Impact of recent proposed regulations on insurance companies.

To qualify as a life insurance company, more than 50% of a company's reserves must qualify as life insurance reserves. Under Sec. 816(b)(1)(A), qualification as a life insurance reserve requires, among other things, computation or estimation "on the basis of recognized mortality or morbidity tables and assumed rates of interest." (Emphasis added.)

Some courts have construed Sec. 816(b)(1)(A) as preventing reserves held with regard to life, annuity or noncancelable accident and health policies (but not computed using actuarial tables) from qualifying as life insurance reserves. In Rev. Rul. 69-302, the IRS also held that in order to qualify as a life reserve, the reserve must be calculated using actuarial tables. The Court of Federal Claims, however, has ruled that neither the statute nor regulations require the use of actuarial tables when a different method results in reserves that "reasonably approximate" actuarial reserves.

The preamble to Prop. Regs. Sec. 1.801-4 points out that the reserve ratio test of Sec. 816(a) was intended to distinguish between life and nonlife companies based on the nature of each company's business, as measured by reserves. The Treasury feels that this objective is not met if a company in essence elects to be taxed as a nonlife company merely by failing to use recognized mortality or morbidity tables and assumed rates of interest. The Treasury is apparently concerned that companies may have the ability to manipulate tax status to avoid additional taxes or limitations.

The proposed regulations allow either the taxpayer or the Service to recompute reserves to satisfy the requirements of Sec. 816(b)(1)(A). Once deemed "life" reserves, they are to be treated as such for the qualification ratio test under Sec. 816(a), as well as for computing a nonlife company's unearned premiums under Sec. 832(b)(4). The proposed regulations limit the information that may be used to recompute the reserves to the information available at the year-end in which the reserves were initially computed.

Congress intended for companies to use statutory reserves for purposes of the qualification test. It will be interesting to see whether these regulations are finalized in present form, given the Treasury's apparent lack of authority to change the law through the issuance of regulations. A public hearing has been scheduled for Apr. 17, 1997. The regulations will be effective for tax years beginning after the regulations have been finalized.

Calculation of Earned Premiums 

The Treasury has also issued Prop. Regs. Sec. 1.832-4 on the calculation of earned premiums. The regulations both define and provide timing rules for the recognition of gross premiums written, return premiums and unearned premiums. Earned premiums are the sum of gross premiums written, less return premiums and premiums paid for reinsurance, plus 80% of the unearned premiums at the end of the prior tax year, less 80% of unearned premiums at the end of the current tax year. The acceleration of taxable income as a result of the 20% reduction was intended to provide a better matching of income and expenses between premium income and the costs associated with generating that income.

In the preamble to the proposed regulations, the IRS discusses the efficacy of the annual statement, and its perception that statutory accounting rules have changed in recent years (perhaps in an attempt to avoid the full application of the 20% unearned premium reduction). While conceding Regs. Sec. 1.832-4(a)(2)'s reliance on the National Association of Insurance Commissioners (NAIC) annual statement, the preamble states that not all items of the NAIC annual statement reflect income in accordance with the Code, and that the NAIC annual statement is not used for purposes of computing taxable income if the practice is inconsistent with the Code.

In some cases, the guidance provided for in the proposed regulations deviates from statutory accounting principles, industry practice and the Service's own position; see Letter Rulings (TAMs) 9647002 and 9648002. Specifically, the proposed regulations define estimated retrospective credits as "return premiums" included in gross premiums written in the tax year in which the insurance company's liability to pay such amounts can be reasonably estimated. Previously, it was the IRS's position that such amounts should be included as part of the unearned premium reserve subject to the 20% reduction. The proposed regulations also address the treatment of retrospective debits and require that such amounts be included in gross premiums written and as premiums receivable, rather than as offsets to the unearned premium reserve. The proposed treatment of both retrospective credits and debits effectively settles the debate over whether Congress intended such amounts to be "netted" in the unearned premium reserve. However. since this treatment is inconsistent with the NAIC annual statement (which is used as the starting point for computing the 20% reduction on the unearned premium reserve), many taxpayers will likely be required to change the method by which they account for these items.

The proposed regulations further require that advance premiums be included in gross premiums written md unearned premiums in the earliest tax year in which any portion of the premiums is received or when the policy begins, thereby subjecting such amounts to the 20% reduction. As indicated by Prop. Pegs. Sec. 1.832-4(a)(7), Example 2(ii), the treatment will require taxpayers to include advance premiums in the unearned premium reserve in excess of amounts actually collected by the taxpayer (i.e., the taxpayer received the first quarterly installment of $125 in December 1998 for a policy that begins in January 1999 and was required to include the full year's premium of $500 both in gross premiums written and in the unearned premium reserve for the year ended December 1998).

In determining the amount of unearned premiums, the proposed regulations provide that "...if the risk of loss arises uniformly over the contract period, the unearned premium is that portion of the coverage which has not expired. If the risk of loss does not arise uniformly, the taxpayer may consider the pattern of incidence of the risk in determining the unearned portion."

The proposed regulations are to apply to the determination of premiums earned for insurance contracts issued or renewed in tax years beginning after the date on which the regulations are finalized. While the effective date of the proposed regulations offers no relief to taxpayers currently arguing these issues, taxpayers should be able to argue that these proposed regulations are an indication of the Service's current position. It would appear that transitional rules will be needed for companies that will have to change their existing accounting methods to comply with these regulations.

A public hearing on the proposed regulations has been scheduled for Apr. 30, 1997.