LIFE INSURANCE COMPANY MAY NOT SPLIT INSURANCE RESERVE LIABILITY FOR FOREIGN CONTRACTS BETWEEN TABULAR RESERVES AND CASH SURRENDER VALUE.

UIL Number(s) 0801.01-02, 0801.02-00, 0818.03-00

                                             Date: August 30, 1989

ISSUES

1. Whether the reserves that Company posts to Exhibit 9 of its annual statement with respect to certain guaranteed renewable accident and health insurance policies issued through its foreign life insurance branch should be viewed, for federal income tax purposes, as comprising (a) reserves representing the aggregate cash surrender values of the policies, or (b) reserves divisible into two parts, including (i) tax year reserves calculated under a two-year full preliminary term method and (ii) additional reserves representing the excess of the aggregate cash surrender value of the policies over the two-year full preliminary term reserves.

2. Depending upon the characterization of the reserves in (1) above, do the reserves on the Y policies qualify as "life insurance reserves" within the meaning of section 801(b) of the Code?

3. Assuming that all or a portion of these reserves qualify as "life insurance reserves" under section 801(b) of the Code, is Company entitled to revalue any portion of the reserves to a net level premium basis under section 818(c)(1)?

FACTS ¹

Company is a stock life insurance company under the applicable state law that files its federal income tax returns on a calendar year basis as a life insurance company taxable under section 802 of the Code. Company is engaged primarily in the business of underwriting guaranteed renewable accident and health insurance policies which provide for hospitalization benefits and for other expenses attributable to z. Company writes policies providing this type of coverage both in the United States and in various foreign countries, primarily Y. Company's business in Y is conducted through a life insurance branch in that country. Company is required to report the operating results of the Y branch to the various state insurance departments that regulate its life and accident and health insurance business within the United States. In addition, the operating results of the Y branch are currently reflected in the determination of Company's federal taxable income.

During the years involved, the volume of Company's underwriting operations in Y grew substantially. As a result of this growth, the number of policies in force in Y and the reserve balances maintained with respect to those policies eclipsed the corresponding totals on similar policies issued within the United States. Thus, during the years involved, the active life reserves that Company calculated and held with respect to the Y policies comprised more than 50% of Company's total reserves as defined in section 801(c) of the Code.

The policies issued by Company in Y are guaranteed renewable accident and health insurance policies which provide benefits only in connection with the death or hospitalization of a covered insured as a result of contracting z. The coverage is provided in return for regular monthly or annual premiums which, regardless of the mode selected, are designed to remain level for the lifetime of the insured. The policy may be issued to either an individual or to a family. If the policy is issued to a family, the "insured" includes the "principal insured" and the "dependent insureds" -- namely, the principal insured's spouse and unmarried children under age 23. Once a policy has been issued, Company may not cancel the coverage except in instances of fraud, misrepresentation, or nonpayment of premiums. However, the policyholder may cancel the policy at any time. In addition, the policy automatically terminates upon the death of the insured or, in the case of a family policy, upon the death of all members of the insured family. In the event of a termination or cancellation of the policy for any reason other than fraud, the policyholder is entitled to receive the cash surrender value of the policy. This amount is computed actuarially based on the interpolated cash values as provided under the policy.

In calculating reserves on the Y policies, Company was subject to different legal reserving requirements depending upon the jurisdiction in which it filed its financial statements. When reporting to regulatory authorities in Y, Company was required to calculate and hold additional (active life) reserves reflecting its estimated liability to provide future hospitalization and death benefits under the policies. Company calculated these reserves applying mortality, morbidity, continuance, and interest factors that were acceptable to regulatory authorities in Y. These factors utilized statistics compiled within Y relating to the pattern of incidence, average period of hospitalization, and mortality rates of z to project future benefit costs for different classifications of insureds. The projected cost of future hospitalization and death benefits was then converted to a series of net level valuation premiums by application of an annuity table adjusted for z deaths only and using a 5 percent interest rate assumption (5 1/2 percent for policies issued after 1978).

Besides applying tabular reserve factors that were specific to conditions in Y in its reserve calculations, Company also used a modified reserve method, which Company refers to as the "Zillmer method", to calculate the active life reserves reported to regulatory authorities in Y. Under this reserve method, the otherwise net level premiums are adjusted during a period of modification by an "expense net premium". The practical effect of the method was to reduce, over a definite period of years, the net level premium reserve by the unamortized portion of an additional first year expense allowance that reflected a predetermined amount of Company's underlying policy issue costs. The amount of such reserve reduction decreased systematically over time until, at the end of the modification period, the "Zillmer" reserves were equal to the corresponding net level premium reserves.

