Q: What does the company need to do to purchase COLI?
A: The company purchases life insurance on a group of employees. The insured’s usually represent a group of selected management or highly compensated employees.
The company pays the premiums and owns the cash value of the policies. The company is also the beneficiary of the insurance. The insured employees do not receive any of the insurance benefits directly, nor do they pay any of the premiums. The coverage does not replace any other insurance owned by the employee or provided by the company (e.g., group-term life insurance).
Changes in the cash surrender value of the COLI policies are included in financial statement income.
Q: Do the policies actually fund the benefits like a pension plan funds retirement benefits?
A: No. The policies are part of the general assets of the company. Properly stated, the insurance informally finances the cost of the benefits.
Q: Is the company required to notify covered employees that the company is purchasing life insurance on them?
A: Yes. Internal Revenue Code Section 101(j) provides that death proceeds paid on an “employer-owned life insurance contract” will remain tax-free only if proper notice is given to the covered employee and the employee gives written consent to be insured before coverage is issued.
Q: Are the insured employees required to undergo medical underwriting?
A: It depends on whether the COLI pool of insureds is large enough to qualify for guaranteed issue underwriting. The insurance is aggregated, not matched to individual employee benefits. Therefore, if your employees do not qualify for guaranteed issue, you will only want to insure employees who can successfully pass medical underwriting.
Q: Why do companies institute COLI programs?
A: Primarily to finance employee benefit plan expenses and increase net income. For example, companies that have substantial costs for medical, group life, and other basic insurance as well as qualified and nonqualified benefit plan expenses can finance these costs with COLI.
The reasons companies choose to use COLI include:
- COLI can earn a competitive after-tax yield compared to other investments.
- COLI can match the long-term nature of benefit plan expenses.
- COLI can act as a hedge against benefit liabilities.
- COLI death benefits can be used to help the company recover plan costs over the long term.
Q: Do many companies have COLI policies?
A: Based on industry surveys1, 74% of companies with over 1,500 employees offer non-qualified deferred compensation plans. These plans are often informally funded by mutual funds or COLI. In our experience, most larger plans use COLI as their funding source.
Q: How are typical COLI policies structured?
A: Typically, companies purchase variable universal life insurance (“VUL”) policies. The cash values of a VUL policy will fluctuate with the market value of the underlying investment options. These fluctuations affect the cash value and the death benefit of the policy and therefore the income that may be available from the policy through loans or withdrawals.
In some situations, COLI is used to informally fund a deferred compensation program that permits employees to choose shadow investments for their plan accounts. In these cases, companies will generally select an investment mix in the VUL policy that matches participant selections to help hedge the company’s liability to participants.
Q: If this were an opportunity for a company to make more money and finance benefit expenses at the same time, why wouldn’t every company do it?
A: A company should buy COLI if the company has these three characteristics:
- The company is profitable
- It has reasonable liquidity
- It has unfunded employee benefit liabilities
Q: Does the company keep the life insurance policies when the insured employees terminate or retire?
A: Yes. The coverage on each individual insured is part of an aggregate COLI pool which finances a range of company benefit obligations to many employees. When an insured employee leaves the company, the COLI is retained to cover the liabilities the company still has to other employees.
Q: If a covered employee leaves the company, how does the employer know when the employee has died so that the death benefit can be collected?
A: To make sure death benefits are collected on a timely basis, we track all covered employees in COLI pools via the Social Security System. When the employee dies we access information via the Social Security System to file the death claim with the carrier.
Q: What has been the general employee reaction to his or her company acquiring COLI?
A: Very favorable. Keep in mind, COLI does not cost the employee anything. It makes their employer more financially viable and it is a plan that has been implemented by many of the country’s largest and most reputable companies. While an employee cannot be forced to be covered within the COLI pool, our experience is that the majority of employees do choose to participate.
Q: Do the employees receive any of the cash benefits from COLI?
A: Generally, no. The COLI coverage, however, benefits employees by making it more financially feasible for the company to provide competitive benefits.
Q: How long does it take to implement a COLI arrangement?
A: Normally 2 to 3 months from start to finish.
FINANCIAL IMPACT ON THE COMPANY
Q: Will COLI have an impact on a company’s financial performance?
A: COLI may favorably impact a company’s financial performance when it increases net after-tax income. The result would then be an increase in earnings per share.
Q: Are COLI premiums deductible by the purchasing company?
A: No. COLI premiums paid, however, do result in an increase in the cash value of COLI which is a company asset.
Q: What are the current earning rates of COLI?
