United States v. Consumer Life Insurance Company First Railroad Banking Company of Georgia v. United States United States v. Penn Security Life Insurance Company, Nos. 75-1221

• Court: United States Supreme Court
• Writing for the Court: POWELL
• Citation: 97 S.Ct. 1440,52 L.Ed.2d 4,430 U.S. 725
• Parties: UNITED STATES, Petitioner, v. CONSUMER LIFE INSURANCE COMPANY. FIRST RAILROAD & BANKING COMPANY OF GEORGIA, Petitioner, v. UNITED STATES. UNITED STATES, Petitioner, v. PENN SECURITY LIFE INSURANCE COMPANY
• Docket Number: Nos. 75-1221,75-1260 and 75-1285
• Decision Date: 26 April 1977

52 L.Ed.2d 4 97 S.Ct. 1440 430 U.S. 725 UNITED STATES, Petitioner,

v.

CONSUMER LIFE INSURANCE COMPANY. FIRST RAILROAD & BANKING COMPANY OF GEORGIA, Petitioner, v. UNITED STATES. UNITED STATES, Petitioner, v. PENN SECURITY LIFE INSURANCE COMPANY.

Nos. 75-1221, 75-1260 and 75-1285. Argued Dec. 6, 1976. Decided April 26, 1977. Syllabus

Under § 801(a) of the Internal Revenue Code of 1954, an insurance company is considered a life insurance company for federal tax purposes if its life insurance reserves constitute more than 50% of its "total reserves," as that term is defined in § 801(c). Qualifying companies are accorded preferential tax treatment. The question here is how unearned premium reserves for accident and health (nonlife) insurance policies should be allocated between a primary insurer and a reinsurer for purposes of applying the 50% test. The unearned premium reserve is the basic insurance reserve in the casualty insurance business and an important component of "total reserves" under § 801(c)(2). The taxpayers contend that by virtue of certain reinsurance agreements ("treaties") they have maintained nonlife reserves below the 50% level. These treaties were of two basic types: (1) Treaty I, whereby the taxpayer served as reinsurer, and the "other party" was the primary insurer or ceding company; and (2) Treaty II, whereby the taxpayer served as the primary insurer and ceded a portion of the business to the "other party," the reinsurer. Both types of treaties provided that the other party would hold the premium dollars derived from accident and health business until such time as the premiums were "earned," i. e., attributable to the insurance protection provided during the portion of the policy term already elapsed. The other party also set up on its books the corresponding unearned premium reserve, relieving the taxpayer of that requirement, even though the taxpayer assumed all substantial insurance risks. In each case, the taxpayer and the other party reported their affairs annually in this way to both the Internal Revenue Service and the appropriate state insurance departments. Despite the state authorities' acceptance of these annual statements, the

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Government argues that the unearned premium reserves must be allocated or attributed for tax purposes from the other parties to the taxpayers, with the result that the taxpayers fail the 50% test and thus are disqualified from preferential tax treatment, primarily because, in the Government's view, § 801 embodies a rule that "insurance reserves follow the insurance risk." Held :

1. The reinsurance treaties served valid business purposes and, contrary to the Government's argument, were not sham transactions without economic substance. Pp. 736-739.

2. Since the taxpayers neither held the unearned premium dollars nor set up the corresponding unearned premium reserves, and since that treatment was in accord with customary practice as policed by the state regulatory authorities, § 801(c)(2) does not permit attribution to the taxpayers of the reserves held by the other parties to the reinsurance treaties. Pp. 739-750.

(a) The language of § 801(c)(2) does not suggest that Congress intended a "reserves follow the risk" rule to govern determinations under § 801. Pp. 740-741.

(b) Nor does the legislative history of § 801 furnish support for the Government's interpretation. Pp. 742-745.

(c) Section 820 of the Code, prescribing the tax treatment of modified coinsurance contracts, affords an unmistakable indication that Congress did not intend § 801 to embody a "reserves follow the risk" rule. Pp. 745-750.

3. Nor is attribution of unearned premium reserves to the taxpayers required under § 801(c)(3), counting in total reserves "all other insurance reserves required by law." There is no indication that state statutory law in these cases required the taxpayers to set up and maintain the contested unearned premium reserves, especially since the insurance departments of the affected States consistently accepted annual reports showing reserves held as the taxpayers claim they should be. Pp. 750-752.

No. 75-1221, 524 F.2d 1167, 207 Ct.Cl. 638, and No. 75-1285, 524 F.2d 1155, 207 Ct.Cl. 594, affirmed; No. 75-1260, 5 Cir., 514 F.2d 675, reversed and remanded.

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Stuart A. Smith, Washington, D. C., for the United States.

