Rev. Rul. 60-275

Advice has been requested whether the annual `premium deposit' paid by a taxpayer under a `subscriber's agreement' with a reciprocal flood insurance exchange, as described below, constitutes a deductible expense for Federal income tax purposes.

The taxpayer in the instant case is a contract carrier corporation engaged in hauling automobiles from an automobile assembly plant. It leases land on which it stores the automobiles as well as the equipment used in moving them. The leased land is bounded by a river, which exposes the leasehold improvements and the stored property to possible flood damage.

The taxpayer, and others exposed to flood risk entered into an agreement to flood risk, entered into an agreement insurance exchange,' whereunder each subscriber pays annually over a specified period a `premium deposit,' the total of which deposits by each subscriber is not in excess of the total insurance coverage desired by such subscriber. The taxpayer applied for 150 x dollars of flood insurance, to be underwritten over a ten-year period, of which ten percent, or 15 x dollars, became effective when the policy was issued and delivered. The taxpayer's property subject to flood loss when valued at 500 x dollars, indicating that the taxpayer, like the other exchange subscribers, was not fully insured.

The exchange credited one percent of the first annual `premium deposit' of 15 s dollars to its `General Reserve Fund' and the remaining amount of the deposit to its `Catastrophe Loss Account.'

The `Catastrophe Loss Account' for each exchange subscriber is charged with a pro rata share of any losses occurring during the year and for any reinsurance costs incurred during the year. The `General Reserve Fund' is to be applied to losses in excess of the `Catastrophe Loss Account' and to certain administrative expenses. The agreement also provides that a subscriber can be called upon for an additional amount not exceeding one annual `premium deposit' to pay excess losses. The amount paid by a subscriber pursuant to such a call is limited to the amount of the excess of losses so that nothing would be available for the `General Reserve Fund' or the `Catastrophe Loss Account.'

The funds of the `General Reserve Fund' and the `Catastrophe Loss Account' are commingled for investment purposes. From investment earnings, a corporation designated as attorney-in-fact to manage the business of the exchange receives a flat six-percent fee to operate the exchange. All net earnings, if any, are credited to the subscribers' `individual surplus accounts.'

The unencumbered balance in an `individual surplus account' may, upon the election of the subscriber, be applied to the annual `premium deposit' or be withdrawn. If the balance is applied to the premium deposit, it becomes an integral part of the `Catastrophe Loss Account' and the `General Reserve Fund.' If the subscriber elects to withdraw the balance, he can do so only upon 30-days' prior notice, which appears to be more than a nominal rule ( i.e. , a requirement which is seldom, if ever, enforced).

The agreement also provides that the credits in the `Catastrophe Loss Account' may be withdrawn upon 60-days' prior notice effective immediately after the end of the current policy year, but that the credits in the `General Reserve Fund' may not be withdrawn. If the exchange is terminated, however, the member subscribers at that time will share pro rata the net balance in the `General Reserve Fund,' if any.

The agreement further states that the subscribers' risks shall be divided into classes or groups in accordance with the nature of their business, flood hazard, location, and flood district and the `Catastrophe Loss Account' shall be debited with the pro rata share of the payments of the adjusted losses incurred by similarly classified subscribers. This classification is to be made as soon as possible after the subscriber becomes a member of the exchange.

Section 162 of the Internal Revenue Code of 1954 provides, in part, as follows:

(a) IN GENERAL.-There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. * * *.

Section 1.162-1 of the Income Tax Regulations provides that among items included in deductible business expenses are insurance premiums against fire, storm, theft, accident, or similar losses in the case of a business. Moreover, the Internal Revenue Service has taken the position that amounts paid by policyholders as premiums to a mutual insurance company are deductible even though there is a likelihood that a portion of the premium paid may be returned to them by the company. See G.C.M. 10798, C.B. XI-2, 58 (1932), and I.T. 2646, C.B. XI-2, 59 (1932).

Following a long-standing rule which denies deductions for all reserves except those specifically authorized by statute ( Arthur M. Brown v. Helvering , 291 U.S. 193, Ct. D. 786, C.B. XIII-1, 223 (1934)), both the Service and the courts have long held that amounts set aside by a taxpayer as a reserve for self insurance, though equal to commercial insurance premiums, are not deductible for Federal income tax purposes as an expense `paid or incurred.' See Rev. Rul. 57-485, C.B. 1957-2, 117, and Pan American Hide Company v. Commissioner , 1 B.T.A. 1249. The fact that the fund is administered by an independent agent does not make contributions to such a fund deductible. See Spring Canyon Coal Company v. Commissioner , 43 Fed.(2d) 78, Ct. D. 237, C.B. IX-2, 379 (1930), certiorari denied, 284 U.S. 654. Moreover, an element of risk-shifting or risk-distributing is one of the requisites of a true insurance contract. See Guy T. Helvering v. Edythe LeGierse , 312 U.S. 531, Ct. D. 1491, C.B. 1941-1, 430.

Since the eventual classification of the taxpayer with other member subscribers of the exchange will be limited to specific groups within the same flood district, each facing similar flood hazards, there is little likelihood that there could be a real sharing of the risks, because the occurrence of a major flood probably would affect all properties in a particular flood basin. Inasmuch as each subscriber to the instant exchange is substantially underinsured, any proceeds received by the taxpayer in the event of flood damage would, in effect, be a return of the taxpayer's own money.

That portion of the `premium deposit' which is never withdrawable by the member subscribers, however, is for a fixed liability rather than a contingent deposit. This is true even though the member subscribers share pro rata the net balance in the `General Reserve Fund' if the exchange terminates, because this fund may be used not only for flood loss and damage claims in excess of the `Catastrophe Loss Account,' but also for the expense of adjusting loss and damage claims and for various fees and taxes applicable to the insurance of the risks of the subscribers. Thus, there would be little or nothing to distribute if the exchange terminated because of excessive losses.

Accordingly, based upon the above-mentioned facts, it is held that an annual `premium deposit' paid by a taxpayer to the instant exchange, the total of which deposits made over a specified number of years will equal the amount of insurance coverage desired by the taxpayer against flood losses, represents a nondeductible contingent deposit to the extent that it is withdrawable by the taxpayer. The nonwithdrawable one percent of the `premium deposit' which is credited by the exchange to its `General Reserve Fund' and applied to losses in excess of the `Catastrophe Loss Account' and to administrative expenses, is for a fixed liability deductible as an actual insurance expense. Amounts representing earnings from investment of the funds are income to the taxpayer for the taxable year in which such amounts are credited to the taxpayer's annual `premium deposit' or become withdrawable.