By Rick Davis and Larry Stoehr
After previously being left out of the Federal Reserve’s version of Basel III rules, BOLI is now included, which could bring complications to those who use it.
Regulatory complications await those having bank-owned life insurance in their portfolio. BOLI, a $158bn asset class with broad penetration into national and regional bank portfolios, benefits from the features of life insurance to provide superior all-in returns verses index
performance.
But in July, the Federal Reserve adopted its final rules implementing Basel III and unfortunately BOLI was included, after having been ignored in earlier proposals.
The result of the rules change is a challenge in BOLI management that will require significant analysis and departures from current practices for bank policyholders. A potential capital shock could have indirect implications for bank corporate clients. The required changes will be phased in beginning January 1, 2014. These new rulings are likely to require further clarification from banking regulators as the industry confronts the challenges of implementation. It is important that banks going into such discussions be fully aware of the implications of the rules as proposed.
Good value
BOLI cash flow is limited to the payment of death benefits, providing an offset to long tailed employee benefit liabilities. From a practical perspective, BOLI is illiquid due to the taxation of withdrawals, but withdrawals may be made at book value with notification at any time and may be worthwhile depending on tax consequences and other considerations.
The base regulatory document for BOLI is the Interagency Statement on the Purchase and Risk Management of Life Insurance (2004-56). In addition, there have been various interpretive letters regarding specific situations, some of which were incorporated into 2004-56. Both Basel III and the Dodd-Frank Act (DFA) have presented new issues. Main considerations in evaluating both current and prospective BOLI holdings can be categorized as:
- Capital Requirements
- Risk Weighting
- Regulatory Reporting
- Credit Risk Analysis
- Contractual Provisions
- Urgent Action
Capital requirements. At the highest level the Basel regimes provide for a distinction between top tier banks and all others. The top-tier banks are required to follow advanced-approach analysis, which, among other things, permits them to use the internal ratings based (IRB) method in evaluating risk-weighted assets.
All others will follow the “Standardized Approach” analysis. The top tier banks must run Advanced Approach and Standardized Approach analyses in parallel, and then use the worse aggregate result in determining compliance with capital requirements.
Basel III established new capital standards based on common equity tier one capital (CETOC). In defining CETOC, trust preferred securities are generally excluded and adjusted other comprehensive Income (AOCI) is included for top tier banks and may be included or excluded by a one-time permanent election for all other banks. CETOC, therefore, is likely to be less than Tier One Capital and possibly more volatile due to the inclusion of AOCI.
The guideline limit for BOLI is 25 percent of capital (2004-56 notes that capital definitions vary by regulator, but generally, tier one capital has been used). While this is not a hard limit, 2004-56 states that regulators will expect justification for exceeding the limit from a concentration perspective and will scrutinize risk management policies and procedures more closely.
If CETOC is the new reference for the guideline limit, this could result in greater regulatory scrutiny for banks near the limit based on tier 1 capital.
Risk weighting. Basel III and 2004-56 follow the risk-weighting approach:
- General account BOLI is risk-weighted at 100 percent as a corporate exposure under the Standardized Approach.
- Separate account BOLI is treated as an equity exposure to an investment fund and must use one of three look-through approaches to risk weighting the asset.
risk-weighting details
For general account BOLI, there had been some industry views of banks using advanced approach to be able to use IRB to lower general-account BOLI risk weighting, based on the insurance company’s credit risk. But Basel III does not appear to distinguish among carriers of different credit quality. This is an important issue to be clarified by regulators.
Separate account BOLI presents new challenges. Under 2004-56, look-through was an option for a bank to use instead of applying 100 percent risk weighting. Basel III appears to no longer permit this. Now, the bank must use one of three look-through approaches applicable to exposures to investment funds:
- Full look-through, which requires full transparency to each underlying exposure.
- Simplified modified look-through, using the highest risk weight of the potential exposures applies to the entire fund.
- Alternative modified look-through, which assumes maximum allocation to the highest risk weighted exposure allowed in the management contract, and so forth until 100 percent of allocations are used.
