Warren E. Burger: We’ll hear arguments first this morning in number 75-1221, United States against Consumer Life Insurance Company and the two other cases consolidated with that case. Mr. Smith.
Stuart A. Smith: Mr. Chief Justice and may it please the Court. These three federal income tax cases are here on writs of certiorari from the United States Court of Claims and the United States Court of Appeals for the Fifth Circuit. Two cases, Consumer Life and Penn Security are from the Court of Claims and the First Railroad cases from the Fifth Circuit. They present a common question whether these taxpayer insurance companies meet the definition of a life insurance company under the Internal Revenue Code. Our tax system provides a marked preference for our life insurance companies insofar that it grants them a narrow tax base. The Court had previously considered the effect of that narrow tax base about ten years ago in the Atlas Life Insurance Company case. Now, other stock insurance companies such as those engaged in the sale of non-life insurance such as cancelable accident and health or casualty insurance are taxable at annual -- on their total annual net income as any other corporation. But life insurance companies have this preference. So it is today a decided advantage to qualify as a life insurance company. But like most taxpayers, that is like most insurance companies, the taxpayers in these cases do not deal exclusively and either life or non-life insurance but in a combination of those two types of insurance. So Congress, since 1921 has provided a mathematical test in the statute designed to limit the preferential life insurance company tax treatment to those companies whose predominant business is the assumption of life insurance risks. And it is done so by in Section 801 (a) of the Internal Revenue Code which represents essentially the same statute that is existed for some 55 years. Essentially the statute provides that reserves are the appropriate measuring rod for determining whether an insurance company is a life insurance company. The statute provides a fraction. The numerator of which is life insurance reserves and the -- for purposes of this case, and the denominator of which is total reserves and in order to be a life insurance company to qualify for this preferential treatment, that fraction has to be more than 50%. It’s like your life insurance reserves have to be more than ½ of your total reserves.
Potter Stewart: That’s simply a matter of statutory definition of what is a life company.
Stuart A. Smith: Exactly.
Potter Stewart: And it’s a -- basically a life insurance company is an insurance company that more -- that does more than its half, more than half of whose business is life insurance measured by its reserves.
Stuart A. Smith: That’s correct Mr. Justice Stewart.
Potter Stewart: Is that it?
Stuart A. Smith: Now the question in this case, in these cases that is, focuses on the quantity of the denominator in fraction that is total reserves. These cases present the question as to whether certain cancelable accident and health insurance reserves which are reserves on what is indisputably non life business are includable in these taxpayers’ total reserves. It’s also undisputed that if it is includable, is that these accident and health insurance reserves are included as we submit, these taxpayers fail to qualify its life insurance companies. And if they are excluded as the Court of Claims held and it’s the taxpayers’ submit, then they do qualify. Now, the case focuses on the effect of two different types of transactions which are presented in combination in all three cases. For purposes of convenience, we have referred in our briefs to these transactions as Treaty one and Treaty two. This is the nomenclature of the Consumer Life Insurance Company case which presents both of those types of reinsurance transactions. Consumer, as I said, presents both kinds of transactions. Penn Security presents a Treaty one type arrangement and the First Railroad case presents only a Treaty two type arrangement. Now, we submit that the facts demonstrate with abandoned clarity that the accident and health insurance business was attributable to the taxpayers, so that the accident and health insurance reserves are includable in the total reserves of these taxpayers, so that their denominator is increased and the fraction falls below 50%. So the end result as of our submission is that the Court of Claims was incorrect in holding that these companies qualified as life insurance companies and the Fifth Circuit was correct in holding that the taxpayer in that case did not qualify. I think it probably would, instead of stating the facts of each case theory items, since they are essentially similar, it probably would be helpful to put the facts before the Court in terms of the Treaty I and Treaty II generic type transaction, because, as I said, the arrangements in all three cases are essentially the same. Now, the Treaty I type transaction, the taxpayer insurance companies, that is Consumer Life and Penn Security, are subsidiaries of corporations engaged in the consumer loan business. This accident and health insurance that we’re involved with here is credit accident and health insurance, because when this people borrow money from a consumer loan business, they generally are encouraged by life insurance and accident and health insurance, and yet --
Potter Stewart: There is -- may I interrupt you. There is no question here about the term life insurance that a borrower takes --
Stuart A. Smith: No Mr. Justice Stewart. I think that was resolved in the Alinco case that that is life insurance and we’re not disputing the correctness of that decision of the Court of Claims. When a --
Potter Stewart: There is also a term accident and health insurance, single premium, isn’t it?
Stuart A. Smith: Exactly; that’s what is involved here. When the borrower -- you know let’s say, borrows $1,000, he is encouraged to purchase a life insurance contract which will payoff the outstanding loan balance, so its decreasing term in life insurance in the event he should die, or in the event that he should become disabled, the insurance is designed to continue to pay the loan payments during the period of his disability and it is a single premium as Mr. Justice Stewart indicated that is paid in advance. Now in most states, finance companies are prohibited to issue such credit life insurance. So, prior to the Treaty I type arrangements in these cases, the consumer finance companies essentially acted as sales agents for independent insurance companies and they receive the commission, which is a substantial condition usually in the neighborhood of that 50%. Now, the Treaty I type arrangements were organized by the tax -- by the consumer life -- the consumer finance companies. They organize these taxpayer insurance companies as subsidiaries in order to command a larger percentage of the profits from this credit insurance business. But as the consumer, facts in consumer life insurance indicate, at first these newly formed insurance companies, the subsidiaries and in the case of Consumer Life it was the Consumer Life Company, did not have sufficient capital to act as a direct insurer on the state law. Under the state of the, you know, of incorporation of the consumer finance company. So what it did was, they acted as reinsurers rather than direct insurers. Now under Treaty I, the way the transaction worked was as follows: The independent insurance company issued the policies to the borrower and collected the premiums in full just as it had previously done before the taxpayer insurance company was organized. And the taxpayer, by contract, by reinsurance contract which in the parlance of the industry is called the Treaty, agreed to reinsure the risk and agreed to reimburse the independent insurer for all losses, and I’m quoting “Actually paid on both life polices and health and accident policies.” So, for purposes of this case, Consumer Life that is, the Treaty I type case, there really is no dispute between the parties although Consumer Life has argued to the contrary but there really is no dispute that under the Treaty I type arrangement these taxpayer subsidiary insurance companies assume the entire insurance risk for these -- before this coverage, because they, by contract, agreed to reimburse the independent insurer for all claims paid. Penn Security doesn’t contend to the contrary and in Consumer Life, well, they do contend, they do dispute this assumption of risk. The Court of Claims found that they freely conceded that they assumed the risk below, and as we point out in our brief, I don’t think there really is any question that they did so concede and that day have assumed the risk by contract. Now in exchange for the assumption of this risk under the Treaty I reinsurance arrangement, the taxpayer, Consumer Life and Penn Security, received substantial percentages of the commissions. Much more substantial than they had, you know, when they were just -- when the taxpayers didn’t exist and the finance companies were dealing with independent insurance companies. In Consumer, the percentage was 90.5% of premiums and the Penn Security it was 98% of premiums. Under the Treaty I arrangement, the independent company, as I said, collected the premiums in full and it also paid all claims under the policies as any direct insurer would. Each month, the independent company remitted to the taxpayer insurance companies their full share of the life insurance premiums that had been paid by the borrowers. But with respect to the accident and health insurance premiums, the independent company remitted to these taxpayers only that portion of the premiums that was readably allocable to the prior month’s coverage. So, for example, assume a $120 accident and health single premium that the tax -- that the borrower pays, that would mean essentially that the independent company would hold that $120 until the end of January and then on February 1st or shortly thereafter, would pay over $10 a month in February which is allocable. January’s coverage and so forth, in March would pay over another $10 which was allocable to February’s coverage.
Warren E. Burger: The way that you described that the initial or sometimes you referred to as the direct insurer is essentially like a general agent in the field who receives the commission for initiating the business whereas the risk taking is by the reinsure.
Stuart A. Smith: Essentially that’s our submission Mr. Chief Justice that for purposes of Treaty I the independent that insurer was really nothing more than a commission agent, because when the smoke clear it was all -- it only held its 9.5% of premiums everything -- it paid the claims out of this fund that was about to drop down and was -- and essentially that the taxpayers agreed by contract to assume the risk and everything that was left over, less its commission, was paid over back to the taxpayer -- to these taxpayer insurance companies.
