supervisory insights: vol. 4, issue 1 - summer 2007 from the director 2 issue at a glance volume 4,...

Inside

Third-Party Arrangements

Staying Alert to Mortgage Fraud

Wind Hazard Insurance

The e-Exam

Recent DevelopmentsAffecting the Accountingfor Split-Dollar LifeInsurance Arrangements

Supervisory InsightsSupervisory InsightsDevoted to Advancing the Practice of Bank Supervision

Vol. 4, Issue 1 Summer 2007

Supervisory Insights

Supervisory Insights is published by theDivision of Supervision and ConsumerProtection of the Federal DepositInsurance Corporation to promotesound principles and best practicesfor bank supervision.

Sheila C. BairChairman, FDIC

Sandra L. ThompsonDirector, Division of Supervision andConsumer Protection

Journal Executive Board

George French, Deputy Director andExecutive Editor

Christopher J. Spoth, Senior DeputyDirector

John M. Lane, Deputy DirectorRobert W. Mooney, Acting Deputy

DirectorWilliam A. Stark, Deputy DirectorJohn F. Carter, Regional DirectorDoreen R. Eberley, Regional DirectorStan R. Ivie, Regional DirectorJames D. LaPierre, Regional DirectorSylvia H. Plunkett, Regional DirectorMark S. Schmidt, Regional Director

Journal Staff

Bobbie Jean NorrisManaging Editor

Christy C. JacobsFinancial Writer

Eloy A. VillafrancaFinancial Writer

Supervisory Insights is availableonline by visiting the FDIC’s website atwww.fdic.gov. To provide comments orsuggestions for future articles, to requestpermission to reprint individual articles,or to request print copies, send an e-mailto [email protected].

Letter from the Director......................................................... 2

Issue at a Glance

Volume 4, Issue 1 Summer 2007

Regular Features

From the Examiner’s Desk . . . The e-Exam 30An e-Exam, or electronic examination, isa financial institution examination inwhich electronic data are exchangedthrough a secure delivery method, thusimproving examination efficiencies forboth banks and examiners. Banks gener-ally maintain a wide variety of informa-tion—written policies and procedures,customer disclosures, board minutes,and even loan files—in electronic format.This article discusses the FDIC’s e-Exampolicy and the impact that being able toexchange documents electronically ishaving on examinations.

Accounting News: Recent Developments Affecting the Accounting for Split-Dollar Life Insurance Arrangements 35Over the past year, the FinancialAccounting Standards Board’s EmergingIssues Task Force has addressed theaccounting for endorsement and collat-eral assignment split-dollar life insurancearrangements under which employersand employees share the rights to thecash surrender value and death benefitsof insurance policies. The consensusesreached by the Task Force will changehow many banks have accounted fortheir existing split-dollar arrangementsand will require them to recognize aliability at the beginning of 2008. Thisarticle discusses the principal elementsof this recent accounting guidance andits effect on banks’ capital and futureearnings.

Regulatory and Supervisory Roundup 42This feature provides an overview ofrecently released regulations and super-visory guidance.

Articles

Third-Party Arrangements: Elevating Risk Awareness 4Many community banks provide products and servicesthrough arrangements with third parties. Appropriatelymanaged third-party relationships can enhance competitive-ness, provide diversification, and ultimately strengthen thesafety and soundness of insured institutions. Third-partyarrangements can also help institutions attain key strategicobjectives. But third-party arrangements also present risks. Inthis article, we show how failure to manage these risks canexpose a financial institution to everything from financial lossto regulatory action and loss of customer relationships.

Staying Alert to Mortgage Fraud 12The Federal Bureau of Investigation reports having more thanone thousand pending mortgage fraud investigations, withover half involving financial institutions as victims. However,they estimate the actual number of mortgage fraud cases tobe closer to 36,000. This article discusses the housing boomof the early 2000s and how the resultant demand led toincreases in mortgage fraud activity. The authors share exam-ples from FDIC examiners and offer fundamental mitigationsteps as well as links to other resources.

Wind Hazard Insurance: No Longer Just a Technical Exception 22Hazard insurance has played a big role in mitigating the risk ofloss of collateral value from catastrophic damage. Examinershave traditionally cited inadequacies in collateral insurancecoverage as technical exceptions when reviewing loan files.But in the current environment, potentially widespread issuesregarding insurance availability and affordability could result inconsequences reaching beyond anything considered techni-cal. This article explores the impact of the rising costs (and insome cases, the lack of availability) of wind hazard insurance,with a focus on Florida.

1Supervisory Insights Summer 2007

Letter from the Director


The risk management examinationand the compliance examinationhave long been regarded as sepa-

rate disciplines. These examinationshave traditionally been performed byseparate teams of examiners, and eachdiscipline had its own specialized train-ing and a somewhat distinctive set ofexamination objectives. More recently,as the volume and variety of new bankproducts and services have evolved, anexus between consumer protectionand risk management in certain typesof situations has become increasinglyapparent. What once were perceived asstrictly compliance issues or strictly riskmanagement issues now are understoodto share many common risk attributes.For example, abusive or predatory lend-ing practices raise both asset quality andmanagement considerations for riskmanagement examiners, and also raiseserious concerns on the compliance sideabout adherence to consumer protectionlaws and regulations. Cooperation andcollaboration between the examinationdisciplines will be more important thanever as we strive to address these risksand maintain supervisory vigilance.

The FDIC has taken several steps toachieve greater synergy between thedisciplines. We created Joint Examina-tion Teams (JETs) made up of compli-ance and risk management examinerswho work together on financial institu-tion examinations to identify risks andcollaboratively apply supervisory strate-gies. We have revised the assistantexaminer training program to ensure amultidiscipline approach to training anddeveloping examination staff, and weencourage all examiners to pursue inter-and cross-divisional training. This sharedapproach is needed to address bothcompliance and safety and soundnessissues arising in the banking industry.High-risk products, including certaintypes of subprime and nontraditionalloans, and issues such as overdraftprotection programs, third-partyarrangements, and identity theft all

have risk management and consumerprotection components that necessitate acoordinated supervisory response. Betterconsumer education, along with clearand accurate disclosures and marketingmaterials, might have prevented some ofthe problems we are seeing today.

In response to emerging issues in themortgage industry, the FDIC and theother federal financial institution regula-tory agencies (the agencies) issued Inter-agency Guidance on NontraditionalMortgage Product Risks in September2006. The publication addresses recentregulatory concerns with interest-onlyand payment-option adjustable rate mort-gages (ARMs). In addition, in March ofthis year, the agencies and the NationalCredit Union Administration issued anInteragency Proposed Statement onSubprime Lending. This Statementproposes two clear guidelines for lenders:approve loans based on the borrower’sability to repay at the fully indexed rate,and provide borrowers with clear andaccurate information to help themunderstand the transaction. These guide-lines build on basic and long-standingconsumer protection and risk manage-ment principles. We look forward toreviewing and considering all commentsreceived on this Statement.

Problems in the subprime lendingmarket also highlight the importance ofproper due diligence when entering intothird-party arrangements. In this issue,“Third-Party Arrangements: Elevat-ing Risk Awareness” addresses boththe benefits and potential risks associ-ated with third-party agreements andoffers some best practices for avoidingthe financial losses and reputation risksthat can result from poorly managedthird-party arrangements. The articlealso highlights how, as third-partyarrangements become more prevalentin all institutions, they present a broadspectrum of risks crossing all examina-tion disciplines—risk management,compliance, trust, and informationtechnology. As the examples in the arti-

cle point out, the risks in many of theserelationships (such as information tech-nology or merchant processing) are wellknown, but others are often overlooked.Inadequate management and control ofthird-party risks can result in a signifi-cant financial impact on an institution,including legal costs, credit losses,increased operating costs, and loss ofbusiness. The problems highlighted inthe article might have been avoided ifthe institutions had conducted thoroughrisk assessments, conducted proper duediligence on the parties with whom theywere partnering, thoroughly reviewedcontracts, and ensured that the third-party product or service meshed withthe institution’s goals and business planand that those products or serviceswere consistent with applicable supervi-sory policies. Examiners from all disci-plines will continue to review banks’third-party arrangements to ensure thatfinancial institutions understand andmitigate the potential risks.

Ineffective due diligence by financialinstitutions can have another unfortunateconsequence: an increase in mortgage-related fraud. The explosive growth inmortgage lending over the past severalyears and competitive pressures onlenders to relax underwriting standardscreated a situation that was ripe foropportunists. “Staying Alert to Mort-gage Fraud” discusses this increasingproblem, explores common types ofmortgage fraud, and provides some miti-gating steps banks can take. The exam-ples in the article demonstrate how a fewsimple, fundamental risk managementpractices by lenders might have signifi-cantly reduced fraud-related losses:monitoring concentration risks, provid-ing training and oversight, establishingclear lending and quality control guide-lines, and conducting due diligence whendealing with third parties or new employ-ees, among others.

The devastating effects of the 2004 and2005 hurricane seasons highlighted theimportance of flood insurance in protect-

ing real estate collateral values. As theUnited States gears up for the 2007hurricane season, coastal communitiesare dealing with a new crisis in the insur-ance area: the rising cost and scarcity ofproperty insurance coverage. “WindHazard Insurance: No Longer Just aTechnical Exception” explores theissues arising from the reduced availabil-ity of wind hazard insurance coverage,including the impact on borrowers’ cashflow and the larger economic impact inaffected communities, particularly inFlorida. Underinsured or uninsuredcollateral, declining collateral values, anddeclining debt service coverage exposelenders to more risk of default and loss.At the FDIC, community and consumeraffairs staffs are working to educateconsumers about this issue, while riskmanagement examiners are reemphasiz-ing the importance of insurance cover-age in the overall assessment of loanquality. Bankers, in turn, must ensurethat lending policies and loan agree-ments address insurance requirements,make reasonable efforts to maintainsufficient insurance coverage on collat-eral, and consider the increasing cost ofwind hazard insurance when assessingrepayment capacity.

Also in this issue are our two regularfeatures. “From the Examiner’s Desk”discusses how the FDIC’s e-Exam policyis improving examination efficiencies,while “Accounting News” addressesrecent developments affecting theaccounting for split-dollar life insurancearrangements.�

We encourage our readers to continueto provide comments on articles, to askfollow-up questions, and to suggest topicsfor future issues. All comments, ques-tions, and suggestions should be sent [email protected].

Sandra L. ThompsonDirectorDivision of Supervision andConsumer Protection


Third-Party Arrangements:Elevating Risk Awareness


find security breakdowns that presentboth compliance and safety and sound-ness issues.

The purpose of this article is toheighten banker and examiner aware-ness of third-party risks and the effectthese risks can have on financial insti-tutions and the consumers they serve.Through examples drawn from actualexaminer experiences, the authorsprovide some insights on identifyingand managing third-party risk and howexaminers assess third-party arrange-ments. The authors also provide a listof additional resources for furtherinformation.

“Third Party” Defined

For purposes of this article, “thirdparty” is broadly defined to include anyentity that has entered into a businessrelationship with an insured depositoryinstitution. Often, these third parties aredeeply involved in the delivery of finan-cial services to the consumer. The thirdparty may be positioned, directly or indi-rectly, between the financial institutionand its customers or otherwise haveunfettered access to the institution’scustomers. Consequently, the quality ofthat third party’s performance is criti-cally important to the financial institu-tion’s long term success. A third partycan be a bank or a nonbank, affiliated ornot affiliated, regulated or nonregulated,domestic or foreign.

The scope of the definition of thirdparty is expansive by necessity. Withinthe banking industry, third-party relation-ships are pervasive. Financial institutionsuse third parties to

n Perform functions on their behalf;

n Facilitate customer access to the prod-ucts and services of third-partyproviders; and

Community banks increasinglyprovide products and servicesthrough arrangements with third

parties. Appropriately managed third-party relationships can enhance competi-tiveness, provide diversification, andultimately strengthen the safety andsoundness of insured institutions. Third-party arrangements can also help institu-tions attain key strategic objectives. Butthird-party arrangements also presentrisks. Failure to manage these risks canexpose a financial institution to regula-tory action, financial loss, litigation, andreputational damage, and may evenimpair the institution’s ability to estab-lish new or service existing customerrelationships. Successful third-party rela-tionships, therefore, start with financialinstitutions recognizing those risks andimplementing an effective risk manage-ment strategy.

The FDIC routinely assesses third-partyarrangements. The FDIC is concernedwhen an arrangement unduly heightensthe risk to an insured depository institu-tion or has potential adverse effects forconsumers. The risks cross all examina-tion disciplines and necessitate closecommunication among examinationteams to thoroughly understand therisk presented by a bank’s particularthird-party arrangements. For example,compliance examiners may find legalproblems with how a third party ismanaging a credit card operation.Those legal problems could result insubstantial liability for the bank thatcould, in turn, affect its capital position.Conversely, risk management examinersreviewing suspicious activity reportsfiled by the institution about third-partymortgage brokers may find informationabout potentially unfair or deceptivepractices that compliance examinersshould review. Information technologyexaminers who review the operationof a third-party service provider may

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n Increase revenue by allowing thirdparties to conduct business on behalfof the financial institution by usingthe institution’s name on the thirdparties’ products and services.

The Risks Are Familiar . . .Sometimes

Third-party risk is not a simple, easilyidentifiable risk attribute, but rather acombination of risks ranging from thefamiliar to the highly complex. Third-party risk can vary greatly, dependingon each individual third-party arrange-ment. The risks are more widely recog-nized in certain arrangements, such asinformation technology and merchantprocessing. However, in many otherarrangements, the risks can seem moreinnocuous—sometimes leading to criti-cal gaps in bank management’s plan-ning and oversight of third-partyarrangements.

Some of the risks are associated withthe underlying activity itself—similar tothe risks faced by an institution directlyconducting the activity. Other potentialrisks arise from or are heightened by theinvolvement of a third party. Significantor more complex third-party arrange-ments will have identifiable risk attrib-utes falling into the following broadcategories.

Strategic risk includes the risk arisingfrom ill-advised business decisions orthe failure to implement appropriatebusiness decisions in a manner consis-tent with an institution’s strategic plan-ning objectives. The use of a third partyto perform banking functions or offerproducts or services that do not helpthe financial institution achieve corpo-rate strategic goals presents an obviousstrategic risk. Third-party arrangementsthat do not provide a return commen-surate with the level of risk assumedexpose the financial institution tostrategic risk.

Reputation risk is the risk arising fromnegative public opinion. Dissatisfiedcustomers, breaches of an institution’spolicies or standards, and violations oflaw can potentially harm the reputationof a financial institution in the commu-nity it serves. Negative publicity involvingthe third party, even if it is not related tothe specific third-party arrangement,presents reputation risk to a financialinstitution.

Transaction risk is the risk arisingfrom problems with customer service orproduct delivery. A third party’s failureto perform as expected by the financialinstitution or by customers—because ofinadequate capacity, technological fail-ure, human error, or fraud—exposes theinstitution to transaction risk. Inade-quate business resumption or otherappropriate contingency plans alsoincrease transaction risk. Weak controlover information technology couldresult in the inability to transact busi-ness as expected, unauthorized transac-tions, or breaches of data security.

Credit risk is the risk that a thirdparty, or any other creditor necessaryto the third-party relationship, is unableto meet the terms of the contractualarrangements with the financial institu-tion or to otherwise financially performas agreed. The basic form of credit riskinvolves the financial condition of thethird party itself. Some contracts withthird parties provide assurance of somemeasure of performance relating to theunderlying obligations arising from therelationship, such as loan originationprograms. Whenever indemnificationor any type of guarantee is involved,the financial condition of the thirdparty is a factor in assessing credit risk.Credit risk to the institution can alsoarise from arrangements where thirdparties market or originate loans,solicit and refer customers, or analyzecredit. Appropriate monitoring of third-party activities is necessary to ensure

Supervisory Insights Summer 2007

predictable results. Institutions often“buy” the types of loans they cannotoriginate in their normal trade area;however, those institutions may lacklenders with sufficient expertise toanalyze the participation loan. At othertimes, a financial institution’s manage-ment may wish, in hindsight, that theyhad known more—not only about theborrowers, but also about the thirdparty with whom they did business.Purchased loans, especially those fromoutside a financial institution’s lendingarea, present the opportunity formisrepresentation or fraud. In additionto strategic and due-diligence issues,there are a multitude of risks specific toany given transaction.

