Company-Owned Life Insurance (COLI)

COLI vs. Taxable Investment Discussion

Companies often seek to provide informal financing for nonqualified benefit programs, such as SERPs and deferred compensation arrangements. Many of these companies choose company-owned life insurance (COLI) as the financing vehicle, because the growth in the COLI is tax deferred and the cash proceeds, when received by the company either as borrowings from the policies or as death benefits upon the death of the insured, are income tax free. In addition, companies can recognize in their financial statements the increase in cash surrender value each year.

For a charted comparison of COLI vs. Taxable Investments, click here.

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Frequently Asked Questions About COLI

Q: Why do companies institute COLI programs?

A: Primarily to finance employee benefit plan expenses and increase net income. For example, companies have substantial costs for medical, group life and other basic insurance as well as qualified and nonqualified benefit plan expenses that can be financed with COLI. The reasons companies use COLI for these costs include:

• COLI can earn a higher after-tax yield than many other investments.
• COLI matches the long-term nature of benefit plan expenses.
• COLI assets can be matched with benefit liabilities to offset the impact on earnings created by the benefit liabilities.

Q: Do many companies have COLI plans today?

A: Based on industry surveys from 1999, 68% of the Fortune 1000 companies finance their SERP obligations with COLI programs; and of the 50 top banks and thrift institutions in the United States, 43 have implemented COLI programs.

Q: How does COLI work?

A: The company purchases insurance on a group of employees. The insureds usually include a group of highly compensated management employees, e.g., assistant vice presidents and above.

The company pays the premium(s) 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 or interfere with any other insurance provided by the company (e.g., group-term life insurance).

The COLI policies produce financial statement income for the company as the credited cash value increases exceed the premiums paid. The net after tax income earned may be higher than the return available on many alternative investments.

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. The policies can either be put in a grantor trust (generally a “rabbi” trust), which remains an asset of the company, or they can be held by the company and not otherwise segregated.

Q: What are the different types of COLI policies?

A: Two basic types are characterized as:

• General Account COLI. Credits a fixed interest rate annually to each policy. The interest rate credited is based on the expected return of the assets purchased by the insurance company less a margin for expenses. The assets are held in the general account of the insurance carrier. Either a “new money” approach or a “portfolio” (both described later) approach is used to determine credited interest rates. General Account COLI policies provide minimum annual interest guarantees in addition to full book value (cash value) guarantees and asset default protection.
• Separate Account COLI. The interest rate credited to a Separate Account COLI policy is a variable yield that is based on the return on the underlying policy assets less a margin for expenses. Such assets are held in separate accounts of the insurance company. The separate account assets are sheltered from the general creditors of the insurance company in the unlikely event of the insurance company’s insolvency. A Separate Account COLI is a variable life insurance policy. Unlike a General Account contract, the cash values of a Separate Account contract will fluctuate with the market value of the underlying assets and are fully subject to the risk of asset default. These fluctuations have a direct impact on the purchaser’s balance sheet and income statement, since the cash value represents the book value of the life insurance contract. Some carriers employ a hedge strategy to smooth the annual returns.

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Considerations on the Purchase of Life Insurance

Click here to download our document detailing considerations on the purchase of life insurance.