Bank‐Owned Life Insurance and Bank Risk

• Date: 01 August 2017
• Author: Travis R. Davidson
• Published date: 01 August 2017
• DOI: http://doi.org/10.1111/fire.12135

The Financial Review 52 (2017) 459–498

Bank-Owned Life Insurance and Bank Risk

Travis R. Davidson

Ohio University

Abstract

The use of bank-owned life insurance (BOLI) has more than tripled since 2001 and has

caught the attention of the Office of the Comptroller of the Currency.I find increases in BOLI

lead to higher levels of liquidity risk, credit risk, and interest rate risk. Robustnesstests confirm

these results and suggest over- and underinvestment in BOLI and use of BOLI as a tax shelter

contribute to risk increases. Results indicate that the concerns expressed by regulators are

warranted, and suggest insurance may not always have the intended effect of reducing firm

risk because of unintended consequences or misuse.

Keywords: bank-owned life insurance, corporate-owned life insurance, key employee

insurance, bank risk

JEL Classifications: G21, G22, G28

1. Introduction

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

insurance (BOLI). When used as intended, these insurance policies are designed to

Corresponding author: Department of Finance, Ohio University,538 Copeland Hall, Athens, OH 45701;

Phone: (740) 593-2034; Fax: (740) 593-2412; E-mail: davidsot@ohio.edu.

I would like to thank Andrew Fodor, Sinan Gokkaya, an anonymous referee, and discussants and par-

ticipants at the Financial Management 2014 annual meeting, the Southern Finance Association 2014

annual meeting, the Eastern Finance Association 2015 annual meeting, and the Ohio University finance

department research series for their helpful comments and suggestions that have improved the paper.

C2017 The Eastern Finance Association 459

460 T. R. Davidson/The Financial Review 52 (2017) 459–498

facilitate a smooth transition until a qualified replacement executive is appointed.

However, some banks use BOLI as part of a yield chasing strategy and as a form of

executive compensation (OCC, 2004). The Officeof the Comptroller of the Currency

(OCC) has expressed concerns that some institutions have a significant percentage of

their assets composed of BOLI but do not fully understand the associated risks (OCC,

2004). Anecdotal stories suggest BOLI is not being used by banks as insurance, but

is instead a tax-deferred investment.

BOLI may help reduce bank risk because of its variety of benefits. The intended

purpose of BOLI is as a risk management tool to offset the negative effects of

the unexpected death of an executive including stock price volatility and negative

stock returns (Johnson, Magee, Nagarajan and Newman, 1985; Worrell, Davidson,

Chandy and Garrison, 1986; Salas, 2010). BOLI can also serve as a tax shelter.

Depending on the beneficiary of the policy,premiums can qualify as pretax expenses

that reduce taxable income, or the cash surrender value of the policy can accumulate

tax-free until the policy matures or is surrendered (Graham and Tucker,2006; Smith,

Angelovska-Wilson and Solomon, 2006). Finally, BOLI can aid in the ability to

hire and retain key employees because many BOLI contracts contain a provision

for the insurance benefit to convert to the executive’s estate. However, the variety

of benefits provided by BOLI may produce incentives to increase BOLI purchases

at the detriment of the firm and owners. BOLI is by nature a long-term asset and

is often funded with the sale of liquid assets which has the potential to adversely

affect the liquidity position of the purchasing institution (OCC, 2004). Because

BOLI exposes banks to counter-party risk and the general inability to manage how

the cash surrender value is invested, it may be difficult for banks to manage the

associated credit risk and interest rate risk. In light of the regulator’s concerns and

potential misuse within the industry,I empirically test if bank risk is affected by BOLI

purchases.

