Accounting for Life Insurance (#341)
/What is the accounting for life insurance for owners and key personnel?
Types of Life Insurance
To begin, there are two main types of life insurance. One is term life insurance, and the other is permanent life insurance. Term life is purchased for a specific period of time, after which the policy expires with no residual benefit. If you keep taking out successive term life policies, the price will keep going up as you age, because your risk of death increases.
Permanent life insurance charges a steady rate over the life of the policy, which is supposed to cover the entire life of the person being covered. Insurers can charge the same rate over time, because they level out the fees; you’re basically paying more than the rate for a term life policy during the early years of the policy, and you’re paying less than that rate during later years. The other big feature of permanent life insurance is that it gradually builds up a residual cash value over time. Early on, this residual value is pretty small, but it can be substantial after a couple of decades.
So, why would a business take out life insurance on its owners or key personnel? Well, that’s because it might need the cash to keep operations running if one of these people dies. For example, if your top salesperson dies, sales might very well drop until you can find a replacement, which might take a long time.
If you’re going to take out a life insurance policy on one of these people, which policy type should you choose? Generally, that would be term life insurance, because you’re only expecting to need the policy for the next few years, while the person is still an employee.
However, the owner of the business might insist on a permanent life insurance arrangement, because he’s planning to stick around for the rest of his life. Or, the owner might make his own family the beneficiary of the policy, rather than the business.
Accounting for Life Insurance
So, how do we account for these variations? We’ll start with the easy one. Any premiums paid for a temporary life policy are charged to expense. Since the premium is usually paid just once, at the start of the coverage period, it’s initially recorded as a prepaid expense – which is actually an asset. Then, you charge off a sliver of it to expense in each month of the coverage period. By the time the coverage period is over, you’ll have charged the entire amount to expense.
So let’s move to a permanent life insurance policy, where the owner is the beneficiary. The organization is only allowed to record an asset when the asset provides it with a future benefit. Since both the death benefit and the residual cash value go to the owner, the company is not receiving any asset at all. This is really just a benefit expense for the company. That means you’d charge the payment to insurance expense, though a case could be made for charging it to benefits expense, instead.
Now, what about cases in which the business controls the life insurance asset and will be provided by it with a future economic benefit? The death benefit proceeds can be considered a future economic benefit, but there’s uncertainty about when the insured person will die, and whether the policy will remain in force. Given this uncertainty, it’s not possible to recognize the death benefit until it’s actually received, which could be years in the future. However, the cash surrender value of the policy provides a future economic benefit, since it’s the amount that can be realized if the policy is surrendered—and this amount can be calculated.
Therefore, the business records the initial cash surrender value of the policy, and then adjusts this recorded value over time, as the underlying cash surrender value also changes. The difference between the premiums paid during the reporting period and any increase in cash surrender value is recorded as insurance expense. Towards the end of the policy period, which may be years from now, the increase in cash surrender value could be greater than the amount of the premium paid, in which case the difference is reported as income.
Then, once the insured party dies, the company receives the policy payout from the insurer. The excess of this payout over the amount recorded as an asset is reported as income, while the life insurance asset is removed from the balance sheet.
For example, a company takes out a half million-dollar life insurance policy on its founder, where the initial annual payment is for $16,000. Of that amount, $6,000 is recorded as a cash surrender value asset, and the rest as insurance expense. Now, let’s roll forward a couple of decades, when the cash surrender value asset has increased to $150,000, at which point the founder dies, and the company receives the half million-dollar death benefit. In this case, the final entry is a half million-dollar debit to cash, a $150,000 credit to eliminate the cash surrender value asset, and a recorded gain of $350,000, which is a credit.
And that covers all of the variations on how a business accounts for life insurance.