R. David Fritz, Jr., CLU
Much of my experience with life insurance has centered on its use in business situations. In the business context, life insurance is traditionally associated with key person coverage, debt replacement and employee benefits. With the current economy, a new role emerged for life insurance—a tool in corporate finance.
Corporate finance is usually associated with the funding and capital structure of corporations. While the goal of corporate finance is ultimately to add shareholders value, a lot of the function deals with risk management. Life insurance can be particularly useful in corporate finance as a funding and risk management tool for helping to manage the company’s internal long-term liabilities. These internal liabilities refer to obligations a company has beyond its credit lines from outside parties, such as banks, vendors, and investors. Examples of these would include redemption agreements the company has with private shareholders, executive benefit commitments made to key personnel and the repurchase liability ESOP’s have to employ participants.
These kinds of commitments are long-term in nature, but feature an ongoing challenge to cash flow management. The triggers for these liabilities can involve certain events such as the shareholder or employee death, disability, retirement, and departure.
Consider a commitment a company assumes when private stock ownership is held by an ESOP. The company seeks a productivity, tax, and capital structure boost by having some or all of the stock owned by the employees for their participation in the ESOP. In doing this, however, the company creates a corporate finance challenge because it has a stock repurchase liability when an employee departs. The company, through the ESOP, must come up with cash to buy out the employee’s stock value. Both the value and timing of the obligation can be challenging. The better the company does, the higher the stock value and larger the repurchase liability. Further, the timing of liabilities depends on whether the covered employee departs, whether upon retirement, termination, death or disability.
A similar challenge presents itself when a business, such as a professional firm, has multiple owners covered under a redemption agreement. The firm creates a liability which may be triggered by a number of events beyond the firm’s control. Because it is a multi-owner buyout, the liability is ongoing—partners leave, partners come on board. Depending on the terms of the agreement and the cash position of the business, the firm may want the option to pre fund this ongoing liability.
There are a number of elements that go into the design of effective corporate financing tools. Key considerations typically include tax and accounting treatment, cash flow, and liquidity. In the past, companies also looked to hedge against risk caused by market and economic conditions. Interestingly, the centuries old concept of life insurance as a financing vehicle can potentially accomplish these objectives.
In the United States business environment, Corporate Owned Life Insurance (COLI) emerged as a popular corporate financing tool. Companies often purchase institutionally priced, or retail priced, life insurance policies on their executives and/or owners, and maintain these policies as corporate assets. In essence, these are key person policies targeted at provided financing to the company’s long-term obligations.
To learn more about how life insurance can help a corporation deal with its long-term liabilities, please feel free to CONTACT an Executive Benefits consultant and learn more.