Rev. Rul. 78-354

Advice has been requested whether the taxpayer, a stock casualty insurance company taxable under section 831 of the Internal Revenue Code of 1954, may continue an election made when it qualified as a life insurance company under section 801(a), to revalue its life insurance reserves from computation on a preliminary term basis to computation on a net level premium basis under section 818(c). If the taxpayer cannot continue such an election, advice is further requested regarding the proper treatment of reserves because of the different valuations used prior to and after the loss of status as a life insurance compny.

For the taxable years 1969 through 1972 the taxpayer qualified as a life insurance company under section 801(a) of the Code and filed its federal income tax returns on Form 1120L. In 1973, because of changes in the nature of the insurance business written, the taxpayer no longer could qualify as a life insurance company, and thus became taxable as a stock casualty insurance company under section 831. As a stock casualty insurance company, the taxpayer properly filed its 1973 tax return on Form 1120.

In 1969, its first taxable year of operation, the taxpayer made an election to revalue its life insurance reserves, all of which were computed on the preliminary term basis, to the net level premium basis under the approximate revaluation method pursuant to section 818(c)(2) of the Code. Under this election the taxpayer's life insurance reserves at the end of the taxable year 1969 (and at the beginning and end of subsequent taxable years through 1972 during which period it qualified as a life insurance company) were computed on the net level premium basis using the approximate revaluation method for federal income tax purposes. For book and annual statement purposes, the life insurance reserves for the taxable years 1969 through 1972 were computed on the preliminary term basis. For the taxable year 1973 when the taxpayer no longer qualified as a life insurance company, it continued to revalue its life insurance reserves under the approximate revaluation method for Federal income tax purposes.

Section 818(c) of the Code provides as follows:

Life Insurance Reserves Computed on Preliminary Term Basis.--For purposes of this part (other than section 801), at the election of the taxpayer the amount taken ino account as life insurance reserves with respect to contracts for which such reserves are computed on a preliminary term basis may be determined on either of the following bases:

(1) Exact revaluation.--As if the reserves for all such contracts had been computed on a net level premium basis (using the same mortality assumptions and interest rates for both the preliminary term basis and the net level premium basis).

(2) Approximate revaluation.--The amount computed without regard to this subsection--

(A) increased by $21 per $1,000 of insurance in force (other than term insurance) under such contracts, less 2.1 percent of reserves under such contracts, and

(B) increased by $5 per $1,000 of term insurance in force under such contracts which at the time of issuance cover a period of more than 15 years, less 0.5 percent of reserves under such contracts.

If the taxpayer makes an election under either paragraph (1) or (2) for any taxable year, the basis adopted shall be adhered to in making the computations under this part (other than section 801) for the taxable year and all subsequent taxable years unless a change in the basis of computing such reserves is approved by the Secretary except that if, pursuant to an election made for a taxable year beginning in 1958, the basis adopted is the basis provided in paragraph (2), the taxpayer may adopt the basis provided by paragraph (1) for its first taxable year beginning after 1958.

Section 1.818-4(a) of the Income Tax Regulations provides, in part, as follows:

Section 818(c) permits a life insurance company issuing contracts with respect to which the life insurance reserves are computed on one of the recognized preliminary term bases to elect to revalue such reserves on a net level premium basis for the purpose of determining the amount which may be taken into account as life insurance reserves for purposes of part I, subchapter L, chapter 1 of the Code, other than section 801 . . . .

Section 1.818-4(e) of the regulations, which deals with the time and manner of making a section 818(c) election, provides, in part, that:

The election to use either the exact revaluation method or the approximate revaluation method shall, except for purposes of section 801, be adhered to in making the computations under part I for the taxable year for which such election is made and for all subsequent taxable years.

Section 818(c) of the Code and the regulations thereunder reflect a special method of accounting that is available to life insurance companies, and once made must be adhered to by those life insurance companies in making computations under Part I of Subchapter L. Congress in providing such an election was attempting to overcome a hardship experienced by some life insurance companies using preliminary term reserves because of the effect of the size of such reserves in the computation of their life insurance taxable income. See H. R. Rep. No. 34, 86th Cong., 1st Sess. 18, 43 (1959), 1959-2 C.B. 736, 748; S. Rep. No. 291, 86th Cong., 1st Sess. 30, 73 (1959), 1959-2 C.B. 770, 792. Casualty insurance companies taxable under section 831(a), however, do not make computations under Part I of Subchapter L. Congress did not expressly intend that casualty companies taxable under section 831(a), which do not compute taxable income under the intricate tax formula applicable to life insurance companies taxable under Part I, should benefit from the section 818(c) election. The language of section 818(c) limits its applicability for purposes of making the computations under Part I of Subchapter L.

Accordingly, because the taxpayer has ceased to qualify as a life insurance company, and thus ceased to make computations under Part I of Subchapter L, section 818(c) of the Code is no longer applicable. The effect of the loss of status as a life insurance company in 1973 is to terminate the election made under section 818(c).

The effect of terminating this election under section 818(c) of the Code in 1973 is to change the basis under which the taxpayer computes its reserves. The taxpayer should compute its reserves for 1973 that are attributable to contracts issued before the taxable year 1973 under the old basis (section 818(c)), and treat the reserves for 1974 and later years under the new basis (preliminary term). For contracts issued in 1973 and later years the taxpayer should compute its reserves under the new basis (preliminary term). For taxable year 1974, the life insurance reserves as included in the computation of unearned premiums as defined in section 832(b)(4) with respect to outstanding business at the end of the preceding year (1973) should be valued on the preliminary term basis. The difference in the valuation of life insurance reserves at the close of the taxable year of the termination (1973) under the old basis, that is, as valued under the section 818(c) election, and under the new basis, that is, as valued on the preliminary term basis, is taken into account in the manner described in section 810(d). See Rev. Rul. 65-240, 1965-2 C.B. 236, which provides that where an insurance company, subject to the tax imposed under section 831, issues life insurance as well as casualty insurance contracts, any increase or decrease in its life insurance reserves due to a change in basis of computing such reserves shall be taken into account in accordance with the same federal income tax rules in respect of reserve strengthening or weakening as are provided for in determining gain and loss from operations of life insurance companies.

The above analysis is illustrated by the following example:

Assume that the amount of life insurance reserves as computed on a preliminary term basis (P.T.) and as revalued under section 818(c)(2) of the Code for the taxable years 1972, 1973, and 1974 are as follows:

                 1972 (Last year taxpayer qualified

Based on the above (other insurance business written by taxpayer is not taken into account for purposes of this example), computations should have been made for Federal tax purposes of the taxpayer as follows:

 1972:  In the last year the taxpayer qualified as a

 1974:  Under section 832(b)(4) of the Code (the second