Business Insurance
Key Person Insurance
Chapter Nine
A business operation often has one or several people who are vital to the smooth operation of the company. In some cases, loss of a key person could actually cripple the company temporarily.
Good insurance planning is necessary in all business functions, but loss of key personnel may be critical to the company. The objective of business life and health insurance is either to maintain a business as a going concern or to retain the values of the business interest for the benefit of the estate following the death (or even disability) of the owner, stockholders, or other key people. Insurance is often used to protect the surviving members of the business where the loss or disability of a partner, stockholder or key employee could:
Adversely affect who controls the company,
Dissolve the business entirely, or
Adversely affect the companys value.
In a closely held business, numerous relationships exist, which must be considered. The deceaseds family must be financially protected, the business must be able to continue to operate (assuming others wish to do so), and there must be sufficient funds to operate effectively. The death or disability of the owner in an individual proprietorship, or one of the owners in a partnership or a small corporation, or of a key employee calls for major financial adjustments, some of which will require up to a year or two to fully complete. Without adequate funds the disabled person, the deceased owners estate, the position of survivors, or a combination of these, may be adversely affected. Certainly careful planning is required, which may require the skills of a business attorney. It is necessary to have legal agreements to ensure that those most able to control and run the company are able to continue doing so without interference from family or other associates that may desire control. It is unlikely that this could be accomplished without the use of insurance.
Buy-And-Sell Agreements
A Buy-And-Sell Agreement (also known as a Buy-Sell Agreement or a Purchase-and-Sale Agreement) is a legal document used to protect the interest of a deceased or disabled member, while also protecting the interest of surviving or healthy members. It is a contract that provides a positive market for the interest of the deceased or disabled person and a guarantee to survivors of its purchase at a reasonable price with the funds available for payment within a reasonable length of time. It is a form of business continuation contract.
The exact details of a buy-and-sell agreement will vary based on the needs of the parties involved. It will also vary based upon the type of company or business organization involved. The names of all parties will appear in the agreement and the purpose of it will be detailed in legal terms. The buy-and-sell agreement may specify the purchase price in dollars or it may simply state a specific formula to be used to arrive at a purchase price. For example, in the case of real estate a fair purchase price today may not be fair in twenty years. Therefore, a formula would be stated, such as an appraisal price. All parties must legally commit to the plan for the purchase of the interest of the deceased or disabled associate. The method of financing does not have to be through a life or disability policy, but that is a common way of doing so. When insurance is used, the method of financing by use of life or disability income insurance is set forth and provision is made for changing the amounts of insurance, when necessary.
It is important to note that there is a provision for changing the amounts of insurance. This would especially be necessary for a change of position within the company. For example, a disability amount of $2,000 per month may be adequate when the contract was designed but ten years later it would be inadequate based on the persons contributions to the business. Therefore, it would be necessary to upgrade the policy to the monthly amount contributed by the owner or employee.
Beneficiary arrangements determine whether the proceeds are to be payable to a trustee who will carry out the transfer or payable directly to the person who, under the agreement, must acquire the business interest of the deceased. A disability income policy is most likely to be payable directly to the person who was disabled while a life insurance policy may be payable to the heirs, to the company, or to the person who will be buying the deceaseds interests. There are many details involved in such a transaction, such as debts and the rights of termination, withdrawal, or amendment. The agreement has important benefits for estate tax purposes if it is properly executed. It will set the taxable values of the business interests for the estate, which may prevent delays in probate. Life and health insurance policies are filed with the agreement. Details are given as to the disposition of the insurance on the life of the surviving associates, as are the rights and privileges under the policies used during the lifetime of the insured. The ownership of the contracts may be by the business firm, by the individual partners, or by a trust, depending on the particular business needs or situation.
It cannot be stressed enough that a well drawn up buy-and-sell agreement is worth whatever the attorney may charge. A poorly drawn document is a waste no matter how little was charged. The carefully drawn agreement, implemented with life insurance, precludes misunderstanding and provides that the interest of a deceased or disabled associate will be purchased at a fair price. Life and health insurance can be used to make this financially possible at the time of need.
