Setting up the right Bank-Owned Life Insurance (BOLI) policy is only part of the story. What happens over the life of the policy is important, too. In this informative video, Jim Calla of Meyer-Chatfield explains how proper maintenance and reporting can make the most of this product.
Why is proper BOLI administration an important issue for banks?
What are the characteristics of a good BOLI administrator?
Since the Great Recession of 2007-2009, the Federal funds rate has been held near zero to help spur the U.S. economic recovery. However, with the decline in the unemployment rate, strong jobs growth in the second quarter of 2015 and low inflation, the Federal Reserve may begin to raise short-term interest rates before the end of this year.
Although no one can predict exactly when interest rates will rise or by how much, we all understand it will occur at some point. Because we have been in a low interest rate environment for so long, the natural question is how will higher market interest rates impact the credited interest rates on bank-owned life insurance (BOLI) policies?
To understand the impact of rising interest rates on BOLI carriers offering fixed-income products, it is first necessary to understand the carriers’ investment philosophies, portfolio compositions and interest crediting methodologies. Although the investment philosophy of each BOLI carrier differs, there are generally some common threads. The investment objective of most BOLI carriers is to build a diversified portfolio of securities across and within asset classes with a long-term orientation that optimizes yield within a defined set of risk parameters. The portfolio strategy often targets investment grade securities, both public and privately issued, with cash inflows that reasonably match the projected cash outflows of their projected liabilities. Corporate bonds are usually the largest holding in the portfolio along with commercial mortgages/mortgage backed securities, private placements, government/municipal bonds and other holdings. The duration of these portfolios is typically four to ten years.
Insurance companies use different interest crediting methodologies for BOLI business. Some carriers use a portfolio approach while others use a new money rate approach. In most cases, the carriers who use a new money rate approach blend it into the portfolio over time. The crediting rate in products from new money rate carriers is based on the carrier’s expected rate of return on premiums received currently. The crediting rate in products from portfolio rate carriers is based on a combination of the rate of return from new premiums as well as the balance of the general account assets of the company or the assets of the specific BOLI portfolio.
Rising interest rates will affect both new BOLI cases as well as existing BOLI policies. As noted above, insurance companies invest heavily in bonds. When market interest rates rise, yields on new bonds will increase while prices on existing bonds will decline. In anticipation of rising interest rates, some carriers shorten the duration of their portfolios or pursue a hedging strategy to manage risks.
Carriers using the new money approach will see a more immediate and positive impact on their initial credited rate for new BOLI policies as their rates, for newly issued policies, are based on current investments yields. Assuming a modest increase in rates, carriers using the portfolio approach may see little or no immediate change in their rate, but will likely see an increase in their credited interest rate over time. This will occur as the portfolio turns over and as new premium that is received is invested at a higher rate.
For existing general account and hybrid separate account BOLI policies, whether a new money or portfolio approach was used, there is no mark-to-market risk as the insurance company, not the policyholder, bears the price risk. For new money products, the interest rate credited to a new purchase is not likely to increase for several years after purchase since the underlying investments supporting the new money purchase typically have durations of four to ten years. Assuming slow and steady interest rate increases, both new money and portfolio products will likely increase over time with the portfolio products expected to increase more rapidly than the new money products. This is because the portfolio products will receive more new cash flows to invest at the higher rates.
A significant interest rate increase over a short period of time may cause most new premium to be placed in new money products, thereby reducing the new premium received into a portfolio product and slowing the time period it takes for the crediting rate to grow to market levels. If this were to occur, the crediting rates on portfolio and new money products would be expected to increase at about the same pace.
Please also bear in mind that it is important for directors and senior management of a bank to monitor not only changes in credited interest rates, but also the net yields. The net yield reflects the actual credited rate less mortality charges and, in some cases, policy fees or other administrative expenses. Accordingly, it is possible for one carrier to have a higher interest rate than another, but a lower net yield.
Many BOLI service providers will meet with their clients at least once a year to discuss the status and performance of their policies. At that meeting, it is vital for board members and senior management to review, among other things, the net yield earned on their policies to determine whether those yields are competitive in light of the type of policy purchased (new money, portfolio, blended portfolio) and current market conditions. Your service provider is well positioned to help you with that analysis and discussion of options, if changes are needed.
In conclusion, rising interest rates will occur at some point, but are likely to have a favorable interest rate impact on both new and existing BOLI clients using a fixed account over the long-term.
Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.
Today’s economy presents numerous challenges to community bank profitability—compressed net interest margins, increased regulation, and management teams fatigued by the crisis. In response to these obstacles, many boards of directors are exploring new ways to reduce expenses, retain qualified management teams, and offer opportunities for liquidity to current shareholders short of a sale or merger of the institution.
For many family-owned banks, their deep roots in the community and a desire to see their banks thrive under continued family ownership into future generations can cause these challenges to be felt even more acutely. In particular, recruiting and retaining the “next generation” of management can be difficult. Cash compensation is often not competitive with the compensatory packages offered by publicly-traded institutions, and equity awards for management officials are unattractive given the limited liquidity of the underlying stock. All the while, these institutions should ensure that their owners have reasonable assurances of liquidity as needs arise or as investment preferences change. In combination, these challenges can often overwhelm a family-owned bank’s desire to remain independent.
Depending on the condition of the institution, implementing an employee stock ownership plan, or ESOP, may help a board address many of these challenges. While the ESOP is first a means of extending stock ownership to the institution’s employees, an ESOP can have other applications for family-owned banks.
Recruitment and Retention An obvious benefit of an ESOP is to provide management and employees the ability to participate in an increase in the value of the bank, aligning their interests with those of shareholders. An equity interest provides economic incentives to join or stay with the bank and the ownership interest provided by ESOPs to employees has been shown to improve workforce productivity and morale.
Source of Liquidity for Shareholders Without significant trading activity in their stock, shareholders of a closely-held institution may seek a liquidity event, which can include the sale of their shares to a third party or a merger with another bank. For these institutions, using the ESOP as part of a stock repurchase plan or to buy out selected shareholders can provide a buyer for large blocks of stock at a reasonable price.
For family-owned institutions, the tax benefits associated with a sale of a family’s interest in the institution to management via an ESOP are considerable. Most individual sellers of stock to an ESOP (and some trusts) qualify for a tax-free rollover of the proceeds of that sale into domestic stocks and bonds of U.S. corporations which meet certain limits on passive income. Under certain circumstances, this tax-free rollover opportunity avoids all federal income and capital gain taxes on the sale of shares to an ESOP.
In order to fund large purchases, the ESOP can take on a limited amount of leverage in order to acquire more shares in a particular year than can otherwise be allocated to plan participants. Before taking on this leverage, the bank should carefully consider how much leverage it can actually handle relative to the contributions that are expected to be made to the ESOP.
Special Benefits for S Corporations ESOPs can also reduce shareholder numbers to facilitate a company’s conversion to an S corporation, which can help significant shareholders avoid the double taxation of dividends that apply to C corporations. Under the Internal Revenue Code, an ESOP counts as only a single shareholder for purposes of S corporation limitations, no matter how many employees have shares allocated to their accounts in the ESOP. Upon a plan participant’s separation from service from the institution, the participant may be entitled to only the cash value of the shares, rather than the shares themselves.
ESOPs also benefit from the S corporation status given their exemption from federal and most state income taxes. Since ESOPs are tax-exempt entities, they do not pay income taxes on their share of the institutions’ income like other shareholders do. When S corporations make distributions to their shareholders, ESOPs can retain that distribution, giving a better return to the ESOP participants. Additionally the cash reserves held in the ESOP from these distributions can be used to pay down ESOP debt incurred to buy shares for the ESOP, fund additional stock purchases by the ESOP, or to fund employee withdrawals from the ESOP.
For a variety of reasons, ESOPs can help family-owned financial institutions better manage the challenges of today’s market by providing a more liquid market for the institution’s shares and an exit strategy for some significant investors short of a sale or merger. ESOPs can also improve employee and senior management engagement and retention at a relatively low cost, which can improve the institution’s bottom line. With careful implementation and board oversight of compliance efforts, ESOPs can be a powerful tool for many community banks.