Rev. Rul. 67-225

Advice has been requested whether a casualty insurance company may include, as part of its unearned premiums, a contingent liability for retrospective rate credits or refunds on policies that have not expired as of the close of the taxable year.

The taxpayer is an insurance company engaged in writing fire, casualty, and liability insurance and is subject to tax imposed by section 831 of the Internal Revenue Code of 1954. It employs the accrual method of accounting.

The taxpayer offers to its insureds, in certain lines of insurance, a retrospective rating adjustment plan. For these lines of insurance, whether or not the policy is subject to the retrospective rating plan, the insured pays an estimated standard premium at the inception of the risk period. Thereafter, the premium is adjusted from its estimated basis to the exact earned standard premium on the basis of the insured's payrolls or other exposure. The difference between the earned standard premium and the estimated standard premium is then charged or refunded to the policyholder.

The retrospective rating process begins after the risk period has expired. The calculation starts with the earned standard premium to which a percentage factor, determined by taxpayer, is applied. The result is called the "basic charge." Losses up to certain limits and expenses attributable thereto are then added to the basic charge. To this total another percentage, denominated as premium tax multiplier, is applied and the result is added. The total of all these elements, basic charge, losses and expenses, and the result obtained from the application of the premium tax multiplier is the retrospectively rated premium. It is subject to minimum and maximum limits thus guaranteeing on the one end, that every premium paid by a policyholder takes into account the risk charges and loading elements and on the other end that the contract is one of insurance rather than mere bookkeeping for a fee. Within these minimum and maximum limits any difference between the earned standard premium and the retrospectively rated premium is refunded by the taxpayer to the policyholder if the policyholder's experience is favorable or paid to the taxpayer by the policyholder if his experience is unfavorable.

On certain of its multiple year policies, the retrospective rating computations are made on the basis of each policy year's experience factors without regard to any other year's experience factors and refund or credit is made by the taxpayer to the policyholder or payment is received or due from him each year. On other multiple year policies, the factors employed in the retrospective rating computation are cumulative and although tentative computations are made at the end of each policy year, such computations are thereafter subject to experience factors in the succeeding policy years. On the latter policies final and fixed determination of the retrospective premium and the refund or credit due must await the termination of the entire contract.

In accordance with the treatment provided for in the annual statement approved by the National Association of Insurance Commissioners (NAIC), formerly known as the National Convention of Insurance Commissioners, the taxpayer, in filing its Federal income tax returns, took retrospective rating credits into account as unearned premiums not only with respect to expired policies but also, on the basis of past experience under the contract, the estimated credits attributable to the expired portion of unexpired policies.

The estimated potential credit on an unexpired policy is not paid if the policyholder's subsequent loss experience and expenses attributable thereto eliminates it. Also, if during the policy year the policy is canceled the retrospective premium endorsement is likewise canceled and the earned standard premium is applicable, computed at customary short rates.

Section 832 of the Code provides, in part, as follows:

(b) DEFINITIONS.--In the case of an insurance company subject to the tax imposed by section 831--

(1) GROSS INCOME.--The term "gross income" means the sum of--

(A) the combined gross amount earned during the taxable year, from investment income and from underwriting income as provided in this subsection, computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners, * * *

* * * * * * *

(3) UNDERWRITING INCOME.--The term "underwriting income" means the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred.

(4) PREMIUMS EARNED.--The term "premium earned on insurance contracts during the taxable year" means an amount computed as follows:

(A) From the amount of gross premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance.

(B) To the result so obtained, add unearned premiums on outstanding business at the end of the preceding taxable year and deduct unearned premiums on outstanding business at the end of the taxable year.

* * * * * * *

Section 1.832-1(a) of the Income Tax Regulations provides, in pertinent part, as follows:

The underwriting and investment exhibit is presumed to reflect the true net income of the company, and insofar as it is not inconsistent with the provisions of the Code will be recognized and used as a basis for that purpose. All items of the exhibit, however, do not reflect an insurance company's income as defined in the Code. * * * In computing "premiums earned on insurance contracts during the taxable year" the amount of the unearned premiums shall include * * * (2) liability for return premiums under a rate credit or retrospective rating plan based on experience, such as the "War Department Insurance Rating Plan," and which return premiums are therefore not earned premiums.

It is the longstanding position of the Internal Revenue Service that the annual statement approved by the NAIC is to be used only as a general guide in computing the income of insurance companies taxable under section 831 of the Code and that it is not controlling for Federal income tax purposes. See Revenue Ruling 60-306, C.B. 1960-2, 211; Revenue Ruling 61-167, C.B. 1961-2, 130, and cases cited therein. The annual statement is not followed if inconsistent with the Code and since the Code does not provide for deductions for contingent liabilities, that part of the computation which takes into account potential credits or refunds applicable to unexpired policies to be determined on the basis of subsequent events would be inconsistent with the Code and is, therefore, not recognized for tax purposes.

