adequate to meet the losses when they occur. For it must always be kept in mind that insurance losses are paid by the policyholders themselves and by no one else.

INSURANCE COMPANIES

The indemnity funds collected in this manner from these large groups of policyholders naturally involve the problem of administration. The business of insurance companies is the administration of these indemnity funds. The insurance companies bring together the vast numbers of policyholders generally necessary to provide a basis for spreading the risks involved. They study the statistical and other records which show the incidence and cost of the various accidents, casualties, and mortality ratios and calculate the premiums required to cover their expected cost. They provide the necessary personnel and facilities for the collection, accounting, and investigation and settlement of policyholders' claims, etc. But they do not (and that is important to bear in mind) pay the claims out of their own funds. They may at times draw on their own funds, if any, or even borrow funds, to pay claims currently, where losses temporarily may be heavier in one year than in another. But in the long run the premiums paid must cover the losses and the expenses of administration or an insurance company cannot survive.

The surplus funds which all insurance companies must accumulate and maintain are therefore merely guaranty or safety funds against errors in calculating the premium contributions of the policyholders. When these funds are drawn upon to pay claims they must be restored out of future premiums and if the premiums currently collected are inadequate they must be increased for this purpose.

TYPES OF INSURANCE COMPANIES

Three principal types of insurance companies have been developed to answer this problem of administering the insurance indemnity funds: stock insurance companies, mutual insurance companies, and reciprocal or interinsurance organizations.

(1) Stock insurance companies are business corporations organized for profit whose stockholders pay in capital and surplus funds required and who in effect agree with their policyholders, in consideration of the premiums paid, to administer the indemnity fund and to guarantee its adequacy. They engage in this business in the expectation of a profit to be realized from savings in premium funds collected from the policyholders and not required to pay losses incurred, and from the investment income from premium funds they hold pending the occurrence and liquidation of the losses insured against. Their policyholders (except in the case of participating stock companies) stand in the same position as the customers of any other business corporation from whom they purchase service.

(2) Mutual insurance companies are corporations organized not for profit but for the administration of an insurance indemnity fund of a large group of policyholders on a cooperative basis. They have no stockholders who invest the guarantee capital and surplus funds required in exchange for an opportunity of earning profits from the insurance business. They accumulate the required surplus funds by

charging, for a time, premiums greater than those necessary to meet the cost of indemnities and administrative expenses and retaining these amounts as surplus funds. In effect they "borrow" these surplus funds from their policyholders. Thereafter they operate on the basis of providing to their policyholders, who are also the owners of the company, insurance at cost or as nearly at cost as is possible of determination. This they do by either returning the unused portion of the premiums to their policyholders in the form of so-called policyholders' dividends or by discounting the premiums at the time they are paid to as nearly cost as is possible of estimation.

As a guarantee of adequacy of its funds to meet the losses incurred mutual companies, which are unable to accumulate or borrow the required surplus funds, require their policyholders to assume the liability of additional premium assessments.

Mutual insurance companies were developed in response to demand among some groups of policyholders for greater equity in calculating premiums than was used by the stock companies who operate among broader groups of policyholders. By limiting the mutual insurance companies' policyholders to certain groups subject to a lesser incidence of loss than the groups insured by the stock companies, these policyholders were able to obtain insurance at a lesser cost. In other cases mutual companies were formed in response to demand for insurance which stock companies either refused or were too slow to furnish.

Like all insurance companies, mutuals hold on hand large premium reserve funds in addition to their surplus funds. On these they earn investment income which they use to either increase their surplus funds or to reduce the premiums collected, either directly or by way of larger policyholders' dividends. Thus the premium paid by a policyholder in a mutual company as distinguished from that in a stock company (nonparticipating) is in effect a deposit and not a final premium. It is subject to adjustment (a) by refund of the savings effected, (b) retention of surplus funds which makes that part of it a loan or advance to the company, and (c) perhaps an additional assessment. Thus, except for that part of the policyholders' dividends or surplus accumulation which is a result of investment income of the mutual company all premium transactions are merely methods of adjusting the premium to the cost of insurance. For the business of mutual insurance companies is the administration of insurance funds on a cooperative basis at cost and not for profit.

