The Elements of a Compensation Plan: What a Board Needs to Know

5-25-15-BCC.pngReviewing compensation within an organization is an integral part of the board’s duties, but it can be challenging to get right. There are a number of reasons for this.

Compensation committees need to determine the bank’s philosophy regarding compensation. Will it be a zero-sum equation where paying more compensation creates fewer dollars for management and/or the shareholders, or an abundance mentality where paying for performance generates shareholder value? Having tension between the two is healthy for setting compensation practices correctly while maintaining balance.

One facet that overlays any compensation structure is regulatory constraints. Over the last decade, there have been three major regulatory pronouncements affecting how banks can structure compensation.

The first is the adoption of the Internal Revenue Code Section 409A, which prohibits the acceleration of payment of deferred compensation.

The second major regulation originates from the Dodd-Frank Act. Essentially, mortgage compensation incentives can only be paid based upon: (i) the dollar volume of the mortgage loans made; or, (ii) the transaction volume generated by the mortgage lender. However, the incentives can vary as to how much is paid to each lender on either method.

The third regulation adopted is the Interagency Guidance on Sound Incentive Compensation Policies effective June 25, 2010. In the guidance, policy steps are set forth that require incentive compensation to be structured to balance the risk to the institution of such incentives, and the guidance dictates that boards are responsible for reviewing this.

In what form will your bank deliver compensation? The following are some major ways that banks pay their executives.

Non-statutory stock options
Non-statutory options (NSOs) can be granted to just about anyone. It is not unusual for a participant to fail to realize that not only must they have sufficient funds to purchase the stock, but that there will be ordinary taxation on the gain in stock value from the exercise price for the shares compared to the fair market value of the shares at exercise. In addition, the participant will also owe Social Security and Medicare taxes on the gain.

Incentive stock options
Incentive Stock Options (ISOs) have the benefit of being taxed as capital gains upon the sale of the purchased shares for the gain over the exercise price. However, there can be one surprise in the way of alternative minimum tax (AMT).

Restricted stock
Restricted stock has become more popular as a delivered component of compensation since restrictions come with the grant of the shares. Unlike options, which do not have restrictions once the options become exercisable, restricted shares often carry a restriction as to when they can be sold. This avoids the potential of a quick sale that can occur with options, leading to volatility in the stock price and negative news when investors and others learn of executive sales of stock.

Deferred compensation
Many banks will use nonqualified deferred compensation to recruit, reward and retain key executives in various formats because plan design can be very flexible, structured as defined contribution or defined benefit plans. With closely-held organizations, the shareholders are not subjected to dilution of ownership with deferred compensation as it is accrues through the financial statements. Also, unlike the equity components previously mentioned, shareholder approval is not required. Programs of deferred compensation require board approval. There are various types of deferred compensation programs including, but not limited to, Supplemental Executive Retirement Plans (SERPs), deferred incentives, deferred grants, phantom stock, stock appreciation rights and elective deferrals.

While it might appear that deferred compensation is expensive because the entire value of any program generates expense to the bank, often bank-owned life insurance (BOLI) is utilized as an asset to offset or recover the cost incurred by the deferred compensation. This happens in two ways. First, the interest earned while the BOLI contracts are owned informally counterbalance the expense of a deferred compensation program. Second, if the participant meets an untimely death, the death benefit the bank receives in addition to the return on its investment is available to offset the additional expense to complete the accrual of the deferred compensation benefit, so that such benefit can be paid in full to the employee’s beneficiaries.

While the components of compensation are numerous, banks can use the various components for certain tiers of executives within the organization. Further, no single component discussed is superior to the other. Each has its advantages and disadvantages, and can be tailored to the bank’s needs.

Report on the Market: BOLI Assets Continue To Have Strong Growth

4-29-15-Equias.pngBank-owned life insurance (BOLI) experienced another year of steady growth, with $149.6 billion in total assets in 2014, a 4 percent increase from the year before, according to the latest research from the Equias Alliance/Michael White Bank-Owned Life Insurance (BOLI) Holdings Report. For banks with less than $10 billion in assets, the growth rate was a robust 7.1 percent.

