Corporate Owned Life Insurance (COLI) is a type of life insurance contract owned by an employer that insures the life of one or more employees. Many employers use COLI to hedge future benefit obligations. Properly structured COLI arrangements limit the insured group to a select group of management or highly compensated employees.
The COLI is an asset of the employer and in some instances is placed in a grantor “rabbi” trust. The cash values are not formally and directly linked to the value of the nonqualified benefit plan; the value of COLI is merely a method to earmark assets to offset the cost of the nonqualified benefit plan. There are several ways to structure the COLI financing strategy:
- Benefit Funding Approach – The cash value that accrues can be used as a sinking fund to cover benefit plan distributions. The cash value is accessed by the employer via “withdrawals to basis” and then loans (this often reduces the death benefit in the policies). Death benefits are used to recover other plan costs, including perhaps the cost of money.
- Investment Yield Approach – In another common strategy, the sponsor elects to pay a stated premium over a defined period of time – generally 7 to 10 years. The annual income generated from the COLI can produce an attractive yield and can indirectly offset the incremental expense of the nonqualified benefit program. Benefit plan distribution needs are funded from corporate cash flow and death proceeds are used to recover all costs incurred with the COLI and the nonqualified benefit plan.
Institutionally priced COLI policies available in the market today can be much more efficient investment vehicles than older insurance policies. It is possible to produce first year cash values in the range of 90% to over 100% of the premium payment. Given the accounting treatment of policies, the impact on company financial statements can be much more favorable than it has been in the past.
- General Account – Policy cash values are invested by the insurance company in its general account portfolio. An interest rate is declared periodically, based on the investment yield expected less an expense margin. The insurance company assumes the investment risk and the cash value is available to the general creditors if the insurance company becomes insolvent.
- Separate Account – Policy cash values are allocated to a series of professionally managed subaccounts. The policy owner selects the asset allocation and assumes all investment risk. The value in the accounts will vary based on market performance and will have a direct impact on the COLI cash value and death benefit. The value in the COLI is sheltered from general creditors if the insurance carrier becomes insolvent.
Generally, the insured group is limited to the employees eligible to participate in the nonqualified benefit plan. If the group of employees is 15 or more, there can be favorable underwriting concessions under a guaranteed issue program. Guaranteed issue requires the employee to complete a one‐page application giving their consent to be insured and generally asking three questions about: 1) tobacco use, 2) actively at work status, and 3) any absence from work in the last 90 days. Smaller groups might require full medical underwriting and the carrier could decline to insure some or all of the employees. A COLI strategy can be designed two ways:
- Aggregate Funded Approach – Contributions for the nonqualified plan are aggregated and then divided among the insured group based on either equal premium amounts or equal face amounts. This approach works well with larger groups (15+) and spreads the insurance risk among the insured population.
- Individually Funded Approach – Each executive is insured with a face amount sufficient to cover their individual benefit liability. This approach is often used with smaller groups and usually requires full underwriting.
Other Factors to Consider
- If designed properly, COLI will have a favorable impact on the employer’s financial statements through the income generated from the cash value.
- Assets held in COLI are accounted for using FASB Technical Bulletin 85-4. The full market value of plan assets and any growth thereon can pass through to the company’s income statement.
- GAAP accounting does not permit the employer to recognize COLI death benefits on the financial statement until a death occurs. The present value of future death benefits should, however, be recognized as an economic gain.
- Corporate owners of insurance contracts are required to report annually to the IRS the number of executives insured, the aggregate death benefit inforce, and other information about the insurance contracts.
- In order to maximize investment yield, a COLI purchase is counter intuitive. The general public wants to purchase as much insurance as possible per $1 of premium paid. An employer will want to purchase the lowest amount of insurance per $1 of premium paid.
What Can NFPEB Do?
NFPEB can provide a detail analysis of a COLI transaction, outlining the financial impact and expected returns. We monitor the top rated COLI carriers and can provide an in-depth analysis of products choices, design, costs, and the supporting due diligence to assist a company in the successful implementation and administration of a COLI program. We will also negotiate the underwriting considerations. After the sale is complete, we provide ongoing reporting and administrative services for our clients.