Banks and insurance companies, both heavy investors in interest-sensitive products, have struggled to adapt their business models to this rising and high interest rate environment. It’s impacting their deposits, loans and securities portfolio. How does it affect their bank-owned life insurance assets?
BOLI is an asset that accrues value over its life, from the purchase price to an eventual maturity amount paid at the death of the insured. The rate of accrual changes yearly due to two primary factors: interest earnings and insurance charges. The maturity value never changes unless it’s increased to meet federal statutes on the definition of life insurance.
While the BOLI asset accrues, the bank recognizes noninterest income on a tax-preference basis, with a final noninterest income amount attributed to the payment of maturity value at death. BOLI is always carried at book value, and rising interest earnings in BOLI can improve bank noninterest income. Additionally, increased interest earnings can improve the long-term internal rate of return of the BOLI if they cause an increase in the maturity value.
Determining BOLI Interest Earnings
Generally, insurance carriers follow one of two methodologies for valuing their investment portfolios supporting BOLI contracts:
Book yield is commonly followed for general account and hybrid separate account products. Its yield is a consistent measure of the aggregate investment portfolio yield of insurance carriers and translates well to the interest earnings for general and hybrid account products.
Total return is associated with the stable value accounting methodology for separate account products. It’s a measure of the performance of the investment accounts underlying separate account products. The bank is exposed to potential interest earnings and asset value volatility, both investment risks associated with the investment accounts.
Two Ways to Declare Interest Earnings
Insurance carriers follow one of two approaches for declaring the interest earnings for BOLI: portfolio method or new money method.
The portfolio method is most commonly applied for BOLI contracts; the carrier determines an aggregate portfolio book yield for declaring interest earnings for all policyowners, regardless of the date of purchase. Carriers will often say their portfolios turn over, on average, 10% per year. This is due to maturities, selling decisions and net positive cash flow for new investment purchases. As the reinvestments occur, the overall portfolio book yield is influenced by the direction of the change in book yields of the new purchases compared to the aggregate portfolio book yield. If the new purchase book yield is below the aggregate book yield, the aggregate will fall. If the new purchase book yield is above the aggregate, the aggregate will rise.
The new money method is an approach where the initial interest earnings of the BOLI purchase are based on the book yield of new investments. Each BOLI purchase can have its own series of interest earnings, as the new money is integrated into the aggregate portfolio over time.
The future interest earnings blends the new money integrated into the aggregate portfolio over a period of years, consistent with the investment portfolio turnover rate. With new money products, every purchase group has its own series of interest earnings rates due to the starting point and the blending rate.
If new money rates are below portfolio rates, the projected cash value performance of new money products isn’t likely to meet the levels of portfolio products for many years into the future. This results from the fact that most insurance companies invest similarly, which translates to similar aggregate investment returns on their portfolios and creates an upper threshold on ultimate interest earnings.
The benefit of rising interest rates is an improvement in the accrued noninterest income, and perhaps the ultimate maturity value, of the BOLI asset for banks.
Insurance Products: 1) are not a deposit or other obligation of or guaranteed by, any bank or bank affiliate; 2) are not insured by the FDIC or any other federal government agency, or by any bank or bank affiliate; and 3) may be subject to investment risk, including possible loss of value. All guarantees are subject to the claims-paying ability of the issuing insurance company. Insurance services provided through NFP Executive Benefits, LLC (NFP EB), a subsidiary of NFP Corp. (NFP). Doing business in California as NFP Executive Benefits & Insurance Agency, LLC. (License #OH86767). Securities may be offered through Kestra Investment Services, LLC, member FINRA/SIPC. Kestra Investment Services, LLC is not affiliated with NFP or NFP EB.