Regulators Issue Statement on Bank-Owned Life Insurance

by Joe B. Jones, Steven J. Terbovich & John M. Charnes

Introduction

In December 2004, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision (OTS) jointly issued OCC Bulletin 2004-56, an inter-agency statement on the purchase and risk management of life insurance. The agencies recognize that bank-owned life insurance (BOLI) can be used effectively to recover costs associated with providing employee benefits. However, the agencies are concerned that some institutions have invested a significant amount of capital in BOLI without undertaking a thorough analysis of the risks, and without gaining a complete understanding of the implications of owning certain BOLI products. The new statement, which supersedes OCC Bulletin 2000-23, specifically addresses the use of separate-account BOLI products and alerts bank management to significant issues raised by purchase of separate-account BOLI.

Separate-account BOLI earns for the bank cash surrender value that is supported by assets in an account that is segregated from the general assets of the insurance carrier. With separate-account BOLI, the bank does not own the underlying separate account and does not control the selection or timing of investments in the account that the carrier creates on the bank's behalf. However, the bank assumes all investment and price risk borne by the separate account.

A previous directive, OCC Bulletin 95-7, defines a concentration of credit as a bank holding direct, indirect, or contingent obligations in an amount exceeding 25 percent of the bank's Tier 1 capital plus the Allowance for Loan and Lease Losses. For an institution that plans to acquire BOLI in excess of the 25 percent threshold, the agencies expect bank management to take two specific actions: (1) conduct an analysis to support that such acquisitions do not give rise to an imprudent capital concentration; and (2) obtain approval from the institution's board of directors or a designated board committee prior to the acquisition. On a case-by-case basis, the OCC may require that a national bank exceeding the capital concentration guidelines submit a special report explaining why the bank believes its capital concentration in BOLI is prudent and is not unsafe or unsound.

Risk Analysis and Management

National bank examiners who investigate BOLI programs will consider the extent to which risks are identified, measured, monitored and controlled by bank management. OCC is interested particularly in the effectiveness of the pre-purchase analysis, and the appropriateness of internal limits for individual and aggregate BOLI policy cash surrender values (CSV). The investigators will evaluate whether or not such limits appropriately address liquidity, reputation, and compliance risks.

The 28-page statement, which is available at www.occ.treas.gov/ftp/bulletin/2004-56.doc, provides guidance on the legal authority of national banks and federal savings associations to purchase and hold certain types of life insurance as necessary to carry on the business of banking or exercise powers granted under the Home Owners' Loan Act. National banks and federal savings associations may purchase life insurance in connection with employee compensation and benefit plans, and insurance to recover the cost of providing pre- and post-retirement employee benefits, among other reasons delineated in the statement. It also provides guidance on accounting considerations, supervisory issues, risk management of BOLI, and risk-based capital treatment.

The agencies include a description of nine specific management actions that should be incorporated into an effective pre-purchase risk analysis of several factors related to BOLI products:

Interest rate risk, which is the possibility of loss of earnings and capital as a result of adverse movements in interest rates. General account products bear interest rate risk associated with the assets in the carrier's general account, which usually consists of investments that are less volatile than those held in separate accounts. Bank management should be especially careful to compare the volatilities of separate account interest-crediting rates with the volatility of the rate of a general account product.
Price Risk, which is the possibility of loss of earnings and capital due to changes in the value of portfolios of financial instruments. The owners of general account contracts can use a cost-plus-accrued-earnings accounting method. Separate account products without stable value protection (SVP) contracts use for accounting purposes the fair value of the assets held in the separate account, so the price risk is highly dependent on the type of assets held. SVP contracts are designed to reduce volatility in reported earnings, but provide no economic benefits unless the policy is surrendered. Ownership of BOLI is most advantageous when it is bought and held until benefit payment, so the purchase of a SVP contract for a separate account life insurance product essentially provides only accounting benefits with no economic benefit.
Liquidity risk, which is the possibility of loss of earnings and capital by an institution unable to meet its obligations when they come due without incurring unacceptable losses. The preferred strategy of buying BOLI and holding until benefit payment means that banks should be sure that they have the long-term financial flexibility to hold the policies in accordance with their expected use. Many separate account products contain language stating that a policyholder can only "crawl out" of the product without incurring penalties, which increases liquidity risk.
Credit risk, which is the possibility of loss of earnings and capital because the carrier failed to meet the terms of the insurance policy or otherwise did not perform as agreed. BOLI products are to be held for relatively long periods of time (e.g., 30 or 40 years), so the credit quality of the insurance carrier is crucial. Obviously, the more highly rated the carrier, the lower the credit risk for general account products. Separate account BOLI products with SVP present an additional source of credit risk. If a third party provides the stable value protection, the credit quality of that provider must also be evaluated.
Reputation risk, which is the possibility of loss of earnings and capital resulting from negative publicity about any of an institution's business practices. Arguably, the purchase of BOLI may bear more reputation risk than some other banking practices because of the potential negative reaction to a bank owing or benefiting from life insurance on some of its employees. Bank management's obtaining explicit informed consent from each covered employee in writing can reduce the reputation risk associated with BOLI. Disclosing the business reasons for and benefits to all employees from the holding of BOLI policies will help to obtain consent and mitigate reputation risk.
Regulatory risk, which is the possibility of loss of earnings and capital arising from potential legislative changes in the tax treatment of future BOLI cash flows. A change in the tax code to make cash flows from BOLI taxable seems unlikely given that legislators have chosen not to change BOLI tax status even after intense scrutiny in recent years. However, such a change would have a negative economic impact. Also, banks should be aware that BOLI earnings might subject them to alternative minimum tax. Owners of separate account products may have greater incentive to exercise influence over the investments in the separate account, but doing so can compel the Internal Revenue Service to characterize the separate account product as an actively managed investment that is subject to income tax.
Transaction/operational risk, which is the possibility of loss of earnings and capital due to the institution's failure to understand or implement the appropriate BOLI product. General account BOLI products are varied and complex due to their accounting and tax treatments. However, they are contracts involving only two parties: the bank and the insurance carrier. Separate account BOLI products may increase transaction/operational risk because of the additional negotiable features they entail: investment options; terms, conditions, and cost of SVP; and mortality options. These more complicated transactions require more effort on the part of the bank to deal with the added tax and accounting issues and take on the additional transaction/operational risk.
Compliance/legal risk, which is the possibility of loss of earnings and capital stemming from violations of, or nonconformance with, laws, rulings, regulations, prescribed practices, or ethical standards. Both general account and separate account BOLI products require a thorough understanding of tax laws and banking regulations by bank management to mitigate compliance/legal risk. Separate account BOLI policy owners must be extra careful to ensure that they are not perceived by regulators as taking control of the separate account assets, especially when they are the only policyholder associated with the separate account.

Bank-Owned Life Insurance

Life insurance is regulated primarily by the states. Under most state laws there are two regulatory regimes for permanent (including BOLI) contracts: universal life and traditional. Most BOLI programs, regardless of contract type selected, are designed with a single premium.

Universal Life Contracts

Universal life is structured as a series of transactions. There is no required relationship between the premium and the amount of insurance, although for most BOLI the death benefit is set equal to the minimum needed to qualify as life insurance under the Internal Revenue Code. The premium, less premium-based loads, becomes the initial cash value. Each month, charges for the carrier's expenses and the cost of insurance are deducted from the cash value. The cash value is increased based upon the investment return of the chosen (general or separate) account. The contract will continue in-force, as long the cash value is sufficient to pay the monthly charges. If a policy is in danger of lapsing due to insufficient cash value, there is a period, usually 60 days, during which additional premium can be paid to keep the policy in force.

Because of the transactional nature of universal life, each charge or credit must be explicitly defined in order for the contract to function. Each charge or credit will have a current level and a guaranteed level. One example could be the interest-crediting rate is currently 5%, but guaranteed never to fall below 3%. A second example could be the current monthly administrative expense charge may be $8, but guaranteed never to exceed $10.

There is no set of defined charges a carrier must make to cover its costs. Therefore, each carrier tends to structure its charges somewhat differently. In addition, unless there is a specific limitation in the contract (or in the prospectus/offering memorandum for separate account products), carriers may recover costs in one area from a different charge apparently unrelated by its name. An example of this is a carrier which chooses to recover a portion of its administrative expenses by increasing the cost of insurance charge. A second example is a carrier which chooses to recover a portion of distribution costs as a reduction in the interest rate credited.

