Bank Owned Life Insurance (BOLI)
Frequently Asked Questions

BOLI Basics

Why Do Financial Institutions Use BOLI?

Primarily to finance employee benefit plan expenses and increase net income. For example, banks have substantial cost for medical, group life, other life insurance, deferred compensation and qualified benefit plan expenses that can be recovered by BOLI. The reasons banks use BOLI for these costs are:

• Higher return on capital
• Tax-free yield if policies are held to death
• Tax-deferred yield if policies are surrendered
• Capital Guarantee
• Liquidity - reasonable ability to terminate agreement
• Tax-favored returns that exceed after-tax returns of more traditional bank investments by 50 to 300 basis points
• Ability to generate gains to offset costs associated with employee benefit programs
• Products are institutionally priced and designed specifically for financial buyers
• Immediately accretive to earnings
• Risks that are well within standard business risks in the bank's investment portfolio
• Guidance on permissible usage well-defined by regulatory authorities
• Ability to immediately increase ROE and ROA
• Matches long term plan of benefit expenses
• May facilitate the establishment of "golden handcuffs"

Is BOLI an Employee Benefit Plan?

No. It is a tax-advantage cost recovery vehicle designed to recover some of the present and future costs of doing business. It is a proactive strategy rather than a reactive strategy.

Do Many Banks or Thrifts have BOLI?

Yes. Nearly all of the super regional banks have implemented significant BOLI programs. There are billions in these plans. Community banks began implementing BOLI plans several years ago when carriers began offering BOLI premiums as low as $1 million. The trend for community bank participation is growing rapidly.

Since This Is An Opportunity For A Bank To Make More Money And Finance Benefit Expenses At The Same Time, Why Wouldn't Every Bank Do It?

Every bank should buy BOLI if it has these three characteristics:

• The bank is historically profitable
• It has reasonable liquidity
• It has employee benefit expenses

How Does BOLI Work?

The bank purchases a specially designed insurance product on the lives of a group of employees. In its simplest form, the bank pays the premium(s) and owns the policies. The bank is also the beneficiary of the insurance. The employees do not receive any of the insurance benefits directly, nor do they pay any of the premiums. The coverage does not replace or interfere with any other insurance provided by the bank, e.g. group term life insurance. There can be variations on the beneficiaries and the payout of the death benefits depending on the desired plan design.

The policies the bank buys produce income for the bank. The income earned is higher than the income the bank can earn on most alternative investments of equal quality and risk. The income is tax deferred - tax free if held to the death of the insured.

Do The Policies Actually Fund The Benefits Like A Pension Plan Funds Retirement Benefits?

No. The annual non-interest income non-taxable from the policies is used to offset annual employee benefit costs like health insurance, FICA, etc. Also, if a bank has a non-qualified defined benefit plan for its executives, or wishes to implement one, it must accrue the liability annually over the service life of the individuals. The annual income from the BOLI is also used to offset these costs.

What Are The Different Types of BOLI Policies?

There are two policy types characterized as:
General Account and Separate Account

An explanation of each follows.

General Account
With an Annual Fixed Yield contract, the carrier invests the premium in its investment portfolio. This is sometimes called a General Account or Portfolio Product. The carrier's portfolio is made up of 5 to 10 year investments including corporate bonds, mortgages and real estate. The carrier credits a yield to the policy based on its portfolio yield. The yield is set annually. Normally the carrier will charge a spread of about 200 basis points less than its portfolio yield. The resulting net yield is what the policy will earn each year. Part of the point spread is charged for the insurance coverage and is ultimately returned to the client via the payments of insurance proceeds. An easy way to think of a portfolio yield is to calculate a 5 to 10 year corporate bond yield less 100 to 200 basis points. The bank is a general creditor of the insurance company.

Separate Account (two types)

Hybrid Separate Account
The investment is placed in a pool of funds (much like a mutual fund with bank eligible investments). These funds have several investment choices, i.e. Treasuries, Agencies, Corporate bonds, Libor + or -, and General Account Clone. The funds are managed by the life insurance company and have a guaranteed floor between 2-2.5%, dependent on carrier. Risk weighting is between 20% and 100%, based on investment portfolio. Bank investments are isolated from insurance carriers assets and the bank is not a general creditor of the insurance company.

Separate Account/Private
The bank is not the general creditor of the company. A true separate account investment with interest rate and credit risk taken on by the bank. This product is mark to market and has the potential to go underwater. There is a stable value wrapper that protects the institution from losses to a certain limit. Usually, stable value wrapper insures a maximum of 10% of value. If investment falls below 10% the financial institution incurs a loss. Risk weighting is between 20% and 100% based on investment portfolio. There is potential for loss.

How Are Policy Premiums Paid?

BOLI can have a single-pay premium or a multi-pay premium. There are advantages and disadvantages for each payment method. The policy type and payment method should be carefully considered. Greenhouse Financial works closely with bank clients to identify and explain each strategy. The best strategy is the one that best serves the bank's objectives.

Making A BOLI Plan Work

Is The Insurance Held At The Bank Level Or The Holding Company Level?

The insurance can be held at either level. Most of the time the insurance will be held at the bank level where the majority of the Company's assets are held.

Does The Bank Keep The Coverage When The Employees Terminate Or Retire?

Probably, but the bank has the discretion to exchange the contract for one on the new employee through a 1035 exchange, if it so desires. (See Surrender Penalty) The employees are tracked by Greenhouse Financial, LLC via the Social Security System. When the employee or former employee dies, we access information via the Social Security System to file the death claim with the carrier.

What Has Been The Employee Reaction To The Plans?

Very favorable. In most cases the plan either provides new benefits that had not been previously promised or assurance that promised benefits would be realized. Keep in mind the coverage does not cost the employees anything. It makes their employer more financially viable and it is a plan that has been implemented by many of the country's largest and most reputable banks.

Do The Employees Receive Any Of The Cash Benefits From BOLI?

Generally no. However, some banks have provided a small additional death benefit to the employees, i.e. $5,000 or $10,000. Also, plan design is flexible. There may be reasons the bank and the executive would prefer a portion of the death benefit be designed to be paid to the executives' beneficiaries.

How Long Does It Take To Implement A Plan?

Normally 2 to 3 months from start to finish. Some carriers will allow fund transfers from the beginning and credit current rates until the project is completed.

Does The Bank Profit From The Death Of The Employees?

When an employee dies, the bank receives a death benefit but loses the future tax benefits of the policy. Mathematically, it would be better for employees to never die as the insurance policies earn a rate of return higher than the bank can earn elsewhere, ignoring the ultimate value of the insurance proceeds.

However, in the event of a premature death of one of the participants, the bank receives tax-free funds to provide the benefits promised to the employee's survivors and to search for a suitable replacement. It is not a windfall for the bank, but the plan does provide protection to the bank and the participants' survivors.

In either case, an unexpected premature death or the expected death at the end of a long life, the proceeds flow into the bank tax-free. The tax-free nature of the death benefits, enhance the powerful cost recovery nature of the proceeds.

Financial

Will BOLI Have An Impact On A Bank's Financial Performance?

BOLI will favorably impact a bank's financial performance by creating higher net after-tax returns and decreasing the current tax expense. The results are an increase in earnings per year.

What Are The Current Earnings Rates Of BOLI?

The rate of return is a function of the type of policy that is purchased. For a General Account policy the after-tax rate of return is tied to the investment portfolio of the life insurance company.

The rate of return from a Variable Separate Account policy is a direct function of the earnings of the investment chosen by the bank. For example, if an MBS fund is selected as the investment fund, the bank will earn the same rate as the MBS fund, less the insurance company's costs. The costs are contractual and explicit.

Is BOLI Liquid?

Yes. Many BOLI policies can be surrendered at any time and the cash value will be paid to the bank. Some carriers, but not all, will require a 4 to 5 year surrender period to allow them to gradually wind down their investment.

What Happens If The Coverage Is Surrendered?

The carrier pays the bank the cash value of the policies. The bank must pay for income tax on any gain, which is determined by the amount of premium(s) paid. For example, if the cash value is $60M and the amount of premium paid is $50M, the bank would recognize $10M of taxable income. This would be taxed at normal rates and subject to an additional 10% penalty.

If The Insurance Had To Be Surrendered In The Future, Is BOLI Still Good For The Bank?

The three issues to consider are taxes, timing, and financial reporting. The annual income from the BOLI is non-taxable and non-interest income. It has a positive impact on after-tax net income. The longer the taxes are deferred, the more likely the surrendered BOLI after-tax and after-penalty returns will have out-performed alternative investments. The income that had been recorded will be taxed for financial reporting.

What Is The Credit Risk Of A BOLI Program?

GHF has made a commitment to the banking community to help alleviate most of the credit risk inside the BOLI product by using a separate account chassis. The only risk lies in the mortality benefit, not in the cash value.

How Does The Carrier Make Money?

This depends upon the type of policy purchased. With an Annual Fixed Yield policy the carrier invests the funds in its general investment portfolio. The carrier then credits its portfolio yield to the policy, less a change for the insurance risk and other expenses. The carrier makes money through the spread.

The carrier makes money with a Variable Yield policy from a combination of charges. They are:

• Monthly policy fee
• Investment management
• Sales load

What Happens If The Carrier Has Financial Trouble?

For general account purpose, the coverage can be transferred to another carrier via an IRC Section 1035 tax-free exchange. IRC Section 1035 allows for tax-free exchanges of "like property" without tax.

For a separate account product the funds are not at risk, but can also be moved, if desired.

What Is The Effect Of A Merger On BOLI Plans?

Merger and acquisition activity has no direct impact on the BOLI performance plan, per se. However, if you are an acquiring bank, the BOLI from the acquisition should be a beneficial addition to your existing portfolio. It will be reviewed in terms of concentration and credit for the newly managed entity.

If you are an institution being acquired, BOLI is an attractive investment on your balance sheet and will enhance your net worth and earnings per share results.

Legal & Regulatory

Is The Amount Of BOLI A Bank Can Purchase From One Carrier Limited By The Bank's Legal Lending Limit?

In General Account, yes. Most banks purchase BOLI from a number of carriers to keep the amount from any one carrier exceeding the allowing range of the bank's legal lending limit.

However, with a separate account product the regulators recognize the separation of the cash value from the death benefit as a "look through" approach where bank eligible investments, i.e., treasuries, agencies, etc. are treated with the appropriate risk weighting and viewed as separate. Thusly, a separate account product does not fall under legal lending limit requirements for the purchase of BOLI.

What Legal Authority Is There For The Purchase Of Life Insurance By National Banks, State Banks And Thrifts?

National Banks
The authority for national banks to purchase life insurance is found in 12 USC 24 (seventh). The OCC has further delineated the scope of that authority through regulations, interpretive rulings and letters addressing the use of life insurance for purposes incidental to banking. One ruling is OCC 2004-56, which clarified that life insurance, can be purchased if it is convenient or useful in connection with the conduct of the bank's business. This authority is subject to supervisory considerations. However, such life insurance holdings must be consistent with safe and sound banking practices.

State Banks
The authority for state banks to purchase life insurance is found in part 362 of FDIC's regulations. Part 362 implements 12 USC 24 and limits purchases of life insurance to those permissible for national banks (i.e., those permissible under OCC 2004-56).

Thrifts
The authority for thrifts to purchase life insurance is found in Section 250 of the Regulatory Handbook of the Office of Thrift Supervision.

How Do You Determine The Amount Of BOLI To Purchase?

There are two guidelines which determine the amount of coverage to be purchased. They are:

• Your State's Insurable Interest Guidelines
• Regulatory Guidelines OCC 2004-56 & OTS-250

The first step is to look at your insurable interest statute to determine how much coverage you can purchase on the life of each employee. The state laws vary. Greenhouse Financial will provide a state-by-state summary and analysis of your employees.

The second step is to adhere to the appropriate regulatory guidelines. The OCC will allow a bank to buy BOLI to finance benefit expenses. Greenhouse provides this actuarial service for quantification of these expenses.

The OCC also provides guidelines on the amount of insurance allowable as compared to the bank's capital. No more than 25% of the bank's capital should be in life insurance.

What Are ALCO Points Of Interest?

Pre-Purchase Analysis
OCC Bulletin 2004-56 identifies the following issues to be considered prior to the purchase of life insurance:

• Measure the need for life insurance
• Quantify the amount of life insurance needed
• Vendor selection
• Carrier selection
• Product selection
• Benefit Analysis
• Reasonableness of the compensation associated with the benefit plan
• Risk Analysis
• Alternatives
• Document the Decision

Risk
OCC 2004-56 cautions a financial institution to consider the various risk factors associated with the purchase of life insurance. They are:

• Transaction risk (not properly understanding or implementing the purchase)
• Credit risk (carrier evaluation)
• Interest rate risk (exposure to movement in rates)
• Liquidity risk (access to cash, if necessary)
• Compliance risk (possible violations of laws, regulations, business practices, ethics)

The OCC, FDIC and other regulatory agencies follow this framework for evaluating the analysis and acquisition of life insurance by their member banks. Greenhouse Financial, LLC will use its technical resources and expertise to guide its clients carefully along the compliance path to safe and sound banking practices.

How Do You Comply With The Regulatory Guidelines Regarding The Amount Of Coverage To Purchase?

OCC 2004-56 has issued the current regulatory guidelines for the purchase and administration of Bank Owned Life Insurance. These guidelines are followed based on the client's pre-purchase analysis. GHF also monitors tax and regulatory guidelines on a continuing basis.

What Are The Steps To Implement The Plan?

BOLI implementation can be achieved within a 1 to 3 month timeframe.

The Next Stage:

1. Discuss plan design
2. Select carriers and product
3. Conduct due dilligence on any financial regulatory or legal issues (benefit documents, etc.)
4. Wire premium

Steps To Implement Plan Are:

1. Make application
2. Execute a binder agreement
3. Legal documents and wire money
4. Administrative service documents and plan accounting

What Happens If The Tax Laws Change?

Most professionals believe if the laws change there will be "grandfathering" of in-force contracts. As such, in-force plans will operate as designed but new employees cannot be included. In the unlikely event the laws change without "grandfathering," the coverage can be surrendered and the bank will have earned a tax-deferred yield.

Executive Benefits

How Does A SERP Work?

A Supplemental Executive Retirement Plan (SERP) begins with a contract between the bank and one or more top executives, e.g. the bank president. The bank might promise the president that if he remains in his position and continues to perform at the expected level, he will receive an income stream at the completion of the contract. For example, the bank could promise $150,000 per year for 15 years to begin at age 65. Since the bank is contractually obligated to provide that benefit, it must accrue an expense equal to the present value of the expected future benefit payments on a systematic basis by the time the executive is eligible for the benefits. The bank purchases a BOLI contract to informally fund the obligation.

There are three reasons why BOLI works so well as a funding mechanism. First, when the bank pays the premium it has little effect on the balance sheet and none on the income statement. The amount moves from cash to cash value on the balance sheet. Secondly, ideally in the first year, and each consecutive year, the increase in cash value is greater than the accrual for the pension benefit obligation. Therefore, the impact on the income statement is positive from the first day the plan is implemented. Third, BOLI has significant tax advantages. The income created by the increase in the cash value each year is not taxable. The expense that accrues is tax deductible. The death benefits flow into the bank tax free and provide full cost recovery with a good return on invested capital. The bank could fund a SERP with any of the other investments it normally makes. However, there is nothing available to the bank at this time that will provide the same security, return, and tax advantages as BOLI.

Why Would A Bank Want A SERP?

The bank may need one to attract and retain top executives. Qualified plans, such as a 401k plan, are called non-discriminatory plans. While they do not discriminate against the rank and file employees, they do discriminate against top executives. If a bank teller contributes the maximum amount to her 401k, at retirement, she may have amassed a retirement nest egg that will provide her with 70 or 80 percent for her terminal salary during her years of retirement. Due to the limitations on contributions, if the bank president does the same thing he may only create a retirement income of 15 to 20 percent of his terminal salary. A SERP is designed to correct that deficiency.

Financial Performa

Bank Owned Life Insurance (BOLI) sometimes includes the use of variable insurance which is a securities product. Securities are offered only by prospectus. Investors should read the prospectus carefully before making a decision to invest. Please call or write our office for a prospectus on any specific security.

Robert Green and Stephen Speirs offer Securities and/or Investment Advice ONLY to residents of AL, AR, FL, LA, or WA. Securities and Investment Advice are offered through G. A. Repple & Company, A Registered Broker/Dealer & Investment Advisor, Member FINRA & SIPC. Home Office: 101 Normandy Rd., Casselberry, FL 32707, Phone: (407) 339-9090.