (other

3la

than plaintiff) or ITT Aetna Corporation and its

subsidiaries (other than plaintiff) as appropriate.)

Aetna has at all relevant times been engaged in the

business of making consumer loans through sub-

sidiaries which, during the years in issue, operated

over 200 finance company offices in approximately

25 states.

3. Plaintiff was originally incorporated under the

name American Universal Life Insurance Company,

and operated under this name during the years in

issue. Its name was changed to ITT Life Insurance

Company in 1966, to ITT Hamilton Life Insurance

Company in 1967, and finally to Penn Security Life

Insurance Company on December 29, 1972.

4. Plaintiff’s principal business, until approxi-

mately 1966, consisted of reinsuring death and dis-

ability risks underwritten by unrelated insurance

companies in respect of credit life insurance policies

issued by those companies to Aetna and its loan cus-

tomers. By 1967, plaintiff’s volume of business in-

creased to the point at which it became more profit-

able for it to write its own credit insurance policies

than to reinsure other companies. Plaintiff today

writes a complete portfolio of the standard forms

of ordinary and term insurance contracts including

individual and group life, accident and health, and

surgical coverage, as well as credit insurance for

borrowers and installment purchasers.

5. Credit life insurance is usually sold as part of

another and more prominent transaction, namely, a

loan of money or an installment sale of tangible

32a

personal property. Its primary function is to pro-

vide a sure, quick, and uncomplicated means for

liquidating the balance due on the loan or installment

sale in the event of the death of the borrower or

purchaser and, where health and accident coverage

is combined with credit life insurance to also pay

the borrower’s monthly installment while he is un-

able to work. It is. generally written for a term

which is coextensive with the contractual term of

the related indebtedness. Occasionally a company

may write a credit insurance policy with a term of

as long as 5 years, but the average in the industry

is two to three years in most instances.

6. Credit insurance may be written under an in-

dividual insurance policy issued directly to the in-

sured debtor, or under a group policy, in which case

the beneficiary-creditor is the policy holder and the

individual insured debtor simply receives a certificate

ot insurance as evidence of coverage under the group

policy. In either case, the creditor is the primary

beneficiary to the extent of the unpaid balance of

the indebtedness at the time of the insured debtor’s

death or disability.

7. Most of the credit insurance policies issued to

Aetna and its loan customers during the years in

issue (1963, 1964, and 1965) were written by three

insurance companies: Old Republic Life Insurance

Company of Chicago, Illinois (Old Republic), Pilot

Life Insurance Company of Greensboro, North Caro-

lina (Pilot), and National Fidelity Life Insurance

Company of Kansas City, Missouri (National Fi-

33a

delity). (Old Republic, Pilot, and National Fidelity

are hereinafter sometimes referred to as “the ceding

companies”). To a much lesser extent, credit in-

surance policies were also issued to Aetna and its

loan customers by Insurance City Life Company

(Insurance City) and the American Bankers Life

Assurance Company of Florida (American Bankers).

Plaintiff had reinsurance agreements or “treaties”

in force with each of the above companies during the

years in issue. ‘

8. All credit life insurance policies and certificates

issued by the ceding companies to Aetna and its

loan customers provided for the payment of the

entire premium (including the disability premium

where accident and health coverage was included

in the policy or certificate) at the inception of the

policy term. When a disability premium under a

single premium policy is first paid by the insured,

it is wholly “unearned,” in the sense that the entire

premium is attributable to the unexpired portion of

the policy. As the term of the policy expires with

the passage of time, a proportionate part of the pre-

mium becomes “earned;” i.e., attributable to insur-

ance protection provided during the expired portion

of the policy.

9. Unlike insurance such as fire, public liability,

and similar types of casualty insurance, credit life

insurance contracts, including those reinsured by

plaintiff (both with and without disability benefits),

cannot be canceled by the insurer during the term

for which they are written. However, the policies

34a

issued by the ceding companies to Aetna and its

loan customers typically provided that insurance

thereunder would terminate prior to the end of the

term of the policy (usually, the maturity date of

the indebtedness): (1) by renewal, refinancing, or

repossession of the collateral for the indebtedness in

connection wit! which the insurance was issued, (2)

upon discharge of such indebtedness by payments

by or on behalf of the debtor to the creditor, (3)

by the indebtedness or any portion thereof being

charged off or being required io be charged off by

the laws applicable to the creditor, and (4) by can-

cellation of the insurance by the insured debtor.

Under any of these circumstances, the policy typi-

cally provided for a refund of the unearned portion

of premiums paid by the insured debtor in ac~ord-

ance with a prescribed formula, usually the kKule

of 78.

