New guidelines require proper due diligence
For banks wishing to purchase insurance products, recent regulatory issuances have made it an opportune time to do so. The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. issued regulatory releases last year which would enable a bank to more readily use life insurance as a means to protect itself against certain risks.
WHAT REGULATIONS SAID
On Sept. 20, 1996, OCC issued Bulletin 96-51 ("Guidelines"), which replaces Banking Circular 249 ("BC 249") as guidelines for national banks to follow in purchasing life insurance. The guidelines are expected to provide for more flexibility for banks in structuring a bank-owned life insurance ("BOLI") program. The guidelines define the parameters of permissible investments in insurance broadly, permitting a wide ]latitude for interpretations.
Similarly, on Aug. 13, 1996, FDIC proposed amendments to Part 362 ("Proposed Rule") of its regulations regarding activities and investments of insured state banks. The proposed rule would simplify the approval process for insured nonmember state banks to purchase insurance products that do not comply with OCC's regulations, but adhere to certain conditions. An insured state bank would need only to notify (not seek approval from) the FDIC that the bank intended to implement a program that did not meet the OCC's guidelines for national banks.
Although always present as a supervisory requirement, the recent trend among the federal bank regulatory agencies is to stress the need for banks to perform a due-diligence or pre-purchase analysis of the various risks associated with insurance prior to purchasing the product. Specifically, the guidelines state that bank management and the board of directors should consider six risks which could have an adverse impact on the bank's capital or earnings as a result of purchasing insurance. These risks are: transaction, credit, interest rate, liquidity, compliance, and price.
INITIAL DUE DILIGENCE
Some of the initial issues in a due diligence review of bank-owned life insurance involve management's determination of the bank's need for the purchase of BOLI, and the amount of insurance required. More specifically, the board or delegatee should do the following:
1. Establish the purpose for which the bank is purchasing the product. Under the new OCC guidelines, a national bank continues to be required to establish that the purchase of insurance is incidental to the business of banking. Therefore, a national bank will need to identify the obligations and risks for which the bank is purchasing insurance and determine that such purpose is incidental to banking.
OCC has historically permitted banks to purchase insurance for the following reasons: key-person insurance, life insurance on borrowers, life insurance purchased in connection with employee compensation and benefit plans, and life insurance taken as security for loans. The guidelines state that permissible uses of BOLI exist beyond those traditional purposes. Obviously, the more novel the purpose for purchasing the BOLI, the more analysis that is necessary to determine that the purchase is safe and sound. If the BOLI product is of first impression, the national bank should obtain an opinion of competent counsel that the BOLI complies with the "incidental to banking" requirement.
Insured state banks will not be limited by the "incidental to banking" requirement if FDIC's proposed rule is adopted. Further, even if the proposal is not adopted (or until it is), an insured state bank can apply for approval from FDIC to purchase insurance products that do not meet OCC standards.
2. Determine the amount of BOLI to purchase. OCC guidelines require a national bank to establish internal quantitative limits on the purchase of BOLI, considering the bank's lending limit (15% of the bank's capital and surplus per insurer) and concentration of credit guidelines (25% of the bank's capital).
Under the proposed rule, insured state banks could be permitted to purchase insurance in amounts well above OCC's limits. The proposed rule limits a bank's direct and indirect investment in annuity contracts and life insurance policies to no greater than 50% of the bank's tier capital from all insurance companies and to 15% for policies purchased from a single insurance company. Other amount limitations regarding the purchase of policies that do not conform to OCC's guidelines are also set forth in FDIC's proposed rule.
3. Life insurance to fund benefit plans. The OCC guidelines contain specific discussions on a bank's purchase of life insurance for "traditional" purposes. The guidelines expressly permit banks to use life insurance as a financing or cost recovery vehicle for employee benefits. The guidelines eliminate the Test B requirement of old Banking Circular 249, the predecessor to the guidelines, and set forth general rules for both financing and cost recovery methods of funding employee benefit plans through life insurance. The cost recovery method requires a present-value analysis, in which the bank projects the dollar amounts of the expected benefits owed to employees and determines the present value of those benefits. The difference between the present value of the life insurance proceeds and the present value of the premium payments is used to reimburse the bank for employee benefit plan payments. For the financing method, the bank must project the annual employee benefit expense associated with the benefit plan and purchase life insurance such that the cash surrender value of the policy offsets such benefit expense.
