THE TAXATION OF INCOME FLOWING THROUGH LIFE 

INSURANCE COMPANIES 

Thomas Neubig and Eugene Steuerle 

U.S. Treasury Department 

OTA Paper 53 January 1984 

OTA Papers are circulated so that the preliminary findings of tax 

research conducted by staff members and others associated with 

the Office of Tax Analysis may reach a wider audience. The views 

expressed are those of the authors, and do not reflect Treasury 

policy. Comments are invited, but OTA Papers should not be 

quoted without permission from the authors, 

Office of Tax Analysis 

U.S, Treasury Department, Room 4040 

Washington, D.C. 20220 

Issued: January 1984 
TABLE OF CONTENTS 

Page 

Preface i 

I. A BRIEF DESCRIPTION OF LIFE INSURANCE PRODUCTS........ 2 

A. Traditional Life Insurance Products ................ 2 

B. Variations of the Standard Products. . .............. 10 

II. THE CURRENT RULES GOVERNING THE TAXATION OF INCOME 

FROM LIFE INSURANCE COMPANIES...................... 12 

A. Taxation at the Individual Level ................... 13 

B. Taxation at the Company Level ...................... 16 

III. MEASUREMENT OF TOTAL TAXABLE INCOME FROM LIFE 

INSURANCE PRODUCTS,. .................................... 26 

A. Tax Preferred Products Offered by Life Insurance 

Companies to Individuals. . ....................... 27 

B. Investment Income Net of Services at the Individual 

Level...;....................... . ................ 31 

C. Separation of Income from Return of Capital ........ 34 

D. Tax Preferred Assets Held by Life Insurance 

Companies ........................................ 37 

E. Other Special Preferences for Life Insurance 

Companies ........................................ 39 

IV. ALLOCATION OF TAXABLE INCOME BETWEEN RECIPIENTS ....... 40 

A. Allocation of Investment Income Between Company

and Policyholders ................................ 41 

8. Attribution of Investment Income to Specific 

. Policyholders. ................................... 42 

C. Mutual Versus Stock Owners ......................... 44 

V. ATTRIBUTION OF TAXABLE INCOME BY TYPE OF ACTIVITIES***- 55 

A. Investment Versus Underwriting Income. ............. 55 

B. The Definition of "Life Insurance" and "Life 

Insurance Companies ............................... 59 
VI. THE TIMING OF TAXABLE INCOME RECEIPT................... 61 

A . The Reserve Method of Accounting for Life 

Insurance Companies................................ 62 

B . An Alternative Method of Computing "Tax Reserves" for 

Life Insurance Companies........................... 70 

BIBLIOGRAPHY............................................... 74 
PREFACE 

This paper represents the second in a series devoted to 

the subject of the taxation of income flowing through financial 

institutions. The first paper (OTA Paper No. 52 - "The Taxation 

of Income Flowing Through Financial Institutions: General Framework and Summary of Tax Issues") developed a general framework of 

analysis and summarized the broad tax issues applying to all 

financial institutions. This paper applies that general 

framework to the case of income flowing through life insurance 

companies. 

Pending legislation may outdate some of the specific.lega1 

provisions discussed in this paper, but the application of the 

general framework used here will still be appropriate for 

analyzing most issues surrounding the taxation of income flowing 

through life companies. The reader should be careful not to view 

issues of life insurance taxation in isolation from the issues 

discussed in other papers of the series. 
THE TAXATION OF INCOME FLOWING THROUGH 

LIFE INSURANCE COMPANIES* 

The tax laws applying to income flowing through life 

insurance companies are among the most complicated in the 

Internal Revenue Code. This complexity arises in part because of 

the complex product (insurance) with which they deal and in part 

because of political compromises over the relative taxation of 

various insurance providers. At the individual level, the 

taxation of income from life insurance products has been modified 

little in the last three decades, despite the changing nature of 

the industry and the development of many non-traditional investment-oriented "insurance" products. 

This paper provides a general analysis of the taxation 

of income flowing through li-fe insurance companies. The analysis 

builds upon the general framework established in "The Taxation 

of Income Flowing through Financial Institutions: General 

Framework and Summary of Tax Issues." -

1/ The first section 

describes various types of life insurance products. A general 

outline of the relevant tax rules is presented in the second 

section. Readers who are familiar with the subject matter of 

both of these sections may wish to skip directly to the 

discussion of the tax issues starting in section III. 

* We are indebted to Andrew Pike, David Garlock, Larry Dildine, 

Seymour Fiekowsky, Hudson Milner, and Gordon Wilson for 

helpful comments, to Gordon Wilson for computer programming

assistance, and to Eunice Taylor and Geraldine Huggins for 

their assistance in the preparation of the manuscript. 

-1/ Thomas Neubig and Eugene Steuerle, "The Taxation of Income 

Flowing Through Financial Institutions: General Framework and 

Summary of Tax Issues," Office of Tax Analysis Paper No. 52,

Department of the Treasury, September 1983. 
-2-

I. A BRIEF DESCRIPTION OF LIFE INSURANCE PRODUCTS 

Individuals purchase life insurance both for investment and 

for other services. A life insurance company holds many assets 

for its customers and receives a rate of return on those investments which it can return to policyholders in a variety of ways. 

Besides investment, other services provided by a life insurance 

company are related primarily to the pooling of risks against 

various events such as mortality, disability or illness. 

It is often difficult to separate funds devoted to meeting 

contingent liabilities (the insurance function) from those used 

to intermediate between savers and investors (the investment or 

intermediation function). Insurance products generally perform 

both functions. At a minimum there is always some lapse of time 

between when premiums are paid and when insurance proceeds are 

returned. During that period, premiums are invested in incomebearing financial assets, with the life insurance company serving 

in the additional role of intermediary between savers (policyholders) and investors. 

A. Traditional Life Insurance Products 

Term Life Insurance 

The product most commonly associated with life insurance 

companies is term insurance. A one-year term insurance contract 

provides substantial risk-pooling services to the individual, but 

has only a minimal investment component. The premium charged 

for an annual term insurance contract is based on the.expected 

death benefits for the insured and the company's loading charges. 

Loading charges cover the cost of providing the service, including commissions to salesmen and returns to the owners of the 

company. 