In designing the nonforfeiture provisions of the Y policies, Company determined the guaranteed cash values of the policies using the same actuarial basis as used in calculating the active life reserves reported to regulatory authorities in Y, with certain modifications. Specifically, Company calculated the policies' cash surrender values by applying the same morbidity, mortality, continuance, and interest factors that it used in calculating the active life reserves reported to regulatory authorities in Y. The additional first-year expense allowance taken into account in deriving the policies' cash surrender values was also the same as that used in calculating the active life reserves. The cash surrender values were lower than the active life reserves, however, because in determining the cash surrender values Company amortized the additional first year expense allowance over ten years (versus five years for reserve valuation purposes) and because the cash surrender values during the first four policy years were subject to reduction by a surrender charge.

In determining the reserve practice that it would adopt for the Y policies on its NAIC annual statement filed for state regulatory purposes, Company contends that it relied upon the advice of its own actuarial staff as well as the advice of actuaries associated with its independent auditors. These actuaries advised Company that the tabular reserve factors and reserve method that had been used to determine the active life reserves for the Y policies reported to regulatory authorities in Y might not be acceptable under the reserving standards of the various states in which Company transacted business within the U.S. In general, the actuaries recommended that Company calculate its NAIC annual statement reserves for the Y policies using the same reserving method and tabular reserve factors for the Y policies as for similar policies issued within the U.S. With respect to guaranteed renewable accident and health insurance contracts issued within the U.S., Company calculated active life reserves using a two-year full preliminary term reserving method, a 3 1/2 percent interest assumption, a generally prescribed mortality table, and morbidity and continuance factors based on experience tables developed from Company's past claims experience. These reserves had been reviewed periodically by various state insurance department examiners, and had been found to satisfy NAIC and state reserving requirements.

Unlike Company's U.S. policies, however, the Y policies provided for guaranteed cash surrender values. These guaranteed cash surrender values, which were determined using the Y factors of mortality, morbidity, continuance, and interest, exceeded the reserves that would have been determined for the Y policies using a two-year full preliminary term method and comparable reserve factors and interest assumptions as for Company's U.S. policies. Therefore, the actuaries advised Company that it would be required to reflect annual statement reserves with respect to the Y policies at least equal to the policies' aggregate cash surrender values in order to satisfy minimum state law requirements. Thus, the reserves that Company actually reflected on Exhibit 9 of its NAIC annual statement with respect to the Y policies consisted of the policies' aggregate cash surrender values. From the standpoint of its intention of complying with minimum state reserving requirements, however, Company contends that its reserves represent two separate reserve components --i.e., a tabular reserve liability calculated under a two-year full preliminary term basis, using tabular reserve factors and an assumed interest rate similar to Company's U.S. policies; and additional reserves reflecting the excess of the policies' aggregate cash surrender values over the two year full preliminary term reserves.

In filing its federal income tax returns, Company elected to revalue all of its annual statement reserves relating to guaranteed renewable health insurance that had been computed on a preliminary term basis to a net level premium basis under section 818(c)(1) of the Code. This reserve revaluation extended to the active life reserves that Company held with respect to the Y policies. Company contends that in revaluing the reserves held with respect to the Y policies, it adjusted only the two-year preliminary term portion of the reserves and did not adjust or otherwise deduct for federal income tax purposes the portion of its reserves reflecting the cash surrender value increment. On its returns, Company identified the reserves that had been revalued as having been calculated on a 3 1/2 percent assumed rate of interest using a two-year full preliminary term method and based on mortality, morbidity, and continuance factors similar to Company's U.S. policies.

In examining Company's federal income tax returns for the years involved, the examining agent reviewed Company's statutory reserve calculations as shown on Exhibit 9 of the annual statement and sought to reconcile these calculations to the "net level" runs used in completing Company's tax returns. The examining agent determined that the additional reserves posted on line 2 of Exhibit 9, Part A of Company's annual statement during the years involved consisted solely of the cash surrender values of the policies-in-force. As indicated, the policies' cash surrender values were based on a 5 percent assumed rate of interest as well as a mortality assumption that took into account the mortality rate of z rather than deaths resulting from all causes. In addition, the cash surrender values were calculated using the "Zillmer method" and a ten year modification period, with the result that the cash surrender values graded into the corresponding net level premium reserves over ten years rather than over the premium payment period (as assumed by the two year full preliminary term method).

The examining agent has raised an issue of (i) whether the reserves for the Y policies reported on Exhibit 9 of Company's annual statement constitute life insurance reserves for federal income tax purposes and, if so, (ii) whether Company may revalue any portion of such reserves to a net level premium basis under section 818(c) of the Code.

APPLICABLE LAW

Section 801(a) of the Code provides that the term "life insurance company" means an insurance company which is engaged in the business of issuing life insurance (either separately or combined with health and accident insurance), or noncancellable contracts or health and accident insurance, if (1) its life insurance reserves (as defined in subsection (b)), plus (2) unearned premiums, and unpaid losses (whether or not ascertained), on noncancellable life, health, or accident policies not included in life insurance reserves, comprise more than 50 percent of its total reserves.

