Monarch Life Ins. Co. v. Commissioner

*717 These are consolidated proceedings for the redetermination of deficiencies in income tax for the years 1933 and 1934 in the amounts of $3,844.59 and $3,574.58, respectively. The parties stipulated the facts and submitted for decision two issues of law, namely, (1) whether respondent erred in disallowing deductions claimed by petitioner representing 3 3/4 percent of the mean*831 of five certain reserve funds required by law and held by petitioner at the beginning and end of the taxable years; and (2) whether respondent erred in refusing to allow deductions as interest paid, representing discount on premiums paid in advance during the taxable years.

FINDINGS OF FACT.

Omitting formal and immaterial matter, the parties stipulated the facts as follows:

The Monarch Life Insurance Co., petitioner herein, is a corporation organized and existing under the laws of the State of Massachusetts, having its home office in Springfiled, Massachusetts. Petitioner was organized December 31, 1931, to take over the business of the Monarch Accident Insurance Co., which was organized in 1921, and the Monarch Life Insurance Co., which was organized in 1926, both under the laws of the State of Massachusetts. The petitioner was licensed to write life, and accident and health insurance contracts, and was so engaged during 1933 and 1934, the taxable years herein involved, in the State of Massachusetts as well as 23 other states and the District of Columbia.

More than 50 percent of petitioner's total reserve funds held during the taxable years were held for the fulfillment*832 of life insurance contracts and petitioner was held to be taxable as a life insurance company.

For the taxable years petitioner filed separate statements for its life insurance business and for its accident and health insurance business, with the Commissioner of Insurance for the State of Massachusetts. These reports were required by chapter 175, section 25, of the General Laws of Massachusetts, and they were in the form adopted by the National Convention of Insurance Commissioners.

*718 During the taxable years petitioner maintained the following reserves which it claims were insurance reserves required by law, but which respondent asserts were not insurance reserves within the meaning of section 203(a)(2) of the Revenue Acts of 1932 and 1934, respectively:

*834 Reserve for incurred disability benefits. - Petitioner's life insurance policies during the taxable years contained a provision that petitioner shall waive the payment of premiums by a policyholder on proof of total disability, which waiver shall operate only during the *719 continuance of such disability, petitioner reserving the right to require annual proof of such continuance. Inasmuch as petitioner's premium rates, and other reserves, are computed upon the assumption that the stated full year's premium will continue to be received when due during the life of the policy, the reserve for incurred disability benefits (item 9, page 5, of "Life Statements") represented a fund maintained to supply, during cotinuance of disability, the premiums thus to be waived. It was required during the taxable years pursuant to statutory authority by the Insurance Department of the State of New York, where petitioner was licensed and transacted business. This reserve was held during the taxable years. It was calculated upon the basis of selected tables of combined mortality and disability, with assumed interest of 3 1/2 percent. The source of the reserve was premium payments and*835 income from the investment thereof.

Reserve for nondeduction of deferred fractional premiums. - Petitioner's life insurance policies during the taxable years contained a provision that when the policy shall become payable by the death of the insured any premium necessary to complete premium payments for the policy year in which such death occurs is waived, except that, in the event of the death of the insured during a period of grace, one quarterly premium shall be deducted from the amount payable thereunder. The reserve for nondeduction of deferred fractional premiums (item 36, page 5 of "Life Statements") represented a fund maintained to supply the fractional premiums which may thus not be received during the policy year of death. It was required pursuant to statutory authority by the Commissioner of Insurance of the State of Massachusetts, as well as by the insurance departments of other states in which petitioner was likewise licensed and transacted business. The reserve was held during the taxable years.

This reserve was computed, with assumed interest of 3 1/2 percent, on the basis of selected tables of mortality. The source of the reserve was premium payments and*836 income from the investment thereof.

Reserve for unearned premiums on accident and health policies. - Petitioner wrote during the taxable years two types of accident and health policies - one a policy which may be canceled at any time by petitioner; the other a policy which (in the absence of fraud) can not be canceled by petitioner as long as premiums are paid. The cancelable policies on certain forms provided for indemnities for specified injuries occurring by accidental means; another form provided likewise for loss of time by sickness. The noncancelable policies provided on certain forms indemnities for specified injuries or *720 loss of time occurring through accidental means or through sickness; another form provided for such losses occurring through accidental means only.

With respect to both types of policy, petitioner maintained during the taxable years unearned premium reserves. The unearned premium reserve on any policy is the portion of the current premium which petitioner has not had time to earn, and which is consequently paid for protection after the date of the statement. In the case of annual premium policies it is ordinarily taken as one-half the*837 premium on the assumption that policy renewal dates are evenly distributed throughout the year.

The unearned premium reserve on any annual premium policy accordingly represents one-half the current premium, the amount of which premium is so fixed that it will, when improved with interest at an assumed rate, provide funds to pay future claims on such policy. In computing the unearned premium reserve during the taxable years, interest was assumed to be 3 1/2 percent. The source of this reserve is thus premium receipts and earnings on the investment thereof.

Petitioner was required to maintain this reserve as above described, during the taxable years, by the Massachusetts Insurance Laws (General Laws of Massachusetts, ch. 175, sec. 10); and by the New York Insurance Laws, sec. 86(2)(a). The reserve was held as so required by state law, in the amounts set out above.

The following amounts, included in this reserve at the beginning and end of each year, represented advance premiums:

*838 With respect to these amounts, petitioner concedes that it is not entitled to the deduction claimed.

Additional reserve on noncancelable accident and health policies. - The two types of accident and health policy issued by petitioner during the taxable years, cancelable and noncancelable, are described above. Because of the noncancelable feature of the latter type of policy, it may be continued by the insured until he reaches the age of seventy. By reason of the increasing age of such an insured, the risk of disability within the scope of the contract increases likewise, assuming the continuance of the policy. The premium is, however, kept level throughout the duration of the contract (subject to a *721 contractual increase at age of fifty on certain forms). Consequently the premium rates must be so fixed, in excess of those applicable to cancelable policies, that such accumulated excess accrued during the early years of such contracts, with assumed interest at 3 1/2 percent will provide a fund, which constitutes the reserve in question, the purpose of which is to meet the excess of claim costs over premium receipts during the later years.

Petitioner was required*839 to maintain such a reserve during the taxable years by the Insurance Law of New York.

This reserve was held, as so required by state laws, during the taxable years, in the amounts set out above.

Reserve for unpaid and unresisted claims. - This reserve was maintained by petitioner during the taxable years in order to provide funds to liquidate future liabilities under both the cancelable and noncancelable accident and health policies, above described; which liabilities are with respect to periodic benefits that will become payable to policyholders disabled at the date of the reserve computation, if such policyholders continue disabled. The reserve as here claimed by petitioner, accordingly represents the present value of all benefits not yet accrued at the date of valuation, arising from disabilities already incurred, which benefits will be paid in the future if the disabled insured survives and remains disabled.

The amount of the reserve is calculated upon the basis of selected tables of mortality and disability, with an assumed rate of interest taken to be 3 1/2 percent during the taxable years. A disabled policyholder is not entitled to receive benefits here in question*840 unless he survives and continues disabled during stipulated successive future periods. The source of the funds set aside in this reserve is premium receipts, and earnings upon investment thereof.

This reserve was required to be held as above, during the taxable years, by the Massachusetts Insurance Commissioner, acting pursuant to the Massachusetts Insurance Law, section 11; and by the Super-intendent of Insurance of New York, acting pursuant to the New York Insurance Law, section 86, subparagraph (2)(b).

This reserve was so held during the taxable years in the amounts set out above.

The additional reserve on noncancelable accident and health policies and the reserve for unearned premiums on accident and health policies relate to disabilities which may arise in the future. On the other hand, the portion of the reserve for unpaid and unresisted claims which is being claimed in this case relates only to disabilities which have occurred but still entail liability for future payments if the disabled policyholders survive and continue disabled. In connection with the computation of the latter reserve no part of that portion of *722 the premium payments which has been*841 added to such reserve is included in either the reserve for unearned premiums or the additional reserve on noncancelable accident and health policies. Each of these three reserves is complementary to the other two, and none in any way duplicates either of the others.

During the taxable years, the petitioner received premium payments on life insurance policies, in advance of their due dates, and allowed discount thereon as follows:

*842 The above amounts were not claimed on petitioner's returns for the taxable years as deductions for interest paid on indebtedness, but are now so claimed.

OPINION.

HILL: The first and principal issue in this case is whether respondent erred in disallowing deductions claimed by petitioner representing 3 3/4 percent of the mean of five certain reserve funds required by law and held by petitioner at the beginning and end of the taxable years, which reserve funds are referred to and described in our findings of fact above.

The Revenue Acts of 1932 and 1934, governing the taxable years, provide in pertinent part as follows:

SEC. 203. NET INCOME OF LIFE INSURANCE COMPANIES.

(a) GENERAL RULE. - In the case of a life insurance company the term "net income" means the gross income less -

* * *

(2) RESERVE FUNDS. - An amount equal to 4 per centum of the mean of the reserve funds required by law and held at the beginning and end of the *723 taxable year, except that in the case of any such reserve fund which is computed at a lower interest assumption rate, the rate of 3 3/4 per centum shall be substituted for 4 per centum. * * *

The parties have agreed that all the*843 reserve funds involved were required by law; they have also stipulated the amounts of the funds held by petitioner at the beginning and end of the taxable years, and for what purposes they were held. Thus, the issue submitted for decision is narrowed to the single question whether these reserve funds were true insurance reserves, within the meaning of section 203(a)(2), supra, or whether, as apparently contended by respondent, they were liability or solvency reserves, not peculiar to life insurance companies.

