I. INTRODUCTION
On December 7, 2004, the federal banking agencies, comprised of the OCC, FRB, FDIC and OTS, issued the first formal statement, entitled the Interagency Statement on the Purchase and Risk Management of Life Insurance (“Statement”), regarding bank-owned life insurance (“BOLI”). The Statement may be referred to as FIL-127-2004 (or OCC Bulletin 2004-56, TB 84 or SR 04-19). While the statement notes that BOLI may be a “useful product to recover costs associated with providing employee benefits” and “serve a number of appropriate business purposes,” the federal banking agencies are providing guidance on the safe and sound banking practices that they expect institutions to employ for the purchase and ongoing risk management of bank-owned life insurance. The banking agencies also emphasize increased due diligence from financial institutions that utilize BOLI products.
The Statement also gives guidance for split-dollar arrangements and the use of life insurance as security for loans. The regulators emphasize the need for both senior management and the board of directors of financial institutions to exercise oversight of BOLI as a safe and sound banking practice, which would include a thorough pre-purchase analysis of risks and rewards and post-purchase risk assessment. The Statement covers the permissibility of BOLI purchases and holdings, as well as inherent risks and their associated safety and soundness considerations. The Statement has an Appendix that describes the types of life insurance and the purposes for which financial institutions commonly purchase life insurance. The Appendix also contains a glossary of BOLI-related terms.
The Statement regarding the pre-purchase analysis of life insurance applies to all BOLI contracts entered into after December 7, 2004, however the Statement’s guidelines regarding ongoing risk management of BOLI subsequent to its purchase applies to all holdings of life insurance no matter when such product was purchased.
II. DEFINITIONS AND GENERAL GUIDELINES
There are a variety of reasons why financial institutions purchase life insurance, e.g., recovering the cost of providing employee benefits; protecting against the loss of “key persons.” There are two broad types of life insurance: temporary (term) insurance and permanent insurance. Temporary (term) insurance gives protection for a specified time period, the premiums do not have a savings component and the contract does not create a cash surrender value (CSV). The purpose of permanent insurance is to provide life insurance protection for the entire life of the insured; the premium structure includes a savings component, which creates a CSV. If permanent insurance is surrendered prior to the death of the insured, then surrender charges may be assessed against the CSV.
Since the ability of FDIC-supervised institutions to purchase life insurance is governed by state law and some state laws permit state-chartered banks to engage in activities (including making investments) that go beyond the authority of a national bank, § 24 of the Federal Deposit Insurance Act generally requires FDIC-supervised institutions to obtain the FDIC’s consent prior to engaging as principal in activities that are not permissible for a national bank. NOTE: Nebraska law recognizes the authority of state-chartered financial institutions to invest in BOLI. III. INTERNAL POLICIES AND PROCEDURES – AGGREGATE VALUES
The Statement advises that a financial institution should establish internal policies and procedures governing its BOLI holdings. These policies and procedures should include guidelines that set a limit on the aggregate CSV of policies from any one insurance company and set an aggregate limit upon the CSV of policies from all insurance companies. The Statement warns that “it is generally not prudent for an institution to hold BOLI with an aggregate CSV that exceeds 25 percent of its Tier 1 capital.” Thus, banking regulators expect that a financial institution that plans to acquire BOLI in an amount that results in an aggregate CSV in excess of this concentration limit or any lower internal limit, obtain prior approval from its board of directors or the appropriate board committee. If such concentration of assets does arise, the regulatory agencies expect that senior management will be able to justify that any increase in BOLI resulting in an aggregate CSV above 25 percent of Tier 1 capital does not constitute an imprudent capital concentration.
IV. PRE-PURCHASE ANALYSIS
An institution’s senior management is expected to conduct a thorough pre-purchase analysis, which will assist in ensuring that an institution understands the risks, rewards and unique characteristics of BOLI. The nature and extent of a pre-purchase analysis should, in the words of the Statement, “be commensurate with the size and complexity of the potential BOLI purchases and should also take into account existing BOLI holdings.”
In order to assist financial institution management in developing an effective pre-purchase analysis, the Statement suggests that such an analysis involve the following listed nine actions by management:
V. RISK ASSESSMENT AND ACCOUNTING
The regulatory agencies expect that each financial institution have a comprehensive risk management process for purchasing and BOLI. A comprehensive assessment of BOLI risks, on an ongoing basis, is an integral element of the risk management process, particularly when an institution’s aggregate BOLI holdings represent a capital concentration. Management should review the performance of the institution’s insurance assets on at least an annual basis with its board of directors. The Statement suggests at least ten elements that should be a part of this review, including risks assessment, death benefits, mortality performance and impact on income and peer analysis of BOLI holdings.
BOLI risks should be assessed, managed, monitored and controlled. The assessment, management, monitoring and control of BOLI risks would include liquidity, transaction/operational (including tax and insurable interest implications), reputation, credit, interest rate, compliance/legal and price risk. Each one of the above-stated risks are present in permanent insurance, e.g., the CSV of permanent life insurance is one of the least liquid assets on an institution’s balance sheet. By comparison, temporary (term) insurance does not expose an institution to liquidity, interest rate or price risk since it does not contain a CSV feature. In this regard, such risks would not need to be evaluated in the comprehensive assessment of the risks of temporary (term) insurance.
Reputation risk, according to the Statement, involves the risk to earnings and capital that may come from the negative perception of a financial institution owning or benefiting from life insurance on employees. To control reputation risk, the Statement advises that an institution seek and document informed consent prior to the purchase of BOLI and to monitor the amount of insurance that is purchased on any one person.
Compliance and legal risks address the issue of commission sharing with bank agencies, e.g., should a vendor splits its commission with a financial institution’s affiliated insurance agency that was not involved in the transaction, the action may violate state laws that prohibit inducements or rebates.
The Statement advises that financial institutions should follow generally accepted accounting principles (GAAP) applicable to holdings of life insurance for reporting purposes. Under GAAP, only the amount that could be realized under an insurance contract as of the balance sheet date (i.e., the CSV reported to the financial institution by the insurance carrier, less any applicable surrender charges not reflected by the insurance carrier in the reported CSV) is reported as an asset.
For the purposes of risk-based capital, a financial institution that owns general account permanent insurance should apply a 100 percent risk weight to its claim on the insurance company. If an institution owns a separate account policy and can demonstrate that it meets certain requirements, it may choose to apply a “look-through” approach to the underlying assets to determine the risk weight. In no case may the risk weight for the separate account policy (excluding any general account and stable value protection portions, which generally receive a 100 percent risk weight) be less than 20 percent.
Some financial institutions have a BOLI insurance portfolio consisting of several policies, each of which has its own surrender charge and there are some insurance carriers that have issued a rider providing that the carrier will waive the surrender charges if all such policies are surrendered simultaneously. The Financial Accounting Standards Board’s Statement No. 5, Accounting for Contingencies, provides that such riders are to be disregarded and that each policy must be reported on an institution’s balance sheet at the policy’s CSV. Therefore, the above-described rider is no longer allowed.
VI. VENDOR QUALIFICATIONS
The selection of vendors is covered by the Statement. A financial institution should evaluate the adequacy of a vendor’s services, reputation, experience, financial soundness and commitment to BOLI products offered. Important considerations when selecting a vendor include the vendor’s ability to provide audited financial statements or other demonstration of financial soundness that can be document, the ability to support risk management for the purpose of annual board reviews, the ability to provide quality BOLI administration, availability of continuing support and counseling and the ability to understand tax, accounting and regulatory implications.
VII. CONCLUSION
The banking regulators Statement on BOLI may be summarized as follows: