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COLI/BOLI, IOLI/STOLI – The good, the bad, and

the ugly

Association of Insurance Compliance Professionals

2009 National MeetingPhoenix, Arizona

Jim MaxsonTony Roehl

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Disclaimer

This presentation is provided as a general informational service to clients and friends of Morris, Manning & Martin, LLP. Therefore, it should not be relied upon as a complete record for purposes of regulatory compliance, nor is it intended to furnish legal advice adequate to any particular circumstances. This presentation does not create an attorney-client relationship. Any opinions expressed herein are solely those of the speaker and do not represent the opinion of Morris, Manning & Martin, LLP or the opinions of any of our clients.

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Overview

1. What is COLI/BOLI

2. What is the Purpose of COLI/BOLI

3. (Relatively) Recent Developments

4. Stranger-Originated Life Insurance

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What is COLI/BOLI

– COLI – Corporate Owned Life Insurance

– BOLI – Bank Owned Life Insurance

COLI/BOLI policies are life insurance policies owned by corporations/banks covering the lives of senior management and key highly compensated employees (generally employees among the top 35% of the most highly paid employees or those earning more than $110,000 per year).

BOLI - $126 billion in cash value in force in 2008

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What is the Purpose of COLI/BOLI

• The purpose of the policies is to fund the cost of employee compensation and employee benefit programs. Including pre- and post-retirement expenses. The time horizon of life insurance works well due to the fact that benefit costs spike in the last year of an person’s life.

• Policies are designed to generate tax free income:

– Tax deferred cash accumulation;– Tax favored cash availability; and– When a death occurs, the policy owner receives the death benefit

tax free.

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(Relatively) Recent Developments

Lawsuits

– Winn-Dixie Stores, Inc. v. Comm’r, 254 F.3d 1313 (11th Cir. 2001), cert. denied, 535 U.S. 986 (2002).

• Winn-Dixie purchased life insurance on almost all full-time employees.

• Program declared to be a sham transaction and the interest on policy loans was not tax deductible – Winn-Dixie takes tax hit.

– Mayo v. Hartford Life Ins. Co., 220 F. Supp. 2d 794 (S.D. Tex. 2002).

• Wal-Mart purchased insurance on approx. 350,000 of its employees. After an hourly employee, died, his estate filed a claim against Wal-Mart to recover the death benefits due under the life insurance policy, claiming that Wal-Mart didn’t have any insurable interest in the worker's life. The court held that the employer had no insurance interest on the worker's life and Wal-Mart was forced to pay out the proceeds of the life insurance program to employees’ estates.

– Dow Chem. Co. v. United States, 435 F.3d 594 (6th Cir. 2006).

• Dow purchased insurance on over 21,000 employees and financed the premiums by borrowing the cash value of the policies. The IRS disallowed the deductions for the loan interest expense because the COLI plans were economic shams.

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(Relatively) Recent Developments

OCC Bulletin 2004-56 – Interagency Statement on the Purchase and Risk Management of Life Insurance

Issued by the Office of the Comptroller of the Currency; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; and Office of Thrift Supervision

Pre-purchase Analysis

The objective of the pre-purchase analysis is to help ensure that the institution understands the risks, rewards, and unique characteristics of BOLI. The nature and extent of this analysis should be commensurate with the size and complexity of the potential BOLI purchases and should also take into account existing BOLI holdings. A pre-purchase analysis includes:

– Identifying the need for insurance and determining the economic benefits and appropriate insurance type;

– Quantifying the amount of insurance appropriate for the institution’s objectives;

– Assessing vendor qualifications;

– Reviewing the characteristics of the available insurance products;

– Selecting carrier;

– Determining the reasonableness of compensation provided to the insured employee if the insurance results in additional compensation;

– Analyzing the associated risks and the bank’s ability to monitor and respond to those risks;

– Evaluating alternatives; and

– Documenting the bank’s decision.

The Bulletin addresses the potential reputational risk to a bank from investing in BOLI and recommends banks thoroughly document employee consent.

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(Relatively) Recent Developments

Annual post-purchase review with the Board of Directors

The post-purchase review should include at a minimum:

– A comprehensive assessment of risks discussed in the guidance;

– Identification of employees who are insured;

– Assessment of death benefit amounts relative to employee salaries;

– Calculation of percentages of insured persons still employed by the institution;

– Evaluation of material changes to BOLI risk management policies;

– Assessment of the effects of policy exchanges;

– Analysis of mortality performance and impact on income;

– Evaluation of material findings from internal and external audits and independent risk management reviews;

– Identification of the reason for, and tax implications of, any policy surrenders; and

– Peer analysis of BOLI holdings.

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(Relatively) Recent Developments

Pension Protection Act of 2006

Adds Section 101(j) to the Internal Revenue Code. Designed to limit perceived abuses of “Janitor Insurance.”

Section 101(j):

– limits tax benefits to corporations only where insurance covers the lives of senior management and key highly compensated employees (generally employees among the top 35% of the most highly paid employees or those earning more than $110,000 per year).

– Imposes pre-purchase consent requirements that are meet by:

1. Notifying the employee in writing that the applicable policyholder intends to insure the employee's life and the maximum face amount for which the employee could be insured at the time the contract was issued,

2. The employee providing written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and

3. Informing the employee in writing that the policyholder will be a beneficiary of any proceeds payable upon the death of the employee.

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What is Stranger-Originated Life Insurance?

• The purchase of life insurance with the intention of assigning the policy or otherwise transferring its ownership and death benefits to an investor having no insurable interest in the life of the insured.

• Typically, an individual is assisted in obtaining a life insurance policy on his or her life through a non-recourse loan from a third-party investor.

• After two years (the customary contestable period), the policy is usually surrendered to the investor in satisfaction of the loan.

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What Are The Problems With STOLI?

• The legal requirement that an insurable interest must exist between the policy owner and the insured dates to the 1600s.

• An insurable interest exists where there is: (i) a reasonable expectation of pecuniary gain through the continued life of the insured; or (ii) loss by reason of the death of the insured; or (iii) a substantial interest engendered by love and affection.

• When a policy is purchased at the initiation of an investor solely for the purpose of sale to that or another investor, the investor has no legal insurable interest.

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What Are The Problems With STOLI?

• In some cases, STOLI policies are obtained by making material misrepresentations or omissions to the carrier about the insured’s health or financial condition.

• In essence, applicants who are participants in STOLI programs may be complicit in insurance fraud.

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What Harm Does STOLI Do?

• Misrepresentations and/or often are made in the application for a STOLI policy, which results in faulty underwriting.

• Many carriers have unknowingly issued billions of dollars of face value in STOLI policies.

• Over time, the arbitrage between the insured’s represented health or financial condition versus the insured’s actual health and financial condition, will result in the carrier suffering significant losses.

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What Harm Does STOLI Do?

• Once unscrupulous agents realize that a carrier is not carefully analyzing applications to identify potential STOLI policies, the carrier can become a target.

• STOLI policies, and the premium associated with them, can impact carriers’ long-term financial assumptions as the lapse rates for these policies will not mirror historical performance.

• Large blocks of STOLI policies may adversely impact the carrier’s long-term financial performance, and will drive up the price of insurance for all of its customers.

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Legislative Efforts to Address STOLI

• NCOIL Life Settlements Model Act defines STOLI as:

“a practice or plan to initiate a life insurance policy for the benefit of a third party investor who, at the time of policy origination, has no insurable interest in the insured. STOLI practices include but are not limited to cases in which life insurance is purchased with resources or guarantees from or through a person, or entity, who, at the time of policy inception, could not lawfully initiate the policy himself or itself, and where, at the time of inception, there is an arrangement or agreement, whether verbal or written, to directly or indirectly transfer the ownership of the policy and/or the policy benefits to a third party. Trusts, that are created to give the appearance of insurable interest, and are used to initiate policies for investors, violate insurable interest laws and the prohibition against wagering on life.

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Legislative Efforts to Address STOLI

• In Section 2(H)(1)(a) “Fraudulent Life Settlement Act” is defined to include “Enter[ing] into any practice or plan which involves STOLI.”

• Section 16. Penalties

– A. It is a violation of this Act for any Person, Provider, Broker, or any other party related to the business of life settlements, to commit a Fraudulent Life Settlement Act.

– B. For criminal liability purposes, a person that commits a Fraudulent Life Settlement Act is guilty of committing insurance fraud and shall be subject to additional penalties under [insert State statute regarding insurance fraud].

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Legislative Efforts to Address STOLI

NAIC Model Act – 2007 Amendments

Section 11. Prohibited Practices

A. It is a violation of this Act for any person to enter into a viatical settlement contract at any time prior to the application or issuance of a policy which the subject of viatical settlement contract within a five-year period commencing with the date of issuance of the insurance policy or certificate unless the viator certifies to the viatical settlement provider that one or more of the following conditions have been met within the five-year period:

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Legislative Efforts to Address STOLI

(3) The viator enters into a viatical settlement contract more than two (2) years after the date of issuance of a policy and, with respect to the policy, at all times prior to the date that is two (2) years after policy issuance, the following conditions are met:

(a) Policy premiums have been funded exclusively with unencumbered assets, including an interest in the life insurance policy being financed only to the extent of its net cash surrender value, provided by, or fully recourse liability incurred by, the insured or a person described in Section 2N(3)(e);

(b) There is no agreement or understanding with any other person to guarantee any such liability or to purchase, or stand ready to purchase, the policy, including through an assumption or forgiveness of the loan; and

(c) Neither the insured nor the policy has been evaluated for settlement.

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The Minnesota Approach

• In May 2009, Minnesota passed 60A.078, a comprehensive statute designed to address and eliminate STOLI.

• Subd. 12.Stranger-originated life insurance practices defined.

"Stranger-originated life insurance practices" or "STOLI practices" means an act, practice, or arrangement to initiate a life insurance policy for the benefit of a third-party investor who, at the time of policy origination, has no insurable interest in the insured. STOLI practices include, but are not limited to, cases in which life insurance is purchased with resources or guarantees from or through a person or entity, who, at the time of policy inception, could not lawfully initiate the policy themselves, and where, at the time of inception, there is an arrangement or agreement, whether spoken or written, to directly or indirectly transfer the ownership of the policy and/or the policy benefits to a third party. Trusts that are created to give the appearance of insurable interest and are used to initiate policies for investors violate the insurable interest requirements and the prohibition against STOLI practices.

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The Minnesota Approach

60A.0784 It is unlawful for any person to:

(1) procure or cause to be procured or effected a policy in violation of section 60A.0783;

(2) engage in STOLI practices or otherwise wager on life;

(3) solicit, market, or otherwise promote the purchase of a policy for the purpose of or with an emphasis on the subsequent sale of the policy in the secondary market;

(4) enter into a premium finance agreement with any person or agency, or any person affiliated with such person or agency, pursuant to which the lender or any person affiliated with the lender shall receive any proceeds, fees, or other consideration, directly or indirectly, from the policy or policyowner or any other person with respect to the premium finance agreement or any settlement contract or other transaction related to such policy that are in addition to the amounts required to pay the principal, interest, and service charges related to policy premiums pursuant to the premium finance agreement or subsequent sale of such agreement; provided, further, that any payments, charges, fees, or other amounts in addition to the amounts required to pay the principal, interest, and service charges related to policy premiums paid under the premium finance agreement shall be remitted to the insured or to the insured's estate if the insured is not living at the time of the determination of the overpayment; or

(5) enter into or to offer to enter into a settlement contract prior to the issuance of a policy that is the subject of the settlement contract or proposed settlement contract.