In Maryland Casualty Co. v. United States,251 U.S. 342, 350, it is said:

The term "reserve" or "reserves" has a special meaning in the law of insurance. While its scope varies under different laws, in general it means a sum of money, variously computed or estimated, which, with accretions from interest, is set aside - "reserved" - as a fund with which to mature or liquidate, either by payment or reinsurance with other companies, future unaccrued and contingent claims, and claims accrued, but contingent and indefinite as to amount or time of payment.

In *844 Helvering v. Inter-Mountain Life Insurance Co.,294 U.S. 686, arising under the Revenue Act of 1921, the Court, in defining an insurance reserve, said:

The word "reserve" has many meanings. Accounts creating reserves are set up in almost every line of business and funds evidenced by the book entires are held for many and widely different purposes. As the act does not permit corporations other than insurance companies to make deductions of the kind here under consideration, "reserve funds" may not reasonably be deemed to include values that do not directly pertain to insurance. In life insurance the reserve means the amount, accumulated by the company out of premium payments, which is attributable to and represents the value of the life insurance elements of the policy contracts.

In Continental Assurance Co. v. United States,8 Fed.Supp. 474, cited with approval by the Supreme Court in the Inter-Mountain case, supra, the Court of Claims said:

After a careful study of the nature and purpose of reserves maintained by life insurance companies in the light of all the decisions which have been rendered upon the subject and the plan*845 of taxable of such companies as provided in the federal taxing acts, we conclude: (1) That accrued liabilities are not the subject of the "reserve fund" deductions granted by Congress in any of the revenue acts; (2) that the "reserve" contemplated in the Federal statutes is "that fund which when added to the present value of future net premiums is equal to the present value of future death claims"; that is, the mathematical equivalent of the obligation incurred by the company to pay the sum insured at the death of the policyholder or upon the surrender and cancellation of the policy; (3) that the "reserve" contemplated in the federal *724 statutes is calculated upon the basis of a selected table of mortality plus an assumed rate of interest; and that reserves not so calculated, whether required by state law or by state officer, are not "reserve funds required by law" within the meaning of the federal statutes; and (4) that the "reserve fund" required by law within the meaning of the federal statutes does not include "solvency" reserves required to be maintained by state law or a state officer to keep the company in sound financial condition.

From the foregoing decisions it*846 appears that the "reserve funds required by law", in respect of which a deduction from gross income is allowed life insurance companies by the taxing acts, include only funds accumulated out of premium payments and "reserved" (1) to mature or liquidate unaccrued and contingent claims, and (2) claims accrued but contingent as to amount or time of payment; and do not include (a) values not directly pertaining to insurance, (b) reserve funds not calculated upon the basis of selected tables of mortality plus an assumed rate of interest, and (c) "solvency" reserves which may be required to keep the company in a sound financial condition.

In order to determine whether petitioner in the present case is entitled to the deductions claimed, we must examine the stipulated facts to ascertain whether the controverted reserve funds come within the limitations above indicated.

Two of the reserve funds involved hrerein, viz., the additional reserve on noncancelable accident and health policies and the reserve for unpaid and unresisted accident and health claims were considered by this Board in *847 Equitable Life Assurance Society of the United States,33 B.T.A. 708, and there held to be reserves required by law within the meaning of the Revenue Acts of 1924 and 1926, which contain provisions similar to the 1932 and 1934 Acts. Accordingly, in so far as the deficiencies result from the denial of deductions computed on the basis of the two reserve funds just mentioned, respondent's action is reversed and we hold for petitioner on authority of the cited decision.

This leaves for detailed consideration here only the first three reserve funds mentioned in our findings of fact; that is, (1) reserve for incurred disability benfits, (2) reserve for nondeduction of deferred fractional premiums, and (3) reserve for unearned premiums on accident and health policies. Reserves (1) and (2) pertain to life insurance contracts, and reserve (3) relates to accident and health policies.

Reserve for incurred disability benefits. - Petitioner's life insurance policies during the taxable years contained a provision that petitioner would waive the payment of premiums by a policyholder on proof of total disability, which waiver would operate only during the continuance of*848 such disability, and petitioner reserved the right to require annual proof of continuance of the disability. This fund represented resented *725 a reserve to supply the premiums so waived. The fund was accumulated out of premium payments, including income from investment thereof, and was required by state law. It was calculated on the basis of selected tables of combined mortality and disability, with an assumed interest of 3 1/2 percent.