10. Under the Rule of 78 or “sum-of-the-digits’’

method, the unearned premium is computed by ap-

plying changing fractions each year (or month, if

unearned premiums are determined monthly) to the

premium paid by the insured. The numerator of the

fraction changes each year (or month) to a number

which corresponds to the sum of the digits of the

remaining unexpired term (years or months) of the

policy, and the denominator, which remains con-

stant, is the sum of all the years’ (or months’) digits

corresponding to the entire term of insurance cover-

age. F'or example, if 2n insured debtor paid a $300

premium for disability benefits at the inception of

35a

a three-year single premium policy, he would be en-

titled to a refund under the Rule of 78 of $300

3+2

3131x8800) if the policy was terminated at the

inni 2+1

beginning of the first year, $150 +t 1X8300)

if the policy was terminated at the beginning of the

second year, and $50 (55758800) if the policy

was terminated at the beginning of the third year.

11. The casualty insurance industry has histori-

cally viewed the unearned premium reserve as that

portion of premiums paid by policyholders that is

attributable to the unexpired terms of outstanding

policies and that would have to be refunded to policy-

holders if all policies in force were to be canceled

as of the statement date. The concept of an un-

earned premium serves several functions with re-

spect to accident and health insurance. Primarily,

the unearned net premium represents funds that

must be held to provide the cost of the insurance

risk which has not yet expired porportionate to the

period for which premiums have been paid in ad-

vance. Unearned loading charges, which are ob-

tained by subtracting the unearned net premium

from the total unearned gross premium reserve,

constitute a solvency reserve for the payment oi

refunds and future expenses. Unearned premium

reserves maintained by the ceding companies on credit

accident and health insurance covering debtors of

Aetna were computed under the Rule of 78 method,

36a

the same method normally used in determining the

required refund to policy holders in the event of a

premature termination of a policy. One result of

including unearned loading charges in the unearned

gross premium reserve is a heavy charge to surplus

which sometimes prevents the ambitious or over-

rapid expansion of a company that might well re-

sult in its ultimate insolvency. Another result is

that it imposes in an indirect manner additional

capital requirements on companies having larger

amounts of business in force.

12. Generally speaking, where insurance coverage

is provided, the premium payable by the insured un-

der the policy is due and payable at the outset of cov-

erage. Whether this requirement obtains as between

a ceding company and its reinsurer company depends

on the provisions of the reinsurance treaty between

them.

13. More than half of the dollar value of benefits

reinsured by plaintiff during the years in issue under

its treaties with the above companies were life in-

surance benefits. Some of the policies covered under

plaintiff's reinsurance treaties were credit life in-

surance policies providing only death benefits. The

remaining policies were credit life insurance policies

combined with accident and health coverage, but the

latter coverage never exceeded the amount of life

insurance benefits provided under the policy (nor-

mally, the amount of the loan). With but one ex-

ception, none of the covered policies provided only

credit accident and health insurance.

37a

The Life Insurance Company Issue

14. For each of its taxable years ended Decem-

ber 31, 1963, 1964, and 1965, the mean of plain-

tiff’s life insurance reserves at the beginning and

end of each year comprised more than 50 percent

of the mean of its total reserves at the beginning

and end of each year, as such reserves were re-

ported on the annual statements submitted by plain-

tiff to the Missouri Division of Insurance and on

the income tax returns filed by plaintiff for those

years. The ratio of plaintiff’s life insurance reserves

to its total reserves under plaintiff’s view of the case

and as computed on its income tax returns for

1963, 1964, and 1965 were as follows:

Jan.1,1963 Dec. 31, 1963 Mean

Life Insurance

Reserves $556,923.00 $733,027.00 $644,975.00

Total eserves 790,108.00 1,092,918.49 941,513.28

Reserve Test Ratio

(1+2) 68.50%

, Jan.1,1964 Dec. 31, 1964 Mean

Life Insurance

Reserves 733,027.00 806,698.00 769,862.50

Total Reserves 1,092,918.49 1,733,125.97 1,413,022.23

Reserve Test Ratio

(1+2) 54.48%

, Jan.1,1965 Dec. 31, 1965 Mean

Life Insurance

Reserves 806,698.00 7,037,233.00 3,921,965.50

Total Reserves 1,733,125.97 7,413,108.58 4,573,117.28

Reserve Test Ratio

(1+2) 85.76%

15. The determination of the Commissioner of In-

ternal Revenue that plaintiff was not a “life insurance

company” as defined in Section 801 of the Code in 1963,

1964, and 1965 was based upon his inclusion in plain-

tiff’s “total reserves” of unearned gross premiums ac-

tually held by the ceding conpanies (1.e. Old Repub-

38a

lic, Pilot, and National Fidelity) in respect of dis-

ability benefits under credit life insurance policies

(combined with health and accident insurance) is-

sued by those companies to Aetna and its loan cus-

tomers. The amounts of “unearned premiums” added

by the Commissioner of Internal Revenue to plain-

tiff’s “total reserves” as of December 31, 1962, 1963,

1964, and 1965 were as follows:

Unearned Premiums Attributed to Plaintiff

Dec. 31, Dec. 31, Dec. 31, Dec. 31,

From 1962 1963 1964 1965

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

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

[sie 1,326,136]

The Government now concedes that unearned pre-

miums under the Old Republic Disability Reinsur-

ance Treaty are not attributable to taxpayers for pur-

poses of qualification as a life insurance company.

16. The unearned premiums attributed to plain-

tiff by the Commissioner of Internal Revenue as of

December 31, 1962, 1963, 1964, and 1965 were ac-

tually held by the ceding companies on those dates

and were included in the unearned premium reserves

shown on the annual statements which they sub-

mitted to the insurance authorities of the various

states in which they did business. In recognition of

their continuing obligations to their policyholders, the

ceding companies were required, both from an ac-

tuarial standpoint and under state law, to establish

such unearned premium reserves while they actuaily

held the unearned premiums in order to have funds

39a

available to pay clairas and refunds to their policy-

holders and to reflect the fact that they had re

ceived premiums from policyholders for insurance pro-

tection to be provided after the statement date. The

annual statements of those companies, in which the

unearned premiums which the Commissioner of In-

ternal Revenue now seeks to include in plaintiff’s re-

serves were shown as unearned premiums of the ced-

ing companies, were accepted by the insurance au-

thorities in all the states in which the ceding com-

panies did business.

The ceding companies maintained the unearned pre-

miums attributed to plaintiff along with their other

reserve funds in accordance with the applicable re-

strictions of state law, and they received the pro-

ceeds from their investments of such funds (interest,

dividends, etc.) as their own income. Plaintiff did

not obtain or use the unearned premiums reflecied

in the annual statements of the ceding companies,

nor were such unearned premiums credited, set apart

or made available to plaintiff. None of the ceding

companies was owned or controlled, directly or in-

directly, by plaintiff, Aetna, or IT&T.

17. The health and accident portion of the com-

bined policies or certificates issued in connection with

group policies were entirely separate insurance con-

tracts which set forth a separate health and accident

premium. However, it has been stipulated that credit

accident and health insurance was never in fact sold

without credit life insurance coverage and, except in

one state, the two coverages were never sold as sepa-

40a

rate contracts. The life insurance reserves main-

tained by taxpayer on the life coverage were calcu-

lated without regard to any health and accident cov-

erage written in combination therewith; conversely,

the ceding companies ignored any combined life in-

surance coverage when they calculated and set up

unearned premium reserves on the health and acci-

dent coverage.

18. Plaintiff had separate reinsurance treaties cov-

ering life insurance risks and disability insurance

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 company 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 reinsur-

ance premium equal of 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 following

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 rein-

surances shall begin simultaneously with that

4la

of Pilot Life and in no event shall the reinsur-

ance of [Taxpayer] be in force and binding un-

less 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 dur-

ing 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

preiniums 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 assumed

by [Taxpayer]:

(1) All premium, occupational and privilege

taxes applicable to the insurance,

(2) The cost of policy forms.

(3) Any special claim expense incurred by

Pilot Life in accordance with Section 3 of Article

IV hereof, and

42a

(4) Any commissions paid to or retained by

agents for writing the insurance; and

B. The total of all claims paid under rein-

sured 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 reinsur-

ance premiums until all premiums on policies

reinsured with [Taxpayer] prior to the termin-

ation 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,

Article IV.

1. [Taxpayer] shall be liable to Pilot Life for

the benefits covered by reinsurance hereunder

to the same extent as Pilot Life is liable to the

persons insured for such benefits and all re-

insurance shall be subject to the terms and con-

43a

ditions of the policy under which Pilot Life is

liable.

2. Whenever a claim is made under a policy

that Pilot Life reinsured under this agreement,

it shall be considered by [Taxpayer] to be a

claim for the full amount of reinsurance on such

policy and [Taxpayer] shall abide by the settle-

ment made by Pilot Life and shall pay the full

amount of reinsurance.

3. Any suit or claim may be tested or com-

promised on the part of Pilot Life and in case of

reduction of the claim made upon Pilot Life, the

claim made upon [Taxpayer] shall be reduced

accordingly. Any special expense incurred by

Pilot Life in defending or investigating any

claim shall be borne by [Taxpayer].

