CHANGES IN COMPUTING LIFE INSURANCE RESERVES ARE SUBJECT TO CHANGE- IN-BASIS RULES.

Rev. Rul. 94-74

ISSUE

If a life insurance company changes the manner of computing its life insurance reserves under section 807(d) of the Internal Revenue Code, what adjustments are required in computing life insurance company taxable income?

FACTS

IC, a life insurance company within the meaning of section 816(a), issues life insurance contracts directly and also reinsures the risks on life insurance contracts issued by other companies. IC is required to determine life insurance reserves under section 807(d) with respect to both directly written and reinsured contracts, and to take net increases or decreases in the reserves into account in computing life insurance company taxable income. In all of the situations described in this ruling, IC computes the amount of the life insurance reserve for a contract in accordance with the limitations in section 807(d)(1).

Situation 1.

In 1993, IC discovered that in prior years it had computed the amount of its life insurance reserves under section 807(d) for certain reinsured contracts issued prior to 1982 using the prevailing commissioners' standard table (the 1980 Commissioners' Standard Ordinary Tables) at the time the reinsurance agreement was entered into rather than the prevailing commissioners' standard table (the 1958 Commissioners' Standard Ordinary Tables) at the time the reinsured contracts were issued. IC further determined that if an amended return were filed for the taxable year ended December 31, 1989, the earliest open taxable year, the closing balance at December 31, 1989, of its reserves under section 807(d) for the reinsured contracts would be $120x greater than the amounts originally claimed.

Situation 2

Pursuant to an examination of IC's tax returns for taxable years 1990 through 1992, the District Director determined that IC had computed its reserves under section 807(d) for certain life insurance contracts using the same interest rates as IC used to compute the statutory reserves for the contracts for state regulatory reporting purposes. The District Director required IC to recompute the amount of its reserves for the contracts under section 807(d) at the close of the 1990 taxable year, the earliest open taxable year, using the higher of the applicable federal interest rate or the prevailing State assumed interest rate in effect when the contracts were issued. This recomputation resulted in a net decrease of $130x in the closing balance at December 31, 1990, of IC's reserves for the contracts. Of this $130x net decrease in reserves, $115x of the reduction was attributable to reserves for contracts issued prior to 1990, and the remaining $15x to reserves for contracts issued during 1990.

Situation 3.

IC historically has computed its statutory reserves for state regulatory reporting purposes for life insurance contracts using curtate functions. A curtate function assumes that all annual net premiums are received at the beginning of the policy year and that all death claims are paid at the end of the policy year. IC also has used curtate functions when computing its life insurance reserves for the contracts under section 807(d).

On its annual statement filed with the states for calendar year 1993, IC computed its statutory reserves at December 31, 1993, for life insurance contracts using continuous functions. A continuous function assumes that annual net premiums are received continuously throughout the policy year and that death claims are paid at the moment of death. IC determined that if continuous functions were used to compute its reserves for the contracts under section 807(d) as of December 31, 1993, the closing balance of the reserves would be $15x greater than the corresponding reserves computed using curtate functions. Of this $15x net increase in reserves, $12x of the increase was attributable to reserves for contracts issued prior to 1993, and the remaining $3x to reserves for contracts issued during 1993.

Situation 4.

For purposes of computing its life insurance reserves under section 807(d), IC organizes its life insurance contracts into policy groupings or cells, each consisting of policies which are identical as to plan of insurance, year of issue or contract duration, age of issue, and other factors. In 1993, IC discovered that due to a computer programming error, certain policy cells issued during 1992 had been omitted from the computation of IC's closing 1992 reserves. Had the omitted policy cells been included in IC's closing 1992 reserves, IC's life insurance reserves under section 807(d) at December 31, 1992, would have been $75x greater than the amounts originally claimed.

APPLICABLE LAW AND ANALYSIS

Section 805(a)(2) authorizes a deduction with respect to the net increase in certain reserves required by section 807(c) to be taken into account. Under section 807(c)(1), the reserves to which this treatment applies include "life insurance reserves as defined in section 816(b)."

Section 807(d)(1) provides that, other than for purposes of section 816 (relating to qualification as a life insurance company), the amount of the life insurance reserve with respect to any contract is the greater of (i) the net surrender value of the contract, or (ii) the reserve determined under section 807(d)(2). In no event may the reserve for any contract exceed the amount taken into account with respect to that contract as of that time in determining the statutory reserves (reduced by any deferred and uncollected premiums taken into account in determining the statutory reserves). Section 807(d)(1) (flush language); see also sections 809(b)(4)(B) and 811(c).