Key Person Principle
The principles underlying key person life and health insurance for one or more individuals of particular value to the company are primarily the same, regardless of its legal form. The objective of key person insurance is to insure the loss of services caused by the death or disability of a vital employee and to provide resources with which to secure a successor in a competitive market. The insurable value may be determined by estimating the portion of the profits for which the key person is responsible, the cost of replacing and retraining an individual to step into the shoes of the key person, or the investment that might be lost by the firm. The life and health insurance purchased to cover these costs may be payable to, and be paid by, the organization that would be affected by the loss. The premiums are not typically deductible, but at the death of the key person the proceeds paid to the organization are not taxed as income either.
Insurable Interest for Life Insurance
Even though the life insurance contract is not one of indemnity, it still requires that there be an insurable interest between the policyowner and the person insured. An insurable interest is only required at the time of purchase, not at the time of death. Therefore, it is possible to maintain the policy even after the key person is no longer key to the companys smooth operation.
The doctrine of insurable interest is broader in the field of life insurance than in any other field of insurance. Some state statutes apply and court cases vary considerably. Generally speaking, however, so far as a persons own life is concerned, there is no monetary limit. In other words, if people are purchasing life insurance on themselves they may purchase whatever amount they desire. Since suicide is excluded in policies for a specified time period, the policy would not pay if the insured killed him or herself in the early policy years. As a result, it is not necessary to limit the monetary amounts of the policy. Additionally, the courts have held that any person has an insurable interest in his or her own life for any dollar amount.
To establish insurable interest in other relationships there must be pecuniary (financial) interest in the continuance of the life of the insured. In some cases, this interest is obvious. For example, the financial interest between a husband and wife is presumed since they both contribute to the relationship. Actual pecuniary loss resulting from the death of an insured, as well as the expectation of future contributions to the business must be established in key person insurance.
A substantial amount of life insurance is written insuring the life of a partner in a business entity since a partner is obviously a contributing member of the company. Typically the proceeds, should the person die, is paid to the company but it may also go to surviving partners if it would mean a financial loss to them personally. Some key person policies are set up to enable the surviving partners the ability to buy out the interest of the deceased from their family members or beneficiaries.
For example:
Tyrone and Aaron have established an insurance agency together. Each of them contributes by making business decisions, but also by the policies they write. When they formed the company, they decided that half of the commissions on each policy written would be given to the agency to further future growth through advertising, office help, and general overhead (rent, utilities, insurance, and so forth). Although this was a general agreement between them, there is no written requirement. Therefore, if one or the other of them died, their beneficiaries would inherit the full commission renewals that are generated. Therefore, unless the remaining partner can manage sufficiently on their own, it may be wise to purchase key person insurance on each of them for the benefit of the other.
Some employees are key to the continuance of the company. In the case of employees, insurable interest is dependent upon the value of the employee to the business. Any employee who could be easily replaced would not be considered insurable as a key person to the company. However, employees who occupy key positions, such as company president, executive officers, or department heads may be difficult to replace. This might especially be true of employees with specific company knowledge that would not generally be held by a new employee no matter how well educated the new person may be. If there is any doubt regarding an insurable interest, it is possible for the employee to purchase the policy rather than the employer. The employee would designate the company as the beneficiary and the employer would pay the premiums on the life insurance policy.
An employee who merely quits would not qualify the company for benefits under the life insurance policy. Only the death of the insured would trigger benefit payment.
Many small corporations are closely held. What is a closely held corporation? A closely held corporation is one where all company stock is held by only a few people (sometimes all stock is held by only two people). Where stock is closely held the lives of primary stockholders may be insured, with the proceeds to be used to buy the stock of the deceased stockholder. This enables the deceased stockholders family to have immediate access to cash and it enables the company to continue without worry of interference of those who may not have the best interest of the company at heart. When life insurance proceeds are designated to purchase the rights of the deceased, there is usually some legal agreement also in place to ensure that the beneficiaries do, in fact, sell the interest to the company.
There may be non-monetary losses if an important company person dies. If non-monetary interests may be established, this is usually sufficient in place of a financial interest (although typically both a monetary and a non-monetary interest exists). Non-monetary interest usually relates to a reasonable expectation of future financial benefits.
