Business-Owned Life Insurance: Preliminary Observations on Uses, 
Prevalence, and Regulatory Oversight (23-OCT-03, GAO-04-191T).	 
                                                                 
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.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-191T					        
    ACCNO:   A08756						        
  TITLE:     Business-Owned Life Insurance: Preliminary Observations  
on Uses, Prevalence, and Regulatory Oversight			 
     DATE:   10/23/2003 
  SUBJECT:   Data collection					 
	     Employee benefit plans				 
	     Federal regulations				 
	     Income taxes					 
	     Interest						 
	     Life insurance					 
	     Regulatory agencies				 
	     Insurance regulation				 
	     Tax deductions					 

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GAO-04-191T

United States General Accounting Office

GAO Testimony

Before the Committee on Finance,

                              United States Senate

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

Highlights of GAO-04-191T, a testimony before the Committee on Finance,
U.S. Senate

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.

October 23, 2003

BUSINESS-OWNED LIFE INSURANCE

Preliminary Observations on Uses, Prevalence, and Regulatory Oversight

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'[email protected].

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.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

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.

  No Comprehensive Data Were Available on the Uses and Prevalence of
  Business-Owned Life Insurance

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.

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.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.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

2If 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.

3Nonqualified 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.

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.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.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

4FDIC, the Federal Reserve Board, and OCC regulate commercial banks, and
FDIC regulates some thrifts.

5The 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.

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.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.

6OTS 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).

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.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.

7In 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.

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.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.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

8"CAST 2002 Corporate-Owned Life Insurance Market Survey, Respondent
Summary," CAST Management Consultants, Inc. (Apr. 2003).

9Cynthia Crosson, "Capturing COLI/BOLI," Best's Review, Vol. 100, No. 9
(2000).

insurance was to fund deferred executive compensation.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.

10SEC 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.

  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.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

11Department 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.

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.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

12The 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.

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 264.13 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.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.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.16 These

13The limit on interest deductibility does not apply to policies purchased
before June 20, 1986.

14In 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).

15The 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).

16In 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.

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.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

17Mayo, 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.

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.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.

18New 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.

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