AMOUNTS ADDED TO LIFE INSURANCE COMPANY'S TERMINAL RESERVES DO NOT CONSTITUTE RESERVE FOR UNEARNED PREMIUMS; REVALUATION DENIED.

UIL Number(s) 0818.03-00

                                             Date: July 29, 1987

ISSUE

1) Whether a life insurance company that computes certain reserves for decreasing term life insurance contracts using a recognized preliminary term basis and elects to revalue such reserves under the approximate revaluation method may revalue under section 818(c)(2)(B) of the Internal Revenue Code, the "additional amounts" added to the reserves to meet state minimum reserve requirements.

2) Whether the "additional amounts" constitute a reserve for unearned premiums.

FACTS

The Company is a life insurance company subject to tax under section 802 of the Code. A portion of the Company's life insurance business is derived from the sale of decreasing term life insurance policies written on an individual basis. Decreasing term life insurance, as the term suggests, provides for insurance protection that decreases over the term of the policy. For example, such a policy might be written for a term of twenty years and pay $20,000 in death benefits if the policyholder were to die in the first policy year; however, the policy might only pay $15,000 if the policyholder were to die in the 6th policy year. The premiums charged for this coverage remain constant in each of the policy years. The Company issues decreasing term life insurance policies with respect to which the life insurance reserves are claimed to be computed on a recognized preliminary term basis.

At the issuance of the decreasing term policies, the present value of future net premiums equals the present value of future benefits. The basic reserve valuation formula, known as the prospective definition of reserves, involves an equation, one side of which represents the present value of future benefits promised under the contract and the other the present value of the sum of money required to provide the benefits. The reserve may be defined, prospectively, as the difference, at any point in time, between the present value of future benefits and the present value of future net premiums. Another way of looking at the reserve is the retrospective view, under which the reserve is considered as the difference between the accumulation at interest and survivorship of the net premiums received in the past and the accumulation at interest and survivorship of the claims paid. With the same mortality table and the same assumed interest rate, the reserve figure, using either the retrospective or prospective method, is identical. Huebner and Black, Life Insurance, 382-383 (8th ed. 1972).

In order to facilitate the computation of the life insurance reserves for the Company's decreasing term policies as of December 31, the date of its annual statement, it is assumed that policy anniversaries are uniformly distributed throughout the year. This is equivalent, on the average, to the assumption that all policies are issued on July 1. Accordingly, the appropriate formula mean reserve, that is, the midpoint between the initial and the terminal reserve, is determined for each policy in force. The sum of the mean reserves of all policies in force represents the aggregate life insurance reserve liability of the Company which appears on its annual statement and is used to determine life insurance taxable income.

The formula mean reserve for each policy in force equals one half of the net valuation premium plus the average of the terminal reserves for the preceding and current policy years.

Formula mean reserve = (Terminal reserve (Preceding year) + Net valuation premium + Terminal reserve (current year) / 2

The terminal reserves or the Company's decreasing term policies may be either positive or negative. Negative terminal reserves actuarially mean that at the end of the policy year the present value of future net premiums will exceed the present value of future benefits.

When negative terminal reserves are calculated, the Company is required by certain state insurance departments to hold a reserve of 50 percent of the net valuation premium. Accordingly, the reserves under the Company's decreasing term policies are computed as the greater or (i) the formula mean reserves at the valuation date, or (ii) one half of the net valuation premium for the year. To accomplish this result with negative terminal reserves, the company increases to zero the sum of the preceding year's terminal reserve plus the current year's terminal reserve. Put another way, the Company brings negative mid-terminal reserves (the average of the current year's and preceding year's terminal reserves) up to zero. Conceptually, "additional amounts" can be seen as being added to the reserves to meet minimum state law reserve requirements. For example, the preceding year's terminal reserve of $30 plus net valuation premium of $100 and the current year's negative terminal reserve of (45) would produce a formula mean reserve of 42.5.

(30 + 100 - 45) / 2 = 42.5

In order to meet the minimum state law reserve requirements, the Company increases to zero the sum of the preceding year's terminal reserve plus the current year's terminal reserve as follows.

(30 + 100 - 30) / 2 = 50

In this example, the "additional amount" added to the reserves pursuant to state law equals 7.5; the difference between the formula mean reserve of 42.5 and the minimum state law reserve of 50.

APPLICABLE LAW

Section 801(b) of the Code provides that the term "life insurance reserves" means amounts --

(A) which are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and

(B) which are set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable health and accident insurance contracts (including life insurance or annuity contracts combined with noncancellable health and accident insurance) involving, at the time with respect to which the reserve is computed, life, health, or accident contingencies.

Section 810(c) of the Code describes the items which are taken into account when determining the net increase or net decrease in reserves. Among the items enumerated in section 810(c)(2) are unearned premiums and unpaid losses included in total reserves under section 801(c)(2).

Section 1.801-3(e) of the Income Tax Regulations provides that the term "unearned premiums" includes those amounts which shall cover the cost of carrying the insurance risk for the period for which the premiums have been paid in advance. Such term includes all unearned premiums, whether or not required by law.

Section 818(c) of the Code provides, in part, that for purposes of Part I of subchapter L (other than section 801), at the election of the taxpayer the amount taken into account as life insurance reserves with respect to contracts for which such reserves are computed on a preliminary term basis may be determined on either of the following basis:

(1) EXACT REVALUATION -- As if the reserves for all such contracts had been computed on a net level premium basis (using the same mortality assumptions and interest rates for both the preliminary term basis and the net level premium basis).

(2) APPROXIMATE REVALUATION -- The amount computed without regard to this subsection --

(A) increased by $19 per $1,000 of insurance in force (other than term insurance) under such contracts, less 1.9 percent of reserves under such contracts, and

(B) increased by $5 per $1,000 of term insurance in force under such contracts which at the time of issuance cover a period of more than 15 years, less 0.5 percent of reserves under such contracts.

Section 1.818-4(a) of the regulations provides, in part, that the reserves a life insurance company may elect to revalue are those computed on one of the recognized preliminary term bases.

In Rev. Rul. 75-51, 1975-1 C.B. 190, a life insurance company elected to revalue its reserves for decreasing term life insurance contracts under the approximate revaluation method pursuant to section 818(c)(2)(B) of the Code. The mean of the reserves held for the taxable year 1973 computed under the preliminary term basis formula was 2x dollars. The amount added to such reserves to meet minimum state law reserve requirements for the taxable year 1973 was 13x dollars. The question posited by the ruling was whether the amount of reserves to be revalued under the approximate method was the amount arrived at using the recognized preliminary term basis formula (2x dollars) or the amount of reserves actually held by the company on its decreasing term life insurance contracts at the time of revaluation pursuant to state law (15x dollars). The ruling held that the portion of the reserves consisting of the "additional amount" that was required to be added to the reserves by the state insurance departments (13x dollars) may not be revalued under section 818(c)(2)(B). Reserves that have been arbitrarily increased in order to meet the minimum reserve requirements of state law are not reserves computed on a preliminary term basis.

In Rev. Rul. 67-435, 1967-2 C.B. 232, a life insurance company was required by state statute to maintain an additional reserve computed on the basis of a fixed percentage of its life insurance reserves which were calculated on the basis of recognized mortality or morbidity tables and assumed rates of interest. The statute provided that the aggregate of the additional reserve could not exceed five percent of the recognized life insurance reserves, except in the case of term insurance the aggregate could not at the end of any year exceed 50 percent of the premiums of that year. The additional reserve would be used only on the contingency of the gross mortality losses for any year being in excess of 105 percent of the average losses during the preceding 5 years or on the contingency of depreciation and losses on assets owned by the company being in excess of 10 percent of its surplus at the end of the preceding year.