19. Plaintiff’s disability reinsurance treaties with

the ceding companies fell into the category of “rein-

surance ceded’’; i.e., they were solely contracts of in-

surance between two insurance companies (the “ced-

ing company” and the “reinsurer”’), and did not

create any contractual obligation running from the

reinsurer (plaintiff) to the policyholders of the ced-

ing companies. Such reinsurance did not relieve the

ceding companies of contractual liabilities to their

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

to refund unearned premiums in the event of cancel-

lation or other termination of a policy before the ex-

piration of its full term. Consequently, 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

44a

reflect the unearned premiunis actually held by those

companies or policies covered by reinsurance treaties

with plaintiff. Ceding companies, however, may ob-

tain a credit on their annual statement forms for

unearned premium reserves actually transferred to

a reinsurer since, as explained by plaintiff’s expert,

the liability for an unearned premium reserve “de-

pends on whether you’ve got the money or not * * *.”

20. An unearned premium reserve measures an

insurance company’s reserve requirements by look-

ing to premiums already paid by policyholders and

then determining the portion of such premiums that

represent payment for insurance to be provided after

the statement date. Plaintiff was not required to

establish an unearned premium reserve with respect

to its reinsurance of the ceding companies because,

as of each statement date, no portion of the rein-

surance premiums received and held by plaintiff rep-

resented payment for insurance to be provided after

the statement date; i.e., all such reinsurance pre-

miums were fully earned.

21. Life insurance reserves may be measured

prospectively as the difference between the present

value of future claims expected to be paid and the

present value of premiums to be received. Even if this

prospective test had been applied to plaintiff’s dis-

ability reinsurance treaties with the ceding com-

panies, under any reasonable assumption as to fu-

ture claims, the present value of reinsurance pre-

miums to be received under such treaties exceeded

the present value of probable claims. Thus, measured

either retrospectively or prospectively, plaintiff did

45a

not have any reserve obligation under its treaties

with the ceding companies.

22. Plaintiff had no contingent obligation to re-

fund reinsurance premiums received from the ceding

companies since it received such premiums only after

they had been fully earned. Nor did plaintiff have

any obligation to refund premiums paid by policy-

holders of the ceding companies in the event of can-

cellation or other premature termination of policies

issued by the ceding companies. Consequently, there

was no need for plaintiff to establish an unearned

premium reserve for the purpose of maintaining a

fund available for the refund of premiums.

23. Plaintiff also had a reinsurance treaty in force

during the years in issue with Insurance City, which

treaty covered both death and disability risks under

credit life insurance policies issued by Insurance

City to Aetna and its loan customers in the State of

Rhode Island. All of the credit life insurance policies

issued by Insurance City to Aetna and its loan cus-

tomers (including those with disability benefits) pro-

vided for the payment of single premiums at the in-

ception of the policy term on both life and accident

and health coverages. Under its reinsurance treaty

with Insurance City, plaintiff was entitled to receive

the full disability premium collected by Insurance

City for the entire policy term on policies covered

under the treaty, less 10 percent of such premiums

retained by Insurance City, in the month following

receipt by Insurance City. Such reinsurance pre-

miums were paid for reinsurance for the entire term

46a

of policies issued by Insurance City to Aetna and its

loan customers during that month, and not merely

for reinsurance actually provided by plaintiff during

such month. Therefore, plaintiff maintained un-

earned premium reserves with respect to that portion

of premiums received from Insurance City which rep-

resented payment for reinsurance to be provided in

the future.

24. The insurance business is regulated by the

states. For example, the state insurance departments

supervise policy forms, agency relationships, invest-

ments, accounting practices, reserves, and the general

financial responsibility of insurance companies. State

law and/or regulations direct insurance companies

to set up reserves that are designed to preserve the

solvency of those companies for the protection of

policyholders.

25. For each of the years 1962, 1963, 1964, and

1965 plaintiff filed an annual statement with the

Missouri Division of Insurance on the form pre-

scribed by the National Association of Insurance

Commissioners for life and accident and health com-

panies. The annual statement is a record of the in-

come and disbursements of an insurance company

during the year on an accrual basis, as well as a

balance sheet which reflects the solvency of the re-

porting insurance company at the end of the account-

ing period. The calendar year is the prescribed ac-

counting period of all life insurance companies, in-

cluding plaintiff.

26. Plaintiff's annual statements for the years

47a

1962, 1963, 1964, and 1965 did not reflect any un-

earned premium reserves with respect to policies

issued by Old Republic, Pilot, and National Fidelity,

or with respect to plaintiff’s reinsurance treaties with

those companies. The only unearned premium re-

serves reflected on plaintiff’s annual statements for

the above years were unearned premium reserves re-

lating to plaintiff’s reinsurance treaty with Insur-

ance City.

