Bank-owned Life Insurance: Regulators Issue New Guidelines

The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the Office of the Comptroller of the Currency issued an interagency statement — the first of its kind — on December 7, 2004 providing additional guidance about bank-owned life insurance (BOLI). BOLI is an insurance product that provides an effective way to offset current employee benefit costs or post-retirement benefits. Many banks have invested in BOLI.

Typically, a bank purchases a life insurance policy on a group of its directors and officers and over time uses the cash value and proceeds from the policy to recover its employee benefit expenses. BOLI enjoys certain tax benefits (the income is generally tax-free) that make it an attractive alternative to funds invested in traditional taxable investments. However, there are risks that must be taken into account. The interagency statement sets forth supervisory expectations for senior management and boards of directors to understand and mitigate these risks. This article provides a brief review of its provisions and offers some practical advice for compliance.

The interagency statement makes clear that a bank must understand the risks of BOLI and implement a risk management process that provides for identification and control of such risks. The regulators are looking for a sound pre-purchase analysis, a meaningful ongoing monitoring program, a reliable accounting process and an accurate assessment of risked-based capital requirements.

To comply with this expectation, a bank must adopt a prudent risk management process which provides the following.

1. Effective senior management and board oversight

The board is expected to understand the risks and role that BOLI plays in the institution’s business strategy. These risks include, among others:

Liquidity risk – BOLI is not a liquid investment. To achieve the best tax results, BOLI should be held to the death of the covered officer or director.

Transaction/operational risk – BOLI is complex. Appropriate review and monitoring is needed to make certain it is properly implemented.

Tax and insurable interest implications risk – Consultation with professionals is essential to make sure it is done right or the consequences can be dire.

Reputational risk – Failure of the insurance company providing BOLI could affect the ability of institution to meet its obligations. Also, failure to establish BOLI in a proper manner (employees insured without their consent) can reflect poorly on the institution.

Credit risk – Carefully select insurance carriers who have acceptable ratings from A.M. Best Fitch, Moody’s, and Standard & Poors. Monitor ratings at least once annually.

Interest rate risk – BOLI interest rates fluctuate after the first year and these annual “resets” reduce (or more frequent) interest rate risks, but boards should monitor the crediting history of BOLI carriers.

Compliance/legal risk – Failure may involve regulatory and liability consequences.

2. Comprehensive policies and procedures, including appropriate limits

  • Because the cash surrender value (CSV) of a policy with any one company represents risk, the CSV should not exceed its legal lending limit nor in the aggregate exceed 25% of its tier 1 capital.
  • The Interagency Statement may allow a bank to exceed the 25% limit under exceptional circumstances, but if an institution approaches or exceeds the concentration limit, regulators will more closely scrutinize the risk management process and documentation.
  • Only the CSV of BOLI, less applicable surrender charges, may be counted as an asset
  • If an institution owns a general account insurance product, it should apply a 100% risk weight to its claim on the insurance company for risk-based capital purposes; if it is a separate account policy, the bank may use a “look through” approach to the underlying assets for the appropriate risk weight, which in no event can be less than 20%. Be aware that separate account products have investment restrictions which need careful consideration.

3. Thorough pre-purchase analysis

  • Identify the need for BOLI and determine its economic benefits – ascertain the accounting and tax treatment and whether it fits with the institution’s strategic plan.
  • Quantify the amount necessary and appropriate for the institution’s objectives – draw the connection between the benefits promised to directors and officers and the need to fund them.
  • Assess vendor qualifications – interview and evaluate the various vendors in the market. If an affiliate is involved, care must be taken not to violate state law prohibitions against the splitting of commissions as an inducement to sale. Many of the higher-rated carriers will no longer provide commissions to an insurance affiliate as it may be viewed as an inappropriate inducement to purchase from that carrier. The Interagency Statement also puts additional responsibilities on the insurance affiliate.
  • Review characteristics of available BOLI products – understand the range of policy design, mortality costs and surrender restrictions.
  • Select carrier or carriers with acceptable ratings and specifically designed policies of banks, bearing in mind it will be a long term relationship.
  • Determine reasonableness of the compensation to be paid to the eligible directors and employees if the insurance will result in additional compensation – excessive compensation constitutes an unsafe and unsound practice.
  • Analyze risks and evaluate alternatives.
  • Retain written documentation of the process.
  • Apply to all purchases of BOLI after December 7, 2004.

4. Effective periodic and ongoing system of risk assessment, management, monitoring and internal control processes established in a BOLI policy for the bank.

  • The board of directors is permitted to delegate oversight to a risk management committee or like body, but the board is ultimately responsible and must be kept informed.
  • Review should be periodic, and otherwise when necessary as circumstances warrant, and must evaluate all risk factors.
  • Apply to all purchases of BOLI whether before or after December 7, 2004.

The bank must take care to follow the regime that it establishes and be able to show the regulators that it is in fact doing so in a regulatory examination. Documentation is critically important in every phase of the process. As part of the purchase and monitoring process, vendors can be extremely helpful in providing information about insurance companies and products, determining the amount of insurance that is necessary, developing policies and required documentation, and assisting the bank to meet its regulatory responsibilities. They play an important role in enabling the board of directors and management to understand the risks and evaluate the consequences. That being said, since a vendor has a financial interest in selling BOLI, the regulators will expect the bank to act independently in carrying out its responsibilities and to not simply accept and endorse what it is told.

In conclusion, BOLI continues to be an important financial tool enabling an institution to provide a competitive benefits package and to recover or offset those costs efficiently. However, it is a sophisticated financial strategy that is not without risks and the bank must manage these risks in a safe and sound manner. The interagency statement provides an excellent resource to guide a bank in fulfilling regulatory expectations.

* John Funk is admitted in New Hampshire, Massachusetts and Vermont.