Section 801(b)(1) of the Code defines "life insurance reserves" as amounts (1) computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest; and (2) set aside to mature or liquidate, by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable health and accident insurance contracts involving, at the time with respect to which the reserve is computed, life, health, or accident contingencies. In addition, section 801(b)(2) provides that, with certain exceptions not relevant here, life insurance reserves must be required by law.

Section 801(c) of the Code provides that the term "total reserves" means (1) life insurance reserves, (2) unearned premiums and unpaid losses (whether or not ascertained) not included in life insurance reserves, and (3) all other insurance reserves required by law.

Section 801(e) of the Code provides that guaranteed renewable life, health and accident insurance shall be treated in the same manner as noncancellable life, health and accident insurance.

Section 1.801-3(d) of the regulations defines the term "guaranteed renewable life, health and accident insurance policy" as a health and accident contract, or a health and accident contract combined with a life insurance or annuity contract, that is not cancellable by the company but under which the company reserves the right to adjust the premium rates by classes in accordance with its experience under the type of policy involved, and with respect to which a reserve in addition to unearned premiums must be carried to cover that obligation.

Section 1.801-4(a)(3) of the regulations provides, in part, that for purposes of determining life insurance reserves, only those amounts shall be taken into account which must be reserved either by express statutory provisions or by rules and regulations of the insurance department of a State, Territory, or the District of Columbia when promulgated in the exercise of a power conferred by statute. More, such amounts must actually be held by the company during the taxable year for which the reserve is claimed.

Section 818(a) of the Code provides, in part, that all computations entering the determination of the taxes imposed by part I of subchapter L shall be made (1) under an accrual method of accounting, or (2) to the extent permitted under regulations prescribed by the Secretary, under a combination of an accrual method of accounting with any other method permitted by this chapter (other than the cash receipts and disbursements method). Except as provided in the preceding sentence, all such computations shall be made in a manner consistent with the manner required for purposes of the annual statement approved by the National Association of Insurance Commissioners.

Section 818(c) of the Code permits a life insurance company issuing contracts with respect to which the life insurance reserves are computed on one of the preliminary term bases to elect to revalue the reserves on a net level premium basis for purposes of determining the amount that may be taken into account as life insurance reserves for purposes of Part I of subchapter L of the Code, other than section 801 (relating to the company's qualification as a life insurance company). When the election is made to revalue the reserves, the company may do so by making either an exact revaluation of its reserves or an approximate revaluation under a formula contained in section 818(c)(2).

Section 1.818-4(a) of the regulations provides, in part, that the life insurance reserves that a life insurance company may elect to revalue under section 818(c) must be computed on one of the recognized preliminary term bases.

Section 1.818-4(c) of the regulations provides that if a life insurance company that elects to revalue its reserves under the approximate revaluation formula has both life insurance reserves and reserves for noncancellable accident and health insurance contracts for which a preliminary term reserving method was used, the company must use the approximate revaluation formula for all of its life insurance reserves other than that portion of such reserves held with respect to its noncancellable accident and health insurance contracts, and must use the exact revaluation method for all of its life insurance reserves held with respect to such noncancellable accident and health contracts.

Section 818(c)(1) of the Code provides that the recomputation of preliminary term reserves using an exact revaluation method shall be made as if the reserves for all of 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 basis).

RATIONALE

Issue 1. WHETHER THE RESERVES THAT COMPANY POSTS TO EXHIBIT 9 OF ITS ANNUAL STATEMENT WITH RESPECT TO THE Y POLICIES SHOULD BE VIEWED AS COMPRISING BOTH TABULAR RESERVES COMPUTED ON A TWO-YEAR PRELIMINARY TERM MODIFICATION AND RESERVES FOR EXCESS CASH SURRENDER VALUES, OR IN THEIR ENTIRETY AS RESERVES REPRESENTING THE AGGREGATE CASH SURRENDER VALUES OF THE POLICIES.

To determine the proper treatment under part I of subchapter L of the Code of the reserves that Company posts on Exhibit 9 of its annual statement with respect to the Y policies, one must first determine whether these reserves should be viewed in their entirety as representing the aggregate cash surrender values of the policies, or whether the reserves should be viewed as consisting of separate reserve components, including tabular reserves calculated under a two-year full preliminary term method and a 3 1/2 percent interest assumption and additional reserves reflecting the excess of the policies' aggregate cash surrender values over the two-year full preliminary term reserves.

Company contends that the reserves reported on Exhibit 9 of its NAIC annual statement for the Y policies represent both a tabular reserve component to provide for future hospitalization and death benefits under the policies, which was calculated in accordance with a reserving method and tabular reserve factors that satisfy the reserve valuation standards for accident and health insurance adopted by the various states in which it transacted business within the U.S., as well as Company's liability for cash surrender values in excess of the tabular reserves. Cf. Rev. Rul. 75-51, 1975-1 C.B. 190 (reserves held by a life insurance company with respect to certain decreasing term policies viewed as consisting of a preliminary term reserve portion and a portion added to satisfy minimum State requirements.) This position also reflects the underlying assumption that there is no direct relationship between the reserving method and tabular reserve factors used by a life insurance company to calculate its life insurance reserves for NAIC annual statement purposes and the amount of the company's liability for cash surrender values.

