Business-Owned Life Insurance: Preliminary Observations on Uses, Prevalence, and Regulatory Oversight
Published: 2003-10-23T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: 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.
subsections: section_title: No Comprehensive Data Were Available on the Uses and Prevalence of Business-Owned Life Insurance
paragraphs: 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. 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.
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. 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. 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.
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. 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. 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.
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. 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.
section_title: Regulators Had Guidelines or Requirements Applicable to Business-Owned Life Insurance but Did Not Identify Significant Regulatory Concerns
paragraphs: 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. 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. 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. 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. 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. 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. 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.
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.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.
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