Taxation of Life Insurance Companies

Taxation of Life Insurance Companies

Order Code RL32180
CRS Report for Congress
Received through the CRS Web
Taxation of Life Insurance Companies
December 24, 2003
name redacted
Consultant
Government and Finance
Congressional Research Service ˜ The Library of Congress

Taxation of Life Insurance Companies
Summary
Life insurance companies determine their federal income tax liability using a set
of Internal Revenue Code provisions that apply only to those companies. This report
provides an overview of these tax provisions.
Life insurance companies sell financial contracts that contain two common
features. First, these contracts generally provide protection against uncertain
financial risks that relate to the timing of the death of insured individuals. Second,
they incorporate a broad variety of financial investment arrangements. Most of the
difficult issues that arise concerning the taxation of life insurance companies relate
to these two economic components of life insurance arrangements. This report
contains a very brief overview of these business activities of life insurance
companies.
The report then provides a brief history of the federal income tax treatment of
life insurance companies. Prior to 1984, when Congress enacted the current tax
provisions, life insurance companies were taxed in a manner that reflected two major
policy decisions. First, a significant component of life insurance company profits
was untaxed. Second, Congress sought to achieve an “acceptable” balance between
the tax burden borne by life insurance companies owned by their shareholders and
the mutual life insurance companies that were owned by their policyholders. These
provisions of prior law led Congress to enact Internal Revenue Code Sections 809
and 815, which have attracted legislative attention in recent years, which are
discussed in this report.
Next, the current tax provisions applicable to life insurance companies,
including an overview of the general approach to taxation, are examined. In general,
life insurance companies include all of their receipts in income and may deduct their
general business expenses. In addition, specialized provisions that apply to insurance
companies make certain that these companies are not overtaxed as compared to other
financial intermediaries. These specialized provisions are discussed, specifically:
(1) the special deductions for “small” life insurance companies that effectively
reduce the tax rate applicable to these companies from 35% to 14%;
(2) the limitation enacted to prevent life insurance companies from deducting
inappropriate expenses that are attributable to generating tax-exempt
income;
(3) the complex provisions that govern the deductions allowed with respect to
a life insurance company’s reserve liabilities; and
(4) the limitation on the amount of policyholder dividends that mutual life
insurance companies are allowed to deduct.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
The Business of Life Insurance Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Life Insurance Company Products and Premiums . . . . . . . . . . . . . . . . . . . . . 2
Life Insurance Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Annuity and Pension Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Common Features of Life Insurance and Annuity Arrangements . . . . . 3
State Regulation and Reserve Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Life Insurance Company as Financial Intermediary . . . . . . . . . . . . . . . . 4
Brief History of Taxation of Life Insurance Companies . . . . . . . . . . . . . . . . . . . . 5
Taxation Prior to the Life Insurance Company Tax Act of 1959 . . . . . . . . . 5
Taxation Under the Life Insurance Company Income Tax Act of 1959 . . . . 6
Overview of Current Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Analysis of Current Law: Major Structural Issues in Taxation of Life
Insurance Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Effective Tax Rate Reduction for Small Life Insurance Companies . . . . . . . 9
Costs Incurred to Produce Tax-Preferred Forms of Income . . . . . . . . . . . . 10
Treatment of Life Insurance Reserve Liabilities . . . . . . . . . . . . . . . . . . . . . 11
Deduction of Policyholder Dividends and the Special Treatment of
Mutual Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Significant Current Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Repeal IRC Section 809 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Forgive Deferred Section 815 Amounts . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Deferred Section 815 Amounts Under the 1959 Act . . . . . . . . . . . . . . 17
1984 Act Treatment of Previous Additions to Policyholders
Surplus Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Taxation of Life Insurance Companies
Introduction
Life insurance companies are generally taxed at the same rates that apply to
other business corporations. Life insurance companies compute their taxable income,
however, under a set of Internal Revenue Code (IRC) provisions that apply only to
life insurance companies. These provisions reflect several distinct policy and
political concerns.
First, life insurance companies sell life insurance, annuity and pension contracts.
These arrangements combine two elements not frequently bundled together in other
financial instruments. Frequently, life insurance products protect their customers
from the risk of financial loss arising from uncertain events. For example, life
insurance may provide financial resources to substitute for the earnings following an
insured individual’s death. Similarly, an annuity may provide financial payments that
will continue until the death of an annuitant or a pension plan beneficiary. The
contingent obligation to pay benefits is one distinguishing characteristic of life
insurance and annuity contracts.
Second, many life insurance products require premium payments that occur
years before the life insurance company makes the corresponding payments of
benefits to beneficiaries. In these circumstances, special tax rules are needed to
calculate the insurance company’s income for any taxable year.
Third, for many years the life insurance industry was characterized by the
presence of two sizable “camps” within the industry: large customer-owned “mutual”
companies and the more numerous investor-owned “stock” companies. Over the
years, Congress has enacted special tax provisions that reflect this division. One of
these provisions remains in effect even though few large life insurance companies
now operate as mutual organizations.
Fourth, Congress has historically designed the tax provisions that affect life
insurance companies with the goal of generating predetermined levels of tax revenue.
To achieve this goal, it has enacted special tax provisions that affect only life
insurance companies.
This paper1 provides an overview of the most significant tax provisions that
apply only to life insurance companies. In addition, it examines Internal Revenue
Code Sections 809 and 815, which have attracted legislative attention in recent years.
1 This report was produced under the supervision of (name redacted).

