Obama Budget Proposal and Treasury Greenbook
In April, the Obama Administration released its Fiscal Year 2014 Budget Proposal. The Department of the Treasury also released its General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals. The proposal and general explanations include the same series of insurance related proposals that have been included in each of the Obama Administration’s previous proposals. We briefly highlight several material items below.
Expansion of Pro-Rata Interest Expense Disallowance
IRC section 264(f) reduces interest expense deductions that are allocable to unborrowed policy cash values (i.e., of permanent life insurance policies owned by corporations) based on a statutory formula. However, policies covering 20% owners, officers, directors or employees of the taxpayer are exempted from the pro-rata interest expense disallowance.
Once again, the Obama proposal seeks to limit the exemption to policies covering 20% owners; thereby expanding the pro-rata interest expense disallowance to encompass policies covering officers, directors and employees of the taxpayer.
The proposed change is prospective in nature; so, if legislation were enacted consistent with the proposal, it would only impact policies purchased after the effective date and existing policies that are subsequently subject to a material change (or IRC §1035 exchange). The OMB estimates that this proposal will reduce the deficit by ~$6 billion over ten years, 19% lower than last year’s projection (perhaps reflective of the recent dearth of new BOLI purchases and/or the low interest rate environment).
Modify Proration Rules for Life Insurance Company General and Separate Accounts
Companies are allowed a tax deduction for a portion of dividends received from other corporations in order to prevent or limit triple taxation of dividends (e.g., at the corporate payor level, the corporate receiver level, and the individual shareholder level).
Similarly, life insurance companies are allowed a deduction that is pro-rated between a policyholder’s share and the company’s share. The Obama proposal seeks to modify the pro-ration rules for this purpose. In the government’s view, the modification would result in the allowed deductions being more reflective of a life insurance company’s actual economic interest in the dividends. The OMB estimates that this proposal will reduce the deficit by ~$5 billion over ten years. The estimate is 34% lower than last year’s projection.
It is not entirely clear how much impact this proposal would have on BOLI owners. Since separate account BOLI programs invest primarily in fixed income investments it is unlikely to directly impact such programs. However, several general account BOLI policies are participating policies (policyholders are entitled to a portion of divisible surplus or dividends), so understanding the potential impact on these policies will be important. Also, many COLI plans include sub-accounts that include equities (e.g., for hedging deferred compensation liabilities). While less prevalent, equity-linked general account products (e.g., equity-indexed annuities) could also be affected.
Modify Rules that Apply to Sales of Life Insurance Contracts
This proposal applies to sales of existing life insurance contracts in the secondary market (i.e., Life Settlements and Viatical Settlements). The proposal includes some recordkeeping requirements and also would modify the existing transfer for value rule to ensure that exceptions to the rule would not apply to buyers of policies. The OMB estimates that this proposal will reduce the deficit by ~$600 million over ten years (21% lower than last year’s projection).
This is the only recurring insurance-related proposal from Obama’s budgets that has progressed to proposed legislation in past years (although nothing has as yet been adopted).
Require Information Reporting for Private Separate Accounts of Life Insurance Companies
This proposal would require life insurance companies to report to the IRS, the policyholder’s taxpayer identification number (TIN), the policy number, the amount of accumulated untaxed income, the total contract account value, and the portion of that value that was invested in one or more “private separate accounts.” A private separate account would be defined as any account with respect to which a related group of persons owns policies whose cash values, in the aggregate, represent at least 10 percent of the value of the separate account. The stated purpose of this reporting requirement is to help the IRS to identify contracts which should be disregarded under the investor control doctrine. It is our understanding that this initiative is directed primarily towards the high net worth individual market, where it is not uncommon for wealthy individuals and/or families to invest substantial sums in hedge funds on a highly bespoke basis. If nothing else, this serves as an excellent reminder of how important it is to maintain familiarity with and ensure compliance with investor control safe harbors.
Require that Derivative Contracts be Marked to Market with Gain or Loss Treated as Ordinary
A broader financial tax reform proposal applies to derivative contracts. Currently, different structures have varied and/or uncertain tax treatment.
This proposal seeks to require all derivative contracts (other than those that are identified in advance of acquisition and accounted for as hedging positions) to be marked-to-market by the last business day of the year and the gain or loss to be treated as ordinary. The OMB estimates that this proposal will reduce the deficit by ~$19 billion over ten years.
Limit the Total Accrual of Tax-Favored Retirement Benefits
Under current law, the maximum benefit permitted to be paid under a qualified defined benefit plan in 2013 is $205,000 per year, adjusted for increases in cost of living. Although subject to contribution limits, defined contribution plans and IRAs currently do not limit the amount that can be accumulated within the accounts.
This budget proposal seeks to implement an aggregate cap on accumulated amounts within tax-favored retirement plans whereby if total accumulations may not exceed an amount required to fund a joint and survivor annuity for the maximum amount permitted for tax-qualified defined benefit plans.
If a taxpayer reached the maximum permitted accumulation, no further contributions or accruals would be permitted, but the taxpayer’s account balance could continue to grow with investment earnings. The OMB estimates that this proposal will reduce the deficit by ~$9 billion over ten years.
Such a law would likely lead to far a greater reliance on non-qualified retirement plans.
Various life insurance industry associations (including AALU, ACLI, NAIFA, and NAILBA) issued a joint press release once again opposing certain aspects of the administration’s proposal. The groups continue to lobby for Congressional Representatives to reject the insurance-related proposals.
Basel III Capital Impact Studies
As reported previously, bank regulators continue to work on a final rule to revise the existing capital rules. The project is identified as a priority for 2013. A number of bills have recently been proposed that would require studies to be completed prior to the issuance of any final rule in relation to revised capital rule proposals.
H.R. 1221 and H.R. 1341
On March 15, 2013, Rep. Stephen Lee Fincher (R-TN) introduced the Basel III Capital Impact Study Act (H.R. 1221). The act would require the Federal banking agencies to conduct an impact study on the cumulative effect of certain provisions of the Dodd-Frank Act before issuing final rules amending the agencies’ general risk-based capital requirements for determining risk-weighted assets. The bill was referred to the House Committee on Financial Services. Mr. Fincher also introduced a bill (H.R. 1341) in March that would require the Financial Stability Oversight Council (FSOC) to conduct a study of the likely effects of the differences between the United States and other jurisdictions in implementing the derivatives credit valuation adjustment (CVA) capital requirement. That bill was referred to both the Financial Services and the Agriculture committees.
S. 731 and S. 737
On April 16, 2013, Sen. Richard Shelby (R-AL) introduced a bill similar to H.R. 1221. (S. 737). The bill would require a comprehensive study of both Basel III and Dodd-Frank related provisions.
Senate Bill 731, introduced by Sen. Joe Manchin (D-WV) on April 16, proposes a study that focuses on the impact on smaller institutions (specifically community, mid-size, and regional financial institutions).
Both S. 731 and S. 737 have been referred to the Committee on Banking, Housing, and Urban Affairs.
On April 24, Senators Sherrod Brown (D-OH) and David Vitter (R-LA) released their well-publicized legislation aimed at ending “Too Big to Fail” by significantly raising capital requirements for the largest institutions. The bill would require bank regulators to institute new capital rules that are not reliant on risk weights (i.e., “walk away from Basel III”). Regional banks would be required to have 8 percent equity to total assets; banks with greater than $500 billion in assets would have a 15% capital requirement.
In separate legislation, companion House (H.R. 1450) and Senate (S. 685) bills were introduced that would require the Treasury to create a list of all commercial banks, investment banks, hedge funds, and insurance companies that it deems too big to fail. Within one year of enactment, Treasury would commence breaking up such firms. Both bills were referred to committees.
