Finding Opportunities in a Rising Interest Rate Environment

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Over the course of a year or so, the Federal Reserve has raised short-term interest rates more than 475 basis points.

Bankers with a portion of their balance sheet assets invested in fixed income securities are all too aware of the “Finance 101” lesson of the inverse relationship between interest rates and the market value of fixed income securities. While the recent Fed actions certainly have negative implications for parts of the bank’s balance sheet, they also have some positive ones.

For instance, banks with available liquidity have some great buying opportunities currently in the market. In addition to obviously investing in government securities with durations on the short end of the yield curve, the cash value yields on certain types of bank owned life insurance, or BOLI, are currently the highest they have been in at least 15 years.

Regulators allow banks to use BOLI to offset the cost of providing new or existing employee benefits. Part of the way BOLI offsets these employee benefit costs is by providing compelling cash value rates of return, which are generally provided by life insurance carriers that carry high credit quality. Another benefit of BOLI is that most types have cash values vests on a daily basis — the cash value doesn’t reduce in a rising interest rate environment. This eliminates the mark-to-market risk associated with other assets on the bank’s balance sheet, such as fixed income securities or loans.

Other higher yielding, high credit quality opportunities are also currently available in the market. Many of the same high credit quality life insurance carriers that offer BOLI have begun offering, or are creating, a guaranteed investment certificate or GIC. GICs are sometimes referred to as a financial agreement or FA. The GIC works much like a certificate of deposit, where the purchaser deposits money with the offering entity — in this case, the life insurance carrier — and earns interest on the deposited money. Much like a CD, the money must be deposited for a fixed length of time and interest rates vary according to the duration. GICs are nothing new; insurance companies themselves have been investing in them for decades.

Another interesting development over the last few months is the ability for banks to invest in a collateralized loan obligation, or CLO. A CLO is a single security that is backed by a pool of debt. As a floating-rate security, it offers income protection in varying market conditions while also minimizing duration. Additionally, CLOs typically offer higher yields than similarly rated corporate bonds and other structured products. We have also seen CLO portfolios added as investment options of private placement variable universal life BOLI designs to provide a bank with additional benefits. This structure has the advantage of giving bank owners the ability to enhance the yield of assets that are designated as offsetting employee benefit expenses. The advantages of this type of structure are obvious in the current inflationary environment.

So while the actions of the Fed have certainly added challenges to the typical banks’ balance sheet, for those institutions who are well positioned, it has also created numerous opportunities.

The Significance of Size, Scale and Structure in BOLI

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A bank is only as strong as its people, its client base and its assets. If your bank owns bank-owned life insurance (BOLI) among its assets, it’s important to know that your BOLI is only as strong as your BOLI insurance provider.

Bank executives familiar with the broad contours of BOLI may not be aware of other important considerations relative to their policies — considerations that may be unique to the product or the insurance carrier. Understanding these nuances can provide valuable insights into the resiliency, financial stability, and performance of your BOLI policy.

BOLI can be one of the most attractive assets on a bank’s balance sheet; in a low-rate environment with market volatility, it’s a good idea to consider including BOLI as part of a well thought-out asset strategy.

Two popular approaches for determining the crediting rates applicable to general account BOLI products are the “portfolio rate” and the “new money rate” methods. The new money rate method features crediting rates based on currently available securities, whereas portfolio-rate general account BOLI policies feature crediting rates based on the performance of an underlying seasoned portfolio. Crediting rates derived from well-diversified, low-turnover portfolios can serve as a form of hedge against volatile and lower market interest rates, while a new money rate product can benefit during a period of persistent and material increased market interest rates.

Each BOLI policy’s minimum guaranteed rate is backed by the credit quality, size and diversification of the issuing insurer’s investment portfolio. A portfolio’s resilience and financial strength are derived from the interplay between the core of investment-grade fixed income securities and holdings of potentially higher-yielding assets.

When it comes to BOLI, size and scale matter. Larger insurers are typically better equipped to purchase and provide exposure to a wider range of diversified assets, which contribute to the portfolio’s yield and BOLI crediting rates that banks value. Smaller carriers may not necessarily have access to the wide range of investment asset classes and market opportunities relative to larger carriers like MassMutual.

Beyond comparisons of the carriers’ investment portfolios and crediting rate approaches, there can be important differences when it comes to the insurers themselves. Because there is a limited universe of BOLI carriers, and their capabilities and strengths vary, each carrier brings unique types and levels of resources to bear. Each insurer offers banks different results based on its investment philosophy and expertise in managing the general investment account underlying its BOLI policies. Certain characteristics that differentiate insurers from each other include company structure, business mix, asset/liability management strategy, access to less widely available investment opportunities, and culture. The expertise, breadth and depth of experience of the insurer’s investment and business professionals should not be overlooked.

As a large mutual life insurer, MassMutual has a dedicated investments group that leverages our expertise in fixed income, equities and alternative assets, including real estate. The asset managers are insurance investors first and foremost, and they understand the business and the characteristics of the liabilities that the investments support.

