96 T.C. 497">*502 Respondent concedes that the disabled lives reserve was computed on the basis of recognized mortality or morbidity tables and assumed rates of interest, satisfying the requirements of section 801(b)(1)(A), and was required under Connecticut law, satisfying the requirements of section 801(b)(2). Respondent, however, asserts that the extended insurance provisions of petitioner's group term life insurance policies constituted cancelable health insurance under section 801(b)(1)(B), therefore preventing the disabled lives reserve from qualifying as a life insurance reserve. Petitioner apparently concedes that the extended insurance, if treated as health insurance, would not qualify as "noncancellable" under section 801(b)(1)(B), and that the disabled lives reserve therefore would fail to qualify as a life insurance reserve. See sec. 1.801-3, Income Tax Regs. Petitioner, however, argues that the extended insurance should not be treated as health insurance but as life insurance, rendering "cancellability" irrelevant ⁵ and qualifying the disabled lives reserve as a life 1991 U.S. Tax Ct. LEXIS 21">*31 insurance reserve under section 801(b). Alinco Life Insurance Co. v. United States, 178 Ct. Cl. 813">178 Ct. Cl. 813, 373 F.2d 336">373 F.2d 336, 373 F.2d 336">348, 373 F.2d 336">354 (1967). For the reasons discussed below, we agree with petitioner.

Before we turn to an evaluation of the parties' arguments, a brief discussion of life insurance reserves and of the historical treatment of reserves for extended insurance for disabled individuals is useful.

The term "reserve," when used in the life insurance context, has a different meaning than that ordinarily1991 U.S. Tax Ct. LEXIS 21">*32 associated with the term. As one treatise states:

The word "reserve" is somewhat misleading, since it does not have the same use here as in the usual commercial dealings * * *. The policy reserve of a life insurance company is a liability. It represents an obligation to the policyowners. * * * [S. Huebner & K. Black, Life Insurance 350 (10th ed. 1982); emphasis in original.]

96 T.C. 497">*503 Likewise, we have stated that life insurance reserves "are bookkeeping entries reflecting liabilities on the insurance company's books and do not represent funds actually set aside in something like a trust fund. * * * It is the company's surplus that actually protects the policyholders." Anchor National Life v. Commissioner, 93 T.C. 382">93 T.C. 382, 93 T.C. 382">419 n.25 (1989) (emphasis supplied). Similarly, the Third Circuit has noted that "contrary to generally held belief, 'reserves' are not trust funds or assets in escrow but are factually and merely statements of liability." Mutual Benefit Life Insurance Co. v. Commissioner, 488 F.2d 1101">488 F.2d 1101, 488 F.2d 1101">1103 (3d Cir. 1974). The amount of a life insurance reserve has been described, in general terms, 1991 U.S. Tax Ct. LEXIS 21">*33 as "the difference, at any point in time, between the present value of future benefits and the present value of future net premiums." S. Huebner & K. Black, supra at 349; USAA Life Insurance Co. v. Commissioner, 94 T.C. 499">94 T.C. 499, 94 T.C. 499">504 (1990). ⁶

A reserve for extended insurance for disabled1991 U.S. Tax Ct. LEXIS 21">*34 individuals provided under a life insurance policy reflects the company's increased potential liability for death benefits resulting from the disability of an individual covered by extended insurance. See Group Life & Health Insurance Co. v. United States, 78-2 USTC par. 9797, 42 AFTR 2d 78-6282 (N.D. Tex. 1978), revd. on other grounds 660 F.2d 1042">660 F.2d 1042 (5th Cir. 1981). The amount of such reserve reflects the fact that no future premiums are to be received for the covered individual and also reflects the prospect of earlier deaths among the disabled. 897 F.2d 599">Group Life & Health Insurance Co. v. United States, supra.

Life insurance provisions providing extended insurance coverage to disabled individuals without payment of premiums also are sometimes referred to as "waiver of premium" provisions. See D. Gregg, Group Life Insurance 73, 75 (3d ed. 1973); Aetna Life Insurance Co. v. United States, 16 Cl. Ct. 364">16 Cl. Ct. 364, 16 Cl. Ct. 364">374-375 (1989). Petitioner argues that its extended 96 T.C. 497">*504 insurance provisions should not be equated with "waiver of premium" provisions on individual life insurance policies1991 U.S. Tax Ct. LEXIS 21">*35 because, in the context of 1-year group term insurance, no future premiums are "due" under the original policy, and the insurance company does not pay the waived premiums to itself, as in the case of waiver of premium provisions on individual life insurance. The expert report submitted by petitioner describes the different accounting and actuarial treatment of the two types of provisions as well as the differences in benefits to policyholders. In the instant case, we need not decide whether reserves for waiver of premium provisions on individual life insurance policies might be treated differently than the disabled lives reserve. Cf. 16 Cl. Ct. 364">Aetna Life Insurance Co. v. United States, supra (concluding that continued coverage in the context of group term life insurance is indistinguishable from waiver of premium benefits in individual policies). Our references to cases involving such reserves are not meant to convey any opinion on such issue; however, as discussed below, we believe that those cases are relevant by way of background and in evaluating respondent's argument concerning the legislative history of section 801(b)(1)(B). We also note that in 94 T.C. 499">Group1991 U.S. Tax Ct. LEXIS 21">*36 Life & Health Insurance Co. v. Commissioner, supra, the District and Circuit Courts referred to the relevant provisions under the group term life insurance policies there in question as "waiver of premium" benefits.

Reserves related to waiver of premium provisions received judicial attention around 1940. The issue in those early controversies involved the requirement that an amount relate to future "unaccrued" claims involving "contingencies" in order to qualify for deductibility as an insurance "reserve," a requirement stemming from the Supreme Court's opinion in Maryland Casualty Co. v. United States, 251 U.S. 342">251 U.S. 342 (1920). See Guadiana, "Federal Income Taxation of Life Insurance Companies: The Life Insurance Reserve," 30 Tax L. Rev. 173 (1975); T. Nash, Federal Taxation of Life Insurance Companies 8-31 to 8-32 (1983). The Government's position was that reserves for waiver of premium provisions did not qualify as insurance reserves because the relevant claims already had accrued or matured. That position stemmed from the fact that, as in the instant 96 T.C. 497">*505 case, the amounts were set aside and computed on the1991 U.S. Tax Ct. LEXIS 21">*37 basis of the insureds who had already become disabled. In Monarch Life Insurance Co. v. Commissioner, 38 B.T.A. 716">38 B.T.A. 716 (1938), affd. 114 F.2d 314">114 F.2d 314 (1st Cir. 1940), the First Circuit explained its rejection of the Government's argument as follows:

The Commissioner contends that this is not a technical insurance reserve because, he says, it is maintained to pay claims which have already accrued or matured.

* * * *

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. * * * It is clear that the reserve is held by the taxpayer against claims of insurance that are "future," unaccrued," and "contingent." * * *

[114 F.2d 314">114 F.2d at 320; emphasis supplied].

The Supreme Court agreed with such analysis and invalidated regulations which excluded from "reserves" amounts representing the "estimated value of future premiums which have been waived on1991 U.S. Tax Ct. LEXIS 21">*38 policies after proof of total and permanent disability." ⁷Helvering v. Oregon Mutual Life Insurance Co., 311 U.S. 267">311 U.S. 267 (1940). See 16 Cl. Ct. 364">Aetna Life Insurance Co. v. United States, supra at 376 n.21. The Supreme Court reasoned that the liability to protect "those who have incurred disability is not a fixed sum, but remains a contingency, still uncertain in duration and amount." 311 U.S. 267">Helvering v. Oregon Mutual Life Insurance Co., supra at 271-272.

In 1970, the Internal Revenue Service ruled that the holdings in Monarch Life and Oregon Mutual are of continuing vitality under section 801(b), and that, under the authority of those cases, a disabled lives reserve is "maintained to pay future unaccrued claims" and qualifies as a "life insurance reserve" where required by law and computed on the basis of recognized mortality or morbidity tables of assumed rates of interest. Rev. Rul. 70-190, 1970-1 96 T.C. 497">*506 C.B. 150.1991 U.S. Tax Ct. LEXIS 21">*39 ⁸ The facts of Revenue Ruling 70-190 involved life insurance contracts which provided disabled individuals with both waiver of premium benefits and monthly disability income benefits; the ruling, however, drew no distinction between the two types of benefit and failed to consider whether either benefit might constitute "health insurance" subject to the noncancelability requirement of section 801(b)(1)(B).

In 1980, the Internal Revenue Service "clarified" Revenue Ruling 70-190 by stating that the "health and accident benefits" involved therein "were, in effect, noncancellable." Rev. Rul. 80-115, 1980-1 C.B. 138. Revenue Ruling 80-115 itself involved 1-year1991 U.S. Tax Ct. LEXIS 21">*40 group term life insurance contracts under which permanently disabled employees were entitled to monthly disability income benefits, as opposed to extended insurance/premium waiver benefits; the ruling held that the reserve maintained to fund such disability income benefits did not qualify as a "life insurance reserve" because it was a reserve for cancelable health insurance. The ruling relied on United Benefit Life Insurance Company v. McCrory, 414 F.2d 928">414 F.2d 928 (8th Cir. 1969), discussed supra note 5 and infra note 25. In the instant case, petitioner has conceded that its reserves held for disability income benefits on certain contracts do not qualify as life insurance reserves. ⁹Revenue Ruling 80-115 did not address directly the treatment of extended insurance or waiver of premium provisions as health insurance.

Respondent makes two arguments on brief in support of his position that the disabled lives reserve does not qualify as a life insurance reserve. First respondent argues that extended insurance is health insurance for purposes of section 801(b)(1)(B) because it provides a current economic benefit to the disabled employee and is equivalent to the receipt of disability income payments by such employee 96 T.C. 497">*507 followed by the use of the cash to pay life insurance premiums. Petitioner counters by arguing that the only benefit actually payable under the extended insurance provisions is a death benefit, and that the extended insurance provisions merely serve to extend basic death benefit coverage.

Respondent cites a variety of treatises for the proposition that waiver of premium provisions are a type of "disability benefit." Petitioner offers citations of its own referring to the benefits as "extension(s) of life insurance," and stating that extended insurance provisions keep life insurance alive and provide a "benefit" only in the event of death.

That the extended insurance provisions1991 U.S. Tax Ct. LEXIS 21">*42 "benefit" disabled employees is clear, as that is the purpose for which they are designed. As the Claims Court noted in Aetna Life Insurance Co. v. United States, 16 Cl. Ct. 364">16 Cl. Ct. 364, 16 Cl. Ct. 364">377 (1989), however, labeling the provisions a disability benefit "simply begs the question"; what we must decide is whether the limitation of such benefit to disabled individuals prevents the associated reserve from qualifying as a life insurance reserve under section 801(b)(1)(B). We therefore turn to the language of section 801(b)(1)(B) and its prior interpretations.

