By Jeffrey G. Lenhart and Christopher J. Honenberger. Both are principals in the law firm of Lenhart Obenshain PC, Harrisonburg and Charlottesville, Va. Lenhart specializes in business and tax matters involving individuals, partnerships, and corporations. Honenberger, a former bank president, specializes in legal and regulatory matters affecting community banks. www.lenhartobenshain.com

 

When a bank’s board and management analyze an institution’s appetite for bank owned life insurance (BOLI) as a strategy to help offset the costs of current and anticipated employee benefits, both must remember the old adage that when dancing with a bear, you don’t stop dancing until the bear stops dancing. In other words, BOLI is a financially significant and long-term company strategy and, good or bad, if adopted, it will remain a bank strategy for a long time and greatly impact the bank’s regulatory and financial health.

Regulatory perspective
To assist banks in making a prudent assessment of BOLI risks, in December 2004 the banking agencies and the Office of Thrift Supervision issued an interagency statement (OCC 2004-56) regarding the purchase and risk management of BOLI. That interagency statement provides general guidance consistent with safe and sound banking practices, and much of this article summarizes the FDIC’s prior advice on the subject. (On Nov. 9, 2007, the Treasury Department and the IRS issued temporary and proposed regulations regarding annual reporting requirements for BOLI programs subject to IRC section 101(j). The temporary and proposed regulations statement does not include any substantive guidance and indications are that final substantive guidance will be forthcoming in early 2008.)

Among the practices covered in the interagency statement is the need for senior management and board oversight of BOLI, including both a thorough pre-purchase analysis of risk and rewards and a post-purchase risk assessment.

As a general matter, the ability of state charted banks to purchase insurance is governed by state law. However, the Federal Deposit Insurance Act provides limited federal oversight in certain circumstances. Therefore, the interagency statement provides applicable oversight to the bank for entering into the BOLI plan.

Further, the bank should follow generally accepted accounting principles (“GAAP”) applicable to life insurance for financial and regulatory reporting purposes. Generally speaking, Financial Accounting Standards Board (“FASB”) Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance, discusses how to account for holdings of life insurance. While proper accounting treatment for the BOLI plan is beyond the scope of this article, the board and management are encouraged to consult with the bank’s accountants regarding proper accounting treatment.

The interagency statement provides that, before entering into a BOLI contract, institutions should have a comprehensive risk management process for both purchasing and holding BOLI. A prudent risk management process includes: 1. effective senior management and board oversight; 2. comprehensive policies and procedures, including appropriate limits; 3. a thorough pre-purchase analysis of BOLI products; and 4. an effective ongoing management of risk assessment, management, monitoring, and internal controls processes, including appropriate internal audit and compliance frameworks.

Although the board may delegate decisionmaking authority related to purchases of BOLI to senior management, the board remains ultimately responsible for ensuring that the purchase and holding of BOLI is consistent with safe and sound banking practices. This article covers the pre-purchase analysis which should take place before entering into a BOLI contract. Part II addresses additional issues.

Pre-purchase analysis stage
An effective pre-purchase analysis involves the following management and board actions:

1. Identify the need for insurance and determine the economic benefits and appropriate insurance type. This involves the bank analyzing the cost and benefits of planned BOLI analysis, including projected policy values (cash surrender value and death benefits) using multiple illustrations of these projections provided by the carrier, some of which incorporate the bank’s own assumptions.

2. Quantify the amount of insurance appropriate for the bank’s objectives. The interagency statement provides that a bank should estimate the size of the employee benefit obligation or the risk of loss to be covered, and ensure that the amount of BOLI purchased is not excessive in relation to this estimate and the associated product risk. When using BOLI to recover the cost of providing employee benefits, the estimated present value of the expected future cash flows from BOLI, less the cost of insurance, should not exceed the estimated present value of the expected after-tax employee benefits cost.

3. Assess vendor qualifications. While it is possible to purchase insurance directly from insurance carriers, the vast majority of insurance purchases are made through vendors. A vendor may design, negotiate and administer the BOLI policy, but the bank should ensure that it understands the product it’s purchasing and that it selects a product that best meets its needs. In particular, an institution that uses a vendor should make appropriate inquiries to satisfy itself about the vendor’s ability to honor its long-term commitments, particularly when the vendor is expected to be associated with the institution’s insurance program over an extended period of time.

4. Review the characteristics of the available insurance products. Design features of permanent insurance determine: a. whether the policy is a general obligation of the insurance company, a separate obligation unique to the bank, or a combination of the two; b. whether the insurance contract is a modified endowment contract that contains certain tax penalties if surrendered; and c. the use of credit earnings to the policy. When purchasing insurance on a key man, management and the board should consider whether the bank’s need for the insurance might end before the death of the insured.

5. Carrier selection. To achieve the tax benefits of insurance, institutions must hold BOLI policies until the death of the insured. Therefore, carrier selection is one of the most critical decisions in a BOLI purchase and one that can have long-term consequences. The bank alone retains the responsibility for carrier selection. Management should review the carrier’s commitment to the BOLI product, as well as its credit rating, general reputation, experience in the marketplace, and past performance.

6. Determine the reasonableness of compensation provided to the insured employee if the insurance results in additional compensation. Insurance arrangements that are funded by the institution and that permit the insured officer or employee to designate a beneficiary are a common way to provide additional compensation and other benefits to the insured.

7. Analyze the associated risk. And to this we add, analyze the ability to monitor and respond to those risks. The bank’s pre-purchase analysis must include a thorough evaluation of all significant risks (as enumerated below), as well as management’s ability to identify, measure, monitor, and control those risks.

