Guidelines for Bank-Owned Life Insurance

Summary
Banks have long provided benefits to their officers and executives in the same way that other businesses offer benefits to their key employees. However, because banks are a highly regulated business, there are a number of unique issues that must be considered. In particular, this paper focuses on guidelines issued by the Officer of the Comptroller of the Currency (OCC). The paper then discusses guidelines the other bank regulatory agencies have in place and how these affect benefit programs.

Introduction
Over the past few years, many of the nation's largest financial institutions have, combined, purchased several billion dollars of BOLI as a means of generating the cash flow needed to fund benefit liabilities. A BOLI program can create significant assets and earnings gains that can closely match the emerging liabilities. BOLI is a highly stable, low-risk source of financing that can offer net annual after-tax returns which are generally higher than traditional bank investments.

In a BOLI program, a bank purchases life insurance policies on the lives of its executives. The bank pays the premiums, owns the cash value, and is the designated beneficiary. BOLI can be structured in a number of ways, depending on whether it is designed to be primarily a "cost-recovery" vehicle or to provide the periodic funding wherewithal to make benefit payments as they become due. An increasingly popular approach in cost-recovery financing is a single premium policy. In some respects, it is similar to the investment banks made in municipal bonds before limitations were instituted — the policies earn generally higher rates, and the interest accumulation is not taxable.

A bank can purchase BOLI to finance employee benefit expenses. The assets need not be segregated or contractually tied to such purposes. Essentially, the assets provide a P&L offset to the costs or accruals for such benefits. When insurance proceeds are realized, the cash can be used to recover the bank's benefit costs.

The OCC has issued updated guidelines that dramatically change the way in which BOLI is used. In general, these changes make BOLI even more attractive as a funding mechanism. The OCC only regulates nationally chartered banks. Other banks are regulated by a number of other organizations and, in certain situations, there may be overlapping regulatory oversight. In addition to discussing the changes established by the OCC, this paper will also discuss changes the other banking regulatory bodies have made.

Historical Background

Banking Circular 249
In 1991, the OCC issued Banking Circular 249 (BC 249), which set out strict guidelines regarding the amounts of life insurance banks could own in given situations. The Circular dealt with BOLI for key persons, coverage on borrowers for loan protection, and insurance funded employee benefits.

At the heart of BC 249 was the principle that the OCC did not view BOLI as improper. It was concerned, however, that in the 1980s a number of banks improperly invested their assets. Where insurance was concerned, the OCC wanted insurance to be owned for its death benefit protection. It did not want to see insurance used primarily for investment purposes. The guidelines of BC 249 were designed to limit bank ownership of insurance to a bank's risk exposure.

Where the bank had a need for insurance on a key person or for loan protection, it was relatively easy to quantify the amount of death benefit. Banks were allowed to own insurance to protect them from loss. However, BC 249 set strict rules regarding termination of the policies when an insured individual retired or was no longer considered a key person. Similarly, when a loan or benefit program supported by an insurance policy was terminated, the insurance policy was also required to be cancelled.

In benefit programs, the amount of risk exposure was often less definable. In particular, BC 249 established a calculation known as "Test B." This was a present value test intended to quantify the amount of appropriate insurance protection. Under Test B, a bank was required to compare, using reasonable actuarial benefits and financial assumptions, the present value of projected cash flows and death benefits from the insurance against the costs of benefits. These costs included administration and insurance premiums related to the program. Under Test B, the two amounts were expected to be reasonably close to each other.

Test B was a difficult calculation to apply. The present value nature of the test often made it best suited for cost recovery of non-qualified, unfunded retirement plans and deferred compensation arrangements. There were many unresolved issues, including questions about what was considered reasonable for financial assumptions. There were questions about whether it was appropriate to aggregate policies and then run the calculations as a group, as is often the practice with BOLI programs. There were ongoing questions with "equity split-dollar" insurance arrangements. Issues specific to split-dollar are discussed in more detail later in this paper. Additionally, Test B also raised a number of issues related to appropriate insurance costs. It appeared that the full amount of the premium for permanent insurance was not always appropriate. The OCC did indicate that the mortality cost loads and "other charges" could be used in the calculations. Not only was this test unclear, it was also difficult to determine these costs in many traditional policies.

