What it means
A business faces real, quantifiable losses when a founder, top salesperson or lead engineer dies unexpectedly: lost revenue, recruitment costs, lender nervousness and sometimes a forced sale. Company-owned life insurance converts that risk into a known annual premium and a defined payout.
There are three common purposes. Key person cover replaces lost profits and buys time to recruit, buy-sell funding gives surviving owners the cash to purchase a deceased partner's shares at an agreed price, and benefit-funding COLI is used by larger employers to offset the cost of deferred compensation promised to executives.
Two policy types dominate. Term insurance is cheap, pays only on death within the term and builds no value, while permanent policies such as whole life or universal life cost more but accumulate a cash surrender value the company can borrow against or cash in.
The accounting is straightforward but often misunderstood. Premiums on a policy the company owns and benefits from are generally not tax deductible, the cash surrender value is carried as an asset, and the death benefit is typically received free of income tax, which is why the after-tax economics can look attractive despite the non-deductible premiums.
There are guardrails worth knowing about. Rules in many jurisdictions require the insured employee's written consent and notice before the policy is issued, and abuse of broad-based COLI on rank-and-file staff has attracted both litigation and legislation, so consent, purpose and governance need to be documented.
In practice
Real-world examples.
Example
A two-partner architecture practice signs a buy-sell agreement valuing each 50% stake at $3,000,000 and buys a $3,000,000 policy on each partner. When one partner dies, the firm receives the proceeds and buys the shares from the estate without borrowing or selling assets.
Example
A regional bank funds a deferred compensation plan for 30 senior managers with permanent COLI policies. The cash value growth is intended to offset the cost of the benefit promises, and the bank discloses the arrangement and the total cash surrender value in its accounts.
Example
A software company with $12,000,000 of revenue takes $1,500,000 of key person cover on its lead architect at the insistence of its lender. The loan covenant requires the policy to be assigned to the bank, so the proceeds would first repay debt before anything reached the company.
Formula
Calculation
Net economic benefit = death benefit or cash surrender value received - total premiums paid.
A company insures its chief revenue officer under a permanent policy with a $2,000,000 death benefit, paying an annual premium of $50,000. After 10 years the total premiums paid are $50,000 x 10 = $500,000, and the policy has built a cash surrender value of $560,000.
If the company surrenders the policy at that point:
Gain = $560,000 - $500,000 = $60,000, of which the part above the premiums paid is generally taxable.
If instead the executive dies in year 10 and the death benefit is paid:
Net benefit = $2,000,000 - $500,000 = $1,500,000, normally received free of income tax.
The company holds the $560,000 cash value as an asset in the meantime, so the true cost of protection is the difference between the premiums paid and the value accumulated, which here is nil.Case study
Seen in the real world.
Bellweather Foods is an illustrative, fictional speciality food manufacturer with 15 people in its executive and senior sales group. It had promised a deferred bonus scheme payable at retirement, and the finance director wanted a funding plan rather than a promise backed by hope.
The fictional company bought permanent policies averaging $8,000 a year per executive, a total premium of $8,000 x 15 = $120,000 a year, with combined death benefits of $9,000,000. It documented written consent from each insured executive, recorded the growing cash surrender value as an asset, and treated the premiums as non-deductible in its tax computation.
Eight years in, the accumulated cash value stood at roughly $1,100,000 against $960,000 of premiums paid, and the death benefit on one executive who died in service covered the company's obligation to his family in full. The board's own review noted the discipline the arrangement imposed: an unfunded promise had become a funded, visible and governed asset.
Watch out
Common mistakes.
- Assuming premiums are tax deductible because the company pays them. Where the company is both owner and beneficiary, premiums are generally not deductible, which is the trade-off for receiving the death benefit free of income tax.
- Buying cover without written consent from the insured employee. Many jurisdictions require notice and consent before the policy is issued, and a policy taken without it can be challenged or the proceeds taxed.
- Treating the death benefit as free money rather than as replacement for a real economic loss. Cover should be sized to the profit contribution, debt exposure and buyout obligation it is meant to meet, not to the largest policy the insurer will write.
Questions
People also ask.
Who receives the payout, the company or the family?
The company, because it is both owner and beneficiary, though the funds are often used to buy the deceased owner's shares from the family under a buy-sell agreement.
Does the policy stay in place if the employee leaves?
Usually not for long, as the insurable interest that justified the policy ends with employment, and companies typically surrender the policy or transfer it under agreed terms.
How is COLI shown in the accounts?
The cash surrender value is carried as an asset on the balance sheet, movements in that value flow through the income statement, and the death benefit is recognised as income when payable.
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