- 4.42.4 Audit Techniques for Specific Areas/Potential Adjustments
- 18.104.22.168 Gross Premiums
- 22.214.171.124 Investment Income
- 126.96.36.199 Assets
- 188.8.131.52 Other Amounts (Income)
- 184.108.40.206 Death Benefits, etc.
- 220.127.116.11 Reserves
- 18.104.22.168.1 Basic Principles of Actuarial Reserves
- 22.214.171.124.1.1 Individual Life Insurance Policy Reserves
- 126.96.36.199.1.2 Traditional Whole Life Policy Reserves
- 188.8.131.52.1.3 Calculating Policy Reserves
- 184.108.40.206.1.4 Reserve Valuation Methods
- 220.127.116.11.1.5 Statutory Reserve Valuation Law
- 18.104.22.168.1.6 Timing Functions
- 22.214.171.124.1.7 Annual Statement Reserve Valuation
- 126.96.36.199.2 Description of Life Insurance Reserves for Tax Purposes
- 188.8.131.52.3 Reserves for Tax Deduction Purposes (IRC section 807)
- 184.108.40.206.4 Reserve Audit Procedures
- 220.127.116.11.5 IRC section 807 Reserve Questionnaire
- 18.104.22.168 Consideration Paid for Assumption by Another Person of Liabilities
- 22.214.171.124 Dividends Reimbursable by Taxpayer
- 126.96.36.199 Interest Expense
- 188.8.131.52 Deductible Policy Acquisition Expense
- 184.108.40.206.1 Combination Contracts Treas. Reg. 1.8481(g)
- 220.127.116.11.2 Group Life Insurance Contract Treas. Reg. 1.8481(h)
- 18.104.22.168.3 Determination of Net Premiums Treas. Reg. 1.8482
- 22.214.171.124.4 Policy Exchanges
- 126.96.36.199.5 ReinsuranceDetermination of Net Premium Treas. Reg. 1.8482(f)
- 188.8.131.52.6 ReinsuranceCapitalization Shortfall Treas. Reg. 1.8482(g)
- 184.108.40.206.7 Reinsurance with Non-U.S. Taxpayers Treas. Reg. 1.8482(h)
- 220.127.116.11.8 Carryover of Excess Negative Capitalization Amounts Treas. Reg. 1.8482(i)
- 18.104.22.168.9 DAC Amortization Periods
- 22.214.171.124.10 General Deduction Limitation
- 126.96.36.199 Other Deductions
- 188.8.131.52 Dividend Received Deduction
- 184.108.40.206 Operations Loss Deduction
- 220.127.116.11 Small Life Insurance Company Deduction
- 18.104.22.168 Limitation on Noninsurance Losses
Part 4. Examining Process
Chapter 42. Insurance Industry
Section 4. Audit Techniques for Specific Areas/Potential Adjustments
Gross premiums and other considerations received on insurance and annuity contracts less return premiums and premiums and other considerations paid for indemnity reinsurance are included in life insurance gross income as defined in IRC section 803(a)(1). Definitions of the terms, premiums and return premiums, and reinsurance ceded are found in Treas. Reg. section 1.809–4(a)(1) of the 1959 act and are relevant in interpreting new IRC section 803(a)(1).
Usually the life insurance company will have detailed summary sheets reconciling the gross premiums less return premiums in Exhibit 1, Part 1, of the Annual Statement to line 1 of the tax return.
The term "gross amount of all premiums and other consideration" includes:
Premiums received in advance and premium deposit funds included in gross income at the time of their receipt under IRC section 803(b)(1). For taxable years beginning on or after September 30, 1990, a life insurance company is required to reduce by 20 percent its opening and closing balances for unearned and advance premiums for contracts whose reserves do not qualify as life insurance reserves (e.g., cancelable accident and health insurance) as prescribed in IRC section 807(e)(7). Life insurance company taxable income is increased by 20 percent of the annual increase in the balance for unearned and advance premiums for these contracts.
Deferred premiums and uncollected deferred premiums are premium installments that are not due as of the financial statement date but will become due before the end of the current policy year. Uncollected premiums and due and unpaid premiums are classified as assets since the premium due date has passed without payment being received before the financial statement date. TRA 1984 under IRC section 811(a)(1) and 811(c)(1), override the holding of the Supreme Court in Commissioner v. Standard Life and Accident Insurance Co., 433 U S 148 (1977), by stating that a reserve may not be established unless the gross amount of premium is properly accrued in that taxable year.
Reinsurance premiums are amounts received by an assuming company for assuming liabilities under a reinsurance contract regardless of whether the contract is yearly renewable term, coinsurance, modified coinsurance, or assumption. See IRC section 803(b)(1 )(E).
IRC section 803(b)(1)(F) includes in the "gross amount of premiums and other consideration" the amount of policyholder dividends reimbursable to the taxpayer by a reinsurer in respect of reinsured policies. TRA 1984 under IRC section 811(a) specifies that both the deduction of the assuming company and the income of the ceding company should be on the accrual basis.
Return premiums include amounts returned or credited which are fixed by contract and do not depend on the experience of the company or the discretion of the management. For example, return premiums include amounts returned to the policyholder because of policy cancellations or erroneously computed premiums. Treas. Reg. 1.809–4(a)(1)(ii). An analysis should be secured and reviewed on amounts claimed as return premiums that includes amounts of premium returned to another life insurance company under indemnity reinsurance, including experience-rated refunds paid by the assuming company to the ceding company even though the amounts would meet the definition of a policyholder dividend, and including payments under assumption reinsurance are deductible by the ceding company as a general deduction under IRC section 805(a)(6) rather than a reduction of premium income.
For tax return purposes, prior to 1963 all discounts (market and original issue) had to be reported on bonds, notes, debentures, or other evidence of indebtedness. For 1963 and subsequent years the taxpayer has to report only original issue discount as defined in IRC section 1232(b). Market discount and "di minimus" original issue need not be reported even though they are listed in Schedule D of the Annual Statement. See Treas. Reg. section 1.1232–3A(b)(4) for an exception to the rule of ratable inclusion of original issue discount. For tax return purposes, taxable bonds issued after July 18, 1984 and acquired after September 25, 1985, the taxpayer may elect not to accrue market discount, but market discount is taxed as ordinary income to the extent of a gain upon sale or maturity. For tax return purposes, taxable bonds issued before July 19, 1984 and acquired on or before September 25, 1985, the taxpayer may elect not to accrue market discount and the discount will be taxed as capital income if the bond is held to maturity. For tax return purposes, taxable bonds issued before 7/19/84 and acquired on 5/1/93 and later, the accrued market discount is taxed as ordinary income on the disposition of the bond.
The company should supply a list of the reported recognized Original Issue Discount (OlD).
The list should be compared with the prior year’s tax list of OlD securities to ensure that none have been excluded with the exception of disposals.
Discounts on bonds acquired in the current year, shown in Schedule D, Parts 3 and 5 of the Annual Statement, not reported as recognized OlD should be verified.
In computing the recognized OlD under IRC section 1232(b) the "number of complete years to maturity" must take into consideration mandatory prepayments. If the Annual Statement does not list mandatory prepayments separately obtain the instruments of indebtedness.
Warrants received with evidences of indebtedness as an "investment unit" results in discount on the indebtedness to the extent of the warrant fair market value.
No amortization of premium or accrual of discount can be reported on bonds in default. These bonds are indicated in Schedule D of the Annual Statement, Part 1, Column 12.
Most companies will indicate in a footnote to Annual Statement Schedule D if they are amortizing premium to earlier call date if it results in lower amortization than to maturity. Only this lower amount may be claimed on the tax return.
The Annual Statement amortization of premium on a convertible evidence of indebtedness will include the amount attributable to the conversion features. The tax return amortization should exclude this attributed amount.
Mortgage discounts may be reported on a composite basis provided such method is regularly employed; period of accrual reflects actual average lives; and all such discounts are eventually reported.
"Bid in Interest" on foreclosed property represents interest income
Commitment fees on loans not made are includible in Gross Investment Income (GIl). These fees, sometimes called "standby fees," are income in the year of receipt.
Amounts received on foreclosed FHA and VA mortgages in excess of basis are includible in GIl and are not capital gains.
The fair market value of warrants or stock received on private placement of loans represent GIl when they are not part of an "investment unit."
Prepayment penalties on corporate mortgages paid in advance now qualify for capital gain treatment.
Prepayment penalties on non-corporate mortgages and other evidence of indebtedness are includible in GIl.
Interest on policy loans charged in advance to policyholders (whether paid or added to the loan balance) is includible in GIl.
Pro rata accrued of interest on policy loans due in arrears is includable in GIl.
Annual Statement rental income includes rents the company charges itself on company owned property. The total charge is stated in a footnote to Exhibit 2 of the Annual Statement. A corresponding charge appears on line 1 of Exhibit 5. For tax return purposes both the rental income and the corresponding rental expense should be eliminated.
Rental income is taxable in the year in which it is collected or accrued whichever is earlier. Rent received in advance is included in gross income under the "claim of right" doctrine.
Interest paid on encumbrances to real estate cannot be deducted from gross rents.
"Security deposits" to be applied against the last month’s rent according to the rental agreement are treated as advance rents and income in the year receipt.
Payments for an easement or right-of-way is considered rents and are includible in GIl.
Copies of partnership and joint venture returns should be secured to verify that income and deductions which retain their character are reported in their proper place on the Form 1120–L.
Transactions with related entities should be audited to ascertain that they are at "arm’s length."
Ordinarily income received, even though unearned, is includible in gross income.
Recaptured depreciation on investment assets should be reported as "gross income from trade or business."
Valuation of total assets plays an important role in the determination of the small life insurance company deduction. If the assets of the life insurance company are equal to or exceed $500,000,000, no small life insurance company deduction is allowable under IRC section 804.
Verification of the assets should start with a reconciliation of the assets in Exhibit 13, column 4 of the Annual Statement to the tax return. The company should supply a detailed schedule itemizing the breakdown of the assets especially the Other Assets, Schedule O, part 1, line 4 of Form 1120–L.
As a rule, Exhibit 13 contains all the assets of a life insurance company. Ledger assets are found in column 1 and nonledger assets are found in column 2. The amount listed in column 4 is the addition of columns 1 and 2 minus the amount of non-admitted assets in column 3.
Exceptions to the assets listed in Exhibit 13 are:
Schedule X assets.
Assets shown short or in footnotes on page 2 of the Annual Statement.
Assets listed without cost or value in Schedule D of the Annual Statement.
Assets netted against liabilities on page 3 of the Annual Statement.
Prepaid assets which are not allowed as a current deduction and that may be amortizable.
Unamortized mortgage loan finders’ fees. The item that is expensed in Exhibit 5 in the year paid, but is capitalized for tax purposes.
Unamortized bonus paid for assumption reinsurance in accordance with Treas. Reg. 1.817–4(d)(2) and (3).
The unamortized portion of the ceding commissions paid prior to September 30, 1990.
The unamortized balance of the capitalized policy Deferred Acquisition Cost (DAC).
Non-admitted assets such as agents’ balances, bills receivable, cash advances, returned checks, utility deposits, etc. have to be restored for the purpose of determining the total assets for the small life insurance company deduction.
Identifiable intangible assets are required to be included in the total assets of a life insurance company.
As stated in text 3.6.2, real estate is valued at fair market value and the value is not reduced by encumbrances.
The company should supply a detailed listing of the claimed fair market values.
The listing should be compared with the details in Schedule A of the Annual Statement to ascertain that all properties are included.
The claimed fair market values should be verified. Where appropriate, a valuation agent or engineer should make these determinations.
The portion of company owned and occupied buildings used by the life insurance company in carrying on its trade or business is required to be included in the total assets at the fair market value of the property.
Interest on mortgage loans more than 90 days past due is included in assets not withstanding different treatment for Annual Statement purposes.
Accrued interest on mortgage loans in foreclosure is includible in assets.
Dividends accrued from either preferred or common stocks are eliminated from total assets since they are only recognized on a cash basis for tax purposes.
Loading on deferred and uncollected premiums is not includible in assets.
Unimproved land to be used as a future site for its branch or home office is includible in assets. See Rev. Rul. 67–243, 1967–2 CE 236.
Escrow and trust funds are generally includible in assets.
Cash usually includes remittances received at year end which have not yet been allocated to premiums due and uncollected, investment income receivable, and other assets. Insurance companies credit these amounts to a suspense account. Since it represents a duplication of assets, a tax return adjustment is made reducing assets. This reduction should be verified to ensure that the suspense item actually represents a duplication of assets.
Cash should not be reduced by sight or claim drafts outstanding.
The value of any interest in a partnership, joint venture or a trust in which the company is a direct participant should be determined by taking the company’s proportional interest times the fair market value of all the assets of the partnership minus the Annual Statement value (Schedule BA, part 1, column 7 of the Annual Statement).
Where a second-tier partnership is involved, the same principles as stated in paragraph (16) above apply.
The total amount of income for non insurance business as defined in IRC section 803(a)(3) if includible in gross income.
Ordinary income from the sale of investment assets from Form 4797 such as recapture of depreciation.
Mutual company "true up" of income from recomputation of the differential earnings amount.
Subtractions from special loss discount account with regard to companies required to discount unpaid losses as required by IRC section 846.
IRC section 805(a)(1) allows a deduction for all claims and benefits accrued and all losses incurred, whether or not ascertained on insurance and annuity contracts. The law regarding what is deductible as a death benefit has not changed from the pre-1984 law. The court cases and rulings still apply in this area.
Benefits incurred on Form 1120–L, line 10 include all of the following statutory items:
Benefits under accident and health policies.
Payments on supplementary contracts (with or without life contingencies).
Payment of dividend accumulations.
These amounts are found in the Annual Statement, page 4, summary of operations, lines 8 through 16A.
Unpaid losses are taken into account as part of benefits incurred rather than as part of the computation of an increase or decrease in IRC section 807(c)(2) reserves as provided in Rev. Rul. 65–33, 1965–1 CB 263 and Rev. Rul. 67–129, 1967–1 C.B. 170.
Losses which have been incurred during the year may not have been reported (IBNRs) at the end of the taxable year.
Losses related to accident and health claims may not be readily determinable at the time they are incurred. The deduction allowed by IRC section 805(a)(1) for these losses represents an exception to the general rule under Treas. Reg. 1.446–1(c)(1)(ii) regarding the "all events test."
A change in the method of computing a deduction for losses incurred to take into account incurred but not reported losses (IBNRs) is a change in accounting method and requires advance approval of the Commissioner under Rev. Rul. 79–210, 1979–2 CB 261.
IBNRs must be based on reasonable estimates using prior experience. IBNRs are reported on Annual Statement Exhibit 11, part 1, line 3.
Disability benefits under accident and health policies. Beginning in 1987, accident and health claim liabilities must be discounted in accordance with IRC section 846 (Annual Statement, summary of operations, page 4, line 11). Exhibit H of the Annual Statement should be used to develop unpaid loss reserves for accident and health lines including disability benefits. Several prior Annual Statements and subsequent Annual Statements from the examination year are the starting point for testing the reasonableness of the reserve in the examination year.
Interest credited to reserves on supplementary contracts that do not involve life, accident, or health contingencies instead of cash payment are reflected as an IRC section 805(a)(2) deduction and not a deduction under IRC section 805(a)(1).
The following are ordinary connotations of the term "reserve" as used for most accounting and income tax purposes:
Valuation Reserves —Such reserves indicate that the value of an associated asset is overstated by the amount of that reserve. A common example of this type of reserve is a depreciation reserve or account. This is a contra asset account, commonly called accumulated depreciation.
Reserves for Contingent Liabilities —These measure the value of potential future losses. An example of this type of reserve might be a reserve set up for an anticipated loss that could arise from a pending lawsuit against the corporation.
Surplus Reserves —Such reserves are really allocations of surplus earmarked for special purposes. An example would be appropriated retained earnings.
Fluctuation Reserves —Such reserves are hybrid reserves between valuation reserves and surplus reserves. Such reserves are used to cushion fluctuations in the market value of marketable securities valued on the balance sheet.
The Annual Statement of a life insurance company will often reflect each of the above ordinary types of reserves, even though the formal accounts of the company may not include any of them.
A valuation reserve such as a depreciation reserve will be reflected in the net value of the asset on the balance sheet. However, for income tax purposes, life insurance companies are not permitted to report their bad debts on a reserve basis; rather, the specific write-off method is required.
A contingent liability reserve will generally be reported under either the line for Miscellaneous Liabilities or the line for Aggregate Write-in Liabilities shown on page 3 of the Annual Statement.
A surplus reserve should always be reported under the applicable line for Special Surplus Funds on page 3 of the Annual Statement. Certain surplus reserves may be required by the statutory authorities.
Life insurance companies had been required to maintain a fluctuation reserve which, prior to 1991, was known as the "Mandatory Securities Valuation Reserve" (MSVR). However, beginning with the 1991 Convention Blank, the MSVR was replaced by two new required fluctuation reserves designated as the "Asset Valuation Reserve" (AVR) and the "Interest Maintenance Reserve" (IMR). These fluctuation reserve items are not different in substance from surplus reserves, except that they are required by the statutory authorities and are preprinted on the Convention Blank as liability items (rather than as special surplus items) on lines 21.4 and 11.4, respectively, of page 3 of the Annual Statement.
The audit procedures for the ordinary type of reserves described above are generally the same for life insurance companies as for ordinary commercial corporations, and should not present special problems for the agent. However, a special circumstance arises for mutual life insurance companies because of the elimination of the MSVR in 1991. Under IRC section 809, applicable only to mutual life insurance companies, the MSVR was included in the determination of the company’s average equity base. However, it is expected that, for 1991 and later years, the AVR and IMR will replace the MSVR in the equity base determination (see "Differential Earnings Amount" in Chapter 5, text 5.4 of this handbook and Treas. Reg. 1.809.10).
Insurance companies are, however, different from ordinary commercial corporations in that they must set aside and maintain significant levels of special reserves which they need to pay insurance policy benefits. A life insurance company sells insurance and annuity contracts (policies) which, in consideration of premiums received from its policyholders, obligate the company to pay benefits if certain future contingent events occur. These contingent events (called risks) include death, survival, disability, accidental injury and sickness. The financial impact of an insurance contract cannot be known exactly until the insured risks occur or the contract otherwise terminates. This may occur soon after a policy is issued, or many years later. For an extremely large number of issued and outstanding insurance policies, however, these risks can be predicted with reasonable accuracy based on the laws of statistical averages. In order to systematically build assets to support their future obligations, a life insurance company must set aside a considerable portion of the premiums it collects, but which it has not yet used to pay benefits, as a reserve fund. These reserve funds, combined with premiums it will receive in the future plus investment earnings, will accumulate over the years and be available to pay benefit obligations.