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The Business of Life Insurance Companies
Life insurance arrangements typically combine two distinct economic
components: a pure insurance component and a savings component. When a
policyholder pays a premium to a life insurance company, a portion of the premium
pays for pure insurance protection. Another portion of the premium can be viewed
as an investment in a financial instrument, similar to a bank deposit or a purchase of
mutual fund shares.
Most of the difficult issues that arise concerning the taxation of life insurance
companies relate to these two economic components of life insurance arrangements.
Before discussing the tax issues, this section presents a brief overview of the risk
protection and financial intermediation activities of life insurance companies.
Life Insurance Company Products and Premiums
The life insurance industry sells a range of insurance products that generally
involve a contingency that relates to mortality, i.e., the timing of the death of an
individual. For example, life insurance companies sell:
! life insurance products, in which payments are made to the
beneficiaries of a life insurance contract following the death of the
insured; and
! annuity and pension products, in which payments are made to an
annuitant (or retiree) for the remainder of his or her life.
Within these broad outlines, the life insurance industry sells a wide variety of specific
products.
Life Insurance Products.2 One common form of life insurance is term life
insurance. As with all forms of life insurance, the insurance company pays the
specified death benefit if the insured dies during the period of coverage. If the
insured remains alive at the end of the policy term, the owner of the policy (and the
designated beneficiaries) has no further economic claims against the life insurance
company. A term life insurance arrangement primarily involves pure insurance
protection, with little or no savings.
Another form of life insurance is “cash value life insurance.” The distinguishing
feature of cash value life insurance is the presence of the contract’s cash value, which
is the amount that the policy owner receives if she terminates the policy. The
accumulation of cash value reflects the existence of a savings feature in this form of
insurance. The savings component is much more significant in cash value life
insurance than in term insurance. Variations on the basic cash value life insurance
design include “Universal” life insurance, “Variable” life insurance, single premium
life insurance and “second-to-die” life insurance. In addition, “Key Person” Life
2 A more detailed analysis of life insurance products is contained in CRS Report RL32000,
Taxation of Life Insurance Products: Background and Issues, by (name redacted).

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Insurance, Corporate Owned Life Insurance (“COLI”) and Split Dollar Life insurance
incorporate cash value life insurance into other financial arrangements.
Annuity and Pension Products. Life insurance companies sell a wide
variety of savings vehicles that are used to provide post-retirement sources of
income. For example, a life insurance company may issue annuity contracts in
connection with an employer’s pension plan. In these annuity arrangements, an
employer makes a series of premium payments during the working years of its
employees. The life insurance company invests these funds and agrees to pay a
pension benefit following the employees’ retirement. This type of arrangement is
primarily an investment vehicle. However, annuity payments generally continue until
the beneficiary’s death. Because the number of payments depends on the timing of
the beneficiary’s death, however, there is also an insurance element in these
arrangements.
Life insurance companies sell a wide variety of other savings vehicles. Some
of these are sold to individuals, including deferred annuities and individual retirement
annuities. In these arrangements, individuals pay premiums to the life insurance
company. The life insurance company credits a return on the invested funds.
Depending on the contractual terms of the annuity, the return may be a fixed rate of
interest or a variable return based upon the performance of specified assets. These
arrangements are primarily savings vehicles that are quite similar to certificates of
deposit issued by banks and mutual fund shares issued by mutual funds. In an
annuity arrangement, however, the policyholder has the right (but not the obligation)
to receive repayment in the form of a series of payments that continues for the
remainder of the beneficiary’s life.
Common Features of Life Insurance and Annuity Arrangements. In
these types of contracts, the life insurance company receives one or more premium
payments as consideration for its assuming its obligations to make benefit payments.
For some insurance products, the life insurance company will receive the premium
payment and will pay all benefits under the contract in the same year. More
frequently, however, the life insurance company receives the premium payment in
one (or more) years, and will pay the benefits under the contracts in subsequent years.
In many instances, the premium charged with respect to a life insurance
contract, an annuity or a pension plan exceeds the amount that the insurance company
is expected to pay out in benefits with respect to that contract during the current year.
Because the life insurance company may become obligated to make benefit payments
in future years, the premium charged will reflect the following amounts:
! the amount that the life insurance company estimates that it will pay
out in the current year;
! the amount that the life insurance company estimates will be
sufficient (in combination with future premium payments and
interest) to pay out benefits in connection with the contract in future
years; and

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! the amount that will be used to pay the life insurance company’s
operating expenses and a profit.
State Regulation and Reserve Liabilities
Each life insurance company is subject to regulation by the state insurance
regulators in the states in which the company conducts business. The primary
concern of the state regulators is to ensure that the life insurance company remains
solvent (in an actuarial sense). The goal of this solvency requirement is to make
certain that the life insurance company will have sufficient assets to pay insurance
benefits when they become due. In demonstrating its solvency, the life insurance
company files an annual statement reporting its assets and its “reserve liabilities.”
In general terms, these “reserve liabilities” represent a mathematical estimate of the
present value of the company’s future liabilities. The life insurance company’s
actuaries compute the reserve liabilities taking into account the following factors:
! the actuarial likelihood that benefit payments will become payable
in any given year;
! the future premium payments specified in the insurance contracts;
and
! the interest that the life insurance company will set aside in future
years (at an assumed rate).
A more detailed discussion of reserve liabilities, and a simple illustration of the
computation of reserve liabilities, are on page 11.
The Life Insurance Company as Financial Intermediary
As previously discussed, many life insurance products incorporate a significant
savings component. In these arrangements, the life insurance company receives
premium payments, a portion of which is invested to benefit the policyholders (or
their beneficiaries). In later years, the company uses the invested amounts, together
with interest credited thereto, to pay the insurance benefits to the beneficiaries of the
insurance contracts. This investment of the policyholders’ funds to provide a future
economic benefit for the beneficiaries is a form of financial intermediation. For this
reason, a life insurance company operates as a financial intermediary.
Other financial intermediaries, such as banks and mutual funds, also receive
funds from their customers. These financial intermediaries invest the funds, and
credit an investment return — interest in the case of banks and changes in the asset
values of the mutual funds — to the accounts of the customers. In calculating the
annual income of these financial intermediaries, the amounts that customers pay to
the financial intermediary as an investment is not treated as income. Rather, the bank
treats these amounts as non-taxable deposits, and the mutual funds treat these
amounts as non-taxable capital contributions. Similarly, the bank (and the mutual
fund) may deduct the interest (or other investment return) allocated to its depositors
(or the owners of the mutual fund shares).

