Petitioners Reply Brief — Commissioner v. Standard Life & Accident Insurance

B Supe: ie Court. U. Ss. Bee

i FILED i

} MAR 25 1977

Eich RODAK, JR., CLE

No. 75-1771 a

Gu the Supreme Court of the United

OctoseR TERM, 1976

=

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

Vv.

StanparD Lire & Acowent InsurRANcE CoMPANY

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF

APPEALS FOR THE TENTH CIRCUIT

REPLY BRIEF FOR THE PETITIONER

DANIEL M. FRIEDMAN,

Acting Solicitor General

MYRON C. BAUM,

Acting Assistant Attorney General,

STUART A. SMITH,

Aasistant to the Solicitor General,

GARY R. ALLEN,

STEPHEN M. GELBER,

Attorneys,

Department of Justice,

Washington, D.C. 20530.

JEANNE L. DOBRES,

Attorney,

Internal Revenue Service

Washington, D.C. 20224.

INDEX

I. The Treasury Regulations prescribing the

treatment of deferred and uncollected

life insurance premiums properly reflect

the fundamental relationship between

premiums and reserves__...--.--------

II. The statutory Phase I and II formulas

accurately measure a life insurance com-

pany’s taxable income only if premiums,

assets and reserves are computed in

accordance with a consistent set of

EE

III. A life insurance company is not entitled to

a deduction or offset for the “load-

ing” portion of its deferred and uncol-

lected premiums in computing its

‘‘assets” and “gross amount of

St Ghdtiebbapeenccamensesne

Conclusion -------. | a

CITATIONS

Cases :

Bankers Union Life Insurance Co. v. Com-

missioner, 62 T.C. 661_-------_-_-__-__

Bingler v. Johnson, 394 U.S. 741_-------

Commissioner v. South Texas Co., 333 U.S.

EEE

Commissioner Vv. Wheeler, 324 U.S. 542___-

Connecticut General Life Ins. Co. v. Eaton,

218 Fed. 188, affirmed per curiam, 223

231-512—-77—_—_-1

Page

10

II

Cases—Continued _—

Federal Life Insurance Co. v. United Cases—Continued jon

States, 527 F. 2d 1096_____- ma AO REA Se 24, 25 United Infe & Accident Insurance Co. v.

Franklin Life Insurance Co. v. United United Statesa 329 F. Supp. 765_--____ 24

States, 399 F. 2d 757, certiorari denied, United States v. Boston Insurance Co., 269

i: gees A 24, 27 Ca Wicca ie 4

Great Commonwealth Life Insurance Co. United States v. Correll, 389 U.S. 299__-_ 27, 28

v. United States, 491 F.2d 109__..______ 24, 27 Western and Southern Life Insurance Co.

Helvering v. Inter-Mountain Life Ins. Co., v. Commissioner, 460 F. 2d 8, certiorari

Oe Ta ia nied 4 denied, 409 U.S. 1038_......___________ 24

Helvering v. Wilshire Oil Co., 308 U.S. Western National Life Insurance Co. of

OD .nntinsneteisininetennaddaaiaaaaaiiiadiiineiaes 12 Texas v. Commissioner, 432 F. 2d 298__ 22, 24

Jefferson Standard Life Insurance Co. v. Statutes and regulations:

United States, 408 F. 2d 842___________ 18, 24 Internal Revenue Code of 1954, as amended

McCoach v. Insurance Company of North (26 U.S.C. (1958 ed., Supp. IT)):

America, 244 U.S. 585..-...-.-..______ 4 ET ES ee 2,3

Midland National Life Ins. Co. v. Commis- ES Ee Oe 4

slonat, GB TER. Gicccnntnintiniiimddiiies 24-25 Section 801(b)(1)(A)__---_______ 3

Monumental Life Insurance Co. v. United Section 801(b)(1)(B)_----_________ 3,7, 11

States, 76-2 U.S.T.C. 99787, decided eee a 3

November 19, 1976 Ct. Cl.)_-------____ 6 ENE ER 13

Mutual Benefit Life Ins. Co. v. Herold, 198 SURED GC iter itintemnntiintiiniee 13, 14

Fed. 199, affirmed per curiam, 201 Fed. Section 805(b)(4)--------____ 17, 18, 19, 26

918, certiorari denied, 231 U.S. 755_-_- 8 SE et citer veicnesencniiiajenicitannianiinn 13

New York Life Ins. Co. v. Edwards, 271 Section 606(e) (1)... encncse 15,17

We, Bi icnccctsnctnenntinitineninaiiaeeides, 4 I ciriereachessaishinaininstptiitiiilescibbedinstices 10

North American Life & Cas. Co. v. Commis- Section 809(c)(1)-.--.-...__________ 19, 26

sioner, 533 F. 2d 1046_----.----.-____ 24 Section 809(d)(2)........-__________ 12

Prudential Ins. Co. v. Herold, 247 Fed. Section 809(d)(11)-------__________ 25

CEE nccsieccvinniminadieieaieeiiiemeiees 8,9 Section 809(d) (12)_---.-....________ 25

Republic National Life Insurance Co. v. Section 810(d)_...-----____- vere 10

United States, 77-1 U.S.T.C. 9 9133, (de- REET ETT 9, 22

cided December 9, 1976 (N.D. Tex.)_... 25 | EES Se 10, 11

IV

Statutes and regulations—Continued

Treasury Regulations on Income Tax (26

C.F.R.):

Section 1.801-4(f)_----------- 3, 6, 7, 13, 27

Bestien 1406-600) ..ccoccccnsmoonsnn 3

Section 1.805-4(a)---------_---__--_- 18

ES 21

Section 1.805-5(a) (4)--------------- 6

Section 1.809-4(a)_-.---.--.---_- 21-22

Section 1.809-4(a) (1)--------------- 6,13

Miscellaneous:

American Institute of Certified Publie Ac-

countants, Audits of Stock Life Insur-

ance Companies (1972)_-------------_-

Beardsley, Life Company Annual State-

ment Handbook (1962) _------------- 5, 20, 22

Conference of Actuaries in Public Prac-

tice, The Proceedings, 1959-1960______- 7,8

105 Cong. Ree. 8428-8429 (1959)_________ 15

Denney, Rua & Schoen, Federal Income

Taxation of Insurance Companies (2d ed.

