utilizing the actual rate directly, another device was installed in the law which was allegedly an industry rule of thumb that would accomplish the same result, namely, to lower the reserve base by 10 percent for every 1 percent by which the earnings rate exceeded the reserve rate. It has never been clear, at least to the writer, why such artificial devices were used to attempt to accomplish what could have been done directly. In any case, the procedure will always provide a much higher deduction for the companies than the use of the actual reserve rate which would be applicable under a corporate approach. For example, if a company used a 21/2-percent reserve rate and had $1 million of reserves, its deduction under a corporate approach would be $25,000. If the average earning rate of the company were 312 percent, the reserve base would be reduced 10 percent, or to $900,000, but the deduction permitted by the new law would be $31,500. The artificiality of this approach is recognized in phase 2 where the actual rate is used.

Phase 2 is applicable mostly to the underwriting income of life insurance companies, i.e., to gross premium income and to the expense associated with this gross income, benefit payments, administrative and selling costs, and additions to reserves from premiums. The most obvious variation away from the corporate tax approach in phase 2 is that only 50 percent of the net income in this phase is included in the tax base. According to the Senate Finance Committee report, "This 50-percent reduction in underwriting gains is made because it is difficult to establish with certainty the actual annual income of a life insurance company." 16 However, as has been pointed out above, the determination of income is no more difficult for insurance companies than for other corporations, and even if the reasons were valid, it should only result in deferral of tax, not elimination of tax. The weakness of the approach is highlighted in the law itself, since 100 percent of net underwriting losses may be included in the tax base, even though losses merely involve a relative change in the relation of the same income and deduction items.

A similar weakness in phase 2 involves a deduction to the companies, in addition to the usual reserve deduction, of 10 percent of the increase in reserves on nonparticipating policies. The justification given for this deduction in the committee report was, in effect, that the companies needed a tax-free contingency reserve on these policies, not because they were more risky, but because policyholder dividends could be adjusted on participating policies." The result essentially is that the Government is underwriting a part of the risk on nonparticipating policies in order to attempt to balance more closely the competitive conditions in the industry. This principle, that the Government should participate through the tax structure in the operations of certain businesses in order to adjust competitive differences, is subject to severe criticism and has rarely been applied in our corporate tax laws.

Phase 3 of the new law is an attempt to move back toward a corporate tax approach and thereby recoup some revenues otherwise lost in phases 1 and 2. The medium used to move in this direction is the

p. 20.

10 "Life Insurance Company Income Tax Act of 1959," S. Rept. 291, 86th Cong., 1st sess., 17 Ibid., p. 22.

allocation of surplus into taxed and untaxed parts. This device implies that there will be tax deferral-a significant type of subsidyon a portion of income even if all of it is eventually subject to tax. The major way in which some of the untaxed surplus can be taxed is if it is distributed to stockholders. Since the distribution must be to stockholders, no mutual company will ever be affected by this provision. Moreover, it is assumed that distributions to stockholders are drawn first from the taxed surplus. Therefore, stock companies can distribute considerable dividends-probably as much as would normally be distributed-and incur no further tax burden. Hence, it seems doubtful that this provision will have any significant effect in increasing taxpayments toward the corporate level, especially since the provision is not fully effective until 1961 and companies can thereby pay larger dividends now in anticipiation of greater tax free surplus accumulations later.

The only other means by which the tax-free surplus accumulations can be subject to tax is if the accumulations exceed certain limits. However, (1) the limits are very high, and (2) each company must exceed all three alternative limits before a tax is imposed. Obviously, this approach involves the Government in the problem of determining what constitutes an appropriate accumulation of surplus. It would seem far better for the Government to tax all net additions to surplus and thereby remain neutral in the business decision whether to distribute or retain earnings.