William H. Rehnquist: Mr. Smith, I think you argued Foster Lumber here --
Stuart A. Smith: That’s correct.
William H. Rehnquist: -- a few weeks ago, don’t you, and you prevailed by a narrowly divided vote over a strong dissent, and it struck there that the Government’s position was that we read the statute as written and don’t make any allowance for equities or substance or that sort of thing. Now here, it seems to me that Government is kind of talking out of the other side of its mouth that’s saying in effect, “Well, we can’t read it quite the way it’s written we’ve got to make sure that substance rather than form prevails.”
Stuart A. Smith: I don’t think so Mr. Justice Rehnquist and the reason I don’t think so is because I think that the statutory term as I will develop at greater length in a few minutes. The statutory term unearned premiums in Section 801 (c) (2) does not, as the Court of Claims held and these taxpayers submit, although, I must say they submitted with varying the degrees of differences among themselves, but we claim that the term unearned premiums refers to unearned premium reserves and not premium dollars, and that the said -- and that the literal words of the statute, we think, support our submission here that the unearned premium reserves are attributable to these taxpayer insurance companies which were on the risk of this insurance. I don’t think that the positions in the two cases are inconsistent I think --
Harry A. Blackmun: Well, you have to take that position in view of your position in Foster Lumber.
Stuart A. Smith: Well, we try to be consistent Mr. Justice Blackmun.
Harry A. Blackmun: Well, the Internal Revenue Service has quite self inconsistency in their past. It has conceded in briefs and in this Court.
Stuart A. Smith: We try to --
Harry A. Blackmun: I am not critical; the case is a case.
Stuart A. Smith: Surely would be -- we would be consistent within a single term of this Court. [Laughter]
Byron R. White: But you do consistently try to collect taxes.
Stuart A. Smith: Absolutely. [Laughter Attempt]
John Paul Stevens: Mr. Smith just to follow up on what Justice Rehnquist said. You’d read the words unearned premium and the statute is saying unearned premium reserve. Is that not right?
Stuart A. Smith: That is correct.
John Paul Stevens: Where is the -- and you acknowledge the unearned premiums are in a different place than the unearned premium reserve.
Stuart A. Smith: The unearned premium dollars are in the different place.
John Paul Stevens: But you say unearned premiums doesn’t mean --
Stuart A. Smith: I think that -- I think as we point out in our brief and I’ll be happy to go into at a greater length during my argument. I think that the words unearned premiums in the statute necessarily refer to unearned premium reserves, they can’t refer to dollars. It just doesn’t make any sense for qualification of life insurance to turn on where particular dollars are located in an economy like ours where everything is put in terms of intangible bank claims, you know, claims on time deposit. I mean the physical location of the money I don’t think makes any different --
John Paul Stevens: The Congress omitted a word, it’s perfectly clear and intended to include where concern --
Stuart A. Smith: I think that so, I think the structure, as I will point out --
John Paul Stevens: So, you are, to a certain extent, asking as to change the language of the statute?
Stuart A. Smith: Well no, I am not asking to change language of the statute; I am asking you to be construed and consistent with what I think is the appropriate way.
John Paul Stevens: Sort of an equitable way?
Stuart A. Smith: Well no and I think that the correct -- right.[Laughter] I’d like to turn out to a description of Treaty II before I go into our argument. Now, under Treaty II, the roles of the taxpayer, insurance companies, and the independent company --
John Paul Stevens: Mr. Smith, let me just cover one another thing with you before you get into Treaty II. In response to the Chief Justice you said that the insurance company, the independent insurance company was in the nature of a general agent performing a bookkeeping function but it isn’t it correct that it hadn’t -- had they been merely a bookkeeper, the reinsure couldn’t have qualified for this insurance coverage. Weren’t they wasn’t that essential that have the stat of the capital in order to --
Stuart A. Smith: Well, they were -- they had the status of a direct insurer in that sense. Yes.
John Paul Stevens: But did they not have that?
Stuart A. Smith: But they were not involved -- but they were not -- I think for state purposes, you know, they were a direct insurer. But I think that the substance of the arrangement was simply, that they weren’t ensuring anything.
John Paul Stevens: But did they not, by qualifying as an insurance company, provide something that the transaction which a general agent or a bookkeeper or a client could not --
Stuart A. Smith: I think that -- I think that’s right. I think that --
John Paul Stevens: And if that were not true they wouldn’t have been in the picture at all.
Stuart A. Smith: I think that’s right. But essentially, I would suggest that if the, you know, to use the analogy I used a few moments ago, had the reinsurer or had an insurance company taken unearned (A&H) accident and health premiums, and put them in a time deposit in a bank and was not permitted to withdraw them except that stated intervals. I don’t think anybody would say that the bank was -- had the reserves on the insurance company. I mean, essentially and I think that the function of this insurance company, this direct insurer, under the Treaty I arrangement, was little more than that, though the functions it performed --
John Paul Stevens: Mr. Smith is that quite fair because, didn’t state law have -- isn’t the purpose of the state law to be sure that a company of a certain capital structure is able to assume the risks that all the policy of holders rely on when they take out there insurance. And isn’t it performing a function in the whole risk taking picture that is essential for a large company to perform?
Stuart A. Smith: It was performing; I suppose it was performing a function under state law because in this particular case, for example, in Consumer Life, Georgia had minimum capitalization requirements with Consumer Life --
John Paul Stevens: And the purpose of a minimum capitalization -- the purpose of those requirements is to be sure there is a company there with efficient substance to assume these risks.
Stuart A. Smith: That’s right. But I think, you know it’s -- I think it’s common knowledge. What happened in this case was that they shopped around for the minimum capitalization state which is Arizona and they set up this reinsure, and I think would prefer as a practical matter the reinsure contracted to pay -- to bare the risk and it did bare the risk. And there really wasn’t to any way that the direct insurer was going to loose anything. He is going to perform these functions which were proceeding --
John Paul Stevens: Before the risk in a way which would not have satisfied state law requirements without this other company in the picture.
Stuart A. Smith: That’s right, because the state law requirements of Georgia would insist that a company issuing insurance in Georgia have a minimum capitalization and that was the direct insurer. Well we don’t think that should make any difference for purposes of qualification for tax purposes like --
John Paul Stevens: But the only purpose of my questioning was to test the importance of your point that they are nothing more than a bookkeeper. They also performed an essential function as a matter of state law, the independent company did.
Stuart A. Smith: I think that’s probably -- I think that’s right. Now, to describe briefly what happened under the Treaty II arrangement, the roles of the taxpayer and the independent company were purportedly reversed. So the taxpayer becomes the direct insurer and the independent company, under this contract, is characterized as a reinsurer. But under in the Consumer Life case, 80% of the accident and health business was purportedly reinsured with the independent company and then First Railroad it was 60% and then 70%. But what kind of reinsurance really was this arrangement? The way it worked was the taxpayer paid these quarterly accidents and health premiums to the independent insurer, take keeping back a tentative commission of 50%. The independent company then paid a quarterly rebate or it called it an experience refund, and that rebate was equal to the premiums less to 50% attentive commission which had already been received, less a 3% or 4% commission, well, 3% in Consumer Life, and then less all claims paid. And if the sum of these three things exceeded the losses under the insurance -- losses to the payment of insurance claims, then those losses will be carried forward and the independent company would be able to charge it against the next quarters experience refund. Now important fact in the consumer case, the loss experience was something like 18% of premiums paid, so there really was no way that the independent company was going to get more than its 3% commission or get less than its 3% commission. In fact in the Consumer Life case, the trial judge found in the Court of Claims that the likelihood, that the loss experience would run so high that the 3% insurer commission would be jeopardized with so remote as to be negligible and that the parties knew this to be the fact. The source --
John Paul Stevens: Mr. Smith, let me just interject you, because I want to be sure you cover it. What is your conception of the independent company in Treaty I situation, is kind of a bookkeeping function?
Stuart A. Smith: Yes.
John Paul Stevens: In Treaty II what is your conception of the contribution to the total arrangement which the independent company made?
