Capturing COLI/BOLI.

Special Report Excerpt: The corporate market's impact on life insurance sales grows.

The corporation as life insurance policyholder is having a growing impact on the overall industry, according to statistics compiled by A.M. Best Co. In 1998, 20 of the largest writers of corporate-owned and bank-owned life insurance--also known as COLI/BOLI--sold more than $10 billion of these policies, masking declining growth in more traditional lines.

The COLI/BOLI product is designed to finance, on a tax-advantaged basis, new or existing employee- or retiree-compensation or benefit plans. One popular product in the bank market is a single-premium contract designed to finance nonqualified deferred compensation for key executives. While the premium is not deductible, corporate owned life insurance offers the tax advantages of life insurance--tax-free payout upon death, along with the taxdeferred buildup of the cash value. Premium paid is immediately converted to cash value carried as an asset owned by the corporation. There is no tax-free payout until someone dies, at which time the death benefit would go to the corporation and begin growing on a tax-deferred basis. It is essentially an investment that offers a higher return as well as liquidity, since a life insurance policy can be surrendered at any time--although the loss of the product's tax advantages are a deterrent to withdrawal.

From a rating perspective, the important questions are: What new risks are being introduced by these products, and are insurers being paid for the risks they are taking?

The COLI/BOLI product has evolved in recent years, with banks making up an increasingly significant proportion of the customer base. Large banks have been the primary customers, although smaller banks are entering the market. A range of products with a variety of product features are available. Some are single-premium and some are recurring-premium products. Different products contain different contract provisions.

While little is known about the market generally, one product in the large-case--$50 million or greater in premium--bank segment is a separate account or variable policy with general-account guarantees in the form of minimum-crediting rates. These variable corporate policies are partly driving the rapid increase in overall variable life sales.

Since, in many cases, assets associated with the product are held in the separate account, they are insulated from general-account claims in the event of liquidation. Where minimum-guaranteed rates apply, the product also has a claim on the general account if the investment fails to deliver that rate.

From the bank's perspective, the life insurance purchase is a reallocation of capital to an asset--the cash value--earning higher returns. It is unclear how or if the tax-free death benefits are tracked. In some cases, specific trusts have been set up to collect these funds and ensure they are used for the stated purpose.

From the life insurer's perspective, the sale of this product involves a shift in the traditional risk structure. When an individual buys a life insurance policy, both the individual and the insurance company take the risk that the policy, through prudent investments, will eventually overcome sales costs and generate longer-term value.

When a corporation buys a COLI or BOLI product, however, the insurance company absorbs the sales costs at issue, while the corporate customer can show all or most of the first-year premium as cash value--that is, an asset on the balance sheet owned by the corporation and growing on a tax-deferred basis. This aspect of the product provides liquidity, although the industry does not view the liquidity risk to be significant, since surrenders or loans involve penalties that negate gains stemming from the tax advantages. Insurers are sufficiently convinced of this so that, in many cases, they are willing to recover the cost of issuing the policy over several years.

Nevertheless, state insurance regulators, through the National Association of Insurance Commissioners, have been examining the potential for disintermediation related to these and other products. They have found that, while most contracts include penalties or surrender charges if there is a transfer,_these penalties are being waived, in some cases through side agreements in the event of a downgrade (usually more than one level) of the insurance company's financial-strength rating. This is in response to competitive pressures.

The primary disintermediation risk is in the potential for 1035 exchanges of large cash values. The designation "1035" refers to a section of the tax code that permits a contract holder to transfer insurance policies to another company without tax penalties. Other regulations may prorate the amount that can be transferred to reflect employees who were originally named in the policy but have since left the company.

The NAIC's review of what has been referred to as "bailout provisions" for investors in the event of a rating downgrade also includes funding agreements sold to money-market funds and other institutional investors.

This is the product that led General American Life Insurance Co., St. Louis, to voluntarily place itself under state supervision in 1999.

The ultimate parent, General American Mutual Holding Co., agreed to the supervision after its credit rating fell and it defaulted on at least $4 billion in funding agreements with institutional investors. Metropolitan Life Insurance Co., New York, is in the process of acquiring General American.

Whether they cover funding agreements or COLI/BOLI, contract provisions vary depending on the company. In both cases, however, the contracts involve nontraditional product features and the success of the product is based on significant assumptions about factors over which the insurance company has little control, such as investor behavior. As the General American debacle demonstrated, these can be risky assumptions. An added risk of COLI/BOLI is the product's vulnerability to tax law changes, which is also outside the industry's control.

COLI/BOLI is an area in which life insurers have been seeing strong growth at a time when they face difficulty in growing traditional business with traditional risks. But they are competing in an arena in which investors impose new, sometimes onerous, contract provisions.

While life insurers are no strangers to the institutional-investor market, they historically have not operated in its most liquid segments. The only way insurance companies can offer investors the higher returns and liquidity not normally associated with tax-advantaged products is to take on added risks, particularly in the area of investment management and liquidity.

Are insurers getting paid for the risks they are taking when selling these products? In cases in which insurers receive spreads of five basis points or less, the answer--on a risk-adjusted basis--is clearly no.

As insurers move into new markets in search of growth, their ability to manage a broad range of risks while optimizing reward will become an increasingly important factor in the rating process.

This statistical study was written by Cynthia J. Crosson, senior financial analyst in A.M. Best Co.'s life/health division. Edward Easop and Dana Mebta, also senior financial analysts in the life/health division, contributed.

A Look at the Numbers

Of the $10.3 billion in first-year direct and single-premium corporate owned life insurance sold in 1998 by 20 large writers of this product, $6.5 billion was reported as individual life and $3.8 billion as group life.

On the individual side, sales of corporate-owned life insurance by this group of companies alone account for more than the total one-year increase--$6.2 billion more in 1998 than in 1997--in ordinary life first-year direct and single-premium for the industry as a whole. Moreover, that $6.2 billion is an inflated number because the single-premium line includes paid-up additions contributed by policyholders, as well as dividends credited by the insurer.

The table that begins on page 94 shows statutory data for individual and group life first-year direct premium for the industry. COLI/BOLI premium is included in these numbers but is not broken out for reasons of confidentiality. Companies report sales of the product in a variety of ways. Some include it in individual first-year direct or single premium, while others report it in the group line. Sales tend to be large, causing volatility. These products also have contributed to an increase in the average size of policies.

Comparing the average policy in force with the average policy issued in 1998 demonstrates this trend. Other factors are contributing to larger policies, as producers increasingly focus on the high end of the individual market to address wealth-transfer and protection needs of the most affluent, whose numbers have grown. An industry shift toward term-life sales is also a factor, because term policies are generally larger.