Section 807(d)(2) provides that the reserve for any contract must be determined using (i) the tax reserve method applicable to that type of contract, (ii) the greater of the applicable federal interest rate or the prevailing State assumed interest rate, and (iii) the prevailing commissioners' standard tables for morbidity or mortality adjusted as appropriate to reflect the risks (such as substandard risks) incurred under the contract which are not otherwise taken into account. See section 10241 of the Omnibus Budget Reconciliation Act of 1987, P.L. 100-203, for amendments to section 807 applicable to contracts issued in taxable years beginning after December 31, 1987.

Section 807(d)(3) prescribes the applicable Commissioners' Reserve Valuation Method (CRVM) in effect when the contract is issued as the tax reserve method for life insurance contracts.

Section 807(d)(4)(A) provides that the "applicable federal interest rate" means the annual rate determined by the Secretary under section 846(c)(2) for the calendar year in which the contract was issued.

Section 807(d)(4)(B) provides that the "prevailing State assumed interest rate" means, for any contract, the highest assumed interest rate permitted to be used in computing life insurance reserves for insurance or annuity contracts of that type of contract under the laws of at least 26 states as of the beginning of the calendar year when the contract was issued.

Section 807(d)(5)(A) provides that the term "prevailing commissioners' standard tables" means, with respect to any contract, the most recent commissioners' standard tables prescribed by the National Association of Insurance Commissioners (NAIC) that are permitted to be used in computing reserves for that type of contract under the insurance laws of at least 26 states when the contract was issued.

The legislative history relating to section 807 indicates that for purposes of determining the applicable prevailing commissioners' standard table to be used in computing reserves for reinsured contracts, the issue date that should be referred to is that of the underlying policies and not the date of the reinsurance agreement. See H.R. Rep. No. 432, 98th Cong. 2d Sess., Pt. 2, 1415, fn. 14 (1984); Senate Committee on Finance, 98th Cong. 2d Sess., Deficit Reduction Act of 1984. Explanation of Provisions Approved by the Committee on March 21, 1984, Vol. 1, 541, fn. 12 (Comm. Print 1984).

Section 807(f) provides that if the basis for determining any item referred to in section 807(c) as of the close of any taxable year differs from the basis for determining that item as of the close of the preceding taxable year, then so much of the difference between (i) the amount of the item at the close of the taxable year, computed on the new basis, and (ii) the amount of the item at the close of the taxable year, computed on the old basis, as is attributable to contracts issued before the taxable year, is taken into account ratably over 10 taxable years (either as an increase or decrease in taxable income), beginning with the year following the year of change.

Section 1.806-4(a) of the Income Tax Regulations provides, in part, that a change in basis of computing any of the items in former section 810(c) (current section 807(c)) is not a change in method of accounting requiring the consent of the Secretary or his delegate under section 446(e).

Section 807(f) was originally enacted as section 810(d) by the Life Insurance Company Income Tax Act of 1959, P.L. 86-69 (1959 Act). In the legislative history of the 1959 Act, the term "basis" is used interchangeably with "method" when describing the effects of a change in basis of computing reserves. See H.R. Rep. No. 34, 86th Cong. 1st. Sess. (1959), 1959-2 C.B. 736, 759; S. Rep. No. 291, 86th Cong. 1st Sess. (1959), 1959-2 C.B. 770, 811. By enacting section 810(d), Congress provided a specific treatment for tax purposes for adjustments resulting from a change in method of computing reserves, which otherwise would have been subject to the general tax rules under section 481 for changes in method of accounting. See, e.g., American General Life and Accident Insurance Co. v. United States, 90-1 USTC paragraph 50,010 at 83,042 (M. Dist. Tenn. 1989) ("section 481 is simply a much more general provision dealing with recapture of tax income in a broad variety of cases . . . [while] section 810, on the other hand, is much more specific and deals with a very narrow and limited type of 'change in method of accounting'"). A stated purpose of section 810(d) was to avoid the income distortion created by taking the entire impact of a change in basis of computing reserves into account in computing taxable income for a single taxable year. See H.R. Rep. No. 34, 86th Cong. 1st. Sess. (1959), 1959-2 C.B. at 749; S. Rep. No. 291, 86th Cong. 1st Sess. (1959), 1959-2 C.B. at 794.