In interpreting section 801(b)(1)(B), we believe that the words "life insurance" and "health insurance" should not be read in isolation. Rather, they should be read in the context in which they appear. The operative language of section 801(b)(1)(B) describes "life insurance reserves" as amounts:

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 (including life insurance or annuity contracts combined with noncancellable health and accident insurance) 1991 U.S. Tax Ct. LEXIS 21">*43 * * * [Emphasis supplied.]

Thus, qualification of a reserve as a "life insurance reserve" depends upon the nature of the claim which the reserve is set aside to pay. Compare Modern American Life Insurance Co. v. Commissioner, 92 T.C. 1230">92 T.C. 1230 (1989) (reserve set aside for the payment of policyholder dividends is not a "life insurance reserve"). In the instant case, the only obligations which petitioner could be held liable to pay under extended insurance were the death benefits for disabled employees who died during the period of extended coverage; the 96 T.C. 497">*508 disabled lives reserve was equal to the present value of such death benefits. Thus, a plain reading of the statute suggests that the disabled lives reserve qualifies as a life insurance reserve. See USAA Life Insurance Co. v. Commissioner, 94 T.C. 499">94 T.C. 499, 94 T.C. 499">533 (1990) ("Anticipated death benefits prior to the death of the insured are clearly 'future unaccrued claims' for purposes of section 801(b)(1)(B)").

The only other court to have addressed the "health versus life insurance" issue is the Claims Court in 16 Cl. Ct. 364">Aetna Life Insurance Co. v. United States, supra.1991 U.S. Tax Ct. LEXIS 21">*44 Both parties agree that Aetna presents the identical issue involved in the instant case. The Claims Court, describing the issue as "novel" and lacking "any significant authority on behalf of either side" (16 Cl. Ct. 364">16 Cl. Ct. at 376, 377), focused on the event necessary to trigger reduction of a reserve, and concluded that the disabled lives reserve was a life insurance reserve "since any payment will be due only upon a disabled employee's death." (16 Cl. Ct. 364">16 Cl. Ct. at 378; emphasis supplied.) ¹⁰1991 U.S. Tax Ct. LEXIS 21">*46 We believe that the Claims Court's analysis in Aetna comports with a plain reading of section 801(b)(1)(B). We also believe that respondent's argument equating the extended insurance with the receipt of income by the disabled employees ignores economic reality. The extended insurance never provided that disabled employees had any right to the current use of any funds from petitioner, and petitioner never was liable for any payment with respect to the extended insurance except the proceeds of the policy if death occurred before an employee recovered from his or her disability. The Court of Claims' discussion of the fundamental1991 U.S. Tax Ct. LEXIS 21">*45 difference between health and life insurance in New World Life Insurance Co. v. United States, 88 Ct. Cl. 405">88 Ct. Cl. 405, 26 F. Supp. 444">26 F. Supp. 444 (1939), affd. on another issue 311 U.S. 620">311 U.S. 620 (1940), provides a useful analytical framework:

The purpose of considering the mortality element * * * in casualty insurance is the opposite of that of the reserve for the life risk in a life 96 T.C. 497">*509 insurance policy. The mortality element in a life policy requires the establishment of a reserve sufficient to meet the policy obligations at maturity; that is, at death. In the case of health and accident insurance death, instead of maturing the liability, terminates the risk with respect to the payment of liability for disability benefits. [26 F. Supp. 444">26 F. Supp. at 464; emphasis supplied.¹¹]

In the instant case, the death of an employee did not "terminate" petitioner's risk of having to make payment; instead, it triggered petitioner's liability for payment.

The opinions of the District Court and the Fifth Circuit in Group Life & Health Insurance Co. v. United States, 78-2 USTC par. 9797, 42 AFTR 2d 78-6282 (N.D. Tex. 1978), revd. and remanded 660 F.2d 1042">660 F.2d 1042 (5th Cir. 1981), also indicate that reserves for extended insurance provisions (referred to in those opinions as "waiver of premium" benefits) of group term life insurance policies may qualify1991 U.S. Tax Ct. LEXIS 21">*47 as life insurance reserves under section 801(b)(1)(B). In that regard, the District Court found that:

The disabled insured's life expectancy is substantially shorter than a normal, healthy insured. Although an amount is included in the basic life reserve for the underlying life policy, the Reserve for Disability-Disabled Lives is set up to recognize that a liability exists for a risk which is far greater than the risk recognized under the basic policy. The assumption is that since the individual is totally disabled, there is a very good chance that the insurance company is going to incur a claim on that individual in the near future. * * * The Disability-Disabled Lives Reserve is a reserve that needs to be established to properly reflect Group Life's liability with respect to increased exposure as a result of disabled policyholders and, therefore, is an amount under Sec. 801(b) which is set aside to mature or liquidate future unaccrued claims arising from life polices. [78-2 USTC at 85,692, 42 AFTR 2d at 78-6287.]

On appeal, the Fifth Circuit, reversing the District Court, held that the reserve in question failed the requirements of1991 U.S. Tax Ct. LEXIS 21">*48 section 801(b)(1)(A), because it was computed by setting aside a flat $ 750 for every $ 1,000 of insurance in force rather than being based on "recognized mortality or morbidity tables and assumed rates of interest." However, the 96 T.C. 497">*510 Court indicated that it was "undisputed" that a "disability-disabled lives" reserve otherwise might qualify as a life insurance reserve (660 F.2d 1042">660 F.2d at 1056¹²), and described such reserves as designed to meet "the prospect of earlier deaths among the disabled." Group Life & Health Insurance Co. v. United States, 660 F.2d at 1049 (emphasis supplied). Thus, although the Fifth Circuit disqualified the reserve there in issue, its opinion suggests that petitioner's disabled lives reserve in the instant case -- which respondent concedes is computed on the basis of the appropriate tables and interest rates -- would qualify as a life insurance reserve. See UNUM Life Insurance Co. v. United States, 897 F.2d 599">897 F.2d 599, 897 F.2d 599">609 (1st Cir. 1990) (comparing results in Group Life & Health Insurance Co., supra, and 16 Cl. Ct. 364">Aetna Life Insurance Co. v. United States, supra, based 1991 U.S. Tax Ct. LEXIS 21">*49 on use of recognized mortality table in the latter case).

Previous cases involving the application of section 801(b) to other types of reserves support our conclusion that the disabled lives reserve is a "life insurance reserve." In Union Mutual Life Insurance Co. v. United States, 570 F.2d 382">570 F.2d 382 (1st Cir. 1978), an insurance company issued life insurance policies which included a "guaranteed insurability" rider option under which policyholders could acquire specified additional amounts of insurance without having to present evidence of current insurability (i.e., by passing a medical examination). In addition to its basic death benefit reserves for the policies, the insurance company maintained an additional reserve for the unexercised guaranteed insurability1991 U.S. Tax Ct. LEXIS 21">*50 options. The Government contended that such additional reserve was not a "life insurance reserve" because it related to policies which might be issued in the future, rather than life contingencies in existing life insurance policies. The First Circuit disagreed, stating that:

The Government fails to recognize that the [guaranteed insurability] option is one of the insurance protections afforded by the very insurance policy initially issued to the policyholder. The policyholder not only is given coverage for the face amount of his current policy but also is guaranteed the option to elect additional coverage at certain specified dates in the future. Thus, we do not think these reserves should fail to 96 T.C. 497">*511 qualify on the asserted ground that they are not maintained with respect to existing policies. [570 F.2d 382">570 F.2d at 394-395; citation omitted. ¹³]

Applying the First Circuit's reasoning to the instant case, the extended insurance offered by petitioner, like the guaranteed insurability option in Union Mutual, provides additional life insurance coverage to persons who otherwise might not be able to obtain it, and is an additional benefit arising1991 U.S. Tax Ct. LEXIS 21">*51 from the original life insurance policy. The fact that a contingency other than death itself triggers availability of the additional benefit (and petitioner's additional liability) should not disqualify the reserve.

The Court of Claims' decision in Lincoln National Life Insurance Co. v. United States, 217 Ct. Cl. 515">217 Ct. Cl. 515, 582 F.2d 579">582 F.2d 579 (1978), also is consistent with1991 U.S. Tax Ct. LEXIS 21">*52 a plain reading of the statute. In that case, the taxpayer issued term life insurance policies with "conversion privilege" riders allowing policyholders to convert the term insurance to permanent life insurance without presenting evidence of insurability. Persons exercising the conversion privilege generally exhibited an "excess" mortality rate because the policyholder's tendency was to convert to permanent insurance at a time when the policyholder had become a "substandard risk." The Court of Claims held that the "preconversion reserve" maintained by the insurance company to provide for such expected excess mortality risk was a "life insurance reserve," describing it as a reserve established to fulfill an additional insurance benefit under the original term insurance policies. Thus, the taxpayer's reserve was set aside to pay life insurance claims.

Similarly, in Mutual Benefit Life Insurance Co. v. Commissioner, 58 T.C. 679">58 T.C. 679 (1972), affd. 488 F.2d 1101">488 F.2d 1101 (3d Cir. 1974), a reserve was set up for provisions allowing a beneficiary to elect to receive death benefits in installments over the rest of the beneficiary's life, 1991 U.S. Tax Ct. LEXIS 21">*53 in lieu of the customary lump sum death benefit payment. Due to a lengthening of beneficiaries' life expectancies, election of the 96 T.C. 497">*512 installment option became increasingly costly to the insurance company, and the company established an additional reserve for the contingency that installment payments might be elected. The Government contended that such additional reserve was not a life insurance reserve, characterizing the election as the purchase of an annuity by the beneficiary with the lump sum proceeds of the policy. We disagreed with that characterization, stating that the optional settlement could not "be distinguished from the obligation of the petitioner to pay a death benefit under a life insurance contract." 58 T.C. 679">58 T.C. 689. In affirming our holding that the reserve qualified as a life insurance reserve, the Third Circuit stated that:

We * * * find that the insurer, in making payment under the specific settlement option involved in this controversy, does not enter into a new contract with the beneficiary but merely carries out the contractual obligation which arose with the initial issuance of the life insurance contract. [488 F.2d 1101">488 F.2d at 1107.]

