Business-Owned Life Insurance
Preliminary Observations on Uses, Prevalence, and Regulatory Oversight Gao ID: GAO-04-191T October 23, 2003Business-owned life insurance is held by employers on the lives of their employees, and the employer is the beneficiary of these policies. Unless prohibited by state law, businesses can retain ownership of these policies regardless of whether the employment relationship has ended. Generally, business-owned life insurance is permanent, lasting for the life of the employee and accumulating cash value as it provides coverage. Attractive features of business-owned life insurance, which are common to all permanent life insurance, generally include both tax-free accumulation of earnings on the policies' cash value and tax-free receipt of the death benefit. To address concerns that businesses were abusing their ability to deduct interest expenses on loans taken against the value of their policies, Congress passed legislation to limit this practice, and the Internal Revenue Service (IRS) and Department of Justice pursued litigation against some businesses. But concerns have remained regarding employers' ability to benefit from insuring their employees' lives. This testimony provides some preliminary information from ongoing GAO work on (1) the uses and prevalence of business-owned life insurance and (2) federal and state regulatory requirements for and oversight of business-owned life insurance.
GAO's preliminary work indicated that no comprehensive data are available on the uses of business-owned life insurance policies; however, businesses can purchase these policies to fund current and future employee benefits and receive tax advantages in the process. Federal bank regulators have collected some financial information on banks' and thrifts' business-owned life insurance holdings, but the data are not comprehensive and do not address the uses of the policies. The Securities and Exchange Commission (SEC), the IRS, state insurance regulators, and insurance companies told GAO that they generally have not collected comprehensive data on the sales or purchases of these policies or on their intended uses, because they have not had a need for such data in fulfilling their regulatory missions. In an effort to collect comprehensive data, GAO considered surveying insurance companies about their sales of business-owned life insurance. However, based on a pretest with six insurance companies, GAO determined that it would not be able to obtain sufficiently reliable data to allow it to conduct a survey. GAO found, however, that some insurers have voluntarily disclosed information about sales of business-owned policies and that some noninsurance businesses have included examples of their uses in annual financial reports filed with SEC. As part of their responsibility to oversee the safety and soundness of banks and thrifts, the federal bank regulators have issued guidelines for institutions that buy business-owned life insurance. Also, they told GAO that they have reviewed the holdings of many institutions with significant amounts of business-owned life insurance and concluded that major supervisory concerns do not exist. SEC officials said that the agency has not issued specific requirements for holders of business-owned life insurance, relying instead on its broadly applicable requirement that public companies disclose information material to investors in their financial statements; SEC did not have investor protection concerns about public firms holding business-owned life insurance. The IRS had some requirements related to the tax treatment of business-owned life insurance and expressed some concerns about compliance with these requirements. State laws governing business-owned life insurance differed; the four states' regulators that GAO interviewed described some limited oversight of the policies, and these regulators and NAIC reported no problems with them.
GAO-04-191T, Business-Owned Life Insurance: Preliminary Observations on Uses, Prevalence, and Regulatory Oversight
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Testimony:
Before the Committee on Finance, United States Senate:
United States General Accounting Office:
GAO:
For Release on Delivery Expected at 2:00 p.m. EDT:
Thursday, October 23, 2003:
BusineSs-Owned Life Insurance:
Preliminary Observations on Uses, Prevalence, and Regulatory Oversight:
Statement of Davi M. D'Agostino, Director, Financial Markets and
Community Investment:
GAO-04-191T:
GAO Highlights:
Highlights of GAO-04-191T, a testimony before the Committee on
Finance, U.S. Senate
Why GAO Did This Study:
Business-owned life insurance is held by employers on the lives of
their employees, and the employer is the beneficiary of these
policies. Unless prohibited by state law, businesses can retain
ownership of these policies regardless of whether the employment
relationship has ended. Generally, business-owned life insurance is
permanent, lasting for the life of the employee and accumulating cash
value as it provides coverage. Attractive features of business-owned
life insurance, which are common to all permanent life insurance,
generally include both tax-free accumulation of earnings on the
policies‘ cash value and tax-free receipt of the death benefit.
To address concerns that businesses were abusing their ability to
deduct interest expenses on loans taken against the value of their
policies, Congress passed legislation to limit this practice, and the
Internal Revenue Service (IRS) and Department of Justice pursued
litigation against some businesses. But concerns have remained
regarding employers‘ ability to benefit from insuring their employees‘
lives.
This testimony provides some preliminary information from ongoing GAO
work on (1) the uses and prevalence of business-owned life insurance
and (2) federal and state regulatory requirements for and oversight of
business-owned life insurance.
What GAO Found:
GAO‘s preliminary work indicated that no comprehensive data are
available on the uses of business-owned life insurance policies;
however, businesses can purchase these policies to fund current and
future employee benefits and receive tax advantages in the process.
Federal bank regulators have collected some financial information on
banks‘ and thrifts‘ business-owned life insurance holdings, but the
data are not comprehensive and do not address the uses of the
policies. The Securities and Exchange Commission (SEC), the IRS, state
insurance regulators, and insurance companies told GAO that they
generally have not collected comprehensive data on the sales or
purchases of these policies or on their intended uses, because they
have not had a need for such data in fulfilling their regulatory
missions. In an effort to collect comprehensive data, GAO considered
surveying insurance companies about their sales of business-owned life
insurance. However, based on a pretest with six insurance companies,
GAO determined that it would not be able to obtain sufficiently
reliable data to allow it to conduct a survey. GAO found, however,
that some insurers have voluntarily disclosed information about sales
of business-owned policies and that some noninsurance businesses have
included examples of their uses in annual financial reports filed with
SEC.
As part of their responsibility to oversee the safety and soundness of
banks and thrifts, the federal bank regulators have issued guidelines
for institutions that buy business-owned life insurance. Also, they
told GAO that they have reviewed the holdings of many institutions
with significant amounts of business-owned life insurance and
concluded that major supervisory concerns do not exist. SEC officials
said that the agency has not issued specific requirements for holders
of business-owned life insurance, relying instead on its broadly
applicable requirement that public companies disclose information
material to investors in their financial statements; SEC did not have
investor protection concerns about public firms holding business-owned
life insurance. The IRS had some requirements related to the tax
treatment of business-owned life insurance and expressed some concerns
about compliance with these requirements. State laws governing
business-owned life insurance differed; the four states‘ regulators
that GAO interviewed described some limited oversight of the policies,
and these regulators and NAIC reported no problems with them.
www.gao.gov/cgi-bin/getrpt?GAO-04-191T.
To view the full product, click on the link above. For more
information, contact Davi M. D'Agostino at (202) 512-8868 or
d'agostinod@gao.gov.
[End of section]
Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss the preliminary results of
GAO's work on business-owned life insurance, done at the request of
Senators Akaka and Bingaman. Business-owned life insurance--including
corporate-owned, bank-owned, and trust-owned life insurance--is held by
employers on the lives of their employees. The employer is the
beneficiary of these policies. Some of this insurance protects against
the loss of key executives--called key-person insurance--while some of
it covers larger groups of employees and is called broad-based
insurance. Unless prohibited by state law, businesses can retain
ownership of these policies regardless of whether the employment
relationship has ended. Generally, business-owned life insurance is
permanent rather than term life insurance, lasting for the life of the
employee and accumulating cash value as it provides coverage.
Attractive features of business-owned life insurance, which are
features common to all permanent life insurance, generally include both
tax-free accumulation of earnings on the policies' cash value and tax-
free receipt of the death benefit.
To address concerns that businesses were abusing their ability to
deduct interest expenses on loans taken against the value of their
policies, Congress passed legislation to limit this practice, and the
Internal Revenue Service (IRS) and Department of Justice pursued
litigation against some businesses. But concerns have remained
regarding employers' ability to benefit from insuring their employees'
lives--specifically, whether (1) employers should be considered to have
an insurable interest in employees' lives that allows them to hold
business-owned life insurance, (2) employers' insurable interest should
continue after the employment relationship ends and, if so, under what
circumstances, (3) employers should be required to obtain their
employees' consent before purchasing business-owned life insurance, and
(4) businesses should be allowed to receive tax advantages from owning
these policies. Proponents of business-owned life insurance point out
that, among its other purposes, businesses use these policies to fund
broad-based benefits for their employees, including pre-and
postretirement health care.
We currently have work underway, and today, I will provide some
preliminary information on (1) the uses and prevalence of business-
owned life insurance and (2) federal and state regulatory requirements
for and oversight of business-owned life insurance.
