If you're a business owner, you may have wondered whether your company needs to provide life insurance to cover the loss of a key person should he or she die unexpectedly.
Consider the example of a 15-employee equipment-parts distribution business. Of six regional salespeople, one – Jack – was responsible for 40 percent of new business each year.
When Jack unexpectedly died, the company's revenues dropped by 25 percent the following year.
Jack was clearly a key person for the business, one whose loss had a severe negative financial impact on the company. Many businesses rely on people like Jack, employees whose value to the company would be difficult or expensive to replace.
For a restaurant, it may be the chef; for a legal practice, the rainmaker. For almost every small to medium-sized business, the key persons include the owners.
Insuring a key person can spell the difference between the failure and survival of a business.
Take another example: Tom and Art were partners. When Art died, his wife Betsy took over his share of the business.
Because the business did not provide key-person insurance, Tom could not buy out Betsy. Their constant disagreements created an unpleasant working atmosphere and they lost almost half of their employees – and clients.
Eventually, Tom let Betsy buy him out at a far lower value than he would have received at the time of Art's death, had they both been covered.
Key-person life insurance can help a company survive by helping to minimize the organizational loss and fiscal strain that can follow the death of a key employee and by helping to assure that:
Business loans or investments can be repaid. When a key person dies (especially an owner), a lender may have the right to call the loan. Life insurance proceeds can help pay off that loan.
Credit can be maintained. At the death of a key person, lenders may become reluctant to lend new money to the business or refinance outstanding loans.
The life insurance can help the firm maintain its credit rating by allowing it to pay bills in a timely manner in spite of the death. It also may demonstrate to the lender that the firm is well managed.
A replacement can be recruited and trained. Months may pass before a qualified candidate can be found. Then it may take time to train him or her to the point where the replacement is as competent as the predecessor.
There also may be a recruiter's fee to pay. So, life insurance proceeds buy time for the business.
The business can help offset lost sales and profits. Insurance proceeds can help offset the future loss in revenue that probably will occur, at least temporarily, when a key person dies.
The key employee can be repurchased with the insurance proceeds. This can enable a partner to buy out a deceased partner's share.
With key-person life insurance, the business owns the policy, pays the premiums and is the beneficiary. Many businesses buy permanent (cash value) life insurance, although term policies also are used.
As with any insurance, premiums will vary based on the age, physical condition and health history of the insured.
Does your company need key-person insurance?
That depends on your company's structure and business continuation plan, as well as the amount of financial hardship potentially faced without a key person.
Not all businesses need key-person insurance. In large companies, there may be less likelihood that a single individual or small group is indispensable to a company's continued success.
In one-person firms, however, the business almost certainly will not survive without the principal, no matter how much money is available.
Some partnerships, such as a medical practice, most likely will have a greater need for key-person coverage during their early years. As the partners' pensions, profit-sharing and net worth grow, insurance may become less necessary for the practice's survival.
For businesses primarily concerned about outstanding loans, many lenders offer and even require credit insurance. In such cases, key-person insurance might be redundant.
For most small- to medium-sized businesses, however, key-person insurance should be considered.
To determine whether your business needs this coverage, think about what would happen if an owner or key employee were no longer a part of the business.
How much would you lose in revenues, goodwill or expertise? How much would it cost to replace these lost assets?
Buying key-person life insurance may be a relatively small expense – one you hope never to collect. But failure to invest in a key-person policy – and then having a key person die – can mean enormous expense.
Your company can absorb small expenses; big expenses can absorb your company.
Rob McFarland is a partner at Rockland Financial Group (www.rocklandfg.com) in Bethlehem. He has more than 25 years' financial management experience, focusing on helping business owners navigate pension and retirement savings programs, succession planning, key-person insurance, nonqualified deferred compensation plans and personal financial strategies. He can be reached at firstname.lastname@example.org or 610-606-0553.