Increasing economic yields with bank owned life insurance
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.
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.
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.