On a theoretical level, there is no direct relationship between the method used by a life insurance company to calculate its life insurance reserves and the method used to derive the cash surrender values of a life insurance policy. Although the policy reserve and the cash surrender value each represent a potential claim against the assets of a life insurance company, the two sets of values serve quite different purposes and are not necessarily computed using the same actuarial assumptions. Prior to 1948, when the Standard Nonforfeiture Law became generally effective, cash surrender values were directly linked to the life insurance reserves computed with respect to underlying policies, so that the cash surrender value provided under the policy at any point in time was equal to the reserve less a surrender charge. It was recognized that this linkage between surrender values and reserves did not necessarily reflect a fair measure of the policyholder's equitable interest in the policy. For example, if a life insurance company chose to compute its reserves under a modified reserving system, such as preliminary term reserve method, this choice of reserving method could have the effect of reducing the policyholder's available cash surrender value under the policy relative to similar policies issued by other companies that employed a net level reserving method. Because of this and other deficiencies, the NAIC adopted a new approach with respect to the determination of cash surrender values which was reflected in the Standard Nonforfeiture Law. Under the Standard Nonforfeiture Law, a minimum cash value is prescribed, using a prospective method which is similar to a reserve calculation, in order to ensure that each policyholder receives an equitable share in the insurer's assets without jeopardizing the interests of continuing policyholders. The minimum cash surrender value requirements of the Standard Nonforfeiture Law do not refer to the life insurance company's reserving practice.

While there is no longer any linkage between cash surrender values and life insurance reserves, in practice there is a relationship between these items. Under the Standard Valuation Law, the calculation of reserves is based on the guaranteed benefits of the policy. The cash surrender value provided by a permanent life insurance policy represents the current contractual benefit payable under the policy. Therefore, in order for the reserves to reflect all of the guaranteed benefits (both present and future) under the policy, statutory reserving requirements require that the total reserves held with respect to a life insurance policy not be less than the cash surrender value. If the cash value of a policy is in excess of the reserves determined under an otherwise permissible method, minimum State requirements require that additional reserves be held equal to the difference between the tabular reserve and the cash surrender value in order to reflect the company's liability for present and future guaranteed benefits. As a result, the cash surrender values become, in effect, the minimum reserves required by law if at any duration under the policy the insurance company fixes the amount of the guaranteed cash surrender value above the level of the tabular reserve.

Accordingly, we conclude that Company's contention that the reserves with respect to the Y policies reported on Exhibit 9 of its NAIC annual statement should be viewed as consisting of the tabular reserve liability for the Y policies computed under a two-year full preliminary term method and a 3 1/2 assumed rate of interest as well as a separate reserve liability for cash surrender values in excess of the preliminary term reserves is incorrect. The reserve liability shown on Company's annual statement cannot be bifurcated because if the tabular reserves are less than the aggregate cash surrender values under the policies, the reserves would not reflect Company's liability for guaranteed benefits (which include cash surrender value benefits) on the reserve valuation date.

Issue 2. WHETHER THE ADDITIONAL RESERVES QUALIFY AS LIFE INSURANCE RESERVES WITHIN THE MEANING OF SECTION 801(B) OF THE CODE.

Having determined that the reserves that Company posts on Exhibit 9 of its annual statement for the Y policies should be considered in their entirety, we next consider the issue of whether those reserves qualify as life insurance reserves for federal income tax purposes.

Section 801(a) of the Code defines a life insurance company as an insurance company engaged in the business of issuing life insurance and annuity contracts or non-cancellable contracts of health and accident insurance provided that its life insurance reserves, plus unearned premiums and unpaid losses on non-cancellable life, health or accident policies not included in life insurance reserves, comprise more than 50 percent of its total reserves.

Section 801(b) of the Code provides, in part, that the term "life insurance reserves" means those amounts (1) which are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and (2) 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. Furthermore, life insurance reserves, with exceptions not relevant in this case, must be required by law.

Section 801(e) of the Code provides that for purposes of Part I of Subchapter L guaranteed renewable life, accident and health insurance shall be treated in the same manner as noncancellable life, health, and accident insurance.

Section 1.801-3(d) of the Income Tax Regulations provides that the term "guaranteed renewable life, health, and accident insurance policy" means a health and accident contract, or a health and accident contract combined with a life insurance or annuity contract, which is not cancellable by the company but under which the company reserves the right to adjust premiums rates by classes in accordance with its experience under the type of policy involved, and with respect to which a reserve in addition to the unearned premiums must be carried to ever that obligation.

Rev. Rul. 70-460, 1970-2 C.B. 135, provides that the required reserves in addition to unearned premiums held under guaranteed renewable health and accident contracts, which are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and held to mature or liquidate future unaccrued claims under such contracts, qualify as life insurance reserves within the meaning of section 801(b) of the Code.