Table 1 illustrates the pricing of an annual term insurance 

contract for a 27 year old male. His expected probability Of 

dying in a given year (the mortality rate) is 0.00199, or 
-3-

Table 1 

Pricing of an Annual Term Life Insurance Product* 

Expected Death Benefits $199 

on a $100,000 Policy

for a 27 Year-old Male 

Mortality rate = 0.00199 

Loading Charges + 60 

(Administrative expenses

commissions, profit) 

Total Premium . $259 

assuming no 

investment 

Present Value of $10 - 9 

Investment Income 

(10% discount rate) 

Total Premium with $250 

investment pass through 

* Note: Assumes premiums are paid at the beginning of the 

year, while death benefits are paid pro rata through the 

year. 

approximately 2 out of 1,000. To cover expected death benefits 

for a group of 27 year-old males, a company would have to charge 

$199 for every $100,000 of insurance coverage. Administrative 

expenses, agents' commissions, and shareholders' return on equity 

are met by charging a loading fee. In this example, the loading 

fee is assumed to equal about 30 percent of the expected death 

benefits. Without investment returns on the premiums, the 

premium charge for a $100,000 'annual term policy would therefore 

be set at $259--$199 in expected death benefits plus $60 in 

loading charges. 
-4-

Since this insurance company receives premium payments in 

advance of a full year's worth of insurance coverage, a portion 

of the premiums can be invested and earn interest until death 

benefits are paid. Suppose that loading charges are paid out 

immediately, but that the typical premium is held on average for 

one-half year before it must be used to cover death benefits. 

Then, at an interest rate of 10 percent, roughly $10 will be 

earned for each expected contingent liability of $199 associated 

with each policyholder. This $10 of income could be used to 

reduce the premiums charged for the policy or could be rebated 

later to policyholders. If the company reduces premiums by the 

present value of the investment income (roughly $9), it could 

still earn company profit through loading charges. 

As a percentage of total life insurance in force, individual 

term life insurance grew from 10 percent in 1954 to 15 percent in 

1970 and then to 19 percent in 1981. Group life insurance, which 

is primarily term insurance covering employee groups, also rose 

from 26 percent of total life insurance in force in 1954 to 

39 percent in 1970 and 46 percent in 1981. Credit life 

insurance, which is term insurance used to repay debt in case the 

borrower dies, was 3 percent of total life insurance in force in 

1955 and 4 percent in 1981. -2/ 

Health Insurance 

Health insurance is similar to term life insurance 

in that it provides a substantial risk-pooling function with 

only a relatively small investment component. The premium 

charged for annual health insurance will cover the expected 

future health expenditures and the company's loading charges. 

Since premiums may be paid at the beginning of periods of 

insurance coverage, companies can invest a portion of the 

premiums and earn interest until costs are incurred. The 

investment income can be used by the company to reduce the 

premiums charged to policyholders. 

-2/ 1983 Life Insurance Fact Book, (Washington, D.C.: American 

Council on Life Insurance, 1983), pp. 15 and 25. 
-5-

Health insurance has also been an increasing component of 

life insurance companies' sales. Health insurance premiums 

accounted for 12 percent of total premium receipts of U.S. life 

insurance companies in 1950, 23 percent in 1960, 31 percent in 

1970 and 30 percent in 1982. -3/ Health insurance typically 

includes protection against the cost of medical expenses, 

including hospital and surgical expenses. It can also provide 

protection against loss of income from accidental death or 

disbursement as well as dental expenses. Health insurance is 

also provided by many property and casualty insurance companies. 

Annuities 

On the other end of the spectrum of investment products, life 

insurance companies offer savings instruments which may include 

little, or no, life insurance or risk-sharing component. As an 

example, suppose a company charges a single premium.in return for 

a promise to pay $100,000 in twenty years to a policyholder or 

his designated beneficiary. An insurance component is added if, 

at the end of the twenty year period, the payment is converted to 

an annuity whose number of payments depend upon the remaining 

life span of the insured. The price of this deferred annuity 

depends on the contract interest rate and loading expenses. 

Since this contract pays the same amount at the same time 

regardless of the life status or any other risk of the purchaser, 

the charge would be unrelated to his age. -4/ 

If the company prices the single premium deferred annuity 

based on a 10 percent interest rate, it would calculate the 

present value of $100,000 to be paid in twenty years at $14,864. 

The company may add a loading charge or it may expect 

3/ 1983 Life Insurance Fact Book, p. 55. -

-4/ A more elaborate policy would guarantee $100,000 if the 

policyholder dies before the twenty-year period transpires. 

This type of whole-life policy is typically called a 20-year

endowment contract. The added cost of a term insurance 

rider would be related to the age of the purchaser. 
-6-

to earn investment earnings (in excess of the contract rate) 

sufficient to cover all expenses including company profit. It 

may, for instance, buy a 20-year zero-coupon bond yielding 

12 percent and assess no loading charge in the purchase price. 

Payments for annuity policies have also been growing as a 

percentage of U.S. life insurance companies' premium receipts. 

Payments for annuities and pensions were 8 percent of life 

insurance companies' total premium receipts in 1960, 10 percent 

in 1970, and 29 percent in 1982. Roughly three-fifths of 

receipts for annuities by life insurance companies in 1981 were 

for group plans, such as employer-provided pension plans. The 

remaining were for individual purchases of annuities or 

individual retirement accounts. 5 /

-

Permanent Life Insurance 

Because the cost of term insurance rises with the age of the 

insured, permanent insurance contracts were developed with level 

premiums and a level death benefit. Permanent life insurance 

involves significant elements of both insurance protection and 

investment. Permanent life insurance can be characterized 

roughly as an interest earning (savings) account into which 

premiums (deposits) are paid and from which withdrawals are made 

to pay for term insurance. The value of the savings component 

equals the accumulated value of premiums paid, plus earnings on 

the savings account, less the cost of the insurance. This "cash 

surrender value" is generally available to the policyholder upon 

surrender or cancelation of the policy. Chart 1 shows the 

increasing cash surrender value of a hypothetical whole life 

insurance policy -

6/ with a face value of $100,000 issued to a 35 

year-old policyholder at a contractual interest rate of 4 

percent. The annual net premium is set at $1,445 through the age 

of 99. 

-

5/ 1983 Life Insurance Fact Book, pp. 55-6.

-6/ A policy with insurance protection until age 95 or later is 

called a "whole life" policy. 
W Z

r 0
-8-

A few general observations may be made. A permanent life 

insurance policy of this type is, in substance, a contract that 

calls for an increasing savings account and a decreasing amount 

of renewable term insurance. While the death benefit provided 

under the policy remains level at $100,000, the amount of 

insurance protection that the company must provide at any given 

time is equal to the excess of face amount over the balance in 

the policyholder's savings account at the beginning of the year. 

