Like any going concern of a certain size, your typical bank seeks to guard against retirement income shortfalls for key executives while balancing risk with reward for directors.
Naturally, it also wouldn’t mind attracting quality management talent while retaining top directors and insuring itself against the loss of critical individuals. Consequently, more than half of all US banks use Bank-Owned Life Insurance (BOLI) to offset existing benefit costs, post tax-advantaged earnings, maximize investment yields and improve the bottom line.
In a BOLI transaction, the bank insures the lives of a group of select management. It pays the premiums, owns the cash value, and is the beneficiary of the policies’ death benefit. BOLI matches the long-term nature of benefit plan liabilities while offering a higher after-tax return than other bank-eligible investments.
How Banks Invest in Life Insurance
BOLI helps banks deliver on benefit promises made to employees while providing competitive benefit programs and containing costs. It involves the purchase of single premium institutionally-priced permanent life insurance on eligible bank officers. The products are no-load and carry no-surrender charge. As mentioned above, the bank is the owner and beneficiary of the policies. Initial lump-sum premium investment equals cash surrender value on day one, and all of the income is tax-free if policies are held to maturity.
Essentially a specialized tax shelter, BOLI allows over 3,200 banks nationwide to leverage its tax-free savings provisions as funding mechanisms for employee-retirement and benefit-program liabilities. To emphasize earnings, policies are structured to maximize investment aspects and minimize the expense of the death-benefit portion of policy.
BOLI generates non-taxable profit and loss (P&L) earnings equal to the growth in cash surrender value. In addition, a portion of the death benefit may be shared with insured officers via a supplemental life insurance plan. Significantly, banks hold anywhere between 15% and 25% of their regulatory capital (Tier 1) in BOLI. In dollar terms, over $188 billion of BOLI cash values reside on banks’ balance sheets.
What Is Tier 1 Capital?
Tier 1 capital is, at root, the most perfect form of a bank’s capital. It is the money stored by the bank in order to keep it afloat and shipshape through the risky transactions it performs, such as trading, investing, lending et al. From a regulator’s point of view, Tier 1 capital is the key measure of the financial strength of a bank because it is composed of core, non-risk capital.
Why is this important? Read on to find out.
Why BOLI Matters
The bank purchases life insurance on the lives of a group of its key employees who participate in the bank’s benefit plans and consent to the policies. As we know, the bank pays the premium, owns the cash value of the policies, and is the beneficiary of the insurance. When properly designed and funded, BOLI has the potential to generate income from the growth of the policy’s cash value and from tax-free insurance proceeds paid to the bank on the death of an insured. Assuming compliance with applicable tax laws, any growth in cash value is tax-deferred and the death benefit is generally tax-free to the bank.
If all this sounds like something very familiar to the savvy investor, it should—since it sounds a lot like whole life and universal life insurance. These two instruments allow ordinary investors to both insure themselves and invest in a way that protects their principal and affords them a measure of upside. Let’s review what they are and how they differ from each other.
Both whole and universal life fall under the blanket of permanent life insurance. Permanent policies provide lifetime coverage. If you cancel your permanent life policy, you receive the policy’s cash value to use however you want—say, to address an emergency. You may also take out a loan by borrowing against the cash value; hence permanent life insurance is also known as cash-value insurance.
Both whole and universal life policies typically feature two parts: an insurance portion and a savings/investment portion. Whole life insurance addresses long-term goals, offering buyers consistent premiums and guaranteed cash-value accumulation. Universal life insurance affords buyers flexibility in the premium payments, death benefits, and the savings element of the policy.
Before purchasing BOLI, a bank’s board and senior management would seek to understand its risks, rewards, and characteristics, and the individual investor should perform a similar analysis when considering whole life or universal life insurance. In the bank’s case, a valid business purpose must be identified, such as offsetting employee retirement and benefit obligations. In the case of an investor, the leading consideration would likely be the minimization of future financial risk from death and a concomitant investment in a low-risk, tax-advantaged financial instrument.
BOLI policies are treated as long-term assets meant to offset the costs associated with a long-term obligation. If necessary, BOLI policies can be surrendered, subject to the terms of the contract and the terms of the stable value agreement. If a policy is surrendered, there may be income-tax consequences if there is gain in the contract on the date of surrender. Similarly, the savvy individual investor would do well to consider the implications of surrendering a whole life or universal life policy.
In summary, as banks invest their non-risk, Tier 1 capital in BOLI, then whole life or universal life policies—in essence, the BOLI accessible to non-bank investors—should be seen as desirable investment options indeed. If bank-owned cash value life insurance is considered a sufficiently safe investment to be a de facto part of most US banks’ Tier 1 capital holdings, then whole life or universal life insurance, which is the closest thing to BOLI available to individual investors, should be an investment that is squarely on their radar.