Mr. DESMOND. We have approximately 350,000 subscribers. We operate only in the southern California area, in 13 counties in southern California. We do not operate beyond the boundaries of California and we do not operate at all in northern California.

Mr. KING. I have been a member for many years. Now, I have learned today that I have been subscribing for many years. I always referred to myself as a member.

Mr. DESMOND. Actually there, Mr. King, we have another operation which has not been brought up today and that is an automobile club. A good many clubs have insurance exchanges in connection with the automobile club. These automobile clubs operate in restricted territories. For example, ours in the 13 counties of southern California-the one in San Francisco operates in northern California, and the one in Detroit operates only in a part of Michigan. In the very early days when insurance rates were very high with the stock companies, the auto clubs started these reciprocal exchanges to offer insurance to the members at cost.

You can be a member of the auto club but not have your insurance there in which case you are a member. You may also have your insurance with the exchange in which case you would be a subscriber to the exchange so you could be a member or a subscriber or just a member. We only insure members. We do not insure the general public, just members.

Mr. KING. Is the setup within the exchange separated as to members of the club as against the subscriber for insurance purposes? Mr. DESMOND. Yes. The records are kept separately.

Mr. KING. Is it a separate entity?

Mr. DESMOND. I would have to say yes. We normally think of the exchange as not being an entity but merely as sort of an aggregation of the insured individuals but in the broadest sense they would be separate entities.

Mr. KING. When was the exchange which we know as the Southern California Auto Club organized?

Mr. DESMOND. I have only been out there 8 months, but I seem to recall that it was around 1908 or 1909. The club was organized just around the turn of the century, I believe, just prior to 1900.

Mr. KING. From now on, I can properly call myself a subscriber to the Auto Club of Southern California?

Mr. DESMOND. You call yourself a member of the club and a subscriber to the insurance exchange.

Mr. BETTS. How do your rates compare with other companies?

Mr. DESMOND. We will be higher than some; lower than others. In reference to what we call board companies, they generally are stock companies charging the highest rate and we would charge lower than they would.

In reference to direct riders such as Allstate, in some areas, we would be higher than they are and in other areas we would be lower than they are. We each make our own rates independently, and you cannot make a flat statement that they are always higher or lower. The CHAIRMAN. Mr. Alger.

Mr. ALGER. I have read your statement, particularly this part on mutual insurance and I am troubled because I have had trouble with previous witnesses in differentiating between a cooperative and a re

ciprocal and I read your definition here on pages 7 and 8 and where the reciprocals have retained earnings.

I fail to see how if money were given right back immediately to people who had put money in-the separate insurees I could understand-and in which case the bills of which you are critical, the two bills before us, would not apply. They would only apply on retained earnings but where you keep the money in the form of retained earnings and then don't want taxation on it, I do not grasp it.

I am having difficulty still after reading your definitions on pages 7 and 8, the difference between a mutual and reciprocal.

Mr. DESMOND. A mutual is actually a business corporation that has two entities. They have the corporation itself, and it has the policyholder. Ordinarily, the premium moneys are transferred to the corporation, the mutual corporation and the mutual corporation legally owns that money and can do with it what it wishes within certain limits, of course. But in a reciprocal operation we really have three elements. We have the exchange itself which is really the aggregate of two elements only, really.

The exchange itself is the aggregation of these individuals insuring one another and the attorney in fact who administers the affairs of the subscribers.

Mr. ALGER. If the attorney in fact has tremendous retained earnings, what does he do with them? He must reinvest them or do something with them.

Mr. DESMOND. The attorney in fact is paying tax on all of his in

come.

Mr. ALGER. I am not talking about his income. He has this tremendous amount of money which he must invest in either a bank or stocks. Now, that is making money. I fail to see how in practice that differs from a mutual, even though I recognize there is an attorney in fact rather than the corporate entity which does not even have a liability, as you pointed out, in your definition as the separate insurers have.

The handling of the retained earnings is what gets me. If you build buildings or invest money, wherein does that differ from what a mutual might do?