For example, since the policyholderls savings account at age 56 

is $33,560, the amount of pure insurance protection during that 

year is equal to $66,440. If a permanent policy remains in force 

long enough, the savings component eventually increases in value 

to the face amount of the policy. At that point there is no 

insurance component and the policy is then said to "mature" or 

"endow. I' 

The cash surrender value of this policy increases in the 

initial years because the level premium is larger than the cost 

of insurance coverage. Even though the mortality rate rises 

steeply in later years, the value of the savings account 

continues to grow because the annual deposit and investment 

income earned always exceed the cost of the term insurance 

coverage. In this example, the cumulative cost of the insurance 

roughly equals the cumulative investment income. Thus, the cash 

surrender value closely tracks the total amount of premiums paid. 

Based on the assumptions described above, the single premium 

necessary to purchase a $100,000 whole life policy would be 

$27,600. Because of the large initial deposit, the amount of 

term insurance protection provided in the initial year is only 

$72,400, significantly less than under a level premium policy. 

Over the life of the policy, the single premium results in lower 
-9-

term insurance costs and a much quicker accumulation of investment income. The cumulative investment income is more than 

double the amount of the cumulative mortality charges until the 

last few years of the policy. Hence, a single premium policy has 

a significantly higher investment component and a smaller 

insurance component than a level premium policy providing the 

same death benefit. -7/ 

The earlier the age at which a policy endows, the greater its 

investment orientation. Under the same assumptions as above, the 

single premium for a policy starting at age 35 and endowing at 

age 65 is $34,800. This amount grows to $100,000 in 30 years, 

even with a modest contractual interest rate of 4 percent. The 

total cost of term insurance coverage under this policy would be 

only $9,400. Hence, virtually all of the cumulative interest 

earnings on the policy are used to increase its cash surrender 

value. Of course, if a higher interest rate were credited to the 

policyholder, the investment orientation of this policy would be 

even more pronounced. 

Permanent life insurance acounted for 50 percent of total 

life insurance in force in 1954', 37 percent in 1970 and 

30 percent in 1981. -8/ One reason for the decline is that 

guaranteed interest rates on permanent life insurance policies 

did not rise nearly as fast as other interest rates. Many other 

investments with low yields, such as traditional passbook 

accounts, also declined in importance relative to other financial 

investments over this same period. 

-7/ Testimony of John E. Chapoton, Department of the Treasury

before the Select Revenue Subcommittee of the House Ways and 

Means Committee on the Taxation of Life Insurance Companies

and their Products, May 10, 1983. 

-8/ 1983 Life Insurance Fact Book, pp. 15, 25 and 30. 
-10-

B. Variations of the Standard Products 

Term insurance, whole life insurance, and deferred annuities 

are now the standard types of life insurance products. Numerous 

variations of these products exist. Two common variations 

involve participation or sharing in the profit of the company 

and variable rates of return on savings. 

Participating Insurance 

To establish sufficient funds to cover possible, but greater 

than expected, liabilities, companies selling non-participating 

policies typically require an initial company surplus from 

capital contributed by shareholders. Companies selling participating policies, on the other hand, pool the resources of 

policyholders to build up this surplus. Participating policyholders, thus, could be thought of as partial or full owners of 

the company. Mutual companies, which have no shareholders, offer 

only participating policies. Some stock companies offer limited 

numbers of participating policies, but have equity owners in 

addition to policyholders. 

Participating policies typically pay dividends to 

policyholders when the “surplus” associated with the policies 

is above what is necessary to protect against liabilities. This 

“surp1us1Imay arise from a variety of sources: higher than 

contractual rates of return on assets, premium payments in excess 

of those needed to cover expenses, improvements in mortality 

rates, or better management and lower costs. 

Participating policies accounted for 50 percent of all life 

insurance in force at the end of 1982, while non-participating 

insurance accounted �or the other 50 percent. Mutual companies 
-11-

provided slightly less than 43 percent of total life insurance 

in force at the end of 1982. Stock companies sold the remaining 

57 percent of which roughly one-sixth was participating. -9/ 

Non-traditional Forms of Life Insurance 

Recent decades have seen rapidly changing financial markets 

and greater uncertainty over the level of future interest rates. 

With increases in inflation and interest rates, many non-life 

insurance investments offer rates of return in excess of 

contractual rates of interest on more traditional permanent life 

insurance contracts. The life insurance industry has gradually 

responded to this changing economic environment by creating new 

products, many of which offer more competitive rates of return. 

Some features of these policies make their saving components 

hardly distinguishable from accounts with banks, thrift institutions or mutual funds. Policyholders may be credited with 

rates of return that are variable and closely related to market 

rates of return, although typically there will also be a minimum 

guaranteed rate of return. Some policies also allow the 

policyholder to choose the investment goals for his policy's 

savings. 

Universal life insurance is one example of the new type 

of insurance product. In addition to a variable interest rate, 

universal life policies differ from traditional permanent 

policies in that policyholders can determine the timing and 

amount of premiums they pay each year; they may also alter the 

amount of death benefit. By changing these parameters, 

policyholders effectively designate more or less of the premium 

payment as an addition to the savings account component of the 

policy. A universal life policy with a large insurance component 

can become a close substitute for renewable term insurance, while 

9/ 1983 Life Insurance Fact Book, 13. 18. 
-- 

-12-

one with a high savings component can be made into a close substitute for an annuity or a savings account at a thrift institution. 

Variable life insurance is another recent type of financial 

contract issued by life insurance companies. Variable life is 

similar to universal life, except that the death payment and cash 

value depend on the total investment return from a portfolio that 

is often more risky because it includes corporate stock and real 

estate. In a variable life policy, a policyholder is also more 

likely to determine the types of assets in which the policy's 

savings are invested. 

Non-traditional forms of life insurance are a significant 

share of the new life insurance contracts. Variable life 

insurance doubled from $3.7 billion in force in 1981 to $7.6 

billion in 1982. Universal life insurance increased from $4.9 

billion in force in 1981 to $40.4 billion in force in 1982. 

Variable and universal life polic'ies accounted for one-sixth 

of the increase in total life insurance in force between 1981 

and 1982. -10/

11. THE CURRENT RULES GOVERNING THE TAXATION OF INCOME 

FROM LIFE INSURANCE PRODUCTS 

The taxation of income flowing through life insurance 

companies has been relatively unchanged since the enactment of 

the Life Insurance Company Income Tax Act (LICITA) of 1959. 

The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, 

however, made several temporary changes for tax years 1982 and 

1983. The tax rules affecting income flowing through life 

insurance companies can be explained most easily by examining 

separately taxation at the individual (policyholder) level and at 

the company level. 

10/ 1983 Life insurance Fact Book, pp. 15 and 26. 
-13-

A. Taxation at the Individual Level 

Compared with the tax treatment of investment income from 

most financial institutions, the taxation of income earned on 

products offered by life insurance companies provides significant 

tax advantages to individual investors. 

