Bank owned life insurance, or BOLI, is a form of life insurance purchased by banks, generally on the lives of their executives and key employees. Although it may sound strange, BOLI is a tax-shelter for the bank, and can also offer it a tax-free source of funds.

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What is bank owned life insurance?
The idea behind bank owned life insurance is simple. Banks purchase life insurance policies for certain employees, and pay a premium, which has a cash redemption value. The bank owns the policy, and is also the beneficiary upon the death of the employee.

According to the Office of the Comptroller of the Currency (OCC), banks may purchase BOLI policies to be used in connection with the funding of employee compensation and benefit plans, as well as for a few other, very specific uses. Basically, the bank sets up the insurance contract, makes payments into a specialized trust account, and employee benefits are then paid out from the fund's proceeds. In other words, from a compliance standpoint, BOLI is used to offset the costs of providing employee benefit programs.

Since the gains and payouts from the life insurance policies are both tax-free, this is a creative tax-free way for the banks to fund their employee benefit programs, while also helping to offset the potential loss of a valuable executive's services.

How does it make money for the banks?
Put simply, BOLI is attractive to the banks because it can produce better returns that the banks couldn't otherwise achieve. Since the growth in the cash value of the insurance policies is tax-free, and returns are further magnified by this benefit.

For example, a bank might expect a BOLI policy to appreciate in value at 3.25% to 3.5% per year. However, since this is a tax-free gain, this is really equivalent to a taxable investment gain of 5% or more. And, anyone who has any idea what kind of interest shorter-term fixed income investments pay right now knows that this type of gain would be difficult for banks to safely achieve elsewhere.

Pros and cons
There are numerous advantages of BOLI, but there are several drawbacks as well.

As I already mentioned, one of the biggest benefits is that BOLI policies produce far superior returns than traditional bank investments, such as municipal bonds, 5- and 10-year Treasuries, and mortgage-backed securities. And, the growth in the cash value of the policies, as well as any death benefits paid out are completely tax-free.

Furthermore, BOLI policies have low risk levels that fit into banks' standard investment criteria. They also help to diversify the bank's investment portfolio, and immediately boost the bank's return on equity (ROE) and return on assets (ROA).

On the negative side, BOLI policies are considered to be long-term illiquid assets on a bank's balance sheet. Sure, the policies can be sold at any time, but just like cashing out an IRA early, selling a BOLI policy before the death of the insured automatically makes the gains taxable plus incurs a 10% penalty on the gains. And, just like with any other insurance product, the policy is only as good as the insurance company that backs it. If the credit quality of the insurer decays over time, it could be an additional risk factor.

How many banks actually use this strategy, and does it work?
According to a 2013 review of FDIC data, 53.4% of U.S. banks held some type of BOLI assets, with an average premium of about $2 million per case on newly issued policies.

While BOLI policies generally make up a rather small portion (2-3% or less) of a bank's assets, they are an effective way to produce strong returns to fund employee benefit programs, which banks would otherwise have to fund with investments that paid significantly less.