SIGE) anmamamenninisnaciinnmeipeninetanne 23

Ernst & Ernst, GAAP [Generally Accepted

Accounting Principles]—Stock Life

Companies (1974)_.--.-....-....... 5, 20, 22

Hearings on H.R. 4245 (Tax Formula for

Life Insurance Companies) before the

Senate Committee on Finance, 86th

oe FS ER ee 14, 16

H.R. Rep. No. 34, 86th Cong., Ist Sess.

(1959) ----- 15, 16, 19, 22

MacLean, Life Insurance (9th ed. 1962) __ 2,

5, 11, 20, 22

McGill, Life Insurance (Rev. ed. 1967)_____ 5, 16

Vv

Miscellaneous—Continued ie

Nash, Federal Taxation of Life Insurance

Companies (Harman rev. 1976) _------- 7,9

Noback, Life Insurance Accounting

ERD conncnlaieigcittibannauncnsndiiin 18

II Proceedings of the National Association

of Insurance Commissioners (1963) ---- 23

S. Rep. No. 291, 86th Cong., Ist Sess.

CRED cnicinnthidviteisitilinidiniiotien 14, 15, 16, 17, 22

Summary of Recommendations Made in

The Hearings on the Taxation of Life

Insurance Companies before the Sen-

ate Committee on Finane 86th Cong.,

Ist Sess. (April 8, 1959) __..---.-______ 15

Wightman, Life Insurance Stetements and

BOCA CETEE 66 ecnccnccccmontes 5d, 20, 22

Gu the Supreme Gourt of the Cited States

OcToBER TERM, 1976

No. 75-1771

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

v.

STANDARD Lire & AccIpDENT INSURANCE COMPANY

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF

APPEALS FOR THE TENTH CIRCUIT

REPLY BRIEF FOR THE PETITIONER

I

THE TREASURY REGULATIONS PRESCRIBING THE TREAT-

MENT OF DEFERRED AND UNCOLLECTED LIFE INSURANCE

PREMIUMS PROPERLY REFLECT THE FUNDAMENTAL

RELATIONSHIP BETWEEN PREMIUMS AND RESERVES

1. In attempting to support the result reached by

the court of appeals that a life insurance company

may assume receipt of its deferred and uncollected

premiums for purposes of computing its “reserves”

but thereafter abandon that assumption when com-

(1)

2

puting its “assets”? and “gross amount of premiums,”

respondent necessarily adopts the position that a

company’s life insurance reserves are conceptually

unrelated to the premiums paid by its policyholders.

Thus, respondent contends (Br. 39-50) that it was

required by state law to include the net valuation por-

tion of the deferred and uncollected premiums in its

reserves and that this state law requirement was a

sufficient and independent basis for recognition of

such a reserve for federal tax purposes under Sec-

tion 801(b) of the Code. However, when it comes to

taking the deferred and uncollected premiums into

account in “assets’’ and “gross amount of premiums,”’

respondent asserts that it did not receive the premi-

ums and had no legal right to compel their payment.

But as we have pointed out in our opening brief

(pp. 29-33), the fundamental relationship between

reserves and premiums refutes respondent’s bifur-

eated analysis. Every life insurance text defines a

life insurance reserve as made up of the sum of net

valuation premiums paid to date, plus interest at the

assumed rate, minus assumed death claims. See, e¢.g.,

MacLean, Life Insurance 90-116 (9th ed. 1962).

In view of the fundamental relationship between

premiums and reserves, a life insurance company’s re-

serves are not bookkeeping entries created in a

vacuum without regard to premiums, as respondent

and the court of appeals would have it, but represent

liabilities to the policyholders only to the extent that

the policyholders pay premiums out of which amounts

can be ‘‘set aside” to meet future claims. See Section

- —

oe 6S

3

801(b)(1)(B). Since the deferred and uncollected

premiums have not been paid and the company bears

no insurance risk with respect to those premiums, the

simpler and more logical approach would be to exclude

deferred and uncollected premiums altogether from

the federal tax computations of the company’s

“reserves,” in accordance with Treasury Regulations,

Section 1.801-4(f) (see our opening brief, pp. 54-58).

2. Contrary to respondent’s (Br. 39-50) and the

amicus American Council of Life Insurance’s

(ACLI) (Br. 10-11) argument, the fact that state

law required respondent to compute its reserves on

the assumption that it received its deferred and un-

collected premiums does not of itself justify reecogni-

tion of such reserves for federal tax purposes under

Section 801(b) without regard to premiums. To 4

sure, Section 801(b)(2) provides that “life insur-

ance reserves must be required by law’’ and Section

1.801-5(b) of the Treasury Regulations defines that

statutory phrase to mean reserves that are required by

state statutes or administrative rules. But there are

other elements of the statutory definition of a reserve

that demonstrate that a life insurance reserve for fed-

eral tax purposes is one that is derived from the pre-

miums paid by the policyholders. Thus, Section 801

(b)(1)(A) and (B) provide that a life insurance re-

serve must also be an “amount” “computed or esti-

mated on the basis of recognized mortality or mior-

bidity tables and assumed rates of interest’’ that is

“set aside to mature or liquidate * * * future un-

accrued claims arising from life insurance * * *.’’ If,

231-512—77——_2

4

as here, the policyholder does not pay the premiums,

the company has nothing to “set aside’’ for the corre-

sponding reserve.

The decisions of this Court uniformly support our

submission that a life insurance reserve is tied to the

payment of premiums, and that state law characteri-

zations cannot alter this fundamental relationship. In

construing predecessor definitional provisions that

were essentially equivalent to Section 801(b) (1), the

Court has stated that the term “reserve’’ “does not

necessarily include whatever a state official may so

designate * * * [but that it] has a technical mean-

ing * * * [as] something reserved from premiums

to meet policy obligations at maturity.’”” New York

Life Ins. Co. v. Edwards, 271 U.S. 109, 119 (emphasis

supplied). Accord: McCoach v. Insurance Company

of North Carolina, 244 U.S. 585, 589; United States v.

Boston Insurance Co., 269 U.S. 197, 202; Helvering v.

Inter-Mountain Life Ins. Co., 294 U.S. 686, 689-690.

There is accordingly no basis to respondent’s and

ACLI’s contention that state law nomenclature ac-

cords independent federal tax recognition to a life in-

surance reserve without regard to premiums.

Finally, as we have shown in our opening brief

(pp. 34-37 and n. 25), the inclusion of the net valu-

ation portion of the deferred and uncollected pre-

miums in reserves derives from the financial reporting

assumption of full premium receipt that is used by

the life insurance industry in order to avoid the ac-

tuarial work involved in computing reserves on a

policy-by-policy basis. Thus, the state law which re-

5

spondent invokes as an independent basis for federal

tax recognition of its reserves does not impose an

insurance liability upon a company for periods with

respect to which premiums have not been paid. To

the contrary, the state law simply permits the use of

life insurance industry’s convention of including the

net valuation portion of deferred and uncollected pre-

miums when computing reserves. However, the insur-

ance texts all recognize that the inclusion of such

premiums in reserves results in ‘‘reserve liabilities

* * * [that] are greatly overstated.” Wightman,

Iafe Insurance Statements and Accounts 545 (1952

ed.) ; id. at 43-44, 155. Accord: MacLean, Life Insur-

ance 318-319 (9th ed. 1962); Beardsley, Life

Company Annual Statement Handbook III-15

(1962) ; Ernst & Ernst, GAAP [Generally Accepted

Accounting Principles]—Stock Life Companies 449-

450 (1974) ; MeGill, Life Insurance 867-868 (Rev. ed.

1967). This overstatement of reserves has no actual

impact on the company’s surplus or solvency because

an equa’ amount is set up as an offsetting asset. Mac-

Lean, supra, at 318-319.

Both the Commissioner’s primary and alternative

positions represent different but equally valid meth-

ods of dealing with the overstatement of reserves

caused by the inclusion of the net valuation portion

of deferred and uncollected premiums in reserves. In

providing for the inclusion of the gross amount of

deferred and uncollected premiums in ‘‘assets” and

“gross amount of premiums,” the primary position

set forth in Section 1.805-5(a)(4) and 1.809-4(a)

6

(1) of the Regulations accepts the industry’s conven-

tion of overstating the reserves. But since that over-

statement rests upon the assumption that all premi-

ums are paid in full, that assumption must be con-

sistently applied so as to include the full amount of

deferred and uncollected premiums in “assets” and

“cross amount of premiums.’ By requiring consist-

ent application of the premium receipt assumption,

the Commissioner’s primary position properly recog-

nizes that life insurance reserves are established only

from the payment of premiums.

The Commissioner’s alternative position likewise

rests upon the fundamental relationship between pre-

miums and reserves. In requiring the exclusion of

deferred and uncollected premiums from reserves if

they are excluded from ‘‘assets” and “gross amount

of premiums,” Section 1.801-4(f) also avoids the com-

putational imbalance produced by the decision of the

court of appeals in this case. It accomplishes this

result by recognizing that the financial reporting de-

vice of overstating reserves by the net valuation por-

tion of deferred and uncollected premiums is a fiction.’

It therefore eliminates such premiums altogether from

“reserves” as well as “assets” and ‘‘gross amount of

premiums.”

Since the overstated reserves do not represent

actual liabilities to policyholders and are not derived

from premiums, they do not represent amounts that

* This is explained in the trial judge’s opinion in Monumental

Life Insurance Co. v. United States, 76-2 U.S.T.C. § 9787 decided

November 19, 1976 (Ct. Cl.).

7

have been ‘‘set aside” for the payment of future

claims within the meaning of Section 801(b) (1) (B)

or the decisions of this Court. Indeed, the exclusion

of the net valuation portion of deferred and uncol-

lected premiums from reserves, in accordance with

Treasury Reculations, Section 1.801-4(f), finds sup-

port in the statement of a leading commentator that

these amounts “are not reserves required by law * * *

and do not meet the test of funds set aside out of

premiums for the benefit of policyholders.” Nash,

Federal Taxation of Life Insurance Companies,

§ 13.09 (Harman rev. 1976). Thus, the exclusion of de-

ferred and uncollected premiums from reserves, under

the Commissioner’s alternative position, is neither

“strongarm” nor ‘‘pernicious,” as the amicus ACLI

argues (Br. 19, 20), but finds solid support in both

the insurance texts and the decisions of this Court.’

3. Contrary to respondent’s (Br. 45-46) and amicus

ACLI’s (Br. 12-13) further argument, neither Pru-

* While respondent (Br. 48-49) and ACLI (Br. 8, 20-21) argue

that Section 1.801-4(f) of the Regulations is invalid, the life

insurance industry itself recognized both the underlying concept

of the Regulation and the necessary relationship between a com-

pany’s “reserves” and “assets” almost immediately after the pass-

age of the 1959 Act. More than a year before the Regulations in

issue were promulgated, the Conference of Actuaries in Public

Practice discussed the possible tax effect of eliminating deferred

and uncollected premiums in computing reserves. See Conference

of Actuaries in Public Practice, The Proceedings, 1959-1960,

36-62. As the following discussion demonstrates, the industry

actuaries recognized that a company was required either to in-

clude the deferred and uncollected premiums in both its “reserves”

and “assets” under the 1959 Act or to eliminate these premiums

8

dential Inc. Co. v. Herold, 247 Fed. 681 (D. N.J.), nor

Bulletin H which purports to follow it, are valid

precedents with respect to the question in this case.

In Prudential Ins. Co., the court concluded that a

life insurance company could increase its reserves by

the net valuation portion of its deferred and uncol-

lected premiums even though it otherwise excluded

such premiums from income under the cash method

of accounting then required by the statute.’

The Prudential decision that a company could in-

clude the net valuation portion of such premiums in

from both sets of computations (“Panel Discussion: How to Live

With the New Federai Income Tax,” id at 50) ;

“Moderator Leste. I have another question for you, Ralph:

‘What thought has been given to computing reserves on a con-

tinuous premium method so that no deferred premium would be

required ¢’

“Mr. Nites. The question here is merely a variation of the over-

all question as to whether reserves should be maintained as low as

possible or as high as possible,

“If a company changes to a continuous premium method so that

no deferred premiums are required, there will result a reduction

in reserves. And, to determine whether this is good or bad, we must

look at the entire picture.