Of the 6,509 banking institutions in the U.S. operating at the end of last year, 3,803 (58.4 percent) held BOLI assets. BOLI was popular among all types of banks, with more than 50 percent of banks of all charter types holding BOLI assets. Leading the way were savings banks with 76.0 percent of the 367 banks in this category owning BOLI and Federal Reserve-member banks with 67.4 percent of the 858 banks in the category owning BOLI.

One of the reasons that bank-owned life insurance (BOLI) continued to experience significant growth in 2014 is that existing policyholders often chose to make additional BOLI purchases. This is not uncommon and is a testament to the satisfaction that many BOLI clients have with both the short and long-term performance of their BOLI policies. BOLI remains popular with banks because:

  • It provides tax advantaged investment income not available with traditional bank investments, as well as attractive yields compared to alternative investments of a similar risk and duration.
  • The growth in the cash value of the BOLI policies generates income for the bank and its shareholders.
  • The bank receives the life insurance proceeds tax-free upon the death of an insured employee who elected to participate in the plan.
  • The bank may, at its discretion, enhance the benefits it provides to the insured employees.

Thus, each year, an increasing percentage of U.S. banks hold BOLI assets and use the income to help offset and recover employee benefit expenses such as healthcare and retirement.

With BOLI currently providing a net yield ranging from 2.50 percent to 4.00 percent, depending upon the carrier and product, it is not difficult to understand why BOLI remains so appealing to banks. For a bank in the 38 percent tax bracket, this translates into a tax equivalent yield of 4.03 percent to 6.45 percent.

Hybrid and Variable Separate Account Plans
Hybrid separate account plans have continued to grow rapidly the past several years. The number of banks using hybrid separate account has increased by 47.7 percent from 862 at the end of 2011 to 1,273 at the end of 2014 and the amount of hybrid assets reported has increased by 53.2 percent from $10.36 billion to $15.87 billion over the same time period.

Hybrid separate account policies have been attractive to banks because they combine features of both general and separate account insurance products. Hybrid separate account policies operate like general account policies in that the price risk and default risk of individual securities within the portfolio remain with the carrier. In addition, the carrier guarantees a minimum crediting rate of 1.00 percent to 2.00 percent. The enhancement that many banks find attractive is that if the carrier ever becomes insolvent, the assets in the separate account are segregated from the general creditors of the carrier. Essentially, the assets in the separate account serve as collateral for the cash value of the policies. Hybrids have only been available in to BOLI marketplace for approximately 13 years compared to 33 years for general account products, so the total asset value is lower, but the growth rate is greater.

The largest portion of BOLI assets continues to be held in variable separate account policies (47.6 percent of total BOLI assets). However, only 1.1 percent of this total was held by banks with less than $1 billion of assets. Like hybrid separate account products, the assets in a variable separate account are segregated from general creditors in the event of the carrier’s insolvency. However, gains and losses of the underlying investment portfolio are passed through directly to the policyholders. While most banks that have purchased variable separate accounts policies utilize “stable value” wrappers to reduce the accounting volatility, the complexity of the product has made it more suitable to larger banks than to smaller banks.

It is also interesting to note that median BOLI assets rose from 7.6 percent to $3.98 million in 2014 from $3.70 million in 2013, and that the median ratio of bank BOLI assets to Tier 1 Capital increased from 17.46 percent of capital in 2013 to 17.67 percent of capital in 2014.

New Policies in 2014
In 2015, IBIS Associates, Inc., an independent market research firm, published a report analyzing BOLI purchases last year based on information obtained from carriers that market BOLI products. According to that report:

  • Life insurance companies reported placing 1,175 BOLI cases in 2014 representing about $3.21 billion in premium. The 1,175 cases included banks purchasing BOLI for the first time as well as additional purchases by banks that already owned BOLI.
  • Of the $3.21 billion in new premium, $2.48 billion (77.2 percent) was put into general account; $698.4 million (21.7 percent) into hybrid separate account; and $35.6 million (1.1 percent) into variable separate account.
  • Of the 1,175 cases placed, 494 (42.0 percent) were under $1 million in premium; 341 (29.0 percent) were between $1 million and $2 million; 242 (20.6 percent) were between $2 million and $5 million; 75 (6.4 percent) were between $5 million and $15 million; and 23 (2.0 percent) were over $15 million.

