By Rick Davis and Larry Stoehr
For treasurers, a well-designed and maintained company-owned life-insurance program can be a flexible, efficient and high- performing asset whose uses are constantly evolving.
Here’s a tool that has long been used by treasurers as a tax-advantaged asset for the direct and indirect funding of long-term company liabilities: Corporate Owned Life Insurance or COLI. Total COLI assets exceed $300bn and are used in some form at most companies.
COLI is an employer-owned or sponsored insurance program in which permanent life insurance is purchased on the lives of employees. This article will be confined to employer-owned COLI in which the employer purchases the insurance and receives most, if not all, of the life insurance proceeds upon the death of the insured.
For treasurers, a well-designed and maintained COLI program can be a flexible, efficient and high-performing asset whose uses are constantly evolving. Properly implemented, COLI has proven to be a safe and effective tool for strategic treasury management. Many treasurers already manage COLI programs that may need to be revisited to take advantage of new approaches in the market.
COLI enjoys the two tax advantages inherent in permanent life insurance: tax deferral of cash value growth and tax-free treatment of death benefits. These tax benefits were extended to corporations under the federal tax code (IRC) in 1921. Since then, there have been a number of attempts to modify the tax and regulatory treatment of COLI. However, the basic tax features of COLI have survived and been reaffirmed over nine decades. Within a defined set of parameters, COLI is a robust and efficient funding tool.
Treasury is integral to the decisions regarding the purchase and management of a COLI program. Program sizes can range typically from $10mn to many billions. Once the decision to go forward is made, there are a variety of choices in product selection, implementation and management to be considered. The most important considerations for treasurers include program structure, accounting and tax issues, purchase timing, and vendor selection.
PROGRAM STRUCTURE
The design of a COLI program is determined primarily by its funding purpose. This can be either direct funding of a benefit, such as a group insurance supplement, key person or buyout protection, or indirect funding using cost recovery or cost-offset principles. Treasurers must understand the funding purpose and then pursue an efficient design keeping in mind the following considerations:
- Insurable interest
- Pricing and risk shifting
- Credit protection
- Mortality
- Liquidity
Many developments have occurred in the past 15 years in each of these areas. Here are some of the highlights.
Insurable interest. This is dictated by state insurable interest laws and IRC 101(j). In general, only the top 35 percent of employees and directors may now be insured, and all participants must consent to be insured after the corporation provides adequate notice (including amount of coverage).
Pricing. COLI products are now offered on universal life, hybrid, or variable universal life platforms and give treasurers a great deal of flexibility in pricing, credit protection, and risk shifting. Although many pricing elements are fixed, insurers sometimes can be flexible in the timing of costs and risk shifting, and thus affect “bottom line” results.
Credit protection. Two areas not well appreciated by outside insurance practitioners are credit protection and mortality treatment; each provides flexibility. The policyholder in a traditional general account or hybrid policy is a preferred creditor of the insurance company, while the separate account is legally separate from the assets and liabilities of the insurance company. A separate account allows greater flexibility in investment choices, but generally has few guarantees, if any, from the insurance company. Cash value of the policy will grow according to a compounding crediting rate provided by the carrier in the case of general account and hybrid policies, or by the investment experience, net of costs, of the separate account assets.
Mortality. The mortality treatment of the policies may be traditional, in which the insurer bears the risk of the adequacy of its COIs, or experience-rated, in which the risk is shared between the insurer and the corporate policyholder. Over the life of a COLI plan, traditional and experience-rated policies will perform similarly, but often experience-rated policies perform better financially in the early years. Experience-rated policies generally require large insured populations and have been subject to tax scrutiny.
Liquidity. COLI is generally surrenderable at will, but liquidity is traded off with economic performance. Most premium payments are flexible and the key consideration is whether a policy is a Modified Endowment Contract (MEC) or not. MECs normally perform better economically than non-MECs; however, MEC treatment discourages the use of insurance as a short-term investment by taxing pre-death distributions on an “interest first” basis and imposing a 10 percent early withdrawal penalty tax. Treasurers must, therefore, fully appreciate the need for liquidity based on funding purpose and the trade-offs involved.
ACCOUNTING AND TAX ISSUES
COLI is an asset governed by ASC 325-30, and the basic accounting treatment is straightforward. The cash surrender value of the policy is categorized as “other assets” (because cash surrender value is defined as realizable as of the statement date; certain policy features related to cash surrender value may require discounting). Changes in cash surrender value flow to the income statement as “other income.” Cash flow from COLI generally comes with death benefits.
Other considerations include the application of FAS 106 to post-retirement benefits, which has created an opportunity to use COLI in many cases, but which also imposes liabilities on some programs.
The principle tax advantages of COLI—tax deferral of cash value increases and tax-free treatment of death benefits—are subject to many legal and regulatory
restrictions. These restrictions may be summarized as:
- Legitimate business purpose beyond gaining tax benefits.
- Economic substance to meet that stated purpose.
- Demonstrable transfer of risk from policyholder to the Insurance Company.
- No policyholder “ownership control” over the assets underlying the policy. This is the “Investor Control Doctrine.”
- Documentation.
The tax treatment of COLI has been revisited by the IRS multiple times over its 90-year history. Precedent indicates adverse legislative or regulatory action are likely to be applied prospectively.
TIMING OF THE PURCHASE
A number of CFOs and treasurers have held back on COLI decisions in the current low-interest-rate environment, choosing to “keep their powder dry” in short term cash instruments. But there is a big opportunity cost to waiting (see chart below).
Because of tax advantages and other product features, corporations should be in a better position if they act now rather trying to time the purchase decision. COLI investment portfolios will follow market trends, and in some cases, can alleviate mark-to-market risk. COLI is a long term financial decision, and normally, COLI is held until death or retirement of the insured, but it is not a decision that necessarily limits flexibility should market conditions call for policy surrender and redeployment of funds.
VENDOR SELECTION
COLI is a highly specialized field of insurance requiring expertise and experience. Vendor selection is a critical aspect of risk mitigation. The consequences of a poorly designed or maintained program can be costly, including loss of tax advantages and imposition of tax penalties, reputation risk, and legal action. It is not efficient for most treasury departments to build this expertise internally so typically they use the services of COLI specialists for both the initial purchase and ongoing maintenance and monitoring.
Most specialists are licensed insurance brokers and are paid by commissions by the insurance carrier for the placement and servicing of the policies, although some are paid by fees or other sources of revenue. Corporate policyholders should perform due diligence on the specialists to understand their expertise and commitment to best practice, and also to understand the nature of their services over the long term.
Maintaining a COLI program goes far beyond reporting cash values and processing death benefits (although the latter can be challenging from time to time). Specialists should have close working relationships with the carriers and, while maintaining independence from them, be able to continually monitor the insurance companies from a credit perspective, beyond merely tracking credit ratings. When applicable, the specialists must be able to diligently monitor third-party manager compliance with management contracts.
COLI can be an efficient funding vehicle and a superior-performing financial asset. Changes in the market over the last 15 years and current market conditions warrant revisiting existing programs or the initiating new ones.
Richard L. Davis, of Davis Advisory Partners, can be reached at [email protected] or +1 (610) 331-5973.
Lawrence R. Stoehr is a partner at Institutional Insurance Group. He can be reached at [email protected] or +1 (336) 387-0490.