Asymmetrical Information

This doesn't pass the smell test. Waving your hands doesn't dispel the smell.

Can I, as am employee or stockholder, take out a life insurance policy on a company exec?

Life insurance policies taken out by anyone but the one whose death is insured against give me the willies.

Regardless of who takes out a policy, any life insurance beneficiaries' interest might deteriorate to "Joe is worth more to me dead than alive."

If the beneficiary is paying for the policy, then the probability would seem even greater.

Tontines (a pool which the sole surviving contributor collects) are generally illegal for a similar reason.

As far as I know, you can take an insurance policy out on anyone you like, provided the insurance company will write it -- which they won't if they don't think you have some interest in the matter, since they'll asume your interest lies in proprietary knowlege of the insured's likely demise, either through insider information, or because you're planning to cause it. But take, for example, the business of people selling their life insurance proceeds, which sounds gruesome, but also allows terminally ill people with no dependants to live their last days the way they want.

The original purpose behind this type of policy purchase by companies was to insure critical executives; sort of like getting insurance for business continuity in case of a major catastrophe [fire, flood, or earthquake causing a business's temporary shutdown]. But these catastrophes are specifically physical, and not due to the natural deaths of employees. What is hard to legally do is discriminating between who is critical and who is not, smell or otherwise.

Megan,

Excellent explanation, even though I'd never heard of COLIs before. Anyone who reads mysteries knows about partner insurance, which is really just a form of COLI. (POLI? Can ROLI be far behind?)

The Communitarian Network piece is ridiculously biased; it makes absolutely no mention of the premiums that had to be paid before the company could benefit from the "windfall". Trust me, the life insurance companies are not paying out more than they're taking in. So "Panera made $3 million by pocketing the death benefits after several of its employees died", but we won't mention that they paid out $3.5 million in life insurance premiums that same year.

Also, I doubt that "widows and orphans are left to fend without a dime, even for funeral costs." A company using COLIs probably offers life policies to their employees, if not actually paying for one. And I'd expect most COLIs are on managers and execs, whose loss would most affect the company. These are the employees who are most likely to have life insurance of their own. Of course, it sounds better to just call them peasants.

Admittedly, there are idiots everywhere. Mark Elam, the acting president of the American Council of Life Insurers, wrote to The Wall Street Journal that corporations use the benefits they gain from the employee's death to help finance health care for retirees. He cited no evidence to this effect. Possibly Mr Elam's job prohibits him from mentioning that there is no "benefit" (on net) from life insurance, but it's ridiculous to say it's going to one or another ongoing expense. (Annual bonuses or special dividends, I could believe.)

BTW, why are the premiums the company pays a business expense? I can't deduct my life insurance premiums, so it always made sense to me that the payout was not taxed. Maybe the simplest solution would be to limit the premium's deductibility. (You would think that a reasonable limit to the company's potential loss would be the salary of the dead employee, for example.)

Thanks,

Fub wrote:"Life insurance policies taken out by anyone but the one whose death is insured against give me the willies."

Taking out an insurance policy on another person's life does not give someone incentive to kill that person. Afterall, if caught, you will go to jail and the insurance company will be forbidden to pay your claim on the basis that you would be profiting from your crime. What if you don't get caught? That's unlikely. The fact that you have such a policy in the first place would make you the prime suspect and it would only be a matter of time before they put the pieces together. And you would live under constant surveillance until they do, a private hell. Fear of providing incentive for murder is a better argument against your buying a policy on your own life than it is against COLI. Your own Life Insurance gives your beneficiaries motive without necessary suspicion.

Life insurance policies taken out by anyone but the one whose death is insured against give me the willies.

Fub, policies are frequently taken out by spouses. And, again, anyone who reads mysteries knows how that can turn out.

Hmm. I see: a Law & Order episode, where a company's office is blown up, and a whole group of employees were killed. The company desperately needs cash for some reason, so the life insurance payout is very convenient. (Write the second half of the show yourself.)

From time to time the press undercovers programs which the general public finds outrageous. Whereas the legislative history of the program is often predicated on altruistic motives; as an example, the COLI program was initiated to provide tax advantaged funding for employee benefits (health and dental care, pensions et al). One would not be suprised that the insurance industry was instrumental is the passage of the program, as it benefited from both sides of the program.

The tax advantages of a COLI is that corporate taxes are deferred on policy investment gains as well as on tax free (death) benefit distributions. In effect, these policies amount to tax-free investments for businesses similar to the insurance annuity programs for individuals.

Various states, such as New York, require that the employees be notified of the program and execute a release, some states don't require said notification.

Finally, the double taxation on dividends doesn't pass the smell test. One might suggest either the elimination of corporate taxes (akin to all of the pass-through legal structures) or tax free dividends (similar to Australian franking, the individual receives a credit for the taxes actually paid by the corporation).

I've always thought that a federal propery tax for all institutions (except for religious-separation of church and state, you know) might be a more efficient in raising funds.

PJ wrote:

"Fub, policies are frequently taken out by spouses. And, again, anyone who reads mysteries knows how that can turn out."

Yes. That's why it gives me the willies.

