Bank-owned life insurance has been a popular way for banks to earn a tax-deferred or even tax-free return on their capital for many years. In fact, banks can invest up to 25% of their Tier 1 capital in BOLI.
Banks have struggled with low yields on bank-approved investments such as U.S. Treasuries since the Federal Reserve dropped rates to zero. BOLI has been welcome relief to that pressure: As of mid-October, the average highest credit quality general account BOLI yielded 2.37% and the highest yield on average was 2.69%, according to the Newcleus BOLI Index. The taxable equivalent yield, based on a 21% tax rate, is 3% to 3.41%.
Despite its popularity, there are still many misperceptions in the market about BOLI that we want to dispel. Let’s focus on general account BOLI, the most common form of BOLI.
1. “BOLI is janitor insurance. Is it even legal?”
The term “janitor insurance” refers to a time when it was common for companies to buy life insurance for their employees without their knowledge or consent. That’s not legal anymore. With the passage of the Pension Protection Act of 2006, firms need to obtain consent from the employees covered by policies where the company pays the premium. In addition, only the top 35% highest paid employees can be considered for coverage.
For example, a regional bank may send out a notice asking for consent and a signature from 200 of the highest-paid employees in the bank, and 150 of them with sign it. Those 150 employees will be covered by BOLI.
2. “I don’t want my bank to profit off the death of employees.”
Many banks, especially community banks, choose to share a portion of the life insurance benefit with the deceased employee’s estate. In essence, the bank pays the premium, not the employee, and earns tax-deferred interest on the BOLI asset along with a death benefit that it can share with the employee. This can be structured in different ways. The bank may decide to offer a life insurance benefit only to the CEO, the members of the executive team, or the 20 top highest paid employees, for example.
3. “We don’t need to add a life insurance benefit.”
The point of BOLI is not life insurance coverage (yes, we know it’s called bank-owned life insurance). It’s not a regular term-life policy, where you write a premium check every month and receive a benefit when someone dies.
BOLI is an asset class. BOLI stays on the balance sheet and is accretive from Day 1. The day after a bank wires the premium, it is paid interest on the principal. The earned interest is tax-deferred until the death of the employee. If the employee dies, the earnings are tax free. But there are regulatory restrictions on the use of BOLI. For example, the Office of the Comptroller of the Currency requires banks to use the earnings to offset the cost of bank compensation and benefit programs.
4. “BOLI is an illiquid asset.”
This is a common misperception of BOLI. Typically, on a term-life policy, there’s no asset you can sell. That’s not true for BOLI. Like other investment products, banks can sell, or surrender the policy, at any time. In a time of widespread declines in asset values, a bank might find that the value of its asset, similar to a bond portfolio, has fallen. But the insurance company will return 100% of the cash surrender value. There are no fees to sell the asset. If a bank surrenders the policy before the death of the covered employee, the bank may owe unpaid taxes on any earnings received.
5. “Now is a bad time to buy BOLI.”
Given that many predict interest rates to go up in the next few years, banks may assume it’s a bad time to buy BOLI. Why lock in capital at a low interest rate when rates are going to go up? Although BOLI is a fixed-rate asset, it reprices at market rates. Typically, a BOLI portfolio has a duration of 5 to 7 years. Each year, 20% of the portfolio will turn over. By the fifth year, 100% of it has repriced.
We hope to have dispelled some of the common misperceptions about BOLI. If you haven’t maxed out the amount of BOLI you can put on your balance sheet, it might be time to take another look.