4. The bank should hire its own experts to assist with the pre-purchase analysis. Many of the issues raised in connection with the purchase of BOLI are complicated and technical. Accounting, bank regulatory, tax, and state insurable interest issues are just a few of the considerations management will need to contend with in purchasing BOLI. The experts should be independent of the insurance carrier(s) being considered.
CHOOSING A BROKER
For banks with little or no experience in the purchase of BOLI, an experienced broker can provide valuable assistance to the bank in making difficult decisions regarding the purchase of insurance.
A bank may use its general corporate procedures for hiring professionals, provided such procedures meet the safety and soundness requirements applicable given the level of risk and size of the investment of the BOLI. When hiring a broker, the bank should typically review the broker's services, general reputation, experience, and financial capacity. The nature and thoroughness of the review should be determined by- the size and complexity of the proposed BOLI purchase. Documentation recording the selection process and the due diligence performed should be retained by the bank.
CHOOSING A CARRIER
The selection of the carriers is one of the most important parts of the due-diligence process because of the long duration and other risks associated with the purchase of insurance. Initially, the bank should investigate the carrier's ratings from at least two of the national credit rating services. An insurance company that is not ranked investment grade will most likely be considered an unsafe investment for a bank. For insured state banks wishing to take advantage of the streamlined notice process, FDIC's proposed rule specifically requires as a condition that the insurance companies be rated in the top two rating categories by a nationally recognized rating service.
In addition to the carrier's credit rating, the bank should independently assess the carrier's financial strength, including adequate surplus, quality of assets, liquidity, earnings, and stability of management. Further, the bank should investigate the insurance companies' use of different policy terms and each company's reputation in the industry for abiding by its contractual obligations.
SELECTING THE RIGHT PRODUCT
To determine which life insurance product is suitable for its needs, a bank should familiarize itself with the different types of insurance products available. The purchase of BOLI may require the bank to assume one or more of the six risks identified in the section that follows. The bank should compare the results of risk analyses for several products and then document the findings.
The bank will also need to analyze the benefits of BOLI, including an assessment of how the purchase will accomplish the bank's objectives. In addition, the bank should review the anticipated performance of the BOLI product, including considerations such as cash flows, income tax reporting, and surrender penalties. As a bank performs its pre-purchase analysis of the different aspects of BOLI, the bank should compare the effectiveness of BOLI in insuring against the risks specified in comparison to other available means of insuring against such risk or obligations. If possible, the bank should run its own analysis of the BOLI product or hire professionals to assist it in analyzing the insurance.
ANALYZING THE RISKS OF BOLI
The OCC's 96-51 guidelines refer banks to the "six risks" which banks should be prepared to manage. Below, we have listed those risks and recommend certain general actions for the bank's board of directors and management to take in complying with the guidelines' due-diligence requirements.
Transaction Risk--defined as the risk to earnings or capital arising from problems with service or product delivery. To reduce transaction risk, banks should have a thorough understanding of how the insurance product works and the variables that dictate the product's performance, such as interest crediting rate, mortality cost, and other expense charges. As with many of the due diligence requirements, the fact-finding responsibilities can be assigned to outside experts. Board or management committee members should have an opportunity to ask questions and request additional information of those experts. The bank should follow existing investment and lending guidelines in determining whether prior board approval is required for the purchase of BOLI. Detailed minutes should be kept of the board or management committee meeting discussing BOLI for regulatory review.
Credit Risk--the risk to earnings or capital arising from a obligor's failure to meet the terms of a contract. The credit risk associated with BOLI will vary depending upon the type of policy purchased. Before a bank purchases BOLI, the OCC guidelines recommend that management evaluate the financial condition of the insurance company and continue to monitor its condition on an ongoing basis. Further, the guidelines recommend that the bank review the insurance carrier's rating, as well as conduct an independent industry, and company analysis.