The tax distinction between life insurance companies and nonlife, health and accident insurance companies, is a wholly arbitrary one. Economically, the products of all insurance companies are quite similar and the various companies frequently compete directly for the same business. In fact, for many years companies classified as life companies have sold far more health and accident insurance than have casualty companies.18 Yet, since 1921 insurance companies have been separated for tax purposes on the basis of the percentage of total reserves related to life insurance and nonlife insurance. If more than 50 percent of total reserves can be associated with life insurance policies, the entire company is considered to be a life insurance company. The weakness of this approach is indicated by the differences in reserve requirements for different types of insurance policies. Life insurance requires a relatively high average proportion of reserve to policy coverage; nonlife policies typically require a relatively smallpercentage reserve. Hence, a company may have a small portion of its business in life insurance, as measured by coverage or premiums, and yet be considered a life insurance company for tax purposes.

The present tax treatment of health and accident insurance companies is complicated by the diversity in types of companies which exist. The taxation of these companies varies according to their organizational structure. The following paragraphs indicate briefly the nature of the various major types of companies, the present tax base for each, and the revisions which might be appropriate under a corporate approach.

Among the large regional or national health and accident companies, stock companies are about twice as numerous as mutual com

18 See, for example, "Statistical Abstract of the United States, 1958," Government Printing Office, p. 482.

panies. However, the stock companies in this field-unlike those in the life insurance sector-tend to be the larger companies, having roughly four times the amount of assets, capital and surplus, and investment income. These stock companies are taxed under present law almost exactly like other corporations. The tax base is approximately the net income as shown in the annual statements submitted to the State insurance commissioners and the tax rates are the usual corporate rates. This tax treatment-which has been in effect continuously since 1921-(a) demonstrates clearly the feasibility of a corporate tax approach for insurance companies, and (b) accentuates the differences between the corporate approach and that used for all life insurance companies, many of which are in direct competition with health and accident companies.

Prior to 1942, virtually all mutual nonlife insurance companies were exempt from taxation.19 Since 1942, most of these companies have computed their tax liabilities on the larger of two alternative tax bases.20 One of these alternatives is, in effect, the usual corporate rate applied to net investment income including capital gains. Hence, this alternative differs slightly from the new life insurance company tax base in that the latter includes some slight portion of underwriting income. Underwriting income is, however, an even more significant component of total income for nonlife than for life companies, due to the lower relative reserves held by the former. The other alternative tax for nonlife mutuals is equal to 1 percent of all gross income, defined to include gross investment income other than capital gains and premiums less dividends to policyholders. This alternative suffers from the weakness common to all gross income taxes that it does not take into account the differences between companies in expenses incurred in earning the gross income. It would seem equally appropriate to apply the corporate tax approach to these companies as to mutual life companies, especially since the stock nonlife companies are now paying taxes under such an approach.

Mutual interinsurers or reciprocal underwriters are one of the special types of insurance organizations. Under this arrangement, a group of persons or firms exchange contracts of insurance through the medium of an attorney-in-fact. In effect, each subscriber is committed to assist in underwriting the risk for each of the others. The liability of each subscriber is several and not joint. Any savings realized from premium payments in any year are immediately credited pro rata to the policyholders in that year and any policyholder will obtain upon leaving the group his share of the undistributed savings. None of these exchanges are incorporated. These groups are now taxed solely on the net investment income alternative to which other nonlife mutuals are subject,21 without consideration of the amount of gross income involved. Consistent with the conclusions developed earlier, this treatment would seem to be appropriate since these are purely mutual organizations. In fact, it may be somewhat embarrassing to apply corporate rates to noncorporate entities, although in this case the effect is probably insignificant.

Perpetual insurance companies are another unique case. Instead of charging annual premiums over the life of a policy, a perpetual

19 Internal Revenue Code of 1939, secs. 101 (11) and 207 (c) (3). 20 Internal Revenue Code of 1954, sec. 821(a)(1) (A) and (B). 21 But with a higher exemption level, 1954 code, sec. 821(b).

47060-59-pt. 3- -30

receives from a policyholder a single premium, or deposit, at the beginning of the term of the policy. This single deposit is designed to be sufficiently large so that the investment income from the deposit is adequate to meet all the future obligations and the expenses of the company without drawing on the original premium which is returned at the termination of the policy.