Stuart A. Smith: It’s also a bookkeeping function.
John Paul Stevens: But why did they need them at all, if you are correct. that there really is a --
Stuart A. Smith: Oh, well they need it -- why did they need them at all. They needed them because in -- what happened was after Consumer Life reached the maximum capitalization, it needed them because it could get, earn more profits essentially.
John Paul Stevens: Then if there were no reinsurance arrangement at all? Why wouldn’t they just completely cancel the reinsurance arrangement if there really is no risk that they after reinsure against? Why would they make more money by just taking them out of the picture completely?
Stuart A. Smith: Well they could. I presume they could have done that but the --
John Paul Stevens: You must have a theory as to why they didn’t.
Stuart A. Smith: Well, the theory has to be essentially that they did this in order to qualify as a life insurance company, because if they issued this A&H insurance directly, then the -- there would be no question, nobody would be here arguing that the reserves were not attributable to these taxpayers, and they would flunk the 50% test. So they needed them essentially to say, “Well look, we put our A&H reserves somewhere else and we don’t have them anymore, so therefore we are a life insurance company.”
John Paul Stevens: Now, that would explain why they would reinsure the A&H, but why would they reinsure the Life?
Stuart A. Smith: They didn’t.
John Paul Stevens: They did not reinsure the Life at all?
Stuart A. Smith: They did not, no.
John Paul Stevens: So the whole purpose of it is to qualify.
Stuart A. Smith: Right! In fact, what happened was in the Treaty I arrangement they paid the life insurance premiums to the taxpayers right away. There was no delay timing of that payment, because for their purposes they wanted to increase their life insurance reserves to qualify under the fraction. Now, --
William H. Rehnquist: One legitimate purpose at any business is the avoidance of taxes.
Stuart A. Smith: Absolutely Mr. Justice Rehnquist, I would not quarrel with that proposition, but I think that a transaction has to have some independent substance, and here, where you have a situation where these premiums are just being held back and paid on a monthly dribble. I mean, that is really the only way to describe it. I think that it is so to blink its reality to say that this A& H business was not the taxpayers’ business, because they were on the risk; they got all the profits from it. There was no way that the other company could loose and the other company was not really insuring anything. I mean it was performing a function but it was performing a function in the one case to qualify under state, to qualify these transactions for state purpose and the other case was simply bold face attempt to qualify as a life insurance company under the fraction, under the statutory fractional formula. Now, with respect to the Treaty II arrangement, the Fifth Circuit correctly held in our view that there was no substance to this agreement as reinsurance that was essentially the other company was simply earning a commission and doing a small set of tasks, receiving the premiums, paying out the claims, and getting no more than 3% and getting no less than 3%. We don’t think -- we agree that we don’t think that’s insurance. Now, the proposition that we urge in these cases is a very simple one. It is that for purposes of the Section 801 (a) reserve ratio test, insurance reserves must follow the insurance risk. Since as I think is abundantly clear from the description of the facts, the taxpayers bore this accidents and health insurance risk under both the Treaty I and Treaty II type arrangements. The accident and the health insurance reserves are includable and they are total reserves, that is the denominator of the statutory fraction, and they do not qualify as life insurance companies. Now, we think the proposition that reserves must follow the risk can be demonstrated in three different ways: First we think the rule comports with the fundamental characteristics of insurance and the essential nature of what an insurance reserve is; second, we think that the language of the reserve ratio test of Section 801 (a) and (c) supports our submission that reserves to follow the risk; and finally, we submit that the legislative history of the reserved ratio test as stating, which dates back to 1921, supports our submission that is insurance reserves must follow the insurance risk. Now, with respect to the first point, I think it’s fairly undisputed and this Court so recognized it for about 40 years ago in the Le Gierse case that the essence of insurance is risk shifting and the essential characteristic of reinsurance is the transfer of risk from one company to another.
Warren E. Burger: What would be your view Mr. Smith on a contract of risk sharing where hypothetically half of the risk was reinsured?
Stuart A. Smith: Well then, I suppose there would be, you know, half of the reserves would be allocable to one and half to the other. But in this case the risk was borne completely Mr. Chief Justice by the taxpayers.
Warren E. Burger: But then the initial insurer, concerning which I inquired before, would be something more than a general agent, wouldn’t he?
Stuart A. Smith: That’s correct, and to the extent that they bare the risk, the reserves corresponding to that risk ought to be included in their total reserves. But when they don’t bare any risk at all, as we submit these independent companies did in these two different kinds of arrangements, I don’t think that they ought to have those reserves chargeable to their total reserves.
Lewis F. Powell, Jr.: Did you say that the reinsuring company would pay the claim? I think you did, under type two.
Stuart A. Smith: Under type two, the way it seems to have worked although the record is not entirely clear that the independent company paid the claim.
Lewis F. Powell, Jr.: By independent do you mean the company that issued the policy?
Stuart A. Smith: Yes, but no that’s the range in Treaty II, in the Treaty II arrangement, the independent company is the purported reinsurer. Although, we would say it’s not really a reinsurer at all. But the company that was called the reinsurer under the Treaty II type arrangement, that is the non-taxpayer would pay the claims. Essentially, what would happen is, you know, the taxpayer would issue the policy and then it would --
Lewis F. Powell, Jr.: Taxpayer is the company that qualifies as a life -- as an insurance company?
Stuart A. Smith: Right, these taxpayers here whose qualification is at issue, it would issue the insurance policy --
Lewis F. Powell, Jr.: Right.
Stuart A. Smith: -- and then it would pay out the premiums on a quarterly basis but take back a tentative 50% commission, and then the independent company would pay out all the claims out of the remainder.
Lewis F. Powell, Jr.: You put me off a bit when you say independent. Couldn’t we speak in terms of the insurer and the reinsurer?
Stuart A. Smith: Well, we could Mr. Justice Powell but my only hesitance to adopt that nomenclatures that we don’t think that the Treaty II arrangement was reinsurance.
Lewis F. Powell, Jr.: But you are not --
Potter Stewart: Speak in terms of the taxpayers and the --
Stuart A. Smith: Okay. Yes, the taxpayer and the other company.
Lewis F. Powell, Jr.: Well, what is the other company, the reinsurer?
Stuart A. Smith: The other company is called the reinsurer.
Lewis F. Powell, Jr.: Well, we are not going to decide the case on the basis --
Stuart A. Smith: Okay.
Lewis F. Powell, Jr.: -- of your nomenclature.
Stuart A. Smith: Exactly. Okay, the reinsurer paid out the claims.
Lewis F. Powell, Jr.: Right. The reinsurer pays or declaim inheres that reimbursed by the insurance company.
Stuart A. Smith: It’s reimbursed out of -- whether essentially is it’s reimbursed out of the claim, out the reimbursed it itself. How is it reimbursed? It’s reimbursed -- it pays these claims out the premium dollars it has, and then it pays back to the taxpayer what’s left over. And if there should ever be any excess of losses over money left over, which is in these cases almost impossible and the parties apparently knew this to be the fact, so the Trial Court and Court of Claims found, then the taxpayer would pay it back out of the next quarter’s premium dollars.
Lewis F. Powell, Jr.: So in that situation, the reimbursement would be delayed?
Stuart A. Smith: Yes. But essentially you know there is no way that the independent company or “the reinsurer” could lose under it. It wasn’t going to get more than 3%, it wasn’t going to less than 3%.
Lewis F. Powell, Jr.: In the event of that delay would interest be paid?
Stuart A. Smith: I don’t know. I really don’t know, but I would suggest that that’s simply a function -- that could be arranged between the parties in a way that -- you know it’s just another bargaining point.
Lewis F. Powell, Jr.: Well, you regard the whole thing as a sham as your brief states.
Stuart A. Smith: I think that’s right. I mean it’s not reinsurance.
Lewis F. Powell, Jr.: Right, but is it also a sham were there is no parent subsidiary relationship and this is a contract of reinsurance negotiated at arms length?
Stuart A. Smith: Well, when I use the word sham one tends to think that you know that it’s no substance and that is sort of a tax avoidance motive, which I think is the case here, but I don’t think it would matter whether it was negotiated at arms length, because when you examine the figures and what, you know, this elaborate arrangement, which is called reinsurance but actually when you strip away all the technical, you know, all the contract provisions, you know, I think for tax purposes this was not reinsurance.
