Blog: COLI 101

Many Americans know life insurance to be a resource for individuals and families to rely on in the event of an untimely passing of the family’s primary “bread winner”. While this is true, there are many other uses for life insurance. At its core, life insurance is a contract between the life insurance manufacturer and a policy owner whereby the former promises to pay a specified amount to a designated beneficiary upon the death of the insured individual in exchange for the latter’s timely payment of premiums – but these contracts can be structured in a variety of ways and the policy owners may or may not be the insured individuals.

COLI 101 is the first blog in a series designed to demystify corporate owned life insurance (COLI). This series will define what COLI is, who buys COLI policies, common reasons why COLI policies are purchased and more.

To understand COLI, it is critical to have a basic understanding of life insurance, including the key definitions of term life insurance and permanent life insurance.

Term Life Insurance
Term life insurance is often the most referenced type of life insurance in public arenas. Term life policies are typically purchased by individuals, either through an employer-sponsored plan or “off the shelf” via a life insurance agent, to protect their family in the event of their death.

Term life policies have a finite duration – typically 1, 5, 10 or 20 years – for which they are offered. The premium due is dependent on term length, the age, gender and health status of the insured individual, and the size of the death benefit (the amount of money the life insurance company promises to pay the beneficiary upon death of the insured individual). These policies remain in-force for the length of the term so long as the policy owner pays the premium on a timely basis. Term life insurance does not accumulate a “cash value”; the entire premium paid each year is consumed to pay for the promised death benefit. When purchased by younger or middle-aged people, term life premiums are typically charged at a low rate compared to the death benefit because most term policies expire without the payment of a death benefit. However, term life premiums can increase steeply for older individuals and age restrictions exist for certain policies. For this reason, term life insurance is typically used to insure against untimely death of the insured individual for a temporary, finite period of time.

Permanent Life Insurance
Unlike term life insurance, permanent life insurance generally refers to policies that are designed and intended to stay in force through the life expectancy of the insured person. They typically allow the policy owner to “pre-fund” later years’ premiums by paying more premiums in early years than the usual term insurance premium, so that the later years’ premiums will not be exorbitant. Permanent life policies contain a cash value component, which is an accumulation of the premiums paid in excess of the term premium required to pay for the death benefit each year, plus dividends or interest credits added to the policy cash value. Within permanent life policies, there are two types of policies: whole life policies and universal life policies.

A significant differentiator between whole life and universal life policies is their treatment of premiums and death benefits. With whole life policies, the premiums and death benefits are fixed throughout the life of the insured individual. There are two types of whole life policies – participating and non-participating. Participating whole life policies increase the cash value with a dividend declared by the insurance company based on the investment experience of its general account assets. The dividends are considered a return of premiums and therefore are not taxable to the policy owner. Non-participating whole life policies increase the cash value with interest at a rate declared (and sometimes guaranteed) by the insurance company. The interest is automatically credited to the policy cash value and therefore is not taxable to the policy owner unless the policy is canceled/surrendered.

Conversely, universal life policies have premiums and death benefits that can be changed by the policy holder. As long as the cash value in the policy is sufficient to pay for the policy charges, the policy will stay in force. Universal life policies have options regarding the treatment of a policy’s cash value and there are various subtypes of policies that exist under the universal life umbrella that stipulate what options are available to policyholders. Similar to whole life policies, any earnings credited to the cash value are not currently taxable to the policy owner.

Types of Universal Life Policies
Universal life insurance is unique because, unlike term or whole life, the death benefit and premium costs can change. There are generally three types of universal life policies: guaranteed universal life, indexed universal life and variable universal life.

1. Guaranteed universal life (GUL) is the most conventional type of universal life policy because the premiums remain steady and cash accumulation is fixed. In GUL policies, the insurance company credits the policy's cash value with a fixed rate of interest, typically declared once each year, and guarantees that the interest will not fall below a specified rate. GUL policies typically have lower premiums than other universal life policies, but the interest gained from them is also typically lower than investment gains in other universal life policies. It is common for many policyowners to buy GUL policies because they are interested in the permanent protection offered by GUL that is not available in a term policy and their decision to acquire the policy is not reliant on the investment benefits.
2. Indexed universal life (IUL) offers policy holders an opportunity to accrue tax-free gains on the cash value of the policy. As the name suggests, the gains are tied to a market index, such as the S&P 500. At a frequency stipulated in the policy, usually annually or every five years, interest income is added to the cash value at a rate of return consistent with the gains of the associated market index, but subject to a “cap”; importantly, if the associated index decreases in value, the decline in cash value of the policy is protected by a “floor” interest rate. The difference between the cap and the floor is known as the “spread.” Spreads can vary greatly between policies; for example, a policy with a floor below 0%, such as -10%, might have a higher cap than a policy with a floor of 0%. Policies with lower floors generally have higher caps because the policyowner is sharing more risk with the insurance company than the policyowner with the smaller spread.
3. Variable universal life insurance (VUL) offers the widest array of investment options for policy holders. Like with IUL, policyholders can accrue tax-free gains on the cash value of the policy, but in VUL policies, policyholders can allocate their policy cash value to a variety of subaccounts that allow for investment in stocks, bonds, money market accounts and other vehicles. VUL policies also differ from IUL policies because VUL cash values shift the entire risk of the investment onto the policy owner, without any caps or floors on the investment performance of the underlying investments. Although there are many investment options available to VUL policyholders, these policies are not designed to be investment accounts in disguise because they are not likely to match or surpass direct investment in the underlying investment vehicles due to management fees and premiums due on the policy. Unlike a typical investment account however, gains in a VUL policy are not taxable as long as the policy is kept in force.

Important term: a “rider” is an amendment to a standard term or permanent life insurance contract designed to tailor the specific contract to meet the needs of the policyholder. Adding a rider to an insurance contract typically incurs an added cost and will add or take away certain provisions of a basic insurance contract. For example, a long-term care rider may be added to an IUL policy to help pay for long-term care related expenses that are not covered by health insurance, such as payment for an assisted-living facility.

Corporate Owned Life Insurance
The term “corporate owned life insurance” or “COLI” refers to life insurance policies that a business purchases on its employees, typically on its senior executives. Importantly, COLI is different from the group life insurance a company might purchase as an incentive for employees that enables them to acquire term life insurance coverage with a limited death benefit for little or no cost to the employee.

Corporations or businesses buy life insurance for a variety of reasons. For example, a company purchases “key person insurance” to protect the company in the event of an unexpected death of an executive or business owner. If the insured business owner does pass away, the company would then receive the policy’s death benefit that it could use to continue operating the business or satisfy any debt obligations with existing creditors in the event that the business ceases operations.

Businesses also buy COLI for use as a tax-advantaged investment vehicle for accumulating assets to support an executive deferred compensation plan, supplemental executive retirement plan or split dollar life insurance plan. These types of strategies often utilize variable universal life policies because of the investment options that exist within the policies.

Upcoming blogs in this series will explore how COLI has been used in the past and its present-day applications. Stay tuned!