Overview

Corporate owned life insurance assets (COLI) and Bank owned life insurance (BOLI) assets may account for close to $1 trillion or more of life insurance company assets. Virtually every major public corporation uses COLI. Why?

The business and rationale is really pretty straight-forward. A corporation (usually a regular corporation) purchases life insurance to finance and fund for multiple objectives – (1) Non-qualified deferred compensation plans (2) Executive benefit programs and (3) Post-retirement benefit programs such as the cost of post-retiree health insurance.

The corporation is the applicant, owner and beneficiary of permanent life insurance – whole life, universal life or variable universal life- insuring the lives of corporate employees covered under the program. In many cases, the life insurance is designed for cost recovery to the corporation for the cost of these programs. More recently, COLI has emerged as an investment vehicle for large corporations who insure large numbers of employees.

Bank owned life insurance may trace itself beginnings to the independent brokerage firm Harris Crouch Long, Scott and Miller in the mid-1990’s. The technique allows a bank to invest Tier 1 capital into bank owned life insurance policies insuring the life of bank employees. The tax advantages of life insurance support an after-tax rate of return within the BOLI program which is significantly greater than the after-tax rate of return on Tier 1 capital. The business purposes supporting the investment typically revolve around the bank’s need to finance the bank’s employee benefit costs. Having said that, BOLI is primarily an investment for the bank.

These programs have steadily evolved from general account whole life and universal life insurance policies to private placement life insurance contracts with traditional and alternative money management to support the tax-advantaged investment return with the contracts.

This article looks at private placement variable immediate annuities as an alternative funding vehicle to both COLI and BOLI. Not that there is anything wrong with COLI and BOLI, but the current regulatory and tax  environment have the federal government laying mines in the path of clients and life insurance companies.

The broad-based COLI programs that insure virtually all of the company’s employees are unpopular with lawmakers and regulators because rank and file employees  have received little or no benefit. As a result, tax rules for COLI continue to become more stringent as well as “Consent to be insured” requirements for the insurance company employees. As it turns out, private placement immediate annuities may be capable of delivering similar investment results to companies over the long-term.

B. Current Practice in the COLI and BOLI Market

COLI has been a preferred funding vehicle for the Fortune 1000 for funding the corporations’ non-qualified deferred compensation arrangements. The tax advantages of life insurance are very appealing in this regard – (1) Tax-free inside buildup of the cash value (2) Tax-free loans and withdrawals (3) Tax-free death benefits. The typical COLI program has the corporation as the applicant, owner and beneficiary of the policy. Many of these programs are underwritten without medical underwriting – guaranteed issue or simplified issue.

The program is frequently funded on a single premium basis. In most cases, the policy is a modified endowment contract under IRC Sec 7702A.  The asset based and insurance costs (Mortality and Expense charge and cost of insurance) along with sales loads easily exceed 1 percent per year.  However, the costs are far less than the cost of current taxation at the corporate level on investment income.

State insurance departments have adopted more stringent Consent to be Insured regulations making it more difficult to insure rank and file employees. These changes were triggered by the proliferation of large scale use of COLI by large corporations as a corporate investment vehicle. The size of the investment was only possible as a result of insuring all of the corporation’s employees in what became known as “janitor insurance” because all of the employees were insured under these programs including the company janitor. In many cases, the employees received no benefit from the program. Congress cried “foul”!

Congress also jumped into the act by adopting IRC Sec 101(j) which was adopted in August 2006. The provision potentially changes the taxation of the COLI and BOLI death benefit from tax-free to taxable unless certain notice and consent rules are met before the policies are issued. The corporation has record keeping requirements. The policy death benefit is taxable for the amount of death benefit in excess of cumulative premiums if the requirements are not met.

An employee must provide consent to be insured after employment is terminated. Exceptions to the adverse tax treatment exist for meeting the notice and consent requirements who are employed within a twelve month period at the time of death or were highly compensated employees as defined under the pension rules (IRC Sec 414(q) and IRC Sec 105(j).

The regulatory and tax trends for COLI and BOLI tend to be negative. Many regulators at the state and federal level unfairly see COLI and BOLI as a corporate tax shelter. With the national deficit being what it is, it may not be the worst thing to consider other alternatives. It could very well turn out that the alternative is as good or better as the original solution.

C.  Private Placement Variable Immediate Annuities (PPVIA)

A private placement  variable immediate  annuity (PPVIA) contract issued by a U.S. life insurance company or an offshore life insurer that has made an IRC Sec 953(d) election to be treated as a U.S. taxpayer. The PPVIA contract is institutionally priced and transparent allowing for complete customization of the investment menu to include multiple real estate investments.

The policy may be issued on either a group or individual policy form. The fact of the matter is that very few PPVIAs exist in the marketplace. Variable immediate annuities are not even well known in the retail immediate annuity marketplace.

Unlike a deferred annuity, a PPVIA provides for annuity payments within the first policy year. Annuity payments may be calculated on a fixed basis or a variable basis. The variable basis assumes initial payments based upon annuity mortality factors as well as an assumed interest rate (AIR). If the annuity’s actual investment performance exceeds the AIR, payments increase. The annuity provides for payments based upon a term of years or a life contingency basis.

Under state insurance law, separate account investments are expressly authorized on a non-guaranteed or variable basis. The separate account assets belong to and are titled in the name of the insurance company.

Separate account contract holders have no right to receive in kind distributions, or direct the purchase or sale of separate account assets. Ownership and control of separate account assets legally and contractually rest with the insurer.  PPVIA contracts are taxed as a variable annuity under the appropriate provisions of the Internal Revenue Code (IRC Sec 72).

E. U.S. Tax Qualification for PPVIAs

IRC Sec 72 governs the taxation of annuities for federal tax purposes. Professionals familiar with annuity taxation assume that annuity contracts owned by a non-natural person such as a corporation do not enjoy the benefit of tax deferral under IRC Sec 72(u)/. This is largely true.

IRC Sec 72(u)(3)(E) and IRC Sec 72(u)(4) provide an exception for immediate annuities. The Code defines an immediate annuity as an annuity that  that provides for its first annuity payment as being no later than one year from the policy issue date. The annuity must provide for an annuity payment that meets the substantially equal periodic payment requirements of IRC Sec 72(t).

IRC Sec 72(t) is the set of tax rules that provide for pension or IRA distributions before age 59 ½. The tax provision provides for a ten percent early withdrawal penalty in addition to regular taxation unless it meets certain exceptions found in IRC Sec 72(t). The applicable exception for our discussion is the exception for substantially equal periodic payments. If a distribution meets the exception requirements, the ten percent penalty does not apply.

The rules for substantially equal periodic payments allow for three different methods of calculation as outlined in Rev. Rul. 2002-62 – the required minimum distribution method, amortization method and annuitization method. The latter two methods use the IRC Sec 7520 rate (currently 1.06 percent) as part of the calculation.

The exclusion ratio for variable annuities determines the amount that may be “excluded” from taxation from each annuity payment. The exclusion ratio for a variable annuity is determined by dividing the expected benefits into the investment in the contract. Payments beyond the annuitant’s actuarial life expectancy are fully taxable to the policyholder.

The substantially equal periodic payment rules specify that the payment may not be changed before the later of five years of payments or the annuitant turning 59 ½,. The rules allow for determination of a payout using the life expectancy of an employee and a designated beneficiary.

Policies must satisfy the federal tax requirements for investment diversification and investor control.The separate account is not treated as a separate entity from the insurance company for tax purposes. Since the assets and liabilities of the separate account belong to the insurance company, any income, gains, or losses of the separate account belong to the insurance company. The insurance company is able to take a reserve deduction for its investment income in the separate account.

IRC Sec. 817(h) imposes investment diversification requirements for variable life insurance and annuity policies. IRC Sec. 817(h) stipulates that a single investment may not exceed more than 55% of the account value, two investments more than 70%, three investments more than 80%, and four investments more than 90%. Therefore, an investment account must hold at least five different investments.

