applied for purposes of discounting these reserve amounts is the period and pattern over which such reserves for that year are to be included in income in accordance with applicable State law. The rate and amount of inclusion in income for statutory accounting purposes is considered to determine the timing of and amount of releases from such reserve which are included in income for income tax purposes. The applicable interest rate is the rate applicable, for the year the premiums are received, under the loss reserve discounting rules applicable to property and casualty insurance companies.

Title insurance case reserves (i.e., known claims reserves) are subject to discounting under the provisions generally applicable to property and casualty insurance loss reserves.

A fresh start for discounting title insurance reserves is provided, calculated in a manner similar to the fresh start for other property and casualty company loss reserves (see the discussion below).

This treatment is provided for title insurance reserves because of the deferral and the consequent failure to acknowledge the time value of money which resulted under prior law with respect to title insurance unearned premium reserves.

Effective Dates

Under the Act, the provisions relating to the treatment of unpaid loss reserve deductions for property and casualty companies apply to taxable years beginning after December 31, 1986.

Under the Act, a transitional rule is provided with respect to the unpaid losses on outstanding business before the effective date of the provision. Under this transitional rule, for purposes of calculating a company's change in unpaid losses with respect to outstanding business, the unpaid losses at the end of the last taxable year beginning before January 1, 1987, and the unpaid losses as of the beginning of the first taxable year beginning after December 31, 1986, are determined as if the discounting provisions had applied to the unpaid losses (and unpaid expenses) in the last taxable year beginning before January 1, 1987. In addition, the interest rate and loss payment pattern assumptions with respect to such outstanding business is to be computed by using the rate and loss payment pattern applicable to accident years ending in 1987.

Further, the Act provides a fresh start with respect to undiscounted loss reserves applicable to the last taxable year beginning before January 1, 1987. Under this fresh start rule, the difference between the amount of undiscounted unpaid loss reserves and unpaid expenses (the recomputed reserves) at the end of the last taxable year beginning before January 1, 1987, and the amount of the discounted balances determined under the transitional rule, are not taken into account for purposes of determining the taxable income of an insurance company after the effective date.33 The

33 In the case of an insurance company that first becomes fully taxable (i.e., not exempt under sec. 501(c)(15) and not electing under sec. 831(b) to be taxed only on investment income) in a later taxable year, e.g., 1995, the fresh start adjustment should be made with respect to the company's undiscounted loss reserves at the close of the year immediately preceding such year. A technical correction may be needed so that the statute reflects this intent.

fresh-start rule also applies to differences in reserves attributable to the change in the period for determining loss of companies whose taxable year is not the calendar year.

Such fresh start adjustment is to be taken into account in full in the first taxable year to which the discounting provisions apply (ie., the first taxable year beginning after December 31, 1986), for purposes of calculating any adjustment to earnings and profits. Reserve strengthening in taxable years beginning after December 31, 1985, is not treated as a reserve amount for purposes of determining the amount of the fresh start. Instead, such reserve strengthening additions to unpaid loss reserves in taxable years beginning in 1986 are treated as changes to reserves in taxable years beginning in 1987, and are subject to discounting. This provision is intended to prevent taxpayers from artificially increasing the amount of income that is forgiven under the fresh start provision. The deduction for reserve strengthening is not to be taken into account twice. Reserve strengthening is considered to include all additions to reserves attributable to an increase in an estimate of a reserve established for a prior accident year (taking into account claims paid with respect to that accident year), and all additions to reserves resulting from a change in the assumptions (other than changes in assumed interest rates applicable to reserves for the 1986 accident year) used in estimating losses for the 1986 accident year, as well as all unspecified or unallocated additions to loss reserves. Reserve strengthening does not include amounts reported to the insurance company from mandatory state or Federal assigned risk pools, if the amount of the loss reported is not discretionary with the insurance company.

4. Protection against loss account for mutual companies (sec. 1024 of the Act and former sec. 824 of the Code)34

Prior Law

Under prior law, mutual property and casualty insurance companies were permitted a deduction for contributions (which are bookkeeping entries) to a protection against loss ("PAL") account (sec. W24). The amount of the deduction was equal to the sum of 1 percent of the underwriting losses for the year plus 25 percent of statutory underwriting income, plus certain windstorm and other losses. In general, contributions to the PAL account were taken into income after a 5-year period. The PAL account thus effected a b your deferral of a portion of mutual company underwriting income.

Reasons for Change

The intent of Congress in enacting the PAL provision had been to provide mutual companies with a source of capital to enable them to compete with stock companies, in the event of a catastrophic loss. While stock companies could enter capital markets

For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1024; H.Rep. 99-426, pp. 676-677; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 1023; S.Rep. 99-313, pp. 510-511; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 369-370 (Conference Report).

and issue new stock to raise money in the event of a catastrophic loss, a mutual company, because it does not issue stock, could not do so. The 5-year partial income deferral provided a source of capital not available to stock companies.

In adopting the provisions of the Act, however, Congress expressed the belief that the deduction for contributions to the PAL account was not serving its intended purpose and therefore should be repealed. The PAL rules did not require that any funded account actually be maintained to protect against losses; rather, the only protection was afforded in the form of tax savings. The utility of the PAL was greatest where least needed, in the case of mutual companies with current taxable income that could benefit from deferral. Further, the comparison to the ability of stock companies with catastrophic losses to raise funds in capital markets may not have been entirely appropriate, because any company may not readily be able to raise funds when its financial prospects are dimmed by serious losses.

Explanation of Provision

Code section 824, allowing a deduction for contributions to a PAL account, is repealed. Amounts credited to PAL accounts in taxable years beginning before December 31, 1986, are included in income in accordance with prior law (as if sec. 824 remained in effect).

