Smaller banks are slowly adopting bank-owned life insurance as a way to counter shrinking loan margins and diminished returns on other investments.
Community banks have traditionally been reluctant to buy life insurance on key employees, a common practice among big banks. But since the recession, higher capital requirements and other factors have made bank-owned life insurance, or BOLI, increasingly attractive. The insurance offers tax breaks and counts as Tier 1 capital, while producing higher yields than most Tier 1 investments.
"The interest in BOLI has really spiked in the past three years or so, once some banks were past the recession and past dealing with real-estate woes," says David Fritz, managing partner of Executive Benefits Network. "For banks that had excess liquidity and a lot of money sitting in Fed funds, the opportunity that BOLI offered was too hard to ignore."
Big banks still dominate the market. Around 80% of the total $145 billion in bank-owned life insurance assets is held by banks with at least $10 billion in assets, according to the Federal Deposit Insurance Corp.
The market has been shifting, however. Banks with less than $10 billion have increased their BOLI holdings by 31% since the end of 2009 and now hold nearly $26 billion, according to FDIC data.
Overall, 57% of all banks hold BOLI assets, compared to 48% at the end of 2009, based on FDIC data.
Community banks' interest in BOLI "has been taking off every quarter for the last few years," says Michael White, a bank insurance consultant who publishes an annual report on BOLI. "With interest rates so low and lending down, they're looking for additional safety and additional yield."
The trend has been most striking among smaller lenders. Banks with $100 million to $1 billion in assets hold an average of 1.1% of their assets in BOLI, up 31 basis points from the end of 2009, according to the FDIC. Larger banks did not, on the whole, tilt their balance sheets toward BOLI over that period.
Another key factor in the BOLI surge has been rule changes that cleared up the legal muddiness that once surrounded the practice.
"Community banks were slower to get comfortable with BOLI because it was an unusual concept, and the regulatory guidance was more vague," says Kathy Smith, president of Bank Compensation Consulting in Plano, Texas. "Education has been a big reason why community banks have been doing it more."
Like other companies, community banks are leery of being seen as profiting off employees' deaths. Company-owned life insurance earned the nickname "janitor's insurance" in the 1980s and 1990s, when Walmart Stores and others were sued for taking out policies on poorly paid employees without their knowledge.
The Pension Protection Act of 2006 clarified the rules for bank- and company-owned insurance. Employers are required to receive an employee's consent before taking out a policy on his or her life, and can only insure the top 35% most highly paid workers.
Banks must also show that they are buying BOLI for a legitimate business purpose and not simply for the tax break or as an investment. Most community banks use BOLI to fund employee-benefit or deferred-compensation programs, which means it can be a useful tool for recruiting and retaining key employees. Many banks offer employees split-dollar life insurance, where the company and the employee share the policy's costs and benefits.
The key for community banks is managing risk, which comes in several forms. The Office of the Comptroller of the Currency requires banks to analyze several types of risk before buying BOLI, including investment risk, the insurer's credit risk and the reputational risk of engaging in what some consider an unseemly practice.
BOLI risks are likely still fresh in many bankers' minds after the financial crisis. In 2008, Wachovia and Fifth Third Bancorp (FITB) each lost more than $300 million on investments tied to their BOLI programs; BB&T (BBT) lost about $12 million.
In each case, the premiums were placed in high-risk investments through separate accounts, a practice that is very uncommon at smaller banks. Separate accounts are pools of BOLI assets segregated from insurers' main accounts on which the bank assumes the investment risk. Community banks generally hold their assets in the insurance companies' general accounts.
"The bigger the bank, the more exotic the life insurance," says Tom Provow, a principal at Evergreen Consulting in Tennessee. "For the big guys, you almost need a Harvard MBA to manage their accounts, but community bankers prefer the safe, low-risk approach."
Because smaller banks typically buy plain-vanilla insurance, most are more concerned with the creditworthiness of the insurer rather than the risks of the investments. To gain tax benefits, banks must hold BOLI until the death of the insured employees, so the long-term nature of the investment makes carrier risk another significant concern.
The need to balance investment risk and carrier risk has spurred interest in hybrid accounts, which combine features of general and separate accounts. In hybrid accounts, premiums remain in the insurer's general accounts but are protected from claims against the insurer, and banks can select from different investment strategies. Banks hold $13.3 billion in hybrid accounts, less than 10% of all BOLI assets, but 20% more than just two years ago.
"We've seen a tremendous increase in hybrid products," says White. "Hybrid gives them the sense of having some upside along with the protection against risk."
While there are instances of banks posting one-time gains on payouts that follow an employee's death, BOLI's the main attraction is consistent income, industry observers say.
"Community banks are not buying BOLI to profit on the death benefit," Provow says. "They're buying it because it's a 3.5% yield right now and there's no place to invest their money."
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