(5) Losses incurred (A) In general The term “losses incurred” means losses incurred during the taxable year on insurance contracts computed as follows: (i) To losses paid during the taxable year, deduct salvage and reinsurance recovered during the taxable year. (ii) To the result so obtained, add all unpaid losses on life insurance contracts plus all discounted unpaid losses (as defined in section 846) outstanding at the end of the taxable year and deduct all unpaid losses on life insurance contracts plus all discounted unpaid losses outstanding at the end of the preceding taxable year. (iii) To the results so obtained, add estimated salvage and reinsurance recoverable as of the end of the preceding taxable year and deduct estimated salvage and reinsurance recoverable as of the end of the taxable year. The amount of estimated salvage recoverable shall be determined on a discounted basis in accordance with procedures established by the Secretary. (B) Reduction of deduction The amount which would (but for this subparagraph) be taken into account under subparagraph (A) shall be reduced by an amount equal to the applicable percentage of the sum of— (i) tax-exempt interest received or accrued during such taxable year, (ii) the aggregate amount of deductions provided by sections 243 and 245 for— (I) dividends (other than 100 percent dividends) received during the taxable year, and (II) 100 percent dividends received during the taxable year to the extent attributable (directly or indirectly) to prorated amounts, and (iii) the increase for the taxable year in policy cash values (within the meaning of section 805(a)(4)(F)) of life insurance policies and annuity and endowment contracts to which section 264(f) applies. In the case of a 100 percent dividend paid by an insurance company, the portion attributable to prorated amounts shall be determined under subparagraph (E)(ii). For purposes of this subparagraph, the applicable percentage is 5.25 percent divided by the highest rate in effect under section 11(b). (C) Exception for investments made before August 8, 1986 (i) In general Except as provided in clause (ii), subparagraph (B) shall not apply to any dividend or interest received or accrued on any stock or obligation acquired before August 8, 1986 . (ii) Special rule for 100 percent dividends For purposes of clause (i), the portion of any 100 percent dividend which is attributable to prorated amounts shall be treated as received with respect to stock acquired on the later of— (I) the date the payor acquired the stock or obligation to which the prorated amounts are attributable, or (II) the 1st day on which the payor and payee were members of the same affiliated group (as defined in section 243(b)(2) ). (D) Definitions For purposes of this paragraph— (i) Prorated amounts The term “prorated amounts” means tax-exempt interest and dividends with respect to which a deduction is allowable under section 243 or 245 (other than 100 percent dividends). (ii) 100 percent dividend (I) In general The term “100 percent dividend” means any dividend if the percentage used for purposes of determining the deduction allowable under section 243 or 245(b) is 100 percent. (II) Certain dividends received by foreign corporations A dividend received by a foreign corporation from a domestic corporation which would be a 100 percent dividend if section 1504(b)(3) did not apply for purposes of applying section 243(b)(2) shall be treated as a 100 percent dividend. (E) Special rules for dividends subject to proration at subsidiary level (i) In general In the case of any 100 percent dividend paid to an insurance company to which this part applies by any insurance company, the amount of the decrease in the deductions of the payee company by reason of the portion of such dividend attributable to prorated amounts shall be reduced (but not below zero) by the amount of the decrease in the deductions (or increase in income) of the payor company attributable to the application of this section or section 805(a)(4)(A) to such amounts. (ii) Portion of dividend attributable to prorated amounts For purposes of this subparagraph, in determining the portion of any dividend attributable to prorated amounts— (I) any dividend by the paying corporation shall be treated as paid first out of earnings and profits attributable to prorated amounts (to the extent thereof), and (II) by determining the portion of earnings and profits so attributable without any reduction for the tax imposed by this chapter.