OCC Bulletin No. 96-51
At least in part, these open questions caused the OCC to reconsider the present value test of BC 249. As early as mid-1995, the OCC informally indicated it was considering new standards. These new standards were finally announced on September 20, 1996 in OCC Bulletin No. 96-51. These new standards removed the rigid, but quantifiable, rules of BC 249 and replaced them with a list of items that had to be considered by the banks as a minimum performance of their due diligence.

Bulletin 96-51 set forth standards not unlike those that should be undertaken by any business entity in analyzing its insurance needs. The standards were less quantifiable and allowed for more flexibility. Along with the new guidelines, the OCC also issued a detailed memorandum explaining the various types of life insurance available, to help bank examiners better understand the types of life insurance they might encounter.

The OCC principles regarding insurance, however, had not changed. The use of insurance was still related to underlying risks. Insurance still was viewed as inappropriate as an investment, but the OCC indicated that it could be purchased where it was necessary to carry on banking functions. These included, but were not limited to, key person insurance, life insurance on borrowers, employee benefits, and as security for loans. If the OCC determined that a bank had excessive insurance, or insurance that was inappropriately purchased, it had the right to take supervisory action. Bulletin 96-51 indicated that this could include requiring the bank to surrender or partially surrender policies.

The list of items set forth in Bulletin 96-51 that had to be considered included:

• a determination by the bank of the need for insurance
• quantification of the amount of insurance needed
• review of the reputation and qualifications of the vendors being considered
• review of the performance, experience and reputation of the insurance carriers
• analysis of the benefits of COLI and of the products being considered
• review of the reasonableness of the benefits being contemplated in light of the covered executive's total compensation package
• analysis of the bank's ability to monitor and respond to risks associated with insurance, and
• an evaluation of the alternatives to insurance

Finally, the Bulletin reiterated the need to document the bank's analysis and to continually revisit (monitor) this analysis.

OCC Bulletin 2000-23
On July 20, 2000, the Controller issued OCC Bulletin 2000-23, providing general guidelines for national banks purchasing life insurance, and rescinding OCC Bulletin 96-51. Bulletin 2000-23 states that "Life insurance is a financial instrument which serves many necessary and useful business purposes."

The Bulletin states that the authority for national banks to purchase and hold life insurance is found in 12 USC 24(Seventh), which provides that national banks may exercise "all such incidental powers as shall be necessary to carry on the business of banking." Purchases of life insurance that the OCC has found to be incidental to banking include key-person insurance, insurance on borrowers, insurance purchased in connection with employee compensation and benefit plans, and insurance taken as security for loans.

Pre-purchase analysis
The Bulletin states that the safe and sound use of bank owned life insurance depends on effective senior management and board oversight. The board's role in analyzing and overseeing bank-owned life insurance should be commensurate with the size, complexity and risk inherent in the transaction. Although the board may delegate decision-making authority to management, the board remains responsible for ensuring that purchases of life insurance are consistent with safe and sound banking practices.

The objective of the pre-purchase analysis is to help ensure that the bank understands the risks, rewards and unique characteristics of COLI. At a minimum, the Bulletin requires that the following ten standards should be considered:

1. Determination of the need for insurance
   The bank should determine the need for insurance by identifying the specific risk of loss or obligation to be insured against. However, the purchase of insurance to indemnify a bank against a specific risk does not relieve a bank from other responsibilities relating to that risk. For example, the purchase of key-person life insurance does not replace or diminish the need for adequate management or succession planning.
2. Quantification of the amount of insurance needed
   The bank should estimate the size of the obligation or risk and make sure that the insurance purchased is not excessive. Banks may include the cost of insurance and the time value of money in making their estimate. Where life insurance is purchased on the lives of a group of employees or borrowers, the bank can estimate the size of the obligation or risk on an aggregate basis and compare that to the aggregate amount of insurance purchased.

   Banks are cautioned that purchasing or holding excessive insurance may be an unsafe and unsound banking practice if it subjects the bank to an unwarranted risk.

