Company-Owned Life Insurance in Business Combinations and Goodwill Testing

By Hugo Nurnberg

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MARCH 2005 - According to a 2002 series of Wall Street Journal articles by Ellen E. Schultz and Theo Francis, an important source of income for hundreds of public companies is death benefits from company-owned life insurance (COLI) on company employees. [When the companies are banks, the policies are called bank-owned life insurance (BOLI).] The articles noted that companies buy life insurance on thousands of present employees, former employees, and retirees. The anticipated increase in business combinations, especially by banks, increases the need for guidance. FASB is currently developing an exposure draft on purchase accounting procedures in business combinations; its deliberations have not included COLI of acquired companies.

There are at least two methods to account for COLI policies acquired in business combinations under existing GAAP. One is to recognize an acquired COLI asset at fair value, followed by immediate write-down to cash surrender value (CSV). The other is to recognize an acquired COLI asset at CSV as well as an additional intangible asset equal to the difference between fair value and CSV at acquisition. Although FASB staff unofficially favors the first method, the second method is more consistent with purchase accounting. Both methods are acceptable in applying the purchase price allocation method for goodwill impairment testing.

Background

For years, many companies owned life insurance policies on essential employees, especially top executives holding significant ownership interests. Such key-employee life insurance was designed to provide the means to buy back the shares of these employees upon death or otherwise compensate companies for the loss of the employees’ services. These insurance arrangements are prevalent in nonpublic companies that have a buy/sell agreement or where the surviving shareholders wish to keep control within the management group. Additionally, lenders sometimes require a borrower to maintain COLI on key employees in order to protect the lenders’ interests.

Starting in the 1980s, many public and nonpublic companies began to purchase COLI on nonessential employees, such as low-level managers, clerks, and janitors, often without the employees’ knowledge or consent. Such COLI investments can be motivated mainly by the tax benefits from tax-free interest income accruing on CSV and the death-benefit proceeds on COLI. Some companies earmark COLI death benefits for employment or postretirement benefit programs, but this earmarking is not legally binding, and is reversible at management’s discretion.

For example, according to one of the aforementioned Wall Street Journal articles, 150 to 200 of the nation’s 600 publicly traded banks have purchased tens of billions of dollars at face value of life insurance on their employees. One insurance broker arranged COLI policies for a number of banks with a face value of $35 billion, covering 79,000 employees, and averaging more than $400,000 per employee. Some large companies do not disclose the extent of their COLI policies, on the basis of immateriality. Even when companies disclose the face value of COLI, they often do not disclose the effect on earnings. For example, Mellon Financial Corp. disclosed in a Wall Street Journal interview that the face value of all its COLI policies is $3.2 billion and contributed $75 million to 2001 net income, but it disclosed neither amount in its published financial reports. On the other hand, in its 2001 Form 10-K, Sovereign Bancorp, Inc., reported $42,671,000 of BOLI other income, or 34.6% of its $123,370,000 net income after taxes before extraordinary items for 2001. Such information is important to investors to determine the portion of earnings from central operating activities versus COLI.

Authoritative Accounting Guidance for COLI

FASB Staff Technical Bulletin 85-4, Accounting for Purchases of Life Insurance (TB 85-4, 1985, paragraphs 2 and 4), prescribes the CSV method to account for COLI, whether the purchaser is the policyholder or the beneficiary. Under the CSV method, the CSV or the amount realizable under the insurance contract is an asset. COLI expense equals the premium paid less the increase in CSV for the period, with an asset reported for the CSV; COLI income results when the premium paid is less than the increase in the CSV for the period. Technical Bulletin 85-4 (1985, paragraph 10) reasons that the current capacity to realize contract benefits is limited to CSV as specified in the insurance contract; it explicitly rejects other methods that report amounts in excess of CSV as assets. It also notes that the CSV method should be used whether the COLI is intended to meet loan covenants or to fund deferred compensation agreements, buy/sell agreements, or postemployment death benefits.

EITF Issue 88-5, Recognition of Insurance Death Benefits (1988), largely reaffirms the CSV method of Technical Bulletin 85-4. EITF 88-5 notes that the death benefit is not realized prior to the actual death of the insured. Accordingly, it concludes that recognizing death benefits on a projected actuarial expected basis, rather than upon the actual death of the insured, is not an appropriate method for recording income from COLI death benefits or for measuring the COLI asset.

Most companies offset COLI loans against CSV, and report only the net amount among other assets. APB Opinion 10, Omnibus Opinion—1966, and FASB Interpretation 39, Offsetting Amounts Related to Certain Contracts, permit but do not require such balance-sheet offsetting when a right of setoff exists. Some companies disclose the CSV and the loans against the CSV at each balance-sheet date; others do not.

COLI Assets Acquired in Business Combinations

Under current GAAP, the accounting for assets acquired and liabilities assumed in a business combination is subject to SFAS 141, Business Combinations. The subsequent accounting for goodwill and other intangibles is subject to SFAS 142, Goodwill and Other Intangibles.

Initial purchase price allocation. Under SFAS 141, an initial purchase price allocation is used to measure and recognize assets acquired and liabilities assumed in a business combination. Assuming positive goodwill, the purchase price allocation involves subtracting amounts assigned to identifiable assets acquired minus liabilities assumed from the purchase price, with the residual recognized as goodwill. Amounts assigned to identifiable assets acquired minus liabilities assumed generally equal their fair values. Exceptions are made for the following:

  • Deferred tax assets and liabilities;
  • Unfunded (overfunded) projected pension benefit obligations (assets);
  • Unfunded (overfunded) accumulated other postretirement benefit obligations (assets); and
  • Preacquisition contingencies.

SFAS 141 does not specify the initial recognition of COLI assets acquired in business combinations. Therefore, the general guidance of SFAS 141 and SFAS 142 applies. COLI assets should be measured at fair value, following SFAS 141, paragraph 7, in applying the initial purchase price allocation, and following SFAS 142, paragraphs 23–24, in determining the fair value of identifiable net assets.

SFAS 142 defines the fair value of an asset as the amount at which the asset could be bought or sold in a current transaction between willing parties, and notes that the best evidence of fair value is quoted market prices in active markets. Because COLI policies are not negotiable, however, and are not typically bought and sold, they do not have quoted market prices in active markets. (Unlike COLI, there is a growing secondary market for certain individually owned life insurance policies. The terminally ill and chronically ill may sell their own policies, as may other insured individuals 65 and older, at a discount from maturity value but substantially above CSV.) Accordingly, following SFAS 142, companies should estimate the fair value of COLI policies based on the best information available, including prices for similar assets and liabilities and the results of other valuation techniques. SFAS 142 notes that the best information available includes assumptions of marketplace participants outside the company. But if that information is not available, a company should use its own assumptions. It also says that present value techniques are often the best available way to estimate asset fair value. Otherwise, SFAS 142 provides little additional guidance in determining fair value and whether companies should obtain outside appraisals.

When a COLI policy will be held to the death of the insured, using the present value of expected future net cash flows to estimate fair value means using the discounted value of expected future death benefits. For a COLI policy covering only one or a few key executive employees, this is difficult if not impossible to accurately estimate; net CSV (i.e., CSV less loans against CSV) may be the best estimate of fair value. Clearly, net CSV is the lowest value at which the company as policyholder would dispose of a COLI policy. Some companies (e.g., Carpenter Technology Corporation, 2002 Form 10-K) report that COLI fair value equals CSV. Similarly, other companies (e.g., Coachmen, 1997 Form 10-K) report that COLI fair value equals carrying value, which in turn equals CSV less loans against CSV.

For a COLI policy covering a large group of employees, on the other hand, CSV is not the best estimate of fair value. SFAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, notes in paragraph A24 that CSV does not equal the fair value of COLI policies. It also notes that COLI policies are hybrid financial instruments with a host contract and an embedded derivative, neither of which is remeasured at fair value. Typically, a separate accounting is required for such hybrid financial instruments, under SFAS 133, Accounting for Derivative Instruments and Hedging Activities. For practical reasons, however, SFAS 149, paragraph 10(g), amends SFAS 133 to exempt COLI policies from this separate accounting requirement. Accordingly, the accounting for COLI policies continues to conform to the CSV method of Technical Bulletin 84-5.

With a large group of employees, fair value should be estimated as the present value of actuarial expected future death benefits based on actuarial assumptions concerning group longevity. Unlike individuals and small groups, actuarial assumptions concerning large group longevity are reasonably accurate. Accordingly, the present value of actuarial expected death benefits can be estimated with reasonable accuracy, and is the best estimate of fair value. Typically, the present value of actuarial expected death benefits exceeds CSV, although not necessarily by much. Companies making acquisitions of other companies with COLI assets presumably have sufficient information to estimate COLI fair value.

SFAS 141 and SFAS 142 are Level A GAAP and take precedence over Technical Bulletin 84-5, which is Level C GAAP. (Technical Bulletin 84-5 addresses the acquisition of COLI policies directly from insurance companies, not incident to business combinations.)

Accordingly, COLI policies acquired in business combinations should be recognized initially at fair value, not CSV. Neither SFAS 141 nor SFAS 142 addresses the accounting for COLI assets subsequent to the combination.

