57 T.C. 58 (1971)
BITUMINOUS CASUALTY CORPORATION, PETITIONER
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
BITUMINOUS FIRE AND MARINE INSURANCE COMPANY, PETITIONER
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Nos. 2510-69, 2511-69.
United States Tax Court
October 14, 1971
Charles W. Davis, Frederic W. Hickman, and Ronald F. Lipp, for the petitioners.
Seymour I. Sherman, for the respondent.
Held: 1. Bituminous Casualty Corp. correctly included in unearned premiums, as defined in sec. 832(b)(4), I.R.C. 1954, its reserves for retrospective rate credits and premium discount as reflected in its Annual Statements in the form approved by the National Convention of Insurance Commissioners. Such reserves were reasonable estimates of the portions of premiums otherwise ‘ earned’ at the end of each taxable year which it would be required to return to policyholders pursuant to its retrospective rating and premium discount policies.
2. Both the Casualty Corp. and the Fire & Marine Co. correctly deducted, under sec. 832(c)(11) and the applicable regulations, their reserves for policyholder dividends as reflected in their Annual Statements. Such reserves were reasonable estimates, determined in accordance with their regularly employed method of accounting, of the portion of premiums otherwise ‘ earned’ at the end of each taxable year which they would be required to return to policyholders pursuant to policyholder dividend resolutions previously adopted.
3. Except for $13,404 which became income to the Casualty Corp. in 1968, no other portion of Casualty's reserve for unpaid drafts or reserve for outstanding checks was properly included in its income for any of the taxable years in question because the amounts reflected in both reserves represent real and continuing liabilities of the Casualty Corp.
In these consolidated cases respondent determined the following Federal income tax deficiencies against the petitioners:
| BITUMINOUS CASUALTY CORP.
| Taxable year
|| Taxable year
Several issues involved in these cases have been resolved by agreement of the parties. The three issues presented for our decision are: (1) Did Bituminous Casualty Corp. properly include in unearned premiums, as defined in section 832(b)(4) of the Code,
its reserves for retrospective rate credits and premium discount, i.e., its reasonable estimates of the portion of the premiums otherwise ‘ earned’ at the end of the taxable year which it would be required to return to policyholders pursuant to its retrospective rating and premium discount policies? (2) Did the Casualty Corp. and the Fire Co. correctly compute their deductions under section 832(c)(11) of the Code by taking into account, pursuant to Treasury regulations, their reserves for policyholder dividends, i.e., their reasonable estimates of the portion of the premiums otherwise ‘ earned’ at the end of the taxable year which they would be required to return to policyholders under policyholder dividend resolutions previously adopted? (3) Was the Casualty Corp. required to restore to income during any of the taxable years in question all or any portion of its reserves for unpaid drafts and checks? FINDINGS OF FACT Many of the facts have been stipulated by the parties. The stipulation of facts and supplemental stipulation, together with the exhibits attached thereto, are incorporated herein by this reference. Bituminous Casualty Corp. (herein called Casualty) is a stock casualty insurance company organized under Illinois law with its principal office and place of business at Rock Island, Ill. It is a medium-sized company, specializing heavily in workmen's compensation coverage. For each of the calendar years 1958 to 1965, inclusive, Casualty filed its Federal income tax returns on Form 1120, with its corresponding annual statement in the form approved by the National Association of Insurance Commissioners (hereinafter called Annual Statement) for each respective year annexed thereto, with the district director of internal revenue at Chicago, Ill. Bituminous Fire & Marine Insurance Co. (herein called the Fire Co.) was organized in 1942 under Illinois law as a wholly owned subsidiary Page 60
of Casualty. At all times here pertinent the Fire Co. has remained such a wholly owned subsidiary and has had its principal office and place of business at the same address as Casualty. Like Casualty, it is heavily involved in workmen's compensation coverage. For each of the calendar years 1962 to 1965, inclusive, the Fire Co. filed its Federal income tax returns on Form 1120, with its corresponding annual statement for each year annexed thereto, with the district director of internal revenue at Chicago, Ill. In all respects relevant to these proceedings, petitioners' computations of taxable income were the same as their computation of ‘ net income’ as reflected in the ‘ Underwriting and Investment Exhibit’ of petitioners' Annual Statements, except that (a) for years prior to 1963, the amount reflected as ‘ dividends to policyholders' was reflected as a deduction in computing taxable income in petitioners' tax returns, but as a ‘ loss in surplus' (rather than a deduction from ‘ net income’ ) in the Underwriting and Investment Exhibit of petitioners' Annual Statements, and (b) with respect to the items indicated in Schedule 1 of the returns for the years 1958 through 1962, and in Schedule M of the returns for the years 1963 through 1965, which relate to tax-exempt interest and transactions with respect to securities bearing such interest, to liabilities for deferred compensation which are nondeductible for tax purposes, and to other items which are self-explanatory in the returns. PREMIUM REBATES- RETROSPECTIVE RATE CREDITS Certain policies (herein called retro policies) written by Casualty have provisions under which the amount of ‘ standard premium’ (i.e., the premium, before adjustments hereafter described, based on the rates indicated in the policy) may be adjusted on the basis of the amount of losses incurred with respect to the term covered by the policy, all pursuant to various retrospective rating ‘ plans' (i.e., formulas) under which policies are written. As applied to a particular policy such formulas may result in a downward adjustment of the premium (in which case a portion of the premium is refunded), in an upward adjustment of the premium (in which case additional premium is collected), or in no adjustment whatever. Under all such formulas the amount of adjustment depends in part upon the amount of ‘ losses incurred’ (which may include allocated loss adjustment expenses, as, e.g., legal and medical expenditures made in connection with such losses) with respect to the term for which the policy is effective. Casualty's retro policies are written on workmen's compensation coverage, sometimes in combination with other coverage. The final amount of premium adjustment under a retrospective rating plan cannot be computed until substantially after the end of the Page 61
policy term because the amount of ‘ losses incurred’ with respect to the policy cannot be finally determined for some considerable time thereafter. The amount of ‘ losses incurred’ for this purpose includes not only payments made to the claimant, but may also include payments of expense for legal and medical services rendered at Casualty's request, including services requested and rendered well after the term of the policy. It also includes estimates of the amounts which may at some future date have to be paid to the claimant or for such expenses. As a result, the amount of ‘ losses incurred’ with respect to the term covered by the policy changes from time to time as payments are made and estimates are revised, and, except as otherwise agreed between the policyholder and Casualty, is not finally determined until all payments are made and no additional amounts are estimated. Depending upon the terms of the retrospective rating plan and the finality of the policyholder's actual experience, final determination of such ‘ losses incurred’ for purposes of the retrospective rating plan and the premium adjustment may occur from 6 months to a number of years after the end of the policy term. In some cases Casualty has made such adjustments as long as 8 or 9 years after the end of the policy term. Except where final determination is made as of 6 months after the policy term, there are typically interim adjustments (subject to later correction) made upon the basis of payments known and estimates made at the time of such interim adjustments. For all years relevant herein, Casualty has computed a reserve for retrospective rate credits (hereinafter sometimes referred to as retro rate credits). That reserve consisted of its estimate, as of each December 31, of that portion of its earned premium (determined on a prorata basis without regard to any reserves for retro rate credits, premium discount, or policyholder's dividends) applicable to retro policies, which would thereafter be refundable to policyholders as retro rate credits, net after deducting additional premiums collectible under the formulas in such policies. The amounts of such retrospective rate credit reserves, as of December 31 in each of the years indicated, were as follows: