The Purchase and Risk Management of Insurance Company Owned Life Insurance (ICOLI) September 16, 2016

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1 The Purchase and Risk Management of Insurance Company Owned Life Insurance (ICOLI) September 16, 2016 IASA Metro NY/NJ & Mid-Atlantic Chapters Fall 2016 Education Conference Atlantic City, NJ MMB Consulting, LLC Miles Hopkins, CPA A. Gregory Finkell, JD 3901 Westerre Parkway; Suite 300 Richmond, VA (804) Copyright 2016 by MMB Consulting, LLC, All Rights Reserved

2 John H. Milne, JD, LLM John H. Milne received his B.A. degree from Virginia Tech in 1970 and his law degree from the University of Richmond in He received his Master of Laws in Taxation in 1979 from Georgetown University. John is a member of the Virginia and Tennessee Bar Associations. He is a former member of the Closely-Held Business (Vice-Chairman) and the Employee Benefits Committees of the Tax Section of the American Bar Association and the Corporate Counsel Section of the Business Law Section of the American Bar Association. He has served as Chairman of both the Tax Section of the Virginia State Bar and the Virginia Bar Association. John is located in the Richmond, Virginia office. Miles J. Hopkins, CPA Miles graduated from Virginia Tech in 2005 with a Bachelor of Science in Accounting and Information Systems. He is a licensed Certified Public Accountant (CPA) in South Carolina. Previously, Miles worked as a consultant in the financial services and insurance industries and as an auditor with Johnson Lambert LLP, a premier insurance focused audit and tax services firm. Miles serves on the Board of Directors of the Carolinas Chapter of the Insurance Accounting and Systems Association (IASA). He is an active member of the American Institute of Certified Public Accountants and the South Carolina Association of Certified Public Accountants. Miles is located in the Charleston, South Carolina office. A. Gregory Finkell, JD Gregg is a former corporate attorney and served as an associate in the Banking and Credit practice group of Simpson Thacher & Bartlett LLP in New York. He is a member of the Central Virginia Estate Planning Council and is a past member of the New York State and American Bar Associations. Previously, Gregg was a financial analyst at a boutique real estate valuation firm in New York, where he evaluated income-producing real estate portfolios in connection with bank financing and underwriting due diligence. He received his B.A. from Colgate University and his J.D., magna cum laude, from Brooklyn Law School, where he was the Notes and Comments Editor of the Brooklyn Law Review. Gregg is located in the West Hartford, CT office. 2

3 About MMB Milne Leone, LLC Designs, services, and administers Executive Benefit, BOLI and ICOLI Plans Clients range in size from under $50 million to over $300 billion in assets Service over $1.7 Billion of cash value with 18 different carriers Approved Service Providers for Northwestern Mutual and Other Top Rated Mutual Companies Recent Speaking Engagements Federal Regulators FFIEC, Capital Markets Conference, Arlington, VA The OCC, Washington, DC Insurance Institute for the Federal Reserve, Boston, MA Regional Office FDIC, Roanoke, VA State Regulators Arkansas State Bank Department Examiners Conference, Little Rock, AR Conference of State Bank Supervisors Annual Meeting and Conference, San Antonio, TX Indiana Department of Financial Institutions Staff Conference, Bloomington, IN Maryland Chapter-Society of Financial Examiners (SOFE), Towson, MD Massachusetts Division of Banking, Boston, MA North Carolina Office of the Commissioner of Banks, Raleigh, NC Virginia Bureau of Financial Institutions, Richmond, VA Professional Associations Tax Section, American Bar Association in Washington, DC, Boston, MA and Orlando, FL The Finance & Accounting Forum-Financial Managers Society, Phoenix, AZ Financial Managers Society, National Webinar BDOSeidman, LLP - Financial Institutions Industry Webex Bank Financial Managers Forum in Bonita Springs, FL State Banking Associations Massachusetts Bankers Association, The New England Conference, Rockport, ME North Carolina Bankers Association, Pinehurst, NC VA Bankers Association, Glen Allen, VA West Virginia Bankers Association, Charleston, WV 3

4 Disclaimers All Examples are Hypothetical and Not Indicative of a Specific Investment or Asset Purchase. The Policies Referenced Contain Both Guaranteed and Nonguaranteed Life Insurance Values. Non-guaranteed Life Insurance Values Can Change. Actual Results May Be More or Less Favorable. The Information Presented is Not a Legal, Tax or Accounting Opinion. Individuals Should Seek Advice Based Upon their Own Individual Circumstances. The Content is Based Upon Current Tax Laws. 4

5 MMB Consulting, LLC TABLE OF CONTENTS I. WHAT IS BOLI/ICOLI? II. III. WHY DO FINANCIAL INSTITUTIONS & INSURANCE COMPANIES PURCHASE BOLI /ICOLI? THE REGULATORY ENVIRONMENT. IV. THE TYPES OF BOLI/ICOLI PRODUCTS. V. INDUSTRY STATISTICS: BANKS. VI. VII. INDUSTRY STATISTICS: INSURANCE COMPANIES. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK. 5

6 I. WHAT IS BOLI & ICOLI? Overview: A Specially Designed Insurance Contract (Some May Be Negotiated) Single Premium Funded Financial Institution is Owner and Beneficiary of Policy Insures Group of Officers and/or Directors Simplified Underwriting or Guaranteed Issue 6

7 I. WHAT IS BOLI & ICOLI? (Continued) Regulatory: Bank Permitted under Interagency Guidelines (OCC ) Must be Funded from an Investment Business Purpose of the Investment is to Offset Employee Benefit Costs Regulatory Guideline is 25% of Tier 1 Capital in Aggregate and 15% Single Carrier Document the Pre Purchase Review of Risks and Rewards Transaction Risk Credit Risk Interest Rate Risk Liquidity Risk Compliance/Legal Risk Price Risk Reputation Risk 7

8 I. WHAT IS BOLI & ICOLI? (Continued) Regulatory: Insurance Generally No Specific Regulations S&P Limits ICOLI to 25% of Insurer s Total Capital & Adjusted Surplus 10% Limit for Aggregate Exposure to Single Entity 8

9 I. WHAT IS BOLI & ICOLI? (Continued) Accounting: Beginning Value is Equal to Single Premium Paid Low or No-Loads or Surrender Charges Some IRC Exchange Limits Increase in Cash Value is Tax Deferred Income Death Benefits are Tax-Free Accounting is Pursuant to FASB Technical Bulletin 85-4 General Account Products-No Mark to Market Tax: IRC 101j The Alternative Minimum Tax (AMT) Could Apply in Some Situations Form 8925 Proposed Elimination of Interest Deduction 9

10 II. WHY DO INSURANCE COMPANIES PURCHASE ICOLI? Increases Earnings Through Funding of Existing Benefit Costs Offsets New Benefit Costs Tax-free Death Proceeds Which Are Greater Than Booked Cash Value 10

11 Hypothetical EPS Effect of $4.0 M Purchase 1st Year Hypothetical BOLI/ICOLI 1.79% $71,778 Less: Opportunity 0.65% After Tax (1.0% Pre-Tax) $26,000 Net Earnings $45,778 Number of Shares Outstanding 600,000 Earnings per Share Increase $0.08 Assumes average age 45 11

12 Hypothetical Lifetime Financial Effects Cash Inflows: Death Proceeds Age 85 $17,150,366 Cash Outflows: Premium Paid $4,000,000 Opportunity 0.65% After Tax $1,183,357 Net BOLI/ICOLI Income Available To Offset Benefits $11,967,009 IRR on Premiums to Total Death Proceeds 3.71% Tax Equivalent Return (35% bracket) 5.70% Number of Shares Outstanding 600,000 Earnings per Share Increase - Lifetime $

13 Effect of BOLI/ICOLI Purchase on Existing Benefit Expenses Hypothetical Benefit Expenses and BOLI/ICOLI Income: Forty Years $4.0 million BOLI/ICOLI investment reduces existing expenses for retirement plans, and group benefits by approximately $13.2 million, net of premium paid and opportunity cost. Benefits grown at 6%. 13

14 BANKS III. THE REGULATORY ENVIRONMENT: Officer And Board Fiduciary Responsibility/Loyalty and Due Care OCC Bulletin & FDIC FIL Requires Comprehensive Risk Management Process Document The Pre Purchase Review Investment And Concentration Limits Product And Vendor Due Diligence SR Ongoing Compliance And Administration Requirements INSURANCE COMPANIES Officer and Board Fiduciary Responsibility/Loyalty and Due Care Generally Unregulated 14

15 IV: TYPES OF BOLI/ICOLI PRODUCTS CHARACTERISTICS WHOLE LIFE UNIVERSAL LIFE General Account General Account Separate Account Hybrid Guaranteed Cash Value & Death Benefit Yes None Risk of Lapse None Risk of Lapse None Risk of Lapse Crediting Rate Portfolio New Money or Portfolio Based on Stable Value & Yield to Worse of Sep Acct Book Yield Mark to Market Risk None None Yes, Depends on Stable Value Floor None (No Stable Value) 15

16 IV: TYPES OF BOLI/ICOLI PRODUCTS CHARACTERISTICS WHOLE LIFE UNIVERSAL LIFE General Account General Account Separate Account Hybrid Risk Weighting: Banks Risk Weighting: Insurance 100% 100% 20%/50%/100% Subject to Offsets 0.8% Life Cos. 5% P&C Cos. 0.8% Life Cos. 5% P&C Cos. Underlying Asset Look-Through 20%/50%/100% Subject to Offsets, Not Validated by Regulators Underlying Asset Look-Through Investment Choices None, Carrier General Account None, Carrier General Account Several Subject to Stable Value Wrap Provider Limited Bankruptcy Risk Yes Yes Separate Account May Be Protected, Matter of State Law, Untested in Courts Death Benefit at Risk Separate Account May Be Protected, Matter of State Law, Untested in Courts Death Benefit at Risk 16

17 IV: TYPES OF BOLI/ICOLI PRODUCTS CHARACTERISTICS WHOLE LIFE UNIVERSAL LIFE General Account General Account Separate Account Hybrid 1035 Exchange Restrictions Yes Yes Yes, Market Adjustment, Stable Value Fees Yes Cost Disclosures Generally No, Bundled Product Generally Yes Yes Generally Yes Mortality Risk Carrier Carrier Carrier or Experience Rating Complexity Simple Simple Generally requires legal, accounting, actuarial and investment advice & expertise Carrier but may be limited by Experience Rating Maybe (Regulators are Uncertain About Treatment) 17

18 V. Industry Statistics: Banks 18

19 Source: 2014 FFIEC Call Reports 19

20 Source: 2014 FFIEC Call Reports 20

21 Source: 2014 FFIEC Call Reports 21

22 VI. Industry Statistics: Insurance Companies *All Statistics are for 2015 unless otherwise noted. 22

ICOLI Holdings - 2015 P&C Companies Life Companies 144 Companies Own $3.

1% of Surplus Average ICOLI Holding was 15.

$390 B Note: The above percentages are calculated using a methodology designed to

23 ICOLI Holdings P&C Companies Life Companies 144 Companies Own $3.4 Billion 75 Companies Own $15.2 Billion Average ICOLI Holding was 5.1% of Surplus Average ICOLI Holding was 15.0% of Surplus Net Admitted Assets of ICOLI Holders Range from Under $10 M to Over $390 B Note: The above percentages are calculated using a methodology designed to prevent double counting of entities and capture only SNL Groups and unaffiliated companies. Some industry statistics indicate that participation rates are as high as 20% and 30% for P&C companies and Life companies, respectively, but it is unclear whether a similar methodology was employed. Source: 2015 SNL Financial Data 23

24 Top 5 ICOLI Holders by Industry P&C Companies Life Companies Liberty Mutual - $842.6 M Farmers Insurance - $447.8 M Hartford Fire - $432.4 M MetLife (P&C) - $316.4 M Alfa Mutual - $152.9 M New York Life - $4.0 B MetLife (Life) - $2.5 B MassMutual - $1.9 B John Hancock - $1.1 B AXA - $855.6 M Source: 2015 SNL Financial Data 24

25 Insurance Industry Statistics Relative to BOLI & ICOLI Total of 1,100+ Life Insurance Carriers Today. Only 40 +/- Carriers Have Sold a BOLI product. Only a few carriers sell ICOLI products. Half of the stock life companies rated by Moody s have been downgraded one of more notches since December 31, 2007, with some declining as much as three notches. 1 less than 25% of the mutual companies have been lowered during this period, and none have been downgraded by more than one rating notch. 1 1 Source: Moody s August 7, 2009 Report, Revenge of the Mutuals 25

26 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 1. MISCONCEPTION: My Vendor Brokers All The Products. Reality: A number of BOLI carriers have products that are proprietary to one or a limited group of BOLI vendors. There is no such thing as a true broker in the BOLI business. Only a limited number of carriers have ICOLI products. Some ICOLI carriers will sell only to P&C companies. Other ICOLI carriers will sell only to other life companies. 26