As demonstrated in the chart on the next page, the full look-through approach can have a dramatic effect on the risk-weighting of the BOLI asset relative to the modified approaches. In the example illustrated, portfolio guidelines permit investments primarily in Treasuries and Government MBS, but allow a 10 percent allocation to private ABS. We observe that without full look-through, the risk weighting can be punitive.
Because of variations in product design, hybrid separate accounts, in which assets are held in a separate account but have the cash value guaranteed by the insurer’s general account, do not fall neatly into the new risk weighting rules.
The bank will need to fully examine these products to decide whether the general account or separate account rules apply. Exposures to stable value products and to the insurer in a separate account BOLI product will be risk weighted at
100 percent as corporate exposures to the wrap provider.
Finally, it appears the 4-56 rules regarding equity-linked exposures related to deferred compensation plans are retained under Basel III. By characterizing such exposures as a “hedged pair” under Basel III, only the “ineffective portion of the hedge” is separately risk weighted. The effective portion of the hedge is risk weighted at 100 percent.
However, Basel III allows an 80 percent correlation standard to establish a hedged pair; 2004-56 requires a “high correlation” (at least 95 percent). Optimal risk weighting can be highly technical, requiring strong legal analysis and advanced quantitative modeling involving specialized discussions with regulators about acceptable data sets and methodologies.
Regulatory reporting. The Basel III requirements related to Separate Account BOLI create specific issues:
- Reporting by carrier to policyholder.
- Investment guidelines and specific assets.
Policy holding banks using the full look-through approach will need significantly more information than carriers have provided in the past regarding the assets in the investment fund. Primarily this was due to IRS restrictions to prevent policyholders from influencing asset management.
Under new Basel rules the policyholder will need more granular information on a timelier basis about the underlying investments in order to comply with look-through requirements. The carrier must obtain necessary information from the manager and relay this information on to the policyholder for reporting.
A draconian issue in reporting relates to securitization exposures within an investment fund. Since DFA eliminated the ratings-based approach, a bank must be able to use the simplified supervisory formula approach or the gross-up approach to evaluate the securitization exposure or else apply a risk weight of 1,250 percent.
Credit risk analysis. For general account policies, Basel III did not address specifically credit risk analysis within BOLI, so 4-56 still applies, requiring an annual review of the credit condition of the insurance carrier and potential risks. DFA, however, prevents banks from relying solely on external credit ratings in reviewing the credit condition of BOLI insurance companies. It is anticipated that banks will need to demonstrate a rigorous understanding of the insurance company’s financial condition, including the relevance of statutory accounting principles.
Contractual Provisions. Basel III risk weighting requires attention to detailed contractual provisions in BOLI policies, especially in stable value wraps. Contractual provisions aimed at limiting the exposure of the wrap provider make an evaluation of the capital implications non-straightforward for both wrap provider and policyholder.
For example, many stable value wraps contain a “regulatory change” termination provision. Also, stable value wraps have typically attempted to exclude bonds that incur credit losses, or terminate the wrap if the policyholder is downgraded or has liquidity issues. Not least, asset manager agreements must closely be examined.
Urgent action items. The CFO should consider the following and take action:
- Re-evaluate its credit analysis of general account BOLI providers, without reliance on ratings agencies, and prepare for additional reporting.
- Separate account and hybrid policies require a thorough review:
- Asset manager investment guidelines
- Granular reporting with carriers and investment managers
- Stable Value contract analysis
- Upgrade reporting on hedged asset/liability pairing
- Develop decision models for portfolio optimization
The regulatory changes in Basel III and DFA have left open a number of issues requiring interpretation. Accordingly, the bank office of the CFO should discuss with its BOLI advisor a strategy for compliance, cost mitigation and engage constructively with regulators during the process.
BOLI advisors must demonstrate that they are fully aware of the implications of these changes for their clients. As ever, the more informed and systematically prepared a bank is in entering discussions with regulators, the more likely it reaches a good outcome.
Rick Davis, Finalytics LLC, at [email protected] or +1 (610) 331-5973. Larry Stoehr, Institutional Insurance Group, at [email protected] or +1 (336) 387-0490.