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The following is the first part of a special report on the website of ABA Bank Directors Briefing newsletter, www.bdbonline.biz © Lenhart Obenshain PC

Safely dancing with the “BOLI bear”


Before your bank sets out to fund its benefits programs with a “key man” policy, both the board and management must scope things out in detail

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. Mr. 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). These regulations are being promulgated pursuant to the BOLI best-practices legislation effective August 2006. 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 those practices 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. The scope of this article is limited to the pre-purchase analysis which should take place before entering into a BOLI contract. Our companion article 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: (i) whether the policy is a general obligation of the insurance company, a separate obligation unique to the bank, or a combination of the two; (ii) whether the insurance contract is a modified endowment contract that contains certain tax penalties if surrendered; and (iii) 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.

The purchase of BOLI can be an effective way for the bank to manage exposure arising from its commitment to provide competitive employee benefits. Consistent with safe and sound banking practices, the bank must, however, understand the risks associated with the product. By addressing the risk issues with a pre-purchase analysis, the bank will, at the least, know if the tune is “bearable” while they waltz!
BJ

 
 

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