How Does Bank Owned Life Insurance Work
Bank owned life insurance (BOLI) is a specialized financial tool that many banks use to manage costs, enhance returns, and protect balance sheets. Although the phrase sounds technical, the basic idea is straightforward: a bank purchases life insurance policies on selected employees (typically officers and senior managers) and records the policy’s cash value as an asset. Over time, the insurance policy accumulates cash value and pays a death benefit when the covered person dies. For banks, BOLI can serve as a tax-efficient, long-term investment that helps offset employee benefit costs such as retiree health care, pension liabilities, and deferred compensation.
This article explains how BOLI works in practice, why banks use it, the types of policies commonly purchased, the accounting and regulatory context, expected returns and risks, and practical steps for implementing BOLI effectively. It includes realistic examples and tables to help you visualize typical outcomes and trade-offs.
What Is BOLI and Why Banks Buy It
BOLI stands for Bank Owned Life Insurance. In simple terms, a bank purchases life insurance policies on the lives of its key employees, pays premiums, and becomes the policy owner and beneficiary. The bank records the policy’s cash value on its balance sheet as an asset and recognizes earnings as the cash value grows. When a covered employee dies, the bank receives a generally tax-exempt death benefit.
Banks buy BOLI for several practical reasons:
- Offset employee benefit costs: Gains can pay for retiree health benefits, supplemental executive retirement plans (SERPs), and other nonqualified compensation.
- Yield enhancement: BOLI often provides a competitive net yield relative to many low-risk, liquid investments available to banks.
- Tax advantages: Earnings inside the policy grow on a tax-advantaged basis (and death benefits are generally tax-exempt), improving after-tax returns for the bank compared with taxable investments.
- Capital and liquidity management: Although not a direct substitute for cash, BOLI can improve the overall returns on the bank’s asset mix while remaining an “other asset” on the balance sheet.
Typical participants are midsize and large community banks, regional banks, and national banks. Single premium BOLI purchases commonly range from $1 million to well over $100 million, depending on the size of the bank and the scope of its benefit obligations.
How BOLI Works — Mechanics and Key Components
The mechanics of BOLI are similar to corporate-owned life insurance used by many companies, but with some industry-specific practices. Here’s a step-by-step view of how a typical BOLI arrangement operates:
- Selection of insureds: The bank identifies eligible employees (usually officers and senior executives) whose lives will be insured. Consent from covered participants is required in most jurisdictions.
- Policy purchase: The bank pays premiums to an insurance carrier. Policies can be single-premium (large upfront premium) or periodic-premium (scheduled payments). Private placement life insurance (PPLI/BOLI) is a common format for large purchases, offering customization and lower fees.
- Accumulation of cash value: Cash surrender value (CSV) accrues inside the policy. The insurance carrier credits interest or investment returns to the CSV based on the product’s design (general account crediting rates, separate account returns, or credited spread over a benchmark).
- Expense and mortality charges: The carrier deducts mortality and expense (M&E) charges, which reduce credited returns. Fees and surrender charges may also apply in early years.
- Reporting: On the bank’s balance sheet, the CSV is generally classified as an asset (often “other assets” or “investment in bank-owned life insurance”), and increases in CSV typically show up as non-interest income or investment income.
- Use of proceeds: Earnings or policy distributions (including loans or surrenders) can be used by the bank to fund employee benefits, pay deferred compensation, or support general operations. Death benefits are typically received income-tax-free under IRC §101(a).
From an operational perspective, the bank coordinates with legal counsel, actuaries, and the insurer to structure the policies and document benefit plans and funding strategies. Good governance, formal policies, and ongoing monitoring are essential.
Common Types of BOLI Policies
Not all life insurance policies are identical. Banks typically choose among a few common structures that match balance-sheet objectives and desired risk profiles.
- General Account BOLI (Traditional BOLI): The insurance carrier credits a declared interest rate that is based on the insurer’s general account performance. These policies often come with first-year expenses and longer surrender-charge periods. Net credited rates in recent years have ranged from roughly 3.0% to 5.5% depending on market conditions and product design.
