both by historical precedence and through pressure of the policyholders who are concerned only with the cost of their insurance being at the lowest price consistent with safety, cannot retain policyholder funds beyond the present and prospective needs of the company.

On he basis of 1958 figures as reported in Best's "Aggregates and Averages," stock companies show a ratio of surplus to net premiums of 82.2 percent, whereas the mutual ratio is 54 percent. Do these figures show that mutual companies have accumulated surpluses to the detriment of their policyholders? They show quite the contrary when compared with stock companies. Certainly there is no evidence that mutuals have accumulated any excess of surplus under the present dual system of taxation which has been in effect since 1942.

The stock companies have tried to argue that the present system of dual taxation gives the mutuals a competitive advantage in the marketplace. The facts deny this assertion. The price differential between the stock and mutual insurance is not due to any tax advantage. The figures show that mutuals on the average have both a lower expense ratio and a lower loss ratio than the average for stock companies. Only this economy of operation, not the tax, accounts for the lower costs and if this is so, as the records indicate, then Congress should encourage the mutuals and not in anyway destroy their effectiveness by a destructive tax to the end that the insuring public may have a competitive insurance market where it may buy protection at the lowest possible cost.

Yet in spite of this savings feature for policyholders, mutuals today have only 25 percent of the total share of the fire and casualty market. The reason is obvious. The mutual company cannot reach out into the equity field for outside financial resources to support the ever-growing premium volume as can the stock companies.

To those who may argue that Congress is presently taxing the underwriting gain of mutual life insurance companies, the following distinctions must be made between a life insurance company and a casualty company:

(1) A life insurance contract, once written, goes on for many years and, in many cases, for life. A casualty policy may change yearly from one carrier to another. There is, therefore, greater stability in the relationship between the carrier and its policyholder in the life insurance field and therefore the greater ability on the part of the company to estimate its income.

(2) The reserves required by each are widely different in nature. The losses to be sustained by a life company may be clearly ascertainable in advance through actuarial methods. Casualty or fire losses do not occur with the regularity as represented by mortality tables. They can happen any time, anywhere, and their severity can never be ascertained in advance. There is no set pattern. Life insurance and casualty insurance are almost markedly different in the field of possible catastrophic loss.

(3) Mutuals in the fire and casualty field do not dominate that field as do mutual life companies in the life insurance field. Neither is there any evidence that their surpluses are such as to permit the mutual casualty companies to disburse larger amounts in policyholder dividends. Indeed, a major problem of many mutuals is to maintain the proper ratio of surplus to net premiums written as public demand for their policies increases.

Congress, too, has given recognition to the essential differences between a mutual life insurance company and a mutual casualty company in the very tax structure which exists at present so that the tax base as applied to the life company is infinitely more favorable to it, and properly so, than is the tax base with reference to the mutual casualty companies.

C. THE PROPOSED LAWS WOULD TEND TO WEAKEN, IF NOT DESTROY, THE MUTUAL COMPANIES

A citizen desiring fire and casualty insurance has several choices today. He may select his broker and have his insurance placed with a stock company. If he does this, he will pay his premium and get his coverage but nothing more. He will be a customer of the insurance company who has purchased a commodity. Or he may have his insurance business placed either directly by himself or through a broker in a mutual insurance company. Initially he may pay essentially the same premium had he placed it with a stock company since the premium for any given risk in any given area is essentially uniform for the same risk regardless whether the carrier is mutual or stock. But having placed it in a mutual company, he has become more than a customer, he has become a part owner. He has a voice equal to every other policyholder in selecting the

board of directors. What is more he can look forward and has a right to expect that his company will be operated in such a manner that he will receive a return at the end of the policy year, of that portion of the premium which was not used up by his company for losses, expenses, and additions to surplus which are necessary for growth and for unforeseeable losses.

If Congress, by taxing that portion of the premium dollar found to be in excess of losses and expenses, deprives the policyholder from receiving his dividend, what motive would the policyholder have in placing his business with a mutual company? It must be realized that stock companies have traditionally and still do, pay commissions to brokers and agents far in excess of that paid by mutual companies. Many mutuals in fact, pay no commissions but get their business by direct contact with the insurance buyer. Therefore, if the taxing power diminishes the opportunity for the policyholder to receive back the excess premium, he in fact will be prompted, if not by himself then by his broker, to place his business with a stock company since the insured would have nothing to gain under those circumstances in joining a mutual company and the broker would be more amply rewarded even though that would add to the cost of insurance.

Thus, we submit that these proposals, while on their face they appear to be tax legislation for purposes of additional governmental income, are in effect, proposals sponsored by stock companies to impair and in fact destroy, the mutual company as a competitor.

D. CONCLUSIONS

We have tried to indicate that tax equality and tax equity are two distinct things. We have tried to show that the essential differences between the mutual operation and the stock operation are important ones; that to tax both on the same base would not be tax equity but in fact, a gross inequity. It has always been a part of the rationale of Congress, and properly so, that the income received by a mutual company from earnings on investments and realized capital gains, was the taxable income of a mutual casualty company since this income is derived from the use of policyholder funds outside of the insurance operation for which the policyholder contributed his funds. There cannot be much argument with that rationale.