The Market’s Future
The near term trend in the marketplace is for higher general account and hybrid separate account purchases and relatively few variable separate account purchases. Finally, the amount of BOLI assets held by U.S. banks is expected to increase annually by 3 percent to 4 percent based on recent results.

Additional Equias articles on BOLI:
BOLI is Becoming an Increasingly Attractive Option for Banks
What Do Bank Boards Need to Know About BOLI

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

Managing the BOLI Risk

Bank-owned life insurance (BOLI) is a popular investment asset that can be used as an added benefit for key executives. For example, a portion of the death benefit may be allocated to the executive. The returns can be used to offset employee expenses such as health care or 401(k) plans. The percentage of U.S. banks holding BOLI continues to grow year after year. The percentage increased from 53.4 percent in 2012 to 56.4 percent in 2013, says David Shoemaker, a principal at BOLI provider Equias Alliance. He talked to Bank Director magazine recently about market trends and what boards should know about risk management of BOLI plans.

Why are banks buying BOLI today?
BOLI continues to offer a higher after-tax yield than most other investments of similar risk and duration. The extra income boosts capital and can aid growth or provide higher shareholder dividends. In a standard general account or hybrid separate account BOLI product, there are no mark-to-market adjustments on the bank’s books. BOLI interest rates are variable and will generally follow changes in market rates (but on a lagging basis), making them more advantageous than fixed-income products in a rising interest rate environment.

What are the risks that a bank should pay attention to?
As part of its annual risk assessment review, the bank should review the current and long-term performance of BOLI as well as the financial condition of the carriers. BOLI regulations going back to 2004 state that banks should perform their own analysis and not just rely on ratings. The Dodd-Frank Act highlighted the importance of this as well.

What impact will Basel III have on BOLI?
Basel III will not have any impact on general account BOLI policies, which are backed by the credit of the insurance company and carry a minimum interest guarantee and a risk weighting of 100 percent. However, hybrid separate account policies, which are also backed by the insurance company, offer additional benefits such as multiple investment accounts that are legally protected from creditors of the carrier. Typically, these policies are assigned risk-weights as low as 20 percent or as high as 100 percent. Under Basel III, our understanding is the bank has the option to evaluate each security in the portfolio individually, which would be a time consuming and expensive task, or may save time and money and simply risk weight the BOLI asset at 100 percent.

What are the responsibilities of the board when it comes to risk management of the bank’s BOLI program?
It is the responsibility of management and the board to make sure there is proper oversight of the BOLI program. The bank should have a BOLI policy that details the bank’s purchase limits for one carrier and for all carriers in aggregate. The policy should outline the processes for performing the pre-purchase due diligence as well as the ongoing risk assessment reviews. The board should have a reasonable understanding of how BOLI works and the risk factors associated with it, including credit and liquidity risk. If the bank owns a variable separate account product, additional due diligence should be performed since it is a more complex product.

Regulators are worried about the risk posed to banks by third-party vendors. How does this impact banks with BOLI?
One of the key messages in the regulatory guidance is that banks should adopt risk management processes commensurate with the level of risk and complexity of the third-party relationship. With regard to BOLI and non-qualified benefit plan design and administration, I believe banks will move increasingly to providers that offer a high level of technical support, including CPAs, attorneys and analysts, and that have significant internal support systems to aid in designing and servicing non-qualified benefit plans as well as BOLI. Companies will want to deal with providers that have internal controls independently tested and certified with a report known as Service Organization Control (SOC) 1 Type 2, through the American Institute of Certified Public Accountants’ SSAE 16 standards.

David Shoemaker is a registered representative of, and securities are offered through, ProEquities Inc., a Registered Broker/Dealer, and member of FINRA and SIPC. Equias Alliance is independent of ProEquities Inc.