Addressing the Risks. Institutionsentering into participation arrangementscan avoid common pitfalls and mitigatethird-party risks by

n Conducting a thorough risk assess-ment. Ensure that the proposed rela-tionship is consistent with theinstitution’s strategic plan and overallbusiness strategy;

n Conducting a thorough due dili-gence. Focus on the third party’sfinancial condition, relevant experi-ence, reputation, and the scope andeffectiveness of its operations andcontrols;

n Reviewing all contracts. Ensure thatthe specific expectations and obliga-tions of both the bank and the thirdparty are outlined and formalized;

n Reviewing applicable accountingguidance. Determine if the participa-tion agreement meets the criteria fora loan sale or a secured borrowing.Key issues to consider include rightsto repurchase and recourse arrange-ments. In some cases, participationloans meet applicable sales criteria,but warrant consideration under risk-based capital standards; and

n Developing a comprehensive monitor-ing program. Periodically verify that

that credit risk is understood andremains within established limits.

Compliance risk is the risk arising fromviolations of laws, rules, or regulations,or from noncompliance with internalpolicies or procedures or with the institu-tion’s business standards. Activities of athird party that are not consistent withlaw, policies, or ethical standards exposefinancial institutions to compliance risk.This risk is exacerbated by inadequateoversight or a weak audit function. Athird party’s failure to appropriatelymaintain the privacy of customer recordswill also create undue risk.

Other risks. Third-party relationshipsmay also subject financial institutions toa variety of unique risks: liquidity, inter-est rate, price, foreign currency transla-tion, and country risks, among others. Acomprehensive list of other types of riskthat arise from an institution’s decisionto enter into a third-party relationship isnot possible without a complete under-standing of the arrangement.

Don’t Neglect the Basics

A simple participation loan is a verycommon third-party arrangement andprovides a good introduction to ourexamples of third-party risk. The par-ticipating financial institution (orpurchaser) does not underwrite theloan, and the borrower does notdirectly interact with the institution.A third party, perhaps not even aninsured financial institution, assumesmany critical functions in the under-writing and servicing processes. In thevast majority of participation loans, theoutcome is as expected: the borrowerpays as agreed and the arrangement isprofitable for the bank. However, themyriad things that can go wrong high-light the basics of third-party risk.

Examiners sometimes find that aparticipation loan does not meet thefinancial institution’s established under-writing standards, too often with

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Third-Party Arrangementscontinued from pg. 5


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the third party is abiding by the termsof the contractual agreement and thatidentified risks are appropriatelycontrolled.

As demonstrated in the examplesdiscussed below, these key steps—riskassessment, due diligence, contractreview, and oversight—are the basicelements of an effective third-party riskmanagement process, regardless of thetype of activity carried out by the thirdparty.

Beyond Credit Risk

Financial institutions sometimes focusalmost exclusively on credit risk andoverlook the potential for other risks. Inone case, an institution decided to enterthe credit card market by partneringwith an entity that purported to special-ize in marketing and processing creditcards. These credit cards, which werepromoted as a product that providedcustomers with “benefits” and “satisfac-tion,” were also marketed as a means ofbuilding or rebuilding a consumer’scredit rating.

According to the agreement with thethird party, the financial institutionwould underwrite and originate creditcards under its own name and immedi-ately sell any related receivables to thethird party. In return, the institutionwould receive a small amount everymonth for each outstanding card. If anindividual cardholder was able to makethe required payments in a timelymanner, he or she could earn a refundof some, or all, of the origination fee.However, the program was structured sothat only a small percentage of cardhold-ers would ever use the card in a tradi-tional manner. More often than not, thesmall credit line was completelyconsumed by fees at origination, leaving

the cardholder with no available creditupon receipt of the card.

Examiners took exception to theproduct being marketed as a credit-building instrument because the institu-tion was unable to provide substantiveevidence that consumers’ credit profilesactually improved by using the creditcard. Examiners were also concernedthat the card had minimal usefulnessfrom the outset because of the highinitial fees. Despite the claims of “satis-faction,” a significant portion of card-holders canceled their credit cardswithin three to six months of issuance.The institution was found to be inviolation of Section 5 of the FederalTrade Commission Act (relating tounfair and deceptive acts or practices),1

was required to make customer reim-bursements, and suffered damage toits reputation.

The Importance of Effective RiskIdentification. There are numerousrisks that may arise from an institution’suse of third parties. In this case, the insti-tution was focused on credit risk ratherthan on compliance and reputation risk.As part of the risk assessment process,management should analyze the poten-tial risks associated with the third partyand the proposed activity. In retrospect,the financial institution could have miti-gated many of the risks resulting fromthis arrangement by

n Conducting a thorough risk assess-ment;

n Making certain promotional materi-als were well-supported and notmisleading;

n Reviewing the third party’s previousexperience with the product as wellas monitoring results of the third-party arrangement, including records


1 The Winter 2006 issue of Supervisory Insights contains a thorough discussion of Section 5 of the Federal TradeCommission Act (unfair or deceptive practices affecting commerce) and cites situations similar to this example.See “Chasing the Asterisk: A Field Guide to Caveats, Exceptions, Material Misrepresentations, and Other Unfairor Deceptive Acts or Practices,” Supervisory Insights, Vol. 3, Issue 2, Winter 2006, www.fdic.gov/regulations/examinations/supervisory/insights/siwin06/index.html.

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of those customers who canceledtheir cards within a few months ofissuance; and

n Reviewing the product for compliancewith governing laws and regulations.

Costly Lessons fromUnsupervised Outsourcing

Institutions often use third parties, suchas mortgage brokers, to generate mort-gage loans. In such cases, financial insti-tutions are expected to ensure that therisk management processes for loanspurchased from or originated throughthird parties are consistent with applica-ble supervisory policies.

An examination of an institution wellversed in mortgage lending revealedsubstantial problems related to itsmortgage broker network. Productofferings by both the institution andits third-party mortgage brokers hadrapidly evolved and expanded. To meetgrowing demand, the institution shiftedits product and delivery channel strate-gies. In only a brief period of time, theinstitution’s broker network expandedsignificantly.

At the same time, the institution’sdue diligence process for brokers wasrelaxed. The institution’s financialstandards for the third-party mortgagebrokers it used quickly became moreliberal than the institution’s lendingstandards. Simple background checks,costing only a few dollars, were fore-gone for the sake of expediency.Monitoring processes were lax. Thelending-volume threshold to triggercloser reviews of loan quality was setso high that practically no brokers wereever subject to the reviews. Underwrit-ing standards were also relaxed. Ineffect, the institution became relianton the brokers to protect its financialinterest and reputation. Further,

management reporting was cumber-some and incomplete. While the insti-tution used a watch list, essentiallybrokers were placed on the list onlyif suspicious activity (i.e., fraud) wasactually reported to federal authoritiesor if specific misconduct was identified.Even when a watch designation wasassigned, the institution’s systemsallowed for continued funding withoutfurther review. Unfortunately, but notsurprisingly, the institution recognizedthese inadequacies only after creditlosses increased substantially.

No Substitute for Due Diligence andOversight. Problems arise not from theabsolute volume of relationships, butfrom the quality of the risk manage-ment processes employed. In thisexample, controls over the networkwere perfunctory at best. The institu-tion appeared to have a process but,in practice, the process controlled verylittle. The institution could have miti-gated the risks discussed as well as theresulting impact on the institution by

n Exercising appropriate due diligenceprior to entering into a third-partyrelationship and providing ongoing,effective oversight and controls;

n Conforming to supervisory standards,including those reiterated in theSeptember 2006 Interagency Guid-ance on Nontraditional MortgageProduct Risks;2 and

n Monitoring loan originations to ensurethat loans met the institution’s lend-ing standards and were in compliancewith applicable laws and regulations.

Hitting the Bottom Line

One financial institution outsourcedmuch of the development and adminis-tration of a new credit product for itscustomers. However, the third party was


2 FIL-89-2006, Guidance on Nontraditional Mortgage Product Risks, and Addendum to Credit Risk ManagementGuidance for Home Equity Lending, October 5, 2006, www.fdic.gov/news/news/financial/2006/fil06089.html.


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not fully aware of the various requireddisclosures or the annual percentage rate(APR) and finance charge calculationsnecessary for compliance with the Truthin Lending Act. As a result, customersreceived disclosure statements thatsignificantly understated the financecharges related to the product.

The institution had already beencautioned by examiners to review newproducts carefully, as a result of duediligence inadequacies identified in pastexaminations. Despite these cautions,bank management did not invest suffi-cient resources to ensure a successfulnew product offered through the thirdparty. Examiners discovered the inaccu-rate disclosure shortly after productlaunch. The institution suspended theproduct but not until numerous loanswith faulty disclosures had been origi-nated. The amount of reimbursementsto customers was significant, along withthe expense and embarrassment thatcame with rectifying the mistake. Hadthe problem not been identified early,the reimbursements required could haveeasily reached an amount large enoughto jeopardize the capital accounts of thefinancial institution.

Unidentified Risks Can Be Costly.Following an assessment of risks and adecision to proceed with a new productline developed and administered by athird party, the institution’s managementmust carefully select a qualified entity toimplement the program. Due diligenceshould be performed not only prior toselecting a third party, but also periodi-cally during the course of the relation-ship. In this example, the institutioncould have mitigated the risks discussedas well as the resulting impact on theinstitution by

n Conducting a comprehensive duediligence that involved a review of allavailable information, including thethird party’s qualifications and experi-ence with the product; and

n Monitoring the third party’s activitiesto make sure the products producedwere in compliance with existing laws,rules, and regulations, as well as theinstitution’s internal policies, proce-dures, and business standards.

A Supervisory Perspective

Before engaging in any third-partyarrangement, a financial institutionshould ensure that the proposed activi-ties are consistent with the institution’soverall business strategy and risk toler-ances, and that all involved parties haveproperly acknowledged and addressedcritical business risk issues. These issuesinclude the costs associated with attract-ing and retaining qualified personnel,investments in the technology poten-tially needed to monitor and managethe intended activities, and the estab-lishment of appropriate feedback andcontrol systems. If the activity involvesconsumer products and services, theboard and management should establisha clear solicitation and origination strat-egy that allows for after-the-fact assess-ment of performance, as well asmid-course corrections.

Proper due diligence should beperformed prior to contracting with athird-party vendor and on an ongoingbasis thereafter. Management shouldensure that exposures from third-partypractices or financial instability areminimized. Negotiated contracts shouldprovide the institution with the ability tocontrol and monitor third-party activities(e.g., growth restrictions, underwritingguidelines, outside audits) and discon-tinue relationships that do not meet highquality standards.

Reputation, compliance, and legalrisks are dependent, in part, upon theintended activities as well as the publicperception of both the financial institu-tion’s and the third party’s practices.Therefore, careful review is warranted,


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and an adequate compliance manage-ment program is critical. In some cases,an institution may need processes inplace to handle potential legal action.In any case, management should estab-lish systems to monitor consumercomplaints and ensure appropriateaction is taken to resolve legitimatedisputes.

Finally, an institution’s audit scopeshould provide for comprehensive, inde-pendent reviews of third-party arrange-ments as well as the underlying activities.Findings should be provided to the finan-cial institution’s board of directors andexceptions should be immediatelyaddressed.3

A financial institution’s board ofdirectors and senior management areultimately responsible for identifyingand controlling risks arising from third-party relationships. The financial insti-tution’s responsibility is no differentthan if the activity was handled directlyby the institution. In fact, as the exam-ples in this article illustrate, greatercare may be necessary depending onthe risks inherent in the third-partyarrangement.

FDIC examiners assess how financialinstitutions manage their significantthird-party relationships. Trust,consumer protection, informationtechnology, and safety and soundnessexaminations all include reviews ofthird-party arrangements. Examinersreview bank management’s record ofand process for assessing, measuring,monitoring, and controlling risks asso-ciated with significant third-partyrelationships. The depth of the exami-nation review depends on the scope ofactivity conducted through or by thethird party and the degree of risk asso-ciated with the activity and the rela-

tionship. The FDIC considers theresults of the review in its overall evalu-ation of management and its ability toeffectively control risk. The use ofthird parties can have a significanteffect on other key aspects of perfor-mance, such as earnings, asset quality,liquidity, rate sensitivity, and the insti-tution’s ability to comply with laws andregulations.

FDIC examiners address findings andrecommendations relating to an institu-tion’s third-party relationships in theReport of Examination and within theongoing supervisory process. Appropri-ate corrective actions, including enforce-ment actions, may be pursued fordeficiencies related to a third-party rela-tionship that pose significant safety andsoundness concerns or result in viola-tions of applicable federal or state lawsor regulations.

Conclusion

Bankers and examiners alike deal withthird-party arrangements on a regularbasis. Third-party arrangements canhelp financial institutions attain strate-gic objectives by increasing revenue orreducing costs and can facilitate accessto needed expertise or efficiencies relat-ing to a particular activity. However,inadequate management and control ofthird-party risks can result in a signifi-cant financial impact on an institution,including legal costs, credit losses,increased operating costs, and loss ofbusiness.

As illustrated in the preceding exam-ples, the risks inherent in third-partyarrangements are not significantlydifferent from other risks financialinstitutions face. In fact, the risks areoften the same—the difference is whereto look for them. Likewise, the frame-


3 From the FDIC’s Risk Management Manual of Examination Policies, www.fdic.gov/regulations/safety/manual/index.html.


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work for risk management is verysimilar. Risks should be identified,activities managed and controlled,information monitored, and processesperiodically audited. Identified weak-nesses should be documented andpromptly addressed. As with any otherundertaking by a financial institution,poor strategic planning, inadequatedue diligence, insufficient manage-ment oversight, and a weak internalcontrol environment are commonelements in problem situations. Simi-larly, the primary element for successis effective management.

Kevin W. HodsonField Supervisor (RiskManagement),Des Moines, IA

Todd L. HendricksonField Supervisor(Compliance),Fargo, ND

Acknowledgments: The authors wishto acknowledge the assistance of FieldSupervisors Brent J. Klanderud (RiskManagement), Omaha, NE, andRandy S. Rock (Risk Management),Sioux Falls, SD, in developing thisarticle. Messrs. Klanderud and Rock,along with the authors, recently ledan Examiner Forum, an internal semi-nar for FDIC examiners in the FDIC’sRisk Analysis Center, on the topic ofthird-party risk. The authors are alsograteful for the encouragement andassistance provided by Mira Marshall,Senior Policy Analyst, CompliancePolicy Section, Washington Office;Kenyon Kilber, Senior ExaminationSpecialist, and Suzy Gardner, Exami-nation Specialist, Planning andProgram Development Section, Wash-ington Office; and the talented exam-iners who identified the situationscited as examples in this article.


List of Resources:FDIC Risk Management Manual of Exami-

nation Policies, Related Organizations,Section 4.3, “Examination and Investiga-tion of Unaffiliated Third Parties,”www.fdic.gov/regulations/safety/manual/section4-3.html.

FDIC Risk Management Manual of Exami-nation Policies, Loans, Section 3.2,“Subprime Lending,” www.fdic.gov/regulations/safety/manual/section3-2.html#subprime.

FIL-89-2006, Guidance on NontraditionalMortgage Product Risks, and Addendumto Credit Risk Management Guidance forHome Equity Lending, October 5, 2006,www.fdic.gov/news/news/financial/2006/fil06089.html.

FDIC Compliance Examination Handbook,“Compliance Examinations,” Sections II,V, VII, and IX, www.fdic.gov/regulations/compliance/handbook/html/index.html.

FIL-52-2006, Foreign-Based Third-PartyService Providers: Guidance on ManagingRisks in These Outsourcing Relationships,June 21, 2006, www.fdic.gov/news/news/financial/2006/fil06052.html.

OCC Bulletin 2001-47, Third Party Relation-ships: Risk Management Principles,November 1, 2001, www.occ.treas.gov/ftp/bulletin/2001-47.doc.

OCC Advisory Letter 2000-9, Third PartyRisk, August 29, 2000, www.occ.treas.gov/ftp/advisory/2000-9.doc.