Rev. Rul. 71-367, 1971-2 C.B. 258, interprets the requirement, found in section 1.801-3(d) of the regulations, that a reserve in addition to the unearned premiums must be carried to cover the company's obligation under a guaranteed renewable accident and health insurance contract. Rev. Rul. 71-367 provides that the unearned premiums are premiums received during the year that have not been earned at the end of the taxable year but will be earned ratably as the risk expires, whereas reserves in addition to the unearned premiums are not earned ratably but rather are amounts computed on the basis of life, health, or accident contingencies, and are set aside to mature or liquidate future unaccrued claims arising from the life, health and accident contingencies with respect to which the reserve is computed.

In the present case, the examining agent contends that the reserves that Company posts on Exhibit 9 of its annual statement with respect to the Y policies, while required by state law, do not qualify as life insurance reserves within the meaning of section 801(b) of the Code because the reserves are not properly computed. Succinctly stated, the agent's position is that Company's active life reserves are not properly computed because, under Company's method of calculating the reserve, the theoretical reserve on the policy issue date is not zero but a negative amount (reflecting the subtraction at duration zero of the additional first-year expense allowance). The examining agent cites to the holding in Standard Industrial Life Insurance Co. v. Commissioner, 42 B.T.A. 1011 (1940), for the proposition that any reserve that is reduced below the amount required under the mortality table and interest rate stipulated by state law is not a life insurance reserve for federal income tax purposes. But see Lamana-Panno-Fallo I. Ins. Co. v. Comm., 127 F.2d 56 (5th Cir. 1942) (requirement of the tax statute that reserve "be required by law" does not concern itself with the sufficiency, but only with the character of the reserves of insurance companies).

Since the contention that the reserves on the Y policies not meet the requirements of section 801(b) of the Code is based primarily on the manner in which the Company's reserving method introduces an additional first-year expense allowance, a further description of Company's method of computing reserves is appropriate.

Under the normal method of computing reserves, the reserve is based on an amount, referred to as the net valuation premium, which when accumulated or discounted by the rates of interest and mortality used in computing the net valuation premium will establish the reserve at zero at issuance of the contract and will exactly provide for all of the benefits at maturity, assuming that deaths take place according to the mortality table and the reserve accumulates at the valuation rate of interest.

Under Company's so-called "Zillmer" method, on the other hand, the first step in the process of computing the reserves is to determine the additional first-year expense allowance. The second step in the process is to calculate the expense net premium. Depending on whether the "Zillmer" reserve is viewed prospectively or retrospectively, the expense net premium may be regarded as either the amount that is added to the future net premiums in order to fully amortize the additional first-year expense allowance over the modification period, or as a decreasing amount that is subtracted each period from the accumulation of level net valuation premiums to reflect the grading of the expense allowance into the net level premium reserve.

Since under Company's "Zillmer" method a higher value is placed on the present value of future net premiums than on the present value of future benefits, a calculation of reserves under this method using the prospective reserve formula will yield a negative opening reserve (reflecting the subtraction of the additional first-year expense allowance). From this fact, it has been argued that reserves calculated under the "Zillmer" method are not life insurance reserves within the meaning of section 801(b)(1) of the Code because the "Zillmer" reserves deviate from the reserves that would be determined solely on the basis of mortality and morbidity tables and assumed rates of interest. This is because the concept of net premium valuation, which underlies the Standard Valuation Law, operates from the basic assumption that the reserve at issuance of the policy is always zero, the present value of the future benefits and the present value of future premiums being equal at that point.

While there may be certain technical computational differences between Company's "Zillmer" reserving method and conventional net premium reserving systems, this office does not believe these computational differences justify a conclusion that Company's "Zillmer" reserves do not constitute life insurance reserves within the meaning of section 801(b) of the Code.

The definition of life insurance reserves in section 801(b) of the Code was originally enacted as section 201(c)(2) of the Internal Revenue Code of 1939, by the Revenue Act of 1942. In general, the statutory definition of life insurance reserves adopted by the 1942 Act followed the definition of reserves contained in prior Treasury regulations. Under these regulations, the term "reserves required by law" was defined to mean reserves which were peculiar to insurance companies and which, while variously computed or estimated, were dependent upon interest earnings to mature or liquidate, either by payment or reinsurance with other companies, future unaccrued and contingent claims. The intent of Congress in codifying the definition of life insurance reserves in the 1942 Act was, according to the accompanying committee reports, to clarify that life insurance companies could compute their reserves by reference to a generally prescribed mortality and morbidity table as well as to expand the definition of life insurance reserves to include reserves for health and accident insurance contracts if the coverage under such contracts was noncancellable. See H.R. Rept. No. 2333, 77th Cong., 1st Sess. (1942), 1942-2 C.B. 372, 453-54; S. Rept. No. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 504, 612. The definition of life insurance reserves added by the 1942 Act was carried over essentially unchanged as section 801(b)(1) by the Life Insurance Company Income Tax Act of 1959.

