How Corporate Owned Life Insurance (COLI) Works: 2019

What Is Company-Owned Life Insurance (COLI)?

Corporate Owned Life Insurance (COLI) is an investment alternative that allows a corporation to accumulate a tax-deferred asset.

With COLI, the corporation purchases and owns a life insurance policy on a key employee or employees.  It is also the primary beneficiary. The corporation pays premiums, receives tax-deferred cash values, and receives tax-free death benefit proceeds.

Before it was COLI, it was called “key man” or “key person” insurance and could only be used to insure the lives of key employees and executives as a hedge against losing them to an unexpected death.  The difference with COLI is that it can be taken out on a group of key employees or partners.

COLI is often a popular way to finance employee benefits such as Supplemental Executive Retirement Plan (SERP) obligations.  About 75% of all Fortune 1000 companies have a COLI program.  In addition, 43 of the 50 top banks and thrifts have a similar program in place known as Bank Owned Life Insurance (BOLI).

SERPs can be a form of deferred compensation that corporations use to reward and retain key executives.  Because SERPs are non-qualified, they may be offered selectively to high earning executives whose qualified plan contributions are limited.

The company and the executive enter into a formal agreement that promises the executive a certain amount of supplemental retirement income based on vesting and other eligibility conditions the executive must meet.

To fund this obligation, corporations pay out of current cash flows or through the funding of COLI. 

A COLI policy generally takes on the form of a cash value life insurance policy. Companies buy an insurance policy of an agreed-upon amount for the employee. The company gets tax benefits because it can deduct the deferred compensation to the employee while also receiving tax-free income from the insurance policy.

Even if the employee quits, the company still has access to the insurance’s cash value. If the employee passes away, the company is a beneficiary of the payout and also gets tax benefits.  In some cases, COLI is structured so that the key executive’s family actually gets the insurance payout instead.

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The Purpose of COLI

In a nutshell, COLI programs are put in place to finance employee benefit plan expenses and to increase a company’s net income. 

Companies that have considerable medical, group life, insurance, qualified and non-qualified benefit plan expenses often use COLI to finance these costs.

COLI can earn competitive after-tax yields compared to other investments and acts as a hedge against incurring burdensome benefit liabilities.

What is the Difference Between BOLI and COLI?

Bank Owned Life Insurance (BOLI) is essentially the same as COLI, but the life insurance policy is purchased and owned by a bank. 

COLI is life insurance on employees’ lives that is owned by any corporate employer. 

Both pay benefits to the employer or directly to the employees’ families. 

Similar to these, there is also Credit Union-Owned Life Insurance (CUOLI) that specifically allows credit unions to offset the costs of employee benefit programs while potentially generating higher yields than more traditional credit union permissible investments. 

Many credit unions utilize CUOLI as an investment strategy just like BOLI and COLI programs but CUOLI is flexible and is not just limited to executive reward programs.  It can also offset other employee benefit programs such as healthcare and other group benefits. 

Because credit unions are finding it more difficult to compete for top talent, CUOLI is being used more and more to offset the costs of retention, reward and retirement strategies for key executives.

How does Company-Owned Life Insurance Work?

Typically, a company will purchase life insurance on a group of highly compensated or critically important employees. 

The company will pay the premiums on the policies and will own the cash value of the policies.  The company is also the beneficiary of the insurance in the event the employee passes away.  Unless otherwise agreed upon, the insured employees do not receive any of the benefits directly and they do not pay any of the premiums. 

Coverage does not replace any other insurance owned by the employee that is provided by the company, such as group term life insurance.

Policies do not actually fund benefits such as pension plans or other retirement vehicles.  The policies are actually part of the general assets of the company and when properly shown on the books, they informally finance the cost of the benefits.

Companies also can keep the life insurance policies in place when the insured executive either terminates employment or retires.  The coverage is considered part of an aggregate COLI pool that helps finance benefits for many employees.  When an insured person leaves the company, the COLI can still be kept to cover the liabilities the company has for other employees.

Even after an employee leaves a company, the company still tracks the employee via Social Security so they will know when the employee has died and that a death benefit can be paid. 

