Blog: COLI 301 - Informally Funding an EDCP

Earlier in this series, we identified several unique characteristics of individually owned life insurance policies and Corporate Owned Life Insurance (COLI) policies, and how life insurance can offer protection for policy owners while also serving as a tax-advantaged investment opportunity. We also discussed how COLI can be used as a funding mechanism by corporations for executive benefits plans, such as: Executive Deferred Compensation Plans (EDCP), Supplemental Executive Retirement Plans (SERP) and Split Dollar Life Insurance plans. COLI 301 will explore the steps organizations take to acquire COLI and implement it into their businesses to informally fund an EDCP.

COLI 301 is the third installment of our COLI 101 series designed to demystify corporate owned life insurance (COLI). This series aims to define what COLI is, who buys COLI, common reasons why COLI policies are purchased and more.

As discussed in COLI 101 and COLI 201, life insurance policies are purchased by persons or entities who will become the policy owners and are not necessarily the insured individual. But before an interested party can purchase a life insurance policy, they must contact a licensed life insurance agent or broker to facilitate the transaction. For the purposes of this blog, we will review considerations a business undergoes when implementing a COLI financed EDCP.

Finding the Right Agent
Life insurance agents are licensed professionals who are authorized to sell life insurance in a particular state by that state’s insurance commission; depending on the type of insurance an agent sells, the agent may also need to have a securities license. Finding a life insurance agent can be done by a simple web search but finding the right agent to meet specific needs isn’t always easy. For instance, many life insurance companies have in-house life insurance agents who are full-time salespeople paid to sell a particular company’s proprietary life insurance products. These individuals may be very well qualified, but in many cases, their primary goal is to sell off-the-shelf insurance, which may include commonly added riders, to individual clients who are seeking protection for their families.

However, when a corporation is interested in implementing a COLI financed executive benefit plan, the corporation will need the assistance of a sophisticated agent with expertise in corporate finance and the associated legal and tax implications of the COLI to help them find the right product and properly install the EDCP. A broad expertise in finance, taxation and law is required because, to operate in an efficient manner, the COLI must be installed and maintained in a manner that is tailored to accommodate the corporation’s income statement, balance sheet and cash flow requirements.

Picking the Right Product
An agent who specializes in COLI is the best suited professional to help a corporation find the right insurance product because they understand what the client needs and what products are available on the market to help the client achieve their goal. When a corporate client and an agent engage in discussions about a COLI financed EDCP, they likely discuss how they can acquire one of two types of products:

1. a registered variable universal life insurance product, or
2. a private placement variable universal life insurance product.

Registered variable universal life policies are securities registered with the U.S. Securities Exchange Commission (SEC) pursuant to the Securities Exchange Act of 1933, whereas private placement policies are exempt from registration because they are only available to certain types of purchasers. Registered products are described in (and sold through) a Prospectus while private placement products use an Offering Memorandum. Both registered and private placement policies enjoy favorable tax treatment, which includes: tax-deferred accumulation of cash value, no current tax on transfers from one fund to another, tax-free withdrawals up to cost basis, tax-deferred loans against cash value above basis, and all deferred taxes completely eliminated if the policy is held to maturity, resulting in tax-free death benefits paid to the beneficiary.

Common Considerations
COLI products are offered by several prominent insurance companies, and insurers that offer COLI products may have both registered and private placement products. Registered variable universal life insurance products can efficiently finance non-qualified executive benefit plans but may be more limited in the investment options they offer and may have a higher cost structure when compared to private placement policies. There are certain economies of scale that apply to larger purchases of COLI, with lower relative premium-based and asset-based charges. Additionally, larger, more sophisticated corporate purchases may qualify for a private placement COLI product, giving the owner access to select from a much larger, more diverse lineup of underlying investment portfolios. Private placement COLI policies are only available to qualified purchasers because they contain unregistered investment options, including actively managed accounts, hedge funds and alternative assets. Note: access to private placement COLI policies is generally limited to sophisticated investors or those who are more capable of sustaining an investment loss.

Investment Options
The investment options offered within a COLI policy can be an important factor for corporations because they determine how the corporation can allocate the cash value it accumulates in the policies. With regard to an EDCP, a corporation may want to offer the EDCP as an excess retirement plan for high-earning employees who want to defer compensation in excess of IRS limits. Therefore, the company would be interested in finding a COLI policy that offers investment options with similar characteristics as the options that are available in the company’s 401(k) plan. While the funds may not be exactly the same as what is available in the 401(k) plan, a COLI financed plan can offer funds with similar underlying investments and expense ratios.

Institutional Pricing
Regardless of product type, registered or private placement, COLI policies are often issued at rates different from those someone might encounter for individual conventional life insurance. Due to economies of scale and other factors, COLI policies typically have lower expenses than their retail counterparts for a few reasons:

• COLI policy purchases are typically larger than retail life insurance purchases. Because the purchases are larger, insurers accommodate lower profit margins for COLI policies than they might for retail life insurance policies. In addition, COLI policies placed on a large number of employees (roughly ten or more) are typically offered via Guaranteed Issue (GI) underwriting. GI policies do not require a medical exam and include fewer questions about medical history in the application.
• COLI policies have a lower rate of policy lapse than retail insurance policies. This is because many companies that purchase COLI are doing so as part of a long-term initiative to secure their business and offer a benefit that is offered in perpetuity, such as an EDCP.
• There can be lower mortality charges associated with COLI policies. Mortality charges, also known as a cost of insurance charge, are fees imposed on a policyholder by the insurer designed to compensate the insurer for assuming the risk that the insured individual may die in any given year. Since the COLI policies usually are written on “white-collar” senior executives who are actively at work when the policies are issued, the mortality charge is typically lower than in a comparable retail policy because the risk of death in any given year is typically lower than in the general population.

Important note: insurance policies can be classified as modified endowment contracts (MEC) by the Internal Revenue Service (IRS) if they exceed certain limits that measure the relationship between the investment component and the life insurance component of the policy. Among the criteria the IRS uses to determine whether a life insurance policy is an MEC is if the premiums paid into the policy during the first seven years exceed the so-called “seven-pay premium,” which is defined as the amount of premiums needed, under normal assumptions, to fully pay up the policy through life expectancy in only seven years. Once a policy is designated as a MEC, it loses some of the aforementioned favorable tax treatment afforded to life insurance policies – specifically regarding access to the cash value through tax-free policy withdrawals or loans. If access to cash value is not important to the policyowner, MECs can be the most efficient type of insurance since the amount of death benefit for which the policyowner must pay a premium is minimized relative to the policy’s cash value component.

Completing the Purchase
As discussed in COLI 201, corporations cannot purchase a life insurance policy on their key executives until they receive authorization or “consent” from said individuals to acquire the policy. Therefore, corporations along with their plan providers must perform an analysis of the potential size of their EDCP to determine how many insurance policies they will need to informally fund the EDCP. Importantly, not all participants in an EDCP need to be insured persons under the corporation’s COLI policies, unless the EDCP also includes a life insurance benefit. That is because the COLI policies and their cash values are assets of the corporation that is sponsoring the EDCP. The individual insured executives generally have no rights or claims against the COLI policies.

Stay tuned for the fourth and final installment of our COLI 101 blog series, which will address accounting considerations for corporate policy owners and administration of COLI policies.