Companies Gain a Death Benefit
Life Insurance Taken on Rank-and-File Staff to Fund Programs

By Albert B. Crenshaw and Bill Brubaker
Washington Post Staff Writers
Thursday, May 30, 2002; Page E01

For many years, employers have insisted that their workers are their most valuable asset. Recently the phrase has taken on new meaning.

Tax litigation and damage suits reveal that many corporations are taking out life insurance on their employees with the company as the beneficiary. In many cases, the workers do not know of these policies, and when some have died their families were shocked to discover that insurance companies were paying hundreds of thousands of dollars to the employer.

This kind of insurance is a new twist on what is called corporate-owned life insurance, or COLI.

Such policies have long been used to cover key executives, whose untimely death might cause a problem for a company. The newer kind of COLI, which covers the lives of rank-and-file workers and provides no direct benefit to them, has sometimes been dubbed "janitors insurance" or "dead peasants' insurance."

Some survivors and insurance experts are offended by the practice.

"It raises very serious public policy questions," said J. Robert Hunter, a former Texas insurance commissioner who is now with the Consumer Federation of America. "What is the purpose of this? If it's just to make money, I don't think that's sufficient" reason to allow it.

But many states, including Maryland and Virginia, specifically permit this kind of insurance, and insurers and employers argue that it enables companies to fund worker benefits, such as retiree health insurance, in the same tax-preferred way that they fund pensions.

And in fact it appears that the appeal of this broader COLI, like many forms of life insurance, is driven not by the need to provide survivors with income but by the generous tax benefits allowed life insurance generally.

Under current law, the investment gains within a life insurance policy are not taxed, which allows them to build up to fund the death benefit, which itself is free of income tax. This tax treatment allows employers to use life insurance policies, in effect, as tax-free investments.

The tax exemption for investment income on life insurance contracts of all kinds is expected to cost the federal government $131.6 billion between now and 2006, according to the congressional Joint Committee on Taxation. That's about a third more than the government forgoes by allowing homeowners to deduct state and local property taxes.

Death benefits may be subject to estate taxes, but there are ways around that. Indeed, estate tax planning is a major attraction of life insurance for wealthy families.

As a result, both individuals and corporations can use life insurance to get around major forms of taxation -- income, gift and estate.

"This is not what anybody ever meant it to be," said Robert S. McIntyre of Citizens for Tax Justice, an advocacy group that opposes tax breaks for corporations and the wealthy. Somebody dies and policymakers think, "let's be nice to the widow. Then it becomes an investment vehicle, then a corporate tax shelter. You'd think Congress would say, 'This isn't what we meant,' and fix it."

In an added twist, which the Internal Revenue Service and Congress have largely stamped out, many companies that bought broad-based COLI policies borrowed against the investment earnings, known as the "cash value," thus getting their money while the workers were still alive, and deducting the interest on the loan.

One target of the IRS has been W.R. Grace & Co., a Columbia, Md.-based manufacturer.

Grace disclosed in a recent public filing that it bought COLI policies in 1988 and 1990 "as part of a strategy" to fund "various employee benefit programs and other long-term liabilities."

The policies were structured to provide a cash flow that is "primarily tax-free" to the company over "an extended number of years," the filing said. At the end of last year the policies had a face value of $2.3 billion. The company reported $18 million in tax-free proceeds from these policies in 2001.

Grace said its COLI premiums were funded in part by borrowing against the cash value of the policies in the 1990s.

The IRS has ruled that Grace was not entitled to deductions taken from 1990 to 1992, and the company has paid $21.2 million in back taxes and interest, the filing said. The company asserts that its deductions were "in compliance with tax laws in effect at the time."

Grace said the IRS hasn't completed its audit. From 1993 through 1998, the company noted that it deducted about $163 million in COLI-related interest.

Executives of Grace, which filed for Chapter 11 bankruptcy reorganization last year, declined to be interviewed for this story.

But even without the interest deduction, companies are rushing to take out policies. Premiums for COLI jumped to $2.8 billion last year from $1.5 billion in 2000, and the two-year growth rate of large COLI policies was 60 percent, according to CAST Management Consultants Inc. in Los Angeles.

The key issue in whether a company can insure its workers is whether an employer has an 'insurable interest' in them -- that is, would the company suffer some economic injury if the workers died. Some experts don't see such a relationship.

In the District, which has no statutes or rules specifically on this point, Insurance Commissioner Lawrence H. Mirel said, "It's not clear to me what the insurable interest would be."

But many states and the National Association of Insurance Commissioners, an association of state regulators that devises model laws and rules that states can copy, concluded several years ago that COLI and related insurance structures "are attractive methods of financing liabilities such as an employer's obligations under a retiree health benefit plan."

Some states have placed restrictions on broad-based COLI policies, but most allow them. Maryland requires companies to obtain permission from workers, and Virginia requires that employees be notified after the policy has been taken out. Both states require that death benefits be in line with the benefit programs the policies are meant to finance.

But broad-based COLI plans typically continue to insure workers who have quit the company or retired, making it difficult for some to see how the company "would suffer a loss if these individuals die."

Insurers and companies that buy the policies say the tax benefits go to a good cause.

"It's dangerous to broad-brush these programs," said Philip Hosmer, spokesman for Allfirst Financial Inc., a Baltimore-based banking and financial services company. "There are obviously employers who use these to insure employees without their even consent or knowledge, which we don't do. We only do this with employees who have given written consent prior to the purchase."

Hosmer said the term "janitors insurance" is unfair because many companies, including Allfirst, buy policies only on upper-echelon employees -- and only after receiving their approval.

Allfirst's policies -- purchased in 1999 and 2000 -- have a face value of $200 million, Hosmer said. Hosmer described them as a "tax-efficient investment strategy that offsets the rapidly escalating costs of employee benefit programs."

Allfirst had revenue from the policies of about $11 million in 2000 and $15.1 million in 2001, he said.

McLean-based Freddie Mac bought COLI policies on 2,000 of its 3,000 employees in 1995, spokeswoman Sharon McHale said. "We wanted to insure most every employee who had been at Freddie Mac for at least a year to provide an offset to the cost of providing benefits," she said. "We notified employees that we were going to do it, explained how it worked," McHale said. Freddie Mac did not insure any workers who called the human resources office to say they were uncomfortable with the idea, she added.

Wachovia Corp., owner of First Union Bank, has insurance on 20,000 of its 80,000 employees, spokeswoman Mary Eshet said. All 20,000 employees are aware that the Charlotte-based company bought insurance on their lives, she said.

"It's an investment to offset the cost of employee benefits . . . such as health benefits," Eshet said. " . . . This enables us to continue to provide a wide range of benefits to all employees."

Virginia-based Hooker Furniture Corp. said it bought COLI policies on about 60 supervisory workers, all of whom consented by signing a two-paragraph statement.

In the statement, the employee agrees "that neither I nor any of my family members, heirs or beneficiaries have now or will have any right of ownership of the policy or any other interest in the policy, including the death benefit proceeds."

Only one employee has declined to sign the statement, according to Robert C. Bye, the insurance agent who wrote the policies.

"We went to these employees and explained what the program was," said Larry Ryder, Hooker's executive vice president for finance and administration. "We told them that if they had any qualms about it whatsoever we would move on to another person. So there was nothing required that they do."

Referring to the retirement benefits the policies fund, Ryder added: "I've got a large, looming liability out there. I've got to come up with a lot of cash over time in order to meet that obligation. . . . My intention is holding the insurance until the employee passes away . . . , and, over time, I'm going to have a stream of tax-free income that's coming in to help me meet obligations of retiring employees."