First, investment income earned on life insurance policies is 

not subject to tax unless the policy endows or is surrendered or 

canceled prior to the death of the insured. Similarly, interest 

income earned on annuities is generally taxable, but the tax is 

deferred until the proceeds are received. Significant tax 

deferral occurs as the result of the "inside interest buildup" 

that is not subject to tax as it is earned, but only when 

distributed. Additional tax savings occur if the policyholder's 

marginal tax rate is lower at the time of realization than when 

the interest income was actually earned. 

Second, when a life insurance policy is held until the death 

of the insured, the portion of the death benefits representing 

accumulated investment income is excluded from taxable income of 

the beneficiaries. -11/ The tax advantage of life insurance held

at death is due to the exemption from tax of accumulated investment income, not from the exemption of other proceeds. Payments 

of proceeds from the term insurance component represent redistributions among policyholders which involve no increase or 

decrease in net income in the economy (as long as the initial 

premiums are made out of after-tax income). If insurance proceeds 

-

11/ Life insurance may also be used to avoid estate taxes. When

the right to receive life insurance benefits is irrevocable 

by the donor, the premiums paid may be treated as a gift,

and the life insurance payment is excluded from the 

estate tax base. 
-14-

are left with the company after the death of the insured under an 

agreement to pay interest, only the interest earned after death 

is taxable to the recipient. -12/

Third, part of the investment income earned on life insurance 

contracts escapes taxation because the income is measured net of 

the cost of insurance services. Current rules require income 

earned on life insurance contracts to be included in taxable 

income when distributed only to the extent that total receipts 

exceed the policyholder's investment in the contract, which 

equals total premiums paid. However, a portion of the premiums 

paid over the life of the policy are used to cover the cost of 

personal insurance protection. These costs would not be 

deductible to a taxpayer who did not save through an insurance 

policy. Investment income thus may be used to pay for the cost 

of personal insurance services without ever being subject to tax. 

Fourthj partial withdrawals and loans against the cash 

surrender value of a policy occur without any tax penalty. They 

are treated as being made first out of the policyholders' 

investment capital, rather than accumulated investment income. 

In contrast, early withdrawal or borrowing against the value of a 

tax-deferred annuity involves a tax penalty and the withdrawal is 

treated as first coming out of accumulated income. In addition, 

interest incurred in borrowing against a policy's cash surrender 

value is generally deductible, even though the income earned on 

the policy is not subject to tax currently. Policyholders who no 

longer wish to continue their savings through a particular policy 

frequently find it advantageous to borrow against their cash 

surrender value and hold a policy until death in order to exempt 

from tax the accumulated investment income. 

-12/ If the beneficiary is the spouse of the insured, up to $1,000 

per year of interest income from the insurance proceeds may

be excluded from taxable income. 
-15-

Fifth, policyholder dividends from participating insurance 

contracts are generally not subject to tax when received, even 

though the dividends include a distribution of profits and 

interest earned by the company. Policyholder dividends, however, 

do reduce the policyholder's investment in the life insurance 

contract; if the policy is surrendered before the death of the 

insured, some income--though received in prior years--may be 

subject to tax at time of surrender or if amounts received exceed 

the investment in the contract. 

Finally, the cost of the first $50,000 of employer-paid 

group-term life insurance is excluded from taxable compensation 

of employees. -13/ Employer-paid premiums for health insurance 

are also not attributed to employees either as direct compensation or, later, as receipts of medical benefits. Some 

proposals would cap this exclusion, but only at fairly high 

levels of premiums. In effect, if an employee purchases health 

or life insurance benefits through an employer, the cost of such 

benefits are deducted from income subject to tax. 

Definition of "Life Insurance" 

Until TEFRA, there was no statutory definition of "life 

insurance." While the Internal Revenue Service at times 

attempted to disqualify certain products from favorable tax 

treatment when they had almost no insurance component, life 

insurance companies have claimed that their products qualified as 

"life insurance" as long as they had only a minimal insurance 

component. 

-13/ In contrast, only $5,000 of company-provided death benefits 

are excluded from taxable income of the beneficiaries. 
-- 

-- 

-- 

-16-

To qualify for the exemption of investment income at death 

and liberal withdrawal and borrowing rules, "flexible premium" 

policies 14/ must meet certain tests. During 1982 and 1983, one 

test placed limitations on both the total amount of premiums that 

can be paid and the minimum amount of pure insurance in a "life 

insurance" contract. _. 

15/ A second test placed a limitation 

on the amount of cash surrender value in a "life insurance" 

contract. 16/ Both of these tests attempted to disqualify from 

the favorable tax treatment contracts that were overly investment 

oriented or lacked a significant amount of pure insurance. 

B. Taxation at the ComDanv Level 

Taxable income of life insurance companies is subject to tax 

at the same statutory tax rates faced by other corporations. The 

unique features of life insurance company taxation revolve around 

the definition of taxable income. To qualify for the many 

special tax provisions in Part I of Subchapter L, a company 

"engaged in the business of issuing life insurance and annuity 

contracts, or non-cancellable contracts of health and accident 

insurance," must keep more than one-half of its total reserves 

for life, health, and accident contingencies. 

-14/ "Flexible premium" policies allow a policyholder to change

the amount and timing of the premiums and the size of the 

death benefit. 

-15/ The sum of the premiums paid can not exceed the greater of 

the policy's single premium or the sum of the level annual 

premiums payable over at least 20 years. In addition, the 

face amount of the policy must be at least 140 percent of the 

.cash surrender value up to age 40, declining to 105 percent 

at age 75 and thereafter. 

16/ The cash value may never exceed the net single premium for 

the face amount of the insurance. 
-17-

Taxable income of life insurance companies is determined by 

reference to lltaxableinvestment income" and "gain from 

operations." -

17/ One can think of these components roughly as

the company's return from financial investments, and the 

company's return from both investment and underwriting services, 

respectively. In practice, taxable investment income is intended 

to approximate the company's total investment income net of the 

share attributed for tax purposes to policyholders. Taxable 

investment income is sometimes called "Phase I income." Gain 

from operations is a measure of total income, including investment income net of the "share of investment yield set aside for 

policyholders" (but under a different attribution rule than for 

taxable investment income), plus a measure of underwriting 

income. Gain from operations is sometimes called "Phase I1 

income." Taxable investment income and gain from operations will 

be described in more detail after a description of total taxable 

income. 