(3) Reciprocals or interinsurance exchanges are unincorporated insurance organizations in which the policyholders (known as subscribers), acting through a common attorney-in-fact, separately and severally, and not jointly with any other, underwrite each other's risks. In a reciprocal each subscriber is both an insured and an insurer. He is insured by all other subscribers against whatever risks are involved, and on the other hand he insures each and every other subscriber. The extent to which each subscriber is liable to every other subscriber is set out in the power of attorney given by all subscribers to their common attorney-in-fact. It is usually limited to the amount of the premium paid and the amount of the subscribers' surplus accounts, plus an additional premium assessment where the surplus funds of the subscribers in the aggregate do not meet the minimum legal surplus requirements.

The essential difference between reciprocals and mutual insurance companies is that in mutuals the surplus funds are owned by all policyholders jointly through the corporation, while in reciprocals the surplus of the organization is the sum of the surpluses owned by the individual subcsribers. While in a mutual the surplus of the corporation is the property of the then group of policyholders, in a reciprocal the aggregate surplus may include surpluses owned by former subscribers no longer insured.

PRESENT TAXATION OF INSURANCE COMPANIES

Because of the nature of its business, insurance companies always received special consideration and were taxed under special sections of the revenue statutes dealing with the taxation of the several types of insurance companies. The revenue statutes recognized the distinction between life and other types of the insurance business as well as the difference between the various types of insurance organizations: stock, mutual, and reciprocal.

Life insurance companies, under the revenue statute enacted in 1959, in essence pay regular corporate rates on the sums of their underwriting and excess investment income available to stockholders if a stock company, or the sum of one-half of underwriting earnings and the excess investment earnings if a mutual company. It is pertinent to note that as recently as the current year Congress recognized the following facts: That life insurance companies' income is not such as to be subject to tax in its entirety as in ordinary corporations; that a distinction must be made between policyholders' and stockholders' income; and that while stockholders' income must be taxed fully, policyholders' income is taxable only partially.

Insurance companies other than life are at present taxed under methods set forth under the Revenue Act of 1942 and since reenacted without any important changes. These statutes provide for different methods of taxation of stock companies, mutual companies, and reciprocal underwriters.

Stock companies are required to pay general corporate rates and to compute their taxable income in generally the same way as ordinary business corporations, except that they may take certain deductions for expenses not allowed ordinary corporations, where methods of accounting prescribed for them by State supervisory authorities do not permit them to defer such expenses. This appears to be a fair and equitable way to tax stock insurance companies. The underwriting profits which they retain out of the policyholders' premium funds are their compensation for the management of the policyholders' funds and are clearly taxable income of a business corporation. The special provisions dealing with the deduction of certain expenses not available to other taxpayers is also a fair provision, for these companies have no control over their accounting practices which are prescribed for them by law, and it would be unfair and a hardship to require them to pay taxes on expenditures they cannot defer and include in their surpluses. It is important to keep in mind in this connection that the amount of surplus an insurance company has, determines ultimately the volume of insurance it can write.

Mutual insurance companies are not required to pay taxes on their underwriting income. Only their investment income is taxed at regular corporate rates. However, the total tax payable cannot be less than 1 percent of their gross income from both premiums and investments. This 1 percent of the gross income acts as a "floor" under the amount of tax to be paid and is in fact a minimum tax. The existing statutes thus recognize the fact that the so-called underwriting income of mutual insurance companies is not earned income or profit as contemplated by the Federal revenue statutes to be subject to taxation. Mutual companies whose gross income is less than $75,000 are exempt from tax.

Reciprocals or interinsurance organizations are required to pay taxes on their investment income only. They are granted an exemption on the first $50,000 of investment income and are taxed at the rate of 93 percent on the excess over this exemption. However, if the regular corporate rates on their entire investment income produce a lower amount of tax they pay the latter. Thus, in the case of reciprocals as well as mutuals existing statutes recognize the fact that their underwriting income is not of such nature as to be subject to tax.

