By Josh Gottlieb
A history of COLI
Past blogs have shared a bit about Corporate-Owned Life Insurance (COLI) and some of the amazing things we’ve accomplished in the past 40 years. Let’s walk through our perspective on these historically promising plans that are now failing clients and learn why that is happening and how we can help. Corporate-Owned Life Insurance is a multibillion-dollar industry, and, in today’s climate, these dollars left sitting on corporate America’s books carry a negative perception given the standard options for policy owners.
In the ‘80s, ‘90s and early ‘00s, firms established spectacular life insurance programs for their clients. Today, these are not faring well and are not as effective as promised. We’ve invested an incredible amount of time and resources in the last five years looking at how we can provide an exit strategy for companies that have billions and billions of dollars of COLI sitting on their books.
In 1986, some rules changed when we were selling COLI in its first generation.
Before this, companies utilized tax arbitrage because, back then, corporate America was paying 50 percent or higher on income tax. They chose to divert assets to tax-free insurance platforms that accumulated at six or seven percent (which had a pre-tax value of 12 to 14 percent) to work around these steep taxation policies. Businesses used these programs to supplement the standard, limited corporate benefits plans for their highly-compensated senior executives. These programs, known as non-qualified deferred compensation and Supplemental Executive Retirement Plans, had support using life insurance. Until June 1986, companies could borrow against those policies and deduct the loan interest.
Then in 1986, tax law changes impacted the deductibility of interest on a policy loan, which affected all new policies going forward. Corporations could no longer leverage insurance; that is, unless there was a limit of $50,000 of loans per life, on which you could deduct the loan interest. The old 1986 COLI plans are still around, and while many of those insured have died, a lot of that pre-1986 business is still sitting somewhere in corporate America.
Firms activated post-1986 programs that didn’t use the unlimited loan interest deduction but worked with the $50,000 loan limit. This worked well from ‘86 to ‘96, and our industry was excited about insuring 10,000 employees instead of 50 executives. In this hypothetical, we had $500 million of loans and could create interest. We found ways to make the interest even higher: create a tax deduction and provide an offsetting credit that would accumulate tax-free inside the policies. We were at a point where some programs had a 16 percent interest rate and eight percent deductible cost. The carriers credited two percent below the 16 percent, or 14 percent, which grew tax-free in the policy. They were making money on the two percent spread or the 75-basis-points spread. Because the client was achieving 14 percent tax-free growth against eight percent after-tax cost, there was a six percent positive spread guaranteed supported by the Federal Government — this was a great deal.
Adjusting to industry changes
In September of 1996, Congress indicated we could no longer do this. Because of that decision, I created a consulting business to figure out how to fix the issues these new laws created. Within our suite of companies, I developed the COLI Plan Revision — CPR for short. This was my (lighthearted) way of breathing life into these programs. I spent time with some incredibly bright, notable experts including individuals who had sold plans as well as company advisors. Some of the clients acted on these programs — which we still operate today — as a way to de-lever and get out of their previous plans.
Today, 24 years later, corporate income tax rates are at 21 percent. Human resources departments at large public companies manage many modern COLI plans because the finance and treasury sectors see little upside in them. The leverage that made sense at 50 percent makes a lot less sense at 21 percent plus the state tax rate. Thus, the economics are not as attractive as they once were. Some companies have COLI assets that might be $50 million dollars of cash value to upwards of $1 billion. The companies we work with only see these assets grow at a rate of two, two and a half, or one and a half percent — nothing particularly worthwhile.
Often, these companies must feed millions of dollars a year in premiums to support these programs from lapsing.
One significant problem is that companies pulled out money from the plans during life and with leverage, and now they have a negative-basis. Even so — further complicating the issue — these COLI plans still have cash value. One of our clients, a Fortune 100 company, has $300 million of cash surrender value in its policies. They feed around eight million dollars per year to add to that sum. Those insured are now all in retirement and received their benefits. If the company terminates the policies, they would pay nearly $200 million in taxes. As a result, quitting would cause a $300 million asset to drop to $100 or $130 million. If they stay the course though, they’d have a drag on earnings because, rather than having the $300 million in-hand, their earnings would be about 10 percent less than their return on capital invested. When properly freed from their COLI plan, they’d make $30 million more each year. If applied to the multiple their stock is trading at, $30 million of earnings might generate another half a billion or billion dollars of value. This is what company stockholders want and also the ideal scenario for executives working to build company value and secure substantial bonuses and stock options for themselves.
A new way forward
Overall, corporate-owned life insurance is a lousy investment relative to the alternatives. Or worse, companies quit and take an enormous tax hit with nothing to show for it. And with today’s returns, it might take the company four to eight years to financially recover from this.
In response to this crisis, we developed a structured strategy called CPR2℠. This time, rather than a COLI Plan Revision, we provide a total COLI Plan Rescue for clients who want out but don’t know how to get there. No other firms offer this kind of service. Instead, they offer replacement programs, typically with a different kind of product with more attractive returns. But no one else advises clients on how to fix old programs.
Our focus is pretty simple. We begin with a study to decide how we’ll work with you. Then, you engage us to determine:
What happens if you keep your COLI plan.
What happens if you quit.
What happens if you enter into our Policy Transfer Plan (PTP).
The Policy Transfer Plan includes proprietary investment technology and strategies. We discuss these with clients under a mutual confidentiality agreement and then design the right alternative solution for you.
The benefit to the policy owner is that our strategy puts all your net equity, everything on your balance sheet, back in your pocket immediately with no income taxation. In the case of our client with $300 million, they wouldn’t pay $174 million in associated taxes — $300 million would end up in the company’s treasury. That’s a good deal if we can do what we say — and we can. If you have two million dollars of net equity, but a huge phantom income problem upon quitting, we can help you find relief. The same goes for companies with two billion dollars of cash value that are looking to free up the cash and avoid phantom income.
One challenge advisors and clients have with corporate-owned life insurance programs is figuring out how to deal with options they received from acquired companies. Upon acquisition, COLI plans purchased years ago now become your company’s headache.
The people involved with these COLI programs are gone and there’s no one to consult with on next steps.
This is where we step in. Our business has focused on COLI issues for over a half-century — we’re early innovators in that department. We know how to deal with risk management issues that arise. We know how to help our clients adapt to changes in tax law, tax rates, product, and in the broader economy. That’s what we do — all day every day — for our clients, and they are incredibly receptive to our solutions. If you have COLI programs or are working with clients with these programs, and you’re unhappy, call us. Let’s find a solution that works for you.
Joshua A. Gottlieb is the Chairman and Chief Executive Officer of The Gottlieb Organization.