It follows that GAAP provides conflicting guidance with respect to COLI assets acquired in business combinations: recognize them at fair value at the combination date consistent with SFAS 141, but report them subsequently at CSV consistent with Technical Bulletin 85-4. There are at least two possible ways to resolve this conflicting guidance:

Immediate write-down. Recognize COLI assets at fair value at the combination date, followed by immediate loss recognition and write-down to CSV. According to Jeffrey Cropsey, a FASB senior project manager specializing in insurance accounting, this is the unofficial FASB staff recommendation for viatical firms. (Viaticating is the process where a terminally ill person, the viator, sells his life insurance policy to a viatical firm for a percentage of total face value, invariably more than the CSV.) For example, in its fiscal 2002 Form 10-K, Life Partners Holdings Inc. reported that it reduced its investment in life insurance policies to CSV, and charged the difference between cost and CSV to expense.

Despite the unofficial FASB staff recommendation, however, this method is inconsistent with purchase accounting, whether for a business combination or for acquiring viaticated life insurance policies. (Strictly speaking, this FASB staff position applies only to acquiring life insurance policies by viatication, not to acquiring COLI policies in business combinations.) For both situations, purchase accounting presupposes an exchange of consideration of equal value. This is the justification for capitalizing the entire purchase cost as an asset. To require expense recognition of part of the purchase cost of either COLI or viaticated policies is inconsistent with presupposing an exchange of consideration of equal value.

An exception to capitalizing the entire purchase cost is expensing the cost of in-process research and development acquired in business combinations under FASB Interpretation 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method. This exception is motivated by the controversial but well-understood limitations of the prescribed accounting for research and development costs under 1974’s SFAS 2, Accounting for Research and Development Costs. Mandating another exception to capitalizing the entire purchase cost of COLI assets is questionable and unsupportable. Additionally, FASB has tentatively decided to eliminate this inconsistency by requiring the capitalization of the cost of in-process research and development acquired in business combinations.

Recognize two assets. Recognize an acquired COLI asset at CSV, and recognize an additional intangible (COLI) asset for the difference between COLI fair value and CSV at the combination date. The additional intangible asset would be suitably described as contractual rights to potential death benefits in excess of CSV. Subsequent accounting for the COLI asset would conform to Technical Bulletin 85-4. Subsequent accounting for the additional COLI intangible asset would involve amortization under SFAS 142 and impairment testing under SFAS 144, Accounting for the Impairment or Disposal of Long-lived Assets. Amortization would require determining something akin to a contractual life. This method is fully consistent with presuming an exchange of consideration of equal value under purchase accounting, the justification for capitalizing the entire purchase cost. Accordingly, it is preferable to immediately write down to CSV at acquisition of the excess of fair value over CSV.

A conceptually superior third alternative would be to initially measure acquired COLI policies at fair value, with subsequent changes in fair value included in net income. This alternative would result in reporting the most relevant measure of value (i.e., fair value) and would avoid some of the practical problems presented by the two alternatives available under existing GAAP. This method, however, is prohibited by Technical Bulletin 85-4.

Effects of COLI Valuation on Goodwill Impairment Testing

Under SFAS 142, goodwill is tested for impairment at the reporting unit level through a two-step process. Step 1 involves comparing the fair value and the book value of each reporting unit. If fair value is greater than book value for the reporting unit, goodwill is not considered impaired, and Step 2 is not required. Step 2 involves recognizing a goodwill impairment loss for any excess of book value over implied fair value. Goodwill implied fair value is calculated in the same manner as goodwill is calculated at acquisition (i.e., using a subsequent purchase price allocation).

The subsequent purchase price allocation involves subtracting amounts assigned to all net identifiable assets (including unrecognized intangible assets and in-process research and development costs) from the estimated fair value of the reporting unit as if the reporting unit had been acquired in a business combination and its estimated fair value was the “purchase price.” As in the initial purchase price allocation at acquisition, with four specified exceptions, amounts assigned to identifiable assets and liabilities are their individual fair values. The implied goodwill of a reporting unit equals its estimated fair value less amounts assigned to its net identifiable assets.

COLI assets are not an exception in the initial purchase price allocation under SFAS 141, nor in the subsequent purchase price allocations under SFAS 142. Accordingly, the general guidance of SFAS 142 governs the estimate of the fair value of COLI policies for goodwill impairment testing. COLI policies for a large group of employees that will be held to the death of the insured should be valued at estimated fair value (i.e., the present value of actuarial expected future cash flows), not at CSV, in the subsequent purchase price allocation for goodwill impairment testing. However, the subsequent purchase price allocation in SFAS 142 is used solely for goodwill impairment testing and recognition, not for recognizing and valuing identifiable assets or liabilities in the accounts. It follows that using fair value of COLI assets for goodwill impairment testing does not conflict with the Technical Bulletin 85-4, prescribed valuation of COLI assets at CSV.


Hugo Nurnberg, PhD, CPA, is a professor of accountancy in the Stan Ross Department of Accountancy of the Zicklin School of Business of Baruch College, City University of New York.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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