3. Vendor selection
   The Bulletin states that the vast majority of COLI purchases are made through vendors, either brokers/consultants or agents.

   The role of a vendor depends on the type of vendor selected. The vendor may be an agent of a specific insurance company, or may be an independent broker who has working relationships with many insurers. A broker will work with the bank in selecting a carrier and in designing, negotiating, administering and servicing the COLI.

   In deciding what kind of vendor to use, or whether to use a vendor, the bank should consider its knowledge of COLI, the resources it can and is willing to spend servicing and administering the COLI and the benefits a vendor will provide. Depending on the role of the vendor, the vendor's services may be extensive and critical to the successful implementation and operation of a COLI plan.

   If the bank uses a vendor, the bank should satisfy itself that the vendor has the ability to honor its commitments, which may be long term. The bank should review the vendor's services, general reputation, experience and financial capability. The nature of the review should depend on the size and complexity of the planned COLI purchase.

4. Carrier selection
   The Bulletin states that COLI plans typically are of long duration and carrier selection is one of the most critical steps in a COLI purchase. The bank should review the product design, pricing and administrative services offered by the carrier and compare them to the bank's needs. In addition, the bank should review the carrier's financial ratings, general reputation, experience in the marketplace and past performance. A broker or consultant may assist the bank in this review.

   The bank also should perform a credit analysis on the selected carrier in a manner consistent with safe and sound banking practices for commercial lending. This is more completely discussed in the "credit risk" section of this Article.

5. Review the characteristics of the available insurance products
   There are a few basic types of life insurance products in the marketplace. However, the Bulletin noted that they could be combined and modified in different ways, so that the final product can be quite complex. The bank should review the characteristics of the various insurance products available and select a product that matches the institution's objectives and needs.

   In an Appendix to the Bulletin, the OCC has included an extensive discussion of various insurance products, including permanent and term insurance, and whole life, universal life, general account and variable and separate account products. The Appendix also includes a discussion of life insurance as a financing or cost recovery vehicle for benefits plans and a discussion of split-dollar insurance arrangements.

   When purchasing key-person insurance, the bank should consider whether the bank's need for the insurance will end before the insured individual dies. In such cases, term or decreasing term may be the most appropriate form of life insurance.

6. Analyze the benefits of COLI
   The bank's analysis of the benefits of COLI should include an assessment of how the purchase will accomplish the objective specified in "Determination of the need for insurance," above. This analysis should include the anticipated performance of the insurance. A more complete discussion of this item is included in the "Transaction Risk" section later in this Article.
7. Determine the reasonableness of compensation provided to the insured employee if the insurance results in additional compensation
   Split-dollar insurance arrangements typically provide additional compensation and/or other benefits to the employee. Before entering into such an arrangement, a bank should identify and quantify the compensation objective and ensure that the proposed arrangement is consistent with that objective. The bank should ensure that the employee's total proposed compensation is not excessive. Excessive compensation is prohibited as an unsafe and unsound practice.
8. Analyze the associated risks and the bank's ability to monitor and respond to those risks
   Ownership of COLI may subject a bank to several risks, including: transaction, credit, interest rate, liquidity, compliance and price. A bank's pre-purchase analysis should include a thorough evaluation of these risks. An explanation of these risks is included later in this Article.

   Further, the Bulletin states that the pre-purchase analysis should determine whether the transaction is consistent with safe and sound banking practice. The bank should consider, among other things:
   

   • The complexity of the transaction
   • The size of the transaction relative to the bank's capital
   • The diversification of the credit risk
   • The financial capacity of the bank
   • The financial capacity of the insurance carrier(s)
   • The bank's ability to identify, measure, monitor and control the associated risks
   In assessing size, the bank should consider the Cash Surrender Value (CSV) relative to capital levels at time of purchase, as well as increases in CSV and projected changes in capital for the duration of the contract.
9. Evaluate alternatives
   Regardless of the purpose of COLI, a bank should evaluate alternatives, such as self-insuring against the risk or generating funds through investments rather than purchase of insurance.
10. Document decision
    The primary purpose of the OCC Bulletin is to provide guidelines that help national banks make informed decisions consistent with safe and sound banking practices. After completing the pre-purchase analysis discussed above, a bank should maintain adequate documentation to show that the bank made an informed decision. The bank should continue to monitor that decision based on the standards set forth in Bulletin 2000-23.