Health Insurance on Key Employees and Owners
Companies often overlook key person health insurance. This is unfortunate since an individual is much more likely to be disabled than die. A disability is just as disrupting to the business as a death since the person is then unable to perform his or her duties. In fact, it may be twice as costly to the company since the person is (1) unable to perform his or her duties, and (2) the company must hire someone to take their place. The objective of key person insurance is to insure the loss of services, not the loss of life. Therefore, it makes no difference whether the loss is due to death or disability. While we often consider disability as payment to the disabled person, in this case it may be payment to the company as well as payment to the employee that has become disabled. It could even be payment only to the company, not to the employee.
For Example:
Jose performs all the software programming for ABC Company. Jose is the only employee with the experience and technical training to provide the type of services ABC Company requires. ABC Company purchases both death and disability insurance on Jose with the business listed as the beneficiary on both policies. If Jose wishes to protect his family as well, he must purchase insurance on his own. ABC Company is only purchasing coverage to protect the business organization from the loss of his services.
In our example, ABC Company was protecting the company from the loss of Joses services. The company was not attempting to protect Joses family from his loss of income. As we have stated, the objective of key person insurance is to prevent financial loss to the company resulting from the loss of employee services due to death or disability. It is not necessarily designed to protect the family of the employee. Furthermore, it provides the resources necessary to secure a successor in a competitive market. Even if ABC Company can hire a successor to Jose, the company would still have to train him or her. During the time that the individual is being trained, he or she may not be able to properly perform the duties, which may also cause a loss of income to the company. The income provided to ABC Company from the key person insurance will replace their lost revenues.
When purchasing this type of coverage, the business must determine what their potential losses will add up to. The insurable value may be determined by estimating the portion of the profits for which the key person is responsible, the cost of replacing and retraining the key person, or the training and experience investment lost by the business entity (or all of the above). The life and health insurance purchased to cover these costs is often payable to, with premiums paid by, the organization itself. Disability premiums, like life insurance premiums, are not typically tax deductible. Also like the life insurance premiums, income realized from the disability policy would not be taxed to the company as income.
Like life insurance key person insurance, when a company is purchasing disability on key personnel, there cannot be any doubt that the individual is vital to the organization. While some, like the company president, would be obvious others may be less so. For example a top salesperson with many personal clients would be vital to the company. If this individual were disabled, it could be very difficult to transfer his or her clients over to another salesperson; it might even prove impossible. The clients might end up changing over to another company entirely. Therefore, the potential financial loss to the company could be severe.
The types of people that are key to an organization will, of course, depend upon the business type. The agent who markets disability insurance must be aware of the many types of people that make up a company. Key employees can include such diverse positions as officers, stockholders in small closely held corporations, engineers, chemists, researchers, positions of management, or any other person that financially affects the company and who is not easily replaced. In some cases, a key employee may not be immediately recognized. For example, consider an auto sales company that has a recognizable advertising person. If the individual that consumers frequently see on television advertisements suddenly dies, will that affect future sales?
While key person insurance traditionally is purchased for the safety of the company, it can also be used to attract and keep key personnel. Due to income taxation, an increase in salary may be less attractive than a plan that would provide a continuation of salary for a number of years following death or disability. Often a combination of coverages is provided: indemnity to the organization for the loss of the employees services as well as salary continuation for the employees dependents. Agents who market key person insurance will find a field ready for their expertise, especially if he or she is experienced in the full use of such policies. If the agent is also able to market group policies for life and health benefits, then he or she becomes a valuable member of the companys professionals, taking a position along with their attorney and accountant.
The Small Companys Exposure
It is easy to recognize the financial exposure large companies face when they lose key personnel. Unfortunately, this financial exposure is not always recognized in small companies. Reduced revenues are just as devastating (perhaps more so) is small organizations. As an insurance agent, the key person is certainly you. For the insurance agent, if he or she is no longer able to market and sell insurance policies who will replace his or her income? This is the case in all small one or two-man companies. Reduced revenues and increased medical expenses often come together when a disability happens. If no one is bringing in continued policy sales, how will the insurance agents family cope with his or her death or disability?
Loss of the Small Business Owner
Even when a company has additional employees besides the owner it is likely that it is the owner that keeps the business going. Owners often supply not only business capital (such as commissions through the sale of policies) but also their time and talents. Even if another agent could be hired by the owners family to continue marketing policies, it is unlikely that he or she would do so with the continuation of the company as their primary concern. Therefore, it may be impossible to actually replace the owner and primary salesperson of the company. The family may be forced to sell or close the company as a result.
