A bank generally purchases life insurance products for business continuity, as an employee benefit (including compensation in the form of life insurance to facilitate estate planning for bank executives), and to fund its expected exposure under employee compensation and benefit programs. A bank may also purchase life insurance to insure the life of a borrower or a group of borrowers. Banks traditionally purchased life insurance products in one of two forms: key-person life insurance or split-dollar life insurance arrangements. Becoming more prevalent is the banking industry's version of corporate owned life insurance (COLI), generally referred to as bank-owned life insurance (BOLI). A summary of key-person life insurance and split-dollar life insurance arrangements appears in Exhibit 1 to provide context. However, this article will specifically focus on BOLI, its risks, rewards, and other considerations.
What is BOLI?
BOLI is a life insurance policy purchased to insure the life of certain bank employees, usually officers and other highly compensated employees. The policies may also be used to fund employee pension and benefit plans, with the bank using the death benefit proceeds to cover pension and benefit plan obligations for non-insured employees. BOLI is usually used as part of a nonqualified retirement/benefit plan1 to fund current and deferred benefits to key executives.
By definition, BOLI is "bank-owned" and the cash surrender value (CSV) of the policy, net of surrender charges, is a bank asset. Premium payments cover three componentsthe investment, coverage of mortality risk, and sales commissionswhile the policy itself has two componentsan investment feature and a death benefit. Since the bank owns the policy, the bank receives the proceeds from the death benefit, accrues revenue from investment earnings, and bears the risk of investment losses. The CSVthe amount the bank would recoup after surrender charges, but before taxes, if it were to liquidate its BOLI holdingsis a savings element in a whole life or universal life policy, and is not taxed as it increases in value. In addition, death benefits paid to the bank are not taxed.
BOLI can be classified as a general account or separate (variable) account product. The features of general and separate account BOLI are summarized in Exhibit 2.
Exhibit 2. BOLI Classifications on Insurance Company Books (62 KB, 1 page)
While BOLI has been popular at many larger banks and bank holding companies, it is becoming increasing popular among that group of institutions, as well as at community banks. More than half the banks nationwide with assets between $100 million and $1 billion have reported BOLI policy purchases in their regulatory report filings.
Chart 1. Number of Commercial and Savings Banks Reporting CSV (37 KB, 1 page)
Chart 2. CSV Reported by Commercial and Savings Banks (40 KB, 1 page)
An increasing number of banks and BHCs are reporting growth in the CSV of life insurance policies.2 As reflected in Chart 1, as of September 30, 2003, 3,134 commercial and savings banks, or 38 percent of all banks, reported CSV. In addition, 41 percent of the BHCs reported CSV as of September 30, 2003. As reflected in Chart 2, the CSV of life insurance policies reported by commercial and savings banks increased significantly in recent years, totaling $58.0 billion by September 30, 2003.
In the Third Federal Reserve District, 125 of the 231 commercial and savings banks reported CSV amounts as of September 2003. The CSV of Third District policies increased from an aggregate $544 million in 2001 to over $1.3 billion in 2003, with an average reported amount of $10.2 million. In addition, 63 Third District bank holding companies reported CSV amounts as of September 30, 2003, with an aggregate investment of $871.2 million and an average investment of $13.8 million. Total BOLI exposure is likely higher both nationwide and in the Third District because the Call Report CSV reporting rules do not require reporting of BOLI holdings below certain thresholds. 3
Concentrations of BOLI investments in some institutions are significant. As of September 30, 2003, 179 banks nationwide reported CSV greater than 25 percent of the sum of Tier I capital and ALLL, with 15 of those banks reporting CSV greater than 50 percent of Tier I capital and ALLL.
BOLI, According to Consultants 4
BOLI was originally intended to be a tax-advantaged product used to fund employee pension and other retirement benefit plans for bank officers and other highly compensated employees. Over the years, however, a number of brokers and consultants have actively marketed additional product features. These marketing efforts and the manner in which financial institutions use BOLI have resulted in increased regulatory scrutiny and have raised Congressional interest about its use.
