Mr. HERLONG. At this point I want to be sure I understand just exactly what all this means.

In your table on page 21, in the first column, you refer to stock companies, the figure 29.70 is the percent of income tax that they pay on their total earnings. Is that correct?

Mr. DESMOND. Yes, sir; percent to net income.

Mr. HERLONG. You say this is brought about by virtue of the fact that most of their holdings are in stocks, where they get a credit for dividends, in municipals and such as that.

Mr. DESMOND. That is correct.

Mr. HERLONG. Any corporation could do that and get the same effective rate, could they not?

Mr. DESMOND. Yes, they do.

Mr. HERLONG. In the column under "Reciprocals" under here, you show under "Exchanges," Federal income tax, $5,848,000. That is the Federal income tax which is paid on your investment income; is that right?

Mr. DESMOND. That is correct.

Mr. HERLONG. Under the next column you add to that the total amount paid by attorneys in fact, $62,614,000. It depends on who does the figuring as to what answers you come up with.

What is this attorney in fact fee? What are these earnings for the attorney in fact?

Mr. DESMOND. It is a portion of the premium dollar which the attorney in fact receives to administer the affairs of the insurance exchange. He is performing one of the three functions in an insurance operation—the administrative function-for which he is receiving a portion of the premium dollar and paying a portion of the insurance expenses.

Mr. HERLONG. The attorney in fact is essentially a management device and that is all it is, is it not? He is at least comparable to the administrative function of a stock insurance company?

Mr. DESMOND. Yes.

Mr. HERLONG. Is this attorney in fact a corporation?

Mr. DESMOND. Not necessarily. It may be a corporation but not necessarily.

Mr. HERLONG. Would it make a difference in the rate of tax he pays, or it pays, whether it was a corporation or an individual?

Mr. DESMOND. Yes, it would make a difference. If he were a corporation he would pay taxes at the rate of 52 percent and if he were an individual he would pay taxes at the individual rate. We included

only the corporate attorneys in fact in this calculation, however. Mr. HERLONG. Only corporate attorneys?

Mr. DESMOND. Yes, sir.

Mr. HERLONG. You refer in your statement here to premiums. written. Do you mean by that premiums written or deposits made? I have heard it discussed both ways here today.

Mr. DESMOND. The commonly accepted term in insurance parlance is "net premiums written." When we speak strictly of exchanges, we tend to say "premium deposits." Sometimes we use the expression "net premiums written" because that is the common language that is used. Reciprocals representing only 3 percent of the industry does not have a very great influence on what terms are used, so we tend, I think, sometimes, to use the same terms for both, but in

essence, strictly it would be a premium deposit for the exchange and net premiums written for the other types of carriers.

Mr. HERLONG. I gather the sense of your testimony to be that all of these companies should pay a tax on the basis of the total amount of premiums written or premium income received rather than any other method; is that correct?

Mr. DESMOND. I am not sure I understand the question.

Mr. HERLONG. You state in here the taxes you pay presently on your premiums. In the last column over here is 2.1 percent and you say that the stock companies pay 1.9 percent. In other words, you are using that as a yardstick for determining whether it is a fair distribution of the tax?

Mr. DESMOND. That is right. But that yardstick has been used by others and it is a yardstick that is commonly used in the insurance industry, what percentage of the premium dollar is paid for premiums and losses and commissions and taxes and so on down the line. It is a commonly used comparison and has been used by others.

Mr. HERLONG. Using that yardstick you say further here if the Boggs-Baker bill were passed your figure would go up to 3.4 percent. Mr. DESMOND. At the very minimum, yes, sir.

Mr. HERLONG. If an attorney in fact is a corporation that has profits after paying the management salaries, who are the stockholders who own this corporation and what do they do with their corporate earnings?

Mr. DESMOND. That is similar to any other corporation. It may pay dividends to its stockholders and they, in turn, would pay taxes on the dividends they receive.

The CHAIRMAN. Are there any further questions?

Mr. Baker.

Mr. BAKER. In arriving at this 2.1 percent of the premium dollar which you say is paid by reciprocals, you add not only the tax that the reciprocal pays, but the tax paid by the attorneys in fact, is that right?