27 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 2. MISCONCEPTION: Stock vs. Mutual The Type Of Insurance Company Really Doesn t Matter. Reality: Moody s 2005 Report on U.S. Life Insurers: we believe that management and the boards of mutual companies are relatively more concerned with solvency and financial strength compared to the growth and profitability objectives that are typically the focus of stockholder-owned insurers. Moody s 2009 Report on U.S. Life Insurers: In the present challenging economic environment, the U.S. mutual life insurance companies have more successfully protected and maintained their creditworthiness than their stockholder-owned rivals. 27

28 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 3. MISCONCEPTION: The BOLI/ICOLI Has A Minimum Crediting Rate. Reality: Most products have a minimum guaranteed crediting rate. Interagency Statement: before purchasing BOLI, an institution should analyze projected values using multiple illustrations... Minimum guaranteed crediting rates show only part of the story. Institutions should assess mortality and expenses. Best analysis includes projections at the contractual guarantees. 28

29 Sample Carriers & Independent Ratings Carrier #1 Carrier #2 Carrier #3 Whole Life Universal Life Universal Life 29

30 $3,000,000 Cash Value Guarantees - M/E/Interest Sample $1 m Premium: Age 45 Underwritten $2,500,000 $2,000,000 $1,500,000 $1,000,000 Carrier #1 Carrier #2 Carrier #3 $500,000 $ Years Carrier #1 Whole Life Carrier #2 Universal Life Carrier #3 Universal Life Guarantees = guaranteed mortality, expenses & interest crediting rate 30

31 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 4. MISCONCEPTION: Death Benefits Are All About The Same. Reality: Interagency Statement: institutions should analyze projected values (CSV and death benefits) using multiple illustrations... The ultimate return is the death benefit. 31

32 Death Proceeds Current Rates Sample $1 m Premium: Age 45 Underwritten $6,000,000 $5,000,000 $4,000,000 $3,000,000 $2,000,000 $1,000,000 Carrier #1 Carrier #2 Carrier #3 $ Years 32

33 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 5. MISCONCEPTION: Our Carrier Is Rated A Excellent. The Higher The Rating Reality: The Lower The Return. Interagency Statement: Carrier selection is one of the most critical decisions in a BOLI purchase. The credit quality of the insurance company is a key variable. An institution should receive a rate of return... comparable to returns on investments of similar maturity and credit risk. An American Bar Association publication says, the minimum criteria requires that carriers have at least two ratings from the top two levels and none below investment grade. Know the carrier s reputation and historic performance. 33

34 Rating Chart Top Two Levels Are Recommended Independent Rating Services Financial Strength Ratings The First Three Levels of a Total Five Levels Moody s S & P s Fitch A.M. Best Extremely Highest Superior Strong AAA A++ AAA A+ 1 Exceptional Aaa 2 Excellent Aa1 Aa2 Aa3 3 Good A1 A2 A3 Very Strong AA+ AA AA- Strong A+ A A- Very High AA+ AA AA- High A+ A A- Excellent A A- Very Good B++ B+ 34

35 Cash Value Current Rates - M/E/Interest Sample $1 million Premium: Age 45 Underwritten $5,000,000 $4,000,000 $3,000,000 $2,000,000 $1,000,000 Years $ Carrier #1 Carrier #2 Carrier #3 Current rates = current mortality, expenses and interest crediting rate 35

36 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 6. MISCONCEPTION: If We Have A Problem With Our BOLI/ICOLI, We Can Switch To Another Carrier. Reality: Interagency Statement: management should inform the board... of any other significant risks... with BOLI [including] the costs associated with changing carriers... and the potential for noncompliance with state... and federal law. A tax-free exchange of one carrier for another may be effected provided there is still an insurable interest and no material change in health. BOLI/ICOLI products typically have exchange restrictions and/or charges. 36

37 37

38 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 7. MISCONCEPTION: We Bought The One With The Highest Return. Reality: Interagency Statement: Carriers not committed to general account ICOLI... may have an incentive to lower the interestcrediting rate... over time... Potential exists for a decline in the interestcrediting rate. Institutions should be aware that the guaranteed... interest-crediting rate may be... reset 38

