WHAT IS COLI?
COLI is a funding strategy that has been broadly utilized by public and private companies, financial institutions, banks and insurance companies as a means of financing executive benefit obligations. COLI offers death benefit protection with an array of unique and preferential tax and accounting opportunities.
- COLI is a life insurance policy purchased by a corporation on the lives of its employees
- The corporation is the owner and beneficiary of the life insurance policy and has all ownership rights
- Corporation may elect to extend some of the rights and benefits of the life insurance policy to the executive
- COLI differs from retail life insurance in that it offers:
- Institutional pricing specifically designed for the corporate marketplace
- Lower expenses, which are reflective of lower policy lapse rates
- Lower mortality charges resulting from the longer life expectancies of insured executives
- Lower insurance carrier profit margins due to economies of scale
- Enhanced early cash values to make it attractive relative to alternative funding arrangements
- Guaranteed Issue underwriting (i.e., no medical examinations required)
- A more sophisticated array of investment alternatives/subaccounts (variable COLI)
WHY DO COMPANIES USE COLI?
- COLI can reduce taxes on invested assets, increasing after-tax returns and enhancing shareholder value
- COLI receives favorable accounting and P&L treatment relative to taxable investments
- COLI offers unique tax advantages over other alternatives:
- Tax-deferred growth of cash value(1)(4)
- Tax-free reallocation of investment funds within policy (variable COLI)(2)
- Tax-free receipt of death proceeds(3)(4)
- Tax-free loans and withdrawals ( up to policy basis)(1)(5)(6)
- The ability to access COLI cash values via tax-free loans and withdrawals provides unique cash flow flexibility
Loans and partial withdrawals will decrease the death benefit and cash value and may be subject to policy limitations and income tax, which includes the possibility of contact lapse.
- Subject to qualification under Tax Code Section 72
- Subject to qualification under Tax Code Section 817(h)
- Subject to qualification under Tax Code Section 101
- Subject to qualification under Tax Code Section 7702
- Subject to qualification under Tax Code Section 7702A
- Subject to qualification under Tax Code Section 7702(f)(7)
TYPES OF COLI
Variable life insurance products are long-term investments and may not be suitable for all investors. An investment in variable life insurance is subject to fluctuating values of the underlying investment options, and it entails risk, including the possible loss of principal.
HOW DOES A COLI ACQUISITION WORK?
- The company/employer is the applicant, owner and beneficiary of each policy
- “Key employees” are the insureds of the life insurance policies (e.g., executives, managers, officers, etc.)
- For federal tax purposes, the critical requirements are having insurable interest under state law and meeting the procedural requirements of IRC §101(j)
- Only key employees who provide written consent will be insured
- No medical exam is usually required
- “Actively at work” verification (e.g., not absent from work more than 3 consecutive days in the past 90 days)
- Employers may offer a survivor benefit to those employees who consent to be insured
- Having an articulated business purpose for the COLI is consistent with the traditional (and favorable) treatment life insurance has been given vis-à-vis pure investments. Such purposes include:
- “Offsetting” or “recovering” employee benefit costs
- Being part of a company program designed to ensure continued company operations in the event of loss of management personnel
COLI PRICING STRUCTURE
- Front End Loads – State premium taxes, federal deferred acquisition cost (DAC) tax and sales loads/expenses
- Monthly Charges – Policy administration fees (which are typically a fixed dollar amount), cost of insurance (COI)charges (which fluctuate based on the age of the insured and net amount at risk)
- Fund Charges/Expenses – Such as investment management fees (IAF) for Separate Account (Variable) lifeinsurance
- Mortality & Expense (M&E) Risk Charges – Typically a percentage charge based on the account value of the policy; may be included as either a monthly policy charge or charged at the investment level (typically only found in Separate Account (Variable) life insurance)
- Back End Loads – Policy surrender charges (most competitive COLI products do not have any surrender charges)
- Other Charges – Some insurance products assess miscellaneous charges such as “death benefit per $1,000” charge
RISKS OF COLI
- Change to the taxation of life insurance
- Congress added IRC §101(j) which clarifies an employer’s right to receive tax benefits of life insurance ownership when insuring employees
- When tax changes have been made in the past, existing policies have generally been “grandfathered” (i.e., tax changes apply prospectively to new policies purchased after legislative enactment)
- Carrier Insolvency – General Account policy assets are subject to the claims of the insurance company’s general creditors in the event of bankruptcy, whereas variable life insurance policy assets are held in a Separate Account and are not subject to the claims of general creditors
- Definition of Life Insurance – Carrier certifies that the policy qualifies as life insurance under current regulations
- Performance of chosen product/carrier – May transfer to another policy/carrier via IRC §1035 tax-free exchange
- Inability to deduct losses in a down market – COLI is a long-term investment and the inability to deduct short term losses in a down market is mitigated by the long-term advantage of tax-deferred buildup on gains
COLI LEGISLATION
COLI Best Practices Measure
The COLI Best Practices measure included in “The Pension Protection Act of 2006” defined the requirements necessary for COLI to continue to receive the accounting and tax benefits outlined in this summary. The new rules will generally apply to COLI contracts issued after August 17, 2006:
- Notice and Consent Requirements
- Before a COLI contract can be issued, a written notice and consent is required to include:
- The employee’s consent to be insured under the contract and
- Acknowledgment that such coverage may continue after the employee terminates employment
- Before a COLI contract can be issued, a written notice and consent is required to include:
- EligibleInsureds
- A Director, or
- A 5 percent or greater owner of the business at any time during the preceding year, or
- Those compensated in excess of $95,000 in the preceding year (2005 figure, to be adjusted for futureinflation), or
- Among the highest-paid 35 percent of all employees, or
- One of the five highest paid officers
- Reporting and Record Maintenance Requirements
FINANCIAL & INSURANCE ANALYSISPrior to any COLI purchase, it is in the best interest of every company to take sufficient steps to ensure it understands what it is buying and how the insurance works. As part of its due diligence process, a company should follow such protocols as:
- Selecting an insurance broker/plan administrator based upon a proven track record and solid, reliable referrals
- Developing assumptions and methodologies to estimate the potential impact of any liabilities that the COLI will be informally funding, and the results a COLI acquisition will have on the Company’s financial statements
- Undertaking a comprehensive review of appropriate insurance products that are available in the market
About Mullin Barens Sanford Financial
Through a powerful combination of independence and experience, Mullin Barens Sanford Financial and Insurance Services (MBS Financial) is a leading consulting firm that assists companies with 409A and other executive benefit needs.
Disclaimer: The materials are designed to convey accurate and authoritative information concerning the subject matter covered. However, they are provided with the understanding that Mullin Barens Sanford does not engage in the practice of law, or give tax, legal or accounting advice. For advice in these areas please consult your appropriate advisors.
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