Rev. Rul. 67-435

Advice has been requested whether a reserve computed on the basis of a percentage of recognized life insurance reserves which a life insurance company is required by State statute to maintain in addition to its life insurance reserves is itself a life insurance reserve within the meaning of section 801(b) of the Internal Revenue Code of 1954.

A life insurance company within the meaning of section 801(a) of the Code does business in state Y and is subject to the requirements of that state applicable to life insurance companies. The requirements of the state of Y with respect to reserves which life insurance companies must maintain in order to do business within the state are contained in various sections of its Revised Statutes. The sections pertinent to the issue presented are designated herein as sections 1 and 2.

Section 1 provides for the maintenance of life insurance reserves computed on the basis of recognized mortality or morbidity tables and assumed rates of interest.

Section 2 requires the maintenance of an additional reserve by a life insurance company whose recognized life insurance reserves required by section 1 are computed on the basis of a higher rate of interest than three percent and such reserves, as so computed, exceed x dollars. The additional reserve must be an amount equal to six percent of the increase in recognized life insurance reserves for the taxable year over the preceding taxable year (for premium-paying term insurance, the reserve at the end of the year is deemed to be the increase in the reserve). The aggregate of the additional reserve amy not exceed five percent of the recognized life insurance reserves, except in the case of premium-paying term insurance the aggregate may not at the end of any year exceed 50 percent of the premiums of that year. The additional reserve may be used only on the contingency of the gross mortality losses for any year being in excess of 105 percent of the average losses during the preceding 5 years or on the contingency of depreciation and losses on assets owned by the company being in excess of 10 percent of its surplus at the end of the preceding year.

The company has been subject to the requirements of `section 2' since its enactment. Its `section 2' reserve has reached the five percent limitation and since reaching that limit is computed by applying a rate of five percent to the amount of the recognized life insurance reserves required by `section 1.' The limitation in the size of the `section 2' reserve with respect to premium-paying term insurance is 50 percent of the premiums received during the year in connection with that type of business. The company has not reached this 50 percent limitation.

Section 801(b)(1) of the Code provides as follows:

For purposes of this part, the term `life insurance reserves' means amounts-

(A) which are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and

(B) which are set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable health and accident insurance contracts (including life insurance or annuity contracts combined with noncancellable health and accident insurance) involving, at the time with respect to which the reserve is computed, life, health, or accident contingencies.

Section 801(b)(2) of the Code provides that, with exceptions not pertinent here, life insurance reserves must also be required by law.

Although all insurance companies are required by the respective states in which they do business to maintain reserves in addition to the life insurance reserves and although, in a sense, all assets of an insurance company may be used to discharge the company's obligations, only those specific reserves which meet the above described tests and as such are attributable to and represent the value of the life insurance element of the policy contracts are accorded the special treatment of life insurance reserves. Thus, not every reserve which a company maintains or is required to maintain is considered a life insurance reserve. The Supreme Court of the United States in McCoach v. Insurance Company of North America , 244 U.S. 585 (1917), stated the basic test as follows:

The Act of Congress, on the other hand, deals with reserves not particularly in their bearing upon the solvency of the company, but as they aid in determining what part of the gross income ought to be treated as net income for purposes of taxation.

The life insurance reserve is in the nature of a trust and represents a policy liability of the company to its policyholders. On the basis of experience, it is known that a certain number of the outstanding policies will become claims at any one time and given the experience of the same age groups, the probabilities of death or disability can be fairly accurately predicted. Thus the life insurance reserve, broadly defined as the difference between the present value of the benefits and the present value of the future premiums is grounded upon assumptions as to the rate of death for every age of life and assumed rates of interest which the company may reasonably expect to be realized upon the investment of the excess premiums for the duration of the policies. The calculation of the reserve is an actuarial function and is the amount theoretically necessary to be `reserved' out of premiums, which, at assumed rates of interest, will enable the company to pay all outstanding policies as they become claims, providing the facts are in accord with the assumptions made. Since only a certain number of the outstanding policies will become claims at any one time, the mortality tables and assumed rates of interest on which the life insurance reserve is based do not provide for every contingency. They do not provide for investment losses, changing expense ratios, or unfavorable mortality experience. If they did, they would produce an assumed rate of mortality far greater than necessary to cover the certain mortality costs.

The `section 2' reserve computed by applying a fixed rate of five percent to the recognized (section 1) life insurance reserves is not itself computed on the basis of any recognized mortality or morbidity table nor is there any assumed rate of interest taken into account in its computation. Moreover, since the `section 2' reserve may be used only on the contingency of the gross mortality losses being in excess of 105 percent of the average losses during the preceding five years or on the contingency of depreciation and losses on the assets owned by the company being in excess of 10 percent of its surplus, it does not represent the value of the life insurance element of the outstanding policies and does not meet the test that the reserve be set aside to mature or liquidate future unaccrued claims as they mature, estimated on the basis of recognized mortality or morbidity tables.

Abnormal mortality, depreciation, and losses on assets owned by the company are purely speculative. The prospect of such speculative losses would, in all likelihood, be a solvency concern of the states in which the company does business. In the event that abnormal excessive claims do materialize, any difference between what was provided for on the basis of recognized mortality and morbidity tables and assumed rates of interest for the normal certain claims and the actual claims would be made up out of the surplus of the company. To provide therefor the states may and do require that a portion of the surplus be earmarked in special contingency, mortality fluctuation, mandatory securities valuation reserves, etc., to which the instant reserve is analogous but such requirements of the states for solvency purposes have no bearing on `what part of the gross income ought to be treated as net income for purposes of taxation.'

Accordingly, the `section 2' reserve maintained by the life insurance company pursuant to State statute is not a life insurance reserve within the meaning of section 801(b) of the Code.