IRS PLR 2013510020 – Loss Recognition on BOLI Surrender
On December 20, the IRS publicly released a private letter ruling (PLR) that was originally issued on September 23, 2013. The PLR related to loss recognition upon the surrender of BOLI policies. The taxpayer requesting the ruling was a national banking association that surrendered three distinct BOLI policies. The taxpayer requested a ruling that it was allowed a loss deduction under section 165, and that the amount of such loss for each surrendered policy would be computed by subtracting the applicable tax basis of the surrendered BOLI policy from the surrender proceeds received.
The IRS provided the requested ruling, noting that the taxpayer’s basis in each policy was the sum of the premium payments and mortality credits, less the cost of insurance (COI) and the mortality and expense (M&E) deductions (net of mortality experience credits). It is worth noting that taxable gain continues to be determined in accordance with IRC §72(e) whereby surrender proceeds are compared to a policyowner’s “investment in the contract” (which is basically the sum of premiums and other consideration paid into the policies). In other words, if there is a taxable gain upon surrender, the cost basis is not adjusted for COI and/or M&E; however, if there is a taxable loss, then the basis is subject to the above identified adjustments.
This PLR is largely consistent with a previously issued private letter ruling (PLR 200945032 released in November 2009).
Revenue Ruling 2009-13, primarily addressing tax implications for sellers of life insurance policies, also embraced the idea of differing tax basis computations for the same asset depending on facts and circumstances. In RR 2009-13, if a policyowner sold a life insurance policy, his/her gain was computed by comparing the amount received to the policies’ “adjusted basis.” However, the only adjustment specifically referenced in RR 2009-13 was to reduce basis by the amount “expended as cost of insurance.” In arriving at that conclusion, the IRS cited a number of judicial precedents in which courts found that the existence of insurance coverage has intrinsic value. Ultimately, the IRS appeared to equate the COI as the best proxy for the value of the insurance coverage that had been used over time.
It is not at all clear to us why the PLRs related to this topic also expressly include M&E deductions in this adjustment. By way of exception, it is clear in this most recent PLR that other expense loads applied to the policies (e.g., asset based compensation charges, custody fees, investment fund charges, wrap fees, etc.). The fact that M&E loads were included whereas the others were excluded appears questionable.
FRB Guidance on Managing Outsourcing Risk
Last month, we reported on the OCC’s new regulatory guidance for managing third-party relationships (OCC Bulletin 2013-29). On December 5, the FRB also released guidance for institutions it supervises, titled Guidance on Managing Outsourcing Risk (SR 13-09).
According to this guidance, institutions should establish policies governing the use of service providers. The policies should include a risk management program that addresses the following:
- Risk Assessments;
- Due Diligence and Selection of Service Providers;
- Contract Provisions and Considerations;
- Incentive Compensation Review;
- Oversight and Monitoring of Service Providers; and
- Business Continuity and Contingency Considerations.
We are available to further discuss this new regulatory guidance.
COI Litigation Update – Norem v. Lincoln Benefit Life and Thao v. Midland National
We have been tracking a number of lawsuits in which plaintiffs have challenged the cost of insurance (COI) rates assessed by insurance carriers. On December 13, 2013, the Seventh Circuit Court of Appeals affirmed two separate district court rulings in favor of the insurance companies. The matters were Norem v. Lincoln Benefit Life and Thao v. Midland National. In both cases, the policies indicate that COIs would be “based on” certain criteria (e.g., age, sex, and payment class). Plaintiffs asserted that the carriers should not be allowed to include other factors (e.g., expense factors and profit margins) in the determination of the applicable rates.
The appeals court considered the plain and ordinary meaning of the phrase “based on” and concluded that it did not imply exclusivity.
While these matters were not directly related to BOLI/COLI policies, when we first reported on these developments, we noted the following:
This topic is likely to garner increased attention by COLI/BOLI owners in the coming years as general account insurance carriers continue to be constrained by contractually guaranteed minimum guaranteed crediting rates that in many instances are significantly higher than current market yields. As such, carriers are likely to begin increasing policy expenses to offset (at least partially) the impact of crediting above-market rates. Most general account BOLI programs fail to provide explicit policyholder protections regarding a carrier’s right to increase expenses (other than contractually guaranteed maximums).
In early December, one prominent general account BOLI carrier, Transamerica, notified its policyowners that “Due to the persistently low interest rate environment, cost of insurance rates on general account policies… will increase.” In most instances, the rates are being increased to the contractual maximum guaranteed rates. We are researching the Transamerica matter and similar situations and are available to discuss possible courses of action.
Simmons v. Bristol-Myers New COLI Litigation
On November 26, a complaint was filed in the Northern District of Illinois – Eastern Division. Gigi Simmons, on behalf of her late husband Bruce Simmons, asserts that Bristol-Myers insured her husband, a rank and file employee, for an amount exceeding several million dollars.
According to the complaint, the decedent had a modest amount of life insurance purchased through his employer’s benefits department. When a representative of a funeral home called Bristol-Myers to inquire about the coverage, he was informed that there was a $6 million policy on Mr. Simmons’ life.
The plaintiff asserts that Mr. Simmons was not informed about any COLI policy on his life, nor did he provide consent to such a policy.
Bristol-Myers has not yet responded to the lawsuit. Michael Myers is a member of plaintiff’s counsel. He has been involved in a number of COLI matters surrounding policies where employees were not provided notification or asked to provide consent to coverage.
On the surface, the alleged facts seem inconsistent with industry practices. While uncommon, it wasn’t unheard of for employers to purchase policies on employees without providing prior notice and obtaining consent (e.g., in states where notice and consent was specifically not required providing that employers fulfilled certain statutory requirements such as offering employees a wellness plan). What seems totally outside the bounds of industry practice was the purchase of such a large face amount on the life of a rank and file employee. Most broad based COLI plans were used to informally finance general welfare benefit liabilities; primarily FAS 106 OPEB related liabilities. The vast majority of those COLI plans were so-called “leveraged” COLI plans, most of which had experience rated mortality charges. Annual premiums for leveraged COLI policies rarely exceeded $16,666 because that was all that was needed to drive the total policy loan to $50,000 during the first seven years, while meeting the requirement that four out of the first seven years’ premiums be paid with un-borrowed funds. Since loan balances above $50,000 produced non-deductible loan interest (i.e., only loan interest on the first $50,000 of a policy’s loan was deductible), there was a strong economic deterrent to setting premiums above $16,666; namely, higher COI charges and correspondingly higher mortality retention charges. In short, employers were purchasing an income tax reduction strategy, not one involving gains as a consequence of an employee’s death.
Needless to say we will closely monitor this case. A copy of the complaint is available upon request.
Bipartisan Budget Act of 2013 – Restricting Access to SSA DMF
The Bipartisan Budget Act of 2013 (H.J.Res.59 – Continuing Appropriations Resolution, 2014), has passed both the House and Senate and is awaiting a signature from the President to become law. The President has indicated that he intends to sign the legislation.
Among other provisions, the Act includes Section 203 (Restriction on Access to the Death Master File). This section is targeted at reducing identity theft associated with government payments and prohibits the Secretary of Commerce from disclosing information contained on the Death Master File with respect to any individual for a period of three calendar years from the date of the individual’s death.
However, certain entities may qualify for ongoing access under a Certification Program to be established by the Secretary of Commerce. The Certification Program requires that an entity meet the following requirements:
- Must have a legitimate business purpose pursuant to a law, governmental rule, regulation, or fiduciary duty;
- Must have systems, facilities, and procedures in place to safeguard such information, and experience in maintaining the confidentiality, security, and appropriate use of such information, pursuant to requirements similar to the requirements of IRC section 6103(p)(4); and
- Must agree to satisfy the requirements of IRC section 6103(p)(4) as if it applied to such entity.
We covered a highly similar proposal that was embodied in Senate Bill 676 earlier this year and notified insurance companies who have been facing state regulatory pressure to expand their use of DMF data in the processing and payment of life insurance proceeds.
We have once again checked in with insurance companies to understand their intentions with respect to seeking the certification required under the act. Depending on how long it takes the Secretary of Commerce to establish a certification program and issue approvals, some insurance carriers and SSN-sweep service firms might experience delays in identifying deaths.
