Rev. Rul. 77-198

Advice has been requested whether the recomputation of a life insurance company's reserves as of December 31, 1975, is a change in basis within the meaning of sections 806(b) and 810(d) of the Internal Revenue Code of 1954, or whether the recomputation results in the creation of new reserves qualifying under section 801(b), under the circumstances described below.

The taxpayer is a mutual life insurance company taxable under section 802 of the Code. In 1975, the Internal Revenue Service examined the taxpayer's Federal income tax returns for the taxable years 1970 through 1974, at which time certain reserves (substandard reserves and extra reserves for group life conversions) were properly reclassified from section 810(c)(1) reserves (life insurance reserves) to section 810(c)(2) reserves (unearned premiums and unpaid losses) because reserves were not computed actuarially so as to qualify as life insurance reserves under section 801(b).

For the taxable year 1975, the taxpayer recomputed the above indicated reserves using recognized mortality tables and assumed rates of interest to qualify such reserves as life insurance reserves as defined under section 801(b) of the Code. The recomputed reserves amounted to 5,000x dollars, which were 200x dollars higher (with respect to contracts issued before 1975) than they would have been had they been computed under the basis used prior to 1975. The recomputed reserves were not attributable to any new or additional policy benefits.

Prior to 1975 the substandard reserves were computed as 50 percent of the extra premiums charged, and the extra reserves for group life conversions were computed as the present value of 65x dollars for each 1,000x dollars of insurance in force.

As a result of the adjustments made by the Service in taxable years 1970 through 1974, the taxpayer reduced the substandard reserves and the extra reserves for group life conversions to zero as of January 1, 1975, and included as of December 31, 1975, the full amount of the recomputed reserves of 5,000x dollars as life insurance reserves as defined in section 801(b) of the Code.

Section 801(b) of the Code defines "life insurance reserves", in part, as amounts that are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and that are set aside to mature or liquidate future unaccrued claims arising from life insurance contracts involving life contingencies at the time with respect to which the reserve is computed.

Section 806(b) of the Code (dealing with change in basis of computing reserves), provides that if the basis for determining the amount of any item referred to in section 810(c) as of the close of the taxable year differs from the basis for such determination as of the beginning of the taxable year, then for the purposes of determining taxable investment income under subpart B, part 1, of subchapter L, the amount of such item--(1) as of the close of the taxable year shall be computed on the old basis, and (2) as of the beginning of the next taxable year shall be computed on the new basis.

Section 810(d)(1) of the Code (dealing with an adjustment for change in computing reserves), provides, in part, that if the basis for determining any item referred to in section 810(c) (relating to, among other items not pertinent here, life insurance reserves and unearned premiums and unpaid losses included in total reserves) as of the close of any taxable year differs from the basis for such determination as of the close of the preceding taxable year, and the amount of the item at the close of the taxable year, computed on the new basis, exceeds the amount of the item at the close of the taxable year, computed on the old basis, then so much of such excess as is attributable to contracts issued before the taxable year shall be taken into account for purposes of determining gain and loss from operations under subpart C, part 1, of subchapter L, over each of the succeeding 10 taxable years as a net increase to which section 809(d)(2) applies.

Section 809(d)(2) of the Code allows a deduction under subpart C, part 1, of subchapter L for the net increase in reserves required to be taken into account by section 810.

Sections 806(b) and 810(d) of the Code are applicable only if the basis for determining the amount of "any item" referred to in section 810(c) as of the close of the taxable year differs, in the case of section 806(b), from the basis for such determination as of the beginning of the taxable year and, in the case of section 810(d), from the basis for such determination as of the close of the preceding taxable year. See Rev. Rul. 69-444, 1969-2 C.B. 145, which holds that an increase in reserves solely because a life insurance company increased benefits under existing policies is not attributable to a change in basis for computing reserves within the meaning of sections 806(b) and 810(d) of the Code.

In the instant case, the recomputation of taxpayer's substandard reserves and extra reserves for group life conversions is not attributable to new or additional benefits on policies in force. For this reason the reserves are not new reserves. The change in computing the reserves for the policies in force was made from a nonactuarial percentage reserve method which produced reserves that did not qualify as life insurance reserves to a method using recognized mortality tables and assumed rates of interest that produced life insurance reserves within the meaning of section 801(b) of the Code. Thus, a change from the taxpayer's former method to the later method of computing the reserves in question is a change in basis of computing reserves.

Accordingly, the taxpayer's recomputation of the subject reserves as of December 31, 1975, represents a change in basis of computing reserves within the meaning of sections 806(b) and 810(d) of the Code. Under the authority of section 810(d), the resulting adjustment of 200x dollars shall be taken into account ratably (20x dollars per year) over the next succeeding 10 taxable years commencing in 1976 as a net increase in certain reserves to which section 809(d)(2) applies.