Letter concludes that national bank may continue to hold a separate account BOLI investment that in turns holds interests in instruments with characteristics of debt securities and a rate of return, a portion of which is linked to equity securities, provided the bank's EIC has no supervisory objection.

O

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

Interpretive Letter 1030

June 2005

12 USC 24(7)

May 26, 2005

Subject: ( ), (“Bank”) Investment in Bank-Owned Life Insurance

(“BOLI”)

Dear ( ):

This is in response to your inquiry whether the Bank may continue to hold a separate account

BOLI investment that in turn holds interests in instruments with characteristics of debt securities

and a rate of return, a portion of which is linked to equity securities. For the reasons set forth

below, we conclude that the Bank’s investment, as described herein, may be permissible,

provided the Bank’s Examiner-in-Charge (“EIC”) has no supervisory objection.

Background

The Bank’s predecessor purchased a separate account policy from ( )

Insurance Company, which later merged with ( ) (“Co.”). The book

value of the Bank’s separate account policy was approximately $4.6 billion, as of March 31,

2005. In January 2002, the Bank reallocated nearly $900 million (amounting to $946 million as

of March 31, 2005) in the separate account policy to four issues of structured notes (“Structured

Notes” or “Notes”).

The Structured Notes

The separate account consists of four issues of Structured Notes and bank-eligible securities.

Bankruptcy-remote special purpose entities (“SPEs”) issued the Structured Notes under SEC

ank reallocated nearly $900 million (amounting to $946 million as

of March 31, 2005) in the separate account policy to four issues of structured notes (“Structured

Notes” or “Notes”).

The Structured Notes

The separate account consists of four issues of Structured Notes and bank-eligible securities.

Bankruptcy-remote special purpose entities (“SPEs”) issued the Structured Notes under SEC

- -

2

Rule 144A.1 All four issuances share essentially the same structure. The Bank’s separate

account holds roughly 80 percent of each issuance.

The Structured Notes have a maturity of 10 years and bear a coupon of either 1.75 or 2.25

percent, for a blended rate of approximately 2 percent, plus a potential or contingent, cumulative

coupon of approximately 10 percent, payable at maturity, depending on the performance of

assets in the SPE. At issuance, the Structured Notes were rated Aa3 (Moody's), and AA (S&P).

The ratings apply to the principal and 2% assured interest, but not the cumulative interest. The

assets of each SPE consist of a Balanced Portfolio and a Protection Agreement.

Balanced Portfolios

Balanced Portfolios hold two types of assets, the ( ) (“BS”)

and, when appropriate, fixed income instruments. ( BS ) represent five specific hedge fund

strategies applied by 50 hedge fund managers. Rather than hold a basket of hedge funds, (Co.)

may simply invest the Structured Note proceeds in mirror securities issued by a ( Co.) affiliate

that synthetically track the performance of the selected hedge fund categories. If a hedge fund

manager performs poorly, assets under the control of that manager are reallocated into fixed

income instruments. The fixed income instruments consist of notes issued by a ( Co .) affiliate,

up to a maximum of 25% of the principal value of the Structured Notes

ecurities issued by a ( Co.) affiliate

that synthetically track the performance of the selected hedge fund categories. If a hedge fund

manager performs poorly, assets under the control of that manager are reallocated into fixed

income instruments. The fixed income instruments consist of notes issued by a ( Co .) affiliate,

up to a maximum of 25% of the principal value of the Structured Notes. Should it be necessary

to reallocate additional assets to the fixed income instrument class, those assets must be invested

in U.S. Treasury Securities. Reallocation to fixed income instruments allows ( Co. ) to assure

that the SPE assets will be sufficient to meet ( Co. )'s obligations at maturity to assure repayment

of principal and the 2% coupon on the Notes.

Protection Agreements

Protection Agreements are contracts between the SPEs and either ( )

(“Co.A”) or ( ) (“Co.B”) that guarantee the holders of the Structured Notes

repayment of principal and a coupon of either 1.75 or 2.25 percent. ( Co .) has issued a surety

bond to back the performance of its subsidiaries under the Protection Agreements, up to $3

billion. If either entity is downgraded to A- (S&P) or A3 (Moody's), ( Co. ) has 90 days

either to find a replacement credit protection provider or collateralize the exposure with Treasury

securities.

Stable Value Protection

A stable value protection (“SVP”) policy protects the Bank’s separate account in an amount

equal to the difference between the book value and the market value of the separate account.

The SVP in effect reduces the earnings volatility of the separate account for mark-to-market

accounting purposes, but does not provide an effective, economic hedge

asury

securities.

