Turns Out You Actually Can Be Too Rich
"Local Credit Union Receives Windfall from Employee's Death"
Imagine how the community you serve-or your regulator-would react if this were the headline in your local paper. The institution that purchases life insurance to pre-fund employee benefits is cautioned to understand and manage the insurable interest and reputation risks inherent in the purchase.
Since 2003, credit unions have been able to "pre-fund" employee benefit liabilities by purchasing otherwise impermissible investments as long as there is a direct connection between the investment and the employee benefit obligation it serves to fund. Business-Owned Life Insurance ("BOLI"), long used by large commercial banks, has seen a surge in activity in credit unions in the past few years. The growth of cash surrender value in a BOLI policy can offer a credit union a very competitive yield, without the mark-to-market risk inherent in traditional fixed-income investments.
As attractive as the BOLI policy yields may be, it is important to remember that it is first and foremost a life insurance contract, the foundation of which is the notion of "insurable interest." This is, in essence, the balance between a risk of loss from the death of the insured versus the wagering on the insured's life. Insurable interest is measured on two fronts: who has an interest, and how much is it.
State Laws Offer Reassurance
We each have an unlimited insurable interest in our own lives. We can buy insurance in our name in whatever amount we want (subject only to a carrier's willingness to provide it to us) and designate our spouses or children as beneficiaries. But what about insurance purchased by, and for the benefit of, an employer, such as the CU? Fortunately, most states now have statutes that clearly state that an employer can have an insurable interest in its employees.
Many of these statutes require some form of notice to, or consent by, the employee in order to establish the interest. Because insurance is principally controlled by state law (statutory and case law), it is important to review your state's law to determine whether an insurable interest exists. As would be expected, it is materially different to support an insurable interest in a chief executive officer than it is in a teller. While the statutes and case law may address the "who" relative to the credit union's insurable interest, they may not address the "how much," and that is where the headline risk lurks.
Assume that an employee makes $75,000 annually. While that employee may be worth millions to her family (breadwinner, primary caregiver, etc.), how much is she "worth" to the credit union? One million? Ten million? You can measure the costs of replacing the employee, as well as the costs of the employee benefits the institution provides, but there is a natural limit to an employer's insurable interest.
While in some states only the carrier issuing the policy can challenge the existence of insurable interest, if a credit union purchases too much insurance on an employee it increases the risk that the employee's heirs will cry foul, claiming that the credit union's BOLI exceeded its insurable interest regardless of the consent the employee may have given. Even if the merits of such a claim may not withstand the scrutiny of the legal process, the threat of such a public action should not be ignored. That is why the Commercial Bank Examination Manual instructs banking examiners to "verify that...the bank's insured amounts are NOT excessive..." and thus expose the bank to unsafe and unsound banking practices.
No Clear-Cut Rule
Despite decades of employers purchasing insurance on their employees, there is no clear, black-and-white rule to follow in measuring the value of the employee. What has developed, however, is a "best practices" maximum measure that is about 20 to 30 times the insured's salary, depending on position within the organization. Remember, the insurance carrier may impose a much lower limit, so it is important to fully disclose the total coverage inforce and planned during the underwriting process. Failure to disclose inforce or planned coverage at other carriers could expose to the credit union to a future fraud claim by the carrier.
If you have BOLI and are concerned that your coverage is excessive, work with counsel to understand the extent of your risk based on your state's insurance statutes and relevant case law. If you determine you have an unreasonable level of coverage on any one individual (or several individuals), all is not lost. One of the easiest fixes is to withdraw or surrender enough of the BOLI cash value to reduce the coverage to an acceptable level. As you are aware, due to their tax-exempt status CUs do not have the same concerns regarding the income recognition issues upon the surrender of a policy as commercial banks.
BOLI is a proven asset for banks, and can be as powerful for credit unions when understood-and prudently implemented following a well-documented pre-purchase analysis-to minimize the headline risk.
Scott Richardson is president/CEO of iZale Financial Group, Schaumburg, Ill., which specializes in nonqualified deferred compensation and BOLI financing for financial institutions. For info: Scott@iZaleFG.com.
Don Norman leads Chicago-based Barack Ferrazzano's compensation and employment practice. For info: DonNorman@BFKN.com.