“However, there is an additional complication here. The elimi-

nation of deferred premiums will reduce the assets, which, in turn,

would increase the current and average earnings rate. So, again,

it can only be emphasized that the answer will depend upon the

particular situation.”

* See, ¢.g., Mutual Benefit Life Ins. Cv. v. Herold, 198 Fed. 199,

214-215 (D. N.J.), affirmed per curiwm, 201 Fed. 918 (C.A. 3),

certiorari denied, 231 U.S. 755; Connecticut General Life Ins. Co.

v. Eaton, 218 Fed, 188, 205-206 (D. Conn.), affirmed per curiam,

298 Fed. 1022 (C.A. 2).

9

its reserves turns upon the court’s mistaken under-

standing that the company had an actuai reserve lia-

bility with respect to these premiums and that it had

‘‘effectively withdrawn [assets] from * * * [its]

use” to cover this reserve (247 Fed. at 686). But as

we have shown, the inclusion of the net valuation por-

tion of deferred and uncollected premiums in reserves

results in an overstatement of reserves which is not

covered by actual assets (see our opening brief, pp.

35-36). Thus, the one commentator who discusses

the Prudential decision at length has stated that he

does not believe “that the court’s conclusion that de-

ferred premiums were properly reserves required by

law can be afforded much validity [because] * * *

the [case] arose before the development of the defi-

nition of reserves required by law reached its full

growth.” Nash, supra, at § 13.06. Since the present

statute now requires life insurance companies to use

an accrual method of accounting for “all computa-

tions” (Section 818(a)) and since it is now well un-

derstood that the inclusion of deferred and uncollected

premiums in reserves overstates the reserves, the

Prudential rationale has been discredited.‘

* Between 1921 and 1959, the question whether reserves and pre-

miums could be computed on the basis of inconsistent assumptions

became relatively insignificant, because life insurance companies

were then taxed solely on “free investment” income, computed

under a series of artificial tax formulas (see our opening brief,

pp. 22-23).

10

II

THE BTATUTORY PHASE I AND Il FORMULAS WILL ACCU-

RATELY MEASURE A LIFE INSURANCE COMPANY'S TAX-

ABLE INCOME ONLY IF PREMIUMS, ASSETS AND RESERVES

ARE COMPUTED IN ACCORDANCE WITH A CONSISTENT SET

OF ASSUMPTIONS

1. As we have pointed out in greater detail in our

opening brief (pp. 39-45, 51-53), the integrity of the

federal tax formulas, which rest upon the proportion-

ate relationship between “reserves’’ and “assets’’

(Phase I) and upon a net income computation of

gross premiums less reserves (Phase II), requires

that all of the statutory elements be computed in ac-

cordance with a consistent set of assumptions. Re-

spondent disputes the need for consistency and argues

(Br. 10, 15-17, 29, 33, 35-36) that there is no statutory

requirement that the tax computations be made on

the basis of the same assumptions. In support of its

contention, it cites (Br. 14-17, 34-35) Sections 806(b),

810(d), and 818(c) as indicating that the premium

receipt assumption does not have to be consistently

applied across the board.

These provisions have no bearing on the question

in this case. They are applicable only to situations in

which a life insurance company “strengthens’’ its re-

serves by changing the mortality or interest rate as-

sumptions (Sections 806(b), 810(d)) or when it

changes its reserve computations from a “preliminary

term’’ to a “net level premium”’ basis (Section 818

11

(c)).° In each of those special cases, the company

simply adjusts the amount of its total assets previ-

ously received and then on hand that will be treated

as “set aside’ (Section 801(b)(1)(B)) for the pay-

ment of future death claims.

Here, however, the inclusion of the net valuation

portion of deferred and uncollected premiums in re-

serves overstates the reserves because the premiums

on which the addition is based have not been received

and could not be "set aside."' Thus, nothing in Sec-

tions 806(b), 810(d) or 818(c) casts doubt upon our

submission that the elements of the tax computation

must be computed in accordance with a consistent set

of assumptions.° j

2. Respondent also argues (Br. 6, 10, 11, 15, 31,

33-34) that the 1959 Act does not establish any pro-

* Under a preliminary term system, an insurance company treats

the first year of an ordinary life policy as a term insurance policy

for one year (hence the expression “preliminary term”). Because

the hypethetical one-year preliminary term policy has only a

small reserve requirement, this system allows the company to

apply almost all of the annual premium for the first year against

the company’s customarily high first-year expenses, In later years, .

the company will add larger amounts to its reserves to make up

the difference. See, generally, MacLean, supra, at 131-140. Sec-

tion 818(c) allows life insurance companies using a preliminary

term system to revalue their reserves for tax purposes on a net

level basis. Thus, a company will still be able to claim the same

deductions and exclusions with respect to its reserves in the first

policy year as if it had not used the preliminary term method.

* Respondent further argues (Br. 17-18) that the contradictory

assumptions of the court of appeals with respect to assets, gross

amount of premiums, and reserves, is consistent with the annual

accounting principle “that a deduction is to be allowed for the

(Continued )

231-512—77—-3

12

portional relationship and consistency of treatment

among reserves, assets, or premium income. There is,

however, nothing in the statute that exempts life

insurance companies from the general rule applicable

to all other taxpayers that all items must be reported

in accordance with the same method of accounting.

See, e.g., Helvering v. Wilshire Oil Co., 308 U.S. 90,

96-99.

The need for consistency is most graphically shown

by the net income computation under the Phase II

formula. The primary difference between the Phase

II formula and the way other taxpayers are taxed is

that life insurance companies are allowed deductions

for the part of their current income that must be set

aside for the payment of future, unaccrued claims.

But the only justification for the special deduction

allowed by Section 809(a) (2) for increases in reserves

is that the company would otherwise be subject to

tax on premium income which it must hold for the

benefit of its policyholders. Thus, there is no basis

upon which respondent could claim a current dedue-

tion under Section 809(d)(2) on the ground that

it is required to set aside a part of its deferred and

year in which it arises and related income is to be taxed in the

year when it is received or accrued even if the deduction and the

income do not fall in the same tax year.” But unlike the case of an

ordinary taxpayer, who accrues or pays out otherwise deductible

expenses with respect to income received in a subsequent year, a

life insurance company’s inclusion in reserves of the deferred and

uncollected premiums results in an overstatement of reserves that

would not normally justify a deduction because it does not repre-

sent an actual liability of the company. However, the Commis-

sioner is willing to recognize this overstatement for tax purposes

only if the full premium receipt assumption is employed also with

respect to “assets” and “gross amount of premiums.”

