Western Cas. & Sur. Co. v. Comm'r of Internal Revenue
| Citation | 65 T.C. 897 |
| Decision Date | 03 February 1976 |
| Docket Number | Docket No. 5971-72. |
| Parties | THE WESTERN CASUALTY AND SURETY COMPANY, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | United States Tax Court |
OPINION TEXT STARTS HERE
Reece A. Gardner and George E. Gibson, for the petitioner.
Edward G. Lavery, for the respondent.
Held, petitioner, a stock fire and casualty insurance company taxable under sec. 831, I.R.C. 1954, is not entitled to include commissions on deferred premium installments in its computation of ‘expenses incurred’ under sec. 832(b)(6), I.R.C. 1954. Held, further, respondent correctly adjusted petitioner's 1967 taxable income under sec. 481, I.R.C. 1954. Held, further, respondent's method of testing the reasonableness of petitioner's unpaid loss reserves, by which overstated reserves were reduced but understated reserves were not correspondingly adjusted upward, resulted in an unwarranted reduction in petitioner's reductions for ‘losses incurred,‘ as defined in sec. 832(b) (5), I.R.C. 1954.
*
Respondent has determined deficiencies in petitioner's income tax for taxable years 1967, 1968, and 1969, and petitioner claims refunds for those years in the following amounts:
+----------------------------+
¦ ¦Deficiency ¦Refund ¦
+----+--------------+--------¦
¦ ¦ ¦ ¦
+----+--------------+--------¦
¦1967¦$5,536,716.34 ¦$290,138¦
+----+--------------+--------¦
¦1968¦465,213.26 ¦118,976 ¦
+----+--------------+--------¦
¦1969¦14,000.93 ¦42,951 ¦
+----------------------------+
Concessions having been made, the following issues are presented for our decision:
(1) Whether petitioner is entitled to include commissions on deferred premium installments in the computation of ‘expenses incurred,‘ as defined in section 832(b)(6);1
(2) If the first issue is decided in the negative, whether respondent correctly adjusted petitioner's 1967 taxable income under section 481; and
(3) Whether the unpaid loss reserves established by petitioner as of the close of the years at issue and included in the computation of ‘losses incurred,‘ as defined in section 832(b)(5), were excessive and should be reduced as determined by respondent.
All of the facts have been stipulated and are so found.
The Western Casualty & Surety Co. (petitioner) is a stock fire and casualty company organized under the laws of Kansas. At the time the petition herein was filed, petitioner's principal office and place of business was at Fort Scott, Kans. Petitioner filed a consolidated income tax return for 1967 on behalf of itself and its two affiliated corporations with the District Director, Wichita, Kans. Its 1969 consolidated return was filed with the Internal Revenue Service Center, Austin, Tex. There is no indication in the record as to where petitioner filed its 1968 consolidated return. The returns for these years were filed on a calendar year basis.
During the years at issue, petitioner owned 199,950 shares of the outstanding 200,000 shares of stock of the Western Fire Insurance Co. During the same period, the Western Fire Insurance Co. owned 99,950 shares of the outstanding 100,000 shares of stock of the Western Indemnity Co., Inc.
In each State where an insurance company is authorized to act as an insurer, the company is required to file statements concerning its financial condition and the results of its annual operations. These statements (hereinafter called annual statements) are presented on forms prescribed by the National Association of Insurance Commissioners and completed in accordance with instructions prepared by this organization.
Since its inception, petitioner has issued insurance policies which covered a period of more than 12 months from the effective date of the policy. Such policies are generally 3-year or 5-year policies. On the date of issuance, the holder of such a policy has the privilege of paying only the premium for the first year of coverage and of paying the premium installment for each succeeding year of coverage on the relevant anniversary of the date of issuance. If the policyholder elects not to pay the premium for any year subsequent to the first, the policy lapses and the policyholder receives no further coverage thereunder.
In addition, petitioner issues single-year policies under which the policyholder has the privilege of paying the premium in installments within the policy year. Failure to pay an installment also causes the policy to lapse and the policyholder to receive no further insurance coverage.
With respect to the above-described policies, those portions of the total premium due over the life of the policy which need not be paid prior to the end of the calendar year in order to maintain coverage and which, in fact, have not been paid by that time are hereinafter referred to as deferred premium installments.