BOLI Growth Continues: Latest Trends in Bank-Owned Life Insurance

7-23-14-Equias.pngBanks and, particularly, community banks, continued to increase their purchases of bank-owned life insurance policies (BOLI) in 2013. Banks are taking advantage of attractive BOLI yields compared to alternative investments, and they are motivated as well by increased liquidity and low interest rates. BOLI provides tax advantaged investment income not available with traditional bank investments. Banks earn income from the growth of the BOLI cash value and from the life insurance proceeds paid to the bank on the death of the insured employee. In addition, BOLI can help offset and recover employee benefit expenses.

Industry Studies
Each year, IBIS Associates, Inc., an independent market research firm, publishes a report analyzing BOLI sales based on information obtained from the insurance companies that market BOLI products. According to the most recent IBIS Associates BOLI Report:

  • Life insurance companies reported that they sold 1,235 new BOLI cases in 2013, up 12 percent from 2012, representing about $3.18 billion in premium in 2013. The 1,235 cases included banks purchasing BOLI for the first time as well as additional purchases by banks that already own BOLI.
  • Of the $3.18 billion in premium sold last year, 59.6 percent was put into general account, 31.8 percent was put into hybrid separate account and 8.6 percent was put into variable separate account.
  • The average premium per case was about $2.57 million, a 20 percent increase from last year.
  • Banks with assets of $250 million to $1 billion purchased the largest number of products last year (42.3 percent of cases).

Based on a review of FDIC data, the Equias Alliance/Michael White Bank-Owned Life Insurance Holdings Report published in 2014 for the year 2013 shows that:

  • Of the 6,812 banking institutions in the U.S., 3,840 or 56.4 percent held BOLI assets in 2013. However, if you exclude banks with less than $100 million in assets from the equation, the percentage of banks holding BOLI jumps to 64.9 percent.
  • BOLI assets totaled $143.84 billion at the end of last year, reflecting a 4.3 percent increase from $137.95 billion at the end of 2012. However, banks with between $100 million and $10 billion in assets had an increase of 7.8 percent in their BOLI assets from 2012 to 2013.
  • The fastest growing plan type in 2013 was hybrid separate account (which combines many of the best features of a general account and variable separate account product). Almost 1,200 or 30.9 percent of the 3,840 institutions reporting BOLI assets held all or part of their funds in the hybrid separate account. Assets in this type of account grew 9.1 percent from 2012 to 2013 while general account assets grew 6.1 percent during that same time and variable separate account assets increased only 1.9 percent.
  • Although the largest portion of BOLI assets was held in variable separate account polices (49 percent of total BOLI assets), this plan type was used by the fewest number of banks. The bank bears the investment risk under this type of plan rather than the insurance company. Further, the number of banks holding variable separate account BOLI assets increased only slightly from 593 at the end of 2012 to 597 at the end of 2013.

Current BOLI Net Yields
BOLI provides a competitive net yield, currently in the range of 3.0 percent to 3.9 percent after all expenses are deducted, depending on the carrier and product. This translates into a tax equivalent yield of 4.84 percent to 6.29 percent, assuming a 38 percent tax rate. Carriers can reset crediting rates annually or quarterly depending on the type of BOLI product used.

In summary, the number of banks purchasing BOLI continues to grow. The tax-deferred interest generated by a fixed income BOLI policy is typically substantially higher than a bank can earn on other investments with a similar risk profile, especially in the current rate environment. Further, income generated by BOLI can help offset the ever increasing costs of a bank’s health care, retirement and other benefit programs.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

Two Risks of BOLI That Boards Should Understand

Over the past 30 years, bank-owned life insurance (BOLI) has proven to be a powerful asset for banks, providing strong yields that help offset the ever-rising cost of benefits. Over 3,840 banks reported BOLI holdings of almost $144 billion in the third quarter of 2013, and the pace of BOLI purchases remains robust.