Now, if you'll excuse me, I'll have another of these delicous Marie LaFarge Christmas cakes.

I see nothing wrong with these policies in general, except that the tax treatment does seem strange. As PJ points out, my premiums, whether for life insurance or car insurance, aren't deductible, so it's reasonable that payouts shouldn't be either. But if companies can deduct the expense then the payout they get should be taxable.

That would reduce the use of these policies to what I suppose was their original purpose: to really insure against the unexpected loss of a key employee.

Actually, no they shouldn't be taxable. An insurance payout is making someone whole for an economic loss they've suffered. They haven't experienced any income off it, just like you haven't gotten any income when you crash your car and Geico gives you money to buy a new one.

The insurance premiums are the fees the company pays to manage its risk against catastrophic loss; as such, they're expenses. The reason you can't deduct your private insurance is due to the fact that humans are taxed on revenue, while businesses are taxed on income. I explain why in the post on the corporate income tax I linked above.

Interesting piece. You've gotten some of the tax details wrong, but the general thrust is on the target. Properly structured, a COLI program may help a company fund survivor benefits -- such as maintaining health care coverage for a deceased employee's family. The policies generally have a small face value and do not provide any real incentive for a company to do in their employees. (If an employee were killed in an industrial accident. the liability for the death would far exceed the insurance death benefit.)

As for the tax details: Premiums are not deductible. What companies are doing is buying cash value insurance (instead of term) and then the companies borrow the cash value from the policy (which just about equals the premium). Then, the company pays the insurance company tax deductible interest on the loan. Meanwhile, the insurance company pays the policy holder (as a credit to the policy cash value) interest on the cash value of the policy. Net net, before the tax deduction, the company and the insurance company are just exchanging checks. After the tax deduction, the company is way ahead.

I hadn't thought about the tax aspect of COLIs (why I like this site!) But it does strike me that Walmart might be able to extract more data on the health and expected longevity of its million plus employees than would be available to an insurance company, and cherrypick for the ones that will die sooner than the underwriter expected. I don't think it would be morally dubious for Walmart to purchase policies on all of its employees, but how would you feel if your company binned you with the 1% most likely to die profitably? Outraged maybe, queasy definitely.

Also, when complaints are made about double taxation, why is the dividend tax always trotted out and the payroll tax ignored? Really, why?

Don't the COLIs continue to be in force even after the employee leaves the company? That was what the Wall Street Journal articles on this topic a few months ago implied (no link since WSJ doesn't have free online articles). That's the part that seems creepy to me -- even after you no longer work for a firm, they can profit from your death.

On a side point, I don't understand when you say "the company is insuring a pool -- unless they have an actuarially significant number of employees to insure, the risk is too great that they'll be on the wrong side of the bell curve, none of their employees will die, and they'll have spent a lot of money for nothing."

I thought risk was the exact reason why you buy insurance. If you're insuring an actuarially significant pool, then you're just paying the insurance company for nothing because you know it's going to come close to even odds, in which case there's no risk because you know the likely outcome, and the profit of the insurance company is just cutting into your bottom line.

I'm not insuring an actuarially significant number of houses--I'm just insuring 1. Which is exactly why I'm insuring it, because of the large variations and risks. If I already have a large number of assets/employees to pool risks, insurance provides no advantage. Right?

I don't appreciate comments about my relative worth alive vs. dead. If we can't joke about nuking Berkeley, we can't joke about my demise. Christ, I haven't earned it near as much as Berkeley.

The controller at my previous job mentioned that Wal-Mart can also count the value of the policies as an asset on financial papers. I never looked into it at the time because I really wasn't that interested. But since I can get free advice here, was he smoking something or are companies padding their balance sheets with these things? That I would be troubled by.

I was very amused at the sense of moral outrage imbued throughout the post. Who exactly, is hurt? Certainly not the employees or their families. What difference does it make to them? If someone wants to argue the government is, I still don't see the issue. They set the rules in the first place.

Much ado about nothing.

"An insurance payout is making someone whole for an economic loss they've suffered. They haven't experienced any income off it, just like you haven't gotten any income when you crash your car and Geico gives you money to buy a new one."

In the first place, companies have suffered no economic loss in the vast majority of these cases. (Do these policies stay in effect even when the employee leaves?)

Second, what if they have? Why should insurance be used to make an "economic loss" profitable? Suppose a large company doesn't carry property insurance on its cars for example, and has an average annual loss of $100,000 from car theft, accidents, etc. Now presumably the premium it would pay if it did insure would be $100,000 a year, its average loss, and it would be protected against a catastrophic year. So in an average year it hands the insurance company $100,000, and the insurance company then gives it back. But if the premium is tax-deductible and the payout is not taxable, then the exchange of money turns into a $35,000 gain for the company.

That's not just managing risk, etc., and you don't need platonic ideal views of taxes to think that this is not really equitable.

Jane, you ignorant slut.

I have no comment.

Joe: Companies do list COLI policies on the balance sheets as an asset. The also deduct the cost of premiums (net of any income earned inside the policy on cash values) on their income statement. If it is a leveraged COLI program (which is the type that produces material tax benefits), the value on the balance sheet will be very small -- most of the cash values would have been borrowed out of the policy.

Bernard: The tax rules for property insurance and life insurance are different. Over a period of time, no one makes a profit on property insurance. To take your example, each year the full premium will be paid even if there is no insurable loss. Even in the year there is a loss (which may exceed the premiums paid in all policy years), the insured party had a tax deductible loss which is reduced by the insurance proceeds. From that viewpoint, the insurance proceeds are taxable -- they reduce the company's taxable loss and therefore increase taxable income.

Don't ask me why property insurance premiums are deductible for tax while life insurance premiums are not. I am sure there must be a good reason. But I'm a tax accountant. I don't make the rules, I just take advantage of them.

In the first place, companies have suffered no economic loss in the vast majority of these cases.

How do you know that? Here are two anecdotal counterexamples:

1. A college friend of mine works for Lockheed Martin, and they're giving him tuition compensation for his continuing graduate education.

2. My dad has acquired a couple Microsoft certifications through his company, because the company wanted him to have that knowledge background for his work.

These are two examples where a company incures a direct financial loss if an employee dies, because presumably, they would have to pay again to bring a new hiree up to the same level of competence.

Furthermore, many jobs involve training and skill-acquisition that are somewhat specific to that job. Thus, if an employee is lost by death, the company could suffer a loss of productivity while a replacement hiree learns the skills that allow him/her to optimally perform his/her tasks.

Jane, you ignorant slut.

I have no comment.

You have no comment, but played an Insult Card anyway? Judging by the squawking, Jane must have found a tender spot.

Consequences of that play:
minus (5) Character
minus (3) Credibility
forfeit (1) turn of play

Alternative outcome:
If the player wishes to sacrifice (5) points Ego and invoke the Sincerity Clause, player may regain turn and play an Apology, instantly recovering (2) lost Credibility points and (3) lost Character points.

Remaining losses are permanent but may be re-acquired in future plays.

LRF - like many of us you clearly aren't an SNL watcher. "Jane you ignorant slut" was a common punch line to a Dan Akroyd skit.

Nonetheless, I do find it odd that Thumper wrote what he did...especially since the full moon isn't due for another week or so.

I just can't believe that this is even in question. Jane set it forth pretty clearly, I don't see another side to this argument other than the one that pulls on the heart strings.

The concept of saying their is no economic loss to the company is just crazy. I like sports so lets take this example. A baseball team is in the hunt to make the playoffs, with a month left in the season their clean up hitter dies, trade deadline is over, they can't get a replacement. Now they don't make the playoffs and reap the rewards of sold out stadiums at playoff prices. Is there an economic loss? DUH!

Seems like a typical socialist/liberal argument against capitalism. If the corporation is making money in relation to the worker then it must be wrong. Last time I checked, if the corporation does not find ways to make money then the workers go by another name....unemployed.

"LRF - like many of us you clearly aren't an SNL watcher. "Jane you ignorant slut" was a common punch line to a Dan Akroyd skit."

I hear that Bob Dole and Bill Clinton will be reprising the old Point-Counterpoint segment on 60 Minutes over the next few months. I would pay good money for a (genuine) MP3 of Bob Dole saying:

"Bill, you ignorant slut."

Accurate, for both insults.

These policies do not cover cleanup hitters, (well, 30 of them do, but that's all) or critical personnel in, as I said, "the vast majority of cases."

According to Etzioni, the policies cover former employees, as well as current ones. What's the loss there? What percentage of payouts are made on people who are actually employees at the time of death?

And what's the loss when one of the "peasants" who is an employee dies? How much does it cost to replace a janitor?

David,

Thanks for clarifying tax treatment. As I understand it, in my example the payout is effectively taxable, and the premium tax-deductible, so I see no inherent inequity.

Peter,

My comments have absolutely nothing to do with anti-capitalism or socialism or whatever else you're afraid is hiding under your bed. They're about the tax system.

I've always thought that a federal propery tax for all institutions (except for religious-separation of church and state, you know) might be a more efficient in raising funds.

Erf. Off-topic, but if you were to exempt only churches, you'd have a much bigger church-state problem on your hand, I'm afraid. You'd be offering a privilege -- immunity from taxation -- to religion that was not available from nonreligion. Lemon says quite specifically that that is a major no-no. After all, the reason that churches carry a tax exemption now is that all nonprofits get the same exemption.

David Walser has the tax issues surrounding COLI about right. The real attraction of COLI was the ability to finance tax-exempt income with tax-deductible interest. The interest deductibility has been mostly eliminated by Congress and the courts.

Without tax benefits, COLI simply becomes an investment issue. Corporations should be free to make their own investment decisions, of course, but it is difficult to see where COLI on a broad base of employees can be a decent investment.

There are two components to a potential return on life insurance: death benefits and investment return. On a broad group of insureds, the mortality income should be about what the actuarial tables would predict. This will result in a small negative return, becuase the life insurance companies have to be compensated somehow. Their premium rates must result in a positive mortality return to the insurer, and a negative return to the COLI buyer; otherwise the insurer loses money.

The investment return is only as good as the insurance company's investment portfolio. While I have heard any number of insurance agents explain how their company provides superior returns, it just isn't so; not everyone can be above average. So - you get market investment returns, reduced by the insurance cost. A smart company can do better by skipping the insurance part.

I doubt this would be much of an issue if corporate income were only taxed once. Current law provides a tax incentive to keep earnings in the corporation, giving management the temptation for mischief, like COLI. If dividends were deductible, shareholders wouldn't tolerate corporations using their money to buy life insurance. While I think a dividends-paid deduction is the way to go, the proposed dividend exclusion is still a big improvement over the current double-tax system.

My 2nd-hand understanding is that tax law is actually structured so that the insurer and the company make money -- on average.

Len,

That's true only where
1. The company can exclude the cash build-up, and
2. The company can deduct the interest.

In that case, they are just arbitraging the spread between a tax-free instrument and a taxable instrument.

Congress has snipped away most of the ability to deduct interest, and the courts are working on the rest (see the Winn-Dixie case linked in my last post, or the CM Holdings case).

My point? Without a tax subsidy, COLI is unlikely to be a good investment. If the corporation wants to invest money, it can do so without insurance expense. In many cases, the best thing they can do is just return the money to shareholders as dividends.

Joe K: your last is especially true as insurance company management costs are relatively sky high and their returns on investment before costs historically suck. The sole reason for COLI even being considered as a legit use available cash is the preferential tax treatment of the premiums and pay outs. The companies could insure their customers, competitors, or employees to get this same treatment, but keeping track of the death status of the first two groups would be difficult.

I have to wonder at what kinds of employees are actually being covered in real life under such policies. The average Wal-Mart guy can be replaced with a quick phone call to the local unemployment bureau. On the other side companies like Intel often having projects involving billions of dollar in capital riding on a handful of engineers.

I just thought I'd mention the term used in the insurance industry for the risk of changes in behavior brought about by the presence of insurance itself: "moral hazard."

I picked this up from my wife, who has practiced insurance law since 1995, and is currently working on her LLM in insurance law.

Jane,

Excellent post. I had never heard of the practice before reading about it on Etzioni's site (which I found after Volokh's plug).

As to tax loopholes created by all of this, it seems to me the easiest solution would be to end taxation of income altogether, and just move to a consumption tax. But that's rather off topic. . .

Sounds like an excellent method of eliminating the federal deficient. Insure the life of the congersmen and send all of them on a fact finding mission to Iraq. Get all of them with a couple of short round.

Sounds like an excellent method of eliminating the federal deficient. Insure the life of the congersmen and send all of them on a fact finding mission to Iraq. Get all of them with a couple of short round.

Fair enough. How would the employers feel about an employee who, immediately on taking up employment, took out a short position in the employer's stock, in order to manage their own risk (would have been pretty useful for Enron employees, for example)? Just trying to work out whether this is a general-purpose sauce, or one that's only for the gander.

Again, I would imagine that it's bad PR, but I wouldn't say it's immoral. (Although I would question whether it's sensible to work somewhere if you feel there's grounds for a short position -- I suppose it depends on your risk tolerance. Also, a short position isn't really a very good hedge unless you have a lot of stock options, since a salaried employee won't take part in the upside enough to offset his short losses. But I digress). I wouldn't tell my employer I'd done this, but then I don't think there's really any reason they should ever find out unless they're a financial institution, or you're an executive (in which case I don't think you should be shorting your company's stock, since at that point a lot of what you're hedging is your own incompetence). I don't think an employer should be any more upset at a short hedge than an employee should be about COLI's, although I recognize that they may be upset anyway, and the resulting bad PR may make the strategy unworkable.

Exactly. COLI is a tax shelter that requires life insurance to work (if it does, in fact, work). For a large employee base, it can hardly be a way for corporate vampires to profit from employee deaths. No insurance company could afford to sell policies where the premiums on a large group were less than the payout on deaths in the group.

Now PR, that's another story. To a stockholder, I think an investment in a failed tax shelter would be the real bad PR.

>>Although I would question whether it's sensible to work somewhere if you feel there's grounds for a short position

And I'd answer that if you think your employer's stock is a Buy, join a union.

In related news, this assertion:

>>the insurance company will either stop writing the policy, or they will require you to take action. And they'll also raise your rates because you're a high risk client.

doesn't ring any bells for any kind of insurance industry I've ever seen. How long would it take an insurance company to recognise a statistical difference between the mortality rate of your employees and those of the general pool of its group life risks? Ten years at least, and more likely close to twenty.

Even given that they thought they'd spotted an anomaly and decided to bump up your quote, how likely is it that they'd be so sure of their ground that they'd quote you a price which would make the deal uneconomic for you? Would your name be so sullied that you wouldn't be able to find an alternative quote?

And finally and most importantly, so what if you got caught out to such an extent that you'd stop being able to carry out that particular scam? As a COLI owner, if you got found out for having poor safety practices or high employee mortality, you always have the option to just walk away from the COLI game, cashing in the surrender value of your unclaimed policies and pocketing the profits you'd made.

I'm sure that this business is nothing more sinister than a rather tasteless tax dodge. But unless my understanding of the state of actuarial science is literally ten years out of date, I don't think that one can support the claim that the insurance industry uses such finely-grained pricing for group life policies that there is literally no moral hazard problem with respect to this insurance. I think it would be entirely possible to make a decent turn out of bumping up the mortality rate on your employees after having insured them; I don't believe any employer would actually do so, but it's a possibility.

DD:

doesn't ring any bells for any kind of insurance industry I've ever seen. How long would it take an insurance company to recognise a statistical difference between the mortality rate of your employees and those of the general pool of its group life risks? Ten years at least, and more likely close to twenty.

Do you have any basis whatever for the 1-2 decade estimate? If it's that bad, a whole lot of actuaries are being horribly overpaid.

All:

As a general note, I think it'd be perfectly acceptible for an employee to take out a policy on a corporate officer. After all, if that guy is worth the money he's being paid, the corporation will take a hit in terms of income in the event of his death. This hit could translate into job risk.

I can buy insuring employees up to a point. If the company pays death benefits directly (I don't know of any that to. That doesn't mean they don't exist, though), I'd say this is warranted. Otherwise...I know of few companies that pay employees what they are worth, as they gain value for the employer in terms of experience or training. Whereas a new company will pay an employee near-market value immediately. I'd say that most training losses are incurred when employees get tired of waiting to be brought up to market scale and take their business elsewhere. Just a conjecture.

If the legitimate-interest notion holds sway, I'd say it's highly questionable in the case of an employer. If the employee in question is so valuable and expensive to replace when alive, there's no excuse for not paying them what they are actually worth. I think it cuts both ways. Alternatively, I could promise to pay the company a few tens of thousands of dollars out of my own insurance in the event of my death while employed, in exchange for them upping my wages to what I'm actually worth. Or at least adding the cost of their premium into my paycheck.

Oddly, I have to get lab work done whenever I want to change my self-insurance. Why is it that my employer doesn't?

David Perron: My experience is that it is very common for companies to pay a small death benefit to an employee's family. (There is even a tax provision that exempts such a death benefit from income taxation.) In addition, it is also common to continue the family's health insurance and other benefits for some period. Do the majority of companies do this kind of thing, I don't know. I do know that many do.

As some have pointed out, on a large employee base it is not possible for an insurance company to assume much of the mortality risk. Still, it is not unreasonable for a company to buy insurance to fund these types of programs. The margins on COLI products are very, very thin. Buying the insurance is not the cheapest way to fund these programs (if the insurance is fairly priced), but it does fix the cost of the program and allows the company to focus its efforts in more profitable areas. For the same reasons, many companies buy health insurance for their employees rather than self-insure. In the long run, self-insurance is cheaper -- but buying insurance allows the company to fix its costs for providing the benefit. The insurance company's profit is just the cost of outsourcing.

Personally, I don't like the idea of a third party taking out a life insurance policy on someone, and I don't think such a thing should be possible without the express consent of the person the policy is on (though I don't know much about the specifics of COLIs so maybe that is the case). Otherwise I can understand it, though I would prefer a policy which payed out in the event of the unexpected loss of the employee to the company, rather than simply his death.

Well, speaking as someone who's helped buy and manage insurance policies for several businesses, I can say that it took them considerably less than ten years to notice our variance from actuarial norms and price accordingly -- our health insurance rates went down, and some other insurance rates went up, based on 2-3 years worth of data.

Robin - In most states (if not all) the insured is required to consent to the insurance application. It is a very common practice for a business to take out insurance on key people, such as the V.P. of Sales. Sometimes the bank will require such a policy be purchased before making a loan. Why? Because if the V.P. of Sales gets hit by a bus on the way back from lunch, the company may be in a world of hurt and might default on the loan. The insurance policy should help the company survive until a new V.P. of Sales can be hired.

So, sometimes there is a legitimate business need for corporate owned life insurance. In the case of policies on the rank and file, normally these policies are tied to survivor benefits for an employee's family. In most cases (all that I am aware of), the employees are required to consent to the purchase of the policy.

As for the question of whether there is something unseemly about someone owning an insurance policy on the life of another, I fail to see what difference it makes. If I own the policy on my life, I won't be around to collect the insurance proceeds! So why is it preferable for me to own the policy instead of the person who will be harmed (financially) by my early demise? There are tax and non-tax reasons that make it far better for my wife, children, or a trust for their benefit, to own any insurance on my life.

I fully understand the concept of perverse incentives. [I keep telling my wife that I want enough insurance protection that she (and the children) will be provided for, but no so much that no one will cry at the funeral.] Believe it or not, the insurance companies are aware that someone might try to profit from an insurance policy. For this reason, you cannot buy an unlimited amount of insurance on the life of an individual. You must first show an insurable need (show how you might be harmed if the insured were to die) and then quantify the amount of that need. As a consequence, the insurance company will not sell a corporation a $5 million policy on a forklift driver. Assuming the insurance company has done its job, the corporation will not profit from the early demise of an insured employee -- the amount of the death benefit will just about cover the corporation's economic loss resulting from the employee's death.

Well I can't belive it required that I read every damn comment until David Walser finally expressed some pertinent facts. But, thankfully I did. Obvioulsy David is in the insurance business and works in the COLI arena.

Key Person Life Insurance is time tested and IRS approved. It is simply common sense in action and it is CORPORATE OWNED LIFE INSURANCE - COLI.

COLI is also used to "recapture the costs" of certain benefit plans that are used to attract and retain key executives. It is also used to racapture the costs of various employee benfit plans and trusts (VEBAs). And yes, those costs can be recaptured years after the individual has retired from the company. Once again, common practice and IRS and DOL approved. There is no news here. (For those of you that are appalled by this, I refer you to Dr. Joseph Belth of Indiana University. He is a Professor Emeritas of Insurance there and an unabashed advocate of eliminating COLI because there is no "insurable interest" and a moral hazard exists. Personally I admire the heck out of him but I think he is way out to lunch on this deal.)

For years (1986 I think) the tax advantage of "minimum deposit" has been eliminated. But the financial concept behind the purchase is real simple and still very viable. There is an inevitable gain to the beneficiary/premium payor in the death benefit of a life insurance policy. The premiums simply do not add up to the death benefit.

Life insurance used to recapture costs and help to replace the loss of talented employees is simply a common sense response to the perils any organization may face. Oh, and it has the advantage of demonstrating fiduciary responsibility to stockholders and remaining employees. (See the example of the loan officer at the bank above).

Actually, it is sort of like insuring the bread winner in a family in order to pay for funeral expenses and/or replace income due to the loss. And the cost of the funeral will be there even after the annual income has stopped. The point is that one still needs insurance for some expenses irrespective of the income the decedent may or may not generate. Pretty basic concepts really - and I really don't think they are too diabolical.

Richard: nobody's talking about "key person" insurance here, and it's completely uncontroversial. We're talking about "dead peasant" insurance, where the economic loss is small relative to the payout and the scheme is basically tax-driven.

Jane: How old were these policies? Are you sure that you weren't just seeing the normal seasoning of life cover (as in, the move from a highballed rate charged to new policyholders who might have misrepresented their riskiness, to a mature policy rate on a known risk), rather than any real movement in the insurer's assumptions? Also, are you sure that the "movements" in mortality assumptions weren't just being used as a figleaf to allow one side or the other to make concessions on a negotiated price? I maintain that, given plausible estimates of the cross-sectional variance of employee mortality between companies, it would be more or less impossible in normal cases to isolate changes in a single company's underlying riskiness with only 2 or 3 years of data.

Jane, you've obviously put a lot of thought into your essay and it deserves a thoughtful response. However, I think your defense of the indefensible fails on a number of points.

You state:

So it turns out that Amitai Etzioni has a new, and excellent blog. In one post, he links a piece critical of the practice of buying COLI insurance, sometimes known by it's more pungent name: Dead Peasants Insurance.

Well, since my favorite pastime is defending the apparently indefensible, and since a lot of people get all huffy and regulatory when they discover the existance of these policies, I think I'll take a stab at saying that while the practice may be bad PR, it isn't really immoral.

Response:

People are "huffy" because life insurance was purchased on them without their knowledge. I, for one, would like to know whenever anyone can profit financially from my demise, particularly someone who may be in a position to control the safety or healthfulness of the environment in which I am employed. Some companies simply aren't as ethical as your hypothetical company. Do you think executives for Enron, Worldcom, or Global Crossing would be above knocking off a few insured peasants if it suited their needs?

You state:

The basic idea of COLI is that a company buys life insurance policies, payable to the firm, to ensure against the economic loss occasioned to the firm when an employee dies. The employee dies; the company gets the benefits; the family gets nothing. This strikes many people as awful.

Response:

Why on earth is it necessary to purchase policies valued at over $300,000 to cover a clerk or a janitor? Are you suggesting that replacement of lower level employees would cost that much? Yes, part time store clerks have been insured for as much as $300,000. I think you'll have a hard time showing that the "insurable interest" in these employees is that high.

You state:

But wait -- why should the family get anything? They weren't paying the premiums. If the policy had been made out to the family, the company would not have bought it, or would have made the family pay the premiums either directly, or through lowering the salary on offer. We're complaining because the family is not getting a benefit from a policy that never would have been purchased if the family had been the beneficiary. In other words, the family isn't losing anything. If you take out an insurance policy on my life because of the irreparable loss you expect to suffer if and when I am no longer around to provide the finest economics and bullmastiff web commentary, and pay premiums on it, it may be ghoulish, but it's neither illegal nor immoral. Nor should my family expect to be given the proceeds of a policy they didn't pay for.

Response:

This is a straw man. The people who are opposed to COLI are not arguing that the beneficiaries should be family. They are arguing that the policies should not be written in the first place. This is not about who should benefit, it's about who should NOT benefit. Employers are in a position to effect the health and well being of their employees. As a matter of principle, any organization that is in such a position of control over an individual should not be in a position to benefit from the individual's demise.

Side note: In Arizona a former spouse cannot be the beneficiary to a life insurance policy that was in effect while the couple was married unless, after the divorce, the assets are specifically signed over by the insured. Why would they have such a rule? Answer: insurable interest.

You state:

One often hears arguments against these policies on the grounds that the companies aren't really suffering any economic loss -- hence the "Dead Peasant" moniker. But this is beside the point, because the point of this sort of policy is not to provide insurance; it is to collect a tax benefit.

Response:

The point of these policies is to obscure the control of money, to move it from a place it ought to be to a place where it probably doesn't belong. In 1996 the government significantly reduced the tax related value of these policies when the deductibility of the premiums was disallowed. Nevertheless, the policies persist. If there is no profit motive behind them, where is the incentive to purchase or maintain them? The fact of the matter is, the companies' administration of the policies are intended to "beat the odds". BTW, tax savings is profit.

You state:

Let's start with the proposition that over the long run, companies on average are not going to make money on these policies. If they were making an economic profit -- that is, more than they were paying out in premiums, adjusted for the time value of the money -- the insurance companies would be losing money, and then they would go out of business and we wouldn't need to argue about COLI policies any more. Thus, this is not a gruesome plot to make on last dollar off the backs of the employees, even though it sounds like it in most newspaper treatments. Over the long run, the cost of the premiums and the capital required to pay for them will be at least equal to the payout. Over the short run, specific companies may make out like bandits, but then there will be other companies that pay out a lot of dough and all their employees live to be ninety. It evens out on a societal basis, which is how one has to look at things like regulating insurance policies.

Response:

Way too simplistic. I would suggest that the base premiums for these policies is probably based on the demographics employee within the entire organization in terms of health, age, habits, etc. I've yet to see anyone scheduled for a physical, or filling out an application or questionnaire to determine rate or eligibility for dead peasant insurance. Moreover, no company buys dead peasant insurance on all of their employees. They are selective. I suspect that when one looks at who is actually insured, one will find that it's often the least insurable employees upon whom the policies are written. They take advantage of the lax rules regarding insurability where group rates are employed. I also suspect that there is a certain amount of collusion between the folks that buy the policies and the commissioned agents that sell them. It doesn't take an actuary to figure out how this works.

Second, of each premium paid, a small portion is skimmed off for administration. The rest is used for investment. Prudently invested in an up economy, the return these investments will significantly exceed the pay out for the group.

Finally, there is the issue of "cash flow" vs. profit. I suspect many of the companies that sell these policies are trading the long-term financial health of the company for short-term gain (commissions on sales and short term ROI). This practice can be propped up for a very long time, as long as they are allowed to keep selling new policies, even if the investments aren't paying a sufficient return. However, if companies ever stop selling new policies, the whole thing is likely to collapse like a house of cards. I suspect that's why the industry is lobbying so heavily against "rank-and-file" employees when companies take out COLIs on them.

You state:

If they're not making any money, though, why do they do it? Well, for one thing, it does cost the company something when an employee dies, even a lowly one. Whether or not that's equal to the value of the policy is a matter for argument, but frankly, if there's anything more tedious than an argument about actuarial valuation techniques, I haven't come across it in my thirty years.

Response:

The reason the "insurable interest" doctrine exists is to make sure that the insured person is worth more alive than dead to the beneficiary. Heretofore, the courts have only looked at the issue dichotomously; that is, either an insurable interest exists or does not exist. This is a mistake. One could, perhaps, convincingly argue that a company has an insurable interest of $1000.00 on the janitor, but there is no way a $300,000 policy can be justified from a replacement cost point of view. I suspect that in the future courts will have to consider the specific amounts in determining whether companies do, in fact, have an insurable interest in rank-and-file employees.

You state:

At any rate, that's not the major reason that a lot of these policies are written. The major reason is that it's tax advantaged. When a company pays insurance premiums, that's a tax-deductible expense. When it collects insurance premiums, on the other hand, it is assumed to be making whole an economic loss, and the benefits are thus untaxed. COLI's are essentially serving as a sort of corporate Roth IRA. Is there anything wrong with that?

Response:

Yes, the sooner the person dies, the more greater the ROI. Second, tax advantage is profit. Third, unless they beat the odds, there is no incentive to purchase these policies, despite the "tax advantage". Tax deductible or not, premiums are still an expense. So, unless returns exceed investment, the purchase of dead peasant insurance would be incredibly dumb financial move.

You state:

Well, for those who believe that there is some sort of magic "fair share" number of corporate taxes that can be known with certitude, and that they are thus qualified to judge when the corporations have departed from the platonic ideal, I'm sure this policy strikes them as horrible. Longtime readers know that I think that for all the time and energy companies waste trying to minimize their tax bill, and that we waste trying to stop 'em, it would be a lot better for all of us to eliminate the corporate income tax and just tax any income they distribute when it hits employees or shareholders. In this case, I don't see how you could "close the loophole" without throwing the baby out with the bathwater.

Response:

There are many rules that apply to corporations that do not apply to individuals, particularly when it comes to taxes. Closing the loophole is simply a matter of writing the law to cover specific business practices.

You state:

GE is certainly going to suffer a net economic loss if any of their executives or even middle managers drop dead -- are you going to keep them from insuring the risk?

Response:

Your skating the issue. The argument against COLIs is not about insuring executives or even middle managers. "Keyman" COLIs are an entirely different matter. They are individual policies purchased by companies on specific executives and are not purchased in a pool. Calculation of premiums is based on the risk associated with the specific individual, not the pool. Finally, the insured party knows of the existence of the policy and has consented to it. "Dead peasant" insurance is about is insuring expendable peons for excessive amounts. It's about purchasing policies the value of which exceeds of any reasonable calculation of pecuniary loss to the beneficiary that may occur as the result of the death of the insured employee. It's about purchasing policies on people without first informing them and obtaining their permission. It's about addressing an incentive for murder or a disincentive for normal consideration the health and welfare of one's employees.

You state:

Or open up a huge can of worms by trying to tax insurance proceeds? Think carefully before you answer, because that exemption is why you don't have to pay taxes on the money Geico paid you when your sister wrecked your car. You might find it a little hard to replace the car after Uncle Sam has taken 30% out for taxes.

Response:

See above. Tax law governing business is an entirely different matter from tax law governing individuals.

You state:

Now, the policies might be dreadful PR, and thus a bad idea. But I don't see how they're particularly immoral, and I certainly don't think that, as many argue, there ought to be a law.

Response:

Another straw man: Law has little to do with morality. It has to do with regulating behavior to insure a continued society. We don't outlaw murder because it's immoral. We outlaw murder because the law is necessary to do so to maintain a functioning society. Indeed, whenever we start mixing law up with morality, we end up with absurdities like Sunday blue laws or trying to regulate sexual behavior between consenting adults.

You state:

UpdateMark Kleiman says that the reason it's bad is that it gives companies an interest in their employees death. But actually, I don't think it does in any meaningful sense.

When I take out a life insurance policy on you, I now have an interest in your death -- and indeed, that interest can be so strong that insurance companies have developed very strict investigatory divisions intended to prevent those who decide to take aggressive action to realize that interest. But it doesn't work that way for a company.

Response:

This is naïve. One of the best-kept secrets in the insurance business is that "strict investigatory procedures" are the exception, not the rule. In the vast majority of cases, only a death certificate is required to pay a claim. Sometimes, they may even check to see if the certificate is a phony. Investigations are expensive and rarely lead to results that are significant enough to deny a claim, despite what you may see on TV. This is true of most individual policies as well as group policies. Finally, when a claim is denied to a big customer, the company risks losing all of the customer's business, including other business insurance, which they are loath to do. Underwriters will often allow themselves to be ripped off occasionally to retain a big customer and cash flow. The call it "customer service".

You state:

Remember, the company is insuring a pool -- unless they have an actuarially significant number of employees to insure, the risk is too great that they'll be on the wrong side of the bell curve, none of their employees will die, and they'll have spent a lot of money for nothing. When you're insuring a pool, you can't gain economic benefit from raising the number of deaths in the population. Why? Because if an abnormal number of people die, the insurance company will notice. If you seem to be causing the deaths, either by running an unsafe workplace or hiring from an especially risky pool (rock climbing sky divers with brain tumors wanted to run the copy machines at Acme Widgets!), the insurance company will either stop writing the policy, or they will require you to take action. And they'll also raise your rates because you're a high risk client. Those rates will be at least the economic cost of covering your new, riskier insurance pool. In other words, any money you make from encouraging your employees to die will be paid to the insurance company as premiums to cover their higher risk of dying. That doesn't even take into account the liability and health insurance costs you would incur if you started trying to kill your employees.

Response:

Ultimately, there is only one pool of life insurance customers per insurance company. Losses within one segment of the pool can be offset by gains within another segment of the pool. Second, insurance companies make money by administration fees and investments. Rates are increased only when they can raise them without losing the customer. Finally, when your insuring over 350,000 employees (and former employees), as in the case of the "worlds largest retailer", small variations from the expected norm will likely go unnoticed, yet can generate big profits for the beneficiary.

You state:

So, no, I don't think it gives a company an interest in their employees' deaths. In fact, a company that's looking out for its economic interests will want their employees deaths to vary right within the normal actuarial range. Which, if they're large enough to be using this sort of scheme, is probably just what they'll do.

Response:

There are controls that prevent me from insuring my spouse's life or the lives of my children for an excessive amount. However, apparently no such controls exist with COLIs. This is one of the scary things about these policies. Whenever a person is worth more to another dead then alive, there is an incentive for foul play.

Side note: Several years ago, the "worlds largest retailer" started running ads targeting retired citizens, specifically retired male citizens, for employment at their stores. Do you think this was altruism? Do you think that the target group makes better workers stocking shelves, climbing on ladders, lifting heavy boxes or unloading trucks? Maybe it was just a patronizing PR campaign saying to older folks "everyone else may think you're useless, but we don't." In light of the COLI issue, perhaps there was a more sinister reason for the campaign.

Comments are Closed.