Types of Corporate Owned Life Insurance Plans

There are two primary types of COLI policies: general accounts and separate accounts. 

General Accounts

With a general account, the insurance company in a general portfolio invests the cash values of the policies. The insurance company takes on all of the risks for the investments and once a company make an investment into a general account, the deposit then belongs to the insurance provider.  This means they can invest that deposit in whatever ways they think are appropriate which results in less earnings volatility.

General accounts tend to be less complicated that separate accounts because less parties are involved. 

Typically, a general account will invest in high quality corporate bonds and collateralized mortgages.  Guaranteed rates will tend to range from 1% to 3%. 

Separate Accounts

This is similar to a general account, but the insurance carrier separates the holdings into a general account and well-known professional brokers and fund managers maintain the investments.  This creates greater investment flexibility but can also produce more earnings volatility depending on the asset class.

The main difference with a separate account is that the account holder is the party who is responsible for the associated investment risks. 

Typically, there is more associated risk with the investments, but there is also the potential for more upside rewards as well.  Returns are based on yields of underlying assets in the portfolio.  There are also no guaranteed minimum crediting rates.

Hybrid Accounts

Hybrid accounts are much less common and as the name suggests, they take some of the best qualities of a general account and a separate account to create a new form of investing.

This account offers the transparency of a separate account, but also incorporates the stability of a general account.

Requirements for Corporate-Owned Life Insurance

Although companies can make more money and finance benefit costs at the same time, COLI generally only makes sense if a company is profitable, has reasonable liquidity and is facing unfunded employee benefit liabilities.

Important Information for the Insured

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. 

The employee must also give written consent to be insured before coverage is issued.  The written information must include that the employer intends to insure the employee’s life and what the maximum face amount could be at the time the policy is issued.  The employee must also be informed that coverage may continue after the employee terminates employment and that the employer will be a beneficiary of any proceeds payable upon the death of the employee.

Also, employees may need to go through medical underwriting to be accepted for coverage.  This will depend on whether the COLI pool of insured people is large enough to qualify for guaranteed issue underwriting. 

In some instances, individual financial information and criminal histories may also be required. The results of any medical tests and information obtained will determine the risk rating and have a direct impact on the pricing/performance of the policy.

If the group being insured consists of more than 15 people, they will qualify for a guaranteed issue program. As such, the employees will only have to answer a few simple questions during the underwriting process.

However, if there is going to be fewer than 15 people insured by the policy, the employees will need to undergo a traditional medical exam, like what most insurance plans require.

This means that if employees do not qualify for guaranteed issue, then a company will only want to insure employees who can successfully pass medical underwriting.

Also, the COLI process can take as long as three months to finalize.

It does not directly affect communication with the insured, but employers need to report annually to the IRS (Form 8925) the total number of its employees, the number of employees covered under a COLI program, and the total amount of insurance in force at the end of the year under the life insurance contracts.

Corporate Owned Life Insurance and Tax Filing

Section 863 of the Pension Protection Act was signed into law in 2006 and added the COLI Best Practices provision to the Internal Revenue Code as subsection (j) to Code Section 101.

In part, it states that COLI death benefits are tax-free only if:

  • The deceased individual was an employee within 12 months of his or her death;
  • The benefits were payable to the employee’s family, beneficiary (not the employer), trust or estate, or were used to purchase an equity interest in the employer, as in a buy-sell agreement; or
  • The employee was a director, a “highly compensated employee” under Section 414(q) of the Internal Revenue Code, or a “highly compensated individual” under Section 105(h)(5) (i.e., among the highest paid 35% of all employees of the employer at the time the contract was issued).

Employers need to report annually to the IRS (Form 8925) the total number of their employees, the number of employees covered under a COLI program, and the total amount of insurance in force at the end of the year under the life insurance contracts.

Pros and Cons of Corporate-Owned Life Insurance

In general, there are a lot of benefits to be derived from participating in a COLI program.  But there are some things that can impact the program as well that you should be aware of as well.