BOLI Holdings Reported by Banks
Asset Size # of Banks # and % Reporting BOLI Assets Tier 1 Capital Reported BOLI CSV % of BOLI to Assets % of BOLI to Capital
< $100M 2,118 770
$48,132 $5,284 $933 1.94% 17.65%
$100M-$300M 2,622 1,499
$277,174 $29,007 $4,852 1.75% 16.73%
$300M-$500M 802 551
$212,624 $21,736 $3,679 1.73% 16.92%
$500M-$1B 677 481
$335,637 $34,358 $5,593 1.67% 16.28%
$1B-$5B 496 394
$782,354 $78,152 $11,827 1.51% 15.13%
$5B-$10B 67 47
$341,573 $32,716 $4,746 1.39% 14.51%
> $10B 106 73
$10,407,383 $865,119 $109,997 1.06% 12.71%
Total 6,888 3,815
$12,404,876 $1,066,373 $141,627 1.14% 13.28%

* Source: Call Reports as of 9/30/2013. Values reported in (000,000s).

BOLI is an investment tool and insurance product on the lives of bank officers which allows for enhanced tax-preferred earnings for the bank.

Interagency guidance on BOLI requires thorough pre-purchase analysis and ongoing risk management of BOLI. While regulators have identified eight risks inherent in BOLI, two of them warrant greater attention, credit risk and interest rate risk. 

Credit risk arises from a carrier’s obligation to pay benefits upon death, or cash surrender value (CSV) upon surrender. In loan terms, will the carrier repay when the “loan” becomes due? A life carrier default, where payment of life insurance is truly in question, can only occur after “busting through” a safeguard framework with multiple layers of policy owner protection. 

The potential 30- to 40-year holding period for a BOLI policy is one of the primary reasons why the carriers that actively offer BOLI are rated in the top 10 percent of their industry—discerning bank purchasers wouldn’t have it any other way. Because of the long-standing framework and history for policy owner protection, we believe there is nominal difference in credit risk among most BOLI carriers.

At a minimum, banks have reviewed credit ratings; some even do a cursory review of carrier financial statements. While that suffices as an initial filter, in the post-Dodd-Frank Act world, banks should no longer rely solely on credit rating agencies to assess the quality of BOLI carriers. A trusted BOLI vendor can help banks get a thorough pre-purchase and monitoring process in place. 

Interest rate risk is the risk to earnings from movements in market rates. It is a function of the maturities of the assets in the carrier’s investment portfolio. Unlike a bank’s bond portfolio, general account and hybrid account BOLI does NOT expose a bank to mark-to-market risk when rates rise. That’s because the insurance company owns the assets on its books and offers a set rate of return to the bank. (Carriers offer separate account BOLI as well, where banks are able to choose the underlying investment portfolio. However, separate accounts can expose the bank to mark-to-market risk.) 

Arriving at BOLI yield is fairly simple: Carriers invest banks’ premiums and retain a portion of their return as compensation for their investment management, resulting in a gross crediting rate. From the gross crediting rate, carriers subtract cost of insurance (COI) charges to compensate them for insurance risk. The end result is the policy’s net yield.

It’s important to note that the potential holding period for BOLI (30-40 years) is NOT its interest rate risk. Carrier portfolios are typically 6-10 years in average duration. While this longer duration is how BOLI provides greater yield potential, in a rising rate environment, it may create a temporary disconnect in expected return. BOLI crediting rates will lag market trends, and it’s important to review BOLI yield projections in that context.

When reviewing BOLI projections, focus on gross crediting rate and COI charges. No carrier can consistently credit more than it can earn on its assets, just as a bank can’t pay more on its deposits than its cost of funds. Ask for and review the carrier’s history of net yield on invested assets. Carriers have had relatively similar investment yields over the past five years. The question to ask is how reasonable is the gross crediting rate given the carrier’s recent actual history?

COI charges are very competitive for most carriers. However, there are clear outliers with higher COIs, suggesting that those carriers must credit a higher rate to overcome their higher COI charges. To our knowledge, no carrier has raised COI charges on existing BOLI, so it is reasonable to expect projected COIs to remain stable. 

In addition to credit risk and interest rate risk, boards should thoroughly evaluate the additional risks of BOLI. The key to a positive experience with BOLI is to fully understand those risks and have reasonable expectations explained to your board by a trusted BOLI advisor. BOLI has a competitive yield, no mark-to-market risk (except for separate account BOLI), very strong credit risk, and gross crediting rates that should adjust with the general market, albeit with a lag. When presented accurately, fully understood and implemented properly, BOLI is an attractive asset for banks to own.

