Rev. Rul. 77-451

Advice has been requested whether additional reserves held by the taxpayer to cover the excess mortality under group conversion contracts are life insurance reserves within the meaning of section 801(b) of the Internal Revenue Code of 1954, if the additional reserves are computed as described below.

The taxpayer is a life insurance company taxable under section 802 of the Code. As required by state law, the taxpayer's group term life insurance contracts provide for the conversion of the group coverage under the contract into individual ordinary life insurance contracts at the election of the insured upon the occurrence of certain events such as termination of employment. Such ordinary insurance, in the amount of the insured's group coverage (or a portion thereof), must be issued by the taxpayer at standard premium rates for the attained age of the insured at the time of conversion and must be issued whether or not the insured is insurable; that is, no evidence of insurability can be required. The inclusion of such a conversion privilege in group term contracts is a standard requirement of the insurance laws of most states.

Studies on the mortality that is experienced with group conversion contracts have shown that a strong anti-selection factor is present in such contracts. In general, employees who are medically impaired utilize the conversion privilege, and employees who are able to qualify for an ordinary policy at standard premium rates under the usual underwriting procedures do not utilize the conversion privilege. The result is a higher than normal mortality experience on group conversion policies, especially during the years immediately after issuance. The adverse effect of the anti-selection factor in group conversion policies tends to lessen with the passage of time.

In view of the foregoing, the taxpayer uses a procedure of computing reserves on group conversion policies which is designed to reflect the excess mortality inherent in such policies. This procedure is as follows:

1. The taxpayer first computes the standard reserve on the converted policy in the same manner that it computes reserves on standard ordinary life policies generally; that is, it computes a reserve on the basis of a recognized mortality table and an assumed rate of interest using the net-premium valuation.

2. Second, the taxpayer computes a deficiency reserve (if any) on the policy which is the amount equal to the excess of the present value of future net premiums over the present value of future actual premiums, and this reserve is treated both for state regulatory purposes and Federal income tax purposes as a deficiency reserve.

3. Third, the taxpayer computes a reserve that is required on the policy (hereinafter referred to as the substandard reserve) using a recognized mortality table that is adjusted by ages and durations to reflect the additional mortality on group conversion contracts. (The mortality table and assumed rate of interest are different from those used in the computation of the standard reserve (step 1).) The taxpayer computes the substandard reserve using a gross-premium valuation, but adjusts the gross premium, the future receipt of which is assumed in the reserve computation, to eliminate therefrom the (anticipated) actual expenses it will incur in administering the policy. The amount of such expenses is determined on the basis of past experience and reflects the fact that no commissions are paid on group conversion contracts and that the expense of the medical examination is avoided on a group conversion contract. Thus, the taxpayer's substandard reserve computation assumes the receipt of the future actual premiums reduced only by the amount of the expenses that will actually be incurred in administering the policy. (In the net-premium valuation no allowance is made for expenses.)

4. Finally, the taxpayer subtracts, from the substandard reserve computed as described in step 3 above, the standard reserve computed as described in step 1, and the deficiency reserve computed as described in step 2. The amount remaining after such subtraction constitutes the taxpayer's reserve for excess mortality on group conversion contracts, which is maintained by the taxpayer in addition to the standard reserve and is the reserve here in issue.

Historically, insurance involves risk-shifting and risk-distributing. Helvering v. LeGierse, 312 U.S. 531, 539 (1934). Life insurance operates to spread risks among policyholders by building up a fund from net valuation premiums paid, and the income therefrom, adequate to pay the face amount of all policies upon the death of each insured. J. Maclean, Life Insurance, 3-19 (9th ed. 1962). Gross premiums are paid by the insured as consideration for the insurance company assuming the risk. The amount of the gross premium is calculated on the assumption that the net valuation premiums will be invested and earn interest which, when added to the accumulated net valuation premiums, will be sufficient to pay the policyholders' death claims as they arise as well as expenses. Thus, a minimum of three elements enter into the construction of a premium schedule to be charged for a stated amount of life insurance; these are mortality, interest, and expense.