Thrift Bulletin 82a, Third Party Arrange-ments, September 1, 2004,www.ots.treas.gov/docs/8/84272.pdf.

Federal Financial Institutions ExaminationCouncil Information Security IT Exami-nation Handbook, July 2006, Appendix A:“Examination Procedures,” www.ffiec.gov/ffiecinfobase/booklets/information_security/information_security.pdf.

12

The housing boom of the early2000s affected many areas of theUnited States, as consumers and

investors took advantage of low interestrates to purchase, upgrade, and investin houses and condominiums. Theentry, and general acceptance, ofnumerous nontraditional mortgageloan products into the financial land-scape also bolstered many people’sgoal of achieving home ownership.The nontraditional products facilitatedan increase in the dollar amount ofmortgages individuals financed, whichhelped spur housing demand. As thisdemand increased, so did price appre-ciation, and the purchase of a housebecame more than just a home formany individuals: residential real estatebecame the new “golden egg.”

Historically, a mortgage transactioninvolved two parties: the lender andborrower. Borrowers conducted theirbusiness across a desk at a local bank,and the only other people involved in theprocess were bank employees (or individ-uals closely associated with the bank).Today, a single mortgage transaction caninvolve a wide number of independentparties who may never meet the borroweror the lender. In addition, the pressure toclose a loan quickly is paramount, as fast-paced consumers look for more conven-ience and less hassle. Unscrupulousindividuals are increasingly manipulatingthese types of circumstances to theiradvantage, resulting in a significant andgrowing mortgage fraud problemthroughout the country.

The following example demonstratesthe egregious nature of mortgage fraud.Picture 1 was included in a fraudulentappraisal used to secure a $250,000mortgage loan on this home in Atlanta,Georgia. However, the appraiser failed to

include the second picture, which showsthe rear view of the property! The loanwas granted, and the lender incurred amaterial loss upon subsequent foreclo-sure and disposition of the property.1

This article explores common typesof mortgage fraud, focusing on exam-ples from a recent poll of FDIC examin-ers. The authors also offer suggestionsand links to additional information forfurther support in mitigating the risksof mortgage fraud.

Mortgage Fraud Reaches NewHeights

Mortgage fraud activity has increasedmarkedly in recent years. In 2005,reported losses associated with mort-gage fraud passed the $1 billion mark

1 Ann D. Fulmer, Vice President of Industry Relations, Interthinx™; HUD STOP Conference, June 22, 2006,Savannah, Georgia.


Staying Alert to Mortgage Fraud

Picture 1

Picture 2

13

nationwide for the first time.2 As shownin the chart titled SAR Filings, suspi-cious activity reports (SARs)3 involvingmortgage fraud doubled from 2003 to2004 and continue to increase. Accord-ing to the National Association of Mort-gage Brokers, as many as two-thirds ofall mortgages are originated by mort-gage brokers. When one considersthat mortgage brokers are not requiredto file SARs, the actual volume ofmortgage fraud activity could bemuch higher.

As of early March 2007, the FederalBureau of Investigation (FBI) had 1,036pending mortgage fraud investigations,4

compared with 818 and 721, respec-tively, in the two previous years. TheFBI estimates, however, that the actualnumber of mortgage fraud cases wascloser to 36,000 for the fiscal yearended September 30, 2006, comparedwith 22,000 the previous year.5 Morethan half of the current investigationsinvolve expected losses greater than$1 million, and financial institutionsrepresent 57 percent of the victims.

Categorizing Mortgage Fraud

The bulk of mortgage fraud falls intotwo broad categories based on the moti-vation behind the fraud.


2 Mortgage Bankers Association, “Mortgage Fraud Perpetrated Against Residential Lenders,” July 2006,from their website. See www.mortgagebankers.org/files/Library/IssuePapers/MortgageFraudPerpetratedAgainstResidentialLenders.pdf.3 A suspicious activity report is a standard form used by all federally insured financial institutions to reportactivities of suspected criminal violations of federal law or suspicious transactions potentially related to moneylaundering. 4 FBI, Mortgage Fraud: New Partnership to Combat Problem, March 9, 2007. Seewww.fbi.gov/page2/march07/mortgage030907.htm.5 Bob Tedeschi, “Mortgages: Fraud Cases Are Rising, FBI Says,” New York Times, January 14, 2007, http://homefinance.nytimes.com/nyt/article/mortgage-column-by-bob-tedeschi/2007.01.14.fraud-cases-are-rising-fbi-says.

SAR Filings(Mortgage Fraud-Related)

Source: Mortgage Loan Fraud: An Industry Assessment Based upon Suspicious Activity Report Analysis, November 2006

Reported SARs Est. Add'l 2006

30,000

25,000

20,000

15,000

10,000

5,000

01996 1998 2000 2002 2004 2006

Chart


Staying Alert to Mortgage Fraudcontinued from pg. 13

n Fraud for property typicallyinvolves a borrower who will over-state income or asset values onhis or her financial statement toqualify for a loan to purchase ahome. In many of these cases,expectations are that if the incomedoes not rise to meet the payment,the home will be sold at a profitfrom appreciation.

n Fraud for profit involves morecomplicated schemes and presentsa higher exposure to the market.Fraudulent methods are used toacquire and dispose of property withthe inflated profits going to theperpetrators of the fraudulent trans-action. Participants in these fraudu-lent transactions involve a varietyof insiders and third parties: strawborrowers, sellers, loan originators,brokers, agents, appraisers, builders,and developers. Opportunities forfraud for profit involving insidersare limited only by the perpetrator’simagination.6

Case Studies: Reports fromExaminers

Bearing headlines such as “EightIndicted in Loan Scam” (Dallas Morn-ing News, March 9, 2007) and “Mort-gage Fraud Alleged in 149 Transactions”(Journal Gazette, Fort Wayne, Indiana,April 1, 2007), the media are filled withstories demonstrating the pervasivenessof mortgage fraud. Rarely, however, dothese stories offer insights into whatmight have been done to detect orprevent the fraud or the effect of thefraud on the insured institutionsinvolved.

To get a picture of how mortgagefraud might be affecting insured finan-cial institutions, and to provide somepractical advice, the authors askedexaminers from across the country toprovide examples of the more commontypes of fraud they were encountering.The types of fraud most prevalent inexaminers’ responses were

n Broker-facilitated fraud;

n Loan documentation fraud;

n Appraisal fraud;

n Property flipping; and

n Misapplication of funds fromconstruction or rehabilitation projects.

As illustrated in the examples thatfollow, examiners are often not theones to first discover a case of fraud.The vast majority of fraud instancesare discovered and reported by theinstitutions themselves.

Broker-Facilitated Fraud

According to a study by BasePointAnalytics LLC, broker-facilitated fraudhas surfaced as the most prevalentsegment of mortgage fraud nationwide.7

Broker-facilitated mortgage fraud occurswhen a broker materially misrepresents,misstates, or omits information that aloan officer relies on to make the deci-sion to extend credit.8 Broker-facilitatedfraud can be fraud for property, fraudfor profit, or a combination of both. Forexample, the borrower may be commit-ting the fraud with the primary interestof obtaining a home, while the brokerfacilitating the fraud is motivated byprofit from closing the loan. The follow-ing represents a case of fraud for profit.

6 The Detection, Investigation and Deterrence of Mortgage Loan Fraud Involving Third Parties: A White Paper,Federal Financial Institutions Examination Council (FFIEC) Fraud Investigations Symposium, February 2005,www.ffiec.gov/exam/3P_Mtg_Fraud_wp_oct04.pdf.7 BasePoint Analytics LLC, Broker-Facilitated Fraud—The Impact on Lenders: A White Paper (2006), www.basepointanalytics.com/mortgagewhitepapers.html. 8 Broker-Facilitated Fraud.


Example: A $165 million communitybank decided to enter the mortgagebanking business. The bank purchaseda small mortgage company and hiredan experienced mortgage banker torun the operation. Nearly five yearsinto the relationship, an investor noti-fied the bank that several loans—alloriginated through the same third-party broker—were being returned forrepurchase. During the bank’s investi-gation of these loans, the FBI alertedthe bank that they were investigatingthis same broker for possible fraud.The bank notified its primary federalregulator, which then contacted theFDIC because of the potential impacton the bank’s financial condition.

Further investigation revealed thatthe broker was working in collusionwith a builder and an appraiser to flipproperties over and over again forhigher, illegitimate profits. In total,more than 100 loans were originatedto one builder in the same subdivision.The bank incurred a loss of approxi-mately $6 million and went to thethird-party broker for reimbursementof the loss. The broker refused to makethe payments, and the case went intolitigation. The bank was eventuallyawarded $3.5 million.

Lessons Learned: In a subsequentdiscussion with FDIC examiners, thebank’s president indicated that he hadalways heard that the most difficult partof mortgage banking was making sureyou implemented the right hedge tooffset any interest rate risk the bankmight incur while warehousing a signifi-cant volume of mortgage loans. He didnot focus much attention on mortgageloan origination because the bank madesure the contracts with the brokers itused included language requiring thebrokers to reimburse the bank forany nonconforming loans that werereturned by the ultimate investor forrepurchase. The bank had representa-

tion and warranty clauses in contractswith its brokers and thought it hadrecourse with respect to the loansbeing originated and sold throughthe pipeline.

During the litigation, the third-partybroker argued that the bank shouldshare some responsibility for this expo-sure because its internal control systemsshould have recognized a loan concen-tration to this one subdivision and insti-tuted measures to deter this risk. Thebank president acknowledged that themonitoring system used at that time didnot adequately measure concentrationrisk with respect to loans being gener-ated by the mortgage banking business.In addition to establishing an adequatesystem to monitor concentration risk,the bank president said that if he had itto do over again, he would institute regu-lar surprise audits to sample loan origi-nation documentation and make sureloans were being underwritten accord-ing to the bank’s standards.

Mitigating Steps:

• Establish a system to monitor concentrationrisk by broker and by project.

• Institute surprise audits to sample loan origi-nation documentation.

Loan Documentation Fraud

While broker-facilitated fraud and loandocumentation fraud are closely aligned,loan documentation fraud extendsbeyond mortgage brokers to all indi-viduals involved in the process. Loandocumentation fraud may involve aborrower, broker, or lender knowinglymaking written false statements orconcealing material facts to influencethe approval of the loan.

According to the BasePoint Analyticsstudy, the most common types of fraudare employment, income, and occupancy

16

misrepresentations—all of which relateto documentation.9 The Mortgage AssetResearch Institute (MARI) reports thatin a sample of loans by one of MARI’sclients, 90 percent of stated incomeswere exaggerated by 5 percent or more,and 60 percent of stated incomes wereinflated by more than 50 percent.10 Theultimate effect of loan documentationfraud on property values and the overalleconomy remains to be seen. Loan docu-mentation fraud is most often fraud forproperty, although if the lender or brokeris aware of the deception, as in the firstexample below, fraud for profit (incomefor the lender or broker) may also beinvolved.

Example: A $43 million communitybank hired a mortgage loan officer fora new loan program designed to benefitminority individuals with poor or nocredit histories. The loan officer begangenerating consistent business, andmanagement did not closely monitorher activities. The loan officer providedcredit to individuals who were using falseor stolen Social Security numbers. Shealso accepted, and in some cases actuallygenerated, false or questionable docu-ments to support the loans, includingfalse rental and utility payment histories.The bank became aware of the problemonly when another institution, whichhad purchased some of these loans,conducted due diligence and discoveredthe falsified information. The bank hadto repurchase these loans, but the bank’stotal exposure has not yet been deter-mined. The FDIC became aware of thisfraud through a routine review of SARsfiled by both institutions.

Lessons Learned: A thorough back-ground check on the loan officer wouldhave disclosed that she used a false SocialSecurity number to obtain her positionwith the bank and falsified other informa-

tion on her employment application. Acall to her former employer would haverevealed that she had been terminatedfrom that financial institution for orches-trating the very same type of fraud. Inaddition, instituting periodic qualitycontrol measures, such as sampling loanfiles, could have identified these practicesearly and limited the bank’s exposure.

Mitigating Steps:

• Establish a “Know Your Employee” program.

• Conduct background checks on newemployees.

• Conduct periodic credit checks on existingemployees.

• Establish clearly defined quality controlrequirements.

• Provide ongoing employee oversight andtraining.

• Structure compensation agreements toinclude loan quality as a contributing factor.

Example: A $1 billion urban financialinstitution became heavily involved inwholesale mortgage lending and beganpressuring employees to increase loanproduction. A disgruntled employeenotified FDIC examiners about wide-spread documentation fraud in thebank’s residential mortgage bankingbusiness. Reportedly, intense pressurefrom senior management to increaseloan production resulted in a practice ofaltering documents by cutting and past-ing customer signatures on differentforms to manufacture false loans. Theseloans were being packaged and sold tothird-party investors, leaving the bankvulnerable to potential buyback claims.The disgruntled employee surrendereddocuments to the FDIC that bankmanagement allegedly told him to



9 Broker-Facilitated Fraud.10 Merle Sharick, Erin E. Omba, Nick Larson, and D. James Croft, “Eighth Periodic Mortgage Fraud Case Reportto Mortgage Bankers Association,” Mortgage Asset Research Institute, Inc. (April 2006), www.mari-inc.com/reports.html.

destroy in an effort to hide the files fromregulators. The FDIC continues to inves-tigate this case, including possible falsestatements by one senior manager thatmay result in a prohibition action, crimi-nal violations, and prosecution.

Lessons Learned: The board of directorsand the audit committee did not establishcomprehensive reporting and monitoringprocedures, largely delegating thisresponsibility to operating management.Information provided to the board wasusually informal and lacked adequate,useful detail. Examiners recommendedthat the board establish clear expecta-tions for the timing and reporting of peri-odic quality control initiatives (e.g., loandocumentation sampling). Examinersalso recommended that managementperform a risk assessment to determineareas of increased exposure and providefraud identification training to staff,including originators, processors, under-writers, and internal audit personnel.Properly trained staff can help identifyred flags such as white outs, squeezed-innames or numbers, and illegible signa-tures with no supporting identification orverification information.

Mitigating Steps:

• Adopt periodic quality control measures,including loan file sampling.

• Train personnel to identify and report redflags.

• Institute adequate internal reporting procedures.

Appraisal Fraud

Appraisal fraud is usually outrightfraud or negligence on the part of theappraiser, often in collusion with otherparties. Some institutions have internalappraisers, but most use outside compa-nies. Manipulating or inflating thecomparable locations, market values,and property characteristics are all

17

tactics of appraisal fraud. Questionablepractices include “windshield appraisals,”where appraisers merely drive by a prop-erty and use inappropriate comparablesthat will get the value where they want itto be. In some cases, appraisers mayfraudulently overstate the benefits of aparticular property to back into the valueneeded for the loan. Appraisal fraud canbe used to qualify an undervalued homefor a higher mortgage amount (usuallyfraud for property) or to inflate the valueof real estate so that the property can beresold or flipped quickly to a straw orduped buyer and the profit retained byperpetrators (fraud for profit). Under thefirst scenario, appraisers may be pres-sured by mortgage brokers or loan offi-cers to falsify an appraisal so that a loantransaction can be approved. Under thesecond scenario, the appraiser actuallyworks in collusion with other conspira-tors to perpetrate the fraud.

Example: A small community bank(total assets less than $250 million)became involved in an inflated appraisalfraud scheme. The bank discoveredinflated appraisals on residential prop-erties securing loans to two borrowerswhen those borrowers defaulted onthe debts. The bank later determinedthat one of the borrowers owned theappraisal firm that prepared the originalappraisals for these properties. Theborrowers allegedly worked in collusionwith bank loan officers to finance theseproperties at inflated values. In total,the bank financed dozens of residentialproperties, with a combined original(fraudulent) appraised value totalingapproximately $2 million. After thedefaults, these properties were reap-praised at less than one-third of theiroriginal appraised value. The banksuffered a significant loss, which hasbeen difficult for it to absorb. The FDICis seeking a removal/prohibition actionagainst the loan officers involved, whohave resigned from the bank. The FDICbecame aware of this fraud by reviewingSARs submitted by the institution.