We think it is plain that the premiums thus waived constituted in effect the payment by petitioner of disability benefits to the same extent as if a totally disabled policyholder had paid the annual premium in full and petitioner had thereupon repaid to the policyholder in cash the amount of the benefits provided for. Hence, this fund was designed to cover future claims that were unaccrued and contingent, since the claims accrued only as the total disability continued and there was no way of ascertaining in a given case how long the disability would in fact continue. In our opinion, petitioner's reserve fund for incurred disability benefits comes squarely within the statute under the interpreting decisions above referred to, and we*849 hold that respondent erred in disallowing the deduction claimed.

Reserve for nondeduction of deferred fractional premiums. - This fund was maintained pursuant to state law; was accumulated out of premium payments and income from investment thereof; and was computed on the basis of selected tables of mortality, with assumed interest of 3 1/2 percent. The fund was maintained to supply fractional premiums which might not be received during the policy year of death under a provision that when a policy became payable by the death of the insured any premium necessary to complete the premium payments for the policy year in which death occurred was waived, except that, in the event of the death of the insured during a period of grace, one quarterly premium should be deducted from the amount payable thereunder.

The reserve fund under discussion is similar to the preceding reserve for incurred disability benefits. The claims covered by this reserve were obviously dependent upon the happening of a future contingency, and at the date of computing the reserve were unaccrued, since it could not be known when the insured would die or whether death would occur during the period of grace. *850 Respondent's action in disallowing the deduction computed on the basis of the present reserve is reversed.

Reserve for unearned premiums on accident and health policies. - Petitioner wrote during the taxable years two types of accident and health policies, and with respect to both types maintained unearned premium reserves. The unearned premium reserve on any policy is that portion of the current premium which the insurer has not had time to earn, and consequently is the portion of the premium paid *726 for protection after the date of the reserve statement. In the case of annual premium policies it is ordinarily taken as one-half of the premium on the assumption that policy renewal dates are evenly distributed throughout the year. The unearned premium reserve on any annual premium policy is the amount which, with interest at an assumed rate, will provide funds to pay future claims on such policy.

In computing its unearned premium reserve during the taxable years, petitioner assumed an interest rate of 3 1/2 percent. The fund was derived from premium receipts, and earnings on investment thereof. It was required by state law.

The unearned premium reserve is*851 the basic insurance reserve, and, in the case of a life insurance company, so obviously comes within the term "reserve funds required by law", as used in the taxing statutes and interpreted by the decisions quoted above, that a discussion of that point here seems unnecessary.

Respondent contends, however, that reserves set up to cover accident and health policies are not in any event allowable reserves under the statute; that deductions are allowable only in respect of reserves maintained for death benefits under life insurance policies.

This is a novel proposition, and we have been unable to find any authority to support it. Section 201(a) of the Revenue Acts of 1932 and 1934, relating to the tax on life insurance companies, defines the term "life insurance company" as meaning "an insurance company engaged in the business of issuing life insurance and annuity contracts (including contracts of combined life, health, and accident insurance), the reserve funds of which held for the fulfillment of such contracts comprise more than 50 per centum of its total reserve funds." The parties to these proceedings have stipulated that more than 50 percent of petitioner's total reserve*852 funds held during the taxable years were held for the fulfillment of life insurance contracts, and that petitioner was held to be taxable as a life insurance company. If petitioner is taxable as a life insurance company, it must follow that its reserve funds must be treated as reserve funds of a life insurance company. Equitable Life Assurance Society of the United States, supra, dealt with reserves on accident and health policies, such as are involved in the present proceedings, and they were there held to be a proper basis for allowable deductions. Respondent's position on this point, we think, can not be sustained, and his action is reversed.

Certain amounts were included in petitioner's reserve for unearned premiums at the beginning and end of the taxable years, with respect to which petitioner now concedes that it is not entitled to the deductions claimed. Such amounts, as stipulated by the parties, *727 are set out in our findings of fact above. The deductions claimed by petitioner will be recomputed in accordance therewith, and as so recomputed we hold to be allowable deductions. Cf. *853 McCoach v. Insurance Co. of North America,244 U.S. 585; Maryland Casualty Co. v. United States, supra;Travelers Equitable Insurance Co.,22 B.T.A. 784.

The second issue presented for decision is whether respondent erred in disallowing amounts claimed by petitioner as deductions for interest, representing discount on premiums paid in advance. Section 203(a)(8) of the Revenue Acts of 1932 and 1934 permits a life insurance company to deduct from gross income "all interest paid within the taxable year on its indebtedness." Discount allowed by petitioner for prepayment of premiums does not constitute interest paid on its indebtedness within the meaning of the statute, and is not an allowable deduction. Illinois Life Insurance Co.,30 B.T.A. 1160 (reversed on another point, 299 U.S. 88). Respondent's action on this issue is approved.

Judgments will be entered under Rule 50.