Rev. Rul. 73-302

Reconsideration has been given to Rev. Rul. 67-225, 1967-2 C.B. 238, in the light of the decision of the United States Tax Court in Bituminous Casualty Corporation, 57 T.C. 58 (1971).

In Rev. Rul. 67-225, the Internal Revenue Service took the position that an estimated retrospective rate credit with respect to the expired portion of a casualty insurance policy which does not terminate on or before the end of the taxable year does not qualify as an unearned premium within the meaning of section 1.832-4(a)(3) of the Income Tax Regulations defining "unearned premiums" to include "a liability for return premiums under a rate credit or retrospective rating plan based on experience." It was reasoned that the term "liability," as used in the regulations, is subject to the "all events" test, and that since the events giving rise to a retrospective rate credit or refund do not occur until the policy expires, at which time all the premiums are earned, a reserve for retrospective rate credits is not properly taken into account as unearned premiums under section 832(b)(4) of the Internal Revenue Code of 1954.

The pertinent facts in the Bituminous Casualty case (that closely parallel those in Rev. Rul. 67-225) are as follows:

The taxpayer, a stock casualty insurance company taxable under section 831 of the Code, writes insurance policies consisting predominantly of workmen's compensation and related employer liability coverage. With respect to certain of these policies, an initial premium is paid by the insured in advance and such premium is adjusted after the policy expires based on the insured's actual payroll and loss experience. The adjustments are made in accordance with schedules or formulas set forth in the policy terms. Depending on the insured's loss experience an adjustment can result in a refund of part of the premium, a liability on the part of the insured for additional premium, or no adjustment to the initial estimated premium. The premium adjustment is not finally determined until all payments are made on policy claims. Depending on the terms of the policy and the finality of the policyholders' actual experience, final determination may not be possible for from six months to a number of years after the end of the policy term. The taxpayer computed a reserve for retrospective rate credits based on its estimates as of December 31 of the portion of its amount of earned premiums (determined on a pro rata basis) that would be refundable to policyholders less its estimate of additional premiums that would be collectible on the policies. Since the taxpayer structured its premium rates to produce a net return of premium, the retrospective rate credits always exceeded the additional premiums required from policyholders. The taxpayer took its reserve for retrospective rate credits into account, for Federal income tax purposes, as unearned premiums as defined in section 832(b)(4) of the Code and the regulations thereunder.

Section 832(b)(1) of the Code provides for the inclusion of "underwriting income" in determining the gross income of a stock casualty insurance company.

Section 832(b)(3) of the Code defines the term "underwriting income" as meaning the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred.

Section 832(b)(4) of the Code provides that the term "premiums 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, and (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 1.832-4(a)(3)(ii) of the regulations provides, in pertinent part, that in computing premiums earned on insurance contracts during the taxable year the amount of unearned premiums shall include liability for return premiums under a rate credit or retrospective rating plan based on experience such as the "War Department Insurance Rating Plan."

The court in The Bituminous Casualty case held that the term "liability," as used in the regulations, was used as the term is understood in the insurance industry. As such, the court concluded that the term included the insurance company's estimated liability for return premiums on the expired portion of insurance policies that were still in effect at the close of the taxable year. The Service contended that Federal income tax consequences cannot be governed by the accounting treatment prescribed for an item by the insurance industry for purposes of the annual statement. The court stated that, although its position is that the annual statement controls the accounting treatment of the items specified in sections 832(b)(3) through (6) of the Code, it was not necessary to base its holding on the controlling effect of the annual statement. Instead, the court viewed the case as a definitional problem that did not bring the annual statement into consideration. The court then concluded that the language used in section 1.832-4(a)(3)(ii) of the regulations could not be more explicit, and that it was designed to permit the use of reserves for estimated rebates and credits in the computation of unearned premiums.

In view of the decision rendered in the Bituminous Casualty case, Rev. Rul. 67-225 is hereby revoked. However, while a reserve for retrospective rate credit or refund is not in fact an unearned premium, an estimated liability for such credit or refund will be taken into account in determining the amount of unearned premiums. For this reason and the implication resulting from the court's dictum as to the controlling effect of the annual statement for Federal income tax purposes, and its discussion of loss adjustment expenses that were not at issue, the Service acquiesces in the result in the Bituminous Casualty case, with respect to the estimated retrospective rate credit reserve issue. See page 1, this Bulletin.