Managing key person risk

As a business owner, you've purchased insurance and put measures in place to protect your company from almost every risk. Yet have you ever stopped to consider whether your business is prepared for something nobody wants to discuss but could be devastating? How would your company respond to the premature death or disability of a key business associate?

Think about it. When you’re away from the business, you spend a considerable amount of time making sure it’s able to function without you. What if you or someone vital to your operations—like your sales officer or chief product developer—was suddenly gone?

Even if there’s a business associate or family member able to step in and take over, transitions take time—time that costs your company money in lost productivity and revenue. If you’re not there to drive healthy cash flow, your business might not be able to meet its payroll and other payables.

Key person life insurance is designed to compensate for financial losses stemming from the death or extended incapacity of an owner or key person. You can buy an individual policy or a corporate-owned life insurance (COLI) policy that covers multiple individuals.

Primary benefits

With key person life insurance, you can:

• Provide liquidity to give your business time to mitigate any financial or operating challenges associated with the loss of an owner or key player.
• Enable your company to buy out the ownership interest of the deceased as stipulated by prior agreement.
• Retire debt guaranteed by the deceased.

A key person policy can help your company meet other needs as well. A long-term disability rider would provide your business with assets when a key player is incapacitated or recovering from an illness. There are plenty of options to explore.

Group coverage

Need to insure several key players at the same time? The threshold for most guaranteed-issue policies—where no individual is denied coverage due to medical risks—is typically at least 10 people, often more.

Determining whether a guaranteed issue or underwritten policy is a better option for your business depends on the risk profile of each person you want to insure. Guaranteed-issue policies use a basic risk questionnaire—the number of workdays an individual has missed due to serious illness—to determine rates.

If your group is too small for guaranteed issue, some insurance companies offer a middle-ground solution known as a simplified-issue policy. The carrier asks more medical questions but doesn’t require a medical exam.

Term vs. permanent coverage

Before taking out a key person insurance policy, you’ll need to decide whether you want term or permanent coverage. Like personal life insurance, the choice boils down to whether you're seeking a financial risk management solution exclusively or willing to pay more for additional financial benefits on top of insurance protection.

At first glance, term insurance looks more attractive. The premiums tend to be lower since it involves buying pure insurance protection, which is ideal for companies with limited budgets.

Permanent insurance locks down your coverage in perpetuity once the pure insurance component is fully funded, providing a tax efficient way to accumulate assets. You can also borrow against the policy’s cash worth or use it to satisfy performance bonding requirements. Although the cost of premiums isn’t tax-deductible, there are no taxes to pay on the insurance benefit in the event of a key person’s death.

One type of permanent key person life insurance is a variable policy where the cash value can be invested in stocks or bonds, and policy owners receive the benefit of professional asset management services.

Another type, known as a split-dollar plan, enables insured individuals to pay for some of the coverage and retain the right to direct a portion of the policy’s death benefit to designated beneficiaries other than the corporation.

IRS requirements

The basic requirement for key person life insurance is that your company would sustain economic loss if the insured person were to die or be incapacitated.

In addition to meeting IRS requirements, the corporate owner of a policy must:

• Provide written notification of the planned insurance to covered employees.
• Inform covered employees that the company is the policy’s beneficiary.
• Receive written consent for the coverage from employees being insured.
• File an annual form (8925) with the IRS.

However, these requirements don’t apply if the insured individuals are company directors, owners of at least 5% of the company during the preceding year, among the five highest paid officers, or among the top 35% of highest paid employees.

Assess your coverage needs.

To determine what type of key person coverage is right for your business and how much you’ll need, answer these questions:

• Who are the key people in your company and how would their sudden death effect your operations?
• If your company has to buy out shareholders upon their death, how large might that obligation be?
• Should the company continue to insure key personnel after they retire to eventually recoup your cumulative investment?
• How attractive would a split-dollar plan be as a form of compensation for key employees?
• Does the policy’s coverage justify its cost?

Once you implement key person life insurance, reassess your needs before annual renewal and ensure you have adequate coverage by answering these questions:

• Have any key personnel recently been hired or promoted?
• Has the company’s value—and its stock—risen to a level where the death benefit for covered shareholders would no longer be sufficient to honor your stock repurchase obligations to the heirs of the deceased?
• Has the health status of any key covered individuals changed enough to alter your original risk calculation for the amount of coverage to purchase?
• Has the market for key person life insurance products changed, providing access to less expensive coverage or insurance contracts with attractive new features?

Although you may not want to consider the possibility of your company losing key personnel, your business will need a financial safety net to make it through just such a transition period.