September 2008


Troubled Asset Relief Program

Treasury’s $700 billion financial bailout plan as currently proposed would extend to types of assets beyond mortgage-backed securities and would include insurance companies and foreign banks with significant U.S. operations.  This may ultimately benefit banks in two ways – those directly owning troubled assets and those owning BOLI issued by carriers who might otherwise be downgraded (or worse).

The Federal Reserve’s granting Goldman Sachs and Morgan Stanley’s requests to convert to bank holding companies, if finalized, will subject them to increased oversight by banking regulators but will also allow them to re-characterize some assets as “held for investment” (thereby avoiding application of mark-to-market accounting).


Basel II Standardized Approach

On July 29, the FDIC, OCC, FRB and OTS jointly published Part II of The Proposed Rules of the Risk-Based Capital Guidelines; Capital Adequacy Guidelines:  Standardized Framework


Under the proposal, the standardized framework generally would be available, on an optional basis, to banks, bank holding companies and savings associations that utilize the general risk-based capital rules (i.e., those that are not required to use the advanced approaches final rule).  The standardized framework is based on the standardized approach for credit risk and the basic indicator approach for operational risk outlined in the “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” released by the Basel Committee on Banking Supervision.  The new proposed rule, when adopted will be in lieu of finalizing the Basel 1A NPR as proposed in December 2006.

Potential Implications for BOLI

Although definitive guidance has not yet been published mapping the new rules to BOLI, it appears as though BOLI, at least separate account BOLI, will be risk weighted according to one of the four approaches enumerated under “Equity Exposures to Investment Funds”: The full look-through approach, the simple modified look-through approach, the alternative modified look-through approach, or (for qualifying investment funds) the money market fund approach.

The simple modified and alternative modified look-through approaches are in many ways similar to the current risk based capital rules.  The full look-through approach (if implemented) would require the bank to risk-weight each of the securities/exposures held by the investment fund as though it were held directly by the bank.  This approach may, under certain circumstances, result in a more favorable risk-based capital computation.

Presumably, most banks will want the approach they choose for BOLI to mirror what they elect for broader risk-weighting purposes.  However, a bank may only use the full look-through approach if it is able to risk-weight each of the exposures held by the investment fund.  Although carriers routinely provide monthly securities holdings reports to BOLI policy owners, it is unclear whether the frequency and timeliness of the reports will suffice in this regard.

Note that the proposal defines an investment fund as a company (i) all or substantially all of which are financial assets and (ii) that has no material liabilities.  Ergo, investments within BOLI in hedge funds or other highly leveraged investment portfolios will not qualify for these approaches.  It is unclear whether principal protected notes within BOLI separate accounts that reference leveraged investments will be considered part of an investment fund.  Such allocations may be considered securitization exposures.  Risk-weights for securitization exposures range from 20%-1250%.  Banks may use external ratings issued by NRSROs to assign risk-weights to certain classes of securitized exposures.  Some exposures may be subject to capital requirements that effectively result in a dollar-for-dollar capital requirement (i.e., a 1,250% risk weight), including, but not limited to, externally rated assets two or more categories below investment grade.

The proposed rulemaking is accepting comments through October 27, 2008.


Basel II (Pillar 2)

On July 31, the FDIC, OCC, FRB and OTS jointly published guidance regarding the supervisory review process for capital adequacy (Pillar 2) provided in the Basel II advanced approaches final rule.


These guidelines, which became effective on September 2, 2008, supplement the final rule published jointly by the U.S. banking agencies in the Federal Register on December 7, 2007 (advanced approaches final rule) and set forth the agencies’ standards for satisfying the requirements for credit risk and operational risk under the advanced approaches rule.

The guidelines address the process for supervisory review in the advanced approaches final rule. Supervisory review covers three main areas:

  1. Comprehensive supervisory review of capital adequacy;
  2. Compliance with regulatory capital requirements; and
  3. Internal capital adequacy assessment process (ICAAP).

Potential Implications for BOLI

Objectives of the guidelines include identifying all material risks (through application and use of the ICAAP).  Some of the risks to which a bank may be exposed include credit risk, market risk, operational risk, interest rate risk, liquidity risk, reputational risk, business or strategic risk, and country risk.  Many of these risks have previously been identified by the regulators as risks attendant to the purchase and ongoing management of BOLI plans.  Banks required to follow the advanced approaches rule that own material amounts of BOLI may conclude that developing an “ICAAP type” assessment of its internal BOLI policies and procedures may be beneficial.


Basel II Updates

In response to criticisms regarding inadequacies within the present Basel II framework (which have, in part, been revealed by the credit crises), the Basel Committee on Banking Supervision released revised proposals for charging capital for incremental risk in the trading book on July 22, 2008.  The new proposed rules extend beyond default risk to encompass credit rating migration risk, spread widening risk and equity prices.  Under the proposal the incremental risk charge (IRC) replaces the previous proposals for an incremental default risk charge (IDRC).  This will cover all positions except those whose valuations depend solely on commodity prices, foreign exchange rates or the term structure of default-free interest rates (e.g., includes debt securities, equities, securitizations, CDOs and other structured credit products).  The proposed guidelines also would require banks to take into account the liquidity horizons applicable to individual trading positions or sets of positions.

The proposed new rules become effective in January 2010, with an additional year to incorporate risks that are not related to default or credit migrations.



California AB 31

As reported in an ad hoc LRA earlier this month, on September 5, to address the CA fiscal emergency, Assembly Member Charles Calderon introduced Assembly Bill 31 (AB 31). The bill would repeal the exclusions from taxation which apply to corporate owned life insurance (inside build-up and death proceeds) and include those amounts in gross income when computing tax liability. Needless to say, the bill, if enacted, would have a devastating impact on COLI/BOLI owned by CA based employers and there is the danger that similar laws might gain traction in other states. In light of the present status of the CA budget, the bill will not progress any time soon.  A preliminary hearing is likely sometime this fall.  NAIFA of CA, several major insurers and others are intervening immediately to attempt to quell any serious further consideration.



Treasury/IRS Release Business Plan

On September 12, the Treasury/IRS released their new business plan, listing the areas where they want to issue new guidance during the next 12 months.  It included two noteworthy items:

  • They intend to issue a “Revenue Ruling regarding the tax-free exchange of life insurance contracts subject to §264(f).”  We believe they want to formally state that a 1035 exchange causes a loss of grandfathering and is a new policy for purposes of 264(f), basically codifying an earlier Private Letter Ruling (PLR 200627021, released 7/7/2006).
  • They intend to issue “guidance on employer owned life insurance contracts under section 101(j).”  This is in addition to finalizing guidance on reporting rules for such contracts.  This guidance apparently will address substantive aspects of 101(j).  We are not sure what this will address.  We do know that the IRS has received several requests for clarification regarding a variety of issues (e.g., how long can an employer rely upon a specific written affirmation by an employee to purchase life insurance on their lives?).



Israel Discount Bank (IDB) v. MetLife and BlackRock

On August 4, the New York Supreme Court granted the motion by MetLife requesting dismissal of all causes of action asserted in the complaint filed against them (and BlackRock) in April 2008.


IDB alleged two breaches of contract claims against MetLife and a breach of fiduciary duty against MetLife and BlackRock, asserting, among other things, that MetLife failed to honor IDB’s reallocation requests.

The court found that the breach of contract claim related to the reallocation request failed because IDB did not allege any damages resulting from MetLife’s deferral of its reallocation request and that IDB had not adequately alleged that the deferral breached any contract in the policy.  The court noted the policy contained explicit restrictions on the right to transfer assets from one separate account to another, including a provision giving MetLife the right to determine the value of assets for which there is no readily available market, citing the following policy language: “If in Metropolitan’s reasonable judgment any transfer would involve the sale of Separate Account assets for which there is then no readily available market, Metropolitan will defer the withdrawal of all or part of the transfer amount for such period as it deems necessary.”


In addition to underscoring the importance of performing, in conjunction with counsel, a thorough review of the policy, PPM, SVA and all governing documentation as part of one’s pre-purchase due diligence process, this case also demonstrates the value of negotiating and properly documenting improved terms, indemnifications, etc. in a letter of understanding (or an equivalent document).  We note that carriers have in recent years been routinely willing to provide a specified time frame (e.g., 7 or 10 days) within which reallocations must be fully executed (i.e., subject to narrowly defined carve outs for alternative asset classes or SVA restrictions).


Fifth Third Bank v. Transamerica Life Insurance Company and Clark Consulting, Inc.

