15 percent as much coal or fuel oil as the farmer patrons. Usually the association forgoes its exemption rather than antagonize everyone in town. Then the association, free from the restrictions of section 521, is free to compete with anyone and everyone in any and all lines of business.

The two special deductions granted to exempt cooperatives by section 522 are of substantial importance to smaller cooperatives, especially if they happen to be organized with capital stock, and should be retained.

V. PATRONS

It has not been possible to prepare this section in a form in which we are willing to have it printed within the time available. We shall submit a supplemental statement at or before the hearing on December 14, 1959.

TAX TREATMENT OF INSURANCE COMPANIES

Roy E. Moor 1

1

In this paper an attempt will be made to examine the various considerations influencing the taxation of insurance companies. Then, on the basis of the conclusions drawn from this examination, an appraisal will be made of the current legislation in this area.

Any economist who wishes to draw policy conclusions such as these must be willing to indicate the personal value standards from which he starts. Since this paper is restricted to the taxation of insurance companies, the initial value standard can be a simple one: it will be assumed for this purpose that the present corporate tax provides an adequate measure of the amount each corporation should pay to the Federal Government, unless there are overriding considerations to the contrary.

2

The first question to be answered in this paper, therefore, is whether the reasons given in the past for variations away from the corporate approach in the insurance area are sufficient to justify a different type of tax treatment. One test that has been used to assess tax fairness; namely, the amount of revenue derived from the insurance industry, will not be considered here. Rather, the emphasis will be the underlying factors that should influence the determination of a tax base.

One of the reasons given for special treatment has been that the companies do not have a product in the same sense as other corporations. Insurance involves a contractual arrangement, frequently for a long period, between an individual or business and an insurance company. The commitment by the company is a contingent one, and the value of the service to the recipient is not measured in the marketplace, except insofar as the policyholder buys or refrains from buying. The price that is paid reflects expectations of future costs, not past outlays, for the production of a specific product.

Despite these characteristics, insurance contracts must be considered as economic products. The contracts are sold in a market in exchange for a consideration. They provide a service to the customer in the same general sense as any other product, i.e., they give satisfaction. In this case, the satisfaction is derived from the knowledge that, in

1 The author is an assistant professor of economics at Williams College. A large portion of the material in this paper was assembled as part of a doctoral dissertation for Harvard University while the author was a fiscal economist with the tax analysis staff of the U.S. Treasury Department. None of the opinions expressed here should be considered as necessarily those of the Treasury Department, however.

No attempt will be made here to document all of the places where these reasons have been given. For two recent and fairly comprehensive collections of statements, see "Taxation of Life Insurance Companies." Hearings before a subcommittee of the Committee on Ways and Means, 83d Cong., 2d sess., 1955; and "Taxation of Income of Life Insurance Companies." Hearings before the Subcommittee on Internal Revenue Taxation, 85th Cong., 2d sess., 1958. For an excellent summary of the issues in this area, see "A Preliminary Statement of the Facts and Issues With Respect to the Federal Taxation of Life Insurance Companies, GPO, November 1954, reprinted in "Taxation of Life Insurance Companies." Report to the Committee on Ways and Means by the Subcommittee on Taxation of Life Insurance Companies, GPO, 1955.

the event of an unhappy occurrence, money will be provided by the insurance company. Costs are thereby incurred by the seller of the product. At least the great majority of sellers have entered the market in order to make a profit by the sale of the products, in the same manner as any other commercial establishment.

Moreover, in the most general sense, there is no significance in the fact that the policies may be paid for over a long period. An economic product exists even though the payment period is typically lengthy. Insofar as the individual is concerned, the regular payments are the same as a rental or credit purchase. In effect, the policyholder is receiving the service so long as he continues his payments. From the company's standpoint, the receipt of premiums is clearly related to individual years. What is more, the commitments can also be associated with specific years. All insurance can be, if desired, considered as 1-year renewable term insurance, in which the premiums and investment income meet the present claims and expenses and the portion of future claims related to the given year. Essentially, the companies are merely paying a portion of future claims in a current year by allocating assets to reserves. The emphasis which is placed by the industry on the length of individual commitments ignores the fundamental characteristic of insurance: the sharing of risks among a large number. Each year, expenses are incurred for a portion of the total group of policyholders and the funds of the entire group are used to meet these expenses.