1991 U.S. Tax Ct. LEXIS 21">*54

Thus, in Mutual Benefit, the proper focus was on the basic nature of the claims as death benefits rather than on the contingency -- i.e., election by the beneficiary -- triggering the company's additional liability for death benefits. Mutual Benefit also stands for the proposition that "nonmortality" factors (in Mutual Benefit, factors concerning benefit election by the beneficiaries) may be taken into account in attempting to make a reserve calculation more exact. USAA Life Insurance Co. v. Commissioner, 94 T.C. 499">94 T.C. 499, 94 T.C. 499">528, 94 T.C. 499">531 (1990); 217 Ct. Cl. 515">Lincoln National Life Insurance Co. v. United States, supra at 593; Ernst & Whinney, Federal Income Taxation of Life Insurance Companies 6-6 (2d ed. 1990). See also Rev. Rul. 69-444, 1969-2 C.B. 145, 146 (reserve maintained to provide for additional indemnity benefit where death results from a vehicular accident is a reserve for "insurance on life" "although [the benefit is] payable only as the result of a particular type of accidental death").

The most recent decision of this Court to interpret section 801(b)(1)(B)1991 U.S. Tax Ct. LEXIS 21">*55 is 94 T.C. 499">USAA Life Insurance Co. v. Commissioner, supra. In that case, the taxpayer issued universal life insurance policies which allowed policyholders to receive the cash value of the policy if it were surrendered to the taxpayer, and partial cash value in the event of partial 96 T.C. 497">*513 surrenders. Under Texas law, insurance companies were required to maintain reserves equal to the aggregate cash surrender value of the policies if that aggregate amount was greater than the basic death benefit reserves; the taxpayer fell into that category of insurance companies and maintained reserves equal to the aggregate cash surrender value of the policies.

The issue in USAA Life arose in light of the taxpayer's attempt to revalue its reserves under the relief provisions of section 818(c). Because the desired relief was unavailable for section 801(b) "life insurance reserves" computed on a net level basis, the Government, rather than the taxpayer, argued that the aggregate cash surrender value set aside by the taxpayer was such a life insurance reserve. The taxpayer took the position that the amount in question could not qualify as a "life insurance reserve" 1991 U.S. Tax Ct. LEXIS 21">*56 under section 801(b)(1)(B) because the cash surrender value of its policies represented a present, accrued liability in the nature of a demand deposit, rather than future unaccrued claims "involving life contingencies." We agreed with the Government, stating that:

petitioner's cash surrender values may be considered future unaccrued claims within the meaning of section 801(b)(1)(B) because the policyholders had yet to surrender the policies and demand the cash values. There was a life contingency involved in any such claim because the future surrender and demand was dependent on the survival of the insured to that time. [94 T.C. 499">94 T.C. 536-537. ¹⁴]

In further support of our conclusion that the reserve was a "life insurance reserve," we stated:

The cash surrender value for one of petitioner's universal life policies could not be practically or meaningfully divorced from the life insurance contract or its associated insurance protection. A policyholder did not purchase the insurance component and the excess cash surrender value component separately. In fact, the cash surrender value was not available to the policyholder, other than by1991 U.S. Tax Ct. LEXIS 21">*57 means of a loan, unless the policyholder surrendered the policy and its insurance protection. [94 T.C. 499">94 T.C. 539; emphasis supplied.]

96 T.C. 497">*514 Applying our reasoning in USAA Life to the instant case, we believe that the extended insurance provisions cannot, in a practical or meaningful way, be divorced from the underlying group term life insurance contracts issued by petitioner. Like the taxpayer in USAA Life, petitioner never offered extended insurance for sale separately, and the ultimate benefit to be provided by extended insurance was the death benefit called for by the original contract. Because the benefit for which the disabled lives reserve was set aside (i.e., extended insurance) cannot be divorced from life insurance protection, the disabled lives reserve relates to life insurance claims under section 804(b)(1)(B).

Second, respondent argues that the legislative history of section 801(b)(1)(B) conclusively establishes that the disabled lives reserve does not qualify. After reviewing such legislative history and the judicial setting in which it arose, we disagree.

The language of section 801(b)(1)(B)¹⁵ was enacted as part of the Revenue Act of 1942 (the 1942 Act), ch. 619, sec. 163(a), 56 Stat. 798, 867. ¹⁶ Prior to that legislation, section 203(a)(2) of the Internal Revenue Code of 1939 provided companies which qualified as "life insurance companies" with a deduction for all "reserve funds required by law." Case law and regulations, however, restricted the allowable deduction to "technical" insurance reserves, that is, amounts (1) directly pertaining to insurance, as opposed to "solvency" reserves not peculiar to insurance companies, (2) computed on the basis of mortality or morbidity tables and assumed rates of interest and (3) related to unaccrued and contingent claims. Helvering v. Inter-Mountain Life Insurance Co., 294 U.S. 686">294 U.S. 686 (1935); Maryland Casualty Co. v. United States, 251 U.S. 342">251 U.S. 342 (1920);1991 U.S. Tax Ct. LEXIS 21">*59 McCoach v. Insurance Co. of North America, 244 U.S. 585">244 U.S. 585 (1917); Monarch Life Insurance Co. v. Commissioner, 38 B.T.A. 716">38 B.T.A. 716, 38 B.T.A. 716">723-724 (1938), affd. 114 F.2d 314">114 F.2d 314 (1st Cir. 1940); art. 203(a)(2)-1 of 96 T.C. 497">*515 Regulations 86 (1935). In our background discussion above, we discussed the last of such requirements.

Relying on the foregoing technical insurance reserve requirements, the Government attempted to deny preferential treatment to a variety of reserves, including "waiver of premium" reserves under life insurance policies (discussed above), basic health insurance reserves, and other miscellaneous reserves. See, e.g., 38 B.T.A. 716">Monarch Life Insurance Co. v. Commissioner, supra.1991 U.S. Tax Ct. LEXIS 21">*60 The Government also advanced the argument that, in the case of a life insurance company, the phrase "reserve funds required by law" should include only reserves relating to life insurance. That second argument was described as "a novel proposition" lacking "any authority to support it," Monarch Life Insurance Co. v. Commissioner, 38 B.T.A. 716">38 B.T.A. at 726, and eventually was rejected by the Supreme Court. Helvering v. Oregon Mutual Life Insurance Co., 311 U.S. 267">311 U.S. 267 (1940); cf. New World Life Insurance Co. v. United States, 88 Ct. Cl. 405">88 Ct. Cl. 405, 26 F. Supp. 444">26 F. Supp. 444 (1939), affd. on another issue 311 U.S. 620">311 U.S. 620 (1940) (contrary view rejected by Supreme Court). Prior to the 1942 Act, the Internal Revenue Code simply drew no distinction between a life insurance company's reserves for life versus health insurance; rather, "Once a company [was] found to be a life insurance company * * *, the type of its policies [was] no longer important; all its business [was] treated as though it were life insurance." Commissioner v. Monarch Life Insurance Co., 114 F.2d 314">114 F.2d at 323.1991 U.S. Tax Ct. LEXIS 21">*61 See also United States v. Occidental Life Insurance Co. of California, 385 F.2d 1">385 F.2d 1, 385 F.2d 1">4-5 (9th Cir. 1967); PanAmerican Life Insurance Co. v. Commissioner, 38 B.T.A. 1430">38 B.T.A. 1430 (1938), affd. 111 F.2d 366">111 F.2d 366 (5th Cir. 1940); Equitable Life Assurance Society v. Commissioner, 33 B.T.A. 708">33 B.T.A. 708 (1935).

The 1942 Act distinguished the treatment of a life insurance company's reserves on cancelable versus noncancelable health insurance. H. Rept. 2333, 77th Cong., 1st Sess. (1942), 1942-2 C.B. 372, 453-454; S. Rept. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 504, 611-612. By altering the treatment of cancelable health insurance, Congress intended to equalize the treatment of life and casualty insurance companies with respect to such business. United Benefit Life Insurance Co. v. McCrory, 414 F.2d 928">414 F.2d 928, 414 F.2d 928">934-93696 T.C. 497">*516 (8th Cir. 1969); 385 F.2d 1">United States v. Occidental Life Insurance Co. of California, supra at 7. ¹⁷ Respondent argues that, because the cases preceding the1991 U.S. Tax Ct. LEXIS 21">*62 1942 Act assumed that "waiver of premium" provisions for disabled individuals were a form of health insurance, Congress must have intended the cancelable/noncancelable distinction of the 1942 Act to apply in limiting the reserve deductions for such provisions.

We are not convinced that Congress intended to change the treatment of waiver of premium reserves as part of the 1942 Act. As indicated in Rev. Rul. 70-190, 1970-1 C.B. 1501991 U.S. Tax Ct. LEXIS 21">*63 (holding pre-1942 cases applicable in construing section 801(b)(1)(B)), the primary issue on which the pre-1942 cases focused in considering "waiver of premium" reserves was whether the claims to which such reserves related already had accrued by reason of the onset of disability. Monarch Life Insurance Co. v. Commissioner, 38 B.T.A. 716">38 B.T.A. at 725; Pan-American Life Insurance Co. v. Commissioner, 38 B.T.A. 1430">38 B.T.A. at 1436-1439. The Government's second argument, i.e., that reserve deductions for life insurance companies should be limited to "life" reserves, was not aimed specifically at waiver of premium reserves. Rather, the cases in which that second argument arose involved policies which provided disability income benefits in addition to premium waiver benefits, ¹⁸1991 U.S. Tax Ct. LEXIS 21">*65 separate cancelable and noncancelable health and accident policies in addition to life insurance policies, ¹⁹ or health insurance policies alone. ²⁰ In fact, in Monarch Life, only the "accrued versus unaccrued claim" issue was considered in deciding the treatment of waiver of premium reserves; the Board of Tax Appeals focused on the Government's argument1991 U.S. Tax Ct. LEXIS 21">*64 against the deductibility of health 96 T.C. 497">*517 insurance reserves only in discussing the taxpayer's separate health insurance policies. See also Guadiana, "Federal Income Taxation of Life Insurance Companies: The Life Insurance Reserve," 30 Tax L. Rev. 173, 189 (1975) (taking the position that the 1942 Act did not change the treatment of disabled lives reserves). Thus, despite references in the cases to waiver of premium provisions as "disability" provisions, ²¹ we do not believe that the judicial setting in which the 1942 Act arose provides convincing evidence of congressional intent to treat such provisions as "health insurance" subject to the cancelable/noncancelable distinction. We believe that, had Congress intended to reverse the favorable treatment of waiver of premium reserves granted by the Supreme Court in 1940, ²² it would have been more explicit about doing so. ²³

1991 U.S. Tax Ct. LEXIS 21">*66 The legislative history of section 801(b)(1)(B) itself contains no indication that Congress intended a separate test of premium waiver provisions for cancelability as health insurance. Rather, the legislative history of the provision expresses Congress' desire to conform to industry standards in describing health insurance contracts:

As the term is used in the industry, a noncancelable insurance policy means a contract which the insurance company is under an obligation to renew at a specified premium, and with respect to which a reserve in addition to the pro rata unearned premium must be carried to cover the renewal obligation. * * *

H. Rept. 2333, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 372, 454; see also S. Rept. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 504, 612. ²⁴

1991 U.S. Tax Ct. LEXIS 21">*67 96 T.C. 497">*518 Such definition does not appear to contemplate treating a waiver of premium provision on a life insurance policy as health insurance to be tested separately for "noncancellability." ²⁵ Moreover, we have not seen any evidence that the insurance industry describes a waiver of premium provision as cancelable, or noncancelable, health insurance. Cf. 38 B.T.A. 1430">Pan-American Life Insurance Co. v. Commissioner, supra at 1431 (describing waiver of premium provision a "noncancellable" benefit). We therefore reject respondent's argument that the legislative history of section 801(b)(1)(B) mandates denial of "life insurance reserve" status to the disabled lives reserve. We note that the only other court to have addressed the issue concluded that the legislative history of section 801(b)(1)(B) was "unhelpful" in resolving it. Aetna Life Insurance Co. v. United States, 16 Cl. Ct. 364">16 Cl. Ct. 364, 16 Cl. Ct. 364">376 (1989).

