Rev. Rul. 61-167

Advice has been requested whether reserves for `fidelity and surety losses incurred but not reported' which are required by the United States Department of the Treasury to be maintained by companies writing fidelity and surety bonds in connection with United States Government contracts are deductible by such companies either as `losses incurred' or as `unearned premiums,' in determining insurance company taxable income under section 832 of the Internal Revenue Code of 1954.

The taxpayer is a fidelity and surety company engaged in writing surety bonds on United States Government contracts and is taxable under section 831 of the Code as an insurance company (other than life or mutual).

Under Treasury Department regulations, all companies transacting fidelity and surety business on contracts in favor of the United States are required to file complete annual financial reports with the Department. These reports are to be made on forms approved by the National Convention of Insurance Commissioners. The Treasury Department regulations also provide that such companies are required to maintain reserves for losses incurred but not reported with respect to fidelity and surety bonds. These reserves consist of specified portions of a company's net fidelity and surety premiums in force on the closing date applicable to the annual financial statement and are based on a prescribed percentage rate determined with reference to the number of years which a company has transacted fidelity an surety business.

In the Underwriting and Investment Exhibit of the insurance Convention Statement, filed with the taxpayer's return, the above-mentioned `reserve for losses incurred but not reported' is included in, and treated as a part of, the deduction claimed for `losses incurred.'

Section 832(b)(1) of the Code, in defining taxable income of certain insurance companies, provides, in part, that gross income earned from investment income and underwriting income is computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners.

The taxpayer contends that the amounts placed in the reserve by him are properly deductible under section 832 of the Code as `losses incurred,' since the maintenance of the reserve is required by the Treasury Department and such amounts are included as a part of the deduction claimed for `losses incurred' in the underwriting and investment exhibit of the financial statement approved by the National Convention of Insurance Commissioners.

In determining allowable deductions under section 832 of the Code, section 832(c) provides, in part, that a deduction shall be allowed for `losses incurred' as defined in section 832(b)(5) of the Code, which provides as follows:

(5) LOSSES INCURRED.-The term `losses incurred' means losses incurred during the taxable year on insurance contracts, computed as follows:

(A) To losses paid during the taxable year, add salvage and reinsurance recoverable outstanding at the end of the preceding taxable year and deduct salvage and reinsurance recoverable outstanding at the end of the taxable year.

(B) To the result so obtained, add all unpaid losses outstanding at the end of the taxable year and deduct unpaid losses outstanding at the end of the preceding taxable year.

Section 1.832-1 of the Income Tax Regulations provides, in part, that in computing `losses incurred' the determination of unpaid losses at the close of each year must represent actual unpaid losses stated in amounts which, based upon the facts in each case and the company's experience with similar cases, can be said to represent a fair and reasonable estimate of the amount the company will be required to pay.

The District Director of Internal Revenue may require every insurance company to which section 832 of the Code applies to submit such detailed information with respect to its actual experience as is deemed necessary to establish the reasonableness of the deduction for `losses incurred.'

Section 832(b) of the Code provides, in part, that the term `gross income,' in the case of an insurance company subject to the tax imposed by section 831, means the sum of the combined amount earned during the taxable year from investment income and from underwriting income computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners.

However, it has long been the position of the Internal Revenue Service that the Convention Form is to be used only as a general guide in computing the gross income of an insurance company other than life or mutual. See Pacific Employers Insurance Co. v. Commissioner , 89 Fed.(2d) 186, Ct. D. 1268, C.B. 1937-2, 312; Commissioner v. United States Guarantee Co. , 190 Fed.(2d) 152; and Rev. Rul. 60-306, C.B. 1960-2, 211.

In addition, section 1.832-1(a) of the regulations provides, in part, that 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 Internal Revenue Code of 1954, it will be recognized and used as a basis for that purpose.

Therefore, the deductibility of amounts as `losses incurred' is contingent upon compliance with the provisions of section 832 of the Code and the regulations thereunder. Those provisions do not provide for the deduction of reserved for unpaid losses, but, instead, provide that the part of the deduction for losses incurred which represents unpaid losses at the close of the taxable year comprise only `actual unpaid losses' which, based on the facts of each case and the company's experience in similar cases, can be said to represent a fair and reasonable estimate of the amount the company will be required to pay. The fact that the maintenance of a particular reserve may be required by the Treasury Department and that such reserve is included in and is a part of the deduction claimed as `losses incurred' on the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners does not qualify such a reserve as deductible `losses incurred' for Federal income tax purposes in the absence of compliance with the provisions of section 832 of the Code and the regulations thereunder.

The reserve maintained by the taxpayer in this case does not comprise actual losses which, based on the facts of each case and the company's experience in similar cases, can be said to represent a fair and reasonable estimate of the amount the company will be required to pay but, in fact, constitutes a contingency reserve, computed on the basis of a percentage rate established by the Treasury Department, which the taxpayer is required to maintain as a condition of writing surety bonds on United States Government contracts.

With respect to whether the reserve constitutes `unearned premiums' deductible under section 832(b)(4) of the Code, it may be stated that such term is generally defined to mean that portion of net premiums which the insurance company has not yet had time to earn or, more precisely, that portion of the premiums paid by the policyholder which must be returned to him on cancellation of the policy, and which is in direct proportion to the unexpired term which the policy has to run. See Rev. Rul. 55-693, C.B. 1955-2, 284.

In some instances, amounts required by a state statute to be placed in reserve have been recognized as having all of the attributes that pertain to `unearned premiums' and have been treated as such for income tax purposes, which such amounts were (1) withdrawn by statute from the use of the company for its general purposes, (2) impressed with a trust in favor of contract holders until the risk was carried for the definite period provided by the statute, and (3) available for reinsurance of the contract in the event the company became insolvent or were to be returned to the contract holder if not used for such purpose. See Early, Jr. v. Lawyers Title Insurance Corporation , 132 Fed.(2d) 42; I.T. 3798, C.B. 1946-1, 127; and Rev. Rul. 57-48, C.B. 1957-1, 212.

In view of the foregoing, the reserve maintained by the taxpayer in this case does not qualify as `unearned premiums' since such reserve is lacking in the recognized attributes appertaining to `unearned premiums.'

Accordingly, it is held that reserves for `fidelity and surety losses incurred but not reported,' which are required by the Treasury Department to be maintained by companies transacting fidelity and surety business on Government contracts, are not deductible for Federal income tax purposes, under section 832 of the Code, either as `losses incurred' or as `unearned premiums.'