A: The rate of return is a function of the type of policy purchased and the carrier’s interest crediting rate. If a VUL policy is used, the rate of return depends on the investment results of the underlying investment options.
Q: Can you access the cash value in a COLI policy?
A: Yes. COLI policies allow the owner to withdraw or borrow against the cash value, and the policies can be surrendered at any time and the cash value will be paid to the company.
Q: What happens if the coverage is surrendered?
A: Upon a surrender, the carrier pays the company the cash value of the policies less any applicable surrender charge. The company will recognize a gain for income tax purposes on the amount of cash value received in excess of the sum of premiums paid. For example, if the cash surrender value is $6 million, and the amount of premiums paid is $5 million, the company would recognize $1 million of taxable income upon surrender. This would be taxed at normal rates. Before surrendering a policy, other alternatives should be reviewed, such as a tax-free section 1035-exchange.
Q: Does it matter from which insurance carrier a COLI policy is purchased?
A: Prior to any COLI purchase, the company should carefully review the financial strength of each proposed carrier, as well as its track record in the market. The financial strength ratings for the issuer do not pertain to the underlying investment options of VUL products, since these values are subject to market risk and will fluctuate in value. Regardless of product type, the financial strength and reputation of a carrier is critical to the future viability and credibility of a COLI program. Product costs do vary by company and individual product.
Q: What happens if the company wants to change insurance carriers?
A: In such a situation, the coverage can usually be transferred to another carrier via an IRC Section 1035 tax-free exchange. IRC Section 1035 allows for a tax-free exchange of “like-kind property”. Surrender charges may apply.
Q: What is the effect of a company merger on COLI policies?
A: Merger and acquisition activity has no direct impact on the COLI plan performance. However, for an acquiring company, the COLI from the acquisition can be a beneficial addition to its existing portfolio if the policy is not heavily leveraged. If the company is acquired, COLI can be an attractive balance sheet asset and may enhance the net worth and earnings per share results.
COLI ACCOUNTING TREATMENT
Q: How is the income from COLI earned and recorded?
A: The company earns income in a COLI arrangement from two sources. The first is from any growth of the cash value of the policy. While the full cash value works for the company, the company records as an asset the cash surrender value (the full cash value less any applicable surrender charges in the event the contract is surrendered). The cash value may increase each year as the insurance carrier credits interest or if the underlying investment options in a VUL policy increase in value. The second source of income comes from the insurance proceeds paid to the company when the insured employees die. The accounting treatment for a typical COLI plan can be summarized as follows:
- COLI purchase is reflected as an OTHER ASSET.
- Earnings (increases to cash surrender value) will be recorded as a nontaxable credit to income (OTHER INCOME).
- Receipt of the net-at-risk portion of death proceeds are also reflected as a nontaxable credit to income (OTHER INCOME).
Q: How does the balance sheet change with the purchase of COLI?
A: The company will normally use available cash to purchase COLI. Since cash and COLI are both assets, there may be no initial change to the balance sheet. However, if the COLI policy increases in value, the income statement will show additional net income which translates into increased net worth.
Q: What impact does alternative minimum tax (“AMT”) have on the transaction?
A: If a company is in AMT, taxes may have to be paid on the cash value growth as well as a portion of the death proceeds, at the AMT rate. The AMT paid is carried forward as a credit which is realized when the company returns to a regular tax-paying status. Payment of AMT, therefore, may generate a tax benefit which the company recognizes in its financial statements.
MISCELLANEOUS ISSUES
Q: If employees are concerned about the company changing its mind after implementing an unfunded nonqualified plan, is there something that can be done to give them added well-being?
A: Yes. Assets to meet the company’s plan obligations can be put in a grantor trust (generally called a “rabbi” trust). The assets still remain a general asset of the company, but the company may not use the assets for any purpose other than to pay employee benefits. If the company becomes insolvent, the asset is still subject to the claims of unsecured creditors.
Q: What is a Modified Endowment Contract (“MEC”)?
A: If a company pays premiums in excess of those allowed by a “seven-pay test”, it becomes a Modified Endowment Contract (“MEC”). If a contract is a MEC, cash withdrawals are taxable and incur a 10% tax penalty to the extent the cash value exceeds premiums paid. Most carriers monitor all policies they administer and will notify the company if its policies are in danger of becoming MECs. The policy’s death benefit proceeds are not affected by MEC status.
1Newport Group https://www.newportgroup.com/knowledge-center/december-2019/an-advance-look-at-our-compensation-retirement-an/