1991 U.S. Tax Ct. LEXIS 21">*68 In conclusion, we hold that petitioner's disabled lives reserve qualifies as a life insurance reserve under section 801(b). ²⁶

FINDINGS OF FACT

During the year in issue, petitioner sold and maintained various types of group term life insurance policies (collectively, group policies), including policies sold to individual employers (employer policies), policies sold to multiple employer trusts (trust policies), franchise mortgage protection life insurance marketed through banks to individuals (franchise policies), group mortgage protection life insurance 96 T.C. 497">*519 marketed through banks to individuals (mortgage policies), and group credit insurance (credit policies). The term of each such policy depended on the relevant contractual provisions, with employer policies and trust policies providing insurance for successive 1-year terms, and franchise and mortgage policies providing a term of coverage which matches the term of the mortgage obligation. Premiums under petitioner's employer or trust policies were payable annually, semiannually, quarterly, or monthly at the option of the policyholder, while premiums under petitioner's franchise, credit, and mortgage policies were payable monthly.

The National Association1991 U.S. Tax Ct. LEXIS 21">*70 of Insurance Commissioners (NAIC) is an organization of State insurance commissioners. The financial statement form prescribed by the NAIC is known in the life insurance industry as the "annual statement" (annual statement) and must be filed annually in each State in which a life insurance company does business. During the year at issue and at all relevant times, petitioner was regulated by the Insurance Commissioner of the State of Connecticut (the insurance commissioner) and filed annual statements with the insurance commissioner.

For annual statement purposes, "deferred premiums" on a life insurance policy are premium installments due between the yearend annual statement date and the next policy anniversary date, and "uncollected premiums" are premium installments that actually have been billed as of yearend but remain due and unpaid. In filing its annual statement with the insurance commissioner, petitioner utilized an "annual premium assumption" for its ordinary life policies as well as for the group policies. An annual premium assumption is an assumption that the total annual premium on a policy has been paid in advance on the policy anniversary date. ²⁷ Historically, 1991 U.S. Tax Ct. LEXIS 21">*71 the assumption arose as a means of simplifying the computation of reserves (known as 96 T.C. 497">*520 policy "valuation") prior to the widespread availability of computers.

Under an annual premium assumption, as of the annual statement date (December 31) deferred and uncollected premiums are deemed to be received. Under actuarial theory, the result of such deemed receipt is an inclusion of the "net valuation portion" of deferred and uncollected 1991 U.S. Tax Ct. LEXIS 21">*72 premiums (i.e., the premium amount needed to meet policy obligations) ²⁸ in life insurance reserves. To offset such additional reserve liability and avoid distortion in the annual statement, amounts attributable to the deferred and uncollected premiums also are included in assets and income in the annual statement.

The NAIC Accounting Practices and Procedures Manual (manual), which contains rules applicable in completing the annual statement, indicates that the use of an annual premium assumption is traditional. The manual also states that such assumption is used by "most companies" in computing reserves on "ordinary" life insurance policies (defined to include individual whole life, term, endowment, and franchise coverage). The manual indicates that an annual premium assumption may be used in the case1991 U.S. Tax Ct. LEXIS 21">*73 of group term life insurance policies, noting that if such assumption is used for group term policies payable more frequently than annually, it would be "appropriate" to take deferred premiums into account in computing assets, income, and reserves. The annual statement form includes, in exhibit 13, a separate line for a "deferred and uncollected premium" asset attributable to group life insurance policies.

With respect to insurance companies filing in Connecticut, the annual premium assumption is used infrequently in the case of group term life insurance, although it is used typically in the case of ordinary whole life policies. Petitioner first reported deferred premiums on its group term life insurance contracts in its 1960 annual statement.

The manner in which an annual premium assumption (or mean reserve method) increases reserves for term life insurance policies may be illustrated by an example. The 96 T.C. 497">*521 "unearned premium reserve" ²⁹ on a term life insurance policy reflects premiums that have been received by the insurance company as of the valuation date but are allocable to the period of coverage beyond the valuation date. The reserve is computed by allocating1991 U.S. Tax Ct. LEXIS 21">*74 premiums ratably throughout the period to which they apply, i.e., up until the due date of the next premium installment. Thus, in the case of a 1-year policy with a monthly net valuation premium of $ 20 payable on the 15th day of the month, the "true" unearned premium reserve (i.e., the reserve absent an annual premium assumption) would be $ 10 as of the last day of the month, as half of the $ 20 has been "earned" over half of the month. The use of an annual premium assumption with respect to such policy causes a significant increase in the unearned premium reserve at the beginning of the policy term. Continuing the example, assuming a policy anniversary date of September 15, ³⁰ and using the annual premium assumption (and actual anniversary date), the unearned premium reserve with respect to such a policy would be $ 240 (i.e., the annual net premium) on September 15 and approximately $ 170 as of the annual statement "valuation" date (December 31) due to a ratable decrease in the reserve of $ 20 per month over 3 1/2 months. Thus, for annual statement purposes, the use of an annual premium assumption in the example would have increased the unearned premium reserve from $ 101991 U.S. Tax Ct. LEXIS 21">*75 to $ 170. It should be noted that the unearned premium reserve for a 1-year term life insurance policy is zero at the end of the policy year (this is known as the "terminal reserve") because, as of that moment in time, there is no future coverage obligation and the entire net valuation premium has been "earned."

Connecticut adopted the NAIC's "Standard Valuation Law," ³¹ under which life insurance companies are required to establish reserves in amounts that must not be less than certain minimum amounts. If a life insurance company establishes a reserve in excess of the statutory minimum, 96 T.C. 497">*522 however, it cannot reduce that reserve without the approval of the insurance1991 U.S. Tax Ct. LEXIS 21">*76 commissioner. ³² During the year in issue, Connecticut law did not specify whether an annual premium assumption must be used in calculating life insurance reserves. Petitioner's use of the annual premium assumption for its group term life insurance policies, however, produced reserves in excess of the statutory minimum (the "true" unearned premium reserve), and petitioner would have been required to obtain the approval of the insurance commissioner in order to reduce its reserves to a level based on actual premium receipts, i.e., the "true" unearned premium method. The insurance commissioner through his agents audits the life insurance reserves displayed in exhibit 8 of the annual statement. In performing his audit, the insurance commissioner applies standards promulgated by the NAIC and the Society of Actuaries which also may be incorporated in Connecticut law. Petitioner's annual statement for the year in issue was approved by the insurance commissioner.

1991 U.S. Tax Ct. LEXIS 21">*77 OPINION

The resolution of the treatment of deferred and uncollected premiums in the instant case involves the application of the Supreme Court's holding in Commissioner v. Standard Life & Accident Insurance Co., 433 U.S. 148">433 U.S. 148 (1977), to group term life insurance policies.³³ In Standard 96 T.C. 497">*523 Life, the Supreme Court found that the general rules of accrual method accounting "simply do not speak to the question of the scope to be given the entirely fictional assumption" that deferred and uncollected premiums have been received by a life insurance company. 433 U.S. 148">433 U.S. at 162. Accordingly, the Court held that the flush language of section 818(a)³⁴1991 U.S. Tax Ct. LEXIS 21">*79 "requires use of the NAIC approach to fill the gap" in accrual method accounting, resulting in the inclusion of the net valuation portion of deferred and uncollected premiums in life insurance reserves, assets, and gross premium income. 433 U.S. 148">433 U.S. at 162. ³⁵ It should be noted that the inclusion of deferred and uncollected premiums (referred to collectively by the Supreme Court as "unpaid premiums") in income is not contemplated under the normal rules1991 U.S. Tax Ct. LEXIS 21">*78 of accrual method accounting because a life insurance company ordinarily does not have a legally enforceable right to collect such premiums. 433 U.S. 148">Commissioner v. Standard Life & Accident Insurance Co., supra at 150. A thorough discussion of Standard Life is set forth in Anchor National Life Insurance Co. v. Commissioner, 93 T.C. 382">93 T.C. 382, 93 T.C. 382">414-421 (1989), which we will not repeat in this opinion. See also Time Insurance Co. v. Commissioner, 86 T.C. 298">86 T.C. 298, 86 T.C. 298">325-327 (1986).

In the instant case, petitioner included amounts attributable to deferred and uncollected premiums on its group term life insurance policies in life insurance reserves, assets, and premium income. Notwithstanding the partially offsetting results of those entries, the net effect of such inclusion 96 T.C. 497">*524 was to decrease petitioner's taxable income for the year in issue. Respondent's notice of deficiency states that petitioner's reserves held with respect to deferred and uncollected premiums do not qualify as life insurance reserves. The notice of deficiency also makes a correlative adjustment to assets.

While acknowledging1991 U.S. Tax Ct. LEXIS 21">*80 that the Supreme Court expressly did not limit its holding in Standard Life to ordinary life insurance policies, respondent argues that such a limitation is warranted by the Supreme Court's finding that State law and the NAIC required the use of an annual premium assumption in computing the taxpayer's reserves, a statement which respondent claims does not hold true in the context of group term life insurance. Respondent points to the testimony of Earle McCan, a Connecticut insurance examiner responsible for reviewing life insurance reserves, ³⁶ that, in the case of group term life insurance, the annual premium assumption was neither "required" (in the ordinary sense of the word) by Connecticut law nor commonly used by insurance companies. Respondent further argues that the reserve in question is not "required by law" within the meaning of section 801(b)(2).