- Separate Account or Variable BOLI: The cash value is invested in separate accounts with market exposure (equity and fixed-income strategies). Returns vary with market performance; these can provide higher upside but introduce market volatility and different accounting considerations.
- Private Placement BOLI (PLB): Customized, large-premium policies sold directly to institutional buyers. PLBs often feature competitive crediting spreads, shorter surrender charges, and tailored risk-sharing arrangements. Minimum single-premiums typically start around $5–10 million for PPLI/BOLI.
- Indexed or Synthetic Variants: Some policies credit interest tied to an index or a combination of instruments. These are less common but used when banks want specific risk/return characteristics.
Choice of product depends on the bank’s risk tolerance, time horizon, tax goals, and liquidity needs.
Accounting, Tax, and Regulatory Treatment
BOLI benefits from a unique intersection of accounting, tax, and regulatory treatment that makes it attractive to banks—but also requires careful compliance and disclosure.
Accounting
When a bank purchases BOLI, it records the cash surrender value as an asset on the balance sheet, usually within “other assets” or as a separate line for BOLI. The growth in cash value is recognized as non-interest income (often labeled “BOLI income” or “other income”). If the bank takes loans or withdrawals against the policy, these are recorded consistent with bank accounting rules. There are no specific GAAP rules that treat BOLI differently from other life insurance assets, but banks follow industry guidance and regulatory expectations for disclosure, valuation, and impairment review.
Tax
Earnings inside the policy (cash value accumulation) are generally tax-favored; the insurer’s credited interest is not taxed to the owner until policy loans or surrenders create taxable events under normal circumstances. Death benefits received by the bank are generally exempt from federal income tax under Internal Revenue Code Section 101(a), subject to some exceptions. These tax advantages make the after-tax yield on BOLI substantially higher than comparable taxable instruments.
Regulatory
Bank regulators expect prudent governance. Key regulatory considerations include:
- Sound underwriting: Banks must follow internal policies and obtain insured consent where required.
- Concentration limits and risk management: Regulators monitor concentration in specific carriers and the bank’s exposure to the insurer’s credit risk.
- Disclosure and reporting: Banks must disclose BOLI holdings and income in financial statements and regulatory filings.
- Capital treatment: BOLI is typically included in regulatory capital assessment through its effect on assets and earnings; regulators may scrutinize aggressive BOLI strategies.
Generally, BOLI is an accepted practice when properly approved and documented, but banks must maintain strong governance and careful monitoring to avoid regulatory issues.
Expected Returns: Realistic Numbers and Comparative Analysis
Banks evaluate BOLI relative to other investment choices. While actual yields vary by product, carrier, and time, a few representative numbers can help illustrate the economics.
Assumptions used in this example:
- Single-premium purchase: $10,000,000
- Gross crediting rate: 5.0% per year
- Mortality & expense (M&E) and other policy charges: 0.5% per year (net crediting rate = 4.5%)
- Holding period: 10 years
- Bank federal tax rate: 21% (for comparative after-tax analysis)
Below is a simple 10-year projection that shows how cash surrender value can grow under these assumptions.
| Year | Beginning Cash Value ($) | Premiums ($) | Credited Interest @ 5.0% ($) | Fees & Charges @ 0.5% ($) | Ending Cash Value ($) |
|---|---|---|---|---|---|
| 0 | — | 10,000,000 | — | — | 10,000,000 |
| 1 | 10,000,000 | — | 500,000 | 50,000 | 10,450,000 |
| 2 | 10,450,000 | — | 522,500 | 52,250 | 10,920,250 |
| 3 | 10,920,250 | — | 546,012 | 54,601 | 11,411,661 |
| 4 | 11,411,661 | — | 570,583 | 57,058 | 11,925,186 |
| 5 | 11,925,186 | — | 596,259 | 59,626 | 12,462,069 |
| 6 | 12,462,069 | — | 623,103 | 62,310 | 13,022,862 |
| 7 | 13,022,862 | — | 651,143 | 65,614 | 13,608,891 |
| 8 | 13,608,891 | — | 680,445 | 68,044 | 14,221,292 |
| 9 | 14,221,292 | — | 711,065 | 71,106 | 14,861,250 |
| 10 | 14,861,250 | — | 743,063 | 74,306 | 15,530,006 |
After 10 years, the projected cash surrender value grows to approximately $15.53 million—an effective compounded net rate near 4.5% per year in this example. Note that these numbers are illustrative and depend heavily on the actual credited rate, policy design, and charges.