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For purposes of reporting a life insurance company’s annual income for state
regulatory purposes and for income tax purposes, it is necessary to reflect the
company’s operations as a financial intermediary. Unfortunately, two factors make
this analysis more difficult in the case of the life insurance company. First, the
insurance premium may not separate the portion that is to be invested for the benefit
of each policyholder. Second, the liabilities owed to the beneficiaries are contingent
— the amount and timing of the benefit payments depend upon the occurrence and
timing of future events. These issues are discussed below in connection with the tax
treatment of the insurance reserve liabilities.
Brief History of Taxation of
Life Insurance Companies
Taxation Prior to the Life Insurance Company Tax Act of 1959
At the outset of the federal corporate income tax, life insurance companies were
taxed according to the same statutory provisions as other corporations. Beginning
with the Revenue Act of 1921, however, Congress has taxed life insurance
companies under of rules that differ from those applicable to normal business
corporations.
From 1921 through 1957, life insurance companies were taxed utilizing the
“free investment income” approach. Under this method, a life insurance company
was taxed only on the portion of its profit attributable to its investment activities.
Cash value life insurance, annuities and pension plan contributions represent, in
whole or in part, a financial investment. The premiums paid with respect to these
types of contracts include an amount that is invested for the benefit of the
policyholder or pension plan beneficiary. The life insurance company invests these
funds and, in effect, credits an investment return to the policyholders.
In calculating its free investment income, a life insurance company started with
its net income from its investment activities. From this amount, the life insurance
company subtracted the portion of this net investment income that was deemed to be
allocable to the company’s obligations to its policyholders. The remainder of the
company’s net investment income was “free” of any obligation towards the
company’s policyholders and was, therefore, subject to income taxation. During the
period from 1921 through 1957, Congress used a number of different formulas to
determine the amount of investment income that was deemed to be allocable to the
company’s policyholders and, thus, deductible in computing the life insurance
company’s taxable income.
In enacting this method of taxation, Congress avoided some of the difficult
issues inherent in taxing life insurance companies. Specifically, taxing life insurance
companies on their free investment income made it unnecessary to decide the extent
to which premiums received represented taxable income and whether life insurance
companies should be allowed an offsetting deduction for the life insurance
company’s reserve liabilities.

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Moreover, a life insurance company may earn “underwriting profits.”
Underwriting profit results if the amounts that a company charges policyholders for
protection against insurance risks exceed the corresponding benefits paid to the
beneficiaries. For example, a life insurance company that sells term insurance may
collect $5 million in premiums for these contracts. If the company pays $3 million
as benefits and expenses with respect to these contracts, the life insurance company
has a $2 million underwriting profit. During the period in which life insurance
companies were taxed on their free investment income, underwriting profits were not
taxed.
Taxation Under the Life Insurance Company
Income Tax Act of 1959
In the years prior to the enactment of the Life Insurance Company Income Tax
Act of 1959 (the “1959 Act”)3, developments in the life insurance industry made it
necessary to abandon the free investment income approach to taxing life insurance
companies. These changes included:
! the growth of the stock life insurance companies relative to the
mutual life insurance companies; and
! the substantial increases in the amounts of term life insurance and
credit life insurance sold. These life insurance products generated
substantial underwriting profits, but relatively small amounts of
premium and investment income.
The 1959 Act sought to respond to these developments by enacting the so-called
three-phase system of taxation.4 Under this extraordinarily complex system, each life
insurance company had to determine its “taxable investment income” (which
roughly corresponded to the “free investment income” tax base used prior to 1958)
and its “gain from operations” (which roughly corresponded to the life insurance
company’s total profits).
Although the details of this three-phase system are beyond the scope of this
paper, the following significant features are worth noting:
3 P.L. 86-69, 73 Stat. 112. Although enacted in 1959, the statutory provisions enacted in
the Life Insurance Company Income Tax Act of 1959 were made retroactive to the
beginning of 1958.
4 The extraordinarily complex statutory rules enacted in the 1959 Act will not be discussed
in detail in this paper. In analyzing a tax dispute arising under the 1959 Act, Judge Fletcher
of the Court of Claims wrote that “[t]hese complex and obscure provisions bear all of the
earmarks of a conspiracy in restraint of understanding.” Lincoln National Life Insurance
Company v. U.S., 582 F.2d 579, 583 (Ct. Cl. 1978).

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! Congress sought to collect a predetermined level of income tax
revenue from the life insurance industry.
! An “appropriate” portion of this tax revenue would be collected
from each of the two segments of the life insurance industry — the
stock segment and the mutual segment.
! Most mutual life insurance companies would continue to be taxed on
their share of the company’s investment income, with an appropriate
limit on the amount of policyholder dividends that a mutual
company could deduct. In technical terms, they were taxed on their
Phase I income.
! The tax liability of most stock life insurance companies would be
based upon their “gain from operations.” This was the Phase II tax
base. These companies were allowed to deduct certain non-
economic “special deductions” and were allowed to defer the
taxation of 50% of the remaining underwriting income.
! If a life insurance company deducted any special deductions, or had
underwriting income that was not taxed in full, these amounts were
added to the company’s “policyholders surplus account.” These
deductions were designed to provide a financial cushion to be used
in the event that the company experienced significant underwriting
losses in future years. If, however, the company distributed these
funds to its shareholders, or if it ceased to be a life insurance
company, the previously untaxed amounts were included in the life
insurance company’s taxable income. When these amounts were
included in income, they were referred to as the Phase III amounts.
Overview of Current Taxation
In 1984, Congress overhauled the federal income tax treatment of life insurance
companies. The fundamental goal of this overhaul was to establish a single scheme
for taxing all life insurance companies and to eliminate the three-phase method of
taxation. Although life insurance companies continue to compute their taxable
income under a set of Internal Revenue Code provisions that apply only to life
insurance companies, they are taxed in a manner comparable to other businesses
operating in corporate form. Certain differences tend to reduce the effective tax
burden imposed on life insurance companies as compared to other corporations.
As with other business corporations, a life insurance company includes all of its
receipts in its income, including all premiums received and all of its investment
income. In computing its taxable income, the company is allowed to deduct its
general business deductions, which include the range of ordinary and necessary
business expenses that all business corporations may deduct. Consequently, a life
insurance company may deduct such routine expenses as salaries, rents, utilities,
advertising costs and other normal operating expenses. The company may also