NAIC to Consider Developing Guidelines for Handling of Unclaimed Death Benefits
On November 8, 2013, the NAIC’s Life Insurance and Annuities (A) Committee (the “Life Committee”) met via teleconference to discuss whether the Life Committee should consider developing guidelines for the consistent handling of unclaimed death benefits.
NAIC president and Louisiana Insurance Commissioner, Jim Donelon, and the Director of Nebraska Department of Insurance, Bruce R. Ramge, are among state regulators pushing for NAIC guidelines. In a November 4, 2013 letter to the Life Committee, the Director of Nebraska Department of Insurance, Bruce R. Ramge, urged the Committee to “begin the process of a formal discussion on life insurers’ use of the Social Security Death Master File or similar databases for purposes of identifying potential unclaimed death benefits” as “[l]ack of guidance creates uncertainty for insurers, regulators, and consumers alike.”
A number of insurance companies have entered into settlement agreements with certain states regarding the handling of unclaimed policy death benefits. In the settlement agreements, some states have mandated the use of Social Security Death Master File to identify deceased policyholders to ensure proper handling of unclaimed death benefits.
FDIC Publication Focuses on Need for Effective Interest-Rate Risk Management
On December 19, the FDIC released the Winter 2013 issue of Supervisory Insights. Among other topics, it included an article titled Industry Trends Highlight Importance of Effective Interest-Rate Risk Management. The article notes that increases in assets across the banking sector are primarily due to growth in securities portfolios and banks with less than $1 billion in assets have seen their long-term asset ratios increase from 19.9% in the second quarter of 2008 to 28.8% in the second quarter of 2013. These and other factors noted in the article have the FDIC concerned about the level of interest rate risk exposure within the industry.
The back end of the Treasury yield curve shifted up in 2013 (the 10 year yield rose from 1.86% at the beginning of the year to 3.04% at the end of the year). Additionally, in December, the FOMC stated that it would begin tapering the bond-buying program in January 2014. The consensus appears to be that the economy will continue its recovery and interest rates will continue an upward path, although the front end of the curve has remained low and flat as the Federal Reserve has maintained a commitment to keep short-term rates near zero.
Federal Insurance Office Issues Report on Modernization, Improvement of Insurance Regulation
Fulfilling a mandate under the Dodd-Frank Act, the Federal Insurance Office (FIO) issued a report to Congress on how to modernize and improve the system of insurance regulation in the United States. The report includes 18 specific areas of near-term reform for the states falling into three broad categories: (1) capital adequacy and safety/soundness, (2) reform of insurer resolution practices, and (3) marketplace regulation.
The report also identifies a number of areas for direct federal government involvement in the regulation of insurance; however, it does not recommend federal regulation as a replacement for state regulation. It suggests that the primary role of the federal government in the near term is to improve standards for states and to assist in international discussions and agreements regarding insurance regulation.
Ad Hoc LRA – December 11, 2013
Agencies Issue Final Rules Implementing the Volcker Rule
On December 10, five federal agencies issued final rules developed jointly to implement section 619 of the Dodd-Frank Act (the “Volcker Rule”). The FDIC’s release is available
Consistent with the proposed rule released in October 2011, the final rules identify separate account BOLI as a non-covered fund, provided certain requirements are met. Below is the applicable language from the final rule [Section 10(c)(7)].
Notwithstanding paragraph (b) of this section, unless the appropriate Federal banking agencies, the SEC, and the CFTC jointly determine otherwise, a covered fund does not include:
(7) Bank owned life insurance. A separate account that is used solely for the purpose of allowing one or more banking entities to purchase a life insurance policy for which the banking entity or entities is beneficiary, provided that no banking entity that purchases the policy:
(i) Controls the investment decisions regarding the underlying assets or holdings of the separate account; or
(ii) Participates in the profits and losses of the separate account other than in compliance with applicable supervisory guidance regarding bank owned life insurance.
The regulators also voted to extend the conformance period by one year. The original conformance period deadline was 7/21/2014. It has been extended to 7/21/2015.