27. State insurance authorities monitor the ade-

quacy of the reserves held by insurance companies

within their jurisdictions by reviewing the annual

statements submitted by those companies and by

conducting a comprehensive audit at least once every

three or four years. The examination includes a veri-

fication and evaluation of assets, the establishment of

liabilities, and a general review of other records and

procedures including the contracts and policies in

force at the valuation date. If an insurance com-

pany did not properly report its liabilities as of the

valuation date under examination, the examiners

would recompute such liabilities in accordance with

actuarial standards and governing state law and

regulations.

28. Plaintiff was audited by the Missouri Divi-

sion of Insurance in 1965 for the period from Sep-

tember 30, 1961, through December 31, 1964. Plain-

tiff was also audited in 1969 with respect to the

period from January 1, 1965, through December 31,

1968, by the Missouri Division of Insurance with

participation by examiners from the States of Mary-

48a

land, Wyoming, and California. There was attached

to the report of examination for the period Septem-

ber 30, 1961, through December 31, 1964, a state-

ment from the consulting actuaries of plaintiff as

follows:

As Consulting Actuaries who aided in the

preparation of the December 31, 1964 Financial

Statement of American Universal Life Insur-

ance Company, [now ITT Hamilton] we affirm

that we determined the policy reserves listed be-

low, and that the amounts thereof were com-

puted in accordance with the terms of the out-

standing policies and the Insurance Code of the

State of Missouri, and that, based upon the rec-

ords of the Company furnished to us, they are

a true statement of the reserve liabilities of the

Company as of December 31, 1964.

1. Aggregate Reserve for Life Policies

$806,698.00

2. Aggregate Reserve for A. & H. Policies

59,673.48

29. The Missouri Division of Insurance did not

require plaintiff to establish unearned premium re-

serves with respect to premiums received by the ced-

ing companies for disability benefits provided by

those companies under policies issued to Aetna and

its loan customers or with respect to reinsurance

premiums received by plaintiff under its disability

reinsurance treaties with such companies. According

to plaintiff's expert witness, no state regulatory au-

thority wovld impose an unearned premium reserve

requirement on an insurance company where, as

49a

under plaintiff’s disability reinsurance treaties with

the ceding companies, such company did not receive

premiums for insurance to be provided in the future.

30. The premium charge for a life insurance con-

tract is computed so as to cover all the contingencies

the insurance company is likely to meet, and these

contingencies are generally grouped into three ele-

ments, namely, mortality, interest, and “loading”

(i.e., profit and expenses}. Mortality refers to that

part of the premium which provides for the occur-

rence of the risk insured against while the second

element takes into account the assumed interest to

be earned by the company. The third element pri-

marily covers profit and the cost incident to manage-

ment of the company, such as salaries, rents, com-

missions, taxes, and other costs of doing business.

In arriving at a premium charge, the first and sec-

ond step is the computation of what is called a “net

premium” which takes into account only the mortal-

ity and interest elements. To the net premium is then

added an amount called “loading” which is calculated

to provide for profit and expenses. The resulting pre-

mium, called the “gross premium,” is the premium

charged to the policyholder.

31. The premium charge for accident and health

insurance coverage is computed similarly to a life

insurance premium, except that the mortality element

of a life insurance premium is replaced by the ‘mor-

bidity” element of the accident and health premium

(i.e., that part of the premium which provides for

the occurrence of the risk of the insured becoming

disabled because of accident or sickness).

50a

32. Unearned premium reserves on casualty (in-

cluding accident and health) insurance have tradi-

tionally been computer on an unearned gross pre-

mium basis; i.e., the reserve is calculated as a portion

of the entire premium received from the policy-

holder, including the portion charged to cover ex-

penses and profits (“loading”). The computation of

unearned premium reserves on an unearned gross

premium basis stems from the historic practice of

maintaining unearned premium reserves equal to

the aggregate amount of premiums that would have

to be refunded if all outstanding policies were can-

celed. However, the cost of carrying the insurance

risk on an accident and health policy is the un-

expired portion of the net premium charged to the

policyholder, That part of the unearned premium

reserve which represents the unexpired portion of the

“loading” charge is not a true insurance reserve at

all, but rather a solvency reserve or reserve for fu-

ture expenses which in effect requires the reserving

company to segregate part of its surplus until the

policy has expired.

Life insurance reserves, in contrast to unearned

gross premium reserves, are “risk oniy” reserves and

do not include any portion of the loading charge

made to the policyholder.

