The underwriting profits on these various types of short-term contracts typically greatly exceed the return on the related investment. Although strongly resisted by the companies affected, the taxation of these gains has been long overdue.

Because of substantial mortality gains and favorable interest margins in recent years, the rise in value of insurance company stock has been almost without parallel. For example, between 1948 and the end of 1957, the stock prices of 19 companies included in a recent survey rose more than tenfold, with most of the gain realized prior to 1956.29

Partial taxation of underwriting gains

Although the decision to tax underwriting gains marks an important forward step, stock companies are estimated to pay only $40 million in tax on their gains in 1958. This estimated tax compares with their total gains on operations of about $450 million before the tax.30 Mutual companies are expected to have little or no taxable gains.

Two major weaknesses of the bill explain the inadequacy of the tax: (1) The fact that only half the underwriting gains are included under phase 2; and (2) the special deduction equal to 10 percent of the annual increase in reserves or 3 percent of premiums on nonparticipating policies (other than group and annuity), whichever is higher. Such amounts are required to be placed in a so-called policyholders' surplus account.

Although the Treasury advocated taxing underwriting gains, it recommended that only half be taxed currently, with tax on the balance deferred until it was actually distributed or accumulated beyond certain specified limits. According to the Treasury, the 50 percent reduction "takes account of the point on which the life insurance industry has insisted that it is difficult, if not impossible, to establish with certainty the true net income of a life insurance company on an annual basis. This uncertainty is said to reflect the long-term nature of the contracts and the resulting need to retain what may temporarily appear as income in the current year as surplus or contingency reserves." 31 Despite the skepticism with which this industry claim appears to have been accepted by both tax committees (which referred in their reports to the "alleged" and "stated" position of the industry in this respect) no attempt was made to stiffen the tax. The firm industry line was broken by only one company, whose spokesman viewed the protestations of the stock companies as "purely a selfseeking effort" that "should be rejected once and for all by your committee." 1932

The industry view conflicts with the high degree of predictability that lies at the heart of life insurance. The fundamental basis for this is well stated by Haughton Bell, vice president and general counsel of Mutual of New York: "There has been a vast amount of statistical material accumulated and tabulated on mortality and morbidity expectancy for every age, physical condition, and occupation, and on

29 The First Boston Corp., "Data on Selected Life Insurance Stocks, 1958."

30 For 1958, stock companies reported an increase in special and unassigned surplus of $255 million and dividends to stockholders of $153 million (Institute of Life Insurance, Letter of June 3, 1959). The $40 million tax liability is estimated in the Senate report on H.R. 4245. 31 Statement to Senate Finance Committee, Senate hearings, 1959, p. 24.

32 E. J. Schmuck, Acacia Mutual Life Insurance Co. House hearings, 1959, p. 247.

other demands such as for loans and cash values. In actual experience, this material has proved so reliable that it fully supports the view that unless some major catastrophe not heretofore experienced in this country should befall *** liabilities will be incurred only within very regular and predictable patterns." 33

Moreover, short-term contracts permit considerable flexibility in the adjustment of rates to changing operating costs, investment yields and mortality experience. This is particularly true of specialty insurance companies, that have been realizing such substantial profits. It is significant in this connection that profits of stock casualty-insurance companies are taxed in full. Since life insurance companies write more than 80 percent of all health and accident insurance in the United States, preferential treatment of their underwriting profits from this source would not appear to be justified.

Finally, accounting problems are not peculiar to the life insurance business. All industrial companies have similar problems of prorating expenditures over their useful life, one of the most uncertain being the timing of depreciation allowances. Such irregularities tend to be compensated for by the use of net operating loss carryovers. In this respect, loss carrybacks would be peculiarly suited to life. insurance companies.

Tax-free additions to surplus

The new act also gives stock companies a spesial deduition equal to the greater of 10 percent of their annual increase in reserves, or 3 percent of premiums on nonparticipating policies. This allowance is intended to provide a "cushion" against the fixed premium margin on nonparticipating policies, similar to the gross premium margin on participating policies of mutual companies. This provision permits stock companies to accumulate tax free in their policyholders' surplus 10 percent or more of their policy reserves. This special deduction makes it possible for many companies to escape tax on their underwriting profits.