Consultants and brokers market BOLI as a core building block for a well-managed balance sheet. Funds invested in BOLI products offer insurance protection and a tax advantage, and consultants group BOLI's tax advantages with those of municipal bonds and other tax-advantaged structures.
Consultants list BOLI's attractions as including:
Returns on BOLI investments can help offset costs of many benefits other than just pension plans. Some examples cited include medical plans, post-retirement plans, excess deferred profit sharing, workers' compensation, company-paid life insurance, accident and disability insurance, and travel accident insurance.
Consultants indicate that BOLI could make economic sense for several reasons, including:
BOLI, According to Lawmakers
In 2002, The Wall Street Journal (WSJ) ran articles criticizing what has come to be called "janitors' insurance," due to certain companies' practices of purchasing life insurance on all of their employees without the employees' knowledge. On April 26, 2002, the WSJ reported that some banks had received as much as 10 to 15 percent of their net income from tax-free earnings on such insurance policy premiums.5 On May 2, 2002, the WSJ reported that at least 150 to 200 of the nation's 600 publicly traded banks had purchased insurance on their employees, worth, in the aggregate, tens of billions of dollars.6
In response to public concerns about these and other insurance practices, several states passed legislation requiring employers to obtain employees' written consent before taking insurance on them. In some states, consent provisions apply to life insurance policies in general, while in others the provisions specifically address COLI. As of July 31, 2003, more than 30 states required written consent, including several states with provisions specific to COLI.7
Given legislators' concerns that COLI, whether in banks (BOLI) or other corporations, might be used inappropriately, an amendment was proposed to Congress's pension reform bill. On February 2, 2004, the Senate Finance Committee unanimously approved a proposal modifying the provisions in the National Employee Savings and Trust Equity Guarantee Act of 2003,8 to allow BOLI benefits to remain tax free under the following circumstances:
The committee rejected an amendment requiring companies to provide a breakdown of employee policies to the IRS. The proposal is expected to be submitted to the Senate for a full vote in the near term.
The American Bankers' Association has indicated its support of the proposal so long as existing policies are grandfathered.9 The insurance industry generally supported the proposal, but objected to the provision that requires employee approval of the amount of coverage.10
BOLI, According to the Regulators
In addition to considering the information in consultants' and brokers' sales pitches and potential legislative activity, bank management needs to consider regulatory guidance on BOLI risks, risk management, and accounting before making any decisions regarding BOLI purchases.
OCC Guidance.11 In 2000, the OCC published formal guidance related to bank purchases of life insurance in Bulletin 2000-23, Bank Purchases of Life Insurance - Guidelines for National Banks.12 In this bulletin, OCC staff noted that insurance purchases are not traditional banking activities, although they are viewed as incidental to banking. Staff noted that BOLI is a complicated, often risky product and should not be used solely for earnings management. They emphasized that bank management must ensure that the BOLI product structure does not pose a significant risk to the FDIC insurance fund and that the bank continues to comply with capital standards.
The OCC identified six risks inherent in the BOLI cash surrender value, including credit, transaction, interest rate, liquidity, compliance, and price. In mitigating these risks, bank management should ensure that BOLI activities are consistent with safe and sound banking practices and that senior management and the board provide effective oversight. Bank management should conduct a pre-purchase analysis of any insurance product to ensure that the bank understands the risks, rewards, and unique product characteristics. As described in more detail in Bulletin 2000-23, at a minimum, the pre-purchase analysis should include:
Joint Interagency Accounting Guidance. On February 11, 2004, the Board of Governors of the Federal Reserve Systemalong with the Office of Thrift Supervision, the Comptroller of the Currency, and the Federal Deposit Insurance Corporationissued Interagency Advisory on Accounting for Deferred Compensation Agreements and Bank-Owned Life Insurance.13 The BOLI-specific guidance states that only the amount that could be realized under the BOLI insurance contract as of the balance sheet date should be reported as an asset. Because there is no right of offset, a BOLI investment should be reported separately from any deferred compensation liability. The Interagency Advisory provides additional details and examples on reporting of the deferred compensation liability related to the other aspects of individual deferred compensation arrangements.