The 10-year ratable adjustment rule of section 810(d) was reenacted as section 807(f) in the comprehensive revision to the life insurance company tax provisions effected by the Tax Reform Act of 1984, P.L. 98-369 (the "1984 Act"). By using language identical to that of prior section 810(d), Congress signalled its intent that section 807(f) be construed in accordance with prior law. See H.R. Rep. No. 432, at 1417; Senate Committee on Finance, Deficit Reduction Act of 1984, at 543 ("The present law allowing income or loss resulting from a change in the method of computing reserves to be taken into account ratably over a 10-year period is retained"). In general, where a provision was carried over from prior law by the 1984 Act, Congress intended the new provision to be interpreted in a manner consistent with the prior law provision. See H.R. Rep. No. 432, at 1402; Senate Committee on Finance, Deficit Reduction Act of 1984, at 524. Under the rulings and case law interpreting prior section 810(d), a change in basis may occur whether the change in manner of computing the reserve is voluntary or involuntary, as well as when there is a change from incorrect to correct reserve computations. See, e.g., American General Life & Accident Ins. Co. v. United States; Rev. Rul. 77-198, 1977-1 C.B. 190 (a change from a nonactuarial method of computing reserves to a method that utilizes recognized mortality tables and assumed rates of interest is a change in basis of computing reserves under former sections 806(b) and 810(d)).

After enactment of the specific tax reserving rules in the 1984 Act, fewer circumstances exist under which changes in assumptions, other than those specified in the statute, used in computing reserves could be made. See Senate Committee on Finance, Deficit Reduction Act of 1984, at 539-40 ("The bill, however, takes a new approach by prescribing specific rules for computing life insurance reserves for tax purposes, and as a consequence, the amount of the deduction allowable or income includible in any taxable year is prescribed regardless of the manner employed in computing State statutory reserves"). Changes in specified assumptions under section 807(d), e.g., the interest rate, mortality table, or federally prescribed method, could occur as a result of erroneous reserve computations. In addition, changes in other assumptions for computing statutory reserves may cause increases or decreases in a company's reserves which are attributable to a change in basis. However, regardless of the nature of a change in "basis" or "method" of computing reserves (i.e., whether the change results from a change in specified or nonspecified assumptions), section 807(f) and section 1.806-4(a) require a 10-year ratable spread of the adjustment resulting from the change in manner of computing reserves without requiring consent to make the change under section 446(e).

Under section 446, a change in method of accounting does not include correction of mathematical or posting errors. See, e.g., section 1.446-1(e)(2)(ii)(b). Because section 807(f) is a more specific application of the general tax rules governing a change in method of accounting, a circumstance that is not a change in method of accounting under the general rules cannot be governed by the more specific rules of section 807(f). Accordingly, consistent with section 446, the correction of reserves for a mathematical or posting error would not be treated as a change in basis under section 807(f).

Section 811(a) provides that a life insurance company is required to compute its taxable income using an accrual method of accounting or, to the extent permitted by Treasury regulations, using a combination of an accrual method of accounting with another permissible method (other than the cash receipts and disbursements method). To the extent not inconsistent with federal income tax accounting rules and other federal tax rules applicable to life insurance companies, all computations, however, are to be made in a manner consistent with the manner required for purposes of the annual statement approved by the National Association of Insurance Commissioners.

In Situation 1, IC discovered that in computing the amount of its reserves under section 807(d) for certain reinsured contracts, it had referred to the date of the reinsurance agreement, as opposed to the issue date of the underlying policies, for purposes of determining the applicable prevailing commissioners' standard mortality table. A change in the computation of the reserves to correct for an erroneous application of the prescribed reserve computation rules of section 807(d)(2) is treated as a change in basis under section 807(f). At the time of the discovery of this error in its reserve computations, IC's earliest open year was the taxable year ended December 31, 1989. Accordingly, IC may recompute the amount of its reserves under section 807(d) for reinsured contracts issued prior to 1982 at the close of the taxable year ended December 31, 1989, the earliest open year, to reflect the prevailing commissioners' standard mortality tables based on the actual issue dates of the underlying policies.

For purposes of computing the net increase or decrease in life insurance reserves for the 1989 taxable year, the year of change, IC determines the closing balance of its reserves under section 807(d) with respect to reinsured contracts using the old basis involving incorrect mortality tables. Pursuant to the adjustment rules of section 807(f), the $120x difference between the amount of IC's reserves for the contracts at the close of the 1989 taxable year, as recomputed on the new basis using the 1958 C.S.O. Tables, and the corresponding reserves computed on the old basis, using the 1980 C.S.O. Tables, is taken into account as a deduction in computing taxable income ratably over 10 taxable years, beginning with the 1990 taxable year.

In Situation 2, the District Director appropriately required IC to recompute its reserves for certain life insurance contracts for the taxable year ended December 31, 1990, the earliest open taxable year, because of a failure to use the appropriate interest rates specified by section 807(d)(2). A change in the manner of computing IC's reserves to correct for an erroneous application of the reserve computation rules of section 807(d)(2) is treated as a change in basis under section 807(f), even though the recomputation of IC's reserves is made on an involuntary basis.