Lessons Learned: Once these activitieswere uncovered, the bank worked aggres-sively to identify all relevant exposure bygetting new appraisals and providingadequate loan loss reserves. However,some improvements to the bank’s loanreview and monitoring procedures couldhave helped the bank identify negativetrends prior to the borrowers defaultingon the debts. First, the bank’s monitor-ing procedures were not sophisticatedenough to establish a connectionbetween either the borrowers or theappraisals supporting these loans. As aresult, this increasing level of exposureremained largely undetected. Second,while each loan was relatively small, thecombined total of these loans was signifi-cant. However, because of the small sizeof each loan, the bank’s internal loanreview did not pick up any of the loans.The bank would have benefited by chang-ing the scope of its loan review to includea sampling of loans from all loan officers,regardless of the loan size. Finally, thebank was not completely familiar withthe appraisal firm used to value thecollateral supporting these loans. If theownership structure of the appraisal firmhad been investigated initially, the bankwould have discovered this apparentconflict of interest, which would havetriggered additional investigation.

Mitigating Steps:

• Develop reports that track problem loans byloan officer, broker, appraiser, underwriter,branch office, settlement agent, and so on.

• Vary the internal loan review scope toinclude a sample from all loan officers.

• Research the background and ownership ofappraisal firms. See 12 CFR 323 of FDIC Rulesand Regulations for additional guidelines onappraisal and appraiser requirements.

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Property Flipping

Property flipping is the practice ofpurchasing properties and reselling themat artificially inflated prices to straw orduped buyers11 and is strictly fraud forprofit. Flipping schemes typically involvefraudulent appraisals, doctored loandocumentation, or inflated buyerincome. Financial incentives to buyers,investors, brokers, appraisers, and titlecompany employees are also commonand indicate the degree of collusionnecessary to flip a property. Based onexisting investigations and mortgagefraud reports, the FBI estimates that80 percent of all reported fraud lossesinvolve collaboration or collusion byindustry insiders.12 A particularly trou-blesome aspect of property flipping isthat it taints property sale databases andpresents the illusion of rising propertyvalues in neighborhoods where the flip-ping takes place.

Example: During a routine examinationof a $1 billion financial institution, exam-iners became suspicious when theynoticed that one loan officer workedapart from other loan originators andhad processing personnel dedicated tohis loan originations. Bank managementindicated the loan officer was the bank’shighest producer and that “even a badmonth was a good month” for that loanofficer. The loan officer maintained ahigh number of loan originations, eventhough he took no referrals from thephone queue. On further investigation,the FDIC discovered that the loan officerhad an undisclosed relationship with alocal mortgage broker. Examiners’review of the officer’s lending activityrevealed several loans that had been orig-inated, sold, and then quickly fell intoforeclosure. Properties were also refi-nanced rapidly, with an affiliate of the


11 Vernon Martin, “Detection of Mortgage Fraud,” RMA Journal, September 2004, www.findarticles.com/p/articles/mi_m0ITW/is_1_87/ai_n14897572. 12 FBI, “Financial Crimes Report to the Public, Fiscal Year 2006.” Seehttp://www.fbi.gov/publications/financial/fcs_report2006/financial_crime_2006.htm.


broker placing second mortgages on theproperty that would immediately be paidfrom the next refinance. A sample of theofficer’s loan documentation discoveredaltered or falsified account statements,purchase and sale agreements, incomefigures, credit reports, and verification ofdeposit forms. The loan officer has sinceresigned from the institution and is thesubject of an ongoing criminal investiga-tion. Total loss exposure to the bank isstill being determined; however, the bankhas already had to repurchase severalloans as a result of this officer’s actions.

Lessons Learned: Bank managementfocused on income generated by this loanofficer and overlooked or ignored severalkey matters that would normally triggerfurther investigation. First, the isolationof this loan officer from others, includingseparate processing support, allowed himto dominate transactions from start tofinish. The lack of dual control overthese transactions greatly enhanced theloan officer’s ability to perpetrate thefraud. Second, the lack of proper reviewand oversight allowed the relationshipwith the mortgage broker to remainundisclosed to management. Implement-ing periodic quality control audits toverify the accuracy and completeness ofdocumentation would have brought theseactivities to light, including the rapid refi-nancing of properties and falsified loansupport documentation.

Mitigating Steps:

• Verify the quality of business generated byhigh-volume producers.

• Establish dual control over loan processingand fund disbursement.

• Implement periodic audits of loan origina-tions by officers.

• Conduct postmortem reviews of loan lossesand look for common names of participantsin the loan origination or processing areas.

19

Misapplication of Funds fromConstruction or RehabilitationProjects

Construction or rehabilitation projectloans are normally established as operat-ing lines of credit. Borrowers make drawsupon these lines of credit and use thesefunds to complete various phases of aproposed construction or rehabilitationproject. Draws are usually matched tothe percentage of the project that iscomplete, with a final percentage heldback as an abundance of caution. Forexample, a builder may ask for a drawthat represents 20 percent of theloan/line total, with verified completionactually totaling around 23–25 percent.The draw is used to pay subcontractorsfor work performed, as well as to provideworking capital for the builder, whosefees are built into the line.

Under fraudulent circumstances,builders may use funds or draws on oneproject to pay for improvements relatedto another project, or may simply divertfunds or draws for their own enrichment—fraud for profit. When this happens,subcontractors do not get paid, and, insome cases, no improvements are madeto the property. In the end, the builderexhausts the line of credit, and the bankis left to dispose of a property with verylittle supporting value.

Example: A $365 million communitybank authorized 13 construction lines ofcredit to a local builder for the construc-tion of speculative houses—those builtwithout a buyer or signed purchase agree-ment. As soon as the lines were approved,the builder began requesting draws. Thebuilder used falsified sales contracts tomislead the loan officer into believingmany of the homes were presold. Theloan officer routinely advanced funds tothe builder and signed off on construc-tion inspection documentation withoutever actually inspecting the constructionsites. After some time had elapsed withno corresponding sales activity, the loan


20

officer began pressing the builder aboutthe status of construction and requestsfor new money. The builder confessedthat no houses had been constructed on11 of the bank’s 13 construction lines.The bank ultimately recorded a loss of $2million on the $2.6 million constructionline. The builder was convicted of fraudand sent to federal prison. The FDICbanned the loan officer from banking.The loss had a significant impact on thebank’s earnings, and the institution’sreputation was tarnished as a result oflocal media coverage. The FDIC becameaware of this fraud by reviewing SARssubmitted by the institution.

Lessons Learned: The monetary rewardand success of attracting and signing aloan client is much more attractive thanthe subsequent job of properly adminis-tering the credit; however, both areequally important to a financial institu-tion. In this instance, the loan officerbecame busy with other responsibilitiesand did not devote the time necessary toproperly monitoring construction drawsand documenting the proper allocationof funds to each project. The institutionhad no established procedures or formsfor conducting and documenting on-siteinspections, except to check the “inspec-tion” box on the disbursement form.Consequently, to authorize a construc-tion draw and deter loan review atten-tion, the loan officer would falselyindicate on loan disbursement forms thatconstruction inspections had beencompleted. Loan oversight was limited toverifying that the “inspection” box waschecked, with no subsequent confirma-tion or review of supporting documenta-tion. In addition, the bank did not reviewor monitor the builder’s deposit accountactivity, which would have revealedconstruction draws being used for amultitude of purposes unrelated to theproject. Verifying the legitimacy of thesales contracts with the proposedpurchasers also would have immediatelyalerted the bank of a possible problem.

Mitigating Steps:

• Monitor construction draws.

• Complete and document on-site inspections.

• Verify sales contracts.

• Monitor builder checking account activity.

Establishing Controls: ACommonsense Approach

Fraud is often compared to a triangle,with the three points of the fraud trianglebeing motive, rationalization, and oppor-tunity. The element of opportunity isparticularly heightened at financial insti-tutions because of the cash and financialtransaction nature of the business. Ascan be seen from the examples and miti-gating steps in this article, developingand implementing a sound internalcontrol environment—including soundlending fundamentals, quality controlprocedures, and audit programs—is a keyfactor in reducing the opportunity for alltypes of mortgage loan fraud. While mostinstitutions are aware of these safeguards,the cost/benefit of internal controlssometimes precludes management frommaking internal controls a top priority.

In addition to the mitigating stepsalready identified, some banks areexploring automated fraud detectionproducts introduced over the past severalyears. These software applications searchbank loan databases and compareborrowers, loan participants, commonnames, addresses, employers, appraisers,and the like, to detect potential red flagsor signs of mortgage fraud. These prod-ucts produce summary ratings or reportsthat serve to identify loans or groups ofloans that may represent an increasedrisk of mortgage fraud and requirefurther investigation. The ultimate deci-sion as to whether these products repre-sent a cost-effective solution remains anindependent choice for each institution.However, it is important that all institu-



21

tions consider the potential impact offraud and establish adequate provisionsfor this risk as part of their normal prof-itability and budgeting process.

Conclusion

Mortgage loan fraud is a large andgrowing problem. It can occur in anyneighborhood and requires that allparties concerned maintain a high levelof vigilance. Bank management shouldkeep alert to fraud triggers, ask ques-tions, review mortgage documentation,perform verifications, and report suspi-cious activity to the appropriate regula-tory and law enforcement authorities in atimely manner. While even the best inter-nal control environment will not preventmortgage fraud in all instances, stronginternal controls, coupled with an alertand knowledgeable staff, are a financialinstitution’s best line of defense.

Ken A. EdwardsSupervisory Examiner, Albany, GA

Jeffry A. PetruyExaminer,Gainesville, FL

Corbin Harrison Examiner,Atlanta, GA

Rebecca A. BerrymanSenior Capital Markets andSecurities Specialist,Atlanta, GA

Timothy J. HubbyAssistant Regional Director,Atlanta, GA

Acknowledgments: The authors wouldlike to acknowledge the assistanceprovided by Stephen Corona, Office ofFederal Housing Enterprise Oversight;Barbara Nelan, Assistant United StatesAttorney, Northern District of Georgia;Sandra Sheley, Director of MortgageSupervision, Georgia Department ofBanking and Finance; Ed Slagle, SpecialAgent, and Gary L. Sherrill, SeniorSpecial Agent, Office of InspectorGeneral, FDIC.


Community groups, industry-related coali-tions, regulatory authorities, and federal,state, and local governments have volumesof information and resources available toanyone looking for additional informationon mortgage fraud. Many states providewebsites with consumer information andonline access to forms used to reportfraud. The following is a list of a few of themany available resources:

The Detection, Investigation and Preventionof Insider Loan Fraud: A White Paper,FFIEC Fraud Investigations Symposium,May 2003

Mortgage Fraud Perpetrated Against Resi-dential Lenders, Mortgage Bankers Asso-ciation, July 2006

Financial Crimes Report to the Public,Federal Bureau of Investigation andDepartment of Justice, May 2005

Federal Deposit Insurance Corporation, RiskManagement Manual of Examination Poli-cies, Sections 9.1–Fraud, and Section10.1–Suspicious Activity and CriminalViolations

Websites:

www.occ.treas.gov: Office of the Comptrol-ler of the Currency (federal regulator fornational banks)

www.fdic.gov: Federal Deposit InsuranceCorporation (federal regulator for state-chartered nonmember banks)

www.ots.treas.gov: Office of Thrift Supervi-sion (federal regulator for federally char-tered savings institutions)

www.federalreserve.gov: Board of Gover-nors of the Federal Reserve System (regu-lator for state-chartered member banks)

www.hud.gov: Department of Housing andUrban Development

www.fbi.gov: Federal Bureau of Investigation

www.mortgagefraudblog.com: Centralclearinghouse on recent mortgage fraudschemes, indictments, and prevention

www.grefpac.org: Georgia Real EstateFraud Prevention and Awareness Coalition(and similar community groups throughoutthe country)

www.mbafightsfraud.mortgagebankers.com:Mortgage Bankers Association

www.ganet.org/dbf.dbf.html: Georgia Depart-ment of Banking and Finance (and otherappropriate state regulatory authorities)

Resource Links

in coastal areas stretching from southernTexas to the northern tip of Maine.2

Given Florida’s higher risk exposure,even higher increases in Florida wouldnot be unlikely.

Wind insurance premium increasesare having a direct negative effect oncommercial and residential borrowers’overall budgets, including their abilityto service debt. It has also been widelyreported that borrowers and investorsare becoming hesitant to buy propertiesaffected by significantly increasing insur-ance premiums. The reported slowing inreal estate sales activity in Florida maybe exacerbated by insurance issues.

The considerable concern to thebanking industry lies in the fact thatthe risk in much of its lending activity—loans secured by real estate—has histor-ically been mitigated with propertyinsurance, including coverage for winddamage. Prudent bankers will monitorthe effect of this issue on real estatemarkets in their geographic areas oflending, as well as the effect on theoverall economy. Concerned lenderswill also consider the potential effectsof changes in wind hazard insurancecoverage and premiums in underwrit-ing loans and in monitoring their over-all real estate loan portfolios.

Historical and InsuranceIndustry Perspective

After a series of hurricanes hit Floridain the 1940s and 1950s, the state beganpursuing a more consistent statewidebuilding code. In 1974, the state imple-mented a uniform building code systemthat seemed reliable until 1992,3 when

22

The banking industry has long reliedon real estate as collateral for vari-ous types of loans. Hazard insur-

ance has played a big role in mitigatingthe risk of loss of collateral value fromcatastrophic damage. Traditionally,examiners have cited inadequacies incollateral insurance coverage as techni-cal exceptions when reviewing loan files.But in today’s environment, issuesregarding insurance availability andaffordability may soon reach beyondanything considered technical.

In this article, we present an overviewof the impact of the rising cost, and insome cases the lack of availability, ofwind hazard insurance, with a focus onFlorida. Although the issue is not new toFlorida, it has intensified to the pointthat it is often labeled a crisis.

Virtually no part of the eastern andsouthern U.S. coastline is immunefrom the threat of severe storm systems.However, because of the growth inFlorida’s population and infrastructure,national storm modeling firms considerFlorida to have the highest level of riskin the nation for catastrophic stormdamage.1 Insurers that continue to offercoverage in high-risk areas are rapidlyand significantly increasing ratescharged to policyholders to replenishreserves, account for the updated model-ing forecasts, and pay the higher costof reinsurance from the anticipatedincreased risk. Map 1 illustrates howrising rates have already squeezed manyFlorida homeowners in terms of theirbudgets and spending habits. Accordingto the Insurance Information Institute,rates are likely to rise between 20 and100 percent over the next year for the43 percent of the U.S. population living

1 Property and Casualty Insurance Reform Committee, Property and Casualty Insurance Reform Committee FinalReport and Recommendations, November 15, 2006, p. 2, www.myfloridainsurancereform.com/finalrpt.htm.2 John Simmons, “Risky Business: With $58 Billion in Claims to Pay for Last Year Alone, U.S. Insurers Are JackingRates, Canceling Policies and Learning to Cope with Climate Change,” Fortune Magazine (November 2, 2006),retrieved March 26, 2007, from http://money.cnn.com/magazines/fortune/fortune_archive/2006/09/04/8384736/index.htm.3 Property and Casualty Insurance Reform Committee Final Report and Recommendations, p. 33.


Wind Hazard Insurance: No Longer Just a Technical Exception


Hurricane Andrew caused $15.5 billionin damage ($21.5 billion in 2006dollars). As a result of this damage, therewere 12 insurer insolvencies and theinsurance market began to collapse. TheFlorida legislature passed a moratoriumto prevent insurers from dropping cover-

age to reduce their own hurricane expo-sure risk.4 In 2000, the legislatureauthorized a new uniform Florida Build-ing Code, which became effective onMarch 1, 2002, making Florida the onlystate in the nation with a statewide build-ing code.5

4 Office of Insurance Regulation, Doing Business in Florida’s Property Insurance Marketplace, August 12, 2006,p. 7, www.flains.org/HC/oirmarkeroverview806.pdf.5 Property and Casualty Insurance Reform Committee Final Report and Recommendations, pp. 33–34.