Therefore, in addition to the common types of reserves that ordinary corporations maintain, life insurance companies must also establish and maintain in their annual statements the following special types of reserve liabilities:
Actuarial reserves (policy reserves).
Unearned premium reserves.
Unpaid loss reserves.
Other liabilities or reserves under insurance or annuity contracts, which may or may not accumulate at interest.
The nature, significance, and tax relevance and treatment of these special types of reserves will be described in the following sections.
Under state insurance laws, a life insurance company is licensed to sell only contracts of life insurance, annuities, accident and health insurance, and special types of group annuity contracts used to provide employee retirement benefits. A contract may be issued to insure only one person (individual contract) or to insure many persons (group contract). A life insurance company, therefore, generally maintains actuarial reserves for many different types of policy forms and benefits. For most life insurance companies, reserves for life insurance policies represent the bulk of their actuarial reserves. Whole life insurance policies provide protection for the entire life of the insured. Term life insurance policies provide protection only for a limited period of time. If a term life policy also pays a lump sum amount to the insured if he lives to the end of the term, the policy is called an endowment life policy. The discussion in this section will be focussed on traditional individual whole life insurance policies. Reserves for term life and endowment life policies, as well as for annuities and accident and health insurance, are based on the same fundamental principles.
Under an individual life insurance policy, a policyholder selects one of several premium payment options. Under a "single premium" policy, the policyholder purchases the policy with a single premium payment at the issue date. It is more common, however, to pay premiums on an annual or more frequent periodic basis, and this discussion will assume that method of payment. The reserve for a fully paid-up premium policy, such as a single premium life insurance policy or a policy for which no further premiums are due, is simply a special case of the reserve for a premium-paying policy.
Under a traditional whole life insurance policy, the insured death benefit (called the face amount of the policy) remains level and guaranteed for the lifetime of the insured person, provided the required premiums are timely paid. The premiums are usually paid in equal annual installments over the lifetime of the insured, or over a fixed number of years. Since the risk of death increases as the insured person ages, the annual cost of insurance under the policy also increases. The annual cost of insurance is called the annual mortality cost, which is simply the expected amount of claim for that year ( "amount at risk" ) based on the insured’s assumed death rate for that year. The assumed annual death rates are obtained from standard actuarial tables, called mortality tables, which the insurance company uses to calculate its premiums and reserves. In order for the insurance company to charge a level annual premium for the policy, when the annual mortality cost is increasing, the premium charge during the early policy years must be greater than the mortality costs for those years. Accordingly, the premium charge for later policy years will be less than the mortality costs for those years. This gives rise to the concept of a policy reserve during the life of the policy because, if the insurance company is to have sufficient funds to pay the claim costs in the later years when those costs exceed the level premiums, it must accumulate the excess level premiums in earlier years. It is this "accumulation" with interest, of past excess level premiums that generates the reserve at each policy duration. Thus, the function served by the reserve is to balance the premiums with the rising mortality costs.
The policy reserves, however, are not actually computed by accumulating, with interest, the actual premiums charged the policyholder and then subtracting the actual past mortality costs. The actual premium charged is called the "gross" premium, which is the total amount that the insurance company determines is required to cover estimated mortality costs, policy expenses and a margin for profit and contingencies. Naturally, the gross premiums must also be competitive with gross premiums charged by other insurance companies if the policy is to be marketable. The setting of gross premium scales for insurance policies is called "pricing," which involves many different actuarial assumptions and complex calculations. Life insurance reserves, on the other hand, are calculated by using an entirely different set of premiums calculated on a "net" basis. These net premiums, sometimes called "valuation net premiums" or "tabular net premiums," are calculated using only mortality and interest assumptions, so as to cover just the mortality costs with no allowance for expenses or profits. The premiums are calculated independently of the gross premiums charged and are used strictly to determine the actuarial reserves. As a margin of safety, the reserve valuation laws of the various states require that life insurance policy reserves for the company’s annual statement must be determined on a net premium basis. The gross premiums charged generally exceed the reserve valuation net premiums. This excess has often been called the "loading." However, since the gross and the valuation net premiums are calculated independently of each other, there are instances where that relationship changes and the valuation net premiums exceed the gross premiums. When that is the case, the state regulatory authorities require that adjustments be made to the reserves otherwise determined so that the annual statement reserves for those policies will not be deficient. Such additional reserves are known as "deficiency reserves."
The first step in the reserve process is to calculate the valuation net premiums using an assumed mortality table and an assumed interest rate, which are the key actuarial assumptions, Under one of several different valuation methods of calculating reserves, known as the Net Level Premium Method, these net premiums are determined as a level amount over the entire premium paying period. Other reserve valuation methods may be used which affect the pattern in which the reserves accumulate, and these will be mentioned later in this section. Once this net premium is determined, policy reserves may be calculated for any policy duration by utilizing either of the two reserve balancing equations—the Retrospective Equation or the Prospective Equation:
Under the retrospective equation, the reserve equals the accumulated value of all past net premiums less the accumulated value of all past assumed mortality costs.
Under the prospective equation, the reserve equals the present value of all future assumed mortality costs less the present value of all future net premiums.
Under both equations, the reserve calculation uses the same mortality and interest assumptions used to derive the net premiums. Both produce identical reserve amounts; the choice depending only on which equation better facilitates the calculation. The accumulations and present values under these reserve equations are determined using actuarial mathematics, i.e., these summations reflect both mortality and interest discounting. To better understand the reserve process, apply the prospective equation at the inception of the policy, i.e., at the policy duration zero, when the reserve must be zero. By substituting zero for the reserve, the prospective equation reduces to the following equation to the present value of all future net premiums, equals the present value of all future assumed mortality costs.
This equation now expresses the fundamental relationship between the net premiums and the expected mortality costs over the entire life of the policy, and becomes the formula initially used to calculate the net premiums.
After selecting a mortality basis and an assumed interest rate and calculating the net premiums, select one of several acceptable reserve valuation methods. The valuation method defines the pattern or rate at which the reserves accumulate over the life of the policy whichever valuation method is selected. The reserve will become the same at some designated future duration eventually. The reserve must accumulate ultimately to the face amount of the policy when the insured attains the terminal age of the mortality table (i.e., the age by which all insured individuals are assumed to have died). The Net Level Premium Method is one of these valuation methods.
The Net Level Premium (NLP) Method has been the traditional method of calculating life insurance reserves used by life insurance companies. Other valuation methods, called "modified reserve methods," have been developed to compensate for an inherent weakness in the NLP method. Under the NLP method, the net valuation premiums remain level over the entire premium paying period. Consequently, the loading included in the gross premium charge, intended to cover policy expenses, is clearly the same amount for each policy year. A life insurance company’s actual policy expenses, however, are not level and, moreover, are significantly higher in the first policy year than in renewal years. The very high first year expenses are a natural consequence of the process of selling and issuing an individual life insurance policy. Agents’ sales commissions are much higher in the first year than in renewal years. There are also first-year non-recurring expenses to underwrite and approve the insurance application, for medical examinations, and for clerical functions to set up initial records and to issue the policy. The total first year expenses generally exceed the expense loading charged in the first year gross premium, and may even exceed the entire first year gross premium. Under the NLP method, the first year net premium is entirely used to cover the assumed mortality costs of that year and establish the first year policy reserve. As a result, the remaining expense loading from the gross premium becomes insufficient to cover first year actual expenses. The life insurance company is then forced to make up this insufficiency by borrowing from its surplus funds, in effect a "surplus loan," which then gets returned to surplus in renewal years as the gross premium expense loading becomes more than sufficient to cover actual renewal year expenses. Normally, this first year new business surplus strain creates little difficulty for well established companies with ample surplus funds. For small or newly established companies with limited surplus, however, this need to draw on surplus to finance new business ( "surplus strain" ) could impair their financial position and their ability to generate new business.
This situation is alleviated by deploying a modified valuation method that recognizes the decreasing incidence of expenses and provides a greater amount of expense loading in the first policy year than in renewal years. This modification accumulates reserves from a first year net premium that is smaller than the net premiums for renewal years. Under modified reserve methods, the sequence of net level premiums under the NLP method is replaced by a reduced first year net premium followed by a series of increased net level premiums for renewal years over a specified number of years. At the end of the specified modification period, the original net level premiums are restored and full NLP reserves are carried. This modified net premium sequence must be equivalent in actuarial value to the sequence of original unmodified net level premiums, so that the modified reserves will grade up to the NLP reserves. Modified reserve methods produce lower reserves than the NLP method in the first policy year and throughout the entire modification or grading period. The intent of these reserve methods is to reduce the first year net level premium, thereby increasing the amount of the first year expense loading. In effect, the modified method borrows some portion of the first year net premium under the NLP method to partially offset the expense loading insufficiency, and progressively returns the borrowed portion to the reserves in renewal years.
Several of the recognized modified valuation methods that have been in general use for calculating life insurance reserves are the Full Preliminary Term (FPT) Method; Commissioners’ Reserve Valuation (CRVM) Method; Illinois Method; New Jersey Method; and the Canadian Method.
The FPT method provides the greatest additional first year expense allowance because its first year net premium covers only the assumed mortality cost of the first year. As a result, the reserve at the end of the first policy year is zero. Thereafter, the modified renewal net premium is exactly the same amount as the net premium under the NLP method for an exactly similar policy issued one year later at an age one year older, and the reserves accumulate accordingly. The FPT method is not appropriate for all types of policies because of excessive additional first year expense allowances for high premium policies, and its application is restricted by state regulatory authorities.
The other methods listed above are called "modified preliminary term methods," because they all modify in some way the additional first year expense allowance under the FPT method. They differ from each other in the amount of the additional expense allowance and the length of the modification period. The CRVM is significant because it has been adopted by the state regulatory authorities, pursuant to the NAIC Standard Valuation Law, as the prescribed valuation method in defining minimum annual statement reserves for individual life insurance policies. It is also significant for income tax purposes, because it is the prescribed method for calculating life insurance tax reserves for life insurance policies under IRC section 807(d). This is discussed further in text 4.6.3 of this handbook.
In order to closely regulate life insurance companies in certain areas of their activities, state insurance laws and regulations impose minimum reserve requirements on all reserves reported in company annual statements. The states’ concern is with insurance company solvency and the protection of policyholder interests. Policy reserves for all life insurance policies must, in the aggregate, equal or exceed a total reserve level which is determined by using certain prescribed assumptions for mortality and interest and a prescribed valuation method. These prescribed standards for determining minimum statutory reserves generally follow the provisions of the NAIC Standard Valuation Law and its interpretations. CRVM is the value method model as incorporated in state statutes prescribed by both the NAIC and Federal tax law for defining individual life insurance reserves. The prescribed standards for mortality and interest will vary by line of business and policy issue date. Statutory standards are established to produce conservative minimum reserve levels in keeping with the states’ responsibility to regulate financial solvency. It should be noted, however, that companies are permitted to use any actuarial basis for determining statutory reserves, provided the approach results in aggregate reserves that equal or exceed the minimum reserves produced by the statutory standards.
Mortality Tables: The life insurance industry conducts ongoing studies of mortality experience under all types of life insurance policies and annuities. For purposes of calculating premiums and reserves, the industry has constructed and published a number of standard mortality tables. A mortality table tabulates annual death rates for each integral age from age 0 (or the earliest significant age) to an arbitrary terminal age, usually around age 100. For ordinary life insurance policy reserves, the mortality tables are, or have been, in common use the Commissioners 1980 Standard Ordinary Tables (1980 CSO); Commissioners 1958 Standard Ordinary Table (1958 CSO); Commissioners 1941 Standard Ordinary Table (1941 CSO); American Experience (AE) Table; and the American Men (AM) Table.
The 1980 CSO Tables, consisting of separate tables for males and females, are the prescribed mortality standards operative on all life insurance companies for policies issued on or after an "operative date" elected by each company, but where such date could not be later than January 1, 1989. The majority of states had adopted it as their prescribed standard by 1982. Prior to the adoption of the 1980 CSO Tables as the prescribed standard, the 1958 CSO Table had been the prevailing state standard for policies issued in 1960 and later years, although it did not become mandatory in all states until 1966. The 1958 CSO Table is a male mortality table; female mortality rates are assumed by using an age setback to the male death rates, initially recommended to be 3–years. Reserves are typically lower under the 1980 CSO than under the 1958 CSO. Prior to the adoption of the 1958 CSO Table, the 1941 CSO table had been the prevailing standard for policies issued in 1948 and later years.
Since mortality experience under other types of life insurance contracts and under annuity contracts differs substantially from mortality experience under ordinary life insurance contracts, special mortality tables have been constructed and are used for setting reserves under those other type contracts. A few of those more recent mortality tables are as the Commissioners’ 1961 Standard Industrial Table (Industrial Life Insurance); Commissioners’ 1960 Standard Group Mortality Table (Group Life Insurance); 1971 Individual Annuity Mortality Table (Individual Annuity); 1971 Group Annuity Mortality Table (Group Annuities); 1983 Table "a" (Individual Annuities); and the 1983 Group Annuity Mortality Table (Group Annuities).
By 1985, the majority of states had adopted, as their prescribed mortality standards for minimum reserves for annuity contracts, the 1983 Table "a" (for Individual Annuities) and the 1983 Group Annuity Mortality Table (for Group Annuities).
Interest Rates: The Standard Valuation Law prescribes the maximum interest rates that may be used in calculating the minimum reserve standards for life insurance and annuity contracts. Again, this is to ensure that such policy reserves will be conservatively valued. Since life insurance and annuity contracts generally reflect long-term commitments, the effect of the assumed interest rates on their reserves can be highly dramatic. Generally, the higher the interest rate assumption, the lower the required reserve.
For many years prior to the 1980 Amendments to the Standard Valuation Law, these prescribed maximum interest rates were at very low levels. For example, for all life insurance contracts, the maximum rate ranged from 3.5 to 4.5 percent. In general, annuities were subject to the same low interest rates up until the latter part of the 1970s, when some relief was given by elevating the maximum rate to 7.5 percent for group annuities and for individual single premium immediate annuities. These low interest rate standards were very unrealistic throughout the 1970s when actual interest rates were escalating to all time high levels with double digit rates commonplace. This excessive conservatism was more fully addressed with the 1980 Amendments by introducing a "dynamic" interest rate approach for establishing the maximum statutory rates. The Standard Valuation Law was changed to define a formula method of determining the statutory interest rate, rather that specifying the actual rate, with such formulas reflecting actual yields on seasoned corporate bonds. Thus, commencing with policies issued after 1982, the maximum interest rates will vary by different product features for life insurance and annuities, and these interest rates are subject to change each calendar year. For example, for life insurance policies, the maximum statutory interest rate varies by the number of years of a policy’s guarantee duration, such that for any calendar year of issue there may be three entirely different valuation interest rates that are applicable. By the dynamic formula approach the maximum interest rates are automatically promulgated each year eliminating the need for each state to amend their insurance laws.
One further component in the calculation of a policy reserve is the timing function. This refers to the assumptions as to the time when claims and premiums will be payable. Normally, it is the practice of life insurance companies to pay death benefits as soon as possible after the death occurs. Premiums, on the other hand, are usually payable at scheduled dates depending on the payment mode elected by the policyholder. However, to facilitate the computation of premiums and reserves, it is customary to make convenient assumptions as to the timing of claims and premiums.
Curtate Function: Under this function, death benefits are assumed to be paid at the end of the policy year of death, and all annual premiums, irrespective of the actual payment mode, are assumed paid at the beginning of the policy year. This claim payment assumption is convenient because annual death rates, as measured to the end of a year, are exactly calculated from mortality tables.
Continuous Function: Under this function, death benefits are assumed to be paid at the moment of death, and all annual premiums, irrespective of the actual payment mode, are assumed to be paid uniformly throughout the policy year. This idealized premium payment assumption is particularly convenient when the actual premium mode is quite frequent, such as the weekly mode (under industrial life insurance) or the monthly mode (when paid through a payroll deduction plan). Special actuarial adjustments are made to convert curtate functions to continuous functions. Reserves calculated by continuous functions will be higher than when calculated by curtate functions. The reason for this is that, since, on average death benefits are assumed to be paid one-half year sooner and premiums are assumed to be received one-half year later, additional reserves are needed to compensate for the loss of interest on the death benefit and for the loss of one-half year’s premium during the policy year of death.
Semi-continuous Functions: Under these functions, either death benefits are assumed to be paid at the moment of death, or annual premiums are assumed to be paid uniformly throughout the policy year.
For any individual policy, actuarial reserves may be exactly calculated for each policy year as of the end of the policy year. A reserve value at the end of a policy year is called a "terminal" reserve. A reserve value at the beginning of a policy year is called an "initial" reserve, which is simply the sum of the terminal reserve for the preceding policy year plus the net premium for the current policy year. For statutory reporting purposes, however, reserves must be established as of the annual statement’s year-end date, December 31, in total for all policies in force as of that date. Life insurance companies issue policies throughout the calendar year and, as a result, policy anniversaries fall on many different dates. For most of the policies in force, the December 31 valuation date will not coincide with a policy year-end date, but will fall at an interim point during the current policy year. When a policy’s reserve must be valued as of a date that falls between its policy year-ends, the valuation is called an "interim" valuation. Life insurance companies often use approximation methods, which deploy terminal reserves, to conveniently estimate interim reserves for annual statement purposes where large numbers of policies are involved. Three such approximation methods in common use are the Mean Reserve, Mid-Terminal Reserve and Interpolated Reserve methods.
