An Empirical Investigation of the Demand for Bank‐Owned Life Insurance

• Author: Roger M. Shelor,Travis R. Davidson
• Date: 01 December 2014
• DOI: http://doi.org/10.1111/fmii.12022
• Published date: 01 December 2014

An Empirical Investigation of the Demand

for Bank-Owned Life Insurance

BYTRAVIS R. DAVIDSON AND ROGER M. SHELOR

Key employee life insurance in the banking industry is called bank-owned life insurance

(BOLI). Banks use BOLI to provide financial support to help reduce disruptions due to

the death of a key executive and as a part of the executive compensation package. We

investigate the characteristics of banks related to the amount of BOLI purchased. Wefind

that BOLI purchases are positively related to bank size and leverage and negativelyrelated

to tax rates and employee salaries. We also find that BOLI purchases are related to bank

ownership structure and profitability.

Keywords: Bank owned life insurance, corporate owned life insurance, executive life

insurance, key employee insurance.

I. INTRODUCTION

Key employee life insurance has served organizational needs for a number of

years. The death of a top management member can cause a difficult transition

period, especially for smaller firms with less developed succession plans. These

insurance policies are designed to facilitate a smooth transition until a qualified

replacement executive is appointed. Unlike traditional property insurance where

the loss is direct and measurable, the firm’seconomic loss covered under employee

life insurance is less tangible and might include negative stock market reactions

(Nguyen and Nielsen, 2010), the opportunity cost suffered from a loss of leadership

and expertise, the unanticipated expenses related to the replacement search, or

disruptions in the firm’s day-to-day operations.

We focus on key employee life insurance in a specific industry, namely the

banking industry.In this setting, the insurance contract is referred to as bank-owned

life insurance (BOLI). Permission to purchase life insurance on key employees

is granted to national banks by 12 USC § 24, to federal savings associations by

the Home Owner’s Loan Act, and to state-chartered banks by individual state

law (OCC, 2004). BOLI can be term life, whole life, universal life, or variable

life insurance and is generally purchased through a vendor rather than directly

from insurance carriers (OCC, 2004). The amount that could be realized under

the contract as of the balance sheet date appears on the balance sheet as an asset

(OCC, 2004). BOLI serves the interests of both the institution and the individual

employee. Following the manager’s death, BOLI provides a cushion during the

transition period and replacement of the executive. Theoretically, the insurance

proceeds are designed to completely or partially offset opportunity costs during

the time of the leadership void. Prior to the insured’s death, BOLI can be used to

Corresponding author: Travis Davidson Ohio UniversityT: 740.593.2034 F: 740.593.2412 davidsot@ohio.edu

C2014 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

304 Travis R. Davidson and Roger M. Shelor

provide liquidity because the purchasing institution may borrow against the cash

surrender value or liquidate the policy (OCC, 2004). Thus, BOLI provides the

firm a reduction in risk while the employee is employed at the firm as well as after

the employee’s death.

BOLI can also benefit depository institutions (DIs) as a tax shelter. In the

simplest form, premiums are considered legitimate business expenses and are

therefore paid before taxes, reducing taxable income. The more valuable tax-

benefit provided by BOLI is a result of the treatment of the cash value of the

insurance policy because the cash value is allowedto accumulate tax-free (Graham

and Tucker, 2006 and Smith el al., 2006). Consequently, an investment in BOLI

provides an attractive risk-adjusted, after-tax yield because banks can surrender

the cash value of a whole-life policy for cash at any time (Poorman, 2007).

Surrendering the cash value prior to the contract’smaturity produces a tax-deferred

savings instrument for the DI. If the policy is held until maturity the cash payout

is generally not taxable at all, producing an even larger tax advantage (OCC, 2004

and Graham and Tucker, 2006).

A third major benefit to the company is retention of a key employee because

of the BOLI contract. Many BOLI contracts contain a provision for the insurance

benefit to convert to the executive’s estate. The benefit can contractually be-

come part of the executive’s estate is two ways. The beneficiary can change from

the company to the executive’s heirs upon retirement or the executive can name

beneficiaries in addition to the company in a split-dollar arrangement. Therefore,

BOLI contracts serve the interests of the company while also becoming an im-

portant part of executives’ total compensation packages. Banks often use BOLI

to provide pre- and post-retirement employee benefits (OCC, 2004). Many banks

explicitly list executive life insurance policies as a form of compensation in their

proxy statements. For example, life insurance is found on the proxy statement as

a component of other compensation at JPMorgan Chase & Co. and The Gold-

man Sachs Group, Inc. Wells Fargo & Company records life insurance on the

institution’s proxy statement as part of their benefits program.

The Office of the Comptroller of the Currency (OCC) reports that “a growing

number of institutions have aggressivelyincreased their holdings of BOLI” (OCC,

2004). Similarly, we find that aggregate BOLI levels have been generally increas-

ing since 2001. Figure 1 displays the sum of BOLI assets reported by all depository

institutions in our sample and suggests that BOLI purchases are increasing in the

banking industry. In light of this increase, we investigatebank characteristics that

are related to the amount of BOLI purchased. Our results add to the literature

in two specific ways. First, we add to the limited literature that addresses key

employee insurance referred to as corporate owned life insurance (COLI). Brown

(2011) finds that board interlocks increase the probability of COLI adoption as a

tax shelter, but banks are specifically not included in the sample. Our results on

BOLI, which is an industry specific type of COLI, suggest other firm character-

istics that may affect the likelihood of adopting key employee insurance. To our

knowledge, we are the first to empirically investigate the relation between bank