Monthly LRA Update

TAX DEVELOPMENTS

IRS Reportable Policy Sale Proposed Rule – Update

As we covered last month, the IRS has proposed rule changes for the application of the transfer for valuable consideration rules under the reportable policy sale (“RPS”) regulations arising in connection with IRC § 1035 exchanges of life insurance contracts and certain transfers of policies under business reorganizations. The comment period is open through July 10. We are supportive of the proposed updates.

As a brief reminder, the proposed updates include a new exception from the definition of RPS for certain direct acquisitions of interests in life insurance contracts by C corporations that arise as part of ordinary course mergers and acquisitions where life insurance constitutes a de minimis amount of the total assets being acquired. The American Bankers Association (ABA) refers to this as the “De Minimis Exception.”

On June 29 the ABA submitted a comment letter related to the business reorganization change. The ABA encourages an expansion of the De Minimis Exception to apply to certain taxable transactions and that it can apply to acquisitions involving holding companies that may not, by themselves, meet the standard of an “active trade or business.”

Suggested Application to Taxable Transactions

The proposed regulations require the business acquisition to qualify as a tax-free reorganization under Section 368(a). The ABA notes that many bank acquisitions are structured as taxable mergers whereby, for non-tax business and regulatory reasons, target bank’s holding company (“Target Holdco”), which may hold some insurance contracts, does not survive.

The ABA suggests that the IRS remove paragraph (D) of the De Minimis Exception.

Suggested Modification for “Active Trade or Business”

The proposed regulations limit the applicability of the De Minimis Exception to the acquisition of a target C corporation that actively conducts a trade or business.

The ABA notes that acquisitive transactions often occur at the holding company level and that a holding company may not meet the “active trade or business” standard under Section 367 regulations. Therefore, ABA recommends either removing the paragraph that includes this requirement from the final regulations (because it is unnecessarily restrictive), or modifying it to include a C corporation that is engaged in an active trade or business or is a member of an affiliated group that includes one or more members that are engaged in an active trade or business (emphasis added).

Our Reaction to the ABA Comment Letter

We are supportive of the ABA’s suggestions and believe that they could be helpful. Note that it is our understanding that even if these suggestions were included, an entity would still need to satisfy the prior law’s exceptions to transfer for value rules under IRC § 101(a)(2). A tax-free reorganization under § 368(a) would likely satisfy the so-called “carryover basis” exception under IRC § 101(a)(2)(A). It is not clear to us that taxable reorganizations as described in the ABA letter would effectively navigate the transfer for value rules notwithstanding a potential exemption to the RPS rules.

The ABA letter did not comment on the 1035 Exchange aspects of the proposed rule.

REGULATORY DEVELOPMENTS

Banking Regulators Finalize Interagency Guidance on Third-Party Relationships

On June 6 the banking regulators released final Interagency Guidance on Third-Party Relationships. This guidance rescinds and replaces previous guidance, including OCC Bulletin 2013-29.

In the new guidance, the regulators emphasize that the use of third parties does not diminish banking organizations’ responsibilities to ensure that activities are performed in a safe and sound manner. Similar to the proposed guidance released in July 2021, the final guidance establishes a principles-based approach to third-party risk management and sets forth a Third-Party Relationship Life Cycle. The guidance includes suggestions on how banks might approach each stage.

Stages of the Third-Party Relationship Life Cycle include Planning; Due Diligence and Third-Party Selection; Contract Negotiation; Ongoing Monitoring and Termination. The guidance acknowledges that banks can align the activities and oversight processes to the risks posed by any particular third-party relationship. More oversight is expected for activities that are deemed critical in nature.

Aspects of the final guidance that appear relevant and useful for banks with respect to managing BOLI third-party relationships include (note this outline is not intended to be comprehensive)

• Planning
  • Identifying and assessing the benefits and the risks associated with the business arrangement;
  • Evaluating the estimated costs, including estimated direct contractual costs and indirect costs expended to augment or alter banking organization staffing, systems, processes, and technology;
  • Understanding potential information security implications, including access to the banking organization’s systems and to its confidential information;
  • Determining how the banking organization will select, assess, and oversee the third party; and
  • Outlining the banking organization’s contingency plans in the event the banking organization needs to transition the activity to another third party or bring it in-house.
• Due Diligence and Third-Party Selection
  • A review of the third party’s overall business strategy and service philosophies;
  • An assessment of the third party’s financial condition;
  • An evaluation of the third party’s depth of resources (including staffing) and previous experience in performing the activity;
  • An evaluation of the qualifications and experience of the third party’s principals and other key personnel related to the activity to be performed;
  • An evaluation of the effectiveness of the third party’s overall risk management, including governance processes and SOC audit assessments;
  • Assessment of the third party’s information security program, including its consistency with the banking organization’s information security program;
  • An assessment of the third party’s operational resilience and business continuity planning;
  • An evaluation of the volume and types of subcontracted activities and the degree to which the third party relies on subcontractors; and
  • An evaluation of whether the third party has appropriate insurance coverage to mitigate potential losses.
• Contract Negotiation
  • Clearly identify the rights and responsibilities of each party;
  • Consider contract provisions that specify the third party’s obligation for retention and provision of timely, accurate, and comprehensive information to allow the banking organization to monitor risks and performance and to comply with applicable laws and regulations;
  • Establish the banking organization’s right to audit and provide for remediation when issues are identified;
  • Describe all costs and compensation arrangements;
  • Address when and how the third party should notify the banking organization of its use or intent to use a subcontractor; and
  • Protect the ability of the banking organization to change third parties when appropriate without undue restrictions, limitations, or cost.
• Ongoing Monitoring
  • Effective third-party risk management includes ongoing monitoring throughout the duration of the third-party relationship, commensurate with the level of risk and complexity of the relationship and the activity performed by the third party.
  • Typical monitoring activities include (1) review of reports regarding the third party’s performance and the effectiveness of its controls; (2) periodic visits and meetings with third-party representatives to discuss performance and operational issues; and (3) regular testing of the banking organization’s controls that manage risks from its third-party relationships.
• Termination
  • Consider options for an effective transition of services, such as potential alternate third parties to perform the activity;
  • Evaluate relevant capabilities, resources, and the time frame required to transition the activity to another third party or bring in-house while still managing legal, regulatory, customer, and other impacts that might arise; and
  • Consider costs and fees associated with termination.

Citations: OCC (Bulletin 2022-17) and FDIC (FIL-29-2022).

Bank Regulatory Policy Update

The developments covered below do not have direct impact on BOLI/COLI programs; however, given the current climate and focus on regulatory updates in the aftermath of recent bank failures, we will continue to monitor the perspectives of bank regulatory leaders.

FDIC Chairman Gruenberg’s Speech (Peterson Institute)

On June 22 FDIC Chairman Martin Gruenberg spoke at the Peterson Institute. His remarks focused on efforts to finalize the Basel III capital standards in the US. He highlighted four areas of risk under the final phase of Basel III:

• Credit risk
  • Chairman Gruenberg reiterated that the FDIC has long had concerns about the use of internal models in establishing minimum capital requirements for credit risk.
  • He advocates for use of a standardized approach for credit risk in lieu of the model-based approach to enhance transparency and comparability of the risk-based capital framework.
• Market risk
  • He provided a brief background leading up to the Fundamental Review of the Trading Book (FRTB) and expressed support for these reforms.
• Operational risk
  • He notes that operational risk exposures have been, and continue to be, a persistent and growing risk for financial institutions (including settlements over conduct and ongoing exposure to ransomware and other cybersecurity risks).
  • The operational risk framework in the United States is currently based on the advanced measurement approach framework. Similar to his views on credit risk, Mr. Gruenberg prefers the revised Basel III approach that replaces the internal model-based approach with a standardized approach that is adjusted for banks’ own historical loss experience.
• Risk associated with financial derivatives
  • He notes that the credit valuation adjustment (CVA) was a major source of losses for banks with derivative trading operations during the global financial crisis. The Basel III reforms would improve the estimation of CVA risk by introducing new frameworks that would be consistent with the more robust methodology under the revised market risk framework.

Chairman Gruenberg also discussed the potential scope of these final reforms and appeared to be in favor of applying the new rules to banks with assets over $100 billion. He stated that community banks would not be impacted by these reforms.

FRB Governor Bowman’s Speech (Salzburg, Australia)

On June 25 FRB Governor Michelle Bowman delivered a speech at the Salzburg Global Seminar on Global Turbulence and Financial Resilience. Her remarks addressed the importance of a responsive (adapts quickly to changing economic conditions, etc.) and responsible (changes that take into account intended and unintended consequences) regulatory framework. She advocates for an independent third party to fully analyze recent events prior to pursuing regulatory reforms (although she is supportive of renewed supervisory focus on liquidity and interest rate risk in particular). Ms. Bowman believes revisions to liquidity requirements may be more effective than increases in capital for a broad set of banks.

FRB Releases Results of Annual Bank Stress Tests

On June 28 the FRB released the results of its annual bank stress test. This year’s stress test included a severe global recession with a 40% decline in commercial real estate prices, a substantial increase in office vacancies, and a 38% decline in house prices. The unemployment rate rose by 6.4% to a peak of 10% and economic output declined commensurately.

All 23 banks tested remained above their minimum capital requirements under the stress test. The aggregate common equity RBC ratio was projected to decline by 2.3% to a minimum of 10.1%. The full report on the findings is available here.

LEGISLATIVE DEVELOPMENTS

Senate Banking Committee Members Propose Bill to Claw Back Executive Compensation

On June 1 a bipartisan group of senators including Elizabeth Warren (D-Mass.) and J.D. Vance (R-Ohio) joined Senators Catherine Cortez Masto (D-Nev.), Josh Hawley (R-Mo.), and Mike Braun (R-Ind.), to update their original legislation and introduce Senate Bill (S. 1045), the Failed Bank Executives Clawback Act.

Under the Act, federal regulators would be required to claw back up to three years of compensation received by bank executives, board members, controlling shareholders and other key decision-makers in the event of a failure or resolution.

The proposed bill lacks clarity on how the failed bank would approach the claw back determination (including the amount to be clawed back). The provision states (emphasis added):

REQUIRED CLAW BACKS— In the case of insolvency, resolution, or the appointment of the [FDIC] as receiver of any insured depository institution with total assets more than $10,000,000,000, the [FDIC] shall claw back all or part of the covered compensation received by any covered party with respect to the insured depository institution during the preceding 3 years. A similar bill (H.R. 2972) sponsored by Rep. Porter (D-CA) has been introduced in the House.

JUDICIAL DEVELOPMENTS

COI Litigation – PHL Variable Granted summary Judgment

On May 31 PHL Variable Life Insurance Company (“PHL”), a member of The Phoenix Companies, Inc., was granted summary judgment in its defense against allegations of improper cost of insurance (COI) rate increases for a group of policies. Plaintiff was a trustee for a trust that owned policies acquired via life settlements. Thirteen policies were at issue in this case. They were issued by PHL in 2007 and 2008.

In 2011 PHL increased the COI rates on the policies. PHL asserts that the COI increases were actuarially justified because the premium funding pattern of the impacted policies differed materially from original pricing projections. In particular, the policies in question were funded with large upfront premiums and minimal ongoing premiums to keep the policies in force.

Plaintiffs contend that the COI rate increases were designed and executed in order to induce life settlement investors to forego premium payments and allow the policies to lapse.

The policy provision required PHL to determine COI rates “based on [PHL’s] expectations of future mortality, persistency, investment earnings, expense experience, capital and reserve requirements, and tax assumptions.” Plaintiffs asserted that basing COI rates on “premium funding levels” (i.e., the amount and pattern of premium payments) was not within the prescribed factors. However, the judge ruled that “investment earnings” inherently encompasses premium funding levels, noting that “…the amount available to invest, and expectations about the amount available to invest in the future, is unambiguously a permissible consideration under the ‘expectations of . . . investment earnings’ factor.”

The court’s opinion included references to a prior case against PHL (Fleisher v. Phoenix Life Insurance Company No. 11-cv-8405(CM) (S.D. NY)). In our May 2015 LRA Update, we noted that the judge in that case interpreted the term “based on” to be an exhaustive list of factors; not a listing of primary factors. As we reported, the Fleisher matter settled.

Docket: Jakobovits v. PHL Variable Insurance Company No. 17-CV-3527-ARR-RER (E.D. NY)