What Is Company-Owned Life Insurance (COLI) and How Does It Work?

Company-Owned Life Insurance (COLI) is a financial tool businesses use to insure the lives of key employees. It offers benefits such as funding executive compensation plans or protecting against financial loss from an employee’s unexpected death.

Understanding COLI’s complexities is essential for companies considering its use. The following sections explore regulatory requirements, policy types, and other key aspects of how COLI functions in corporate finance strategies.

Eligibility and Regulatory Requirements

Eligibility for COLI typically focuses on “key” employees, such as executives or individuals critical to a company’s success. This classification influences underwriting, policy terms, and premiums.

Regulatory oversight is governed by the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC). ERISA ensures policies align with the company’s and stakeholders’ interests, while the IRC outlines tax-related provisions. For example, under IRC Section 101(j), death benefits are tax-exempt only if the insured was an employee within 12 months before death or if the proceeds fund employee benefits.

State regulations add another layer of complexity. Some states require employee consent for COLI policies and mandate disclosure of policy details. Noncompliance with these requirements can result in penalties or policy invalidation, making adherence essential.

Policy Types

Understanding COLI policy types is critical for aligning insurance strategies with corporate goals. The main types are Term, Whole Life, and Universal Life, each with distinct features.

Term

Term life insurance provides coverage for a specific period, typically 1 to 30 years. It’s a cost-effective choice for companies seeking temporary protection against the loss of key employees. Premiums are lower than permanent insurance options but do not accumulate cash value. From an accounting perspective, term premiums are expensed as incurred, aligning with Generally Accepted Accounting Principles (GAAP).

Whole Life

Whole life insurance offers permanent coverage with a cash value component that grows over time, providing both a death benefit and a financial asset. The cash value is recorded as an asset on the balance sheet, while premiums are expensed. Companies often use whole life policies for long-term financial planning, including funding executive compensation plans, due to their stability and dual benefits.

Universal Life

Universal life insurance provides flexibility, allowing adjustments to premiums and death benefits as financial needs evolve. It also includes a cash value component, which grows based on insurer-determined interest rates. The cash value is recorded as an asset, similar to whole life policies. This flexibility benefits companies with fluctuating cash flows or evolving needs, but careful monitoring is required to manage policy costs and performance effectively.

Premium Funding Approaches

The method of funding premiums significantly impacts a company’s financial strategy. Common approaches include direct payment, financing through debt, or leveraging the cash value of existing policies.

Direct payment from cash reserves is straightforward and simplifies accounting but requires careful cash flow management to maintain liquidity. Financing premiums with debt can preserve cash for other investments but introduces interest expenses and requires consideration of debt capacity.

Using the cash value of existing COLI policies as a funding source is another option. Borrowing against this value minimizes reliance on external financing but reduces the policy’s death benefit and may trigger tax consequences if loans are unpaid.

Tax Implications

COLI’s tax treatment offers potential benefits when managed correctly. Death benefits can be excluded from taxable income under IRC Section 101(j) if specific conditions are met, such as obtaining employee consent and ensuring the insured qualifies within designated categories.

While premium payments are generally not tax-deductible, the cash value of COLI policies grows tax-deferred, enhancing financial planning opportunities. However, accessing these funds through withdrawals or loans may trigger tax events, requiring careful oversight.

Accounting Methods

Accounting for COLI requires adherence to GAAP standards to ensure accurate financial reporting. For policies with cash value, the cash surrender value is recorded as an asset, representing the amount receivable if the policy is terminated. Increases in cash value are recognized as income but remain untaxed until accessed. Loans against the policy are recorded as liabilities, with interest expenses accounted for separately.

For term policies, premiums are expensed as incurred, offering a simpler accounting approach. Companies must disclose details about their COLI policies in financial statements, including coverage amounts and associated liabilities, to maintain transparency and compliance.

Claim Handling Procedures

Handling COLI claims requires timely notification to the insurer upon the insured employee’s death, along with the submission of required documentation, such as a death certificate. Delays can complicate the process and impact payout timelines.

Insurers review claims to ensure compliance with policy terms and legal requirements, including verifying eligibility under IRC Section 101(j) for tax-exempt treatment. Companies should be prepared to provide additional information if necessary, particularly for policies with complex features.

Death benefits, often tax-exempt, must be accounted for in financial statements under GAAP. If proceeds are used for specific purposes, such as funding employee benefits, additional disclosures may be required to ensure transparency. Proper claim handling safeguards the financial benefits of COLI and reinforces ethical and compliant practices.