SECTION 8. EXAMPLE

The following example illustrates the manner in which an insurance company applies the safe harbor method to determine the amount of premium acquisition expenses treated as incurred for the taxable year.

Example . (i) IC is an insurance company taxable as described in section 4 of this revenue procedure that files its returns on a calendar year basis. IC writes automobile insurance policies which provide insurance coverage for a one-year period beginning on January 1st and ending on December 31st. The premiums for the policies are payable on a monthly installment basis. For annual statement reporting purposes, IC reports gross premiums written for these insurance policies based on the calendar year in which the related coverage commences. For purposes of calculating its premiums earned under § 832(b)(4), IC is required by § 1.832–4(a)(5)(i) to report gross premiums written for the policies for the earlier of the taxable year that includes the effective date of the related policies or the year in which all or a portion of the premiums for the policies are received. However, pursuant to § 1.832–4(a)(5)(iii), IC has adopted the method of reporting advance premium installments in gross premiums written for the taxable year of receipt.

(ii) As of December 31, 2002, IC has collected $250 of advance premium installments during the year with respect to insurance policies with effective dates in 2003. IC determines that the premium acquisition expenses attributable to these advance premium installments are $62.50 and that the total amount of premium acquisition expenses expected to be incurred over the effective period of the related insurance policies is $750. On its 2002 annual statement, IC reports total amount of premium acquisition expenses of $1,250, consisting of $1,000 of paid expenses plus a $250 increase in unpaid expenses. The expenses shown on IC’s 2002 annual statement did not include the $62.50 of premium acquisition expenses attributable to $250 of advance premium installments that IC collected in 2002 with respect to policies with effective dates in 2003, but did include $50 of premium acquisition expenses attributable to $200 of advance premium installments that IC collected in 2001 with respect to policies with effective dates in 2002. Pursuant to § 1.832–4(a)(5)(iii), IC had already included those $200 of advance premium installments in gross premiums written and unearned premiums when calculating the amount of premiums earned under § 832(b)(4) for the 2001 taxable year.

(iii) For the taxable year ending December 31, 2002, IC changes to the safe harbor method of deducting premium acquisition expenses described in section 5.02 of this revenue procedure. To determine the deductible premium acquisition expenses for the 2002 taxable year, IC adds the amount of premium acquisition expenses paid during the taxable year ($1,000) to the increase in unpaid expenses as shown on the 2002 annual statement ($250). The increase in pro forma premium acquisition expenses for the taxable year equals $12.50 ($62.50 - $50.00 = $12.50). For the 2002 taxable year, IC’s unearned premium reserve offset amount equals $10 (($250 x .20 = $50) - ($200 x .20 = $40)). Accordingly, IC’s deductible premium acquisition expenses for the 2002 taxable year equal $1,260 ($1,000 + 250 +10). The $2.50 of pro forma

premium acquisition expenses which cannot be deducted in 2002 as a result of the limitation in section 5.02(ii) is added to IC’s pro forma premium acquisition expenses at the end of the 2003 taxable year.

(iv) To determine the amount of premium acquisition expenses deductible under the safe harbor method, IC also must apply the annual pro rata expense limitation of § 1.832–4(a)(5)(vii) with respect to those insurance policies for which IC collected advance premium installments during 2002. For this purpose, IC compares the ratio of the amount of expenses allowable under the safe harbor method over the total premium acquisition expenses for the related insurance policies (($62.50 - 2.50 = $60)/$750 = .08) with the ratio of the advance premium installments over the total gross premiums written for the related insurance policies ($250/ $2,000 = .125). As .08 is less than .125, the amount of premium acquisition expenses determined under the safe harbor method satisfies the annual pro rata expense limitation of § 1.832–4(a)(5)(vii).

(v) On its 2002 federal income tax return, IC follows the general automatic change procedures of Rev. Proc. 2002–9, as modified by this revenue procedure, to change to the safe harbor method. This change in method of accounting results in a negative § 481(a) adjustment of $50, the pro forma acquisition expenses attributable to the $200 of advance premium installments received by IC for the 2001 taxable year. Pursuant to section 5.04 of Rev. Proc. 2002–9, as modified by Rev. Proc. 2002–19, IC takes the $50 negative § 481(a) adjustment into account in one-year in computing its taxable income for the taxable year ending December 31, 2002.