Accounting for key employee life insurance depends on the type of policy. Term insurance premium payments represent a pure current expense. Such costs should be charged against income rather than retained earnings.
Insurance premiums paid on a permanent (cash value) type of policy are bifurcated. To the extent a premium payment generates an increase in the policy’s cash value, a charge should be made to an asset account. To the extent the premium paid exceeds the increase in the policy’s cash value, a charge should be made to expense.
The firm’s balance sheet should show policy cash values as a non-current asset. When an insured dies, the gain upon the receipt of the insurance payment is typically reflected as a special entry for nonrecurring amounts on the Annual Statement of Operations. Alternatively, a corporation’s gain on the receipt of death proceeds may be carried directly to the Retained Earnings Account.
It is the opinion of the authors that the method of accounting described above is antiquated and does not reflect the economic reality of the transactions over time considering the present products and riders available to businesses in the late 1990s and early twenty-first century.
An alternative method of accounting, called the ratable charge method, seems to provide a more realistic approach and has been used by a number of accounting firms even though it is not officially accepted. In essence, under the ratable charge method total premiums to be paid over a predetermined period (such as for ten years or to age fifty-five) are determined on the assumption that the insured is likely to live and will continue to remain an employee of the business that long. The guaranteed cash surrender value at the end of the selected period is then subtracted from the total premiums to be paid. The result is a net cost which is then amortized (ratably) as a level annual charge over the premium paying period.
This prime assumption upon which the ratable charge method relies becomes more likely if the policy in question contains what is often called a policy exchange rider, which is an option the client’s firm has to continue the policy on another life if the insured employee should decide to leave the firm. In other words the company could substitute a new key employee for the one no longer employed. (In most cases the rider allows the exchange with no additional costs to the client’s company.) The existence of an exchange rider would seem to offer an answer to the criticism that if the policy is discontinued prior to the end of the selected premium payment period, the ratable charge method would result in a large write-off of an unamortized deferred charge.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM