Early this year the Office of the Comptroller of the Currency announced a ban on purchase by national banks of a form of insurance they have used to fund key-person protection for themselves and retirement programs for top officers.

In May, the agency quietly revised the decision.

The change will no doubt be well received by the many community banks around the country that need a benefit program for their key officers in order to retain their managemetn expertise.

At issue is "modified-endowment" insurance - life insurance that generally is purchased with a single premium payment and subject to certain tax code restrictions enacted in 1988.

Tax-Sheltered Income

Life insurance provides both a death benefit and tax-sheltered accumulation of cash value. A bank can use the cash value as the funding source for benefit payments to an executive at retirement.

The tax-sheltered income feature has made life insurance very appealing to banks. In various examinations over the past few years, the Comptroller's office found that some banks had very large percentages of their capital and surplus in life insurance contracts.

At least one bank had retained key-person, single-premium life insurance policies for investment return purposes even after the key executives had left the bank.

Limits on Banks

By federal statute and regulation, national banks are limited in how they can employ depositor's funds; for example, a bank cannot invest in the stock market for its own account.

A national bank's authority to buy life insurance comes from 12 U.S.C. Sec. 24(7), which does not authorize the purchase for the bank's own account, as an investment.

Any national bank that bought modified-endowment life insurance for purposes of investment did so outside this mandate.

Because some banks appeared to be overfunding their benefit or key-person programs with life insurance - perhaps motivated principally by the investment feature -the Comptroller's office decided to clarify the matter.

According to the agency's May 19 banking circular, national banks can use life insurance as a funding vehicle for retirement benefit plans if the amount is reasonable compensation and does "not substantially exceed" the liability for the benefits the bank has agreed to pay the executive upon retirement.

With key-person insurance protection, the amount "must closely approximate the risk of loss."

Other guidelines also apply.

The circular says banks should scrutinize the insurance company, evaluating its financial condition before buying a policy and monitoring afterward. The circular also specifies that banks can still make loans secured by life insurance policies.

February Ban Softened

The May circular was a revision of the agency's Feb. 4 circular, which allowed life insurance to be purchased under the above guidelines but prohibited banks from purchasing modified-endowment life insurance, because of its investment orientation.

Comments submitted to the Comptroller's office in response to the February circular pointed out that life insurance sold on a modified-endowment basis can offer the safest and most cost-efficient means for a bank to fund a retirement program for its key officers.

This is true for three reasons:

* The bank can get a discount.

* With companies that credit 100% cash value to the amount of the premium, the cost has no effect on the bank's balance sheet.

* The bank has a steadily increasing asset, with interest income compounding over a longer period on a larger initial amount than with the typical periodic-pay life insurance.

Tax Aspect in Doubt

Tax code restrictions on modified-endowment insurance include a 10% penalty tax to a taxpayer who borrows or withdraws from the cash value before age 59 1/2.

It is not known whether this penalty will apply when the bank, rather than the executive, is the taxpayer (and policyholder). The IRS regulations will not be out for another year.

But even if the restriction does apply, the bank would ordinarily not be affected. Borrowing or withdrawals from the policy to fund the executive's retirement benefits usually occur after the normal retirement age, 65.

Mr. Bickel is a tax attorney and the vice president of Washington-based Executive Plans Corp., which designs non-qualified deferred compensation plans for financial institutions. Mr. Solomon, a former director of the Fed's division of banking supervision and regulation, is with the Washington law firm of Colton & Boykin.

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