September 2010

REGULATORY DEVELOPMENTS

Dodd-Frank Act – Hedge Fund/Private Equity Fund Definition

Section 619 of the Dodd-Frank Act addresses bank prohibitions on proprietary trading (commonly referred to as the Volcker Rule) and restrictions on banks relationships with hedge funds and private equity funds. The Act defines hedge funds and private equity funds to mean an issuer that would be an investment company, as defined in the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of the ’40 Act or such similar funds as appropriate to be determined by rule. Generally, all unregistered (commonly sold via private placement memoranda), separate account BOLI products rely on the registration exceptions described in section 3(c)(1) or 3(c)(7) of the ’40 Act (note that many investment divisions within unregistered separate account BOLI are also unregistered and rely upon similar exemptions from registration).  With the possible exceptions noted below, this would appear to subject bank policyholders of unregistered separate account BOLI products to the general divesture requirements for hedge funds and private equity funds (divestiture over a four year period).

Limited relief appears to be granted under the “Permitted Activities” subsections of the Act:

(1) IN GENERAL- Notwithstanding the restrictions under subsection (a), to the extent permitted by any other provision of Federal or State law, and subject to the limitations under paragraph (2) and any restrictions or limitations that the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, may determine, the following activities (in this section referred to as ‘permitted activities’) are permitted:

(A) The purchase, sale, acquisition, or disposition of obligations of the United States or any agency thereof, obligations, participations, or other instruments of or issued by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), and obligations of any State or of any political subdivision thereof.

(C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.

So it seems that even in the absence of regulatory corrections, there appears to be circumstances whereby divesting policies would not be required (e.g., allocating to carefully constructed MBS and/or government only investment divisions, situations where policies are used to hedge non-qualified mirror plans and possibly in connection with broader hedging purposes such as general welfare liabilities).

The troublesome “hedge fund, private equity fund” definition appears to be the result of a gross oversight and not consistent with the intent of the law.  We have notified several leading separate account BOLI issuing insurance carriers who are researching the issue and coordinating action through a trade association.  We are also notifying institutional money managers to encourage appropriate supportive action.  There is general agreement that a concise, corrective regulatory remedy can be formulated and proposed for adoption.  We are closely tracking developments and will provide updates as appropriate.

 

Senate Hearing on Dodd-Frank Implementation

On September 30, the Senate Banking Committee held a hearing on implementing the Dodd-Frank Act. The witnesses included representatives from the Treasury, SEC and the federal banking regulatory agencies.  Each agency provided an update on their respective office’s efforts undertaken so far as well as priorities in carrying out the specific requirements mandated by Dodd-Frank.  In written testimony, Acting OCC Comptroller John Walsh questioned section 939A (review of reliance on credit ratings) specifically stating that the prohibition against references to ratings in regulations under that section goes further than is reasonably necessary to respond to the issues.  Mr. Walsh recommended that section 939A be amended to direct regulators to require that ratings-based determinations be confirmed by additional risk analysis in circumstances where ratings are likely to present an incomplete picture of the risks presented to an institution, or where those risks are heightened due to concentrations in particular asset classes.

The agencies also addressed their views on the relationship between Dodd-Frank and Basel III.  The consensus seemed to be that the Basel III proposals were largely consistent with Dodd-Frank and that implementation of Basel III rules by federal banking agencies would serve to advance the objectives of Dodd-Frank.

Another notable topic was the progress of the Financial Stability Oversight Council (FSOC), which will be chaired by the Treasury Secretary and includes as members, among others, heads of the federal banking agencies.  Deputy Treasury Secretary Neal Wolin suggested that at the first meeting (October 1), the FSOC would be releasing two resolutions to seek public comment on how to implement statutory restrictions on banking institutions’ proprietary trading and investments in private funds (i.e., the Volcker Rule) and designating systemically important nonbank institutions.