When purchasing BOLI, the bank usually pays a single premium, which may be as much as several million dollars to over a billion dollars for large banks, depending on the nature of the policy. For reporting on the Call Report, the purchase of BOLI results in an increase in "other assets," called "Cash Surrender Value of Life Insurance" or "CSV." Over time, the CSV is adjusted to reflect performance of the underlying investment(s). Regardless of this accounting treatment, it is important to remember that BOLI is not a fund investment, but rather is an obligation of an insurer.
Federal Reserve Considerations. The Federal Reserve System has not publicly published specific examination guidance related to BOLI, believing that its guidance related to investments, other assets, insurance, and risk management is broadly applicable in this area. In addition to the general safety and soundness guidance in those areas, Federal Reserve examination staff expect that financial institutions considering the purchase of or already owning BOLI understand the implications of current and potential changes to tax laws, state insurable interest laws, other state or federal legal and regulatory requirements, and early liquidation penalties. In addition, financial institutions should consider the appropriateness of an executive's total salary and compensation package, including compensation and benefits accruing from or funded by life insurance products and arrangements.
Risk Based Capital Considerations. Because of the risks inherent in BOLI, the Federal Reserve currently requires a 100 percent risk weighting for both general account and separate account BOLI for risk-based capital purposes. This requirement applies to both state member bank and bank holding company BOLI investments.
SR 95-51 Risk Considerations. Below is a summary of the risks arising from the purchase of BOLI in terms of the risk categories employed by the Federal Reserve System's supervision staff for evaluating state member banks and bank holding companies.
Credit Risk. The performance of any life insurance contract depends on the financial ability and paying capacity of the insurance company that underwrites the contracts. Consequently, banks should only deal with insurance companies highly rated by the rating agencies such as A.M. Best, Moody's, and Standard & Poors. The bank should observe the usual credit management techniques of portfolio diversification and financial monitoring of the insurance company, and should have policies that provide guidelines for limiting BOLI concentrations and exposure to a single insurance company.
Liquidity Risk. Since the objectives of BOLI involve long-term funding for deferred benefit programs, and because of the tax consequences and surrender charges, CSV should not be viewed as a liquid asset. The tax consequences of withdrawing the CSV from a BOLI policy discourage conversions of these assets. Taxes are due on the entire CSV buildup within the policy and, in some instances, early withdrawal penalties may be assessed.
Market Risk. When the investments are held in the insurance company's "general accounts," interest rate risk is inherent in the policy's "credited interest rate," which is based, in turn, upon the insurance company's own investment results. If the underlying investments are held in a "separate account," interest rate risk is directly related to the performance of the specific investments held in the separate accounts. In either instance, the CSV buildup can be based on either fixed or floating rate returns, and the CSV can fluctuate depending upon the returns from the underlying investments supporting the policies.
Operational and Legal Risks. Transactions must be executed properly regarding conversions or claims being made on the policies to ensure timely receipt of benefits. In addition, contractual language should be clearly understood to ensure that the policies provide the expected benefits. Management must remember that BOLI's appeal and financial advantage could be adversely affected by changes in the tax or other laws and be prepared to take appropriate action, if necessary.
Risk Management Considerations. Bank management should exercise sound risk management practices when deciding to purchase BOLI, as it would with any investment product. At a minimum, the bank should have board-approved written policies that address:
BOLI can be an attractive product when used as part of a nonqualified deferred compensation and benefits program. It provides incentives to company executives, compensation to a company in the event of an executive's death, tax advantages not generally available in a nonqualified retirement and benefit plan, and an attractive after-tax yield to the bank. The purchase of BOLI or any other insurance product should match the objectives of bank management, director-approved risk guidelines, and the bank's risk profile. Bank management should remain cognizant of the fact that insurance is primarily the transfer of the financial effect of losses and should be considered as a part of the broader risk management process. It is imperative that management understands the risks and rewards of its investment decisions and appropriately identifies and quantifies all risks. Remember the adage, "If it looks too good to be true, it probably is."
If you have any questions on BOLI, please contact your primary banking regulator. If you are regulated by the Federal Reserve Bank of Philadelphia, please contact your institution's central point of contact or assigned manager at the Reserve Bank. Questions on this article can be addressed to Anne Maxwell at 215 574-6495.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.