law. Even when enacted that law was the subject of doubts and divided opinion. Certainly by today it is a sufficiently mature taxing measure to offer scope for fair criticism of both its theory and its practical impact. For these reasons, as well as the more personal one of doubt about the value of any comment I could offer on the new life insurance company tax measure, I shall limit my discussion to the taxation of casualty insurers.

2

PRESENT LAW

For the past 16 years, the Federal income tax payable by casualty insurers has been determined on one basis for stock companies and on a quite different basis for mutual companies. Before examining these differing tax treatments, it should be noted that this distinction of taxing method is not found in the tax treatment of life insurance companies; the stock and mutual life insurers are taxed in the same fashion.3

Stock casualty insurers are taxed in essentially the same manner as ordinary commercial corporations, and this tax treatment has been in effect since long prior to 1942. Mutual companies, on the other hand, were left free of Federal income taxes until the adoption of the Revenue Act of 1942, and since 1942 they have been taxable under a special formula.

7

The tax base of a stock casualty company is not materially different in scope from that of a noninsurance corporation. That tax base includes both net investment income and net underwriting income," and it is subjected to ordinary corporate tax rates. By contrast, a mutual casualty insurance company is taxed at regular corporate rates on a tax base which includes only its net investment income. However, the tax payable by a mutual may not be less than 1 percent of the sum of its net premiums and gross investment income. The "net premiums" portion of the base for this 1-percent alternative tax means gross premiums earned less only dividends to policyholders."

8

There is a third but relatively minor group of casualty insurers, the reciprocal companies, which were also free of tax prior to 1942. From 1942 to the present, the reciprocal companies have paid regular corporate rates on net investment income only-without regard to the 1-percent gross income tax "floor" just noted for the mutual companies.10

Since becoming subject to Federal income taxation, in 1942, the experience of the mutual companies has been such that ordinary cor

The presently effective provisions of law were adopted in the Revenue Act of 1942, and now appear as Internal Revenue Code of 1954, secs. 821-823, 831-832.

3 This sameness of tax treatment of the two types of life insurers also pertained under the various formulas in effect prior to adoption of the Life Insurance Company Income Tax Act of 1959.

4 The statutory definition of the tax base of a stock casualty insurer is a lengthy one, but in its essence the tax base of "insurance company taxable income" is developed consistent with accrual principles familiar from noninsurance fields.

5 Including net capital gains.

Consisting of premiums earned less the sum of losses and underwriting expenses

incurred.

7 Internal Revenue Code of 1954, sec. 831.

8 Internal Revenue Code of 1954, sec. 821.

Dividends to policyholders of a mutual company are recognized as merely a reduction in the effective premium charge to current policyholders (Internal Revenue Code of 1954, sec. 821 (a) (2)). This "net premiums" measure is also sometimes referred to as "gross underwriting income," but by either label reference is made to premium vield reduced by dividends to policyholders, but not reduced by losses or underwriting expenses.

10 The reciprocal companies are given only passing attention here, as they account for scarcely 3 percent of the fire and casualty insurance written in recent years.

porate rates on net investment income would usually produce a tax of less than 1 percent of the sum of net premiums plus gross investment income. As a consequence, it has normally been the 1-percentof-gross "floor" provision which has measured the actual tax burden of the mutual companies. This has resulted from the large increase in net premiums of the mutuals, rather than from a decline in their investment net.

IMPACT OF PRESENT LAW

It is obvious that there can be only an accidental relation between the burden of a gross income tax and that of a net income tax. In a year of heavy incidence of covered casualties and high jury verdicts, an insurer may have an overall net loss, even though its investment yield has increased. In such a case even the smallest tax on gross income obviously imposes a greater burden than any rate of tax on net income. However, over the years since 1942 a sufficient experience has been acquired to show that the mutual casualty companies as a group have borne a noticeably lighter Federal income tax burden than have the stock casualty companies. For the period 1943 through 1957 the results of the two differing tax treatments may be illustrated in a short table: 11

The difference in tax burden indicated by this comparison of effective tax rates is more than large enough to assure discontent on the part of some stock insurers. But at the same time, the mutual companies have expressed dissatisfaction with the hardships which can arise from the 1 percent of gross "floor" in their tax burden. Taking into account both the discrimination of a higher tax burden on the stock companies, and the punishment which may arise (and has some times arisen) from the 1-percent gross income levy on the mutuals, it is hard to reach any conclusion other than that the existing law as to taxation of casualty insurers is greatly in need of change.

