Bankers Quarterly
BOLI In The Community Bank
By Gary M. Cowles,
CLU ChFC
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A banker recently described BOLI (Bank Owned Life Insurance) as "a
perpetual municipal with a yield that resets to the market". The benefit
of BOLI is simple; it generates an increase of 200 to 250 basis points in
after-tax investment yield depending on tax rates. While increased yield is the
result, investment cannot be the sole purpose for the transaction. The OCC
mandates that the purpose be incidental to the business of banking, one such
purpose is the financing of employee benefit expenses. Qualifying benefit
expenses may be existing programs such as health or pension plans or they may be
new benefit programs like nonqualified supplemental executive or director
benefit plans.
The BOLI strategy involves a reallocation of bank assets. Assume a bank has
an average capital earnings rate of 5.0%. If the bank has a 40% marginal tax
rate this translates to a rate of 3.0% on a net after-tax basis. If the bank
were to reposition $1,000,000 worth of its capital to a single premium BOLI
contract, the following results. The BOLI contract has a cash value of
$1,000,000 upon issue and at the end of the first plan year the policy has a
cash value of $1,050,000. The bank has earned a 5.0% annual rate of return on
its investment and books a net gain of $50,000; the BOLI gain is non-taxable.
This compares to a gain of $30,000 that the bank would have recognized had the
assets remained in traditional taxable investments. It is this $20,000 of
tax-leveraged gain generated by BOLI that finances or offsets the cost of new
or existing benefit plans.
For years large banking institutions have recognized the benefits of BOLI,
buying large amounts for the purpose of enhancing their income statement
through increased after-tax yields. Only recently however have competitive
products been available to the smaller community bank. This has created
significant interest amongst community bankers, many have implemented or are
considering BOLI financing for new or existing benefit plans.
Regulatory compliance is a foremost concern of most community banks when
considering a BOLI purchase. The OCC, OTS and FDIC have all issued guidance
related to bank purchases of life insurance. The OCC has issued technical
bulletins 96-51 and subsequently 2000-23 that provides the most comprehensive
guidelines for banks to ensure that purchases of life insurance are consistent
with safe and sound banking practices. The main focus of the technical
bulletins is what is called a prepurchase analysis. It includes required
consideration of need and amount of insurance, vendor and carrier selection,
benefits and risks associated with the purchase, alternative evaluations and
documentation of the decision process. Some of the more noteworthy issues
addressed by OCC 2000-23 include determination of incidental purpose, limits on
purchase amounts, liquidity and accounting for the insurance.
As previously mentioned, the purchase of BOLI cannot be solely for
investment purposes. It must be incidental to the purpose of banking.
Regulatory guidelines specifically identify several safe harbors for life
insurance purchases including key-person insurance, life insurance on
borrowers, life insurance purchased to finance new or existing employee
compensation or benefit plans and life insurance purchased as security for
loans. The purpose for single premium BOLI is typically the financing of new or
existing employee compensation or benefit plans. Such plans include qualified
pension plans and postretirement medical benefits. Or, as is very commonplace
in community banks, nonqualified supplemental executive or director benefit
plans.
Supplemental plans are used to restore or supplement the retirement and/or
welfare benefits of a select group of employees. The financing of a
supplemental plan is a key to successful implementation. Supplemental plans are
nonqualified, this means that they do not receive the beneficial tax treatment
of a qualified plan. Therefore, the appropriate financing vehicle is essential
for minimizing the expense incurred when a plan is adopted. BOLI provides a
unique combination of benefits and tax advantages that make it an attractive,
cost reducing vehicle for supplemental plan funding.
Regulatory guidelines identify two common methods for utilizing life
insurance as a financing vehicle for benefit expenses, the cost recovery method
and the cost offset method. The single premium BOLI method typically falls
under the cost offset approach, "With this method, the bank projects the
annual employee benefit expense associated with the benefit plan, then
purchases life insurance on the lives of certain employees. The amount of
insurance purchased is enough so that the income earned on the CSV offsets the
benefit expense. The collection of death benefits may further enhance the
company's return." Typically, it is the gain in cash value in excess of
opportunity cost that determines the amount of the purchase.
Regulatory direction on purchase limits is relatively straightforward, no
more than 25% of capital and 15% or less with any one carrier. Guidelines also
direct banks to consider legal lending limits (12 CFR Part 32) and
concentration of credit guidelines (OCC Bulletin 95-7,
A banks liquidity also needs to be looked at when considering a BOLI
purchase. BOLI policies are typically classified as Modified Endowment
Contracts (MEC) and as a result are designed to be held until the death of the
insured. A MEC is a policy that is subject to regular income taxation of
withdrawals, loans or surrenders to the extent of income in the policy and a
10% penalty tax prior to the taxpayer attaining age 59 1/2. Because BOLI is
owned by a corporation, the attainment of age 59 1/2 will never occur,
subjecting the policy to the 10% penalty tax indefinitely. However, tax
treatment of a MEC does not differ from a non-MEC when the policy is held until
death of the insured. All proceeds are received tax-free. There are very few
circumstances under which a bank would be forced to surrender a properly
designed plan. The purchase of a MEC is therefore not a concern for most banks.
Accounting for BOLI is done in accordance with FASB Technical Bulletin 85-4.
Cash Surrender Value (CSV) is recorded as an "other asset". The
increase in CSV over time is booked as "other non-interest income".
If it is the intention of the bank to hold the BOLI until the death of the
insured, then the increases in CSV should be recorded as tax-free income. CSV
should be updated at least quarterly to remain within call report requirements.
As evidenced by some of the complexities just described, vendor selection is
also critically important to the success of a BOLI funded plan. Implementation
of a plan requires knowledge and expertise that only a specialist organization
would have. While regulators do not require banks to engage a specialist when implementing
a BOLI plan, most choose to do so.
So, with all that said, does BOLI sound to good to be true? This may be the
case under certain circumstances. Washington insiders claim that there may be
future tax legislation that limits the benefit of BOLI for the money center
banks that are investing hundreds of millions even billions of dollars in BOLI.
IRS scrutiny as evidenced by several recent IDR's appears to be focused on the
issues of experience rated and separate account products that are typically
found only in the money center bank environment. Experience rating allows the
insurance company to share unfavorable mortality experience costs with its
policyholders. Separate Account products allow the policyholder to retain a
degree of control over the underlying investments of the insurance policy.
Fortunately most community banks should not be affected by any of these
potential changes. It is expected that any proposed legislation will include
grandfathering of existing plans and a safe harbor for products that are
general account and clearly transfer mortality risk to the insurance company.
The bottom line; under the right circumstances BOLI is not only appropriate
but essential for allowing community banks to cost effectively implement
benefit plans that serve the vital purpose of attracting, retaining and
rewarding the most valued resource a bank has, its employees.
Gary M. Cowles, CLU ChFC Is a Senior Vice President with MKA Capital
Planning , a nationally recognized independent consulting firm that specializes
in designing, implementing, financing and administering nonqualified
supplemental benefit programs.
For more information regarding nonqualified supplemental benefit planning or
BOLI financing, contact Gary M. Cowles, CLU ChFC, Senior Vice President, MKA,
Reprinted with the authorization of Gary M. Cowles, CLU ChFC and MKA