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deduct all benefits accrued with respect to its insurance contracts during the taxable
year.
Special provisions of the tax law are designed so that the tax burden of life
insurance is not excessive compared to the taxation of other financial intermediaries.
Specifically, amounts that customers pay to a life insurance company as an
investment are not taxed. This is accomplished in a two-step manner that is unique
to the taxation of insurance companies. First, a company must include in income the
full amount of premiums that the policyholder pays. Second, a company is allowed
to deduct any net additions to its life insurance reserves. The reserve liabilities
generally reflect the investment component of the contractual arrangements.
Similarly, the increase in reserves also reflects the amount of interest that the life
insurance credits with respect to the policyholders’ investments.
Analysis of Current Law:
Major Structural Issues in Taxation
of Life Insurance Companies
Although life insurance companies generally are taxed in a manner comparable
to other business corporations, the taxation of life insurance companies deviates from
the general corporate tax principles in four significant respects. When Congress
created the current system for taxing life insurance companies in 1984, it made the
following major policy decisions:

! The taxable income of life insurance companies would be based
upon their total economic profit. Congress decided, however, to
adjust the industry’s tax burdens by effectively reducing the tax rate
applicable to life insurance companies. (IRC Section 806).
Following the general reduction in corporate tax rates enacted in
1986, however, the lower tax rates now apply only to “small” life
insurance companies.
! Limitations were enacted to prevent life insurance companies from
deducting costs that are attributable to tax-exempt income, and
thereby generate inappropriate double tax benefits.
! Every life insurance company was allowed to deduct increases in the
level of its reserve liabilities. For tax purposes, Congress
established “objective” standards for calculating the reserve
liabilities for all life insurance companies. (IRC Section 807).
! Congress was concerned that mutual life insurance companies may
have enjoyed inappropriate tax advantages arising from the mutual
form of doing business. In response to this concern, and to achieve
what Congress viewed as an appropriate allocation of the tax
burdens between the stock and mutual life insurance companies,
Congress created an explicit limitation on the amount of

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policyholder dividends that a mutual life insurance company could
deduct. (IRC Section 809).
Each of these matters is discussed below.
Effective Tax Rate Reduction for
Small Life Insurance Companies
In designing the life insurance company provisions of the Tax Reform Act of
1984, one of the legislative goals was to raise a predetermined level of federal
income tax revenue from the life insurance industry. To produce this level of tax
revenue, Congress first estimated the level of revenue generated under the structural
provisions that taxed life insurance companies on their total economic profit.
Because the estimated revenue exceeded the predetermined targets, Congress enacted
two extraordinary deductions that reduced the effective tax rates of life insurance
companies to levels that would have generated the desired level of tax revenues.
The first extraordinary deduction was called the “special deduction.” It equaled
20% of a life insurance company’s taxable income. This effectively reduced a large
life insurance company’s rate of tax from the 46% statutory corporate tax rate then
applicable to a 36.8% rate. In 1986, Congress reduced corporate tax rate to 34% for
corporations with taxable income of more than $335,000. In light of this general
reduction in corporate tax rates, Congress eliminated this 20% special deduction in
1986.
The second extraordinary deduction is the so-called “small life insurance
company deduction.” Under Internal Revenue Code Section 806, a “small” life
insurance company may deduct 60% of its otherwise taxable income, subject to
several limitations. First, the small life insurance company deduction cannot exceed
$1,800,000. Second, if a life insurance company’s otherwise taxable income exceeds
$3 million, the deduction is phased out, so that no deduction is allowed for life
insurance companies with taxable income in excess of $15 million. Third, no
deduction is allowed for a life insurance company that has assets in excess of $500
million.
To illustrate the operation of the small life insurance company deduction,
consider the following example. Assume that a company has taxable income of $2
million before taking the small life insurance company deduction. The small life
insurance company deduction equals $1.2 million (i.e., 60% of its otherwise taxable
income). The company’s taxable income of $800,000 is taxed at the generally
applicable corporate tax rate. Although technically a deduction, this provision has
the effect of reducing a small life insurance company’s effective rate of taxation to
40% of the normal rate applicable to corporations. Thus, a small life insurance
company with income of up to $3 million will be subject to a maximum effective tax
rate of 14%, rather than the 34% statutory rate.
In enacting this provision, Congress recognized that this deduction did not
reflect an expense that constituted a cost of doing business. Rather, it recognized that
small life insurance companies had “enjoyed a tax-favored status for some time [prior