Total Taxable Income 

Total taxable income depends on the relationship between 

taxable investment income and gain from operations, as shown in 

Table 2. Taxable income equals gain from operations if gain 

-

17/ An additional provision requires that taxable income of

stock life insurance companies include amounts subtracted 

from a "policyholders' surplus account ." This account 

represents an accumulation of certain previously untaxed 

income, including one-half of gain from operations in 

excess of taxable investment income plus certain special

deductions (discussed later in this section). Subtractions 

from the policyholders' surplus account occur only when 

distributions are made from the account or when the account 

exceeds certain limits. This additional provision could be 

considered a form of recapture tax and is sometimes called 

"Phase I11 income." In practice, few companies have yet to 

pay a significant amount of tax under this provision. 
-- 

-18-

Table 2 

Taxable Income of Life Insurance Companies 

Taxable Income Base Required Tax Position 

Gain from Operations if Gain from Operations < Taxable 

Investment Income 

Taxable Investment Income if Gain from Operations > Taxable 

+ 0.5 [Gain from Operations Investment Income - Taxable Investment Income] 

from operations is less than taxable investment income, that is, 

if the company has underwriting for tax purposes. 18/ 

If the company has reported underwriting profits, taxable income 

equals taxable investment income plus one-half of the excess of 

gain from operations over taxable investment income. 

Taxable Investment Income 

Let us now examine in more detail the measure of taxable 

investment income. This measure was intended to approximate the 

company's investment income by subtracting from total investment 

income the portion of investment income owed to policyholders. 

Since this latter amount was usually guaranteed, net capital 

gains could also be expected to reside with the company. 

In determining taxable investment income of the company, 

however, the tax.laws do not merely exclude from total investment 

income the amount actually credited to the policyholders. Total 

-I%/ A company could report underwriting losses for tax purposes 

even when it has true underwriting income. The difference 

occurs as a result of excess reserve deductions, policyholder

divid'ends, or other special deductions. 
-19-

investment income from all sources instead is allocated between 

the company and its policyholders on the basis of a formula 

which relates the average assumed rate on the policies (for 

purposes of determining reserves) to the actual yield realized by 

the company on its investments. Investment income earned on 

reserves held in "separate" accounts that are established in 

connection with certain pension plans and variable annuities is 

allocated entirely to policyholders and is excluded from taxable 

investment income. Finally, a "small business" deduction of 

10 percent of investment income, up to $25,000, is allowed for 

all companies. 

Pre-TEFRA allocation formula. Prior to TEFRA, the allocation 

formula for dividing investment income (outside of separate 

accounts) into the company's share and the policyholders' share 

was based on the 10-1 rule or Menge formula (named after Walter 

0. Menge, an actuary who suggested the formula). The Menge 

formula calculated the excludable portion attkibutable to 

policyholders with the following equation: 

1) Policyholders' Share = R[1-10 (R-RA) ] (Reserves) 

where R equals the lesser of the current earnings yield or its 

five-year average and RA equals the average rate of interest 

assumed on reserves. 

Some examples will illustrate the odd nature of this 

parabolic function. -19/ First, if the assumed yield (RA) 

was 4 percent and the actual yield (R) was 6 percent, the 

-19/ If the assumed rate, R , is constant, the formula is that 

of a qarabola in R. Taat is, the Policyholders' Share = - IOR + [I + 10RA] R. 
-20-

company was allowed to exclude 80 percent of invesfment income 

earned on reserves as attributable to policyholders. If 

policyholders were actually credited interest at the assumed 

rate, then only 67 percent of investment income from reserve 

assets (4 percent/6 percent) was set aside for the benefit of 

policyholders. With an assumed rate of 4 percent and an actual 

yield of 10 percent, the company excluded 40 percent of 

investment income, which was the precise amount credited 

policyholders. At interest rates between the assumed 4 percent 

rate and a 10 percent rate, the excluded amount exceeded the 

amount credited to policyholders. At an assumed rate of 

4 percent and interest rates higher than 10 percent, the excluded 

share was less than amounts credited; if the lesser of the 

current rate or a five-year average rose to 14 percent, the 

excluded share equaled zero. 

As interest rates rose in the late 1970's, man-y life 

insurance companies were expecting to move to the downward 

sloping portion of the parabolic function where they would 

exclude a smaller amount of investment income. Since actual 

yields were based on the lesser of the current yield or the prior 

five-year average, few, if any, insurance companies reached the 

point where the amount excluded was less than the amount credited 

to policyholders. Thus, the Menge formula allowed companies to 

exclude from their income more investment income than they 

credited to policyholders, but the amount of the exclusion was 

expected to decline by the early 1980's. -20/ 

The rationale for using the Menge formula rather than simply

allowing companies a deduction for the amount of interest 

credited to policyholders is somewhat-difficult to ascertain. 

The 1959 Act reformed prior law by moving away from calculating the policyholders' share of investment income on the 

basis of an industry average or a fixed formula. The Menge

formula at least related allocation of shares to the 

experience of each individual company. The argument for use 

of the current earnings rate was that competitive pressures

would force life insurance companies to credit to policyholders rates of interest on reserves higher than the stated 
-21-

TEFRA allocation formula. The allocation formula for taxable 

investment income was changed for tax years 1982 and 1983 to a 

"geometric" formula by TEFRA. The new formula sets the 

policyholders' share as follows: 

2) Policyholders' Share = R [0.9 ['O0 (R-RA) I [Reserves]. 

The amount excludible as the policyholders' share is still 

based on the relationship between the average assumed rate and 

the actual yield (again, the lesser of the current yield or its 

five year average). The new formula insures that if interest 

rates remain within their recent historic range, the excluded 

amount will be larger than the amount credited to policyholders. 

For instance, with an assumed interest rate of 4 percent and an 

actual yield of 10 percent, insurance companies could exclude 

the equivalent of 5.3 percent of reserves (10 percent times 

53 percent) rather than the 4 percent contractual rate. 

Gain from Operations 

Gain from operations in its simplest guise can be viewed as a 

measure of total income of the life insurance company, including 

both investment and underwriting income, net of the share of 

investment income set aside for policyholders. In calculating 

gain from operations, however, investment income is allocated to 

policyholders differently than in calculating taxable investment 

income. The exclusion of the policyholders' share is the amount 

credited to policyholders (at the assumed interest rate). 

(Continued) 

contract rate. However, the Menge formula did not recompute 

reserves to compensate accurately for an increase in the 

current earnings rate. Thus, companies in effect were 

allowed to deduct the policyholders' share calculated at 

higher interest rates and higher reserve deductions computed 

at lower interest rates. 
-22-

Deductions for additions to reserves. Since permanent 

insurance premiums cover both the cost of insurance protection 

and an amount set aside as policyholder savings, part of the 

gross premium is roughly equivalent to a deposit in a bank. Such 

a deposit represents an addition to both assets and liabilities 

of the institution, not income. Thus, a deduction equal to the 

net additions to policyholder reserves (or the increase in 

liabilities) is allowed to offset the equivalent amount of 

receipts (or increase in assets). Other depository institutions 

achieve a similar result by counting neither the deposit as a 

receipt nor the equivalent addition to reserve as a deduction 

in calculating taxable income. 

