Impact of Basel III on BOLI
Equias Alliance | November, 2013
During the first two weeks of July 2013, the Federal agencies (OCC, Federal Reserve and FDIC) adopted significant changes to the US regulatory capital framework for banking organizations. It is being referred to as the “New Capital Rule” or “Final Rule”. The changes are intended to improve the capital position of banking organizations in response to the Dodd-Frank Act and Basel Committee on Banking Supervision.
The new rule is effective January 1, 2015 for financial institutions with total consolidated assets of less than $250 billion. It will apply to:
- All insured banks and savings associations
- Bank holding companies with more than $500 million in assets
- Savings and loan holding companies domiciled in the US
The new rule is effective January 1, 2014 for the largest US banks.
Prior to the enactment of Basel III, banks relied on the Interagency Statement on the Purchase and Risk Management of Life Insurance (“Interagency Statement”, OCC 2004-56) to guide them on the rules related to the risk-weighting of BOLI assets. In addition, community banks often relied solely on one or more of the three major rating agencies to determine the actual risk-weighting of their BOLI investments. With the adoption of Basel III by the federal agencies and the passage of Dodd-Frank, banks may no longer rely solely on the major rating agencies for the risk-weighting of their assets, and new regulations have been issued regarding the risk-weighting of BOLI assets held in General Account and Separate Account policies.
In General Account BOLI, the general assets of the insurance company issuing the policy support the policy’s cash value, and the book value and credit risk of the portfolio are guaranteed by the carrier. Further, a minimum interest rate guarantee is provided.
General Account BOLI will be treated as a corporate exposureunder the new rules which means it will continue to be riskweighted at 100%. This is consistent with the treatment it had under the Interagency Statement.
In Separate Account BOLI, the policy’s cash value is supported by assets segregated from the general assets of the insurance company. Multiple investment options are available if a policyholder selects Separate Account. Changes in the market value of the underlying portfolio flow through to policyholders on a pro-rata basis.
Separate Account BOLI under the New Capital Rule is considered to be an equity exposure to an investment fund. There are three approaches for risk-weighting Separate Account assets under the new rule:
- The full look-through approach where the aggregate risk-weighted asset amounts for all investments held by the fund are multiplied by the banking organizations proportional interest in the fund
- A simple modified look-through approach, similar to one of two methods available under the current rules, whereby a banking organization multiplies its exposure to the fund by the highest risk weight of any of the assets in the fund
- An alternative modified look-through approach whereby a banking organization assigns risk-weights on a pro rata basis according to the investment limits in the fund’s prospectus/offering memorandum. This is similar to the other methodology available under the current rules. Special rules apply if the sum of the permitted investments across market sectors exceeds 100%.
Regardless of which methodology a banking organization selects, the minimum risk-weight is 20%.
HYBRID SEPERATE ACCOUNT
In a Hybrid Separate Account policy, the policy’s cash value is supported by assets segregated from the general assets of the insurance company and is not subject to claims from other creditors of the insurer. In addition, asset defaults are absorbed by the General Account. The Hybrid Separate Account also typically offers multiple investment options with various risk-weightings (some under 100%) as well as a minimum interest rate that provides a guarantee against investment losses.
It is not clear under the New Capital Rule whether Hybrid Separate Accounts will be treated as General Account or
Separate Account for regulatory capital purposes. Some argue that it should be treated as General Account. If treated as General Account, Hybrid Separate Account would be risk-weighted as a corporate exposure (100% risk-weighting). Others argue that Hybrid Separate Accounts should be treated as Separate Account. If treated as Separate Account, the BOLI policyholder may be able to obtain a risk-weighting under 100%.
Under the Final Rule, to qualify as a Separate Account, the following conditions would have to be met: (1) the account must be legally recognized under applicable law; (2) the assets in the account must be insulated from general liabilities of the insurance company under applicable law and protected from the insurance company’s general creditors in the event of the insurer’s insolvency; (3) the insurance company must invest the funds within the account as directed by the contract holder in designated investment alternatives or in accordance with specific investment objectives or policies; and (4) all investment performance, net of contract fees and assessments, must be passed through to the contract holder, provided that contracts may specify conditions under which there may be a minimum guarantee, but not a ceiling.