In enacting both the Revenue Act of 1942 and the Life Insurance Company Income Tax Act of 1959, Congress deliberately avoided including within the definition of life insurance reserves a requirement that reserves computed in accordance with State law requirements must be recomputed on some standardized or uniform basis in order to be accepted for tax purposes. Section 801(b) of the Code provides that life insurance reserves must be computed or estimated on the basis of recognized mortality and morbidity tables and assumed rates of interest and held to mature or liquidate future unaccrued claims involving life, health and accident contingencies. This definition describes certain broad characteristics of life insurance reserves in order to distinguish those reserves that are held in order to enable the life insurance company to meet its future contractual obligations from reserves that States may require for solvency concerns or reserves evidencing general business liabilities. Thus, the definition of life insurance reserves under section 801(b), while requiring that an insurance company's reserves must be the product of an actuarial computation, implicitly recognizes that the actuarial bases used by life insurance companies in computing their reserves may differ substantially as between lines of business, plans of insurance, underwriting classifications, and policy issue dates, as well as that there may exist significant differences in the selection of the specific reserve factors and methods employed by different companies.

In addition, judicial precedents dealing with the computational requirements of section 801(b)(1) of the Code have held that a life insurance company may include as part of the calculation of its life insurance reserves elements other than the basic tabular reserve factors of mortality, morbidity, and interest without the inclusion of these additional elements causing the reserves to be disqualified for tax purposes. See, e.g. Mutual Benefit Life Ins. Co. v. Comm., 488 F.2d 1101, 1107 (3rd Cir. 1973), cert. denied 419 U.S. 882 (1974) (the fact that the computation of a reserve included elements other than mortality tables and assumed rates of interest does not disqualify the reserve under section 801(b)); accord Lincoln National Life Ins. Co. v. U.S., 582 F.2d 579 (Ct. Cl. 1978); Equitable Life Ins. Co. of Iowa v. Comm., 73 T.C. 447 (1979). In general, the approach taken by the courts has been to accept a life insurance company's reserve calculations as meeting the requirements of section 801(b)(1) so long as the additional factors are included as part of an actuarial computation and the company can demonstrate that these additional elements are appropriate to reflect the company's liability for future benefits. Thus, while section 801(b)(1) requires that life insurance reserves be computed on the basis of mortality or morbidity tables and assumed rates of interest, the courts have not disqualified reserves that deviate from the reserves computed directly from a mortality table so long as the reserves bear an actuarial relationship to the risks provided for and are required under the applicable State law. See also section 818(a)(computations entering into the determination of the taxes imposed upon a life insurance generally to be made consistent with the manner required for annual statement purposes).

Accordingly, because section 801(b)(1) does not restrict life insurance companies to the use of any specific reserve computational method, this office believes that the Company's use of the so-called "Zillmer" method to calculate its active life reserves does not cause these reserves to be disqualified as life insurance reserves under the Code and the regulations. Furthermore, as required by section 801(b)(1), Company's calculation of active life reserves for the Y policies included the use of mortality and morbidity tables and assumed rates of interest, which assured that the active life reserves bore an actuarial relationship to Company's liability for future hospitalization and benefit costs under the policies. Accordingly, this office concludes that Company's additional reserves on the Y policies constitute the life insurance reserves on the policies within the meaning of section 801(b)(1).

Issue 3. WHETHER COMPANY IS ENTITLED TO REVALUE THE ADDITIONAL RESERVES ON THE Y POLICIES TO A NET LEVEL PREMIUM BASIS UNDER SECTION 818(c)(1) OF THE CODE.

Section 818(c) of the Code permits a life insurance company that issues contracts with respect to which the life insurance reserves are computed on one of the recognized preliminary term bases to elect to revalue those reserves on a net level premium basis for purposes of applying the provisions of part I of subchapter L, other than section 801 (relating to the company's qualification as a life insurance company). When an election is made to revalue the reserves, the company may do so by making either an exact revaluation or an approximate revaluation using a formula provided in section 818(c)(2) of the Code.

Section 1.818-4(c) of the regulations provides that if a life insurance company that elects to revalue its reserves under the approximate revaluation formula has both life insurance reserves and reserves for noncancellable accident and health insurance contracts for which a preliminary term reserving method was used, the company must use the approximate revaluation formula for all of its life insurance reserves other than that portion of such reserves held with respect to its noncancellable accident and health insurance contracts, and must use the exact revaluation method for all of its life insurance reserves held with respect to such noncancellable accident and health contracts. See also Rev. Rul. 60-61, 1960-1 C.B. 268.

Section 818(c)(1) of the Code provides that the recomputation of preliminary term reserves using an exact revaluation method shall be made as if the reserves for all of 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 basis).

Section 1.818-4(a) of the regulations refers to the reserves that a life insurance company may elect to revalue under section 818(c) as reserves computed on one of the "recognized preliminary term bases." The same language appears in the committee reports accompanying the Life Insurance Company Income Tax Act of 1959, the legislation that enacted section 818(c). Cf. H. Rept. No. 34, 86th Cong. 1st Sess. (1959), 1959-2 C.B. 736, 766.