39 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 7. MISCONCEPTION CONTINUED: We Bought The One With The Highest Return. Reality Continued: Some carriers subsidize higher first-year rates on new sales at the expense of old policyholders. Other carriers may back-end load mortality and expenses. 12 +/- of the 40 +/- carriers that sold BOLI/ICOLI in recent years have withdrawn from the market or have suspended sales. Will the carrier continue to support its BOLI/ICOLI if it withdraws from the market? 39

40 Existing BOLI/ICOLI Credited With 4.80% 4.70% 4.60% 4.50% 4.40% 4.30% 4.20% 4.10% 4.00% 3.90% 3.80% 3.70% Lower Interest Rate Than New BOLI/ICOLI 1st Qtr 2nd 3rd 4th New BOLI/ICOLI Existing BOLI/ICOLI 40

41 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 8. MISCONCEPTION: We Bought A Separate Account BOLI/ICOLI. Reality: Interagency Statement: The protected status of separate account assets is generally untested in the courts. Transactional/operational risk may also arise as a result of the variety of negotiable features... New York recommends that institutions obtain opinions as to creditor protection, qualification as life insurance, and whether there are sufficient assets in the separate account to cover mortality and expenses. Virginia says community banks may not have the expertise or resources to evaluate and manage separate account products. 41

42 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 9. MISCONCEPTION: Our Bank Has An Insurance Agency. Reality: Interagency Statement: Institutions should be aware that the splitting of commissions... presents compliance risk. Most states prohibit the payment of inducements or rebates. Payments to an affiliate that did not perform services for the institution could raise other regulatory and supervisory issues. 42

43 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 9. MISCONCEPTION CONTINUED: Our Bank Has An Insurance Agency. Reality Continued: Commissions are subject to income tax. Several BOLI/ICOLI carriers do not permit vendors to split commissions. Does the institution s insurance agency have the expertise and experience to design, service, and administer BOLI/ICOLI? 43

44 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 10. MISCONCEPTION: Our Vendor Is Monitoring The Situation. Reality: Interagency Statement: A prudent risk management process includes... effective senior management and board oversight [and] an ongoing system of risk assessment, management, monitoring, and internal control... Reliance upon pre-packaged, vendor-supplied compliance information does not demonstrate prudence... Vendors may have a financial interest to not inform the institution of problems. 44

45 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 11. MISCONCEPTION: I ll Be Retired Soon, So Why Do I Care About BOLI/ICOLI. Reality: Actual benefits from BOLI/ICOLI may differ significantly from what was originally projected. The executive could suffer a loss of benefits, the institution could experience higher benefit costs, or both. 45

46 $120,000 Split Dollar Plans Reduced BOLI/ICOLI Growth Squeezes Executive s Death Proceeds $100,000 $80,000 $60,000 $40,000 Shortage Promised Benefit $20,000 $0 Age 45 Age 55 Age 65 Age 75 Age 85 Net Amount Available (Death Benefit less Cash Value) 46

47 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 12. MISCONCEPTION: I Think Everything Is Fine. Reality: 12 +/- out of the 40 +/- BOLI carriers, have left the BOLI business or suspended sales. 23 +/- BOLI carriers have suffered rating downgrades since Only limited number of BOLI carriers are in the ICOLI market. Interest crediting rates have declined. Stock life insurance carriers are pressed to meet quarterly earnings goals. 47

48 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 12. MISCONCEPTION CONTINUED: I Think Everything Is Fine. Reality Continued: Tax and legal developments could affect BOLI/ICOLI holdings. Interagency Statement: Management... should review the performance of the... insurance... with its board at least annually. More frequent reviews are appropriate if there are significant changes to the BOLI program such as... [D]ecline in the financial condition of the insurance carrier... [C]hange in the tax laws... 48

49 VII. THE 12 COMMON MISCONCEPTIONS A CLOSER LOOK 12. MISCONCEPTION CONTINUED: I Think Everything Is Fine. Reality Continued: Institutions should have a comprehensive investment policy in place directed at the Purchase and Risk Management of BOLI/ICOLI. 49

The Purchase and Risk Management of Insurance Company Owned Life Insurance (ICOLI) December 14, IASA Carolinas Winter Meeting 2015 Charlotte, NC

The Purchase and Risk Management of Insurance Company Owned Life Insurance (ICOLI) December 14, 2015 IASA Carolinas Winter Meeting 2015 Charlotte, NC MMB Consulting, LLC Miles Hopkins, CPA 40 Calhoun Street,