Earlier this year, Fifth Third Bank (FITB) filed suit against one of its BOLI carriers, Transamerica Life Insurance Company (an Aegon subsidiary) and its broker, Clark Consulting, Inc. alleging $323 million in damages stemming from losses suffered in one of its separate account BOLI plans (one in which FITB had invested over $612 million in the Falcon Fund, a highly leveraged, alternative fixed income investment).  In its suit, FITB references its write downs in the value of its BOLI plan and alleges a host of failures by Transamerica and Clark, including a failure to recognize the occurrence of an “Automatic Re-allocation Event” that would have transferred the underlying assets from Falcon to a more conservative investment (thereby limiting/avoiding significant further losses).

Transamerica and Clark filed an Answer on June 16.



FAS 157

Beginning in early July we began hearing (from carriers and industry sources) that audit firms were showing new found interest in verifying the fair value of separate accounts within COLI/BOLI policies.  It is unclear whether Wachovia’s write-down of $300+ million due to BOLI losses was a result of breaches in the MV/BV ratios of its SVPs, a result of its auditor’s valuation of the underlying investment allocations to Falcon and FIDAC (and the permanent nature of the realized losses suffered – notwithstanding the presence of an SVP), or a combination of both.  It is our understanding that auditors are not questioning or challenging the recording of policies at the cash surrender value as prescribed under FASB TB 85-4, but rather are challenging the value of the separate account assets on which the policy cash surrender value is based.

Although FAS 157 does not require fair value accounting under any new situations (FAS 159 permits fair value accounting in some situations where it was previously unavailable), it does define fair value and establishes a framework for measuring it in those situations where fair value accounting is required (TB 85-4 effectively requires fair value accounting of cash surrender values tied to assets held in separate accounts).

FAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” and provides three valuation methodologies: the Market Approach, the Income Approach and the Cost Approach.  FAS 157 further requires inputs to these three valuation techniques be based on a three level hierarchy (Levels 1-3).

Auditors are in some situations requiring an examination to verify the valuation of the COLI/BOLI policy as reported by the insurance carrier to the policy owner.  In situations where the underlying portfolio includes asset classes that are illiquid, where there is no established secondary market or where market values are otherwise questionable, the inputs will be determined under either Level 2 or Level 3 and the possibility for differing valuations will exist (i.e., between the carrier reported value and the auditor’s valuation).

This represents yet another strike against illiquid and difficult to value instruments within BOLI plans.  Recent market tumult underscores the need for liquid positions with reliable marks that can be expeditiously exited if necessary.  Some (not all) fixed income hedge funds and highly leveraged bank eligible funds contain draconian restrictions on liquidations.  When such restrictions are present, they can exacerbate the risk of loss, especially during extreme market conditions.


Stable Value

Recent market conditions, many of which are touched upon above, have dramatically altered SVP providers’ perceptions regarding risk.  Prior to July 2007, the average ratio of market value to book value for all SVPs likely averaged between 94%-97%.  Royal Bank of Canada’s (RBCs) Q3 Report to Shareholders discloses a market value just 83% of book value ($8.073 billion of notional BV v. $6.703 fair value/market value).  Much, if not most, of this differential is likely attributable to exposures to hedge funds and highly leveraged fixed income funds.  However, in recent months, many non-leveraged fixed income strategies have suffered losses or significantly underperformed benchmarks due to sub-prime and/or Alt A exposures or other investments which have suddenly become illiquid.

Consequently, the SVP landscape has been changing nearly as rapidly as the financial markets.  Less than a year ago there were four providers actively competing in the SVP market; JPMorgan Chase (JPMC), Bank of America (BofA), Royal Bank of Canada (RBC) and AIG Financial Products (AIGFP).  Today only JPMC and BofA remain active and the rules of engagement are a far cry from a few months ago.  JPMC and BofA are scrutinizing investment guidelines to a heightened degree and requiring substantive tightening of language.  Asset classes that were previously acceptable to a generous extent are being carefully carved down to de minimis levels or eliminated altogether while terms tighten and fees rise.

Although the present SVP market is clearly not a buyers’ market, there are rumblings of possible new entrants, which if true, could result in more favorable offerings.



