Bank-owned insurance subject to regulations

The Missouri Department of Economic Development Division of Finance continues to receive inquiries from banks regarding bank-owned life insurance. Many questions are generated by a bank’s interest in pursuing such a program, or following an examination where the bank’s insurance program has been questioned or criticized by state or federal bank examiners.

Legal requirements and regulatory guidance are now readily available to bankers.

Step by step

Any bank implementing a bank-owned life insurance program or reviewing an existing program needs to consider the following: Division of Finance rule 4 CSR 140-2.055; Missouri’s insurable interest statute related to employer or corporate owned insurance; Section 376.531, RSMo; and the Interagency Statement on the Purchase and Risk Management of Life Insurance FIL 127-2004.

The Division’s rule specifically authorizes bank-owned life insurance for coverage of loss related to the death of key persons, to fund employee compensation benefits (split-dollar programs or programs to offset costs of employee compensation and benefits), and for loss related to the death of borrowers. A bank is not authorized to purchase or hold life insurance for speculative investment or to fund ownership transition plans.

Section 376.531 establishes an insurable interest for employers in the lives of their employees, directors and retirees, but it requires an opt-out notice to be given and limits the insurable interest in nonmanagement and retired employees by tying the interest to welfare and benefit plan liabilities.

Due diligence

FIL 127-2004 provides guidance describing the due diligence required of banks for both a pre-purchase analysis and a periodic review of a bank’s corporate-owned insurance program.

Life insurance products are typically illiquid and present significant surrender charges and tax liabilities if policies are cancelled. There is a tremendous variation in product characteristics and the quality of the product, and of life insurance companies and vendor services. While many insurance brokers and insurance companies strive for quality – the life insurance industry is commission- and profit-driven – these motives may compromise the product, advice and services provided. Therefore, effective oversight by senior management and the board is crucial to achieve an effective bank-owned life insurance program.

A bank examination may demonstrate that a bank has failed to exercise appropriate diligence in its pre-purchase analysis or periodic review of the bank-owned insurance program, or alternatively, no documentation exists to demonstrate any diligence.

For example, a bank may hold high-dollar policies on former or retired executives with little documentation of the original purpose for the bank-owned insurance. In these instances, the policies appear to be key-person coverage. Under both 4 CSR 140-2.055 and FIL 127-2004 the bank could be required to dispose of the policies. In addition, if the bank can no longer demonstrate an insurable interest in these lives, it is possible that a relative or heir of the officers will attempt to claim the proceeds on the death of the insured.

Tax liability

Banks seeking to surrender a life insurance policy often find that substantial surrender charges apply and that significant tax liability may accrue. To avoid this outcome, the bank may wish to undertake a thorough review of its bank-owned insurance program. If the policies cannot be prudently cancelled or the named insured substituted, the bank may decide to retain the policies to offset employee compensation and welfare benefits as documented in a revised bank-owned life insurance program. Note, however, that a thorough pre-purchase analysis would have anticipated these events, and the bank’s original insurance program could have addressed these issues through appropriate design and product selection.

Keith Thornburg is counsel for the Missouri Department of Economic Development’s Division of Finance.

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