Insurance Company May Revalue Reserves

2. Whether revaluation should be allowed for the * * * reserves in the aggregate for the year ended * * * in accordance with TAM 9018001.

3. Whether * * * may recompute its * * * reserves for the year ended * * *

2. The total * * * reserves should be aggregated for purposes of section 818(c)(2).

3. * * * may retroactively recompute its * * * reserves to correct any mathematical or clerical errors. The agent may also consider any changes that would be helpful in arriving at the best possible estimate of * * * reserves for its * * * policies. Consequently, we recommend that * * * be allowed to recompute its * * * reserves, subject to verification by the agent.

Facts:

[4] The facts, as we understand them, are as follows. * * * began issuing its * * * policies during the tax year ended * * * The policy is described on page 653 of the RAR as "a reasonably straightforward flexible premium universal life insurance policy." * * * established reserves on the * * * policies, and added an amount sufficient to meet state minimum reserve requirements; in this case, apparently, the cash surrender value of the policies. On its annual statement for * * * reported * * * reserves of $* * * This amount is broken down by the agent on page 642 of the RAR into a "Calculated CRVM ["Commissioner's Reserve Valuation Method"] Reserve" equal to * * * ³ and a "Surrender Value" equal to $* * * It is noted, however, on page 4 of your request for advice and on page 2 of the case manager's memorandum, that * * * did not bifurcate its * * * reserves, i.e., did not divide its total reserves into two reserves on its annual statement for * * * as was done by the taxpayer in USAA Life Insurance Co. v. Commissioner, 94 T.C. 499 (1990), rev'd, 91-2 USTC 50, 362 (5th Cir. 1991) /4/.

[5] * * * revalued its * * * reserves under section 818(c)(2) for the tax year ended * * * After procuring the written report of an outside actuary, * * * of * * * the agent conceded that: (1) the reserves were computed or estimated on the basis of a recognized mortality table and assumed rate of interest; (2) a portion of the reserves were calculated using a recognized preliminary term method, the National Association of Insurance Commissioners ("NAIC") Universal Life Insurance Model Regulation ("the Model Regulation"); and (3) the policy in question is a permanent plan of insurance. ⁵

[6] The case manager's memorandum indicates that the original RAR presented a primary position, which was later conceded by the government, and an alternative position. Under the alternative position, the agent proposes to disallow the revaluation of the portion of the * * * reserves added to meet state minimum reserve requirements. The case manager indicates that the proposed disallowance would amount to $* * * and states that the calculation of this disallowance assumes that a preliminary term reserve that is equal to * * * can be revalued. As we see it, the case manager's memorandum raises several related issues: whether the portion of the * * * reserves added to meet state minimum reserve requirements may be revalued; whether the remaining portion of the reserves, alleged to be * * * can be revalued; and whether the total * * * reserves should be aggregated for revaluation purposes. Accordingly, we have expanded the scope of the issues originally contemplated on page 4 of your request for advice to include both parts of the * * * reserves.

Discussion:

[7] Section 818(c), enacted as part of the Life Insurance Company Tax Act of 1959, provides in relevant part as follows:

[10] The legislative history underlying section 818(c) demonstrates that Congress intended the revaluation election as a relief provision to ensure that life insurance companies that, for reasons of conserving surplus or writing a larger volume of new business, had calculated their annual statement reserves on a preliminary term basis (and therefore held lesser reserves than companies that used the net level basis) would not suffer a competitive disadvantage. See S. Rep. No. 291, 86th Cong., 1st Sess., 1959-2 C.B. 770, 792; see also H.R. Rep. No. 84, 86th Cong., 1st Sess., 1959-2 C.B. 736, 748. ⁶

[11] Traditionally, based upon section 818(c) and Treas. Reg. section 1.818-4, the Service has argued that in order for section 818(c) to apply:

[13] The third requirement concerns the qualification of * * * reserves as a life insurance reserves. It is the position of the Service that if the reserves are not life insurance reserves under section 801(b), they do not qualify for revaluation under section 818(c). In Modern American Life Insurance Co. v. Commissioner, 92 T.C. 1230 (1989), the court itemized the statutory criteria that a reserve must meet in order to be considered a "life insurance reserve" under section 801(b):

[15] The fourth and final requirement which * * * must meet to revalue its * * * reserves under section 818(c)(2) is that the reserves must be computed on a recognized preliminary term basis. Prior to USAA Life, little authority existed as to whether a particular reserve constituted a preliminary term reserve eligible for section 818(c)(2) revaluation. The regulations refer to reserves "computed on one of the recognized preliminary term bases," although the "recognized" limitation does not appear in the statute. Treas. Reg. section 1.818-4(a).