Stable Value Protection

A stable value protection (“SVP”) policy protects the Bank’s separate account in an amount

equal to the difference between the book value and the market value of the separate account.

The SVP in effect reduces the earnings volatility of the separate account for mark-to-market

accounting purposes, but does not provide an effective, economic hedge. To realize the

economic benefits of the SVP, the Bank must surrender the separate account policy, which

would trigger tax liability for the cumulative earnings of the policy, thus negating one of the

principal advantages of BOLI, tax deferral of earnings.

1 17 C.F.R. 230.144A.

- -

3

Discussion

Life Insurance

National banks may purchase and hold life insurance under 12 U.S.C. § 24 (Seventh), which

provides that national banks may exercise “all such additional powers as shall be necessary to

carry on the business of banking.” The OCC has found purchases of life insurance to be

incidental to banking in several situations, for example in connection with employee benefit

plans, key person insurance protection, recovering the cost of providing employee benefits,

obtaining coverage on borrowers, and as security for loans. The OCC may approve other uses

for insurance on a case-by-case basis. The OCC has indicated that national banks may not

purchase life insurance for speculative purposes, to acquire shares from the estates of

shareholders in order to control who owns the bank, or as an estate planning benefit to insiders

(unless the benefit is part of a reasonable compensation).2

Bulletin 2004-56

The OCC’s current guidance on purchases of life insurance by national banks is contained in

Bulletin 2004-56.3 National banks may purchase life insurance for a purpose that is incidental to

banking, but not purely as an investment.4 One of the purposes that the OCC has found to meet

that standard is in connection with employee compensation or b

easonable compensation).2

Bulletin 2004-56

The OCC’s current guidance on purchases of life insurance by national banks is contained in

Bulletin 2004-56.3 National banks may purchase life insurance for a purpose that is incidental to

banking, but not purely as an investment.4 One of the purposes that the OCC has found to meet

that standard is in connection with employee compensation or benefit plans. National banks may

purchase life insurance to fund or recover the cost of compensation or benefits for their

employees, officers or directors. However, if the separate account contains equity securities, the

OCC has imposed a further limitation; the equities in the account must effectively hedge the

bank’s liability under the compensation or benefit plan that the insurance is intended to fund.5

“An effective economic hedge exists when changes in the economic value of the liability or other

risk exposure being hedged are matched by counterbalancing changes in the value of the hedging

instrument.”6

Such a relationship would exist where the obligation under an insured institution’s

deferred compensation plan is based upon the value of a stock market index and

the separate account contains a stock mutual fund that mirrors the performance of

that index. . . . If the insurance cannot be characterized as an effective economic

2 See Interpretive Letter No. 926 (Sept. 7, 2001) and Interpretive Letter No. 878 (Dec. 22, 1999).

3 Dec. 7, 2004 (“Bulletin”), issuing the Interagency Statement on the Purchase and Risk Management of Life

Insurance (“Interagency Statement”).

4 See Interpretive Letter No. 926, supra.

5 As long as the separate account holds debt, however, the holding is permissible and there is no inquiry concerning

the adequacy of the hedge that the separate account is intended to provide.

6 Interagency Statement at 18.

suing the Interagency Statement on the Purchase and Risk Management of Life

Insurance (“Interagency Statement”).

4 See Interpretive Letter No. 926, supra.

5 As long as the separate account holds debt, however, the holding is permissible and there is no inquiry concerning

the adequacy of the hedge that the separate account is intended to provide.

6 Interagency Statement at 18.

- -

4

hedge, the presence of equity securities in a separate account is impermissible,

and the agencies will require institutions to reallocate the assets unless retention

of the policy is permitted under federal law.7

The Bank bases its purchase of Notes on the authority of a national bank to purchase life

insurance. The Bank’s business purpose in holding the separate account policy is to defray the

costs of employee benefits such as active employee and retiree medical benefits and funding

401(k) company match and long-term disability payments. These are permissible purposes for

purchasing BOLI.

Generally one does not examine the assets in an insurance policy in reviewing permissibility

issues, in part because life insurance is considered a general obligation of the insurer. The

exception to this approach is when the bank holds a separate account policy. One looks through

the policy to the underlying assets in the account, if those assets are equity securities, to

determine whether the securities effectively hedge the liabilities the insurance is intended to

hedge. There is no hedging requirement under the OCC’s current guidance, however, if the

Notes are deemed to be debt securities. The debt securities in the separate account still must

qualify as bank permissible investments under 12 C.F.R. Part 1 or some other authority.