Effective Date

The repeal of the deduction for contributions to a PAL account is effective for taxable years beginning after December 31, 1986.

5. Special exemptions, rates, and deductions of small mutual companies; combination of Parts II and III of subchapter L (sec. 1024 of the Act and secs. 501, 821, 823 and 831 of the Code)35

Prior Law

Under prior law, mutual property and casualty companies were classified into three categories depending upon the amounts of the company's gross receipts. Mutual companies with certain gross receipts not in excess of $150,000 were exempt from tax (sec. 501(c)(15)). Companies whose gross receipts exceeded $150,000 but did not exceed $500,000 were "small mutuals" and generally were taxed solely on investment income. This provision did not apply to any mutual company that had a balance in its PAL account, or that, pursuant to a special election, chose to be taxed on both its underwriting and investment income. Additionally, small mutuals which were subject to tax because their gross receipts exceed $150,000 could claim the benefit of a special rule which phased in the regular tax on investment income as gross receipts increased from $150,000 to $250,000. Companies whose gross receipts exceeded $500,000 were ordinary mutuals taxed on both investment and

35 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1025; H.Rep. 99-426, pp. 677-678; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 1024; S.Rep. 99-313, pp. 511-512; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 369-370 (Conference Report).

underwriting income. Mutual reciprocal underwriters or interinsurers were generally taxed as mutual insurance companies, subject to special rules (sec. 826).

Like stock companies, ordinary mutuals generally were subject to the regular corporate income tax rates. Mutuals whose taxable income did not exceed $12,000 paid tax at a lower rate. No tax was imposed on the first $6,000 of taxable income, and a tax of 30 percent was imposed on the next $6,000 of taxable income. For small mutual companies that were taxable on investment income, no tax was imposed on the first $3,000 of taxable investment income, and a tax of 30 percent was imposed on taxable investment income between $3,000 and $6,000.

Mutual companies that received a gross amount from premiums and certain investment income of less than $1,100,000 were allowed a special deduction against their underwriting income (if it was subject to tax). The maximum amount of the deduction was $6,000, and the deduction was phased out as the gross amount increased from $500,000 to $1,100,000.

Reasons for Change

Congress determined that the prior-law rules applicable to small and certain ordinary mutual companies were inordinately complex and should be simplified. Congress concluded that one provision should afford benefits comparable to prior law to small mutual companies. Further, Congress concluded that it was appropriate to eliminate the distinction between small mutual companies and other small companies, and extended the benefit of the small company provision to all eligible small companies, whether stock or mutual.

Explanation of Provision

The Act provides that mutual and stock property and casualty companies are eligible for exemption from tax if their net written premiums or direct written premiums (whichever is greater) do not exceed $350,000. This provision changes the nature of the ceiling amount for tax exemption from certain gross receipts to direct or net written premiums, and increases the ceiling amount from $150,000 to $350,000.

In addition, the Act repeals the special rates, deductions and exemptions for small mutual companies and substitutes a single provision (sec. 831(b) of the Code). The new provision allows mutual and stock companies with net written premiums or direct written premiums (whichever is greater) in excess of $350,000 but less than $1,200,000 to elect to be taxed only on taxable investment income. To determine the amount of direct or net written premiums of a member of a controlled group of corporations, the direct or net written premiums of all members of the controlled group are aggregated. In determining whether a taxpayer is a member of a controlled group of corporations for purposes of eligibility for the provision, a 50 percent ownership test applies.

Parts II and III of subchapter L of the Code are consolidated into Part II, under the Act. Part II of subchapter L relates generally to taxation of property and casualty insurance companies.

Effective Date

The provisions are effective for taxable years beginning after December 31, 1986.

6. Study of treatment of property and casualty insurance companies (sec. 1025 of the Act)36

Prior Law

Under prior and present law, property and casualty insurance companies are generally permitted to deduct dividends and similar distributions paid or declared to policyholders in their capacity as such. Stock companies could not, however, fully deduct dividends paid to shareholders. Policyholder dividends and shareholder dividends are treated differently for tax purposes at the distributee level as well as at the company level. Policyholder dividends are generally considered price rebates and are not taxable distributions (unless the insurance premiums were deducted by the policyholder). Dividends paid to shareholders in their capacity as shareholders, on the other hand, constitute ordinary income to the recipient shareholders to the extent of the distributing corporation's earnings and profits. Unlike mutual property and casualty companies, however, mutual life insurance companies reduce the amount of deductible policyholder dividends by an amount intended to reflect the portion of the distribution allocable to the companies' earnings on equity (as distinguished from the proportion which is a policyholder rebate).

Reasons for Change

Congress recognized that there may be inequity arising from the difference in tax treatment of dividend distributions of stock property and casualty companies, and policyholder dividends of mutual companies. It may be appropriate, as in the case of life insurance companies, to treat a portion of mutual property and casualty company policyholder dividends as a distribution of earnings on equity of the company; however, the rule applying this concept in the life insurance area is enormously complex and controversial in application. Therefore, before applying the concept (or another approach, if preferable) to property and casualty insurers, Congress believed it would be preferable to review the results and recommendations of a study to be conducted by the Treasury Department.

Congress also concluded that it is important to monitor the new property and casualty insurance provisions to see that their purpose to measure more accurately the income of property and casualty insurers is being carried out. Similarly, Congress concluded that it is important to monitor the application of the corporate minimum tax (whose purpose is to ensure that all taxpayers pay a minimum amount of tax on their income) to property and casualty insurers.

36 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, secs. 1026 and 1027; H.Rep. 99-426, pp. 678-680; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 368-369 (Conference Report).