These companies are mutual in character. However, for tax purposes, they are treated in the same manner as stock nonlife insurance companies with two qualifications: the single deposit premiums are not included in gross income and dividends to policyholders are not deductible.22 Hence, in effect, perpetuals are taxed on investment income and capital gains less all expenses, including underwriting expenses. Since the deposits are never-in the pure case-used directly by the company to meet expenses and since they are fully refunded to the individual policyholders who contributed them, the present treatment seems consistent with the general principles developed earlier. Roughly the same effect and greater consistency with the general corporate approach-would be obtained by including both the premium income and the dividend deduction in the tax base.

The final and perhaps most difficult-special situation concerns the so-called factory mutuals. These companies, like the perpetuals, charge large single premiums. However, unlike the perpetuals, the single premium is not sufficiently large so that the investment income from the premium can cover all expenses of operations. Hence, a certain portion of the single premium must be absorbed over time to help defray insurance claims and operational costs. Factory mutuals are presently taxed under the same sections as mutual nonlife insurance companies generally. However, because of the relatively large investment income derived from the more sizable premiums, these companies are always taxed on the net investment income alternative. This appears to be a clearcut instance in which an inequity exists because the companies are not taxed like other corporations. As with all insurance companies, factory mutuals should have all of their income included in the tax base and then be able to deduct all business expenses, both investment costs and insurance costs. The perpetual treatment does not seem applicable since the premiums are in fact used to meet expenses. In essence, the dollars that are used have no labels.

The foregoing paragraphs indicate the type of comments which might be made about H.R. 7671 which is designed to conform the taxation of nonlife companies to that provided by the new life insurance company treatment. It seems desirable to standardize the treatment between life and nonlife insurance companies, but the same logic that supports such a standardization also pushes one to the further conclusion that there should be uniform tax treatment of all corporations, regardless of the product they sell.

22 1954 code, secs. 832 (b)(1)(C) and 832(b)(11). This general treatment is also applied to "mutual marine insurance companies" although this term has never been precisely defined and its application is vague. For an even more anomolous section in this area, see 1954 code, sec. 526.

THE TAX TREATMENT OF LIFE INSURANCE

George E. Lent1

Life insurance has long enjoyed a preferential position in the Federal tax structure. Policyholders generally have escaped direct taxes on their insurance income, and, until 1958, underwriting income of life-insurance companies had not been taxed since 1921.

Life insurance companies have traditionally been taxed only on their so-called free-investment income. This is the excess of their net-investment income over interest requirements on policyholders' reserves and other contractual liabilities. The need for a new approach to life insurance company taxation has been officially recognized since 1947, when operation of the 1942 formula completely freed the insurance business from tax. Since then it has been superseded by stopgap legislation, based on various free-investment-income formulas, pending agreement on permanent legislation. The newly enacted Life Insurance Company Income Tax Act of 1959, applicable to income of 1958 and future years, finally removed from the books the 1942 formula that has been dormant since 1949. This paper is concerned principally with the inadequacies of this so-called permanent formula.

I. THE LIFE INSURANCE COMPANY INCOME TAX ACT OF 1959

The 1959 act marks a major breakthrough in restoring a total income approach to the taxation of life insurance company income, which was abandoned in 1921. Taxable income consists of three major parts: (1) taxable investment income; (2) one-half of current underwriting gains; and (3) the other half of underwriting income when distributed to shareholders or meeting other tests. The three major steps used in computing the tax include:

Step 1: Taxable investment income

Taxable investment income includes interest, dividends, rents, and other forms of investment income (after investment expenses) less a deduction for income required to meet reserve and other policy contract obligations. This reserve deduction is based on the average rate of return earned by each company, applied to its average adjusted policy reserves; reserves are reduced 10 percent for each 1 percentage point by which the earnings rate exceeds the average interest assumed by the company in computing its reserve requirements. Additional deductions are provided of 10 percent of net investment income, to a maximum of $25,000. Fully effective in 1961, earnings on pension plans are exempt. The new law also taxes, for the first time since 1921, capital gains realized by insurance companies.

1 Visiting professor of business economics and director of research, the Amos Tuck School of Business Administration, Dartmouth College.