CCiittiizzeennss PPrrooppeerrttyy IInnssuurraannccee CCoorrppoorraattiioon’n’ss PPrreemmiiuummss HHaavvee IInnccrreeaasseedd RRaappiiddllyy iinn SSeevveerraall CCoouunnttiiees

*Represents base rates without any underwriting criteria such as discounts/credits or surcharges. Data for HO-3 (Homeowners) additional risk: $150,000 masonry structure, 2% hurricane deductible, $500 deductible for all other perils, Coverage: Both hurricane and non-hurricane.Source: Market Research Unit, Florida Office of Insurance Regulation

CCoouunnttyy MMeeddiiaann == $$11,,5599112200004–4–22000066 MMeeddiiaann IInnccrreeaassee == 2211..55%%

GGrroowwtthh RRaatteess,, 2200004–4–22000066

2255%%––5500%%

5500%–%–110000%%

110000%%++

BBaassee RRaattee CCoommppaarriissoonn**66//3300//22000066

$$11,,003333––$$11,,116644

$$11,,116644––$$11,,559911

$$11,,559911––$$33,,118822

$$33,,118822––$$55,,777799

Map 1


Also in 2002, the Florida legislaturepassed Senate Bill 1418, known as theWindstorm Bill.6 The bill created Citi-zens Property Insurance Corporation(Citizens), a federally tax-exemptcorporation, to provide full wind, hurri-cane, and hail policies for residentialand commercial properties that areunable to obtain insurance in thevoluntary market, i.e., an insurer oflast resort. Citizens receives no directstate government funding; its claimsand operational costs are paid frompremiums collected. If Citizens runsa deficit within a fiscal year, it has theauthority to assess all property insur-ance companies to cover the amountof the deficit. These assessments arepassed on directly to the policyholders.7

Nevertheless, a total of eight hurricanesin 2004 and 2005, including Katrina,caused nearly $36 billion in losses withinFlorida. As if that was not enough, hurri-cane forecasting models are predictingmore frequent and severe storm systemsin the region, which are expected to onlyheighten the pattern of losses.8

While residents and business ownersare frustrated over increasingly expen-sive insurance rates, insurers must raiserates to replenish reserves in prepara-tion for future claims. In his testimonyto one of Florida’s state legislativecommittees, Dr. Robert P. Hartwig,senior vice president and chief econo-mist of the Insurance Information Insti-tute of New York, stated, “After briefperiods of profitability, the market isperiodically jarred by catastrophiclosses that wipe out all or most of theprofits since the last major event.”9

With billions of dollars in exposurebeing added to Florida each year fromthe infrastructure needed to supportcontinuing population and economicgrowth, the insurance industry in generalseems to be reaching the maximum levelof risk it is willing to accept. Many insur-ance companies are no longer writingnew wind hazard policies and are cancel-ing existing policies to reduce their expo-sure in the state. Some insurers havecompletely stopped writing propertyinsurance policies in Florida.

Between 1998 and the second quarterof 2006, the number of insurancecompanies writing residential policiesin Florida dropped from 225 to 167. Inthat same time period, the number ofinsurance companies writing commer-cial policies declined from 120 to 80.10

With the burden of insuring residentialand commercial properties gettingpushed more and more onto the state,Citizens—whose policies number nearly1.3 million—is writing more than70,000 new policies per month. Asthe second largest homeowner insurerin Florida, next to State Farm, Citizenswas exposed to $434.3 billion ininsured risks as of April 6, 2007.11

The difficulties in obtaining insurancecoverage are not limited to Florida.Insurance companies are either notrenewing homeowner policies or aresignificantly raising premiums tocompensate for the risk in states allalong the Gulf of Mexico and AtlanticOcean coasts. For example, last year,Allstate did not renew any of its home-owner policies in New York City andthree counties in the area, which

Wind Hazard Insurancecontinued from pg. 23

6 Senate Bill 1418 can be retrieved from the Florida legislature’s website at www.leg.state.fl.us/session/index.cfm?Mode=Bills&Submenu=1&BI_Mode=ViewBillInfo&Billnum=1418&Year=2002.7 My Florida Insurance Reform, “Why am I being assessed for Citizens Insurance if they are not my insurer?”www.myfloridainsurancereform.com/faq.htm#3.8 Property and Casualty Insurance Reform Committee Final Report and Recommendations, p. 25.9 “Overview of Florida Hurricane Insurance Market Economics,” testimony delivered on January 19, 2005, byRobert P. Hartwig, Ph.D., CPCU, to the Florida Joint Select Committee on Hurricane Insurance. 10 Property and Casualty Insurance Reform Committee Final Report and Recommendations, p. 15.11 “Policies in Force and Exposure,” retrieved April 23, 2007, from www.citizensfla.com.

25

Allstate considers the “catastrophe-prone areas” of New York. According toHoward Mills, New York state’s insur-ance superintendent, “We need todramatically increase awareness that weare in an area not only susceptible to ahurricane, but long overdue for a hurri-cane. . . . There’s a reason why compa-nies like Allstate are trying to reducetheir exposure. It’s an inevitability.”12

Allstate cancelled 95,000 homeownerpolicies in Florida in 2005. As of Novem-ber 2006, Allstate had dropped an addi-tional 120,000 policies that had come upfor renewal and is no longer writing newpolicies in Florida. According to EdwardLiddy, Allstate’s chief executive officer,“We [Allstate] do not get adequate ratesin that regulated system.”13

Rising Reinsurance Costs andAvailability Issues

In 2006, then-Governor Bushappointed a special Property and Casu-alty Insurance Committee14 (Commit-tee), and the Florida state legislatureconvened special sessions to discussthe insurance issue and reinvigoratethe state-run insurance provider of lastresort. According to the Committee,which was charged with researching theproblems plaguing the insurance indus-try and offering recommendations tostabilize insurance rates for homeown-ers and commercial property owners,“Reinsurance capacity for Florida prop-erty risk is nearly tapped out.”15 (Seetext box “Florida Addresses the Insur-ance Crisis” for more discussion ofactions being taken within the state.)With the insurance industry’s exposure

rising so significantly, rating agenciessuch as Standard & Poor’s, Moody’s,and Fitch have begun requesting thatreinsurance companies infuse or retainmore capital or curtail their exposure—or risk being rated less favorably.

Potential Economic Impact

The economic impact of rising insur-ance costs on Florida and in other partsof the nation is difficult to quantify.According to the Florida DemographicEstimating Conference data as of Febru-ary 19, 2007, over the next ten years,Florida’s population will grow by3.8 million, or 21 percent, comparedto a growth of 3.7 million, or 25 per-cent, over the previous ten-year period.There is concern, however, that thewind-hazard insurance crisis, particu-larly in and around the coastal areasof the state, could adversely affect thenormally robust in-migration and invest-ment in Florida real estate of all types.If in-migration were to slow significantly,economic growth in Florida would alsobe expected to slow.

Jack McCabe, a real estate consultantin Deerfield Beach, Florida, reported,“We are seeing insurance rates 200 to300 percent more than a year ago,” andhigher insurance costs have contributedto the sluggish real estate market. Mr.McCabe added that “it makes Floridalook not as affordable for vacation homebuyers.”16

In July 2006, The New York Timesfeatured an article in its NationalPerspectives section on so-called “half-backs,” natives of northern states whoretire to Florida but later change their


12 Jeff Vandam, “Storm Fears Touch Off a Scramble for Insurance,” New York Times (August 27, 2006), retrievedMarch 10, 2007, from http://query.nytimes.com/gst/fullpage.html?res=9B04E5D8133EF934A1575BC0A9609C8B63. 13 Simmons, “Risky Business.” 14 The Committee was formed on June 27, 2006, through Executive Order Number 06-150. See www.myfloridainsurancereform.com. 15 Property and Casualty Insurance Reform Committee Final Report and Recommendations, p. 51.16 Amy Gunderson, “Home Away; Bracing for Higher Premiums,” New York Times (January 3, 2007), retrievedFebruary 12, 2007, http://query.nytimes.com/gst/fullpage.html?res=9805E4DD1130F930A35752C0A9619C8B63.

26

minds and move “half way” back north.They are leaving Florida to live in statesto the north, such as Tennessee, totake advantage of cheaper real estateprices and to escape rising insurancecosts and other hurricane-relatedexpenses. Bob Gilley, principal ownerof Tellico Lake Realty in Tennessee,recently reported that 40 percent ofthe people coming to Tellico are fromFlorida.17

Data provided by the Florida Associa-tion of Realtors show that Florida’s exist-ing-home sales declined each month in2006 as compared with a year earlier;the number of existing-home sales inDecember 2006 was 29 percent belowthe sales of existing homes in December2005. While there are certainly anumber of factors tied to the decliningsales, the cost of wind hazard insurancemay be a contributing factor.


17 Lisa Chamberlain, “Drawn to Eastern Tennessee’s Natural Beauty,” New York Times (July 9, 2006), retrievedJanuary 14, 2007, from http://query.nytimes.com/gst/fullpage.html?res=9B03E5D81330F93AA35754C0A9609C8B63&partner=rssnyt&emc=rss.

Florida legislators and business interests have establishedcommittees, task forces, and programs to begin to sort throughpossible solutions to the problem. Recent actions include thefollowing:

• In a special session in January 2007, the Florida legislaturepassed House Bill 1A, Hurricane Preparedness and Insurance.a

The special session, which considered the recommendations ofthe Property and Insurance Reform Committee and other inter-ested parties, concentrated on hurricane insurance premiumrate-hike relief and restructuring of the insurers of last resort inthe state. The House bill effectively reduces in the near term thewind insurance portion of premium rates, varying by type andlocation of the property location. The reductions average 24 per-cent across Florida, varying from 10 percent in the panhandlearea of north Florida to 53 percent in the Miami-Dade Countyarea of south Florida.

• House Bill 1A also expands the reinsurance and catastrophic losscoverage levels provided by the Florida Hurricane Catastrophe(CAT) Fund. The CAT Fund, a trust fund created in 1993 and admin-istered by the state, serves as a mandatory source of reinsurancefor residential property insurers. This reinsurance is provided atsignificantly less expensive rates than private reinsurance. Insur-ance companies normally purchase private reinsurance to covertheir losses below their CAT Fund retention rate or to cover theirexposure that exceeds CAT Fund coverage.b Under the new law,

costs undertaken by insurance companies for reinsurance thatduplicates available CAT Fund coverage cannot be factored intorates assessed against insured property owners.

• The Property & Casualty Joint Underwriting Association forCommercial Wind Coverage (JUA) was established in August 2006to provide wind-only policies for commercial properties valued at$1 million or less, as well as coverage for contents and businessinterruption up to $750,000 and $250,000, respectively, for totalmaximum coverage of $2 million.c

• In 2006, the Florida Department of Financial Services created theFlorida Comprehensive Hurricane Damage Mitigation Program(FCHDMP), also known as the “My Safe Florida Home” program,to help Florida residents strengthen their homes against naturaldisasters. The FCHDMP offers free home inspections by qualifiedhurricane mitigation inspectors to eligible homeowners, and itprovides matching grants for qualifying residents who mitigate therisk of potential storm damage through strengthening their homes.d

• The Florida Bankers Association created an Insurance Task Forcein September 2006 to help solve the imminent property insurancecrisis from a banker’s perspective.e The task force presented an11-point agenda with recommendations to the special January2007 legislative session and is continuing to work with federal andstate legislators to ensure that banking interests are representedin solving Florida’s insurance crisis.

a House Bill 1A, January 25, 2007. See www.myfloridahouse.gov.b Property and Casualty Insurance Reform Committee, Property and Casu-alty Insurance Reform Committee Final Report and Recommendations,November 15, 2006, pp. 47–48, www.myfloridainsurancereform.com/finalrpt.htm.

c Property and Casualty Insurance Reform Committee Final Report andRecommendations, pp. 28–29.d See www.mysafefloridahome.com.e “FBA Announces Insurance Agenda,” September 28, 2006, See PressReleases at www.floridabankers.com/StaticPages/Publication_Media_Info.aspx.

Florida Addresses the Insurance Crisis


27

Impact on Insured FinancialInstitutions

Commercial real estate (CRE) lendingis a key component of lending programsfor many Florida financial institutions.Acquisition, construction, and develop-ment loans are a significant portion ofCRE lending in Florida communitybanks. This lending is a niche for manycommunity banks that feel they cancompete with larger institutions basedon local decision making and personalservice. A slowdown in real estate devel-opment and investment caused by therising cost of wind insurance couldaffect the ability of some smaller banksto thrive. Moreover, underinsured oruninsured collateral, declining collateralvalues, and declining debt-service cover-age expose lenders to more risk ofdefault and loss.

Banks are facing a number of situa-tions brought on by the insurance crisis.Since summer 2006, the FDIC’s AtlantaRegion has been tracking Florida bankexamination findings as they relate tothe cost and availability of wind hazardinsurance. Examiners are also closelymonitoring issues related to wind insur-ance and have discussed the actual andpotential effects with the industry andother regulators in various forums. Theexamples below are indicative of whatexaminers have encountered:

n Investors are declining to purchaseFlorida real estate because of theprohibitive cost or lack of availablewind hazard insurance.

n Borrowers are reporting policy nonre-newals and cancellations. Some banksreport a slight increase in the use offorced-placed insurance as someborrowers are unable to find insur-ance.18 So far, these banks have beenable to find policies, although at ahigher cost.

n Insurance premiums are increasing—in excess of 500 percent for someborrowers.

n Some banks are considering approv-ing loans without insurance wherethe land-only value is twice the loanbalance.

n Some banks are requiring morecollateral in consideration for waivingfull insurance coverage; others arerefusing to waive insurance at all.

n Borrowers are increasing deductiblesto help curb the increases in premi-ums for wind hazard insurance oncollateral.

n Some borrowers have considered self-insuring collateral.

Other federal banking agencies andthe state of Florida’s Office of FinancialRegulation report similar findings.

While troubling, these situations havenot yet risen to a level that has substan-tially elevated the risk profile of a partic-ular bank. However, Florida bankers aregenerally concerned and are closelymonitoring the effects of the wind insur-ance crisis on their banks.

Prudent Risk ManagementPractices

No federal banking statute or regu-lation requires full hazard insurancecoverage on all real estate collateralimprovements or bank premises,although some of the federally spon-sored lending organizations (FederalHousing Administration, FederalNational Mortgage Association, FederalHome Loan and Mortgage Corporation,Small Business Administration, etc.)may require full insurance coverageprior to committing to purchase orguarantee all or part of commercialor residential real estate loans. States

18 Force placing is a normal part of a loan agreement where the bank obtains and directly pays for an insurancepolicy and passes the cost on to the borrower.


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vary as to insurance requirements,and Florida has no statutes or regula-tions requiring full wind insuranceprotection of loan collateral or bankpremises. FDIC Rules and Regulations(see 12 CFR 365) require prudentreal estate lending policies, whichwould include the general requirementof insurance to enhance loan quality.However, this requirement is applied ona macro lending basis. Individual loanexceptions are normally listed as techni-cal exceptions in the Report of Examina-tion and not criticized unless excessive.

Examiners in the FDIC’s AtlantaRegion were recently reminded thatinsurance coverage should be reviewedas part of the normal loan review andexamination function. As is normalfor any emerging risk, examiners areexpected to ensure that banks monitorthe insurance situation as it affects loancollateral and make reasonable docu-mented efforts to maintain sufficientinsurance. Examiners are not expectedto criticize banks when uninsured orunderinsured collateral results fromcircumstances beyond management’scontrol.

The FDIC is monitoring significantinsurance issues closely and is commu-nicating with the other regulatory agen-cies and the industry to keep to theforefront emerging risk management,asset quality, and consumer affordabil-ity issues. The wind insurance crisisposes potentially difficult decisions forbankers regarding the acquisition ofinsurance for existing loan collateral orwhether certain loans can be originatedwithout the benefit of wind insurance. Aswith any emerging risk, prudent consider-ations and practices of bankers mayinclude

n Ensuring that lending policies andprocedures address insurance require-

ments and the reporting of exceptionsto the board of directors of the finan-cial institution;

n Ensuring that mortgage loan agree-ments and other pertinent documenta-tion address insurance requirements;

n Making reasonable, documentedefforts to obtain and maintain suffi-cient insurance coverage on collateral;

n Including potential hazard insuranceeffects in the underwriting and ongo-ing analysis of debt service; and

n Considering significant insuranceissues when analyzing the allowancefor loan and lease losses.