8. Evaluation of alternatives. Regardless of the purpose of the BOLI, a comprehensive pre-purchase analysis should include an analysis of available alternatives. Prior to acquiring BOLI, the bank should have thoroughly analyzed the risk and benefits, compared to alternative methods for recovering costs associated with the loss of key persons, including pre- and post-retirement employee benefits.

9. Document the decision. A well-managed institution must maintain adequate documentation supporting its comprehensive pre-purchase analysis, including an analysis of both the types and designs of products purchased and the overall level of BOLI holdings.

 

Now that you’re dancing

with the “BOLI bear,”  how to maintain harmony?

  

You don’t want the bear stepping on your foot—or worse. 

Risk management framework
In addition to conducting the risk assessment as part of a thorough pre-purchase analysis, monitoring BOLI risks on an ongoing basis is critical, especially if the aggregate BOLI holdings represent a capital concentration. The bank’s management should review the performance of the institution’s insurance assets with the board at least annually. More frequent reviews may be appropriate if significant changes are anticipated.

This risk management review should include, but not necessarily be limited to:
1. Comprehensive assessment of the risks to the bank.
2. Identification of which employees are, or will be, insured.
3. Assessment of death benefit amounts relative to employee salaries.
4. Calculation of the percentage of insured persons still employed by the bank.
5. Evaluation of the material changes to BOLI risk management polices.
6. Assessment of the effects of policy exchanges.
7. Analysis of mortality performance and impact on income.
8. Evaluation of material findings from internal or external audits and independent risk management reviews.
9. Identification of the reason for, and tax implications of, any policy surrendered.
10. Peer analysis of BOLI holdings.

Risk management specifics
In assessing the various risks as part of its ongoing risk assessment, the board and bank management should consider the following:

1. Liquidity risk: In purchasing permanent insurance, the bank should recognize the illiquid nature of the product and ensure that the bank has the long-term financial flexibility to hold the asset in accordance with expected use. The inability to hold the life insurance until the death of the insured, where the death benefit will be collected, may compromise the success of the BOLI plan. The illiquid nature of insurance assets, combined with the difficulty of projecting liquidity needs far into the future, is a major reason the bank should keep its BOLI holdings below the recommended concentration guidelines.

2. Transaction/operational risks: As it relates to BOLI, the transaction/operational risk is the risk to earnings and capital arising from problems caused by the bank’s failure to fully understanding or properly implement a transaction. To help mitigate this risk, bank management should have a thorough understanding of how the insurance product works and the variables that dictate the product’s performance. The variables most likely to affect product performance are the policy’s interest crediting rate, mortality costs, and other expense charges.

3. Tax and insurable-interest implications: Before making the decision to purchase BOLI and periodically thereafter, management should also explicitly consider the possible financial impact (e.g. tax provisions and penalties) of a future decision to surrender the policy. A tax change that makes BOLI cash flow subject to income tax, while perhaps deemed unlikely, could have a negative impact on the economics of the BOLI holdings. The bank should also recognize that earnings from BOLI could make it subject to alternative minimum tax as well.

To benefit from the favorable tax treatment of insurance, a BOLI policy must be a valid insurance contract under applicable state law and must qualify under applicable federal law. Furthermore, the favorable tax equivalent yields of BOLI result only when an institution generates taxable income. If the bank has no federal income tax liability, then it receives only the nominal interest crediting rate as a yield.

In such an environment, BOLI loses much of its yield advantage relative to other investment alternatives.

4. Reputation risks: This is the risk to earnings and capital arising from negative publicity regarding an institution’s business practice. While this risk arises from virtually all bank products and services, it is particularly prevalent in BOLI, because of the potential perception associated with the institution owning and benefiting from life insurance on its employees. The bank should consider taking steps to reduce the reputation risks associated with BOLI purchases by maintaining appropriate documentation evidencing informed consent by the employees concerned.

5. Credit risk: The potential impact on earnings and capital arising from an obligor’s failure to meet the terms of a contract with the institution or otherwise perform as agreed. All life insurance policyholders are exposed to credit risks. Most BOLI products have long time frames for full collection of cash proceeds (i.e., the death benefit). For general account policies, the cash surrender value is an unsecured, long- term and non-amortizing obligation of the insurance carrier.

6. Interest rate risk: This is the risk to earnings and capital arising from movement in interest rates. Due to the interest rate risk inherent in general account products, it is particularly important that management fully understand how these products expose the policyholder to interest rate risks. The interest rate risk associated with these products is primarily a function of the maturities of the assets in the carrier’s investment portfolio, which often range from four to eight years. When purchasing a general account policy, an institution chooses one of a number of interest crediting options (i.e., the method by which the carrier will increase the policy’s cash surrender value). Using the “portfolio” crediting rates, the bank will earn a return based upon the existing yield of the carrier’s portfolio each year.

7. Compliance/legal risk: The risk to earnings and capital arising from violations of, or non-conformance with, laws, rulings, regulations, and ethical standards. Failure to comply with applicable laws could compromise the success of the BOLI program and result in fines or penalties. Tax benefits are critical to the success of most BOLI plans.

8. Price risk: The risk to earnings and capital arising from changes in the value of the portfolios of the financial instruments. Because the bank does not control a separate account asset, it is more difficult to control price risk of those assets than if they were directly purchased.

Looking forward on BOLI
A BOLI program can be an effective way for the bank to manage exposure arising from its commitment to provide employee compensation and pre- and post-retirement benefits. Consistent with safe and sound banking practices, the bank must, however, implement a risk management process that provides for the identification and control of such risks. A meaningful ongoing monitoring program, reliable accounting process and accurate assessment of risk-based capital requirements are all components of the type of risk management process the agencies expect institutions to employ.

 

1. •••
2. As long as the board and management “bear” in mind these essential monitoring and assessment obligations, the BOLI Bear dance floor will remain a reasonably safe and pleasant place to be. BJ

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