Smart Strategies For Investing In Bank-Owned Life Insurance

Bank-owned life insurance (BOLI) is a product where the bank is the beneficiary and usually the owner of the policy. Banks use BOLI as a tax shelter and to fund employee benefits. Banks typically purchase BOLI policies for top executives or directors, and the policy is bought on an executive's life. The bank then makes payments into a specialised fund set aside as an insurance trust, and all benefits are paid out from this fund. BOLI is a long-term, illiquid asset, and while it can be surrendered at any time, the gains are taxable and incur a 10% penalty.

The benefits of bank-owned life insurance

Bank-owned life insurance (BOLI) is a financial product that has become increasingly popular among banks as an investment tool and a means of securing key employee benefits. Here are the benefits of BOLI:

Tax-Advantaged Investment

The cash value growth of BOLI policies is not subject to annual taxation, allowing banks to accumulate funds faster than with traditional taxable investments. The tax-adjusted cash value growth within a BOLI policy often produces a higher return than alternative investments.

Source of Non-Interest Income

BOLI provides a source of non-interest income for banks. As long as the policy remains in force, it generates a steady stream of income, contributing to the bank's bottom line. The cash surrender values grow tax-deferred, providing the bank with monthly bookable income.

Employee Benefits

BOLI enables banks to offer valuable benefits to their key employees, such as executive bonuses, supplemental retirement income, or funding for employee benefit plans. BOLI can also act as a risk management tool, as the death benefit received can help cover the costs of finding and training a replacement for a key employee.

Cash Value Growth

The cash value of BOLI policies grows over time, creating a valuable asset for banks that can be accessed when needed, providing additional liquidity.

Retaining Bank Leaders

BOLI can be used as a tool to attract and retain key employees and executives. By offering competitive benefits packages, banks can ensure they retain their top talent.

Diversification of Investment Portfolio

BOLI provides banks with an alternative asset class that is not directly tied to market fluctuations, thus diversifying their investment portfolio.

While BOLI offers numerous benefits, it is important to note that there are also risks and considerations, such as regulatory compliance, interest rate sensitivity, and the potential for costly surrender charges. Banks must carefully evaluate their specific circumstances and long-term goals before deciding to invest in BOLI.

How bank-owned life insurance works

Bank-owned life insurance (BOLI) is a product where the bank is the policy beneficiary and usually the owner. It is a permanent life insurance policy that banks purchase for high-earners, board members, or other key employees whose death could cause a financial loss for the bank. The bank pays for the policy and receives the benefits after the insured individual's death.

BOLI is used as a tax shelter for financial institutions, leveraging its tax-free savings provisions to fund employee benefits. The cash surrender values grow tax-deferred, providing the bank with monthly bookable income. Upon the insured's death, the bank receives tax-free death benefits.

There are three types of BOLI accounts: General, Separate, and Hybrid. The General Account is the oldest and most common type, where the bank's investment deposit becomes part of the insurance carrier's general account, typically invested in bonds and real estate. The Separate Account allows the insurance provider to segregate the holdings into investments managed by fund managers, providing detailed reporting of the bank's portfolio. The Hybrid Account combines the benefits of both General and Separate Accounts, offering a guaranteed credit rating and detailed information about investment holdings.

In a typical scenario, the bank sets up a BOLI contract and makes payments into a specialized fund, the insurance trust. All employee benefits covered under the plan are paid out from this fund. Banks use BOLI to fund employee benefits at a lower cost, as all premiums and capital appreciation are tax-free. BOLI can also help banks retain key employees by offering additional retirement plans as part of their compensation packages.

While BOLI offers tax advantages and long-term income generation, there are also downsides to consider. BOLI is considered an illiquid asset, and if a bank surrenders the policy, they will be required to pay taxes on the gains. Additionally, the credit quality of the BOLI issuer is a significant concern, as a poor credit rating can expose the bank to risk.

Pros and cons of bank-owned life insurance

Bank-owned life insurance (BOLI) is a product where the bank is the beneficiary and owner of the policy. It is used as a tax shelter for financial institutions, leveraging its tax-free savings provisions as funding mechanisms for employee benefits.

Pros of BOLI:

• Tax-efficient: Cash values grow tax-deferred and death benefits are tax-free, providing a significant advantage over other bank investments.
• Source of Non-Interest Income: BOLI generates a steady stream of income, contributing to the bank's bottom line.
• Employee Benefits: BOLI enables banks to offer valuable benefits to key employees, such as executive bonuses, supplemental retirement income, or funding employee benefit plans. It also helps offset the financial impact of losing a key employee.
• Diversification: BOLI offers an alternative asset class, diversifying the bank's investment portfolio and providing additional liquidity.
• Cash Value Growth: The cash value of BOLI policies grows over time, creating a valuable asset for banks.

Cons of BOLI:

• Regulatory Risks: BOLI is subject to regulatory requirements, adding complexity to bank operations.
• Interest Rate Sensitivity: BOLI returns are sensitive to interest rates, and a prolonged period of low interest rates may lead to lower cash value growth.
• Costly Surrender Charges: Surrendering the policy prematurely can result in significant charges, eroding the cash value.
• Alternative Investment Opportunities: Allocating too much to BOLI may cause banks to miss out on other potentially more lucrative investments.
• Policyholder Risks: If the insured employee lives longer than expected, the bank may need to pay premiums for an extended period, impacting overall returns.
• Credit Quality of Carrier: The credit quality of a BOLI carrier is essential. If a bank purchases a policy from a company with a poor credit rating, it exposes itself to risk.
• Capital Commitment: The premiums can be a sizable capital commitment, which may be a challenge for some banks.
• Illiquid Asset: BOLI is considered an illiquid asset, and if surrendered, the gains within the policy become taxable with a potential penalty on any gains.

Types of BOLI accounts

Bank-owned life insurance (BOLI) is a strategic financial tool used by banks to fund employee benefits while enjoying tax advantages. There are three primary types of BOLI accounts available to banks and corporations: General Account, Separate Account, and Hybrid Account.

General Account BOLI

The General Account is the oldest and most common type of BOLI product. Banks typically invest their BOLI funds in conservative assets such as bonds and real estate. The insurance carrier of this type of BOLI generally maintains a credit rating, which can change over time. Banks receive a broad overview of the investments within the general account, but detailed insights into individual investments are limited. There is no guaranteed minimum credit rating, relying instead on the carrier's overall financial stability. One notable downside of the General Account BOLI is the lack of protection against creditors, which means that these BOLI assets may be at risk in case of financial difficulties or bankruptcy.

Separate Account BOLI

The Separate Account BOLI offers a more detailed and transparent approach to investment. In this setup, the insurance provider separates the general account holdings into investments managed by dedicated fund managers. These managers provide the bank with specific details about the portfolio's composition and performance. Credit ratings of these individual accounts often rely on a yield-to-worst ratio, and there is no guaranteed minimum credit rating. A significant advantage of Separate Account BOLI is the enhanced protection it offers against creditors, providing a shield for the bank that holds these policies.

Hybrid Account BOLI

The Hybrid Account BOLI combines elements of both General and Separate Account types, offering a middle ground. Banks and corporations receive a guaranteed credit rating for their investments, similar to Separate Account BOLI. Additionally, they gain access to detailed information about the holdings, akin to what separate accounts provide. This type of BOLI seeks to balance the simplicity of the General Account with the transparency and creditor protection offered by the Separate Account.

Why banks purchase life insurance

Banks have been purchasing bank-owned life insurance (BOLI) since the 1980s. BOLI is a type of permanent life insurance policy that banks use to benefit from tax advantages and to fund employee benefits.

Why Banks Purchase BOLI

Tax Advantages

The primary benefit of BOLI for banks is the associated tax advantages. Income earned on the policies is tax-free for the bank, and when an insured employee dies, the cash payments the bank receives are also tax-free. This tax-free status allows banks to generate higher returns compared to their own products and other traditional bank investments.

Funding Employee Benefits

BOLI is also used to fund employee benefits, particularly for key employees whose deaths could cause financial loss for the bank. This includes highly compensated employees, board members, and executives. By purchasing BOLI, banks can offset the costs of employee benefits, such as healthcare, 401(k) programs, and vacation days.

Long-Term Growth and Stability

BOLI provides long-term growth and stability for banks. The cash value of BOLI policies grows over time, and this growth is tax-deferred until the policy is surrendered. This stable growth, combined with the tax advantages, makes BOLI an attractive tool for banks to offset existing or new benefit costs.

Protection Against Loss of Key Employees

BOLI also serves as protection for banks against the loss of key employees. In the event of an insured employee's death, the bank receives a substantial tax-free death benefit, protecting the bank's financial interests.

High Funding Limits

BOLI policies offer high funding limits, which are advantageous for banks when providing robust retirement plans for their key executives. These funding limits are more generous than those for traditional retirement plans like 401(k)s or IRAs.

Overall, BOLI offers banks a way to generate competitive returns, take advantage of tax benefits, and fund employee benefits, particularly for key personnel.

Frequently asked questions