Mean Reserves: This method assumes that a large group of policies have issue dates evenly distributed throughout the calendar year (so that the "average" anniversary date is July 1, and an average one-half a policy year has elapsed by December 31), and premiums are paid annually at the beginning of the policy year (so that by December 31 it is assumed that every policy has paid a full year’s premium for the current policy year). The mean reserve (or, mid-year reserve) for each policy equals the average (mean) of the current policy year’s initial and terminal reserves. For a large group of policies which do pay annual premiums, the mean method is a reasonable estimate of their total reserves at December 31; and for those annual premium policies which do have a July 1 anniversary date, the mean reserve is the theoretically correct reserve at December 31. For many of the policies in the group that pay their policy year premiums in installments, the mean reserve method’s annual premium assumption overstates the premiums actually paid by December 31 for the current policy year and, thereby, overstates their December 31 reserves. When premiums are paid on a "fractional" or "modal" basis (e.g., semi-annually, quarterly, or monthly) some portion of the total fractional premiums for the current policy year will fall due after December 31, and that portion is called "deferred fractional premiums." To effectively offset the mean method’s inherent reserve overstatement for policies with deferred fractional premiums, statutory reporting requires certain accounting procedures. The total of all gross deferred premiums is compiled and explicitly reported in the annual statement and included in premium income for the current calendar year, gross loading charges are deducted from that income as expenses, and a special asset account is established on the balance sheet as of December 31 equal to the related net valuation deferred premiums (as if the net deferred premiums were amounts receivable). Net valuation deferred premiums are used because the sole purpose of this asset account is to offset the excess net premiums included in the mean reserves. If any deferred fractional premiums are actually paid prior to December 31, they are not included in the deferred premium asset and, under statutory reporting conventions, they are not treated as advance premiums. Moreover, any gross premiums that were due prior to December 31, but uncollected as of that date, are accounted for in the same manner as deferred premiums, with the net portion included in the same asset account. This asset account is identified in the balance sheet as "life insurance premiums deferred and uncollected." Life insurance companies may determine their net deferred and uncollected premiums either on a seriatim basis (i.e., a policy-by-policy listing of gross and net premiums), or on an aggregate basis (i.e., applying group ratios of net to gross deferred and uncollected premiums from historical experience). In the special case where terminal reserves are based on continuous functions, whereby premiums are assumed to be paid uniformly throughout the policy year, the mean reserve is simply the average of the terminal reserves for the preceding and current policy years. There are no adjustments required to these reserves, since the annual premium payment assumption under the mean method does not apply. There are no deferred fractional premiums to adjust for. The mean reserve method is commonly used for computing annual statement reserves for ordinary life insurance policies.
Mid-Terminal Reserves: Under this method, it is also assumed that the policies in the group have an average anniversary date of July 1 and that one-half a policy year has elapsed by December 31. However, no direct assumption is made as to the amount of current policy year premiums paid in by December 31. Therefore, the mid-terminal reserve is determined as the average (mean) of the terminal reserves for the preceding and current policy years, plus an unearned premium reserve equal to the portion of the modal premium due prior to December 31 which covers the period from December 31 to the next modal premium date. The unearned premium reserve may be based on net valuation premiums or gross premiums, and it may be calculated by using either the exact unearned period or a simplified approximation such as one-half the modal period. Under this method, no deferred fractional premium asset is established. If the policy pays annual premiums, then the mid-terminal method is identical to the mean method when one-half year’s net premium is used as the unearned premium reserve. The mid-terminal reserve method is generally used for computing annual statement reserves for industrial life insurance and for individual health insurance policies.
Interpolated Reserves: This method introduces a refinement to the mid-terminal reserve method. There is no assumption as to an average anniversary date of July 1. Instead, the actual anniversary date of each policy is taken into account by applying a linear interpolation between the terminal reserves for the preceding and current policy years based on the exact fraction of a year elapsed from the actual anniversary date to December 31. The unearned premium reserve, which is added to the interpolated terminal reserves, is then determined as the exact unearned portion of the net modal premium. As in the case of the mid-terminal method, no deferred fractional premium asset is established, since no direct assumption is made as to the amount of current policy year premiums paid in by December 31. If the policy has an anniversary date of July 1 and it pays annual premiums, then the interpolated reserve method is identical to both the mean and mid-terminal methods. Some companies use the interpolated reserve method for computing annual statement reserves for ordinary life insurance policies as a refinement and to eliminate the need to establish a deferred fractional premium asset.
The current Federal income tax law relating to life insurance companies was enacted under the Tax Reform Act of 1984 (TRA 1984). Subsequent legislation under the Tax Reform Act of 1986 (TRA 1986), the Omnibus Budget Reconciliation Act of 1987 (OBRA 1987) and later Acts amended the original TRA 1984 in many important respects, including significant aspects of reserves. Notwithstanding these revisions, the reserve sections of the Code remain structurally the same as they were originally enacted under TRA 1984.
Reserves play an extremely important role in the Federal taxation of life insurance companies. Under IRC section 816(a), reserves are the key element in determining whether a company that qualifies to be taxed as an insurance company would further quality to be taxed specifically as a life insurance company. This key element is known as the "reserve ratio test" which requires that "life insurance reserves," as defined by IRC section 816(b), and certain other reserves, must comprise more than half of the life insurance company’s total insurance reserves. Moreover, under IRC section 807, the net increase or decrease during the tax year of these life insurance reserves and certain other reserves directly affect the life insurance company’s taxable income for the year. IRC section 807 also prescribes specific rules as to how life insurance reserves and certain other reserves must be computed for the purpose of determining the increase or decrease in reserves for the year. These computational rules are intended to establish uniform Federal tax standards applicable to all life insurance companies in computing certain reserves for tax deduction purposes, and to limit the level of these reserve deductions. These computational rules were the major change to life insurance company reserves adopted by TRA 1984. The Code definition of life insurance reserves, as those reserves affect the reserve ratio test, and the types of contracts for which life insurance reserves are held, will be discussed in this section. Since the reserves that are used for the reserve ratio test are those held by the company for state regulatory purposes in the annual statement ( "statutory reserves" ), the location of those reserves in the annual statement will be identified. Some examples of those types of reserves which generally qualify as life insurance reserves, and those that generally do not, will be given. The specific rules for reserve computations prescribed by IRC section 807 will then be discussed in text 4.6.3 of this handbook.
To better appreciate the foundation of the current tax law treatment of life insurance company reserves, we will begin with a brief summary of the history of key Federal tax laws affecting reserves:
Revenue Act of 1913 —Under this Act, life insurance companies were taxed on their total income from all sources. Since reserves were required to meet policy obligations, the assets held in support of those policy reserves were not available to the company for its free use. Under this Act, therefore, companies were permitted to deduct from income the amount required by state law to be added during the year to its reserve funds.
Revenue Act of 1921 —Starting with this Act, life insurance companies were taxed only on their investment income. Consequently, it was no longer necessary to allow a deduction for the full increase in reserves. Companies were permitted, however, to deduct from their investment income the amount of interest required to be added to their reserves each year. Under the Act, the deduction was fixed at an interest rate of four percent applied to the company’s mean reserves. This interest rate was then changed periodically thereafter by various tax laws enacted through 1957.
Life Insurance Company Income Tax Act of 1959 —This Act significantly changed the taxation of life insurance companies effective with the 1958 tax year. Once again companies were taxed on their total income from all sources, but now they were taxed by a complicated three phase structure for determining taxable income. When determining taxable investment income, they were allowed to deduct the policyholder’s share of investment income calculated by specific statutory rules. When determining the gain from operations, the net increase in reserves for the year was deductible, but such deduction was reduced to avoid a double reserve deduction. An important provision in the law also allowed companies which valued their life insurance reserves under a preliminary term method to adjust those reserves for tax purposes to higher net level premium reserves, either by exact recalculation or by statutory approximation rules. This adjustment provision was intended to create tax parity for small or newly formed companies, who typically used preliminary term reserves, with large, well established companies who at that time typically used net level premium reserves. As time passed, most companies adopted preliminary term reserves for their statutory reserves, and then capitalized on the tax adjustment rule to obtain significantly increased tax reserve deductions.
TRA 1984 —For various reasons, including simplification of the life insurance company tax law, the 1959 Act was repealed and a new tax structure was enacted under TRA 1984, effective with the 1984 tax year. Companies continued to be taxed on their total income, but under a single phase structure consistent with the way other commercial corporations are taxed. Although life insurance companies now receive a deduction for the full annual increase in their reserves, under this Act the law prescribes specific rules, including actuarial methods and factors, for computing life insurance reserves and certain other reserves strictly for the purpose of determining a life insurance company’s taxable income. The definition of life insurance reserves still applies exactly as it did under the 1959 Act, but under TRA 1984 it has practical application only with respect to the reserve ratio test to determine if the insurance company may be taxed as a life company, and to identify that subset of total deductible reserves that must be calculated by the tax law rules.
Tax Code Definition of Life Insurance Reserves:
As discussed in text 4.6.1 of this handbook, actuarial reserves are conservative estimates of the amount of funds that must be set aside which, together with future tabular net premiums, will be exactly sufficient to pay the future policy claims as they fall due. The reserve amounts are equal to the present value of future expected benefits less the present value of future tabular net premiums, where the present values are discounted for interest and mortality and, as appropriate, also for morbidity (for example, for disability type benefits).
The Code contains a precise definition of actuarial reserves for life insurance and annuity benefits and, with certain restrictions, for accident and health (A & H) benefits, and designates these reserves as "life insurance reserves." As defined in IRC section 816(b), life insurance reserves are reserve amounts which satisfy all the following conditions: Must be computed or estimated on the basis of recognized mortality and/or morbidity tables, and assumed rates of interest. Must be set aside to mature or liquidate, by payment or reinsurance, future unaccrued claims. Such future claims must arise under life insurance contracts or annuity contracts, or noncancelable A & H insurance contracts (including life insurance or annuity contracts which are combined with noncancelable A & H insurance). Such future claims must involve at the time the particular reserves are computed, life, accident, or health contingencies (i.e., mortality or morbidity risks). The reserves must be required by law (i.e., by state law, rules or regulations), except for two situations specifically cited in IRC section 816(b).
It is important to note that it is the statutory life insurance reserves actually held in the company’s annual statement that are the tax basis reserves to be used for purposes of the reserve ratio test, provided the reserves meet the conditions above, except that statutory reserves must be reduced by the following adjustments mandated by the Code and the Regulations: Any deficiency reserves included in the statutory life insurance reserves, even though required by state law, must be excluded for tax purposes. This is the case even though IRC section 816(b) has a general requirement that the reserves must be required by state law. See IRC section 816(h). For a description of deficiency reserves, see text 4.6.1, paragraph (4) of this handbook. Any reserve amount set aside and held at interest to satisfy obligations under any contracts which do not provide permanent guarantees with regard to life, accident or health contingencies must be excluded from life insurance reserves, and from all other insurance reserves that otherwise would be included as total reserves in the denominator of the reserve ratio. IRC section 816(f). In other words, such reserves are not taken into account for qualification purposes. Policy loan amounts outstanding on contracts for which life insurance reserves are held must be excluded from life insurance reserves, but only for qualification purposes. IRC section 816(d). If any deferred and uncollected premiums, or any due and unpaid premiums, are not required to be included in the company’s gross income for the tax year, then an appropriate reduction must be made to the life insurance reserves for such premiums. This reduction shall be made only if the life insurance reserves were calculated on the assumption that premiums are paid annually in advance, or that all premiums due prior to the statement date have been paid. Treas. Reg. 1.801–4(f) and IRC section 811(c).
Qualification Standards for a Life Insurance Company:
Business Standard —An insurance company must first meet the doing business standard required under the Code to quality for taxation as a life insurance company, rather than as a property and casualty insurance company. The doing business standard requires that the company must be engaged in the business of issuing life insurance and annuity contracts, or noncancelable accident and health (A & H) insurance contracts. IRC section 816(a). Under state insurance laws, property and casualty insurance companies cannot issue life insurance or annuity contracts but, like life insurance companies, they can issue A & H insurance. Although A & H insurance originated within the casualty insurance industry, it was the life insurance industry’s intensive involvement beginning during the 1930s, particularly in group medical care insurance, that accelerated the development of A & H insurance. Today, the marketing of A & H insurance is dominated by life insurance companies. Most A & H insurance now is provided under group master contracts issued to employers, associations and other qualified groups to insure employees, members and families. Most group insurance (whether life or A & H) is issued on a term basis, usually one-year term. This permits the insurance company to adjust premium rates at the end of the term or to cancel the master contract. An insurance company that sells life insurance or annuities clearly meets the doing business standard, but a problem can arise if it issues only A & H insurance. In this situation, tax qualification as a life insurance company would be denied unless some of the company’s A & H business was issued under noncancelable or guaranteed renewable contracts. Such contracts are typically issued only on an individual basis. If the insurance company meets the life business standard, the next standard that the company’s insurance business must meet is the critical measurement standard, the reserve ratio test under IRC section 816(a).
Reserve Ratio Test —The reserve ratio test is a measure of an insurance company’s actual activity in the business of issuing long-term commitments under life insurance and annuity contracts, and analogous long-term commitments under noncancelable and guaranteed renewable A & H insurance contracts. If the reserves that support an insurance company’s long-term commitments equal more than half of its total insurance reserves for all of its commitments, the reserve ratio test is satisfied. The reserves used in the numerator of the ratio, intended to measure reserves supporting the company’s long-term commitments, are the life insurance reserves [described above in text 4.6.2, paragraph (4)], plus the unearned premium reserves and unpaid loss reserves held under noncancelable life, accident or health policies that were not otherwise included in the life insurance reserves. The reserves used in the denominator of the ratio are the total insurance reserves that are required by state law, but adjusted as required by the tax law. Virtually all major life insurance companies could have little problem meeting this test. However, the reserve ratio test can present a problem for small or new life insurance companies, or for insurance companies, chartered as life insurance companies, who have a limited business such as A & H or credit insurance, and who seek to be taxed favorably as a life insurance company.
Accident and Health (A & H) Insurance:
A & H insurance provides protection against economic losses that result from accidents or sickness. This insurance may be provided under A & H insurance contracts alone or in combination with life insurance contracts. A & H insurance contracts may be issued under individual or group contract forms, or under special credit insurance contracts used only to insure debtors for loan obligations. A great variety of benefits exist under many forms of A & H contracts, but all such insurance may be classified into three general categories:
Disability Income Insurance (Loss of Time) —This insurance provides periodic payments for a specified period of time while the insured has a qualified disability. It is intended to partially replace income lost by the insured because of inability to work at a gainful occupation. Income benefits vary in amount and duration of payment. Contracts may provide short-term benefits (up to two years), or long-term benefits payable for at least five years, but frequently payable for life or until age 65.
Accidental Death and Dismemberment Insurance (AD&D) —This insurance provides lump-sum payment if the insured dies from a covered accident. It also provides a lump-sum payment if the insured suffers loss of body members (hand, foot or eye) from a covered accident, where the payment amount is a fraction of the death benefit. This insurance may also pay multiples of the accidental death benefit if death is a result of commercial travel.
Medical Care Insurance (Hospital & Medical) —This insurance provides reimbursement of the insured’s actual covered expenses for treatment of injuries and sickness. Various contracts may cover hospital, surgical and/or physician’s expenses and may also cover diagnostic and nursing services, medicines, medical appliances and dental care. Comprehensive coverage is provided under major medical contracts. Medical care insurance is generally issued to permit coverage of the insured’s family members. This insurance is primarily written under master group insurance contracts issued to employers and other qualified groups to insure employees, members and their families. Group insurance contracts are typically issued on a one-year term basis, subject to renewal at the insurance company’s discretion.
Accident and Health (A & H) Reserves:
Because of the myriad of benefit provisions under A & H insurance and the inherent difficulty in measuring the related morbidity experience, state legal requirements for A & H reserves have generally been less explicit than for life insurance and annuity reserves. The Standard Valuation Law has for many years defined very specific minimum reserve standards for life insurance and annuity policies. For A & H, most state laws simply provided that companies establish sound values for their reserves that would not be less than reserves under standards contained in insurance department regulations. Some states, not having adopted specific reserve standards, based their requirements on reserve item instructions in the statutory annual statement. Specific reserve standards for individual A & H contracts, adopted by the NAIC in 1964, served over the years as the basis for reserve regulations issued by many state insurance departments. Insurance department regulations could be revised to change reserve requirements, such as the adoption of new morbidity tables, without having to amend state law. In 1989, the NAIC adopted a new model regulation setting forth new minimum A & H reserve standards for both individual and group contracts (other than credit), superseding all previous NAIC A & H reserve standards. The agent should become familiar with this model regulation. The tax law is also generally less explicit about its A & H reserve requirements than it is for life insurance and annuity reserves.
Exhibit 9 is the annual statement’s reporting exhibit for all A & H reserves. In this exhibit, reserves under all types of A & H contracts are classified as "Active Life Reserves" (Part A) and "Claim Reserves" (Part B). Within each of these categories, reserves are reported separately by group, credit and individual contract lines of business. Individual contract reserves are further separated into six sub-categories based principally on the contract’s renewal agreement (noncancelable, guaranteed renewable, etc.). The credit insurance column includes both group and individual credit insurance with loan durations not greater than 120 months. Active life reserves are required for all in force contracts. Claim reserves, sometimes called unpaid loss reserves, are required in connection with claims to be paid after the statement date. The specific requirements for statutory reserves will generally depend on the contract classes described above, the type of reserve and the nature of the contract’s renewal agreement.
Active Life Reserves —Active life reserves are established to recognize that the premiums charged are intended to cover future liabilities as well as current claim costs. All contracts must have an Unearned Premium Reserve (UPR). The UPR represents that portion of the gross premiums paid or due for the current premium period allocated to the period from December 31 to the next premium due date. Methods of computing the UPR can vary considerably between and within companies. It may be computed on the exact pro rata method using actual premium due dates, or by the "monthly pro rata method" used by many companies. Under the monthly method, all premiums in force at December 31 are tabulated into premium mode/due month cells, and then an appropriate factor is applied to each cell to derive the UPR on the assumption that all policies are issued in the middle of the month. For group policies paying monthly premiums due on the first day of a month, the method will usually be modified so that no UPR is established for that block of policies. Under credit insurance contracts, premiums may either be paid as single premiums based on the initial insured debt, or as monthly premiums based on the monthly outstanding balance of the insured debt. Most credit insurance is now issued under group contracts. For single premium insurance, the single premium is generally included in the debt and the creditor (policyholder) remits the single premium to the insurance company for each newly insured debtor on a monthly basis. Under the monthly premium method, the group creditor remits the premiums due monthly. The UPR for single premium credit insurance may be calculated by the actuarial method, pro rata method or the "rule of 78" method. The actuarial method calculates the reserve as the single premium for the outstanding debt balance and its remaining term, and results in the most accurate reserve. The UPR for monthly premium group credit insurance is usually calculated by the same methods used for other group A & H contracts. The UPR for all types of A & H contracts do not qualify as tax basis life insurance reserves. Moreover, the UPR for cancelable A & H contracts may not be included as qualifying UPR in the numerator of the reserve ratio test. However, for noncancelable or guaranteed renewable A & H contracts, the UPR may be included in the numerator of the reserve ratio test and help to qualify the company as a life insurance company.