 

Basel III: New Global Capital and Liquidity Requirements

On September 12, the oversight body of the Basel Committee on Banking Supervision (BCBS) issued a press release announcing a substantial strengthening of global capital and liquidity requirements, and its plan to fully endorse the agreement it had reached on July 26 in relation to the proposed reforms to the Basel II framework at the G20 Seoul Summit on November 11-12.  These elements are intended to form part of a package of reforms to be known as Basel III.  The new capital requirements will raise the minimum requirement for common equity, the highest form of loss-absorbing capital, from the current 2% to 4.5% of total risk-weighted assets (“RWAs”).  The overall Tier 1 capital requirement, comprising not only common equity but also other qualifying financial instruments, will increase from the current minimum of 4% to 6%.  There will be no change to the minimum total capital requirement, which will remain at the current 8% level.

In addition to the minimum capital requirements, banks will be required to hold a capital conservation buffer of 2.5%.  This buffer may be used to absorb losses during periods of financial and economic stress, but if a bank’s buffer falls below 2.4%, the bank will be subject to constraints on the payment of dividends and discretionary bonuses, until the buffer is replenished.  This buffer must be funded with common equity, after application of deductions.  This effectively mandates a minimum core Tier 1 capital ratio of 7%.  Another bank requirement is a countercyclical buffer of up to 2.5% percent of assets that would be composed of common equity or other fully loss-absorbing capital, to be built up in good times and drawn down in bad ones.

The BCBS intends that systemically important banks should have loss-absorbing capacity beyond these minimum standards, and work is being carried out on this issue by the Financial Stability Board and the BCBS to develop an integrated approach which may include a combination of capital surcharges, contingent capital and bail-in debt.  In addition work is continuing to strengthen resolution regimes and to strengthen the loss-absorbency of non-common Tier 1 and Tier 3 capital instruments.

The new capital rules will be phased in from January 1, 2013 to January 1, 2019.  Member countries must transpose the new rules into their national laws prior to, and begin implementing them from, January 1, 2013.  However, they may impose shorter transition periods, as appropriate.

The liquidity proposals radically alter the landscape for banks.  Basel III will require banks to establish two models to ensure adequate liquidity: a 30-day model, called the “liquidity coverage ratio,” and a longer one-year liquidity process, called the “net stable funding ratio.”  The liquidity coverage ratio seeks to provide assurance that banks maintain an adequate level of unencumbered, high-quality assets that can be converted to cash to meet their liquidity obligations for a 30-day period.  The net stable funding ratio would measure funding on an ongoing viable entity basis, over one year where the bank experiences events such as a significant decline in profitability; a downgrade in debt, counterparty credit or deposit ratings; or an event which impacts the reputation or credit quality of the bank.  The details of this ratio have yet to be finalized.

After an observation period beginning in 2011, the liquidity coverage ratio will be introduced on January 1, 2015.  The revised net stable funding ratio will move to a minimum standard by January 1, 2018.  The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary.

 

ACCOUNTING DEVELOPMENTS

US FASB and IASB Complete First Stage of Conceptual Framework

On September 28, the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) announced the completion of the first phase of their joint project to develop an improved conceptual framework for International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP).  The objective of the framework project is to create a sound foundation for future accounting standards that are principles-based, internally consistent and internationally converged. The new framework builds on existing FASB and IASB frameworks.  The IASB has revised portions of its framework while the FASB has issued “Concepts Statement 8” to replace “Concepts Statements 1 and 2.”  This first phase deals with the objective and qualitative characteristics of financial reporting.  On Friday, October 1, a podcast will be posted by FASB that will examine and explain the purpose of a concepts statement.

 

JUDICIAL DEVELOPMENTS

Baker v. Dow Chemical

An August 31st partial summary judgment opinion out of the Southern District of Texas was very positive as it relates to BOLI/COLI programs that garner consent.  In this matter, Dow Chemical took out COLI policies on the lives of employees with their consent in 1991 and separately offered a $5k incentive payable to participating employees’ beneficiaries.  The plaintiffs, estate representatives of 3 deceased employees, questioned Dow’s insurable interest, claimed that the consent was invalid because Dow misrepresented how Dow would benefit from the policy and alleged that Dow misappropriated employee personal information.  Ruling in favor of Dow, the court reasoned that the estate representatives could not attest to what the deceased employees thought about the terms of the consent and that the materials that accompanied the consent were clear.  The court further reasoned that even if the employees were confused that the applicable four-year statute of limitations on reformation had run since the employees provided consent in 1991.  Additionally, the decision noted that the estate representatives did not make any objections when they claimed the $5k benefit.  The choice of law reasoning was also noteworthy.  The policies were issued in Michigan, but the employees in question were in Texas and therefore had to comply with Texas insurable interest. Texas law allows insurance policies issued in other states to be offered in Texas if the other state had substantially similar requirements.  The court found Texas law to be less restrictive than Michigan’s insurable interest law and therefore found Michigan’s law to be substantially similar and enforceable in Texas.