1991 U.S. Tax Ct. LEXIS 21">*81 We are unwilling to adopt respondent's distinction of Standard Life based on the State law and NAIC "requirements" applicable to ordinary versus group term life insurance policies for several reasons. First, the Supreme Court's finding that State law "requires" insurance companies to use an annual premium assumption was based on a stipulation of the parties in that case which appears questionable or incomplete. Indeed, General Counsel Memorandum 38404 (June 6, 1980) underlying Revenue Ruling 81-243, 1981-2 C.B. 149, states that:

We have been unable to document the statement of the Supreme Court in the Standard Life & Accident case that state law requires the inclusion of deferred and uncollected premiums in life insurance reserves. In fact, our analysis of the history of the treatment of deferred and collected [sic] premiums indicates that the annual statements required to be filed under state law as evidence of companies' financial condition merely provided 96 T.C. 497">*525 for the valuation of all policies on an annual basis in accordance with generally accepted practice. This procedure resulted in what the courts characterized 1991 U.S. Tax Ct. LEXIS 21">*82 as a state law requirement that a reserve be maintained for all those policies valued annually which would include deferred and uncollected premiums. See T. Nash, Federal Taxation of Life Insurance Companies 6-4 (Vol. 1, 1979). [Emphasis supplied.]

Respondent, on brief, similarly indicates that there is no suggestion in the Standard Life opinion that the Supreme Court "in fact performed [a] laborious analysis [of State law], rather than relying on the stipulated record," and notes that the Commissioner generally has not disputed the requirement of an annual premium assumption. See also Southwestern Life Insurance Co. v. United States, 9 Cl. Ct. 102">9 Cl. Ct. 102, 9 Cl. Ct. 102">111-112 (1985) (referring to the "apparently unfounded and therefore gratuitous concessions made at argument on behalf of the Commissioner" in Standard Life). ³⁷

1991 U.S. Tax Ct. LEXIS 21">*83 The testimony of Mr. McCan and the language of the manual weaken any distinction between ordinary and group term life insurance based on State law and NAIC "requirements"; Mr. McCan testified that he did not think that an annual premium assumption was "required" under Connecticut law even in the case of individual (i.e., ordinary) life insurance, ³⁸1991 U.S. Tax Ct. LEXIS 21">*84 and the manual merely states that, in computing reserves on ordinary insurance, "most" companies use an annual premium assumption. ³⁹ In summary, based on the record and on our own review of Connecticut law, we are left to conclude that, in the case of both ordinary and group term life insurance, the use of an annual assumption is elective, although more common in the case of ordinary life insurance. We therefore reject respondent's attempt to distinguish Standard Life based on the different State and NAIC "requirements" for ordinary versus group term insurance.

96 T.C. 497">*526 Respondent further argues that the Standard Life holding is limited to ordinary life insurance policies based upon the Supreme Court's statement that "for the past century, insurance companies have added an amount equal to the net valuation portion of unpaid premiums in their reserves with an offsetting addition to assets." Commissioner v. Standard Life & Accident Insurance Co., 433 U.S. 148">433 U.S. 148, 433 U.S. 148">150 (1977) (emphasis supplied). Respondent, subtracting 100 years from the year of the Supreme Court's opinion and thereby arriving at 1877, concludes that the Court could not have been referring to group term life insurance, because the first group term life insurance policy was not issued until 1911. We find that such argument1991 U.S. Tax Ct. LEXIS 21">*85 (which is relied upon in Rev. Rul. 81-243, supra) represents an overexercise of literalism. In short, the weakness of respondent's argument serves to underscore the fact that there is no express indication in Standard Life that the holding is limited to ordinary life insurance.

Because the Supreme Court's findings as to State and NAIC "requirements" in Standard Life were based on stipulated facts absent in the instant case, we are left to decide whether petitioner's computation method for deferred and uncollected premiums on group term life insurance was "consistent with the manner required for purposes of the annual statement" under the flush language of section 818(a) and whether the relevant reserve was "required by law" under section 801(b)(2). We believe that those two questions must be answered consistently and that our precedent under section 801(b)(2) provides an affirmative answer.

In Mutual Benefit Life Insurance Co. v. Commissioner, 58 T.C. 679">58 T.C. 679 (1972), affd. 488 F.2d 1101">488 F.2d 1101 (3d Cir. 1974), ⁴⁰ a New Jersey statute specifically permitted the taxpayer to set up 1991 U.S. Tax Ct. LEXIS 21">*86 additional reserves for provisions in its policies allowing beneficiaries to elect to receive death benefits in lifetime installments. The Government argued that such additional reserves, prompted by reason of increases in life expectancies, were not "required by law" within the meaning of section 801(b)(2)because they were discretionary or permissive 96 T.C. 497">*527 under the New Jersey statute. We rejected such argument, stating that:

On its face, the phrase "required by law" would appear to exclude a reserve which in the first instance was permissive rather than mandatory. In the taxation of the life insurance industry, however, we must look beyond the ordinary meaning of the words in the statute. Alinco Life Insurance Co. v. United States, 373 F.2d 336">373 F.2d 336, 373 F.2d 336">352-353 (Ct. Cl. 1967). [58 T.C. 679">58 T.C. 689.]

We then quoted section 1.801-5(b), Income Tax Regs., defining "required by law" to include not only State statutes but also rules and regulations of State insurance departments, and noted that under the New Jersey statute, approval by the New Jersey insurance commissioner would be required to reduce the additional 1991 U.S. Tax Ct. LEXIS 21">*87 reserve once established. We thus held the additional reserve to be "required by law," stating that:

It cannot seriously be argued that the additional reserve voluntarily set up by the petitioner prior to the years before the Court was not required to be maintained by virtue of the regulatory powers specifically granted to the State commissioner of banking and insurance. In the taxable years under consideration, therefore, there was on the books of the petitioner a reserve established in prior years pursuant to State law which had achieved the status of a reserve required to be maintained under the regulatory authority of the State agency. * * * [58 T.C. 679">58 T.C. 690.]

The Third Circuit agreed, explaining that:

Thus, while the initial decision to set up a reserve was entirely voluntary, its continuance was not. What the Company did in 1946 was of its own choosing, but in 1958 to 1960 it was not free to drop the reserve or to alter its formulation without having specific permission from the Insurance Commissioner. To argue that the Company was not required to carry the reserve in the years in question is to ignore reality. * * * A man may enter into 1991 U.S. Tax Ct. LEXIS 21">*88 a marriage voluntarily, but that is not a reason to limit his obligation imposed by the law to support his family. * * * [488 F.2d 1101">488 F.2d at 1106; fn. ref. omitted; emphasis supplied.]

In Equitable Life Insurance Co. of Iowa v. Commissioner, 73 T.C. 447">73 T.C. 447 (1979), we followed Mutual Benefit in addressing the meaning of the term "required by law." Equitable Life also involved policies allowing beneficiaries to receive death benefits in the form of life annuities, and the taxpayer sought and received the approval of the Iowa Insurance Commissioner to establish additional reserves to 96 T.C. 497">*528 reflect inaccuracies in the mortality table and interest rate assumptions upon which its basic death benefit reserves were calculated. Although the Iowa statute contained no specific provision relating to such additional reserves, the Iowa statute provided that:

Any * * * company which at any time shall have adopted any standard of valuation1991 U.S. Tax Ct. LEXIS 21">*89 producing greater aggregate reserves than those calculated according to the minimum standard herein provided may, with the approval of the commissioner, adopt any lower standard of valuation, but not lower than the minimum herein provided. [73 T.C. 447">73 T.C. 459 n.11; emphasis supplied.]

Characterizing our holding in Mutual Benefit Life as being based on "the fact that any change in the reserves required the approval of the State regulatory agency," 73 T.C. 447">73 T.C. 462, we held the reserve in Equitable Life to be "required by law" in view of the need for such approval under Iowa law.

In the instant case, the relevant Connecticut statute ⁴¹ contains language identical to the provision involved in Equitable Life (both Iowa and Connecticut having adopted the NAIC's "Standard Valuation Law"). Mr. McCan also confirmed that, in practice, a company wishing to change from the reserve method used by petitioner for group term life insurance policies to a "true" unearned premium method would be required to obtain the approval of the insurance commissioner for such change. Accordingly, under our holdings in Mutual Benefit and1991 U.S. Tax Ct. LEXIS 21">*90 Equitable Life, petitioner's reserve attributable to deferred and uncollected premiums was "required by law."

We recognize that the Claims Court has reached a contrary conclusion in a case also involving reserves with respect to deferred and uncollected premiums. Southwestern Life Insurance Co. v. United States, 9 Cl. Ct. 102">9 Cl. Ct. 102 (1985). Like this Court, however, the Claims Court called into question the validity of the Supreme Court's assumption in Standard Life that State law "requires" the use of an annual premium assumption, apparently referring to such assumption as an "unfounded" concession made on behalf of the Commissioner. The Claims Court's analysis departs from our own in that it turns on the different meanings, in 96 T.C. 497">*529 English usage, of the words "required" and "permit," holding that a deferred premium reserve permitted by law is not a reserve "required by law." Because the Claims Court's analysis only focuses on the initial decision1991 U.S. Tax Ct. LEXIS 21">*91 to set up a reserve and does not consider whether an initially permissive reserve may become "required" by reason of the need to obtain approval for its reduction, we find our analysis more persuasive.

Respondent, moreover, urges us to adopt the approach of the First Circuit in Union Mutual Life Insurance Co. v. United States, 570 F.2d 382">570 F.2d 382 (1st Cir. 1978). In that case, the First Circuit held that a reserve for a policy option permitting an insured to obtain additional insurance without a physical examination was not "required by law" where State law lacked any statutory provision expressly authorizing the additional reserve or any rule or regulation of the State insurance commissioner dealing with such additional reserve. In 73 T.C. 447">Equitable Life Insurance Co. of Iowa v. Commissioner, supra at 461, however, we distinguished Union Mutual from a situation, such as that involved in the instant case, in which "the statute required reserves at the minimum rate for life insurance and annuity contracts and permitted such reserves at a higher rate," but also required permission to lower a reserve once a higher rate was established. 1991 U.S. Tax Ct. LEXIS 21">*92 Because the Connecticut statute applicable in the instant case is identical in relevant part to the statute relied upon in Equitable Life, we adhere to our holding in Equitable Life in interpreting section 801(b)(2).

In conclusion, we hold that petitioner's reserve with respect to deferred and uncollected premiums on group term life insurance policies was "required by law" under section 801(b)(2).

We believe that the foregoing analysis also applies in deciding whether the annual premium assumption was, under the flush language of section 818(a), consistent with the manner of computation "required for purposes of the annual statement approved by the [NAIC]." ⁴²The regulation defining "reserves required by law" under section 801(b)(2)96 T.C. 497">*530 states that reserves required by law also are required for purposes of the annual statement referred to in section 818(a):

(b) Reserves required by law defined. For purposes of part I, subchapter L, chapter 1 of the Code, the term "reserves required by law" means reserves which are required either by express statutory provisions or by rules and regulations of the insurance department of a State, Territory, or the District 1991 U.S. Tax Ct. LEXIS 21">*93 of Columbia when promulgated in the exercise of a power conferred by statute, and which are reported in the annual statement of the company and accepted by state regulatory authorities as held for the fulfillment of the claims of policyholders or beneficiaries. [Sec. 1.801-5(b), Income Tax Regs.; emphasis supplied.]