Debt v

y securities, to

determine whether the securities effectively hedge the liabilities the insurance is intended to

hedge. There is no hedging requirement under the OCC’s current guidance, however, if the

Notes are deemed to be debt securities. The debt securities in the separate account still must

qualify as bank permissible investments under 12 C.F.R. Part 1 or some other authority.

Debt v. Equity

Certain substantive characteristics distinguish common stock from debt securities.8 Common

stock usually is perpetual with broad voting rights, while debt securities generally have a limited

life and few, if any, voting rights. Common stock provides an ownership interest and

appreciation in the market value of the issuer and dividends. In contrast, debt securities offer

investors fixed or fluctuating periodic interest payments, and return of principal at maturity.

With debt securities, if the issuer should fail, the claims of the common stockholders are

subordinate to the debt holders’. Rating agencies may assign credit ratings to debt securities, but

typically do not rate equity instruments.

In this case, the separate account holdings more closely resemble debt than equity securities.

The Structured Notes possess the following characteristics typically associated with debt

securities. The Notes have a fixed maturity, pay regular periodic interest payments at a blended

rate of 2 percent, and return principal at maturity. The holders of the Notes have superior claims

to those of the SPE’s common stockholders. The Notes do not have voting rights. The Notes are

rated by rating agencies and are considered debt instruments for federal tax and accounting

purposes.

The Notes resemble equities in only one respect. In addition to the blended 2% coupon, the

Notes can pay a coupon of up to 10 percent, depending on the return of hedge fund assets held by

7 Id.

8 See, e.g., Landreth Timber Co. v. Landreth, 471 U.S. 681, 686-87 (1985); United Housing Foundation, Inc. v

encies and are considered debt instruments for federal tax and accounting

purposes.

The Notes resemble equities in only one respect. In addition to the blended 2% coupon, the

Notes can pay a coupon of up to 10 percent, depending on the return of hedge fund assets held by

7 Id.

8 See, e.g., Landreth Timber Co. v. Landreth, 471 U.S. 681, 686-87 (1985); United Housing Foundation, Inc. v.

Forman, 421 U.S. 837, 850-51 (1975); R. Hamilton, Fundamentals of Modern Business (1989).

- -

5

the SPE that issued the Notes. The variable portion of the return is more similar to the return of

shares of an investment company invested in hedge funds or equities, although we note that debt

obligations may have variable returns. Altogether the Notes more closely resemble debt in

sufficient respects to be classified as debt rather than equity.

Part 1

An investment security means a marketable debt obligation that is not predominantly speculative

in nature. A security is not predominantly speculative in nature if it is rated investment grade.

When a security is not rated, the security must be the credit equivalent of a security rated

investment grade.9 These requirements apply to both the principal and interest payable on the

debt security. The Structured Notes held in ( Bank )'s BOLI separate accounts may qualify as

investment securities under Part 1. The Notes were issued under SEC Rule 144A and thus are

marketable.10 The principal and blended 2% assured interest portions of the Structured Notes

bear investment grade ratings and thus meet the quality requirements of Part 1.11 The unrated

portion of the interest on the Notes may qualify as the credit equivalent of investment grade, as

discussed below.

The structured note in this situation raises the question of the permissibility of a debt instrument

that has a non-rated interest component

interest portions of the Structured Notes

bear investment grade ratings and thus meet the quality requirements of Part 1.11 The unrated

portion of the interest on the Notes may qualify as the credit equivalent of investment grade, as

discussed below.

The structured note in this situation raises the question of the permissibility of a debt instrument

that has a non-rated interest component. Because of the structured nature of the security, the

Bank may collect none, some, or all, of the contingent coupon. As a prudential matter, where a

part of the return on a debt security is not rated, and the bank seeks to demonstrate that it is the

credit equivalent of investment grade, the bank must document, through its own financial

analysis, that there is a high probability that the security will produce a reasonable investment

return over the life of the investment. For example, based upon an analysis of historical hedge

fund returns, the bank could simulate a probability distribution of future performance. Through

this analysis, the bank might be able to document that there is a high probability that the

structured note will have an investment return (including the 2% rated portion) equal to or

greater than the return for a similarly rated corporate exposure, with an appropriate spread

premium for security structure risk, of the same maturity. Whether the unrated portion of a

security may qualify as the credit equivalent of investment grade will depend on the facts and

circumstances of each case.