Reserve requirements are set primarily by State laws, 

Because the concern of these laws is with the protection of 

policyholders, not with the accurate accounting of economic 

income, assumptions with regard to required interest rates, 

mortality rates and reserve methods typically are conservative. 

The Tax Code nonetheless has allowed a deduction for all 

additions to reserves required by State laws. Also, companies 

may use assumed interest and mortality rates even more conservative than required by State laws in computing their reserves 

for tax purposes. Therefore, deductions for additions to 

reserves generally are in excess of what is economically 

necessary to cover expected expenses or liabilities, This 

results in an understatement of (expected) company income and 

significant tax deferral. 

With regard to the timing of premium receipts and loading 

expenses, life insurance companies can calculate their reserves 

for tax purposes using a net level premium method or preliminary 

term method or a combination of those methods. The net level 

premium method assumes that additions to reserves are made out of 

a constant premium, net of loading charges. This method assumes 

that loading expenses are amortized over the duration of the 

policy, even though agents' commissions and administrative costs 
-23-

typically are paid in the initial years and are deducted 

currently. The preliminary term method, on the other hand, 

assumes that all loading expenses are covered by the initial 

premium payments. With this latter method, the net addition to 

reserves is lower the first year, but higher during the rest of 

the premium-paying period. 

Companies can choose modified preliminary term methods that 

compute the amount of reserves closer to the amount allowed under 

the net level premium method. Thus, companies can assume that 

only part of the initial premium payments are used for loading 

expenses and assume that the remaining amount is used to pay 

current insurance charges or to fund reserves. Modified 

preliminary term methods often speed up the additions to reserves 

by "grading" reserves up to the level allowed under net level 

premium reserve methods over a 5-15 year period. 

Life insurance companies that compute their reserves for 

State regulatory purposes on a preliminary term basis are allowed 

to compute their reserves on a net level premium basis for tax 

purposes. Revaluation of State law reserves from preliminary 

term to net level premium can also be computed by an approximate 

method. Prior to TEFRA, the approximate revaluation method 

allowed preliminary term reserves for other than term insurance 

to be increased by $21 per $1,000 insurance in force, less 

2.1 percent of reserves already established under such contracts. 

TEFRA permanently reduced the revaluation amount from $21 to $19 

per $1,000 of non-term business written after March 31, 1982. -21,'

Even with the revision, the approximate revaluation formula 

permits an adjusbnent substantially in excess of that needed 

to approximate a net level premium reserve for most policies. 

-21/ Term insurance contracts, which at the time of issuance cover 

a period of more than 15 years, can be revalued through an 

approximate method which increases reserves $5 per $1,000 of 

such insurance in force, less 0.5 percent of existing 

reserves under such contracts. This provision was not 

changed by TEFRA. 
-- 

-24-

Special deductions. Life insurance companies are allowed 

special deductions not available to other financial institutions. 

These special deductions were designed as part of the 1959 Act to 

improve "parity" in the amount of taxes paid by the mutual- and 

shareholder-owned sectors of the life insurance industry. 

Two special deductions are related directly to premiums. 

First, life insurance companies can deduct two percent of 

premiums for accident and health insurance contracts and group 

life insurance contracts. This special deduction, it was 

argued, would compensate for the fact that group insurance 

policies have less diversification of risk than non-group 

policies. -22/ Second, stock companies are allowed to deduct 

the greater of three percent of premiums on non-participating 

contracts or an additional ten percent of the increase in 

reserves for such contracts. The special deduction for 

non-participating contracts supposedly allows stock companies 

to build up a surplus out of pre-tax income similar to the 

surplus achieved by mutual companies through redundant premium 

charges. -23/ Neither special deduction, however, requires a 

reserve fund to be established out of the pre-tax earnings to 

cover any additional risk incurred. Since profits for many 

companies are only a small percentage of sales, each of the 

deductions can have significant effect on taxable income. 

Another special deduction is allowed for policyholder 

dividends paid on .participating insurance contracts. As 

described in the first section, policyholder dividends may be 

paid when the surplus associated with participating policies is 

above the amount necessary to protect against large unexpected 

liabilities. Part of policyholder dividends consists of return 

-

22/ U.S. Congress, Senate Committee on Finance, Life Insurance 

Company Income Tax Act of 1959, Report Together with 

Supplemental Views of the Committee on Finance to Accompany

H. R. 4245, 86th Congress, 1st session, March 14, 1959, 

p. 23. 

-23/ U.S. Congress, Senate Committee on Finance (1959), p. 22. 
-25-

of capital from prior year's premiums or from excess premiums 

paid in the same year. Since investment earnings and underwriting gains increase company surplus, policyholder dividends 

also include some return of income. Accordingly, a limitation 

was placed on the amount of deductible policyholder dividends and 

other special deductions. -24/ (Section I11 discusses the 

difficulty of measuring the income component of policyholder 

dividends.) 

Prior to TEFRA, the amount of special deductions was limited 

to the excess of gain from operations above taxable investment 

income, plus $250,000. -25/ Thus, the special deductions could 

eliminate, or defer -26/, tax liability on underwriting income 

plus a small amount of investment income. The proportion of 

policyholder dividends that could be deducted declined during the 

1960's and 1970's for both stock and mutual institutions. This 

decline coincided with a reduction in the ratio of excess of gain 

from operations to taxable investment income. As interest rates 

rose, investment income grew. To reflect actual interest rates 

higher than the policies' contractual rates, some companies 

reduced premiums, while other companies increased policyholder 

dividends. 

TEFRA temporarily expanded the limitation on special 

deductions to the greater of 1) excess of gain from operations 

above taxable investment income plus up to $1 million, depending 

-24/ U.S. Congress, Senate Committee on Finance (1959), p. 22.

-25/ The additional $250,000 deduction against taxable investment 

income was allowed especially to help small companies that 

might experience temporary underwriting losses when they

expand their operations. U.S. Congress, Senate Committee 

on Finance (1959), p. 22. 