Additional Active Life Reserves —For noncancelable or guaranteed renewable A & H contracts only, active life reserves greater than the UPR must be established. This is because the insurance company has a longer commitment to continue coverage under a level premium contract where claim costs increase with the insured’s age. The effect of level premiums, increasing claim costs and the contract’s renewal guarantee create reserve requirements analogous to those under noncancelable level premium life insurance. The instructions for Exhibit 9 state that an additional policy reserve, above the UPR, must be held for any policy which provides a guarantee of renewability, and that the NAIC standards adopted in 1964 are acceptable bases for these reserves. The usual practice is to compute the UPR as described above and then determine the additional reserve on the mid-terminal basis. The NAIC minimum reserve standards specify the two-year preliminary term valuation method to calculate this reserve. With respect to long-term care insurance, a one-year preliminary term method may be used. Exhibit 9 has a separate line item for each of the UPR and this additional reserve, but the instructions permit the inclusion of the UPR on the same line for the additional reserve. Current NAIC guidance requires that the UPR not be less than the present value of future claims attributable to the unexpired policy term. This deficiency reserve does not quality as tax-basis reserve. This additional reserve will usually meet the conditions to be treated as tax basis life insurance reserves, provided the A & H contract meets the definition of a noncancelable or guaranteed renewable contract contained in the Regulations. Moreover, the definition itself requires that the A & H contract has such an additional active life reserve. Therefore, as qualified life insurance reserves, they can be included as such in the numerator of the reserve ratio test, together with the contract’s UPR and its includible unpaid loss reserves.
Claim Reserves —Sometimes called "disabled life reserves," these reserves are established when a claim actually occurs and that claim involves continuing loss after the statement date. A claim occurs when the insured becomes disabled, injured or sick giving rise to a benefit obligation under the contract. In the "Glossary of Actuarial Terms" published by the Actuarial Standards Board, A & H claim reserves are defined as "the actuarial present value as of a valuation date of future, contingent claim payments for claims incurred as of the valuation date, whether or not the claims have been reported." The discussion of claim reserves and their distinction from claim liabilities is appropriate in a life insurance context, but not in a property and casualty context. Claim reserves are to be contrasted with "claim liabilities," which refer to the insurance company’s obligation for accrued claim payments due on or prior to the statement date, whether or not the claims have been reported, which remain to be paid. Claim liabilities are not reported as Part B reserves in Exhibit 9; they are reported in Exhibit 11. Claim reserves must be established for both reported claims and claims unreported as of the statement date. For unreported claims, reasonable estimates based on the company’s past experience must be determined. These estimates are then apportioned between the unaccrued amount to be reported in Exhibit 9 as claim reserves and the accrued amount to be reported in Exhibit 11 as claim liabilities. For certain A & H claims, especially those for medical care, reported claims also involve estimates of claim reserves to be reported in Exhibit 9. These claim estimates are developed on the basis of the company’s past loss experience and, to a great extent, on actuarial judgement. Certain types of claim reserves, if held under noncancelable or guaranteed renewable contracts only, and calculated to satisfy the conditions of IRC section 816(b), may qualify as tax basis life insurance reserves. An example of such a claim reserve would be the reserve for disability income benefits due after December 31 for insured lives already disabled on that date. Claim reserves for noncancelable or guaranteed renewable A & H contracts which do not meet the conditions for life insurance reserves, however, may be included as unpaid loss reserves in the numerator of the reserve ratio test. However, claim reserves for an A & H contract which is neither noncancelable nor guaranteed renewable cannot qualify as life insurance reserves, nor can they qualify as unpaid loss reserves that may be included in the numerator of the reserve ratio test. The Service position is that all claim reserves for cancelable A & H contracts must be shown in the denominator. See Harco Holdings, 977 F 2d 1027 (7th Cir.) 1992. Hence, in the case of a disability income claim reserve in respect to a disabled life as of the statement date, where the reserve is actuarially computed in compliance with IRC section 816(b), the claim reserve will not qualify as a life insurance reserve if the A & H contract is cancelable, but will qualify if the A & H contract is noncancelable.
Life Insurance and Annuity Reserves:
Exhibit 8 is the annual statement exhibit for reporting policy reserves for life insurance and annuity contracts. Exhibit 8 reserves are reported under four major lines of business or types of contracts — industrial life insurance; ordinary (individual) life insurance or annuities; credit life insurance (for loans not in excess of 120 months); and group life insurance or annuities.
Life insurance policy reserves are reported in Part A and annuity policy reserves are reported in Part B of the Exhibit. Supplementary type benefit reserves are reported in Part C, Part D, Part E and Part F, and all other reserves of a miscellaneous nature are reported in Part G of the Exhibit. Life insurance and annuity reserves which qualify as tax basis life insurance reserves under IRC section 816(b) should be included in Exhibit 8. However, not all Exhibit 8 reserves will qualify as life insurance reserves, because they may not meet all the conditions of IRC section 816(b).
Gross reserves for policies issued directly by the company, as well as business reinsured with the company (reinsurance assumed), are reported on a separate line within each Part of Exhibit 8 for each distinct actuarial basis used to calculate reserves. An actuarial basis is defined by the specific mortality table, interest rate(s) and the valuation method used to calculate the reserves. The insurance company is required to specify the details of the actuarial basis for each reserve line. The total reserves for all business which is reinsured with another company (reinsurance ceded) are reported as a single line item for each major line of business under each Part and are so identified as reinsurance ceded reserves. The reinsurance ceded reserves are then subtracted from the total gross reserves to obtain the net reserves.
Life insurance policy reserves in Part A generally qualify to be treated as tax basis life insurance reserves. Ordinary life insurance policies may be whole life, term life or endowment life, but the reserves for any of these policy forms will usually qualify as life insurance reserves. However, under group term life and credit life insurance policies, unearned premium reserves are examples of policy reserves that often fail to satisfy the actuarial requirements of IRC section 816(b)(1)(A) and, thus, will not qualify as life insurance reserves. Traditional mean reserves for one-year term group life insurance policies are equal to one-half the tabular net valuation premium. If the policy reserves are determined in this manner, they will qualify as tax basis life insurance reserves, provided actual ages and net valuation premiums based on recognized mortality tables are used. However, if the reserves are computed by a gross unearned premium method, the reserves do not qualify as life insurance reserves. Moreover, such reserves may not be included as UPR in the numerator of the reserve ratio test. The agent is advised to carefully examine the company’s reserve calculation methods for its group term life and credit life insurance policies, and to research the Service’s policy and rulings related to reserves for these type policies.
Annuity policy reserves in Part B also generally qualify to be treated as life insurance reserves. Group annuity deposit-type contracts are used to accumulate funds to provide retirement benefits for employees under qualified pension plans. Before employees retire and they begin to receive their pensions, deposit funds are held by the insurance company as active life reserves. These active life reserves may be reported in Exhibit 8 or they may be reported elsewhere in the annual statement (as for example, in Exhibit 10). Even if these reserves are reported in Exhibit 8, if the group annuity contract does not contain permanently guaranteed annuity purchase rates, that will be used by the insurance company to charge the deposit fund for the cost of guaranteeing the pension when the employee retires, then the active life reserves do not qualify as tax basis life insurance reserves. Under IRC section 816(f), these reserves are excluded from both the numerator and denominator. However, if the insurance company guarantees the pension at the time the employee retires, the company will then set aside a retired life annuity reserve in Exhibit 8 for that pension, and these retired life reserves will qualify as life insurance reserves. This treatment for group annuity deposit contracts also applies to individual deferred annuity contracts. Under such contracts, the accumulated deposits paid in under the contract may eventually be applied, at the policyholder’s election, to acquire an immediate annuity at a deferred retirement age. Individual deferred annuity contracts typically include minimum guaranteed annuity purchase rates which, at the time an immediate annuity election is made, are applied to the accumulated deposits to determine the annuity benefit. Single premium immediate annuity contracts, which guarantee an annuity income for the life of an individual, or for a guaranteed period and then for life, may be purchased directly by individuals by the payment of a single premium to the insurer. Reserves held in Exhibit 8 for such contracts will also qualify as life insurance reserves. However, if the annuity is payable only for a guaranteed period of time, whereby none of the annuity payments depend on the survivorship of the annuitant, then any reserves held in Exhibit 8 for such an annuity will not qualify as life insurance reserves. This form of annuity is called an annuity certain. Annuity reserves are also held in Exhibit 8 for another form of group contract called a group single premium annuity contract. This form of contract, also purchased by the payment of a single premium, is used to provide guaranteed immediate and deferred retirement annuities for a group of individuals if the qualified pension plan which covered the individuals should terminate, or for other reasons. Annuity reserves under such contracts will qualify as life insurance reserves if the annuity payments to the individual annuitant depend on survivorship.
Reserves for supplementary contracts with life contingencies are shown in Part C and will normally qualify as life insurance reserves. Supplementary contracts are agreements under which the death benefit proceeds of a life insurance policy are paid to the beneficiary by a series of payments rather than in a lump sum, and constitute a full settlement of the life insurance contract. If the supplementary contract provides that the settlement payments are contingent upon the life of the beneficiary, even if the contract guarantees the payout of the original death benefit amount, the supplementary contract is classified as one "with life contingencies." In effect, the settlement becomes an immediate life income annuity. If the settlement payments do not depend on the survivorship of the beneficiary, but are paid only for a specified period, the supplementary contract is classified as one "without life contingencies," and the reserves for that type of contract are reported in Exhibit 10 of the annual statement. The reserves for supplementary contracts "without life contingencies" will not qualify as life insurance reserves under the Code, because the settlement payments do not depend on the life of the beneficiary.
Reserves for accidental death benefits are shown in Part D, and if actuarially computed will qualify as life insurance reserves. Accidental death benefits under an ordinary life insurance policy are supplemental to the basic death benefit, and are offered as an optional additional benefit for an additional premium charge. The accidental death benefit typically equals the basic death benefit and, when it does, the underlying policy is called a "double indemnity" policy.
Reserves for disability benefits under life insurance policies are shown separately between reserves for active lives and reserves for disabled lives. Active life reserves are shown in Part E, and disabled life reserves are shown in Part F. Active life reserves are established to set aside funds to provide for waiver of premium benefits and other disability type benefits in the event an insured person becomes disabled. Under a waiver of premium provision, the basic death benefit insurance remains in effect, but the required policy premiums are waived while the insured remains disabled. Other disability type benefits include income benefits and extension of group life insurance to disabled employees. Disability benefits under ordinary life insurance policies are offered as optional supplemental benefits for additional premium charges. If the active life disability reserves for ordinary life insurance policies are actuarially computed, they will qualify as life insurance reserves. Disabled life disability reserves are established when the insured person becomes disabled and the claim is incurred. If disabled life disability reserves under ordinary life insurance policies are actuarially computed, they will also qualify as life insurance reserves (see Rev. Rul. 70–190). Under group term life insurance contracts, which are cancelable life insurance contracts, active life and disabled life disability reserves will not qualify as life insurance reserves under the Code (the agent should refer carefully to the Service’s position on disability reserves under group term contracts and read Rev. Rul. 80–115). However, since the disability provisions under most group term life insurance contracts usually take the form of an extension of the death benefit coverage to disabled employees (occasionally referred to as a "waiver of premium" provision), some courts have held that reserves for disabled lives, but not for active lives, maintained under such a group life provision will qualify as life insurance reserves provided the reserves are actuarially computed.
Miscellaneous additional policy reserves are shown in Part G. They may or may not qualify as life insurance reserves. Examples of such reserves are: Deficiency reserves, which are specifically excluded from life insurance reserves by the Code. Deficiency reserves, however, will generally be implicitly included with basic policy reserves reported in Part A. Reserves for immediate payment of claims will usually quality as life insurance reserves if actuarially computed. These additional reserves are held if, in rare cases, the basic death benefit reserves held in Part A did not reflect this claim payment assumption. Reserves for nondeduction of deferred fractional premiums, and for the return of any unearned premiums, on the death of the insured will qualify as life insurance reserves if actuarially computed. The nondeduction reserve is held if, after the death of the insured, the remaining fractional premiums due for the current policy year are not deducted from the death benefit, and the basic policy reserve reported in Part A was calculated by the mean reserve method. The reserve for return of unearned premiums is held if the unearned portion of the premiums paid for coverage after the death of the insured is returned at death, but only if this policy provision was not reflected in the basic policy reserve reported in Part A. The agent should determine if any miscellaneous reserves reported in Part G, that otherwise would qualify as life insurance reserves, were not already implicitly included in the reserves reported in other Parts of Exhibit 8.
A list illustrating those reserves and liabilities that do not generally qualify as life insurance reserves is included under Treas. Reg. 1.801(4)(e). Although this regulation was originally promulgated under former IRC section 801 of the 1959 Act, it applies as well to IRC section 816 of the current tax code. The agent is advised to use that list as a quick reference guide.
This section of the handbook will describe the rules laid out in IRC section 807 that govern the deduction from taxable income that life insurance companies are permitted with respect to reserves. TRA 1984 incorporated major changes in such reserve deductions, foremost of which was the introduction of specific computational rules in the Code for determining tax basis life insurance reserves and for certain other reserves. The computational rules for life insurance reserves are prescribed in IRC section 807(d). Additional special rules for computing reserves are prescribed in sections 807(e), 811(c)(1), 811(d) through 812 and adjustment rules for changes in the computation of reserves are prescribed in IRC section 807(f).
Effect of Reserves on Taxable Income —Under IRC section 805(a)(2), a life insurance company is allowed to deduct the net increase during the tax year in those reserves listed in IRC section 807(c). Conversely, under IRC section 803(a)(2), the company must include in gross income any net decrease in such reserves during the tax year. The net increase or decrease in the applicable tax basis reserves is determined by comparing the closing and opening balances of these reserves [decrease under IRC section 807(a) and increase under IRC section 807(b)]. The closing balance of the reserves is always reduced by the amount of the policyholders’ share of tax-exempt interest and, in the case of mutual life insurance companies, by any excess of policyholder dividends over the company’s Differential Earnings Amount determined under IRC section 809.
Reserves Taken Into Account —The specific categories of reserves that are taken into account for the purpose of measuring the net increase or decrease in tax basis reserves are listed in IRC section 807(c). Six categories of reserves and items similar to reserves are listed, as follows (these appear in the same order as they do in the Code):
Life insurance reserves [as defined in section 816(b)].
Unearned premiums and unpaid losses included in total reserves under IRC section 816(c)(2).
Amounts discounted at the appropriate interest rate necessary to satisfy those obligations under insurance and annuity contracts which do not currently involve life, accident or health contingencies.
Dividend accumulations and other amounts held at interest under insurance and annuity contracts.
Premiums received in advance and liabilities for premium deposit funds.
Reasonable special contingency reserves established and maintained to provide insurance for retired persons and/or premium stabilization under group term life or A & H insurance contracts.
Non-contingency Reserves Under IRC section 807(c)(3) —For the purpose of determining the tax basis reserve amount under IRC section 807(c) (3), the interest rate that is used for discounting is the highest of three interest rates: the Applicable Federal interest Rate (AFR); the Prevailing State assumed interest Rate (PSR); and the underlying interest rate used by the life insurance company in determining the guaranteed benefit. The AFR and the PSR are defined in IRC section 807(d). In the case of the third interest rate, the company’s underlying rate, it may be the interest rate implicit in determining the guaranteed benefit obligations for which the liability is established, or it may be the interest rate(s) implicit in the gross premium charge for the guaranteed benefits. The identification of the appropriate underlying rate will depend on the specific character of the benefit obligation that is guaranteed and discounted for interest. Since the underlying interest rate may not be identified by a simple reference to the reserve item in the annual statement, the agent may need to request detailed information from the taxpayer. In any event, the tax basis discounted value of any reserve item that is classified under IRC section 807(c)(3), may not be less than the net surrender value, if any, available under the contract.
Unpaid Loss Reserves Under IRC section 807(c)(2) —For the purpose of determining the amount of the unpaid loss reserves under IRC section 807(c)(2), the discounting rules of IRC section 846 shall apply for tax years after 1986 (TRA 1986). Section 846 was enacted primarily to define rules for discounting unpaid loss reserves under casualty insurance policies of property and casualty insurance companies. However, the rules were extended to life insurance companies, but only with respect to their casualty-type business, namely A & H insurance contracts. These rules do not apply to loss reserves under life insurance contracts. In regard to unpaid loss reserves under A & H insurance contracts, there has been some uncertainty as to whether these discounting rules apply only to claim reserves held in Exhibit 9 of the Annual Statement, or to both claim reserves and claim liabilities held in Exhibit 11. It appears that IRC section 846 rules apply to both types of unpaid losses under A & H insurance contracts, since IRC section 807(c) cross-references IRC section 805(a)(1) in describing the scope of the rules to life insurance company unpaid losses, and that section deals with deductions for accrued claims. Disabled lives reserves for disability income benefits under noncancelable or guaranteed renewable contracts are normally treated as life insurance reserves under section 816(b) and valued as IRC section 807(c)(1) reserves. Therefore, such loss reserves would not be subject to IRC section 846. Under the special rules of IRC section 846(f)(6), applicable to A & H insurance, the interest rate for discounting unpaid loss reserves shall be the AFR in effect for the year in which the claim incident occurred. For disability income unpaid losses under cancelable contracts, the insurance company may use a mortality or morbidity table that reflects the taxpayer’s experience. For all other A & H unpaid losses, the insurance company may assume that the unpaid losses will be paid in the middle of the year following the year the claim incident occurred. That means that the discounted unpaid loss reserve should reflect one-half year’s interest discount at the applicable interest rate.
Life Insurance Reserves Under IRC section 807(c)(1) —The most significant effect that TRA 1984 had on reserve deductions was with respect to life insurance reserves. This category of reserves is defined by IRC section 816(b), but TRA 1984 changed the permitted amount of these reserves for deduction purposes. Prior to the 1984 tax law, the reserve deduction for life insurance reserves were the statutory reserves with certain tax basis adjustments. With the enactment of TRA 1984, life insurance reserves, for purposes of determining a company’s taxable income, must be computed by the rules of IRC section 807(d). The following will summarize the substance of these computational rules.
When the life insurance reserve for any contract is calculated by the rules of IRC section 807(d)(2), the reserve amount is often called the "Federally Prescribed Reserve" (FPR). Although the Code does not use this term, we will use it throughout this discussion. The amount of the FPR for a contract is determined by applying prescribed standards for each of three elements that comprise the actuarial basis of the reserve for that contract, as Tax Reserve Method; Interest Rate; and Prevailing Commissioners’ Standard Mortality or Morbidity Table. The prescribed standards for each of these three elements are described in IRC section 807(d). These will be discussed later in text 4.6.3, paragraph (7).
However, the final amount of the tax basis life insurance reserve for any contract will not necessarily be the calculated FPR. Under IRC section 807(d)(1), that reserve amount shall be the greater of the FPR and the Net Surrender Value (NSV) of the contract. The NSV of a contract is defined as its cash surrender value, less any penalty or charge deducted on surrender, but disregarding any market value adjustment that may be added or subtracted on surrender. Essentially, the NSV is the cash equivalent amount that the policyholder would be entitled to if the policyholder canceled the policy prior to death or maturity. Thus, the NSV becomes a minimum limitation for the FPR in the event the calculated FPR is less than the NSV. Moreover, the tax basis life insurance reserve may not exceed the contract’s Statutory Reserve (SR) actually held in the company’s annual statement. At all times, therefore, the maximum limitation for the contract’s FPR is its Statutory Reserve. For tax purposes, a company must perform a dual valuation of its life insurance reserves by calculating a FPR in addition to the SR for each contract for which it holds life insurance reserves. After doing that, it must compare the calculated FPR against the NSV, and the Statutory Reserve, to ensure that the FPR falls within the minimum-maximum limitations.
