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.

* 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.