Scott Richardson is a registered representative of Independent Capital Company, Inc., Parma, Ohio.  IZALE Financial Group is not affiliated with Independent Capital Company, Inc.

Is Your Compensation Plan Generous Enough?

6-24-13_Equias.pngWhile banks continue to have challenges with low interest rates and slow loan growth, two issues are always critical: (1) the need to attract, retain and reward executive talent and (2) the need to consistently optimize earnings.

Many bankers put compensation and retirement discussions on the back burner for the past four or five years, but are showing a renewed interest in these programs as the crisis has eased. While salary, annual performance bonuses and equity plans are important elements to consider in a compensation plan, many banks have been offering nonqualified plans to help balance the total compensation plan for key executives.

If a bank upgrades its executive compensation and benefits to compete for outstanding talent, won’t the additional cost reduce earnings? Not really. When you are able to attract and retain key officers, the bank can expect to be rewarded with superior performance and increased earnings. Additionally, banks can generally offset these unfunded benefit liabilities with the tax-advantaged earnings from bank-owned life insurance (BOLI).

There are several types of nonqualified benefit plans and unlimited benefit and contribution formulas as well as performance-based strategies that can be incorporated to meet board approval. Where do you begin?

Begin by Understanding Your Shortfall
By design, qualified plans regulated by ERISA (the Employee Retirement Income Security Act) do not provide top executives with sufficient retirement benefits and do not reflect the shareholder value they create. Salary caps, the virtual elimination of defined benefit pension plans and the relatively low level of 401(k) matching contributions typically limit executives’ retirement benefits to 30 to 50 percent of final pay. Knowing the extent of your shortfall (amount needed at retirement compared to estimated amount available) is vital to the design of an effective nonqualified plan.

Regulatory guidance says that the overall compensation package must be reasonable; therefore, SERPs and other nonqualified plans should take into consideration other compensation being provided.

Prevalence of Nonqualified Plans
Such plans are common in the banking industry. According to the American Bankers Association’s 2012 Compensation and Benefits Survey, 68 percent offer some kind of a nonqualified deferred compensation plan for top management (CEO,C-Level, EVP), and 43 percent of respondents offer a SERP.

Nonqualified Plan Basics

  • Supplemental executive retirement plans (SERPs) can be designed to address an executive’s shortfall. Generally, under the terms of a SERP, an institution will promise to pay a future retirement benefit to an executive, separate from any company-sponsored qualified retirement plan.
  • Deferred compensation plans (DCPs) minimize taxation on base salary and bonuses by allowing executives to make elective deferrals into a tax-deferred asset. The bank can also make contributions to the executive’s account using a matching or performance- based methodology.
  • Performance-driven benefit plans tie the bank’s overall objectives to an executive’s measurable performance. As these plans are based on reasonable performance benchmarks critical to the bank’s success, they address corporate governance concerns by increasing compensation only when objectives are met. Part or all of the distributions are made on a deferred basis for a variety of reasons.
  • Split-dollar plans allow the bank and the insured officer to share the benefits of a specific BOLI policy or policies upon the death of the insured. The agreement may state that the benefit terminates at separation from service or it may allow the officer to retain the life insurance benefit after retirement if certain vesting requirements are met.
  • Survivor-income plans/death benefit-only plans specify that the bank will pay a benefit to the officer’s survivor (beneficiary) upon his or her death. Typically, the bank will purchase BOLI to provide death proceeds to the bank as a hedge against the obligation the bank has to the beneficiaries. The benefits are paid directly from the general assets of the bank.

How Banks Use BOLI to Offset the Benefit Expense
The cost of each of the above plans varies by type and design. BOLI is a tax-advantaged asset whereby every $1 of premium equates to $1 of cash value on the bank’s balance sheet. Basically, BOLI is an investment asset that generates a return currently in the range of 3.00 percent to 3.50 percent after all expenses are deducted, which translates into a tax equivalent yield of 4.84 percent to 5.65 percent (assuming a 38 percent tax bracket). From an income statement standpoint, the cash surrender value (CSV) is expected to grow every month. Increases in the CSV are booked as non-interest income on a tax preferred basis. From a cash flow perspective, BOLI is a long-term accrual asset that will return cash flow to the bank upon the death of the respective insured(s).