Bank Premises InsuranceCoverage

Banks’ lending activities are notthe only area affected by the risingcost of insurance. Banks generallyinsure their own premises against thepossibilities of fire or storm damageusing extended insurance packagesthat indemnify against losses fromwindstorms, cyclones, tornados, hail,and other natural disasters. In evalu-ating the effectiveness of a bank’srisk management program, examinerslook to see that management deter-mines if, and how much, extendedcoverage is warranted.19 Variablesfor both examiners and bankers toconsider include the locations of thebank premises, the probability ofstorm occurrence, the number andlocations of bank branches, theadequacy of disaster recovery plans,the bank’s capital level, and the amountof risk the board of directors is ulti-mately willing to take.

Most banks have prudently acquiredproperty insurance as a cost-effectivemeans of hedging against a catastrophicevent. However, some Florida banks have

19 FDIC, Risk Management Manual of Examination Policies, Section 3.5, “Premises and Equipment,”www.fdic.gov/regulations/safety/manual/section3-5_toc.html.



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not been able to secure the continuationof full windstorm coverage for some orall of their buildings. When such insur-ance is unavailable or otherwise cost-prohibitive, banks are expected tocontinue working to obtain adequatecoverage and to provide capital at suffi-cient levels to absorb potential winddamage expenses not covered by insur-ance, while also following accountingrules regarding the establishment ofcontingency reserves if necessary. Aswith insurance for collateral, examinersare expected to ensure that banks moni-tor their insurance situation with respectto bank premises and make reasonable,documented efforts to maintain suffi-cient coverage.

Looking Ahead

While the Florida legislature, com-munity groups, and industry associa-tions have worked diligently to providerelief to home and business owners,the 2007 hurricane season is fastapproaching. Forecasters predict the2007 Atlantic hurricane season willbe more active than the average forthe 1950–2000 seasons. They furtherpredict a 40 percent probability for atleast one major (category 3, 4, or 5)hurricane landfall for the U.S. coast,including the Florida peninsula. (Thiscompares with an average probabilityof 31 percent for the last century.)20

With each new hurricane seasoncomes the potential for damage andlosses that could put further pressureson the insurance industry. However,effective risk management practicesmay help to lessen the impact on finan-cial institutions.

Insurance is a highly valued tool formitigating credit risk, but problems withmaintaining affordable insurance areforcing lenders and borrowers alike torethink what makes a sound loan andinvestment. Regulators, bankers, anddevelopers all understand just how sensi-tive the value and debt-service capabilitycan be for an income-producing prop-erty when insurance costs materiallychange. Increasing insurance costs havecut into profits and reduced disposablecash, and they have the potential tonegatively affect collateral values. Whilethe FDIC has not seen significant deteri-oration in individual banks, examinerswill be looking for prudent bank prac-tices, such as monitoring real estatecollateral, taking reasonable precautionsin keeping collateral insured, stress test-ing loan-to-values and debt-service abili-ties, and documenting banks’ efforts.Although no one knows when anothercatastrophe might occur, it is critical forinstitutions to continue to employproper risk mitigation efforts to protectagainst possible losses.

Michael T. RegisterExaminer,Tampa, FL

Christopher T. HallExaminer,Tampa, FL

Devin A. BaillairgéExaminer, Tampa, FL

David Crumby Assistant Regional Director,Atlanta, GA

20 Philip J. Klotzbach and William M. Gray, “Extended Range Forecast of Atlantic Seasonal Hurricane Activity and U.S. Landfall Strike Probability for 2007,” Department of Atmospheric Science, Colorado State University,December 8, 2006.


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It is Friday afternoon, and an exami-nation of the bank starts on Monday.The bank has not provided paper

copies of its policies, procedures, boardminutes, or sample customer disclosures.No loan files have been pulled. The bankhas spent minimal time and resourcesresponding to examiner requests forinformation. Yet preexamination plan-ning has been completed, and, usingstandard procedures, the examinationhas been risk-scoped.

How was this achieved? The bankis undergoing an e-Exam, conductedunder the FDIC’s e-Exam policy.1 Allof the documents and data needed forpreexamination planning were providedelectronically using appropriate secu-rity measures. Moreover, a significantamount of the examination activitieswill be conducted in the FDIC’soffices—not at the bank.

The Changing Face ofExaminations

An important component of bankexaminations is the review of a bank’sbooks and records, which includes awide variety of written documents.Improved technology for electronic stor-age and retrieval of written documentshas created opportunities to improve thequality and timeliness of the documentreview conducted during examinations.Over the past few years, examinershave asked for more and more off-siteinformation, performing most of thepreexamination analysis and some ofthe ongoing examination tasks outsidethe bank. In most cases, however, muchof the information needed for an exam-ination was aggregated and copied bythe bank, which was time consuming,burdensome, and often resulted inseveral boxes of documents being

created for the examiners. Until recently,examiners had to be on-site at least forcertain tasks: to analyze the areas requir-ing extensive documentation that couldnot be readily copied, such as loan filesor other sizeable financial reports, and toobtain missing information.

Given the advancements in technology,FDIC examiners have explored how theexamination process could be mademore efficient. By securely exchangingelectronic information, could we reducethe burden of the examination processon both bank management and examin-ers, while still maintaining an effective,risk-focused examination process?

Introducing the e-Exam

An e-Exam, or electronic examination,is a financial institution examination inwhich electronic data are exchangedthrough a secure delivery method.E-Exam procedures can be used for allexaminations conducted by the FDIC,including risk management, compliance,and Community Reinvestment Act exam-inations. State authorities and otherregulatory agencies also may employ e-Exam procedures at joint examinationswith the FDIC.

Banks generally maintain a wide vari-ety of information—written policiesand procedures, customer disclosures,board minutes, and even loan files—inelectronic format, either as an originallycreated document or as a scannedimage. Managers at many institutionshave been offering their imaging toolsto examiners for some time, usuallyallowing access to imaged documentsthrough compact discs (CDs) or bankterminals on-site. In early 2004, institu-tions began approaching the FDIC viatelephone calls and personal contacts attrade events suggesting that examiners

From the Examiner’s Desk . . .The e-Exam

1 Division of Supervision and Consumer Protection Memorandum, “e-Exam Policy,” Transmittal No. 2006-018, July 7, 2006. Under the e-Exam policy, examiners are directed to maximize the use of electronic information,when available, to conduct examinations and visitations.


31

use banks’ imaging technology duringexaminations to make the process moreefficient for both them and the examin-ers. Developing policies and proceduresfor electronically transferring such docu-ments was the next logical step, and it isthe basis of the e-Exam concept.

The FDIC’s e-Exam policy is designedto meet the needs of bankers and exam-iners by using these imaging tools toenhance the examination process. Underthe policy, board minutes and financialreports can be reviewed off-site in thepreexamination planning stage, loanreviews can be conducted off-site usingimaged loan files, and additional infor-mation requests or amended documentsresponding to examiner questions orconcerns can be transmitted electroni-cally as the examination comes to aclose. Examiners can and do, however, goon-site for discussions with managementand certain types of transaction testing.2

Improving ExaminationEfficiencies for Bankers andExaminers

Industry response to e-Exams has beenpositive. Examination work conductedon-site requires extensive bankresources, including work space,employee time, and distractions fromthe normal course of bank business.Moreover, providing documentation toexaminers electronically, rather than asthe traditional hard copy, saves consider-able time and effort for bank manage-ment.

Nikki Beisler, a senior vice presidentwith First Bank and Trust Company ofIndiantown, Florida, offers the follow-ing thoughts on the e-Exam policy anda recent e-Exam at her institution: “Ilove it. It saves time as I do not have totake time to create paper copies. It is

easier to send documents electronicallybecause we already have them in anelectronic format. I am able to be moreorganized through this process. Beingfrom a small institution, I have to weara lot of hats, and there is not enoughtime to get things done. The process issimple to use and allows me to savetime and be organized. The examina-tion went very smoothly.”

As for the examination force, theresponse has been overwhelmingly posi-tive. Many examiners consider thepotential reduction in travel—one of themost-often-cited reasons for examinersleaving the FDIC—to be one of the mostimportant benefits of the e-Examprogram. The e-Exam policy alsosupports the flexibility examiners havein choosing their work environmentthrough the FDIC’s Telework Program.

Security Is Paramount

The FDIC’s e-Exam policy accommo-dates financial institutions’ desire toprovide imaged documentation and real-izes the benefits of using emerging tech-nologies as part of the examinationprocess. However, enhanced policy andprocedure considerations are necessaryto mitigate information security risksarising from the use of e-Exam proce-dures. Strict adherence to applicableinformation security policies and proce-dures are required to effectively accom-modate the use of emerging technologies.

The extent of imaging technologiesemployed, the financial institutionmanagement’s willingness to participatein e-Exams, and the available securitymeasures represent the primary consid-erations when implementing e-Examprocedures. Although many technologiesare available to accommodate the elec-tronic exchange of information, the only


2 The following portions of the fair lending review must be conducted on-site: criteria interview, a sample ofactual loan files to ensure imaged files received electronically are complete, and any follow-up discussions if theoff-site file review indicates possible disparate treatment.

From the Examiner’s Desk . . .continued from pg. 31

ones currently approved for use in ane-Exam are FDICconnect, web-basedapplications, and electronic media(including CDs and DVDs). These threedelivery technologies, which arediscussed later in this article, haveproven their reliability and consistencyand provide a degree of security fordelivery of bank information. In allinstances, however, the increased volumeof portable, electronic confidential infor-mation associated with e-Exams necessi-tates enhanced security measures toensure the continued confidentiality,integrity, and availability of financialinstitution records and data. Therefore,the FDIC has structured formal securitypolicies according to the specific deliverychannels used, and the e-Exam policyoutlines the necessary measures to miti-gate the unique threats and challengesthat each delivery channel presents.

Different TechnologiesFacilitate the e-Exam

Based on the results of ongoing surveys3

completed by FDIC examiners and


bankers, the FDIC estimates that approx-imately 800 FDIC-supervised institutionshave some document imaging capabili-ties, with more than 250 of these institu-tions being fully imaged. The e-Exampolicy provides examiners the flexibilityto work with various technologies banksmay employ to facilitate an e-Exam. Aspreviously mentioned, three deliverymethods are currently used during exam-inations to navigate and view imageddocuments in a secure manner: FDIC-connect, CDs/DVDs, and web-basedapplications.

FDICconnect

Using a secure Internet connection,FDICconnect provides on-demand fileexchange capabilities and automatedencryption with the transmission andstorage of data. All FDIC examiners andinsured financial institutions registeredwith FDICconnect can use the Examina-tion File Exchange (EFE) module ofFDICconnect. (See text box for informa-tion on registering with FDICconnect.)The FDICconnect application is easy forboth examiners and bankers to navigate,

While FDIC strives to complete examinations with local examiners,for a variety of reasons, that is not always possible. When thathappens, examiners from out of the area—sometimes even out ofthe region—help out. I recently served as the examiner-in-charge(EIC) of a bank located in another region. Having the option ofconducting an e-Exam facilitated getting much of the work done atmy field office, while shortening some of my on-site activities.

The $68 million bank effectively transmitted the requested items,including loan files, through FDICconnect. Using the informationprovided in advance by the bank, my crew of eight examiners, allfrom out of the bank’s area, was able to effectively risk scope theexamination. Four examiners conducted portions of the examinationat the bank, while the remaining four examiners conducted the loan

review from the field office. Using FDICconnect, the examinerswere able to review loan files, collect missing documentation, andcomplete the loan review with little difficulty.

As EIC, I felt the e-Exam was efficient and cost effective. Wewere able to save considerable dollars in travel expenses and, bysaving more than 60 hours of travel time, complete the examinationin only one week. Overall, bank management was receptive to theprocess and expressed their preference for having fewer examin-ers on-site than in past examinations.

Patrick BachelorExaminerKansas City, MO

Perspectives from an FDIC Examiner

3 In 2004, the FDIC implemented a Document Imaging Survey, completed by examiners in conjunction with exami-nations, to assess the potential for using imaging technologies in future examinations. The survey was replacedon May 21, 2007, with an enhanced e-Exam Imaging Inventory, which examiners will use to monitor the extent ofbanks’ use of imaging technologies and to assist with identifying developing technologies.


providing a user-friendly, safe, and securemethod for transmitting files duringexaminations. Bankers simply aggregateand copy requested examination infor-mation to FDICconnect for review byexaminers. Currently, this is the mostfrequently used method of exchangingexamination-related information—mostlikely because it is easy to use andbankers and examiners are comfortablewith FDICconnect ’s built-in security andencryption features.

Compact Discs

Prior to the development and accept-ance of FDICconnect, CDs/DVDs wereoften the primary means of obtainingimaged documents at examinations.Many bankers and examiners continueto use CDs/DVDs, particularly whenInternet connections are not availableor access speeds are poor. Bankmanagement can aggregate and copyrequested examination information toCDs/DVDs for review by examiners,much as they would for e-Exams usingFDICconnect. Bankers and examinershave also found that CDs/DVDs caneasily be used to obtain missing docu-mentation or to meet additional exam-iner requests once the examination hascommenced. For example, if examinersare on-site and missing just a couple ofpolicies or a loan file, it may be easier

to copy these documents to a CD/DVDand simply hand it to the examinersrather than establishing an FDICconnectsession for an electronic transfer. Ingeneral, using CDs/DVDs requires verylittle technical assistance. However,some additional security precautionsare necessary. Bankers sometimesexpress reservations about having elec-tronic data, including confidentialcustomer information, outside the insti-tution’s control because of privacy andsecurity issues related to safeguardingsuch information. The FDIC shares thisconcern and therefore requires thatCDs/DVDs be properly secured throughencryption and that proper physicalsecurity controls be in place whentransporting disks.

Web-Based Applications

Some institutions maintain infor-mation on a web server. Under thisarrangement, examiners use standardweb browsers and FDIC laptops toretrieve images over the Internet viaencrypted sessions. The institution andthe FDIC are able to secure the confi-dentiality and integrity of bank infor-mation by using user ID/passwordauthentication and by enforcing appro-priate access controls to restrict exam-iners’ abilities to create, modify, ordelete bank information.

Registering with FDICconnect

The FDIC encourages all financial institutions to register to use FDICconnect by completinga Designated Coordinator (DC) Registration Form available at www2.fdicconnect.gov. Becausean executive officer of the financial institution is required to sign the registration form, eachinstitution’s management is aware of the principal person on their staff who “speaks for theinstitution” using FDICconnect.

Institutions should choose the coordinator carefully and implement controls to address opera-tional risks inherent in online transactions. FDICconnect staff will provide the coordinator withtechnical guidance for using FDICconnect. The coordinator may designate other individuals’access to execute transactions on behalf of the institution. These users can be employees ofthe institution, the holding company, an outside data servicer, or a law firm. When appropriate,such as in the case of data servicers, authorized FDICconnect users may execute transactionson behalf of more than one institution.


Because much of the informationrequired to conduct an examination isalready available on the institution’sweb server, bank management oftenhas to extend little, if any, effort tomeet examiner requests for informa-tion. This approach for accessing bankinformation is considered reliable,consistent, and effective. Again, thereare some additional security precau-tions that have to be taken with web-based applications. Although there issome concern that direct websiteaccess may not support multifactorauthentication (i.e., user ID/password,biometrics, or token-based devices),examiners’ limited access (just for theduration of the examination, onlywithin business hours, and to a singleURL address) reduces the potential forexaminers to be misdirected or subjectto a successful phishing attempt.

The Future of the e-Exam

Technology will continue to offer newways to make examinations more effi-cient. As the banking industry contin-ues to take advantage of advancementsin technology, such as document imag-ing and remote access capabilities, theuse of e-Exam procedures will doubt-less grow.

The FDIC has established an e-ExamWorking Group to monitor developments

in technology, including imaging. Thisworking group, with the help of subject-matter experts in the FDIC regions, will

n Monitor changes in technology;

n Provide an accurate system fortracking institutions with documentimaging;

n Ensure that policies and proceduresare updated;

n Provide recommendations for meetingincreases or changes in hardware andsoftware needs so that we can respondto advancements in the industry; and

n Pilot, test, and develop procedures fornew technologies.