Mr. DESMOND. I think the best way I can answer you is this: In normal forms of business we have corporations, we have partnerships and we have individuals, each one of them operating under a different legal form. In insurance you have stock companies, you have mutuals and you have reciprocals. Reciprocals are a unique form of legal organization that is not found any place other than in insurance, and the distinction is that the exchange is an aggregation of individuals insuring one another.

Mr. ALGER. Every man on the stand has given us that definition. Mr. Cate contradicted it and I do not necessarily agree with him, but he said you do have profits. You people say, on the contrary, you do not have profits. So I have to make up my mind. In the meantime I know you have large sums of money which you do not turn back. If you turned that money back, these bills which are being criticized by you folks would not apply because the bills before us, H.R. 6660 and H.R. 6659 only take into account where there is profit.

If you turn the money back it does not apply to the reciprocal then, so what is the concern expressed by you folks in those bills?

Mr. DESMOND. The concern is this: If these bills are applied we will be paying substantially more taxes than the stock companies are. Mr. ALGER. How would you pay it if you are returning it to the subscribers?

Mr. DESMOND. We have not always returned it to the subscribers. We have figures here what this committee would call underwriting income of $157 million in the exchange and $121 million in the attorney in fact. I am saying we have paid our taxes on this. The moneys that have been accumulated in the exchange are accumulated for the benefit of the subscribers. They cannot be paid to third-party stockholders and when you consider the entire reciprocal operation that we have paid our fair share of taxes and if you apply the Baker-Boggs bill we will be paying more than our fair share.

We will be paying 3.4 percent out of every premium dollar as compared to the 1.9 for stock companies and we will be paying 31 percent as compared to 19 percent for the stock companies.

It will increase our taxes to the point where we are paying considerably more than the stock companies.

Mr. ALGER. Then you do agree that you do make profit as such? Mr. DESMOND. Not in the same sense that a stock company does.

Mr. ALGER. I think I can understand the difference in the way both of you handle it, but I do not understand it and it is not your fault. I shall study your statement further.

The CHAIRMAN. Are there any further questions?

You said a moment ago that the attorney in fact might well be a corporation. What is the status of this exchange that you refer to? Is it in corporate form or not?

Mr. DESMOND. The one I work for?

The CHAIRMAN. No; the usual one.

Mr. DESMOND. The typical one is to have a corporate attorney in fact.

The CHAIRMAN. What is the status of the exchange? Is it a partnership, a corporation, or what?

Mr. DESMOND. Legally, it is an aggregation of individuals insuring one another. We do not like to refer to the association but what you might think of have an association of individuals

The CHAIRMAN. Is it set up under a State law that permits this particular type of business unit?

Mr. DESMOND. Reciprocals are now, yes, permitted by State law. When they were originally formed there was no law with respect to reciprocals and they were formed actually apart from the law.

The CHAIRMAN. It is not set up the way a farm cooperative is set up. A farm cooperative is a farm-type corporation under a State law. This is not a corporation, is it?

Mr. DESMOND. No; you and I could get together and say, "Let's throw $100 each into the pot and if either one of us has a loss we will pay ourselves out of that fund."

The CHAIRMAN. That is in the nature then of a partnership?

Mr. DESMOND. Yes. It is in the nature of a partnership.

Mr. IKARD. If somebody brought a lawsuit against you, would they bring it against the attorney in fact or against the exchange?

Mr. DESMOND. Before enabling legislation had been passed, it had to be brought against the attorney in fact.

Mr. IKARD. In effect, you are saying that you do have investment income on which you do pay a tax, and that the principal of these funds are held until such time as you either use them for the purpose of carrying out your insurance obligations or turn them back to members of your exchange. In essence, is that what you are saying? Mr. DESMOND. Yes, sir. Investment income arises from the fact that premiums are paid in advance of when losses are incurred so you have a fund which is available there for investment.

Mr. ULLMAN. What is the typical way exchange reserves are invested?

Mr. DESMOND. I would say that the typical example is that a fair proportion of their fund would be invested in Government bonds and that a fairly large proportion would be invested in municipals. Mr. ULLMAN. If they want to build a new office building, for instance, can the corporation use the reserve funds to invest in an office building?

Mr. DESMOND. If the subscribers permit it, yes. The subscribers can limit or permit that type of investment in their contract with the attorney in fact.

Mr. ULLMAN. Is the practice of owning real estate very widespread? Mr. DESMOND. I would say it would vary. In our particular case, real estate is not owned by the exchange itself. There is no real estate owned by the exchange itself. I do not know that I can give you an adequate answer as to what is typical.

Mr. ULLMAN. The corporation would own the office building, if possible?

Mr. DESMOND. We do not have the corporate attorney in fact, but as I mentioned earlier we do have this separate entity called the Automobile Club which owns the buildings.

The CHAIRMAN. I am not certain, Mr. Desmond, whether the record thus far indicates just exactly the way that a reciprocal, a mutual, and a stock company are taxed under existing law. Let me see if this is right.

The stock company, first, is taxed at corporate rates on what we consider to be the earnings of that operation. That is, it is total income less expenses and reserve requirements; is that correct? Mr. DESMOND. Yes, sir.

The CHAIRMAN. Including its underwriting income.

Mr. DESMOND. That is right.

The CHAIRMAN. If it adds up to $10,000, it pays a corporate tax on $10,000.

Now, in the case of the mutual, it is taxed at the corporate on its investment income less reserve required and other amounts are paid back to the policyholders, presumably.

Mr. DESMOND. No, there is no reserve deduction.

The CHAIRMAN. It is strictly, then, on the basis of the investment income?

Mr. DESMOND. Yes, sir.

The CHAIRMAN. Or, with respect to mutuals, 1 percent of the gross premium income

Mr. DESMOND. Gross income which would include investment income, also.

The CHAIRMAN. Whichever would be greater?

Mr. DESMOND. Yes, sir.

The CHAIRMAN. I would imagine most of them pay under the latter device, the 1 percent of the gross income?

Mr. DESMOND. Yes, sir.

The CHAIRMAN. Then the reciprocal is taxed on the basis of the corporate rate applied to the investment income that the reciprocal may have; is that right?

Mr. DESMOND. With the further qualification that there is a $50,000 exemption.

The CHAIRMAN. I have wondered all along whether or not any tax on gross income was ever a fair way to tax, but that does not apply to the reciprocal, does it? You are not taxed in the alternative on the basis of 1 percent of your gross income, whichever is greater.

Mr. DESMOND. We are not taxed on the alternative, the additional, but we are taxed on the attorney-in-fact item.

The CHAIRMAN. This question disturbed me a long time about flat tax which is an excise tax, I guess, on gross income, which is not applicable in your case.

Mr. DESMOND. No, it is not.

Mr. ALGER. I have completed your statement and on page 19, along the line of what the chairman just asked you, you point out the remaining funds are profit. You say the attorney in fact after the payment of administrative costs, if any, may have funds remaining. The remaining funds are profit and taxes are paid on these profits just as taxes are paid by the stock insurance company on its profits.

How is the reciprocal part apart from the attorney in fact? Mr. DESMOND. The attorney in fact would be the corporation. Mr. ALGER. I understand your statement here to say it is taxed apart from the attorney itself."

Mr. DESMOND. They are taxed on the basis of income, direct corporate investment income with a $50,000 exemption. Between $50,000 and $100,000 they pay rates of 93 percent of the excess over $50,000 or regular corporate rates, whichever are less.

Mr. ALGER. Your statement earlier makes sense to me now where you pointed out where under the Baker-Boggs bill you would be paying more than the stock companies. Is that your contention?

Mr. DESMOND. Yes, that is correct, when the entire industry is considered.

The CHAIRMAN. We will go into that item further, Mr. Alger. Mr. Desmond, we appreciate your coming to the committee and perhaps as we go through this along with what the others have said, it may all fit into place and we will get the overall picture when we put the various parts of the puzzle together.

Thank you very much.

Mr. DESMOND. Thank you.

The CHAIRMAN. Mr. Lester, you have been before the committee before, but for purposes of this record, will you please identify yourself?