Results for the entire sample of banks suggest that liquidity risk and credit risk

increase as BOLI purchases increase. Due to documented differences in operations

of banks of different sizes (e.g., Berger, Miller, Petersen, Rajan and Stein, 2005) I

perform analyses separately with banks assigned to one of three size groups. I present

evidence that interest rate risk rises in response to increased BOLI holdings for large

banks while liquidity risk and credit risk rise in response to BOLI increases for

medium and small banks. Bank risk generally rises when BOLI increases and gen-

erally falls when BOLI decreases. Additionally, I find BOLI is positively associated

with the probability of bank failure for smaller institutions. These findings persist

when different measures of BOLI are used, after controlling for factors that affect the

corporate demand for insurance, irrespective of the statistical technique employed.

Taken as a whole, my findings indicate that the OCC’s concerns regarding misuse of

BOLI are well-founded, and that bank regulators should consider monitoring the use

of BOLI more closely.

This investigation adds to two distinct bodies of literature. The first investigates

determinants of bank risk. While an exhaustive discussion is beyond the scope of

T. R. Davidson/The Financial Review 52 (2017) 459–498 461

this paper, I highlight some of the factors that have recently been associated with

bank risk.1Interest rate increases (decreases) by the Federal Reserve result in an

increase (decrease) in bank default likelihood (Akhigbe, Madura and Martin, 2007),

but large banks and small banks are affecteddifferently by monetary policy (Viale and

Madura, 2014). A perception among the popular press and some lawmakers is that

recent deregulation led to increased competition and increased bank risk (Wallison,

2010); but, empirical evidence is ambiguous (Akhigbe and Whyte, 2004; Beck,

De Jonghe and Schepens, 2013; Anginer, Demirguc-Kunt and Zhu, 2014). Bank

compensation practices have also come under fire from the popular press as a source

of risk (Friedman, 2009; Karmin, 2009). Lawmakers agreed and included several

sections covering executivecompensation in the Dodd–Frank Wall Street Reform and

Consumer Protection Act. Empirical evidence confirms that compensation practices

and managerial ownership can increase risk, but not universally (Sullivan and Spong,

2007; Fortin, Goldberg and Roth, 2010; DeYoung, Peng and Yan, 2013; Raviv and

Sisli-Ciamarra, 2013; Bennett, Guntay and Unal, 2015).

Recent investigations havecaused my understanding of how capital affects bank

risk to become more nuanced. Ghosh (2015) presents evidence that suggests banks

with high capital levels have lax credit standards or are more willing to increase the

risk of their loan portfolio. Berger and Bouwman (2013) show that capital is effective

in reducing the probability of bank failure for small banks during all economic

conditions, but capital reduces risk at large banks primarily during banking crises.

Many other factors have been shown to affect bank risk differently depending on

bank size including the Troubled Asset Relief Program (Black and Hazelwood,

2013); exposure to credit risk, sovereign risk, and real estate investments (Bessler

and Kurmann, 2014); and diversification (Demsetz and Strahan, 1997). Further, the

effect of diversification on bank risk has been shown to depend on the type of

diversification (DeYoung and Roland, 2001; Fraser, Madura and Weigand, 2002;

DeYoungand Rice, 2004; Stiroh, 2004; DeYoung and Torna,2013; van Oordt, 2014).

My finding that increases in BOLI are associated with increases in risk is consis-

tent with the findings of DeYoung and Torna (2013) that asset-based diversification

can increase risk. Thus, I add to this literature by documenting another nontraditional

asset that is associated with bank risk.

The second strand of related literature addresses corporate insurance purchases

and dates back at least to Cummins (1976). As owners of a corporation, sharehold-

ers can shelter themselves from firm-specific losses through proper diversification,

rendering the corporate purchase of insurance unnecessary. However, a number of

theoretical rationales for the purchase of insurance have received empirical sup-

port. Mayers and Smith (1982) suggest that progressive tax rates and tax-loss carry-

back and carry-forward provisions make purchasing insurance beneficial from a tax

1See DeYoung and Roland (2001), Stiroh (2004), and Bessler and Kurmann (2014) for more detailed

surveys.