How to Handle the Accounting for Collateral Assignment Split-dollar Life Insurance Plans
By Marc Giampaola, Director, Assurance Services & Michael Parillo, Senior Manager, Managed Services & Consulting
Split-dollar life insurance is an arrangement between two parties to share the costs and benefits of a permanent insurance policy. Often these arrangements are between an employer (the “company”) and an employee (the “executive”), involving a whole life or indexed universal life (“IUL”) policy. Companies generally use the policies as a Supplemental Executive Retirement Plan (“SERP”), which are considered non-qualified benefit plans.
The two most common types of split-dollar life insurance arrangements are endorsement and collateral assignment, which are defined based on which party controls the policy. Within these agreements, there are multiple documents executed, most commonly:
- Life insurance policy – Issued by the insurance company to the policy owner on the life of the insured.
- Split-dollar agreement – Agreement between employer and employee providing details of the agreement.
- Promissory note – A loan issued by the company to the employee for the cost of the policy.
Endorsement split-dollar life insurance is an employer-owned policy that endorses some or all of the death benefits to the employee’s beneficiary. The employer owns and controls the policy and, therefore, makes all policy decisions (i.e., surrender). A separate agreement is entered into between the employer and employee to define the split of costs and benefits between the two parties.
Collateral assignment split-dollar life insurance policies are owned by the employee with some benefits assigned to the employer. The employee owns and controls the policy while the employer makes the premium payments. Premiums are loans to the employee. Some level of interest on the amount borrowed must be paid. The employer is ultimately reimbursed for the premiums paid and related interest from the death benefit or the cash surrender proceeds.
There are different types of collateral assignment arrangements based on the structuring of the note within the agreement. They are as follows:
- Non-recourse arrangements rely solely on the underlying insurance policy for all repayment of principal and interest to the employer. The employee, or the employee’s estate, is not responsible for funding any shortfall by the policy to return the premium and related interest; however, any shortfall could be taxable to the employee as forgiveness of debt income.
- Limited recourse arrangements rely primarily on the underlying insurance policy for all repayment of principal and interest owed to the employer. However, if there is a shortfall, the employee or the employee’s estate may be called upon to make up the deficiency. These arrangements generally have terms requiring the employer to seek payment from the life insurance company first; the employee is secondarily liable.
- Full-recourse arrangements are similar to limited-recourse arrangements, with the difference that the employer can seek repayment of the principal and interest from the employee directly if there is a shortfall, without first pursuing any recovery from the life insurer. The employee has substantially the same net liability for any shortfall but would have the burden of satisfying the shortfall and then pursuing recovery from the policy.
Policies are established with a fixed number of premium payments (generally 7 or 10) that are pre-funded by the employer and, therefore, treated as a single loan to the employee. The employer makes the first premium payment directly to the issuing insurance company and funds the remaining premium payments by either:
- Providing cash to the insurance company and establishing a premium deposit account;
- Establishing a deposit account at a bank or credit union under the employee’s name; or
- Purchasing a single premium immediate annuity (SPIA).
The method of funding has no impact on the accounting, as there is a single loan made to the employee.
Most commonly, companies utilize collateral assignment split-dollar life insurance set up under non-recourse or limited-recourse arrangements. As such, the focus of the accounting section will be on these types of arrangements.
- ASC 310: Receivables (“ASC 310”)
- ASC 325: Investments – other (“ASC 325”)
- Loans and investments, November 2020 Edition (“PwC Loans Guide”)
ACCOUNTING FOR SPLIT-DOLLAR ARRANGEMENTS
The accounting for split-dollar arrangements is generally the same regardless of the structure of the agreement. Additionally, whether the promissory note is non-recourse or limited-recourse has no effect on the journal entries recorded over the life of the arrangement.
Recording the Loan at Issuance
In executing the transaction, the employer provides funding for the premium payments of the life insurance policy in exchange for a promissory note from the employee. The transaction meets the definition of a loan as defined by ASC 310-10, which states:
A contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor’s statement of financial position. Examples include but are not limited to accounts receivable (with terms exceeding one year) and notes receivable.
Upon issuance of the loan, the employer provides cash through one of the funding methods described above and establishes a loan receivable from the executive. As an example, assume the defined loan amount is $3.0 million. The value of the loan is measured at issuance equal to the cash outlay by the Company. ASC 310-10-30-2 states:
As indicated in paragraph 835-30-25-4, when a note is received solely for cash and no other right or privilege is exchanged, it is presumed to have a present value at issuance measured by the cash proceeds exchanged.
In these arrangements, the company does not provide any other right or privilege. The promissory note is received in exchange for the cash needed to fund the premiums of the policy. As such, the value of the loan is equal to the cash paid.
