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.
Another feature of todays COLI products is that they have evolved to provide very high early cash values. There are often costs associated with the introduction of an executive benefit plan and these costs can in effect be financed through the policy itself.
Like most life insurance products, COLI insurers pay commissions to an agent or broker who sell their product. Frequently this agent or broker assists with the design and implementation of the plan as part of the commission arrangement, meaning that the start-up costs or design and implementation of the plan is paid in part or entirely by the commission from the COLI product.
Further, the early cash values from these products are often still high enough to have little or no impact on the companys earnings or balance sheet due to the implementation of the plan. Alternatively, the corporation can pay a fee for the entire cost of plan implementation. This option, however, clearly creates a direct cost. If the insurance company finances this cost through the COLI policy, not only is there no direct implementation cost, but the impact of this financing never shows up in any financial ratios–a feature enjoyed by many CFOs.
Similarly, plan administration can be financed by the COLI policies as well. Sometimes benefit plans are designed to credit the participant a return, net of charges built into the COLI policy, to help cover these administrative costs. More often the COLI policy can be structured to return these administrative costs to the corporation out of the death benefits generated by the policy. Either way, COLI can be used to offset the earnings and balance sheet impact of these plan administrative costs.
Banks buy COLI for many of the same reasons other corporations do. However, banks are different from other entities in that the bank owned life insurance (BOLI) investments are subject to much closer regulatory scrutiny.
Banks must value and report their cash value assets based on their current market value. As a result, many insurance companies offer special funds that give the bank the upside potential of the market-based investment and, for a small cost they can eliminate the market value fluctuation. Furthermore, banks must back their investments with capital that varies with the underlying risk of the invested asset. More risk generates greater required capital.
As a result, insurance companies have developed funds that minimize this risk-based capital allocation. This allows the bank to enhance its net return by shifting risk from its balance sheet to the insurance companys balance sheet. These stable value and low risk based capital products represent yet another evolution of the COLI/BOLI market.
In sum, COLIs many benefits include tax advantage and cash liquidity, as well as a clear asset/liability and investment correlation. It can be effectively used as a tool to finance plan implementation or simply provide an effective offset to initial as well as long term plan liabilities.
The BOLI market has also enjoyed the evolution of numerous other life insurance advantages. These features combine to position life insurance as an attractive earnings and balance sheet management tool for both corporations and banks.
David B. Covington, FSA, MAAA, CLU, ChFC, is assistant vice president of product development for Corporate Strategies Group, MONY Life Insurance Company, New York. He can be reached via e-mail at david_covington@MONY.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, April 15, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.