Rev. Rul. 67-180

Advice has been requested as to the nature of retrospective rate credit refunds on casualty policies issued by an accident department of a life insurance company, and whether any amounts set aside at the end of the taxable year with respect to potential rate credit refunds on contracts expiring after the close of the taxable year are deductible for Federal income tax purposes.

The taxpayer is a multiple-line insurance company which qualifies as a life insurance company subject to tax imposed by section 802 of the Internal Revenue Code of 1954. In addition to life insurance, it writes accident and health, and casualty insurance, including workmen's compensation, auto liability, and liability other than auto. The operational statistics of its life and casualty lines are not consolidated but are treated as if there existed separate life and casualty insurance companies.

On all casualty insurance policies issued by the taxpayer, whether or not subject to a retrospective premium rating formula, an estimated standard premium is charged at the inception of the risk period. Thereafter, the taxpayer audits the insured at least annually during the period of coverage and the earned standard premium is determined on the basis of the insured's payrolls or other exposure. The difference between the earned standard premium and the estimated standard premium is then charged or refunded to the policyholder.

On a retrospective rated policy, certain additional computations are made commencing with the earned standard premiums as determined above and already paid. A percentage factor, as determined by the taxpayer, called a `basic charge' is applied to the earned standard premium. Added thereto are losses up to certain limits and expenses attributable thereto. To this total, another percentage, denominated as premium tax multiplier, is added. The total of the basic charge, losses and expenses, and the addition for the premium tax is compared with the earned standard premium previously paid. Any difference between the two is refunded to the policyholder if the experience is favorable or paid to the taxpayer by the insured if the experience is unfavorable.

On a three-year retrospective plan, the computations are made at the end of each policy year taking into account all the experience for the periods preceding the period of computation.

The first question involved concerns the nature of the liability to return, after all or part of the risk has attached, a portion of the amount paid by the policyholder with respect to a policy subject to a retrospective rate endorsement.

Dividends to policyholders, unearned premiums, and return premiums all have the common denominator of being an adjustment of premium. However, they are conceptually distinguishable from each other, and therefore the treatment of each is different under the Internal Revenue Code.

Dividends are an allocation of divisible surplus payable to the policyholders in their capacity as such and are taken into account, in determining underwriting income, as a deduction under section 809(d)(3) of the Code. Unearned premiums have a technical meaning. They are amounts which cover the cost of carrying the insurance risk for the period for which the premiums have been paid in advance and are held to take care of anticipated losses on policies. Section 1.801-3(e) of the regulations. In determining underwriting income, unearned premiums are taken into account as increases (deductions) and decreases (income) in reserves under sections 809(d)(2) and 809(c)(2) of the Code, respectively. The decreases in reserves would be offset by deductions for claims and benefits accrued under section 809(d)(1) of the Code.

Return premiums, on the other hand, are not taken into account as a reserve or deduction item but rather as an adjustment to gross premiums under section 809(c)(1) of the Code, an income provision, in a fashion similar to the subtraction, in commercial practice, of returns and allowances from gross receipts to arrive at gross income from sales. It has a limited meaning and as defined in section 1.809-4(a)(1)(ii) of the regulations is limited to situations where the premium has been erroneously calculated, where the policy has been canceled before the end of the contract period, or has been procured through fraud, or issued through a mistake of law or fact, or is void. Briefly, in other words, `return premiums' apply only to an adjustment for premiums to which no risk has attached. Since reserves for such adjustment are not held to take care of anticipated losses on the policies as the premium is earned but rather to take care of the contingency that some part of the premium may have to be returned, they would not constitute technical insurance reserves. Therefore, the adjustment for `return premiums' could properly be reflected only as an adjustment of gross amount under section 809(c)(1) of the Code. Thus, since a reserve for `return premiums' would not be a technical insurance reserve, `return premiums' are not unearned premiums even though both have the same no risk attaching quality.

Unearned premiums are defined in section 1.801-3(e) of the regulations as `those amounts which shall cover the cost of carrying the risk for the period for which the premium has been paid in advance.' This language reflects cases arising under earlier statutes when life insurance companies prior to 1921 were entitled to a deduction for the interest required to be added to their `reserves required by law.' The only recognized `reserves required by law' were those pertaining directly to insurance which were set aside and funded to take care of anticipated losses on policies. This excluded amounts held on account of matured obligations and also amounts which did not represent insurance in existence during the taxable year for the reason that in one case the reserve had served its purpose and the amounts held had become pure liabilities and, in the other case, there being no insurance in existence there could be no reserve attributable thereto. See McCoach v. Insurance Company of North America , 244 U.S. 585 (1917); Maryland Casualty Company v. United States , 251 U.S. 342 (1920) as modified and explained in United States v. Boston Insurance Company , 269 U.S. 197 (1925), T.D. 3792, C.B. V-1, 300 (1926); Colonial Surety Company v. United States , 178 F.Supp. 600 (1959).

The basic concepts in these earlier cases are applicable today even though the scheme of taxation for life insurance companies is now quite different. Application of the principles in these and numerous similar cases suggests that a reserve for an estimated potential retrospective rate credit with respect to a policy which has expired, in whole or in part, and to which the risk has already attached, in whole or in part, as the case may be, is not a reserve to take care of future, unaccrued, claims and losses to be paid for out of such reserve as it is earned, and neither is it a reserve pertaining to insurance.