When examining the points at which criticism of the existing law may fairly be levied, it should be kept in mind that every casualty insurer has two sources of income: Premium yield (often termed "underwriting income") and the yield from investment of retained capital, surplus, and reserves. It is apparent that a net income tax upon a base including both types of income effects an automatic offset of net loss in one division against net income in the other. Thus, regardless of which source accounts for a positive net income figure for the year, companies with like net incomes will bear like tax burdens.

The statistics here, and those appearing elsewhere in this paper, were taken from published tabulations of the National Committee for Insurance Taxation. The data appear, with the auditor's letter of certification, in booklets submitted to the Committee on Ways and Means and reproduced in part in "Hearings on General Revenue Revision, House Committee on Ways and Means," 85th Cong., 2d sess., pt. 1, at pp. 804-808 (1958). [Cited hereafter as 1958 hearings.]

By contrast, for a given company taxed according to the existing mutual formula, the flat 1-percent tax on gross income may accidentally approximate in amount a net income tax at regular corporate rates on net income from both divisions, but another company with lower underwriting losses and expenses will bear a disproportionately low income tax burden even though it has the same net premium and gross investment income.

The comment above is merely one illustration of the fact that a true net income tax, on a tax base including both types of income, has appealing operating advantages. There is no tax payable for a year of overall loss, and there is an automatic offset of any underwriting loss against investment gain in years of overall profit. In addition, where there is a unitary tax base the benefits of the net operating loss carry back and carryover become available.

The present tax formula for mutual insurers has neither of these economically sensible attributes. Today a mutual insurer is taxed upon its net investment income even in a year when it suffers a net underwriting loss in excess of its investment net. Further, the mutual company will probably pay the 1-percent-of-gross alternative tax, so that even in such a year of overall loss its effective tax burden will be greater than a regular corporate rate tax on its net investment income. To compound the injury, in a year of heavy underwriting losses the dividends paid to policyholders by a mutual company may have to be reduced, thus increasing the net-premium portion of the tax base for the 1-percent gross income tax alternative despite the fact that gross premium writings showed no increase. There will thus result what I believe may fairly be termed an economic idiocy: In a year of overall loss, the mutual insurer's income tax burden will not decline from that borne in a prior profit year, but may actually increase both proportionately and absolutely.12

At the same time, there can be no doubt the existing dual-tax-base system places a heavier proportionate tax burden upon the stock companies. For this reason, there have been numerous proposals made to the Congress for removal of the distinction in tax treatment between the two types of companies. Spokesmen of the mutual insurers, however, have opposed changes in the existing law despite the structural disadvantages and economic threat it holds for mutual companies. The growth and general prosperity of the mutual companies have calmed their fears of paying a tax on gross income even in a year of overall net loss, and have thus allowed them to defend the existing system with devoted vigor.13 On the other hand, spokesmen for stock companies have been no less enthusiastic in expressing desires to have the stock companies and mutual companies taxed alike.

PHILOSOPHY BEHIND PROPOSALS FOR CHANGING THE TAX BASE

Before examining the major point of various proposals for equalizing the taxation of casualty insurers, it should be noted that they all

13 A recent example of this extreme consequence of the present mutual_taxation formula may be found in the experience of the State Farm Mutual Automobile Insurance Co. for the year 1956. In that year State Farm had net investment income of $9,076,000, but also had an underwriting loss of $10,322,000, so that for the year the company had a net loss of $1,246,000. Despite this loss, State Farm had a Federal income-tax burden for 1956 of $2,789,000. This was 19.4 percent above State Farm's Federal income taxes for the immediately preceding year when the company enjoyed a net income of more than $22,500,000.

13 See, for example, the statement of Mr. John J. Wicker, Jr., counsel for the Mutual Insurance Committee on Federal Taxation, 1958 hearings, pt. 3, at pp. 3278-3291.

have one thing in common: the tax base is defined to include net income from underwriting, as well as from investments. It is at exactly this point that the spokesmen for the mutual companies have in the past pressed their attack against any proposal for change.

The mutual insurers argue that a mutual company can have no net income from underwriting. They insist that all underwriting receipts, above underwriting losses and expenses, are the property of the policyholders, whether repaid as dividends to policyholders or retained in the company indefinitely. The mutual spokesmen maintain that the purpose behind creation of reserves and surplus should be controlling, and the avowed purpose of a mutual company in retaining a part of its net underwriting yield is not to mature a profit for anyone, but to build protection for the mutuals' policy members.

It seems largely agreed that a mutual's dividends paid to its policyholders may be but a return of a portion of the premiums paid, without income consequence to the company from its temporary possession of the sums so returned. The mutual insurers further insist, however, that surplus and reserves derived from underwriting yield (i.e., the unreturned part of net underwriting income) are of the same character and entitled to the same treatment as the portion of underwriting yield actually returned to the policyholders. This view of the mutuals has been presented to the Congress on a number of occasions, perhaps most recently by the Mutual Insurance Committee on Federal Taxation.1 The opposing view has also been frequently presented to the Congress. At least as early as 1942, the Committee on Ways and Means was persuaded that a mutual company may, indeed, realize a net income on the underwriting side.15 While the measure adopted by the House of Representatives in 1942 did not survive the Senate Finance Committee, which adopted instead the provisions which remain as present law, there has been no shortage of recurring suggestions to the Congress that mutual insurers can derive income other than from investments. H.R. 7671 and 7672, introduced in June of this year, are but the most recent of such proposals.

In discussing the tax base for mutual insurers, therefore, it may well be that the threshold question concerns the mutual's rights to retain tax free their undistributed net from underwriting. The conceptual problem here, if there is a problem, is to decide whether or not retained surplus and reserve of a mutual company should be recognized as the property of the company or, on the contrary, should be recognized as remaining the property of the policyholders.

14 "A stock company has three entities: company, policyholders, and stockholders. The stockholders organize and own and operate the company primarily for the purpose of making profit for their stockholders while affording insurance protection for their policyholders. The surplus of a stock company belongs to the stockholders and can, within limits, be paid to them as dividends.

"But a mutual company has only two entities: the company itself and its policyholder members. There is no other interest to which a part of the company's surplus may be diverted. The policyholder members and the company are, to all intents and purposes, one and the same. This is a fundamental difference and affects the disposition that may be made of surplus.

"In a mutual company, only the policyholder has a beneficial interest in the surplus and the surplus serves only as a protective fund for him. A policyholder's dividend is the return to the policyholder, out of surplus, of the unused and unneeded portion of his own money." 1958 hearings, pt. 3 at 3280.

In

"Obviously, as you all know, income taxation is not based on volume of business. the case of profitmaking companies, it is based on what you have got left, net profits. In the case of nonprofit companies owned by the policyholders instead of outside ownership, its basis should be on the only earnings that they make; namely, investment income.' 1958 hearings, pt. 3, at 3290.

15 See the quoted portions of the 1942 report of the Committee on Ways and Means, infra, at note 22.

In practice, the surplus and reserves of a mutual insurer are retained indefinitely. In the unlikely event of collapse or liquidation of a mutual company on some distant tomorrow, the surplus and reserves then on hand would go to benefit that tomorrow's members, rather than today's. When a policyholder departs his mutual company he takes with him not even a contingent claim to any part of the company's retained portion of underwriting yield or investment yield.

The present tax freedom of a mutual's retained underwriting profits rests upon nothing more nor less substantial than the mutual policyholder's "interest," as an owner, in his company's surplus and reserves. But this interest, if it may be so called, has no measurable value and by all other tests is also purely ephemeral. That "interest" cannot be realized, short of liquidation of the company, and even then a changed membership is virtually certain to have altered the cast of those benefits. It cannot be transferred by the policyholder while he remains a member of a mutual, nor can it be pledged, bequeathed, donated, or otherwise reduced to any form of use of possession by him. Finally, it does not survive the policyholder's death nor the termination of his membership in the mutual for any other reason.

It is true, of course, that the surplus and reserves of a mutual company serve as security to the policyholder in his role as an insured; but, this is equally true of the surplus and reserves of a stock company and the holders of the stock company's policies of insurance.

In conclusion, then, it is more than difficult to understand how a mutual policyholder can be said to possess such an interest in his company's surplus or reserves as to constitute him the owner of those funds, rather than such ownership being in the company itself. Even if some sort of "property interest" by the policyholder could be detected, it is scarcely the sort of interest upon which important Federal tax consequences should depend.

THE UNIQUE CHARACTER OF A MUTUAL

While it should be recognized that a mutual company may derive a net income from its underwriting activities, as well as from its ownership of investments, it is nonetheless true that a mutual company is an entity having no proprietors other than its policyholdermembers of the moment. As spokesmen for the mutual companies have put it, with a stock company there are three entities (company, policyholders, and stockholders), but with a mutual company there are only two entities (company and policyholder-members). This difference in character is not to be ignored. Indeed, as with the similar farmer's cooperatives, and the quite dissimilar ordinary business partnership, it would seem that there is no occasion to tax the same dollar of income first to the company and then to any proprietor of the company to whom that income may be distributed. This understanding was evidenced in 1951 when the Congress amended the tax treatment of the so-called exempt farmer's cooperatives.16 The 1951 Revenue Act subjected to tax all net income of the cooperatives not distributed or definitely allocated to their current members. The Senate Finance

16 Internal Revenue Code of 1939, secs. 101 (12), 148, as amended, ch. 521, 65 Stat. 491 (1951).