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to the enactment of the Tax Reform Act of 1984] and [Congress] believe[d] that it
would not be appropriate to dramatically increase their tax burden at this time.”5 The
legislative history does not address reason why small life insurance companies
should be taxed at lower rates than other business corporations with the same level
of income.
Costs Incurred to Produce Tax-Preferred Forms of Income
Certain forms of income are taxed in a preferential fashion under the income
tax. For example, interest paid to owners of certain state and local bonds is exempt
from taxation. (IRC Section 103). Similarly, a corporation that receives
intercorporate dividends is permitted a deduction equal to between 70 and 100% of
the dividend (IRC Section 243).
A taxpayer who incurs deductible expenses to earn tax-preferred income may
engage in what tax analysts call “tax arbitrage.”6 A simple illustration demonstrates
the tax benefits that arise in tax arbitrage transactions. Consider a taxpayer who
borrows $100,000 which is used to purchase a tax-exempt bond. Assume that the
taxpayer pays interest on the borrowed funds at a 6% rate and that the tax-exempt
bond pays interest at a 5% rate.
In this example, were there no restraints on “tax arbitrage,” the taxpayer receives
$5,000 of interest income and pays $6,000 of interest expense. On a pre-tax basis,
the taxpayer loses $1,000 per year as a result of engaging in these transactions. On
an after-tax basis, however, this transaction is profitable. Assuming that the
taxpayer’s income is taxed at a 35% marginal tax rate, the tax-deductible interest
payment of $6,000 generates tax savings of $2,100 (0.35 x $6,000). This tax savings
convert the pre-tax loss of $1,000 into an after-tax profit of $1,100.
The Internal Revenue Code contains several provisions that reduce the tax
benefits that otherwise would arise in tax arbitrage transactions. For example,
Internal Revenue Code Section 265 limits the deduction for interest deemed to be
allocable to investments in tax-exempt bonds. The tax provisions governing life
insurance companies contain the most comprehensive limitation on deductions
arising from tax arbitrage (IRC Sections 805(a)(4) and 807(a)(2)). These provisions
apply to all tax-exempt interest and most intercorporate dividends. Under these
provisions, the tax-preferred investment income is “prorated” between the company
and the policyholders. This proration is based upon the portion of the life insurance
company’s investment income that is allocable to the policyholders.
For example, if 90% of the company’s investment income is used to satisfy the
company’s obligations to its policyholders, only 10% of the tax-preferred income is
deemed to be allocable to the company’s own investment. As result, the company
is allowed a deduction with respect to only 10% of the intercorporate dividends
5 U.S. Congress, House of Representatives, H.Rept. 432 (pt 2), 98th Cong., 2nd sess. 1410
(1984).
6 Generally, individuals cannot (but businesses can) deduct the interest on borrowed funds
used to purchase securities paying interest which is taxable.

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received. Similarly, the proration rules effectively disallow the deduction for interest
allocable to the policyholders’ share of the company’s tax-exempt interest income.
Treatment of Life Insurance Reserve Liabilities
As previously discussed, life insurance companies operate as financial
intermediaries. To measure a life insurance company’s income and net worth, it is
necessary to take into account its reserve liabilities.7 Under both the 1959 Act and
the 1984 Act provisions, life insurance companies were allowed to take their reserve
liabilities into account in measuring their taxable income. Specifically, life insurance
companies were allowed to deduct any increase in the level of the company’s life
insurance reserves and they were required to include in income any decrease in their
life insurance reserves.8 The methodology utilized in calculating the reserve
liabilities, however, differed in the two Acts.
To determine the level of life insurance reserves, actuaries undertake complex
calculations that take into account numerous factors. The most important factors
utilized in making these calculations are: (1) the actuarial likelihood that benefit
payments will become payable in any given year; (2) an assumed rate of interest; (3)
the future premium payments specified in the insurance contracts; and (4) the
technical actuarial method utilized in the computation. Each of these factors can
influence the calculated level of reserves.
To illustrate, assume that a life insurance company will become obligated to
make a payment of $10,000 ten years from today. Because the liability is for a
known sum of $10,000 and there is certainty concerning the date of payment, the
only variable factor is the rate of interest that the life insurance company will credit
to satisfy this obligation. If the company calculates its reserve with respect to this
contract utilizing a 3% assumed rate of interest, the reserve will be $7,441 (i.e., the
present value of $10,000 payable in 10 years using a 3% discount rate). If, however,
the reserve is computed utilizing a 5% interest rate, the reserve will be only $6,139.
The difference in the level of the computed reserves affects both the annual
income and the net worth of a life insurance company. Assume that a life insurance
company receives a premium payment of $7,500 to create the obligation to pay
7 The Joint Committee on Taxation characterizes the deduction of life insurance reserves
as a tax expenditure, and it estimates that this deduction reduces tax collections by $6.8
billion for the years 2003-2007. Joint Committee on Taxation, Estimates of Federal Tax
Expenditures for Fiscal Years 2003-2007 (JCS-5-02), Dec. 19, 2002.
8 A life insurance company establishes reserves for periods before all benefits are paid with
respect to an insurance contract. Although the life insurance company may deduct the
amount paid as a benefit under an insurance contract, this deduction is offset by the amount
of reserves established with respect to that contract. For example, consider a life insurance
company that paid $100,000 to the beneficiaries of a life insurance contract following the
death of the insured. If the company had established a reserve of $90,000 with respect to
this contract, the company is entitled to a net deduction of $10,000 — which equals the
$100,000 payment reduced by the $90,000 reserve which is no longer needed to fund future
benefit payments.