Lewis F. Powell, Jr.: But may I ask this question?
Stuart A. Smith: Sure.
Lewis F. Powell, Jr.: If it is a sham, what would be the business reason for an independent reinsurer to enter into a sham arrangement as to be nice?
Stuart A. Smith: Earn a 3% commission. You know for doing relatively a small amount of work. I mean, when we say sham, I don’t want to -- I don’t think that you have to go that far and knockout the agreement in some sort of a sham. I think that essentially when we are talking about reinsurance at page -- the examiners handbook which was introduced in evidence in the First Railroad case at page 211 of that appendix, it defines re-insist -- the essential element of every true reinsurance contract is the undertaking by the reinsurer to indemnify the ceding insurer not only in form, but in fact, against loss or liability by reason of the original insurance. Unless the so called reinsurance contract contains this essential element, no credit whatsoever shall be allowed etcetera, etcetera. Well you know, the insurance industry wouldn’t recognize this as reinsurance and we don’t think it is reinsurance. Insurance is taking on a risk. Reinsurance is transferring of a risk, but there was no risk transferred in the Treaty two type arrangements.
Lewis F. Powell, Jr.: But the state agency do recognize the agreement?
Stuart A. Smith: The state agency recognized it but the state -- we don’t think that really matters for purposes of Section 801 (c) (2) as I think we pointed out in our reply brief. The regulations there say whatever is regarded, whatever might be the case on the local law, but the point to the matter is that the state agents really you know, approach this thing from an entirely different point of view. Whether you believe that they were smart people or not smart people, their essential purpose was to make sure that some company was solvent and that the policy holder was not going to lose. They weren't --
John Paul Stevens: But on that very point Mr. Smith. Supposing in the Treaty two situation, the taxpayer became insolvent that I suppose is theoretically possible --
Stuart A. Smith: Yes that is --
John Paul Stevens: -- you say as the practical matter its unlikely to happen. In that event the risk would fall squarely on the reinsurer, would it not?
Stuart A. Smith: That is correct and that is the only case that --
John Paul Stevens: Well, isn’t there a second case. Supposing you had a very serious epidemic and unpredictable number of claims accrued that were far above what anybody anticipated. Is it not possible that the reinsurer would assume that risk?
Stuart A. Smith: That is also correct.
John Paul Stevens: So there are two risks that the reinsurer assumes that are both rarely unlikely, but yet our risk --
Stuart A. Smith: Right and I think that the case has to be examined in terms of what is likely. You know, we are talking about -- we’re talking about claims of 18 -- claims experience of 18% or 22%. I don’t --
John Paul Stevens: If we look at likelihoods and probabilities rather than the literal language of the contracts in the statute?
Stuart A. Smith: Yes. Yes, I think that’s right. Now I want to talk a little bit about what a reserve is, simply because I think that’s critical to what this case is all about. An insurance reserve is not as the Court of Claims I think held and as one of the taxpayers here argues and the other taxpayers argue in the sort of slight variation, is not anything that one keeps in one's pocket. Its not an asset. It’s simply a projected liability for, you know, a kind of un-accrued liability for what an event that might occur in the future in which an insurance company basically has to bear in mind. So --
John Paul Stevens: It’s a -- a reserve is a liability. Does the balance sheet require that there be an off setting asset for that liability?
Stuart A. Smith: I don’t think so.
John Paul Stevens: Was this to be a liability to this case?
Stuart A. Smith: Right. For example, I think you know the way to look at this case is to say you know, if an insurance company assumes a risk and it has to know the reserves for this and let’s say if it buys stock at a $100.00 and the stock goes down to zero and it has made a bad investment. Nobody would say that its reserves depleted. It still has a reserve of a $100.00. It just doesn’t, you know we’ll have to use other assets to cover that reserve, but it still have a reserve. The reserve is keep to the liability, to the risk an insurance company assumes under a policy. And you know, there really is no matching principle as such. We are talking about the premium dollars have to follow the reserve. Essentially, what we are talking about is when the liability is assumed to the policy holder that triggers the creation of the reserve and the fact that these premium dollars happen to be in another pocket so to speak, for a delayed reaction of about a month or so, shouldn’t make a difference in this case because its not really physical location of an asset because a reserve is not anything physical that you can sort of grab onto. The insurance company doesn’t segregate assets and say “You know these are all reserve funds.” There is no such thing as a reserve fund as such. The reserve is the projected liability.
Lewis F. Powell, Jr.: In the case of health and accident insurance, do you also have a reserve for the unearned premium as distinguished from the reserve representing the risk on premium?
Stuart A. Smith: Well, Mr. Justice Powell in the health and accident insurance, there is no accepted table the way there is in life insurance to sort measure the risk. So, as a result the insurance parlance is to the effect that the unearned premiums equal the reserve mathematically.
Lewis F. Powell, Jr.: Is that they way it’s recorded on the books?
Stuart A. Smith: That’s the way it would be recorded on the books, but that doesn’t mean as I think we’ve point that in our brief in greater detail, that the unearned premium dollars are the reserve. The reserve is -- represents this projected liability to the policy holders. The doc -- yes.
Lewis F. Powell, Jr.: To take your $120.00 example, you started putting a $120.00 if you had the entire right to the premium on the reserve side of your balance sheet as a liability.
Stuart A. Smith: Yes.
Lewis F. Powell, Jr.: Would you?
Stuart A. Smith: It would be put -- it’s not really a balance sheet asset like a liability, but it would go in summary of operations, but yes.
Lewis F. Powell, Jr.: Well, a reserve is on the liability side of a balance sheet.
Stuart A. Smith: Yes, that’s right.
Lewis F. Powell, Jr.: At the end of the first month that reserve would be reduced by 1/12?
Stuart A. Smith: That’s right.
Lewis F. Powell, Jr.: Now, that would be taken into income at that point, the 1/12 of the premium?
Stuart A. Smith: Well, it would be a sort of an unrestricted I suppose, you know, in that sense, yes.
Lewis F. Powell, Jr.: Yes, but it would be income?
Stuart A. Smith: Yes.
Lewis F. Powell, Jr.: On which the taxpayer would pay a tax. Do you put anything on the balance -- on the asset side of the balance sheet to reflect the fact that you have earned 1/12 of the premium?
Stuart A. Smith: I don’t think so. The assets have always existed. You know, you're just assuming one insurance company. The insurance company doesn’t have anymore assets.
Lewis F. Powell, Jr.: You put a claim --
Stuart A. Smith: Its essentially has reduced liability.
Lewis F. Powell, Jr.: What do you put on the asset side of the balance sheet at the beginning, a $120.00?
Stuart A. Smith: At the beginning, I suppose it would be -- well, it would be put in as an asset of premiums received, I suppose and then --
Lewis F. Powell, Jr.: And before it is collected?
Stuart A. Smith: Well, let's put it -- oh I see your point. Well, I think that standard -- I think as we point out in brief the standard general accounting treatment for this kind of transaction is that it is an asset. You know, the tax referred to it is funds held by ceding insurer or reinsurers so to speak, so it is an asset. I don’t really think there has to be this matching.
Lewis F. Powell, Jr.: Well, carry on Mr. Smith. I was just trying to visualize balance sheet transactions implicated by what you are talking about, but I don’t know that the is necessarily --
Stuart A. Smith: Yes. I think our essential point here is that the -- and I want to save the remaining time for rebuttal, is that the unearned premiums in this phrase under the statute does not refer to the physical dollars or refers to the reserve and the reserve has to be attributable to the company that assumes the risk because the reserve represents this projected liability and since I think it’s plain and it really can’t be seriously disputed that these companies will -- these taxpayer companies were all on the risk. I think that they have to be -- it’s their business and I think that their insurance business necessarily has to be put in the denominator of total reserves.
John Paul Stevens: Before you sit down, excuse me.
William H. Rehnquist: Your asking us to make two changes in the statute that one we had the word reserve to the word premium and then we attribute the reserve to the insurer?
Stuart A. Smith: I don’t think you have to change in statute Mr. Justice.