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Rebuttable Presumption of STOLI

60A.0786 Presumption of STOLI practices.

A settlement contract, or any agreement the effect of which is to sell or acquire the policy or a beneficial interest in the policy, entered into within the four-year period commencing with the date the policy is issued creates a rebuttable presumption of STOLI practices if either of the following circumstances are present:

(1) there was an agreement or understanding, before issuance of the policy, between the insured, policyowner, or owner of a beneficial interest in the policy, and another person to guarantee any liability or to purchase, or stand ready to purchase, the policy or an interest in the policy, including through an assumption or forgiveness of a loan; or

(2) both of the following are present:

(i) all or a portion of the policy premiums were funded by means other than by the insured's personal assets or assets provided by a person who is closely related to the insured by blood or law or who has a lawful and substantial economic interest in the continued life of the insured. For purposes of this provision, funds from a premium finance loan are considered assets of the insured or that person only if the insured or that person is contractually obligated to repay the full amount of the loan and to pledge personal assets, other than the policy itself, for loan amounts exceeding the policy's cash value; and

(ii) the insured underwent a life expectancy evaluation within the 18-month time period immediately prior to the issuance of the policy and, during the same time period, the results of the life expectancy evaluation were shared with or used by any person for the purpose of determining the actual or potential value of the policy in the secondary market.

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STOLI Is Difficult To Detect

• There is no single form of STOLI program. There are non-recourse, partial recourse, hybrid, modified hybrid programs, etc. . .

• STOLI programs have and will continue to morph as carriers catch on to the latest program.

• It can be difficult to keep track of the latest iterations of STOLI, and there is the risk that the barn door is constantly being closed after most of the horses have already escaped.

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What Can Carriers do About STOLI?

• The best way to combat STOLI is never to issue the policies in the first place.

• Carriers should invest in an automatic review program to identify the indicia of STOLI and subject such applications to heightened scrutiny.

• Carriers should also review their book of existing policies to determine if there are STOLI policies contained therein.

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STOLI Detection & Elimination

1. Sorting and Preliminary Analysis

– The first step is to create a unique template that will integrate into the carrier’s policy processing system.

– The template should incorporate the major flags that indicate that a life insurance policy is STOLI.

– The template will then be run against the carrier’s database of in-force policies.

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STOLI Detection & Elimination

2. Reaction and In-depth Analysis:

– Once trends in policies have been identified, a closer analysis can be undertaken in order to determine whether specific policies are STOLI.

– Recommendations for dealing with those policies identified as STOLI can then be made.

– Options may include challenges on the basis of fraud if policies are still in the contestability period, or rescinding policies if no insurable existed at the time the policies were issued.

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STOLI Detection & Elimination

3. New Business Screen

– A template unique to each carrier should be created in order to screen new policies and flag in-coming applications that have the indicia of STOLI policies.

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James W. Maxson is Of Counsel in the firm’s Insurance and Reinsurance Practice. Mr. Maxson’s areas of expertise include life settlements, mergers and acquisitions, securities and regulatory issues. Mr. Maxson is Co-Chair of the firm’s Life Settlements group and his practice focuses on all aspects of the life settlement industry. He has performed extensive work in the areas of licensing, regulatory compliance, fund structuring, and policy acquisitions. Mr. Maxson received his bachelor’s degree from Denison University and Ohio State University College of Law.

Thank You

Jim MaxsonPhone: 404.495.3646jmaxson@mmmlaw.com

Tony Roehl is an Associate in the firm’s Insurance and Reinsurance and Corporate Practices. Mr. Roehl’s principle areas of concentration are insurance regulation and corporate matters involving entities within the insurance industry. Mr. Roehl received his bachelor’s degree from the University of Florida and his law degree from the University of Michigan.

Tony RoehlPhone: 404.495.8477troehl@mmmlaw.comhttp://www.linkedin.com/in/tonyroehl