What the Bank Should Have Done

January 6, 2003
TO THE CHIEF EXECUTIVE OFFICER OF THE INSTITUTION ADDRESSED:
The purpose of this guidance letter is to clarify the New York State Banking Department’s (the “Department’s”) position on Bank Owned Life Insurance (“BOLI”) programs. This letter also provides general guidance to enhance management oversight of these programs.
Background
BOLI includes all life insurance that a bank owns or has a beneficial interest in. The Department has previously opined that State chartered banks and thrift institutions may invest in BOLI under their “incidental powers,” as set forth in Sections 96(1), 234(1), 234(23) and 383(14) of the Banking Law, as the case may be. A purchase of life insurance must address a legitimate need of the bank for insurance. Purchases of life insurance that have been found to be incidental to banking include insurance taken as 1) security for loans, 2) insurance on borrowers, 3) key-person insurance, and 4) insurance purchased in connection with employee compensation and benefit plans. In general, the purchase of insurance coverage must meet a business need to fall within authorized activities. Life insurance may not be purchased to generate funds for the bank’s normal operating expenses (except in connection with employee compensation and benefit plans), for speculation, or for the primary purpose of providing estate-planning benefits for bank insiders unless it is a part of a reasonable compensation package.
Management Oversight
The safe and sound use of BOLI is dependent upon effective oversight by the board of directors and senior management. The board must understand how BOLI fits into the overall business strategy of the bank. This begins with a comprehensive and documented pre-purchase analysis by the board of directors and senior management which, at a minimum, includes the following considerations:
Determination of the need for insurance
Quantification of the amount of insurance needed
Vendor selection (if a vendor is used)
Carrier selection
Review of available insurance products
Analysis of BOLI benefits
Reasonableness of benefits provided to insured employees (if BOLI results in additional compensation)
Analysis of associated risks and the ability to monitor and manage them.
Evaluation of BOLI alternatives
Documentation of the decision to institute a BOLI program
The use of insurance should be explicitly evaluated in comparison to non-insurance alternatives such as loan reserving, cash compensation, succession planning and ongoing benefit plan expensing. Moreover, non-insurance alternatives should be quantified. Most often a combination of insurance and non-insurance risk management strategies will be optimal.
Besides consideration of non-insurance alternatives, the impact of a BOLI program on capital should also be included. A unique feature of some BOLI programs is that assets (Cash Surrender Value – “CSV”) will accumulate over long periods of time with few anticipated reductions (death benefit payments). For risk-based capital weighting, CSV is assigned a risk weighting of 100%.
The surrender of insurance before maturity (the death of the insured) could result in a loss in value or the imposition of early termination penalties. In addition, the early termination of an entire BOLI program could have an adverse effect on the financial condition of an institution, with significant impact upon its capital position. Purchases of life insurance should be accounted for in accordance with Generally Accepted Accounting Principles, i.e. FASB Technical Bulletin No. 85-4 “Accounting for Purchases of Life Insurance.”
Risk Management of a BOLI Program: Policies, Practices and Procedures
Basic risk management for any BOLI program should minimally include: a) a written statement of business purpose approved by the board of directors; b) quantification of need; c) identification of risks and benefits; d) establishment of authorization and approvals appropriate for the complexity of the program; and, e) requirement for periodic program evaluation. Risks associated with BOLI must not only be assessed at the inception of the program, but continually over the program’s life. Since the risks associated with BOLI can impact the institution’s earnings, capital and liquidity, a BOLI program should be reviewed and assessed by management at least on an annual basis.
This annual review should include analysis provided by external consultants and an independent internal comparison of the risks and returns. The due diligence supporting the purchase and ownership of BOLI should have unique elements tailored to the specific type of insurance coverage. BOLI provides death protection and investment returns. The more comprehensive assessments include an evaluation under a range of assumptions including stress scenarios. The evaluation should identify the most critical variables (investment returns, taxes and interest rates) and extend beyond estimating the cost of insurance to estimates of earnings stability and net worth growth.
Investment results under BOLI contemplate substantial tax benefits arising from interim deferral of taxes on investment income held within the policy and the absence of taxation upon payment of the death benefit. To achieve intended investment results the institution must comply with tax and insurance rules regarding business purpose, insurable interest and lack of investment control. Most often, investment returns will be sub-par without tax considerations. As such, these compliance factors are critical and warrant use of outside legal and tax counsel.