Although the last sentence of section 1.832-1(a) of the above-quoted regulations indicates that unearned premiums include liability for return premiums under a rate credit or retrospective rating plan based on experience, a liability to return part of the premium paid for a risk which has already attached and the policy expired, in whole or part, cannot be considered to be unearned premiums on outstanding business as of the close of the taxable year.

Unearned premiums have a technical 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 and are maintained for the purpose of maturing and liquidating, either by payment as they are earned or reinsurance with other companies, future unaccrued and contingent claims arising under the contract. Thus, amounts held at the end of the taxable year with respect to matured obligations or with respect to expired policies or portions thereof cannot be considered to be unearned premiums for the reason that in the one case the unearned premiums have served their purpose as they were earned and in the other case, there being no insurance in force with regard to an expired policy or portion thereof, there can be no unearned premiums attributable thereto. As stated in Colonial Surety Co. v. United States, 178 F. Supp. 600 (1959):

Every insurance company sets up a reserve for unearned premiums, but this is not done in anticipation of the possibility that some part of the premiums will have to be returned, but to take care of anticipated losses on the policies. This was decided as early as McCoach v. Insurance Co. of North America, 244 U.S. 585; and Maryland Casualty Co. v. United States, 251 U.S. 342. * * * only an unearned premium reserve is deductible, and that * * * is a reserve set up to take care of anticipated losses on policies, and that reserves to take care of other contingencies, although they are proper to insure solvency, are not deductible for tax purposes.

* * * This was so even though they were reserves which the insurance commissioner required the company to set up. It was so held in McCoach v. Insurance Co., supra, and in United States v. Boston Ins. Co., 269 U.S. 197 * * *.

See also Continental Assurance Co., Inc. v. United States, 8 F. Supp. 474 (1934); Commissioner v. Monarch Life Insurance Co., 114 F. 2d 314 (1940).

Application of the principles enunciated in these and other cases suggests that a reserve for estimated contingent retrospective rating credits or refunds on expired policies, or portions thereof, is not a reserve to take care of future, unaccrued contingent claims and losses on insurance policies but is, instead, a nondeductible reserve set up "* * * in anticipation of the possibility that some part of the premiums will have to be returned * * *." Such reserve, therefore, is not unearned premiums or any other technical insurance reserve.

Unearned premiums on casualty contracts are earned pro rata as the period of risk expires. Claims and benefits accruing during that period of risk are paid out of such earned premiums. With respect to that period, there is no longer any risk outstanding to which an unearned premium is attributable. Once the unearned premiums have been earned, they cannot thereafter become unearned. The purpose of section 1.832-1(a) of the regulations is to make it clear that in computing premiums earned there is a deduction for the liability for a retrospective rate credit. The regulation permits such liability to be taken into account arithmetically with unearned premiums for purposes of computing earned premiums but such provision for their accounting does not make the liability, with respect to a policy which is no longer in force, a technical unearned premium. The words in the penultimate sentence of section 1.832-1(a) of the regulations, "* * * the amount of the unearned premiums * * *", merely refer to amounts to be included in premiums earned on insurance contracts during the taxable year and not to the term "* * * unearned premiums, on outstanding business * * *" as used twice in section 832(b)(4)(B) of the Code. It is concluded that section 1.832-1(a) of the regulations provides that a retrospective rating credit may be deducted in computing premiums earned only when the liability therefor becomes fixed and reasonably ascertainable in amount in the same sense that there is a fixed liability to return the unearned premium upon cancellation. Thus, the term "liability" as used in section 1.832-1(a) of the regulations is subject to the "all events" test and when all the events occur which gives rise to a retrospective rate credit or refund, such amount is to be accounted for in computing premiums earned.

Accordingly, if the taxpayer's one year policy does not terminate on or before the end of the taxable year, the estimated contingent retrospective rate credit or refund on the expired portion of the policy is not an unearned premium and may not be taken into account. Where the policy terminates on or before the end of the taxable year and the total experience factors which are taken into account in determining the ultimate credit or refund due and payable on the entire policy are known or reasonably ascertainable, the liability for the credit or refund becomes fixed and shall be taken into account by the taxpayer in computing earned premiums.

As to the taxpayer's multiple year policies, if the retrospective premium is computed only on the basis of the experience factors at the close of each policy year and without regard to subsequent experience factors, then there is a fixed liability to refund at the close of each policy year and such liability shall be taken into account at that time in computing earned premiums as if the policy were an expired one-year policy. If, on the other hand, the experience factors are cumulative and the ultimate determination of the retrospective premium must await the expiration of the entire contract, any potential credit or refund is a contingent liability and shall not be taken into account prior to the expiration of the entire contract.

26 CFR 1.832-4: Gross income.

Liability for retrospective rate credits. See Rev. Rul. 67-225, page 238.