13

uncollected premiums unless those premiums are

themselves included in the current year’s income.

Treasury Regulations, Section 1.809-4(a) (1). By the

same token, if respondent wants to defer reporting

those premiums as income until the following year, it

must also defer its deduction for the part of those

premiums set aside for future policy claims. Treasury

Regulations, Section 1.801-4(f).

Respondent’s contention (Br. 30-33) that reserves

and assets are independent variables under the Phase

I computation is likewise erroneous. Respondent

argues that the Phase I formula does not prescribe

a “simple proportional relationship between life in-

surance reserves and assets” (Br. 31) because the

exclusion for the policyholders’ share of investment

yield is determined in terms of a company’s “adjusted

reserves [earnings] rate’’ (Section 805(b)) and “ad-

justed life insurance reserves” (Section 805(c)).’ As

’ Indeed, respondent even suggests (Br. 30) that our description

of the Phase I formula (see our opening brief, pp. 5-6, 39-40)

“cannot be derived from the statutory provisions.” But as we ex-

plained in our opening brief (pp. 5-6, 39-40), Section 805(b)

defines a company’s earnings rate as the company’s investment

yield divided by its assets. Apart from the adjustments referred

to above in the text, the Phase I formula can therefore be ex-

pressed mathematically in terms of the following equations:

Earnings Rate X Reserves= Exclusion (Section 805(a) )

Investment Yield

Assets

This equation can be restated mathematically in the following

terms:

x Reserves= Exclusion (Section 805(b) )

Reserves

Assets

Thus, contrary to respondent’s argument (Br. 30-33), the statute

itself prescribes the proportionate relationship between “reserves”

and “assets.”

xX Investment Yield= Exclusion

14

we pointed out in our opening brief (pp. 5-6, nn. 5, 6),

both the earnings rate and the amount of reserves

used in the Phase I formula are subject to adjust-

ment in the final determination of the amount of the

annual exclusion. But while these adjustments make

the computation more detailed, they do not alter the

essential proportional relationship between assets and

reserves that is at the heart of the Phase I formula.

The purpose of these adjustments supports rather

than detracts from, our position that reserves and

assets should be computed on a consistent basis. As we

have noted in our opening brief (pp. 23-24, 39-40),

the Phase I formula was established by Congress in

order to divide a company’s investment income be-

tween the company and its policyholders in accord-

ance with the company’s actual earnings experience,

instead of on the basis of assumed rates of interest

used by individual companies or an industry-wide

ratio as was the case under prior law. See 8. Rep. No.

291, 86th Cong., Ist Sess. 5, 15-16 (1959). Thus,

the life insurance industry itself recommended the ad-

justment pursuant to which an average earnings rate

over a period of years (Section 805(b)) would be

used in the Phase I formula.” As a result, the impact

* See, ¢.¢., Hearings on H.R. 4245 (Tax Formula for Life In-

surance Companies) before the Senate Committee on Finance,

86th Cong., Ist Sess., pp. 67-68 (statement of Deane C. Davis),

149-150, 165, 175-178 (statement of Richard C. Guest), 252, 259-

260 (statement of Henry S. Beers) (1959). A list of the various

industry proponents of the Phase I formula was included in a

pamphlet prepared by the Staff of the Joint Committee on In-

ternal Revenue Taxation at the time the 1959 Act was con-

15

of disproportionately high or low earnings in any one

year is minimized and the formula provides a more

realistic method for determining what proportion of

a company’s total investment income 29) wena at-"

tributable to the company’s policyholder ‘reserves and

what part represents earnings on the company’s own

surplus. See S. Rep. No. 291, supra, at 5, 15-16; 105

Cong. Rec. 8428-8429 (1959) (remarks of Senator

Curtis). See also H.R. Rep. No. 34, 86th Cong., Ist

Sess. 10 (1959).

Under the Menge Formula of Section 805(¢)(1), a

company’s life insurance reserves are adjusted to take

into account any difference between the company’s

actual earnings experience and the assumed rate of

interest that was used by the company in originally

establishing its reserves (see our opening brief, p. 39,

n. 29). The formula, which was based on ‘‘industry

experience,” is designed to “restate” the company’s

reserves as if the company’s actual earnings rate had

been applied as the assumed rate from the outset.

S. Rep. No. 291, supra, at 15-16. Thus, the formula

provides that a company’s reserves are to be re-

duced 10 percent for each percentage point by which

the company’s average earnings rate (“adjusted re-

serves rate’’) exceeds the assumcd rate of interest

used by the company in initially setting up its re-

serves. Conversely, if a company’s assumed rate of

interest exceeds its adjusted earnings rate, the

sidered. See Summary of Recommendations Made in The Hearings

on the Taxation of Life Insurance Companies before the Senate

Committee on Finance, 86th Cong., Ist Sess. (April 8, 1959),

16

company’s reserves will be increased by 10 percent

for each percentage point by which the company’s

assumed earnings rate exceeds its actual earnings

rate. H.R. Rep. No. 34, supra, at.11; S. Rep. No.

291, supra, at 15-16. See McGill, supra, at 915-916,

n. 6. See also Hearings on H.R. 4245 (Tax Formula

for Life Insurance Companies) before the Senate

Committee on Finance, 86th Cong., 1st Sess., pp. 175-

176 (statement of Richard C. Guest) (1959).

Thus, contrary to respondent’s argument (Br. 31-

32), the Menge Formula does not refute the existence

of a proportional relationship between reserves and

assets. Instead, it is intended to eliminate any “dis-

eretionary actuarial assumptions” in computing re-

serves and thereby yield a more realistic allocation of

earnings between the company and its policyholders.

See Hearings on H.R. 4245 (Tax Formula for Life

Insurance Companies), supra, at 149, 169, 175-178

(statement of Richard C. Guest); S. Rep. No. 291,

supra, at 5, 15-16. As one industry spokesman who

testified in favor of the Menge Formula explained, it

was designed to establish a “standardized reserve”

that would serve as a more realistic basis for deter-

mining the exact “proportion” of a company’s total

investment income that is attributable to its reserve

requirements. Hearings on H.R. 4245 (Tax Formula

for Life Insurance Companies, supra, at 165, 175-178."