An insurance company is required to report is annual premiums in force and its gross and net premiums on its annual statement. In making these computations, the instructions on filling out the annual statement allow the company to include deferred premium installments either as the premiums become due or as if these premiums were prepaid. For annual statement reporting purposes, petitioner has, for many years, opted to include its deferred premium installments as if they were prepaid.
As of December 31 of each year, petitioner establishes a reserve for unearned premiums and, for many years, has included deferred premium installments in the unearned premium reserve.
Upon substantially all insurance policies issued by it, petitioner pays commissions to the agents who sell the insurance. On any particular policy, the amount of the commission is dependent upon the amount of premium actually paid by the policyholder. Thus, in the case of a policy on which the policyholder need not and does not pay the entire premium on the date of issuance, the agent receives only that commission which is allocable to the initial premium payment. The agent receives the remainder of the commission if and when the policyholder pays the remaining premium installments.
The total amount of commissions which will be payable on a policy if it is kept in force for its entire life is added by petitioner to its reserves for commissions at the time a policy is written. The reserves are then reduced by the amounts of any commissions actually paid to the agents. As of December 31 of the years of 1966 to 1969, inclusive, petitioner's combined reserves for commissions on deferred premium installments were as follows:
+----------------+
¦1966¦$6,527,381 ¦
+----+-----------¦
¦1967¦6,794,327 ¦
+----+-----------¦
¦1968¦7,105,545 ¦
+----+-----------¦
¦1969¦6,864,459 ¦
+----------------+
During the years 1967, 1968, and 1969, petitioner paid commissions on premiums received during said years as follows:
+----------------+
¦1967¦$5,182,236 ¦
+----+-----------¦
¦1968¦5,301,437 ¦
+----+-----------¦
¦1969¦5,774,857 ¦
+----------------+
On both its annual statements and Federal income tax returns for the years 1967, 1968, and 1969, petitioner computed its commission expense deduction as follows:
+-----------------------------------------------------------------------------+
¦ ¦1967 ¦1968 ¦1969 ¦
+--------------------------------------------+----------+----------+----------¦
¦ ¦ ¦ ¦ ¦
+--------------------------------------------+----------+----------+----------¦
¦Commissions paid during the year ¦$5,182,236¦$5,301,437¦$5,774,857¦
+--------------------------------------------+----------+----------+----------¦
¦Reserves for commissions on deferred premium¦6,794,327 ¦7,105,545 ¦6,864,459 ¦
¦installments as of the close of the year ¦ ¦ ¦ ¦
+--------------------------------------------+----------+----------+----------¦
¦Total ¦11,976,563¦12,406,982¦12,639,316¦
+--------------------------------------------+----------+----------+----------¦
¦Reserves for commissions on deferred premium¦ ¦ ¦ ¦
¦installments as of the close of the ¦6,527,381 ¦6,794,327 ¦7,105,545 ¦
¦preceding year ¦ ¦ ¦ ¦
+--------------------------------------------+----------+----------+----------¦
¦Commission expense ¦5,449,182 ¦5,612,655 ¦5,533,771 ¦
+-----------------------------------------------------------------------------+
As of December 31, 1953, petitioner's reserves for commissions on deferred premium installments amounted to $122,939.
Petitioner issues insurance policies in 19 different lines of insurance coverage. As of December 31 of each year its establishes a ‘reserve for unpaid losses' in each line. The reserve for each line is comprised of case-by-case estimates of unpaid liability on reported claims as well as statistically computed estimates of liability on losses incurred but not reported at yearend. Also, some reserves include an additional amount (hereinafter referred to as voluntary loss reserves) voluntarily included in the loss reserves for certain lines in which the reserves otherwise computed have historically proven inadequate.
Of the 19 lines of insurance coverage, 16 are reported on schedule O of the annual statements and 3 are reported on schedule P. Petitioner did not compute any voluntary loss reserves prior to 1963. From 1963 through 1969, however, petitioner did include voluntary loss reserves in some of the schedule P lines of coverage.
With regard to the unpaid loss reserves established by petitioner for the schedule O lines in each of the years at issue, respondent reduced the reserves as follows: respondent developed a ratio between the reserves for unpaid losses at the end of each of the preceding 5 years and the unpaid losses which subsequent experience showed to have been...
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