To obtain this information, we analyzed the financial reports that
banks filed with their regulators as well as the corporate annual
financial statements that publicly traded insurers and noninsurers
filed with the Securities and Exchange Commission (SEC). In addition,
we interviewed officials of the IRS, SEC, the federal bank regulators,
four state insurance departments, the National Association of Insurance
Commissioners (NAIC), two life insurance associations, and six life
insurance companies. We began our work in February 2003, and it is
still ongoing.
Summary:
Based on our preliminary work to date, no comprehensive data are
available on the uses of business-owned life insurance policies;
however, businesses can purchase these policies to fund current and
future employee benefits and receive tax advantages in the process.
Federal bank regulators have collected some financial information on
banks' and thrifts' business-owned life insurance holdings, but the
data are not comprehensive and do not address the uses of the
policies.[Footnote 1] SEC, the IRS, state insurance regulators, and
insurance companies told us that they generally have not collected
comprehensive data on the sales or purchases of these policies or on
their intended uses, because they have not had a need for such data in
fulfilling their regulatory missions. In an effort to collect
comprehensive data, we considered surveying insurance companies about
their sales of business-owned life insurance. However, based on a
pretest with six insurance companies, we determined that we would not
be able to obtain sufficiently reliable data to allow us to conduct a
survey. We found, however, that some insurers have voluntarily
disclosed information about sales of business-owned policies and that
some noninsurance businesses have included examples of their uses in
annual financial reports filed with SEC. As part of their
responsibility to oversee the safety and soundness of banks and
thrifts, the federal bank regulators have issued guidelines for
institutions that buy business-owned life insurance. Also, they told us
that they have reviewed the holdings of many institutions with
significant amounts of business-owned life insurance and concluded that
major supervisory concerns do not exist. SEC officials said that the
agency has not issued specific requirements for holders of business-
owned life insurance, relying instead on its broadly applicable
requirement that public companies disclose information material to
investors in their financial statements; SEC did not have investor-
protection concerns about public firms holding business-owned life
insurance. The IRS had some requirements related to the tax treatment
of business-owned life insurance and expressed some concerns about
compliance with these requirements. State laws governing business-owned
life insurance differed; the four states' regulators that we
interviewed described some limited oversight of the policies, and these
regulators and NAIC reported no problems with them.
No Comprehensive Data Were Available on the Uses and Prevalence of
Business-Owned Life Insurance:
Neither federal nor state regulators collected comprehensive data on
the uses and prevalence of business-owned life insurance. Although no
comprehensive data were available on the uses of such policies,
businesses may purchase life insurance to ensure recovery of losses in
the event of the untimely death of key employees and to fund pre-and
postretirement employee benefits. Accounting standards require that the
future costs of postretirement benefit plans be recorded as liabilities
at their present value on current financial statements. The accounting
standards do not require that such liabilities be directly offset with
specified assets. However, businesses may choose to fund such future
costs using life insurance, thereby becoming eligible for tax-free
policy earnings and tax-free death benefit payments on the
policies.[Footnote 2] When businesses use nonqualified plans to provide
postretirement benefits, they avoid the funding and other restrictions
of tax-preferred qualified plans, while retaining control over the plan
assets.[Footnote 3]
Federal bank regulators did not collect comprehensive data on the uses
and prevalence of business-owned life insurance by banks and thrifts,
although they collected some financial information on such policies as
part of monitoring the safety and soundness of individual institutions.
Regulatory officials said that they collect this information to support
their supervision of individual institutions. For supervisory purposes,
banks and thrifts are only required to disclose the cash surrender
value of business-owned life insurance and earnings from these policies
in their quarterly financial reports to the regulators if the amounts
exceed certain thresholds. For example, the Federal Deposit Insurance
Corporation (FDIC), Federal Reserve Board, and Office of the
Comptroller of the Currency (OCC) require the institutions they
regulate to disclose the cash surrender value of policies worth more
than $25,000 in aggregate and that exceed 25 percent of "other assets,"
which include such items as repossessed personal property.[Footnote 4]
The Office of Thrift Supervision (OTS) requires the thrifts it
supervises to report the cash surrender value of policies if the value
is one of the three largest components of "other assets." In addition
to the banks and thrifts that meet a disclosure threshold, other
institutions sometimes voluntarily provide data on their business-owned
life insurance policies.
Our preliminary results indicated that about one-third of banks and
thrifts, including many of the largest institutions, disclosed the
value of their business-owned life insurance holdings as of December
31, 2002, either voluntarily or because they met the reporting
threshold.[Footnote 5] The remaining two-thirds either did not meet the
reporting threshold or did not own business-owned life insurance. We
found that 3,209 banks and thrifts (34 percent of all institutions)
reported the cash surrender value of their policies at $56.3 billion.
Twenty-three of the top 50 banks and thrifts--ranked by total assets--
reported owning policies worth $36.9 billion, or 66 percent of the
reported total of all banks and thrifts. Overall, 259 large banks and
thrifts--those with assets of $1 billion or more, including those among
the top 50--held 88 percent, or $49.4 billion, of the total reported
cash surrender value of business-owned life insurance.
The quarterly reports that commercial banks and FDIC-supervised thrifts
submitted did not require them to categorize business-owned life
insurance policies according to their intended use. OTS-supervised
thrifts, in contrast, were required to report the value of their key-
person policies and the value of business-owned life insurance policies
held for other purposes as separate items, if they met the reporting
threshold. However, since the disclosure threshold applied separately
to the two categories, OTS-supervised thrifts could be required to
report on only one type of policy, rather than the total value of their
business-owned life insurance holdings, even if they held both key-
person and other policies.[Footnote 6]
According to SEC, agency regulations do not specifically require public
companies to disclose the value or uses of business-owned life
insurance in the financial statements submitted to the agency. The
federal securities laws that SEC administers are designed to protect
investors by requiring public companies to disclose information that is
"material" to investors in their financial statements--that is,
according to SEC, information that an investor would consider important
in deciding whether to buy or sell a security or in making a voting
decision related to a security that the investor owns. SEC officials
said that for most companies, business-owned life insurance holdings
are not likely to be material to the company's financial results, and
therefore would not be subject to SEC reporting requirements.
IRS officials told us that the agency has not collected comprehensive
information on the value of or income from business-owned life
insurance policies, and agency officials said that they do not need
this information. Specifically, businesses are generally not required
to include the earnings or death benefits from business-owned life
insurance in their taxable income. Businesses that are subject to the
alternative minimum tax include income from death benefits and earnings
from insurance when calculating the tax, but they are not required to
list the insurance-related values or the uses of the policies on the
alternative minimum tax form. Also, businesses that are required to
complete Schedule M-1, Reconciliation of Income (Loss) per Books with
Income per Return, as part of their Form 1120, U.S. Corporation Income
Tax Return, would report earnings on business-owned life insurance as
part of the income recorded on their books but not on the tax return.
However, according to IRS officials, these earnings might not be
separately identified as they are often "lumped" with other
adjustments.
State insurance regulators, concerned with state requirements, rates,
and solvency issues, have collected extensive financial information
from insurers, but not at the level of detail that would describe the
uses or prevalence of business-owned life insurance policies.[Footnote
7] State insurance regulators use insurers' financial statements to
monitor individual companies' solvency, and aggregate information on
business-owned life insurance has not, in state regulators' views, been
necessary for such monitoring. Insurers' financial statements list the
number of all policies in force and premiums collected during the
reporting period, but broken out only by individual and group policies,
not by whether businesses or individuals owned the policies.
In an effort to compile more comprehensive data on business-owned life
insurance, we worked with the representatives of six insurance
companies and the American Council of Life Insurers (ACLI) to develop a
survey of the uses and prevalence of business-owned life insurance
sales. Although the insurance companies' representatives cooperated in
a pretest of the survey, and ACLI representatives said that they would
encourage their members to participate in the survey itself, the
results of the pretest led us to conclude that we would not be able to
obtain sufficiently reliable data to allow us to conduct the survey.
These representatives told us that they do not have a business need to
maintain the comprehensive data on business-owned life insurance that
we needed for the survey. They said that insurers do not routinely
summarize information on the numbers of policies and insured
individuals, cash surrender value of policies, and uses of business-
owned life insurance. They explained that various factors made it
difficult to obtain summary information, including that individual
businesses may own multiple policies; that the same individuals may be
insured under multiple policies; and that when purchasing policies,
businesses may state multiple policy uses or policy uses may change
over time. They also explained that extensive efforts would be required
for insurance companies to obtain information from their computer
systems and, in some cases, paper files to identify business-owned
policies on employees where the business is also the beneficiary.
Our preliminary review of the financial statements of 32 life insurance
companies that filed 10-K annual reports with SEC and that were among
the 50 largest such companies ranked by assets, disclosed some
information on business-owned life insurance. Although SEC did not
require insurance companies to identify business-owned life insurance
sales in their annual statements to the agency, nine insurers reported
over $3 billion in business-owned life insurance premiums from 2002
sales. Five of the insurance companies also reported that total
premiums from 2002 business-owned life insurance premiums ranged from
10 to 53 percent of each company's 2002 total life insurance sales
premiums. In addition, three insurance companies reported the value of
their business-owned life insurance assets as totaling about $28
billion as of December 31, 2002.
Insurance companies have also reported business-owned life insurance
sales in response to industry surveys. CAST Management Consultants,
Inc., conducts research on business-owned life insurance and, in a
summary report, estimated 2002 annual business-owned life insurance
premiums of $2.1 billion, based on the survey responses of 20 insurance
carriers increased by CAST adjustments.[Footnote 8] CAST
representatives declined to provide us any information about the
complete survey, which is available only to "qualified market
participants." We could not, therefore, determine whether CAST was able
to collect the information we sought to obtain by conducting our own
survey. In addition, a representative of the A.M. Best insurer rating
company said that the company collects information on business-owned
life insurance, but does not currently report the data. A.M. Best
reported aggregate premiums from business-owned life insurance for 1998
(the last year for which it reported data) as more than $10 billion for
20 large insurers.[Footnote 9]
Some businesses included anecdotal information about how they intended
to use business-owned life insurance in the annual financial statements
they filed with SEC. Our preliminary analysis of 100 randomly selected
Fortune 1000 public companies' financial statements filed with SEC
showed that 15 of the selected businesses referred to owning such
policies, including 11 that provided information about their intended
uses of the policies. The most commonly cited use of business-owned
life insurance was to fund deferred executive compensation.[Footnote
10] One business reported using policies to help fund postretirement
health care benefits, and another reported using the policies to help
fund an employee benefit plan for management employees as well as
executives.
Some businesses have also provided survey responses on their uses of
business-owned life insurance to fund executive benefit plans. Clark/
Bardes Consulting conducts an annual executive benefits survey and
reports on the uses of business-owned life insurance by companies to
fund nonqualified deferred compensation plans and supplemental
executive retirement plans. In the 2002 results from its survey of
Fortune 1000 corporations, Clarke/Bardes reported that 65 percent of
those companies that fund nonqualified deferred compensation plans and
68 percent of those that fund nonqualified supplemental executive
retirement plans do so using business-owned life insurance.
Finally, the federal government estimated that the current tax
exclusion of earnings on the cash value of business-owned life
insurance results in over a billion dollars in foregone tax revenues
annually--these estimates do not reflect the exclusion of additional
income from death benefit payments. In its "Estimates of Federal Tax
Expenditures for Fiscal Years 2003-2007," the Joint Committee on
Taxation estimated that the foregone tax revenues resulting from the
tax exclusion of investment income on life insurance for corporations
would total $7.2 billion for 2003 through 2007. Similarly, the Office
of Management and Budget, in its fiscal year 2004 budget "Analytical
Perspectives," estimated foregone tax revenues of $9.3 billion for 2003
through 2007 resulting from the tax exclusion of life insurance.
Regulators Had Guidelines or Requirements Applicable to Business-Owned
Life Insurance but Did Not Identify Significant Regulatory Concerns:
The federal bank regulators, SEC, the IRS, and state insurance
regulators had guidelines or requirements applicable to business-owned
life insurance but did not identify significant regulatory concerns.
The federal bank regulators had guidelines for purchases of business-
owned life insurance by banks and thrifts. OCC and OTS guidelines
describe the permissible uses of business-owned life insurance and
require national banks and OTS-supervised thrifts to perform due
diligence before purchasing policies and to maintain effective senior
management and board oversight.[Footnote 11] According to agency
officials, FDIC and the Federal Reserve Board follow OCC's guidelines.
The guidelines that are common among the regulators state that banks
and thrifts can only purchase life insurance for reasons incidental to
banking, including key-person insurance, insurance on borrowers, and
insurance purchased in connection with employee compensation and
benefit plans. Before purchasing policies, a bank's or thrift's
management must conduct a prepurchase analysis that should, among other
things, determine the need for insurance, ensure that the amount of
insurance purchased is not excessive in relation to the estimated
obligation or risk, and analyze the associated risks and the bank's or
thrift's ability to monitor and respond to those risks. The guidelines
also state that a bank or thrift should consider the size of its
purchase of business-owned life insurance relative to the institution's
capital and diversify risks associated with the policies. The
guidelines require banks and thrifts to document their decisions and
monitor their policies on an ongoing basis. In addition, banks and
thrifts using business-owned life insurance for executive compensation
should ensure that total compensation is not excessive under regulatory
guidelines.
The federal bank regulators we spoke with said that their risk-based
examination programs target any aspect of banks' and thrifts' purchases
of business-owned life insurance that would raise supervisory concerns.
The regulators monitor institutions' safety and soundness through their
risk-based examinations, which they said assess banks' and thrifts'
compliance with guidelines on business-owned life insurance on a case-
by-case basis. For example, all of the regulators said that if the
value of the policies exceeded 25 percent of the regulator's measure of
the institution's capital, they would consider whether further
supervisory review or examination of these holdings was warranted. The
regulators said that additional review or examination would be likely
if the policies were held with one or very few insurers.
As of December 31, 2002, 467 banks and thrifts reported business-owned
life insurance holdings in excess of 25 percent of their tier 1
capital.[Footnote 12] We asked the bank regulators to explain their
oversight of 58 institutions with the largest concentrations, all in
excess of 40 percent of tier 1 capital. Bank regulatory officials said
that their agencies were monitoring these institutions' levels of
holdings, had conducted preliminary reviews or detailed examinations,
and concluded that major supervisory concerns do not exist.
SEC officials said that the agency's regulations for public companies
do not specifically address business-owned life insurance; rather, SEC
has relied on its broadly applicable disclosure requirements to surface
any investor protection concerns. SEC requires public companies to
prepare their financial statements in accordance with generally
accepted accounting principles (GAAP), which would require them to
disclose information about business-owned life insurance policies when
such information is material. According to SEC officials, however,
following GAAP would rarely require purchases of and earnings from
business-owned life insurance to be shown as separate line items
because they typically are not financially material to the company. SEC
officials also said that the agency would have an oversight concern if
it became aware of a public company's failure to disclose material
purchases of or earnings from business-owned life insurance, or if
problems developed in accounting for these policies. However, they said
that, to date, such problems have not arisen, and they have not had
investor-protection concerns about public companies holding such
insurance.
The IRS had some requirements related to the tax treatment of business-
owned life insurance. The Internal Revenue Code defines life insurance
for tax purposes and sets out the current limitations on permissible
tax deductions that businesses can claim for the interest on policy
loans against life insurance policies. Federal laws and IRS regulations
have changed some aspects of the tax treatment of business-owned life
insurance. While policy owners may access the cash value of their
policies by borrowing against them, policy owners' ability to deduct
the interest on such loans was limited by the Tax Reform Act of 1986
and further limited by the Health Insurance Portability and
Accountability Act (HIPAA) of 1996, which amended Internal Revenue Code
section 264.[Footnote 13] Before these limitations, some businesses
were leveraging their life insurance ownership by borrowing against the
policies to pay a substantial portion of the insurance premiums. Known
as leveraged business-owned life insurance, these arrangements created
situations where businesses incurred a tax-deductible interest expense
while realizing tax-free investment returns.[Footnote 14] Various
sources have reported that HIPAA curtailed new sales of leveraged
policies, although such policies that were purchased in the past remain
part of the life insurance policies currently in force. However, IRS
officials expressed concern that HIPAA did not eliminate the tax
arbitrage opportunities available through business-owned life
insurance and that banks and other highly leveraged financial
institutions may be indirectly borrowing to purchase policies on
employees.[Footnote 15] IRS officials said that the agency is also
concerned that banks are using separate account policies to maintain
control over investments in a way that is inconsistent with the
Internal Revenue Code.[Footnote 16] These officials said that the
agency is continuing to study these business-owned life insurance
issues at selected banks. Finally, in September 2003, the IRS issued
final regulations on the tax treatment of split-dollar life insurance
policies--policies in which the employer and employee generally share
costs and benefits. Under the regulations, corporations cannot provide
tax-free compensation to executives using split-dollar policies.