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$10,000 in 10 years. If it can use a 3% interest rate in calculating its reserves, the
deduction for the increase in its reserves equals $7,441. In this case, the life
insurance company’s income in connection with this contract is $59 (i.e., the $7,500
premium - the $7,441 reserve increase). In contrast, the life insurance company will
have income of $1,361 if it uses a 5% assumed interest rate for reserve calculation
purposes (the $7,500 premium - the $6,139 reserve increase). It should be noted,
however, that in this latter case the life insurance company will have larger increases
in its reserves in subsequent years, with the consequence that its income will be
smaller in those years.
The tax law has used two different approaches with respect to the actuarial
assumptions used to compute life insurance reserve liabilities. Under the 1959 Act,
life insurance companies used, for tax purposes, the same actuarial assumptions that
the companies chose to use for reporting their reserve liabilities on their Annual
Statements for state regulatory purposes. The principal concern of the state insurance
regulators is to assure solvency — that is, to make certain that life insurance
companies set aside sufficient assets to meet their future liabilities to their
policyholders. To accomplish this goal, the insurance regulators want to prevent life
insurance companies from understating their liabilities. Consequently, the regulators
specify “minimum” actuarial assumptions but permit the use of more conservative
assumptions. Thus, the state insurance regulators may prevent life insurance
companies from using an interest rate assumption in excess of 5%, but a life
insurance company could choose to use an interest rate assumption of 3% or 4%.
While drafting the life insurance company tax provisions of the 1984 Act,
Congress recognized that some life insurance companies used reserve actuarial
assumptions that were exceedingly conservative, thereby reducing the amount of
income subject to taxation. For this reason, it enacted Internal Revenue Code Section
807, which contains new limits on the actuarial assumptions that may be used for
computing reserves for tax purposes.
As a general rule, the life insurance reserve used for tax purposes for any
contract is the greater of: (1) the net surrender value of the contract; and (2) the
reserve computed in compliance with the requirements of IRC Section 807. In
general, this provision precludes the use of actuarial assumptions that would produce
unduly large reserves. Consequently, the reserve levels tend to be the minimum level
of reserves that the states mandate. Specifically, IRC Section 807 mandates that the
most significant actuarial assumptions be determined as follows:
(1) the actuarial likelihood that benefit payments will become payable will
be based upon minimum state regulatory standards. The reserves
computed with respect to contracts issued in a given year are determined
utilizing the “prevailing commissioners’ standard table for mortality and
morbidity.” The National Association of Insurance Commissioners (the
“NAIC”) publishes Commissioners’ Standard Tables when sufficient new
actuarial data becomes available. When life insurance companies are
allowed to use the new table for computing reserves for state regulatory
purposes in at least 26 states, the table becomes the prevailing table.

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(2) the assumed rate of interest will be the greater of two rates. The first
rate is the “prevailing State assumed interest rate.” This term is defined as
the highest assumed interest rate that life insurance companies may use in
at least 26 states to compute reserves with respect to the particular type of
insurance contract. The second rate is the “applicable federal rate.” This
is a rate published by the Internal Revenue Service that reflects the average
of mid-term interest rates during the 60-month period preceding the year
for which the rate is calculated.
(3) the technical actuarial computation method will be based upon
methods approved by the state regulatory authorities. Actuaries
employ different mathematical techniques in calculating reserves. The
state regulatory authorities specify which technical methods may be used
for purposes of calculating the reserves reported on the Annual Statement.
Some of these methods utilize a “preliminary term” approach, which tends
to produce relatively small reserves in the initial years of an insurance
contract. Other techniques produce larger reserves in those years. Internal
Revenue Code Section 807, which specifies which of these techniques may
be used for tax purposes, generally mandates the use of a preliminary term
approach.
Deduction of Policyholder Dividends and the Special
Treatment of Mutual Companies
In general, corporations cannot deduct amounts paid as dividends to their
shareholders. In addition, the shareholders are required to include in income the
amount of dividends that they receive. This treatment applies to distributions that life
insurance companies make to their shareholders in the same manner as it applies to
general business corporations.
Life insurance companies make distributions to their policyholders that, in the
parlance of the insurance industry, are also called dividends. These are policyholder
dividends, which are defined as any distribution not fixed by the terms of the
insurance contract. For example:
! an insurance contract may specify that interest will be credited at a
rate that will never be less than 3%. The contract may also provide
that interest may be paid at higher rates determined at the discretion
of the insurance company. Any interest paid in excess of the 3%
guaranteed rate of interest is treated as a policyholder dividend.
! a life insurance company may agree to provide term life insurance
protection to the employees of a business. The life insurance
contract states that the life insurance company may rebate a portion
of the premium paid for this protection if the company, in its
discretion, determines that the profits for its term insurance business
exceeded the company’s targets. Any rebate paid in connection with
this term insurance arrangement is characterized as a policyholder
dividend.

CRS-14
The interest payments that a financial intermediary makes to its depositors are
generally treated as deductible business expenses. Rebates that a business pays to its
customers are also deductible. In general, life insurance companies are also allowed
to deduct these amounts when payments are made to their policyholders.
The conceptual problem arises when a mutual company pays policyholder
dividends to its policyholders. Historically, many of the largest life insurance
companies were organized as mutual organizations. Unlike a general business
corporation, mutual organizations do not have a separate class of owners. Rather, the
mutual company’s policyholders are also the owners of the organization. The
difficult question is whether the mutual life insurance company pays dividends to its
policyholders in their capacity as customers or in their capacity as owners of the
enterprise.
IRC Section 809 was enacted with the goal of creating tax parity between
mutual life insurance companies and stock-owned life insurance companies. In
enacting IRC Section 809, Congress indicated that it believed that mutual life
insurance companies effectively distribute a portion of their corporate earnings to
their policyholders in their capacities as owners of the enterprise.9
A key conceptual difficulty is that a mutual life insurance company’s
policyholders also are customers and creditors of the insurance company.
Consequently, it is impossible to determine whether amounts that a mutual life
insurance company allocates to its policyholders represent rebates of premiums,
interest or corporate earnings.10 For this reason, the drafters of IRC Section 809
attempted to derive an indirect method of measuring the amounts distributed to the
policyholders in their capacity as owners of the enterprise. Specifically, they made
the following assumptions:
(1) a mutual life insurance company’s distributed earnings would be
proportionate to the company’s equity;
(2) in the aggregate, stock life insurance companies and mutual companies
will earn comparable rates of return; and
9 The policyholders generally did not include these amounts in income because the amounts
were treated as nontaxable pension or life insurance benefits. In general, an owner of a life
insurance contract includes benefits in income only if: (1) the policy is surrendered prior to
the death of the insured; and (2) the amount received upon the surrender exceeds the
premiums paid with respect to the contract. Amounts credited with respect to a pension plan
are not taxed currently. Rather, taxation occurs only when the plan participant receives her
pension.
10 A life insurance company can allocate amounts to policyholders using several different
techniques. First, the life insurance company could credit the “policyholder dividends” to
the cash values of life insurance or annuity contracts, or it could increase the accumulation
value of pension contracts. Second, the life insurance company could increase the rate of
interest that it commits itself to pay with respect to its life insurance, annuity or pension
contracts. Third, the life insurance company could reduce the premiums that it charges.