William H. Rehnquist: Well additions to the language that Congress --
Stuart A. Smith: Well, I think when you look at the structure of the statute it talks about -- there are three kinds of reserves. One, life insurance reserves; Two, unearned premiums and unpaid losses not included in life insurance reserves; And three, all other insurance reserves required by law. The first thing you notice is that one and three are plainly reserves. Unpaid losses not included in life insurance reserves also strikes one as a reserve, as in fact it is a reserve. And unearned premiums the insurance text all refer to it is a reserve. I mean, it is a short hand expression for a reserve. And I think that the calculation of accident and health insurance, casualty insurance is put in terms of unearned premiums and it is either unearned premiums or unearned premiums reserves. I don’t think that you know Congress have to add that word reserve, I think they were writing a statute for a very sophisticated industry that knew what it wanted and wanted to measure this -- you know make this qualification on the basis of reserves and I don’t these companies make it because its -- they bore this risk under this casualty insurance. That is not life insurance and they flunk the 50% test.
Lewis F. Powell, Jr.: Mr. Smith, I do want to ask one other question because under your theory the unearned premium reserve on the accident and health business remains with the taxpayer because it only takes the risk as you analyze it. Whereas the unearned premium dollars would be with the reinsurer in the Treaty two situation. Would you say that there is an unearned premium reserve matching the unearned premium dollars in the reinsurer as well as in the taxpayer or just a reserve in two places at once?
Stuart A. Smith: It possibly could be. You know for state counting for purposes. I think --
John Paul Stevens: No, for federal tax purposes assuming that the reinsurer was also a company that was in the --
Stuart A. Smith: Oh no. the federal –
John Paul Stevens: It will never be included in the reinsurer's --
Stuart A. Smith: The Commission of Internal Revenue would never put the reserve in both places. It would either be one and the other, and we say as with the taxpayers.
John Paul Stevens: Even if it was of difference between qualifying as a life company and for the reinsurer?
Stuart A. Smith: Oh, I think that we would -- our rule that the reserves follow the risk, we would obviously, possibly lose some cases under this rule. I mean, we are not -- we would not inconsistently put reserves in a place that where risk wasn’t just to disqualify a company. I think that --
John Paul Stevens: Well, but the fact that you say the risk is in the taxpayer does not necessarily negate the possibility that it’s also in the reinsurer?
Stuart A. Smith: There maybe a slight risk as you pointed out from insolvency and so forth and so on but, you know that’s a negligible --
John Paul Stevens: You wouldn’t think --
Stuart A. Smith: We don’t require attribution of the reserve.
John Paul Stevens: What if the risk were just a little more probable in the other company. There is a legal risk under the terms of the contract and they also have the premium dollars. Would that ever require them that be considered also having that?
Stuart A. Smith: Well that might be you know, that could be sort or a -- there is a type of reinsurance known as excess loss reinsurance and which probably could be calculated. There might be a small fraction of the reserve left with the other side for that with the independent company for tax purposes. But I think that when we are talking about what happened in the Treaty two case, it really the risk was that reachable and I think the reserve belongs with the company that realistically bore the risk here, the taxpayers and they have to include that in their total reserves.
John Paul Stevens: So, the issue really turns on a kind of a finding of fact as to which company realistically takes the greater share of the risk?
Stuart A. Smith: And we think at both cases --
John Paul Stevens: Rather than the terms of the contract.
Stuart A. Smith: Right and we think in both cases, First Railroad and Consumer, the findings of fact, you know, even in the District Court in First Railroad which held against the Government acknowledged that it was almost remote and negligible that the other company had pour any risks. Thank you.
Warren E. Burger: Mr. Jones.
John B. Jones, Jr.: Mr. Chief Justice and may it please the Court. I’m counsel for Penn Security in number 1285 and to just remind the Court our case presents solely a Treaty one situation because I think much of what Mr. Smith has just said has no barring on a Treaty one situation. I’ll be followed by Mr. Harper for the First Railroad and he will be representing a taxpayer as a Treaty two situation and Mr. Masinter will conclude and his case includes both the Treaty one and the Treaty two issues. I’m sure the Court is aware from its questions that what the statutory test says and that Penn Security meets the statutory test in terms of the reserves which it has on its books and which it reports to state authorities and which they have approved. And I think it is also, I preferred nothing suggested by the Government that there is any way you can read the code or the regulations which would suggest to you that some other reserves maybe attributed. Rather as I see the reserves follow the risk test which has been expounded here this morning. It’s sort of a touchstone which is offered by the Government to better carry out the statutory purpose and the argument is really whether that new touchstone test can be reconciled with the statute and the regulations.
Warren E. Burger: In your situation, Penn Security, is there any privity between the insured person policy holder and the beneficiary on the one hand and the reinsurer?
John B. Jones, Jr.: No.
Warren E. Burger: Privily is between the initial insurer and the insurer and stops there?
John B. Jones, Jr.: That is correct and of course the initial insurer is also not related to the reinsurer in our case. No relationship between them at all, it is an outside company. We feel that applying this test to Penn Security shows that it is a very unwise clause on the statute. Penn Security which meets the statutory reserve test actually reinsures more life risk than accident and health risks, and that arises because they never sell accident and health without life. They sometime sell life without accident and health. In terms of what it cost them to carry the insurance, we have findings in our case that it requires company in order to meet the claims under the policies, it will cost them more to meet their life claims and to meet their accident and health claims. Penn Security has no interest in the reserve funds which are held by this independent outside insurer. There is no way in the world that you can use the word shifting in talking about the reserves applied to the Treaty one situation. Those funds come in from the policy holders to the direct insurer and the question is on accident and health insurance when they come over to the direct insurance company. And in fact the eccentricities of the Government rule shown here by the fact that we do qualify for 1965 no matter what this court says here and indeed we have some arguments in our brief that maybe I’ll get to which shows why even if they attribute here. We’d still qualify as a life insurance company and we don’t think 15 years after the event, this kind of game should be played with somebody who is in clear compliance with the statute. Perhaps, if this had been adopted as a regulation in an earlier date a case could be made for it. Now, the Government doesn’t -- does not despite the use of the word sham, does not have any element of sham in our reinsurance agreement. This is an outside company which reinsures and indeed they say sham were not in the case, we don’t get the income. It’s only the reinsurance which gets income. And the Government makes much of the point that under this reinsurance agreement, all the risk shifts to Penn Security. But that I suppose is always true and at least -- excuse me strike that, but the normal pattern of reinsurance and insurance company would like to get rid of all its risk under a policy and it’s quite natural that if it reinsures it will be taken off the policies in term. It does not want to have the residual risk of the catastrophe which was mentioned here earlier and reinsurance has been around a long time. These arguments which the Government now proposes would throw a great monkey wrench into the reinsurance business if every time you reinsure a 100% you had to talk about shifting the reserve. And indeed, we submit and we think that one of the key elements that tells the Government that it’s really trying to make new law here as this revenue ruling 7508 and that’s a life insurance case and isn’t directly involved here. But you’ll see there that where the direct insurer actually paid over the income on the retained funds to the reinsurer so was a stronger cases sort of like economy finance where it did that, they still did not require attribution of the reserves there and as we pointed out in our brief there is a regulation which would give them license to. We think this is an ad hoc argument to try and as a last gasp to get at these credit life insurance companies. The terms of the reinsurance treaties at least in this Treaty one situation on arms length deal between the reinsuring company and the direct insurer. And the direct insurer has to make terms that will make -- will let him keep in the business by paying the right amount to the reinsurer and if he gets too greedy then they will go somewhere else so there is free bargaining. And I don’t believe that it can be suggested any reason why once you to go into this reinsurance business you should not be allowed to cast it in terms which qualify you for the taxation with Congress has specified for life insurance companies. As Mr. Smith stated earlier it is not argued here that somehow credit life doesn’t fit within the 1959 statute and that is settled by the Alinco case and then by the Superior Life case in the lower court. Now, some focus is made and rightly so on the manner in which the premiums for accident and health are paid. They are done on the – on as unearned basis while life is done on a paid over directly, but this is a term reached by the party and has several effects. One which will be discussed more by my following counsel is what that does on the ability of the insuring companies to sell more insurance. It is important to them to have their reserves adjusted as it is always been the case on the handling of reinsurance. There is a tax impact and that’s what brings us here. But between the parties, this is perhaps the most important term of the deal. If you look at the accident and health insurance and you can work this out on pencil and paper, if you have A & H policies that last three years and you get your premium in advance from the insureds and you