As an example, let’s assume a 50-year-old executive will be provided a $100,000 per year nonqualified benefit payment for 15 years at age 65. The annual pre-retirement after-tax cost averages $47,000 per year. The bank could invest $2 million into BOLI to fully offset the annual after tax benefit cost.

While bank challenges still remain, providing a balanced and affordable compensation plan that includes nonqualified benefit plans can help make a difference for growing shareholder value.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

BOLI is Becoming an Increasingly Attractive Option for Banks

4-24-13_Equias_Post.pngBank-owned life insurance (BOLI) has been available in the marketplace for over 30 years now. And yet, industry studies show that year after year, the number of banks and savings associations holding BOLI and the amount of BOLI assets held by such institutions continues to increase.

Industry Studies

Each year, IBIS Associates, Inc., an independent market research firm located in McLean, Virginia, publishes a report analyzing BOLI sales based on information obtained from the insurance companies that market BOLI products. According to the IBIS Associates BOLI Report for 2013:

  • Life insurance companies reported that over 1,100 BOLI cases were sold in 2012 representing approximately $4.4 billion in assets. The 1,100 cases included banks purchasing BOLI for the first time as well as additional purchases by banks that already have BOLI on their balance sheet.
  • Of this $4.4 billion in assets, approximately $2 billion was attributable to one very large sale.
  • Excluding this large case sale, the average premium per case was approximately $2 million last year.

Based on a review of FDIC data, the Equias Alliance/Michael White Bank-Owned Life Insurance Holdings Report for 2013 shows that:

  • Of the 7,083 banks and savings associations in the U.S., 3,782 or 53.4 percent report held BOLI assets in 2012.
  • Banks increased their BOLI holdings (i.e., cash surrender values) from $131.95 billion in 2011 to $137.95 billion last year.
  • Although the largest portion of BOLI assets was held in variable separate account polices (where the bank assumes the investment risk rather than the insurance company), more banks added hybrid separate account policies (that combines the best features of a general account and variable separate account product) in 2012 (10 percent) than any other policy type.

Attractiveness of BOLI

Some have asked why BOLI is still such an attractive asset choice for banks. Briefly, the tax-deferred interest generated by a fixed income BOLI policy is typically substantially higher than a bank can earn on other investments with a similar risk profile. The higher earnings from BOLI can be used to:

  • Help offset the rising cost of employee benefits such as healthcare and retirement programs through use of the tax-deferred income from BOLI assets. For instance, BOLI provides a competitive yield, currently in the range of 3.25 percent to 3.50 percent after all expenses are deducted, which translates into a tax equivalent yield of 5 percent to 5.4 percent. *
  • Increase a bank’s earnings as well as shareholder value. For example, if a bank in the 38 percent tax bracket were to hypothetically invest $5 million in a BOLI fixed income account with a net yield of 3.25 percent, it would generate $162,500 in income. A similar investment of $5 million in a 5-year government agency bond yielding .93 percent would generate $46,500 in income, before taxes. Thus, the investment in BOLI would generate more than $116,000 in additional income for the bank which would enhance return on assets, return on equity and shareholder value. *
  • Help diversify the bank’s balance sheet by investing 2 percent to 3 percent of its assets in a BOLI policy since investment in the general assets of an insurance company through a BOLI policy would be a new asset class for most banks.

In addition to these benefits, a BOLI policy can enable a bank to earn tax-free income and receive death proceeds from policies when they are held to maturity. A bank may also decide to share a portion of the life insurance coverage with its key executives and directors.

Over the years, BOLI has proven to be a valuable asset since now more than 50 percent of the banks in the U.S. have BOLI on their balance sheet.

