With persistent low interest rates over the last decade, bank-owned life insurance (BOLI)
owners have seen the impact on their cash value yields. While many focus on these bottom line yields, the potential for improving yields through death benefit optimization is often overlooked.
It is widely known that the amount of death benefit relative to the cash value will determine the cost of insurance in a policy. To understand the opportunity for yield improvement, one must also understand how BOLI death benefits are determined.
Typically investment BOLI is structured with the minimum death benefit possible. This minimizes insurance costs and maximizes cash value yields. To qualify as life insurance, the death benefit for each insured cannot be less than the cash value multiplied by a value, known as the “corridor factor”. Corridor factors will decrease with attained age, causing the gap between death benefit and cash value to shrink over time, allowing BOLI insurance costs to remain low at advanced ages.
With higher interest rates, cash value growth rates exceed the annual rate of reduction in corridor factors, causing modest increases in death benefits (CV x corridor) over time. Carrier systems are efficient at handling this scenario. However, in an era of low crediting rates, cash value growth will not exceed decreases in corridor factors, resulting in decreasing minimum death benefits. Importantly, BOLI owners should understand that the decreases need to occur. If not, the policy ends up with excess death benefit and higher insurance costs. This leads to lower cash value yields, which only exacerbates the situation in future years. In a worst case, cash value yields turn negative and may ultimately cause a policy lapse.
The key question becomes whether the insurance carrier’s administration system will automatically reduce death benefits as needed. There is a mixed bag across insurance carriers and products. To assure that death benefits are maintained at proper levels, illustrations can be requested “as is”, and also with a minimum death benefit scenario.
This will highlight any excess death benefits, and we can quantify the pickup in yield upon restructuring. If reductions are needed, modifying death benefits is a simple process. A form needs to be signed by the bank, and the insureds are not involved.
Death benefit reductions should be explored, but they aren’t always optimal. While it isn’t common in BOLI, some policies use the guideline premium test (GPT) to qualify as life insurance. A reduction on GPT policies may lead to taxable withdrawals, so one must tread carefully.
Second, if face amount is reduced, this must be an option in the insurance policy. To avoid a material change under IRC Section 101(j), only policies allowing face reductions should be modified. Last, some argue that older insureds should keep higher death benefits.
This becomes a question of priorities for the bank. Are cash value yields most important, or is the ultimate death benefit paid important enough that the bank is willing to sacrifice current cash value yield?
Contact your Newport Representative for more information.
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