We recommend that the bank establish an underwriting policy for BOLI based on the bank's commercial loan underwriting standards and investment policy standards.
Interest Rate Risk--the risk to earnings or capital arising from movements in interests rates. Interest rate risk varies for general and separate account policies. As a practical matter, banks have virtually no control over interest rate risk in general account policies, and not much more for separate accounts. Notwithstanding, banks are expected to fully understand the risks associated with the policy by reviewing the policy's past performance over various business cycles and to take whatever steps are available to moderate that risk. Certainly, a bank should not invest in a BOLI product if the pre-purchase analysis indicates that the bank will be required to assume extreme interest rate risk.
Liquidity Risk--the risk to earnings or capital arising from a bank's inability to meet its obligations when they come due without incurring unacceptable losses. Life insurance policies are typically illiquid as there is no secondary market for them. Further, even if cash surrender values can be accessed quickly, surrender charges, tax penalties and taxes on gains may require substantial costs for such access. Therefore, liquidity risk should be a concern to bank management.
Banks should recognize the illiquid nature of the investment and ensure that they have the long-term flexibility to deal with the illiquid asset. This would include the bank analyzing its current liquidity ratios and the projected liquidity ratios following the purchase of BOLI. Only if those ratios are within the bank's regulatory requirements should the bank purchase BOLI.
Compliance Risk--the risk to earnings and capital arising from violations of, or non-conformance with laws, rules and regulations. National banks must comply with the 96-51 guidelines, as well as other applicable banking laws. Banks should consult their legal advisors to determine whether their BOLI program complies. The necessity for this consultation is greater if a bank wishes to purchase innovative BOLI products or if the purposes identified for the BOLI are untested. In addition, the bank should ensure that the BOLI program complies with state insurable interests laws, tax laws, and Employee Retirement Income Security Act (relating to certain employee benefit plans) to the extent that they are impacted by the nature of the BOLI products and their purposes.
Price Risk--the risk to earnings or capital from changes in the value of portfolios of financial instruments. Similar to interest rate risk, banks are unable to control the risks associated with changes in the value of portfolios or financial instruments. Nevertheless, banks are charged with the responsibility of understanding the price risks associated with different insurance products and determining that those risks are appropriate for the bank to assume.
As a practical matter, one of the most important actions a bank can take to comply with the OCC guidelines is to completely and accurately document the pre-purchase analysis performed by the bank. Without satisfactory, records, a bank would be in a difficult position in attempting to illustrate to its regulatory examiner that the appropriate due diligence was performed.
BOLI basics and life insurance generally
Bank-owned life insurance or "BOLI," its well-known acronym, has gained popularity among financial institutions in recent years as a means of safely and profitably investing large sums of money for the long-term. The traditional BOLI product is structured so that the financial institution buys a policy insuring the lives of its employees (usually officers and senior managerial level employees).
Permanent life insurance, the more typical type of insurance used for BOLI products, provides life insurance protection for the entire life of the insured employee. In addition, permanent insurance has a cash buildup in the policy, which may be accessed for other uses, depending upon the terms of the policy and the tax consequences of such usage.
The types of permanent life insurance include whole life, which usually involves the payment of fixed premiums over the life of the insured, and universal life, which is often viewed as providing more flexibility with respect to the premium payments and death benefit protection.
Temporary or term insurance provides life insurance protection for a specified time period, and benefits are paid only if the insured employee dies during such period. Term insurance does not usually involve a cash surrender value component, and therefore is a less popular cost offset mechanism for financial institutions.
A bank purchasing BOLI would also have a choice as to whether its insurance would be in the form of a separate or general account. General account policies are a part of the general assets of the insurance company. The assets of variable or separate account policies, conversely, are segregated from the general asset structure of the insurance carrier.
The main article is dedicated to providing banks with a brief overview of the necessary due diligence to be performed before a bank purchases BOLI.
By Brian W. Smith and Wendy L. Morris, partner and associate, respectively, with Mayer, Brown & Platt, a Washington, D.C.,-based law firm.…