SHOULD THE UNDERWRITING INCOME OF MUTUALS AND RECIPROCALS BE

TAXED

Because insurance companies are singled out for special treatment in the revenue statutes, the question is raised from time to time as to why it should be so and why all insurance companies should not pay on the same basis as any other business corporations. To many groups of taxpayers not familiar with the principles of the insurance business, this special treatment of insurance companies seems unfair and appears to be one of the loopholes in the revenue statutes which should be closed. To the stock insurance companies, who are in competition with the mutuals and reciprocals, it also frequently appears unfair to see their competitors relieved from taxation on their underwriting income while they themselves are not. Some of them, even though they do understand the nature of the problem, feel that for competitive reasons all types of companies should be taxed alike and that either the stock companies should be relieved from taxes on their underwriting income or the mutuals and reciprocals be made subject to tax on theirs. To answer these queries clearly, it is first necessary to define the term "underwriting income." This term is used quite loosely in the insurance business as well as by the general public. Underwriting income is the difference between the premiums earned by an insurance company in any given year or period and the cost of losses and expenses incurred during the period. This difference may be a gain or it may be a loss depending on whether the premiums earned are greater than the losses and expenses incurred or the reverse. In the light of the earlier discussion of principles of insurance, this underwriting income is the measure of the adequacy or inadequacy of the premiums charged to maintain the policyholders' indemnity fund. In a stock company, where the premium is final and this fund is guaranteed by the stockholders, the income is obviously a profit to these stockholders and is therefore subject to tax. If it is a loss it is a deductible loss from

investment income or on a carryover basis. To a mutual it is a measure of the adjustment required in their rate structure to be either returned in dividends to policyholders or retained for surplus as "borrowings" or additional investment by the policyholders as a group, if a gain, or made good out of future premiums, if a loss.

To a reciprocal it is also a measure of the adjustment required in its rate structure, except that here the accounting for the difference is not with the policyholders as a group, but with each subscriber individually. The gains or the losses are due or are chargeable pro rata, or as agreed in the power of attorney, to each subscriber's account. And whatever amount the reciprocal as a group may decide to retain as "borrowings" or as additional investment for surplus funds, must be credited in the same manner to each subscriber's account. Clearly taxing such "underwriting income" of mutuals or reciprocals would be contrary to the very objective of the revenue statutes of taxing only income or profits earned. As previously brought out, the "underwriting income" of mutuals and reciprocals is only a measure of adjustment of its premiums to a cost basis, and is a loan or investment when retained for surplus funds. To tax it would be equivalent to taxing capital transactions, such as borrowings and paid-in surplus in stock companies.

It has been said that failure to tax the underwriting income of mutuals and reciprocals leads to the accumulation by them of untaxed surpluses not owned by the individuals who originally contributed thein. In the mutuals they are owned by the corporation and therefore it is said they should be taxed. By the same token the surplus paid in to a business corporation by individuals no longer stockholders also belongs to the corporation but no one would ever raise the issue of taxing such funds. In the reciprocals, of course, the surplus belongs to the individual subscribers and taxing such surpluses would be equivalent to taxing capital. The surpluses still standing to the credit of subscribers no longer active are no different from active balances from the standpoint of taxability; they are capital and not income. For those cases of mutuals and reciprocals where surpluses might be accumulated beyond reasonable requirements an amendment to the appropriate sections of the revenue statutes preventing such unreasonable accumulation may be in order.

SHOULD THE INVESTMENT INCOME OF MUTUALS AND RECIPROCALS BE TAXED

The answer to this question is quite clear: It should be and it is. The cooperative venture of the members of a mutual insurance company, or the subscribers of a reciprocal, is for the purpose of obtaining insurance at cost. Investment of premium reserves and surplus funds is a collateral activity entered into for a gain and is therefore taxable. Since it would not be practical to tax such gains individually by tracing them to each member of a mutual or subscriber of a reciprocal, it should, and it is, taxed to the group as a whole and reaches the individuals by way of reduced policyholders' dividends.