Risks associated with COLI
The Bulletin also includes a discussion of the risks associated with COLI. "Risk" is defined as the potential that events, expected or unanticipated, may have an adverse impact on the bank's capital or earnings.

The Bulletin identifies six risks associated with COLI, as follows:

1. Transaction
2. Credit
3. Interest rate
4. Liquidity
5. Compliance
6. Price

Foreign exchange, strategic and reputation are other risks that affect banks but are not deemed present in the purchase of COLI.

1. Transaction risk
   This is the risk to earnings or capital arising from problems with service or product delivery and is deemed a function of a bank not fully understanding or properly implementing a transaction.

   In addition to following the other guidelines contained in the Bulletin, OCC 2000-23 states that a bank should take two additional steps to help reduce transaction risk. Bank management should have a thorough understanding of how the insurance product works and the variables that affect the product's performance. These variables include the policy's interest crediting rate, mortality cost and other expense charges. Before purchasing COLI, a bank should analyze projected policy values (CSV and death benefits) from multiple illustrations provided by the carrier.

   Bank management also should understand and analyze how COLI will affect the bank's financial condition, including the effect on earnings, capital and liquidity. Management should consider the impact on earnings and capital if the bank were to surrender the policies before the death of the insured.

2. Credit risk
   This is the risk arising from an obligor's failure to meet the term of its contract with the bank or otherwise failing to perform as agreed. All life insurance policyholders are exposed to credit risk and the credit quality of the insurer and length of the contract are key variables. Credit risk is a function of the carrier's ability and willingness to pay death benefits as agreed.

   A bank's credit exposure on term insurance is based on the carrier's obligation to pay death benefits on the death of the insured. The risk on term insurance is not reflected on the bank's balance sheet.

   With permanent insurance, the credit risk arises from the insurer's obligation to pay death benefits on the death of the insured and its obligation to return the CSV to the policyholder on request. This risk is reflected on the bank's balance sheet.

   Before purchasing life insurance, management should evaluate the financial condition of the insurance company and continue to monitor its condition on an ongoing basis. In addition to reviewing the carrier's ratings, the bank should conduct an analysis consistent with safe and sound banking practices for commercial lending, with due regard to the relative size and complexity of the transaction.

3. Interest rate risk
   This is the risk to earnings or capital from movements in interest rates.

   General account products expose the bank to interest rate risk as a function of the policy's interest crediting rate, which is established by the insurance carrier. Interest crediting rates, over the long term, are principally a function of the carrier's investment portfolio performance. The policy's CSV grows at a slower rate if the interest-crediting rate declines. Since a bank records its investment in permanent insurance at the policy's CSV, a bank's earnings will decline as the policy's interest crediting rate declines.

   Before purchasing permanent insurance, a bank should:
   

   • Review the policy's performance over past business cycles
   • Analyze projected policy values (CSV and death benefits)
   • Consider having the carrier use a different interest crediting rate for different policy projections
   Variable or separate account products also may expose the bank to interest rate risk. If the separate account consists of Treasury securities, the bank is exposed to interest rate risk in the same way as if it held Treasury securities directly in its own portfolio. However, it is more difficult to control this risk since the bank does not control the separate account assets.

   Therefore, before purchasing a separate account product, bank management must thoroughly review and understand the investment policy and management of the separate account and make sure that it is appropriate for the bank. Also, the bank should establish reporting and monitoring systems that will allow the bank to monitor and respond to price fluctuations.

4. Liquidity risk
   Liquidity risk is the risk to earnings or capital arising from an inability to meet the bank's obligations when they become due, without incurring unacceptable losses. The Bulletin states that life insurance policies are not marketable and are illiquid and no secondary market for policies exists. Although the CSV of policies may be accessed, the Bulletin concludes that such action typically involves substantial loss. This lack of liquidity is more significant in that banks normally convert liquid assets (cash or marketable securities) in order to purchase life insurance.

