The Many Advantages Of COLI As A Balance Sheet Tool
You may already know that life insurance is becoming a very popular financial tool for many corporations today. But, did you know that it is also a popular corporate earnings and balance sheet management tool?
Companies with certain executive benefit plans will purchase corporate-owned life insurance (COLI) to offset the corporate liabilities created by these plans. Under the Internal Revenue Code, the plans are usually “not qualified” for tax purposes. This means that normally any funds set aside to pay these liabilities incur income tax to the corporation as they accumulate.
Since these liabilities are usually long-term obligations, the tax on this accumulation can be substantial. Therefore, life insurance is often chosen by the corporation to use in meeting these obligations, as it enjoys a tax advantage on this accumulation.
While tax advantages are certainly important to the life insurance purchase decision, there are many other reasons to select COLI. For example, executive benefit obligations are often long-term in nature. COLI, by the same token, is generally a long-term financial tool.
At its core, COLI pays a death benefit when the insured executive dies. However, COLI also contains pre-death liquidity features. These features are a critical component to corporate earnings and balance sheet management. This liquidity means the COLI owner can take surrenders or loans from the policy if needed prior to the death of the policys insured. If the policies are managed properly, these distributions can even occur on a tax-deferred basis. However, it is typically better not to take distributions of this kind, as they tend to reduce the death benefit amount at the very time when death is more likely to occur.
This liquidity feature, commonly referred to as the policy cash value, allows the corporation to set up an asset on its books. This asset can be earmarked to provide for the liability payment and is often placed in a trust. Though still subject to the claims of creditors if the company goes bankrupt, these funds are generally secure for all other purposes.
From a balance sheet perspective, the corporation is simply exchanging cash for cash value. However, COLI can be better then cash, because its cash value grows tax-free and its maturity and pre-death liquidity correlates well with the associated liability. Lets talk a bit more on this correlation.
As stated, the executive benefit liabilities and the life insurance asset are both long-term propositions. Typically, the liability is some form of retirement income benefit. Payment of these benefits can correlate with the death benefit of the life insurance contract. Obviously there is not a one-to-one correlation between the asset and liability; but it is possible that the policys liquid cash value as well as the notion that death benefits from one policy can be used to pay retirement for another participant can make this correlation fairly close. Beyond this death benefit correlation, a powerful investment correlation exists as well. Lets now talk about this investment correlation.
Several executive benefit plans allow the executive to direct how his or her retirement accounts will be invested. Though not a true investment, the executive “election” can form the basis on how the liability will grow. While corporations are not required to allocate COLI cash values based purely on executive preferences, most of the COLI policies available today offer a wide variety of fund choices.
Therefore, the corporations cash value allocation can be structured to closely match and correlate with the executives benefit account allocation, thus helping to insulate the balance sheet from any asset and liability mismatch. In other words, structured properly when the executive benefit liability fluctuates with the market, the life insurance cash value asset will vary with the market as well. In fact, some plans are specifically designed where the executives benefit allocation choices are tied to the fund choices available under the COLI policy.