keep that money and you only have to pay it out once -- 136 for each month, you’ll find that the calculation builds up a fund times one-and-a-half -- one-and-a-half times the annual premium rate. And that one-and-a-half times the annual premium rate is -- belongs to the direct insurer. He can invest that and if his rate of investment is say 5% you will see that 5% on one-and-a-half times the annual rate is a great deal more than the 2% commission which appears on the face of the contract. So, I submit to the Court that this provision for retaining the reserves on accident and health is one of the most important provisions between the parties and has tremendous economic substance and could certainly not be disregarded under any standards that we have seen in the past. Now, our position is that this reserve follow the risk has no authority in the statute. It's to be contrasted with Section 482 which does give the commissioner license to do that. We think it runs to the extent the code speaks at all on the subject of attribution reserves that goes the other way in Section 820. Now, it’s not involved here, but it seems a little odd that If the rule were as the Government claims here that the reserves follow the risk that Section 820 would be written just the way it is. And we find that the Government's attempt here runs afoul of four regulations requirements. One, that the premium -- in order to create unearned premium reserve the premiums must be paid in advance, that is one of the requirements. The second is that it must actually held. The third is it has to do -- there are two aspects to it of being required by the state law, and finally whether if you do go to an attribution to this, you really want to use the gross A & H premium. Now in terms of paid in advance, we don’t have any dispute that that language in the regulations applies. The Government suggests in its reply brief that this is satisfied as to Penn Security by the fact that the insureds paid there premiums in advance to the direct insurer. Well, I think that’s an extraordinary stretching of language. Those premiums which were paid in advance had no relation to any liability of Penn Security. Its liability to the direct insurer arose only when the premiums were paid monthly by the direct insurer to Penn Security. If the direct insurer did not pay those amounts, there would be no liability in Penn Security and if you are looking in terms of the regulations, the insurance risk which is referred to in the regulation about paid in advance very clearly refers to the reinsurance risk which is assumed by Penn Security, not the risk which the direct insurer assumes. Now, we come to the language which says that the reserve must be actually held and that’s discussed quite a bit in the brief. The Government says reserves are sometimes described in colloquial manner as fund set aside, but that’s not the appropriate interpretation and we heard that this morning that they should be treated as liabilities. Well, we agree that if you look through the insurance text throughout the country you can find some terms which speak this way. But we think that the very use of the words actually held in the regulations meant that the -- in drafting the terms and the regulations, it was not suggested that anything other than funds actually held would be involved. In other words, they adopted what have been described as a colloquial description and insisted on it. If additional authority is needed, we would suggest that the Court look at revenue ruling 67 180 which makes it very clear that the IRS has continued to apply under 1959 act all those early cases which talk about funding a reserve, Maryland casualty being one of the leading cases, they also point out that Atlas Life case was mentioned here earlier this morning. Atlas Life makes it very clear that they are talking about a funding of a reserve. And indeed if you don’t fund the reserve, you are going to get in a very difficult situation where you create a liability that will be a very distorted picture of the company's position unless some assets are brought in. But let’s just go back to the statutory language, even if we concede that somehow you can hold a liability as opposed to holding an asset within the meaning of the regulation, what about the word “actually”? Its a word actually means anything. It must mean that the company actually holds it, not that the Commissioner of Internal Revenue can come along10 years later and create a liability that you didn’t have. So, we would think that the word actually even if he is right about what it means reserves are funded or not, the word actually alone is enough to keep the Government from proceeding on this case. There two aspects to being required by state law and one of them arises under 801 (c) (2) where the Government correctly point out, you can read the statute and the regulations as not requiring Government approval under (c) 2. But we don’t really conclude as the Government does that hear alone, among all the rules of insurance taxation in this very complicated section of the code, in this one place Congress intended the Commissioner of Internal Revenue to have a free hand to go around and make rules which improve on what the state authorities have done and give him a chance to make a better tax law than what the -- what would come from following the state regulations. That is just too contrary to the rest of the code and we would submit to the Court that a better reading is to say that the difference in language about state requirements is to accommodate the decision in National Protective Insurance Company which is cited in the briefs. There the taxpayer held the brief which was at least arguably not required by state authorities and that case held that it should be included in the reserve and we can see removing the requirement that it'd be required by state law in order to say if in fact you have a reserve, you are going to have to include it in the computation, whether or not it’s required by state law. But it is a far cry to go from that to say that it -- this particular language choice gives the Commissioner power to do his own creating of reserves. As is apparent from our briefs, and it has been discussed, there is a difference between gross and net premiums. Accident and health insurance is judged on the basis of traditionally in the industry on gross premiums and that includes the morbidity risk which I would beg to differ with the Government counsel is just as well established as mortality risk. Plus expenses, plus profit and in the type of insurance we are talking about here, the risk of carrying the insurance is only 1/3 and if you are going to attribute the risk, if that’s what the Government is really after then I think, you should depart from the statutory adoption of the industry practice and only attribute that port of the risk which corresponds to the mortality risk in life insurance. Because then as we have demonstrated here, it would be seen to this company as a life insurance company by that method as well. Our point is that if you depart from the statute then it seems to me you’re not bound by the fact that states for many purposes require using gross premium and one particular reason which would apply here is that the direct insurer has the obligation to refund the premiums in the event the insurance is canceled. That’s one of the reasons for maintaining the gross reserve. Here, in our case Penn Security is not -- once that policy is canceled Penn Security never sees it and the refund comes from the direct insurer. So there would be a very strong reason, if you are really looking for improving on the statutory test to use net premiums in this situation. Well, just let me conclude and remind the Court of just how predominantly this company is an insurance company because of the fact that it meets the 50% test. It sold more life insurance than accident and health, had more life risk than accident and health risk and those reserves which are being attributed to it are clearly held by the direct insurer as an important part of the arrangement which of course is made. Thank you.
Warren E. Burger: Very well Mr. Jones. Mr. Harper.
James R. Harper: Mr. Chief Justice and may it please the Court. The Government is correct in appointing out that the Government provided a mathematical test, a ratio, but I believe it is subject to criticism. We are not pointing out to you that the Congress has also passed a statutory framework for the analysis of these problems. Not only has the Congress enacted law, but the treasury itself has explained many of the terms. Without proceeding to the more orderly part of my discussion, I’d like to point out that it’s quite painful to me that the Government would come in and tell you that the statute said unearned premiums and meant reserve. Because I point out to you in Section 801 (3) (e) the treasury itself defined unearned premiums. Unearned premiums are those amounts which shall cover the cost of carrying the insurance risk. I feel it is in fact a liability. I don’t see how it’s going to cover the insurance risk. I think they have aborted their own regulations and tried to ignore them. I point out may other differences, but before I do I’d like to discuss for a moment “risks.” It was appointed out by Mr. Justice Stevens that there are two risks. I’d like to point a third. There is a distinct third risk and that is in having too small, an insurance base to adequately determine premiums. For example in our case here, there was evidence that a number of the agents had loss experiences that were above the 96%. I point out to you that one of the risks is that you do not have a broad enough base to have a determinable premium. And let’s talk for a moment about premiums and may I distinguish because it must be done, may I distinguish the risks of a life insurance and the risks of an accident and health. It has over the many years been clear that the life of a group of people was predictable, the mortality tables would so advice you, not as to one individual man but the death is a predictable thing. The amount of a reserve for life insurance becomes an obligation because each day that inevitable death approaches. The risk then is greater as time passes and man gets older. It is entirely the opposite for accident and health. Every month you get by, I think we are all happy while we made another month and we are not sick, I’m glad I’m not like old George. Every month that’s true of the accident and health insurance business. This is a risk not predictable upon the basis of actuarial certainty. A risk which is so indeterminate that the law requires that the entire unearned premium be set aside at the moment of sale, when you sell life insurance you can look at the premium you got, look at the mortality table, and you have earned some income at that moment. In the case of accident and health it's not so.
Byron R. White: Mr. Harper is it critical to your position that there be a difference in the predictability of the morbidity risk as opposed to the mortality risk?