To understand comparative value, it helps to look at typical alternatives for bank investment dollars. Below is a simplified comparison of hypothetical returns on comparable $10 million investments over a 10-year horizon.
| Investment | Gross Annual Return (Illustrative) | After-Tax Equivalent (Bank @21%) | Notes |
|---|---|---|---|
| BOLI (net credited) | 4.5% | 4.5%* | Tax-advantaged accumulation; death benefits generally tax-exempt |
| Corporate Bonds (A-rated) | 3.8% | 3.0% | Interest taxable; credit and duration risk |
| Municipal Bonds (Tax-exempt) | 2.4% | 2.4% | Limited availability; lower yields for banks |
| Short-Term Investments (e.g., T-bills) | 1.5% | 1.2% | Highly liquid, low long-term return |
*Bank tax treatment of BOLI is generally favorable; internal after-tax comparability can be more favorable than shown because the policy’s cash value growth is not taxed in the same way as interest income.
In many scenarios, the after-tax and after-fees yield from a BOLI policy is superior to typical taxable investments available to banks. The magnitude of the advantage depends on the chosen product, carrier crediting rate, and the bank’s tax/profitability profile.
Risks, Costs, and Common Pitfalls
BOLI is attractive, but not without risks and costs. Below are the major considerations banks should evaluate and actively manage.
| Risk | Potential Effect | Common Mitigants |
|---|---|---|
| Insurer credit risk | Loss or reduction of credited returns; potential impairment of policy value | Diversify carriers, monitor insurer ratings, use high-rated carriers, include commutation or replacement provisions |
| Liquidity risk | Early surrender charges or limited ability to access cash quickly | Match BOLI funding to long-term liabilities; maintain separate liquidity reserves |
| Regulatory scrutiny | Regulatory objections, additional capital requirements, negative examination findings | Strong governance, clear documentation, conservative underwriting, regular reporting |
| Interest rate and credit spread risk | Crediting rates may fall with market rates, reducing future earnings | Lock-in competitive crediting spreads via private placements, diversify product mix |
| Concentration risk | Overreliance on BOLI for earnings can magnify downside if policy performance weakens | Set internal concentration limits; stress-test assumptions |
Additional cost considerations include upfront commissions and internal administrative expenses, plan drafting costs, and potential tax compliance costs. While many policies are cost-effective on a long-term basis, short holding periods can produce poor returns due to surrender charges and initial expenses.
How Banks Implement BOLI — Best Practices and Governance
Instituting BOLI requires disciplined governance, clear policies, and collaboration across the bank. Typical steps include:
- Board approval and formal policy: A board-approved BOLI policy should define objectives, eligibility criteria, diversification limits, and reporting requirements.
- Needs analysis: Actuarial and financial analysis that maps expected BOLI earnings to benefit obligations (e.g., estimate retiree health liability of $2.5 million over 10 years and structure BOLI funding accordingly).
- Due diligence on carriers and products: Review carrier credit ratings, product features, guaranteed elements, withdrawal/surrender provisions, and historical crediting practices.
- Vendor and advisor selection: Use independent advisors, legal counsel, and actuaries to avoid conflicts of interest and ensure best execution.
- Implementation: Secure insureds’ consents, finalize policy documents, fund the purchase, and set up internal accounting and monitoring processes.