A related justification for special tax treatment concerns the future uncertainties which affect the measurement of a year's income. In effect, the position is taken that even if insurance companies sell a product, the income derived from the sales cannot be measured in terms of annual periods. The nature of most insurance contracts requires the companies to set aside certain amounts as reserves. In the case of life insurance companies, these reserves derive largely from the fact that constant premiums are charged through the years of the policy coverage, even though risks of payment increase with age. Hence, reserves are established in the early years of policies to anticipate premium inadequacies in later years. For fire and casualty companies the reserves are largely in the form of contingency funds to meet liabilities in excess of average anticipated experience. Since net additions to these reserves must be taken from current receipts, the additions would presumably be justifiable deductions under the usual corporate tax approach. However, the additions to reserves are just estimated amounts, based merely on reasonable expectations, which may subsequently prove to reflect true costs only very inaccurately. At the same time, insurance companies, especially life companies, are not able to vary premium rates on fixed contracts to take account of differences between estimated and actual costs.

This line of reasoning is actually one of the weaker justifications presented for special tax considerations. Putting aside for the moment the reserve question, the accounting problems in measuring the annual net income of insurance companies are minuscule. In fact, the problems are simplified by comparison to other corporations be

See, for example, H. H. Baily, “Specialized Accounting Systems," 2d ed., New York: Wiley, 1951, pp. 227–246.

5

cause all insurance companies file uniform accounting statements, including a profit-and-loss statement, to the State regulatory commission in each State in which business is done. With respect to the computation of reserves, some differences among companies in estimating the future do occur, although these are largely standardized by the use of generally accepted mortality and morbidity tables. Moreover, the differences that do exist are essentially similar to, for example, variations among industrial companies in depreciation policies (which must be based on estimates of the future) or variations among mercantile firms in inventory valuation. Finally, if there is sufficient concern about differences in reserve bases, a system of successive approximations and carryback adjustments can be adopted which will bring reserve deductions very close to their true value.

More fundamentally, however, these difficulties are essentially like all other business uncertainties. Any business, in setting a price, must estimate future contingencies if investment of capital is involved. Commitments for future profit and the risks associated with the commitments are inherent in a capitalistic system where private companies attempt to anticipate the factors influencing a product's sale. The fact that premiums are fixed is basically the same as recognizing that, to a lesser or greater extent, prices of all products are fixed by market conditions. Moreover, the mere fact that some product prices can fluctuate is obviously no guarantee against losses due to future changes in conditions. Hence, the conclusion here is that tax differences due to varying estimates of the future are typical throughout the corporate area and the income of insurance companies can be measured at least as accurately on an annual basis as income of other corporations. In essence, if insurance companies ask the Government to provide special tax treatment for them on these grounds, they are really requesting the Government to underwrite currently a portion of the conjectural future risks which the companies are in business to carry themselves and which all other corporations do carry to lesser or greater extent.

Another reason for opposing the imposition of the usual corporate income tax on insurance companies has been the mutual nature of a portion of the industry. Basically, it is maintained that mutual companies are groups of individuals who are providing their own protection through sharing risks. Following from this starting point, there would be no long-run profit with respect to pure insurance coverage, except in the nontaxable sense of gain through one's own efforts as contrasted with production and sale to others. Because of the problems indicated above with respect to the annual measurement of income, it is difficult for mutual companies to distribute to their policyholder-owners all of the actual profits of the company each year, but it is strongly contended by mutual company representatives that 100 percent of all profits are distributed back to each generation of policy

This form is slightly different for life and nonlife insurance companies. For a discussion of the life company form, see E. C. Wightman, "Life Insurance Statement and Account," New York: Life Office Management Association, 1952.

5 See for example, John S. Thompson, "The Commissioners 1941 Standard Ordinary Mortality Table," Transactions of the Actuarial Society of America, vol. XLII, pt. II, No. 106 (September 1941), p. 329.

By this same logic, there would be taxable income to mutual companies from investments, since investments involve providing a service to others and obtaining a net yield from that service. It is generally agreed that mutuals should be taxed on this investment income.