[16] In USAA Life, the Tax Court held that the taxpayer was not entitled to revalue certain reserves for universal life insurance contracts under section 818(c). The court observed that the taxpayer's use of a preliminary term reserve method did not result in any meaningful surplus relief. ⁸ The court also determined that the NAIC Model Regulation could be accepted as a recognized preliminary term method. We have not been advised as to whether the outside actuary in the instant case considered surplus relief in his report. We agree, however, that the agent's concession, based upon the aforementioned actuarial report, that a preliminary term method, the NAIC Model Regulation, was used is appropriate and is consistent with the Tax Court's analysis in USAA Life.

[17] In applying section 818(c)(2) to the instant case, the * * * reserves would be entitled to the $* * * revaluation under section 818(c)(2)(A) if they are preliminary term reserves held for "other than term insurance" (commonly known as "permanent insurance") or the $* * * revaluation under section 818(c)(2)(B) if they are preliminary term reserves held for term insurance with an original term extending beyond * * * The * * * reserves would be entitled to no revaluation if they are preliminary term-reserves held for term insurance policies of less than * * * Your request indicates that, based upon the actuarial report, the agent has conceded that the * * * policies are permanent insurance, thereby making them eligible for the section 818(c)(2)(A) revaluation of $* * *

[18] Finally, we address whether the portion of the * * * reserves added to meet state minimum reserve requirements and the remaining portion of the * * * reserves, alleged to be * * * can be revalued separately, or should be revalued in the aggregate. The agent has raised separate arguments in support of disallowing each portion of the reserves. In proposing to disallow the portion of the reserves added to meet state minimum reserve requirements, the agent cites Rev. Rul. 75-51, 1975-1 C.B. 190. That revenue ruling provides that a life insurance company that computes its reserves using a preliminary term reserve basis for its decreasing term life insurance contracts may not revalue under section 818(c) that portion of the reserves added to satisfy minimum requirements of state law; however, the underlying preliminary term component of the reserves are subject to revaluation. The agent proposes to disallow revaluation of the remaining portion of the reserves on the grounds that this amount, even though computed on a preliminary term basis, is * * * On page * * * of the RAR, the agent observes that, with respect to this portion of the reserves, "there is no reserve to be revalued."

[19] The agent agrees that the facts in USAA Life closely resemble the facts in this case, except that * * * did not bifurcate the reserves. The agent refers to TAM 8716002 and TAM 8727007, in which revaluation of flexible premium universal life insurance reserves was not permitted. In both of these TAMs, however, it was held that the reserves were not computed on a recognized preliminary term basis.

[20] In response, * * * argues that the agent has misinterpreted Rev. Rul. 75-51. * * * argues that under Rev. Rul. 75-51, it would still be entitled to revalue the reserve of * * * arrived at under the preliminary term method. * * * maintains that the fact that this amount is * * * is consistent with the operation of the preliminary term method, which is designed to offset large first year expenses incurred in connection with the sale of life insurance. The agent concedes that the amount of reserve after revaluation would not be * * *

[21] In support of its position, * * * cites TAM 8749004, in which the Service permitted revaluation of a negative reserve. Further, * * * argues that by following the agent's position, companies would not be entitled to revalue reserves in the common situation where a contract's first year preliminary term reserve was * * * notes that this would apply equally to universal life insurance and other whole life insurance contracts, regardless of whether an excess cash surrender value reserve had been established.