33. The unearned premium reserves of the ceding

companies attributed to plaintiff were calculated on

an unearned gross premium basis. As stipulated by

the parties, the following “tabular morbidity re-

serves” represent the total “net premium” (i.e.,

5la

morbidity) element in the unearned gross premium

reserves held by the ceding companies (including Old

Republic) with respect to disability benefits included

in credit life insurance policies issued by the ceding

companies to Aetna and its loan customers:

Total Tabular

Date Morbidity Reserves

December 31, 1962 $434,213

December 31, 1963 503,279

December 31, 1964 559,401

December 31, 1965 652,489

However, in view of defendant’s concession that

no unearned premiums (either net or gross) may be

attributed to plaintiff from Old Republic (see find-

ing 15, supra) the “net premiums” or “tabular mor-

bidity reserves” in this paragraph have been restated

by plaintiff’s actuary so as to remove “net pre-

miums” held by Old Republic. Mr. E. Dean Forbes,

A.S.A., the actuary who computed the original tabu-

lar morbidity reserves appearing in paragraph 57

of the Stipulation of Facts has made this recomputa-

tion, removing net premiums held by Old Republic,

and leaving only net premiums held by Pilot, National

Fidelity, and plaintiff (under its Insurance City

treaty).

In accordance with said recomputation, it is found

that the following “Tabular Morbidity Reserves” rep-

resent the total “net premium’’(7.e., morbidity) ele-

ment in the unearned gross premium reserves re-

flected on the annual statements of Pilot, National

Fidelity, and plaintiff (under the Insurance City

Reinsurance Treaty) on December 31, 1962, 1963,

52a

1964, and 1965, respectively, with respect to credit

accident and health insurance issued to loan cus-

tomers of Aetna and its subsidiaries:

Total Tabular

Date Morbidity Reserves

December 31, 1962 $378,238

December 31, 1963 438,390

December 31, 1964 494,819

December 31, 1965 575,216

The above “Tabular Morbidity Reserves” were com-

puted on the basis of the 1964 Commissioners’ Dis-

ability Table, a recognized morbidity table approved

by the National Association of Insurance Commis-

sioners.

34. Plaintiff qualifies as a “life insurance com-

pany” within the meaning of Section 801 of the

Code for the years 1963 and 1965, even if unearned

premium reserves of the ceding companies on dis-

ability benefits included in credit life insurance pol-

icies issued to Aetna and its loan customers are

added to plaintiff’s “total reserves” for those years,

if the attributed reserves are calculated on a net

basis. Plaintiff also qualifies as a life insurance com-

pany for the year 1964 if attributed reserves are cal-

culated on a net basis assuming, however, that plain-

tiff is entitled to included unpaid losses on credit life

insurance in both the numerator and denominator of

the life insurance company qualification formula in

that year.

Plaintiff’s qualification ratio for each of the years

in issue, based on a “net premium” attribution, is as

follows:

53a

Plaintiff’s Qualification Ratios Assuming Attribution of Net

Premiums from Pilot and National Fidelity

Jan 1,1963 Dec. 31, 1963 Mean

Life Insurance Reserves $556,923 $733,027 $644,975

Total Reserves 1,036,028 1,302,649 1,169,338

Qualification Ratio (1+2) 55.1%

Jan. 1,1964 Dec. 31, 1964 Mean

Life Insurance Reserves 733,027 806,698 769,863

Total Reserves 1,302,649 1,873,862 1,588,255

Qualification Ratio (1+2) 48.4%

Jan. 1, 1965 Dec. 31, 1965 Mean

Life Insurance Reserves 806,698 1,626,902 1,216,800

Total Reserves 1,873,862 2,305,514 2,089,688

Qualification Ratio (1+2) 58.2%

35. Those credit life insurance policies issued by

the ceding companies to Aetna and its loan customers

which included disability benefits are sometimes re-

ferred to in the insurance industry as life insurance

contracts combined with accident and health insur-

ance. They are conceptually identical to combined

life, health and accident insurance contracts issued

by insurance companies since the early part of this

century, which provide payment of the face amount

of policies in the event of death, or, if the insured

becomes disabled, of installments of the face amount

over a period of years.

36. The terms “cancellable’ and “noncancellable”

have definite and specific meanings in the insurance

industry. The National Association of Insurance

Commissioners has defined the term “noncancellable”

as follows (NAIC, Report to the National Associa-

tion of Insurance Commissioners Subcommittee on

Definition of Non-Cancellable Insurance and Guar-

anteed Renewable Insurance 156 (1960):

54a

The terms “noncancellable” or “noncancellable

and guaranteed renewable” may be used only in

a policy which the insured has the right to con-

tinue in force by the timely payment of pre-

miums set forth in the policy (1) until at least

age 50, or (2) in the case of a policy issued

after the age 44, for at least 5 years from its

date of issue, during which period the insurer

has no right to make unilaterally any change in

any provision of the policy while the policy is

in force.