The issue is whether the reserves on the Y policies, which were calculated the "Zillmer" method, may be treated as preliminary term reserves so as to qualify for revaluation to a net level premium basis under section 818(c)(1).

At the time section 818(c) was enacted, preliminary term reserving methods were generally recognized as being actuarially sound and were widely used in the life insurance industry. Although the genesis of preliminary term reserving methods had originally been aimed at alleviating the surplus strain the use of preliminary term reserving methods was not confined to life insurance companies of a specific size or business mix. The reserve valuation standards adopted by the various states permitted the use of a number of preliminary term reserving methods. In addition, all forms of preliminary term reserving methods had extensive modifications in actual use. The authority to make such modifications rested on the life insurance company's ability to demonstrate that the resulting reserves exceeded the minimum reserves required by State law.

Moreover, even prior to the enactment of section 818(c) in the Life Insurance Company Income Tax Act of 1959, preliminary term reserving methods had already been recognized in the tax law. Under the 1939 Code, there was a provision (section 201(c)(3)) which provided that life insurance reserves computed on a preliminary term basis were to be adjusted to a net level basis by application of a 107% factor for purposes of the required filing of each life insurance company's adjusted reserves and reserve earnings rate (i.e., the elements of the formula used to determine the Secretary's ratio). The legislative history underlying this provision indicated that Congress recognized that a number of preliminary term methods were being used and intended the 7% adjustment to be applied irrespective of the specific preliminary term method employed. See S. Rep. No. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 504, 612.

Since state valuation standards accepted a number of preliminary term reserving methods for purposes of meeting minimum reserve requirements, as well as the fact that all varieties of preliminary term reserving methods had extensive modifications in actual use, this office believes that the term "recognized preliminary term method", which appears both in the legislative history as well as the regulations, should not be interpreted in a restrictive sense. This interpretation is consistent with the connotation of the term "recognized" when used in other actuarial contexts. See Knickerbocker, The Present Status of Life Insurance Reserves, Tax Lawyer, Vol. 23, No. 2, 367, 368 n. 8 (1970); see also Mutual Benefit Life Ins. Co. v. Commissioner 58 T.C. 679 (1972), aff'd 448 F.2d 1101 (3rd Cir. 1973), cert. denied 419 U.S. 882 (use of the term "recognized" in the context of mortality or morbidity table "was intended to expand, not to restrict, the definition of life insurance reserves").

Furthermore, the legislative history underlying section 818(c) of the Code indicates that the purpose of the revaluation election was to avoid a disparity in tax treatment that would otherwise result between life insurance companies based on the reserving system employed. Congress was aware that many life insurance companies had adopted preliminary term reserve methods in order to conserve statutory surplus and to write a larger volume of new business. Because of the central role played by life insurance reserves in the determination of an insurance company's federal income tax liability, however, Congress believed that unless a reserve adjustment mechanism was provided, those companies that used preliminary term reserve methods would suffer a tax penalty relative to other companies that, because of their larger capital and surplus, could afford to use the more conservative net level reserve method. The legislative committee reports underlying section 818(c) explained the purpose of the election as follows:

ELECTION FOR LIFE INSURANCE RESERVES COMPUTED ON PRELIMINARY TERM BASIS. -- Some life insurance companies compute their life insurance reserves on what is called a preliminary term basis. The effect of this is take the full agents' commissions (which are larger in the initial period of a life insurance contract) out of amounts which would otherwise be added to reserves during the first year of a contract and to add correspondingly larger amounts to reserves in later years. The effect of this is to work a hardship on insurance companies using the preliminary term reserves as compared with those which use ordinary reserves, since the policy and other contract liability deduction depends on the size of the reserves. Moreover, additions to the reserves, deductible under phase 2, would in some cases be smaller. To avoid this result, life insurance companies which had computed their reserves on a preliminary term basis and permitted to recompute their reserves on a net level premium basis. This can be done either by an exact revaluation of the reserves to a net level premium basis or by approximating this result under a formula set forth in the bill. (H.R. Rept. No. 34, 86th Cong. 1st Sess. (1959), 1959-2 C.B. 736, 748.; See also, S. Rept. No. 291, 86th Cong. 1st Sess. (1959), 1959-2 C.B. 770, 792).

Therefore, the revaluation election provided by section 818(c) of the Code allows a life insurance company that uses a preliminary term reserving method for calculating its reserves for State law purposes (because this reserving method increases the company's statutory surplus and allows it to write a larger volume of new business) to adjust these reserves to a net level premium basis for purposes of determining its Federal income tax liability (because this method generally results in a larger liability (because this method generally results in a larger policyholders' share exclusion of investment yield and first-year increase in reserve deduction).

