ABA Banking Journal - January 2008 - (Page 38D) INSURANCE REPORT: DIGITAL MAGAZINE EXTRA BOLI PART II 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. In such an environment, BOLI loses much of its yield advantage relative to other investment alternatives. 4. 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. Reputation risks: This 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. 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: 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. 5. 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. Credit risk: 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. Interest rate risk: This 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 Price risk: 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. 6. ❖❖❖ 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 38d JANUARY 2008/ABA BANKING JOURNAL www.ababj.com/subscribe.html www.ababj.com/subscribe.html
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