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Home > Library > Stable Times > Volume 3, Issue 2  The quarterly publication of the Stable Value Investment Association Second Quarter 1999 • Volume 3 Issue 2 Stable Value COLI/BOLI ProductsBy Jon Fraade, AIG Financial Products For many years, banks and corporations have purchased life insurance in order to provide the funding needed to meet the non-tax qualified benefit programs that they provide to their employees. Generally speaking, this insurance is referred to as Corporate-Owned Life Insurance (COLI) AND Bank-Owned Life Insurance (BOLI). In recent years, a new product has been developed by a number of the leading BOLI providers - a stable value BOLI policy. The purpose of this article is to provide the reader with the general rationale for the use of a COLI/BOLI policy, followed by a description of the new stable value policy. Most corporations provide a variety of employee benefit programs, only a limited number of which are "qualified" by the Internal Revenue Service. The best -known qualified benefit is a company's pension plan, which allows for the tax-free investment of trust assets that are for the benefit of the employees. Some of the more common non-qualified benefits are retiree medical benefits, supplemental retirement benefits for higher paid employees, and pre-retirement survivor benefit plans. In these cases, the investment income that is generated on money that is set aside to fund these benefits is generally taxable and the cost of these benefits can only be deducted when they are actually paid to employees. As a result, there are two significant incremental costs to the corporation related to a non-qualified plan; first, that investment income is taxed and second, that the income is taxed on a current basis with any offsetting deduction related to the benefit often not allowed for may years. In light of the unattractive tax attributes related to non-qualified benefit programs, many corporations use COLI (or BOLI in the case of banks) as an investment product that helps them to meet their future liabilities. With a COLI policy, the corporation purchases life insurance on its employees. A corporation may purchase life insurance on its employees if insurable interest exists at the time of the purchase; ongoing insurable interest is not required. For insurable interest to exist at the time of purchase, the benefits purchased must be reasonable in relation to the liabilities related to the benefits for the employees and, in some states, consent to purchase life insurance must be obtained from the insured employees. As part of this policy, the corporation makes one or more premium payments (deposits can range from $1 million to $100 million or more) to the insurance policy. As a result, the policy has both a cash value (initial deposit, plus or minus investment performance, less insurance charges) and death benefit value. Because the deposit is within an insurance policy, it grows on a tax-deferred basis until such time that the insured withdraws money from the policy. In addition, death benefits are paid on a tax-free basis. Therefore, the investment has the potential to appreciate on an effectively tax-free basis, provided that the owner is willing to defer a withdrawal under the policy and to wait for the death of the insured. The tax deferred (and potentially tax-free) appreciation of this investment significantly offsets the upfront costs of a COLI policy - most of which relate to various state and federal surcharges. Given that it may be a long time until the employees covered by the policy die, it is possible to "borrow" against the policy in order to obtain interim liquidity, which reduces the future tax deferred growth in the investment balance but, at the same time preserves the owner's potential for tax-free appreciation. Why Stable Value? The development of the stable value BOLI market mirrors, in part, the development of the synthetic GIC market. First of all, the premium payments into these policies are significant in size and are, by their nature, long-term. In order to get the maximum benefit, it is not unusual for the holding period to be 20-40 years long, or even indefinitely. Because these programs represent a small portion of a corporation's capital but produce an excellent return over the long-term, corporate financial officers view these programs as indefinite investments without the need for short-term liquidity. Initially, banks used insurance products backed by the insurance company's General Account, which by its nature provides a stable return. This stable return is especially important for banks, as the mark-to-market on a BOLI policy flows through a bank's income statement. Given the leveraged nature of a bank, wide swings in the value of a BOLI policy, and the resulting impact on both capital and net income are generally unacceptable. At the same time that banks demanded a stable value product, they also expressed a view that has become very common in the qualified stable value market: the desire for increased asset diversification and for the potentially higher returns that arise from the use of active bond management. The result of these demands has been the development of a variable BOLI product where underlying assets are held in a separate account of the insurance company but the mark-to-market volatility is dampened through the use of a stable value wrapper. The stable value wrapper provides for accrual of the portfolio value and a crediting rate, which is based on the current market yield and the amortization of investment gains or losses over a predetermined period. The stable value BOLI product is usually one of several investment options that may be offered in a variable BOLI policy. Accounting Issues While similar in some respects to a synthetic GIC, the accounting treatment for a stable value BOLI product relies primarily on Financial Accounting Standards Board Technical Bulletin 85-4, Accounting for Purchases of Life Insurance. AICPA Statement of Position 94-4, does not apply because it is limited to stable value investments that are owned by defined contribution and health and welfare plans. FAS 85-4 states that the investment should be valued as "the amount that could be realized under the insurance contract as of the date of the statement of financial position." Therefore, as of each reporting date, the owner needs to have full access, at "book" value, to the assets in the policy. This is fundamentally different than a stable value investment in a qualified plan because access is held centrally, usually by the insured's Treasurer, an individual who is assumed to be financially astute. From a provider's perspective, the risk related to accessing the underlying portfolio at par, is considerable. The primary basis upon which a provider can get comfortable providing this put is a view that the liquidation of the policy will give rise to a tax liability that the owner might not have alternatively incurred. In addition, the provider may add a number of other provisions to the policy to reduce the risk of this put. Since BOLI needs to be structured as an insurance product in order to obtain the preferential tax treatment, most of the stable value wrap providers have been affiliated with the insurance company that is providing the policy. Finally, because of the nuances of this developing product, the initial cost of making the investment, and the long-term nature of this investment, it is very important to make sure that the accounting for this product be fully vetted by the owner and its auditors.
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