Moreover, State regulatory authorities review a life insurance company's annual statement. Thus, even though the use of a particular computation method results in reserves in excess of the statutory minimum, if such reserves are "required" by State law during the year in issue by virtue of the need to obtain State approval for a change, the computation method in question also is consistent with the manner of computation "required" to be used by the company in completing its annual statement for such year. Accordingly, we hold that petitioner properly used an annual premium assumption for its group term life insurance policies pursuant to the flush language of section 818(a).

1991 U.S. Tax Ct. LEXIS 21">*94 Respondent makes one further argument for excluding petitioner's reserve attributable to deferred and uncollected premiums from "life insurance reserves." Specifically, respondent argues that the reserve was not an amount "set aside" as required by section 801(b)(1)(B). Respondent points to the inherently fictional nature of such reserve, which was based on the fact that the annual premium assumption was used. Respondent also points to the fact that the increase in reserve is offset by a deferred premium "asset" under Standard Life. In support of his argument, respondent cites section 1.801-4(a), Income Tax Regs., which states that life insurance reserves "must actually be held by the company during the taxable year for which the reserve is claimed." ⁴³ We reject respondent's argument for disqualifying 96 T.C. 497">*531 the reserve based on several considerations. As one commentator has noted in connection with the "set aside" requirement:

A [life insurance] reserve is not and never has been a "fund" in the legal sense. The current regulations could also lead to some misunderstanding when they state that "such amounts must actually be held by the company during the taxable year." 1991 U.S. Tax Ct. LEXIS 21">*95 Reserves are not amounts set apart from the general assets of the company. Instead, the company, by establishing reserves on its books, represents that it will have sufficient assets to back up those reserves and thereby provide the necessary solvency needed to meet policyholder claims. Any argument that a reserve is a fund separate and apart from the general assets of an insurance company is quickly rebutted when one remembers that from 1909 to the current date Congress has attempted to allow deductions or exclusions predicated only on reserves which are "required by [State] law," that is, reserves which represent liabilities on a company's annual statement. [Guadiana, "Federal Income Taxation of Life Insurance Companies: The Life Insurance Reserve," 30 Tax L. Rev. 173, 181-182 (1975); fn. refs. omitted; emphasis supplied.]

1991 U.S. Tax Ct. LEXIS 21">*96 An insurance treatise similarly states that:

To qualify as a life insurance reserve, amounts must be "set aside." This does not mean that specific amounts of assets must be earmarked for a particular purpose. The regulations say that reserves must actually be held by the life insurance company to qualify as life insurance reserves. This requirement is generally satisfied by reflecting the reserve in the annual statement. [K. Tucker & D. Van Mieghem, Federal Taxation of Insurance Companies, par. 2.24 (1986); fn. refs. omitted.]

Recently, we also have characterized life insurance reserves as "bookkeeping entries reflecting liabilities on the insurance company's books and * * * not * * * funds actually set aside in something like a trust fund. * * * It is the company's surplus that actually protects the policyholders." Anchor National Life Insurance Co. v. Commissioner, 93 T.C. 382">93 T.C. 382, 93 T.C. 382">419 n.25 (1989). See also Mutual Benefit Life Insurance Co. v. Commissioner, 488 F.2d 1101">488 F.2d 1101, 488 F.2d 1101">1103 (3d Cir. 1974). Thus, despite the use of the words "set aside" in section 801(b)(1)(B), it is quite clear that the general concept of life 1991 U.S. Tax Ct. LEXIS 21">*97 insurance reserve does not require an actual receipt of funds by the company and placement of those funds in an account.

96 T.C. 497">*532 Moreover, we believe that the Supreme Court's analysis in Standard Life mandates that the fictional assumption of advance receipt of annual premiums be accepted in defining reserves under the provisions of the Life Insurance Company Income Tax Act of 1959, applicable in the instant case. The Supreme Court, in discussing the passage of the 1959 legislation, stated that:

In view of the critical importance of the definition of reserves in the entire statutory scheme, as well as in the conduct of the company's business, the practice of including net unpaid [i.e., deferred and uncollected] premiums in reserves cannot have been unknown to Congress. It is clear, we think, that no radical departure from past law was intended. [433 U.S. 148">433 U.S. at 157-158; fn. ref. omitted; emphasis supplied.]

The Supreme Court then expressly adopted the fictional assumption that, in accordance with NAIC accounting methods the net valuation portion of the premium has been paid. See 93 T.C. 382">Anchor National Life Insurance Co. v. Commissioner, supra at 414-421.1991 U.S. Tax Ct. LEXIS 21">*98 We have reached the same conclusion under sections 801(b)(2) and 818(a) even absent the stipulated facts concerning State and NAIC "requirements" which were present in Standard Life.

Section 818(a) provides a method of making "all computations entering into the determination of the taxes imposed by [sections 801 through 820]." Thus, the provision expressly applies for purposes of computing the "life insurance reserves" described in section 801. We believe that the Supreme Court's acceptance of the fictional assumption that unpaid premiums have been received for purposes of section 818(a) also requires acceptance of the premise that reserves for such premiums may be "set aside" for purposes of section 801(b)(1)(B). ⁴⁴1991 U.S. Tax Ct. LEXIS 21">*99 Finally, because the annual statement method applicable under section 818(a) does not "net" the deferred premium asset against the reserve for deferred and uncollected premiums, ⁴⁵ we reject respondent's attempt to 96 T.C. 497">*533 impose such a "netting" by means of the "set aside" requirement of section 801(b)(1)(B).

Based on the foregoing, we hold that petitioner properly included net deferred and uncollected premiums in life insurance reserves, assets, and premium income. ⁴⁶

FINDINGS OF FACT

During the year in issue, petitioner sold life insurance policies through life insurance agents. The relationship between petitioner and its agents was governed by the terms of "Standard Commission Contracts" (contracts) entered into between petitioner and the agents. Under the contracts, petitioner gave the agent the right, among other things, to solicit applications for insurance and to "service" the resulting policies subject to the contract terms and company regulations.

The contracts themselves did not specify any servicing activities required of an agent. Nevertheless, petitioner's "Rate Manual," which was supplied to every agent during the year in issue as a guide and reference source to agents' activities, indicated that the agents had immediate responsibility for the quality of certain policyholder services because the agents had direct contact with policyholders. The section of the Rate Manual entitled "Agent's Digest of Policyholder Service" informed agents of the appropriate form and signature requirements for numerous service transactions, including assignments, beneficiary changes, policy changes, 1991 U.S. Tax Ct. LEXIS 21">*101 and policy loans (including premium loans, cash loans, and automatic premium loans).

96 T.C. 497">*534 Petitioner's "Branch Office Manual," which contained rules and regulations for the operation of petitioner's branch offices, also referred to the services provided by agents to policyholders and contained specific rules for the provision of continued service to "orphan" policyholders, that is, those policyholders for whom the original selling agent was unable to deliver adequate service (sometimes because of termination of the agency with petitioner). The Branch Office Manual also contained information about petitioner's "Policyholder Service Reports," which were documents prepared by petitioner's centralized service center, distributed to petitioner's branch offices, and finally sent to petitioner's agents for delivery to policyholders. Policyholder service reports contained detailed information about the status of the policy, including facts about policy loans.

During the year in issue, 85 percent of the ordinary life insurance policies issued by petitioner were whole life and endowment contracts which had "cash values." The policies with cash values generally contained provisions permitting1991 U.S. Tax Ct. LEXIS 21">*102 policyholders to borrow against such values; under those provisions, petitioner was obligated to make policy loans, within certain limits, without regard to the desirability or profitability of such loans relative to other investments available to petitioner. The interest rates charged by petitioner on policy loans generally were lower than current market rates at the time the loans were extended. During the year in issue, Connecticut law provided for a maximum fixed interest rate of 8 percent on policy loans, and the interest rates on petitioner's policy loans varied between approximately 6 and 8 percent.

Some of the cash value life insurance policies issued by petitioner during the year in issue and in prior years were marketed on a "minimum deposit" basis to high income individuals and corporations (such policies are hereinafter referred to as minimum deposit policies). Minimum deposit was a method of reducing the after-tax cost of insurance by financing premium payments with regular policy loans. However, for the interest payments on such loans to be deductible for Federal income tax purposes under section 264(c), four out of the first seven annual premiums had to be paid 1991 U.S. Tax Ct. LEXIS 21">*103 other than through borrowing against cash value. 96 T.C. 497">*535 Petitioner was an industry leader in the minimum deposit market, having designed four types of minimum deposit policies. Between 75 and 80 percent of the cash values of petitioner's minimum deposit policies were utilized as policy loans. As of December 31, 1980, the dollar amount of petitioner's outstanding policy loans was $ 664,145,903.

The sales efforts required to sell minimum deposit policies were more extensive than the efforts required for the sale of other life insurance policies. Multiple written borrowing proposals were prepared by branch office personnel based on information supplied by the agents. The agents then were responsible for explaining the mechanics and tax consequences of each option to the prospective policyholder and the policyholder's tax adviser. Each year, moreover, the policyholder of a minimum deposit policy would receive a computer-generated notice stating that the gross annual premium was due; such notice would not contain any information about the option of borrowing to pay such premium. It therefore was an agent's responsibility to contact the minimum deposit policyholder and explain, 1991 U.S. Tax Ct. LEXIS 21">*104 either in person or by letter, the options available to the policyholder with respect to "payment" of the premium billed.

Not all of petitioner's agents had significant involvement in the sale of minimum deposit policies; minimum deposit policies generally were written by more experienced agents. Policies other than minimum deposit policies had loan features, but such loan features were not always utilized by the policyholders; in some instances the cash value of such policies did not support significant policy loans until the passage of many years. Petitioner attempted to discourage systematic borrowing from ordinary life insurance policies that were not designed specifically for minimum deposit. As of the end of the year 1981, with respect to in-force life insurance and endowment policies issued by petitioner prior to 1981, 64 percent of the total cash value of such policies was borrowed.

Petitioner's agents' compensation was based on commissions equal to various percentages of first year and renewal premiums on policies sold. The duration of renewal commissions depended upon several factors, including the agent's 96 T.C. 497">*536 annual production of new paid premiums and the agent's1991 U.S. Tax Ct. LEXIS 21">*105 length of service with petitioner. Because the receipt of renewal commissions always depended upon petitioner's continued receipt of premium payments, agents had an incentive to provide policyholders with adequate service to prevent policyholders from moving their business to a competitor.