Over 90 percent
of the business units in the
The sole proprietor death or disability places several decisions at the doorstep of his or her family:
1. Should the business be sold?
2. Can the business be sold? There are some types that do not readily find a buyer since the company would not be profitable once the owner has died or become disabled.
3. Can the agents family continue the business without his or her expertise or salesmanship?
4. Is it possible to hire individuals with the ability to carry the business forward?
5. Are there other family members both able and willing to step forward and carry on?
The primary decision is simple: liquidate the business, continue the business, or sell the business. Once that decision has been reached, other decisions will then follow, but nothing can be considered until the first question is answered. In many proprietorship companies the owner is the reason the business exists. Without him or her, the company cannot continue. Even if someone can be hired, it means an extra expense for the company since income must now be generated not only for the owner or the owners family, but also for the people they are now forced to hire. Revenues are likely to decline because the companys recognition came from the owner who is now unavailable to current clients. There will be a quantity of clients that move to other companies as a result.
Sole proprietorships should plan ahead if possible by having a buy-and-sell agreement in place. Of course, this is not always possible since a ready buyer may not be available without the availability of the owner being present (since he or she is the reason the company succeeds). However, if the company could continue without the present owner, a buy-and-sell agreement may prevent some of the problems that would otherwise exist for the owners family. It is often a key employee that would be interested in buying the business. An insurance policy put in place would supply the funds allowing the key employee to acquire the business should the owner die or become disabled.
Of course, sole proprietorships are not the only small companies that suffer when the owner or primary owner dies. The same is true for closely held corporations and partnerships.
The legal relationship between partners is a personal one, and includes husbands and wives. While we would like to believe that all marriages are made in heaven, statistics tell us otherwise. When a married couple enters into a legal business and then experiences a divorce the business is likely to suffer financially. Few couples are able to separate personal and business relationships. A previously drawn contract specifying business relationships and ownership can be a valuable tool. When a married couple constitutes the partnership the actual business may be ran by only one of the two members. Therefore, only one may be a key employee, but both retain all legal rights and debts of the company.
Each partner is fully responsible for the business acts and debts of all other partners. If the business partners are not husband and wife, the divorce of one partner can affect the assets of the company adversely since they may be drawn into the divorce.
If one partner withdraws from the firm, the partnership is terminated. It must then be either liquidated or reorganized, with the withdrawing partner receiving compensation in some way. If the partners disability causes the withdrawal the firms resources will be severely strained. This might especially be true if the partner was a key employee. Although financial resources are strained, the partners may want to continue the disabled partners income at the same level. If a partner is permanently disabled, the firm may find it advantageous to buy that partners interest so that he or she can be replaced. The partnership is not legally compelled to liquidate or reorganize. This will be a choice of the remaining partners.
Of course, a partnership may be terminated due to death. In that event, the law requires that the partnership be either terminated or reorganized. The issues involved between liquidation and reorganization are similar regardless of whether the choice comes from disability or death of one of the partners. If liquidation is chosen the assets of the business may be sold and the net proceeds divided proportionally among the surviving partners and the heirs of the deceased partner. Seldom is liquidation a satisfactory solution. Liquidation nearly always results in loss. Additionally, the surviving partners are out of a job. Selling the business rather than liquidating it may keep the company intact, but it will not necessarily add income to the surviving partners or the deceaseds partners family. Each company has a specified worth, usually based on assets. However, it may provide continuing jobs for the surviving partners, which may prove to be an advantage for them. Additionally, a company sold as a continuing business is not likely to result in a loss since all debts will be sold with the company.
When a company is sold rather than liquidated, four options are usually available to the remaining partners and the heirs:
1. The heirs of the deceaseds interest may become partners in the new partnership.
2. The heirs may sell the deceased partners interest to an outside party.
3. The heirs may buy the surviving partners interests.
4. The surviving partners may buy the deceased partners interest from his or her heirs.
If the heirs want to become partners in the new partnership or if the heirs decide to sell the deceased partners interest to an outside party then the law typically requires the consent of the surviving partners. In most cases, it is felt that the most satisfactory solution is for the remaining partners to buy out the interest of the deceased or disabled partner. This prevents either liquidation or sale of the company, allows for the remaining partners continued employment, and the business can continue to prosper under continued management. If no insurance is in place for this specific purpose, two problems may prevent purchasing the deceased or disabled partners share:
Price agreement, and
Financing the purchase.