We submit, however, that income derived from the insurance operation and not returned to the mutual policyholder as a return of the redundant portion of the premium is still held for policyholder protection. Funds contributed by the policyholder for insurance protection and held as such should not be taxed as income as long as those funds are held and are performing their insurance function.

We have tried to show that the surplus of a mutual company is different in its very nature from the surplus of a stock company; that it represents funds held within the company for the protection of the policyholder and is its only bulwalk (a) against catastrophic and unexpected losses, and (b) to provide for its growth in premium volume. We have shown that the surplus of a stock company, over and above the contingencies required by law, may be and are in fact, distributed in one form or another to the owners of the company so that they are not necessary for the performance of the insurance function. We wish to call your attention to the necessity of the surplus of a mutual company as a bulwark against catastrophic and unexpected losses. Premium rates in casualty insurance are fixed on the basis of experience as reflected for a long term (3 to 5 or even longer year periods) prior to the date the rate is fixed. They, therefore, do not necessarily represent the loss experience of the companies at the time that they are fixed. In any one year, for instance, the losses in fire insurance may be below the preceding 3-year average. Under an annual system of accounting, as required by law, the mutual carrier may show an underwriting gain. At that very time, losses may be very heavy in this particular line of insurance. Can this be considered a taxable profit when it is known from the outset that the rate on which it was based was a reflection of not what is actually occurring in the year in which the accounting is made, but for a longterm experience? The overamount collected in a year in which loss experience is below average, will be needed to cover the losses in the years in which loss experience is above average. If a part of the accounting gain is confiscated in taxes in the below-normal year, the mutual company has nowhere to go for funds that can be available to it in the years when losses exceed the average other than to its surplus, which if impaired by taxation, would place the mutual company in a very unsound position. The stock company, in the same position, could float additional stock and thus raise additional surplus.

70510 0-61-pt. 3-25

This is not a hypothetical case, it is an established fact. Prior to 1936, the New England area was not considered one subject to catastrophic windstorm losses. It was in no know hurricane area. Premium rates reflecting the past experience were, therefore, very low. Yet within a period of 10 years thereafter, that area suffered many major catastrophic storms which would have wrecked the New England mutual companies were it not for their substantial surplus reserves. Therefore, what many people prior to these storms would have considered redundant reserves, proved to be no more than adequate to meet the contingencies. The surplus contributed solely by the policyholder of a mutual company is not a profit but in fact a reserve fund, a policyholder's protective fund accumulated as a precaution to insure prompt and full loss payment. We have tried to demonstrate that the dividend that a mutual policyholder receives is not a share of income or profits as is the dividend payable to a stockholder of a stock company. It is a return to the policyholder of the unused portion of his premium. If the mutual companies ability to return part of the premium to the policyholder is impaired or destroyed by the tax on underwriting gain, it loses its reason for existence and will result in its disappearance from the competitive scene where it sells insurance at the lowest possible cost to the insuring public.

If the proposal should become law, therefore, it would destroy the effective and desirable competition of mutual companies. We have indicated how the effect of the tax would impair the growth of the mutual companies. We have stressed the difference in objectives between the mutual and the stock company. In this respect, we wish to reemphasize, because it is of such great importance, that the very history of the growth and development of stock insurance and mutual insurance pinpoints the very necessity for maintaining the present tax structure as an equitable basis.

The history of the growth and development of stock insurance proves the effectiveness of the profit motive as a stimulant for capital formation and insurance development. Once a demand for coverage is discernible, investors will supply the needed funds to create the insurance capacity for an expanding market or for new coverages.

But the motivating force behind the formation of mutual companies is quite different. These companies were formed and perpetuated by men seeking to secure protection for themselves under a plan where their protective funds are not owned by nonpolicyholders and where insurance protection could be secured most effectively and with automatic rewards to the policyholder.

To the extent that effective mutual competition has influenced the adoption of cost reduction, loss prevention, or other improvements by stock companies, the mutual operation has benefited the entire insuring public.

Because of the modern trend and the public demand for package policies and multiple-line writing, the financial needs of mutual companies have become greater to support that type of insurance. It is respectfully submitted that no tax law should place any segment of the insurance business under a handicap in conforming to a pattern growing out of public demand.

The differences we have outlined between these two types of organization are basic and do require and justify separate tax treatment. The present method of taxing these basically different types of insurance organizations has remained unchanged for almost two decades. During all of that rather long period, there has developed no conclusive evidence that any segment of the casualty business has suffered because of this dual system of taxation. The present tax provisions have worked out well and with as little inequity as could be found in any tax plan. There is no reason to believe, in the light of all the circumstances, that some other plan would be more equitable than the present one. We therefore urge you to oppose H.R. 7671 and H.R. 7672. Thank you very much for having given this your consideration. Respectfully submitted.

EMANUEL MORGENBESSER, of Counsel.

The CHAIRMAN. Our next subject actually is cooperatives and our first witness on that subject is our esteemed colleague from Tennessee, the Honorable Clifford Davis.