The tax regulations, Reg. 1.817-5 specify that all of the interests in the same real property project represent a single issue for diversification purposes. The regulations allow a five-year initial period for real estate accounts in order to comply with the diversification requirements. The same regulations provide for a two-year plan of liquidation provision in which the fund may be non-conforming with the investment diversification requirements.

The other significant component for U.S. tax qualification is the Investor Control Doctrine. The Investor Control Doctrine has been developed as a series of rulings and court cases.  Under the traditional variable annuity or life contract, the insurer and not the policyholder is considered the owner of the underlying separate account assets.

The policyholder is not taxed on the increase in the contract’s account value. However, if the insurer gives the policyholder a degree of control over investments underlying the contract that is inconsistent with treatment of the insurer’s status as owner of the assets, the tax benefits of the policy will be forfeited. Investor control is determined based upon the facts of a specific situation.

D. Strategy Example

Facts

Acme Inc. (long live the Roadrunner, a testimony to his persistence and customer loyalty to Acme), is a public corporation that maintains a non-qualified deferred compensation plan for its highly compensated executives. The plan has been informally funded using corporate owned life insurance. Due to inadequate investment performance, the program is underfunded. The company would like to allocate $100 million to provide for additional long-term funding for the program. The company is considering a corporate owned annuity which will be held within a Rabbi Trust.

Solution

The trustee of the Rabbi trust is the applicant, owner and beneficiary of a private placement immediate annuity. The measuring lives for the annuitant are the company’s youngest employee, a sixteen year old part-time employee and the designated beneficiary for joint life expectancy determination purposes, the new born baby of one of the company employees.

The initial investment into the PPVIA contract is $100 million. The investment performance assumption in all years is 8 percent. Based on the formulae for the calculation of the required payments under IRC Sec 72(t), an approximate calculation is as follows:

1. Required Minimum Distribution Method – $1.95 million in Yr. 1 (increases each year)
2. Amortization Method – $2.1 million in all years
3. Annuitization Method - $2.09 in all years

Note : The IRC Sec 7520 rate is 1.07 percent. The exclusion ratio is approximately 65 percent meaning that only 35 percent of each annuity payment will be subject to taxation. Based on the numbers above, $735,100 or less than one percent will be subject to current taxation at corporate rates. The tax rate at 35% is $257,350 which is a 25 basis point cost of the original investment amount of $100 million.

The insurance costs of a COLI and BOLI product exceed this amount by large measure.

The annuitants are strictly measuring lives for purposes of determining the substantially equal period payment requirements under IRC Sec 72(t). The policyholder, the corporation, retains all of the rights of ownership. The annuitants have no rights or benefits.

The policy will be issued by Royal Life. The policy is a private placement immediate annuity (PPVIA) than provides for fixed annuity payout. The PPVIA contract features several customized insurance dedicated funds.

As discussed above, less than one percent of each annuity payment is subject to current taxation. The actual tax cost on the annuity payment is a negligible amount of the initial investment, 25 basis points.  The balance of the investment income within the SPIA accumulates on a tax-deferred basis.

The PPVIA contract provides for partial and complete commutation of the annuity account balance. The corporation as the policyholder may exercise this option on a periodic basis to reach and distribute additional funds from within the PPVIA. The approximate frictional “drag” due to contract costs is approximately 15-20 basis points per year.

The projected account balance on the initial $100 million investment  based upon an 8 percent investment return can be seen below:

                        Year                          Projected PPVIA Account Balance

                        10                                                       $169.5 million

                        15                                                        $235.7 million

                        25                                                       $476 million                       

                        30                                                       $686.1 million

Summary

Who knows what the future holds regarding the taxation of COLI and BOLI? The Presidential election next week and the so-called “lame duck” Congress will be scrambling to find solutions to prevent the fiscal “free fall” off the cliff that has been predicted. Something has to give?

It is highly unlikely that the life insurance industry will volunteer to sacrifice but should it happen, a corporate owned annuity could be a nice replacement. In fact, it may be a fine alternative without any changes to the taxation of COLI and BOLI. This initial article was intended as a first impression for  a new idea.

I hope that you liked it!