   The Bulletin states that management should recognize the illiquid nature of insurance and make sure that the bank has sufficient flexibility to hold this asset in the manner contemplated.

5. Compliance risk
   Compliance risk is the risk arising from violations to or failure to conform with laws, rules, regulations, prescribed practices or ethical standards. Such failure could compromise the success of a COLI program and result in significant losses to the bank because of fines, penalties or loss of tax benefits. Tax benefits may be critical to the success of COLI plans, so management should ensure that its plans comply with tax laws. In addition, management should ensure that its plans comply with other legal and regulatory requirements, such as state insurable interest rules, ERISA, Regulation O and the Guidelines Establishing Standards for Safety and Soundness. Due to the significance of the compliance risk, a bank may wish to seek the advice of qualified counsel.
6. Price risk
   This is the risk to earnings or capital arising from changes in the value of portfolios of financial instruments. Typically, the policyholder of a separate account product (i.e., variable life insurance) assumes all price risk associated with the investments within the separate account, as the carrier guarantees neither the CSV nor the interest-crediting rate. The level of price risk depends upon the assets held within the separate Account.

   Since the bank does not control the separate account assets, it is more difficult for the bank to control price risk. Therefore, the Bulletin provides that before purchasing such a product, bank management should thoroughly review and understand the instruments governing the investment policy and management of the separate account. Management should understand the inherent risk and ensure that it is appropriate for the bank. Also, the bank should establish systems that will allow it to monitor and respond to price fluctuations.

   The Bulletin states that banks may purchase separate account insurance products that hold equity securities. Such purchases are permissible where they hedge the bank's obligation under employee compensation and benefit plans. The Bulletin gives as an example a bank's obligation that is measured by a stock market index and the separate account containing a stock mutual fund that mirrors the performance of that index. The Bulletin cautions that if the insurance cannot be characterized as an effective hedging transaction, the presence of equity securities in a separate account is impermissible.

In addition to the general considerations discussed above, when purchasing a separate account product involving equity securities, a bank should:

• Analyze the bank liability being hedged and the equity securities being held as a hedge in the separate account. This analysis should document the correlation between the liability and the securities, expected return for the securities (including standard deviation of returns) and current and projected asset and liability balances.
• Determine a target hedge effectiveness ratio and establish a method for measuring the effectiveness of the hedge. Establish a process for changing the program if the hedge is not effective and consider the cost of program changes.
• Establish a process for analyzing and reporting the effect of the hedge on the bank's income statement and capital ratios. The analysis usually shows results with and without the hedging transaction.

Accounting considerations
The Bulletin states that banks should follow generally accepted accounting principles (GAAP) for financial reporting and Call Report purposes. Financial Accounting Standards Board (FASB) Technical Bulletin 85-4, "Accounting for Financial Purchases of Life Insurance" (TB85-4) discusses accounting for investments in life insurance and generally is appropriate for all forms of COLI.

Under TB 85-4, a bank should report its interest in COLI as an "other asset." The increase in the CSV would be reported as "other non-interest income." In accordance with Call Report requirements, the bank should update its interest in the CSV at least quarterly.

Application of Bulletin 2000-23
The guidelines in OCC Bulletin 2000-23 are applicable to all purchases of life insurance by banks after the date of the bulletin (July 20, 2000). Purchases of life insurance before that date are evaluated as follows:

1. Purchases after February 4, 1991 should comply with either BC-249 or OCC 2000-23
2. Purchases before February 4, 1991 are provided a safe harbor and no further action is required if the following conditions are met:
   
   • The policies are convenient or useful in connection with the bank's business
   • The policies do not threaten the safety and soundness of the institution, and
   • The policies do not represent insider abuse or violate other laws, rules, or regulations

Miscellaneous Points
It is a bank's responsibility to provide documentation with respect to its purchase of life insurance. Although a vendor can help prepare the documentation, the bank needs to have the information in its records for any examiner to see. NYLEX Benefits prepares this documentation as an integral part of its design and implementation process.

If, after an examination, a bank disagrees with an examiner's determination, there is an appeals process available. The bank could file an appeal with the Deputy Comptroller for the bank's district. Or the bank could appeal to the OCC Ombudsman, who reports directly to the Comptroller of the Currency and is responsible for handling a wide range of issues.

