SECTION 2. BACKGROUND

.01 Section 832(b)(1) provides that the gross income of an insurance company subject to tax under § 831 includes the company’s “underwriting income.”

.02 Section 832(b)(3) defines “underwriting income” as “premiums earned on insurance contracts during the taxable year, less losses incurred and expenses incurred.”

.03 Section 832(b)(4) provides that to compute premiums earned, an insurance company reduces the amount of gross premiums written on insurance contracts

2002–28 I.R.B. 105 July 15, 2002

.01 Premium acquisition expenses . A premium acquisition expense is an expense that is primarily related to the production of gross premiums written on an insurance contract and directly varies with the amount of gross premiums written on the underlying contract. For example, agent and broker commissions, premium taxes, and premium-based assessments generally qualify as premium acquisition expenses because these expenses vary with and are primarily related to the acquisition of gross premiums written on new and renewal insurance contracts. An annual expense allowance payable by a reinsurer to assume all or a portion of the risk on insurance contracts of another insurance company is treated as a premium acquisition expense to the extent that this expense allowance reflects the reinsurer’s reimbursement of the premium acquisition expenses incurred by the direct writing company. However, expenditures with respect to salaried personnel and general administrative costs typically will not qualify as premium acquisition expenses. Although a portion of these costs may be associated with activities relating to the issuance of insurance contracts, these expenditures do not vary directly based on the amount of gross premiums written for the associated contracts.

.02 Pro forma premium acquisition expenses . A pro forma premium acquisition expense is any unpaid premium acquisition expense that is not shown on the insurance company’s annual statement for the year in which the insurance company includes the gross premiums written to which that expense relates in the calculation of premiums earned under § 832(b)(4).

.03 Pro forma unearned premium reserve . The pro forma unearned premium reserve is the portion of an insurance company’s year-end unearned premiums (other than amounts to which special rules in §§ 832(b)(7)(A) and 832(b)(8) apply) attributable to gross premiums written that are not shown on the company’s annual statement, but which the company is required to report in the calculation of premiums earned under § 832(b)(4) for the taxable year in accordance with the provisions of § 1.832–4.

during the taxable year by return premiums and premiums paid for reinsurance. Subject to the exceptions in §§ 832(b)(7), (b)(8), and 833, this amount is increased by 80 percent of the unearned premiums on outstanding insurance contracts at the end of the preceding taxable year, and is decreased by 80 percent of the unearned premiums on outstanding insurance contracts at the end of the current year. This 20 percent reduction in the amount of an insurance company’s deduction for increases in unearned premiums is intended to represent the allocable portion of the company’s expenses incurred in generating the unearned premiums. S. Rep. No. 313, 99th Cong. 2d Sess. 496 (1986), 1986–3 (Vol. 3) C.B. 496; H. Rep. No. 426, 99th Cong. 1st Sess. 669 (1985), 1986–3 (Vol. 2) C.B. 669. .04 Sections 1.832–4(a)(3) through (11) of the Income Tax Regulations, effective for taxable years beginning after December 31, 1999, prescribe specific rules regarding the manner in which an insurance company determines gross premiums written, return premiums, and unearned premiums for purposes of the calculation of premiums earned under § 832(b)(4). These rules apply regardless of the accounting practices used by the insurance company to record gross premiums written and unearned premiums on its annual statement filed for state regulatory reporting purposes. Section 1.832– 4(a)(4) defines “gross premiums written” as “all amounts payable for the effective period of the insurance contract.” Section 1.832–4(a)(5)(i) generally requires the insurance company to report gross premiums written “for the earlier of the taxable year that includes the effective date of the insurance contract or the year in which the company receives all or a portion of the gross premium for the insurance contract.” In some situations, this rule may result in gross premiums written being taken into account in the calculation of premiums earned under § 832(b)(4) for a taxable year earlier than the year in which those written premiums are reported on the company’s annual statement.

.05 Section 1.832–4(a)(5) provides special methods of reporting gross premiums written for certain categories of insurance contracts with installment premiums, including contracts for which an

advance premium installment is received prior to the effective date of the underlying contract, cancellable accident and health insurance contracts, and certain multi-year insurance contracts with premiums payable at guaranteed rates. To use one of these special methods of reporting gross premiums written, the insurance company must satisfy an annual pro rata expense limitation with regard to the amount of premium acquisition expenses deducted for the underlying contract. Section 1.832–4(a)(5)(vii). This annual pro rata expense limitation ensures that the company does not deduct the premium acquisition expenses for the insurance contract more rapidly than the company includes the gross premiums written for the associated contract in the calculation of premiums earned under § 832(b)(4).

.06 Section 832(b)(6) provides that “expenses incurred” means all expenses shown on the insurance company’s annual statement. Expenses incurred generally are calculated as the sum of the expenses paid during the taxable year, plus the increase in unpaid expenses during the taxable year. To be included in expenses incurred, an expense listed on the annual statement also must be an allowable deduction under § 832(c). Section 832(c) lists various categories of allowable deductions, including “all ordinary and necessary expenses incurred, as provided in § 162 (relating to trade or business expenses).” See § 832(c)(1).

.07 The 20 percent reduction in the deduction for increases in unearned premiums under § 832(b)(4) was intended to correct the mismatching that results from the deferral of unearned premium income and the current deduction of premium acquisition expenses. S. Rep. No. 313, at 496 (1986); H. Rep. No. 426, at 668–69 (1985). Consistent with this intent, the Internal Revenue Service will allow insurance companies within the scope of this revenue procedure to account for premium acquisition expenses using the safe harbor method described in section 5.02 of this revenue procedure.