Rev. Rul. 67-435 held that the additional reserves were not life insurance reserves within the meaning of section 801(b) of the Code because they were not computed on the basis of recognized mortality or morbidity tables or assumed rates of interest. Moreover, since the additional reserve could be used only if a contingency occurred, the reserve was not set aside to mature or liquidate future unaccrued claims. The ruling concluded that abnormal mortality, depreciation, and losses on assets owned by the company were purely speculative. The prospect of such speculative losses would, in all likelihood, be a solvency concern of the states in which the company does business which would have no bearing on life insurance company taxable income. In the event that abnormal excessive claims do materialize, any difference between what was provided for on the basis of recognized mortality and morbidity tables and assumed rates of interest for the normal claims and the actual claims would be made up out of the surplus of the company.

In Rev. Rul. 69-302, 1969-1 C.B. 186, an insurance company which reinsured credit life insurance contracts computed its reserves for such policies under a method in which gross premiums were earned ratably as the period of risk expired. The method used was one commonly applicable in determining the pro rata earned and unearned portions of the gross premiums written for casualty insurance contracts. The ruling held that the method used was not an actuarial computation or estimation of a reserve on the basis of recognized mortality tables and assumed rates of interest. Accordingly, the reserves maintained by the insurance company for the credit life contracts it had reinsured did not qualify as life insurance reserves under section 801(b) of the Code.

RATIONALE

The issue in this technical advice revolves around the characterization of the "additional amounts" added to the Company's life insurance reserves pursuant to state law. Section 818(c) of the Code specifically applies to life insurance reserves with respect to contracts for which the reserves are computed on a preliminary term basis. Therefore, in order to be eligible for revaluation under section 818(c), it is required that the "additional amounts" constitute life insurance reserves within the meaning of section 801(b) of the Code.

The Company contends that the state minimum reserve requirement of one-half of the net valuation premium is an amount which is computed on the basis of a recognized mortality table and an assumed rate of interest under a recognized preliminary term method of computing reserves. In all such instances this reserve as so computed would be held to mature or liquidate future unaccrued claims arising from the life insurance contracts involved and would be required by law. Such reserves, arguably, satisfy the requirements for "life insurance reserves" under section 801(b) of the Code.

For the reasons developed below, we have concluded that the "additional amounts" do not constitute life insurance reserves under section 801(b) of the Code and are ineligible for revaluation under section 818(c).

Firstly, it is undisputed that the net valuation premiums for the Company's decreasing term policies are computed on the basis of recognized mortality tables and assumed rates of interest, this fact does not support the conclusion that one-half of the net valuation premium constitutes the life insurance reserves. The net valuation premium is not the only component which must be taken into account in the calculation of the formula mean reserve. The formula mean reserve for each policy in force equals the mean of the terminal reserves for the preceding and current policy years, plus one half of the net valuation premium. Fifty percent of the net valuation premium would generally not equal the difference between the present value of future benefits and the present value of future net premiums for all policy durations. Assuming a net valuation premium of 100, the formula mean reserve for the first year of a policy valued on the full preliminary term method would equal 50.

0 + 100 + 0 / 2 = 50

For the first policy year the Company's position is correct, in that one-half of the net valuation premium constitutes the life insurance reserve. This is due to the fact that there is no first-year terminal reserve under the full preliminary term method. However, for subsequent policy years, the existence of negative or positive terminal reserves will not produce a formula mean reserve equal to one-half the net premium. Contrary to the Company's contention, negative and positive terminal reserves must be reflected in the formula mean reserves to constitute life insurance reserves computed on the basis of recognized mortality tables and assumed rates of interest under section 810(b) of the Code. Accordingly, the "additional amounts" do not constitute life insurance reserves and are analogous to solvency reserves. See Rev. Rul. 67-435 and Rev. Rul. 69-302.

Secondly, these amounts are not set aside to mature or liquidate future unaccrued claims. At those policy durations where a strictly actuarial computation produces a terminal reserve of zero, or a negative amount, the future premiums payable will be sufficient to provide for the taxpayer's future obligations on the policies and to cover any negative reserves. State insurance departments usually do not permit negative reserves to be shown on the annual statement. Some state insurance departments, instead, require a minimum reserve of 50 percent of the net valuation premium for policies with negative mid-terminal reserves. The "additional amounts" added to reserves by this state requirement produce reserves that do not qualify as life insurance reserves within the meaning of sections 801(b) or 818(c) of the Code. Any such amount added arbitrarily or solely to fulfill a state solvency requirement would fail to qualify as a life insurance reserve for federal income tax purposes.