Pre-Purchase Analysis

What does a bank need to consider in deciding whether to purchase BOLI? The joint banking regulatory Interagency Statement of 2004 identified the factors a bank should consider in making such a decision including why the purchase is being made, the qualifications of the vendors (financial ratings, BOLI experience), the key risks (liquidity, credit, interest rate, etc.), an evaluation of the policy types available (variable separate account, hybrid separate account, general account) and a review of the bank’s capital position as well as risk tolerance.

Market Trends

For the reasons shown above, the number of banks purchasing BOLI for the first time or making an additional purchase of BOLI continues to grow year by year. Hybrid separate account and general account polices (where the general assets of the insurance company support the policyholder’s cash surrender value, but are not protected from claims on the insurer), have been the most popular BOLI product in recent years.

Although BOLI is not suitable for all banks, the statistics show that an increasing number of banks appreciate the benefits it does offer and are making it a part of their investment portfolio.

Additional Equias articles on BOLI:
The Impact of Rising Interest Rates on BOLI
Report on the Market: BOLI Assets Continue To Have Strong Growth

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

*The projected yield is based on an average of the interest rates offered by three carriers in the BOLI market as of April 1, 2013 and assumes the bank is in the 38 percent tax bracket.

Ken Derks is a registered representative of, and securities are offered through, ProEquities, Inc., a Registered Broker/Dealer, and member FINRA and SIPC.   Equias Alliance is independent of ProEquities, Inc.

Dealing With Change In The BOLI Marketplace

What are the major concerns for banks that are learning that their BOLI service provider is now exiting the market?

Bennett Meyer: Bank directors who thought they had made the “safe choice” by choosing one of the industry’s largest service providers now find that their BOLI and compensation consultant is facing the loss of back office support, including product, technical and administrative support. As a result, they must reevaluate how they receive these services.

They might be tempted to automatically switch to the service provider selected by their original consultant. However, it is important for a bank to perform due diligence and investigate any organization to ensure that the consultant is aligned with a service provider that can provide full back office support.

So what should banks look for in a service provider?

Bennett Meyer: The obvious place to start is to make sure the firm has a proven record and a solid reputation. Next, it is critical that the service provider rigorously monitor the plan’s regulatory compliance, review product performance and, working with the consultant, recommend appropriate changes. Collaboration between the consultant and service staff can help the bank achieve the highest level of compliance and optimize the return on its investments.

The consultant and the service staff should have a strong, personal relationship with the bank. The bank should be able to talk with a BOLI professional about any aspect of its BOLI program—whether tax, accounting or regulatory. Electronic reports will provide information, but they don’t always provide the specific answers available from a live, knowledgeable and experienced person.

Banks should also evaluate how the service provider is funded. The two most common funding models are fee-supported and business-supported. If a service provider is dependent upon a BOLI salesman or the bank to pay ongoing fees, the bank incurs a real cost and might eventually find itself paying higher fees to the service provider. If, however, a service provider is self-supported from the business it administers, without cost to the bank, there is a much greater likelihood that the service provider will remain financially stable well into the future.

With the recent changes in the marketplace, what advice would you offer to bank directors struggling with compensation issues?

Flynt Gallagher: The best piece of advice we can offer is: Don’t go it alone. It is virtually impossible for committee members to stay abreast of the latest regulations. Just as it is prudent to engage an attorney to handle complex legal issues, it has become a “best practice” for compensation committees to retain professional consultants to help them understand the legal, tax, accounting and regulatory changes affecting compensation.

Committees should also enter into year-round consulting arrangements so that their advisors are always available. This ongoing relationship is important if they are to understand how the bank’s compensation plans interrelate and how they will operate under various scenarios, such as a separation from service or a change in control.

TARP and shareholder value continue to be major areas of concern. What can banks do to protect themselves?

Flynt Gallagher: We suggest that every bank comply with the spirit of TARP, SEC and/or the Dodd-Frank Act, even if it did not receive TARP funds. The fact is that many of these regulations are becoming industry best practices.

We also advise board members to be acutely aware of how executive compensation impacts shareholder value. This is especially true in the case of incentive compensation. Regulatory agencies require a compensation committee to identify and manage the inherent risks embedded in their compensation arrangements.