Since each carrier recovers costs differently and generally all charges can be increased within contractual guarantees to reflect changes in the carrier's costs in any area, it is usually of little value to compare individual charges between carriers. More important is the net effect of all credits less charges. For a selected premium, a BOLI universal life illustration will show the death benefits and cash values under both current assumptions and guaranteed charges and credits. There are no regulatory required minimum cash values for universal life. Under many universal life BOLI illustrations being shown today, the guaranteed cash value eventually begins declining until it reaches zero sometime before age 100, at which time the guaranteed death benefit becomes zero.

Traditional Contracts

As was discussed above, universal life guarantees are a function of the premium paid and the level of charges assessed over time. In contrast, traditional participating single premium contracts have explicit guarantees. There is a defined relationship between the amount of the premium and the policy's initial death benefit. Once the premium is paid, this amount of insurance is guaranteed for the lifetime of the insured. There is also a schedule of guaranteed cash values defined for each and every year. This schedule increases until it is equal to the initial death benefit at the policy anniversary that is nearest age 100 of the insured. The premium is determined using a relatively conservative set of assumptions for interest, mortality, and expenses. The guaranteed cash values must meet minimums determined by state-mandated mortality and interest assumptions as well as a state-mandated formula.

Each year after issue, if actual experience is better than the assumptions made in setting the guarantees, the amount not needed to cover expenses, mortality and the increase in the guaranteed cash value is returned to the policy owner through a dividend. Dividends are earned at the policy anniversary. Dividends are not guaranteed. However, if dividends are paid and used to buy paid-up additions, the paid-up additions will have their own guaranteed death benefit and schedule of increasing guaranteed cash values. Due to this structure of guaranteed values and dividends, traditional policies do not have a set of explicit charges and credits that can be split out in way comparable to universal life.

Comparing Expenses

All insurance carriers must cover the same basic set of costs: premium tax, distribution, underwriting and issue, administration, increase in reserves, death claims, etc. In addition, stock carriers must cover a cost that mutual carriers do not: dividends to stockholders. As discussed above, because carriers have considerable latitude in how they recover these costs, any comparison of individual charges can be misleading. However, a comparison of the total charges is most important, as the carrier that does the best job on the fundamentals of investment return, expense control and careful underwriting will be in the strongest position to provide the greatest long-term value.

On a universal life policy it is possible to reconcile the change in cash values within a policy year. Starting with the beginning of year cash value, mortality and expense charges are subtracted and interest credits are added to arrive at the end of year cash value. Some carriers do not assume future improvements in mortality or expenses on their illustrations. When comparing carriers' illustrations, BOLI purchasers should determine whether future improvements are assumed for mortality and expenses, and adjust their comparisons accordingly.

Conclusion

Figures 1 and 2 indicate that 3,384 commercial and savings banks in the U.S. held BOLI policies that totaled $65.8 billion in CSV on September 30, 2004. These figures have been rising steadily over the past few years. This rise, along with increased scrutiny by regulators, bears witness to the efficacy of BOLI for financing employee benefits. The OCC 2004-56 Interagency Statement on the Purchase and Risk Management of Life Insurance provides bank managers with a great overview of the risk analysis and management proce
ses that they should undertake when selecting a BOLI product and carrier. These policies and procedures should be in writing and available for inspection when the regulators visit.

Figure 1. Source: Federal Reserve Bank of Philadelphia

Figure 2. Source: Federal Reserve Bank of Philadelphia.

Joe B. Jones and Steven J. Terbovich are Principals with Executive Benefit Network, a bank compensation consulting firm in Lawrence, KS 66049. John M. Charnes is Professor in the University of Kansas School of Business, 345 Summerfield Hall, Lawrence, Kansas 66045. The authors gratefully acknowledge the assistance of Cynthia L. Course, Senior Financial Specialist at the Federal Reserve Bank of Philadelphia, in obtaining the data depicted in Figures 1 and 2.

First published on BankersOnline.com 1/12/05