Increasing economic yields with bank owned life insuranceArticle added by Neil Jesani on January 30, 2013

Neil Jesani

Piscataway, NJ

Joined: January 25, 2013

When it comes to investment options, the economic benefits and taxes advantages of BOLI are obvious.

​Banks and credit institutions have to carefully consider the risk and return trade-offs when allocating capital for assets. The tax advantages of bank owned life insurance (BOLI) make it a great option for allocating assets into a bank’s balance sheet. The BOLI market has seen various innovations and today, asset classes such as hedge funds and secured/senior loan funds are offered within.

When it comes to investment options, the economic benefits and taxes advantages of BOLI are obvious. This is why more than 80 percent of the top 100 largest banks in the U.S. have BOLI. Over the past few years, the insurance has offered yields that are more than 200 basis points (bps) when compared to tax returns. This explains why banks and financial institutions are increasingly adopting the financial product.

The basics of BOLI

Under state insurance law, banks have an “insurance interest” in their top level executives because they would suffer opportunity or actual costs should the employees die. BOLI is a life insurance product purchased by banks on the lives of their top management employees. The insured employees have to consent to the insurance, after which the bank takes over management of the plan.

The cash values of BOLI accumulate tax-free at the net crediting rate. Most banks use BOLI for financing or cushioning losses for pre- and post-retirement benefits of its executives. The main concept of bank owned life insurance is financing of benefits. However, it is not necessary to add benefits along with the purchase of BOLI. From an investment point of view, there are three types of BOLI:
  • General account — The investments that support this type of account include real estate loans and other assets under the management of the insurance company.
  • Separate account — The investments that support this type of account are usually bank-eligible bond funds. The investments are designed and managed by expert fund managers and do not need to be bank-eligible.
  • Hybrid account — The investments here are bank-eligible investment pools that are designed and managed by the insurance company.
The amount of disclosure or transparency of the three accounts varies. With a general account BOLI, the yield of the insurance company’s portfolios and the net yield by the bank are indirectly related. The only exception is with indexed accounts. Insurance carriers (excluding indexed accounts again) can pay any rate that they deem is appropriate. There are only two instances that can affect the market rate paid on a general account BOLI. These are the desire to remain competitively priced and market pressures. With separate and hybrid-account BOLI, the costs for the investments are disclosed in the appropriate contracts and documents. This greater transparency reflects a macro trend in the financial marketplace in the wake of ever-increasing disclosure.
The hallmarks of BOLI

With life insurance, the cost of a plan increases as the policyholder ages. However, this is not necessarily the case with bank owned life insurance. When determining a long-term internal rate of return for BOLI, higher insurance costs may be cushioned with the insurance benefits payable when the executive dies.

One important feature of BOLI is that the bank can surrender its policy for cash at any time. This move can have tax consequences when the policy has not matured. However, the benefit is that it is the book value rather than the market value of the investments made on the insurance that is considered. Therefore, banks can avoid market issues where investments are valuated based on the prevailing market prices. In an economic value of interest rate sensitivity analysis, the bank will be left with a stable book value across actual and simulated interest-rate environments, regardless of the volatility the underlying investments are facing.

BOLI makes economic sense in two ways:
    a) It offers attractive yields compared to tax returns. The returns are typically higher than the return from other investments. In fact, the BOLI returns rank among the highest business line risk adjusted return on capital.

    b) BOLI allows banks to transfer the market risk or price to others. As a result, there is no consequence for accounting purposes and a stable economic value for asset/liability management purposes.
BOLI has evolved to provide many alternative asset investment options, from simple money-market funds to complex investment types. As the complexity of BOLI investments increases, so do the analytic approaches. A few years back, bank owned life insurance was analyzed on a yield basis. However, today most BOLI investments, especially separate-account BOLI, are evaluated with total-return metrics.

As the BOLI marketplace is still relatively small, many bond funds follow a consistent approach in presenting their risk and total-return metrics. The approach used in the BOLI market is consistent across other investment classes including hedge funds, equity and bond.
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