Mr. DESMOND. I would just change the terminology a little and say the taxes of the exchange and the taxes of the attorney in fact, making up the total operation, are added together, yes, sir.

Mr. BAKER. To add at the 1.9 percent of the total dollar that you say the stock companies have, do you add to the 52-percent rate? Mr. DESMOND. No; I die not do it because I did not do it in the reciprocal operation. They pay salaries to people who pay the taxes on what they receive, too. I was just taking the functions, and I am saying the functions in the exchange and in the attorney in fact are the same functions that are in the stock corporation.

Again, referring you to that figure of $279 million I am saying if the reciprocal were a stock corporation, that is the amount of net income it would report as a stock company, so these figures are on a comparable basis.

Mr. BAKER. The 1.9 percent of the premium dollar that you say the stock companies pay, and I think that is right, is set at 52 percent of the net income of that corporation.

Mr. DESMOND. No, it is 52 percent of their underwriting income and then a 52 percent on their taxable investment income, but a good part of their investment income is not taxable.

Mr. BAKER. But you add other income to the taxable part of the income. To the taxable part of the income you have your total taxable income, do you not?

Mr. DESMOND. That is right, but they have a substantial investment income there which alters the picture, I think. It gives a different picture than people normally think of.

Mr. BAKER. You are talking about tax-exempt income?
Mr. DESMOND. That is right.

Mr. BAKER. That is available to anybody.

Mr. DESMOND. Not to the extent that it is available to stock insurance companies because they have such large portfolios and they have such a large investment income that it affects the competitive balance to a considerable extent, it seems to me.

Mr. BAKER. In other words, the 1.9 is the result of applying the 52-percent corporate to the tax income of the corporation, is it not, under the existing law?

Mr. DESMOND. That is right.

Mr. BAKER. How is the 2.1 made up?

Mr. DESMOND. It is made up of the tax on investment income of the exchange plus a 52-percent tax on the income of the attorneys in fact.

Mr. BAKER. And the attorney in fact is the fellow who runs the reciprocal?

Mr. DESMOND. That is right.

Mr. BAKER. What justification is there for adding his salary into the tax and not adding the board of directors of a stock company in? Mr. DESMOND. Because this includes no salaries of officers. There would be corporate officers in the attorney in fact. There would be some officials in the exchange. Those are not added in. The only reason these are added in is to combine the same functions in a reciprocal operation that you have in a stock insurance company. These are completely comparable.

Mr. BAKER. Does not the reciprocal deduct salaries paid to the producers of that income under the existing law?

Mr. DESMOND. I am not sure I understand your question.

Mr. BAKER. Before you apply the effective rate to the taxable income of a reciprocal, do you not take advantage of all deductions under the existing laws such as salaries and salesmen's expenses and entertainment?

Mr. DESMOND. Yes, insofar as they are applicable.

Mr. BAKER. Take out to the 2.1 the figure, whatever it is, that you have for, I believe you called it operating the exchange or the attorney in fact or whatever it might be, and what would that 2.1 be?

Mr. DESMOND. That would be the figure that has been presented by Treasury. That would be the figure that was presented by Mr. Cate and that would be around 0.4 percent of whatever that figure was. I do not recall.

Mr. BAKER. In answer to the chairman's question, you said some reciprocals pay out all surplus money, or whatever you call it, and some of them do not, but of the ones who do not pay out, that money belongs to the subscribers. Is that the effect of what you said? Mr. DESMOND. Yes.

Mr. BAKER. But if you do not pay it out for several years, it belongs to the subscribers at the time you paid it out and not to the ones who paid it in 3 or 4 years ago.

Mr. DESMOND. No. Legally it would belong to all of the subscribers, whoever contributed to the reserves of the exchange, unless they agreed otherwise among themselves. These reciprocals are based on individual private contracts between the subscribers, and they could provide that if they so wished.

Mr. BAKER. Say you were paying out $1,000. Do you pay it to the subscribers who are on your books today or do you go out and pay it back to a lot of people who may be off your books?

Mr. DESMOND. You are talking about a reciprocal who does pay it

out.

Mr. BAKER. Yes.

Mr. DESMOND. He would receive his proportionate share of the reserves when he terminated.