Federal Insurance Regulation – HR 5840

In mid-April, a bill was introduced in the House (HR 5840), which seeks to establish a federal “Office of Insurance Information” (OII) in the Department of the Treasury. The OII would be headed by a Deputy Assistant Secretary appointed by the Secretary of The Treasury charged with receiving, analyzing, collecting and disseminating publicly available information and issuing reports regarding all lines of insurance (except health insurance).  The OII would also establish Federal policy related to international insurance matters and would pre-empt any state law or regulation to the extent it was inconsistent with Federal policy on international insurance.  Finally, the OII would advise the Treasury Secretary on major domestic and international insurance policy issues (e.g., financial guarantee insurance, catastrophe insurance and reinsurance collateral requirements).

HR 5840, The Insurance Information Act of 2008, could come to the House floor as early as later this week (September 22).  There is no companion bill as yet in the Senate and the Bill was passed by the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises when only a third of the members were present.

Despite fear and suspicion about an OII being merely the first step toward an optional Federal Insurance Charter, many industry associations have been supportive of its passage, including, most surprisingly, the National Association of Insurance Commissioners (NAIC).  In stark contrast, The National Conference of Insurance Legislators (NCOIL) continues to vigorously fight its adoption.


409A Compliance

In response to the December 31, 2008 deadline to bring executive compensation arrangements into compliance with 409A, The Groom Law Group issued a 409A Year-End Survival Guide.

FASB issues Staff Positions – FAS 133-1 and FIN 45-4 amending FAS 133 and Fin 45 and clarifying the effective date of FAS 161 relating to disclosures regarding credit derivatives and certain guarantees. 

FASB issues proposals to amend FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities and FIN 46(R), Consolidation of Variable Interest Entities.  The federal banking agencies (OCC, FRB, FDIC and OTS) are evaluating the proposed changes for possible impact on banking organization’s financial statements as well as regulatory implications.

FASB and IASB announce goal of convergence of GAAP and IFRS by 2011.  SEC proposes move from GAAP to IFRS filings beginning in 2014.  SEC may allow companies to switch using a phased in approach.

IFRS issues Taxonomy Guide relating to the use of XBRL for preparers, supervisors and developers.

SEC issues proposed rule for Nationally Recognized Statistical Rating Organizations  (NRSROs) to address concerns regarding integrity of current credit rating procedures for determining credit ratings for securities collateralized by subprime mortgages.  The proposed rules include a new rating symbology convention for structured finance products.

SEC issues proposed rule on Interactive Data to Improve Financial Reporting which would require domestic and foreign public companies to provide their financial statements to the SEC and on their corporate websites in interactive data format using the eXtensible Business Reporting Language (XBRL). Under the proposed rules, investors could download financial statement information directly into spreadsheets and analyze the information with the use of commercial off-the-shelf software.

SEC moves closer to issuing formal proposal for reforming 12(b)-1 fees.  Recommendations are expected soon.

GAO publishes report regarding the risks of defined benefit pension plans investing in hedge funds and private equity and recommending that the DOL issue guidance on investing.


Ad Hoc LRA – September 12, 2008

California AB 31

Please see below – this is a message I received from an industry association earlier today.  The actual proposed language has not shown up on our legislative search service – we will pass it along as soon as it does.  A similar proposal was floated in IL a few years ago and died pretty quickly.  Hopefully, this was have a similar fate.

September 12, 2008

To: All NAIFA-California Members

From: Mike Ables, Government Relations Chair

            Shari McHugh, Legislative Advocate

 Re: Life Insurance Taxation

Earlier this week there was a bill introduced by Assemblyman Charles Calderon that would tax not only the inside buildup of cash value in a corporate owned life insurance policy, but also TAX THE DEATH BENEFIT in California.

At this point we are taking NOTHING for granted.  The bill may die in the “rules committee”, or it may gain legs and start to move through the legislature.  If the bill does die this year, you can be sure that someone will likely try to resurrect it for the next session.  We are already working on a pre-emptive strike so that it does not come to life anytime soon.  If this bill does come to life this year and when called upon, we will need your help ASAP in the form of key-contact visits, and various “action alerts.”

We know you are ready to act immediately, but please wait for instructions.  Shari has numerous meetings scheduled for early next week, and more information will be available.  Stay tuned…and if you know somebody who sells life insurance in the State of California and is not a member of NAIFA-California…PLEASE TALK TO THEM ABOUT THIS!