-26/ The untaxed portion of gain from operations is added to the 

company's Rpolicyholdersl surplus account". The tax will be 

deferred rather than eliminated if the untaxed portion of 

gain from operations is included in future taxable income. 
-- 

-26-

on the size of the company, or 2) the sum of all policyholder 

dividends credited to qualified pension plans, the statutory 

amount of $1 million, and 77.5 percent of policyholder dividends 

paid by mutual life companies or 85 percent of the sum of 

policyholder dividends and the deduction for nonparticipating 

contracts for stock companies. The differential between the 

mutual and stock companies' allowable percentage was an ad hoc 

adjustment for the equity return or "ownership differential" of 

mutual companies. 

111. MEASUREMENT OF TOTAL TAXABLE INCOME FROM LIFE 

INSURANCE PRODUCTS 

Total economic income generated from life insurance products 

is commonly divided into investment income earned on assets and 

income from providing insurance and other non-investment 

services. From an economic perspective, total investment income 

equals the investment yield on all assets held by the insurance 

company minus the factor cost of servicing the investment 

portfolio. Total service income equals the net amount paid for 

services; in the simplest case of pure insurance with no 

investment component, service income equals total receipts less 

payments of insurance proceeds, which in turn equals the factor 

cost of servicing the contracts. That is, the income earned by 

the factors involved in providing services equals the value of 

the services or products received by policyholders. -

27/ This

income is paid to many factors both within and outside the 

company as labor compensation, rent, interest to non-policyholder 

creditors, and company profit. Company profit from providing 

services (other than investment services) is generally labeled 

"underwriting income." Because it is essentially a residual 

number--the remainder after all other costs and investment income 

are subtracted from receipts--its measurement is often subject to 

a great deal of dispute. 

-

27/ See Table 1.1 in Neubig and Steuerle (1983), p. 12.
-27-

At the policyholder level, it should be clear that total 

income does not include all payments received. Analogous with 

the game of roulette, if premium payments (or bets) are made out 

of income already counted, then the returns on those bets do 

not add to income, but rather represent a redistribution of 

income. _. 28/ After accounting for this redistributional effect, 

the net income added simply equals the return to the house in the 

case of the roulette wheel or the payments to factors in the case 

of insurance. Policyholders as a group are willing to receive 

total insurance proceeds less than total premiums paid because 

the difference represents the value of services received. If the 

house (or insurance company) adds an invesment policy which 

allows prepayment for chips (or insurance) to be received at some 

point in the future, then the investment return on those savings 

also represents an addition to economic income. 

This brief review of the components of economic income allows 

us to turn to the five major sources of differences between the 

measurement of taxable income and 'total economic income actually 

flowing through life insurance companies: tax-preferred products 

offered by life insurance companies to individuals; services 

financed with nontaxable investment income; incorrect separation 

of returns -to capital (income) from returns -of capital (principal); tax-preferred assets held by life insurance companies; and 

special tax preferences exclusively for life insurance companies. 

Related questions of whether total income is allocated properly 

among recipients or types of activities, and whether deductions 

for future liabilities are appropriate, are reserved for later 

sections of this paper. 

A. Tax-Preferred Products Offered by Life Insurance 

Companies to Individuals 

Current tax laws allow life insurance companies to offer 

substantial tax savings to households that purchase certain 

insurance products. These preferences fall into three principal 

-28/ Neubig and Steuerle (1983)r p. 39. 
-28-

categories: the deferral of investment income from taxation; the 

exclusion of investment income from taxation; and the deduction 

or exclusion from income of the value of purchases of certain 

types of insurance. These exclusions, deferrals and deductions 

are generally not allowed for purchases of similar types of 

products from other financial institutions. 

Deferral of Income 

One of the most important tax preferences for life insurance 

arises from the deferral of investment income from the current 

tax base of individuals. The inside buildup of investment income 

is deferred from taxation until the policy is canceled or 

matures. Even if the taxpayer is in the same tax bracket at time 

of withdrawal as during time of buildup, the deferral of taxation 

can result in a substantially lower present value of taxes and a 

higher rate of.return net of taxes than if the income were taxed 

currently. In fact, many policyholders are in substantially 

lower brackets at time of withdrawal and thus achieve even 

further tax savings. 

Deferral of taxes is allowed for the earnings on both 

permanent life policies and on annuities sold by life insurance 

companies. Our discussion here refers to purchases made by 

taxpayers out of after-tax income rather than annuities connected 

with pension plans and individual retirement accounts. For some 

policies, there need not be even a significant element of 

insurance against death, and the entire premium may go into the 

equivalent of a savings account. For instance, a premium may be 

used to purchase a deferred annuity--a policy which provides for 

the accumulation of previous payments and interest until the 

policyholder withdraws the fund or converts the fund into a right 

to receive periodic payments. If the policy also allows for 

withdrawal of savings at any time, then there is hardly any 

difference between it and a simple savings account. 
-29-

The benefits of tax deferral can be illustrated using the 

hypothetical permanent life insurance policy described in section 

I. A policyholder who surrenders or cancels the policy at age 

70, would have earned $40,704 of investment income on the policy 

and would have a tax liability of $12,211 if subject to a 

30 percent marginal tax rate. -29/ No tax liability is paid on

the investment income earned until the policy is canceled. 

Assuming the policyholder is in the same marginal tax bracket for 

the duration of the policy, the tax savings from postponing tax 

liability until surrender is roughly equivalent to a 40 percent 

reduction in the present value of taxes that would have been 

paid on the investment income. The advantages of tax deferral 

increase with the length of deferral. 

Income Exclusion 

The second. type of tax preference provided to those 

purchasing policies of life ihsurance companies arises from the 

exclusion from taxation of investment income received upon death. 

The exclusion is not granted if the savings are withdrawn 

before death. We have already noted that the exclusion of term 

insurance proceeds is appropriate to the measure of aggregate 

income if the premium payments have been made out of after-tax 

income. Redistributions of after-tax income need not be taxed. 

A beneficiary of a life insurance policy, however, may receive 

not only a redistribution from living policyholders, but also the 

capital in the deceased's savings account and the accumulation of 

investment earnings in that account. The deferral of tax on 

investment earnings is converted into a permanent exclusion from 

tax through the death-time exclusion. The Tax Code thus provides 

a strong Sncentive for persons with bequest motives to save 

through insurance policies rather than directly through other 

investment vehicles . 

-29/ In fact, the tax liability would be considerably iess 

' because of the deduction of costs of services due to 

inaccurate measurement of the investment in the contract. 

See section III(B). 
-30-

Deduction of Costs of Services 

In addition to exclusions and deferrals of the inside 

interest buildup of life insurance products, the Tax Code also 

allows a deduction or exclusion from income for the cost of 

insurance products. In particular, employees' taxable 

compensation is measured net of the cost of employer-provided 

health insurance, a variety of disability and accident policies, 

and the first $50,000 of employer-paid group term life insurance. 

