REVENUE RULING 70-190
1970-1 C.B. 150, clarified in Rev. Rul. 80-115

[IRS Annotation]
A reserve for payment of disability benefits established after the disability claim has been incurred and approved and held under contracts that also provide life insurance coverage qualifies as a life insurance reserve under section 801(b) of the Code.

Rev. Rul. 70-190
Advice has been requested whether the reserve held by the taxpayer for the payment of disability benefits (after the disability claim has been incurred and approved) under contracts providing both disability insurance and ordinary life insurance coverage qualifies as a life insurance reserve within the meaning of section 801(b) of the Internal Revenue Code of 1954.

The taxpayer is a life insurance company taxable under section 802 of the Code. One of the insurance contracts the taxpayer writes provides life insurance benefits payable at death of the insured or on maturity of the policy in the case of endowment (basic life insurance coverage) combined with disability income and waiver of premium benefits. When the policies go into force, two reserves are established, viz., a reserve for basic life insurance benefits and a reserve entitled Disability Benefits-Active Lives. Premiums received for the basic life insurance benefits fund the basic life reserve and additional premiums received for the disability benefits fund the Disability Benefits-Active Lives reserve. When an insured becomes disabled and entitled to the monthly income payments specified in the contract and to the waiver of premium benefit, a third reserve entitled Disability Benefits-Disabled Lives is established. This third reserve is funded by a transfer from the Disability Benefits-Active Lives reserve in an amount actuarially computed to provide disability benefits during the current disability. The disability income payments to the insured are paid out of this reserve. Further, all premiums due under the contract are, by virtue of the waiver of premium benefit, paid by transfer from the Disabled Life reserve to the basic life insurance reserve and to the Active Lives Disability reserves. Thus, all premiums due under the contract are received during the premium paying period—in cash from the nondisabled insureds and by transfer through operation of waiver of premium benefit from the disabled insureds.

The disabled insured's recovery terminates the taxpayer's obligation to pay disability benefits on the particular current disability claim. Death of an insured (or maturity of the policy in case of endowment) terminates the entire contract and the taxpayer is then liable to pay the basic life insurance benefits provided for in the policy. Amounts in each of the three reserves that are attributable to the terminated policy are then released to the general corporate assets of the taxpayer.

Each of the above-described reserves is computed on the basis of recognized mortality or morbidity tables, at assumed rates of interest, and is required by law. No duplication exists among them.

The specific question involved is whether the reserve for Disability Benefits-Disabled Lives is a reserve that is maintained to pay future unaccrued claims within the meaning of section 801(b) of the Code.

Section 801(b)(1) of the Code provides as follows:

(b) Life Insurance Reserves Defined.—

(1) In General.—For purposes of this part, the term "life insurance reserves" means amounts—

(A) which are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and

(B) which are set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable health and accident insurance contracts . . . involving, at the time with respect to which the reserve is computed, life, health, or accident contingencies.

Section 801(b)(2) of the Code provides that with exceptions not here pertinent, life insurance reserves must also be required by law.

In effect, this statutory definition reflects case law beginning with McCoach v. Insurance Company of North America, 244 U.S. 585 (1917) [151] when, before 1921, insurance companies were given deductions for "reserves required by law" and, after 1921, were permitted to exclude from their investment income the interest required to be added to their "reserves required by law." However, not all "reserves required by law" qualified for that treatment. The only reserves that did qualify for special treatment were technical insurance reserves i.e., those that pertained directly to insurance, were calculated on the basis of an actuarial table applicable to the nature of the risk involved, with an interest assumption involved in the calculation, and maintained out of premiums and investment earnings for the purpose of maturing and liquidating future, unaccrued and contingent claims.

In Helvering v. Oregon Mutual Insurance Company, 311 U.S. 267 (1940), Ct.D. 1476, C.B. 1940-2, 234, the Supreme Court in considering combined life, health, and accident policies and the reserves held thereunder stated at page 271:

* * * in the combined life and health and accident policies, the health and accident reserves are based upon contingencies of the commencement and continuance of disability. They have a direct and inseparable relationship to the very insurance contracts which bring respondent under a special tax scheme. Nor is there a distinction * * * between that part of the reserve set aside to protect policy holders not yet disabled and that part set aside to protect those already disabled. The liability to those who have incurred disability is not a fixed sum, but remains a contingency, still uncertain in duration and amount. Reserves held for such a contingent liability are true reserves in the insurance sense.

And in Commissioner v. Monarch Life Insurance Company, 114 F.2d, 314 (1940), one of the questions presented was whether a reserve for incurred disability benefits was a technical insurance reserve so that it could qualify as a "reserve required by law." The court held that it was stating at page 320:

The claim is not accrued because, though the disability has been incurred, the continuance of the disability is uncertain, and thus the waiver is contingent. The extent of the probable liability and the amount of the reserve created are fixed by reference to mortality and disability tables plus an assumed interest rate. When the premium becomes due and total disability exists, the premium is paid out of the reserve and is no longer a part of the reserve. It is clear that the reserve is held by the taxpayer against claims of insurance that are "future," "unaccrued," and "contingent." It is a true technical insurance reserve . . .

The above-stated principles are no less applicable under the present statutory definition of life insurance reserves than they were to "reserves required by law" that were accorded special treatment only where they were, inter alia, held for future, unaccrued and contingent claims.

Accordingly, the reserve labelled Disability Benefits-Disabled Lives that is held to pay disability benefits under contracts also providing life insurance benefits (as described herein) qualifies as a life insurance reserve under section 801(b) of the Code.