Rev. Rul. 70-460

Advice has been requested whether the taxpayer, a life insurance company subject to tax imposed by section 802(a) of the Internal Revenue Code of 1954, may, with respect to its noncancellable health and accident and its guaranteed health and accident insurance policies, treat both the unearned premiums and the reserve maintained in addition thereto as life insurance reserves as defined in section 801(b) of the Code.

Noncancellable health and accident and guaranteed renewable health and accident insurance policies are defined in sections 1.801-3(c) and 1.801-3(d), respectively, of the Income Tax Regulations. The period of risk under both types of policies is for a particular term, usually one year, but renewability of both types is assured at their inception. A noncancellable policy also guarantees a specified premium that remains level throughout the life of the policy or to a termination date at a stipulated age of 60 years or over even though the risk insured against increases with each renewal term as the insured gets older. It follows, therefore, that in each of the earlier terms of the policy the premium exceeds the cost of insurance for those periods while in each of the later terms the cost of insurance exceeds the premium. Accordingly, the earlier years' excess premium must be "reserved" beyond the specified terms of the policy in order to enable the company to meet its long term commitment under later terms of the policy. Section 1.801-3(c) of the regulations recognizes the long term commitment of the company by defining a noncancellable policy as, among other things, one "with respect to which a reserve in addition to the unearned premiums (as defined in paragraph (e) of this section) must be carried to cover that obligation."

The premium charged under a guaranteed renewable policy may be adjusted but such adjustment can only be made by classes. Thus, there can be no change in the rating classification of the individual and the premium, even when adjusted, must still be based on the original insuring age of the individual. Therefore, notwithstanding the right to adjust premiums for unpredictable factors that affect cost, such as hospital, medical, or surgical expenses, the risk under the guaranteed renewable policy like the risk under the noncancellable policy, increases upon each renewal of the policy as the age of the insured increases. Therefore, the excess premium under early terms of the policy must be "reserved" beyond their stated terms in order to enable the company to meet its long term obligation. Section 801(e) of the Code recognizes this aspect of guaranteed renewable health and accident insurance by providing that such policies are to be treated as noncancellable policies and section 1.801-3(d) of the regulations definies such policy, as among other things, one "with respect to which a reserve in addition to the unearned premiums * * * must be carried to cover that obligation." With respect to both the noncancellable and the guaranteed renewable contracts, the taxpayer was required to and did maintain a reserve in addition to the unearned premiums. It computed both the unearned premiums and the additional reserve on the basis of mortality or morbidity tables and assumed rates of interest.

Unearned premiums are that portion of the premium over and above the actual cost of insurance for the period for which the premium is paid, proportioned to the part of the period that has not yet expired. They are earned ratably as the term of the policy expires and therefore are fully earned at the end of the period for which the premium has been paid. See Massachusetts Protective Assn. v. U.S., 114 F. 2d 304 (1940), Ct. D. 1483, C.B. 1941-1, 383; section 1.801-3(e) of the regulations.

However, the reserve in addition to the unearned premiums is, as stated above, necessary to enable the company to meet its long term obligations under the noncancellable and guaranteed renewable health and accident policies. It follows that such reserve is not earned ratably. Rather it is funded out of the excess of premiums over costs in the early terms of the policies, on the basis of recognized mortality or morbidity tables and maintained at assumed rates of interest in order to provide for the excess of claims over premiums when those claims accrue in the later terms of the policies.

Accordingly, the taxpayer may not treat the unearned premiums, i.e. the pro rata portion of the current year's premium that the taxpayer has not yet had time to earn and that is not held for long term commitments, under both the noncancellable and the guaranteed renewable health and accident insurance policies as life insurance reserves within the meaning of section 801(b) of the Code. However, the taxpayer may treat the required reserve in addition to the unearned premiums, which reserve is 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, as life insurance reserves within the meaning of section 801(b) of the Code.