[22] * * * also points to the analogous situation involving the definition of noncancellable or guaranteed renewable accident and health insurance contracts. In defining such terms, Treas. Reg. section 1.801-3(d) requires that a "reserve in addition to the unearned premiums" be carried, and notes that it has been held that accident and health contracts, under which reserves are computed on a two-year preliminary term basis, may satisfy this definition during the first two policy years even though the actual reserve held under such preliminary term method was equal to zero. United First Insurance Co. v. Commissioner, 768 F.2d 164 (7th Cir. 1985); National States Ins. Co. v. Commissioner, 55 AFTR2d 85-1262 (8th Cir. 1985).

[23] * * * also argues that Rev. Rul. 75-51 is inapplicable to situations where the "excess" reserve relates to cash surrender values, even if the * * * cash surrender values exceeded properly computed CRVM reserves. In support, * * * cites TAM 9018001. In this TAM, the Service concluded that both the preliminary term reserve and the excess cash surrender value amount should be viewed in the aggregate for tax purposes and that revaluation of such amount was appropriate under section 818(c)(1). The Service distinguished the policies at issue from the decreasing term policies in Rev. Rul. 75-51, and determined that the revenue ruling applied only to contracts under which the additional reserves "were arbitrary amounts that were not actuarially computed to mature or liquidate future claims." * * * argues that the reserves held in connection with the * * * product are essentially equivalent to the reserves in question in the TAM.

[24] As further support for the proposition that the two reserve amounts must be considered in the aggregate, * * * cites USAA Life, supra. As noted above, in USAA Life, the taxpayer's reserves had two components, a reserve purportedly computed on a preliminary term basis, included in Exhibit 8, part A of its Annual Statement, and a reserve equal to the excess of cash surrender values over the preliminary term reserve, held in Exhibit 8, part G. The Tax Court held that the purported preliminary term reserve could not be revalued under section 818(c) because the entire reserve, viewed in the aggregate, was actually a net level reserve rather than a preliminary term reserve, and was thus not eligible for revaluation. ⁹ Finally, * * * argues that the government conceded on brief in USAA Life that Rev. Rul. 75-51 had no application to the taxpayer in that case, because the reserves were not arbitrarily established.

[25] At the outset, we reiterate our uncertainty as to whether the actuary retained by the government determined that the total * * * reserves were computed on a preliminary term basis, or whether he determined that only the portion alleged to be * * * was computed on a preliminary term basis. As discussed above, * * * did not bifurcate its * * * reserves, as the taxpayer did in USAA Life, so it appears to us that the actuary may have looked at the total * * * reserves.

[26] Even in the face of this uncertainty, however, we can conclude that the total * * * reserves should be aggregated for purposes of section 818(c)(2). In support of our conclusion, we point specifically to the Tax Court's aggregation of the Exhibit SA and BG reserves in USAA Life. We also note the Tax Court's findings that the taxpayer's division of its total reserves on its annual statement "carried no substantive weight," and that the taxpayer's inconsistent treatment of its Exhibit 8A and 8G reserves both on its annual statements and on its tax return for * * * gave the distinction no meaning.

[27] We also find support for our conclusion in TAM 9018001, cited by * * * above. In TAM 9018001, a life insurance company posted to Exhibit 9 of its annual statement reserves for certain guaranteed renewable accident and health insurance policies issued through its foreign life insurance branch. At issue was whether the reserves should be viewed, for purposes of section 818(c), as reserves representing the aggregate cash surrender values of the policies, or reserves divisible into two parts, including: (1) tax year reserves calculated on a two-year full preliminary term method; and (2) additional reserves representing the excess of the aggregate cash surrender value of the policies over the two-year full preliminary term reserves. The Service concluded that the reserves: (1) should be viewed in their entirety as representing both the policy reserves as well as the cash surrender values of the policies; (2) qualified as life insurance reserves within the meaning of section 801(b); and (3) were calculated on a preliminary term method for purposes of section 818(c). Accordingly, revaluation under section 818(c) of the active life reserves for the policies to a net level premium basis was permitted.

