Turning Straw Into Gold: BOLI Exchanges and the Open Insurable Interest Question

In July, we wrote about the final regulations under T.D. 10052, which confirm that a Section 1035 exchange is no longer, by itself, a reportable policy sale or a transfer for valuable consideration.[1] We flagged one caveat at the time: the new contract must still satisfy Section 7702 and applicable state insurable interest laws. For holders of bank-owned life insurance (BOLI), that caveat has quickly become the main event. 

Why BOLI holders are looking now

Many BOLI portfolios were purchased when interest rates were substantially lower. Those contracts often reflect rates from a different era, while carriers today are issuing contracts priced off a much higher-rate environment.

"Banks have been sitting on legacy BOLI that no longer reflects the rate environment, and the 1035 regulations removed a real obstacle to fixing that," said Michael Ori, Co-founder and Managing Partner of Institutional Architects. "In our experience, a well-executed restructuring can pick up roughly 200 to 300 basis points of return on the same cash surrender value, without recognizing the built-in gain that a surrender would trigger."

In a sense, it is turning straw into gold. With the federal tax overlay now cleaner, the questions we are hearing have shifted from "Will the exchange be taxed?" to "Can we still hold this coverage at all?"

The insurable interest problem

An exchange produces a new contract, and in most states a new contract means insurable interest must exist when the contract is issued. A bank generally has a clear insurable interest in current officers, directors and key employees. Seasoned portfolios, especially those inherited through bank mergers, often cover individuals who have long since retired, resigned or moved on. For those insureds, the bank may be unable to show the interest required by state law at issuance, and carriers are understandably cautious about issuing replacement coverage. The federal bank regulators have made the same point on their side: compliance with the interagency BOLI guidance does not determine whether a policy satisfies state insurable-interest requirements.[2]

Louisiana goes first

Louisiana is one of the few states we are aware of that has taken legislative steps to address this issue. Senate Bill 509, signed on June 1 as Act No. 588 and effective August 1, amends the state's insurable interest statute to provide that a bank "shall be deemed to maintain its insurable interest in a former employee for the purposes of exchanging one bank-owned life insurance policy for another."[3][4]

The statute does not answer every question. It directs the Louisiana insurance commissioner to determine "the method and manner in which a bank may obtain consent for the exchange," taking into account, among other things, whether the policy funds employee benefits, existing consent requirements, cybersecurity controls, alignment with federal and interstate requirements and continuity of coverage.[5] Until that guidance is issued, the consent mechanics remain open, even in Louisiana. Other states have not yet followed suit, so for most portfolios the analysis still turns on the governing state's statute, the carrier's underwriting position and the insured's consent.

Georgia also has addressed this issue, though more broadly applying to corporations by defining “employee” to include “any former employee, but only for the purpose of replacing existing life insurance that will be surrendered in exchange for new life insurance in an amount not exceeding the insurance being surrendered.”[6]

And, Illinois has at least touched on this issue with employers having an insurable interest in “retired employees.”[7]

The federal pieces still matter

Two federal issues remain on the checklist:

• Section 101(j). Employer-owned contracts issued after August 17, 2006, must satisfy the notice, consent and eligible-insured requirements to preserve the death benefit exclusion. Under Notice 2009-48, a contract issued in a Section 1035 exchange for a pre-August 18, 2006, contract keeps its grandfathered status. Still, a material increase in death benefit or other material change causes the new contract to be treated as newly issued.[8] Restructurings should be designed to avoid that result.
• Section 7702. The new contract must qualify as life insurance under the current Section 7702 rules, which affects how the replacement contract is designed and funded. 

What BOLI holders should consider

The economics of BOLI restructuring are compelling, and T.D. 10052 removed a meaningful federal obstacle. The state law analysis, however, is not fully settled. Before committing to an exchange, banks and their advisers should segment the portfolio between active and former employees, confirm the governing state's insurable interest rules, understand each carrier's requirements (including any indemnity it may request) and document consent and Section 101(j) compliance. We are working with clients and their consultants on these issues and would be glad to discuss how they apply to a particular portfolio.

This post is for general informational purposes and does not constitute legal counsel.