The facts indicate that the subject individual ordinary life insurance contracts elected under the group conversion privilege are level-premium installment contracts. Under a level-premium plan, the net valuation premiums in earlier years are greater than the current cost of insurance, so that such excess plus earnings thereon will make up for the shortage in later years when the insurance cost exceeds the net valuation premiums. A life insurance company sets up reserves in the liability column of its balance sheet to reflect the fact that the excess premiums are prepayments for insurance coverage and must be available in later years. See J. Maclean, Life Insurance, 111 (9th ed. 1962).

When the policy reserve is described as the accumulation, at the assumed interest rate, of the net valuation premiums received less the death claims provided for by the mortality table, the reserve is viewed retrospectively. Another way of looking at the reserves is the so-called prospective view, under which the reserve is equal to the discounted value of future benefits less the discounted value of future premiums. See Rev. Rul. 67-435, 1967-2 C.B. 232; J. Maclean, Life Insurance, 112 (9th ed. 1962); and D. Gregg and V. Lucas, Life and Health Insurance Handbook, 161-162 (3d ed. 1973).

Section 801(b) of the Code provides that the term "life insurance reserves" means those amounts (1) which are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and (2) 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. Furthermore, life insurance reserves, with exceptions not relevant in this case, must be required by law.

In order for the definitional requirements of section 801(b) of the Code to be meaningful, a particular life insurance policy at any given point in time, given a recognized mortality table and assumed interest rates, must have one reserve, which will be the same amount, regardless of how the reserve is viewed. Thus, the specific method for computing life insurance reserves under section 801(b) is indicated by the requirement that it be done on the basis of recognized mortality tables and assumed rates of interest. Given a recognized mortality table and assumed interest rates for each policy, there is a unique net-premium valuation reserve that remains the same size whether it is computed prospectively or retrospectively. The net-premium valuation reserve is unique because it assumes that the net premium, or net level premiums, will always be available for the payment of claims; the net premium is the amount that, in the aggregate and on the basis of assumed rates of mortality and interest, is just sufficient to pay all death claims as they come due. Whereas the calculation of a gross premium will also include loading for expenses, the net premium, and therefore the net-premium valuation reserve, takes into account only factors that are actuarially related to and based on recognized mortality tables and assumed rates of interest.

On the other hand, a gross-premium valuation reserve, similar to the computation of the taxpayer's substandard reserve, does not yield the same reserve when computed from both the prospective and retrospective views. If gross premiums are assumed to be larger than net premiums, then from a prospective view the reserve will be smaller than a reserve computed by the net-premium valuation; but, from a retrospective view, the reserve will be larger than a reserve computed by a net-premium valuation. A gross-premium valuation method distorts the policy reserve computation and yields inaccurate results because the gross premium includes expense loading, a factor that is not actuarially related to the chosen mortality table and assumed interest rates.

In order for the definitional requirements under section 801(b) of the Code to be meaningful, life insurance reserves must be computed by a net-premium valuation. This conclusion is assumed by the exclusion of deficiency reserves from the term "life insurance reserves." The definition of a deficiency reserve under section 801(b) implicity acknowledges that only the net-premium valuation portion of a contract reserve is a life insurance reserve. Furthermore, the special accounting provisions of section 818(c) for reserves computed on a preliminary term basis also support the conclusion that life insurance reserves are based upon net-premium valuations.

Accordingly, because the taxpayer's substandard reserve is not computed by using a net-premium valuation, it is not computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest within the intendment of section 801(b) of the Code; and therefore it is not a life insurance reserve. Likewise, because the taxpayer's additional reserve (as described in step 4) is not computed on an independent basis, but results from the computation of the taxpayer's substandard reserve, the additional reserve is not a life insurance reserve within the definition of section 801(b).