Pros

  • A COLI program can earn a competitive after-tax yield compared to other investments.
  • It can serve as a hedge against benefit liabilities.
  • Death benefits from a COLI program can be used to help the company recover plan costs over the long term.
  • COLI can act as a buffer for those times when the more important the individual is to the fundamental operations of the organization, or the higher the individual’s seniority, the more difficult it is to replace them.  The insurance policy can help cover the associated costs of finding a replacement, which can often be significant.
  • COLI can match the long-term nature of benefit plan expenses.  It can also help a company earn an additional income that could conceivably be more than what they pay in insurance premiums.
  • Death benefits are not taxable, and investment earnings on insurance premiums can grow tax-free within the policy unless it is surrendered before the insured party’s death.
  • While employees do not normally receive any cash benefits from COLI, the COLI coverage does benefit employees by making it more financially possible for the company to provide better and more competitive benefits.
  • COLI may favorably impact a company’s financial performance when it increases net after-tax income.  This would result in an increase in earnings per share.
  • COLI allows the owner (the company) to withdraw or borrow against the cash value of the policy.  Policies can be surrendered at any time and the cash value will be paid to the company.
  • If a company wants to change insurance carriers, this can usually take place through an IRC Section 1035 tax-free exchange.  IRC Section 1035 allows for a tax-free exchange of “like-kind property”.  The only down side is that surrender charges may apply.
  • In some situations, COLI is used to informally fund a deferred compensation program that permits employees to choose shadow investments for their plan accounts.  
  • When a COLI plan’s death benefits are paid to an employee’s family directly, the company paying the premiums can still deduct them from corporate profits and earnings legally. 
  • COLI does not cost the employee anything.  It makes their employer more financially viable and while an employee cannot be forced to be covered within the COLI pool, the majority of employees do choose to participate.

Cons

  • COLI programs have drawn criticism from some who question the ethics of companies benefiting financially from the death of employees.
  • In certain circumstances, individual financial information and criminal histories may also be required prior to underwriting. The results of medical tests and information obtained will determine the risk rating, and the pricing/performance of the policy.
  • COLI is considered to be a long-term illiquid asset.  It can be surrendered at any time without policy charges but any gains in the policy now become taxable as well as a 10% IRS penalty on the gain.  

Corporate vs. Personally-Owned Life Insurance

Owners of private corporations sometimes need to decide whether the owner of the life insurance policy should be the corporation or the individual. There are advantages and disadvantages to both.

Personal Ownership Advantages:

  • The policy and its proceeds may be creditor protected if a family beneficiary is named.
  • Any beneficiary or multiple beneficiaries can be named.
  • Cash surrender value will not affect the enhanced capital gains exemption.
  • Personal access to policy cash value may be easier and may be taxed at a lower rate

than accessing and obtaining the proceeds from a corporately owned policy.

Disadvantages:

  • More pre-tax dollars may be required to pay the premium if the personal tax rate is greater than the corporate tax rate.

Corporate Ownership Advantages:

  • Administration is easier if multiple policies are required.
  • Fewer pre-tax dollars may be required to pay the premium if the corporate tax rate is less than the personal tax rate.
  • All or part of the premium may be deductible for tax purposes if the policy is required to be assigned as collateral for a loan and the loan interest is deductible as a business expense for tax purposes.
  • The death benefit less any adjusted cost basis can flow through the corporation’s capital dividend account by way of capital dividend and it can be received tax-free by any remaining shareholders and/or the shareholder’s estate.

Disadvantages:

  • It is not protected from corporate creditors.
  • The corporation is generally the only beneficiary of the policy to avoid taxable

shareholder benefits.

  • Cash surrender value could affect the qualified small business corporation status for

purposes of the enhanced capital gains exemption.

Current Status of COLI

As evidenced by the high percentage of large corporations in America who have implemented COLI, it has become a useful and beneficial tool to help fund employee benefits in many instances.  It is used to attract, retain and motivate key contributors who play important roles in a company’s success.

Non-qualified plans such as COLI have been prevalent in Fortune 1000 size companies for decades and have become much more common with smaller employers over the last several years.