* Respondent also suggests (Br. 32, n. 40) that if the com-

pany’s actual earnings rate exceeds its assumed rate by sub-

hee —

17

3. Finally, respondent (Br. 26-28) and the amicus

ACLI (Br. 22-23, n. 30) argue that deferred and un-

collected premiums are not includable in a company’s

‘tassets” under Section 805(b)(4) because they are

not investment-type assets. They urge that the term

“assets’’ in Section 805(b)(4) should be limited to

invested assets because the Phase I computation is

geared to determining a company’s actual earnings

rate.

But Section 805(b)(4) makes no distinction be-

tween investment and noninvestment assets. It refers

to “all assets of the company” with the exception of

certain assets (excluding money) used in carrying on

the company’s insurance business. Indeed, the fact

that the statute includes “nonadmitted assets,” a term

the life insurance industry uses to refer to various

assets that cannot be considered in determining a

company’s solvency, such as debit balances due

stantially more than five percentage points, the Menge Formula

may begin to overcompensate for the disparity. Indeed, if the

actual earnings rate is more than 10 percentage points greater

than the assumed rate, the adjustment required by Section

805(c) (1) would eliminate the tax exclusion altogether. Congress,

of course, did not contemplate such a disparity between a com-

pany’s actual earnings rate and the assumed rate at which it cred-

its investment income to its policyholders, and respondent has

suggested no reason to doubt the effectiveness of the Menge for-

mula in determining realistic reserve requirements in more normal

ranges of experience. In fact, Congress anticipated that com-

petitive pressures in the life insurance industry would prevent

any unrealistic disparity between a company’s actual and assumed

earnings rates, and that the Menge Formula would properly

operate within a normal range. See S. Rep. No. 291, supra, at 5.

18

from agents,” demonstrates that noninvestment assets

are within the statutory definition of “asset.” As

the Fourth Circuit stated in Jefferson Standard Life

Insurance Co. v. United States, 408 F. 2d 842, 858,

certiorari denied, 396 U.S. 828, ‘‘the Phase I compu-

tation is not restricted to invested assets, but encom-

passes the total assets of a life insurance company and —

the portion thereof devoted to policy reerves” (footnote

10See American Institute of Certified Public Accountants,

Audits of Stock Life Insurance Companies 41-42 (1972) ; Noback,

Life Insurance Accounting 94 (1969).

11 Section 805(b) (4) provides that the only exclusion from its

definition of “asset” is “real and personal property (excluding

money) used by * * * [a company] in carrying on an insurance

trade or business.” The exclusion covers office buildings, furuiture

and fixtures. See Treasury Regulations, Section 1.805-4(a).

Respondent also suggests (Br. 27, 37, n. 46) that deferred and

uncollected premiums might be excluded from a company’s

“assets” on the grounds that these premiums are a “notional

asset * * * used in the conduct of the insurance business” (Br. 27).

But the argument proves too much. As the court observed in

Jefferson Standard Life Insurance Co. v. United States, supra, 408

F. 2d at 858-859, the exclusion in Section 805(b) (4) for “real and

personal property (excluding money) used * * * in carrying on

an insurance trade or business” must be limited to a company?

home office and branch office building, furniture and equipment. A

of the assets of a company engaged in the life insurance business

are presumably related to the conduct of that business, Thus, if

assets such as deferred and uncollected premiums are treated as

property used in the trade or business of carrying on an insurance

underwriting operation, Section 805(b) (4) would be “rendered

meaningless because the exceptions would be construed so broadly

as to include literally all assets, so that nothing would be left.” 408

F. 2d at 858. See also, Bankers Union Life Insurance Co. vy. Com-

missioner, 62 T.C. 661, 676.

ED SU ne

19

omitted; emphasis supplied). See also H.R. Rep. No.

34, supra, at 10, 12 n. 1.”

III

A LIFE INSURANCE COMPANY IS NOT ENTITLED TO A DE-

DUCTION OR OFFSET FOR THE “LOADING” PORTION OF

ITS DEFERRED AND UNCOLLECTED PREMIUMS IN COM-

PUTING ITS ‘‘ASSETS” AND “GROSS AMOUNT OF

PREMIUMS”

1. We come now to the position of the amicus Amer-

ican Council of Life Insurance. Contrary to the result

the court of appeals reached, the amicus acknowledges

that some part of a life insurance company’s deferred

and uncollected premiums is includable in “assets”

and “gross amount of premiums.’’ However, ACLI

contends (Br. 21-32) that a life insurance company

is required to include only the net valuation portion of

deferred and uncollected premiums in “assets’’ and

“oross amount of premiums.” Thus, under the ACLI

#2 Respondent further contends (Br. 28-29, n. 38) that even if

the deferred and uncollected premiums are includable in a com-

pany’s assets under Section 805(b) (4), these premiums should

be taken into account at an adjusted basis of zero. But the ad-

justed basis of an item that is received by a taxpayer as part of its

taxable income is determined by the amount that the taxpayer is

required to use in reporting the item of income in question. Thus,

if a life insurance company is required to include its deferred and

uncollected premiums as part of its “gross amount of premiums”

under Section 809(c) (1), as we submit, the adjusted basis of these

premiums for purposes of Section 805(b) (4) would be equal to the

amount taken into income under 1} j,ase II.

20

approach, a company could claim a deduction or off-

set for the “loading’”’ portion of the deferred and un-

collected premiums, 1.e., the difference between the

gross premium paid by the policyholder and the net

valuation premium.”

There is, however, no statutory or rational basis for

a deduction or offset for loading from either “assets’’

or “gross amount of premiums” (see our opening

brief, pp. 47-48, 54). In support of such a deduction,

the amicus relies (Br. 23-25) upon the annual state-

ment form approved by the National Association of

Insurance Commissioners and used by the insur-

ance departments of most states. Pursuant to the

NAIC form, an insurance company offsets the over-

statement of its reserves in the amount of the net

valuation portion of the deferred and uncollected pre-

miums by creating an asset equal in amount called

“Life insurance premiums and annuity considerations

deferred and uncollected” (see, e.g., Ex. E, A. 60-61).