S. 676 – Proposal to Restrict Access to Death Master
On April 9, 2013, Sen. Bill Nelson (D-FL) introduced Senate Bill 676, or the “Identity Theft and Tax Fraud Prevention Act of 2013.” Among various other measures, the bill would restrict public access to DMF data for a period of time after an individual’s death. Section 301 of the bill would prohibit the Secretary of Commerce from disclosing DMF information to any non-governmental person or entity (unless the recipient is certified under a program established by the bill) with respect to any individual who has died at any time during the calendar year in which the request for disclosure is made or the succeeding two calendar years.
The certification process allows certain individuals to be authorized by the Secretary of Commerce to immediately receive DMF information. Among those who would be eligible for immediate access are entities requiring DMF access to facilitate timely and proper administration of an insurance policy or benefit program. It is unclear who eligibility will extend to and who may be excluded (e.g., BOLI insurance companies, employers, BOLI administrators).
The bill has been referred to the Committee on Finance.
Baker v. American Greetings
On April 19, the parties jointly filed for preliminary approval of a class action settlement. As a reminder, this matter consolidates Baker v. American Greetings and Collier v. American Greetings. Collier was identified as a class member of a previous settlement (Havenstrite v. Hartford), but elected to opt out of that settlement class and pursue this matter. Baker reports that she became aware that her father may have been insured after watching a documentary.
The settlement is for $12.5 million. One third (or ~$4.2 million) would be payable to plaintiffs’ counsel. The named plaintiffs would each receive $25,000; and, aside from a fee to the settlement administrator, the remainder (~$8.2 million) would be split among class members who make valid claims. If all potential class members file valid claims, the amount per claim would be ~$9,500.
The settlement class is defined as: The estates and heirs of all former American Greetings employees (i) who are deceased; (ii) who were not officers or directors of American Greetings; (iii) who were insured under one of the following corporate owned life insurance plans: Provident Life & Accident 61153, Provident Life & Accident 61159, Mutual Benefit Life Insurance Company 111, Connecticut General ENX219, and Hartford Life Insurance Company 361; and (iv) for whom American Greetings has received a death benefit on or before the date on which the Court enters the Order of Preliminary Approval.
Unfortunately, the settlement appears to be significant enough to encourage plaintiff’s counsel (Michael Myers of Myers, McClanahan and Espey) to continue pursuing similar matters.
FRB Final Rule re Nonbank Financial Companies
On April 3, the FRB released a final rule that establishes the requirements for determining when a company is “predominantly engaged in financial activities.” The requirements will be used by FSOC when it considers the potential designation of a nonbank financial company for consolidated supervision by the Federal Reserve. The final rule also defines the terms “significant nonbank financial company” and “significant bank holding company.”
A company is considered to be predominantly engaged in financial activities if 85 percent or more of the company’s revenues or assets are related to activities that are defined as financial in nature under the Bank Holding Company Act.
The final rule largely adopted the approach in the proposed rule, with certain exceptions. The final rule will become effective on May 6, 2013.
Basel III Capital: A Well-Intended Illusion
On April 9, Thomas M. Hoenig, Vice Chairman of the FDIC delivered a speech regarding bank regulatory capital policies to the International Association of Deposit Insurers in Basil, Switzerland. His remarks strongly advocate greater reliance on tangible leverage ratios (set at a significantly higher threshold than the latest Basel III proposal) as opposed to a ratio of Tier 1 capital to risk-weighted assets.
His full remarks are available on the FDIC’s website (http://www.fdic.gov/news/news/speeches/index.html).
NY DFS Scrutinizes Private Equity Acquisition of Insurance Companies
In remarks to the Hyman P. Minsky Conference on April 18, New York Department of Financial Services (DFS) Superintendent Ben Lawsky said the DFS is taking a closer look at transactions in which private equity firms are acquiring insurance companies, particularly fixed and indexed annuity writers. The NY DFS is concerned that private equity investors generally manage investments with a much shorter time horizon than is required for prudent insurance company management.
Mr. Lawsky noted that private equity firms rarely acquire control of banks because the regulatory requirements associated with such acquisitions are more stringent.