The unusual tax savings made possible by this provision are not warranted by the nature of the life-insurance business. From a financial standpoint, probably the outstanding characteristics of the life-insurance business are the long-term nature of the business and the regularity and evenness of the flow of funds in and out of the companies. It is essentially involved with the issuance of long-term contracts; and its liabilities consist of fixed monetary obligations under these contracts that are predictable and unaffected by changes in the value of money. The policyholder has a relatively fixed commitment to pay premiums or default on his insurance policy. Funds therefore flow into the insurance company with great regularity, and expenses tend to follow broad trends rather than fluctuating widely from year to year.

In the last 50 years, there have been only two periods of abnormal demands on insurance companies: the "flu" epidemic of 1918 and the wave of policy loans and surrenders that occurred during the great depression. But even in these two periods, the inflow of funds was more than sufficient to offset the outgo. For example, in one of the

33 House hearings, 1954, p. 205.

34 House report, 1959, p. 7.

worst years, 1933, the cash receipts of 45 large companies, representing 85 percent of all assets, were approximately double their cash disbursement for that year.35 It is possible, of course, that some smaller, inadequately financed companies may find themselves in difficulties. For this reason, the new law provides a considerable measure of relief to smaller businesses.

Moreover, the mortality tables commonly used provide a built-in protection against adverse experience. The margin for protection is evidenced by the progressive reduction that has taken place in the death rate among policyholders due to rising living standards and medical advances. In the 1930's, for example, the average death rate was 7.5 per 1,000 policyholders; by the 1950's, through 1958, the average death rate declined to 6.1 per 1,000, a reduction of about 19 percent.36 Continued improvement in life expectancy should continue to improve the odds on the risks assumed by life insurance companies.

Surpluses are also essential as a protection against capital losses. Although it is impossible to judge the adequacy of company surpluses, except by the test of past experience, decisions in this area tend to be more than adequately safeguarded by great depression standards. At the end of 1957, capital and surplus for 39 mutual companies averaged 6.8 percent of assets; for 59 stock companies the average was 17.5 percent of assets; smaller stock companies averaged 23.9 percent.37 Although writedowns in the value of corporate securities averaged about 5 percent during the great depression, actual losses were in the neighborhood of only 2 percent.38 Moreover, temporary declines in the market value of securities do not affect the ability of life-insurance companies to meet their long-term liabilities. Declines in the market value of Government securities, for example, reflecting rising interest rates, are of significance only if a company is being liquidated. Yet, some companies offer as evidence of the need for large surpluses temporary writedowns which are largely of a bookkeeping nature.

The tax upon distribution

Phase 3 provides that any income distributed to stockholders in 1959 and later years out of the so-called policyholders' surplus shall be subject to income tax. This income is also taxed if it exceeds 15 percent of reserves or 50 percent of premiums, whichever is higher, provided it exceeds 25 percent of reserves at the end of 1958.

Such a tax on distributed earnings provides a powerful incentive to retain earnings. Even under present conditions, stock companies generally follow conservative dividend policies. For example, in 1957, only 4 of 21 stock companies studied distributed more than a

35 Sherwin C. Badger, "The Valuation of Assets." in Investment of Life Insurance Funds, University of Pennsylvania Press (1953). Cited by H. Bell, House hearings, 1954, p. 202. 36 "Life Insurance Fact Book, 1959," p. 58.

37 Senate hearings, 1959, p. 185. 38 See H. Bell, op. cit., p. 277. According to Bell, "On the basis of very rough calculations, therefore, if the securities reserve established by the commissioners is to absorb writedowns on defaulted issues and some others *** it would seem to require, for corporate bonds, a maximum reserve of something above 3 percent but less than 5 percent." Similar data for mortgage loans are not available.

third of their operating gains after tax, and none distributed as much as half. The average distribution was 24 percent.39

The limits established by the bill to "trigger off" the tax on undue retentions are generously high, and only in exceptional cases are they likely to be effective.

Incidence of the tax on stock companies

Stock companies have long maintained that taxation of their profits would place them at a competitive disadvantage with mutual companies. This allegation cannot be supported in practice or theory. The profits of the insurance business, as in any business, represent the excess of income over costs. Stock companies must compete with mutual companies in the net cost of their contracts to the policyholder after policy dividends. If they were not successfully competing in this respect, they would not have been able to realize the substantial gains they have earned in the past. A tax on net profits (or gains) would impinge only on the excess of revenue over policy costs, and not on the cost of insurance itself. The incidence of a tax on net underwriting gains, therefore, would be on the stockholder and not on the policyholder.