As the landscape of technology evolves,the examination process must also evolveto ensure that the FDIC is conductingbusiness in the most effective, efficient,and secure manner. The FDIC’s e-Exampolicy was developed in that spirit,improving the efficiency of the examina-tion process without compromising itsintegrity.

Stephen P. JonesCase Manager,San Francisco, CA

Shawn D. MeyerField Supervisor (Risk Management), Madison, WI

From the Examiner’s Desk . . .continued from pg. 33

dollar arrangements with employeesnow need to review how they accountfor them. For many banks, the applica-tion of the EITF consensuses will resultin a change in accounting principles thatwill require them to recognize a liabilityat the beginning of 2008 for any bene-fits provided to these employees thatextend to postretirement periods.

Split-Dollar Life InsuranceArrangements

The December 2004 Interagency State-ment on the Purchase and Risk Manage-ment of Life Insurance,2 which providesguidance regarding supervisory expecta-tions for the acquisition and holding oflife insurance by banks and savings asso-ciations, also addresses split-dollar lifeinsurance arrangements. As noted in theInteragency Statement, under split-dollararrangements, the employer and theemployee share the rights to the insur-ance policy’s cash surrender value (CSV)and death benefits. In general, the differ-ence between endorsement and collat-eral assignment split-dollar life insurancearrangements is in the ownership andcontrol of the life insurance policy. In anendorsement arrangement, the employer(bank) owns the insurance policy andcontrols all rights of ownership; in acollateral assignment arrangement, theemployee owns the policy and controlsall rights of ownership.

According to the EITF’s descriptionof a typical endorsement split-dollararrangement,

An employer purchases a life insur-ance policy to insure the life of an

35

Accounting News:Recent Developments Affecting the Accounting

for Split-Dollar Life Insurance Arrangements


In recent years, an increasingnumber of banks have acquired lifeinsurance assets to finance the cost

of employee benefits, protect againstthe loss of key persons, or provide retire-ment and death benefits as part ofcertain employees’ compensation. Datareported in the Consolidated Reports ofCondition and Income (Call Report)reveal that more than 47 percent of allbanks held life insurance assets as ofDecember 31, 2006. For these banks,their total life insurance assets exceeded$96 billion, which represented morethan 11 percent of their aggregateequity capital.

Banks often use split-dollar life insur-ance arrangements to provide retire-ment and death benefits to employees.These arrangements are commonlystructured as either “endorsement” split-dollar arrangements or “collateralassignment” split-dollar arrangements.Although both types of split-dollar lifeinsurance arrangements have existed formany years, within the past year theFinancial Accounting Standards Board(FASB) has ratified separate consen-suses reached by its Emerging IssuesTask Force (EITF) on the accounting forthese two types of arrangements. Theconsensuses in EITF Issues No. 06-4 andNo. 06-10 cover endorsement and collat-eral assignment split-dollar life insurancearrangements, respectively.1 The EITFaddressed the accounting issues associ-ated with these arrangements because ofdiversity in practice with respect to thedeferred compensation and postretire-ment benefit aspects of typical split-dollar arrangements. As a consequence,institutions that have entered into split-

1 See EITF Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects ofEndorsement Split-Dollar Life Insurance Arrangements (EITF 06-4), and EITF Issue No. 06-10, Accounting forCollateral Assignment Split-Dollar Life Insurance Arrangements (EITF 06-10). The FASB ratified the EITF’s consen-suses on these issues on September 20, 2006, and March 28, 2007, respectively. 2 FIL 127-2004, Bank-Owned Life Insurance: Interagency Statement on the Purchase and Risk Management of LifeInsurance, December 7, 2004, www.fdic.gov/news/news/financial/2004/fil12704.html.

36

employee and pays a single premiumat inception of the policy. Based onthe insurance carrier’s experience(for example, mortality) it can eithercharge or credit the policyholder forthe negative or positive experience,respectively. The additional premiumor credit is typically effectuatedthrough an adjustment to the cashsurrender value of the policy. Theemployer enters into a separate agree-ment that splits the policy benefitsbetween the employer and theemployee….To effect the split-dollararrangement, the employer endorsesa portion of the death benefits to theemployee (the employee designates abeneficiary for this portion of thedeath benefits). Upon the death of theemployee, the employee’s beneficiarytypically receives the designatedportion of the death benefits directlyfrom the insurance company and theemployer receives the remainder ofthe death benefits.3

In contrast, as described in the EITF’smaterials, a typical collateral assignmentsplit-dollar arrangement has the followingcharacteristics:

An employee purchases a life insur-ance policy through an arrangementwith the employer to insure theemployee’s life…[or] the employerpurchases a life insurance policy andtransfers ownership of the insurancepolicy to the employee…The employerusually pays all or a substantial part ofthe premium. The employee irrevoca-bly assigns a portion or all of thedeath benefits to the employer ascollateral for the employer’s interestin the insurance policy [i.e., theemployer’s loan to the employee] (thecollateral assignment arrangement).Amounts due to the employer vary

but, typically, the employer is entitledto receive a portion of the death bene-fits equal to the premiums paid by theemployer or premiums paid plus anadditional fixed or variable return onthose premiums.4

The appendix to the 2004 InteragencyStatement contains similar descriptionsof these two split-dollar arrangements.The Interagency Statement furtherprovides that an institution’s economicinterest in the insurance policy underly-ing the split-dollar arrangement should atleast be equal to the premium or premi-ums paid plus a rate of return compara-ble to returns on investments of similarmaturity and credit risk.

Liability Recognition for Split-Dollar Arrangements underthe EITF Consensuses

The EITF reached similar conclusionsas to whether an employer should recog-nize a liability and related compensationcosts for postretirement benefits associ-ated with both endorsement and collat-eral assignment split-dollar life insurancearrangements. For both types of split-dollar arrangements, determiningwhether the employer should recognizea liability for postretirement benefitsshould be based on the substantiveagreement with the employee. Thus,“if the employer has agreed to maintaina life insurance policy during theemployee’s retirement or provide theemployee with a death benefit,”5 theemployer should recognize a liabilityfor its postretirement benefit obligationto the employee. The liability must berecognized in accordance with FASBStatement No. 106, Employers’ Account-ing for Postretirement Benefits OtherThan Pensions (FAS 106), “if, in

3 EITF Abstracts, Issue No. 06-4, paragraph 2.4 EITF 06-10, Issue Summary No. 1, paragraph 2.5 Unless otherwise noted, this quotation and subsequent quotations are taken from the EITF Abstracts for IssueNo. 06-4 or Issue No. 06–10.


Accounting Newscontinued from pg. 35

37

substance, a postretirement benefit planexists,” or Accounting Principles BoardOpinion No. 12, Omnibus Opinion—1967 (APB 12), “if the arrangementis, in substance, an individual deferredcompensation contract.” To determinethe substance of an arrangement, allavailable evidence should be consid-ered, including the “explicit writtenterms of the arrangement, communi-cations made by the employer to theemployee, the employer’s past prac-tices in administering the same or simi-lar arrangements, and whether theemployer is the primary obligor for thepostretirement benefit.”

Furthermore, when evaluating a collat-eral assignment split-dollar arrangement,an employer would be deemed to haveagreed to maintain a life insurance policy“if the employer has a stated or impliedcommitment to provide loans to anemployee to fund premium payments onthe underlying insurance policy duringthe postretirement period.” In theabsence of evidence to the contrary,there is a presumption that an employerwill “provide loans to an employee tofund premium payments on the under-lying insurance policy in the postretire-ment period if the employer has providedloans in the past or if the employer iscurrently promising to provide loans inthe future.” For example, if, under theterms of the collateral assignmentarrangement, the employer has either astated or implied obligation “to provideloans to an employee to cover the experi-ence gains and losses of the insurancecompany, that may indicate that theemployer has a postretirement benefitobligation” to be recognized.

Therefore, after considering all avail-able evidence surrounding a split-dollararrangement, if the substance of the

arrangement is the employer’s agree-ment to maintain a life insurance policyon the employee during his or her retire-ment, “the estimated cost of maintainingthe insurance policy during the post-retirement period should be accrued.”Similarly, if the substance of the arrange-ment is the employer’s agreement “toprovide the employee with a death bene-fit, the employer should accrue, over theservice period, a liability for the actuarialpresent value of the future death benefitas of the employee’s expected retirementdate.” These accruals should be made inaccordance with FAS 106 or APB 12, asappropriate.

APB 12 requires that

an employer’s obligation under adeferred compensation agreement beaccrued according to the terms of theindividual contract over the requiredservice period to the date theemployee is fully eligible to receivethe benefits, i.e., the “full eligibilitydate.”…[It] does not prescribe aspecific accrual method for the bene-fits under deferred compensationcontracts, stating only that the “costof those benefits shall be accrued overthat period of the employee’s servicein a systematic and rational manner.”The amounts to be accrued eachperiod should result in a deferredcompensation liability at the full eligi-bility date that equals the then pres-ent value of the estimated benefitpayments to be made under the indi-vidual contract.6

FAS 106 also directs an employer to“recognize and measure the obligationfor postretirement benefits based on theactuarial present value of all future bene-fits attributed to an employee’s servicerendered to that date [i.e., to the full

6 Instructions for the Preparation of Consolidated Reports of Condition and Income, Glossary, “Deferred Compen-sation Agreements,” page A-15 (3-04). Further guidance on accounting for deferred compensation agreements,including examples, is provided in the Interagency Advisory on Accounting for Deferred Compensation Agree-ments and Bank-owned Life Insurance. See FIL-16-2004, Accounting and Reporting, February 11, 2004,www.fdic.gov/news/news/financial/2004/fil1604.html.


38

eligibility date]. FAS 106 requires anemployer to attribute the costs of thosepostretirement benefits over therequired service period.”7

The EITF noted that the facts andcircumstances relating to a collateralassignment split-dollar arrangementmay change in periods after the incep-tion of the arrangement, for example,as a result of an amendment to thearrangement or a change from theemployer’s past practice in administer-ing these arrangements. Therefore, anemployer should periodically evaluatethe substance of its collateral assign-ment arrangements to determinewhether any change in an arrangementhas altered its substance and, hence,whether a liability for a postretirementbenefit obligation should be recognizedor a previously recognized liabilityshould be adjusted.

Asset Recognition for Split-Dollar Arrangements underthe EITF Consensuses

An employer must also ensure that itproperly recognizes the asset resultingfrom its split-dollar arrangements withemployees. Because the owner of theinsurance policy differs under the twotypes of split-dollar arrangements, theresulting asset held by the employermust reflect the nature of the employer’sinterest in the life insurance.

In an endorsement split-dollar arrange-ment, the employer owns the insurancepolicy. Thus, the accounting guidancein the FASB’s Technical Bulletin 85-4,Accounting for Purchases of LifeInsurance (TB 85-4), as interpreted bythe EITF in Issue No. 06-5, Accountingfor Purchases of Life Insurance—

Determining the Amount That CouldBe Realized in Accordance with FASBTechnical Bulletin 85-4 (EITF 06-5),should be applied to the insurancepolicy. Under TB 85-4, “the amount thatcould be realized under the insurancecontract as of the date of the statementof financial position should be reportedas an asset.” Normally, this amount isthe CSV of a policy, less any applicablesurrender charges not reflected by theinsurance carrier in the reported CSV.However, EITF 06-5 explains thatthe employer, as policyholder, shouldalso consider any additional amountsincluded in the contractual terms of thepolicy in determining the amount thatcould be realized under the insurancecontract.

In this regard, EITF 06-5 notes thatan insurance policy’s contractualterms may include a “claims stabiliza-tion reserve” account and a provisionthat allows the policyholder to recoverthe upfront “deferred acquisition costs”(DAC) tax over a specified period oftime.8 When either of these amountsis present in an insurance policy usedin an endorsement split-dollar arrange-ment and the amount is realizablebased on the policy’s contractualterms, this realizable amount shouldbe included as part of the amountreported as a life insurance asset onthe balance sheet. Thus, as long as thesplit-dollar arrangement entitles theemployer to the entire CSV reportedby the insurance carrier (less any appli-cable surrender charges not reflectedtherein) plus any additional realizableamounts, the employer should reportthis total amount as an asset.

In contrast, because the employeeowns the life insurance policy in acollateral assignment split-dollar

7 EITF 06-4, Issue Summary No. 1, Supplement No. 2, Revised, page 20.8 Under EITF 06-5, when measuring the amount that could be realized under an insurance contract, “amountsthat are recoverable by the policyholder in periods beyond one year from the surrender of the policy [such as theDAC tax] should be discounted in accordance with” Accounting Principles Board Opinion No. 21, Interest onReceivables and Payables (APB 21).



39

arrangement, an employer’s process forrecognizing and measuring the asset insuch an arrangement is not as straight-forward. According to EITF 06-10, thisprocess should be “based on the natureand substance” of the arrangement,which requires the employer to “evalu-ate all available information.” To deter-mine the nature and substance, “theemployer should assess what futurecash flows the employer is entitled to,if any, as well as the employee’s obliga-tion and ability to repay the employer.”As an example, the EITF cited a collat-eral assignment split-dollar arrangementin which the employer is entitled torecover only the CSV of the employee’sinsurance policy even if the employer’sloan to the employee is a larger amount.Under such an arrangement, theemployer’s asset as of any balance sheetdate would be limited to the CSV. Asa second example, if the employee isrequired “to repay the [loan from the]employer irrespective of the collateralassigned and the employer (a) hasdetermined that the employee loan iscollectible and (b) intends to seekrecovery beyond the cash surrendervalue of the life insurance policy, theemployer should recognize the valueof the loan (including accrued interest,if applicable) considering the guidancein” APB 21.

Under APB 21, if the employer’s loanto the employee requires repaymentonly of the premiums paid by theemployer on the insurance policy, i.e.,without the payment of interest or arate of return on those premiums, theemployer should “record a receivablefrom the employee at a discountedamount for the premiums paid.”9 Thus,the employer would need to determinethe expected repayment date of theloan to the employee based on theterms of the split-dollar life insurancearrangement as well as the appropriateinterest rate at which to discount the

loan. APB 21 states that “the rate usedfor valuation purposes will normally beat least equal to the rate at which thedebtor [i.e., the employee] can obtainfinancing of a similar nature from othersources at the date of the transaction.The objective is to approximate the ratewhich would have resulted if an inde-pendent borrower and an independentlender had negotiated a similar transac-tion under comparable terms and condi-tions.” The employer would applythe interest method to amortize theresulting discount on the loan to theemployee over the life of the loan atthe rate used for valuation purposes.

Effective Date for the EITFConsensuses

The consensuses reached on EITF 06-4 and EITF 06-10 are expected torepresent a significant change inaccounting practice for many bankswith split-dollar life insurance arrange-ments. As a result, the EITF delayed theeffective date of these consensuses toallow adequate time for implementa-tion. Thus, both consensuses take effectfor fiscal years beginning after Decem-ber 15, 2007, i.e., as of January 1,2008, for banks with calendar yearfiscal years. Calendar year banks withsplit-dollar life insurance arrangementsmust first report in accordance withthese consensuses in their March 31,2008, Call Reports and in any first quar-ter 2008 financial statements theyissue. Earlier application of the consen-suses is also permitted.

When the EITF initially reached atentative consensus in EITF 06-4 inJune 2006, it proposed that the consen-sus should take effect for fiscal yearsbeginning after December 15, 2006.For calendar year banks, this meantthat they would have had to apply thisconsensus at the beginning of 2007. Inconsidering comments received on its

9 EITF 06-10, Issue Summary No. 1, paragraph A2.


40

tentative consensus on EITF 06-4 thatrequested a delay in the effective date,the EITF recognized that, absent anychanges to banks’ existing endorsementsplit-dollar arrangements, many bankswith such arrangements would see areduction in their Tier 1 capital upontheir initial application of the consen-sus. This regulatory capital reductionwould be the consequence of having torecognize a liability for postretirementbenefits that these banks had not previ-ously accrued on their balance sheets.Accordingly, the EITF reconsideredthe effective date and moved it one yearinto the future. When the EITF subse-quently reached its consensus on EITF06-10 for collateral assignment split-dollar arrangements, it decided in theinterest of consistency to set the samedelayed effective date as for EITF 06-4.