Moreover, where part of the investment return is unrated and based on equity returns, the bank

must also establish to the satisfaction of the bank’s EIC the adequacy of the bank’s reviews of

the investment and risk management controls, and limit the total amount of any securities

acquired under Part 1 with unrated, equity-based returns, to no more than 10 percent of the

9 See 12 C.F.R. 1.2(e).

10 See 12 C.F.R. 1.2(f)

11 See 12 C.F.R. 1.2(e).

based on equity returns, the bank

must also establish to the satisfaction of the bank’s EIC the adequacy of the bank’s reviews of

the investment and risk management controls, and limit the total amount of any securities

acquired under Part 1 with unrated, equity-based returns, to no more than 10 percent of the

9 See 12 C.F.R. 1.2(e).

10 See 12 C.F.R. 1.2(f)

11 See 12 C.F.R. 1.2(e).

- -

6

bank’s capital and surplus.12 Accordingly, the Bank must establish, to the satisfaction of the

Bank’s EIC, that the contingent portion of the interest on the Notes meets these criteria.

Safety and Soundness

As Bulletin 2004-56 makes clear, in addition to credit and interest rate risks, BOLI exposes

national banks to liquidity, transaction, reputation, and compliance risks, which often are

difficult to measure and control. National banks that acquire BOLI must undertake a thorough

prepurchase analysis and have a sound risk control framework to assess BOLI exposures on an

ongoing basis. National bank purchasers of BOLI should develop and implement comprehensive

policies that articulate their tolerance for the risks that BOLI presents. Bank management

should conduct an analysis to support that acquisitions of BOLI do not give rise to imprudent

capital concentration. Also, bank management should obtain approval from the board of

directors or a designated board committee prior to the acquisition of BOLI beyond established

limits or the capital concentration threshold.

The BOLI described herein presents a very complex transaction that is appropriate only in a

well-diversified portfolio for institutions with superior credit and investment expertise, as well as

sophisticated risk management processes. Where the separate account holds complex

instruments with unrated, equity-based returns, review of the specific instruments by the OCC

will be needed in order to determine that the holding is consistent with Bulletin 2004-56

at is appropriate only in a

well-diversified portfolio for institutions with superior credit and investment expertise, as well as

sophisticated risk management processes. Where the separate account holds complex

instruments with unrated, equity-based returns, review of the specific instruments by the OCC

will be needed in order to determine that the holding is consistent with Bulletin 2004-56.

Because of the complexity of the instruments, an appropriate level of diligence will be expected

of the bank, and supervisory non-objection from the bank’s EIC should be obtained. An

appropriate exercise of due diligence should include:

• A review by outside counsel of the legal documents involved in the transaction.

• An initial assessment and ongoing monitoring of the performance of the underlying

hedge funds, so that the bank will know at all times its credit exposure under the SVP

policy.

• A review of BOLI holdings by an independent control or risk management unit to ensure

compliance with OCC Bulletin 2004-56.

In addition, the bank should establish a compliance process to determine and monitor bank

compliance with the supervisory conditions contained in this Letter.

Conclusion

We conclude that the Bank’s investment in BOLI, as described herein, may be permissible as an

investment in life insurance under section 24(Seventh). The separate account holdings more

closely resemble debt than equity securities so the hedging accuracy standards for equity

holdings in separate account BOLI do not apply. The Notes have a limited term, are rated, have

12 See 12 C.F.R. 1.5, which requires that a national bank adhere to safe and sound banking practices as well as the

specific requirements of Part 1 in purchasing and holding investment securities.

dings more

closely resemble debt than equity securities so the hedging accuracy standards for equity

holdings in separate account BOLI do not apply. The Notes have a limited term, are rated, have

12 See 12 C.F.R. 1.5, which requires that a national bank adhere to safe and sound banking practices as well as the

specific requirements of Part 1 in purchasing and holding investment securities.

- -

7

a fixed coupon, offer holders claims superior to common shareholders, and do not provide voting

rights. Although the Notes’ contingent coupon may resemble the return on an investment in

equity securities, the Notes more closely resemble debt in sufficient respects to be classified as

debt rather than equity.

Where, as here, the separate account holds complex instruments with unrated, equity-based

returns, the Bank should conduct an appropriate level of due diligence, provide the OCC an

opportunity to review the specific instruments to determine that the holding is consistent with

Bulletin 2004-56 and obtain supervisory non-objection from the Bank’s EIC. If you have

questions concerning this matter, please contact Donald Lamson, Securities and Corporate

Practices Division, at 202-874-5210 or Kurt Wilhelm, NBE, Treasury and Market Risk Division,

at 202-874-5670.

Sincerely,

/s/ Daniel P. Stipano

Daniel P. Stipano

Acting Chief Counsel