Rev. Rul. 55-705

The inconsistent manner in which life insurance companies in general have computed their nonlife insurance reserves under section 806 of the Internal Revenue Code of 1954 reflects the need of clarification by the Internal Revenue Service of the method to be used in the computation of the adjustment for certain reserves as provided by that section.

Briefly stated, the issues are (1) whether in computing the amount of adjustment for certain nonlife insurance reserves only reserves held against future unaccrued contingent payments should be included or whether there should also be included policy claims and losses outstanding which represent accrued liabilities, and (2) whether reserves for deferred maternity benefits should be included in `unearned premiums' or in `unpaid losses' in computing the amount of adjustment for certain nonlife insurance reserves.

Section 806 of the Internal Revenue Code of 1954 is substantially the same as section 202(c) of the Internal Revenue Code of 1939 and provides in part as follows:

In the case of a life insurance company writing contracts other than life insurance or annuity contracts (either separately or combined with noncancellable health and accident insurance), the term `adjustment for certain reserves' means an amount equal to 3 1/4 percent of the unearned premiums and unpaid losses on such other contracts which are not included in life insurance reserves * * *.

Prior to the enactment of the above section (section 202(c)), a life insurance company writing health, accident or other insurance contracts was taxable only on investment income. Since there is very little investment income derived from the investment of premiums on such contracts, the real income from the accident, health and other business derived from premiums was not taxable. As a result, section 202(c) of the 1939 Code was enacted in order to provide a more easily determinable tax base for the cancellable health and accident and other business of life insurance companies. See Senate Report No. 1631, 77th Cong., C.B. 1942-2, 504, at 614.

While the insurance industry often refer to `unearned premiums' as a `reserve,' it is not such a reserve as involves future contingencies nor is it based upon recognized mortality or morbidity tables as is the case in the reserve for the present value of amounts not yet due on future claims.

Section 806 of the Code and section 39.202-2 of Regulations 118, which, under the provisions of Treasury Decision 6091, C.B. 1954-2, 47, continue in effect pending the issuance of new regulations pertinent to the corresponding sections of the 1954 Code, provide for a base consisting of `unearned premiums' and `unpaid losses' and not for `unpaid premium reserves' and `unpaid loss reserves.' Thus, in the computation of the `adjustment for certain reserves' as provided by section 806 of the Internal Revenue Code of 1954, all `unearned premiums' and all `unpaid losses' should be included.

The second issue for consideration is whether, in computing the amount of the adjustment for certain reserves, reserves for deferred maternity benefits are includible in `unearned premiums,' or whether they represent `unpaid losses.' The description of this type of policy shows that the insurer incurs no liability from the date of issue until a period of nine months thereafter. Then for the period of the last three months of the year of issue and for an extension of nine months beyond the year of issue (making a full twelve-month period of actual liability) the insurer is liable for maternity benefits to the policyholder. It is apparent that the insurer is not on the risk until nine months after the contract is issued or the policyholder's insurance begins. Premiums in these circumstances cannot be earned except during the period in which the insurer is on the risk, which includes the three-month period of the year of issue and the nine-month period of insured's rights under the policy. When the insured event occurs, claim liabilities or claim reserves are set up for benefits which may be due and unpaid at the time or which may become due in the future.

The term `unearned premiums,' as applied to insurance companies other than life and to noncancellable policies in general, has been held to mean not only advance premiums collected which the company had not yet had time to earn, but also to include the net value of policies, defined as the liability of the company upon insurance contracts other than accrued claims. It has been further held that an insurance company other than life or mutual is entitled, in computing the `premiums earned,' to exclude therefrom the net addition made during that year to the additional reserve for noncancellable health and accident policies required by law, or, in other words, that this addition to the reserve fund was a part of `unearned premiums.' See Massachusetts Protective Association, Inc. v. U.S. , 114 Fed.(2d) 304, Ct. D. 1483, C.B. 1941-1, 383; Travelers Equitable Insurance Co. v. Commissioner , 22 B.T.A. 784, acquiescence, C.B. X-2, 71 (1931); United Life Insurance Co. v. Commissioner , 47 B.T.A. 960, acquiescence, C.B. 1943-23; and G.C.M. 22503, C.B. 1941-1, 265. The limitation to cases involving noncancellable health and accident insurance was subsequently withdrawn by G.C.M. 25256, C.B. 1947-1, 68, as a result of the decision in the case of the C.P.A. Co. v. Commissioner , 7 T.C. 912, acquiescence, C.B. 1947-1, 1, in which it was held, in the case of an insurance company other than life or mutual writing noncancellable retirement, discharge, sick, accident and life insurance on a level premium basis, that reserves with respect to retirement and death benefit features of its policies, as required by the State, constitute `unearned premiums,' and therefore the increase in reserves during a taxable year should not be included in gross income.

The reasoning employed in these decisions is equally applicable to cancellable policies where premiums paid for maternity benefits represent a present payment for future coverage when no premiums will be paid. As such, they constitute `unearned premiums' during the period for which such premiums have been paid but upon which the company is not liable or `on the risk' under the terms of the policy