Some accident and health policies are written for

the life of the insured at a guaranteed annual pre-

mium. A reserve in addition to the unearned pre-

mium reserve must be maintained on such policies

as a consequence of charging a premium for a bene-

fit that costs increasingly more to provide as the

insured grows older. This additional reserve is ac-

cumulated from premium payments and _ interest

earnings that will not be needed to pay claims arising

during the current policy year of the contract. The

reserve is computed on the basis of recognized mor-

bidity tables at an assumed rate of interest. An ad-

ditional reserve is also required where the policy is

written for some term which is shorter than the in-

sured’s life where the premium charged provides a

benefit that costs increasingly more to provide as the

insured grows older. Neither Old Republic, Pilot, nor

National Fidelity maintained an additional reserve

in addition to the unearned premium reserve with

respect to credit accident and health insurance cov-

ering debtors of Aetna and its subsidiaries.

55a

Although there is no analogy in life insurance to

the unearned gross premium reserve required in

casualty insurance, a life insurance reserve may be

roughly compared with the unearned net premium

element in the unearned premium reserve because

both are computed on the basis of the actuarial cost

of carrying the risk.

Plaintiff's Group Annuity Policy No. 101

37. On December 22, 1965, plaintiff issued Group

Annuity Contract No. 101 to the St. wouis Union

Trust Company as Trustee of Pension Fund No. 6

of the International Telephone Retirement Plan for

Salaried Employees, which contract has remained

outstanding and in effect to the present time. On or

about December 22, 1965, plaintiff received securities

valued at $5,929,057.24 from the St. Louis Union

Trust Company for the purchase of single premium

annuities for certain retired individuals covered by

the International Telephone Retirement Plan for Sal-

aried Employees which obligated plaintiff to pay an-

nuities to such retired individuals (and their spouses,

in some cases) under the terms of Group Annuity

Contract No. 101. Prior to this transaction, no group

annuity or individual annuity contracts had been

purchased by IT&T, the St. Louis Union Trust Com-

pany, or any Trustee of any pension fund existing

under the International Telephone Retirement Plan

for Salaried Employees from any insurance company

or other person on the lives of the individuals cov-

ered under Group Annuity Contract No. 101.

56a

38. Plaintiff maintained a reserve of $6,072,004

on December 31, 1965, with respect to its liabilities

under Group Annuity Contract No. 101 on that date.

Such reserve was computed on the basis of a recog-

nized mortality table (1951 G.A.) and an assumed

rate of interest (314%), and was set aside to mature

or liquidate future unaccrued claims arising under

Group Annuity Contract No. 101.

Deficiency Reserves

39. The accepted definition of a deficiency re-

serve in the insurance industry is the amount by

which the present value of the future premiums re-

quired (by statute) for a life insurance or annuity

contract exceeds the present value of the future pre-

miums and consideration actually charged for such

contract.

40. By definition, there can be no deficiency re-

serve requirement with respect to a life insurance

or annuity contract once all premiums called for un-

der such contract have been paid. Thus, there can

never be a deficiency reserve required with respect

to a single premium life or annuity policy under which

the entire premium is payable at the inception of the

policy. All of the life and annuity policies reinsured

or issued by plaintiff during the years in issue were

single premium policies of this type. On an ordin-

ary whole life insurance policy, the deficiency re-

serve required at the inception of the policy, if any,

gradually diminishes as premiums are received by

the company. Defendant now concedes this issue.

57a

History of the Controversy

41. For each of the years 1963, 1964, and 1965,

plaintiff timely filed with the District Director of In-

ternal Revenue at St. Louis, Missouri, a Federal in-

come tax return on Treasury Form 1120L, U.S. Life

Insurance Company tax return, and computed its

taxable income and tax as a life insurance company

according to Section 802 of the Code. The tax shown

to be due on the returns filed for those years, as re-

ported in the table below, was paid in full.

Tax Shown to

be Due on

Year Plaintiff’s Return

SEE Ree OPT A ae eae Te ee $479,356.02

SES ee ere ae eee Se eae 377,217.70

I inal a tes 467,266.14

42. On August 18, 1967, plaintiff filed with the

District Director of Internal Revenue at St. Louis,

Missouri, claims for refund of income taxes previously

paid in respect of the years 1963, 1964, and 1965

(hereinafter referred to as the 1967 claims) in the

following amounts:

Year Amount Claimed

OSE eL ene r ne $156,148.50 (or $148,737.56 in the

PRS ue Rice teal ante 140,482.78 alternative)

BE “ditciiesRt ed eee 47,252.76

Neither the Secretary of the Treasury nor his dele-

gate having theretofore rendered a decision on the

1967 claims, plaintiff, on April 4, 1968, filed suit for

a refund of such income taxes in this court.

