COLI Primer

A Primer on Corporate-Owned Life
Insurance (COLI) Including Rabbi

Trust-Owned Life Insurance
2008
Aon Consulting, Inc.
Executive Benefits
3565 Piedmont Road NE
Building One, Suite 600
Atlanta, Georgia 30305
1.404.264.3141

A Primer on Corporate-Owned Life Insurance (COLI) Including Rabbi Trust-Owned Life Insurance Page 2

Table of Contents
Introduction ....................................................................................................................................................... 3
COLI Basics ....................................................................................................................................................... 4
Why Purchase COLI?...................................................................................................................................... 4
Cost of COLI.................................................................................................................................................... 5
Liquidity........................................................................................................................................................... 5
Accounting....................................................................................................................................................... 6
COLI Administration ......................................................................................................................................... 7
Issuing Contracts............................................................................................................................................. 7
COLI Receipts ................................................................................................................................................. 8
COLI Structure and Design .............................................................................................................................. 9
Pricing Components........................................................................................................................................ 9
Experience Rating (Mortality Retention)........................................................................................................ 12
Policy Structure............................................................................................................................................. 14
Investments ................................................................................................................................................... 15
Other Potential Costs and Risks ................................................................................................................... 15
Miscellaneous COLI Issues............................................................................................................................ 17
Aon Consultings Role.................................................................................................................................... 18
Sample Report Abbreviations........................................................................................................................ 19


Introduction
This report is intended to give the reader a basic understanding of what COLI is, what it is used for, why it is
used, and how it works. For purposes of this report, COLI refers primarily to private placement variable
universal life (PPVUL) insurance contracts used to fund benefits. As its name implies, COLI is owned by the
corporation, not by the employee. COLI is purchased on the lives of executives, typically executives who are
eligible for plan benefits.
When a rabbi trust owns COLI, many people refer to the arrangement as Trust-Owned Life Insurance (TOLI).
However, TOLI is more commonly used as an acronym for insurance owned inside a VEBA trust. Insurance
owned inside a rabbi trust is quite different from insurance owned inside a VEBA trust. VEBA TOLI is a FAS
106 plan asset and receives different accounting treatment than rabbi TOLI does. For purposes of this primer,
rabbi TOLI is referred to as COLI, and it is treated like COLI for tax, accounting, and ERISA purposes.
Information in this report is provided in a question-and-answer format, based upon frequently-asked questions
from our COLI clients. The primer also provides an-item-by item explanation of a typical COLI annual report,
enabling the reader to understand the relevance and impact of the various credits, loads, fees, and other
expenses that are associated with COLI.


COLI Basics
Why Purchase COLI?
Q1.1 Why do some corporations buy COLI?
A1.1 Corporations often choose to finance benefit obligations. However, net annual earnings on
investments are subject to income tax at the maximum federal corporate rate of 35%, in addition to
any state taxation. Because life insurance cash value grows on a tax-deferred basis, and death
benefits are generally received tax-free, the use of COLI allows a corporation to generally avoid
income taxes on investment income. While there are frictional insurance costs associated with
COLI, typically amounting to 50 to 100 basis points or less over the life of a funding program, the
after-tax rate of return of COLI should exceed the after-tax return on a portfolio of taxable investments
with comparable pre-tax returns.
Q1.2 Why would a corporation not buy COLI?
A1.2. Some companies choose not to finance post-retirement benefits at all. They operate on a pay-as-
you-go basis and generally feel that the opportunity cost of funding exceeds the advantage of tax-
preferred build-up in COLI. Some companies that do finance benefit obligations choose not to fund
with COLI, despite its tax advantages. Common reasons that companies choose not to fund with
COLI include the perceived complexity of life insurance, the timing mismatch between benefit
payments and death benefit proceeds, liquidity concerns, potential tax cost on surrender, and a
general aversion to life insurance for the benefit of the company when there is no direct benefit to
the insured.
Q1.3 How does COLI differ from other life insurance products?
A1.3 Similar to other investment-oriented life insurance products such as bank-owned life insurance (BOLI)
and VEBA TOLI, COLI is institutionally-priced life insurance with minimal up-front loads, high early
cash value, and minimized insurance costs. Like many large BOLI and TOLI arrangements, large
case COLI is primarily purchased as a private placement variable universal life (PPVUL) contract.

Variable life insurance must either be sold as a registered security or through a private placement.
Private placement contracts differ from registered contracts in that many product features and pricing
are negotiated between the buyer and the insurance carrier selling the product. Often, discrimination
concerns prevent carriers from negotiating and applying special pricing to registered products. This
concern is a key reason for using PPVUL.

Mortality and expense (M&E) charges

Investment management fees (IMF)

Sales loads

Costs of insurance charges (COI)

Fund managers

Premium tax and Deferred Acquisition Cost (DAC) tax treatment

Experience-Rating Provisions


Cost of COLI
Q1.4 What are the frictional costs involved with COLI?
A1.4 Frictional costs are the costs charged by the insurance company in exchange for providing the
insurance contracts. Generally these costs can be divided into three categories: direct costs,
financing costs, and capital costs.

Direct Costs
Direct costs are costs incurred by the carrier and passed on to the product in some form. Such
costs include: premium tax, DAC tax, commissions and other sales loads, IMF, reinsurance
premiums, and death claims. When these costs are charged against the premium or cash value,
they represents direct frictional costs. When the direct charge is not immediate, the ultimate
charge will include a financing element, as described below.

Financing Costs
Financing costs are costs associated with the amortization of any direct cost that is typically
charged in the first year. For example, if the carrier incurs a 2% premium tax and does not deduct
2% from the premium immediately, then the carrier is financing the direct frictional cost of that
premium tax. The carrier must ultimately recover that 2% cost over time plus an interest cost to
compensate for not charging the 2% in year one. Since 100% of the premium is at work and
invested in the contract, and since the insurance company has paid out 2% to the state in
premium tax, the carrier is in effect loaning money to the policy owner and therefore will collect
interest on that loan.

Capital Costs
Capital costs are costs associated with the risk capital that the carrier must set aside to support
this business. For example, if the carrier takes in a $1,000,000 net deposit, it generally must set
up a reserve of $1,000,000 to support the contract. In addition, the carrier must dedicate about
$60,000 of its own capital and surplus to support the contract. This capital and surplus must be
invested conservatively to meet state regulatory requirements. For example, a carrier may earn
6% on these conservative investments but have an 11% earnings target for all the business that it
writes. In order to meet its earnings targets, the additional 5% must come from the COLI contract,
and therefore represents another frictional cost.
Additional detail about frictional costs can be found in Section Three.
Liquidity
Q1.5 How can COLI provide the liquidity needed to meet benefit cash flow requirements?
A1.5 Like all permanent life insurance, COLI offers three primary ways for policies to generate cash.
Death benefits are the most efficient way to receive cash, and they are generally tax free. Cash can
also be removed from the COLI via withdrawals and loans.
Q1.6 How are COLI withdrawals and loan proceeds taxed?
A1.6 Tax-free withdrawals and loans can be taken from COLI policies if some very important conditions are
met. First, the policy from which the withdrawal or loan is taken must not be considered a modified
endowment contract (MEC). (A detailed discussion of the definition of and implications of modified
endowment contracts can be found in the policy structure section of this report.)

Presuming that the contract is not a MEC, withdrawals can be taken up to the policy basis, and are
generally tax-free. Beyond that, policy loans can be taken tax-free. Loan interest is charged, and may


either be paid in cash or added to the loan balance. However, loan interest incurred on policies
issued after J une 1986 is not considered a deductible expense. Typically, loans are not repaid until
the death of the insured, at which time they are deducted from the policy death proceeds.

The main concern with completely stripping out the cash value from the policy with withdrawals and
loans is that the policy could run out of value and potentially lapse, meaning that no death benefit
coverage remains. If this happens, the owner will need to put money back into the policy, (e.g., repay
loans), to keep the policy from lapsing. If the policy lapses, then tax must be paid on any accumulated
gains (Accumulated gains equal the gross cash value less outstanding basis). Generally, if a lapse
occurs after a series of loans and withdrawals, then the gross cash value equals the outstanding loan
and the basis is zero.

Another caution applies to any withdrawal made during the first 15 years of the contract that would
reduce the death benefit provided under the contract. When contracts are funded at the definitional
limit, as most COLI contracts are, then withdrawals in the first 15 years may be subject to taxation. If
cash is needed from the policy during the first 15 years, it would likely be more efficient to take loans
against the cash value so that death benefits are not reduced. After 15 years, tax-free withdrawals
from non-MEC contracts may be more efficient.
Q1.7 Is there a crossover point after which COLI can be surrendered and still have been
advantageous on an after-tax basis?
A1.7 Yes, but the crossover point depends on several factors. A reasonable estimate for the crossover
point is eight to nine years. This estimate assumes a single premium deposit into a non-MEC COLI
policy that is fully experience-rated, has no death claims, and earns a gross return around 8%. This
scenario yields the eight- to nine-year crossover when compared to a taxable investment that also
earning 8% and is taxed at a 35% annual tax rate. Factors that would shorten the time to the
crossover point include higher tax rate or interest assumption, and any death claims that could be
assumed for a larger group. Factors that would extend the time to the crossover point include
additional premium payments, lower interest assumptions, and a MEC policy status.
Q1.8 What options are available to get out of a COLI transaction?
A1.8 Options for terminating the contract include a full surrender or managing the death benefits to
maximize the insurance component of the policies. Surrendering policies subjects the proceeds to
income tax, to the extent that the policy values exceed the policy basis.

As an alternative, some owners with experience-rated contracts attempt to manage their death
benefits to avoid payment of taxes. Using this approach, death benefits, and therefore cost of
insurance (COI) charges, are held at a high level, which over time will reduce CV to below basis
(i.e. no gain). The COI also increases the mortality reserve which will be drawn down when a
death occurs. The goal is to surrender the contracts either when the taxable gain is zero or
immediately following a death that reduces the mortality reserve to zero. This approach avoids any
tax on surrender.
Accounting
Q1.9 What are the accounting implications of COLI?
A1.9 Most institutionally-owned life insurance follows the accounting treatment set forth in FASB Technical
Bulletin 85-4, as amended by Emerging Issues Task Force (EITF) Issue 06-5. The asset is recorded
at cash surrender value, and changes in cash value (net of any premiums paid) flow directly through
the income statement as Other Income.


Q1.10 What are the accounting risks associated with COLI?
A1.10 Auditors are beginning to question whether the Net Asset Values (NAVs) used to value insurance
company separate account portfolios are an accurate measure of the fair value of the underlying
securities that compose the separate account portfolio.

Employers should understand the composition of the separate account portfolios in which COLI is
invested and how those individual securities are valued.

Stable value wrappers can smooth the fair value of cash value for a fee, but employers should
understand any dollar or percentage limits of these wrappers.
COLI Administration
Issuing Contracts
Q2.1 How much COLI should a company buy?
A2.1 The primary consideration is matching the expected payments from the COLI with the expected
benefit payments. Initial projections determine the initial premium. Each year new projections are
made, based on prior experience and revised assumptions, to determine additional COLI premium
needed, if any. Since the policy premium requirements are flexible, any new funding can typically be
accomplished with existing contracts.

Also, since withdrawals and loans are generally available from non-MEC contracts, there is
substantial flexibility in the expected payments from the COLI. If MEC contracts are used, some funds
should be held in more liquid investments, since there may be periods when death benefits are not
sufficient to cover benefit payments. COLI should generally not be used to fund any liability that
matures in the next few years, since COLIs tax advantages may not offset the premium and DAC tax
cost in such a short time frame.
Q2.2 Who should be insured and how much coverage should be purchased?
A2.2 Beyond the general funding goal of matching projected plan benefits with projected death benefits,
the policy owner must establish a reasonable insurable interest in any potential insured person.
Insurable interest is a state law issue and therefore varies based upon the state where the insured
resides at the time the policy is issued. Generally the amount of coverage should not substantially
exceed the benefits provided by the plan for which the coverage is purchased. In many states this
determination can be made on an aggregate basis for the entire plan and insured population. In all
states, this determination need only be made when the policy is issued or materially modified.
Q2.3 How should the purchase or continued ownership of COLI be communicated to
insured participants?
A2.3 Again, state law guides the communication to insured participants before and sometimes after
purchase, and therefore varies by state. Historically, some form of consent was obtained or
notification provided relating to the insurance purchase.

Recently however, federal legislation was passed setting forth specific guidelines for both consent
and notification. This law also limits employers to only insure directors or highly compensated
employees in accordance with the statute. Individuals must positively consent to the purchase of
insurance by the employer on their life, and must be notified in advance of the maximum amount of
coverage that may be issued. This applies to contracts issued or materially modified after 8/17/06.


Failure to comply with these provisions of the COLI Best Practices as outlined in the Pension
Protection Act could result in loss of the tax-free nature of most of the death proceeds under IRC
101(j).
Q2.4 What happens when an insured participant terminates employment or participation in
the plan?
A2.4 Termination of employment or participation should have no impact on COLI. Under state insurance
laws, the owner of a life insurance policy generally only needs to have an insurable interest in the life
of the insured at the time the policy is issued. To the extent that an insured is no longer employed by
the employer, the employer may or may not have a continuing insurable interest in an insured
depending upon his or her continuing status as a plan beneficiary. To the extent the insurable interest
is lost with respect to an individual policy because the insured is no longer a plan beneficiary; the only
impact is that the policy cannot be exchanged tax-free to another product in the future. This is the
general interpretation of insurable interest by most, but not all states.
COLI Receipts
Q2.5 How are COLI receipts coordinated with benefit outlays?
A2.5 As discussed elsewhere, properly structured tax-free withdrawals and loans can be taken from the
COLI policies to pay plan benefits. However, it is generally most efficient to hold the policy until the
death of the insured. As such, it would be ideal to purchase COLI policies whose expected death
claims match the timing of projected plan benefit payments. Then, to the extent that there is a cash
flow mismatch, any imbalance can be made up with policy withdrawals and loans, or excess death
benefits can accumulate in a taxable fund until needed.
Q2.6 How are death claims made on former employees with whom the company has lost contact?
A2.6 Social Security numbers are gathered and maintained for all insured lives. Periodically (generally
once a quarter) these numbers are compared to those maintained by the Social Security
Administration. This process is often called a Social Security sweep. If the comparison indicates a
death has occurred, then a death certificate is ordered from the county in which the death
occurred. This information is usually available from the employer or by contacts made to the last
known address.
Q2.7 How does the company collect death proceeds, and how long does the process take?
A2.7 Once it is determined that a death has occurred, proof of death is obtained from the probate court of
the county where the insured died. With this proof established, a death claim is filed with the carrier
and the claim payment is mailed or wired to the company as named beneficiary of the policy. This
process typically takes anywhere from a period of a few months to as much as a year from the time
the death event is reported. Taxable interest accrues on the death proceeds from the date of death to
the date of payment.


COLI Structure and Design
Pricing Components
Q3.1 What constitutes the frictional costs associated with COLI and how much frictional cost
should there be?
A3.1 Frictional costs include any charges that reduce the net value that can be realized by the policy owner
upon surrender. Most institutionally-priced COLI, particularly PPVUL contracts, offer frictional costs
that are quite explicit, transparent, and generally negotiated. A short discussion of each potential
frictional cost follows.

Premium Tax
Premium Tax is imposed by most states primarily to cover the cost of regulatory oversight,
although it is also available to general state revenue. The typical rate equals two percent of
premiums paid into the policy; however there are substantial variations among the states.

Many carriers base the premium tax rate they pay on the state where the policies are issued or
delivered. They then charge those rates to the policy. Generally this is the state where the
employer is domiciled. Some carriers base the tax rate on the state where the insured resides.
Often there are reciprocal tax arrangements between the state where the carrier is domiciled and
the otherwise appropriate premium tax state. Other carriers simply charge 2% based on the
assumption that this is the applicable average rate for their entire book of business. Again, this
rate can be an important point of negotiation and consideration in the COLI transaction.

Once the applicable rate is determined, the policy owner must decide whether to pay the tax
directly as a deduction from the premium that is credited to policy cash values or to pay for the
tax over time, typically as an additional M&E charge against cash value. If the M&E approach is
selected, it will generally include a financing cost since the carrier pays for the premium tax up
front and recovers that cost over time. Typically there is a 10 basis point increase to the M&E
charge for each 1% of premium tax incurred.

Deferred Acquisition Cost Tax (DAC Tax)
DAC Tax is a somewhat indirect federal income tax, often referred to as an interest-free loan to
the federal government. Heres how it works. When a premium is paid, the insurance carrier must
include 7.7% of the premium in taxable income, in addition to any other taxable income that the
premium might generate. As discussed below, the carrier reduces taxable income to recover this
tax, without interest, over an 11-year period following the premium payment.

Carriers generally charge for DAC Tax in one of three ways. The first two, quite similar to the
premium tax discussion, are based on a percent of premium charge of 1% to 1.25% or a
financing of that charge via additional M&E. Again, the charge is approximately 10 basis points
M&E for each 1% premium charge.

The other technique involves deducting a larger percent of premium charge from the cash value
and setting up a DAC reserve that is payable to the policy owner over the remainder of the 11-
year recovery period following surrender of the policy. While the policy is inforce, funds are
transferred from the DAC reserve account to the cash value over the 11-year period. Typically the
initial premium charge and DAC reserve equals 4.15% of the premium. Immediately, 5% of the
DAC reserve is credited to the cash value. At the beginning of the next nine years, 10% of the
initial DAC reserve amount is credited to cash value. In the eleventh policy year the final 5% is


credited to cash value. Subsequent premium payments are handled in a similar fashion over each
11-year period following the premium payment.

Commission and Sales Load
Frequently there are no commissions or sales loads associated with institutionally-priced COLI
transactions. Typically there are no commissions built into the cost structure and, to the extent the
carrier recovers any other marketing or development cost, those amounts are covered as part of
the M&E charge. If commissions are built into the transaction (and there are good reasons to do
that are described elsewhere in this paper) such amounts can either be direct deductions from
the premium credited to cash value or they can be financed by the carrier and deducted over
time, similar to the treatment of premium tax outlined above.

Cost of Insurance (COI)
The net amount at risk (NAR) equals a policys total death benefit minus the cash value. Monthly
COI charges are based on this NAR amount as long as the contract is in-force. The NAR is
typically multiplied by a monthly COI rate to arrive at the total COI charge or deduction from the
cash value for the upcoming period.

The COI rates of pooled contracts are generally established by the carrier and may include a non-
specific element for overhead, profit, or cost recovery. However, the profit and recovery elements
of fully experience-rated contracts, are much more clearly identified. This topic is discussed more
detail in the mortality retention section shown below, as well as in the experience-rating overview.

Mortality Retention
Mortality retention is the specific charge deducted from the COI charge as it flows from the cash
value to the experience-rating mortality reserve. This charge is generally about 3% to 6% of the
guaranteed charge, or 5% to 10% of the current charge. Regardless of how this charge is
assessed, it will contain a risk element cost as well as some profit for the insurance carrier.

Investment Management Fees (IMF)
Investment management fees are direct charges against the selected funds that cover the
costs of fund managers and potential sub-advisors who manage the funds. These charges
range from as little as a few basis points on some simple index-based funds to as much as an
annual 400 basis points on certain more complex alpha, derivative, and leveraged funds. This
basis point charge is deducted each day from the fund value before that value is used or
reflected in the policy.

Generally, there is not an element of this charge that benefits the carrier in PPVUL COLI
transactions. It is solely used to pay for the work the fund managers do. However there can be
and often is a revenue-sharing element paid from the fund manager to the carrier in retail
products. This revenue-sharing is another element for profit and overhead that should not be
overlooked in structuring a COLI program.

Policy Administration Charges
Policy administration charges are per-life charges, typically $10 to $50 per year, used to pay the
carriers cost to administer the policies. This charge covers the cost of services such as tracking
policy values, ongoing reporting, processing premiums, withdrawals and loans, and paying death
claims. This charge does not include any policy management oversight, design analysis,
performance review, or insurance advice. For large PPVUL cases, which involve many policies
that are processed and reported on an aggregate basis, these charges can become substantial
and are another source of carrier profit and overhead.


Loan Interest Spread
Loan spread is the difference between the interest paid on loan funds and the interest credited to
the cash values that secure the loaned funds. Typically the interest credited to the cash value that
secures loaned funds is set to the minimum rate allowed under the contract, generally 4% on
older contracts and 3% on newer contracts. The loan interest rate charged is then set to a higher
rate, generally 25 to 50 basis points higher than the guaranteed rate. In this instance the policy
owner is paying more in loan interest to the carrier than the carrier is crediting to the policy cash
value. This difference is the loan spread.

It may seem unfair that the carrier earns a spread on funds that are not being managed and are
fully secured by the policy cash value. However, the carrier is still required by state regulatory
requirements to set aside additional capital to support the cash value. As discussed earlier, this
required capital must be invested conservatively. If the returns on these conservative investments
are lower than the carriers overall profitability target, then the carrier will recover these forgone
returns through policy charges.

Some products, typically found in retail markets, contain wash loan features. In these products
the loan spread is zero or a very low figure. This allows illustrations of loans in the later policy
years look more attractive. However, the underlying cost of the loan spread under these contracts
still exists, and is paid from other charges that are incurred whether or not the policy loan feature
is used.

Mortality and Expense Charge (M&E)
M&E, mentioned several times above, is the catch-all charge used to cover financing of premium
tax, DAC tax, commissions, and sales loads, if any. It also covers capital cost, overhead, and
profit. The M&E charge for smaller cases without any tax or commission financing is typically
about 50 basis points annually. For larger cases the charge is less than 25 basis points. The M&E
charge is applied at a daily equivalent rate against the policy cash value.
Q3.2 What are DAC taxes?
A3.2 The Deferred Acquisition Cost tax, or DAC tax, is a federal tax imposed on insurance carriers. The
tax requires carriers to defer 7.7% of otherwise deductible expenses over 10 years. The delay in
deduction results in a tax liability of 2.695%; 7.7% times an assumed 35% tax rate. This liability is
recovered over 11 years in a modified straight line fashion 5% in year one, 10% in years two
through ten, and 5% in year 11. The tax is essentially an interest-free loan by the carrier to the
government. The cost to the carrier is the opportunity cost of the deferred deduction. Depending upon
the carriers hurdle rate, the cost equals approximately 1.0% to 1.25% of each premium.
Q3.3 How are DAC taxes recovered by the carrier in a COLI transaction?
A3.3 The carriers recover the cost of the DAC tax in one of three ways:
1. A straight pass-through of the opportunity cost of the DAC tax, charged as a percent of premium
ranging between 1.0% and 1.25%
2. Amortized and charged as an asset charge of approximately six to ten basis points per year for
up to 30 years.
3. A pass-through of the DAC tax cash flows to the policy owner a premium load of 4.146%
(2.695% grossed-up for taxes, since the premium load is taxable income to the carrier), followed
by DAC refunds over ten years that are credited to the cash value of the policy owner in the
amount of approximately 10% per year of the initial premium load.


Q3.4 What are the pros and cons of paying advisors through fees versus commissions?
A3.4. Commissions can be difficult to redirect to another administrator if plan servicing begins to suffer.
Fees, on the other hand, are fairly easily redirected from one service provider to another.
Experience Rating (Mortality Retention)
Q3.5 What is experience rating?
A3.5 Experience rating is generally used to allow the COLI owner to benefit directly from favorable
mortality experience realized by their specific block of business. Also, the experience-rating
mechanism can serve to smooth out the impact on earnings due to unexpected deaths.

Many COLI purchasers feel that the carriers COI charges are priced too conservatively. The COLI
owners expect that their experience will be better than other policies that are included in the carriers
general mortality pool. However, if the case mortality is poor, then the COI charges will be
substantially higher when compared to a fully pooled/non-experience rated case.
Q3.6 How does experience rating work?
A3.6 Normally, in a non-experience rated (or pooled mortality) case, the insurance company assesses a
COI charge for each policy based on the amount of coverage and underwriting characteristics (age,
sex, smoker status, etc.) of the insured. While these charges reduce the policys cash value over
time, the owner eventually gets back all or some of those charges when an insured participant dies.
Owners may get back more or less than the cumulative charges with each death, but over time and
on average, owners get back all of the COI charges less the carriers charge for risk and profit.
Generally, the carrier does not adjust the COI charges based on the prior claims or lack thereof for
non-experience-rated cases.

There are generally two types of experience rating: retrospective and prospective. With retrospective
experience rating, adjustments are made to COI charges or mortality reserves each year. Initially
the carrier deducts a slightly higher-than-normal COI from the policy cash value and puts that money
in a reserve fund that the COLI owner can access if all COLI policies are terminated. After the first
year of an experience-rated arrangement, the owner may have slightly less cash value than under a
non experience-rated situation. However, they also have a fund equal to the COI charge, less a small
retention charge, that they can recognize as an asset in addition to the cash value. (This mortality
reserve is also referred to as a premium or claims stabilization reserve, or a contingency reserve.) As
time goes on, the mortality reserve accumulates with additional COI deposits plus interest and when
a death claim does occur, the net amount of the claim is deducted from the fund.

Favorable experience
At some point, if claims experience is favorable and the mortality reserve exceeds a certain
threshold, then the amount of the fund in excess of the threshold can be moved into the policy
cash value and invested in any of the variable funds available under the COLI contract. While the
funds are in the mortality reserve, variable investments are typically not available. Instead, these
assets are usually held in the insurers general account. This means the insurance company
invests the funds, and credits a rate to the policy owner. These funds are a general asset of the
insurance company, subject to the claims of creditors in the event of insolvency.

If a limited menu of variable funds are available for the mortality reserve, they will enjoy the same
separate account protection as afforded to the investments in the cash value account. However,
carriers offering this option will also reserve the right to move the assets into the general account
if experience is unfavorable.


Unfavorable experience
If claims experience is not favorable and the mortality reserve falls below a certain floor, then
either the COI charge (that is deducted from the cash value and added to the mortality reserve)
will be increased until the desired cushion is attained, or the insurance carrier will apply a one-
time charge to the cash value. The insurance carrier is limited by how much it may increase its
charges, based upon contractual guarantees. However, the initial COI rate, the retention
amount (or risk charge for the mortality component), the mortality reserve floor and threshold,
and the interest rate credited to the mortality reserve are all negotiated elements of the
experience-rating transaction.

Prospective experience rating is different from retrospective experience rating. Prospective
experience rating is similar to the normal pooled approach, except, the pool consists only of
insured lives connected to the COLI transaction or case under consideration. Each year the
insurance carrier looks at prior death claim experience and adjusts the COI rate up or downup
if claims are higher than expected, and down if claims are lower than expected. With the
prospective approach there is no mortality reserve and no earnings-smoothing inherent to the
COLI contract.

Experience rating smoothes net income by the owner being able to recognize an increase in the
mortality reserve (part of the COLI asset value) to offset the expense associated with the monthly
cost of insurance charge, which reduce the cash value (another part of the COLI asset value).
Similarly, gains at death are offset by a charge to, or reduction of, the mortality reserve.

To summarize:

Cost of insurance charges reduce invested cash values, but increase the mortality reserve

Death proceeds in excess of cash values (net amount at risk) increase cash but reduce this
mortality reserve
As a result, experience rating immunizes a company from the earnings volatility caused by the
timing of deaths.
Q3.7 When and why would a company choose to use experience rating?
A3.7 Experience rating should be negotiated when the initial COLI policies are placed. It is possible to add
the experience rating feature later; however, the initial contract must address the potential for such a
program. The primary reasons to choose experience rating are to benefit from favorable mortality
experience, to reduce frictional costs, and to smooth earnings impact.
Q3.8 Why would a company choose not to use experience rating?
A3.8 Some tax court cases have indicated that certain experience-rating arrangements do not contain a
sufficient transfer of risk to qualify as insurance. If COLI is not considered insurance because it lacks
the requisite risk-shifting, then it does not receive the tax-advantaged treatment on cash value growth
and death benefit proceeds provided to life insurance under the Internal Revenue Code.

Often, however, insurance carriers will guarantee that their contracts will be considered life insurance,
and will reimburse the owner for any lost tax benefits if it is determined that the contracts are not life
insurance. Care should be exercised in negotiating an experience-rating arrangement to ensure that
a transfer of risk is present, and that any tax-treatment guarantees provided by the carrier are sound.
Rather than dealing with these concerns and risks, some COLI buyers choose not to include
experience rating in the COLI transaction at all.


Policy Structure
Q3.9 What is the basic structure of policies issued for COLI transactions?
A3.9 There are many types of life insurance available in the market. Large case COLI policies are
generally private placement variable universal life insurance contracts with high cash value in
relation to the premiums paid and in relation to the death benefits provided. Private placement
means the contracts are not registered with the SEC, and are constructed for the sophisticated
investor, more or less specifically for each case. Variable means the cash value funds are invested at
the discretion of the policy owner in any of the various investment funds made available under the
contract. Universal life means the contracts are flexible and can be managed to maximize
performance or meet a variety of needs for the owner. High cash value and premiums in relation to
the death benefit mean the contracts are structured to have death benefits as low as possible and still
satisfy the definition of life insurance under Internal Revenue Code 7702.

There are two alternative tests available under the code that can be used to qualify a policy as life
insurance. The simpler of the two tests is the Cash Value Accumulation Test (CVAT). With this test,
the ratio of the death benefit to the cash value must exceed a certain threshold at all times. The
threshold is defined such that the expected present value of the death benefit using certain mortality
and interest assumptions is greater than the current cash value. This threshold varies by the attained
age of the insured and is based on statutorily-defined mortality and interest.

Currently, for policies issued in the past 20 years or so, the mortality is based on the 1980
Commissioners Standard Ordinary (CSO) Table and the interest rate used is 4%. There is some
flexibility in selection of variations of the 1980 CSO and calculation techniques. However, the
factors used from one carrier to another are similar. Most COLI policies use the CVAT test to qualify
as life insurance.

The other test is the Guideline Premium Test (GPT). Under this test the sum of the premiums paid
can not exceed the greater of the Guideline Single Premium (GSP) and the sum of the Guideline
Level Premiums (GLP) to date. The GSP is the single premium sufficient to fully-fund the death
benefit. The GLP is the level premium payable to age 95, or later, that will theoretically fund the
death benefit. These calculations are performed using the statutory mortality and interest as defined
for the CVAT calculations. However, the GSP calculations use a 6% interest rate and GLP and CVAT
calculations use a 4% rate. There are a number of other calculation and re-calculation rules that apply
to the GPT that are beyond the scope of this document.
Q3.10 What is a MEC, and what are the advantages and disadvantages of this policy structure?
A3.10 A modified endowment contract (MEC) is defined under Internal Revenue Code 7702A as any policy
that does not pass the seven-pay test. The seven-pay premium is the premium sufficient to fully
fund the death benefit over the first seven years of the contract. Basically, if premiums paid to date
exceed the sum of the seven-pay premiums allowed to date, then the policy will be forever classified
as a MEC. Once again statutorily-defined mortality and a 4% interest rate are used for this
calculation. As with the GPT test, there are a number of calculation and re-calculation rules applicable
to MECs that are beyond the scope of this document.

MEC contracts still enjoy tax-free build-up of the cash value and death benefits are received tax free
as well. However, any loan or withdrawal distributions from a MEC contract are taxed when received
up, to the accumulated gain in the contract. In addition, there is a 10% penalty on any distributions
from a MEC that are subject to tax. After the accumulated gain is fully-taxed, further distributions are
not taxed or penalized until additional gain accrues.


The main advantage to a MEC is that the death benefit required during the premium paying period
can be substantially lower than the death benefit required for a non-MEC. This leads to lower
mortality friction on the cash value build up. This advantage, however, is substantially mitigated when
experience rating is used, since most of the higher mortality friction on the cash value goes to
accumulate a higher mortality reserve in the experience rating mechanism.
Investments
Q3.11 What limitations, if any, are there on the selection of fund managers and investments within a
PPVUL contract?
A3.11 The primary issues with fund manager selection relate to investor control and suitability. The owner
of the contract should never exercise control over the fund manager as specified in Revenue
Rulings 2003-91 and 2003-92. Generally speaking, the COLI owner may have input regarding the
fund manager selection or investment philosophy of the fund. However, they should not actively
control or provide input to the daily fund management. Compliance with these guidelines will protect
the policy owner from being treated as the owner of the assets in the separate account for federal
income tax purposes.

Suitability deals with the carriers willingness to accept the fund manager and the fund managers
willingness to set up a separate insurance-dedicated fund for the sole purpose of investing money
that comes from this and other COLI contracts.
Other Potential Costs and Risks
Q3.12 What, if any, tax risks are associated with COLI?
A3.12. The following areas present potential tax risks, all of which can be mitigated or eliminated through
careful planning and pre-purchase due diligence.

Lack of risk transfer, as discussed in the experience rating Q&A

Investor control, as discussed in the investments Q&A

Tax treatment of cash value withdrawals from a MEC, as discussed in the policy
distributions Q&A

Insufficient ratio of policy death benefits to cash value, causing the contract to fail the definition of
life insurance test of Code 7702, as discussed in the definition of life insurance Q&A

Failure to comply with the COLI Best Practices could result in a taxable death benefit, as
discussed in the Q&A detailing COLI purchases.
Q3.13 Are there any other risks are associated with COLI?
A3.13 Carrier solvency
It is generally believed that the assets held under separate account contracts are not subject to the
claims of the general creditors of a carrier in bankruptcy. However, either the bankruptcy court or the
receiver acting on behalf of the state insurance authorities may freeze separate account assets and
potentially increase non-guaranteed charges until the bankruptcy proceeding are concluded. Even if
the separate accounts are not frozen, the process and cost of finding another carrier or simply waiting
for another carrier to assume the business, as well as the potential issues associated with an IRC
1035 exchange, will all be difficult.


Potential Claims from Heirs
Heirs of deceased employees who were covered by COLI policies have successfully challenged
the payment of death proceeds to the corporation in states such as Texas.

Accounting for Undiscounted DAC Reserve
Until the release of EITF 06-5, some companies counted the undiscounted value of the DAC
reserve as an asset. This reserve may be received over as much as a 10 year period following
surrender. DAC reserves expected to be received more than one year after surrender should be
discounted to reflect the time value of money, since not discounting these amounts would
overstate surrender value. EITF Issue 06-5 specifically requires the discounting of DAC reserves.
Q3.14 Are there any surrender penalties associated with COLI policies?
A3.14 There are generally no explicit surrender charges for COLI policies. Sometimes, however, there are
charges that apply if contracts are surrendered under an IRC 1035 tax-free exchange. This is
particularly likely when fixed accounts or stable value arrangements are present.

Some contracts only allow fixed or stable value account funds to be accessed over an extended
period. This is known as a crawl-out provision. Also, most contracts provide that the carrier can
withhold payment upon surrender under any circumstance for up to six months. As a practical matter,
however, this carrier right is rarely exercised.

In the event that a policy owner has utilized the pass-through method for paying DAC tax (as
described previously), they will receive payment of the balance of their DAC receivable over the
remaining years, rather than at the time of surrender.
Q3.15 Are there any other costs associated with COLI policies?
A3.15 There is an opportunity cost associated with plan assets held in the mortality reserve or DAC tax
asset. To the extent that a relatively low interest rate is credited to these funds when higher return
alternatives are available, the policy owner must forgo the potential to earn a higher rate of return on
these assets.
Q3.16 What steps can be taken to improve the pricing of COLI already in place?
A3.16 Carriers are generally reluctant to improve product pricing once the case has been sold. However, it
is possible to negotiate reductions in many of the frictional elements. It is very important to fully
understand all contractual rights, market alternatives, and surrender implications prior to entering a
negotiation for reductions. The COLI owner should also take into account how any proposed pricing
changes will be received by the carrier. With this information, the COLI owner can position its
alternatives in relation to the carriers current and desired pricing position going forward. It is very
important that these negotiations be handled on a very professional basis, since the desired result is
a continued long-term relationship with the carrier.


Miscellaneous COLI Issues
Q4.1 Does ERISA have any impact on COLI?
A4.1 No. COLI is not an ERISA plan asset.
Q4.2 How does COLI differ from trust-owned health insurance (TOHI)?
A4.2 TOHI is a relatively new and not widely used product that offers the same tax advantaged cash value
build up and benefit distributions as COLI. However, it insures medical risks rather than mortality
risks. The product pays medical claims up to a specified maximum per individual per year. Only one
insurance carrier currently offers TOHI (J ohn Hancock, who has trademarked the acronym TOHI),
and only a handful of policies have been sold to date. The most efficient use of TOHI would seem to
be in tandem with COLI, to cover both short and long term cash flows and to provide tax-free
earnings and proceeds throughout the life of a funding program.
Q4.3 Are there any potential advantages to writing or reinsuring COLI through a captive?
A4.3 This is a new and unproven concept that has garnered some attention recently from an application to
the Department of Labor by Whirlpool seeking a prohibited transaction exemption for having its
captive insurer reinsure TOLI in Whirlpools VEBA. (This application was subsequently withdrawn)
While there may be some tax and other financial advantages to the concept, the idea is very complex,
and this approach may involve risks beyond those present in a traditional COLI arrangements.
Choosing whether to move forward with this approach would require extensive analysis on a case-by-
case basis, as well as the involvement of tax counsel to determine if it is worth pursuing.


Aon Consultings Role
Aon Consulting is expertly positioned to provide the consulting and administration services you need to get
the most from your COLI program. Our Executive Benefits practice will provide these services. This practice,
comprising nearly 100 professionals with expertise in the areas of tax, accounting, law, actuarial science, and
finance, includes team members holding more than 60 professional designations, several of whom are
nationally recognized experts in many specialty areas.
Consulting services we provide to support COLI programs include:

Education regarding COLI contract specifics

In-depth analysis to assure that policy management aligns with your program and corporate objectives

Recommendations for adjustments, based upon periodic review of objectives

Annual review of policy pricing and, if appropriate, recommendations to improve pricing or design

Negotiations with carrier to improve policy pricing, if appropriate

Implementation of program changes with carrier
Policy administration services include:

Population of all certificates on our proprietary Policy Administration System (PAS), enabling inventory
and census management

Quarterly audit of insurance carriers valuation, including a review of the following monthly entries (to the
extent that they apply to your program):

Premiums paid

Insurance benefits collected

Partial withdrawals and surrenders

Policy loans and interest accrued

Investment fund returns

All elements of cash value build-up

Premium loads

Expense charges

Risk charges

Mortality charges

Gross and net investment income, by fund

For experience-rated contractsAnnual review and negotiation of the insurance carriers mortality
charges for the coming policy year

Death claim tracking through quarterly Social Security sweeps

Coordination with carrier in filing death claims


Sample Report Abbreviations

BOLI Bank-Owned Life Insurance

COI Cost of Insurance

COLI Corporate-Owned Life Insurance

CSO Commissioners Standard Ordinary (mortality table)

CVAT Cash Value Accumulation Test

DAC Deferred Acquisition Cost

DOL Department of Labor

GLP Guideline Level Premium

GPT Guideline Premium Test

GSP Guideline Single Premium

IMF Investment Management Fees

IRC Internal Revenue Code

M&E Mortality & Expense

MEC Modified Endowment Contract

NAR Net Amount at Risk

PPVUL Private Placement Variable Universal Life

PSR Premium Stabilization Reserve

TOHI Trust-Owned Health Insurance (trademarked by John Hancock)

TOLI Trust-Owned Life Insurance

VEBA Voluntary Employee Benefit Association

COLI Primer

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A Primer on Corporate-Owned Life

Insurance (COLI) Including Rabbi

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