Under some insurance programs, New York State insurance regulations require that employees approve the purchase of life insurance at initiation of coverage and have a notification and terminate right when they leave employment. Procedures that standardize notification and documentation should exist to ensure compliance with these insurance requirements and other applicable laws and regulations. Failure to comply could jeopardize the tax benefits associated with the insurance.
In addition, when BOLI is part of a management compensation program, documentation should support the absolute and relative appropriateness of the amounts, and should be reported to the board of directors or a designated committee thereof. The transfer of economic value (cash surrender value and death benefits) to management is a particularly sensitive matter and should be disclosed to shareholders.
Compliance and “appropriateness” are key factors that help ensure a BOLI program does not adversely affect an institution’s reputation. Programs should be transparent to shareholders and employees, and be simple to explain. Benefits should cover a broad rather than limited group, with the insured group matching as closely as possible the beneficiary group.
Monitoring
Besides the evaluation of compliance, reputational and legal risks, credit and liquidity risks need to be considered. For credit risk, the institution should perform a credit analysis on selected carriers consistent with safe and sound banking practices for commercial lending. Although CSV does not fall within the definition of a credit exposure, it should be added to other extensions of credit (loans, etc.) to determine the aggregate exposure to a single insurance company.
Concentrations
Concentrations need to be assessed. A concentration is considered to exist when more than 25% of an institution’s total capital is at risk in one industry or group of related entities. Each institution should carefully evaluate its overall investment in life insurance (CSV) to determine an appropriate aggregate level. Institutions should not automatically assume that a concentration level as high as 25% is justified.
Individual Limitations
CSV may be supported by the general assets (general account) or segregated assets (separate account) of an insurance company. In order to provide effective security, a separate account must satisfy the following three conditions: 1) availability of a legal opinion providing support that the insurance obligation is, in fact, a separate account; 2) availability of a legal opinion confirming that relevant state insurance law provides policyholders with a preference to separate account assets; and, 3) the presence of a recent valuation establishing that the separate account assets equal or exceed the related separate account policy liabilities.
It is the Department's position that a maximum of 15% of total capital is appropriate as a single exposure limit to any one insurance company when the CSV is held in a general account. CSV due from any one insurance company may equal, but not exceed, 25% of total capital provided that the amount in excess of 15% of capital is fully supported by assets (based on market value) held in a separate account.
If a bank's BOLI program currently exceeds these recommended limitations, the bank is expected to develop and present to the Department a plan outlining the steps to be taken to bring the program within these guidelines.
Restrictions
Banks may purchase separate account insurance products that hold equity securities only for the purpose of hedging their obligations under employee compensation and benefit plans (i.e. where the amount of a deferred compensation obligation is measured by the value of a stock market index). Documentation must support the designation and effectiveness of the hedge. At a minimum, this includes: analyzing the correlation between the liability and the equity securities; analyzing the expected returns for the securities and current and projected asset and liability balances; measuring hedge effectiveness and establishing a target hedge effectiveness ratio; and, analyzing and reporting the effect of the hedge on the bank’s income statement and capital ratios.
If the insurance cannot be characterized as an effective hedging transaction, the presence of equity securities in a separate account would not be permitted. The holding of a bank’s own stock is not permissible under any circumstance.
It should be noted that under recently passed Sarbanes-Oxley legislation, some types of split dollar life insurance are potentially prohibited. Institutions should check with their legal and tax advisors to determine if modifications to their plans are necessary.
Regulatory Oversight
Department examiners, as part of their overall supervisory examinations, will review an institution’s BOLI program. Examiners will focus on reviewing: a) written policies and procedures approved by the board of directors; b) periodic risk assessment of the program; c) compliance with applicable New York State Insurance Department rules; d) compliance with Department guidelines regarding concentrations to an individual insurance company or in aggregate insurance products; and, e) transparency of disclosure of executive compensation utilizing the BOLI program.
Questions concerning the topics discussed in this letter should be directed to:
Mr. James SchmidbauerSupervising Risk Management SpecialistDivision of Market RegulationNew York State Banking DepartmentOne State StreetNew York, New York 10004-1417Telephone: (212) 709-1539Facsimile: (212) 709-1634E-mail address: James.Schmidbauer@banking.state.ny.us
Very truly yours,
Elizabeth McCaulSuperintendent of Banks
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