43. On October 24, 1968, after plaintiff had filed

a petition claiming a refund of income taxes paid in

respect of the years 1963, 1964, and 1965 in this

court, and prior to a hearing of plaintiff’s claims, the

Commissioner of Internal Revenue determined de-

ficiencies in plaintiff’s income tax for the years 1963,

1964, and 1965 in the following amounts:

Year Deficiency

I onccccrcctrtccccnnsctitanapasasasittisiiiusitesaseee $337,376.70

TTI ccccvescsenesccsinesinnastsspasiamsisssssaseetsissalaa 362,986.20

BD ccccrecencncccnsnsstentmscsiaiiaiiialtciiaaeadie 265,412.05

The asserted deficiencies were based upon a deter-

mination that plaintiff did not qualify as a life insur-

ance company during the years 1963, 1964, and 1965

under Section 801(a) of the Code, but rather was

taxable as an insurance company other than a life

or mutual insurance company in those years.

44. Plaintiff did not file a petition with the Tax

Court for a redetermination of the asserted deficien-

cies within the time allowed by Section 6213(a) of

the Coce, or at any time thereafter. On February 14,

1969, the Commissioner of Internal Revenue assessed

the amount of the asserted deficiencies in plaintiff’s

income tax for the years 1963, 1964, and 1965, to-

gether with interest on such deficiencies, and de-

manded payment thereof. Plaintiff contests the valid-

ity of this assessment. On March 5, 1969, the fol-

lowing amounts were paid to the District Director of

Internal Revenue at St. Louis, Missouri, under pro-

test, in respect of the deficiencies in plaintiff’s income

taxes assessed for the years 1963, 1964, and 1965,

and interest thereon:

Year Deficiency Interest Total

Ee . $337,376.70 $99,747.96 $437,124.66

EA eT 362,926.20 85,540.48 448,526.63

a 265,412.05 46,621.63 312,033.26

45. On April 21, 1969, plaintiff filed with the

District Director of Internal Revenue at St. Louis,

Missouri, claims for refund of the amounts assessed

by the Commissioner of Internal Revenue on Febru-

ary 14, 1969, and paid by plaintiff on March 5, 1969,

as additional income taxes, and interest thereon, for

the years 1963, 1964, and 1965 (hereafter referred

to as the 1969 claims). Plaintiff received a formal

notice of disallowance of its 1969 claims from said

District Director on December 3, 1969, and filed its

First Amended Petition with this court on March

30, 1970, seeking recovery of income taxes with

respect to both its 1969 and 1967 claims.

46. On May 8, 1969, defendant filed a motion with

this court for leave to file an amended answer to

plaintiff’s petition. Defendant’s motion was allowed

and an amended answer was filed on July 8, 1969,

which amended answer included a counterclaim al-

leging that the Commissioner of Internal Revenue had

assessed additional income taxes and interest for the

years 1963, 1964, and 1965 and demanded payment

thereof and that such assessment had not been paid.

Plaintii filed a reply to defendant’s counterclaim on

August 12, 1969, alleging, inter alia, full payment of

such additional taxes and interest.

47. In its Answer to plaintiff’s First Amended

Petition defendant stated that “since the Plaintiff has

paid the taxes for which the counterclaim was filed

60a

and amended its petition to include a claim for re-

fund for these taxes, a counterclaim by the defendant

is no longer necessary, nor required by law.” De

fendant’s Answer to First Amended Petition, Count

I §13(d), Count II, §11(d), Count III, J 13(d),

Count IV, §/ 13(d).

Ultimate Finding of Fact

48. During each of the years 1963, 1964, and

1965, plaintiff was a life insurance company engaged

in the business of issuing or reinsuring life insur-

ance and annuity contracts (issued either separately

er combined with accident and health insurance) and

its life insurance reserves plus unearned premiums

and unpaid losses on non-cancellable life, health or

accident policies not included in life insurance re-

serves comprised more than 50 percent of its total

reserves during each of those years within the mean-

ing of Section 801 of the Interna] Revenue Code of

1954.

CONCLUSION OF LAW

Upon the foregoing findings of fact which are

made a part of the judgment herein, the court con-

cludes as a matter of law that plaintiff is entitled

to recover, and judgment is entered to that effect,

with the determination of the amount of recovery to

be made in further proceedings under Rule 131(c).

® ©. 8. coveenmert pawwrine orrice; 1976 200294 200