“…The banking industry – one of the most powerful and influential industries in the United States – has a deep affection for cash value life insurance and treats it like a golden asset.”
– Barry James Dyke, “Cash Value Life Insurance: Contempt Prior to Investigation”
It’s more than a bit ironic. We say “it’s like money in the bank” when speaking of a sure thing, something solid and secure. But if we’ve been paying attention to the bank failures in the U.S. over the last decade, we ought to realize that “money in the bank” is about as sure and secure as the famous “Unsinkable Ship” that hit an iceberg in 1912.
Of course, the FDIC has provided life rafts for bank failures so that savers have some protection against such failures, up to $250k. But are FDIC guarantees a solution, or simply a temporary fix that hides the risks our financial institutions take with our dollars?
Since the Financial Crisis, banks have put a lot of new cash in an old-fashioned product designed build greater protection, security, and profits they can depend on in unpredictable times. In this article (and part 2), we’ll examine what this asset is, how banks use it, how much they own, why they purchase it, and what can we learn from their example.
The Financial Double Standard
Banks retail financial products such as checking and savings accounts, CD’s, credit cards, mutual funds, and mortgages. But if you walk into a bank and try to put your money where the bank puts much of theirs, they won’t be able to help you. Why? Because they don’t sell the financial product they use themselves to:
- hold and grow cash reserves
- avoid taxes on gains and windfalls
- protect themselves from unexpected loss
- keep pace with rising costs
- fund employee benefits programs
- and prepare for an unpredictable future.
This product is high cash value life insurance, and in the banking industry, it’s known as Bank Owned Life Insurance, or BOLI.
Never heard of BOLI? You’ve got company. Motley Fool’s “Math Guy,” Matthew Frankel, calls it “a little-known way that banks make money,” explaining that BOLI is life insurance purchased by banks on the lives of their executives and key employees. It is primarily used to offset the costs of employee benefits, such as healthcare, 401(k) programs, and vacation days, although it also plays an important role in helping banks meet their capital requirements.
The majority of banks in the U.S., including over three-fourths of banks with assets of $500 million or more, purchase life insurance that is held as a general asset of the bank (separate and distinct from policies established for the benefit of the insured or key individual). Since the practice was established in the 1980’s, banks have purchased increasing amounts of bank-owned life insurance because BOLI actually outperforms the safe assets that banks sell to their customers.
Frankel explains in a nutshell why life insurance has become a major line item of most banks’ balance sheet: “BOLI policies produce far superior returns than traditional bank investments… and, the growth in the cash value of the policies, as well as any death benefits paid out, are completely tax-free.”
The Basics of BOLI
BOLI is a type of “COLI,” or, Corporate-Owned Life Insurance. Charlie Hicks of the Meyer-Chatfield Group gives a brief overview of BOLI in this video from BankDirector.com:
The bank owns the policy, pays the premiums, and is also typically the beneficiary upon the death of the employee. Payments are made into a special trust account and employee benefits are then paid out from the fund’s proceeds.
Bank-owned policies are not the same type of policy you might purchase as an individual, although BOLI policies share similarities with other types of permanent life insurance, especially high cash value whole life. Like whole life, bank-owned policies have both a cash value and a death benefit component. Unlike most whole life policies, bank-owned policies are single premium MECs, or Modified Endowment Contracts, which means that withdrawals or policy loans from MECs can trigger tax consequences and even penalties.
Bank-owned policies are treated as long-term investments that are rarely leveraged or surrendered. Perhaps most similar type of policy publicly available is a Single Premium Whole Life policy, which is also a MEC and has some distinct advantages and disadvantages.
Another key difference between whole life insurance and bank-owned policies is the potential use of the policy. While private life insurance policies can be used to fund anything — a business start up, home improvements, rental home down payment or college tuition — BOLI is highly regulated and used almost exclusively to offset the cost of employee benefit programs.
In spite of occasional rhetoric that banks are “profiting from the deaths of their employees,” BOLI profits actually benefit other bank workers, funding such things as health insurance premiums, 401(k) programs, vacation days and post-retirement benefits or pay. The Executive Benefits Network affirms that BOLI is the “predominant investment asset for financing the cost of employee benefit plans.”
Banking on a Return
According to BoliColi.com, BOLI is a tax-favored asset with returns that typically exceed after-tax returns of more traditional bank investments such as municipal bonds, mortgage-backed securities and 5-and 10-year Treasuries by 150 to 300 basis, or 1.5 – 3% annually. The most common reason cited by bankers for purchasing BOLI are that it “provides competitive returns with superior credit quality,” reports BankDirector.com.
The favorable tax treatment of life insurance has a sizable impact on returns. In October of 2016, BankDirector.com confirmed, “Current BOLI net yields are in the range of 3.00 percent to 3.75 percent which generates tax equivalent net yields of 4.85 percent to 6.05 percent for a bank in the 38 percent tax bracket.”
The impact of this tax treatment is shown below in a chart from BoliColi.com, which illustrates how policies work to generate a higher equivalent yield when compared with taxable assets:
(The “net amount at risk” described above is the death benefit subtract the accrued cash surrender value. It represents the risk for the insurance company, not the bank.)
Of course, the yields mentioned above are for Cash Surrender Value alone. As with personal life insurance, death benefits are not calculated as “yields,” although they can provide significant additional financial value to beneficiaries, including spouses, children, charities, alma maters, and employers.
Tier 1 Capital
Tier 1 capital represents a bank’s equity and reserves. It is the core capital that is the measure of a bank’s financial strength as well as its protection against the risks it takes. It represents the highest quality capital that, from a regulator’s point of view, is essential to the health of a bank. According to Frankel,
“BOLI assets are beloved by banks for their robust capital profiles… Since the policies are considered somewhat liquid – due to their cash-surrender value – they can be counted as Tier 1 capital under new capital requirement rules.
The 2016 Equity Alliance/ Michael White BOLI Holdings Report indicates that FDIC asset-concentration guidelines are 25 percent of Tier 1 capital, meaning that Cash Surrender Values (CSV) can provide up to 25% of a bank’s top-shelf capital. The chart below illustrates the actual percentages of BOLI held as Tier 1 capital amongst banks of various sizes:
Why do banks find BOLI such an attractive Tier 1 asset? While banks have leveraged themselves dangerously and excessively in recent memory, the largest of them destabilizing the entire world economy when they failed, life insurance companies invest for long-term stability and do not employ leverage. This makes bank-owned policy cash value a high quality, low-risk asset. As financial author Barry James Dyke explains,
“…if a life insurance company has $1 million on deposit, that company may loan no more than $920,000, and usually only a fraction of that. As such, life insurers are 100 percent reserve-based lenders, which makes them stable institutions in down economies.”
More About BOLI (and a free ebook…)
When we continue with part two of “The Banker’s Bunker: Where Banks Save Their Money,” we examine the explosive growth of bank-owned life insurance, from zero to over $160 billion in assets. We’ll look at the benefits that have led more than 6 out of 10 banks to put significant portions of their Tier 1 assets in life insurance. You’ll see a list of the top 20 banks that hold the most life insurance and answers to FAQs about BOLI. Finally, we’ll see what we can learn from the BOLI trend that can be applied to our personal economies. Click here for Part 2 of “The Banker’s Bunker”.
If you think of life insurance as some kind of “necessary evil” that only people with dependents buy out of guilt or obligation, it might be time to re-think your assumptions. After all, many of our most powerful financial institutions have been quietly purchasing billions.
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