Rev. Rul. 70-192

Advice has been requested whether, in computing life insurance reserves, a change in the assumption as to the time of payment of death benefits, from an end of the policy year to a middle of the policy year, is a change of basis in computing such reserves under section 806(b) and section 810(d) of the Internal Revenue Code of 1954.

The taxpayer is a life insurance company taxable under section 802 of the Code. Prior to 1968, it computed its life insurance reserves with respect to its ordinary life insurance policies on the basis of recognized mortality tables, assumed rates of interest, and the assumption that death benefits are payable at the end of the policy year in which the death of the insured occurs. To conform more nearly with its actual practice in paying death benefits, the taxpayer, beginning with the taxable year 1968, changed its timing factor assumption as to when death benefits are payable from an end of the policy year to a middle of the policy year. The change was approved by the State department of insurance.

Section 806 of the Code concerns certain changes in reserves and assets applicable in the determination of taxable investment income (sections 804-806 of the Code). It provides, in pertinent part:

(b) Change of Basis in Computing Reserves--If the basis for determining the amount of any item referred to in section 810(c) as of the close of the taxable year differs from the basis for such determination as of the beginning of the taxable year, then for the purposes of this subpart the amount of such item--

(1) as of the close of the taxable year shall be computed on the old basis, and

(2) as of the beginning of the next taxable year shall be computed on the new basis.

Section 1.806-4(b) of the Income Tax Regulations, Example 1, illustrates the application of section 806(b) where a portion of the life insurance reserves are "strengthened by reason of a change in mortality or interest assumptions, or otherwise."

Section 810 of the Code sets forth rules for certain reserves applicable in the determination of gain and loss from operations. Subsection (d) of section 810 of the Code concerns the adjustment for change in computing reserves and, in effect, requires that any difference resulting from a change of basis for determining section 810(c) items be taken into account in accordance with the rules of that section at the rate of one-tenth of such amount over the ten years succeeding the year of change as a net increase (deduction) to which section 809(d)(2) of the Code applies or as a net decrease (income) to which section 809(c)(2) of the Code applies, as the case may be.

Reserves within the meaning of section 801(b) of the Code that are held with respect to life insurance policies are predicated upon assumptions as to the rate of death for every age of life and rates of interest that the company may reasonably expect to realize on investment of a portion of the premiums charged for the policies. Out of the premiums received, the company must set aside on the basis of recognized mortality tables a sum of money that must be invested so that, with the interest increment at a rate the company assumes it will earn annually over the life of the policies, it will be able to meet its liability on those policies when the claims thereon arise. The calculation of the reserve held with respect to life insurance policies is an actuarial function and is the amount theoretically necessary to provide the funds with which to pay obligations under outstanding policies as they become due, providing the facts are in exact accord with the assumptions made. Therefore, any change in the actuarial assumptions on which the life insurance reserves are based would require a strengthening or weakening of such reserves, depending on the new actuarial assumptions. Otherwise, the reserves would have a greater or lesser amount than is theoretically necessary to provide the funds with which to pay the future, unaccrued and contingent claims.

In the instant case, the taxpayer's change in assumption as to the time of payment of death benefits means that the amount set aside from premiums that had been assumed would be invested for the entire policy year will, in the year of change, earn only a half year's interest at the assumed rate. Therefore, unless the reserves are strengthened by the interest for half a year at the assumed rate, they will not be able to provide the funds with which to pay obligations under outstanding policies as they become due.

Accordingly, the change in the timing factor assumption as to the payment of death benefits is held to be a change in actuarial assumption and thus a change in basis within the meaning of section 806(b) and section 810(d) of the Code. In computing taxable investment income, the life insurance reserves on which the assumed timing factor was changed as to payment of death benefits is to be computed and taken into account in accordance with section 806(b) of the Code; in computing gain and loss from operations, the increase in such reserves is to be computed in accordance with section 810(d) of the Code and taken into account ratably over the ten years succeeding the year of change.