But as we have pointed out in greater detail in

our opening brief (pp. 34-37, 46-48), the inclusion of

the net valuation premium on the assets side of the

NAIC form arises from the need to establish a

‘‘quasi-asset” to offset the overstatement of the re-

serves and balance the accounts. Thus, the NAIC

method does not clearly reflect income of a life insur-

ance company; it simply provides for corrective ad-

justments to compensate for the historical practice

*® Detailed definitions of the terms “loading” and “net valua-

tion premium” are set forth at pp. 8-9 of our opening brief.

21

of computing reserves on the assumption of full pre-

mium receipt. Wightman, supra, at 43-44. See also

id. at 155, 545; MacLean, supra, at 318-319. Ernst &

Ernst, supra, at 449-450; Beardsley, supra, at IITT-15.

What then is the proper impact of the premium re-

ceipt assumption upon the “assets’”’ and “gross amount

of premiums” computations? For purposes of com-

puting its reserves, respondent used the financial re-

porting assumption that the annual premiums had

been paid in full as of the anniversary dates of each

of its policies. It thereupon increased its reserves by

the net valuation portion of those premiums—the ac-

tuarial amount to be set aside to meet future death

claims.

But the assumption underlying the reserve computa-

tion was that the policyholders paid their premiums

in full and not some lesser amount. Respondent (Br.

3, 24 n. 30, 37 n. 45) and the amicus ACLI (Br. 5-6,

11, 30) err in suggesting that the “only assumption

* * * is that the net valuation portion of [the] de-

ferred and uncollected premiums has been received by

year-end” (Resp. Br. 24, n. 30). The parties stipulated

(A. 17) and the Tax Court found (Pet. App. A 3a)

that the assumption is that the gross annual premium,

including the gross amount of all deferred and uncol-

lected installments, is paid in advance on the anniver-

sary date of each policy. Thus, a consistent applica-

* Indeed, respondent and ACLI acknowledge elsewhere (Resp.

Br. 15, 40; ACLI Br. 6) that the assumption used in computing

the reserve is that the policyholder paid the gross annual

premium.

22

tion of the premium receipt assumption requires that

the gross amount of the premium be taken into ac-

count in ‘‘assets” and “gross amount of premiums.”

Treasury Regulations, Sections 1.805-5(a) and 1.809-

4(a). Simply put, policyholders pay gross premiums

and not the net valuation portion of their premiums.

As the Fifth Cireuit stated in Western National Life

Insurance Co. of Texas v. Commissioner, 432 F. 2d

298, 301, “[t]here would be no percentage to be trans-

ferred to reserves if the entire deferred and uncol-

lected premiums were not accrued.”’

2. There is no support for the amicus ACLI’s con-

tention (Br. 26-29) that Congress intended the NAIC

annual statement form to govern the tax computations

under the 1959 Act. As we have pointed out in our

opening brief (pp. 48-50), Section 818(a) provides

that life insurance companies must make all tax

computations under an accrual method of accounting.

Although the statute also refers to the NAIC annual

statement, the pertinent committee reports show that

Congress intended that the NAIC method would come

into play only when “not inconsistent with the provi-

sion of the 1954 Code and an accrual method of ac-

counting.” H.R. Rep. No. 34, supra, at 42; S. Rep. No.

291, supra, at 72-73.

The insurance texts uniformly recognize that the

corrective adjustments made on the NAIC annual

statements are not consistent either with accrual ac-

counting or with the premium receipt assumption

used in the computation of reserves. See Wightman,

supra, at 43-46; Ernst & Ernst, supra, at 449-450.

23

See also Beardsley, supra, at [1I-15, MacLean, supra,

at 318-319. Indeed, the life insurance industry’s own

Joint Committee on Blanks of the American Life

Convention and Life Insurance Association of Amer-

ica concluded that “the basic objectives of the annual

statement and of the tax return are so different in

concept as to preclude revision of the annual state-

ment blank solely to conform to tax accounting con-

cepts.” II Proceedings of the National Association of

Insurance Commissioners 445-446 (1963). Thus, the

four courts of appeals that have considered the in-

dustry’s claim have all properly rejected the argu-

ment that the NAIC annual statement employs an

accrual method of accounting with respect to de-

#® Contrary to the amicus ACLI’s further argument (Br. 27), the

fact that state insurance regulation employs the NAIC financial

reporting method does not require that it be used for federal tax

purposes. As we have pointed out in our opening brief (pp. 36-

37), the goal of the various adjustments on the NAIC form is to

permit the assumption of full premium payment without distort-

ing the report of the company’s solvency on its annual report.

However, the federal tax statute requires an accrual method of

accounting. To the extent that there are differences, the NAIC

form must yield to the tax accrual rules prescribed by Congress.

As one text has stated (Denney, Rua & Schoen, Federal Income

Taxation of Insurance Companies 9.3 (2d ed. 1966) ) :

“There are several areas where differences exist between the

accrual basis used for the annual statement and the general rules

of accrual for tax purposes. The insurance business has long been

held to be one in which the public interest is of great importance

‘and regulatory laws have been established primarily for the pur-

pose of protecting the policyholder. Consequently, the emphasis

of the annual statement has been on the solvency of the company.

Such emphasis leads to provisions for contingencies for the pur-

poses of the annual statement which are at variance with tax

accrual rules which have been developed throughout the years.”

24

ferred and uncollected premiums. See Franklin Life

Insurance Co. v. United States, 399 F. 2d 757, 760

(C.A. 7), certiorari denied, 393 U.S. 1118; Jefferson

Standard Life Insurance Co. v. United States, supra,

408 F’. 2d at 849-850, 855-856; Western National Life

Insurance Co. of Texas v. Commissioner, supra, 432

¥, 2d at 301; Western and Southern Life Insurance

Co. v. Commissioner, 460 F. 2d 8, 12-13 (C.A. 6), cer-

tiorari denied, 409 U.S. 1063.

3. Moreover, both respondent (Br. 21) and the

amicus ACLI (Br. 29) argue that the failure to per-

mit a deduction or offset for loading will produce

the ‘‘anomalous” result that a company will have a

larger amount of income in a year if premiums are

deferred than it would if they weré in fact received.