John B. Jones, Jr., Washington, D. C., for Penn Security Life Insurance Company.

James R. Harper, Atlanta, Ga., for the First Railroad & Banking Company of Georgia.

E. Michael Masinter, Atlanta, Ga., for the Consumer Life Insurance Company.

Mr. Justice POWELL delivered the opinion of the Court.

The question for decision is how unearned premium reserves for accident and health (A&H) insurance policies should be allocated between a primary insurer and a reinsurer for federal tax purposes. We granted certiorari in these three cases to resolve a conflict between the Circuits and the Court of Claims. 425 U.S. 990, 96 S.Ct. 2200, 48 L.Ed.2d 814 (1976).

I

An insurance company is considered a life insurance company under the Internal Revenue Code if its life insurance reserves constitute more than 50% of its total reserves, IRC 1954, § 801(a), 26 U.S.C. § 801(a),¹ and qualifying com-

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panies are accorded preferential tax treatment.² A company close to the 50% line will ordinarily achieve substantial tax savings if it can increase its life insurance reserves or decrease nonlife reserves so as to come within the statutory definition.

The taxpayers here are insurance companies that assumed both life insurance risks and A&H nonlife risks. The dispute in these cases is over the computation for tax purposes of nonlife reserves. The taxpayers contend that by virtue of certain reinsurance agreements or treaties, to use the term commonly accepted in the insurance industry they have maintained nonlife reserves below the 50% level. The Government argues that the reinsurance agreements do not have that effect, that the taxpayers fail to meet the 50% test, and that accordingly they do not qualify for preferential treatment.³

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Specifically the dispute is over the unearned premium reserve, the basic insurance reserve in the casualty insurance business and an important component of "total reserves," as that term is defined in § 801(c).⁴ A&H policies of the type involved here generally are written for a two- or three-year term. Since policyholders typically pay the full premium in advance, the premium is wholly "unearned" when the primary insurer initially receives it. See Rev. Rul. 61-167, 1961-2 Cum. Bull. 130, 132. The insurer's corresponding liability can be discharged in one of several ways: granting future protection by promising to pay future claims; reinsuring the risk with a solvent reinsurer; or returning a pro rata portion of the premium in the event of cancellation. Each method of discharging the liability may cost money. The insurer thus establishes on the liability side of its accounts a reserve, as a device to help assure that the company will have the assets necessary to meet its future responsibilities. See O. Dickerson, Health Insurance 604-605 (3d ed. 1968) (hereafter Dickerson). Standard accounting practice in the casualty field, made mandatory by all state regulatory authorities, calls

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for reserves equal to the gross unearned portion of the premium.⁵ A simplified example may be useful: A policyholder takes out a three-year A&H policy for a premium, paid in advance, of $360. At first the total $360 is unearned, and the insurer's books record an unearned premium reserve in the full amount of $360. At the end of the first month, one thirty-sixth of the term has elapsed, and $10 of the premium has become "earned." ⁶ The unearned premium reserve may be reduced to $350. Another $10 reduction is permitted at the end of the second month, and so on.

II

The reinsurance treaties at issue here assumed two basic forms.⁷ Under the first form, Treaty I, the taxpayer served as reinsurer, and the "other party" was the primary insurer or "ceding company," in that it ceded part or all of its risk to the taxpayer. Under the second form, Treaty II, the taxpayer served as the primary insurer and ceded a portion of the business to the "other party," that party being the reinsurer. Both types of treaties provided that the other party

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would hold the premium dollars derived from A&H business until such time as the premiums were earned that is, attributable to the insurance protection provided during the portion of the policy term that already had elapsed. The other party also set up on its books the corresponding unearned premium reserve, relieving the taxpayer of that requirement. In each case, the taxpayer and the other party reported their affairs annually in this fashion to both the Internal Revenue Service and the appropriate state insurance departments. These annual statements were accepted by the state authorities without criticism. Despite this acceptance, the Government argues here that the unearned premium reserves must be allocated or attributed for tax purposes from the other parties, as identified above, to the taxpayers,⁸ thereby disqualifying each of the taxpayers from preferential treatment.

No. 75-1221, United States v. Consumer Life Ins. Co. In 1957 Southern Discount Corp. was operating a successful consumer finance business. Its borrowers, as a means of assuring payment of their obligations in the event of death or disability, typically purchased term life insurance and term A&H insurance at the time they obtained their loans. This insurance commonly known as credit life and credit A&H is usually coextensive in term and coverage with the term and amount of the loan. The premiums are generally paid in full

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at the commencement of coverage, the loan term ordinarily running for two or three years. Prohibited from operating in Georgia as an...