- Ongoing monitoring and reporting: Quarterly or semiannual review of credited rates, carrier condition, policy performance, and regulatory reporting.
- Exit planning: Policies should have clear change-of-control, commutation, or replacement provisions if the bank’s strategy changes.
Best practice examples include maintaining a diversified portfolio of carriers (no single carrier exposure above a board-defined threshold), stress testing credited-rate sensitivity, and documenting how BOLI will be used to fund specific benefit liabilities.
Practical Example — Matching BOLI to Benefit Liabilities
Imagine a community bank with a projected retiree health obligation of $2.5 million payable over the next 12 years. Management wants to fund at least 80% of that obligation with BOLI proceeds while keeping other liquidity available for operational needs.
One practical approach:
- Purchase a $3.0 million single-premium BOLI policy targeting a net credited return of approximately 4.25%.
- Use earnings and partial policy withdrawals (or loans) to reimburse post-retirement health claims as they arise.
- Maintain additional short-term investments equal to one year of expected benefits to avoid forced surrenders during market stress.
- Periodic review: If credited rates decline, the board reviews additional funding or alternative measures to cover obligations.
This targeted approach links the BOLI investment to a specific liability, reducing the chance of mismatch and strengthening the governance narrative when regulators review the bank’s strategy.
FAQs — Common Questions About BOLI
Is BOLI safe? No investment is entirely without risk. BOLI is generally conservative when purchased from financially strong insurers and structured for long-term holding. Insurer credit risk and liquidity/surrender considerations remain.
Who are the typical insureds? Typically, insureds are senior officers and key employees. The insureds must give informed consent, and the bank must meet legal and privacy requirements.
How much do banks invest in BOLI? Investment size varies by bank. Community banks may purchase from $1–10 million, while larger regional banks can have hundreds of millions in aggregate BOLI holdings. Typical single-premium purchases frequently start at $1 million to $5 million depending on product and carrier.
How long should a bank keep BOLI? BOLI is designed as a long-term instrument. Holding periods of 7–15 years (or longer) are common to allow initial expenses and surrender charges to amortize and to realize compounded tax-advantaged returns.
Can BOLI proceeds be used for anything? Yes. Once the bank receives policy distributions or death benefits, funds are available for general corporate purposes. However, best practice is to earmark BOLI proceeds to offset the employee benefit costs for which the program was established.
Putting It Together — Is BOLI Right for Your Bank?
BOLI can be a powerful tool for banks seeking tax-efficient, long-term yield enhancement and a way to fund employee benefit obligations. When used prudently and with strong governance, BOLI often offers higher net yields than many taxable investment alternatives. The decision to purchase BOLI should follow a disciplined process that includes financial modeling, regulatory compliance, carrier selection, and ongoing monitoring.
Key checklist before proceeding:
- Do you have clear funding objectives for BOLI proceeds?
- Is your board and senior management aligned and committed to a long-term holding period?
- Have you performed scenario analysis and stress tests for insurer credit events and lower credited-rate environments?
- Are policies in place to avoid concentration and to ensure transparent disclosure?
- Do you have access to qualified external advisors (legal, actuarial, advisory) with BOLI experience?
If the answer to these questions is yes, and the bank’s internal modeling shows a meaningful contribution to funding obligations or improving risk-adjusted yields, BOLI may be a suitable part of the bank’s investment and benefits strategy.
Conclusion
Bank owned life insurance offers banks a distinctive blend of tax efficiency, yield enhancement, and liability-matching capability. It is not a one-size-fits-all solution, but when structured properly and governed conservatively, BOLI can be a valuable component of a bank’s asset and benefit funding strategy. The keys to success are thoughtful alignment with liabilities, careful carrier selection, diversified implementation, and robust board-level oversight.
If you are considering BOLI, start with clear objectives, realistic modeling, and independent due diligence—then document policy and governance decisions to support sound implementation and regulatory transparency.
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