For a bank whose split-dollar life insur-ance accounting practices differ fromthe consensuses reached by the EITF,the effects of applying the relevantconsensus for the type of split-dollararrangement into which the bank hasentered with its employees should berecognized “through either (a) a changein accounting principle through a cumu-lative-effect adjustment to retained earn-ings…as of the beginning of the year ofadoption or (b) a change in accountingprinciple through retrospective applica-tion to all prior periods.” Because eachReport of Income in a bank’s Call Reportcovers a single discrete calendar year-to-date period rather than presentingcomparative statements, a bank is notpermitted to implement a change inaccounting principle through retrospec-tive application to prior years’ CallReports. Therefore, unless a calendaryear bank elects earlier application ofthe relevant split-dollar EITF consensus,it will report the cumulative effect ofapplying the consensus as of January 1,2008, as a direct adjustment to its equitycapital in item 2 of Call Report ScheduleRI-A—Changes in Equity Capital, anddisclose this amount in item 4 of Sched-

ule RI-E—Explanations.

Examination Considerations

Under the 2004 Interagency State-ment on the Purchase and Risk Manage-ment of Life Insurance, institutionsshould have a comprehensive riskmanagement process for purchasingand holding life insurance. A prudentrisk management process includes effec-tive senior management and board over-sight as well as an effective ongoingsystem of risk assessment, management,monitoring, and internal control. As akey aspect of the ongoing monitoringprocess, management should provide arisk management review of the institu-tion’s insurance assets to the board ofdirectors at least annually. The Intera-gency Statement provides examples ofsituations when more frequent reviewsare appropriate. Although changes inaccounting requirements are not specifi-cally included among the examples, theEITF’s two recent consensuses are ofsufficient significance as to warrant areview outside of the annual cycle.

Among other elements, an institution’srisk management review should includea comprehensive assessment of the risksof its life insurance holdings. In particu-lar, the Interagency Statement notes thattransaction/operational risk arises due tothe tax and accounting treatments of lifeinsurance products and instructs an insti-tution to thoroughly review and under-stand how the accounting rules will applyto the insurance products it is consider-ing purchasing. Therefore, whenaccounting rules change, a thoroughreview and understanding of the effect ofthe changes should be an integral part ofthe institution’s risk management review.The Interagency Statement also notesthat “[s]plit-dollar life insurance hascomplex tax and legal consequences”and that material modifications of thesearrangements may unfavorably altertheir tax treatment. As a consequence,the Interagency Statement cautions insti-



41

tutions to “consult qualified tax, insur-ance, and legal advisors” before enteringinto or modifying split-dollar life insur-ance arrangements.

Because the application of the consen-suses in EITF 06-4 and EITF 06-10 mayrequire banks with split-dollar life insur-ance arrangements to initially recognizea liability for postretirement benefits,which will reduce both equity capitaland regulatory capital, and to subse-quently recognize compensation costsover the remainder of the employees’required service periods until their fulleligibility dates, banks should use thetransition period during 2007 for riskmanagement reviews that assess thesubstance of their split-dollar arrange-ments. In these reviews, banks shouldalso consider the nature of their interestin the life insurance policies associatedwith their split-dollar arrangements toensure that they are properly reportingtheir insurance assets. The results ofthese reviews, including consultationswith their external accountants andother qualified advisors, should enablemanagement to understand and evalu-ate the accounting consequences of theEITF consensuses; ascertain the impactof the consensuses on equity capital on

their effective date and on earningsthereafter; and determine the actionsneeded, if any, to remedy the effects ofapplying the consensuses beginning in2008. These actions may includeconsidering whether to eliminate orreduce the postretirement benefitsprovided under these arrangementsafter addressing any relevant tax conse-quences from such modifications.

Thus, when examining banks that haveentered into split-dollar life insurancearrangements with employees, examin-ers should ensure that management isaware of the recent accounting guidanceissued by the EITF and is assessing, orhas completed an assessment of, theimpact that the consensuses will have ontheir organization as part of a timely riskmanagement review of these insurancearrangements. In cases where manage-ment has not yet taken appropriateaction, examiners should seek manage-ment’s commitment to promptly addressthe EITF guidance relevant to its split-dollar arrangements.

Robert F. StorchFDIC’s Chief Accountant,Washington, DC


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New Government-Wide ID Theft HomePage Established (PR-33-2007, April 23,2007)

The Federal Deposit Insurance Corporation (FDIC), a participant in the government-wideIdentity Theft Task Force, provided a direct link to the new, centralized government websiteon identity theft. The new site, www.idtheft.gov, was launched April 23, 2007. Initially, thesite will provide the task force’s strategic plan. The plan, which represents the input of 17federal agencies, including the FDIC, sets out recommendations to prevent identity theft, tohelp identity theft victims recover from those crimes, and to prosecute and punish identitytheft–related criminals.

Institutions Encouraged to Work withMortgage Borrowers Who Are Unableto Make Their Payments (PR-32-2007,FIL-35-2007, April 17, 2007)

The FDIC, Federal Reserve Board (FRB), Office of the Comptroller of the Currency (OCC),Office of Thrift Supervision (OTS), and National Credit Union Administration (collectively,the federal financial institution regulatory agencies) issued a statement encouraging finan-cial institutions to work with homeowners who are unable to make mortgage payments.Prudent workout arrangements that are consistent with safe and sound lending practicesare generally in the long-term best interests of both the financial institution and theborrower. Institutions will not face regulatory penalties if they pursue reasonable workoutarrangements with borrowers. See www.fdic.gov/news/news/press/2007/pr07032.html.

Comments Sought on Proposed ModelPrivacy Form (FIL-34-2007, April 16,2007; PR-24-2007, March 21, 2007)

The federal financial institution regulatory agencies, the Securities and Exchange Commis-sion (SEC), the Federal Trade Commission, and the Commodity Futures Trading Commissionjointly published a notice of proposed rulemaking (NPR) seeking comment on a modelprivacy form financial institutions could use to satisfy the privacy notice requirements ofthe Gramm-Leach-Bliley Act (GLBA). The proposed privacy form would also provideconsumers with the opportunity to limit certain information-sharing practices, as permittedby the GLBA and the Fair Credit Reporting Act. Comments on the proposed rule were dueby May 29, 2007. See www.fdic.gov/news/news/financial/2007/fil07034.html.

Supervisory Policy on Identify TheftIssued (FIL-32-2007, April 11, 2007)

Comments Sought on ExpandedExamination Cycle for CertainInstitutions (PR-29-2007, April 3, 2007)

The FDIC issued its Supervisory Policy on Identity Theft. The policy describes the charac-teristics of identity theft. It also sets forth the FDIC’s expectations that institutions under itssupervision take steps to detect and prevent identity theft and mitigate its effects toprotect consumers and help ensure the safe and sound operation of financial institutions.See www.fdic.gov/news/news/financial/2007/fil07032a.html.

The FDIC, FRB, OCC, and OTS (collectively, the federal bank and thrift regulatory agencies)requested public comment on proposed interim rules expanding the range of small institu-tions eligible for an extended 18-month on-site examination cycle. The proposed interimrules, which became effective May 10, 2007, allow well-capitalized and well-managedbanks and savings associations with up to $500 million in total assets and a compositerating of 1 or 2 to qualify for an 18-month (rather than a 12-month) on-site examinationcycle. Until recently, only institutions with less than $250 million in total assets could qualifyfor an extended 18-month on-site examination cycle. The proposed interim rules alsorevise the provisions governing the on-site examination cycle for the U.S. branches andagencies of foreign banks. The public comment period closed May 10, 2007. Seeww.fdic.gov/news/

Regulatory and SupervisoryRoundup


This section provides an overview of recently released regulations and supervisory guidance, arranged inreverse chronological order. Press Release (PR) or Financial Institution Letter (FIL) designations areincluded so the reader may obtain more information.

Subject Summary


May 7, 2007. Seewww.fdic.gov/news/news/press/2007/pr07018a.html.Comments Requested on ProposedSupervisory Guidance for Basel II (PR-13-2007, February 15, 2007;FIL-20-2007; February 28, 2007; Federal

The federal bank and thrift regulatoryagencies sought comment onproposed guidance describing theagencies’ expectations for bankingorganizations that would adopt theAdvanced Internal Ratings-BasedApproach (IRB) for credit risk and the

Institutions and Insured ForeignBranches in Risk Category I (FIL-19-

magnitude of the adjustment should be.These guidelines are intended tofurther clarify the analytical processesand the controls applied to them inmaking assessment rate adjustments.Comments on the proposed guidelines

Advanced Measurement Approaches (AMA) for operational risk under the proposed newBasel II capital framework. The proposed guidance also establishes the process for super-visory review and the implementation of the capital adequacy assessment process underPillar 2 of the Basel II framework. Comments on the proposed guidance were due May 29,2007. See www.fdic.gov/news/news/financial/2007/fil07020.html.Comments Requested on Proposed Guidelines on Assessment Rate Adjustment for Large

2007, February 27, 2007; Federal Register, Vol. 72, No. 34, p. 7878, February 21, 2007)The FDIC sought comment on a proposed set of ten guidelines that would govern theprocess for determining when an assessment rate adjustment is appropriate and what the

were due March 23, 2007. See www.fdic.gov/news/news/financial/2007/fil07019.html.Certain Reporting Requirements Repealed (FIL-7-2007, January 26, 2007)The FDIC issued a final rule repealing FDIC Part 349, Reports and Public Disclosure ofIndebtedness of Executive Officers and Principal Shareholders to a State Nonmember Bankand Its Correspondent Banks. The final rule became effective on December 22, 2006. See

Register, Vol. 72, No. 39, p. 9084, February 28, 2007)

www.fdic.gov/news/news/finan-cial/2007/fil07007.html. Supervisory Policy on PredatoryLending (FIL-6-2007, January 22, 2007)

The FDIC issued its Supervisory Policy on Predatory Lending, which describes certaincharacteristics of predatory lending and reaffirms that such activities are inconsistentwith safe and sound lending and undermine individual, family, and community economicwell-being. The statement describes the FDIC’s supervisory response to predatory lending,including a list of policies and procedures that relate to consumer lending standards. Seewww.fdic.gov/news/news/financial/2007/fil07006a.html.

Final Statement Concerning ElevatedRisk Complex Structured FinanceActivities (PR-3-2007, January 6, 2007)

The federal financial institution regulatory agencies and the SEC issued a final statementon the complex structured finance activities of financial institutions. The statementdescribes the types of internal controls and risk management procedures that should helpfinancial institutions identify, manage, and address the heightened legal and reputationalrisks that may arise from certain complex structured finance transactions. See

news/press/2007/pr07029.html. Comments Requested on ProposedStatement on Subprime MortgageLending (FDIC-PR-18-2007, March 2,

2007; FIL-26-2007, March 9, 2007)The federal financial institution regulatory agencies sought comment on the proposedStatement on Subprime Mortgage Lending (Subprime Statement). The Subprime Statementaddresses the risks and emerging issues relating to subprime mortgage lending practices,most notably certain adjustable rate mortgage lending products. Comments were due by


Regulatory and Supervisory Roundupcontinued from pg. 43

www.fdic.gov/news/news/press/2007/pr07003a.html. Comments Requested on DraftGuidelines on Small-Dollar Loans

(PR-107-2006, December 4, 2006)

The FDIC sought comment onproposed guidelines from statenonmember banks to encourage themto offer affordable small-dollar loanproducts. FDIC-supervised institutionsthat offer these products in a responsi-

ble, safe, and sound manner may receive favorable consideration under the CommunityReinvestment Act. Comments were due February 2, 2007. Seewww.fdic.gov/news/news/press/2006/pr06107a.html. Final Rule Amending Part 328, Advertisement of FDIC Membership (FIL-112-2006,

December 27, 2006; Federal Register,Vol. 71, No. 218, p. 66098, November 13,2006)The FDIC issued the final rule amend-ing FDIC Part 328, Advertisement ofMembership. Recent amendments to

Comments Requested on Modificationsto the Risk-Based Capital Framework(Basel IA) (PR-112-2006, December 5,2006; FIL-111-2006, December 26, 2006;

framework proposed in the Basel IINPR. The comment period closedMarch 26, 2007. Seewww.fdic.gov/news/news/finan-cial/2006/fil06111.html.

the Federal Deposit Insurance Act required the FDIC to prescribe an official sign that allFDIC-insured depository institutions would be required to display. The rule accomplishesthat requirement and provides for other changes to the regulation. The final rule tookeffect November 13, 2006. See www.fdic.gov/news/news/financial/2006/fil06112.html.

Federal Register, Vol. 71, No. 247, p. 77446, December 26, 2006)The federal bank and thrift regulatory agencies jointly issued an NPR and sought commenton possible modifications to the risk-based capital standards for all domestic banks, bankholding companies, and savings associations that are not subject to the risk-based capital

Comments Requested on Large-Bank Deposit Insurance Determination ModernizationProposal (PR-111-2006, December 5, 2006; FIL-109-2006, December 21, 2006; FederalRegister, Vol. 71, No. 239, p. 74857, December 13, 2006)The FDIC, through an advance notice of proposed rulemaking (ANPR), sought comment onwhether and how the largest insured depository institutions should be required to modify

their deposit systems so that the FDICmay calculate deposit insurancecoverage quickly in the event of aninstitution’s failure. Comments weredue March 13, 2007. Seewww.fdic.gov/news/news/finan-cial/2006/fil06109.html. Revised Policy Statement Issued on

the Allowance for Loan and Lease Losses (PR-115-2006, December 13, 2006; FIL-105-2006,December 13, 2006)The federal financial institution regulatory agencies issued a revised Interagency PolicyStatement on the Allowance for Loan and Lease Losses (ALLL) and supplemental frequentlyasked questions. The policy statement revises and replaces the banking agencies’ 1993policy statement on the ALLL. See www.fdic.gov/news/news/financial/2006/fil06105a.pdf. Joint Guidance Issued on Commercial Real Estate Lending (PR-114-2006, December 6, 2006;


The FDIC issued updated Guidelinesfor an Environmental Risk Program toreflect changes to the ComprehensiveEnvironmental Response, Compensa-

tion, and Liability Act. Environmental contamination and its associated liability can have asignificant effect on the value of real estate collateral. It is also possible for a lendinginstitution to be held directly liable for the environmental cleanup of collateral acquired bythe institution. Institutions should have in place appropriate safeguards and controls tolimit exposure to this potential environmental liability. See www.fdic.gov/news/news/finan-

cial/2006/fil06098a.pdf. Final Rule Issued on Late DepositInsurance Assessment Penalties(FIL-97-2006, November 9, 2006;Federal Register, Vol. 71, No. 217,

Final Rules on Deposit InsuranceAssessments and the DesignatedReserve Ratio (PR-101-2006,November 2, 2006; FIL-102-2006, andFIL-103-2006, November 30, 2006;

creates a new system for risk-basedassessments and sets assessmentrates beginning January 1, 2007. Theother rule sets the designated reserve

took effect January 1, 2007. Seewww.fdic.gov/news/news/finan-cial/2006/fil06102.html and

ratio at 1.25 percent. The amendments were made to implement the Federal Deposit Insur-ance Reform Act of 2005 and were intended to make the deposit insurance assessmentsystem react more quickly and more accurately to changes in institutions’ risk profiles andto ameliorate several causes for complaint by insured depository institutions. The final rule

www.fdic.gov/news/news/financial/2006/fil06103.html. Guidelines for an Environmental Risk Program Issued (FIL-98-2006, November 13, 2006)

Federal Register, Vol. 71, No. 230, pp. 69270 and 69282, November 30, 2006)The FDIC issued final rules to amend Part 327 of the FDIC rules and regulations. One rule

FIL-104-2006, December 12, 2006;Federal Register, Vol. 71, No. 238, p.74580, December 12, 2006)The federal financial institution regula-tory agencies jointly issued Guidance

on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.The guidance reminds institutions that strong risk management practices and appropriatelevels of capital are essential elements of a sound commercial real estate (CRE) lendingprogram, particularly when an institution has a concentration in CRE loans. Seewww.fdic.gov/news/news/financial/2006/fil06104.html.

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