VI. EQUITY AND ECONOMIC CONSIDERATIONS.

Because of their concern that insufficient consideration had been given to its economic impact, a minority of the Ways and Means Committee seriously questioned the effect of heavy State and Federal insurance taxes on incentives to save and to provide for family security, and the industry has made repeated claims that life insurance is the most heavily taxed form of thrift in the United States. State premium taxes are estimated at $240 million for 1958, and may reach about $300 million in 1959. The combined 1959 industry taxload will thus be about $800 million.

State premium taxes were introduced early in the 19th century, principally in connection with the regulation of insurance companies. Such taxes on life, casualty, and fire insurance premiums are now an important source of State revenue, amounting to about 3 percent of their total tax receipts. They have expanded to the point where only a small fraction of the revenue is devoted to regulatory purposes, with the preponderance of receipts going into the general fund. While they apply to all insurance premiums, there is considerable variation in their application: net premiums are used in some States, group premiums in others; annuities have increasingly been exempted as a form of savings, and an offset or exemption is usually provided with respect to any State income tax otherwise applicable.*

42

By some curious reasoning, industry spokesmen hold the Federal Government responsible for taking these taxes into account in the Federal levy. One has gone so far as to propose that State premium taxes be credited against Federal income tax liabilities. This position

39 First Boston Corp., op. cit.

43

40 House Report, 1959, VI, supplemental views on H.R. 4245, pp. 87-88.

41 See, for example, statement of Claris Adams, vice president and general counsel of the American Life Convention, House hearings, 1959, p. 50.

42 H. B. Maclean, "Life Insurance" (McGraw-Hill Book Co., Inc., 1957), 8th ed., pp. 462-465.

43 See testimony of Haughton Bell, House hearings, 1955, pp. 161–164.

47060-59-pt. 3—31

is based on the contention that Congress surrendered its regulatory and taxing power when it passed Public Law 15. This law consented to continued State regulation and taxation of the insurance business, which the Supreme Court declared to be interstate commerce and within the jurisdiction of the Federal Government.45 Since the Federal Government acquiesced in continued State taxation and regulations of what was essentially interstate commerce, it is claimed that the States are entitled to preempt any Federal taxing authority otherwise applicable. According to Bell, "It follows logically that little or no Federal income tax is properly payable by this industry.'

9946

This ingenuous position is not supported by any precedent or logic based on Federal-State relations. The fact that the Federal Government relinquished this area of regulation to the States does not preclude Federal taxation of insurance companies any more than the Federal taxing power should be diminished by State taxation of business conducted wholly within a State. Although the Federal Government acceded to State taxation of insurance business which transcends State lines, clearly it did not at the same time relinquish its own power to tax the life insurance business.

It is difficult to justify State taxes on life insurance premiums other than on regulatory grounds. But it is known that the cost of regulation absorbs only a small fraction of the revenues.47 While the Federal "double taxation" would appear to intensify this penalty on prudence, the Federal levy is based on taxable income (net investment income) that escapes the premium tax. In this respect, life insurance taxation conforms to sound principles of intergovernmental fiscal relations.

It is virtually impossible to determine the effect of life insurance taxation on the demand for life insurance and personal saving through this channel. The insurance and savings elements are inseparably linked in ordinary life and other long-term, level-premium contracts. Taxation of investment income clearly increases the price, but the tax is very indirect and there is little or no awareness of its net effect by policyholders generally. It is highly unlikely that the new, higher, effective tax rate on investment income will have any discernible effect on its future growth, particularly in view of higher taxation of alternative investments.

From a strictly investment standpoint, life insurance income will continue to enjoy a very favorable tax position under the new act, in comparison with other investments. Dividends, interest on savings deposits, and private corporate and U.S. Government bonds are subject to Federal income tax rates up to 91 percent, in addition to State income taxes. Although interest on State and local securities is tax free, the investor makes an initial sacrifice in yield that greatly exceeds the life insurance tax rate. The low Federal life insurance tax rate, therefore, makes possible one of the most attractive forms of investment to middle and higher income individuals.

44 79th Cong., 1st sess. (Mar. 9, 1945). This resolution provides in part: "That the Congress hereby declares that the continued regulation and taxation by the several States of the business of life insurance is in the public interest, and that silence on the part of the Congress shall not be construed to impose any barrier to the regulation or taxation of such business by the several States."

45 Southeastern Underwriters' Association v. U.S., 322 U.S. 533 (1944).

46 House hearings, 1955, p. 185.

47 A study of the Chamber of Commerce of the United States indicated that in 1940 less than 5 percent of revenues from all types of insurance were devoted to regulatory purposes. Tax Bulletin No. 531 (October 1942).