Thirdly, Rev. Rul. 75-51 specifically held that the "additional amount" required to be added to the company's decreasing term reserves do not qualify for revaluation under section 818(c). Implicit in this holding is that the "additional amounts" do not constitute life insurance reserves under section 801(b). Therefore, the "additional amounts" are not life insurance reserves computed on the preliminary term basis within the meaning of section 818(c) of the Code.

Decreasing term policies with level gross premiums usually develop negative reserves for a taxable year in which a valid election under section 818(c)(2) is in effect, that negative reserve should be increased in accordance with the provisions of 818(c)(2)(B). If the reserve so revalued is still negative, then the resulting negative reserve should be raised to zero. If the reserve so revalued is positive, then that resulting positive reserve may be used for purposes of part I of subchapter L of the Code (other than section 801). Only term policies which at the time of issuance cover a period of more than 15 years are eligible for the approximate revaluation method described in section 818(c)(2)(B).

ISSUE 2

The taxpayer contends that if the "additional amounts" are not life insurance reserves, they must be treated as unearned premiums under section 810(c)(2) of the Code. We do not agree. Unearned premiums have a precise meaning. They are those amounts which cover the cost of carrying the insurance risk for the period for which the premium has been paid in advance. Like life insurance reserves, they, too, are maintained for the purpose of maturing and liquidating, either by payment as they are earned or by reinsurance with other companies, future unaccrued and contingent claims arising under the contract. See section 1.801-3(e) of the regulations. See also Colonial Surety Co. v. United States, 178 F. Supp. 600, 602 (1959); Continental Assurance Co., Inc. v. United States, 8 F.Supp. 474 (1934) Commissioner v. Monarch Life Insurance Co., 114 F.2d 314 (1940). In this case, the "additional amounts" do not qualify as unearned premiums for the same reason they do not qualify as life insurance reserves, i.e., these amounts are not set aside to mature or liquidate future unaccrued claims and are analogous to solvency reserves.

In addition, the formula mean reserve can be viewed as composed of an "unearned premium element" (50% of the net valuation premium) and a "mid-terminal reserve element" (the average of the terminal reserves for the preceding and current years). See E.C. Wightman, Life Insurance Statements and Accounts, 567 (1952, reprinted August 1962), which describes the reserve for a net level term policy as a combination of the unearned premium for the current policy year and the interpolated amount of the accumulated fund required to equalize the annual premiums under the respective policy. Accordingly, we reject the Company's contention that it be allowed an unearned premium reserve deduction equal to 50% of the net valuation premium when, in fact, this element is already reflected in the formula mean reserve.

It is not a relevant distinction that for decreasing term policies the mid-terminal reserve element may produce a negative value (because in past years the cost of insurance based on the net amount at risk was greater than the net premiums and tabular interest) which reduces the unearned premium element to an amount less than 50 percent of the net valuation premium. The unearned premium element is still reflected in the formula mean reserve which shows the difference between the present value of premiums and the present value of benefits. Furthermore, under the Company's position, an unearned premium reserve for decreasing term policies would not exist for all policy durations. Rather, such a reserve would exist only for those policy durations which generate a negative mid- terminal reserve element. Unearned premium reserves are typically written in the casualty insurance area where gross premiums written are earned ratably as the period of risk expires. Wightman, supra, p. 563-564. Implicit in the nature of such reserves are that they are taken into account for all policy durations and not for selected policy durations as the Company contends. This inconsistent treatment of the unearned premium element serves as a further admission that the unearned premium element is reflected in the formula mean reserve and not as a separate unearned premium reserve.

CONCLUSION

1. The "additional amounts" do not constitute life insurance reserves under section 801(b) of the Code and are ineligible for revaluation under section 818(c).

2. The "additional amounts" do not constitute a reserve for unearned premiums.

A copy of this technical advice memorandum is to be given to the taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.