Pros and Cons of Hedge Funds as BOLI Option

By Dolan, Richard F. | American Banker, December 16, 2005 | Go to article overview

Pros and Cons of Hedge Funds as BOLI Option


Dolan, Richard F., American Banker


The Federal Reserve's "measured pace" tightening has led to a spread of approximately 50 basis points between three-month London interbank offered rate and the five-year swap rate. That spread was nearly 200 basis points just about a year ago.

This dramatic change in the shape of the U.S. yield curve has caused many bank treasurers to rethink the macro strategy of their investment portfolios to help sustain net interest margin and earnings.

Some have responded by changing asset classes by migrating to more curve-friendly strategies like municipal bonds, while others have turned to the bank-owned life insurance marketplace. Indeed, this year will probably prove to have eclipsed 2003 and 2004 combined in BOLI activity.

Bank-owned life insurance is widely used not only to help manage a variety of long-term employee benefit liabilities but also to improve ongoing earnings by generating tax-free returns. The latter is the primary motivation of late. Some banks have added to their BOLI portfolios, while others are reevaluating older portfolios, trying to earn additional tax-free return from current policies.

Most of the activity has involved separate-account BOLI, in which the carrier establishes dedicated investment strategies segregated from its general assets. This allows policy owners to select among different funds -- much like a 401(k).

Banks have been executing investment reallocations within their policies, have converted to separate-account policies, or both. Their treasurers have probably reviewed a variety of new investment choices available in the BOLI realm, including inflation-oriented and leveraged mortgage funds and "alternative investment strategies."

Hedge funds are starting to capture the attention of treasurers for good reasons and bad ones.

The good is that hedge-fund exposure offers some attractive attributes that a bank typically cannot get on its own -- specifically, diversification among asset classes and strategies. Many BOLI carriers now offer funds of funds, in which the separate account invests in a manager that in turn invests in a variety of submanaged hedge funds. Within a fund of funds, each hedge fund pursues a different capital markets strategy, such as convertible-bond arbitrage, long-short equities, and relative-value trading. …

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