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Tax Benefits of Life Insurance Help to Boost the Bottom Line

Monday, December 30, 2002 - 00:00
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This article is part of a series that won the 2003 George Polk Award for Financial Reporting. A list of those articles is available at, and a web archive of this article is maintained at

Corporate owners get a variety of tax and accounting benefits from life insurance on employees.

The kind they load up on is "cash value" life insurance, so-called because besides a death benefit, it includes a tax-sheltered investing account. This account is like a big, nondeductible IRA: The policyholder deposits money into it, the insurer subtracts a slice to pay for fees and insurance, and the remainder grows tax-free. That growing remainder is known as the cash surrender value, or cash value. It's an asset.

For families, these cash-value policies are often a poor deal, because the commissions are usually high. But employers negotiate low commissions. It can make sense for them to round up cash they might have lying around, on which they're earning taxable returns, and plow it into a life-insurance policy, where the returns aren't taxed.

The downside is that the money is tied up for long periods, essentially until the insured employees die. The employer could get at it by surrendering the policy, but that would make the gains taxable. Employers used to take big simultaneous loans against the policies, but interest on such loans is no longer deductible. What does free up the money, sooner or later, is the death of the employee. It brings a death benefit, which isn't taxable.

These death benefits, except in rare cases where a number of employees die unexpectedly soon, aren't usually a windfall to the employer. Insurers price their products carefully, so that, over time, the sums an employer pays for the insurance coverage will roughly balance what the insurer has to pay out in death benefits.

Income Stream

So if the deal ties up money so badly, why bother? The answer: All the years that this (tied-up) money is growing, the employer can keep reporting the accumulating gains as income.

The reason is that under generally accepted accounting principles, life insurance investments are treated differently from many other kinds of investments. If the employer had invested in a stock portfolio, and it gained in value, the gains wouldn't add to the company's income until it sold the stock. All the company could do in the interim is add the portfolio gains to its balance sheet.

But if an investment in life insurance grows, the gains flow straight to the income statement every quarter, boosting earnings. And, of course, those are tax-free gains, unlike the kind the company would get from a stock portfolio.

What about an investment loss? The chance of that is remote with policies that pay fixed returns, which are common. Some policies are invested in stocks, and they of course do lose money at times. Insurers offer mechanisms that help companies to smooth out the gains and losses over several periods, and generally avoid recording hits to income.

Policy Loans

In the late 1980s and early 1990s, many companies took the tax benefits of life insurance one step further, by taking out big loans against the policies at the same time as they bought them.

Here's how it worked. An employer would pour $100 million into insurance on its employees, paying the insurer that much money, plus fees. The insurer credited the employer with, say, a 10% rate of return on this money, or $10 million in the first year, tax-free.

But the employer immediately borrowed out the entire $100 million, paying the insurer 12% interest, or about $12 million the first year.

Wonder how the policy could earn 10% if the proceeds had all been lent back to the employer? The answer is that the employer, technically, borrowed from the insurer, rather than withdrawing its premiums. They remained there, earning their 10%.

So now the employer, paying $12 million in interest and earning $10 million, was out $2 million. Not a good deal? Not until you consider that the $10 million is tax-free, while the $12 million of interest paid is deductible. At a 40% tax rate, that saved the employer $4.8 million off its other taxes.

Bottom line: The employer still had its $100 million, it was paying $2 million to the insurer, and it saved $4.8 million on its taxes -- a net gain of $2.8 million.

As for the insurer, it had made an essentially riskless two-percentage-point spread.

In 1996, Congress put a stop to this by abolishing deductions for interest on policy loans. In response, companies began taking out other loans -- on which interest was still deductible -- and then buying more life insurance. This move has virtually recreated the deal Congress thought it had abolished. It's particularly attractive for employers with cheap access to borrowed money, such as banks.

Whether or not it is leveraged this way, corporate-owned life insurance provides a relatively predictable stream of tax-free investment returns, flowing to the bottom line for years.