Community banks continue to deal with a shortage of skilled labor and rising employee benefit costs. So many are turning to bank-owned life insurance (BOLI). BOLI is a highly tax-efficient long-term investment option. It also can be a powerful tool for funding benefits for executives and other key employees, enhancing a bank’s appeal to prospective workers. For example, a bank may use BOLI to fund retiree health benefits, nonqualified deferred compensation plans and supplemental executive retirement plans. Here’s a brief introduction.
How does it work?
To take advantage of BOLI, a bank purchases life insurance policies — either directly or through an insurance trust — on the lives of executives or other highly compensated employees who consent in writing to be insured. The bank owns the policies, pays the premiums and is the designated beneficiary. Typically, the bank uses the proceeds of these policies to offset or underwrite various benefits for key employees. However, some banks elect to share some of the proceeds with the insured’s family.
Banks are allowed to use BOLI for specific purposes. Examples include funding employee benefit and compensation plans, providing key person insurance, and recovering some employee benefit costs. Banks can’t purchase BOLI for rank-and-file employees — the policies are limited to employees the bank has an “insurable interest” in. Generally, that means the loss of the insured employee would have a significant negative financial impact on the bank, or the insurance proceeds will be used to fund benefits promised to the employee or his or her beneficiaries.
What are the pros and cons?
One advantage is that BOLI can be an attractive investment and benefit-funding strategy, often outperforming the after-tax returns of other traditional bank investments. A policy’s cash value grows on a tax-deferred basis. If the policy is held until the insured’s death, the death benefits are also generally tax-free to the bank.
In addition, BOLI can help banks reduce the risks of losing key employees. So, it can be a highly effective tool for providing valuable benefits to key employees while managing risk.
One big disadvantage is that if the bank surrenders a BOLI policy, the surrender charges, taxes and penalties can be costly. Also, BOLI policies are illiquid assets, which can expose a bank to liquidity risk. This is a major concern today, in light of recent bank failures due to liquidity issues.
How do banking regulators view BOLI?
The federal banking agencies have given their blessing to BOLI, provided banks have a comprehensive risk management process for purchasing and holding it. This includes effective senior management and board oversight. “Bank-Owned Life Insurance: Interagency Statement on the Purchase and Risk Management of Life Insurance” provides guidance from the federal banking agencies on using BOLI.
For example, the statement directs banks to establish internal policies and procedures governing their BOLI holdings, including guidelines that limit the aggregate cash surrender value (CSV) of policies from any insurance company and from all insurance companies. According to the statement, “It is generally not prudent for an institution to hold BOLI with an aggregate CSV that exceeds 25% of its Tier 1 capital.” It also advises bank management to conduct a thorough pre-purchase analysis to help understand the risks, rewards and characteristics of BOLI.
Worth a look
Implementing a BOLI program can be complex. But in today’s environment, it may be worthwhile for banks seeking a competitive edge in the battle to attract and retain quality talent.
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