In so arguing, respondent and the amicus assume

that the loading element is comprised entirely of

deductible expenses. Thus, in support of a deduction

for loading, respondent and the amicus rely upon a

line of decisions permitting a deduction only for

Phase II purposes for unpaid and unaccrued agents’

commissions and state premium taxes that would

become payable upon the receipt of the deferred and

uncollected premiums. See Great Commonwealth Life

Insurance Co. v. United States, 491 F. 2d 109, 113-

116 (C.A. 5); Federal Life Insurance Co. v. United

States, 527 F. 2d 1096 (C.A. 7); North American

Life & Cas. Co. v. Commissioner, 533 F. 2d 1946 (C.A.

8); United Life & Accident Insurance Co. v. United

States, 329 F. Supp. 765 (D. N.f1.); Midland Na-

25

tional Life Ins. Co. v. Commissioner, 66 T.C. 550,

563-566," on appeal (C.A. 8).

But these decisions are not authority for the de-

duction of the undifferentiated loading element of

the deferred and uncollected premiums sought by the

life insurance industry. They rest upon the narrow

rationale that state premium taxes and agents’ com-

missions that are readily attributable to deferred and

uncollected premiums are deductible only for pur-

poses of the Phase IT income computation under

Section 809(d)(12) (now Section 809(d)(11)), which

permits a deduction for “all other deductions allowed

under this subtitle for purposes of computing tax-

able income to the extent not allowed as deductions

in computing investment yield.”

However, contrary to respondent’s and the amicus’

assumption, loading is not a deductible expense but is

simply the difference between the gross premium and

the net valuation portion designated as actuarially

required to be set aside to meet future claims. Thus,

loading is not an expense item but an income item

analogous to the margin of gross profit built into the

selling price for goods and services. As the Seventh

Circuit observed in Federal Life Insurance Co. v.

United States, supra, 527 F. 2d at 1098, “ ‘loading’ as

a unit * * * [is] a concept not mentioned in the

1° There is no provision under Phase I for reducing a company’s

total assets by the amount of any liabilities, whether accrued or

unaccrued. See Republic National Life Insurance Co. v. United

States, 77-1 U.S.T.C, § 9133, decided December 9, 1976 (N.D.

Tex.).

26

statute * * * [and] [i]t seems quite proper that not

all portions of loauing should be allowed as a deduc-

tion; loading includes elements of profit which will

never be deductible and elements of anticipated ex-

pense subject to various contingencies which may or

may not ever occur * * *.”

Accordingly, there is no statutory or judicial

authority in support of the industry’s and respond-

ent’s alternative claimed deduction (see A. 5) of the

loading element from “assets”? and “gross amount of

premiums.” *’

4. Finally, the anomalous results the ACLI (Br. 29)

and the respondent (Br. 38) suggest would occur un-

less the loading portion of deferred and uncollected

premiums is excluded from both the ‘‘gross amount

of premiums” under Section 809(¢)(1) and ‘“‘assets”

under Section 805(b)(4) are, in large part, attribut-

able to the fact that respondent and other life insur-

ance companies compute their reserves on the assump-

tion that deferred and uncollected premiums have

been paid, and not to the Commissioner’s requirement

that deferred and uncollected premiums, if taken into

account for the purpose of computing reserves, must

be consistently accrued for all purposes under the 1959

Act.

Once the premium receipt assumption and the result-

ing overstatement of reserves are accepted for tax

7 Since respondent did not raise the issue of the deductibility

of state premium taxes and agents’ commissions in the courts

below, thee is no occasion for this Court to address the additional

question presented by the amicus Lincoln National Life Insurance

Company as to the correctness of the decisions that have thus far

uniformly permitted a deduction for those items.

27

purposes, there will always be differences in tax treat-

ment arising from variations in the amount of annual

premiums which a company actually has received and

the amount of premiums which it assumes that it has

received. The only way to eliminate all such dispari-

ties and achieve true tax neutrality between companies

that collect all of the premiums taken into account in

computing reserves, and those companies that take sub-

stantial amounts of deferred and uncollected premi-

ums into account and thereby overstate their reserves,

would be to exclude the net valuation portion of

deferred and uncollected premiums from the reserves

in accordance with Section 1.801-4(f) of the Regula-

tions. Indeed, the courts have properly characterized

this approach as both “simpler”? and “far more

accurate’ (Franklin Life Insurance Co. v. United

States, supra, 399 F. 2d at 761; Great Commonwealth

Life Insurance Co. v. United States, supra, 491 F. 2d at

116). Respondent and the life insurance industry can

therefore hardly complain of the Treasury’s willingness

to accept the distortions inherent in the in dustry’s over-

statement, of reserves on the condition that the gross

premium receipt assumption be likewise applied with

respect to “assets” and “gross amount of premiums.”

‘‘ Alternatives,” 01 course, will always be available,

here, as elsewhere under the Code. United States v.

Correll, 389 U.S. 299, 306. But it is the function of the

Regulations, in the first instance, to choose among

such alternatives. As this Court has repeatedly empha-

sized, ‘‘[t]he role of the judiciary * * * begins and

ends with assuring that the Commissioner’s regula-

28

tions fall within. his authority to implement the con-

gressional mandate in some reasonable manner.” Id.

at 307. Accord: Bingler v. Johnson, 394 U.S. 741, 749-

751; Commissioner v. South Texas Co., 333 U.S. 496, 501.

The Regulations resolve the deferred and uncollected

premium question in a manner that is both consistent

with the structure of the 1959 Act and in accord with

basic accounting logic. Possible alternative ap-

proaches notwithstanding, these Regulations repre-

sent a “reasonable and valid exercise of the [Commis-

isoner’s] rule-making power” (Commissioner v.

Wheeler, 324 U.S. 542, 546), and should therefore be

sustained.

CONCLUSION

For the reasons stated above and in our opening

brief, the judgment of the court of appeals should be

reversed.

Respectfully submitted.

DaniEL M. FRIEDMAN,

Acting Solicitor General.

Myron C. Baum,

Acting Assistant Attorney General.

Stuart A. SMITH,

Assistant to the Solicitor General.

Gary R. ALLEN,

STEPHEN M. GELBER,

Attorneys.

JEANNE L. DoBREs,

Attorney,

Internal Revenue Service.

Marcu 1977.

U.S. GOVERNMENT PRINTING OFFICE: 1977