State law requires that one party have an insurable interest in another
to be able to take out a life insurance policy on that person and
defines the conditions for one party to have an insurable interest in
the life of another person. Historically, insurable interest related to
a family's dependency on an individual and a business's risk of
financial loss in the event of the death of a key employee. The
significance of employers having an insurable interest in their
employees is illustrated by the 2002 decision of a federal district
court in Texas. The court found that Wal-Mart did not have an insurable
interest in employees' lives under Texas law, given the nature of the
policies taken out on each of 350,000 Wal-Mart employees, and that
under Texas law, Wal-Mart could not collect on the death benefits paid
under policies covering deceased employees.[Footnote 17]
NAIC, a membership organization of chief state insurance regulators
that helps promote coordination among the states, initially developed
model guidelines for business-owned life insurance in 1992 and revised
them in 2002. The 1992 guidelines suggested that states consider
including in their laws provisions that recognize employers' insurable
interest in employees, including nonmanagement employees who could
expect to receive benefits. The 2002 revision added a recommendation
for states to consider requiring employee consent to be insured and
prohibiting employers from retaliating against employees who refused to
grant their consent.
Since NAIC adopted the revised guidelines, several states have passed
legislation requiring employers to obtain employees' written consent
before taking insurance on them. In some states consent provisions
apply to life insurance policies in general, while in others these
provisions specifically address business-owned life insurance. Our
preliminary analysis indicated that, as of July 31, 2003, more than 30
states required written consent, including several states with
provisions specific to business-owned life insurance. However, most of
these states exempted group life insurance policies from consent
requirements. Also, in some states consent requirements were satisfied
if an employee did not object to a notice of the employer's intent to
purchase a policy. Additionally, at least one state required employers
to notify employees when purchasing business-owned life insurance, but
did not require employee consent.
Officials of NAIC and four state insurance departments--California,
Illinois, New York, and Texas--stated that, in recent years, some state
legislatures adopted laws broadening the definition of employers'
insurable interest to include broader groups of employees in order to
permit using business-owned life insurance to finance employee benefit
programs, such as current employee and retiree health care. The
officials said that such laws responded in part to Financial Accounting
Standard 106, which took effect in 1992 and requires businesses to
report the present value of future postretirement employee benefits as
employees earn them. Also, our preliminary analysis showed that several
states limit the aggregate amount of insurance coverage on
nonmanagement employees to an amount commensurate with the business's
employee benefit liabilities. In addition, a few states recognize an
employer's insurable interest in employees, provided that businesses
use the proceeds solely to fund benefit programs.
Insurance department officials from the four states also told us that
they primarily address compliance with their respective laws through a
review of the proposed policy forms that insurers must submit for
approval before marketing policies in their states. For example, in New
York, the insurance department developed a checklist of items that must
be included on forms that will be used for business-owned life
insurance policies to ensure that the forms comply with the state's
notification, consent, and other requirements. While NAIC officials
said that state insurance regulators would generally have the authority
to review policies currently in force for compliance with any state
requirements, the officials from the four states said that they had not
examined policies sold to confirm that employees consented to be
insured or, where applicable, to test whether the amounts of coverage
were appropriate. Officials in the four states said that their
departments would investigate business-owned life insurance sales
through their market conduct examinations of insurers if they observed
a pattern of consumer complaints about such sales.[Footnote 18]
However, the officials said that generally they had not received
complaints about business-owned life insurance. Also, NAIC officials
told us that the organization maintains a national database of consumer
complaints made to state insurance regulators and that business-owned
life insurance has not been a source of complaints.
Mr. Chairman, this completes my prepared statement. I would be happy to
respond to any questions you or other Members of the Committee may have
at this time.
FOOTNOTES
[1] "Banks and thrifts," as referred to in this testimony, are the
commercial bank and thrift institutions regulated by the Federal
Deposit Insurance Corporation, the Federal Reserve Board, the Office of
the Comptroller of the Currency, and/or the Office of Thrift
Supervision. However, our testimony does not cover bank holding
companies and foreign banks with domestic branches.
[2] If a business owns life insurance policies, the earnings and death
benefit proceeds are among the factors that could make the business
subject to the alternative minimum tax. In general, the alternative
minimum tax is based on a corporation's regular taxable income adjusted
for certain tax preference income items, such as exclusions,
deductions, and credits. The amount due is the amount by which the tax
computed under this system exceeds a corporation's regular tax.
[3] Nonqualified employee pension benefit plans, unlike qualified
plans, are not subject to the requirements of the Internal Revenue Code
and the Employee Retirement Income Security Act of 1974 as to who can
participate, the amount of benefits provided, and how the plan is
funded. Further, in contrast to qualified employee benefit plans, the
assets of nonqualified plans are not beyond the reach of a business's
creditors in bankruptcy proceedings.
