Regulatory Focus - The Changing of the Guard

The financial services industry is one of the most highly regulated industries in America. Therefore; it is of little surprise that the regulatory agencies overseeing the activities of the financial institutions have come under increased scrutiny from Congress. On March 18, 2009 several of the agencies testified before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs. The primary purpose of this testimony was to outline what has been learned from the most recent financial crisis as well as what action that the agencies will take to strengthen their supervision and examination processes in the area of risk management activities.

The OCC was one of the agencies that provided testimony to the Subcommittee. Senior Deputy Comptroller Timothy Long presented the OCC’s view on the industry and outlined the role of risk management for within banks. SDC Long’s comments provide insight into the focus and temperature of the regulatory agencies attention to effective risk mitigation functions at financial institutions. Below is an excerpt of SDC Long’s testimony.

The first step in risk-based supervision is to identify the most significant risks and then to determine whether a bank has systems and controls to identify and manage those risks. Next, we assess the integrity and effectiveness of risk management systems, with appropriate validation through transaction testing. This is accomplished through our supervisory process which involves a combination of ongoing monitoring and targeted examinations. The purpose of our targeted examinations is to validate that risk management systems and processes are functioning as expected and do not present any significant supervisory concerns. Our supervisory conclusions, including any risk management deficiencies, are communicated directly to bank senior management. Thus, not only is there ongoing evaluation, but there is also a process for timely and effective corrective action when needed. To the extent we identify concerns; we “drill down” to test additional transactions.

These concerns are then highlighted for management and the Board as “Matters Requiring Attention” (“MRAs”) in supervisory communications. Often these MRAs are line of business specific, and can be corrected relatively easily in the normal course of business. However, a few MRAs address more global concerns such as enterprise risk management or company-wide information security. We also have a consolidated electronic system to monitor and report outstanding MRAs. Each MRA is assigned a due date and is followed-up by on-site staff at each bank. If these concerns are not appropriately addressed within a reasonable period, we have a variety of tools with which to respond, ranging from informal supervisory actions directing corrective measures, to formal enforcement actions, to referrals to other regulators or law enforcement.

Our supervision program includes targeted and on-going analysis of corporate governance at our national banks. This area encompasses a wide variety of supervisory activities including:

· Analysis and critique of materials presented to directors;

· Review of board activities and organization;

· Risk management and audit structures within the organization, including the independence of these structures;

· Reviews of the charters, structure and minutes of significant decision making committees in the bank;

· Review of the vetting process for new and complex products and the robustness of new product controls; and

· Analysis of the appropriateness and adequacy of management information packages used to measure and control risk.

It is not uncommon to find weaknesses in structure, organization, or management information, which we address through MRAs and other supervisory processes described above. But more significantly, at some of our institutions what appeared to be an appropriate governance structure was made less effective by a weak corporate culture, which discouraged credible challenge from risk managers and did not hold lines of business accountable for inappropriate actions.

We all can agree that effective risk mitigation functions within banks will provide for a strong and stable financial system. Therefore the current process needs to be strengthened and improved. It appears as though the regulatory agencies will be increasing their efforts to ensure that such improvements are developed and implemented across each business line. Organizations the fail to do so will be identified and given “special” supervisory oversight.

For the complete testimony of SDC Long please visit: http://www.occ.gov/ftp/release/2009-23b.pdf

Is Your Insurance Policy a Toxic Asset?

There are worse things in life than death. Have you ever spent an evening with an insurance salesman? While this comment made by Woody Allen does provide a chuckle it might not be that far from the truth when it comes to administering Irrevocable Life Insurance Trusts (ILITs). It is becoming quite apparent why trustees of insurance trusts can’t just sit on the sidelines. There is a need to proactively review the ILIT insurance assets.

ILITs continue to provide an excellent financial planning vehicle and are a key safety net for many. The current volatility in the markets and with investment portfolios down substantially over the past year, the insurance assets may be even more vital. While there are unique risks associated with the administration of ILITs, there are also considerable opportunities.