The Code and the committee reports to the 1984 Act indicate that this minimum-maximum comparison for the FPR should be performed on a contract-by-contract basis. This presupposes that life insurance companies will calculate the FPR and the Statutory Reserve on a seriatim basis. Notwithstanding that, the committee reports indicate that the minimum comparison of the FPR to the NSV may be performed by grouping policies with similar characteristics. It is not clear how this could be done, nor is it very practical to do so if the grouping method could not also apply to the maximum comparison to the SR. As a matter of practice, most life insurance companies have the computer capacity to perform the seriatim comparison and, in fact, do it that way. The agent should be aware of the approach the company used to perform the comparison. If grouping approximations were used, the agent should ensure that the methods used did not result in significantly overstated deductions for the life insurance reserves.
Several other important conditions are placed on these minimum-maximum FPR comparisons. Except for the designated tax reserve method, interest rate and commissioners’ tables that must be used to calculate the FPR, the calculation of the FPR must be done on the same actuarial basis as the statutory reserves. For example, if the statutory reserve was calculated using continuous timing functions, or if the mean reserve method was used, then the FPR must be calculated in the same manner. If the mean reserve method was used, then for fractional premium policies there will be deferred fractional premiums as of the statement date. It is required that the tax basis life insurance reserve be adjusted so that the reserve will not be overstated by the effect of such premiums. The reserve must also be adjusted to remove the effect of any premiums due prior to the statement date that were uncollected as of that date. The reason for these adjustments is to properly match income with deductions, because these deferred and uncollected premiums may not be included in the company’s gross income until received. In adjusting the calculated FPR for net deferred and uncollected premiums, the net premiums to be used are those by which the FPR is calculated. Accordingly, statutory reserves are adjusted for net deferred and uncollected premiums on the corresponding statutory reserve basis. The minimum-maximum comparisons should be performed after the premium adjustments have been made for each contract. The agent may find that some companies will make the adjustment for deferred and uncollected premiums on an aggregate basis after the seriatim comparisons have been made, frequently subtracting the statutory deferred and uncollected premiums as a conservative measure. If the adjustment was made that way, the agent should ensure that it did not result in any significant overstatement of tax basis life insurance reserves. Reserves for all benefits under the contract should be reflected in the FPR comparisons. This is a critical condition because, if any supplementary benefits under the contract are not included prior to the comparison, the NSV minimum limitation might prevail. This could result in a greater tax basis reserve than would otherwise be the case, because many benefits supplementary to the basic benefit do not have cash surrender values. Under IRC section 807(e), there are some exceptions to this general condition. These exceptions pertain to certain designated supplemental benefits, certain substandard risks and certain benefits under some pre-1989 contracts. These exceptions will be explained in text 4.6.3, paragraph (8). The FPR, as calculated by the Federal tax reserve standards, is not permitted to include any deficiency reserve. Simply put, that means that the valuation net premiums calculated by the Federal standards must be used to calculate the FPR, even if those net premiums are greater than the actual gross premiums charged. However, in the comparison to the statutory reserve, any deficiency reserve included in the contract’s statutory reserve is allowed to be included for purposes of the maximum FPR limitation. Hence, if the maximum limitation prevails, and the SR becomes the contract’s tax basis life insurance reserve, it will reflect that deficiency reserve. Pursuant to IRC section 811(d), excess interest reserves under any contract should be excluded from the FPR and statutory reserve. Excess interest reserves arise when any interest that is guaranteed to be credited to the contract beyond the end of the tax year is computed at an interest rate that exceeds the greater of the AFR and the PSR in effect for the contract. Simply put, this restriction means that the FPR and SR shall be computed as if such interest guarantees applied only to the end of the tax year.
General Computational Rules for Federally Prescribed Reserves:
The Federal prescribed factors for calculating the FPR are set forth in IRC section 807(d)(2). They consist of three computational factors that define the Federal actuarial basis for life insurance reserves. The three factors consist of a tax reserve method; an interest rate; and a mortality or morbidity table. The purpose of using Federal reserve factors is to limit the amount of tax deductible life insurance reserves to the minimum level under the prevailing valuation standards of the States. Even though the minimum reserve standards of the States apply on an aggregate basis to all of a company’s life insurance and annuity reserves, the federal factors must be applied to each separate contract to which the factors apply. These actuarial factors will be described in detail in the following paragraphs.
Tax Reserve Methods: Under IRC section 807(d) (3), the specific reserve method that must be used will depend on the type of contract for which the FPR is calculated. A reserve method becomes a prescribed tax reserve method when it is designated by the NAIC as a prescribed method for statutory reserves. The tax reserve methods by type of contract are life insurance—CRVM; annuity—CARVM; noncancelable A & H—two-year full preliminary term; and long-term care—one-year preliminary term. If a particular contract is not in one of these categories, the method to be used will be the NAIC prescribed valuation method that applies to that contract at the contract’s issue date. Interpretation of CARVM or CRVM should be that prescribed by NAIC in the year the contract is issued. If the NAIC has not prescribed a valuation method for a particular type contract, the method to be used will be a method that is consistent with a prescribed tax reserve method and is most appropriate for that type of contract at its issue date. Under the 1984 Act, a limited exception is permitted for noncancelable A & H contracts. Under this exception, a company that calculated its statutory reserves for these contracts by the net level method may elect to calculate its tax reserves by the same method, provided at least 99 percent of the applicable reserves are calculated by the net level method and the company continues to use the net level method for both statutory and tax purposes. Under CARVM, surrender charges under annuity contracts must be deducted from the annuity reserve. For annuity contracts issued before 1985, contingent surrender charges must be deducted from tax reserves. For annuity contracts issued after 1984, contingent surrender charges are deducted only if the contract’s "bail-out" interest rate is not greater than the PSR applicable to a whole life insurance contract. A policyholder may surrender an annuity contract and not incur a contingent surrender charge if the actual interest rate credited by the company falls below the "bail-out" rate.
Interest Rates: For contracts issued after 1987, the applicable interest rate to be used is the greater of the AFR and the PSR. For contracts issued before 1988, the applicable rate is simply the PSR.
PSR—The prevailing State assumed interest rate is defined in IRC section 807(d)(4)(B). For any insurance or annuity contract, it is the highest interest rate permitted by the majority of states to be used in calculating statutory life insurance reserves for that type of contract. The rate is determined as of the beginning of the calendar year in which the contract was issued. Prior to 1988, for non-annuity contracts only, a company could elect to use the PSR for the preceding calendar year. This election option was repealed by OBRA 1987, and it is no longer available for contracts issued after 1987. OBRA 1987 also repealed the requirement that the PSR for whole life insurance contracts be used for noncancelable A & H contracts when no such rate was prevailing for such contracts.
AFR—The applicable Federal interest rate is defined in IRC section 807(d)(4)(A). This rate was introduced by OBRA 1987, and it is the interest rate to be used in calculating the FPR for a contract issued after 1987, if the AFR for any calendar year is higher than the PSR otherwise applicable to the contract. The AFR is the same interest rate used to discount casualty type loss reserves under IRC section 846. An election may be made by the company to recompute its tax basis life insurance reserves every five years, for all contracts issued in a given calendar year, by using the higher of the new AFR established for that fifth calendar year and the original PSR. This may be done only if the new AFR has changed by at least 0.5 percent from the previously used AFR. Once a company makes this election for a given block of contracts, the life insurance reserves must be recomputed in this manner every five years, unless the company obtains the Secretary’s consent to revoke the election. Change in reserves resulting from this election is not treated as a change in basis.
Mortality and Morbidity Tables: The mortality or morbidity tables that must be used to calculate the FPR are defined in IRC section 807(d)(5). They are referred to as the prevailing commissioners’ standard tables. For any type contract, the prevailing table is the most recent commissioners’ standard table (as prescribed by the NAIC) permitted to be used by the majority of states in calculating statutory minimum reserves for that type contract at the time it was issued. When a prevailing table is replaced by a new table, a company may elect to continue calculating its life insurance tax reserves by using the former table in lieu of the new table for a period of three years. The three year period begins with the calendar year following the year the new table became prevailing. There are special rules on the application of prevailing tables. For any contract issued prior to 1948 for which there was no commissioners’ standard table when it was issued, the table to be used is the one used in calculating the statutory reserves. For any contract issued after 1947 for which there was no commissioners’ standard table when it was issued, the table to be used will be provided by Treasury regulations (see Treas. Reg. Sec. 1.807–1, December 1989). If multiple tables exist, or multiple options under a single table are available, which otherwise satisfy the general requirements for a prevailing table, the table or option to be used is the one that generally produces the lowest reserves.
Source of Interest Rates and Tables: The agent may obtain the required interest rates and prevailing tables for calculating the Federal Prescribed Reserve from published revenue rulings. Applicable revenue rulings that have been published to date are Rev. Rul. 92–19 and supplements provided in Rev. Rul. 93–58 Rev. Rul. 94–11 and Rev. Rul. 95–4. These four rulings provide a complete array of PSRs and AFRs through 1995 and the prevailing tables. New revenue rulings will be issued to update this information for future years.
Special Rules for Computing Federal Prescribed Reserves—IRC section 807(e):
Net Surrender Values: In determining the tax basis life insurance reserve for any contract, IRC section 807(d)(1) requires that the calculated FPR shall not be less than the contract’s Net Surrender Value. IRC section 807(e)(1) provides a definition of a contract’s NSV. In general, the net surrender value of any contract is its cash surrender value, as defined under the contract, reduced by any penalty or charge which may be imposed when the contract is surrendered. For tax reserve purposes, however, the NSV should not reflect any "market value adjustment" that might otherwise be required at the termination and surrender of a contract for its cash value. Market value adjustments are made under certain contracts when they are terminated and a cash distribution is made, so as to adjust its cash distribution value from a book to a market value in recognition of any difference between a new money interest rate and the actual interest rate the contract’s assets were earning at the time of its surrender. A market value adjustment decreases the NSV if the new money rate is higher than the contract’s actual earnings rate, and it increases the net surrender value if the converse is true. Group annuity contracts frequently have these market value adjustments imposed at surrender. For group annuity contracts, also referred to as group pension contracts, the net surrender value shall be determined as the balance in the "policyholder’s fund," reduced by any penalty or forfeiture imposed on surrender, but ignoring any market value adjustment. Pension plan contracts are explicitly defined under IRC section 818(a).
Group Contract Issue Date: In calculating a contract’s FPR, the interest rate and the mortality/morbidity table are determined by reference to the contract’s date of issue. For individual contracts, the date of issue is specified on the policy form. For any group insurance or annuity contract, IRC section 807(e)(2) defines the date of issue as, generally, the date the master plan is issued. However, if a benefit becomes guaranteed to a participant after the master plan issue date, then the date the benefit becomes guaranteed must be used as the issue date for calculating the FPR for those benefits.
Supplemental Benefits: In general, all benefits under a single contract must have their life insurance reserves recomputed by the Federal reserve standards of IRC section 807(d)(2), and that total FPR for all benefits combined must be compared to the contract’s NSV under IRC section 807(d)(1). However, IRC section 807(e)(3) provides special treatment for certain specified supplemental benefits for which separate statutory reserves are held by the life insurance company in its annual statement. For any of the listed supplemental benefits, the reserves do not have to be recomputed by the Federal standards. Rather, the statutory reserves for those supplemental benefits are used, and those statutory reserves are then added to the FPR for all other contract benefits before the NSV comparison is effected. Furthermore, if any of the listed supplemental benefits meet the definition of a "qualified FPR supplemental benefit," then such a benefit may be treated as if it was provided under a separate contract in determining the total tax reserve. That means, for a "qualified supplemental benefit," the statutory reserves are used, but those statutory reserves are added in as life insurance tax reserves after the NSR comparison is effected for all other benefits under the base contract. This special treatment, permitted under IRC section 807(e)(3)(A), will often result in a higher tax reserve for the contract than if the reserve comparison had included the qualified supplemental benefit. That result will occur when the NSV exceeds the FPR for all other benefits under the contract, thus becoming the tax reserve for those benefits, to which the statutory reserve for the qualified supplemental benefit is added to produce the contract’s total tax reserve. In order to be eligible for special treatment, the benefit must be one of the supplemental benefits listed in IRC section 807(e)(3)(D), which are guaranteed insurability; accidental death or disability benefit; convertibility; disability waiver benefit; and other benefits prescribed by regulations. In order for any of the listed supplemental benefits to be treated as a "qualified supplemental benefit," the supplemental benefit must satisfy the two requirements specified under IRC section 807(e)(3)(C): A separate premium or charge for the supplemental benefit is identifiable, and the NSV of any of the contract’s other benefits is not available to fund the supplemental benefit.
Substandard Risks: IRC section 807(e)(5)(A) also provides for special treatment with respect to substandard risks, similar to that given to qualified supplemental benefits. The amount of any life insurance reserve for any "qualified substandard risk" is also computed separately from all other benefit reserves under the contract. That is, the separate tax reserve for such substandard risks is not included with other tax reserves under the contract before the comparison is made with the NSV. However, in contrast to a reserve for a qualified supplemental benefit, the reserve for a qualified substandard risk must be computed using the federal reserve standards of IRC section 807(d)(2); the tax reserve is not simply the statutory reserve, as would be the case for the supplemental benefit. In order for a substandard risk to be deemed "qualified," the following requirements under IRC section 807(e)(5)(B) must all be satisfied: A separate statutory reserve for the risk must be maintained in the company’s annual statement. A separate premium or charge for the risk is identifiable. The NSV under the contract may neither be increased nor decreased in value because of such risk. The NSV under the contract cannot be used regularly to pay premium charges for such risk. Two limitations apply to the reserve for qualified substandard risks, as provided under IRC section 807(e)(5)(C) and (D), as follows: The amount of the life insurance reserve cannot exceed the sum of the separately identifiable premiums charged for the risk, plus interest and less mortality charges for the risk. The aggregate amount of insurance in force under those contracts to which the special rule of IRC section 807(e)(5)(A) applies may not exceed 10 percent of the company’s total insurance in force under all of its life insurance contracts (excluding its term insurance). For any insurance in force above the 10 percent limitation, the substandard risk is reflected by an appropriate adjustment to the prevailing mortality table otherwise used to compute the FPR for the contract’s underlying benefits, as opposed to adding an additional FPR to cover the substandard risk.
Certain Term Life Insurance and Annuity Benefit Riders: Special treatment under IRC section 807(e)(6)(A) is given to certain term insurance and annuity benefits issued as riders under life insurance contracts issued before 1989. The special treatment is the same as provided to qualified supplemental benefits and qualified substandard risks, in that a separate computation of the tax basis life insurance reserve is allowed and that reserve is excluded from all other contract reserves in the comparison with the contract’s NSV. However, as for qualified substandard risks, the tax basis reserve must be computed using the Federal reserve standards of IRC section 807(d)(2). A life insurance contract under which this special treatment is provided must have been issued before 1989 under a plan of insurance filed by the life insurance company issuing that contract in at least one State before 1984, and that plan of insurance is currently on file in the appropriate State for that contract The specific term insurance or annuity benefits for which the special treatment applies must meet the same two requirements for supplemental benefits to be considered "qualified" , as follows: A separate premium or charge for the rider benefit is identifiable. The NSV for any of the contract’s other benefits is not available to fund the applicable term insurance or annuity benefit.
Unearned Premium Reserves on Cancelable A & H Contracts: Under IRC section 807(e)(7), special rules apply in respect to the recognition for tax deduction purposes of unearned premium reserves and premiums received in advance held under any insurance contracts not described in IRC section 816(b)(1). The contracts for which these rules do apply, therefore, are cancelable A & H insurance contracts, which are primarily group A & H insurance contracts. The general rule under IRC section 807(e)(7)(A) is that only 80 percent of the unearned premium reserves and advanced premiums that the company would otherwise have included as reserve balances under IRC section 807(a) and (b) shall be included as reserve balances under those respective sections. The 20 percent reduction in these types of deductible reserves became effective for taxable years beginning on or after September 30, 1990. A transitional rule under IRC section 807(e)(7)(B) applies for taxable years beginning on or after September 30, 1990, but not beginning after September 29, 1996. Thus, the transition period is six (6) taxable years. Under this transitional rule, the life insurance company must include in its gross income, for each of the six transition taxable years, an amount equal to 3–1/3 percent of its closing reserve balance for its relevant IRC section 807(e)(7) unearned premium reserves and advance premiums for the company’s most recent taxable year beginning before September 30, 1990. Thus, if the company’s first transition tax year was 1991, then its opening and closing reserve balances for the 1991 tax year would be 80 percent of the relevant reserves, but it would include in its 1991 gross income 3–1/3 percent of its 1990 closing reserve balance for the relevant reserves. Then, for its 1992 tax year, it would include in that year’s gross income another 3–1/3 percent of its 1990 closing reserve balance for the relevant reserves; and, so on, for the rest of its transition years, with the last 3–1/3 percent in the 1996 tax year.
Adjustment Rules for Changes in Reserve Computations–IRC section 807(f):
For various reasons, a life insurance company may change their bases of computing their statutory actuarial reserves from one year to the next. The State insurance examiners may require, or merely suggest, that a company change its reserve bases for certain blocks of business in order to strengthen reserves maintained for that business. Frequently, life insurance companies take the initiative in changing reserve bases so they may present an enhanced (or, more conservative) financial appearance in their annual statements. Changing market conditions and a company’s own experience influence any company decision to strengthen (increase) or weaken (reduce) its reserves.
When a life insurance company changes its statutory reserve bases, it must report such changes in Exhibit 8A of the Annual Statement. The change may involve any of its valuation methods (NLP, CRVM, etc.) and/or its actuarial assumptions for interest and mortality/morbidity. For statutory reporting, the effect of the change in reserve basis must be measured and reported in Exhibit 8A. The effect of the basis change is the difference in the amount of the reserve computed on the new basis as compared to the old basis, determined as of the end of the year of change. The effect is only measured with respect to contracts issued before the year of change for which the reserve basis was changed. Insurance companies may adopt any reserve basis they wish for newly issued contracts; such adoption for newly issued contracts does not constitute a reserve basis change and does not require any special annual statement accounting. In the statutory annual statement, the entire reserve effect of the basis change is treated as a direct charge, or credit, to surplus in the year of the change. Consequently, no part of the reserve effect is ever reflected in the statutory "gain from operations" (income statement) for the year of the change, or for any other year. That means, for the purpose only of measuring net income in the gain from operations for the year of change, the reserves at the end of the year of change are still calculated on the old reserve basis. However, when determining the net income in the gain from operations for the year following the year of change, the reserves at the end of the year of change are then calculated on the new reserve basis. Since the reserve basis change is considered to be a non-recurring transaction it is appropriate that the effect of the basis change be passed entirely through the surplus account and, hence, avoid distortions to annual net income reported in the gain from operations.