The journal entry to record the example transaction is:
|Dr: Officer Loan Receivable||$3,000,000|
Recording the Interest Accrual
Once the loan is established, it begins earning interest based on the note rate, typically the long-term Applicable Federal Rate for the month and year the agreement becomes effective. Interest compounds annually. In the example transaction, assume an annual interest rate of 2.50%. Each month the company earns interest on the outstanding loan balance, and a journal entry is recorded to accrue interest on the loan. Interest is paid from the death benefit and, therefore, increases the receivable from the executive in each accounting period. The entry below represents the monthly accrual of interest:
|Dr: Officer Loan Receivable-Accrued Interest||$6,250|
|Cr: Interest Income||$6,250|
(calculated as $3,000,000 loan * 2.5% interest / 12 months)
Recording the Settlement of the Loan
The loan is settled upon death or surrender of the policy. The company is entitled to the value of the original loan and accrued interest from inception. The cash owed to the company is paid from the death benefit or surrender value, with the remainder being paid to the employee (surrender) or the employee’s estate (death). Based on the example, assuming settlement and surrender of the insurance policy 24 months post entering into the policy (i.e., $150,000 interest earned), the entries to record the receipt of cash and settlement of the receivables are as follows:
|Cr: Officer Loan Receivable||$3,000,000|
|Cr: Officer Loan Receivable-Accrued Interest||$150,000|
Other Considerations for Subsequent Measurement
At each period-end, the company needs to analyze the value of the outstanding loan for changes in the valuation. Generally, these loans are considered not held for sale and, therefore, are reported at outstanding principal adjusted for any charge-offs, allowance for loan losses, deferred fees, and unamortized premiums or discounts based on ASC 310-10-35-47, which states:
Loans and trade receivables that management has the intent and ability to hold for the foreseeable future or until maturity or payoff shall be reported in the balance sheet at outstanding principal adjusted for any chargeoffs, the allowance for loan losses (or the allowance for doubtful accounts), any deferred fees or costs on originated loans, and any unamortized premiums or discounts on purchased loans.
Additionally, the company should analyze at each period-end any probable collection issues and the need for an allowance that would reduce the asset balance.
Value of the Loan
With an insurance policy securing the loan, further consideration is needed to determine the value of the loan. For endorsement arrangements, the employer owns the policy and, therefore, owns the surrender decision. The company values the loan at the lesser of the premiums paid or cash surrender value of the policy as of the period end date. This amount can generally be obtained from the statement provided by the insurance company.
For collateral assignment arrangements, the employee owns the policy, so the company does not control the surrender decision. However, the company does maintain the right to collect on the loan under the collateral assignment. Therefore, the company may need to consider the cash surrender value of the policy when determining the value of the loan. ASC 325-30-35-1 states:
An asset representing an investment in a life insurance contract shall be measured subsequently at the amount that could be realized under the insurance contract as of the date of the statement of financial position…
Depending on the type of note used in the agreement–non-recourse or limited-recourse– when determining the carrying value of the loan at each period-end.
For limited-recourse, the loan is secured by the cash surrender value of the insurance policy, but the company also has the option to seek repayment from the employee if the cash surrender value is less than the outstanding loan amount. Since the loan is secured by both the policy and by the employee, the cash surrender value is not the only consideration when determining the value of the outstanding loan. As such, the value of the outstanding loan does not need to be adjusted if the cash surrender value is less than the outstanding loan, and there is no further consideration needed at period-end for these types of arrangements.
For non-recourse notes, the loan is secured solely by the cash surrender value of the policy and, therefore, potential for a loss related to the loan exists if the cash surrender value is less than the loaned amount. The cash surrender value is the realizable amount of a life insurance contract at any given date. The accounting guidance does not allow a life insurance asset to exceed cash surrender value less an allowance for credit losses. The company is entitled to the premiums paid plus interest earned under these arrangements. The carrying value of the portion of the loan for which premiums were paid would need to consider the cash surrender value. This portion of the loan would be valued by the company as the lesser of the cash surrender value and the cumulative premiums paid by the reporting entity.
This is based on the premise that surrender is not within the control of the company and it is uncertain whether the company will be reimbursed for cumulative premiums paid upon death or surrender. Any premiums paid in excess of this amount should be recorded as an expense.
As an example, if the outstanding loan related to a non-recourse policy was $3,000,000 and the cash surrender value of the policy was $2,500,000, the company would need to reduce the carrying value of the loan to the cash surrender value and recognize a loss related to the loan. The entry below represents how the company would record the adjustment:
|Dr: Loss – Officer Loan||$500,000|
|Cr: Officer Loan Receivable||$500,000|
While the general accounting for these arrangements is similar, specific details and terms within all documents included in the agreement need to be evaluated when determining the appropriate accounting, and companies should consult their accountant with any questions. Additionally, there are potential individual income tax implications for the executive related to these arrangements that should be considered.