What Is Bank Owned Life Insurance and How Does It Work?

Bank Owned Life Insurance (BOLI) is a specialized financial product used by banking institutions to manage various financial obligations. Banks purchase life insurance policies on their executives or key employees, acting as both the owner and primary beneficiary. The fundamental purpose of BOLI is to help offset the rising costs of employee benefits, such as retirement plans or healthcare.

How Bank Owned Life Insurance Works

Bank Owned Life Insurance operates with the bank paying premiums for policies it holds on its key employees. The bank maintains ownership of these policies and is designated as the beneficiary, meaning it receives the policy’s proceeds. The cash value component within these policies grows over time on a tax-deferred basis, accumulating wealth for the bank.

This accumulated cash value offers a source of liquidity for the bank, which can be accessed through policy loans or withdrawals if needed. These policies are generally intended to be long-term holdings, with maximum benefits realized if held until the insured employee’s passing. Upon the death of an insured employee, the bank receives the death benefit, which is typically free from federal income tax. The death benefit from these BOLI policies is paid directly to the bank, not to the insured employee’s family or beneficiaries.

Reasons Banks Purchase Bank Owned Life Insurance

Banks strategically invest in BOLI primarily to serve as a funding mechanism for their employee benefit programs. The earnings generated from BOLI assets can help offset the costs associated with various employee benefits, including executive retirement plans, deferred compensation arrangements, and health benefits.

The tax-advantaged growth of the cash value within the policies, coupled with the tax-free death benefit, contributes to the bank’s non-interest income. This unique tax treatment provides a higher after-tax yield compared to many traditional bank investments. BOLI can also be utilized as a tool for retaining key talent by providing a dedicated funding source for deferred compensation or other supplemental executive benefit plans, thereby strengthening employee loyalty and reducing turnover.

Accounting and Tax Treatment of Bank Owned Life Insurance

For financial reporting purposes, BOLI is generally classified as an asset on a bank’s balance sheet, typically under the “other assets” category. The value reported reflects the policy’s cash surrender value, which is the amount the bank would receive if it were to liquidate the policy. Changes in this cash surrender value, whether due to growth or withdrawals, directly impact the bank’s income statement, usually recognized as non-interest income.

From a tax perspective, the cash value growth within BOLI policies is generally tax-deferred, meaning taxes on these gains are postponed until the funds are accessed. The death benefit received by the bank upon the insured’s passing is typically exempt from federal income tax under current tax laws, specifically Internal Revenue Code Section 101. For the death benefit to be tax-free on employer-owned life insurance, Section 101 requires that the employee receive written notice of the bank’s intent to insure them and provide written consent to the coverage.

While the cash value growth and death benefits offer tax advantages, the premiums paid by the bank for BOLI policies are generally not tax-deductible. If a BOLI policy is surrendered before the insured’s death, any gain exceeding the premiums paid becomes taxable income for the bank. Additionally, if the policy is classified as a Modified Endowment Contract (MEC), distributions or loans from it may be subject to ordinary income tax on gains and a 10% penalty tax on those gains.

Regulatory Oversight of Bank Owned Life Insurance

The use of BOLI by banks is subject to strict regulatory oversight to ensure prudent management and financial stability. Key regulatory bodies include the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and various state banking departments. These agencies issue guidelines and bulletins providing specific supervisory expectations for BOLI.

Banks are required to conduct thorough due diligence before purchasing BOLI, including a comprehensive analysis of potential risks and benefits. This involves evaluating the insurance carrier’s financial condition and ensuring the investment aligns with the bank’s strategic objectives and risk tolerance. Ongoing monitoring of BOLI holdings is also mandated, with regular assessments of performance and risk.

Regulations also address capital treatment, often requiring BOLI assets to be risk-weighted at 100% for capital adequacy purposes. Additionally, there are specific limits on BOLI holdings, such as an aggregate cash surrender value not exceeding a certain percentage of the bank’s Tier 1 capital, around 25%. Banks must also comply with disclosure requirements, including annual filings with the IRS and maintaining records of employee consent for the insurance coverage.