Neither the value of the insurance proceeds 30/ - nor the cost of

the services received are included in taxable income of the 

beneficiaries. 

If all income were to be taxed, then the purchase price of 

the fringe benefits and the investment income on the policies 

would be included in taxable income. Alternatively, the payments 

made from these policies (e.g., cash paid to the beneficiaries of 

life policies or payments for medical bills), plus the value of 

insurance services received, would be treated as income subject 

to tax. Uniform income taxation would require that all life 

insurance proceeds be subject to tax when both the income used to 

make premium payments and the accumulated investment income have 

not been taxable. For most insurance programs, it is probably 

fairer and more rational to tax the income used to buy insurance 

than the redistributed income received as benefits due to death, 

disability, or illness. -31/

-30/ A major exception involves disability payments or wage

continuation plans of persons who are not permanently disabled or not otherwise eligible for the disability income 

exclusion. Even though some of these payments are taxable, 

the value of the services received by covered employees

remains nontaxable. 

-31/ mil M. Sunley, "Employee Benefits and Transfer Payments"

in Comprehensive Income Taxation, edited by Joseph A. 

Pechman (Washington, D.C.: The Brookings Institution, 

1977), p. 76. 
-31-

All of the preferences discussed in this section apply 

essentially at the individual level. There are two implications, 

however, at the level of the financial institution. First, tax 

preferences increase demand for the preferred products. Economic 

theory holds that the benefits of tax preference may be shared 

between demanders and suppliers, and thus, the financial institutions may indirectly gain some of the benefits essentially 

granted to individuals. In the short run, this benefit may be a 

higher level of profitability or wages paid to factors; in the 

long run, it may result in a larger life insurance sector. 

Second, taxes paid to the government by insurance companies may 

represent not only taxes on the income of the "equity" owners of 

those institutions, but also indirect taxes on the income of 

policyholders which benefits from tax exclusions, deferrals or 

deductions granted at the individual level. 

B: Investment Income Net of Services at the Individual Level 

An income tax should measure only the net return, not the 

gross return, to investment. Thus, the cost of earning investment income is generally a deductible expense at both the 

individual and company level. Economic'income will be mismeasured, however, if the cost of non-investment services 

received are also deducted from individuals' investment income. 

Most individuals purchasing just term life or health 

insurance receive no deduction for any portion of their premiums. 

It is recognized that purchasers of insurance receive a benefit 

in return for their payment. For these policyholders as a group, 

the net value of the insurance services equals premiums paid less 

payments received. Persons holding policies with an investment 

component, on the other hand, have a decided tax advantage over 
-32-

holders of term or health insurance because the cost of insurance 

services received is effectively deducted from investment income. 

The measure of investment income is thus understated by the value 

of the services purchased. 

The issue is made more complicated by the existence of two 

kinds of services--investment services and non-investment or 

insurance services--in most insurance products. Fortunately, the 

net investment return is often stated directly by the insurance 

company either in a guaranteed rate or in a rate directly attributed to the savings component. Such investment income has 

already been reduced by the company to account for its costs of 

servicing the investment, and it should not be reduced further to 

account for the cost of other services. Under current law, 

however, taxable income earned on a policy that is canceled or 

which matures prior to the death of the insured equals the cash 

surrender value minus total premiums paid. Using total premiums 

paid as the "investment" in a life insurance contract effectively 

allows the cost of the personal protection service to be deducted 

from income. Technically, even if deferral is allowed, the 

investment in an insurance contract should equal total premiums 

paid less the cost of comparable renewable term insurance 

coverage. 

Table 3 shows the difference between the amount of taxable 

investment income and actual investment income for the 

hypothetical policy described in section I. Taxable income 

is only $8,328 if the policy is surrendered at age 70, while 

accumulated investment income equals $40,704. The difference 

of $32,376 equals the cost of term insurance coverage paid 

out of investment earnings during the preceeding 35 years. The 

mismeasurement of the policy's investment (or basis) effectively 
-33-

Table 3 

Comparison of Taxable and Actual Investment Income 

of Hypothetical Permanent Insurance Policy * 

. : Ratio of 

: Cash : Taxable : Actual : Taxable 

Age at : Surrender : Investment : Investment : Investment : to Actual 

Surrender : Value : or Basis : Income : Income : Income (%) 

40 

50 

$ 8,040 

24,087 

$ 8,673 

23,129 

$ 0 

958 

$ 1,058 

7,448 

0.0 

12.9 

60 42,356 37,585 4,771 20,536 23.2 

70 60,369 52,040 8,328 40,704 20.5 

80 75,639 66,496 9,143 67,248 13.6 

90 87,113 80,952 6,162 98,842 6.2 

99 100,000 93,962 6,038 131,177 4.6 

* Calculations are based on an example of a level-premium,

level-death benefit policy described in Section I. 

allows a deduction for the cost of the insurance services. 

The tax liability on investment income earned on the policy is 

reduced by roughly 80 percent, not counting the additional 

advantage of tax deferral. 

All insurance, even term life and annual health insurance, 

have some investment component. Premium payments are held by the 

company in investments earning a rate of return. Some of that 

rate of return is implicitly returned to the policyholder in the 

form of a lower price for the insurance service. Here, again, 

the positive investment income of the policyholder, by being 

measured as zero is understated, although the amounts involved 

are not large relative to the cost of the policies. 
-34-

One reason that this tax preference is often unrecognized is 

that other preferences at the individual level are even more 

generous. The owner of a canceled or matured policy receives 

deferral of earnings, not just understatement of earnings by the 

amount of services effectively purchased with prior investment 

income. For life insurance proceeds paid at death, all income is 

excluded from tax, not merely deferred and understated. 

C. Separation of Income from Return of Capital 

An income tax must distinquish between returns -to capital

(income) and returns _. of capital (principal). Stockholders, for 

instance, must know the extent to which any payment includes 

dividends paid from income rather than returns of investment 

dollars for which there is no related income. Similarly, in the 

case of life insurance contracts, it must be determined whether 

payments include income or only returns of capital or premiums. 

We have already noted that payments of insurance proceeds include 

both returns to capital (through investment earnings on savings) 

and returns of capital (through redistributions among policyholders and returns of savings deposits). Dividends from 

participating insurance contracts also contain each of these 

types of returns. 

Policyholder Dividends 

Policyholder dividends, along with reductions in the price of 

insurance, are the principal means by which life insurance 

companies distribute income and excess capital to participating 

policyholders. In the case of a mutual life company, where there 

are no shareholders, up-front price reductions and policyholder 

dividends are the only ways to make distributions to policyholders who are technically the owners of the company. The