Days cash on hand (DCOH) represents the number of days a business can continue to pay its operating expenses with the current cash it has available. For hospitals and larger medical clinics, DCOH serves as an important measure of liquidity, and an organization needs a certain amount of it to meet the requirements of lenders, rating agencies and others.
For example, hospitals that earn an AA+ credit rating typically keep 425 or more DCOH.1 Depending on the size of the hospital, this could mean that tens or even hundreds of millions of dollars of DCOH are tied up in accounts earning less than one percent.
So, in today’s low interest rate environment, how can hospitals and medical clinics expect to achieve any sort of meaningful net yield on DCOH?
Typically, in order to increase the yield on these assets, the organization must be willing to accept inappropriate risks, such as reduced liquidity, safety or creditworthiness. It is also critical to preserve its characterization as a non-security asset so as to not impact the organization’s ability to fully collateralize it for future borrowing purposes.
Fortunately, a little-known strategy utilized by America’s largest banks can provide a meaningful solution to the low yields being earned by hospitals and medical clinics on DCOH and, perhaps, other tranches of safe, liquid capital.
Learning from the Banks
For over 35 years, commercial banks have used life insurance to achieve a higher return on their safest and most liquid assets and to offset employee benefit costs. Today, 68 percent of U.S. banks with assets between $100 million and $1 billion currently own BOLI.2
With bank-owned life insurance (BOLI), the bank purchases, owns, and is the beneficiary of a policy insuring an executive’s life. Cash values grow tax-deferred, providing the bank with monthly bookable income. Upon the executive’s death, tax-free death benefits are paid to the bank.
As of December 31, 2017, there was $167.8 billion of BOLI cash value on banks’ financials.3 Bank of America, for example, now owns over $22 billion of BOLI cash value, compared to less than $9.2 billion in real estate, including bank premises.4
With hospital-owned life insurance (HOLI), hospitals and larger medical clinics now have the option to do with DCOH what the commercial banks do with their safest capital, minus the middleman: invest a portion of DCOH in institutionally-priced policies that ensure the lives of the organization’s executives, department heads and physicians.
BOLI and HOLI provide banks, hospitals and medical clinics with significant and measurable benefits:
- Returns that typically exceed those of more traditional “safe” investments, such as cash in a financial institution, muni funds, mortgage-backed securities, and 5- and 10- Year Treasurys, by 150 to 300 basis points or more;
- Cash values that grow tax-deferred (tax-free, if held until death) with downside protection and minimum growth guarantees;
- Death benefits, if any, that are paid tax-free;
- Assets that are 100 percent liquid and may be redeemed at any time without surrender charges;
- Holdings that are characterized as “fixed” with the premiums deposited in an insurer’s general account, not classified as a “security” under SEC regulations (which could impact the ability to post it as collateral for future borrowing purposes);
- Diversification of the investment portfolio with risks well within the standard, a positive correlation to interest rates, and well-defined guidance from regulatory authorities; and,
- Can immediately boost the organization’s return on equity (ROE) and return on assets (ROA) without exposure to equity risk.
Booking HOLI as an Asset
The HOLI net cash surrender value as of the balance sheet date should be reported as an “Other Asset.”
The net earnings (losses) on or increases (decreases) in the life insurance assets should be reported on the income statement as “Other Noninterest Income.”
Putting the Money to Good Use
The extra income generated by the cash value is typically earmarked to offset the cost of employee benefit programs and supplemental retirement benefit plans.
The policy death benefits are most commonly used to:
- Provide a benefit to the insureds while they are still employed by the organization;
- Recover the cost of supplemental retirement benefit plans;
- Fund a charitable foundation; and/or,
- Improve the health of existing under-funded pension plans.
A nonprofit hospital had $100 million of DCOH in cash, U.S. Treasurys, CDs, and short-term bonds, producing an average yield of one percent per year. Assuming no change in yield, this strategy will produce $10,462,213 in total income for the organization over the next 10 years and $22,019,004 over the next 20 years.
The hospital wanted to increase the yield on DCOH without sacrificing safety or liquidity, so it repositioned the $50 million into specially-designed life insurance policies. The policies were accounted for as an “other asset” on the organization’s balance sheet.
The projected yield of the policy cash value is approximately five percent per year. The $50 million in policies will produce $31,444,731 in income to the organization over the next 10 years and $82,664,885 over the next 20 years. The hospital plans to use the income to offset employee benefit expenses while retaining the flexibility to divert it elsewhere if needed.
In addition, the total death benefit of the policies on the lives of the hospital’s key people exceeds $150 million. The organization chose to provide selected employees with a pre-retirement death benefit equal to three times his or her last annual salary, which serves as an incentive to stay with the hospital and perform. Remaining death benefits will be used to reimburse the hospital for premiums paid, then to enhance its existing under-funded pension plan.
If at any time, the hospital would like to access the cash value of these policies, it may do so without penalty within just a few days.
New Loan Option can be Compelling
An organization can take money from the cash value account using tax-free policy withdrawals or loans. But certain types of policies offered by select carriers now offer an option for the hospital to borrow against the policy while continuing to earn interest on the borrowed dollars. It’s called a “participating loan” option, and as long the organization earns more on the borrowed funds in the cash value account than the carrier is charging in loan interest, the organization has the potential to come out even further ahead. The organization always has the option to select the traditional and more conservative “wash loan” option, but the borrowed funds are not earning a return inside the policy.
Changes in payment trends brought about by the Affordable Care Act, technology expenditures related to electronic health records, and fluctuations in cash flow from higher deductibles and patient copays have all impacted the need for hospitals and medical clinics to have readily available cash.
Hospitals and medical clinics usually balance DCOH needs by tying their strategic plans to their capital plan and budgets and projecting how much cash is needed. Given the current uncertainties in the industry, there is now a need for more DCOH than in the past.
Rather than subjecting DCOH to the today’s low yields offered by banks and in other “safe” investments, it may make sense for hospitals and medical clinics to consider HOLI for a portion of their DCOH. The flexibility that the organization retains to use a portion of the death benefit as an employee retention tool and to recover the costs associated with the plan can make dollars allocated to HOLI even more valuable.
1 “65 Financial Benchmarks for Hospital Executives,” Becker’s Hospital CFO Report, 2/21/17.
4 Figures as of 3/31/18. www.fdic.gov