Why Do Businesses Benefit From Life Insurance on Employees?

Buying life insurance on a key employee to protect the business against the loss of that employee is widely accepted as a legitimate business practice. However, many large corporations have taken the practice to extremes by buying life insurance on non-key employees so they can reap the benefits when they die. It may be controversial and morbid, but, within certain limits, it is not illegal.

The practice of buying life insurance on an employee is common and accepted in situations in which a company stands to lose revenue and profits from the loss of a key employee. Often times, a key employee is a major contributor to the success of a company. When a company loses a key employee to a premature death, it can impact revenue if the employee plays a major role in generating that revenue. Not only will the company have to replace lost revenue, it has to expend substantial resources to replace the employee. In these situations, keyperson life insurance is often purchased, with the company named as the owner and beneficiary of the policy.

Larger corporations also purchase keyperson life insurance on senior executives and employees who bring critical human capital to the business. However, many companies expanded the practice to include employees up and down the value chain, including those who sweep the floors and empty the garbage at night. As the owner of these policies, a company collects tax-free death benefits upon the death of the employee. Companies that follow this practice offer as the reason the necessity to use the proceeds to finance the increasing costs of health care and pension obligations. Companies claim that the tax advantages of life insurance make it the most cost-effective way to fund these obligations. However, to outside observers, it simply looks like the company is profiting from the death of employees.

The practice became so widespread that regulators were compelled to step in and draw some boundaries, disallowing corporate ownership of life insurance on all but the highest-paid 35% of employees. In addition, the employees must give their consent. However, for companies the size of JPMorgan Chase & Co. (NYSE: JPM), Wells Fargo & Co. (NYSE: WFC) and Bank of America Corp. (NYSE: BAC), that still includes thousands of employees, and hundreds of corporations engage in the practice. It is estimated that hundreds of billions of dollars of corporate-owned policies are in place, with more than $1 billion added each year. As current and former employees die, the policies can provide the companies with a steady stream of income in perpetuity.

Although the practice is used by companies in most industries, banks stand to gain the most from life insurance proceeds. While many companies claim that the proceeds are necessary to fund current and future obligations, the proceeds can be used for any purpose. Because banks are able to quickly collect cash from life insurance companies in the form of cash value surrenders, their life insurance holdings are counted as Tier 1 Capital, which is a measure of a bank’s financial strength. Some banks have as much as 25% of their Tier 1 Capital invested in life insurance policies. Bank of America has nearly $18 billion in cash surrender values, as of 2016, which it could collect at any time.

When the practice appeared to get out of hand, Congress included some provisions in the 2006 Pension Protection Act for controlling it. In addition to the limitation on which employees can be included, it outlined some best practices for companies to follow. However, lawyers and the Internal Revenue Service (IRS) have been less accommodating, taking many companies to court over claims of employee abuse and the use of policies as tax avoidance schemes. Despite these attempts to penalize the practice, companies and banks continue to benefit greatly from the use of life insurance policies on their employees.