Understanding New BOLI Regulations
By William J. Landers
Financial institutions can use “bank-owned life insurance” to help address a variety of employee benefit liabilities, including executives’ supplemental retirement plans, while also increasing shareholder value.
It has always been important, however, for institutions to make sure that they have documented the need for, and application of, the BOLI and that they are using high credit-quality insurance products. OCC Bulletin 2004-56, issued in December 2004, updates and provides added impetus to this mandate.
As institutions evaluate new purchases of BOLI, or examine existing policies to make sure they are meeting financial objectives in both a shareholder-friendly and regulatory-compliant manner, it is important to understand key guidelines associated with best BOLI practices.
BOLI BACKGROUND BOLI is typically used to insure a group of bank employees and sometimes directors, typically from the assistant vice president level and higher. The bank must determine under state law that it has an “insurable interest” in the employees. In addition, the bank should gain the positive consent of all employees who will be insured.
The bank pays the premiums on the policies, owns the policies, and is the beneficiary of the death benefits from the policies. It can designate this asset for such expenses as nonqualified, supplemental retirement plans, an important executive benefit that financial institutions use to retain and attract quality executives. Nonqualified plans are often a large, growing and non-financed liability at institutions.
BOLI can also be used to help meet other employee benefit costs, such as health care expenses. Outside the realm of bank employees, BOLI can also be used as insurance on borrowers as well as insurance as security for loans.
BOLI has two compelling tax benefits, similar to other insurance. The cash value of the life insurance grows “tax-deferred,” which allows the bank to book annual increases in cash surrender value as tax-deferred “other income.” When held until the death of an executive, the initial premium, as well as the previously deferred gains in cash value plus the death benefit, are all paid out in cash on a tax-advantaged basis.
KEY REGULATORY ISSUES AND RECENT DEVELOPMENTS
While regulators have recognized the positive role that BOLI can play for banks from an operational and financial perspective, they want to make sure that institutions use sensible practices when purchasing BOLI. Throughout the years, the OCC and other regulators have been focused on making sure that banks do not engage in short-term “yield chasing” when obtaining BOLI, and that they can demonstrate that the BOLI will serve a clear business purpose.
OCC Bulletin 2004-56 is particularly notable because it emphasizes the importance of the board of directors being involved in the purchase decision, and ongoing scrutiny, of BOLI products. This includes an annual review of the BOLI product(s), to gauge their financial performance and to make sure BOLI is serving its intended business purposes.
Banks have also been advised to understand the risks and limitations of separate account insurance products. As with any alternative investment, the funds selected for separate accounts must be bank eligible. For example, unless the bank is using the separate account product as a “highly correlated” hedge against a deferred compensation plan with equity investment alternatives, it is impermissible for the bank to invest in equity securities within the separate account (Bulletin 2004-56, Attachment, p. 3).
Because of these issues and others, experienced consultants can help banks determine the type and amount of insurance to purchase and to complete the required pre-purchase due-diligence process. Institutions that in the past simply used a friend of the bank or went directly to an insurance company should seriously reconsider this approach in the current regulatory environment.
Even the regulatory authorities recognize that, “[T]he vendor’s services can be extensive and may be critical to successful implementation and operation of a BOLI plan” (Bulletin 2004-56, Attachment, p. 7). Without such a qualified vendor/consultant, institutions may need to retain attorneys and accountants to delve into understanding existing policies, or new ones that might be purchased. The anxiety and uncertainty that this may create in the post Sarbanes-Oxley era is not something that many institutions want to risk.
OCC Bulletin 2004-56: Further Primer
OCC Bulletin 2004-56 is a single interagency statement, issued by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System (Division of Banking Supervision and Regulation SR-04-19), the Federal Deposit Insurance Corporation (FDIC Financial Institutions Letter-127-2004), and the Office of Thrift Supervision (OTS Thrift Bulletin 84).
It is a comprehensive document pertaining to the pre-purchase analysis of BOLI purchases after Dec. 7, 2004, while also outlining the ongoing risk management of all BOLI, regardless of when it was purchased.