Let’s first deal with some of the risks. During the next year, you will encounter two important risks associated with your life insurance assets:

1. Policy Lapses – this will definitely be an issue for variable life policies that have been negatively impacted by the market decline.

2. Insurance Company Impairment or Failures – insurance company rating downgrades are occurring with increasing frequency and federal government bailout assistance may not be adequate.

Based upon our experience and knowledge, we believe that substantial increases in ILIT monitoring and administration efforts will be needed. This is much easier said than done when the current environment requires expense control and head count reductions are the norm in the risk mitigations area. However, at the very least the following steps should be taken.

• Evaluate more frequently – especially your variable life insurance policies.
• Re-test the policies – obtain current “in-force illustrations” at the very least.
• Obtain actuarial support – expertise is needed to comply with your fiduciary duty.
• Review premium adequacy – determine the ability to afford increased premiums.
• Monitor ratings of insurance companies - understand the limitations of the ratings.
• Understand account objective(s) – verify that the ILIT is still appropriate and discuss alternatives.

In addition, recent regulatory guidance provides additional information. OCC Banking Bulletin 2008-10 highlights the need to ensure that all assets receive an annual review. The Bulletin states:

In addition to being a regulatory requirement, annual investment reviews are among the most useful tools bank fiduciaries have to ensure they meet their fiduciary responsibilities and properly administer their customers’ accounts. An annual investment review is a point-in-time evaluation of both account assets and objectives. Regardless of the tools employed by a particular institution, management supervision, information systems, and follow-up are all critical to an effective investment review process. An effective investment review process should be based upon policies and procedures that provide clear standards for scope, documentation, and exception reporting and tracking. The process should:

· Ensure that account investment objectives are current and appropriate, and that investments are consistent with those objectives.

· Ensure that the investment review provides for an annual assessment of the portfolio in its entirety. This is particularly important when unique assets make up a portion of the account.

· Include exception tracking that identifies and provides for follow up and resolution of exceptions such as securities not included on “approved” or “retention” lists, assets posing potential conflicts of interest, or asset concentrations.

· Include performance measurements and a process for handling performance outliers.

· Ensure that each asset is valued using an appropriate valuation process.

Unique or hard-to-value assets should be included as part of the annual investment review. The review of these assets should:

· Be sufficiently detailed to document the bank’s determination that the asset is appropriate for the investment objectives of the account and should be retained.

· Include a careful review of Asset Retention letters because these investment directions can require a bank to hold assets that may be inconsistent with the bank’s investment strategies. A bank should accept Asset Retention letters only from authorized parties.

· Provide updated asset valuations appropriate for the type of asset and nature of account.

As a fiduciary the items listed above are your responsibility. Failure to properly address these areas in policies, procedures, and practice subjects your organization to increased risk potential. However; when properly implemented you have created a differentiator for your service and thus created the environment for increased opportunity. Opportunities include:

• Increase revenue potential – proper priced ILIT administration.
• Increase knowledge and awareness – better understanding of the product.
• Increase business opportunities – relationships with estate planners and other COIs (Centers of Influence).
• Decrease risk and litigation – consistent application of an effective process.

Should you like additional information or detail on any of the items discussed above, please contact us.

What We Can Learn From Recent Scandals or Back To The Basics

The use of the term “Ponzi scheme” is appearing quite regularly in the financial press these days. While several such alleged schemes have received their fair share of the headlines, what hasn’t been as evident are the warning signs that should have been heeded. Fiduciaries have a duty to control and mitigate the risks associated with all investments. While much focus has been placed on the alternative investment arena, the re-enforcement of some basic risk mitigation policies will provide confidence for your clients and prospects. Perhaps the horse has already left the barn so to speak, but here are some basic “red flags” to consider when making investment decisions:

· Lack of segregated custody

· Use of an affiliated broker dealer

· Use of a small, unknown auditing firm not registered with PCAOB

· Lack of access to Portfolio Managers

· Lack of transparency

· Secretive or unexplainable investment strategy

Nothing in the above list is unique or worthy of a lengthy dissertation, but rather the simplicity of it makes it all the more amazing that approximately $60 billion has been put at risk because due diligence on the above was not adequately addressed.