Mr. BAKER. Is that universal practice?

Mr. DESMOND. I would say it is universal practice in those who follow the policy of returning the savings to the subscriber when he terminates.

Mr. BAKER. Can you give me any idea of what percentage you pay it out?

Mr. DESMOND. I do not have exact figures on this but I would say in terms of numbers of reciprocals, possibly 50 percent would pay it out. In terms of the percentage of premium volume, I would say that the number that paid it out would be in the distinct minority in terms of the premium volume.

Mr. BAKER. Those who pay it out would be in the minority?
Mr. DESMOND. Yes.

Mr. BAKER. But in terms of reciprocals it would be about even?
Mr. DESMOND. Yes.

Mr. BAKER. There are some who never pay this money out?

Mr. DESMOND. There are some who do not follow the practice of returning to the subscriber his proportional share of the surplus when he leaves. There are some.

Mr. BAKER. Then there is no tax paid on that?

Mr. DESMOND. That is right.

Mr. HERLONG. According to what you said, Mr. Desmond, then there are two types of reciprocals and perhaps the industry should be divided up into four categories instead of three, if one type of reciprocal retains part and another pays it out, should they not have separate tax treatment?

Mr. DESMOND. I don't know whether there are two types or four types. All reciprocals are based on individual contracts so you might say there are 60 different types, actually, because each one of the arrangements may be slightly different than another. But I would say even in the case of those who do not pay out the surplus when a subscriber terminates, then it would not be equitable to tax what is remaining which is held for the protection of all of the other subscribers, because we would be paying considerably more taxes than the stock companies do.

Mr. HERLONG. I am not clear and I guess will not be on this matter of the attorneys in fact and this $62 million income tax for which you have taken credit in your schedule.

You are dealing here now with a bunch of people. You people are the experts in the field and you are dealing with people who are not expert in the field, but would you give us a "for-instance" as to exactly how this attorney in fact makes money so that he can pay income tax on it? Would you spell it out for us in language that even I can understand?

Mr. DESMOND. The best way is to again break it down into the three functions. What will actually happen is that the subscribers will decide to insure one another in this exchange but they do not want to be involved in the management of its affairs, so they will appoint an attorney in fact and they will, in effect, say to him in their contract to him, that you are entitled to receive, for example, 10 percent of the premiums that are collected for which you will pay all of the administrative expenses. Out of the balance of the premium dollar, 90 percent of the premium dollar, you shall pay the losses and the expenses in connection with the losses; that is, the losses adjusting expenses, as we call them. The exchange then gets, say, 90 percent of the premium, pays the losses and expenses and what remains remains for the benefit of the subscribers or may be returned to the subscriber when he leaves. The attorney in fact gets a flat, fixed percentage of the premium dollar, 10 percent in my example, and pays all of the administrative expenses. Anything that he has remaining after the payment of those expenses is income on which he pays an income tax.

Mr. HERLONG. And that is where you get this $62 million?

Mr. DESMOND. Yes, and that is a function that is comparable to a function performed by stock companies.

Mr. HERLONG. If he does not operate efficiently he does not have to pay any income tax.

he can.

Mr. DESMOND. There is incentive to him to operate as efficiently as That is one of the reasons this arrangement is entered into. Mr. HERLONG. Where is that different from an arrangement to pay a board of directors 10 percent for the operation of that company and what was left would be their salaries? Is it possible to enter into an arrangement like that?

Mr. DESMOND. The best answer I can give you there is the exchange would have advisory boards and the attorneys in fact would have boards of directors who may be receiving salaries and we have not included their salaries in this computation. We tried to take comparable functions, functions that are performed by the stock company and show that they are performed actually in two separate elements in the reciprocal operation and one of which is the attorney in fact. Mr. HERLONG. I think that is all, Mr. Chairman.

The CHAIRMAN. Are there any further questions?

Mr. KING. What do you mean by subscriber?

Mr. DESMOND. Subscriber has the same connotation as a member would in a club, say. It is similar to the policyholder in the stock company. We term them subscribers, but they are policyholders insuring one another. They subscribe to this exchange of contracts.

Mr. KING. In the Automobile Club of Southern California, approximately how many subscribers do you have?

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