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