James R. Harper: No, I think not only insofar as the reasons which would justify the undertaking. For example --
Byron R. White: Is the rate charge for the life insurance in this credit business different for depending on age or the borrower? I thought it was all term insurance.
James R. Harper: It is all term insurance.
Byron R. White: The rates vary with the age of the borrower?
James R. Harper: It does -- it does not vary with the age, however the --
Byron R. White: Well then how does your argument about mortality and all play in with this for it will concern the age.--
James R. Harper: Well, it plays in here very definitely because you cannot take any portion of this accident and health risk insurance into income. It is reserved and set aside. You earn money when you sell life insurance. There is no money earned when accident and health insurance is sold.
Potter Stewart: After each of the months passes, it's earned, isn’t it?
James R. Harper: It is earned in a pro rata amount.
Potter Stewart: Pro rata amount. Yes.
James R. Harper: Now, I’d like to --
Potter Stewart: Aren’t the morbidity tables just about as reliable as the mortality tables? Mortality --
James R. Harper: Oh, I think they are just -- I think this are different names for the same as I’ve understood it --
Potter Stewart: No. Death is death as certain.
James R. Harper: This is just the reciprocal one or the other, but that does not predict the risk of going to the hospital for example or being disabled, but I must point out another reason. Actually held, I think was actually covered briefly ceding statement, but let me point out, that the problem of state authorities is to be sure that there are funds there to pay the insured when he is entitled indemnification. We then find that there is a clear requirement first that the amount be actually held. That means that there must be a funded reserve. There are two types of reserves. There are those reserves that a bondholder might insist upon merely earmarking a portion of surplus. But if that bondholder wants to be certain that bonds are going to be paid at the appointed time, he requires that funds be allocated and we know the term sinking fund and I say that that’s what they wanted here. When the state authorities set out the requirement of actually held, they did mean that it was a funded reserve and we submit that premiums were the funds. Now, in the regulations which they have ignored completely there is the very interesting requirement of Section 1 805 (b). Reserves required by the law means those reserves which are reported on the annual statement. This annual statement goes to the state authority. They don’t just want a funded reserve. They want it reported to the state as to what the reserve is. Now, there are some differences here between the parties, but I'd like to point it out that at the time these people in Georgia undertook to go into accident and health insurance, they went into it because of a claimer of their agents to have a single policy, a single insurance company that would cover it. They also undertook it with what we described as minimum capital, but let me point out to you that minimum capital under our statute was $400,000.00. By the time they undertook the accident and health insurance business, the insurance reserves or what we know as the surplus funds were well over $400,000.00 and by this agreement we brought into play and into risk reserves that we are well over $400,000.00 in the re-insuring company. It was real, it was real in that it starts --
John Paul Stevens: Mr. Harper let me just interrupt because there is something running through my mind that I’m not sure I understand. You have a Treaty two situation, is that correct? And you re-insure, your client is a direct insurer and you re-insure the A & H business but not the life business, is that correct?
James R. Harper: We had some --
John Paul Stevens: Is that correct?
James R. Harper: Our company originally acted as a reinsurance business for life insurance at one point.
John Paul Stevens: Well, with the respect to the years that --
James R. Harper: And there were some --
John Paul Stevens: With respect to the years in issue, is it correct that you re-insured the accident and health business and not the life business?
James R. Harper: I think that’s correct. I would not be certain.
John Paul Stevens: Is there a business reason for that other than the favorable tax consequences?
James R. Harper: There is a business reason --
John Paul Stevens: And if, so what is it?
James R. Harper: -- in that we need a broader base. Although, we had over $400,000.00 in reserves. The authorities that testified and the college professor who testified recognized that the ability to take on new business was limited to those who had policies, prem -- policy premiums that no more than --
John Paul Stevens: Now, what was that broadened your base, the reinsurance of the A & H business, did that broaden your base?
James R. Harper: It did broaden the base, but of course it also --
John Paul Stevens: Why wouldn’t it broaden it even more to re-insure the life business as well?
James R. Harper: Well of course, the life business is a little more profitable among other things. Life, credit life is a much better deal than accident and health. And I think that probably that was undertaken for business reasons to make more money. I think, it is also undertaken probably because of tax reasons. I’d like to point out though that we took in --
John Paul Stevens: In other words on the A & H business, your primary motivation was to broaden the base at the sacrifice of some profit? In the life business you are more interested in making profit, not interested in broadening your base?
James R. Harper: Well, this made it possible to broaden or to sell more insurance across the board, very definitely and it was very critical to broaden the base because you have to set premiums and it has to be a reliable standard. We want to make some money, but the big thing about reinsurance and they failed to note this, the big thing about reinsurance is that it tends to stabilized results. The actuary who testified in our case testifies that the basic purpose is really spread the fluctuation of a companies earnings to sort of level out their claims experience. And this is the kind of a transaction that would have been undertaken with third parties, just as quickly as it would have been undertaken by people with enough money in Georgia to bear the reinsurance risk. Now, there are sound reasons for it. The Government complains that there was a carry over provision. But this too spreads fluctuation from year to year. It tends to insulate you from shock losses, from catastrophic amounts which could wipe you out. I’d like to point out that to some extent this risk, test must depend upon hindsight. It is easy for Mr. Smith to say there is not much risk of insolvency, but insurance companies do go insolvent. This very company here after it went into accident and health and exhibit 23 will show it, there were years in which they lost money. And when they increased their sales by three-fold, they then begin to realize a profit on accident and health. They had to go into accident and health in order to meet the claimer of their agents. I think I must develop some -- to some extent the business purpose. I’d like to go back to the rules of this Court and particularly to the Helvering against Gregory in which we quoted all the time. Everybody says you don’t have to arrange your affairs to pay the most tax. Mr. Justice Hand went on to say that the underlying presumption is plain. That the act was undertaken for reasons to germane to the business. And we do not proceed upon any business purpose here that was not to germane to and that it did not forward the insurance business. That reinsurer was required and Judge Ronnie (ph) said the reinsurer is required to commit its assets to reserve status for reinsurance purposes and to pay tax on the reserve for tax purposes. They bore all the legal consequences of the required reserves. They reported the reserves as required by law and there was no exception taken to it. The reinsurer bore none of these risks. The statement requirement has an economic impact --
Warren E. Burger: You are using -- you are now getting into your colleague's time Mr. Harper.
James R. Harper: I’m not through, but I quit.[Laughter]
Warren E. Burger: Unless he wants to deal his time to you which --
James R. Harper: I’m sure he does.[Laughter]
Warren E. Burger: Mr. Masinter.