Under the agents' contracts, petitioner paid "vested" renewal commissions to the agent who had sold the policy even if the selling agent was no longer under contract with petitioner. If the selling agent was unable to continue to provide service to a policyholder, the "orphaned" policyholder generally would be assigned another agent. In the case of "orphaned" minimum deposit policyholders, agents assigned to service those policyholders had an incentive to provide quality service (despite the absence of any renewal commission) because the policyholders generally were affluent individuals who might make other insurance purchases.

Under the agents' contracts, in addition to the first year and renewal commissions, agents were entitled to "persistency bonuses," which bonuses were not vested but were dependent on the continuation of a contractual relationship between the agent and petitioner. Agents1991 U.S. Tax Ct. LEXIS 21">*106 who satisfied minimum production levels also received reimbursement from petitioner of a portion of their administrative expenses as well as benefit packages consisting of health insurance, short-term disability insurance, and group life insurance. Petitioner's branch offices did not provide general secretarial assistance to the agents.

In 1977, petitioner surveyed (the 1977 survey) its top-producing agents. An "Agency Vice President Newsletter" described the 1977 survey as follows:

In a few days, a number of selected agents will be asked to participate in a study of the time agents spend in activities directly related to policy loans. The reason for the study is that in the corporate tax returns policy loans are considered an expense and such expenses are tax deductible. As you know, these are the only expenses for which we are allowed a tax deduction. All other field expenses are paid by the company without benefit of tax relief.

Since the study occurs at a time when we are actively seeking more full premium business, there is the possibility that some agents may interpret the study as somehow being connected with their minimum deposit sales. 96 T.C. 497">*537 Consequently, they may1991 U.S. Tax Ct. LEXIS 21">*107 be suspicious or reluctant participants. * * * Please encourage your agents to participate fully since the results of the study will enable us to document considerable tax savings.

A cover memorandum sent to "Office Managers and Office Supervisors" in connection with the 1977 survey explained the tax-oriented purpose of the 1977 survey and directed office managers and supervisors to explain such purpose to the agents and assist them in completing the survey. The high-producing agents to whom the 1977 survey was distributed comprised the category of agents most likely to sell minimum deposit policies.

During the year in issue, petitioner paid or incurred $ 32,689,623 in agents' commissions on its ordinary (i.e., individual) life insurance business, including whole life, annuity, endowment, and term policies. Fifteen percent of the ordinary life insurance policies issued by petitioner during the year in issue were term policies which do not have cash values and with respect to which petitioner did not extend any policy loans. Petitioner, however, did not maintain statistics identifying the amount of agents' commissions attributable to sales of such term policies.

On its Federal1991 U.S. Tax Ct. LEXIS 21">*108 income tax return for the year in issue, petitioner treated approximately 34 percent of the agents' commissions, or $ 11,147,161, as investment expenses. That percentage was calculated by dividing petitioner's gross investment income attributable to ordinary life insurance products ($ 141,794,036) by its total gross income (investment income plus premium income, or $ 415,774,862) attributable to such products. The amount of interest income from policy loans received by petitioner during the year in issue (and included in gross investment income of $ 141,794,036 on petitioner's return) was $ 33,231,123.

OPINION

Respondent's determination disallowed the deduction of the $ 11,147,161 in agents' commissions as investment expenses under section 804(c)(1). Respondent contends that agents' commissions are expenses of producing underwriting (i.e., premium) income and as such are deductible, if at all, only under section 809(d)(11) (in computing "gain and loss from operations"). A description of the "three phrase" 96 T.C. 497">*538 system of the Life Insurance Company Income Tax Act of 1959, ⁴⁷ the intricacies of which may render a deduction under section 804(c)(1) much more valuable than a deduction1991 U.S. Tax Ct. LEXIS 21">*109 under section 809, is contained in Union Central Life Insurance Co. v. Commissioner, 77 T.C. 845">77 T.C. 845, 77 T.C. 845">849-854 (1981), revd. on other grounds 720 F.2d 420">720 F.2d 420 (6th Cir. 1983), on remand 84 T.C. 361">84 T.C. 361 (1985), and will not be repeated here. See also USAA Life Insurance Co. v. Commissioner, 94 T.C. 499">94 T.C. 499, 94 T.C. 499">516-517 (1990); Liberty National Life Insurance Co. v. United States, 816 F.2d 1520">816 F.2d 1520, 816 F.2d 1520">1522 n.3 (11th Cir. 1987) (explaining "why a company would desire to allocate an expense to investment expenses rather than to underwriting expenses"); Harman, "The Pattern of Life Insurance Company Taxation Under the 1959 Act," 15th Ann. Tul. Tax. Inst. 686 (1965).

Petitioner contends that commissions paid to its agents qualify under section 804(c)(1) as "general expenses" a portion of which may be "assigned to1991 U.S. Tax Ct. LEXIS 21">*110 or included in investment expenses." "General expenses" are defined in the applicable regulations as "any expense paid or incurred for the benefit of more than one department of the company rather than for the benefit of a particular department thereof." Sec. 1-804-4(b)(1)(ii), Income Tax Regs. In that regard, the "investment department" of a life insurance company is to be distinguished from its "life insurance business," or underwriting department. See sec. 1.804-4(b)(4), Income Tax Regs.; 77 T.C. 845">Union Central Life Insurance Co. v. Commissioner, supra.⁴⁸ "Investment expenses" are defined in the regulations as "those expenses of the taxable year which are fairly chargeable against gross investment income." Sec. 1.804-4(b)(1)(i), Income Tax Regs.

1991 U.S. Tax Ct. LEXIS 21">*111 Respondent's argument that the agents' commissions were incurred exclusively for the benefit of petitioner's underwriting department was addressed by the Fourth Circuit in Liberty Life Insurance Co. v. United States, 594 F.2d 21">594 F.2d 21 (4th Cir. 1979). In that case, the taxpayer treated commissions as investment expenses based on its agents' 96 T.C. 497">*539 policy loan services. The Government disputed such treatment, pointing to the fact that the agents' commissions were based solely on premium income and not on the provision of services to policyholders. The Fourth Circuit, however, disagreed, stating that:

The issue is simple and clearcut: Does the loan servicing work of the field representatives generate investment income? If so, an allocable portion of the commissions paid as compensation for those activities is a legitimate investment expense. * * * [594 F.2d 21">594 F.2d at 25.]

Thus, according to the Fourth Circuit's reasoning, where an activity generates investment income, some amount of the expense associated with the activity should be deductible against such income. The statute is silent on the issue, and section 1.804-4(b)(1), 1991 U.S. Tax Ct. LEXIS 21">*112 Income Tax Regs., requires no more. See also T. Nash, Federal Taxation of Life Insurance Companies 31-52 (1983).

In the instant case, the evidence clearly shows that the activities of petitioner's agents "generated" investment income in the form of policy loan interest. Respondent, however, maintains that it is inappropriate to use policy loan activities as a basis for treating commissions as an investment expense because (a) commissions do not increase proportionately with increased policy loans, (b) commissions are taken into account in pricing premiums, and (c) agents' activities with respect to policy loans are aimed at selling policies and maintaining those that are in force, rather than at generating interest income for the insurance company. In Liberty Life, the Fourth Circuit considered and rejected similar arguments, stating:

(1) the use of premiums alone for calculating the agents' commissions is not dispositive, since those commissions are intended as full compensation for all of the agents' duties, including the loan work. (2) The profitability of the policy loans as investments is also of little significance in this inquiry; profitable or not, the loans1991 U.S. Tax Ct. LEXIS 21">*113 were legitimate interest-bearing investments with expenses connected to them. (3) The inclusion in the premium calculation of the costs of loan services actually supports the plaintiff's position, since the compensation for the field representatives' services is calculated directly from those premiums. (4) Plaintiff's motive in making the policy loans is irrelevant to the question of whether or not they were investments. Plaintiff no doubt offered these loans to make its underwriting business more attractive to prospective clients. Nevertheless, the loans generated investment income, and we find no 96 T.C. 497">*540 requirement of "investment intent" in the statute, regulations, or legislative history. * * * [594 F.2d 21">594 F.2d at 25; emphasis supplied.⁴⁹]

1991 U.S. Tax Ct. LEXIS 21">*114 Respondent distinguishes Liberty Life on the ground that the District Court had found that the agents performed loanoriented services that "ordinarily" would be handled by an insurance company's home office personnel. ⁵⁰1991 U.S. Tax Ct. LEXIS 21">*115 Respondent argues that, in the instant case, petitioner's home and branch office personnel did perform policy loan services for which a deduction has already been claimed, and that allocating agents' commissions based on policy loan services would duplicate that deduction. We do not agree. While the agents in Liberty Life may have routinely performed some services that generally were not performed by petitioner's agents (for example, delivering loan checks and collecting loan payments), the duties for which a deduction was allowed in that case included "explaining the terms of the loans," ⁵¹ a duty which clearly fell upon petitioner's agents, rather than upon other personnel employed by petitioner.

Respondent distinguishes Liberty Life on the additional ground that the Fourth Circuit found that no separate compensation was paid for the agents' servicing functions, and that commissions therefore included payment for policy loan servicing activities. In that regard, respondent urges us to adopt the approach of the Claims Court in Ohio National Life Insurance Co. v. United States, 11 Cl. Ct. 477">11 Cl. Ct. 477 (1986), affd. per curiam 807 F.2d 1577">807 F.2d 1577 (Fed. Cir. 1986). In Ohio National Life, the Claims Court denied the taxpayer's allocation of a portion of agents' commissions to investment expense, finding that the commissions were payable exclusively for policy sales. The Claims Court, in reaching its conclusion, relied in part on the fact that some of the agents' contracts provided for a "renewal expense allowance" under the separate subheading of "compensation for 96 T.C. 497">*541 servicing of policies of agency," and found that other agents1991 U.S. Tax Ct. LEXIS 21">*116 were compensated for their policy servicing activities with insurance and pension plan benefits.

We find Ohio National Life distinguishable from the instant case because none of petitioner's contracts with its agents contained provisions referring to compensation for servicing activities. Contrary to the Claims Court's findings in Ohio National Life, we do not find that pension and insurance benefits served as the compensation for the agents' servicing activities; there is no evidence of such linkage in the instant case, and such benefits were provided by petitioner only to agents meeting minimum production requirements unrelated to servicing activities. Moreover, we do not find that the partial expense reimbursement allowance provided by petitioner served as the compensation for agent's servicing activities. Finally, as emphasized in the above quote from Liberty Life, the Fourth Circuit held that a taxpayer's "intent" in making a payment does not control his ability to allocate a portion of such expense against investment income. 594 F.2d 21">594 F.2d at 25. As stated in T. Nash, Federal Taxation of Life Insurance Companies 31-5 (1983), "Since a policy1991 U.S. Tax Ct. LEXIS 21">*117 loan earns interest, it is an investment item and the expenses attributable to it should be charged to the investment area." Based upon the foregoing, we hold that petitioner was entitled to assign a portion of agents' commissions to investment expenses.