As discussed above, Company's so-called "Zillmer" reserve method is similar in concept and technique to a preliminary term reserving method because the use of the "Zillmer" method results in reserves that are lower than the corresponding net level premium reserves due to the amortization of the additional first year expense allowance. As such, the "Zillmer" method serves the same actuarial function as a preliminary term reserve method because it modifies the pattern of reserve increases to provide additional loading in the first or initial policy years, when a life insurance company's administrative expenses are highest, and thereby relieves the surplus strain caused by the writing of new business. This initial reserve reduction is made up by increasing the net premium additions to the reserve at later policy durations, when there is an excess of loading relative to expenses.

The principal difference between Company's so-called "Zillmer" method and a preliminary term reserve method lies in the manner in which the expense allowance is determined. Under Company's reserve method, the amount of the expense allowance (and hence the amount of surplus relief provided the insurer) is a function of the additional first-year expense allowance, which reflects a predetermined portion of Company's actual policy issue costs. By contrast, under a full preliminary term reserve method, surplus relief is provided by use of the reserving assumption that the net premiums for the first or first and second policy years are available for current claims only, with subsequent additions to the policy reserve being calculated by a net level premium method, but treating the policy as if it had been issued one or two years later than the actual date of issue and with a correspondingly reduced premium payment period. Thus, the amount of surplus relief available under a preliminary term method is necessarily limited to the excess of the net level premiums over the actuarial cost of term insurance for the preliminary term period. This difference between Company's "Zillmer" method and a preliminary term method, however, mainly goes to the manner in which the expense allowance is determined rather than to the underlying concept and technique of the reserving systems.

Accordingly, notwithstanding that the "Zillmer" method is not a "recognized" preliminary term method in the sense that it is one of the reserve methods described in the reserve valuation standards adopted by the various states for purposes of computing minimum reserves, we believe that it is consistent with the Company to treat its active life reserves on the Y policies as preliminary term reserves that are eligible for revaluation under section 818(c)(1) of the Code.

In making this revaluation, however, section 818(c)(1) of the Code provides that the recomputation of preliminary term reserves to a net level premium basis using the exact revaluation method shall be made as if the reserves for 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 basis). Because Company recomputed its reserves assuming the use of a two-year full preliminary term method as well as mortality, morbidity, continuance, and interest factors similar to its U.S. policies, rather than the actual reserving method and tabular reserve factors used in calculating the underlying reserves, the recomputation of the reserves on the Y policies was not made in accordance with the requirements of section 818(c)(1).

Further, this office does not believe that the above conclusion is inconsistent with Rev. Rul. 75-51. In that revenue ruling, the Service indicated that if a life insurance company issues decreasing term life insurance policies, it may not revalue under section 818(c) of the Code the reserves that it is required to hold in order to satisfy the minimum requirements of State law; however, the underlying preliminary term component of the reserves are subject to revaluation. Company has indicated that the States in which it transacted business would have permitted the use of a two-year full preliminary term method together with interest rates that were lower than the Y reserve interest rate; however, the States also imposed a minimum reserve requirement that Company's reserves not be less than the cash surrender values of the policies. Hence, Company argues that, under Rev. Rul. 75-51, it should be permitted to revalue what would have been its preliminary term reserves, even though the cash surrender values reported on Company's annual statements utilized the "Zillmer" method and Y factors of mortality, morbidity, and interest. This office believes, however, that the holding of Rev. Rul. 75-51 was based on the concept that the amounts added to the taxpayer's reserves on its decreasing term policies were arbitrary amounts that were not actuarially computed to mature or liquidate future claims. Thus, the State mandated reserve was not a life insurance reserve under section 801(b) of the Code and was not eligible for revaluation for that reason. By contrast, Company's reserves on the Y policies reflect the aggregate cash surrender values of the policies and exceed the minimum reserve requirements of State law. Thus, these reserves are an actuarial measure of Company's liability for present and future benefits under the policies. Since the reserves on the Y policies constitute life insurance reserves, and since the "Zillmer" method resulted in Company holding a lesser reserve than the corresponding net level premium reserve, the reserves on the Y policies may be revalued under section 818(c)(1) of the Code, but this revaluation must be made in accordance with the Y factors of mortality, morbidity, and interest.

CONCLUSIONS

1. The reserves that Company posted to Exhibit 9 of its annual statement with respect to the Y policies should be viewed in their entirety as representing both the policy reserves as well as the cash surrender values of the policies.

2. The reserves that Company posted to Exhibit 9 of its annual statement with respect to the Y policies qualify as life insurance reserves within the meaning of section 801(b) of the Code.

3. The reserve method used by Company to calculate such reserves was a preliminary term reserving method for purposes of the revaluation election provided by section 818(c) of the Code. Accordingly, Company may revalue the active life reserves for the Y policies to a net level premium basis under section 818(c)(1). In making the revaluation, however, section 818(c)(1) requires that the revaluation adjustment to a net level premium basis must be made using the same mortality, morbidity, continuance, and interest factors to calculate the net level reserves as used in calculating the underlying preliminary term reserves.

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.