It should be noted that some policy structures that are currently classified as Hybrid Separate Account may not fully meet the definition of Separate Account requirement (4) above as all investment performance (gains and losses) are not immediately passed through to the policyholder. It may be difficult for some community banks after January 1, 2015
to take advantage of the lower risk-weighting available with such a product because of the new rules.
CHALLENGES FOR SEPERATE ACCOUNT USERS
If a banking organization has a Separate Account or qualified Hybrid Separate Account, there are challenges ahead regardless of which methodology the financial institution selects:
- Under the full look-though approach, the banking organization might not have the resources needed to do an independent risk-weighting assessment of each asset (exposure) in the portfolio. At this juncture, it is unclear whether carriers or investment managers will provide this information to policyholders because of legal considerations. There is also a question as to whether an independent review of a portfolio’s CUSIP data will be considered a sufficient due diligence analysis by regulators.
- Under the simple modified look-through approach, the banking organization must multiply its exposure to the fund by the highest risk weight of any of the assets in the fund. It is not uncommon for a fund to have at least one asset class within it with a high risk-weighting that would taint the risk-weighting of the entire fund and could cause the risk-weighting of the overall portfolio to exceed 100%.
- Under the alternative modified look-through approach, the banking organization assigns risk-weights on a pro rata basis according to the investment limits in the fund’s prospectus/offering memorandum. Although this approach is used by some banks today, anecdotal evidence suggests that some carriers are likely to have investment guidelines that would result in a higher risk-weighting, once again, possibly exceeding 100%. Some carriers do not set maximum limits on the percentage of funds that could be invested in a particular asset class with a risk-weighting exceeding 100%. An extreme example is where the investment guidelines allow unlimited investment in each asset class. If one of those assets classes was non-Agency securitizations which carry a 1,250% risk-weighting, the entire portfolio would have a risk-weighting of 1,250%. In some instances, a carrier may be unwilling to modify its current investment guidelines because changing them might financially help one segment of its policyholders that use the alternative modified look-through approach, but hurt another segment of its policyholders that use the full look-through approach. If carriers do make changes to reduce/eliminate exposure to particular asset classes with higher risk-weightings, they must also be careful not to violate the diversification requirements of Section 817(h) of the Internal Revenue Code.
CONCLUSION REGARDING HYBRID SEPERATE ACCOUNTS
One of the advantages of selecting a Hybrid Separate Account was that such a policy structure enables the BOLI policyholder to potentially obtain a risk-weighting of less than 100%. As a result of Basel III, it will now be more difficult for some banking organizations to retain that lower risk-weighting.
For a number of community banks that have Hybrid Separate Account, it may be advantageous for such banks if Hybrid Separate Accounts are classified by regulators as General Account rather than Separate Account. The key reason is that a number of these portfolios that currently have a low risk-weighting could end up with a risk-weighting in excess of 100%, depending upon the actions of carriers in the months ahead.
The issue of whether Hybrid Separate Accounts will be treated as a General Account or Separate Account is expected to be resolved during the next several months. The issue of whether carriers and investment managers will be willing and able to provide risk-weighting data on their portfolios and/or revise their investment guidelines to keep the risk-weighting under 100%, while still offering a competitive yield, should also be resolved by that point.
Regardless of whether the Hybrid Separate Account is classified as a General Account or Separate Account, Basel III does not reduce or otherwise impact the credit protection features provided by the Hybrid Separate Account policy structure.
In the final analysis, it is vitally important that community banks have a means to determine the risk-weighting of their BOLI Separate Account portfolios without an undue expenditure of time, money or resources.
Possible third-party sources for banking organizations to obtain assistance in gathering data about the investments and risk-weighting of the investments in their BOLI Separate Account or Hybrid Separate Account portfolios are carriers, investment managers and firms such as BlackRock and Bloomberg. It is unclear at this juncture whether these firms will be willing or able to provide the type of data banks need to perform acceptable due diligence. Of course, cost will also be an issue.
Many of the issues noted above are expected to be resolved during the next several months by the regulatory agencies so that community banks will know how to proceed as of the effective date of January 1, 2015.
Equias Alliance is closely monitoring developments in the marketplace related to Basel III and its impact on BOLI and will keep interested parties updated.
The information contained in this report has been obtained from third-party sources and is believed to be reliable. However, its accuracy and completeness cannot be guaranteed.