 

Jones v. Bridgestone Americas

The same plaintiffs’ firm in Baker, The Clearman Firm, filed another lawsuit in the southern district of Texas against Bridgestone Americas.  Filed on April 14, this matter is being brought by a surviving spouse of a deceased employee of Firestone Tire & Rubber Company who was employed from 1975-1989.  The Bridgestone Corporation acquired Firestone in 1988 and Bridgestone Americas is now the successor in interest to Bridgestone Corporation.  The plaintiff claimed that in March 2010 she was informed by current Bridgestone employees that she did not receive benefits she was entitled to receive and was specifically informed that there was a life insurance policy on her husband.  The suit claims that Bridgestone was unjustly enriched, because it never had an insurable interest on the life of the employee, that Bridgestone fraudulently concealed the existence of the life insurance proceeds among other claims.  The matter also includes class action allegations.  In its answer, Bridgestone Americas denied the allegations and affirmatively stated that it does not maintain and has never maintained COLI policies on its employees.

 

OTHER DEVELOPMENTS

BOLI/COLI in the News

On September 16, a local ABC affiliate in Saginaw, MI ran a story about a COLI program for city workers.  In 2004, the city of Saginaw, MI purchased 48 policies covering the lives of the city’s supervisors in order to fund post-retirement benefits.  The city recently received the first death benefit from the plan (approximately $324k).  The current assistant city manager was quoted as saying that the city pays about $130k per year for the policies and that the city is taking a closer look at whether the program should continue.

On September 24, there was an opinion piece posted on NRToday.com (Roseburg, OR) entitled “Dead Peasant Insurance Notice.”  The writer’s goal was to put his readers on notice of secret insurance policies that companies have on employees particularly noting large corporations that have a presence in Roseburg (among those noted in the article were Walmart, AT&T, PP&L and Bank of America).  Further, the writer called on his readers to find out if their employers had such policies and to contact their local congressional leaders to put an end to “the outrageous practice of Dead Peasant Insurance.” Apparently, the author was not aware of passage of the COLI Best Practices Act in 2006.

 

NAIC to Measure Impact of Principles-Based Reserving on Insurers

On September 23, the NAIC announced that they have selected the actuarial consulting firm Towers Watson to work with state regulators and interested parties to examine principles-based reserves (PBR) provisions of the Draft Valuation Manual.  Back in June, the NAIC appointed a new subgroup to study the impact of PBR on the life insurance industry.  This study will aid in the completion of the NAIC Valuation Manual, which will define the methods used by regulators and insurers to calculate insurance companies’ reserves.  These efforts would favor principles-based reserves over the static formulas traditionally used to calculate the reserves held in order to protect consumers’ financial interests in insurance products.  Work on the PBR impact study is expected to start immediately and to be completed by March 31, 2011.

 

NAIC Selects BlackRock Solutions to Model CMBS

On September 2, the NAIC announced that it had selected BlackRock Solutions to assist state regulators as they determine risk-based capital (RBC) requirements for the commercial mortgage- backed securities (CMBS) held by insurers.  As the third-party financial modeler, BlackRock will assist in the assessment of more than 7,000 CMBS holdings by U.S. insurance companies at the end of 2010, measured in terms of unique Committee on Uniform Security Identification Procedures (CUSIPs).  BlackRock will coordinate with the NAIC to develop expected losses for each CMBS CUSIP, allowing insurance companies to map their CMBS holdings to the appropriate RBC designation and accompanying solvency requirements.  Last year, PIMCO was selected to model residential mortgage-backed securities and that project has been completed.