Mr. Davis, we appreciate having you with us this morning to help us with all the many problems we have before us, and, sir, you are recognized.

STATEMENT OF HON. CLIFFORD DAVIS, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TENNESSEE

Mr. DAVIS. Thank you, Mr. Chairman, and gentlemen of the committee. As some of you will recall, I have had a bill to tax the earnings of cooperative corporations since the memory of man runneth not to the contrary. Putting it a little different way, I think it is almost as old as the bill introduced by my distinguished friend and leader from New York, Mr. Keogh, so that should let you know of my long interest, but I can assure you, gentlemen, that I am very grateful to you for your courtesy in hearing me and I promise that by the clock I will not require more than 5 minutes.

Substantial earnings from commercial activity of co-op corporations are not being currently taxed. Equitable taxation of these earnings is of concern to the Federal Government, and to every income taxpayer, and is of special concern to the co-ops, their patrons and their competitors in the marketplace.

Of particular importance in the South are our primary cotton industries-ginning, compressing, warehousing, shipping, marketing, cottonseed crushing, etc. Limits on cotton production have necessarily curtailed all these operations with the possible exception of warehousing, and of course, there has not been any soil bank or other offsetting advantages asked by or granted to these cotton industries.

It has been repeatedly asserted and I have heard no real denial that the present disparity in tax treatment of cooperative corporations as contrasted with that of the remaining segments of the cotton industry, has been most serious. Tax revenues have progressively declined, as more and more of the fully taxed segment find the competitive situation impossible, and give up the struggle to the loss of both the cotton industries and the families involved.

I presume that Mr. Reed, who, I notice, is scheduled to follow me as a witness will point out the growth in cartelization of the cotton industries which is occurring in some sections where there are interrelated cooperative corporations some owning the others and controlling cotton from the seed to the textile mill.

He tells me that this expansion is basically financed by retained taxfree earnings, which even aside from revenue loss is a compelling reason to equalize the tax rules in the interest of fair play and competitive enterprise.

I noticed in the Congressional Record of May 10 an account of a midwest super-co-op owned by 850 cooperatives. It reported making a million dollars worth of improvements on an oil refinery, construction of a $5 million pipeline, increasing authorized capital stock to over $100 million, expanding operations to 14 plants providing prescription mix fertilizers and paying off after 11 years $1.6 million of its 1950's patronage paper. Nothing was said about its income tax, if any.

I heartily concur with the statement in the President's tax message repecting co-op earnings that:

This situation must be corrected in a manner that is fair and just both to the cooperative and to competing business.

My bill does that.

Suppose we now turn to the farmer members of the co-op. Insofar as I know, the fundamental reason for granting tax concessions to co-ops is the theory that this is essentially providing aid to the farmer.

I noticed in the President's message a recognition of the plight of the farmer who receives co-op scrip as a patronage dividend. Under the regulations before they were changed to conform to the court decisions holding that no market value scrip was not income, the farmer was required to pay taxes just as if he had received the face amount of scrip in cash.

I understand the Treasury has recommended that what was in the regulations should be now put in the statute. The Treasury seems to feel that the courts will then reverse themselves and say that no market value scrip is income. Anyhow, the Treasury recommends a 20-percent withholding (in cash not in scrip) and the application of the amount withheld by the farmer toward payment of his tax.

I believe that my bill does better for the farmer than does this proposal.

I should particularly like to call the committee's attention to the fact that neither under present law, nor under the Treasury's proposal, do so-called city consumer cooperatives or their patrons pay any tax on the city consumer cooperatives allocated earnings. Nor does the Treasury bill affect this situation. The city consumer co-op would not even be subject to withholding.

Could the President have meant this to be overlooked, when he said that

substantial income from certain cooperative enterprises either to the cooperative

* is not being taxed or its members. This situation must be corrected in a manner that is fair and just both to the cooperative and to competing business.

, My bill is simple in principle. Like Mr. Mason's bill, it subjects all co-ops' net earnings to income taxes-it permits no tax avoidance through deduction or exclusion of either patronage dividends or ordinary dividends. This is fair to the co-op and its competitor. Both are treated alike.

The second part of my bill, frankly, provides a special tax advantage to farmer patrons of genuine farmer co-ops. It follows the general description of these co-ops in existing law.

Here is the way it works. The co-op will send the recipient of its patronage or other dividend a statement of the tax it paid-for example, suppose the co-op's income tax is at the minimum 30-percent rate. If the farmer's dividend is, say $70, this would mean $100 earnings with a $30 tax. So the farmer would report $100 earnings in figuring his income taxes. But after figuring his taxes he would then deduct the $30 the co-op had paid.

I hope this committee will consider my bill and I earnestly invite your consideration of its basic principles:

(1) Full taxation of all co-op earnings at the corporate level. (2) Adjustment of the income tax to the farmer member level by way of a tax credit if and to the extent the co-op distributes its earnings to the member and the member includes it in his tax return.

I have never discussed this proposal with any farmer member of a co-op who did not approve it when he understood it, nor with any business competitor of a co-op who did not feel that it would promote fair competition in the market place, nor with any tax expert who questioned its feasibility or constitutionality.