However, for income tax purposes, the treatment of a reserve basis change differs from the statutory treatment described under (b) above. Under IRC section 807(f), if the basis of reserve computation at the end of a current tax year, with respect to a group of in force contracts issued before the current tax year, differs from the basis of computation for those same contracts at the end of the preceding tax year, recognition of the effect of the basis change is deferred until the following tax year. Moreover, the total effect on taxable income of the reserve basis change is not recognized in a single tax year, but rather spread ratably over the ten tax years following the current tax year. The ten-year spread is achieved by an additional deduction from, or credit to, the company’s taxable income otherwise determined for each of the ten future tax years. The total effect of the basis change (i.e., the reserve increase, or decrease, to be spread in equal amounts over ten years) is the difference between the reserves computed on the new basis and those computed on the old basis, all determined at the end of the current tax year. The current tax year is referred to as the "year of change." However, because of the adjustment rules of IRC section 807(f), the reserve balance for the affected contracts at the end of the "year of change" must be the reserves computed on the old reserve basis. The old reserve basis is required at that point in time because, pursuant to the statute, the basis change must have no effect on taxable income for the year of change. However, at the beginning of the tax year immediately following the year of change, the reserve balance for the affected contracts is the reserves computed on the new reserve basis. The new reserve basis is then used from that point in time forward. In effect, it is as if the reserve basis change became operative as the beginning of the first day of the tax year following the tax year or change. IRC section 807(f) applies to all changes in the basis of computations for any of the reserve items listed under IRC section 807(c), provided the change directly affects the amount of the tax basis reserves.
IRC section 807(f) was included under TRA 1984 as a reenactment of IRC section 810(d), which former Code section was originally enacted under the 1959 Life Insurance Company Income Tax Act. Former IRC section 810(d) provided the basis change rules under the 1959 Act. Therefore, when issues arise which bear on the IRC section 807(f) basis change rules, it is incumbent upon the agent to fully reference all pertinent revenue rulings, regulations and court decisions related to former IRC section 810(d), as well as the specific guidance promulgated under the current tax law. At the present time, the only revenue ruling that has been issued under IRC section 807(f) is Rev. Rul. 94–74, issued on December 5,1994.
Rev. Rul. 94–74 addresses the issue of how IRC section 807(f) rules apply to changes in the basis of computing Federally prescribed life insurance reserves under IRC section 807(d), whether those reserve changes be initiated by a life insurance company or by an IRS agent during examination. The revenue ruling demonstrates four situations that could arise in actual practice under which the manner of computing certain life insurance reserves are changed, thus producing different reserve amounts. In two situations, life insurance reserves are erroneously computed under the computational rules of IRC section 807(d)(2), and subsequently changed to comply with those rules. In another situation, a discretionary method of computing statutory life insurance reserves is changed, necessitating that the same change be made in computing the tax reserves. In the fourth situation, a block of policies is erroneously omitted from the reserve calculations due to a computer programming error. The revenue ruling holds that, in the first two situations, IRC section 807(f) rules apply because the change in the method of computing the life insurance reserves was required to correct for an erroneous application of the prescribed rules of IRC section 807(d)(2). That holding applies whether the correction is initiated by the taxpayer or by the IRS on examination. The revenue ruling further holds that IRC section 807(f) rules also apply to the third situation involving a discretionary change in the method of calculating statutory reserves. Finally, the revenue ruling holds that IRC section 807(f) rules do not apply to the fourth situation, since missing cells arising from a computer programming error constitute mathematical or posting errors. Correction of erroneous reserves attributable to such errors is not considered a change in basis under IRC section 807(f). The agent should become thoroughly familiar with the illustrative situations and the related holdings of Rev. Rul. 94–74.
Where possible, obtain prior examination reports, workpapers and historical files. Review for possible roll-over issues. Follow up with the company’s tax and/or actuarial staff. Determine from an inspection of the tax return and the Annual Statement, and from discussions with the taxpayer, how the taxpayer treated any reserve adjustments made in prior examination years. Follow up as necessary.
The first step in the reserve audit is to determine if the insurance company qualifies to file a Form 1120–L, i.e., if the company qualifies to be taxed as a Life Insurance Company. Initial verification can be made from the information section of Form 1120–L and from the statutory Annual Statement. Review question number 3 on Schedule M of Form 1120–L (shown at page 8 of the 1993 Form 1120–L). Review the IRC section 816 reserve qualification ratio and the factors that must be complied with.
You must verify that the company meets all three of the qualification tests—Insurance Company Test; Life Insurance Business Activity Test; and Life Insurance Reserve Ratio Test.
This is accomplished in stages. The initial stage is to inspect the information provided in Form 1120–L itself. In Schedule M of Form 1120–L, question number 3 reports the life insurance company reserve ratio, and requests that a schedule be attached showing the computation of this ratio. This ratio must be verified by the agent as an essential part of the reserve audit. The reserve ratio is based on the statutory Annual Statement reserves. These amounts can be reconciled to the statutory reserves reported in the Annual Statement, where such reserves are shown mainly in Exhibits 8, 9, and 10. Depending on the size and complexity of the company’s insurance business, you may need the assistance of company employees.
The following types of insurance companies are more likely than others to encounter problems qualifying as a life insurance company—credit life insurance companies; accident and health insurance companies; and mutual assessment companies.
Obtain the most recent and prior state examination reports. Review the sections relating to the company’s insurance operations, business practices, and reserves.
Compare and/or verify the reserve amounts in the state examination report with the company’s Annual Statement. Discuss any differences between the state reports and the Annual Statements with the company’s tax manager and/or actuarial staff.
Obtain Form B, information required to be filed by members of a holding company group. Most states require such a filing if the insurance company is part of a holding company group. This report will provide you with information similar to a Form 10K.
Submit to the company’s tax manager or other representative the "IRC section 807 Reserve Questionnaire" (see text 4.6.5 of this handbook). This should be done at the earliest stages of the examination, since it will usually take the company an extensive period of time to fully respond to the Reserve Questionnaire.
The company’s answers to the Reserve Questionnaire may identify potential reserve problems. Potential reserve problems should be discussed with the tax manager and/or a company actuary familiar with the reserves.
If the company’s answers to the Reserve Questionnaire are received early in the examination cycle, they may be used to identity important reserve areas to be examined and, thereby, serve to more effectively restrict the scope of the reserve audit. The company’s answers may disclose an improper calculation under IRC section 807. You should verity the following: Did the company answer the Reserve Questionnaire completely? If not, discuss this with the tax and actuarial staffs. Were reserve approximations used? Did the company change the bases or methods of computing any reserves from those used for the prior year? You should review IRC section 807(f) and Rev. Rul. 94–74 as to what constitutes a change in computing reserves and the adjustment rules thereunder. Where possible, determine if the company used the proper valuation methods, mortality/morbidity tables and interest rates in calculating the reserves. Were the correct factors used for each year of issue?
All questionable, incomplete and missing answers to the IRC section 807 Reserve Questionnaire should be followed up and resolved with the company so that you are satisfied. It is important that all questions be answered in a complete and thorough manner.
If there has been a change in the method of computing reserves from the prior year, you should consider the following additional matters:
Did the appropriate State insurance department approve the change? If so, ask for a copy of the approval letter and all correspondence between the company and the insurance department relating to the change.
What was the nature of the change? Why did the company make the change? Was the change simply to correct for a past error in the company’s methodology? Was it to correct for a misapplication of the computational rules of IRC section 807? Or, was it truly for the purpose of strengthening or weakening reserves?
Request the company’s actuarial department to provide a sample of the reserve computation on both the old and new bases.
You should try to measure the tax impact of the change. If the change appears to be material, consider requesting the taxpayer to calculate the year end reserve amount on the old basis so it can be compared with the new basis, if the taxpayer has not already done that. Alternatively, you might simply estimate that amount by yourself by using statistical sampling methods or by requesting assistance from a CAS. You could also request assistance from one of the IRS actuaries in the Examination Division, or you could engage the services of an independent actuary, assuming the issue at hand would justify the cost of such an actuarial presence.
Verify that the opening reserve balances for the current tax year agree with the closing reserve balances for the prior tax year. Normally, the opening balance for the current year is simply set equal to the prior year’s closing balance, and that would be true for both statutory and tax basis reserves. If they don’t agree, you should find out why that is the case, and ask for an explanation from the taxpayer.
Tax basis reserves should never exceed the corresponding statutory reserves, and are normally less than statutory reserves. It should be noted that there will be situations, under tax law, where the tax basis reserves are set equal to the corresponding statutory reserves. That will be the case, as for example, when the reserves are for "supplemental benefits" as those type benefits are defined in IRC section 807(e)(3).
Also, reserves for those supplemental benefits which are classified as "qualified supplemental benefits" under IRC section 807(e)(3) are treated separately from all other benefit reserves under a contract, as if such benefits were provided under an entirely separate contract. Hence, such reserves for a given contract are excluded from that contract’s basic benefit reserve in performing the comparison test of IRC section 807(d)(1), and are simply added to the basic benefit reserve for the contract as additional tax basis reserves.
You should verify that the opening reserve balances for the first examination year were computed on a basis consistent with the basis used to calculate the company’s "fresh start tax reserves." The "fresh start tax reserves" refer to the tax reserves established by the taxpayer as of the beginning of the 1984 tax year, when TRA 1984 became effective. You should then verify that tax reserves for each subsequent tax year were computed consistently with those of the first tax year.
You may use the Reserve Questionnaire to help you determine if the reserve balances were computed appropriately under IRC section 807. After going through the Reserve Questionnaire, it may become necessary to extend the scope of the reserve examination. Therefore, you will need to do the following:
Obtain the statutory reserve valuation runs for each year under examination and for the year preceding the first examination year. The code book, which contains the accounting/system codes, should be obtained so that you can isolate each plan of insurance. Actuarial workpapers should be obtained, which should tie the valuation runs to the proper reserve Exhibit of the Annual Statement. You may need the assistance of the tax department and/or the actuarial department to properly reconcile the source information to the reported data shown in the Annual Statement Exhibits.
Obtain the valuation runs that generated the tax reserves. For some companies, the tax reserve calculations will be on the same tape or disk that generated the statutory reserves. For other companies, the statutory reserves and tax reserves are separately generated and are shown on separate output. You should request the taxpayer to produce paper copy summarizing the reserve data. If this is not available, then either the taxpayer or an IRS Computer Audit Specialist will have to put the information into a form that you can work with. You should reconcile the tax reserve balances from the valuation runs to the tax reserves reported in the company’s tax return. The company must explain any differences.
Another audit technique you might use is to perform a "reserve ratio comparison analysis." In this type of analysis, the actual ratios of tax reserves to their corresponding statutory reserves are first determined for selected reserve groupings or plans of insurance or annuities that are under examination. These calculated actual ratios are then compared to "guideline ratios" (or, ranges of ratios) which have been predetermined for those plans of insurance/annuities. If any calculated ratios are inconsistent with their predetermined guidelines, you may then be able to limit the reserve audit to only those specific areas where a major problem may exist. The purpose of the ratio analysis, therefore, is only to identify areas of possible reserve errors. You will have to establish the desired reserve groupings, assemble the reserves, and calculate the reserve ratios.
The "reserve ratio comparison analysis" will involve Annual Statement Exhibits 8, 9 and 10 and other reserves reported on page 3. You should first separate the reserves by Annual Statement line of business, and then by major plan of insurance within each line. If possible, the reserves for reinsurance should also be separated by plan of insurance, or, if not possible, by separate identifiable groupings of reinsurance.
Ideally, the reserves should be reduced by the appropriate amount of deferred and uncollected premiums, if at all feasible, before calculating the actual reserve ratios. However, if this reduction is not feasible, then the ratios may be calculated ignoring the adjustment and used for the ratio comparisons. It should not significantly distort the results.
After the selected reserve ratios have been calculated, those calculated ratios are compared with the appropriate guideline ratios which are set forth in the document entitled "General Guidelines for Equity Base and Tax Reserves for Form 8390." In general, the calculated actual ratios should fall within the published guidelines for the corresponding plans of insurance.
You may wish to use an Enable worksheet program diskette obtaining the full array of published guideline ratios, rather than working from the document referenced under (b) above. This should facilitate the comparison analysis. You may obtain this program by requesting it from the Life Insurance Industry Specialist.
Normally, the reserve ratio for any individual policy or line of business will be less than one, because, under IRC section 807(d)(1), the tax reserves may not exceed their corresponding statutory reserves. However, there are circumstances whereby the tax reserves are set equal to their statutory reserves. For example, if a policy’s net surrender value (NSV) should exceed the calculated Federal Prescribed Reserve, the policy’s tax reserve is set equal to the NSV. If the policy’s statutory reserve was also set equal to the NSV (because of statutory minimum reserve requirements), then the tax reserve and statutory reserve for the policy are the same and the ratio equals one. You should, however, investigate further when the calculated ratios are close to one, and should surely do so if they exceed one.
For any given policy, the ratio will increase from one year to the next, as its tax reserve approaches its statutory reserve, and the reserve ratio approaches one. A policy’s reserve ratio will typically be lower for the more recently issued policies and for those with the younger issue ages. As a consequence, the increase in a policy’s ratio from one year to the next will be greater in the early durations and for the younger insureds. This pattern will generally prevail for a block of maturing policies, and you should typically expect an annually increasing reserve ratio for the block, but where the rate of annual increase is declining.
On the other hand, if you observe a decrease in the reserve ratio from one year to the next for a block of business, there may have been some error or inconsistency in the reserve calculations in one of those years. You should investigate any decreasing ratios and discuss them with the company’s tax manager and actuary.
The tax reserves could be correctly calculated and the associated ratios could still fall outside the guideline ratios. The following are some acceptable reasons for calculated ratios failing to meet the guidelines: A change in the actuarial basis of computing reserves from one year to the next. A rapidly growing line of business. A declining line of business. An immature line of business with unreliable statistics.
If you determine that a tax reserve has been incorrectly calculated, you should then estimate the size of the reserve error and its effect on the tax liability. This should be done before you propose an adjustment. To estimate the magnitude of the error, you might use the following procedure:
Analyze the reserve ratio (tax reserve to statutory reserve) for the available years. From this data, determine what the pattern of ratios has been over these years. Has the pattern been increasing, decreasing or level? Use this pattern to estimate the appropriate ratio for the year at issue (i.e., the year for which you will estimate the tax reserve).
Assuming that the applicable statutory reserves are correct, then multiply those statutory reserves by the estimated reserve ratio (determined under (a) above) to produce a rough estimate of the tax reserves.
Compare the estimated tax reserves from (b) above to the tax reserves reported in the tax return. This will provide you with a reasonable estimate of the size of the reserve error.
For a mutual life insurance company, you will also have to measure the effect of the reserve error on the Differential Earnings Amount.
You should then estimate the effect on taxable income for the current tax year and for subsequent tax years. If these estimates indicate a material tax deficiency or a significantly reduced operating loss for the affected tax years, you should refine the calculation of the corrected tax reserves by one of the following approaches: Request the taxpayer to recalculate the tax reserves on the basis which you have determined to be the correct basis. Request assistance from an IRS actuary in the Examination Division, or from an independent actuary.
In the calculation of the FPR, did the company properly determine the necessary reduction in that reserve value for deferred and uncollected premiums, if applicable, and did they make this reserve adjustment?
Request the company to provide all appropriate policy information that would be required to determine tax reserves applicable to the following, for which special treatment and/or computational rules apply under IRC section 807(e):
Qualified Supplemental Benefits, under IRC section 807(e)(3).
Qualified Substandard Risks, under IRC section 807(e)(5).
Term Life Insurance and Annuity Benefits provided by riders issued under certain life insurance contracts which qualify to be treated as benefits provided under a separate contract, under IRC section 807(e)(6).
Request the company to provide the information required to select the required interest rates and mortality/morbidity tables for computing tax reserves under accident and health insurance policies.
Has the company properly discounted all unpaid loss reserves under their accident and health insurance policies, pursuant to the requirements of IRC section 846 as made applicable to life insurance companies for tax years after 1986?
Has the company properly reduced their unearned premium reserves under their cancelable accident and health insurance policies by the required 20 percent pursuant to the special tax reserve rule of IRC section 807(e)(7) applicable for tax years after 1990?
Often, companies will replace or modify their reserve valuation systems. When this has occurred, you should discuss these system changes with the appropriate company personnel. You should request that a CAS attend these meetings to help achieve or determine the following:
To correct any known errors which the previous systems may have generated in the tax and/or statutory reserve calculations.
To ascertain what steps the company has taken to be certain that the new or modified valuation systems are properly calculating reserves.
Whether or not the generation of different tax reserve values after the reserve system changes were made a change in the basis of computing tax reserves subject to the change rules under IRC section 807(f).
Numerical Analysis and Presentation of IRC section 807(c) Reserves:
For all tax reserves held under IRC section 807(c), separately identify the total tax reserve amount by IRC sections 807(c)(1); 807(c)(2); 807(c)(3); 807(c)(4); 807(c)(5); and 807(c)(6).
Separately identify reserves by type of insurance coverage, by issue year, interest rate, mortality and morbidity table and reserve method.
Identify the reserve amounts held in the statutory Annual Statement (statutory reserves) comparable to the tax reserve categories identified under paragraph (a) above.
IRC section 807(c)(1) Life Insurance Reserves—Reserve Comparisons:
IRC section 807(d)(1) requires that a reserve value comparison must be made on a contract-by-contract basis. The reserve values in the comparison must reflect all benefits provided by the contract, including riders and paid-up additions. Certain contract benefits, however, may be excluded in the comparison, as specifically permitted by IRC section 807(e). This comparison is made of the following three contract values—Net Surrender Value (NSV), defined by IRC section 807(e)(1); Federal Prescribed Reserve (FPR), defined by IRC section 807(d); and Statutory Reserve (SR).
Were these three values actually compared on the contract-by-contract basis prescribed by IRC section 807(d)(1)? If not, what method was used? What, if any, methods and assumptions were used to approximate an actual contract-by-contract comparison?
What other approximations, if any, were used in the comparisons?
How were paid-up additions treated in the reserve comparisons?
Were any negative amounts used in the reserve comparisons? If so, identify those reserves.