Thus, an amount set aside for the contingency that some part of the premium paid under a policy subject to a retrospective rate endorsement may have to be returned cannot be either unearned premiums or return premiums, since, if the risk has attached, it does not apply to insurance in force and if the risk has not attached, it is not held to take care of future, unaccrued insurance claims and losses.

The conclusion reached above is not affected by section 1.832-1(a) of the regulations which states in part that `the amount of unearned premiums shall include * * * (2) liability for return premiums under a rate credit or retrospective rating plan based on experience, such as the `War Department Insurance Rating Plan,' and which return premiums are therefore not earned premiums.'

Simply because under such regulation section the liability for retrospective rate credits is arithmetically taken into account together with unearned premiums, for purposes of computing earned premiums under section 832 of the Code, does not make such liability a technical unearned premium or any other insurance liability provided for by the Code. The regulation merely sets forth the manner in which earned premiums of certain insurance companies are computed.

Since the `basic charge' described above; i.e., a percentage of the standard premium and the starting point for the computation of the retrospective premium appears to be the minimum premium which takes into account the risk charge and the loading elements of such premium and since those elements are taken into account any difference between the standard premium paid by the policyholder at the inception of the risk period and the retrospective premium is a difference which depends on the experience of the company. Thus, any retrospective rate credit allowed would be a dividend within the meaning of section 811 of the Code and section 1.811-2 of the regulations. Therefore, the sole question remaining is whether a reserve for dividends to policyholders, as defined in section 1.811-2(c) of the regulations, attributable to potential rating credits on contracts expiring after the close of the taxable year is deductible for Federal income tax purposes.

Section 1.811-2(c) of the regulations provides, in part, as follows:

(c) RESERVES FOR DIVIDENDS TO POLICYHOLDERS DEFINED-(1) IN GENERAL. The term `reserves for dividends to policyholders' as used in section 811(b)(1)(A) and (B) and paragraph (b)(1) of this section, means only those amounts-

(i) Actually held, or set aside as provided in subparagraph (2) of this paragraph and thus treated as actually held, by the company at the end of the taxable year, and

(ii) With respect to which, at the end of the taxable year or, if set aside, within the period prescribed in subparagraph (2) of this paragraph, the company is under an obligation, which is either fixed or determined according to a formula which is fixed and not subject to change by the company, to pay such amounts as dividends to policyholders (as defined in section 811(a) and paragraph (a) of this section) during the year following the taxable year.

(2) AMOUNTS SET ASIDE. (i) In the case of a life insurance company (as defined in section 801(a) and paragraph (b) of [Section] 1.801-3), all amounts set aside before the 16th day of the 3rd month of the year following the taxable year for payment as dividends to policyholders (as defined in section 811(a) and paragraph (a) of this section) during the year following such taxable year shall be treated as amounts actually held at the end of the taxable year.

Generally, dividends on insurance policies are determined according to a formula which is fixed at the end of the calendar year but payment is only made on the policy anniversary date which may or may not fall within the same calendar year if the policy is in force on that date. Because of this almost universal industry-wide practice, the language in the proposed regulations at section 1.811-2(c) that limited the year-end dividend reserves only to amounts where there was an obligation `* * * fixed and not contingent * * *' was changed to `* * * under an obligation, which is either fixed or determined according to a formula which is fixed and not subject to change * * *' as quoted above in the final regulations.

This change in language in the regulations, however, does not have any effect upon the earning factors for a particular period which is taken into account in determining the dividend payable on the next anniversary date. In other words, the dividend according to a fixed formula must be based upon the divisible surplus at the end of the calendar year and the divisible surplus at that time can only be determined from the basis of experience factors which have already occurred. Thus, under the language of the final regulations only a determined amount may be included in the year-end dividend reserve, and an amount cannot be determined if its calculation depends upon experience factors after the close of the taxable year.

The replacement of the `fixed and not contingent' rule in the proposed regulations by the `determined according to a formula which is fixed' language in the final regulations was intended not to preclude additions to the year-end dividend reserve of `determined' amounts when there is a contingency beyond the control of the taxpayer affecting whether the determined amount will be paid. An example of such contingency is a participating policy which is contingent on renewal, or the policyholder being alive, on the anniversary date.

Accordingly, the reserve for dividends to policyholders does not include any amounts attributable to potential retrospective rate credits or refunds with respect to casualty insurance contracts expiring after the close of the taxable year. Thus, the taxpayer would be entitled to a deduction for a reserve for dividends to policyholders at the time it meets the requirements of section 1.811-2(c) of the regulations on both the one-year and the three-year contracts. If on the three-year contract it meets those requirements annually it would be entitled to the deduction annually. On the other hand, in a case where the entire contract would have to expire before it could meet the requirements (where the loss and expense computations are cumulative), it would not meet the requirements of the regulations until the entire contract expired.

This Revenue Ruling is equally applicable to retrospective rate credits based on experience with respect to group life and group accident and health contracts written by life insurance companies.

¹ Also released as Technical Information Release 902, dated May 10, 1967.