The mutual structure enables insurers like MassMutual to take a long-term perspective. Decisions made with the next several decades in mind, not the next quarter, better align with the long-term nature of BOLI assets. This long-term view fuels our approach to maintaining financial strength and stability and drives our competitiveness.

Further, a carrier’s long-term market presence and commitment can be aided by diversification within its own subsidiaries, business lines and income streams. Just like in banking, having a diverse set of businesses can help reduce the economic sensitivity of an insurer. Diversified insurance carriers that offer a variety of solutions with varying characteristics are built to weather economic cycles and provide stability to a carrier. The combination of diverse income streams with a diversified pool of assets is a sound approach to help endure a wide variety of economic environments.

Banks have a variety of options when it comes to which BOLI insurer they select. Understanding each carrier’s structure, business mix, investment philosophy and market approach can inform executives’ choices as they embark on financial relationships that last decades.

Insurance products issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111-0001.

Keeping Benefits Simple During M&A

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Mergers and acquisitions are an attractive growth strategy for many banks, but deals are increasingly and needlessly complicated by existing employee benefit plans.

The United States entered the longest economic expansion in history during the third quarter of 2019, surpassing the 120-month run between March 1991 to March 2001. There have been parallels of economic events and potential perils between then and now: a strong housing market, corporate tax cuts, low interest rates, and a mergers and acquisitions environment that rivals the 1990s, resulting in a loss of more than 4% of the nation’s banks per annum on average. From March 1991 to today, the number of U.S. banks has decreased by over 60%. The industry is not only used to M&A but expects it.

But in recent years, we’ve seen a growing burden and complexity in navigating through bank M&A deals, in part due to existing nonqualified benefit plans and bank-owned life insurance, or BOLI, programs. Burdens include heightened regulations on allowable plan designs, evolving tax laws and stricter compliance and due diligence requirements.

Now more than ever, it has become increasingly likely that BOLI or nonqualified benefit plans will be involved in a transaction, and odds are that the acquired portfolio and plans were part of a previous deal.

About 64% of banks across the country owned BOLI at the end of 2018, according to data from S&P Global Market Intelligence, including 63% of banks under $2.5 billion in total assets, 82% of banks between $2.5 billion and $35 billion, and 64% of banks over $35 billion.

The BOLI market continues to expand as banks continue to consolidate, and new premium sales have averaged over $3.5 billion annually in the past five years. Additionally, approximately 65% of banks have a nonqualified benefit plan, split-dollar life insurance plan or both, based on records of Newcleus’ 750 clients.

Program sponsorship continues to expand, because BOLI and nonqualified benefits continue to be important programs for institutions. Implementing nonqualified benefit plans can serve as a valuable resource for banks looking to attract and retain key talent. Both selling and acquiring institutions need to understand the mechanics of benefit and BOLI programs in order to avoid inaccurate plan administration and mismanagement following a combination. This includes:

Non-Qualified Benefit Plans

  • Reviewing the plan agreement: Complete a thorough analysis of the established plan agreements. Understand all triggering events for benefits, available options to exit the plan and the agreement’s change-in-control language.
  • Accounting implications: The bank, in partnership with their plan administrator, should properly vet the mechanics and assumptions used in existing plan accounting. For example, change-in-control benefits could specify a discount rate that must be used for benefit payments, which may differ from rates used on existing accounting reports. They should also ensure that all plan benefits deemed de minimis have been accounted for, such as small split-dollar plans.
  • 280G: Complete a 280G analysis to understand the possible implications of excess parachute payments, including limitations (i.e. net best benefit provisions) caused by existing employee agreements and related non-compete provisions.

BOLI Programs

  • Insurance carrier due diligence: Bankers should complete a thorough review to ensure that acquired BOLI meets the holding requirement that is outlined by the bank’s existing BOLI investment policy, if applicable.
  • Active/inactive BOLI population: As the insured and surviving owner relationship becomes more separated, it is paramount that executives maintain detailed census information, including Social Security numbers, for mortality and insurable interest purposes.
  • Policy ownership: Many banks have implemented trusts to act as the owner of certain BOLI policies. While this setup is permissible, changes in control can impact a trust’s revocability. Institutions should review this information prior to closing, given that there may be limited options to directly manage those policies post-deal close.

These programs are not in the executives’ everyday purview, nor should they be. That’s why it’s so important for institutions to establish partnerships that help guide them through the analysis, documentation and due diligence process for BOLI and nonqualified benefit plans.

Banks may want to consider working with external advisors to conduct a thorough review of existing programs and examine all plan details. They may also want to consider administrative systems, like Newcleus MINTS, that streamline reporting and compliance requirements. Taking these steps can help reduce unnecessary headaches, and create a solid foundation for future BOLI purchases and new nonqualified benefit plans.

What To Know About BOLI Today

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Bank-owned life insurance is a common tool that helps financial institutions offset the costs of employee benefits, and boards should review the BOLI program every year. Steve Marlow and Kelly Earls of Bank Compensation Consulting explain what boards should know about BOLI, including the impact of tax reform.

  • Why Banks Purchase BOLI
  • Evaluating Existing Programs
  • Impact of Bank Size on BOLI Options
  • How Tax Reform Will Affect BOLI