There are five main topics covered by the statement:
• Legal authority;
• Accounting considerations;
• Supervisory guidance;
• Risk management of BOLI;
• Risk-based capital treatment.
While the OCC specifies a number of reasons why institutions can specifically purchase BOLI, it also outlines reasons it cannot be purchased. These include:
• Funding for stock repurchase from the estate of major shareholder;
• Estate planning benefits for insiders unless it is part of a reasonable compensation package;
• Generation of funds for normal operating expenses other than employees’ compensation and benefits.
In addition, the OCC makes clear that equity-linked variable life insurance may only be used as a highly correlated hedge for an equity-linked liability.
Banks must follow GAAP accounting and the provisions of FASB Technical Bulleting No. 85-4, Accounting for Purchases of BOLI, when purchasing BOLI. As such, the asset value will be equal to the amount realizable from each insurance contract on the date of the balance sheet, net of any surrender charges. The cash surrender value will be carried in the “other asset” category. Earnings from the increases in cash surrender value are to be reported as “other noninterest income.”
Comprehensive risk management programs are required when purchasing BOLI. This must include:
• Effective senior management and board oversight;
• Policies and procedures, including limits on BOLI ownership;
• Pre-purchase analysis of BOLI products;
• An ongoing system of risk assessment and management, including internal controls.
With respect to senior management and board oversight, the board must understand the complex risk characteristics of BOLI and BOLI’s role in the bank’s business strategy. They can delegate the purchase authority to senior management.
The total BOLI limits will generally be 25 percent of the sum of Tier I Capital and Loan Loss Allowance. Board approval will be necessary for higher holdings and the bank will also have to provide other justification and documentation for exceeding this threshold.
There are also limits in place on the amount of BOLI that can be provided from a single carrier. This generally should not exceed 15 percent of the sum of Tier I Capital and Loan Loss Allowance.
Consideration must also be given to regulatory limits imposed by applicable state law. For example, for state chartered commercial banks in New Jersey, the 15 percent and 25 percent limits are applied to “total capital funds,” which is defined as the “aggregate of the capital stock, surplus and undivided profits of the bank” (see N.J. Stat. ßß 17:9-41(1) (definition of “capital funds”) & 17:9A-62 (limitations on liability).
The pre-purchase analysis should identify the need, and determine the economic benefits and appropriate insurance. The specific risk of loss, as well as specific costs to be recovered, should be documented. Calculations should also be undertaken to document that the purchase is not excessive, such as determining the present value of future cash flows from BOLI do not exceed the present value of after-tax employee benefit costs.
Vendors should also be carefully assessed. This should include making sufficient inquiries to determine their ability to handle commitments in the short and long term.
The characteristics of available insurance products should be reviewed. One of the most critical decisions is to do a credit analysis consistent with commercial lending, and make sure that quality products are being purchased.
Risk-Based Capital Treatment BOLI assets in general account products receive a 100 percent risk-based capital weight. Assets in separate accounts may be treated differently.
BOLI will continue to provide important benefits to financial institutions, as well as their shareholders, for many years to come. Today, however, it is more important than ever for bank management and directors to understand BOLI. This applies to both new purchasing decisions and to evaluating the institution’s current BOLI holdings.
As such, it is necessary to devote the time to evaluating BOLI alternatives and documenting the need for it, understanding regulatory guidelines, and working with a consultant who will ensure that the bank not only meets these guidelines, but also that the BOLI will be properly administered and serviced for years to come. Banks that approach BOLI in this manner will have a strong, safe and secure asset that addresses burgeoning liabilities, generates shareholder value, and meets the reasonable concerns of both board members and regulators today.
William J. Landers, J.D. (firstname.lastname@example.org) is a consultant with The Todd Organization, NJBankers’ recognized BOLI provider. The Todd Organization is a leading nationwide provider of executive benefits plans to financial institutions as well as companies in an array of other industries.