CRS-15
(3) any difference between the observed pre-tax profit of mutual life insurance
companies (as a group) and the pretax profit of investor-owned life
insurance companies (as a group) would be attributable to a distribution of
corporate earnings to the policyholders in their capacity as owners of the
mutual enterprise.
IRC Section 809 implemented these assumptions in a complicated manner. In
simplified terms, IRC Section 809 utilizes the following steps:
(1) Each mutual life insurance company and each of the 50 largest investor-
owned life insurance companies must compute its “equity base” (as that
phrase is defined in IRC Section 809(b)).
(2) Each mutual company and each of the 50 largest investor-owned life
insurance companies must compute its pretax profit by computing its
“statement gains from operations” (as that term is defined in IRC Section
809(g)(1)).
(3) The Treasury Department computes the average earnings rate for the
mutual companies (as an aggregate entity) and the average rate of the 50
largest stock life insurance companies.
(4) After the Treasury Department adjusts these averages (as mandated in IRC
Section 809(d)), it calculates the “imputed earnings rate” for a given
taxable year. The imputed earnings rate is the pretax rate of return that
IRC Section 809 deems to be the pretax rate of return that mutual life
insurance companies (as a group) should have earned — given the pretax
rate of return of the mutual life insurance companies.
(5) For each year, the Treasury Department compares the imputed earnings
rate and the average earnings rate for the mutual companies.
To the extent that the imputed earnings rate is higher than the average earnings
rate for the mutual companies, Congress assumed that the difference resulted from
a distribution of corporate earnings to the policyholders of the mutual life insurance
companies. In these circumstances, IRC Section 809(a) disallows any deduction for
the “differential earnings amount” which equals the difference between these two
rates of return multiplied by each mutual company’s “equity base.”

CRS-16
Significant Current Issues
Repeal IRC Section 809
From its enactment, IRC Section 809 has been heavily criticized on both
conceptual and pragmatic grounds. In addition, President Bush’s fiscal 2004 budget
proposal included a provision to repeal IRC Section 809.
The conceptual criticisms of Section 809 have focused on two arguments. First,
some tax analysts have argued that the theoretical underpinnings of Section 809 are
not sound. These arguments are based on the following three lines of analysis.
! Some argue that a “prepayment” analysis demonstrates that tax
equity is achieved only if mutual companies are allowed to deduct
all amounts distributed to their policyholders. This analysis is based
on the fact that an investor-owned corporation is not taxed when it
receives contributions to capital from its shareholders. If a mutual
life insurance company’s policyholders pay amounts to acquire an
ownership interest, these amounts are taxed as premium income to
the company. Commentators argue that this difference demonstrates
that IRC Section 809 has no theoretical justification.11
! Others argue that the implicit assumptions underlying IRC Section
809 are deeply flawed. Specifically, they argue that it does not make
sense to assume that stock and mutual life insurance companies will
necessarily earn comparable rates of return. In addition, they argue
that IRC Section 809 does not adequately reflect variations in the
operations of different mutual companies.
! Others argue that there is no empirical evidence that mutual life
insurance companies provide greater benefits to their policyholders
than do stock life insurance companies. As a result, they argue that
there are no distributions to the mutual policyholders in their
capacity as owners of the mutual enterprise. Consequently, they
conclude that no special tax provision is needed to equalize the tax
treatment of stock and mutual life insurance companies.
Pragmatic criticisms of IRC Section 809 also exist. The first pragmatic
argument focuses on the ineffectiveness of IRC Section 809. For the years 2001,
2002 and 2003, Congress established a temporary differential earnings rate of zero.
(IRC Section 809(j)). The House of Representatives has approved H.R. 3521, which
contains an extension of this provision to 2004. For most of the preceding years, the
actual differential earnings rate was also zero. It is unclear what led to this result.
Three possibilities are:
11 M. Graetz, “Life Insurance Company Taxation: An Overview of the Mutual-Stock
Differential” in Life Insurance Company Taxation — The Mutual vs. Stock Differential,
Larchmont, New York (Rosenfeld, Emanuel, 1986).

CRS-17
(1) mutual companies do not allocate any earnings to their policyholders in
their capacity as owners of the enterprise;
(2) mutual life insurance companies were able to increase their apparent pretax
profit rate by realizing their capital gains to a greater extent than stock life
insurance companies; and
(3) some other flaws exist in the structure of Section 809.
A second pragmatic argument focuses on changes in the life insurance industry
following the enactment of Section 809. In the intervening years, a number of mutual
life insurance companies (including the largest mutual companies) have
“demutualized” to become investor-owned companies. Consequently, of the 25
mutual companies that were the largest mutual life insurance companies in 1984, at
least 21 no longer operate as mutual companies. As a result, the perceived need to
“balance” the relative tax burdens of the stock and mutual segments of the life
insurance industry that led Congress to enact Section 809 may be greatly lessened.
Forgive Deferred Section 815 Amounts
Deferred Section 815 Amounts Under the 1959 Act. As discussed
above, from 1958 through 1983, life insurance companies were taxed under the so-
called three-phase method of taxation. Under this system of taxation, each life
insurance company had to determine its “taxable investment income” and its “gain
from operations.”
In rough terms,12 a company’s taxable investment income represented the
company’s profits from its actions as a financial intermediary. Cash value life
insurance, annuities and pension plan contributions represent, in whole or in part, a
financial investment. The premium payments made with respect to these types of
contracts include an amount that is invested for the benefit of the policyholder or
pension plan beneficiary. The life insurance company invests these funds and credits
amounts to the policyholders’ cash values.
In calculating its taxable investment income, a life insurance company started
with its net income from its investment activities. From this amount, the life
insurance company subtracted the portion of this net investment income that was
deemed to be allocable to the company’s obligations to its policyholders. Under the
provisions of the tax law in effect from 1958 through 1983, the company’s taxable
investment income was taxed at the full corporate tax rate.
12 The Life Insurance Company Tax Act of 1959 included numerous technical provisions
and non-economic “special deductions” that are not discussed in this paper. Many of these
provisions had the effect of reducing a life insurance company’s taxable investment income
to levels significantly below the company’s profits from its operation as a financial
intermediary. Similarly, certain of these provisions reduced a company’s gain from
operations to levels below the company’s total economic profit.

