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

Now that you’re dancing with the “BOLI bear,” how to maintain harmony?


You don’t want the bear stepping on your foot—or worse.

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

In the first article in this special report, the authors addressed the pre-purchase analysis recommended by banking agencies and the Office of Thrift Supervision issued in December 2004 in an inter-agency statement (OCC 2004-56) regarding the purchase and risk management of bank owned life insurance. The article also covered pending regulations regarding annual reporting, from the Treasury and IRS.

In the first part of this report, we suggested that selecting a bank-owned life insurance strategy is much like dancing with a bear—you don’t stop dancing until the bear stops dancing! So how do we make sure that the music remains “danceable” throughout your BOLI experience? The interagency statement suggests that banks incorporate a comprehensive risk management strategy with the introduction of BOLI into the bank’s employee benefit strategy. This second article, in part, summarizes the FDIC’s advice regarding ongoing risk management.

In approaching this matter, it is important to keep in mind that only a limited number of life insurance companies have been in the BOLI market. Over recent years, many of these carriers have been acquired; suffered rating downgrades by one or more of the major independent rating services; and/or ceased selling BOLI products. In other cases, returns have been disappointing. From an investment standpoint, staying in step on the BOLI dance floor can be a problem. BOLI is not an investment, but a strategy to assist in offsetting the costs of employee benefits. Nevertheless, the bank’s board must apply investment analysis to determine if this product is an appropriate vehicle for meeting those expenses.

Risk management framework
 In addition to conducting the risk assessment as part of a thorough pre-purchase analysis, monitoring BOLI risks on an ongoing basis is critical, especially if the aggregate BOLI holdings represent a capital concentration. The bank’s management should review the performance of the institution’s insurance assets with the board at least annually. More frequent reviews may be appropriate if significant changes are anticipated.

This risk management review should include, but not necessarily be limited to:

1. Comprehensive assessment of the risks to the bank.

2. Identification of which employees are, or will be, insured.

3. Assessment of death benefit amounts relative to employee salaries.

4. Calculation of the percentage of insured persons still employed by the bank.

5. Evaluation of the material changes to BOLI risk management polices.

6. Assessment of the effectives of policy exchanges.

7. Analysis of mortality performance and impact on income.

8. Evaluation of material findings from internal or external audits and independent risk management reviews.

9. Identification of the reason for, and tax implications of, any policy surrendered.

10. Peer analysis of BOLI holdings.

Risk management specifics
 In assessing the various risks as part of its ongoing risk assessment, the board and bank management should consider the following:

1. Liquidity risk. In purchasing permanent insurance, the bank should recognize the illiquid nature of the product and ensure that the bank has the long-term financial flexibility to hold the asset in accordance with expected use. The inability to hold the life insurance until the death of the insured, where the death benefit will be collected, may compromise the success of the BOLI plan. The illiquid nature of insurance assets, combined with the difficulty of projecting liquidity needs far into the future, is a major reason the bank should keep its BOLI holdings below the recommended concentration guidelines.

2. Transaction/operational risks. As it relates to BOLI, the transaction/operational risk is the risk to earnings and capital arising from problems caused by the bank’s failure to fully understanding or properly implement a transaction. To help mitigate this risk, bank management should have a thorough understanding of how the insurance product works and the variables that dictate the product’s performance. The variables most likely to affect product performance are the policy’s interest crediting rate, mortality costs, and other expense charges.

3. Tax and insurable-interest implications. Before making the decision to purchase BOLI and periodically thereafter, management should also explicitly consider the possible financial impact (e.g. tax provisions and penalties) of a future decision to surrender the policy. A tax change that makes BOLI cash flow subject to income tax, while perhaps deemed unlikely, could have a negative impact on the economics of the BOLI holdings. The bank should also recognize that earnings from BOLI could make it subject to alternative minimum tax as well.

To benefit from the favorable tax treatment of insurance, a BOLI policy must be a valid insurance contract under applicable state law and must qualify under applicable federal law. Furthermore, the favorable tax equivalent yields of BOLI result only when an institution generates taxable income. If the bank has no federal income tax liability, then it receives only the nominal interest crediting rate as a yield. In such an environment, BOLI loses much of its yield advantage relative to other investment alternatives.

4. Reputation risks. Reputation risk is the risk to earnings and capital arising from negative publicity regarding an institution’s business practice. While this risk arises from virtually all bank products and services, it is particularly prevalent in BOLI, because of the potential perception associated with the institution owning and benefiting from life insurance on its employees. The bank should consider taking steps to reduce the reputation risks associated with BOLI purchases by maintaining appropriate documentation evidencing informed consent by the employees concerned.

5. Credit risk. Credit risk is the potential impact on earnings and capital arising from an obligor’s failure to meet the terms of a contract with the institution or otherwise perform as agreed. All life insurance policyholders are exposed to credit risks. Most BOLI products have long time frames for full collection of cash proceeds (i.e., the death benefit). For general account policies, the cash surrender value is an unsecured, long- term and non-amortizing obligation of the insurance carrier.

6. Interest rate risk. Interest rate risk is the risk to earnings and capital arising from movement in interest rates. Due to the interest rate risk inherent in general account products, it is particularly important that management fully understand how these products expose the policyholder to interest rate risks. The interest rate risk associated with these products is primarily a function of the maturities of the assets in the carrier’s investment portfolio, which often range from four to eight years. When purchasing a general account policy, an institution chooses one of a number of interest crediting options (i.e., the method by which the carrier will increase the policy’s cash surrender value). Using the “portfolio” crediting rates, the bank will earn a return based upon the existing yield of the carrier’s portfolio each year.

7. Compliance/legal risk. Compliance/legal risk is the risk to earnings and capital arising from violations of, or non-conformance with, laws, rulings, regulations, and ethical standards. Failure to comply with applicable laws could compromise the success of the BOLI program and result in fines or penalties. Tax benefits are critical to the success of most BOLI plans.

8. Price risk. Price risk is the risk to earnings and capital arising from changes in the value of the portfolios of the financial instruments. Because the bank does not control a separate account asset, it is more difficult to control price risk of those assets than if they were directly purchased.

Looking forward on BOLI
 A BOLI program can be an effective way for the bank to manage exposure arising from its commitment to provide employee compensation and pre- and post-retirement benefits. Consistent with safe and sound banking practices, the bank must, however, implement a risk management process that provides for the identification and control of such risks. A meaningful ongoing monitoring program, reliable accounting process and accurate assessment of risk-based capital requirements are all components of the type of risk management process the agencies expect institutions to employ.

As long as the board and management “bear” in mind these essential monitoring and assessment obligations, the BOLI Bear dance floor will remain a reasonably safe and pleasant place to be.

BJ

 
 

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