Banks are limited in the amount of BOLI they can purchase by Federal and state regulations and insurance company limits. OCC Bulletin 95-7 establishes a guideline for concentration of credit at 25% of Tier I Capital (plus allowance for loan and lease losses), with no more than 15% with any one carrier. The 25% guideline includes commercial loans to insurance carriers. With the average of single premium BOLI purchases in the range of $50 million, the capacity of the insurance industry to absorb this business is limited. Because of the strain on capital created by reserve requirements associated with general account products, there are only a handful of carriers who have the capital capacity and the desire to underwrite this business.

Other Regulatory Agencies
The OCC is responsible only for nationally chartered banks. There are a number of other regulatory bodies, all of which have overlapping authority, including:

The Federal Depository Insurance Corporation (FDIC)
The regulatory body with the broadest reach is the FDIC, which has widespread regulatory authority as the insurer of all depository institutions. The FDIC has primary authority over all state-chartered banks (as opposed to nationally chartered banks) that have chosen not to join the Federal Reserve System. These are called "state non-member banks" due to their nonmember status with the Federal Reserve.

The FDIC has certain supervisory authority over all other state-chartered banks through its powers to insure deposits. This includes issues related to the purchase of life insurance. This stems from the powers given to the FDIC in the late 1980s and early 1990s. Although some of the FDIC's powers date back to the time it was created in the 1930s, some of the banking issues that arose during the 1980s caused Congress to expand the powers of the FDIC. It always could exercise a certain level of control simply by refusing to insure a bank's deposits. The FDIC now has the ability to issue cease and desist orders if it believes a bank's practices will either place the insurance fund at risk or if the bank will fail to meet its minimum capital requirements.

The Federal Reserve and Office of Thrift Supervision
The Federal Reserve has its own regulatory oversight. It is the primary regulator of state banks who have elected to become members of the Federal Reserve System (state member banks), as well as all bank holding companies. There is no FDIC oversight of bank holding companies, as these organizations do not take client deposits.

The FDIC has regulatory authority over state member banks due to its congressionally granted powers. This allows the FDIC to regulate purchases of insurance if it believes a bank has violated the FDIC guidelines detailed below. The Office of Thrift Supervision (OTS) is responsible for thrifts and savings and loans. Originally the Federal Savings and Loan Corporation (FSLIC) controlled these organizations. As a result of the banking problems in the 1980s, FSLIC became financially unstable and its authority was split. General oversight authority was given to a new organization, the OTS, and deposit insurance was taken over by the FDIC, which insures these banks under a separate insurance fund.

Conclusion
The changes offered by the OCC Bulletin 2000-23 generally are welcome. The standards have been updated and there is a clear recognition that in appropriate situations life insurance separate accounts can hold equity securities. Meaningful analysis is required before a bank buys life insurance and documentation of the reasons for buying insurance is essential. NYLEX Benefits is uniquely well equipped to provide administrative support services to help a bank document its purchase of insurance.

About NYLEX Benefits
NYL Executive Benefits ("NYLEX Benefits") provides supplemental executive benefit programs to a wide range of commercial clients. We focus on developing cost effective executive benefit solutions that are designed to attract, reward and retain key employees.

Our services are designed to assist clients at all stages in the adoption and operation of executive benefit programs and include:

• Initial assessment
• Plan design
• Funding
• Plan implementation
• Ongoing administration

NYLEX Benefits' professional staff includes the following professional disciplines, all dedicated to supporting our client's programs, processes, systems and services:

• Accountants
• Actuaries
• Attorneys
• Benefit specialists
• Insurance specialists

We take great care to assure that client programs are practical and cost effective and that they are designed to achieve our clients' strategic and operational goals.

NYLEX Benefits
301 Tresser Boulevard, Suite 1200
Stamford, CT 06901
(203) 353-5800
FAX: (203) 353-5844

This article is for informational purposes only and is not intended as legal, accounting or tax advice. Clients should consult with their own professional advisors as to how this material may apply to their own specific circumstances.
BOLI Guidelines (00249417 4-03)

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