[28] In allowing the revaluation in TAM 9018001, however, the Service determined that section 818(c)(1) requires that the revaluation adjustment to a net level premium basis be made using the same mortality, morbidity, continuance, and interest factors to calculate the net level reserves as were used in calculating the underlying preliminary term reserves. We believe that the same caveat should apply to section 818(c)(2). It is not clear whether the same mortality, morbidity, continuance, and interest factors were used to calculate the cash surrender value reserves in the instant case, although, as noted above, we believe that the cash surrender values are life insurance reserves. We recommend, however, that prior to allowing revaluation, the mortality, morbidity, continuance, and interest factors used to calculate the cash surrender value reserves be compared to those underlying the remaining portion of the * * * reserves.

[29] Finally, we will comment on Rev. Rul. 75-51 and * * * argument that the government conceded on brief in USAA Life that the revenue ruling had no application to the taxpayer because the reserves in that case were not "arbitrarily established." During the Tax Court proceedings, the government was asked by the court to distinguish Rev. Rul. 75-51. In its opening brief, the government stated that the revenue ruling is premised on the concept that the additional reserve amounts added to meet state law requirements are not life insurance reserves. The government also argued on brief that both the 8A portion and the 8G portion of the reserves at issue must be considered when determining whether USAA Life calculated its reserves on a preliminary term basis within the meaning of section 818(c). See Opening Brief for Respondent, pp. 42-43. Rev. Rul. 75-51 was distinguished again in the government's reply brief in the Tax Court proceedings in USAA Life, in which the government argued that:

[32] Based upon the foregoing, we recommend the following. If the actuary determined that total * * * reserves were calculated on a preliminary term basis, then we would advise you to concede that the total reserves are subject to revaluation under section 818(c)(2)(A). If the actuary determined that only the portion of the reserves separate from the state minimum required reserves was calculated on a preliminary term basis, then we would advise you to concede that that portion is subject to reevaluation under section 818(c)(2)(A), and argue that the deduction of the excess, i.e., the cash surrender value reserves, is duplicative. This argument was raised by the government in the remand proceedings in the Tax Court in USAA Life, supra. See Supplemental Brief for Respondent, pp. 30-68. We have enclosed a copy of the brief for your information.

Recomputation of Reserves (Issue 3)

Facts:

[33] * * * argues that Rev. Rul. 75-51 is factually distinguishable, in that the revenue ruling dealt with a situation in which the company's preliminary term reserves were insufficient to satisfy minimum state reserve standards, and additional amounts were required to be set aside. * * * argues that it erroneously calculated CRVM reserves for * * * policies having cash surrender values as being equal to * * * on * * * whereas in fact, the CRVM reserves, if properly computed, would have exceeded the related cash surrender value. * * * asks that it be permitted to recompute its CRVM reserves for * * * to correct its prior erroneous computation. It alleges that because the computation was a mathematical error rather than an actuarial error, it should be allowed the recomputation. * * * would concede that the amount recomputed should be limited to the amount actually held as a reserve in its * * * Annual Statement. The agent has not indicated whether he agrees that the reserve was erroneously computed.

Discussion:

[34] Case law allows a taxpayer to retroactively correct clerical or accounting errors and recompute reserves. Union Mutual Life Insurance Co. v. United States, 420 F.Supp. 1181, 1204-06 (D. Me. 1976), aff'd in part and rev'd in part on other issues, 570 F.2d 382 (1st Cir. 1978), cert. denied, 439 U.S. 821 (1978). A taxpayer must follow its chosen accounting and tax reporting methodology, however, unless it receives permission from the Commissioner to change that methodology. Irvine v. Commissioner, 212 F.Supp. 937 (D. Wyo. 1963); United States v. Kleifgen, 557 F.2d 1293 (9th Cir. 1977); Pacific Mutual Insurance Co. v. Commissioner, 48 T.C. 118, 129 (1967), rev'd on another issue, 413 F.2d 55 (9th Cir. 1969); and sections 446 and 471.

[35] Based on the latter line of cases and statutory law, the government argued in its opening brief in the Tax Court proceedings in USAA Life that the taxpayer could retroactively recompute its universal life reserves only to correct mathematical errors, and any judgmental errors made by USAA in its original preliminary term reserve computations were not correctable.