CRS-18
Again in rough terms, a company’s “gain from operations” represented the life
insurance company’s total profit as computed for tax purposes. In addition to its
profits from its actions as a financial intermediary, the company’s gain from
operations included the company’s profits from its underwriting activities. Unlike
the company’s profit attributable to its financial intermediary function, only a portion
of a life insurance company’s underwriting profit was taxed in the taxable year in
which it was earned.
Technically, if a life insurance company’s gain from operations exceeded its
taxable investment income, the company was subject to tax on the sum of: (1) its
taxable investment income and (2) 50% of the excess of its gain from operations over
its taxable investment income. The untaxed 50% of a life insurance company’s
underwriting profits was tax-deferred. A life insurance company was required to
maintain, for tax purposes, an account called the policyholders’ surplus account. In
any year in which the company had untaxed underwriting income, it was required to
increase its policyholders’ surplus account by the untaxed amount. In addition, life
insurance companies were allowed to deduct amounts under provisions that
authorized non-economic “special deductions.” The amounts deducted under these
provisions were also added to the policyholders’ surplus account. If the company
distributed these amounts to its shareholders or if the corporation was dissolved, the
previously untaxed amounts were included in the life insurance company’s income.13
The legislative history to the 1959 Act indicates that Congress permitted life
insurance companies to defer the taxation of one-half of a company’s underwriting
profits because of the claim that it is difficult to establish with certainty the annual
income of life insurance companies.14 Concern was expressed that, given the long-
term nature of contracts, computation of income on an annual basis will characterize
certain amounts as profit which, as a result of subsequent events, will be needed to
fulfill obligations arising under these contracts. If the untaxed profits are distributed
to shareholders, however, it was recognized that the life insurance company no longer
needed those funds to meet its obligations to its policyholders.

1984 Act Treatment of Previous Additions to Policyholders Surplus
Account. The 1984 Act eliminated the three-phase system for taxing life insurance
companies. As a result, no further deferral of underwriting profits was allowed. In
addition, the 1984 Act retained the requirement that a life insurance company must
include in income any amount deemed to be distributed out of a company’s existing
policyholders surplus account.
President Clinton’s 2000 budget proposals contained a proposal to require life
insurance companies to include in income any remaining balance in their
policyholders surplus accounts. This proposal focused on the fact that the original
13 Under IRC Section 815, a distribution triggered income recognition only if the amount
of the distribution exceeded the previously taxed retained earnings of the corporation.
Income recognition was also triggered if the company ceased to be an insurance company
or if it ceased to be taxed as a life insurance company for two successive years.
14 Report of the Committee on Ways and Means to accompany H.R. 4245, H.Rept. 34, 86th
Cong., 1st sess. 13 (1959).

CRS-19
rationale for the deferral — that the long-term nature of the life insurance and annuity
contracts made it difficult to determine profits on an annual basis — no longer
existed. Because the deferrals took place between 20 and 40 years ago, it is unlikely
that unanticipated losses will occur with respect to the insurance contracts issued
during those earlier years. Congress took no action with respect to this proposal.
On the other hand, the Senate Finance Committee approved an amendment to
the proposed National Employee Savings and Trust Equity Guarantee Act on
September 17, 2003 that would suspend the application of the rules imposing income
tax on distributions to shareholders from the policyholders’ surplus account for the
years 2004-2009. The provision also would have modified the order in which
distributions reduced the various accounts, so that distributions would have been
treated as first made out of the policyholders’ surplus account. The apparent primary
rationale for this proposal is that little, if any, tax revenue will be generated under the
existing provisions governing the policyholders’ surplus account. Under current law,
life insurance companies have the ability to decide whether to undertake discretionary
distributions to their stockholders that “trigger” the tax. Consequently, life insurance
companies may avoid this trigger by limiting the distributions that they make to their
shareholders.
References
Kenneth Black, Jr. and Harold Skipper, Jr., Life & Health Insurance (13th ed.)
(Prentice Hall, 2000).
Emanuel Burstein, Federal Income Taxation of Insurance Companies (Insurance
Taxation and Regulation Publications, Inc. 1996).
Ernst and Young LLP, Federal Income Taxation of Life Insurance Companies, 2d ed.
(Lexis Nexis, 2002).
Michael Graetz, Life Insurance Company Taxation — The Mutual vs. Stock
Differential (Rosenfeld, Emanuel, 1986).
William Harman, Jr., “The Structure of Life Insurance Company Taxation — The
New Pattern under the 1984 Act,” Journal of American Society of CLU (March
and May, 1985).
William Harman, Jr., “The Pattern of Life Insurance Company Taxation Under the
1959 Act,” 15th Ann. Tulane Tax Inst. 686 (1965).
Keith Tucker, J. Dale Dawson and Thomas Brown, “Federal Taxation of Life
Insurance Companies: The Evolution of a Tax Law Responding to Change,” 37
Southwestern Law Journal 891 (1984).

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