Having decided the question of whether any of the agents' commissions may be assigned to investment expenses, we next inquire into the proper method for making the assignment. Petitioner would have us look past the policy loan activities of its agents in determining the commissions "fairly chargeable" ⁵² against investment income. Specifically, petitioner contends that commissions were an acquisition and maintenance cost of the policies, pointing to the policies' production of both investment income and underwriting income for petitioner. Petitioner also presents evidence that insurance policies are priced based on both the underwriting income and the investment income to be earned therefrom. On such grounds, petitioner argues for its claimed allocation of agents' commissions 96 T.C. 497">*542 against investment income (based on the ratio of total investment income from ordinary policies to total income, including premium income, from1991 U.S. Tax Ct. LEXIS 21">*118 such policies). We do not agree with petitioner's position.

Section 804(c)(1) and the relevant regulations ⁵³ clearly contemplate two main categories of insurance company functions; namely, investment and underwriting. The primary function of petitioner's agents was to generate premiums, which clearly fall into the underwriting category. Petitioner would have us negate the distinction between the two categories by transmuting a premium-generating expense into an investment expense simply because premiums are the capital that is invested by an insurance company. Under petitioner's reasoning, moreover, not only commissions, but any other expense aimed at the generation of premiums, potentially would be classifiable in part as an investment expense. While the use of an allocation ratio based on a comparison of total investment income to total income may be appropriate where the expense in question is not susceptible of more appropriate allocation, ⁵⁴ it cannot withstand1991 U.S. Tax Ct. LEXIS 21">*119 scrutiny in the case of agents' commissions.

Petitioner basically concedes that the only investment-oriented activities of its agents were policy loan activities. The notion that agents' commissions may be allocated to investment expenses to the extent that they relate to policy loan services of the agents is also indicated in several insurance treatises. 1991 U.S. Tax Ct. LEXIS 21">*120 See Ernst & Whinney, Federal Income Taxation of Life Insurance Companies 10-18 to 10-20.2 (2d ed. 1989); T. Nash, supra at 8-54; G. Lenrow, R. Milo, & A. Rua, Federal Income Taxation of Insurance Companies 278 (3d ed. 1979); D. Van Mieghem & T. Brown, Federal Taxation of Insurance Companies 421 (1986). ⁵⁵

1991 U.S. Tax Ct. LEXIS 21">*121 96 T.C. 497">*543 Petitioner alternatively argues that (if the allocation method claimed in its return is denied) commissions should be treated as investment expenses based on the percentage of time spent by its agents on policy loan-related functions. In Liberty Life, the District Court focused on the amount of time spent by agents in servicing policy loans in upholding the taxpayer's allocation of commissions (equal to a fixed dollar amount per loan) to investment income. The District Court noted the results of a time study by the taxpayer (conducted subsequent to the year in issue in Liberty Life) which indicated that 5 percent of its field representatives' time was spent in making and servicing policy loans. Liberty Life Insurance Co. v. United States, 40 AFTR 2d par. 77-5164 at 77-5576 to 77-5577, 76-2 USTC par. 9646 at 85,037 (D.S.C. 1977), affd. 594 F.2d 21">594 F.2d 21 (4th Cir. 1979). In Union Central Life Insurance Co. v. Commissioner, 77 T.C. 845">77 T.C. 845, 77 T.C. 845">864-865 (1981), revd. ⁵⁶1991 U.S. Tax Ct. LEXIS 21">*123 720 F.2d 420">720 F.2d 420 (6th Cir. 1983), on1991 U.S. Tax Ct. LEXIS 21">*122 remand 84 T.C. 361">84 T.C. 361 (1985), we noted that "Neither the Code nor the regulations under section 804 prescribe the manner by which general expenses are to be apportioned between the investment and underwriting departments of a life insurance company," and focused on the allocation methods suggested by commentators while noting that we are not obligated to use them. The treatise quoted in Union Central states that "a portion of agents' commissions may be allocable to investment expenses on the basis of time spent 96 T.C. 497">*544 in explaining and processing policy loans," and refers to the use of a ratio of time spent on investment activities to time spent on all activities, for the allocation of certain salaries. Lenrow, Milo, & Rua, supra at 278-279. Another treatise similarly suggests the use of a "time or cost study" for the allocation of commissions to policy loan "investment assets." Ernst & Whinney, supra at 10-20.2. Thus, we agree with petitioner that a time survey with respect to policy loan activity represents one appropriate method of allocating agents' commissions to investment income. ⁵⁷

1991 U.S. Tax Ct. LEXIS 21">*124 Petitioner offers the results of two surveys of the time spent by its agents on loan-related activities; one, the 1977 survey described above in our findings of fact, and the other, a 1988 survey (the 1988 survey) detailed in an expert report prepared for the instant litigation. Respondent objects to the introduction of the 1977 survey into evidence on the basis of hearsay, and objects to the use of its results in petitioner's expert report.

We agree with respondent that the 1977 survey is flawed in several respects. First, the surveyed agents were petitioner's "highest producers" in total premium income and admittedly were more likely to engage in minimum deposit policy sales than the average agent. Such a "skew" towards agents likely to engage in loan activities was exacerbated by the "weighing" of the results of one of the questions by reference to the volume of renewal commissions received by the agent. Second, the cover memorandum issued to office managers and supervisors indicates that the surveyed agents may have been informed of the tax-oriented purpose of the survey and of the preferability of high responses to questions about the percentage of time spent on policy 96 T.C. 497">*545 1991 U.S. Tax Ct. LEXIS 21">*125 loans. While petitioner's expert concluded that such bias in favor of high responses was "probably cancelled out" by a competing bias (namely, petitioner's encouragement of "full premium" business), such "cancelling" of biases does not convince us that the 1977 survey was completely objective. Third, the 1977 survey was designed by employees of petitioner rather than by survey experts.

In Lutheran Mutual Life Insurance Co. v. United States, 816 F.2d 376">816 F.2d 376 (8th Cir. 1987), the Eighth Circuit considered a virtually identical scenario, involving a survey of the time agents spent on policy loan matters. In commenting on the apparent exclusion of the survey from evidence by the District Court, the Eighth Circuit stated:

To establish the trustworthiness of a survey, it must be shown (1) that a proper "universe" was examined and a representative sample was chosen; (2) that the persons conducting the survey were experts; (3) that the data were properly gathered and accurately reported; (4) that the sample design, the questionnaires, and the manner of interviewing met the standards of objective surveying statistical techniques; and (5) that the interviewers, 1991 U.S. Tax Ct. LEXIS 21">*126 as well as the respondents, were unaware of the purpose of the survey. [816 F.2d 376">816 F.2d at 378; citations omitted.]

While agreeing that the survey failed the above requirements in light of flaws similar to those present here (including the fact that only full-time agents were surveyed, that the survey was conducted by an employee, and that some participants probably knew its purpose), the Eighth Circuit stated that "a less stringent application of generally accepted sampling techniques might well have been applied by the trial court" and that the Circuit Court itself "might have been inclined to accept the results of the survey, applying a little Kentucky windage to compensate for [its] empirical inadequacies." 816 F.2d 376">Lutheran Mutual Life Insurance Co. v. United States, supra at 379. In the instant case, we believe that the most appropriate course of action is to admit the 1977 survey into evidence while giving due regard to its empirical inadequacies in evaluating its weight. See Fed. R. Evid. 803(24) (favoring admission of evidence "more probative on the point for which it is offered than any other evidence which the proponent1991 U.S. Tax Ct. LEXIS 21">*127 can procure through reasonable efforts"). In that regard, we note that an expert in insurance company statistics (the author of petitioner's 96 T.C. 497">*546 expert report described below) evaluated the results of the 1977 survey and found that the distribution of responses was reasonable, with a considerable number of "zero" responses to the question of sales time devoted to policy loan features.

Petitioner also submitted the results of the 1988 survey as part of an expert report. While the author of that expert report concededly is an expert in statistics, the 1988 survey suffers from one of the same flaws as the 1977 survey, namely, the use of a sampling of agents not representative of a cross section of all agents. On cross-examination, petitioner's expert confirmed that the agents surveyed by his organization were members of petitioner's "presidents' club" and "directors' club" and represented top producing, more experienced agents. He also stated in that regard that "The relatively new agents I don't think would have been involved in policy loan activities very much." The results of the 1988 survey therefore were skewed in favor of agents engaged in higher than average loan activity.

1991 U.S. Tax Ct. LEXIS 21">*128 Petitioner's expert report also suffered from additional flaws, most notably its reliance on the results of the 1977 survey in drawing a conclusion with respect to the year in issue. While the report noted two independent studies as "a backdrop against which to evaluate Phoenix Mutual's [1977] study," the responses in those studies apparently included "servicing activities" other than policy loan activities, and the populations surveyed included only members of the National Association of Life Underwriters, who are typically more experienced agents.

Petitioner's expert report presents the following chart summarizing the 1988 survey and the 1977 survey:

The report concludes by stating that: "My best estimate of the 1980 percentages would be that they are between the 1980 [sic] and 1977 figures, and probably closer to the 1977 figures than the 1988 figures since the tax situation was more similar to 1977 than to 1988." Based on that 96 T.C. 497">*547 conclusion, petitioner argues for an allocation to investment expense of 17 percent of first-year1991 U.S. Tax Ct. LEXIS 21">*129 commissions and 19 percent of renewal commissions paid during the year in issue.

While we rejected petitioner's allocation of commissions based on the ratio of total investment income from ordinary policies to total income from the policies, we note that the ratio of policy loan interest from the policies to total income from the policies is equal to approximately 8 percent. Because policy loan interest was the category of investment income generated by the agents, we think that ratio would be more appropriate to consider, if any income ratio is an appropriate method of making the proper allocation.

After weighing all of the evidence in the instant case, including the trial testimony of petitioner's agents and the stipulated testimony of other agents, we find that petitioner is entitled to an allocation of some portion of its agents' commissions to the investment function. We, however, do not agree with any of the percentages suggested by petitioner. Therefore, applying our authority under Cohan v. Commissioner, 39 F.2d 540">39 F.2d 540 (2d Cir. 1930) (see 816 F.2d 376">Lutheran Mutual Life Insurance Co. v. United States, supra at 379), we hold that petitioner was1991 U.S. Tax Ct. LEXIS 21">*130 entitled to treat 13 percent of its first year and renewal commissions on ordinary life insurance policies, or $ 4,249,651, as an investment expense for the year in issue.

To reflect the foregoing,

Decision will be entered under Rule 155.