More than 30 million small business owners in the U.S. are tasked with meeting industry regulations while protecting their businesses for long-term success. If in an industry that requires a surety bond, such as contracting, landscaping, or HVAC services, some owners may benefit from using a Corporate Owned Life Insurance (COLI) to fulfill their bonding obligations.

Doing so allows them to use their bonding assets to accomplish other business goals, such as protecting their business using key person insurance, supplementing their retirement savings or succession planning, and more.

Background on Corporate-Owned Life Insurance (COLI) and bonding requirements

Some companies must hold cash or liquid assets as a financial assurance that they will fulfill business obligations or meet industry regulations. These bonding or surety requirements are usually met in one of two ways:

• By holding the requirement in cash or a liquid asset; or
• By paying a premium to a surety company to guarantee the bond amount. 

Payments on surety bonds, typically a percentage of the bond amount, can be significant and strain a business’ cash flow, and premiums paid to a surety company are generally not recoverable. 

But business owners who are subject to surety requirements and have a need for life insurance may be able to leverage COLI as a bonding asset through a process called “collateral assignment,” where the policy’s cash value or death benefit can be used as collateral for the bond.

Potential use-cases for life insurance in a business scenario

The optimal situation for using COLI as a bonding asset occurs when a business has another protection need that life insurance fulfills, such as:

1. Mitigating key person risk: When a business is concerned about the financial impact of potentially losing a crucial team member, such as a founder or executive, a key person policy can cover the costs of recruiting and training a suitable replacement, offset potential revenue losses, and provide financial security during the transition period. 
2. Providing additional benefits to key employees: When a business wants to provide compensation outside of an executive’s salary and bonus, a corporate split dollar plan shares the costs and benefits of a permanent life insurance policy on an employee. Upon the employee's death, the death benefit is split between the employer, who recovers their share of the premiums paid, and the employee's designated beneficiary. 
3. Accounting for business continuation: Buy/sell arrangements fund a smooth transition in cases where the owner is unable to run or wishes to exit the business. Here, insurance proceeds enable remaining owners to buy out the affected owner's share.

While term insurance can be used to protect a business in some of the above scenarios, such as in a key person arrangement, businesses can elect to purchase a permanent life insurance policy to use the cash value of the policy as a bonding asset. 

Structuring COLI for bonding purposes

In an arrangement where COLI is used to meet bonding requirements, the business would be both the owner and beneficiary of the life policy. The cash that the business holds for bonding purposes is used as the source of the policy premium.

This has little impact on the corporate balance sheet in the early years, as cash value accumulates in conjunction with the premium paid. The cost to the business of funding the policy is offset by the cash value of the plan, which is shown as an asset on the balance sheet. 

Case study: COLI helps meet bonding and key person requirements

Ethan is a 40 year old business owner in preferred health. He is currently spending $50,000 per year to meet surety requirements.

Ethan may be able to use the committed cash to also serve a protection need for the business, such as purchasing key person insurance in order to hedge against the possibility that he is unable to run the business. Doing so would enable him to continue to meet the business’ surety requirements, while also conferring a benefit to the business.

If he were only interested in purchasing key person insurance, Ethan could use a term policy. However, since a term policy doesn’t have a cash value, he opts to purchase a permanent policy, which is a liquid asset that can be used as collateral to meet surety requirements. If he chooses, he can also use the policy as a retirement supplement to transition out of the business in the future.

The table below illustrates Ethan’s contributions to the policy ($50,000/year):

‍Investing in a permanent policy in this case would:

• Yield an ongoing death benefit of $721,128;
• Allow the premium payment to be recognized as cash value immediately; and
• Grow the cash value through Year 20, increasing the value of the asset to the business while still serving as a bonding asset.

Next steps

A permanent life policy can generate long-term cash value for the bonding asset, in addition to serving a number of potential uses for the business, such as helping with succession planning via buy sell coverage or protecting the business with a key person policy.