For purposes of computing net increases or decreases in life insurance reserves for the 1990 taxable year, the year of change, IC determines the closing balance of the reserves at December 31, 1990 for contracts issued prior to 1990 using the old basis involving incorrect interest rates. Pursuant to the adjustment rules of section 807(f), the $115x net reduction to the closing balance of the reserves for these contracts resulting from the use of the appropriate interest rates specified in section 807(d)(2) is taken into account as an increase in taxable income ratably over 10 taxable years, beginning with the 1991 taxable year. The $15x reduction in IC's reserves at December 31, 1990, which is attributable to the use of the appropriate interest rates for contracts issued during 1990 is not subject to the 10-year adjustment rule of section 807(f) because the reserves at December 31, 1990, attributable to these contracts must be computed using correct interest rates.

In Situation 3, IC changed assumptions with respect to the timing of premium collections and payment of death claims for purposes of computing its statutory reserves. The NAIC prescribed reserve method for life insurance contracts, or CRVM, does not require the use of a particular timing assumption with respect to these items for purposes of determining the minimum acceptable reserve under state law. Because the prescribed tax reserve method under section 807(d)(3)(A) does not specify the use of either curtate or continuous functions, IC must apply the same timing assumption for premiums and death claims when computing the amount of its reserves for tax purposes as it uses in computing the state statutory reserves for the contracts. See section 811(a). Accordingly, the change from curtate to continuous functions for purposes of determining the amount of IC's reserves on life insurance contracts for state regulatory reporting purposes results in a change in basis under section 807(f). See also Rev. Rul. 70-192, 1970-1 C.B. 153 (same result under prior law).

For purposes of computing increases or decreases in life insurance reserves for the 1993 taxable year, IC must compute the closing balance of its reserves under section 807(d) with respect to life insurance contracts issued prior to 1993 using the old basis involving curtate functions. Pursuant to the adjustment rules of section 807(f), the net increase of $12x resulting from the recomputation of the closing reserve balance for these contracts using continuous functions must be taken into account as a decrease in taxable income ratably over 10 taxable years, beginning with the 1994 taxable year. The $3x increase in IC's reserves at December 31, 1993 which is attributable to the use of continuous reserve factors for contracts issued during 1993 is not subject to the 10-year adjustment rule of section 807(f) because the reserves at December 31, 1993, attributable to these contracts must be computed using continuous functions.

In Situation 4, the understatement of IC's reserves at December 31, 1992, caused by the omission of certain policy groupings issued during 1992 is the result of a mathematical or posting error. Correction for IC's omission of reserves for certain contracts is not a change in basis under section 807(f) or a change in method of accounting under sections 446 and 481. Because this mathematical or posting error occurred in 1992, IC should file an amended return for that taxable year, restating the closing reserves at December 31, 1992, to reflect the correct reserve amounts and taking these recomputed reserves into account in redetermining its life insurance company taxable income for that year. Thus, as the tax effects of correcting this error are taken into account for the 1992 taxable year, the adjustment to IC's closing reserves at December 31, 1992 with respect to this error is not spread over 10 years under section 807(f).

HOLDING

A change in the manner of computing a life insurance reserve under section 807(d) is subject to the change in basis rules under section 807(f). Thus, there is no requirement under section 446(e) to obtain the Commissioner's consent to make the change. The 10-year ratable adjustment rule of section 807(f) applies to the adjustments resulting from a recomputation of the reserves for a contract to correct for an erroneous application of the prescribed computational rules of section 807(d)(2), whether the recomputation is initiated by the taxpayer or the Service. If a change in basis of computing reserves is required to correct for an erroneous application of the computational rules of section 807(d)(2), either the taxpayer or the Service may make the change retroactively by amending (or adjusting) the taxpayer's returns (not otherwise barred by the statute of limitations) for periods for which there was an erroneous application of the prescribed rules.

The 10-year ratable adjustment rule of section 807(f) also applies when the amount of the reserves for a contract is changed as the result of a change in a computational assumption (other than the tax reserve method, interest rate, or the prevailing commissioners' standard mortality or morbidity table specified by section 807(d)(2)) used in determining the statutory reserves for a contract. For tax purposes, the year of change is the year for which the taxpayer changes the method of computing its reserves for the contract for state regulatory reporting purposes.

An adjustment to the amount of a life insurance reserve under section 807(d) to correct for a mathematical or posting error is not considered a change in basis under section 807(f). Adjustments attributable to the correction of a mathematical or posting error must be made to both opening and closing reserves for the affected year, and are not subject to the 10-year ratable adjustment rule of section 807(f).

DRAFTING INFORMATION

The principal author of this revenue ruling is Gary Geisler of the Office of the Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Geisler on (202) 622-3970 (not a toll-free call.)