Heirs may not have a realistic picture of the worth of their inherited interest. When two or more partners exist without having specified a mutually binding buy-and-sell agreement, disagreement on the value of the partnership can continue for years. Eventually such disagreements can cause the business to fail. When buy-and-sell agreements are reached while all partners are healthy and in equal bargaining positions, such time-consuming squabbles can be eliminated. Even if the heirs feel the agreement does not provide them with as much money as they feel to be fair, the agreement is legally binding. It allows the surviving partners to organize a new partnership and continue the business.
In closely held corporations, sometimes referred to as a close corporation, all the stock is held by a few individuals and not offered for public sale. Typically the stockholders have common ground, such as blood relationships or bonds similar to partnerships. In fact, a closely held corporation is often called an incorporated partnership.
It is important to remember how a corporation functions: usually each stock represents one vote. Therefore, a person holding 50 percent of the stock also holds 50 percent of the votes on any issue brought forth. A minority owner, usually an employee, will have little power unless his or her combined stock ownership equals at least 51 percent of the total stock issued. Where multiple employees own stock, they may be able to combine forces to exercise control, assuming all the employees can organize well enough (and agree on primary issues) to take control. Again, their combined strength would have to equal at least 51 percent of the voting stock or equal more votes than the largest shareholder. Not all stock may have voting rights. Some companies issue stock without voting rights, but normally each stock is accompanied by the right to vote.
Being incorporated does not eliminate all the problems of a disabled or deceased stockholder. It will still be necessary to determine the best course of action. If the disability is permanent, either the other stockholders or the corporation itself, if legally permitted, will have to buy out the disabled member. If there are funds available for this purpose, it should be a smooth transition. A corporation that has a risk manager is likely to have an insurance policy in place for such a situation. Unfortunately, many small corporations do not assign anyone to act as risk manager. If no agent has suggested that such a policy be purchased, there may not be one in place.
When a shareholder dies, the corporations existence is not affected. Where the law protects partnerships from unwanted partners, the corporation does not have the same legal protection. The heirs of the stock can sell them to anyone they choose or they can exercise their rights of stock ownership at meetings. When just two people own all stock equally, the company can experience severe problems as each stockholder (each having 50 percent voting rights) stall all decisions affecting the business. There have been cases where the divorce of two equal owners causes the company to fail because each party confuses their divorce with the operations of a successful business.
When the originator and employees own a stock company, the death of the originator can lead to problems if the heirs do not have the same business sense as their deceased family member. We have seen many failed businesses after the creator of the company died leaving it in the hands of an unqualified person. If the remaining stockholders, often employees, do not have the capital to buy them out or do not have a buy-and-sell agreement setting a fair price, they may find their company slowly dying as inexperienced heirs try to run the company their way. Employees realize that the corporation profits are primarily the result of their efforts. When the heirs come forth to claim salaries that have not been earned or attempt to expand in ways that adversely affect the bottom line, the remaining stockholders (employees) will resent those with the majority of the stock (thus voting rights). Obviously, an investment that leads to fighting among stockholders, personal recriminations, and perhaps even legal action is not conducive to a profitable business.
Planning Ahead for Death or Disability
While we all realize we will die at some point, few of us expect to die during our working years. Most people now purchase life insurance to protect their families but many do not purchase life insurance to protect their business organizations, whether that happens to be a partnership or a corporation or a sole proprietorship. If no risk manager has been assigned or if the owner of the company is not aware of the risks involved with his or her death or disability, this aspect of a company may go unprotected. Agents can play a vital role by pointing out the need to protect business rights and business income.
The most overlooked risk is disability of a key employee or disability of the business owner or stockholder. As we have state, disability is far more likely statistically than death, yet disability remains the most unprotected risk in our lives. Probably few insurance agents have protected their family by insuring their ability to work. If they do not even protect themselves and their families, it is unlikely that they are offering this risk protection to their clients. It remains one of the great untapped markets.
Thank you,
United Insurance Educators, Inc.
End of Chapter Nine