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

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petitioners Reply Brief
- **Published:** January 1, 1977
- **Citation:** 433 U.S. 148

## Text

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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385004_0058%3A06. Public record. Not legal advice.