Rev. Rul. 71-367

Advice has been requested whether health and accident insurance policies, issued under the circumstances described below, are guaranteed renewable health and accident insurance contracts that, pursuant to section 801(e) of the Internal Revenue Code of 1954, are to be treated in the same manner as noncancellable life, health, and accident insurance contracts under section 801(a) of the Code.

The taxpayer is engaged in the business of writing health and accident insurance policies. Such policies are for a one year term but are renewable at the option of the insured for successive one year terms so long as the premiums are paid. The taxpayer may adjust premium rates on the renewal of the policies but only by classes in accordance with its experience under the type of policy involved.

During each of the first three years the policies were in force, the taxpayer held only the gross pro rata unearned premiums with respect to such policies. Beginning with the fourth year the policies were in force, pursuant to the requirements of the state insurance commissioner, the taxpayer established, in addition to its unearned premiums, a separate reserve with which to mature or liquidate future unaccrued claims arising out of its health and accident contracts. The computation of this separate reserve involved life, health, or accident contingencies. In computing the unearned premiums, account was taken of the additional reserve. Such additional reserve and the unearned premiums not already included therein together totalled more than the previously held unearned premiums.

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 Income Tax 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, which is not cancellable by the company but under which the company reserves the right to adjust 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 the unearned premiums (as defined in section 1.801-3(e) of the regulations) must be carried to cover that obligation. Such policy shall be considered guaranteed renewable even though it states a termination date at a stipulated age, if such age is 60 or more.

Section 1.801-3(b)(2) of the regulations provides that an insurance company writing only noncancellable life, health, or accident policies and having no "life insurance reserves" may qualify as a life insurance company if its unearned premiums and unpaid losses (whether or not ascertained), on such policies comprise more than 50 percent of its total reserves. In view of section 801(e) of the Code, section 1.801-3(b)(2) of the regulations is also deemed to apply to a company writing guaranteed renewable life, health, or accident policies.

Section 1.801-3(e) of the regulations defines the term "unearned premiums" to mean those amounts which shall cover the cost of carrying the insurance risk for the period for which the premiums have been paid in advance.

Whether the taxpayer's health and accident insurance policies qualify as guaranteed renewable health and accident contracts for Federal income tax purposes depends on the meaning of the phrase in section 1.801-3(d) of the regulations that "* * * a reserve in addition to the unearned premiums (as defined in paragraph (e) of this section) must be carried to cover that obligation." Unearned premiums are earned ratably as the risk period expires. They reflect the fact that the insurance company has received premiums during the year that have not yet been earned at the end of the taxable year but will be earned merely by the passage of time. On the other hand, the reserve in addition to the unearned premiums is not earned ratably but rather, are amounts, computed on the basis of life, health or accident contingencies, set aside to mature or liquidate future, unaccrued claims arising from the life, health and accident contracts with respect to which the reserve is computed. See Massachusetts Protective Assoc. Inc. v. United States, 114 F. 2d 304 (1940); Commissioner v. Monarch Life Insurance Co., 114 F. 2d 314 (1940), and cases cited therein.

Generally, the reserve in addition to the unearned premiums is necessary in the area of noncancellable health and accident policies because the policy is renewable at the sole option of the insured. If, in such a situation, the premium called for by the policy is at a level rate, it would have to be greater in the early years of the policy than the pure cost of insurance so that the excess may be accumulated, with interest, to offset the increase in mortality risks as the insureds get older. United Benefit Life Insurance Co. v. McCrory, 242 F. Supp. 845, at 849 (1965). Because hospital and medical expense benefit policies, renewable solely at the option of the insureds, involve not only increasing mortality risks as the insureds get older but also the uncertainty of the costs of medical care, the premiums for such policies do not necessarily remain level but may be increased at renewal. However, such increase in premium cannot be made with respect to an individual insured but only with respect to the class of which he is a part. This affords a certain stability to the premium that, together with the security of the coverage, necessitates a reserve in addition to the unearned premiums similar to that required under the noncancellable level premium contracts. For this reason guaranteed renewable health and accident policies, not cancellable by the insurance company and with respect to which a reserve in addition to the unearned premiums must be carried, is treated in the same manner as a noncancellable health and accident policy. See section 1.801-3(d) of the regulations.

In a case where no reserve in addition to the unearned premium was maintained to cover an insurance company's obligation under its group accident and health policies, such policies were held not to qualify as guaranteed renewable health and accident policies. See Group Life and Health Insurance Company v. United States, 434 F. 2d 115 (1970).

The amounts held by the taxpayer during the first three years the policies were in force consisted of the full gross pro rata unearned premiums. These would be earned merely by the passage of time as the risk period expires. During that period, it was not considered necessary to set aside any amount in a reserve, and no amount was set aside, in addition to the unearned premiums, to mature or liquidate future unaccrued claims arising under the contracts.

Accordingly, the health and accident policies issued by the taxpayer do not qualify as guaranteed renewable policies as defined in section 1.801-3(d) of the regulations during the first three years the policies were in force. Thereafter, a reserve in addition to the unearned premiums was required and amounts were set aside in a reserve in the nature of a life insurance reserve held to mature or liquidate future unaccrued claims. Beginning with the fourth year the policies were in force, they qualify as guaranteed renewable health and accident policies within the meaning of section 801(e) of the Code.