IRC section 807(d)(3)(C) does not allow deficiency reserves to be included in the calculated tax reserves (i.e., in the FPR). Were deficiency reserves included in any FPR values that were used in the reserve comparisons? If so, identify those reserves. In Exhibit 8 of the company’s Annual Statement, were such deficiency reserves included on any line in the Exhibit other than explicitly reported on line 1 of Part G of the Exhibit? If so, identify those reserves.
Describe the methods used to reduce the reserves by deferred and uncollected premiums. Was this reduction performed before or after the reserve comparisons?
Were supplemental benefits which do not meet the requirements under IRC section 807(e)(3) to be treated as "qualified supplemental benefits" excluded from the reserve comparisons? If so, identify those benefits.
Were reserves for reinsurance assumed and reinsurance ceded reflected in the reserve comparisons? If so, describe how they were reflected.
Were reserves for non-deduction of deferred fractional premiums, and reserves for return of premiums at the death of the insured, reflected in the reserve comparisons? If so, describe how they were reflected.
Were there any changes in the methods or assumptions used in performing the reserve comparisons from one year to the next?
Net Surrender Value (NSV)—IRC section 807(e)(1): The following questions relate to the net surrender values used in the IRC section 807(d)(1) reserve comparisons:
Were any surrender charges or penalties used to reduce the NSV used in the reserve comparisons? If so, describe how they were reflected.
Were any market value adjustments reflected in the NSV used in the reserve comparisons? If so, describe how they were reflected.
Were any pension plan contracts included in the reserve comparisons? If so, describe the relationship between the net surrender value and the balance in the policyholder’s fund for those contracts.
Were any approximations used to calculate the net surrender values? If so, describe all such approximations.
Identify any plans of insurance which have surrender charges or penalties, or market value adjustments, as such terms are used in IRC section 807(e)(1)(A). Provide sample policy forms for all such plans of insurance.
Describe the adjustment, if any, which was made to the NSV for deferred and uncollected premiums.
Describe the actual methods used by the company to calculate a policy’s cash surrender value (CSV) as of a date other than the policy’s anniversary date, for those policies under which premiums are paid more frequently than annually.
Federal Prescribed Reserve (FPR)—IRC section 807(d)(2): The following questions relate to the Federal Prescribed Reserves computed by the rules of IRC section 807(d)(2) and used in the IRC section 807(d)(1) reserve comparisons:
Describe how CRVM was applied to fixed premium universal life, flexible premium universal life, excess interest whole life and all other similar types of nontraditional life insurance policies.
How were surrender charges treated in the application of CRVM?
For all policies issued before 1988, identify for each issue year the Prevailing State assumed interest Rate (PSR), defined in IRC section 807(d)(4)(B); the interest rate used to compute the FPR; and the amount of the FPR.
For all policies issued after 1987, identify for each issue year the Applicable Federal interest Rate (AFR), defined in IRC section 807(d)(4)(A); and the same information described under paragraph (4)(c) immediately above.
Has the company elected to recompute the AFR every five years as described in IRC section 807(d)(4)(A)(ii)? If so, state the years to which this election applies.
Were any reserves calculated using mortality or morbidity tables different from those specified in Rev, Rul. 92–19 (1992–1, CE 685), including supplements thereto, and Treas. Reg. 1.807–1? If so, identify those reserves.
Were any reserves calculated using decrements other than mortality or morbidity? If so, describe the decrements used and identify the reserves affected by the use of those decrements.
Were any reserves calculated using modifications to the required mortality or morbidity tables? If so, describe the modifications made and identify the reserves affected by those modifications.
Describe any reserves for which approximations were used instead of an exact calculation based on the reserve methods, interest rates and mortality/morbidity tables specified in IRC section 807(d).
IRC section 807(e)(3) defines "qualified supplemental benefits." Identify the tax reserves for each of the specified types of qualified supplemental benefits. For each type of benefit, provide documentation to support that there was a separately identifiable premium or charge for that benefit.
IRC section 807(e)(5) describes the treatment of substandard risks. Identify the tax reserves held for "qualified substandard risks" as defined in IRC section 807(e)(5). Provide documentation to support the qualified status of these reserves.
Identify the reserves for term life insurance and annuity benefits provided by riders held under certain life insurance policies issued before 1989 which were computed separately from other reserves under the policy.
Statutory Life Insurance Reserves (SR)–IRC section 809(b)(4)(B):
Were the statutory reserves used in the IRC section 807(d)(1) reserve comparisons the same as those reserves set forth in the Annual Statement for the applicable contract?
If they were not the same, identity the reserves affected and the magnitude of the difference.
IRC section 807(c)(2) Unearned Premium and Unpaid Loss Reserves:
For all tax years prior to 1987, identify any tax reserves which differ from the comparable statutory reserves; and state the reasons for those differences.
For all tax years after 1986, were any unpaid loss reserves discounted by the use of an interest rate other than the interest rate prescribed under IRC section 846(c)? If so, identify the unpaid loss reserves and the interest rate used. Were any unpaid loss reserves discounted by the use of a loss payment pattern other than the loss payment pattern prescribed under IRC section 846(d)? If so, identify the unpaid loss reserves and the loss payment patterns used. For all unpaid loss reserves discounted by the use of the company’s own loss payment pattern experience, identify the unpaid loss reserves; identify the loss payment patterns used; provide documentation to support the loss payment patterns; and provide interest rate(s) used for the discounting.
IRC section 807(c)(3) Non-contingency Reserves:
For all policies issued before 1988, identify for each issue year the PSR; the interest rate assumed in determining the guaranteed benefit; the actual interest rate used for discounting the reserves; and the amount of the reserve.
For all policies issued after 1987, identify for each issue year, the AFR; and the same information described under paragraph (7)(a) immediately above.
Were any approximations used in the reserve calculations? If so identify those reserves and describe the approximations.
IRC section 807(c)(4) Reserves for Dividend Accumulations, etc.:
Identify any tax reserves which differ from the comparable statutory reserves.
State the reasons for those differences.
IRC section 807(c)(5) Reserves for Advance Premiums, etc.:
Identify any tax reserves which differ from the comparable statutory reserves.
State the reasons for those differences.
IRC section 807(c)(6) Special Group Contract Contingency Reserves:
Identify any tax reserves which differ from the comparable statutory reserves.
State the reasons for those differences.
Miscellaneous Questions Regarding Reserves:
How were reserves with respect to reinsurance reflected? Describe the treatment separately for reinsurance assumed and ceded.
Identify any plans of insurance or annuities which provide interest rate guarantees for which the reserve restrictions of IRC section 811(d) apply. Describe the methods used to exclude from tax reserves the effect of the interest rate guarantees beyond the end of the tax year.
Describe the treatment of the reserves for non-deduction of deferred fractional premiums and for return of premiums at the death of the insured.
Identify all reserves held under contracts issued by foreign branches of U.S. life insurance companies as defined by IRC section 807(e)(4).
Were any changes made in the reserve methods or assumptions from one tax year to the next? If so, provide the affected reserves; a description of the old and new methods and assumptions; and the amount by which the affected reserves increased or decreased as a result of the changes.
The deduction allowable under IRC section 805(a)(6) represents the consideration attributable to the assumption of block reinsurance by another insurer. The consideration arises when a taxpayer makes payment to another company for assuming all of a taxpayer’s risks in a block of policies.
This deduction is used to report assumption (rather than indemnity) reinsurance agreements. Assumption reinsurance occurs when all or part of the business of a life insurance company is taken over by another company under an arrangement whereby the reinsurer becomes solely liable to the policyholders.
The transaction is usually evidenced by a blanket contract which designates the individual risks by identifying them as members of the group, and which lists the assets to be transferred, values mutually agreed to, and liabilities to be assumed.
In the event capital assets are transferred as all or part of the consideration, capital gain or loss may be realized.
A deduction is allowable for the amount of policyholder dividends paid or accrued by a ceding company and reimbursed by the taxpayer (assuming company) under the terms of a reinsurance contract. The ceding company includes the reimbursed amount in premium income.
For deferred acquisition cost purposes, the interim rules of IRC section 848(d)(1)(B) require the reinsurer to treat the amount of policyholder dividends reimbursable to the ceding company as a return premium.
IRC section 805(a)(8) allows a life insurance company, subject to the modifications of IRC section 805(b), all deductions which are allowed under subtitle A, income taxes, of the Code. Included in these deductions is the deduction for interest expense under IRC section 163. IRC section 805(b)(1) states that no deduction shall be allowed to a life insurance company for interest in respect to reserves described in IRC section 807(c). The interest with respect to reserves is includible as a part of the computation of that reserve and is therefore allowed in the deduction for increase in reserves.
The initial examination step for interest expense is to review the taxpayer’s workpapers to determine the items which have been included in interest expense on the return.
Interest expense claimed should be cross-referenced to the obligations which were outstanding during the year and a determination should be made as to the validity of the obligations and the correctness of the rates utilized in the interest calculations.
Consideration should be given to intercompany transactions and transactions with foreign corporations which gave rise to a deduction for interest expense. The application of IRC section 482 and IRC section 845 should be considered if the transactions giving rise to interest expense are of this nature.
Special consideration should be given to any interest which relates to nonqualified deferred compensation plans. In general, the provisions of IRC section 404 do not allow a deduction for interest accrued on deferred compensation plans until a corresponding amount is includible in the employee’s income. If the interest expense includes such items, additional examination procedures should be undertaken to determine the deductibility.
The company’s share of any partnership interest expense on loans should be tied to the Form 1065 (U.S. Partnership Return) filed by the partnership.
The company’s interest expense accruals should be reviewed to determine the accuracy of the calculations and whether the item is allowable.
Interest on indebtedness incurred or continued to purchase or carry tax-exempt obligations is not allowable as an interest expense deduction. A separate entry is to be made on the Form 1120–L to reduce the total interest expense for this type of interest.
IRC section 848 requires insurance companies to capitalize and amortize policy acquisition expense. IRC section 848 provides a "proxy" method to determine the amount of policy acquisition expenses to be capitalized. This method is based on net premiums, including both first year and renewal premiums.
To determine the amount of policy acquisition expenses to be capitalized, a percentage rate is applied against the net premiums of specified insurance contracts. Specified insurance contracts are defined as "any life, annuity, or noncancelable accident and health insurance contract (or any combination thereof)." The definition of specified insurance contracts expressly excludes any pension plan and any flight insurance or similar contracts. Qualified foreign contracts are also excluded per IRC section 807(e)(4).
The current specified insurance contract categories and their corresponding rates are as follows:
The specified insurance contract of "other life" includes noncancelable and guaranteed renewable accident and health contracts. In addition, an annuity contract that is combined with noncancelable accident and health insurance will be treated as a noncancelable accident and health contract and included in the "other life" category.
The amount capitalized may not exceed the insurance company’s general deductions. The term "general deduction" includes the deductions allowed under IRC section 161 and following such as general trade or business deductions (including commissions), interest expense, taxes, bad debts, depreciation and qualified plan deductions (IRC section 401 and following).
Accident and health insurance policies that would otherwise qualify as guaranteed renewable accident and health insurance policies, which are treated under IRC section 816(e) as noncancelable policies, will quality as guaranteed renewable policies during their first 2 years in force when the insurer maintains a reserve in addition to the reserve for unearned premiums that is computed on a two-year preliminary term basis. For guaranteed renewable accident and health contracts under IRC section 848(a) and IRC section 848(c)(1)(C), the issuing companies will be required to amortize and capitalize an amount of otherwise deductible expenses equal to 7.7 percent of net premiums for the taxable year on these contracts.
The application of deferred acquisition cost provisions under IRC section 848 is applied before the application of the unearned premiums for accident and health policies are reduced by 20 percent in accordance with IRC section 807(e), which requires life insurance companies to reduce by 20 percent unearned premiums for accident and health insurance contracts. This rule is effective for years beginning on or after September 30, 1990. A transition rule proves for a six-year spread of the opening difference. For calendar year companies this requires that 20 percent of the December 31, 1990 unearned premiums be included in taxable income ratably over the six-year period 1991–1996.
Annuities 1.75 percent Group Life 2.05 percent Other Life 7.70 percent
The proper characterization of contracts for IRC section 848 purposes is vital to its proper application. The question arises as to the treatment of premiums on contracts that provide more than one type of coverage. Premiums for one type of coverage might be hidden or mislabeled by placing that coverage inside a contract providing a type of coverage subject to a lower DAC percentage. The combination contract rule proved to be one of the more controversial parts of the proposed regulations. The final regulations retain the combination contract rule from the proposed regulations, but add significant exceptions that should provide relief in almost all cases. If the premium allocable to each type of insurance coverage is "separately stated" on the insurance company’s annual statement, the capitalization rate to be used for each separately stated premium is that which would apply to the related coverage if it were provided under a separate contract. If the separately stated exception is not met, the entire premium is subject to the highest DAC capitalization rate.
The final regulations add a de minimis rule. Under the rule, the premium for a coverage does not have to be separately stated if the premium is a de minimis premium. A de minimis premium is defined as either one that is not more than two percent of the premium for the entire contract; or is determined to be de minim is based on all the facts and circumstances.
The combination contract rule in the final regulations does not apply to a contract combining noncancelable accident and health insurance with annuity. IRC section 848(e)(3) requires that such a contract be treated as being subject to the 7.70 percent rate.
A 2.05 percent DAC rate applies to group life insurance contracts; a rate that is significantly lower than the 7.70 percent rate applicable to individual life insurance contracts [IRC section 848(c)(1)].
What constitutes group life insurance is very important. The statute requires three things for a contract to be considered a group life contract—group affiliation requirement; premiums must be determined on a group basis; and insurance proceeds must be payable to persons other than the employer of the insured, an organization to which the insured belongs, or other similar person. In addition, the contract must qualify as a group life insurance contract under applicable law (usually state law), the coverage must be provided under a master contract issued to a group policyholder and the premiums for the contract must generally be reported as either group life insurance premiums or as credit life insurance on the company’s Annual Statement.
Group affiliation requirement —There are five categories of groups which meet the affiliation requirement of IRC section 848(e)(2)(A)—an employee group; a debtor group; a labor union group; a credit union group; and an association group satisfying certain conditions including having been in actual existence for at least 2 years and having at least 100 members. The final regulations added the following: Employees of an association, labor union, or credit union may be treated as members of these respective groups. A group consisting of students of one or more universities or other educational institutions. A group consisting of members or former members of the U.S. Armed Forces. A group of individuals covered by a contract insuring against future funeral expenses. The final regulations did not allow combinations of groups from different categories to be considered members of the same group.
Determination of premiums on a group basis —In perhaps their most controversial component, the proposed regulations set forth a two-part test to determine whether premiums for a contract were determined on a group basis—an identical premium test and an eligibility test. The final regulations retain the identical premium requirement but do not incorporate the eligibility requirement. It is quite significant that the final regulations "reserve" a provision to deal with the latter at a future time if necessary. If the premiums allocable to the ineligible members are no more than five percent of the total premiums charged to the group as a whole, only the premiums allocable to the ineligible members are treated as individual life insurance premiums.
Restrictions on proceeds —The proceeds of a group life insurance contract must be payable to persons other than to the employer of the insured, an organization to which the insured belongs, or other similar person. The final regulations clarify that the organization that is a prohibited payee includes only organizations that either sponsor the contracts or are the group policyholders. [Treas. Reg. 1.848–1(h)(7)(iii)]. With respect to payments of proceeds to welfare benefit funds, the proposed regulations referred to the "death benefits" being paid to the employee whereas the final regulations refer to "benefits" being paid to the employee. Some have read that change in wording as allowing the life insurance proceeds to be retained by the plan for the payment of other employee benefits.
In general, "net premiums" with respect to any category of specified insurance contracts include the excess of gross premiums and other consideration for the contracts, over return premiums and premiums and other consideration incurred for reinsurance of such contracts. IRC section 848(d)(1), Treas. Reg. 1.848–2(a)(1).
Gross premiums "include" advance premiums, fees, assessments, amounts on insurance a company charges itself representing premiums with respect to benefits for its employees, and the net "positive consideration" for a reinsurance agreement—i.e., one insurer excluded these premiums as miscellaneous revenue rather than as gross revenue because they were classified as such under state law. However for tax purposes they are considered gross premiums. Treas. Reg. 1.848–2(b)(1)(v).
Gross premiums "exclude" dividends from a contract applied to pay premiums or purchase additional coverage under the contract, excess interest accumulated within the contract, experience-rated refunds applied to pay premiums under the contract or applied to a premium stabilization reserve contract, waived premiums, premiums paid for contract through a partial surrender or withdrawal or through the surrender or withdrawal of a paid-up addition, and amounts treated as premiums upon the selection of a settlement option under a life contract, amounts received or accrued from a guaranty association relating to a "troubled" insurer are excluded from gross premiums.
Amounts in a premium deposit fund or similar account are taken into account in determining gross premiums when such amounts are either applied to or irrevocably committed to the payment of premiums on specified insurance contracts. An amount is considered "irrevocably committed" only if neither the amount nor any earnings thereon may either be returned to the policyholder or any other person, other than on surrender of the contract.; or used by the policyholder to fund another contract. If the amounts are received by an insurer under a retired lives reserve arrangement, they will be considered irrevocably committed.
External exchanges (i.e., in which a contract is exchanged for a specified insurance contract issued by another insurance company) will continue to give rise to DAC premium. Treas. Reg. 1.848–2(c)(2).
The final regulations limit the number of types of internal exchanges (i.e., in which a specified insurance contract is issued by the same company) which give rise to DAC premium. These types of internal exchanges are cases in which the new contract relates to a different category of specified insurance contract than the original contract; cases where the new contract does not cover the same insured as the original contract; and cases in which there is a change in the interest, mortality, morbidity, or expense guarantees with respect to the nonforfeiture benefits provided in the original contract. Treas. Reg. 1.848–2(c)(3).
In determining whether an internal exchange is accompanied by a change in the interest, mortality, morbidity, or expense guarantees, the final regulations provide three instances where such a change will not be found. Where there is only a change in a temporary guarantee with respect to amounts credited as interest, or charged as mortality, morbidity, or expense charges and the new guarantee applies for a period of 10 years or less. Where the determination of benefits on annuitization uses rates that are more favorable to policyholders than the guaranteed rates. Where the changes are made with court or state regulatory approval in the case of a company that is insolvent, in rehabilitation, or in a conservatorship or similar state preceding. If a policy exchange gives rise to gross premiums, the final regulations look to the most recent sales price by the insurer of a comparable contract. If this amount is not readily ascertainable, it may be approximated by using the interpolated terminal reserve of the original contract as of the date of the exchange. Treas. Reg. 1.848–2(c)(4). The final regulations include a special rule—i.e., that only 30 percent of the amount otherwise includible in gross premiums as the result of an exchange is includible if the exchange results from a "policy enhancement or update program." Treas. Reg. 1.848–2(c)(4)(iii). Any exchange involving a group term life insurance contract without cash value per Treas. Reg. 1.848–2(c)(4)(ii) specifies that the value of the new contract is deemed to be zero.
