Indexed universal life is now the preferred COLI product
The insurance industry is seeing a resurgence in the company-owned life insurance, or COLI, market. This revival is primarily driven by new growth in multiple, specialized industries such as medical, construction and technology.
With growth comes opportunity — including the opportunity to hire new employees. Companies today need a tool to help attract top talent and stand out from competitors.
At the same time, competitors have similar opportunities. So it’s important to also retain key employees who may be subject to poaching.
Part of retaining key employees includes helping senior executives fill the retirement gap created through Social Security and qualified plan limits, which may be too low to meet the long-term retirement needs of this group of employees.
These nonqualified benefit plans can be either unfunded or informally funded. If unfunded, the benefits will have to be paid out of future revenue, which creates uncertainty for the company and the executive.
Because of the available tax and cost recovery advantages, life insurance is a popular option for most large companies. Historically, companies have used variable universal life (VUL) as the funding mechanism. Recently, there has been a shift to indexed universal life (IUL) due to its:
Lack of direct downside market risk
Potentially lower internal costs
What is IUL?
IUL provides for upside potential based in part on the upward movement of a stock market index, subject to certain limitations, while offering protection against the impact of market downturns.
IUL has the potential for interest crediting up to the stated cap rate, which could range from 10-12 percent, depending on the crediting strategy selected. IUL products also include an interest rate “floor,” which is typically set at zero percent, protecting against loss.
If there’s a period in which the market index yields negative returns, the interest credited will never be lower than the floor, and there’s no recovery time within the IUL policy before positive crediting can resume. When the crediting period that follows a negative market index return ends, it resets index performance so any subsequent recovery in the index results in positive crediting. IUL products offer the right balance of flexibility, accumulation potential and protection to work well in the COLI market.
A tale of two COLIs
Consider Company X, which has a nonqualified plan that has been in place for 20 years. It has accumulated more than $40 million in cash value inside VUL policies to help fund a supplemental retirement plan. A few plan participants have retired, and many more are approaching retirement age.
The value within the policies plus future growth will be necessary to help fund the retirement benefit obligations.
If the market has a down year (e.g. negative 15 percent), the company loses a significant portion of the funds available to meet the cost of benefit obligations and must now either hope the market returns to previous or higher levels quickly or it must use company cash flow to cover the benefit expense.
The company could hedge against market risk by moving all or a portion of the cash value into a fixed account within the VUL policies, but then future growth would be at a much more limited level, potentially failing to keep pace with the benefit expense.
Bottom line: The company is left exposed to risks that arguably have a high probability of occurring.
A compelling solution is to exchange some of the VUL policies for IUL products that protect against the downside risk but still provide better upside growth potential than a fixed account. This plan creates better diversification and helps mitigate the potential risks.
n another example, Company Y created a nonqualified plan to provide retirement income for its senior partners but to date hasn’t established a funding strategy for the plan. Younger partners are concerned about the cash flow needed to buy out the senior partners at retirement and pay out their retirement income benefits. The company doesn’t want to subject its cash reserves to market risk so it hasn’t been willing to place any money into VUL, mutual funds or other equity investments.
When presented with the opportunity to place some of its cash reserves in IUL, the company accepted based on:
A guaranteed cash surrender value equal to at least the amount of premiums paid, which meant in the worst case scenario, the company could get all of its money back.
The potential to earn indexed interest credits up to a stated cap rate, in this case 12 percent, on its cash value based on S&P 500 Index growth, less dividends — without the risk of losing cash value due to a market decline.
The company elected to build in a dual cost recovery plan that:
Allowed it to pay current obligations out of company cash flow and then recover those costs from cash value in subsequent years.
Allowed it to recover from the tax-free death benefits the aggregate premium outlay with an inflation factor, as well as the cost of any survivor benefits promised under the plan.
Indexed universal life is becoming the COLI product of choice. It addresses the shifting economics and lower risk tolerance prevalent in businesses today. Businesses are looking for an easy-to-administer product that may provide a return of premium over time and offers an opportunity for cash value growth. Diminishing the impact of a market downturn is appealing for businesses and IUL typically has a lower cost structure than COLI plans funded with VUL products.