[4] FDIC, the Federal Reserve Board, and OCC regulate commercial banks,
and FDIC regulates some thrifts.
[5] The data do not include bank holding companies or foreign banks
with domestic branches. The Federal Reserve Board started collecting
data on business-owned life insurance from bank holding companies in
2003, but the data were not available at the time of our analysis. The
federal bank regulators did not collect business-owned life insurance
data on foreign banks with domestic branches.
[6] OTS has proposed requiring all the thrifts that it supervises to
report the value of both their key-person and other business-owned life
insurance policies, beginning in 2004. "Proposed Agency Information
Collection Activities; Comment Request--Thrift Financial Report," OTS,
68 Fed. Reg. 3318 (Jan. 23, 2003).
[7] In commenting on this testimony, New York state insurance
regulators said that while they did not collect detailed information on
the prevalence or uses of business-owned life insurance, information
about insurers that have a high volume of business-owned life insurance
sales would be useful to them in conducting market conduct
examinations. They also referred to survey data that they have
collected since 2000 on business-owned life insurance, and we have
requested this information from them.
[8] "CAST 2002 Corporate-Owned Life Insurance Market Survey, Respondent
Summary," CAST Management Consultants, Inc. (Apr. 2003).
[9] Cynthia Crosson, "Capturing COLI/BOLI," Best's Review, Vol. 100,
No. 9 (2000).
[10] SEC requires companies to disclose information pertaining to the
compensation of top officers. Therefore, the fact that companies most
frequently disclosed the use of business-owned life insurance to fund
executive compensation does not mean that this is necessarily the most
common use of such policies.
[11] Department of Treasury, OCC, "Bulletin 2000-23" (July 20, 2000).
Department of Treasury, OTS, "Regulatory Bulletin RB 32-26" (July 31,
2002). These bulletins rescinded previous guidelines.
[12] The ratio of cash surrender value to tier 1 capital illustrates
the institution's overall exposure to risk, including credit risk (the
risk of counterparty default), since tier 1 capital is a measure of the
equity cushion that banks have available to absorb loss, including
credit losses from their holdings of business-owned life insurance.
[13] The limit on interest deductibility does not apply to policies
purchased before June 20, 1986.
[14] In addition to the legislation addressing leveraged business-owned
life insurance plans, the IRS and Department of Justice prevailed in
three cases involving the proper treatment of loan interest related to
such plans. These plans covered over 55,000 employees. The courts found
that the leveraged plans lacked economic substance, making the interest
deduction unallowable. See In re C.M. Holdings, Inc., 301 F.3d 96 (3rd
Cir. 2002); Am. Elec. Power v. United States, 326 F.3d 737 (6th Cir.
2003); Winn Dixie Stores v. United States, 254 F.3d 1313 (11th Cir.
2001), cert. denied, 535 U.S. 986 (2002). The taxpayer prevailed in a
fourth case. See Dow Chemical Co. v. United States, 250 F Supp. 2d 748
(E.D. Mich. 2003).
[15] The Congressional Research Service has reported that businesses
could use overall indebtedness to indirectly support tax-preferred
investment in business-owned life insurance. Since debt is fungible and
businesses can deduct interest expenses to support investments, some
businesses may borrow for purposes unrelated to life insurance and
thereby have funds available to purchase these policies. Under such
circumstances, it would be difficult to distinguish debt that is used
to finance business-owned life insurance from that which is not.
Congressional Research Service, The Library of Congress, Corporate-
Owned Life Insurance: Tax Issues (Washington, D.C.: updated June 26,
2003). Congressional Research Service, The Library of Congress,
Taxation of life Insurance Products: Background and Issues (Washington,
D.C.: July 18, 2003).
[16] In separate account life insurance, an asset account is maintained
independently from the insurer's general investment account. This
arrangement permits wider latitude in the choice of investments,
particularly equities.
[17] Mayo, et al., v. Hartford Life Insurance Company, et al., 220 F.
Supp.2d 794 (2002). Texas law on insurable interest was changed after
Wal-Mart purchased the policies in question to grant an insurable
interest to third parties who take out life insurance on those giving
informed consent.
[18] New York insurance department officials said that other factors
might also cause the department to investigate an insurer. For example,
they said that the department would investigate, as part of its market
conduct examinations, insurers that sell a significant amount of
business-owned life insurance.