Under IRC section 848 (d)(1), a company’s "net premiums" subject to DAC capitalization (for each category of specified insurance contracts) is determined by taking into account the "premiums and other consideration" incurred for reinsurance. Under the final regulations, this rule is implemented in a series of steps:
The company first determines whether it has "net positive" or "net negative" consideration with respect to each of its reinsurance agreements. If an agreement covers more than one category of contracts, the portion of the agreement relating to each category of specified insurance contracts is treated as a separate agreement for this purpose. Treas. Reg. 1.848–2(f)(7). If the company has net positive consideration from the agreement, that amount is added to its premium and consideration from contracts (other than reinsurance agreements) of the same category. If the company has net negative consideration from the agreement, that amount is subtracted from its gross premiums in determining net premiums for the same category of contract subject to DAC capitalization. Treas. Reg. 1.848–2(a) and (b)(1).
Due to this determination of "net positive" or "net negative" consideration, the amount of gross premiums reported on Schedule G is not necessarily the same as gross premiums reported on page 1, line 1 of the Form 1120–L
The proposed regulations applied the full netting rule to all amounts arising for taxable years beginning after December 31, 1991. The final regulations delay application of the full netting rule for three years with respect to reinsurance contracts entered into before the proposed regulations were issued. The final regulations provide that a reinsurance agreement is considered entered into at the earlier of the date of the reinsurance agreement or the date of a binding written agreement to enter into a reinsurance transaction if the written agreement evidences the parties’ agreement on substantially all material items. Treas. Reg. 1.848–2(k)(4).
The final regulations treat the transfer of policyholder loan receivables as items of consideration under a reinsurance agreement. Interest on the loan is treated as investment income to the party holding the receivable. Treas. Reg. 1.848–2(f)(8).
The amount required to be capitalized under IRC section 848 (i.e., the company’s "specified policy acquisition expenses" ) cannot be greater than its "general deductions," under IRC section 848(c)(1). IRC section 848(d)(1)(B) authorizes regulations to ensure consistency between the ceding company and the reinsurer for DAC purposes.
The regulations deny a party to a reinsurance agreement any credit for DAC premium transferred away unless the party can prove the amount the other party will actually capitalize with respect to that transferred premium. Treas. Reg. 1.848–2(g). The regulations also contain complicated rules to limit the transfer of DAC capitalized amounts under reinsurance agreements if the level of general deductions would prevent capitalization in whole or in part (a "capitalization shortfall" ).
The danger of losing DAC credit for transfers to a party with low general deductions can be avoided by making the joint election. The proposed regulations provided that the election should be attached to the Federal income tax return for the first taxable year ending after the election becomes effective. Prop. Reg 1.848–2(f)(7)(iii). The final regulations expanded that to allow attachment of the election to the return for the first taxable year ending on or after December 29, 1992, if that is later than the date allowed in the proposed regulations. Treas. Reg. 1.848–2(g)(8). That will allow companies making elections with respect to pre-1993 years to attach them to their 1992 returns.
These "capitalization shortfall" rules apply to all amounts arising in 1992 and thereafter (regardless of when the reinsurance agreement was entered into) and to amounts arising before 1992 under reinsurance agreements entered into after November 14,1991. Treas. Reg. 1.848–2(k)(2).
A U.S. company may not "take credit" for amounts under a reinsurance agreement paid to a non-US taxing company (either as a ceding company or as a reinsurer)—IRC section 848(d)(1)(A). The final regulations add an elective rule to achieve consistency and avoid multiple DAC capitalization. Under that rule, an electing company first calculates its net consideration (either positive or negative) for the taxable year from reinsurance agreements with foreign companies.
If the net consideration is negative, it reduces, not below zero, any unamortized balances of prior-year capitalization attributable to reinsurance agreements with foreign companies, and To the extent remaining, it carries over to reduce future net positive consideration attributable to reinsurance agreements with foreign companies. Treas. Reg. 1.848–2(h)(6). The regulations make clear that a "foreign negative" may not be used to offset any costs subject to capitalization or unamortized balances attributable to direct or reinsurance business not attributable to reinsurance agreements with foreign companies. Treas. Reg. 1.848–2(h)(6)(ii).
If the net consideration is positive, it is offset by any carryover from prior years of net negative consideration attributable to reinsurance agreements with foreign companies. To the extent remaining, it is treated as additional specified policy acquisition costs subject to DAC capitalization. Treas. Reg. 1.848–2(h)(4). If an amount is capitalized that is attributable to reinsurance agreements with foreign companies, it may be offset under IRC section 848(f) (e.g., by a "domestic" negative capitalization amount in another category of contracts). Treas. Reg. 1.848–2(h)(4).
The foreign reinsurance election applies to taxable years ending on or after September 30, 1994. Treas. Reg. 1.848–2(k)(5). It may be applied retroactively. The election is made by attaching an election to the Federal income tax return for the year for which the election becomes effective. Treas. Reg. 1.848–2(h)(3)(ii).
Under IRC section 848(f), if in any year there is an overall negative capitalization amount (the extent to which return premiums and premiums and other consideration incurred for reinsurance exceed the gross premiums and consideration received for contracts) for any category of specified insurance contracts, the amount required to be capitalized for the year under other categories is reduced. Any remaining negative capitalization amount not used for this purpose is used to reduce the unamortized balance of previously capitalized amounts (i.e., a current deduction is allowed for the resulting reduction).
The regulations permit an insurance company to carry over to future years any "excess negative capitalization amount" , i.e., the portion of any negative capitalization amount remaining after its reduction by the unamortized balance of previously capitalized amounts. Treas. Reg. 1.848–2(i). Furthermore, that ability to carryover applies retroactively. Treas. Reg. 1.848–2(k)(6).
The capitalized costs generally are to be amortized on a straight-line basis over 120 months, beginning with the first month in the second half of the taxable year in which the capitalization occurs. If the year of capitalization is a full 12-month fiscal year, 6 months of amortization will be allowed. If the year of capitalization is less than 12 months, there will be less than 6 months of amortization in the short taxable year.
A 60-month amortization period is allowed for the first $5 million of specified policy acquisition costs in any taxable year. This shorter amortization period is phased out on a dollar for dollar basis, as the policy acquisition expenses exceed $10 million. The shorter amortization period will not be available if the specified policy acquisition expenses equal or exceed $15 million for a taxable year. See the following Figure 22.214.171.124–1.
A life insurance company has $12 million of specified policy acquisition expenses in 1991. Of those costs, $3 million ($5 million–($12 million -$10 million) would be amortized over 60 months, and the remaining $9 million would be amortized over 120 months. For 1990, only a portion of the premium is subject to capitalization; however, the statute doesn’t annualize the $5,000,000 time reduction. Thus, for 1990, most likely most companies will amortize their 1990 expenses over only 60 months. Example: Contract Type Net Premiums IRC section 848(c)% DAC Annuity $ 300,000,000 1.75% $ 5,250,000 Group Life 500,000,000 2.05% 10,250,000 Non-Grp Life 200,000,000 7.7% 15,400,000 Non-Can A&H 200,000,000 7.7% 15,400,000 Total Amount capitalized under IRC section 848 = $46,300,000; because this is 1990, only 93/365 of the net premiums are subject to DAC. Thus the DAC for 1990 is 25.48 percent of the total yearly amount. In this case, $46,300,000 x (93/365) = $11,797,240. Since this amount exceeds $10,000,000, the amount that may be amortized over 60 months is reduced to $3,202,760 ($5 million ($11,797,240–$10,000,000), with the remaining $8,594,480 amortized over 120 months.
Once the type of contract is determined and the amount of net premiums is known, the amount of deductions that must be amortized and capitalized over either 60 or 120 months can be determined. This amount reduces the amount of the general deductions that a company may take in a given year.
If general deductions are $10,000,000 and the amount determined under IRC section 848 is $2,000,000 then the company may only deduct $8,000,000 currently as expenses plus the appropriate amount of the $2,000,000 DAC amount.
The amount of acquisition expenses that must be capitalized cannot exceed the amount of the actual general deductions.
If the general deductions are only $100,000 and the amount determined under IRC section 848 is $200,000, the company may only deduct the $1 00,000 which would have been deductible under IRC section 848.
Under IRC section 848(c)(2) and Treas. Reg. 1.848–1(i) the amount of the general deductions is determined without regard to amounts capitalized or amortized under IRC section 848(a).
For a calendar-year company, this limitation is less likely to apply in 1990 than in later years, because no allocation of general deductions between the pre-September 30, 1990 and the post-December 29, 1990 periods is permitted. The limitation would apply only if the specified policy acquisition expenses for the last quarter of 1990 exceed the general deductions for the entire 1990 taxable year.
Expenses includible in "Other Deductions" are explained in Chapter 3, text 3.3.9 of this handbook. Items (a) through (m) below require special attention.
When a life insurance company’s pension plan is non-qualified for agents, no accrual of contributions is allowable. In some cases, interest will be credited to the accounts of participants in nonqualified plans. Such interest is deemed to be a part of the deferred compensation provided for under the plan and is deductible under IRC section 404(a)(5).
Accruals of premium taxes and other expenses should be verified to see that they are not excessive.
Arrangements with insurance agents which involve contingent commissions should be scrutinized to determine the proper deduction for the current year. Advances to agents should also be carefully reviewed.
Interest incurred on indebtedness is deductible. This includes interest on agent’ credit balances.
No deduction should be allowed for unpaid loss adjustment expense reserve maintained in connection with unpaid accident and health claims. There is no provision in the Code which allows a deduction to a life insurance company for future expenses which have not been incurred.
No deduction is allowable for computer software purchased. The cost should be amortized.
Deductions derived from noninsurance business should be scrutinized.
No deduction is allowable for fines or penalties paid to a government for violating any law.
Publicly-held corporations may not deduct compensation to a "covered employee" to the extent that the compensation exceeds the amount as specified by law.
For mutual life insurance companies only, if the differential earnings amount for the preceding tax year exceeds the recomputed differential earnings amount for that tax year, include the excess in "Other Deductions." Treas. Reg. 1.809–9 provides that the differential earnings rate and the recomputed differential earnings rate used to compute such amounts, cannot be negative.
Agents’ commissions are not general expenses shown in Exhibit 5 of the Annual Statement. Instead they are items reported in the summary of operations, page 4 of the Annual Statement. As such, they qualify as expenses for the Other Deductions section of the Form 1120–L.
The environmental tax amount is treated as an item for Other Deductions
Form 1120–L, Schedule G, policy acquisition expenses, line 11. Deductible general expenses are reported separately under the Other Deductions category.
The provisions of IRC sections 243, 244, and 245 (as modified by IRC section 805(a)(4)) apply to a life insurance company. IRC section 246 is also applicable in accounting for the Dividend Received Deduction (DRD). Schedule A, Form 1120–L is included in the tax return which mathematically determines the allowable DRD. Although the DRD is not reconcilable to the Annual Statement, the total dividends received by the life insurance company are. (Schedule A, line 15, column a).
The mathematical calculations set forth in Schedule A multiply the amounts entered on the various lines in column a by the applicable percentage listed in column b. The product of this multiplication is entered in column c. Lines 1 through 9 of Schedule A, Form 1120–L are added together to arrive the gross DRD found in line 10, column c of Schedule A. The company’s share percentage from Schedule F, line 32 of Form 1120–L is then multiplied against the gross DRD to arrive at the company’s prorated share of the DRD. To the company’s share of the DRD, the dividends not subject to proration (e.g., dividends from affiliated companies) are added to arrive at the total DRD (Schedule A, line 16, column c).
According to Rev. Rul. 82–11 1982–1, C.B. 429, all corporate taxpayers are entitled to a DRD when they are the owner of the stock on the date of record. The rate of the DRD is dependent upon the ownership and the type of stock held in accordance with IRC sections 243, 244 and 245. In accordance with IRC section 246(c)(1)(A), the 45-day rule is applicable to all stock acquired after March 1, 1986.
An operations loss deduction under IRC section 810 is allowed in lieu of, but similar in many respects to, the net operating loss deduction under IRC section 172 which is permitted other companies. For purposes of determining the loss from operations available as an operations loss carryback or carryover, the operations loss deduction itself is not allowed, and the dividends received deduction is computed without regard to the percentage of taxable income limitations.
The operations loss may be carried back 3 years and forward 15 years, just as a net operating loss. It cannot be carried back, however, to a year where the company was not a life insurance company. An election to forego the carryback period and carry the operations loss forward 15 years may be made. In addition, a special carryover rule, IRC section 810(b)(1)(C) is available for a "new company" as defined in IRC section 810(e).
An operations loss deduction may not be used to offset phase Ill taxable income as a result of a distribution from the policyholders’ surplus account balance. Further information concerning policyholders’ surplus account distributions is contained in text 4.11, Other Deductions, above.
The small life insurance company deduction is computed based on tentative Life Insurance Company Taxable Income (LICTI). Tentative LICTI includes the operations loss deduction, therefore, any carryback of an operations loss deduction will require the recomputation of the small life insurance company deduction. Recomputation of the small life insurance company deduction will result in additional operations loss being used in the carryback or carryover year. The same is true of the effect of the operations loss carryback to a taxable period in which the special life insurance company deduction was allowable.
IRC section 844 provides special rules which are to be applied if there are changes in status between life insurance company and non-life insurance company for the loss year or any carryover year. The rules are complex but should be fully explored if this situation exists.
Several Code sections may be applicable to the allowance of an operations loss deduction under specific situations and should be researched as necessary. A detailed analysis of these Code sections is beyond the scope of this handbook but it is important to pursue issues which involve any of the following features.
In the case of acquisitions, the provisions of IRC sections 269, 381 and 382 should be considered. IRC section 482 may be applied to prevent evasion of taxes or to clearly reflect income in relation to an operations loss deduction if it is determined to be necessary to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among companies owned or controlled directly or indirectly by the same interests.
The provisions of IRC section 845 may apply to the allowance of an operations loss deduction if the loss relates to a reinsurance agreement which involves tax avoidance or evasion or a reinsurance contract having significant tax avoidance effect.
If there is a consolidated return in the loss year or any carryback or carryover year, the limitations on life/non-life consolidated returns must be considered. IRC section 1504 and Treas. Reg. 1.1502–47 provide detailed guidance for life insurance companies filing consolidated returns. The examiner must become familiar with the specific limitations and requirements early in the examination.
As a minimum, the following examination steps should be taken to ascertain the correctness of an operations loss deduction.
Review copies of loss year return(s) and intervening years and consult with the case manager if those returns are deemed to be worthy of examination.
Review computation of the operations loss deduction and ascertain whether prior examination adjustments are included in the computation.
Prepare a schedule, by year of loss, which reflects the carryover of the losses and takes into account any prior or current examination adjustments.
To qualify for the small life insurance company deduction, a life insurance company must have less than:
$15 million of tentative life insurance company taxable income
$500 million in assets
All life insurance company members of the same controlled group are treated as one company in computing the deduction. Any small life insurance company deduction determined with respect to the group must be allocated among the life insurance companies in the group in proportion to their respective tentative LICTIs.
For the asset test, the assets of all members of a controlled group must be included, whether or not they are life insurance companies.
The deduction is equal to 60 percent of the first $3 million of tentative LICTI, reduced by 15 percent of the tentative LICTI in excess of $3 million until a company reaches the maximum tentative LICTI of $15 million. The maximum small life insurance company deduction is $1,800,000.
In computing the small life insurance company deduction, the tentative LICTI for any tax year must be determined without regard to income from noninsurance business. Any loss from a noninsurance business is subject to the consolidated return nonlife loss limitation provisions.
Activities traditionally carried on by a life insurance company for investment purposes or involving the performance of administrative services in connection with life, pension, and accident and health benefits are treated as insurance businesses.
Real estate activities traditionally conducted by life insurance companies are treated as insurance businesses.
Participation in an oil and gas venture as a limited partner will ordinarily be treated as part of an insurance business. However, a working interest may be characterized an a noninsurance business.
IRC section 806(b)(3)(C) places a limitation on the amount of loss from a noninsurance business which shall be allowed as an offset to income from insurance business. This limitation is computed under the principles of IRC section 1503(c). IRC section 1503(c) establishes rules for the filing of consolidated returns by groups which include life insurance companies and companies which are not life insurance companies. The basic rule of IRC section 1503(c) is that losses from non-life insurance businesses which may offset life insurance income are limited to the lesser of 35 percent of the noninsurance business losses or 35 percent of life insurance income.
IRC section 806(b)(3)(C) therefore places the same limitations on a life insurance company which has noninsurance business activities within its corporate entity as the limitations which are placed on similar noninsurance activities within a consolidated group.
Form 1120–L contains a separate schedule, Schedule I, for the computation of the limitation on noninsurance losses. This schedule provides a mathematical calculation of the amount of the noninsurance loss limitation. The amount arrived at on the schedule is then entered on the return as an increase to LICTI in the determination of total taxable income.
Although the calculation of the limitation on noninsurance losses should be verified, the examination should focus primarily on the items includible as noninsurance business income and deductions.
IRC section 806(b)(3)(A) provides that "noninsurance business" means any activity which is not an insurance business. The Code does not provide further explanation of a noninsurance business. IRC section 806(b)(3)(B) provides that certain activities shall be treated as an insurance business; specifically an activity traditionally carried on by life insurance companies, which does not constitute the active conduct of a trade or business, or an activity which involves the performance of administrative services in connection with plans providing life insurance, pension, or accident and health benefits. In addition, IRC section 806(b)(3)(B) allows that a real estate activity shall be treated as an insurance business even if it constitutes the active conduct of a trade or business.
The committee reports for the Tax Reform Act of 1984 should be consulted for additional information on noninsurance business activities.
During the examination, the examination team should be alert to the potential that noninsurance activities, engaged in by the taxpayer, may not have been included in the calculation of the limitation on noninsurance losses. The inclusion of gains from activities which are actually insurance activities can also result in a distortion of the limitation computation.
If activities are identified, which appear to be of a noninsurance nature, which were not included in the computation or if insurance activities were included in the computation, a determination must first be made as to whether the aggregate of such activities would result in an adjustment to the loss from noninsurance activities. If the aggregate of such activities does not result in a loss or an adjustment to the loss, the issue should not be pursued. If the aggregate of the additional activities does result in a loss, each separate activity must be scrutinized and the nature of the activity fully developed during the examination.
Any examination adjustment proposed for the IRC section 806(b)(3)(C) limitation must be computed taking into account all other examination adjustments which have an effect on LICTI.