E. Michael Masinter: Mr. Chief Justice and may it please the Court. I’m counsel for respondent Consumer Life Insurance Company. In this case, the Government seeks to reverse the holding of the Court of Claims and asks this Court to hold that certain unearned premium reserves relating to accident and health insurance should be attributed or imputed may actually be a better word, to respondent. Reserves which respondent did not hold, but were held by unrelated insurance company, reserves which respondent was not required to maintain pursuant to state law or state regulatory purposes, reserves which respondent was not required to maintain pursuant to standard accounting and actuarial principles applicable to this industry. Now, this case involves both the Treaty one and the Treaty two situation. In the Treaty one situation, American Bankers Life Insurance Company was the unrelated company and it wrote the insurance and respondent was the reinsurer. In the Treaty two situation, respondent was the insurer and the unrelated company was the reinsurer. The facts are un-controverted that the reserves where actually held by American Bankers, the unrelated company and that American Bankers earned the investment income on these reserves, and included these reserves in their reports for state reporting purposes. Both respondent and American Bankers were subject to regular tri-annual examinations by the state authorities of Arizona, Georgia, and Florida, and other states. And during the years at issue, none of these state insurance commissions required either respondent or American Bankers to change their method of reporting of these reserves. As all the counsels seem to agree, the central issue here is the definition of reserves as set forth in Section 801 of the code as to which we believe there are two overriding principles. Firstly, that the test for qualification as a life insurance company is clearly set forth in the code as the reserve ratio test, that is to qualify as a life insurance company. A company’s life insurance reserves must comprise more than 50% of its total reserves. And secondly, the Congressional intent is clear that state law shall control in matters relating to the substantive definitions of insurance companies. Nevertheless, in the face of these clear principles, the Government seeks attribution of these reserves on a very novel theory. This theory is that reserves follow the risk, a theory which we would submit goes beyond the clear wording of the statute and the intent of Congress because this theory maintains that the legal definition of reserves is who bears the ultimate insurance risk. The term reserves, total reserves, and reserves required by law are all used in the statute. But the statute does not define them technically. However, the cases in this Court have consistently held and this goes back to the Maryland Casualty case that these terms are deemed to have a technical meaning. That is to say, a meaning consistent with that used by the state law, by the state regulatory authorities and a meaning consistent with the common and prudent business practice in the insurance industry. Nonetheless, the Government argues that state law is irrelevant and the Government also says today that the state insurance regulatory authorities don’t care about these reserves as they are before the Court in the cases today. We would suggest that the state regulatory authorities who have the primary responsibility for looking for the safety of the policy holders, and therefore, looking for the solvents for the safety and importance of the solvency of these companies would not respond very favorably to the Government's comments. Now the reserve ratio test in Section 801 has been in the code for a long time. It was originally enacted in 1921. The present statutory definition was enacted as part of the Revenue Act of 1942 and during this long history, never has there been one suggestion in any case or in the legislative history before Congress that the test should be reserves follow the risk. Another thing that is important is that the cases have always used the term funds held. And in fact the treasury’s own regulations require that funds must be held. In the present case, it is important to note that in both Treaty one and Treaty two situation, the accident and health reserves covered by these reinsurance treaties were not held by respondent and pursuant to the terms and treaties themselves and pursuant to the requirements of state law. These unearned premiums did not constitute the assets of respondent on its balance sheet, and therefore, there was no requirement that it maintained the corresponding reserve. The court below placed very heavy in emphasis on the requirements of the statutory provisions of the states of Georgia and Arizona. In recognition, we would submit of the clear Congressional intent that state law must apply in matters relating to substantive definitions of insurance companies. The Government’s argument in this case today ignores the requirements of the state law as interpreted by the regulatory authorities of both Georgia and Arizona. Court of Claims stressed the generally accepted principles that where a statute is ambiguous or doubtful and in the absence of judicial authority to the contrary, the uniform and consistent interpretation of that statute by the regulatory body charged with the responsibility of administering the statute is entitled to great weight. This principle is clearly applicable in the present case and this Court should give right weight to the fact that the state regulatory authorities of both Arizona and Georgia made no change in the reporting of the reserves of respondent. This was the case even after there were two tri-annual examinations during the taxable years at issue and this was the case when special attention was given to these reinsurance treaties and the reserves by the examiner from the state of Arizona. And even after these two examinations and their special attention was given, no change was made in the reporting of the reserves by respondent. Therefore, we would submit that a departure from such a time honored principle as we have referred to is not warranted by the facts in this case. As each of these consolidated cases clearly indicate, we are swallowed up in a sea of complex terms and equally complex contractual arrangements which are perplexing to lawyers and layman alike. The depth of this complexity it seems to me demonstrates even more clearly that Congressional wisdom of leaving substantive definitions to the state regulatory authorities who have a vested interest in regulating the industry and who have a necessary training and expertise to comprehend these complex reinsurance arrangements. Indeed --
John Paul Stevens: Counsel could I just interrupt on one question, factual question. Does the record tell us in the Treaty two situation, who does the administration, who at the basic claim, the reinsurer or the direct insurer?
E. Michael Masinter: Your Honor, I believe under the terms of the contract, the claim would have -- actually be paid by the direct insurer because a contract provides that to reinsurer shall reimburse the direct insurer, but other than the contract I don’t think there is any specific evidence on that point. I would have to go further and explain that it is common and customary in this industry for a company like American Bankers for example to assist in maintaining the books and the records because it is clear that they do have staff and the machinery and the computers and that type of thing whereas the companies like Consumer did not have the inadequate personnel to perform the record keeping. We would submit, Your Honor that these complex reinsurance arrangements are the results of highly creative people, actuaries and businessman alike. And that ones their efforts have come together to produce a complex and sophisticated reinsurance arrangements such as we have in these cases today that the federal income tax consequences should flow from the regulatory interpretation of these arrangements and not otherwise. We think it is very important that federal income tax consequences look to the substantive law of the states. This is clearly the most efficient and effective method of imposing our federal income tax system on this industry and would permit a greater certainty in the planning of the tax and financial affairs of these companies. The Government has argued on brief that the issues and the cases dealing with the issue of substance versus form should be applicable in this case. The Government cannot be heard to say that these issues are applicable here. These treaties cannot be disregarded for lack of economic substance or business purpose. The court below clearly found that these reinsurance treaties had a business purpose, but moreover and more importantly, these theory should have no application to the reinsurance transaction in this case. Out of the multitude of cases that had dealt with the question of substance versus form before this Court and other lower Federal Courts. One very clear common threat or common principle has developed. A principle conceived by Judge Learned Hand in his dissent in the case of Gilbert versus Commissioner and which was followed by this Court in the Knetsch case. Judge Hand’s test was, if the taxpayer enters into a transaction that does not appreciably affect his beneficial interest except to reduce his tax, the law will disregard it. Stated conversely, this test would recognize business transactions for tax purposes if they were treated consistently for material non-tax purposes. Furthermore, we would submit that this test would have the effect of recognizing for tax purposes transactions between unrelated parties dealing in arms length except transactions which have no economic purpose apart from tax savings, as clearly was the situation in the Knetsch case. Since the transactions in the present case possessed material business motives apart from tax deferment motives, the appreciable effect test as applied to the facts in this case would compel a result that these reinsurance transactions should not be disregarded for lack of economic substance or business purpose. In this case, we see a factual situation where the respondent and an unrelated insurance company carefully arranged their business relationship in a sophisticated, business like manner, totally in compliance with state law and state regulatory law and totally in compliance with the income tax statute when it was permitted to qualify as a life insurance company. The challenge it would seem to me, if any is to be made to this reinsurance arrangement which is so common in the credit insurance industry, properly lies in the converse where statutory provisions maybe studied with care and precision and where statutes maybe written to apply in a consistent fashion to the entire industry, a result that we would submit is paramount in this complex area of a law. Sophisticated business arrangements that had been in effect for many years in a particular industry as is the case here, should not be overturned on the basis of legal theories which find no support in the case law the legislative history or in fact among the regulatory bodies who have the responsibility for regulating the industry and to whom the federal taxing law looks for substantive guidance. We would strongly urge this Court to affirm the decision of the Court of Claims. Thank you.
Warren E. Burger: Mr. Smith you have about two minutes left.
Stuart A. Smith: Yes. I just have a few points to make Mr. Chief Justice. Counsel for Penn Security, Mr. Jones attempted to characterize that Treaty one arrangement as one in which the company, that is the taxpayer, assumed the risk as it received these premiums on a monthly basis. But I think if the Court examines the agreement which is set forth at page 40 A of the appendix, Article 2, simple contradicts that assertion. It says, “The liability of taxpayer on all reinsurance shall begin simultaneously with that of Pilot Life, that is the other company, and in no event shall the reinsurance of taxpayer be in force and binding unless the policy issued by Pilot Life is enforced.” I think it's plain that the very -- that the port of this agreement was that at the very beginning once the policy holder has paid the premium, Penn Security and Consumer Life in the Treaty one arrangement were on the risk and if they were on the risk. They have to project that liability and they have to -- that those insurance reserves are includable in its total reserves. I would think that the tax law and the insurance law is not that primitive that it cannot recognize that these contractual assumptions of risk in exchange for a receipt of premiums which are going to drop down to these taxpayers should not be attributed to it as accident and health insurance business are to be includable in the total reserves, the denominator of the statutory fraction. I have one last point to make and that is with the respect to business purpose. There has been a lot of talk this morning from counsel for the taxpayers that that they were business purposes to these agreements, and that they were very sophisticated. That may well be the case, but there was no insurance purpose to these Treaty two arrangements. The risk in the Treaty two arrangement stayed with the taxpayers and the Treaty one arrangement it was real reinsurance that was assumed by the taxpayers. That to us means that it was insurance business, accident health insurance which has to be attributed to the taxpayers. Thank you.
Warren E. Burger: Thank you gentleman. The case is submitted.