[36] Factual findings contained in the Tax Court and Fifth Circuit opinions, however, caused the government to broaden its original position on the computational error issues. Both the Tax Court and Fifth Circuit not only found that USAA Life had intended to use a preliminary term method in computing its universal life insurance reserves, but also that USAA Life had specifically chosen the CRVM computation method as set forth in the NAIC Model Regulation. On brief, the government agreed, that for purposes of USAA Life alone, all of the various corrections and approaches suggested by the experts and the court should be considered in arriving at the best possible estimate of the taxpayer's reserve and expense allowance for its universal life insurance policies. In reaching this conclusion, the government considered the following factors: (1) the experts' testimony at trial concerning the variety of possible actuarial approaches and assumptions which could be used; (2) the types of errors USAA Life actually made; (3) the CRVM method; and (4) most importantly, the Tax Court's detailed discussion of the computation area in its opinion, at pages 510-512.

[37] As we indicated in footnote 3, we understand that reserves for flexible premium universal life insurance policies must exceed zero. * * * appears to be making the same argument. We do not have enough information to determine whether the suspected understatement of the * * * reserves is due solely to mathematical or clerical errors. Although the government continues to maintain, in general, that judgmental errors made in original preliminary term reserve computations are not correctable, we have no objection to the agent considering any changes that would be helpful in arriving at the best possible estimate of the * * * reserves. Consequently, we recommend that * * * be allowed to recompute its * * * reserves, subject to verification by the agent.

[38] This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the Service, including the taxpayer(s) involved, and its use within the Service should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document also is tax information of the instant taxpayer which is subject to section 6103 of the Internal Revenue Code.

[39] Please contact Nancy Vozar at FTS 622-7870 if you have any questions regarding the foregoing.

² Unless otherwise indicated, section references throughout are to the Internal Revenue Code of 1954, as amended, and to the Treasury regulations promulgated thereunder, as in effect during the year at issue.

³ Our understanding is that a reserve for flexible premium universal life insurance must exceed zero, even in the first year the related policies are issued. Thus, it is not clear to us how this portion of the reserve can be equal to * * * This observation may lend support to * * * argument, discussed in Issue 3 below, that mathematical errors have occurred.

⁴ The holdings of the Tax Court and the Court of Appeals for the Fifth Circuit in USAA Life are discussed below.

⁵ It is not clear to us whether the actuary examined the total reserves reported on * * * annual statement for * * * or only the portion alleged to be * * *

⁶ Historical Note: The revaluation election under section 818(c) was originally provided as a means of assisting small companies, which generally used preliminary term methods. The election was not limited to small companies, however, and the approximate revaluation formula often produced reserves in excess of an exact net level reserve. Since the section 818(c) election resulted in tax benefits being claimed that were substantially beyond the original intent of the relief provisions, the provision was repealed by the Tax Reform Act of 1984.

⁷ On appeal, the Fifth Circuit concluded that whether or not the cash surrender reserve required by a state was a life insurance reserve under section 801 was irrelevant in determining how the taxpayer calculated its reserves, and held that the statutory language of section 818(c) required only that the taxpayer use the preliminary term method in order to obtain the deduction. The Fifth Circuit's holding would not be binding on the Tax Court, however, in the instant case, in which an appeal would lie to the * * * Jack E. Golsen, 54 T.C. 742 (1970), aff'd on another issue, 445 F.2d 985 (10th Cir.), cert. denied, 404 U.S. 940 (1971).

⁸ This holding of the Tax Court, however, was later reversed by the Court of Appeals for the Fifth Circuit. The appellate court found that the taxpayer had, in fact, used a preliminary term method to compute its life insurance reserves, and rejected the Tax Court's analysis that the provisions of section 818(c) embody a surplus relief test. USAA Life Insurance Co. v. Commissioner, 91 USTC para. 50362.

⁹ As noted above, the Fifth Circuit reversed the Tax Court's holding that the reserve was actually a net level reserve, and remanded the case on several issues.